Accounting
ALL-IN-ONE
Accounting
ALL-IN-ONE
by Ken Boyd, Lita Epstein, Mark P. Holtzman,
Frimette Kass-Shraibman,
Maire Loughran, Vijay S. Sampath, John A. Tracy,
Tage C. Tracy, and Jill Gilbert Welytok
Accounting All-In-One For Dummies®
Published by:
John Wiley & Sons, Inc.,
111 River Street,
Hoboken, NJ 07030-5774,
www.wiley.com
Copyright © 2014 by John Wiley & Sons, Inc., Hoboken, New Jersey
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Library of Congress Control Number: 2013954224
ISBN 978-1-118-75800-7 (pbk); ISBN 978-1-118-81365-2 (ebk); ISBN 978-1-118-81374-4 (ebk)
Manufactured in the United States of America
10 9 8 7 6 5 4 3 2 1
Contents at a Glance
Introduction................................................................. 1
Book I: Setting Up Your Accounting System.................... 5
Chapter 1: Grasping Bookkeeping and Accounting Basics............................................ 7
Chapter 2: Outlining Your Financial Road Map with a Chart of Accounts................ 17
Chapter 3: Using Journal Entries and Ledgers.............................................................. 27
Chapter 4: Choosing an Accounting Method................................................................ 43
Book II: Recording Accounting Transactions................. 53
Chapter 1: Keeping the Books......................................................................................... 55
Chapter 2: Tracking Purchases....................................................................................... 67
Chapter 3: Counting Your Sales...................................................................................... 79
Chapter 4: Processing Employee Payroll and Benefits................................................ 91
Chapter 5: Computing and Reporting Payroll Taxes.................................................. 111
Book III: Adjusting and Closing Entries...................... 123
Chapter 1: Depreciating Your Assets........................................................................... 125
Chapter 2: Paying and Collecting Interest................................................................... 137
Chapter 3: Proving Out the Cash.................................................................................. 147
Chapter 4: Reconciling Accounts and Closing Journal Entries................................. 157
Chapter 5: Checking Your Accuracy............................................................................ 175
Chapter 6: Adjusting the Books.................................................................................... 185
Book IV: Preparing Income Statements and
Balance Sheets......................................................... 195
Chapter 1: Brushing Up on Accounting Standards..................................................... 197
Chapter 2: Preparing an Income Statement and Considering Profit........................ 207
Chapter 3: Assessing the Balance Sheet's Asset Section........................................... 223
Chapter 4: Digging for Debt in the Balance Sheet’s Liabilities Section.................... 239
Chapter 5: Explaining Ownership in the Equit y Section of the Balance Sheet........... 253
Chapter 6: Coupling the Income Statement and Balance Sheet................................ 265
Book V: Reporting on Your Financial Statements......... 279
Chapter 1: Presenting Financial Condition and Business Valuation........................ 281
Chapter 2: Laying Out Cash Flows and Changes in Equity........................................ 291
Chapter 3: Analyzing Financial Statements................................................................. 305
Chapter 4: Reading Explanatory Notes and Disclosures........................................... 321
Chapter 5: Studying the Repor t to the Shareholders................................................. 335
Book VI: Planning and Budgeting for Your Business.... 347
Chapter 1: Incorporating Your Business..................................................................... 349
Chapter 2: Choosing a Legal Structure for a Business............................................... 361
Chapter 3: Drawing Up a Business Plan to Secure Cash............................................ 371
Chapter 4: Budgeting for a Better Bottom Line.......................................................... 383
Chapter 5: Mastering and Flexing Your Budgeting..................................................... 395
Chapter 6: Planning for Long-Term Obligations......................................................... 407
Book VII: Making Savvy Business Decisions................ 419
Chapter 1: Estimating Costs with Job Costing............................................................ 421
Chapter 2: Performing Activity-Based Costing........................................................... 437
Chapter 3: Examining Contribution Margin................................................................. 453
Chapter 4: Accounting for Change with Variance Analysis....................................... 469
Chapter 5: Making Smart Pricing Decisions................................................................ 487
Book VIII: Handling Cash and Making
Purchase Decisions................................................... 497
Chapter 1: Identifying Costs and Matching Costs with Revenue.............................. 499
Chapter 2: Exploring Inventory Cost Flow Assumptions........................................... 507
Chapter 3: Answering the Question: Should I Buy That?........................................... 519
Chapter 4: Knowing When to Use Debt to Finance Your Business.......................... 533
Chapter 5: Interpreting Your Financial Results as a Manager.................................. 547
Book IX: Auditing and Detecting Financial Fraud........ 555
Chapter 1: Mulling Over Sarbanes-Oxley Regulation................................................. 557
Chapter 2: Preventing Cash Losses from Embezzlement and Fraud....................... 571
Chapter 3: Assessing Audit Risk................................................................................... 585
Chapter 4: Collecting and Documenting Audit Evidence........................................... 607
Chapter 5: Auditing a Client’s Internal Controls......................................................... 625
Chapter 6: Getting to Know the Most Common Fraud Schemes.............................. 647
Chapter 7: Cooked Books: Finding Financial Statement Fraud................................. 663
Index....................................................................... 673
Table of Contents
Introduction.................................................................. 1
About This Book............................................................................................... 1
Foolish Assumptions........................................................................................ 2
Icons Used in This Book.................................................................................. 2
Beyond the Book.............................................................................................. 3
Where to Go from Here.................................................................................... 3
Book I: Setting Up Your Accounting System.................... 5
Chapter 1: Grasping Bookkeeping and Accounting Basics . . . . . . . . . 7
Knowing What Bookkeeping and Accounting Are All About...................... 8
Distinguishing between bookkeeping and accounting...................... 8
Taking a panoramic view of bookkeeping and accounting............... 9
Wrapping Your Brain around the Accounting Cycle................................. 10
Working the Fundamental Accounting Equation........................................ 14
Chapter 2: Outlining Your Financial Road Map with a
Chart of Accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Getting to Know the Chart of Accounts....................................................... 17
Connecting the chart of accounts to financial statements.............. 18
Organizing the accounts...................................................................... 18
Balancing transactions......................................................................... 19
Setting Up Your Chart of Accounts.............................................................. 20
Mulling Over Debits versus Credits............................................................. 21
Understanding Double-Entry Accounting.................................................... 22
Revisiting the balance sheet equation............................................... 22
Recording journal entries.................................................................... 22
Figuring out a complex journal entry................................................. 24
Chapter 3: Using Journal Entries and Ledgers . . . . . . . . . . . . . . . . . . . . 27
Keeping a Journal........................................................................................... 27
Using journals to record cash transactions...................................... 28
Recording accrual transactions.......................................................... 31
Exploring other journals...................................................................... 33
Checking out examples of common journal entries......................... 35
Bringing It All Together in the Ledger......................................................... 37
Realizing what a ledger is.................................................................... 37
Posting to the ledgers.......................................................................... 38
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Viewing an example of a general ledger............................................. 38
Recognizing the purpose of the trial balance................................... 39
Putting Accounting Software to Work for You............................................ 40
Chapter 4: Choosing an Accounting Method . . . . . . . . . . . . . . . . . . . . . 43
Distinguishing between Cash and Accrual Basis........................................ 43
The cash basis....................................................................................... 44
The accrual basis.................................................................................. 45
Sorting through Standards for Other Types of Accounting...................... 46
Managerial accounting......................................................................... 47
Not-for-profit accounting..................................................................... 47
Governmental accounting................................................................... 48
International accounting...................................................................... 49
Considering the Conceptual Framework of Financial Accounting........... 49
The objective of financial reporting................................................... 50
Characteristics of accounting information........................................ 50
Elements of the financial statements................................................. 51
Financial statement measurements.................................................... 52
Book II: Recording Accounting Transactions.................. 53
Chapter 1: Keeping the Books . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Analyzing the Effect of Business Transactions........................................... 55
Revisiting the fundamental accounting equation............................. 56
Getting familiar with accounts............................................................ 56
Defining debits and credits.................................................................. 57
Knowing more about the transaction methodology........................ 57
Managing Your Bookkeeping and Accounting System.............................. 58
Categorizing your financial information: The chart
of accounts......................................................................................... 58
Standardizing source document forms
and processing procedures............................................................. 59
Hiring competent personnel................................................................ 60
Enforcing strong internal controls..................................................... 62
Wrapping Up with End-of-Period Procedures............................................. 63
Tidying up the books............................................................................ 63
Leaving good audit trails..................................................................... 64
Staying alert for unusual events and developments........................ 64
Designing truly useful reports for managers..................................... 65
Chapter 2: Tracking Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Keeping Track of Inventory........................................................................... 68
Entering initial cost.............................................................................. 69
Managing inventory and its value....................................................... 71
Table of Contents
Buying and Monitoring Supplies................................................................... 75
Staying on Top of Your Bills.......................................................................... 76
Segregating duties to prevent theft.................................................... 76
Taking advantage of discounts........................................................... 77
Chapter 3: Counting Your Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
Collecting on Cash Sales................................................................................ 79
Discovering the value of sales receipts............................................. 80
Recording cash transactions in the books........................................ 81
Selling on Credit.............................................................................................. 82
Deciding whether to offer store credit............................................... 82
Recording store credit transactions in the books............................ 83
Proving Out the Cash Register...................................................................... 85
Tracking Sales Discounts............................................................................... 86
Recording Sales Returns and Allowances................................................... 87
Monitoring Accounts Receivable.................................................................. 89
Accepting Your Losses.................................................................................. 89
Chapter 4: Processing Employee Payroll and Benefits . . . . . . . . . . . . 91
Staffing Your Business................................................................................... 91
Completing government forms........................................................... 92
Picking pay periods.............................................................................. 96
Determining wage and salary types................................................... 97
Collecting Employee Taxes........................................................................... 98
Sorting out Social Security tax............................................................ 98
Making sense of Medicare tax............................................................. 98
Figuring out federal withholding tax.................................................. 99
Settling up state and local w­ithholding taxes................................. 100
Determining Net Pay.................................................................................... 100
Surveying Your Benefits Options............................................................... 101
Tax-exempt benefits........................................................................... 101
Taxable benefits.................................................................................. 102
Dealing with cafeteria plans.............................................................. 102
Preparing Payroll and Posting It in the Books.......................................... 103
Calculating payroll for hourly employees....................................... 103
Doling out funds to salaried employees.......................................... 104
Totaling up for commission checks................................................. 104
Putting it together to prepare payroll.............................................. 106
Depositing Employee Taxes........................................................................ 107
Chapter 5: Computing and Reporting Payroll Taxes . . . . . . . . . . . . . . 111
Paying Employer Taxes on Social Security and Medicare...................... 111
Filing Form 941.................................................................................... 112
Knowing how often to file.................................................................. 113
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Completing Unemployment Reports and Paying
Unemployment Taxes............................................................................... 113
How states calculate the FUTA tax rate........................................... 114
Calculating FUTA tax.......................................................................... 114
Filing and paying unemployment taxes to state governments..... 118
Carrying Workers’ Compensation Insurance............................................ 118
Maintaining Employee Records.................................................................. 120
Book III: Adjusting and Closing Entries....................... 123
Chapter 1: Depreciating Your Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
Defining Depreciation................................................................................... 125
Knowing what you can and can’t depreciate.................................. 126
Figuring out the useful life of a fixed asset...................................... 127
Delving into cost basis....................................................................... 128
Evaluating Your Depreciation Options...................................................... 128
Walking through the straight-line method...................................... 130
Accelerating by using declining balance......................................... 130
Calculating sum-of-the-years’-digits................................................. 132
Using the units-of-production method............................................. 133
Seeing how the methods compare................................................... 133
Figuring partial year depreciation.................................................... 135
Tackling Taxes and Depreciation............................................................... 135
Section 179........................................................................................... 136
MACRS.................................................................................................. 136
Chapter 2: Paying and Collecting Interest . . . . . . . . . . . . . . . . . . . . . . 137
Deciphering Types of Interest..................................................................... 137
Simple interest.................................................................................... 138
Compound interest............................................................................. 138
Handling Interest Income............................................................................ 139
Delving into Loans and Interest Expenses................................................ 140
Short-term debt................................................................................... 140
Long-term debt.................................................................................... 143
Chapter 3: Proving Out the Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
Why Prove Out the Cash?............................................................................ 147
Making Sure Ending Cash Is Right.............................................................. 148
Closing the Cash Journals........................................................................... 150
Finalizing cash receipts...................................................................... 150
Finalizing cash outlays....................................................................... 154
Using a Temporary Posting Journal........................................................... 155
Chapter 4: Reconciling Accounts and Closing Journal Entries . . . . 157
Reconciling Bank Accounts......................................................................... 157
Tracking down reconciling items..................................................... 159
Using a computerized system........................................................... 160
Table of Contents
Posting Adjustments and Corrections....................................................... 161
Prepping to Close: Checking for Accuracy and Tallying
Things Up................................................................................................... 162
Paying attention to initial transaction details................................. 162
Summarizing journal entries............................................................. 163
Analyzing summary results............................................................... 167
Planning for cash flow........................................................................ 168
Posting to the General Ledger.................................................................... 168
Checking Out Computerized Journal Records.......................................... 169
Chapter 5: Checking Your Accuracy . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
Working with a Trial Balance...................................................................... 175
Conducting your trial balance........................................................... 176
Dealing with trial balance errors...................................................... 178
Testing Your Balance by Using Computerized Accounting Systems..... 179
Developing a Financial Statement Worksheet.......................................... 181
Replacing Worksheets with Computerized Reports................................ 183
Chapter 6: Adjusting the Books . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
Adjusting All the Right Areas...................................................................... 185
Depreciating assets............................................................................ 187
Allocating prepaid expenses............................................................. 188
Counting inventory............................................................................. 189
Allowing for bad debts....................................................................... 190
Recognizing unpaid salaries and wages........................................... 193
Testing an Adjusted Trial Balance............................................................. 194
Book IV: Preparing Income Statements
and Balance Sheets................................................... 195
Chapter 1: Brushing Up on Accounting Standards . . . . . . . . . . . . . . . 197
Exploring the Origins of Accounting Standards....................................... 198
Recognizing the Role of the American Institute of Certified Public
Accountants (AICPA)................................................................................ 199
Tying together regulators for audits of publicly
traded companies........................................................................... 199
ASB audit and attestation standards................................................ 200
AICPA Code of Professional Conduct............................................... 201
Checking Out the U.S. Securities and Exchange Commission (SEC)...... 202
Getting to Know the Financial Accounting Standards Board (FASB)........ 203
Understanding generally accepted accounting
principles (GAAP)........................................................................... 204
Looking online for FASB standards.................................................. 205
Pick a standard: Domestic or international..................................... 205
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Chapter 2: Preparing an Income Statement
and Considering Profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207
Understanding the Nature of Profit............................................................ 207
Choosing the Income Statement Format................................................... 208
Deciding What to Disclose in the Income Statement............................... 210
Considering expense disclosure....................................................... 210
Presenting the right amount of expense information.................... 210
Examining How Sales and Expenses Change Assets
and Liabilities............................................................................................ 211
Sizing up a business’s financial condition....................................... 211
Noting how accounting transactions affect the income
statement and balance sheet......................................................... 212
Considering the Diverse Financial Effects of Making a Profit................. 214
Introducing T-accounts...................................................................... 214
Combining activity into one journal entry...................................... 215
Explaining additional transactions related to profit...................... 216
Reporting Extraordinary Gains and Losses.............................................. 217
Segregating the income statement................................................... 217
Considering business disruptions.................................................... 217
Questioning whether activity is truly unusual................................ 219
Correcting Common Misconceptions about Profit.................................. 220
Clearing up profit misconceptions................................................... 220
Comparing to industry standards.................................................... 221
Waving the red flag when you see revenue and credit
sales increase.................................................................................. 221
Chapter 3: Assessing the Balance Sheet’s Asset Section . . . . . . . . . 223
Homing in on Historic Cost......................................................................... 224
Discovering What Makes an Asset Current............................................... 224
Cash...................................................................................................... 224
Short-term investments..................................................................... 226
Accounts receivable........................................................................... 227
Notes receivable................................................................................. 230
Inventory.............................................................................................. 230
Prepaid expenses................................................................................ 232
Keeping Track of Noncurrent (Long-Term) Assets.................................. 232
Meeting the tangibles: Property, plant,
and equipment (PP&E)................................................................... 233
Investigating intangible assets.......................................................... 235
Exploring the Asset Section of the Balance Sheet.................................... 237
Chapter 4: Digging for Debt in the Balance Sheet’s
Liabilities Section . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
Seeing How Businesses Account for Liabilities........................................ 239
Keeping Current Liabilities under Control................................................ 241
Accounts payable............................................................................... 242
Payroll and taxes................................................................................ 243
Table of Contents
Unearned revenue.............................................................................. 244
Other short-term liabilities................................................................ 244
Planning for Long-Term Obligations.......................................................... 246
Financing asset purchases with debt versus equity...................... 247
Managing long-term debt................................................................... 247
Anticipating contingent liabilities..................................................... 248
Accounting for Bond Issuances.................................................................. 249
Mulling over bond basics................................................................... 249
Examining sample bond transactions.............................................. 250
Journaling bond transactions........................................................... 251
Chapter 5: Explaining Ownership in the Equit y
Section of the Balance Sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
Understanding How Owner Equity Varies among
Business Entities....................................................................................... 253
Sole proprietorship............................................................................ 253
Partnership.......................................................................................... 254
Corporation......................................................................................... 255
Distinguishing between Two Types of Capital Stock............................... 255
Preferred stock.................................................................................... 255
Common stock.................................................................................... 256
Recording stock transactions on the balance sheet...................... 256
Defining Paid-In Capital................................................................................ 257
Recording Retained Earnings...................................................................... 258
Spotting Reductions to Stockholders’ Equity........................................... 258
Paying dividends................................................................................. 259
Buying back shares: Treasury stock................................................ 261
Exploring Stock Splits.................................................................................. 261
Computing Earnings per Share................................................................... 262
Simple capital structure..................................................................... 262
Complex capital structure................................................................. 263
Chapter 6: Coupling the Income Statement and Balance Sheet . . . . 265
Rejoining the Income Statement and Balance Sheet................................ 266
Seeing connections between accounts............................................ 266
Using transactions to explain the connections............................... 267
Introducing Operating Ratios...................................................................... 269
Comparing expected with actual operating ratios......................... 269
Generating balance sheet amounts by using ratios....................... 270
Adding Fixed Assets, Depreciation, and Owners’ Equity........................ 273
Dealing with fixed assets and depreciation..................................... 273
Tacking on owners’ equity................................................................ 275
Completing the Balance Sheet with Debt.................................................. 276
Going over the debt section of the balance sheet.......................... 276
Tying in the new equity section........................................................ 277
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Book V: Reporting on Your Financial Statements.......... 279
Chapter 1: Presenting Financial Condition
and Business Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
Clarifying the Values of Assets in Balance Sheets.................................... 281
Considering options for balance sheet ­valuation........................... 282
Comparing two balance sheet valuations........................................ 283
Introducing Business Valuation.................................................................. 285
Grasping the practical applications of business valuations......... 285
Considering a CVA designation......................................................... 286
Comparing Business Valuation Methods.................................................. 287
Replacing assets: Replacement value.............................................. 287
Using future earnings and cash flow................................................ 288
Chapter 2: Laying Out Cash Flows and Changes in Equity . . . . . . . . . 291
Understanding the Difference between Cash and Profit......................... 291
Seeing how noncash transactions affect profit............................... 292
Distinguishing costs from expenses................................................. 292
Realizing the Purpose of the Statement of Cash Flows............................ 293
Walking through the Cash Flow Sections.................................................. 294
Figuring cash operating results........................................................ 295
Showing cash investing transactions............................................... 297
Accounting for financing activities................................................... 298
Recognizing Methods for Preparing the Statement of Cash Flows........ 299
Using the direct method.................................................................... 301
Starting indirectly with net income.................................................. 302
Interpreting the Statement of Cash Flows................................................. 303
Looking Quickly at the Statement of Changes
in Stockholders Equity............................................................................. 304
Chapter 3: Analyzing Financial Statements . . . . . . . . . . . . . . . . . . . . . 305
Judging Solvency and Liquidity.................................................................. 305
Understanding the risks of late payments....................................... 306
Recognizing current assets and liabilities....................................... 306
Brushing up on current and quick ratios........................................ 308
Understanding That Transactions Drive the Balance Sheet................... 310
Analyzing three types of balance sheet transactions.................... 310
Reviewing changes in balance sheet accounts............................... 311
Measuring Profitability................................................................................ 312
Understanding trend analysis........................................................... 313
Focusing on return on investment................................................... 314
Homing in on return on equity.......................................................... 315
Exploring Activity Measures....................................................................... 315
Accounts receivable turnover........................................................... 316
Inventory turnover............................................................................. 317
Table of Contents
Comparing Horizontal and Vertical Analysis............................................ 317
Using horizontal analysis................................................................... 318
Implementing vertical analysis......................................................... 319
Using Common Size Financial Statements................................................. 320
Chapter 4: Reading Explanatory Notes and Disclosures . . . . . . . . . . 321
Realizing How Corporations Should Govern Themselves....................... 321
Identifying Corporate Characteristics....................................................... 322
Reviewing Common Explanatory Notes.................................................... 324
Leveling the playing field among financial statements.................. 324
Explaining significant accounting policies...................................... 325
Looking for important event disclosures........................................ 328
Putting the Onus on the Preparer.............................................................. 332
Chapter 5: Studying the Repor t to the Shareholders . . . . . . . . . . . . . 335
Why Private and Public Companies Treat Annual Reports
Differently.................................................................................................. 336
Fulfilling Three Purposes............................................................................. 337
Serving a marketing and PR function............................................... 337
Stating financial performance and goals.......................................... 337
Meeting regulatory requirements..................................................... 338
Reading the Annual Report to Shareholders............................................ 338
Meeting the chair of the board of directors.................................... 339
Highlighting key financial data.......................................................... 339
Touting company achievements....................................................... 341
Looking into the future...................................................................... 341
Getting to know key management and board members................ 342
Walking through Form 10-K......................................................................... 342
Facing page: Identifying the affected company............................... 343
Part I: Finding out more about the registrant................................. 343
Part II: Revealing the company’s financial performance............... 343
Part III: Identifying management and corporate governance........ 345
Part IV: Exhibits, financial statement schedules, and
signature........................................................................................... 346
Book VI: Planning and Budgeting for Your Business..... 347
Chapter 1: Incorporating Your Business . . . . . . . . . . . . . . . . . . . . . . . . 349
Securing Capital: Starting with Owners..................................................... 349
Contrasting two sources of equity................................................... 350
Leveraging equity capital with debt................................................. 352
Recognizing the Legal Roots of Business Entities.................................... 353
Incorporating a Business............................................................................. 354
Issuing stock shares........................................................................... 355
Offering different classes of stock shares........................................ 355
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Determining market value of stock shares...................................... 357
Keeping alert for dilution of share value......................................... 358
Recognizing conflicts between stockholders and managers........ 360
Chapter 2: Choosing a Legal Structure for a Business . . . . . . . . . . . . 361
Differentiating between Partnerships and Limited
Liability Companies.................................................................................. 361
Partnerships........................................................................................ 362
Limited liability company (LLC)....................................................... 363
Limiting liability: Professional corporations and LLPs.................. 363
Understanding how partnerships and LLCs distribute profits..... 364
Going It Alone: Sole Proprietorships.......................................................... 365
Describing a sole proprietorship...................................................... 365
Understanding liability and financial reporting.............................. 365
Choosing the Right Legal Structure for Income Tax................................ 366
C corporations.................................................................................... 366
S corporations..................................................................................... 368
Partnerships and LLCs....................................................................... 369
Summing up the legal structure issue.............................................. 370
Chapter 3: Drawing Up a Business Plan to Secure Cash . . . . . . . . . . 371
Outlining the Basic Business Plan.............................................................. 371
The executive summary..................................................................... 372
The market assessment..................................................................... 373
The operational overview.................................................................. 374
The financial summary: Performance and required capital.......... 374
Developing a Business Plan......................................................................... 375
Recognizing the evolution of business plans: BOTE, WAG,
and SWAG......................................................................................... 375
Getting the process going.................................................................. 377
Analyzing and streamlining information with SWOT and KISS..... 378
Incorporating Third-Party Information into Your Plan............................ 380
Gathering the info............................................................................... 381
Riding the CART concept: Complete, ­accurate,
reliable, and timely......................................................................... 381
Chapter 4: Budgeting for a Better Bottom Line . . . . . . . . . . . . . . . . . . 383
Brushing Up on Budgeting Basics.............................................................. 383
Meeting the master budget................................................................ 384
Understanding key budgeting concepts.......................................... 384
Planning strategically......................................................................... 385
Recognizing Factors That Impact Your Budgeting Process.................... 385
Experience counts.............................................................................. 386
Timing is everything........................................................................... 386
People get you headed in the right ­direction.................................. 387
Sales projections pay off.................................................................... 387
The Nuts and Bolts of Budgeting................................................................ 388
Understanding the budgeting financials.......................................... 389
Reviewing revenue and production ­budgets.................................. 392
Table of Contents
Chapter 5: Mastering and Flexing Your Budgeting . . . . . . . . . . . . . . . 395
Budgeting with Cash or Accrual Accounting............................................ 395
Cash basis accounting: Using your checkbook to budget............. 396
I accrue, you accrue, we all accrue with accrual accounting....... 398
Budgeting to Produce the Income Statement and Balance Sheet.......... 398
The well-balanced balance sheet...................................................... 399
The incredible income statement..................................................... 399
Flexing Your Budget: When Plans Change................................................ 400
Controlling your business................................................................. 400
Dealing with budget variances.......................................................... 401
Implementing a flexible budget......................................................... 402
Chapter 6: Planning for Long-Term Obligations . . . . . . . . . . . . . . . . . 407
Managing Long-Term Debt.......................................................................... 407
The many faces of notes payable..................................................... 408
Treasury bonds defined..................................................................... 413
The dark side of debt-free.................................................................. 414
Accounting for Bonds.................................................................................. 415
Valuing bonds payable....................................................................... 415
Figuring out the present value of a bond......................................... 416
Issuing at face value........................................................................... 417
Book VII: Making Savvy Business Decisions................ 419
Chapter 1: Estimating Costs with Job Costing . . . . . . . . . . . . . . . . . . . 421
Understanding How Job Costing Works.................................................... 421
Cost objects: The sponges that absorb money.............................. 422
Charging customers for direct and indirect costs.......................... 423
Implementing job costing in manufacturing: An example................. 425
Taking a Closer Look at Indirect Costs by Using Normal Costing.......... 428
Budgeting for indirect costs.............................................................. 429
Following a normal job costing system........................................... 430
Following the Flow of Costs through a Manufacturing System.............. 432
Control starts with control accounts............................................... 432
Walking through a manufacturing cost example............................ 433
Applying the methodology to other control accounts.................. 435
Chapter 2: Performing Activity-Based Costing . . . . . . . . . . . . . . . . . . 437
Avoiding the Slippery Slope of Peanut Butter Costing............................ 437
Recognizing a single indirect cost allocation.................................. 438
A fly in the peanut butter: Dealing with different levels
of client activity............................................................................... 439
Undercosting and overcosting.......................................................... 440
Designing an Activity-Based Costing System............................................ 442
Refining your approach...................................................................... 442
Grouping costs by using a cost hierarchy....................................... 443
Testing your ABC design.................................................................... 444
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Using Activity-Based Costing to Compute Total Cost, Profit,
and Sale Price............................................................................................ 448
Allocating indirect costs evenly by product................................... 449
Analyzing and reallocating cost activities....................................... 449
Changing allocations to cost pools.................................................. 450
Changing prices after ABC................................................................. 451
Chapter 3: Examining Contribution Margin . . . . . . . . . . . . . . . . . . . . . 453
Computing Contribution Margin................................................................ 454
Figuring total contribution margin................................................... 454
Calculating contribution margin per unit........................................ 456
Working out contribution margin ratio............................................ 456
Preparing a Cost-Volume-Profit Analysis................................................... 457
Drafting a cost-volume-profit graph................................................. 457
Trying out the total contribution margin formula.......................... 459
Practicing the contribution margin per unit formula..................... 460
Eyeing the contribution margin ratio formula................................ 460
Generating a Break-Even Analysis.............................................................. 461
Plotting the break-even point............................................................ 461
Using the formula approach.............................................................. 462
Shooting for Target Profit............................................................................ 463
Observing Margin of Safety......................................................................... 465
Using a graph to depict margin of safety......................................... 465
Calculating the margin of safety....................................................... 465
Taking Advantage of Operating Leverage................................................. 466
Graphing operating leverage............................................................. 466
Looking at the operating leverage formula..................................... 467
Chapter 4: Accounting for Change with Variance Analysis . . . . . . . 469
Setting Up Standard Costs........................................................................... 469
Establishing direct materials standards.......................................... 470
Determining direct labor standards................................................. 472
Calculating the overhead rate........................................................... 473
Adding up standard cost per unit..................................................... 474
Understanding Variances............................................................................ 474
Computing direct materials variances............................................. 475
Calculating direct labor variances.................................................... 478
Computing overhead variances........................................................ 481
Looking past the favorable/unfavorable label................................ 482
Teasing Out Variances................................................................................. 483
Interpreting variances in action........................................................ 483
Focusing on the big numbers............................................................ 484
Tracing little numbers back to big problems.................................. 485
Chapter 5: Making Smart Pricing Decisions . . . . . . . . . . . . . . . . . . . . 487
Differentiating Products.............................................................................. 487
Taking All Costs into Account with Absorption Costing......................... 488
Table of Contents
Pricing at Cost-Plus...................................................................................... 489
Computing fixed markups.................................................................. 489
Setting a cost-plus percentage.......................................................... 490
Considering problems with cost-plus pricing................................. 490
Extreme Accounting: Trying Variable-Cost Pricing.................................. 491
Working out variable-cost pricing.................................................... 492
Spotting the hazards of variable-cost pricing................................. 493
Bull’s-Eye: Hitting Your Target Cost........................................................... 493
Calculating your target cost.............................................................. 494
Knowing when to use target costing................................................ 495
Book VIII: Handling Cash and Making
Purchase Decisions.................................................... 497
Chapter 1: Identifying Costs and Matching Costs with Revenue . . . 499
Defining Costs and Expenses in the Business World............................... 500
Satisfying the Matching Principle............................................................... 500
Identifying Product and Period Costs........................................................ 501
Discovering Which Costs Are Depreciated............................................... 501
Handling real property depreciation................................................ 502
Allocating costs between land and buildings.................................. 502
Expensing repairs and maintenance................................................ 503
Preparing a Depreciation Schedule............................................................ 503
Deciding When to Recognize Revenue....................................................... 505
Going over the revenue recognition principle................................ 505
Recognizing revenue and cash flow................................................. 506
Chapter 2: Exploring Inventory Cost Flow Assumptions . . . . . . . . . . 507
Discovering How Inventory Valuation Affects
the Financial Statements.......................................................................... 507
Comparing merchandising and manufacturing companies.......... 508
Connecting inventory to revenue..................................................... 508
Logging Inventory for Service Companies................................................. 509
Classifying Inventory Types........................................................................ 509
Accounting for merchandising company inventory....................... 509
Accounting for manufacturing company inventory....................... 512
Getting to Know Inventory Valuation Methods........................................ 513
Understanding guidelines used for all methods............................. 513
Specific identification......................................................................... 514
Weighted average............................................................................... 514
First-in, first-out (FIFO)....................................................................... 515
Last-in, first-out (LIFO)....................................................................... 515
Comparing inventory cost-flow assumptions................................. 515
Preparing an Inventory Worksheet............................................................ 518
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Accounting All-In-One For Dummies
Chapter 3: Answering the Question: Should I Buy That? . . . . . . . . . . 519
Identifying Incremental and Opportunity Costs....................................... 520
Keeping It Simple: The Cash Payback Method......................................... 520
Using the cash payback method with equal annual
net cash flows.................................................................................. 521
Applying the cash payback method when annual net cash
flows change each year.................................................................. 522
It’s All in the Timing: The Net Present Value (NPV) Method.................. 523
Calculating time value of money with one payment
for one year...................................................................................... 524
Finding time value of money with one payment
held for two periods or more........................................................ 525
Calculating NPV with a series of future cash flows........................ 526
Measuring Internal Rate of Return (IRR)................................................... 529
Considering Qualitative Factors................................................................. 530
Chapter 4: Knowing When to Use Debt to Finance Your
Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533
Understanding the Basics of Debt Capital................................................. 534
Debt maturity...................................................................................... 534
Debt security....................................................................................... 535
Other debt attributes......................................................................... 536
Determining When Debt Is Most Appropriate.......................................... 537
When you can offer security or collateral....................................... 537
When business is stable..................................................................... 538
When you have financial strength.................................................... 538
Using Loans, Leases, and Other Sources of Debt..................................... 539
Borrowing from banks........................................................................ 539
Making friends with asset-based lenders........................................ 541
Leasing as a source of capital........................................................... 542
Tapping government programs and the SBA.................................. 543
Using other sources of debt-based capital...................................... 544
Getting Creative with Capital...................................................................... 545
Generating internal cash flow........................................................... 545
Leveraging unsecured creditors....................................................... 545
Going after government aid, gifts, and grants................................. 546
Partnering up....................................................................................... 546
Chapter 5: Interpreting Your Financial Results as a Manager . . . . . 547
Gauging the Relative Importance of Information..................................... 548
Reviewing Profit and Earnings.................................................................... 548
Judging profit performance............................................................... 548
Testing earnings per share (EPS) against change
in bottom line.................................................................................. 549
Judging the Company’s Cash Position....................................................... 551
Tackling Extraordinary Gains and Losses................................................. 552
Recognizing the Risks of Restatement....................................................... 553
Remembering the Limits of Financial Reports.......................................... 554
Table of Contents
Book IX: Auditing and Detecting Financial Fraud........ 555
Chapter 1: Mulling Over Sarbanes-Oxley Regulation . . . . . . . . . . . . 557
Pre-SOX Securities Laws.............................................................................. 558
The Securities Act of 1933: Arming investors
with information.............................................................................. 558
The Securities Exchange Act of 1934: Establishing the SEC.......... 559
Other securities laws.......................................................................... 563
The Scope of SOX: Securities and Issuers................................................. 563
Determining what a security is......................................................... 564
Defining an issuer............................................................................... 565
Figuring out how stock exchanges work......................................... 566
Unveiling the SOX surprise................................................................ 567
The Post-SOX Paper Trail............................................................................ 569
Form 10-K............................................................................................. 569
Form 10-Q............................................................................................. 570
Form 8-K............................................................................................... 570
Chapter 2: Preventing Cash Losses from Embezzlement and
Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 571
Setting the Stage for Protection.................................................................. 571
Preventing loss with internal controls............................................. 572
Recognizing the dual purpose of internal accounting
controls............................................................................................ 573
Struggling with fraud committed by the business.......................... 574
Putting Internal Controls to Work.............................................................. 575
Going down the internal controls checklist.................................... 576
Considering some important details of internal control............... 580
Recognizing Limitations of Internal Controls........................................... 582
Keeping internal controls under control......................................... 583
Finding fraud that slips through the net.......................................... 583
Chapter 3: Assessing Audit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 585
Using the Audit Risk Model......................................................................... 585
Listing the financial statements........................................................ 586
Introducing audit risk......................................................................... 586
Inherent risk: Recognizing the nature of a client’s business......... 587
Control risk: Assessing a client’s ability to detect and
correct problems............................................................................ 589
Detection risk: Figuring out your chances
of overlooking inaccuracies........................................................... 590
Following Risk Assessment Procedures.................................................... 592
Recognizing the nature of the company.......................................... 593
Examining the quality of company management............................ 593
Asking employees for information.................................................... 594
Analyzing processes and paperwork............................................... 595
Observing the client at work............................................................. 596
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Accounting All-In-One For Dummies
Figuring Out What’s Material and What Isn’t............................................ 597
Distinguishing errors from fraud...................................................... 598
Explaining the triangle of fraud......................................................... 600
Evaluating Your Audit Risk Results............................................................ 604
Tailoring the audit to a low-risk situation....................................... 604
Responding to a high-risk assessment............................................. 605
Documenting audit risk results......................................................... 606
Chapter 4: Collecting and Documenting Audit Evidence . . . . . . . . . . 607
Management Assertions: Assessing the Information
a Client Gives You..................................................................................... 608
Defining financial statement presentation and disclosure............ 608
Monitoring classes of transactions.................................................. 609
Analyzing account balances.............................................................. 611
Eyeing the Four Concepts of Audit Evidence............................................ 612
The nature of the audit evidence...................................................... 612
The competence of the audit evidence............................................ 613
The sufficiency of the audit evidence.............................................. 614
The evaluation of the audit evidence............................................... 615
Applying Professional Judgment................................................................ 617
Exercising skepticism......................................................................... 617
Brainstorming with audit team members........................................ 618
Using Your Audit Program to Request the Right Evidence..................... 620
Documenting the Audit Evidence............................................................... 621
Types of documentation.................................................................... 621
Ownership and retention of the audit documentation.................. 624
Chapter 5: Auditing a Client’s Internal Controls . . . . . . . . . . . . . . . . . 625
Defining Internal Controls........................................................................... 626
Identifying the Five Components of Internal Controls............................. 627
Determining When You Need to Audit Internal Controls........................ 629
Defining substantive strategy and control testing strategy.......... 629
Figuring out which strategy is best.................................................. 630
Testing a Client’s Reliability: Assessing Internal
Control Procedures.................................................................................. 631
Considering external factors............................................................. 631
Evaluating how management assesses its controls....................... 632
Using questionnaires to evaluate internal controls....................... 634
Designing your tests of controls....................................................... 635
Using sampling to test internal controls.......................................... 636
Knowing when internal controls are sound or flawed................... 639
Documenting your conclusion.......................................................... 641
Limiting Audit Procedures When Controls Are Strong............................ 641
Tailoring Tests to Internal Control Weaknesses...................................... 642
Timing a Client’s Control Procedures........................................................ 643
Setting a timeline for the client......................................................... 644
Conducting interim versus year-end audits.................................... 644
Table of Contents
Chapter 6: Getting to Know the Most Common Fraud Schemes . . . . 647
Frauds Committed by Businesses.............................................................. 647
Preying on vulnerable populations.................................................. 648
Picking investors’ pockets................................................................. 648
Doing business with bribes............................................................... 649
Laundering money.............................................................................. 649
Perpetrating construction fraud....................................................... 650
Dealing in subprime and predatory lending.................................... 651
Taking advantage of employees........................................................ 651
Frauds Committed against Businesses...................................................... 652
Employee theft.................................................................................... 653
Vendor and customer fraud.............................................................. 653
Insurance fraud................................................................................... 653
Real estate and mortgage fraud........................................................ 654
Bilking the Government............................................................................... 655
Tax fraud.............................................................................................. 655
Contract fraud..................................................................................... 658
Medicare and Medicaid fraud........................................................... 659
Social Security fraud........................................................................... 660
Introducing the Ponzi Scheme.................................................................... 661
Chapter 7: Cooked Books: Finding Financial Statement Fraud . . . . . 663
Exploring the Financial Statement Fraud Triangle................................... 664
Understanding the incentive behind financial
statement fraud............................................................................... 664
Seeing the fraud opportunity............................................................ 665
Coming up with a rationalization for the fraud............................... 665
Spotting the Common Methods of Fraud.................................................. 666
Hidden liabilities................................................................................. 666
Cookie jar reserves............................................................................. 667
Off–balance sheet transactions......................................................... 667
Notes no one can comprehend......................................................... 668
Uncovering Financial Statement Fraud...................................................... 669
Comparative techniques.................................................................... 669
Ratio analysis...................................................................................... 670
Beneish model..................................................................................... 671
Data mining.......................................................................................... 672
Index........................................................................ 673
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Accounting All-In-One For Dummies
Introduction
T
o the general public, accounting means crunching numbers. Accountants
are bean counters, whose job it is to make sure enough money is coming
in to cover all the money going out. Most people also recognize that accountants help individuals and businesses complete their tax returns. Few people
give much thought to the many other facets of accounting.
Accounting is much more than just keeping the books and completing tax
returns. Sure, that is a large part of it, but in the business world, accounting
also includes setting up an accounting system, preparing financial statements
and reports, analyzing financial statements, planning and budgeting for a
business, attracting and managing investment capital, securing loans, analyzing and managing costs, making purchase decisions, and preventing and
detecting fraud.
Although no single book can help you master everything there is to know
about all fields of accounting, this book provides the information you need to
get started in the most common areas.
About This Book
Accounting All-In-One For Dummies expands your understanding of what
accounting is and provides you with the information and guidance to master
the skills you need in various areas of accounting. This book covers everything from setting up an accounting system to preventing and detecting
fraud. This book gives you nine Books in one:
✓ Book I: Setting Up Your Accounting System
✓ Book II: Recording Accounting Transactions
✓ Book III: Adjusting and Closing Entries
✓ Book IV: Preparing Income Statements and Balance Sheets
✓ Book V: Reporting on Your Financial Statements
✓ Book VI: Planning and Budgeting for Your Business
2
Accounting All-In-One For Dummies
✓ Book VII: Making Savvy Business Decisions
✓ Book VIII: Handling Cash and Making Purchase Decisions
✓ Book IX: Auditing and Detecting Financial Fraud
Foolish Assumptions
In order to narrow the scope of this book and present information and guidance that would be most useful to you, the reader, a few foolish assumptions
about who you are had to be made:
✓ You’re an accountant, accountant wannabe, a businessperson who
needs to know about some aspect of business accounting, or an investor who needs to know how to make sense of financial statements.
This book doesn’t cover how to budget for groceries or complete your
1040 tax return. In other words, this book is strictly business. Some
chapters are geared more toward accountants, while others primarily
address business owners and managers.
✓ You’re compelled to or genuinely interested in finding out more about
accounting. If you’re not motivated by a need or desire to acquire the
knowledge and skills required to perform fundamental accounting tasks,
you probably need to hire an accountant instead of becoming one.
✓ You can do the math. You don’t need to know trigonometry or calculus,
but you do need to be able to crunch numbers by using addition,
subtraction, multiplication, and division.
Icons Used in This Book
Throughout this book, icons in the margins cue you in on different types
of information that call out for your attention. Here are the icons you’ll see
and a brief description of each.
It would be nice if you could remember everything you read in this book, but
if you can’t quite do that, then remember the important points flagged with
this icon.
Tips provide insider insight. When you’re looking for a better, faster way to do
something, check out these tips.
Introduction
“Whoa!” This icon appears when you need to be extra vigilant or seek professional
help before moving forward.
Beyond the Book
In addition to the abundance of information and guidance on accounting that’s
provided in this book, you also get access to more help on the web. There’s a
free Cheat Sheet at www.dummies.com/cheatsheet/­accountingaio that
you can check out from any web-enabled device. It features ten key a
­ ccounting
terms, tips for controlling cash, essential formulas for cost accounting, and
definitions of key financial accounting terms. It also explains the relationship
between cash flow and profit.
To dig into some bonus materials, visit www.dummies.com/extras/
accountingaio, where you’ll find articles that explain how to
✓ Choose accounts for a chart of accounts in your industry
✓ Create an audit trail to facilitate the review of your accounting records
✓ Adjust your accounting records with accruals and deferrals
✓ Make your business an attractive borrower
✓ Assess profitability of investments with present value and future value
✓ Manage inventory strategically to improve profit
✓ Eliminate bottlenecks that increase production costs
✓ Evaluate capital spending and opportunity costs
✓ Segregate duties to help prevent fraud
Where to Go from Here
Although you’re certainly welcome to read Accounting All-In-One For Dummies
from start to finish, feel free to skip and dip, focusing on whichever area of
accounting and whichever topic is most relevant to your current needs and
interests. If you’re just getting started, Books I to III may be just what you’re
looking for. If you’re facing the daunting challenge of preparing financial statements for a business, consult Books IV and V. If you own or manage a business, check out Books VI to VIII for information and guidance on managerial
accounting. And if you’re in charge of preventing and detecting incidents of
fraud, check out the chapters in Book IX.
3
4
Accounting All-In-One For Dummies
Book I
Setting Up Your Accounting
System
Visit www.dummies.com for free content that helps you learn more and do more.
In this book…
✓ Wrap your brain around bookkeeping and accounting fundamentals. These basic concepts allow you to correctly post
accounting transactions.
✓ Create a chart of accounts, so you can track debits and credits
by using double-entry accounting. Every type of accounting
transaction uses some combination of accounts.
✓ Maintain financial journals and the general ledger and use
accounting software to simplify these tasks. These tools help
you generate meaningful financial statements.
✓ Distinguish among cash, accrual, and other accounting methods and choose the right method for a business. Most businesses use accrual accounting, which allows the company to
match revenue with the expenses incurred to generate the
revenue.
Chapter 1
Grasping Bookkeeping and
Accounting Basics
In This Chapter
▶ Examining the differences between bookkeeping and accounting
▶ Getting to know the accounting cycle
▶ Maintaining balance with the fundamental accounting equation
M
ost folks aren’t enthusiastic bookkeepers. You probably balance your
checkbook against your bank statement every month and somehow
manage to pull together all the records you need for your annual federal
income tax return. But if you’re like most people, you stuff your bills in a
drawer and just drag them out once a month when you pay them.
Individuals can get along quite well without much bookkeeping — but the
exact opposite is true for a business. A business needs a good bookkeeping
and accounting system to operate day to day. A business needs accurate and
timely data to operate effectively.
In addition to facilitating day-to-day operations, a company’s bookkeeping
and accounting system serves as the source of information for preparing
its periodic financial statements, tax returns, and reports to managers. The
accuracy of these reports is critical to the business’s survival. That’s because
managers use financial reports to make decisions. If the reports aren’t
­accurate, managers can’t make intelligent decisions.
Obviously, then, a business manager must be sure that the company’s
­bookkeeping and accounting system is dependable and up to snuff. This
chapter shows you what bookkeepers and accountants do, so you have a
clear idea of what it takes to ensure that the information coming out of the
accounting system is complete, accurate, and timely.
8
Book I: Setting Up Your Accounting System
Knowing What Bookkeeping and
Accounting Are All About
In a nutshell, accountants “keep the books” of a business (or not-for-profit
or government entity) by following systematic methods to record all the
­financial activities and prepare summaries. This summary information is
used to create financial statements.
Financial statements are sent to stakeholders. Stakeholders are people who
have a stake in the business’s success or failure. Here are some examples of
stakeholders:
✓ Stockholders: If you own stock in General Electric, for example, you
receive regular financial reports. Stockholders are owners of the
­business. They need to know the financial condition of the business
they own.
✓ Creditors: Entities that loan money to your business are creditors. They
need to review financial statements to determine whether your business
still has the ability to repay principal and make interest payments on the
loan.
✓ Regulators: Most businesses have to answer to some type of ­regulator.
If you produce food, you send financial reports to the Food and
Drug Administration (FDA). Reviewing financial statements is one
­­responsibility of a regulator.
The following sections help you embark on your journey to develop a better
understanding of bookkeeping and accounting. Here you discover the
­differences between the two and get a bird’s-eye view of how they interact.
Distinguishing between bookkeeping
and accounting
Distinguishing between bookkeeping and accounting is important, because
they’re not completely interchangeable. Bookkeeping refers mainly to the
recordkeeping aspects of accounting — the process (some would say the
drudgery) of recording all the detailed information regarding the transactions
and other activities of a business (or other organization, venture, or project).
The term accounting is much broader; it enters the realm of designing
the bookkeeping system, establishing controls to make sure the system
is ­working well, and analyzing and verifying the recorded information.
Accountants give orders; bookkeepers follow them.
Chapter 1: Grasping Bookkeeping and Accounting Basics
Bookkeepers spend more time with the recordkeeping process and d
­ ealing
with problems that inevitably arise in recording so much information.
Accountants, on the other hand, have a different focus. You can think of
accounting as what goes on before and after bookkeeping: accountants
design the bookkeeping and accounting system (before) and use the
­information that the bookkeepers enter to create financial statements, tax
returns, and various internal-use reports for managers (after).
Taking a panoramic view of
bookkeeping and accounting
Figure 1-1 presents a panoramic view of bookkeeping and accounting for
businesses and other entities that carry on business activities. This brief
overview can’t do justice to all the details of bookkeeping and accounting,
of course. But it serves to clarify important differences between bookkeeping
and accounting.
Figure 1-1:
Panoramic
view of
bookkeeping
and
accounting.
,
©John Wiley & Sons, Inc.
Bookkeeping has two main jobs: recording the financial effects and other
relevant details of the wide variety of transactions and other activities of the
entity; and generating a constant stream of documents and electronic outputs
to keep the business operating every day.
Accounting, on the other hand, focuses on the periodic preparation of three
main types of output — reports to managers, tax returns (income tax, sales
tax, payroll tax, and so on), and financial statements and reports. These
­outputs are completed according to certain schedules. For example, financial
statements are usually prepared every month and at the end of the year
(12 months).
9
Book I
Setting
Up Your
Accounting
System
10
Book I: Setting Up Your Accounting System
Accounting All-In-One For Dummies is concerned predominately with f­ inancial
and management accounting. Financial accounting refers to the periodic
­preparation of general-purpose financial statements (see Books IV and V ).
General purpose means that the financial statements are prepared according
to s­ tandards established for financial reporting to stakeholders, as explained
earlier in this chapter.
These financial statements are useful to managers as well, but managers
need more information than is reported in the external financial s­ tatements
of a business. Much of this management information is confidential and
not for circulation outside the business. Management accounting refers
to the ­preparation of internal accounting reports for business managers.
Management accounting is used for planning business activity (Book VI) and
to make informed business decisions (Book VII).
This chapter offers a brief survey of bookkeeping and accounting, which
you may find helpful before moving on to the more hands-on financial and
­management topics.
Wrapping Your Brain around
the Accounting Cycle
Figure 1-2 presents an overview of the accounting cycle. These are the basic
steps in virtually every bookkeeping and accounting system. The steps are
done in the order presented, although the methods of performing the steps
vary from business to business. For example, the details of a sale may be
entered by scanning bar codes in a grocery store, or they may require an
­in-depth legal interpretation for a complex order from a customer for an
expensive piece of equipment. The following is a more detailed
description of each step:
1. Prepare source documents for all transactions, operations, and other
events of the business; source documents are the starting point in the
bookkeeping process.
When buying products, a business gets an invoice from the supplier.
When borrowing money from the bank, a business signs a note ­payable,
a copy of which the business keeps. When preparing payroll checks, a
business depends on salary rosters and time cards. All of these key
­business forms serve as sources of information entered into the
­bookkeeping system — in other words, information the bookkeeper uses
in recording the financial effects of the activities of the business.
Chapter 1: Grasping Bookkeeping and Accounting Basics
11
Book I
Setting
Up Your
Accounting
System
Figure 1-2:
Basic
steps of the
accounting
cycle.
©John Wiley & Sons, Inc.
2. Determine the financial effects of the transactions, operations,
and other events of the business.
The activities of the business have financial effects that must be recorded —
the business is better off, worse off, or affected in some way as the result of
its transactions. Examples of typical business ­transactions include paying
employees, making sales to customers, ­borrowing money from the bank,
and buying products that will be sold to customers. The bookkeeping
process begins by determining the ­relevant information about each
transaction. The chief accountant of the business establishes the rules
and methods for measuring the financial effects of transactions. Of course,
the bookkeeper should comply with these rules and methods.
3. Make original entries of financial effects in journals, with appropriate
references to source documents.
Using the source documents, the bookkeeper makes the first, or o
­ riginal,
entry for every transaction into a journal; this information is later
posted in accounts (see the next step). A journal is a chronological
record of transactions in the order in which they occur — like a very
detailed personal diary.
Here’s a simple example that illustrates recording a transaction in a
­journal. Expecting a big demand from its customers, a retail ­bookstore
purchases, on credit, 100 copies of The Beekeeper Book from the
­publisher, Animal World. The books are received, a few are placed on
12
Book I: Setting Up Your Accounting System
the shelves, and the rest are stored. The bookstore now owns the books
and owes Animal World $2,000, which is the cost of the 100 copies. This
example focuses solely on recording the purchase of the books, not
recording subsequent sales of the books and payment to Animal World.
The bookstore has established a specific inventory asset account called
“Inventory–Trade Paperbacks” for books like this. And the liability to
the publisher should be entered in the account “Accounts Payable–
Publishers.” Therefore, the original journal entry for this purchase records
an increase in the inventory asset account of $2,000 and an increase in the
accounts payable account of $2,000. Notice the balance in the two sides
of the transaction: an asset increases $2,000 on the one side and a liability
increases $2,000 on the other side. All is well (­ assuming no mistakes).
4. Post the financial effects of transactions to accounts, with references
and tie-ins to original journal entries.
As Step 3 explains, the pair of changes for the bookstore’s purchase
of 100 copies of this book is first recorded in an original journal entry.
Then, sometime later, the financial effects are posted, or recorded in
the s­ eparate accounts — one an asset and the other a liability. Only the
­official, e
­ stablished chart, or list of accounts, should be used in r­ ecording
transactions. An account is a separate record, or page, for each asset, each
liability, and so on. One transaction affects two or more accounts. The
journal entry records the whole transaction in one place; then each piece
is recorded in the accounts affected by the t­ ransaction. After ­posting
all transactions, a trial balance is generated. This d
­ ocument lists all the
accounts and their balances, as of a certain date.
The importance of entering transaction data correctly and in a timely
manner cannot be stressed enough. The prevalence of data entry errors
is one important reason that most retailers use cash registers that read
bar-coded information on products, which more accurately captures the
necessary information and speeds up data entry.
5. Perform end-of-period procedures — the critical steps for getting
the accounting records up-to-date and ready for the preparation of
­management accounting reports, tax returns, and financial statements.
A period is a stretch of time — from one day (even one hour) to one
month to one quarter (three months) to one year — that’s determined
by the needs of the business. Most businesses need accounting reports
and financial statements at the end of each quarter, and many need
monthly financial statements.
Before the accounting reports can be prepared at the end of the period
(see Figure 1-1), the bookkeeper needs to bring the accounts up to date
and complete the bookkeeping process. One such end-of-period
­requirement, for example, is recording the depreciation expense for the
period (see Book III, Chapter 1 for more on depreciation).
Chapter 1: Grasping Bookkeeping and Accounting Basics
The accountant needs to be heavily involved in end-of-period
­procedures and be sure to check for errors in the business’s accounts.
Data entry clerks and bookkeepers may not fully understand the unusual
nature of some business transactions and may have entered ­transactions
incorrectly. One reason for establishing internal controls (see Book II,
Chapter 1) is to keep errors to an absolute minimum. Ideally, accounts
should contain no errors at the end of the period, but the accountant
can’t assume anything and should perform a final check for any errors.
6. Compile the adjusted trial balance for the accountant, which is the
basis for preparing management reports, tax returns, and financial
statements.
In Step 4, you see that a trial balance is generated after you post the
accounting activity. After all the end-of-period procedures have been
completed, the bookkeeper compiles a comprehensive listing of all
accounts, which is called the adjusted trial balance. Modest-sized
­businesses maintain hundreds of accounts for their various assets,
­liabilities, owners’ equity, revenues, and expenses. Larger businesses
keep thousands of accounts.
The accountant takes the adjusted trial balance and combines similar
accounts into one summary amount that is reported in a financial report
or tax return. For example, a business may keep hundreds of separate
inventory accounts, every one of which is listed in the adjusted trial
balance. The accountant collapses all these accounts into one summary
inventory account presented in the balance sheet of the business. In
grouping the accounts, the accountant should comply with established
financial reporting standards and income tax requirements.
7. Close the books — bring the bookkeeping for the fiscal year just
ended to a close and get things ready to begin the bookkeeping
­process for the coming fiscal year.
Books is the common term for a business’s complete set of accounts
along with journal entries. A business’s transactions are a constant
stream of activities that don’t end tidily on the last day of the year,
which can make preparing financial statements and tax returns
­challenging. The business has to draw a clear line of demarcation
between activities for the year ended and the year to come by closing the
books for one year and starting with fresh books for the next year.
Most medium-sized and larger businesses have an accounting manual that
spells out in great detail the specific accounts and procedures for recording
transactions. A business should regularly review its chart of accounts and
accounting rules and policies and make revisions. Companies don’t take this
task lightly; discontinuities in the accounting system can be major shocks and
have to be carefully thought out. The remaining chapters in Book I lead you
through the process of developing an accounting system. See Book III for
details on adjusting and closing entries.
13
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14
Book I: Setting Up Your Accounting System
Working the Fundamental
Accounting Equation
The fundamental accounting equation (also known as the accounting equation
or the balance sheet equation) helps explain the concept that all transactions
must balance.
Assets = Liabilities + Owners’ equity
Net assets equals assets minus liabilities. If you do some algebra and subtract
liabilities from both sides of the previous equation, you get this formula:
Assets – Liabilities = Owners’ equity
Or:
Net assets = Owners’ equity
Before going any further, acquaint yourself with the cast of characters in the
equation:
✓ Assets are resources a company owns. Book IV, Chapter 3 discusses
all the typical types of business assets. Some examples are cash,
­equipment, and cars. You use assets to make money in your business.
In other words, the resources are used up over time to generate sales
and profits.
✓ Liabilities are debts the company owes to others — people other
than owners of the business. See Book IV, Chapter 4 for the scoop on
­liabilities. The biggies are accounts payable and notes payable.
✓ Owners’ equity (or simply equity) is what’s left over in the business at
the end of the day. If you sold all your assets for cash, then paid off all
your liabilities, any cash remaining would be equity. Many ­accounting
textbooks define equity as the owners’ claim to the company’s net
assets. Book IV, Chapter 5 discusses the different components of equity.
You may read the explanation of owners’ equity and think, “That’s just
another way to say ‘net worth.’” But you can’t use the term net worth
interchangeably with owners’ equity in an accounting setting. Generally
accepted accounting principles (GAAP), explained in Book IV, Chapter 1,
don’t allow accountants to restate all assets to their fair market value,
which would be required to calculate a company’s net worth.
Chapter 1: Grasping Bookkeeping and Accounting Basics
Here’s a simple example of the fundamental accounting equation at work:
Assets = Liabilities + Equity
$100 = $40 + $60
Or, after subtracting liabilities from each side of the equation:
Assets – Liabilities = Equity
$100 – $40 = $60
Finally, you can restate assets less liabilities and net assets:
Net assets = Owners’ equity
$60 = $60
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16
Book I: Setting Up Your Accounting System
Chapter 2
Outlining Your Financial Road Map
with a Chart of Accounts
In This Chapter
▶ Introducing the chart of accounts
▶ Warming up with balance sheet accounts
▶ Creating your own chart of accounts
▶ Grasping the basics of debits and credits
▶ Getting schooled in double-entry accounting
C
an you imagine the mess your checkbook would be if you didn’t record
each check you wrote? If you’re like most people, you’ve probably forgotten to record a check or two on occasion, but you certainly learn your lesson
when you realize that an important payment bounces as a result. Yikes!
Keeping the books of a business can be a lot more difficult than maintaining a
personal checkbook. You have to carefully record each business transaction to
make sure that it goes into the right account. This careful bookkeeping gives
you an effective tool for figuring out how well the business is doing financially.
You need a road map to help you determine where to record all those transactions. This road map is called the chart of accounts. This chapter introduces you to the chart of accounts and explains how to set up your chart of
accounts. This chapter also spells out the differences between debits and
credits and orients you to the fine art of double-entry accounting.
Getting to Know the Chart of Accounts
The chart of accounts is the road map that a business creates to organize
its financial transactions. After all, you can’t record a transaction until you
know where to put it! Essentially, this chart is a list of all the accounts a
18
Book I: Setting Up Your Accounting System
business has, organized in a specific order; each account has a description that includes the type of account and the types of transactions that
should be entered into that account. Every business creates its own chart of
accounts based on the nature of the business and its operations, so you’re
unlikely to find two businesses with the exact same chart.
Connecting the chart of accounts
to financial statements
Some basic organizational and structural characteristics are common to all
Charts of Accounts. The organization and structure are designed around two
key financial reports:
✓ The balance sheet shows what your business owns (assets) and who has
claims on those assets (liabilities and equity).
✓ The income statement shows how much money your business took in
from sales and how much money it spent to generate those sales.
You can find out more about income statements and balance sheets in
Books IV and V. The following lists present a common order for these
accounts within each of their groups, based on how they appear on the
financial statements.
Organizing the accounts
The chart of accounts starts with the balance sheet accounts, which include
✓ Current assets: Accounts that track what the company owns and
expects to use in the next 12 months, such as cash, accounts receivable
(money collected from customers), and inventory
✓ Long-term assets: Accounts that track what assets the company owns
that have a lifespan of more than 12 months, such as buildings, ­furniture,
and equipment
✓ Current liabilities: Accounts that track debts the company must pay
over the next 12 months, such as accounts payable (bills from vendors,
contractors, and consultants), interest payable, and credit cards payable
✓ Long-term liabilities: Accounts that track debts the company must pay
over a period of time longer than the next 12 months, such as mortgages
payable and bonds payable
Chapter 2: Outlining Your Financial Road Map with a Chart of Accounts
✓ Equity: Accounts that track the owner’s claims against the company’s
net assets, which includes any money invested in the company, any
money taken out of the company, and any earnings that have been reinvested in the company
The rest of the chart is filled with income statement accounts, which include
✓ Revenue: Accounts that track sales of goods and services as well as
revenue generated for the company by other means
✓ Cost of goods sold: Accounts that track the direct costs involved in
selling the company’s goods or services
✓ Expenses: Accounts that track expenses related to running the business
that aren’t directly tied to the sale of individual products or services
When developing the chart of accounts, you start by listing all asset, liability,
equity, revenue, and expense accounts. All these accounts come from two
places: the balance sheet and the income statement.
This chapter introduces the key account types found in most businesses, but
this list isn’t cast in stone. You should develop an account list that makes the
most sense for how you’re operating your business and the financial information you want to track.
The chart of accounts is a management tool that helps you make smart business decisions. You’ll probably tweak the accounts in your chart annually
and, if necessary, add accounts during the year if you find something that
requires more detailed tracking. You can add accounts during the year, but
it’s best not to delete accounts until the end of a 12-month reporting period.
Balancing transactions
A chart of accounts helps you keep your balance sheet accounts in balance in
accordance with the balance sheet equation discussed in Chapter 1:
Assets = Liabilities + Equity
As you see in the prior section, the chart of accounts groups accounts based
on the three categories in the balance sheet equation. All the asset accounts,
for example, have account numbers that are close together, as explained in
the next section. You can easily separate the chart of accounts into assets,
liabilities, and equity — and see whether the balance sheet equation balances (in total dollars).
19
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20
Book I: Setting Up Your Accounting System
Setting Up Your Chart of Accounts
Cooking up a useful chart of accounts doesn’t require any secret sauce. All
you need to do is list all the accounts that apply to your business. A good
brainstorming session usually does the trick.
When first setting up your chart of accounts, don’t panic if you can’t think of
every type of account you may need for your business. Adding to the chart of
accounts at any time is very easy. Just add the account to the list and distribute
the revised list to any employees who use the chart of accounts for entering
transactions into the system. (Even employees not involved in bookkeeping
need a copy of your chart of accounts if they code invoices or other transactions or indicate to which account those transactions should be recorded.)
The chart of accounts usually includes at least three columns:
✓ Account: Lists the account names
✓ Type: Lists the type of account — asset, liability, equity, revenue, cost of
goods sold, or expense
✓ Description: Contains a description of the type of transaction that
should be recorded in the account
Nearly all companies also assign numbers to the accounts, to be used for
coding charges. If your company is using a computerized system, the computer
automatically assigns the account number. Otherwise, you need to develop
your own numbering system. The most common number system is:
✓ Asset accounts: 1,000 to 1,999
✓ Liability accounts: 2,000 to 2,999
✓ Equity accounts: 3,000 to 3,999
✓ Revenue accounts: 4,000 to 4,999
✓ Cost of goods sold accounts: 5,000 to 5,999
✓ Expense accounts: 6,000 to 6,999
This numbering system matches the one used by computerized accounting
systems, making it easy for a company to transition to automated books at
some future time.
Most companies create an accumulated depreciation account and match it
with each unique fixed asset account. So, if you have a fixed asset account
called delivery trucks, you likely have an account called accumulated
depreciation – delivery trucks. Book value is defined in Book III, Chapter 1 as
cost less accumulated depreciation. This chart of accounts approach allows
Chapter 2: Outlining Your Financial Road Map with a Chart of Accounts
management to view each asset’s original cost and the asset’s accumulated
depreciation together — and calculate book value.
If you choose a computerized accounting system, one major advantage is
that a number of different Charts of Accounts have been developed for various types of businesses. When you get your computerized system, whichever
accounting software you decide to use, all you need to do is review its list of
chart options for the type of business you run, delete any accounts you don’t
want, and add any new accounts that fit your business plan.
If you’re setting up your chart of accounts manually, be sure to leave a lot of
room between accounts to add new accounts. For example, number your cash
in checking account 1,000 and your accounts receivable account 1,100. That
leaves you plenty of room to add other accounts to track cash.
Mulling Over Debits versus Credits
In this section, you discover the mechanism of journal entries, which you use
to enter financial information into the company’s accounting software. To
properly post journal entries, you need to understand debits and credits.
Writing journal entries is a major area of confusion for anyone who’s just
getting started in accounting, because they involve debits and credits that
are often counterintuitive. If you’re just starting out in accounting, consider
reading this section more than once. After you read this section and start
posting some journal entries, you’ll get the hang of it.
These rules regarding debits and credit are always true:
✓ Debits are always on the left. In journal entries, debits appear to the left
of credits.
✓ Credits are always on the right. In journal entries, credits appear to the
right of debits.
See the next section for examples of journal entries.
The following rules are also true, but with a few exceptions:
✓ Assets and expenses are debited to add to them and credited to subtract
from them. In other words, for assets and expenses, a debit increases the
account, and a credit decreases it.
✓ Liability, revenue, and equity accounts are just the opposite: These
accounts are credited to add to them and debited to subtract from
them. In other words, for liability, revenue, and equity accounts, a debit
decreases the account, and a credit increases it, as you would expect.
21
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22
Book I: Setting Up Your Accounting System
This book covers three exceptions to these two rules. Treasury stock (covered
in Book IV, Chapter 5), allowance for doubtful accounts (see Book IV, Chapter 3),
and accumulated depreciation (Book III, Chapter 1) are contra-accounts, which
offset the balance of a related account. Other than these exceptions, these two
rules hold true.
Understanding Double-Entry Accounting
All businesses, whether they use the cash-basis or accrual accounting method
(see Chapter 4), use double-entry accounting — a practice that helps minimize errors and increase the chance that your books balance. Double-entry
accounting doesn’t mean you enter all transactions twice; it means that you
enter both sides of the transaction, debiting one account and crediting another.
Revisiting the balance sheet equation
In double-entry accounting, the balance sheet equation plays a major role, as
explained in “Balancing transactions” earlier in this chapter.
In order to change the balance of any accounts, you use a combination of
debits and credits. In some cases, you may debit and credit multiple accounts
to record the same transaction. Regardless of how many accounts are
affected, these additional rules hold true:
✓ The total dollar amount debited will equal the total amount credited.
✓ The total dollar change in the asset accounts (increase or decrease) will
equal the change in the total dollar amount of liabilities and equity. This
concept is consistent with the balance sheet equation: Assets on the left
must equal liabilities on the right.
Recording journal entries
All accounting transactions for a business must be recorded as journal entries,
following a specific three-column format followed by a transaction description:
✓ Account titles in the left column
✓ Debit dollar amounts in the middle column
✓ Credit dollar amounts in the right column
✓ Transaction description below the journal entry (to indicate the nature
and purpose of the transaction for future reference)
Chapter 2: Outlining Your Financial Road Map with a Chart of Accounts
Here’s an example:
Book I
Account
Debit
Inventory
$3,000
Credit
Accounts payable
$3,000
To purchase sprockets for sale to customers.
The following sections present some typical journal entries — entries that
many companies frequently post in their accounting records.
Posting entries to one side of the balance sheet equation
Suppose you purchase a new $1,500 desk for your office. This transaction
actually has two parts: You spend an asset — cash — to buy another asset —
furniture. So, you must adjust two accounts in your company’s books: the cash
account and the furniture account. Here’s what the transaction looks like in
double-entry accounting:
Account
Debit
Furniture
$1,500
Cash
23
Credit
$1,500
To purchase a new desk for the office.
In this transaction, the debit increases the value of the furniture account, and
the credit decreases the value of the cash account. Both accounts impacted
are asset accounts, so the transaction affects only the assets side of the balance sheet equation:
Assets + $1,500 furniture – $1,500 cash = L
iabilities (no change)
+ Equity (no change)
In this case, the books stay in balance because the exact dollar amount that
increases the value of the furniture account decreases the value of the cash
account.
Using both sides of the equation
To see how you record a transaction that impacts both sides of the balance
sheet equation, consider an example that records the purchase of inventory. Suppose you purchase $5,000 worth of widgets on credit. These new
Setting
Up Your
Accounting
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24
Book I: Setting Up Your Accounting System
widgets add value to both inventory (an asset account) and accounts
payable (a liability) account. Here’s what the transaction looks like in
double-entry accounting:
Account
Debit
Inventory
$5,000
Accounts payable
Credit
$5,000
To purchase widgets for sale to customers.
In this case, the books stay in balance because both sides of the equation
(assets on the left and liabilities on the right) increase by $5,000:
Inventory + $5,000 = Accounts payable + $5,000 + Equity (no change)
You can see from the two example transactions in this section how
double-entry accounting helps to keep your books in balance — as long as
each entry into the books is balanced. Balancing your entries may look simple
here, but sometimes entries can get complex when more than two accounts
are impacted by the transaction.
Figuring out a complex journal entry
To take the subject of journal entries one step further, take a look at a more
complex journal entry. Assume you sell a company truck. You bought the
truck for $30,000. As of the date of sale, you’ve recognized $25,000 of accumulated depreciation. You receive $6,000 for the sale. The transaction is
complex, because more than one debit and credit are required.
Starting with cash
As an accountant, you have several issues to resolve. First, consider which
accounts in the chart of accounts are affected. Second, the total debits must
equal total credits.
Accountants figure out journal entries every day. If you’re not sure where to
start, think about whether or not cash should be part of the journal entry. In
this case, the answer is yes. Because cash increased, you need to debit the
asset account cash for $6,000.
Now go over the other “knowns” for this transaction. You sold someone the
truck (an asset). In the “Mulling over Debits versus Credits” section earlier
in this chapter, you see that you credit to reduce assets. The truck account
should be credited for $30,000.
Chapter 2: Outlining Your Financial Road Map with a Chart of Accounts
25
Getting to a balanced entry
Book I
In Book III, Chapter 1, you discover that accumulated depreciation represents all depreciation taken on an asset since the purchase date. You also
see that accumulated depreciation carries a credit balance. When you sell
the truck, you remove the accumulated depreciation by debiting the account
for $25,000.
Setting
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Now for the hardest part. So far, you’ve debited cash $6,000 and debited accumulated depreciation for $25,000. On the credit side, you credited the truck
account for $30,000. In total, you have $31,000 in debits ($6,000 + $25,000) and
$30,000 in credits. To balance this entry you need an additional $1,000 credit.
Think about which account you should use.
If you sell an asset, accounting standards require that you record a gain or
loss on sale. Because you need a credit entry, you record a gain. Here’s how
your complex journal entry looks:
Account
Debit
Cash
$6,000
Accumulated depreciation
$25,000
Credit
Truck
$30,000
Gain on sale of truck
$1,000
To record the sale of a truck for a gain.
The combination for the cash received and depreciation removed ($31,000)
was more than the original cost of the truck sold ($30,000). The result is a
gain of $1,000.
This thought process is what accountants use to post complex journal
entries.
26
Book I: Setting Up Your Accounting System
Chapter 3
Using Journal Entries and Ledgers
In This Chapter
▶ Becoming familiar with journals and the general ledger
▶ Writing journal entries
▶ Balancing the books
▶ Saving time and reducing errors with accounting software
A
ccounting involves a great deal of record keeping or booking — the ­process
of recording accounting transactions. Some booking tasks involve basic
data entry done by clerks. Junior accountants or bookkeepers may p
­ erform
other booking tasks, such as preparing journal entries — the ­accountant’s way
to enter transactions into the accounting system. (For e
­ xample, the accountant
records any bank charges shown on the company’s monthly bank statement.)
You find out more about journal entries later in this chapter.
Whether you’ll need to book journal entries during your accounting career
depends on a couple factors. If you work for a small company in a one- or
two-person accounting department, you could very well be the c­ ontroller (the
chief accounting officer for the business) and be doing the journal entries
yourself. If, instead, you work for a large accounting firm that p
­ rovides
­services to many clients, chances are you won’t book journal entries ­yourself.
However, you’ll most certainly review journal entries while ­providing your
services, such as when you audit a company’s financial ­statements. And you
may propose journal entries for your client to book if you find errors.
No matter where your accounting career takes you, you need to know what
booking involves, as explained in this chapter.
Keeping a Journal
Accounting journals, like diaries, keep a record of events. But a
­ ccounting
­journals record business transactions taking place within a company’s
­accounting ­department. Accountants call journals the books of original
entry because no transactions get into the accounting records without being
entered into a journal first.
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Book I: Setting Up Your Accounting System
A business can have many different types of journals. In this section you
find out about the most common journals, which are tailored to handle cash,
accrual, and special transactions.
Using journals to record cash transactions
All transactions affecting cash go into the cash receipts or cash disbursements journal. Some accountants and accounting software programs refer to
the record of cash disbursements as the cash payments journal. No
worries — both terms mean the same thing.
When accountants use the word cash, it doesn’t just mean paper money and
coinage; it includes checks and credit card transactions. In accounting, cash
is a generic term for any payment method that is assumed to be automatic.
See Book IV, Chapter 3 for balance sheet details.
When you sign a check and give it to the clerk behind the store counter, part
of your implicit understanding is that the funds are immediately available to
clear the check. Ditto paying with a credit card, which represents an immediate satisfaction of your debit with the vendor.
Cash receipts journal
The cash receipts journal keeps a record of all payments a business receives
in cash or by check, debit card, or credit card. Book II, Chapter 3 discusses
cash activity related to sales to customers. This discussion of cash covers a
variety of transactions. Here are examples of some cash events that require
posting to the cash receipts journal:
✓ Customer sales made for paper money and coinage: Many types of
businesses still have booming cash sales involving the exchange of
paper money and coins. Some examples are convenience stores, retail
shops, and some service providers such as hair salons.
✓ Customers making payments on their accounts: If a business lets its
customers buy now and pay later, any payments due are entered into
accounts receivable, which is money customers owe the business. See
“Recording accrual transactions,” later in this chapter, for details. Any
payments a customer makes toward those amounts owed are recorded
in the cash receipts journal.
✓ Interest or dividend income: When a bank or investment account pays
a business for the use of its money in the form of interest or dividends,
the payment is considered a cash receipt. Many businesses record
­interest income reported on their monthly bank statements in the
­general journal, discussed a little later in this section.
Chapter 3: Using Journal Entries and Ledgers
Interest and dividend income is also known as portfolio income and may
be considered passive income because the recipient doesn’t have to
work to receive the portfolio income (as you do for your paycheck).
✓ Asset sales: Selling a business asset, such as a car or office furniture, can
also result in a cash transaction. As an example, suppose a company is
outfitting its executive office space with deluxe new leather chairs and
selling all the old leather chairs to a furniture liquidator; the two parties
exchange cash to complete the sale.
Keep in mind that this list isn’t comprehensive; these are just a few of the
many instances that may necessitate recording a transaction in the cash
receipts journal.
Cash receipts may receive different treatment on a company’s income
s­ tatement. For example, cash sales to customers are treated one way, while
cash received for the sale of a building — a transaction that’s not part of the
normal business activity — is treated differently. The details are explained in
Book IV, Chapter 2.
Setting up the cash receipts journal
The cash receipts journal normally has two columns for debits and four columns for credits:
✓ Debit columns: Because all transactions in the cash receipts journal
involve the receipt of cash, one of the debit columns is always for cash.
The other is for sales discounts, which reflect any discount the business
gives to a good customer who pays early. For example, a customer’s
invoice is due within 30 days, but if the customer pays early, it gets a
2 percent discount.
✓ Credit columns: To balance the debits, a cash receipts journal contains
four credit columns:
• Sales
• Accounts receivable
• Sales tax payable, which is the amount of sales tax the business
collects on a transaction (and doesn’t apply to every transaction)
• Miscellaneous, which is a catchall column where you record all
other cash receipts such as interest and dividends
Not all sales are subject to sales tax. Your state department of revenue
­ etermines which sales transactions are taxable. For example, in many states,
d
fees for accounting or legal services aren’t subject to sales tax.
29
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30
Book I: Setting Up Your Accounting System
In addition to the debit and credit columns, a cash receipts journal also
­contains at least two other columns that don’t have anything to do with
debits or credits:
✓ The date the transaction occurs
✓ The name of the account affected by the transaction
Depending on the company or accounting system, additional columns may
be used as well.
Figure 3-1 shows an example of a portion of a cash receipts journal.
Figure 3-1:
A partial
cash
receipts
journal.
©John Wiley & Sons, Inc.
Cash disbursements journal
On the flip side, any payment the business makes by using a form of cash
gets recorded in the cash disbursements (or payments) journal. Here are a
few examples of transactions that appear in a cash disbursements journal:
✓ Merchandise purchases: When a merchandiser, a company selling goods
to the public, pays cash for the goods it buys for resale (inventory), the
transaction goes in the cash disbursement journal.
✓ Payments the company is making on outstanding accounts: This
includes all cash disbursements a company makes to pay for goods or
services it obtained from another business and didn’t pay for when the
original transaction took place. More on this topic in the “Recording
accrual transactions” section later in this chapter.
✓ Payments for operating expenses: These transactions include checks
or bank transfers a business uses to pay utility or telephone invoices.
Operating expenses are incurred to manage your day-to-day business,
in addition to your cost of sales.
The cash disbursements journal normally has two columns for debits and
two for credits:
Chapter 3: Using Journal Entries and Ledgers
✓ Credit columns: Because all transactions in the cash disbursements
journal involve the payment of cash, one of your credit columns is
for cash. The other is for purchase discounts, which are reductions in
the amount a company has to pay the vendors for any purchases on
account. For example, a business offers vendors a certain discount
amount if they pay their bills within a certain number of days. It’s
the same process that’s explained in the earlier cash receipts journal
­section. In this case, the company pays less, due to a discount. With
cash receipts, a discount means that the company may receive less.
✓ Debit columns: To balance these credits, the debit columns in a cash
­disbursements journal are accounts payable and miscellaneous (a ­catchall
column in which you record all other cash payments for transactions,
such as the payment of operating expenses).
A cash disbursements journal also contains at least three other columns that
don’t have anything to do with debiting or crediting:
✓ The date the transaction occurs
✓ The name of the account affected by the transaction
✓ The pay-to entity (to whom the payment is made)
Depending on the company or accounting system used, more columns could be
used as well. Figure 3-2 shows an example of a partial cash disbursements journal.
Figure 3-2:
A partial
cash
disburse­
ments
journal.
©John Wiley & Sons, Inc.
Recording accrual transactions
Accrual transactions take place whenever cash doesn’t change hands.
For example, a customer makes a purchase with a promise to pay within
30 days. Using accruals and recording business transactions using the accrual
method are the backbone of accounting. Unfortunately, figuring out accruals,
­understanding how accrual transactions interact with cash transactions, and
knowing when to record an accrual transaction can be quite a challenge.
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Book I: Setting Up Your Accounting System
Never fear. The following sections introduce the two accrual workhorse
journals — the sales and purchases journals — walk you through the accrual
transactions you’re likely to encounter, and provide a sampling of typical
accrual transactions. Book III, Chapter 6 explains many types of accrual
­journal entries in detail.
Sales journal
The sales journal records all sales that a business makes to customers on
account, which means no money changes hands between the company and
its customer at the time of the sale. A sales journal affects two d
­ ifferent
accounts: accounts receivable and sales. In the sales journal, accounts
­receivable and sales are always affected by the same dollar amount.
Figure 3-3 presents an example of a sales journal.
Figure 3-3:
A partial
sales
journal.
©John Wiley & Sons, Inc.
When you record credit sales in your sales journal, you follow up by posting
the transactions to each customer’s listing in the accounts receivable ledger.
(See the “Bringing It All Together in the Ledger” later in this chapter.)
Use the sales journal only for recording sales on account. Sales returns, which
reflect all products customers return to the company after the sales are done,
aren’t recorded in the sales journal. Instead, you record them in the general
journal, discussed later in this chapter.
Purchases journal
Any time a business buys products or services by using credit (on account),
it records the transaction in its purchases journal. The purchases journal
typically has a column for date, number, and amount. It also has the following
columns:
✓ Accounts payable: Because the company is purchasing on account,
the current liability account called “accounts/trade payable” is always
affected.
✓ Terms: This column shows any discount terms the company may have
with the vendor. For example, 2/10, n/30 means the company gets a
2 percent discount if it pays within 10 days; otherwise, the full amount is
due in 30 days. (The n in this shorthand stands for “net.”)
Chapter 3: Using Journal Entries and Ledgers
✓ Name: The company records the name of the vendor from whom the
purchase is made.
✓ Account: This column shows to which financial statement account(s)
the purchase is taken. The example in Figure 3-4 shows two accounts —
accounts payable (A/P) and purchases. Because no other accounts
(such as sales tax) are affected, A/P and purchases are for the same
dollar amount. If the company collects sales tax too, a column is added
to report this amount as well.
Figure 3-4:
A partial
purchases
journal.
©John Wiley & Sons, Inc.
Exploring other journals
The discussion of journals wouldn’t be complete without a brief rundown of
other special journals you’ll see during your foray into accounting, as well as
the general journal. The following sections cover both topics.
Special journals
Here are three additional journals you’ll encounter:
✓ Payroll journal: This journal records all payroll transactions including
gross wages, taxes withheld, and other deductions (such as health
insurance paid by the employee) leading to net pay, which is the amount
shown on the employee’s check. Head over to Book II, Chapters 4 and 5
for more on payroll accounting.
✓ Purchases return and allowances journal: This journal shows all
­subtractions from gross purchases because of products a company
returns to a vendor or discounts given to the company by the vendor.
✓ Sales returns and allowances journal: This journal shows all
­subtractions from gross sales as a result of products customers return
or discounts given to customers.
This list isn’t all-inclusive; some companies have other journals, and some
smaller companies may not use all of these. However, if you understand the
basic methodology of all the journals discussed in this chapter, you’ll be well
prepared to tackle journal entries.
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Book I: Setting Up Your Accounting System
General journal
The general journal is a catchall type of journal in which transactions that
don’t appropriately belong in any other journal show up. Many companies
record interest income and dividends in the general journal.
This journal is also used for adjusting and closing journal entries:
✓ Adjusting journal entries: One key reason you would adjust journal
entries is to make sure the accounting books are recorded by using the
accrual method. For example, on April 30, employees have earned but
not yet been paid $5,000 in gross wages (the next payroll date is May 2).
So to make sure that your company’s revenue and expenses are matched,
you book an adjusting journal entry debiting wages expense account for
$5,000 and crediting wages payable (or accrued wages) for $5,000.
You also adjust journal entries to reclassify transactions. This occurs
when the original transaction is correct but circumstances change
after the fact and the transaction needs to be adjusted. For example,
your company buys $1,000 of supplies on April 1, and the transaction is
originally booked as supplies inventory. On April 30, an inventory of the
supplies is taken. Only $800 of the supplies remain, so you have to debit
your supplies expense account for $200 and credit supplies inventory
for $200.
✓ Closing journal entries: You use this type of entry to zero out all t­emporary
accounts. These accounts don’t make it into the financial statements.
Revenue and expense accounts are temporary accounts, because their
­balances are adjusted to zero at the end of each ­accounting period (month
or year). You then transfer the net amounts (net income or a net loss)
to the balance sheet. (See Book IV, Chapter 2 for information about the
income statement.) There are four closing journal entries:
• You debit all revenue accounts and credit income summary for the
same amount. Income summary is a temporary holding account
you use only when closing out a period.
• You credit all expenses and debit income summary for the same
amount.
• You either debit or credit income summary to reduce it to zero and
take the same figure to retained earnings. Retained earnings r­ epresent
the cumulative net income, less all dividends (distributions of profit)
paid to owners since the company was formed.
Chapter 3: Using Journal Entries and Ledgers
Here’s an example: If in step one you credit income summary for
$5,000 and in step two you debit income summary for $3,000, you
now have a credit balance of $2,000 in income summary. So to
reduce income summary to zero, you debit it for $2,000 and credit
retained earnings for the same amount.
• Finally, if the owners have paid themselves any dividends during
the period, you credit cash and debit retained earnings.
Honestly, you likely never have to prepare the first three closing entries
­ ourself because all accounting software systems perform this task for you
y
automatically. However, you do need to understand what goes on with the
debits and credits when the books close. You have to do the fourth closing
entry yourself. That’s because the automated accounting systems requires a
manual journal entry for the dollar amount of the dividend.
You clear out only temporary accounts with closing journal entries. Balance
sheet accounts are permanent accounts. Until you cease using the account (for
example, you close a bank account), no balance sheet accounts are zeroed out
at closing.
Checking out examples of common
journal entries
It’s time for you to review a few journal entries so the concepts related to
them really come to life. First, keep in mind the general format of a journal
entry, which is shown in Figure 3-5:
Figure 3-5:
The
standard
journal entry
format.
©John Wiley & Sons, Inc.
✓ The date of the entry is in the left column.
✓ The accounts debited and credited are in the middle column.
✓ The amounts are shown in the two right columns.
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Book I: Setting Up Your Accounting System
Proper journal entries always list debits first followed by credits. See Book II,
Chapter 2 for an explanation of debits and credits.
Journal entries can have more than one debit and more than one credit. And
the number of accounts debited and credited doesn’t have to be the same. For
example, you can have five accounts debited and one account credited.
However, the dollar amount of the debits and credits has to match.
Consider an example of a journal entry for service income, which records
cash and accrual income. You provide a service to your client, Mr. Jones, on
May 15, giving him invoice #200 in the amount of $700 for services rendered.
Before he leaves your office, he pays you $200 in cash with a promise to pay
the remaining balance of $500 next week. The journal entry to record this
transaction is shown in Figure 3-6.
Figure 3-6:
Recording
service
income.
©John Wiley & Sons, Inc.
Under the accrual method of accounting (see Chapter 4), both the cash
receipts and the promise to pay the remaining balance have to be reported at
the time the transaction takes place because the service has been rendered
and the income has been earned.
Every journal entry should have a brief description. It doesn’t have to be a
­paragraph but should be long enough that you or anyone else reviewing the
journal entry can figure out why you made it. A common mistake is to make the
description just a little too brief, forcing you to go back through the t­ ransaction
to figure out why you made the journal entry. The description for the journal
entry in Figure 3-6 (“To record invoice #200”) is brief but totally understandable.
Take a look at one more journal entry before moving on. Suppose you borrow
$5,000 from your bank on July 1. Your arrangement calls for you to pay $200
interest on July 31 and pay back the loan in full plus another $200 in interest on
August 30. Figure 3-7 shows how your journal entries look from soup to nuts.
Chapter 3: Using Journal Entries and Ledgers
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Figure 3-7:
Journalizing
a loan
transaction.
©John Wiley & Sons, Inc.
Bringing It All Together in the Ledger
At this point you may be thinking, “Okay, the journals are the books of original entry, but what happens then? How do entries into these journals turn
into financial statements?” That’s the topic of this section. The accounts and
amounts debited or credited affect the company’s ledgers, as explained next.
Realizing what a ledger is
A ledger records applicable transactions taking place in a company during
a particular accounting cycle. Picture a big book. Every page of the book
has a title that corresponds with an account from the chart of accounts. For
instance, page 1 may be titled “1001 Cash in Bank.” On this page, you’d list
the total of the funds you deposited in your company checking account, as
well as the total of all the withdrawals for a given period — say for a month.
A business has one big dog ledger: the general ledger, which lists all
­transactions taking place in all the accounts during the specified a
­ ccounting
period. You may also see subsidiary ledgers that list in detail transactions
­happening only in specific accounting circumstances. For example, the
­payroll subsidiary ledger lists all payroll transactions. The accounts ­receivable
­subsidiary ledger lists all customers owing your company money and the
amount of their current outstanding balances.
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Book I: Setting Up Your Accounting System
Posting to the ledgers
When you post to the ledgers, you simply take accounts and numbers from
transactions entered in the journals and record them in the correct ledger. If
a subsidiary ledger is the first point of recording, the transaction e
­ ventually
flows through the subsidiary ledger to the general ledger. For example, a
­customer sale on account first posts to the sales journal and then is reported
in the accounts receivable subsidiary ledger under the customer’s name.
Then that amount flows from the accounts receivable subsidiary ledger to
the accounts receivable listing in the general ledger, combining with all other
­customers owing the business money to show a grand total of accounts
­receivable. Following with the same transaction, the combined total of all the
transactions in the sales journal also posts to the sales listing in the general
ledger.
Until modern accounting software arrived, posting to the ledgers was a ­laborious
process requiring the use of ledger paper with 14 columns. Fortunately, this
practice has become a thing of the past because accounting software has
become so affordable and easy to use.
Most accounting software programs require no formal procedure to post to
the ledgers. Every time you enter a transaction in a journal, it automatically
posts to the correct ledger. However, proprietary accounting software (which
means a business holds exclusive rights to use) may require the user to
actively select the posting command.
Viewing an example of a general ledger
General ledgers vary according to the nature of the business, a company’s
preferences, and the software used. Figure 3-8 shows a very simple partial
general ledger for a small services company. It starts with a revenue account,
“consulting fees,” and ends with an operating expense account, “bank charge.”
Columns similar to the debit, credit, and balance columns in Figure 3-8 are
used in earlier figures in this chapter. Here’s what some of the other columns
mean:
✓ Type: The original nature of the transaction.
✓ Date: The day the transaction took place.
✓ No.: The identifying number from the journal of original entry. For
­example, 1008 is the company check number used to pay James Fine.
✓ Name: Whatever name you put in the journal of original entry.
Chapter 3: Using Journal Entries and Ledgers
39
Book I
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Figure 3-8:
A partial
general
ledger.
©John Wiley & Sons, Inc.
✓ Memo: Any explanation for the transaction that you put in the original
entry. Using this section is important. If your journal entry involves
four accounts, each account has this same memo information when
it’s posted to general ledger. The memo notes make it much easier to
­understand why the entry was posted.
Recognizing the purpose
of the trial balance
The trial balance is a listing of all the accounts in the general ledger and the
balance of each account as of a certain date. The trial balance checks to
make sure all debits equal credits. Any imbalance indicates the presence of
an error that must be identified and corrected. Accountants also use the trial
balance as a front-line tool to review the accuracy of the financial statements.
To find out more about running trial balances, see Book III, Chapter 5. This
chapter provides a short explanation, and an example trial balance.
Suppose you run a trial balance, quickly scan it, and see that an expense
account carries a balance that seems too high based on your professional
judgment and knowledge of the company. You check the general ledger and
see that a rent payment of $5,000 was posted to postage expense by mistake.
You can then correct the error before producing any financial statements.
Figure 3-9 shows an example of a partial trial balance.
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Book I: Setting Up Your Accounting System
Figure 3-9:
A partial trial
balance.
©John Wiley & Sons, Inc.
Accounting software shouldn’t allow a user to enter a transaction that’s out
of balance. (Out of balance means that the total dollar amount of debits
doesn’t equal credits.) If an out-of-balance transaction occurs, the software
has a serious bug that you need to report to the developer.
Putting Accounting Software
to Work for You
A bewildering array of accounting software is available today for small- and
medium-sized businesses. (Larger corporations tend to develop their own
computer-based accounting systems or hire a programmer to develop
­specialized software.)
Today a business can select from a wide array of accounting software
­ ackages. Two popular choices for small businesses are QuickBooks and Sage
p
Peachtree. A quick Internet search for “accounting software” can help you
track down additional options. Unless your company has its own custom
Chapter 3: Using Journal Entries and Ledgers
accounting software and information technology (IT) staff, consider seeking
the advice and assistance of an outside consultant in choosing, implementing,
upgrading, and replacing accounting software. If you don’t have the funds to
hire a consultant, here’s some free advice:
✓ Choose your accounting software very carefully. Switching to a different
accounting program later is a major headache, so choose software that
serves your current needs and provides room to grow.
✓ In evaluating accounting software, you and your accountant should
­consider three main factors: ease of use; whether it has the p
­ articular
features and functionality you need; and the likelihood that the
vendor will continue in business and be around to update and make
­improvements to the software.
✓ Make sure your accounting software leaves good audit trails, which you
need for management control, for your CPA when auditing your financial
statements, and for the IRS when it decides to audit your income tax
returns. The lack of good audit trails looks very suspicious to the IRS.
See Book IX for a discussion of audits.
✓ Pay attention to security features and best practices. You need very
tight controls over all aspects of using the accounting software and who
is authorized to make changes in any of the modules.
Online accounting systems that permit remote input and access
over the Internet or a local area network with multiple users present
­special ­security problems. Think twice before putting any part of your
­accounting system online (and if you do, institute airtight controls).
More and more businesses seem to be switching to the cloud for doing
more and more of their accounting tasks. The cloud consists of a network
of offsite computer servers that users connect with over the Internet. You
can choose to do your accounting in the cloud or use the cloud simply as
the backup storage location for your accounting records. Cloud providers
offer a wide variety of accounting and business software and services that
are too ­numerous to discuss here. Cloud servers have a reputation of being
very secure, but you still need very strong controls over the transmission of
accounting information to and from the cloud.
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Book I: Setting Up Your Accounting System
Chapter 4
Choosing an Accounting Method
In This Chapter
▶ Getting clear on the cash and accrual methods of accounting
▶ Walking through other types of accounting
▶ Finding out about FASB’s conceptual framework
T
o perform accounting tasks, you must choose to follow either of two
methods: cash basis or accrual basis. In addition, you can approach
accounting in several ways, depending on the nature of your business and
the audience that reads your financial statements. For example, businesses
use accounting to track transactions and keep investors informed; and their
managers use accounting to make better decisions. Not-for-profit organizations primarily use accounting to help with budgeting and grant proposals.
Accountants serving government agencies must also focus on budgeting
while providing citizens and government agencies and officials with the
information they need.
This chapter explains the differences between cash and accrual basis
accounting, describes the various ways accounting is used, and introduces
you to the Financial Accounting Standards Board’s Statements of Financial
Accounting Concepts. (If you aren’t familiar with the FASB, check out
Book IV, Chapter 1.) This chapter walks you through some of these concepts,
tying them into material you encounter in Books IV and V.
Distinguishing between Cash
and Accrual Basis
You can’t keep books unless you know how you want to go about doing so.
The two basic accounting methods are cash-basis accounting and accrual
accounting. The key difference between these two accounting methods is the
point at which you record revenue and expenses in your books. If you choose
44
Book I: Setting Up Your Accounting System
cash-basis accounting, you record transactions only when cash changes
hands. If you use accrual accounting, you record revenue when it’s earned, and
expenses when they’re incurred — regardless of when cash changes hands.
The accrual method of accounting allows you to apply the matching principle
of your transactions. This principle states that revenue should be matched
with the expenses incurred to produce the revenue, regardless of when cash
changes hands.
Suppose your company buys products to sell from a vendor but doesn’t
actually pay for those products for 30 days. If you’re using cash-basis
accounting, you don’t record the purchase until you actually lay out the cash
to the vendor. If you’re using accrual accounting, you record the purchase
when you receive the products, and you also record the future debt in an
account called accounts payable.
The following sections describe each method in greater detail along with the
pros and cons of each method.
The cash basis
Cash-basis accounting couldn’t be easier. You record revenue when the
company receives payments, and you record expenses when the company pays
for something. The cash basis is essentially posting accounting transactions by
using your checkbook. Your checkbook deposits for March represent March
revenue, and your checks and debits for March are your expenses for that month.
Missing the matching principle
The ease of using the cash method is more than offset by the fact that the
method fails to match revenue to the expenses the company incurs to earn
that revenue. Because the matching principle isn’t applied, cash basis financial
statements usually don’t present as accurate a picture of how the business is
performing as accrual method financial statements do.
Consider an example. Let’s say ABC Corp. has revenue of $40,000 and
expenses totaling $15,000 associated with that revenue in April. $20,000 of the
revenue was received in cash, and the rest is on account. ABC Corp. paid cash
for the entire $15,000 of expenses. Using the cash method, ABC Corp.’s net
income for April is $5,000 ($20,000 cash revenue less $15,000 cash expenses).
But that $5,000 of net income grossly under-represents the volume of activity
the company had during the month. The figures could be just as wildly inaccurate if the company didn’t pay any of its expenses and had cash sales of
$30,000 — or for any other scenario involving the use of cash changing hands
as a criteria for recording net income.
Chapter 4: Choosing an Accounting Method
45
Adjusting the accounting records
Book I
Some small businesses use the cash method because they have little activity
in the way of accounts receivable or payable. But the vast majority of businesses use the accrual basis, explained in the next section.
Setting
Up Your
Accounting
System
Because of the issues companies encounter with the cash method, most
companies eventually switch to the accrual method. Often a financial statement user insists on the change. Maybe you’re applying for a company bank
loan. Your banker believes that the accrual method provides a more accurate
view of your profit and loss each period. So, the banker asks to see prior year
financials using the accrual period.
As you can imagine, adjusting your accounting records from the cash to accrual
method may take a lot of work. You must review every revenue and expense
transaction and determine whether the accounting needs to be changed.
The accrual basis
Using the accrual method of accounting, you record revenue when it’s earned
and realizable, and you record expenses when they’re incurred — regardless
of whether or when money changes hands. Wondering what the criteria are
for revenue to be earned and realizable? The earned criterion is satisfied
when the vendor satisfactorily performs on its contract with the customer.
Typically, revenue is considered earned when the vendor delivers the goods
or services. Realizable means that the company has good reason to believe
it will receive payment; for example, the customer swipes his debit card and
enters his PIN.
A company can choose the criteria it uses to recognize revenue in the
accounting records. The timing of revenue recognition depends on the company’s industry, as well as the firm’s history of receiving payments. A company
may recognize revenue when it sends an invoice, or when it ships the goods.
Even if the revenue is realizable, the point at which the revenue is considered
earned can vary.
The accrual method takes cash out of the equation, because money changing
hands doesn’t determine whether you recognize a transaction. As a result, a
company using the accrual method has an accounts receivable, which shows
how much money customers owe to the business, and an accounts payable,
which shows all the money a company owes to its vendors.
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Book I: Setting Up Your Accounting System
The statement of cash flows, discussed briefly at the end of this chapter and
explained in detail in Book V, Chapter 2, is the accountant’s bridge between
the cash and accrual methods of accounting. That’s because the statement of
cash flows shows cash sources and uses — an aspect missing from the accrual
method. Therefore, it gives the users of the financial statements a chance to
look beyond and through the accrual-based numbers.
Sorting through Standards for
Other Types of Accounting
Financial accounting is the process of compiling accounting transactions to
create financial statements. Here are some other types of accounting that
accountants may perform:
✓ Managerial accounting: Creating internal accounting reports that company managers use to make decisions.
✓ Not-for-profit accounting: Generating financial statements for not-forprofit entities, using a different set of financial reports. Not-for-profit
firms raise money from donations, grants, and other sources. They don’t
produce revenue primarily from selling a product or service. As a result
their financial reports are different.
✓ Governmental accounting: Like not-for-profits, governments (federal,
state, and local) have a unique method for creating financial statements.
✓ International accounting: The global accounting industry is attempting
to create a single set of accounting standards for international commerce. At this point, countries outside the U.S. maintain at least some
accounting rules that are different. As a result, rules for foreign entities
may differ from U.S. accounting rules.
The following sections explore these different areas of accounting
more closely.
If you work in an accounting field other than financial accounting, you
must follow standards different from (or in addition to) those discussed in
Book IV, Chapter 1. Other organizations besides the financial accounting
standard-setters give official guidance on how to prepare financial statements
and reports. For example, instead of following generally accepted accounting principles (GAAP), governmental entities follow procedures set up by the
Governmental Accounting Standards Board (GASB).
Chapter 4: Choosing an Accounting Method
To find out more about financial accounting, see “Considering the Conceptual
Framework of Financial Accounting,” later in this chapter. The next few sections give you the lowdown on other types of accounting and note who provides guidance to accountants in these fields.
Managerial accounting
Managerial accountants provide economic and financial information for
the internal users of financial statements, such as a company’s department
heads, shift leaders, and human resources department. For example, human
resources personnel use managerial accounting reports to make sure they
have the right mix of employees to maintain a smooth-running operation.
Additionally, managerial accounting reports measure quality, performance,
and how close each department or business unit comes to meeting its goals.
They also measure managerial effectiveness and efficiency.
In order to be useful, managerial reports are issued frequently — sometimes
daily. There’s no messing around! Other times, accounting staff prepare and
distribute the reports the day after a reporting period ends. For internal
reporting to management, the rules are similar to those you follow when
playing horseshoes — getting close is often good enough.
Because managerial reports are used only internally, no regulatory bodies or
other outside agencies mandate how managerial accountants do their job.
Instead, managerial accountants look to the Institute of Management
Accountants (IMA) for guidance on carrying out their accounting duties. The
managerial accountant code of ethics is contained in the Standards of Ethical
Conduct for Management Accountants. For more information, check out the IMA
website at www.imanet.org. To find out more about managerial accounting,
see Managerial Accounting For Dummies by Mark P. Holtzman, CPA (Wiley).
Not-for-profit accounting
Not-for-profit businesses are run for the public good — not driven by any
profit motive. You may consider these entities to be “mission-driven.” Every
not-for-profit has a particular mission that it has defined for itself. These
types of organizations include hospitals, schools, religious organizations, and
charitable agencies.
Net income of an exempt organization isn’t taxed federally. To qualify for
exempt status in the United States, an organization fills out an application package that must be approved by the Internal Revenue Service. After the approval
process, which can take months, the organization is then exempt from paying
the normal taxes levied on a for-profit business by the federal government.
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Book I: Setting Up Your Accounting System
The not-for-profit accountant’s job involves two important components (in
addition to the typical accounting duties): preparing budgets and preparing
the financial information for grant applications. Budgets are crucial because
the organization needs to be able to predict what amount of money it must
obtain through grants, donations, and fundraising efforts in order to serve
the organization’s purpose.
Not-for-profits apply for grants awarded by government entities and private
foundations. The purpose of the grant should fit the organization’s mission. If
your organization promotes trails for hiking and biking, you might apply for a
grant to encourage kids to walk or ride bikes to school. The entity awarding
the grant requests financial information in the grant application and insists
that the not-for-profit report periodically on how the funds are used.
Wondering if not-for-profits also have to report by using accrual basis
accounting and according to FASB and GAAP standards? As explained in
Book IV, Chapter 1, the FASB Accounting Standards Codification is the source
of authoritative GAAP to be applied by all nongovernmental entities. So the
answer is yes, a not-for-profit follows FASB and GAAP unless an FASB pronouncement specifically excludes not-for-profits.
One difference in keeping the books for profit seeking versus not-for-profit
organizations is that not-for-profits use fund accounting, which groups accounting transactions together into funds or accounts that share a similar purpose.
This way, the organization has a better idea of the resources it has available
for each specific function.
If not-for-profit accounting interests you, check out Nonprofit Bookkeeping &
Accounting For Dummies by Sharon Farris (Wiley) for much more information
about this field.
Governmental accounting
Governmental accountants work for city, county, state, and federal government
agencies. Their job is similar to the not-for-profit accountant’s job because
they deal with budgets and government agencies that have no profit motive.
Budgeting is important because budgets serve as the primary tool in allocating
governmental cash sources to urban, suburban, and rural parts of the communities served.
At the city, county, or state level, the cash comes in from sources such as ad
valorem (property) taxes; funding from the federal government such as for
schools, streets, and roads; interdepartmental governmental transfers; fines
and forfeitures; sales and use tax; licenses and permits; and municipal bond
issuances. Funds are then appropriated to cover costs. The appropriations are
either approved or disapproved during the setting of the budget. Finally, disbursements are made throughout the fiscal year for approved budget items.
Chapter 4: Choosing an Accounting Method
Governmental accountants also prepare financial statements that are open
to the general public. The financial statements must show accountability to
citizens while pursuing the goals of efficiency and effectiveness. The financial
statements are also used by external users to decide whether to invest in the
municipality’s bond issuances. The regulatory authority for governmental
accountants is the Governmental Accounting Standards Board (GASB). You
can find out more information about GASB at www.gasb.org.
International accounting
International accountants work for multinational businesses performing
financial and managerial accounting, tax return preparation, and auditing.
(Auditing is the process of investigating financial information prepared by
someone else to see whether it’s stated fairly. Check out Book IX for additional details.) They should be familiar with the legal regulations and standards of the countries in which their employers conduct business.
International accountants have to deal with foreign currency translations,
such as how many U.S. dollars (USD) equal how many euros (EUR). They also
manage two special risks:
✓ Expropriation: The seizure of company assets by the host government
✓ Blocked funds: When the host government doesn’t allow any company
funds to be repatriated to the United States
An important organization for international accountants is the International
Accounting Standards Board (IASB), whose website is www.iasb.org. The
IASB is currently working in tandem with the FASB to provide comparability
between the accounting standards — in other words, to bring U.S. and international GAAP together. This process is referred to as harmonization, and the
purpose is to develop a single set of global accounting standards that will provide high quality, transparent, and comparable financial statement reporting.
Considering the Conceptual Framework
of Financial Accounting
Accounting dates back to the Stone Age as a way of figuring out the supply
and demand of commerce. Long before people had stores and cash registers,
they had to have some way of ensuring an equitable trade of goods for goods
or goods for service. Also, accounting was put to use as far back as the Holy
Roman Empire (and probably even earlier) to make sure that all subjects to
the empire were paying their assessed taxes.
49
Book I
Setting
Up Your
Accounting
System
50
Book I: Setting Up Your Accounting System
As noted in Book IV, Chapter 1, accounting standards were virtually nonexistent until the Great Depression of 1929. And it wasn’t until the mid-1970s
that the Financial Accounting Standards Board (FASB) began the process of
spelling out a framework of financial accounting concepts.
The FASB organizes its conceptual framework in Statements of Financial
Accounting Concepts or Concept Statements. (Accountants use the abbreviation CONs to refer to them.) Financial accounting textbooks usually mention
these CONs only in passing. However, if you’re new to the wonderful world
of financial accounting, these concepts can give you a firm foundation for
understanding financial accounting. The information that comes next provides general background on why financial accounting standards work the
way they do and what they attempt to accomplish.
The following sections provide the condensed version of the concepts, but
first you find out about what financial accounting is attempting to accomplish.
The objective of financial reporting
The purpose of financial accounting is to classify and record all accounting
events taking place during the course of a company’s business. These events
include earning revenue, paying bills, bringing in gains, and incurring losses.
The results of all these events are arranged on the correct financial statement (the balance sheet, income statement, and/or statement of cash flows)
and reported to the external users of the financial statements. External users
include investors, creditors, banks, and regulatory agencies such as the IRS
and the U.S. Securities and Exchange Commission (SEC).
Characteristics of accounting information
Besides organizing accounting events into financial statements, financial
accountants serve the needs of external users by delivering the information
they need in a format they understand. To achieve this goal, accountants
must produce financial reports that exhibit the following characteristics:
✓ Understandability: The information on the financial statement has to
be understandable to people not privy to the internal workings of the
business. The financial information must be laid out in a fashion so that
users with a reasonable understanding of the business world (and a willingness to do research on specific topics as needed) can ferret out all
important accounting facts about the business.
Chapter 4: Choosing an Accounting Method
✓ Relevance: This characteristic means that the financial statements give
the users enough info so they can form opinions about the final outcome
of events that took place in the past and how any present or future events
are likely to shake out. Also, the financial statements should give the
users enough info so that they can tell whether any opinions they made
about future events that have now come to fruition were indeed correct.
✓ Reliability: Financial statements aren’t worth the paper they’re written on
unless the information they present is verifiable, neutral, and materially
correct. For example, if the income statement (see Book IV, Chapter 2)
shows $10 million of sales, that $10 million should represent sales that
actually took place, not projections (or what company management
wants the users to think occurred).
✓ Comparability: Comparability means the quality of the information is
such that users can identify differences and similarities among companies they’re evaluating — or among different financial periods for the
same company. For example, users need to know what method(s) the
companies are using to depreciate assets. Without this knowledge, the
users can’t accurately evaluate the relative worth of one company over
the other. (Head over to Book III, Chapter 1 for more on depreciation.)
✓ Consistency: Consistency means the company uses the same accounting
treatment for the same type of accounting transactions — both within
a certain financial period and among various financial periods. Doing
so allows the user to know that the financial accountant isn’t doing the
accounting equivalent of comparing apples to oranges.
Elements of the financial statements
A primary focus of accounting in the business world centers on the proper
preparation of financial statements: the income statement, balance sheet, and
statement of cash flows. Accountants can’t just stick accounting transaction
data on the statements wherever they feel like. GAAP contains many, many
rules that dictate how information must be organized on the statements (see
Book IV, Chapter 1). These rules pertain to both how the financial accountant
shows the accounting transactions and on which financial statements the
information relating to the transactions appears:
✓ Income statement: This financial statement shows the results of business operations consisting of revenue, expenses, gains, and losses for a
specific period of time. The end product is net income or net loss. Here
are the basic facts on the four different income statement components:
• Revenue: Gross receipts earned by the company selling its goods
or services
• Expenses: The costs to the company to earn the revenue
51
Book I
Setting
Up Your
Accounting
System
52
Book I: Setting Up Your Accounting System
• Gains: Income from non-operating-related transactions, such as
selling a company asset
• Losses: The flip side of gains, such as losing money when selling
the company car
A lot of non-accountants call the income statement a statement of profit
or loss or simply a P&L. These terms are fine to use because they
address the spirit of the statement.
✓ Balance sheet: The balance sheet, which is compiled as of a certain
date, has three sections: assets, liabilities, and equity. Standing on their
own, these sections contain valuable information about a company.
However, a user has to see all three together on the balance sheet to
form an opinion about the company’s operations.
Here are the basics about each balance sheet component:
• Assets: Resources owned by a company, such as cash, equipment,
and buildings
• Liabilities: Debt the business incurs for operating and expansion purposes, such as accounts payable, accrued wages and notes payable
• Equity: The amount of ownership left in the business after deducting total liabilities from total assets
✓ Statement of cash flows: The statement of cash flows, created as of a
specific date, contains certain components of both the income statement and the balance sheet. The purpose of the statement of cash flows
is to show cash sources and uses during a specific period of time — in
other words, how a company brings in cash and what the company uses
that cash for.
Financial statement measurements
Communicating via the financial statements with parties interested in
the business requires the measurement of all accounting transactions.
Measurement refers to the fact that every accounting event must have a cost
or a value in order to be recognized on the financial statements. You may be
confused about the difference between cost and value. Well, you’re not alone.
This issue can be thorny even among seasoned financial accountants.
Depending on their nature, accounting transactions may be recorded in different ways. If a transaction is recorded at historic cost, it shows how much
the company paid in cash or assumed in debt during the transaction. Net realizable value (NRV) can also be used, which is the amount of cash a business
anticipates receiving from an asset in the normal course of business — after
factoring in any related costs. You find all sorts of good information about
historic cost in Book IV, Chapter 3.
Book II
Recording Accounting
Transactions
Check out www.dummies.com/extras/accountingaio for additional
g­ uidance on documenting your accounting transactions to leave a clear audit trail.
In this book…
✓ Manage your accounting system to keep your books balanced.
When you post entries to your accounting system, the total dollar amount of debit entries should equal the credits.
✓ Track purchases, inventory, and costs, and pay your bills. For
many companies, inventory is the largest cost to the
business.
✓ Record sales in cash and store credit and account for discounts, returns, and bad debt. These practices help you calculate total sales correctly.
✓ Prepare and record payroll to keep track of employee compensation and payroll taxes. This is one of the most complex areas
of accounting, because the rules on tax withholdings frequently
change.
✓ Account for Social Security and Medicare taxes, unemployment compensation, and workers’ compensation. Each of these
entities receives reports on payroll withholdings, along with
payments.
Chapter 1
Keeping the Books
In This Chapter
▶ Getting a bird’s-eye view of accounts and transactions
▶ Establishing your accounting system
▶ Closing out at the end of a period
I
ndividuals can get along quite well without much bookkeeping — but
the exact opposite is true for a business. In addition to facilitating dayto-day operations, a company’s bookkeeping system serves as the source
of information for preparing its periodic financial statements, tax returns,
and reports to managers. The accuracy of these reports is critical to the
business’s survival.
Obviously, then, business managers have to be sure that their company’s
bookkeeping and accounting system is dependable and up to snuff. This
chapter shows you what bookkeepers and accountants do, mainly so you
have a clear idea of what it takes to be sure that the information coming
out of the accounting system is complete, timely, and accurate.
Analyzing the Effect of Business
Transactions
This section walks you through the basics of bookkeeping, including the
rule of debits and credits and why proper debiting and crediting keeps the
financial statements in balance. You also discover the five steps for entering
transactions into the accounting records.
Modern financial accounting is a double-entry system: For every entry into the
company accounting records, there has to be an opposite and equal entry. In
other words, debits must always equal credits. Technology gives you a hand
here: No accounting software package worth its salt will let you enter an
unbalanced transaction into the accounting books. For more about
double-entry accounting, see Book I, Chapter 2.
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Book II: Recording Accounting Transactions
Revisiting the fundamental
accounting equation
The fundamental accounting equation (also known as the accounting equation
or the balance sheet equation) requires that all transactions balance when
they’re posted to the equation. It demands that
Assets = Liabilities - Owners’ equity
A truncated version of this equation states
Net assets = Owners’ equity
This version of the equation just moves liabilities over to the other side of the
equal sign; net assets are all assets minus all liabilities. Before you can begin
to set up your accounts and enter transactions, you must have a good grasp
of this fundamental accounting equation, discussed in Book I, Chapter 1.
Getting familiar with accounts
As an accountant within a business, you summarize accounting transactions
into accounts that you use to create financial reports. Every account your
company uses is annotated in a list called the chart of accounts — a list of
all accounts and each account’s balance. The business uses that chart of
accounts to record transactions in its general ledger. The general ledger is
the record of all financial transactions within the company during a
particular accounting cycle. You find out more about the general ledger
later in this chapter.
The chart of accounts isn’t a financial report. It’s merely a list of all accounts
you’ve previously set up to handle the company transactions.
When you’re “doing the books,” as the saying goes, you record your normal
business transactions by using accounts you set up in the chart of accounts.
Each account in the chart of accounts has a unique account number.
Regardless of what accounting software package your company uses, the
numbering sequence is pretty much set in stone to ensure consistency
among companies and among their financial reports. For more about creating
and using a chart of accounts, see the section “Categorizing your financial
information: The chart of accounts,” later in this chapter.
Chapter 1: Keeping the Books
57
Defining debits and credits
When you understand the basics of accounts and the chart of accounts
(see the previous sections), it’s time to find out about the mechanism
of journal entries, which you use to enter financial information into the
company’s accounting records.
Writing journal entries is a major area of concern for small business owners,
first-year accounting students, and students who are taking accounting only
because it’s required for a business degree. The logistics of presenting the
journal entry don’t cause the concern; instead, the worry is how to figure out
which account is debited and which is credited.
Assets and expense accounts are increased with a debit and decreased with a
credit. Liability, revenue, and equity accounts are just the opposite: These
accounts are credited for increases and debited for decreases. There are some
occasional exceptions to these rules. Book III, Chapter 6 explains accumulated
depreciation. This account is a contra-asset, which is an asset account that’s
increased by crediting. Accumulated depreciation is the only exception
discussed in the book.
Knowing more about the transaction
methodology
Before you enter an event into a business accounting system, you have
to consider the transaction methodology, a five-step process for deciding
the correctness of whatever entry you’re preparing. After you get into the
financial accounting rhythm, this process becomes an automatic analysis
you do by rote. Here are your five considerations:
✓ What’s going on? This question addresses the precipitating event for
the entry. For example, did the company buy a new piece of business
equipment or sell some product to a customer?
✓ Which accounts does this event affect? Is the account an asset,
liability, owners’ equity, revenue, or expense? Assets would definitely
be affected by the purchase of business equipment, and revenue would
be affected by a customer sale. To get started, ask yourself whether the
event affects cash. Cash is often the most-used account in your chart of
accounts.
✓ How are the accounts affected — by a debit or credit? Looking back to
your rules of debits and credits, buying assets adds to the account, so
it’s a debit. Making a sale adds to a revenue account, so it’s a credit.
Book II
Recording
Accounting
Transactions
58
Book II: Recording Accounting Transactions
✓ Do all debits for an entry equal all credits for the same entry? Think
about the fundamental accounting equation discussed earlier in this
chapter. Every debit requires an equal credit.
✓ Does the entry make sense? Do the accounting actions you take
match the facts and circumstances of the business event? For example,
although the net effect on the books is the same, you can’t credit an
expense to record revenue.
Each type of account in your chart of accounts has a normal balance. The
normal balance is the balance you expect to see in an account at any point in
time. For example, you debit cash (an asset balance) to increase it. A normal
balance for an asset account is a debit balance. If you review account balances
and notice a credit balance in cash, that fact should be a red flag. It may mean
that your cash account is overdrawn or negative.
Managing Your Bookkeeping and
Accounting System
Too many business managers and owners ignore their bookkeeping and
accounting systems or take them for granted — unless something goes
wrong. They assume that if the books are in balance, everything is okay.
Book I, Chapter 2 covers exactly what having “books in balance” means —
it does not necessarily mean that everything is okay.
To determine whether your bookkeeping system is up to snuff, check out the
following sections, which provide a checklist of the most important elements
of a good system.
Categorizing your financial information:
The chart of accounts
Suppose that you’re the accountant for a corporation and you’re faced with
the daunting task of preparing the annual federal income tax return for the
business. For instance, the Internal Revenue Service (IRS) requires that
you report the following kinds of expenses (and this list contains just the
minimum!):
✓ Advertising
✓ Bad debts
✓ Charitable contributions
✓ Compensation of officers
✓ Cost of goods sold
Chapter 1: Keeping the Books
59
✓ Depreciation
✓ Employee benefit programs
✓ Interest
✓ Pensions and profit-sharing plans
✓ Rents
✓ Repairs and maintenance
✓ Salaries and wages
✓ Taxes and licenses
You must provide additional information for some of these expenses. For
example, the cost of goods sold expense is determined in a schedule that
also requires inventory cost at the beginning of the year, purchases during
the year, cost of labor during the year (for manufacturers), other costs, and
inventory cost at year-end.
Where do you start? For each category of information that you must report,
you need an account, a record of the activities in that category. An account is
basically a focused history of a particular dimension of a business. Individuals
can have accounts, too — for example, your checkbook is an account of
the cash inflows and outflows and the balance of your checking account
(assuming that you remember to record all activities and reconcile your
checkbook against your bank statement). You probably don’t keep a written
account of the coin and currency in your purse, wallet, or pockets, but a
business needs to keep track of all its cash no matter where it is. An account
serves as the source of information for preparing financial statements, tax
returns, and reports to managers.
The formal index or list of all accounts is referred to as the chart of accounts.
The chart of accounts, even for a relatively small business, often contains
more than 100 accounts. Larger business organizations sometimes need
thousands of accounts. The larger the number, the more likely that the
accounts have number codes according to some scheme — for example, all
assets may be in the 100 to 300 range, all liabilities in the 400 to 500 range,
and so on. To get the lowdown on how to set up your chart of accounts,
check out Book I, Chapter 2.
Standardizing source document forms
and processing procedures
Just as humans need a constant circulation of blood to live, businesses
need a constant flow of paperwork. Even in this modern age of the Internet,
electronic communication, and computers, a business generates and depends
on a lot of paperwork. And much of this paperwork is used in the accounting
Book II
Recording
Accounting
Transactions
60
Book II: Recording Accounting Transactions
process. Placing an order to buy products, selling a product to a customer,
determining the earnings of an employee for the month — virtually every
business transaction needs paperwork, generally known as source documents.
Source documents serve as evidence of the terms and conditions agreed
upon by the business and the other person or organization that it’s dealing
with. Both parties receive some kind of source document. For example, for
a sale at a cash register, the customer gets a sales receipt, and the business
keeps a running record of all the transactions in the register, which can be
printed later if need be.
Clearly, an accounting system needs to standardize the forms and procedures
for processing and recording all normal, repetitive transactions and should
control the generation and handling of these source documents. From the
bookkeeping point of view, these business forms and documents are very
important because they provide the input information needed for recording
transactions in the business’s accounts. Sloppy paperwork leads to sloppy
accounting records, which won’t do when the time comes to prepare tax
returns and financial statements.
If you’re the owner of a small business, you may want to check out an office
supply store to see the kinds of forms that you can buy right off the shelf. You
can find many basic forms and documents for executing and recording
business transactions. Also, computer accounting software packages today
include templates for most business forms and source documents that a
business needs.
Hiring competent personnel
A business shouldn’t be penny-wise and pound-foolish: What good is
meticulously collecting source documents if the information on those
documents isn’t entered into your system correctly? You shouldn’t try to
save a few bucks by hiring the lowest-paid people you can find. Bookkeepers
and accountants, like all other employees in a business, should have the
skills and knowledge to perform their functions. Here are some guidelines
for choosing the right people to enter and control the flow of your business’s
data and for making sure that those people remain the right people:
✓ Education and experience: The ideal level of education and experience
for accounting employees can vary greatly. Many accountants
in large business organizations have a college degree with a major in
accounting. This may also be the case for the head of accounting in
a smaller company. However, as you move down the pay scale in any
accounting department, you find that more and more employees don’t
have a college degree and perhaps don’t even have any courses in
Chapter 1: Keeping the Books
61
accounting — they learned bookkeeping methods and skills through
on-the-job training. Even without the degree or formal accounting
coursework, these employees can be very effective workers.
✓ Certifications: When hiring higher-level accountants in a business
organization, decide whether they should be certified public
accountants (CPAs). Larger businesses insist on this credential, along
with a specific number of years’ experience in public accounting. Until
recently, the other main professional accounting credential was the
CMA, or certified management accountant, sponsored by the Institute of
Management Accountants (IMA). The CMA credential is American born
and bred. In contrast, the Chartered Global Management Accountant, or
CGMA designation, is co-sponsored by the American Institute of CPAs
and the British Chartered Institute of Management Accountants. Unlike
the CPA license, the CMA and CGMA designations recognize professional
achievement and experience but the government doesn’t regulate these
credentials.
A business is prudent to require the CPA, CGMA, or CMA credential
for its chief accountant (who usually holds the title of controller).
Alternatively, a business could regularly consult with a CPA in public
practice for advice on its accounting system and on any accounting
problems that arise.
Note: For bookkeepers, the American Institute of Professional
Bookkeepers sponsors the Certified Bookkeeper designation. For more
information, visit www.AIPB.org.
✓ Continuing education: Bookkeepers and accountants need continuing
education to keep up with changes in the income tax law and financial
reporting requirements, as well as changes in how the business
operates. Ideally, bookkeepers and accountants should be able to
spot needed improvements and implement these changes — to make
accounting reports to managers more useful. Fortunately, many courses
are available at reasonable costs for keeping up on the latest accounting
developments. Many continuing education courses are available on the
Internet, but be cautious and check out the standards of any Internet
course. States generally require that CPAs in public practice take 30 to
40 hours per year of continuing education to keep their licenses.
✓ Integrity: Possibly the most important quality to look for is also the
hardest to judge. Bookkeepers and accountants need to be honest
people because of the control they have over your business’s financial
records. Conduct a careful background check when hiring new
accounting personnel. Small-business owners and managers have closer
day-in and day-out contact with their accountants and bookkeepers,
which can be a real advantage — they get to know their accountants
and bookkeepers on a personal level. Even so, you can find many cases
where a trusted bookkeeper has embezzled many thousands of dollars
over the years.
Book II
Recording
Accounting
Transactions
62
Book II: Recording Accounting Transactions
Enforcing strong internal controls
Any accounting system worth its salt should establish and vigorously enforce
effective internal controls — additional forms and procedures over and above
what’s strictly needed to move operations along. These additional procedures
serve to deter and detect errors (honest mistakes) and all forms of dishonesty
by employees, customers, suppliers, and even managers. Unfortunately, many
businesses pay only lip service to internal controls; they don’t put into place
good internal controls, or they don’t seriously enforce their internal controls
(they just go through the motions).
Internal controls are like highway truck weigh stations, which make sure
that a truck’s load doesn’t exceed the limits and that the truck has a valid
license plate. You’re just checking that your staff is playing by the rules.
For example, to prevent or minimize shoplifting, most retailers now have
video surveillance and security tags in or on their merchandise. Likewise,
a business should implement certain procedures and forms to prevent
(as much as possible) theft, embezzlement, kickbacks, fraud, and simple
mistakes by its own employees and managers.
The Sarbanes-Oxley Act of 2002 (see Book IV, Chapter 1) requires that public
companies establish and enforce a special module of internal controls over
their external financial reporting. Although the law applies only to public
companies, some accountants worry that the law’s requirements will have
a trickle-down effect on smaller private businesses as well. Unlikely, but it
could happen.
Many small-business owners tend to think that they’re immune to insider
embezzlement and fraud, especially when the people working for them are
family members or friends. Yet, in fact, many small businesses are hit very
hard by fraud and usually can least afford the consequences. To protect your
business, you should put checks and balances into place to discourage
dishonest practices and to uncover any fraud and theft as soon as possible.
Following are five common internal control procedures you can implement to
protect your business:
✓ Require a second signature on cash disbursements over a certain dollar
amount.
✓ Match receiving reports based on actual counts and inspections of
incoming shipments with purchase orders before cutting checks for
payment to suppliers.
✓ Require both a sales manager’s and another high-level manager’s
approval for write-offs of customers’ overdue receivable balances (that
is, closing the accounts on the assumption that they won’t be collected),
including a checklist of collection efforts that were undertaken.
Chapter 1: Keeping the Books
63
✓ Require that auditors or employees who don’t work in the warehouse
take surprise counts of products stored in the company’s warehouse
and compare the counts with inventory records.
✓ Require mandatory vacations by every employee, particularly
bookkeepers and accountants, during which time someone else does
that person’s job (because a second person may notice irregularities
or deviations from company policies).
Wrapping Up with End-of-Period
Procedures
Suppose that all transactions during the year have been recorded correctly.
Your job’s done, right? Not so fast. Now you need to tidy up those books
and prepare end-of-period reports for management. As you perform those
tasks, you also need to be sure to leave clear audit trails and keep an eye out
for any out-of-the-ordinary events or developments. The following sections
explain what you need to do to wrap it up at the end of a period.
Tidying up the books
Prior to creating financial reports, you need to perform a couple additional
procedures at the end of the period to make sure that the accounts are
correct and complete. After those steps are completed, you can prepare
financial statements and income tax returns for the year. Two main things
have to be done at the end of the period:
✓ Record routine adjusting entries: Depreciation expense isn’t a
transaction that’s recorded during the day-to-day bookkeeping process.
(Book IV, Chapter 2 explains depreciation expense.) You record
depreciation expense at the end of the accounting period (a month or
a year). Accountants refer to these transactions as adjusting entries.
The purpose of adjusting entries is to update and correct the revenue,
income, expense, and loss accounts for the year. Year-end adjusting
entries are necessary to have correct balances for determining profit
for the period.
✓ Review other business developments that may affect the accuracy of
the accounts: Assume a company discontinued a product line during the
year. The product line’s remaining inventory may have to be removed
from the inventory asset account, with a corresponding loss recorded
in the period. Maybe the company settled a long-standing lawsuit, and
the amount of damages needs to be recorded. Layoffs and severance
packages are another example of what the chief accountant needs to
look for before preparing financial reports.
Book II
Recording
Accounting
Transactions
64
Book II: Recording Accounting Transactions
End-of-period accounting procedures can stir up controversy of the heateddebate variety. These procedures require that the accountant make decisions
and judgment calls that upper management may not agree with. For example,
the accountant may suggest recording major losses that would put a big dent
in profit for the year or cause the business to report a loss. The outside CPA
auditor (assuming that the business has an independent audit or review of its
financial statements) often gets in the middle of the argument. These kinds of
debates are precisely why business managers need to know some accounting.
Leaving good audit trails
Good accounting systems leave good audit trails. An audit trail is a clear-cut,
well-marked path of the sequence of events leading up to an entry in the
accounts. The trail starts with the source documents and follows through
to the final posting in the accounts. You create an audit trail so an auditor
can “re-walk” the path. Even if a business doesn’t have an outside CPA do
an annual audit or review, the accountant has frequent occasion to go back
to the source documents. An accountant may need to either verify certain
information in the accounts or reconstruct the information in a different
manner. Suppose that a salesperson is claiming some suspicious-looking
travel expenses; the accountant would probably want to go through all this
person’s travel and entertainment reimbursements for the past year.
If the IRS comes in for a field audit of your income tax return, you’d better
have good audit trails to substantiate all your expense deductions and sales
revenue for the year. The IRS has rules about saving source documents for a
reasonable period of time and having a well-defined process for making
bookkeeping entries and keeping accounts. Think twice before throwing away
source documents too soon. Also, ask your accountant to demonstrate and lay
out for your inspection the audit trails for key transactions, such as cash
collections, sales, cash disbursements, and inventory purchases. Even
computer-based accounting systems recognize the importance of audit trails.
Well-designed computer programs provide the ability to backtrack through
the sequence of steps in the recording of specific transactions.
Staying alert for unusual events
and developments
Business managers should encourage their accountants to stay alert to
anything out of the ordinary that may require attention. Suppose that the
accounts receivable balance for a customer is rapidly increasing — that is,
the customer is buying more and more from your company on credit but isn’t
paying for these purchases quickly. Maybe the customer has switched more
Chapter 1: Keeping the Books
65
of his company’s purchases to your business and is buying more from you
only because he is buying less from other businesses. That’s a good thing. But
maybe the customer is planning to stiff your business. Or maybe the customer
is planning to go into bankruptcy soon and is stockpiling products before the
company’s credit rating heads south. Two really bad things.
Don’t forget internal time bombs: A bookkeeper’s reluctance to take a
vacation could mean that she doesn’t want anyone else looking at the books.
To some extent, accountants have to act as the eyes and ears of the business.
Of course, that’s one of the main functions of a business manager as well, but
the accounting staff can play an important role.
Designing truly useful reports
for managers
End-of-period reports include the three biggies — income statement, balance
sheet, and cash flow statement — and any other financial statements
management requires to do its job. End-of-period reports, when done well,
serve several purposes:
✓ Fulfill government financial reporting requirements
✓ Keep investors posted on the financial state of the business
✓ Keep management posted on the financial state of the business
✓ Provide financial information to managers, so they can make better
business decisions
To produce clear and useful reports, consult management to assess its needs.
Proactively study the manager’s decision-making responsibilities and provide
the information that is most useful, presented in the most easily digestible
manner.
In designing the chart of accounts, keep in mind the type of information
needed for management reports. To exercise control, managers need much
more detail than what’s reported on tax returns and external financial
statements. Consider regrouping expenses into different categories for
management decision-making analysis. A good chart of accounts looks to
both the external and the internal (management) needs for information.
So what’s the answer for a manager who receives poorly formatted reports?
Demand a report format that suits your needs! Books IV and V cover financial
reporting in detail.
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Book II: Recording Accounting Transactions
Chapter 2
Tracking Purchases
In This Chapter
▶ Tracking inventory and monitoring costs
▶ Keeping your business supplied
▶ Paying your bills
I
n order to make money, your business must have something to sell.
Whether you sell products or offer services, you have to deal with costs
directly related to the goods or services you sell. Those costs primarily come
from the purchase or manufacturing of the products you plan to sell or the
items you need in order to provide the services.
All companies must keep careful watch over the cost of the products to be
sold or services to be offered. Ultimately, your company’s profits depend on
how well you manage those costs because, in most cases, costs increase
rather than decrease over time. How often do you find a reduction in the price
of needed items? Doesn’t happen often. If costs increase but the price to the
customer remains unchanged, the profit you make on each sale is less.
In addition to the costs to produce products or services, every business has
additional expenses associated with purchasing supplies needed to run the
business. The bookkeeper has primary responsibility for monitoring all these
costs and expenses as invoices are paid. Bookkeepers can alert company
owners or managers when vendors increase prices. This chapter covers
how to track purchases and their costs, manage inventory, buy and manage
supplies, and pay the bills for your purchases.
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Book II: Recording Accounting Transactions
Keeping Track of Inventory
Products to be sold are called inventory. As a bookkeeper, you use two
accounts to track inventory:
✓ Purchases: Where you record the actual purchase of goods to be sold.
You use this account to calculate the cost of goods sold, which is an item
on the income statement (see Book IV, Chapter 2 for more on the income
statement).
✓ Inventory: Where you track the value of inventory on hand. This value
is shown on the balance sheet as an asset in a line item called inventory
(see Book IV, Chapters 3–5 for more on the balance sheet).
Companies track physical inventory on hand by using one of two methods:
✓ Periodic inventory: Conducting a physical count of the inventory in
the stores and in the warehouse. This count can be done daily, monthly,
yearly, or for any other period that best matches your business needs.
(Many stores close for all or part of a day when they count inventory.)
✓ Perpetual inventory: Adjusting inventory counts as each sale is made.
In order to use this method, you must manage your inventory by using
a computerized accounting system that’s tied into your point of sale
(usually cash registers).
Even if you use a perpetual inventory method, it’s a good idea to
periodically do a physical count of inventory to be sure those numbers
match what’s in your computer system. Because theft, damage, and loss
of inventory aren’t automatically entered in your computer system, the
losses don’t show up until you do a physical count of the inventory you
have on hand.
When preparing your income statement at the end of an accounting period
(whether that period is for a month, a quarter, or a year), you need to
calculate the cost of goods sold in order to determine your profit.
In order to calculate the cost of goods sold, you must first find out how many
items of inventory were sold. You start with the amount of inventory on hand
at the beginning of the month (called beginning inventory), as recorded in
the inventory account, and add the amount of purchases, as recorded in the
purchases account, to find the goods available for sale. Then you subtract
the inventory on hand at the end of the month, which is determined by
counting remaining inventory.
Here’s how you calculate the number of goods sold:
Beginning inventory + Purchases = Goods available for sale – Ending
inventory = Items sold
Chapter 2: Tracking Purchases
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After you calculate goods available for sale, remember that your goods can
end up in only two places: You may sell the goods (cost of goods sold) or have
unsold goods sitting on your shelves (ending inventory).
After you determine the number of goods sold, you compare that number
to the actual number of items sold by the company during that accounting
period, which is based on sales figures collected through the month. If
the numbers don’t match, you have a problem. The mistake may be in the
inventory count, or items may be unaccounted for because they’ve been
misplaced or damaged and discarded. In the worst-case scenario, you may
have a problem with theft by customers or employees. These differences are
usually tracked within the accounting system in a line item called
inventory shrinkage.
Entering initial cost
When your company first receives inventory, you enter the initial cost of that
inventory into the bookkeeping system based on the shipment’s invoice. In
some cases, invoices are sent separately, and only a packing slip is included
in the order. If that’s the case, you should still record the receipt of the
goods, because the company incurs the cost from the day the goods are
received and must be sure it will have the money to pay for the goods when
the invoice arrives and the bill comes due. (You track outstanding bills in the
accounts payable account.)
Entering the receipt of inventory is a relatively easy entry in the bookkeeping
system. For example, if your company buys $1,000 of inventory to be sold,
you make the following record in the books:
Purchases (Asset account)
Accounts payable
Debit
$1,000
Credit
$1,000
The purchases account increases by $1,000 to reflect the additional costs, and
the accounts payable account increases by the same amount to reflect the
amount of the bill that needs to be paid in the future. The purchases account
is used to isolate inventory purchased during the period (month or year).
Purchases are part of the formula to calculate cost of goods sold (Book II,
Chapter 2 explains this formula in detail):
Cost of goods sold = Beginning inventory + Purchases – Ending inventory
When inventory enters your business, in addition to recording the actual
costs, you need more detail about what was bought, how much of each item
was bought, and what each item cost. You also need to track
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Book II: Recording Accounting Transactions
✓ How much inventory you have on hand.
✓ The value of the inventory you have on hand.
✓ When you need to order more inventory.
Tracking these details for each type of product bought can be a nightmare,
especially if you’re trying to keep the books for a retail store. That’s because
you need to set up a special inventory journal with pages detailing purchase
and sale information for every item you carry. (See Book I, Chapter 3 for the
scoop on journals.)
Computerized accounting simplifies this process of tracking inventory.
Details about inventory can be entered initially into your computer
accounting system in several ways:
✓ If you pay by check or credit card when you receive the inventory, you
can enter the details about each item on the check or credit card form.
✓ If you use purchase orders, you can enter the detail about each item on
the purchase order, record receipt of the items when they arrive, and
update the information when you receive the bill.
✓ If you don’t use purchase orders, you can enter the detail about the
items when you receive them and update the information when you
receive the bill.
When you receive inventory with a bill, you can collect the data in a
computerized accounting software program. Similar information is collected
on the software program’s check, credit card, and purchase order forms.
In addition to recording the name of the vendor, date received, and
payment amount, you also record details about the items bought, including
the quantity and cost. When you load each item into the computerized
accounting system, you can easily track cost detail over time.
After you receive the inventory, you then set up an inventory item in the
computerized accounting system. Note that in addition to the item name,
two descriptions are added to the accounting system: One is an abbreviated
version you can use on purchase transactions (to save time), and the
other is a longer description that’s displayed on customer invoices (sales
transactions). You can input a cost and sales price if you want, or you can
leave them at zero and enter the cost and sales prices with each transaction.
If you have a set contract purchase price or sales price on an inventory item,
it saves time to enter it on this form so you don’t have to enter the price each
time you record a transaction. But, if the prices change frequently, it’s best to
leave the space blank so you don’t forget to enter the updated price when you
enter a transaction.
Chapter 2: Tracking Purchases
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Your accounting system should collect information about inventory on hand
and when inventory needs to be reordered. To be sure your store shelves are
never empty, you can enter a number that indicates at what point you want
to reorder inventory. Accountants refer to this point as the reorder point.
When the number of units on hand declines to the reorder point, you order
more product.
After you complete and save the form that records the receipt of inventory,
your accounting software should automatically:
✓ Adjust the quantity of inventory you have in stock.
✓ Increase the asset account called inventory.
Book II
✓ Lower the quantity of items on order (if you initially entered the
information as a purchase order).
Recording
Accounting
Transactions
✓ Average the cost of inventory on hand.
✓ Increase the accounts payable account.
Managing inventory and its value
After you record the receipt of inventory, you have the responsibility of
managing the inventory you have on hand. You also must know the value of
that inventory. You may think that as long as you know what you paid for the
items, the value isn’t difficult to calculate. Well, accountants can’t let it be
that simple, so there are actually four different ways to value inventory:
✓ LIFO (last in, first out): You assume that the last items put on the
shelves (the newest items) are the first items to be sold. Retail stores
that sell nonperishable items, such as tools, are likely to use this type
of system. For example, when a hardware store gets new hammers,
workers probably don’t unload what’s on the shelves and put the newest
items in the back. Instead, the new tools are just put in the front, so
they’re likely to be sold first.
✓ FIFO (first in, first out): You assume that the first items put on the
shelves (the oldest items) are sold first. Stores that sell perishable
goods, such as food stores, use this inventory valuation method
most often. For example, when new milk arrives at a store, the person
stocking the shelves unloads the older milk, puts the new milk at the
back of the shelf, and then puts the older milk in front. Each carton of
milk (or other perishable item) has a date indicating the last day it can
be sold, so food stores always try to sell the oldest stuff first, while it’s
still sellable.
✓ Weighted average: You average the cost of goods received, so there’s no
reason to worry about which items are sold first or last. This method of
inventory is used most often in any retail or services environment where
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Book II: Recording Accounting Transactions
prices are constantly fluctuating and the business owner finds that an
average cost works best for managing the cost of goods sold.
✓ Specific identification: You maintain cost figures for each inventory
item individually. Retail outlets that sell big-ticket items, such as cars,
which often have a different set of extras on each item, use this type of
inventory valuation method.
Accountants are big on consistency. After you choose an accounting method,
you should stick with it. If your accounting method is the same each year, your
financial results will be comparable year-to-year. A financial statement reader
will be able to compare your results and notice trends. If you decide to change
the method, you need to explain the reasons for the change in your financial
statements. You also have to go back and show how the change in inventory
method impacts your prior financial reporting.
Figuring out the best method for you
You may be wondering why it matters so much which inventory valuation
method you use. The key to the choice is the impact on your bottom line as
well as the taxes your company will pay.
The total cost of your inventory and the number of units purchased and sold
are the same — regardless of whether you choose the FIFO, LIFO, or weighted
average method (see the previous section for explanations of these methods).
Also, if prices rise over time (which is normally the case), your newer
inventory items will be more expensive. This analysis assumes that the three
inventory methods use the same sale prices per unit. After all your inventory
items are sold, your total profit will be the same for the three methods.
FIFO, because it assumes the oldest (and most likely the lowest-priced) items
are sold first, results in a low cost of goods sold number. Because cost of
goods sold is subtracted from sales to determine profit, a low cost of goods
sold number produces a high profit. For more on cost of goods sold, see
“Keeping Track of Inventory,” earlier in this chapter.
The opposite is true for LIFO, which uses cost figures based on the last price
paid for the inventory (and most likely the highest price). Using the LIFO
method, the cost of goods sold number is high, which means a larger sum is
subtracted from sales to determine profit. Thus, the profit margin is low. The
good news, however, is that the tax bill is low, too.
Rather than constantly dealing with the ups and downs of inventory costs,
the weighted average method smooths out the numbers used to calculate
a business’s profits. Cost of goods sold, taxes, and profit margins for this
method fall between those of LIFO and FIFO. If you’re operating a business
in which inventory prices are constantly going up and down, you should
definitely choose this method.
Chapter 2: Tracking Purchases
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Comparing the methods
To show you how much of an impact inventory valuation can have on profit
margin, this section compares three of the most common methods: FIFO,
LIFO, and weighted average (see the earlier section “Managing inventory and
its value” for details on each). In this example, assume Company A bought
the inventory in question at different prices on three different occasions.
Beginning inventory is valued at $500 (that’s 50 items at $10 each).
Here’s the calculation for determining the number of items sold (see “Keeping
Track of Inventory”):
Beginning inventory + Purchases = Goods available for sale – Ending
inventory = Items sold
50 + 500 = 550 – 75 = 475
Here’s what the company paid to purchase the inventory:
Date
April 1
April 15
April 30
Quantity
150
150
200
Unit Price
$10
$25
$30
Here’s an example of how you calculate the cost of goods sold by using the
weighted average method:
Account
Beginning inventory
Purchases
Total inventory
Average inventory cost
Cost of goods sold
Ending inventory
Units and Dollar Amounts
50 units
150 units @$10
150 units @$25
200 units @$30
550 units
$11,750 ÷ 550 units = $21.36
475 units × $21.36 = $10,146
75 units @$21.36 = $1,602
Total
$500
$1,500
$3,750
$6,000
$11,750
As mentioned earlier in the section “Keeping Track of Inventory,” your goods
available for sale can end up in only two places: cost of goods sold or ending
inventory. The total inventory listed in the previous table is also goods
available for sale. Your total inventory ($11,750) should equal the sum of cost
of goods sold and ending inventory ($10,146 + $1,602 = $11,748). The slight
difference is due to rounding the weighted average cost per unit. Use this
formula to check any inventory valuation method.
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Book II: Recording Accounting Transactions
Here’s an example of how you calculate the cost of goods sold by using the
FIFO method. With this method, you assume that the first items received are
the first ones sold, and because the first items received here are those in
beginning inventory, this example starts with them:
Account
Beginning inventory
Next in — April 1
Then — April 15
Then — April 30
Cost of goods sold
Ending inventory
Units and Dollar Amounts
50 units @$10
150 units @$10
150 units @$25
125 units @$30
475 units
75 units @$30
Total
$500
$1,500
$3,750
$3,750
$9,500
$2,250
Note: Only 125 of the 200 units purchased on April 30 are used in the FIFO
method. Because this method assumes that the first items into inventory are
the first items sold (or taken out of inventory), the first items used are those
on April 1. Then the April 15 items are used, and finally the remaining needed
items are taken from those bought on April 30. Because 200 were bought on
April 30 and only 125 were needed, 75 of the items bought on April 30 are left
in ending inventory.
Here’s an example of how you calculate the cost of goods sold by using the
LIFO method. With this method, you assume that the last items received are
the first ones sold, and because the last items received were those purchased
on April 30, this example starts with them:
Account
April 30
Next — April 15
Then — April 1
Cost of goods sold
Ending inventory
Units and Dollar Amounts
200 units @$30
150 units @$25
125 units @$10
475 units
75 units @$10
Total
$6,000
$3,750
$1,250
$11,000
$750
Note: Because LIFO assumes the last items to arrive are sold first, the ending
inventory includes the 25 remaining units from the April 1 purchase plus the
50 units in beginning inventory.
Here’s how the use of inventory under the LIFO method impacts the company
profits. The example assumes the items are sold to the customers for $40 per
unit, which means total sales of $19,000 for the month (that’s $40 × 475 units
sold). This example looks only at the gross profit, which is the profit from
sales before considering expenses incurred for operating the company. See
Book IV, Chapter 2 for information about the different profit types and what
they mean. Gross profit is calculated with the following equation:
Sales – Cost of goods sold = Gross profit
Chapter 2: Tracking Purchases
75
Table 2-1 shows a comparison of gross profit for the three methods used
in this example scenario.
Table 2-1
Comparison of Gross Profit Based
on Inventory Valuation Method
Income Statement Line Item
FIFO
LIFO
Weighted Average
Sales
$19,000
$19,000
$19,000
Cost of Goods Sold
$9,500
$11,000
$10,146
Gross Profit
$9,500
$8,000
$8,854
Looking at the comparisons of gross profit, you can see that inventory
valuation can have a major impact on your bottom line. LIFO is likely to give
you the lowest profit because the last inventory items bought are usually
the most expensive. FIFO is likely to give you the highest profit because the
first items bought are usually the cheapest. And the profit produced by the
weighted average method is likely to fall somewhere between the two.
Keep in mind that all three inventory valuation methods generate the same
total cost and total profit, when all the inventory items are sold, as explained
earlier in this section.
Buying and Monitoring Supplies
In addition to inventory, all businesses must buy supplies that are used to
operate the business, such as paper, pens, and paper clips. If the supply
cost can’t be directly traced to the manufacturing or purchase of goods or
services for sale, the cost is immediately expensed.
Your best bet is to carefully track supplies that make a big dent in your budget
with an individual account. For example, if you anticipate paper usage will be
very high, monitor that usage with a separate account called “paper expenses.”
Many companies don’t use the bookkeeping system to manage their supplies.
Instead, they designate one or two people as office managers or supply
managers and keep the number of accounts used for supplies to a minimum.
Other businesses decide they want to monitor supplies by department or
division and set up a supply account for each one. That puts the burden of
monitoring supplies in the hands of the department or division managers.
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Book II: Recording Accounting Transactions
Staying on Top of Your Bills
Eventually, you have to pay for both the inventory and the supplies you
purchase for your business. In most cases, the bills are posted to the
accounts payable account when they arrive, and they’re paid when due.
A large chunk of the cash paid out of your cash account (see Book VIII for
more information on the cash account and handling cash) is in the form of
the checks sent out to pay bills due in accounts payable, so you need to
have careful controls over the five key functions of accounts payable:
✓ Entering the bills to be paid into the accounting system
✓ Preparing checks to pay the bills
✓ Signing checks to pay the bills
✓ Sending out payment checks to vendors
✓ Reconciling the checking account
As you pay bills, you need to take precautions to keep everyone honest and
try to take advantage of any discounts vendors offer for early payment, as
discussed in the following sections.
Segregating duties to prevent theft
Segregation of duties is the process of delegating different tasks to different
people to prevent fraud. To segregate duties, assign one person to each of the
following three roles:
✓ Custodian: An individual in your organization who has physical custody
of assets, such as the checkbook and keys to the company warehouse.
✓ Check signer: The check signer has authority to access or move assets.
When you write a check, you’re moving cash.
✓ Record keeper: After the transaction is completed, the record keeper
records the transaction in the accounting system.
In your business, the person who enters the bills to be paid into the system
probably also prepares the payment checks, but someone else should do the
other tasks. You should never allow the person who prepares the checks to
review the bills to be paid and sign the checks, unless of course that person’s
you, the business owner.
Chapter 2: Tracking Purchases
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Properly managing accounts payable can save your company a lot of money
by avoiding late fees or interest and by taking advantage of discounts offered
for paying early. If you’re using a computerized accounting system, the bill
due date and any discount information should be entered when you receive
the inventory or supplies.
If you’re working with a paper system rather than a computerized accounting
system, you need to set up some way to be sure you don’t miss bill due dates.
Because an increasing number of businesses are using computerized systems,
this book won’t spend more time explaining the nuances of a paper system.
Taking advantage of discounts
In some cases, companies offer a discount to customers who pay their bills
early. Assume a vendor gives you payment terms of “2% 10 Net 30.” That
means that if the bill is paid in 10 days, the vendor company can take a
2 percent discount; otherwise, the amount due must be paid in full in 30 days.
In addition, many companies state that interest or late fees will be charged
if a bill isn’t paid in 30 days.
A firm has an amount due for the bill of $1,000. If the company pays the
bill in ten days, it can take a 2 percent discount, or $20. That may not seem
like much, but if your company buys $100,000 of inventory and supplies in
a month and each vendor offers a similar discount, you can save $2,000.
Over the course of a year, discounts on purchases can save your business a
significant amount of money and improve your profits.
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Book II: Recording Accounting Transactions
Chapter 3
Counting Your Sales
In This Chapter
▶ Taking in cash and offering in-store credit
▶ Staying on top of discounts, returns, and allowances
▶ Monitoring customer payments due
▶ Dealing with bad debt
E
very business loves to take in money, and that means bookkeepers have
a lot to do to make sure sales are properly tracked and recorded in the
books. In addition to recording the sales, you must track customer accounts,
discounts offered to customers, and customer returns and allowances.
Unfortunately, some customers never pay, in which case you must adjust the
books to reflect nonpayment as a bad debt.
This chapter reviews the basic responsibilities that fall to a business’s
­ ookkeeping and accounting staff for tracking sales, making adjustments
b
to those sales, monitoring customer accounts, and alerting management to
slow- and no-paying customers.
Collecting on Cash Sales
Most businesses collect some form of cash as payment for the goods or
­services they sell. Cash receipts include more than just bills and coins;
checks and credit cards also are considered cash sales for the purpose of
bookkeeping. In fact, with electronic transaction processing, a deposit is
usually made to the business’s checking account the same day (sometimes
within just seconds of the transaction, depending on the type of system the
business sets up with the bank).
The only type of payment that doesn’t fall under the umbrella of a cash payment is purchases made on store credit — credit offered to customers directly
by your business rather than through a third party, such as a bank credit card
or loan. See “Selling on Credit,” later in this chapter, for details.
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Discovering the value of sales receipts
Businesses generate sales receipts in one of three ways: by the cash register,
by the credit card machine, or by hand (written out by the salesperson).
Whichever of these three methods you choose for your sales transactions,
the sales receipt serves two purposes:
✓ Gives the customer proof that the item was purchased on a particular
day at a particular price in your store, in case he needs to exchange or
return the merchandise.
✓ Gives the store a receipt that can be used at a later time to enter the
transaction into the company’s books. At the end of the day, the receipts
also are used to prove out the cash register and ensure that the cashier
has taken in the right amount of cash based on the sales made.
You’re probably familiar with cash receipts. To show you how much useable
information can be generated on a sales receipt, here’s a sample receipt from
a sale at a bakery:
Sales Receipt 4/25/2015
Item
Quantity
Price
Total
White Serving Set
Cheesecake, Marble
Cheesecake, Blueberry
1
1
1
$40
20
20
$40
20
20
80.00
4.80
84.80
90.00
5.20
Sales Tax @ 6%
Cash Paid
Change
A look at a receipt, such as this one, tells you the amount of cash collected,
the type of products sold, the quantity of products sold, and the amount of
sales tax collected.
Your company may use some type of computerized system at the point of
sale (usually the cash register) that’s integrated into the company’s accounting system. Sales information is collected throughout the day by the cash register. The automated system can post accounting entries to sales, sales tax
collected, cash, inventory, and other accounts.
Chapter 3: Counting Your Sales
81
If you don’t use a computerized system, you can post accounting entries
manually, based on cash register activity. Here’s what an entry in the cash
receipts journal would look like for the receipt of cash:
Debit
Cash in checking
Sales
Sales tax collected
Cash receipts for April 25, 2015
Credit
$84.80
$80.00
4.80
Here’s an explanation of each line item in the receipts journal
✓ Cash in checking, an asset account on the balance sheet, is debited,
which increases the asset account.
✓ Sales is a revenue account that’s posted to the income statement. The
credit to sales increases the revenue account.
✓ Sales tax collected is a liability account in the balance sheet. (See Book
IV for more about balance sheets and income statements.) The credit to
sales tax collected increases the liability account.
Note that total debits equal total credits ($84.80). This is referred to as a
­balanced entry. Debits and credits are discussed in Book I, Chapter 2.
Businesses pay sales tax to state and local government entities either monthly
or quarterly, depending on rules set by the states. Your business must hold
the money owed in a liability account to be certain you’re able to pay the
taxes collected from customers when they’re due.
Recording cash transactions
in the books
If you’re using a computerized accounting system, you can enter more detail
from the day’s receipts and track inventory sold as well. A standard sales
receipt includes the following key pieces of information:
✓ Customer’s name and address and perhaps the ID number you assign to
that customer
✓ A description of the item(s) sold, along with the number or quantity sold
✓ Payment method; for example, cash, check, credit card, or debit
✓ The option to print the receipt or e-mail it to the client
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Book II: Recording Accounting Transactions
In addition to the information included in the cash receipts journal, a
­computerized accounting system also collects information about the items
sold in each transaction. The system then automatically updates inventory
information, reducing the amount of inventory on hand as product is sold.
When the inventory number falls below the reorder number you set (see
Chapter 2), the accounting system alerts you to pass the word on to whoever
is responsible for ordering more inventory.
If your company accepts credit cards, expect sales revenue to be reduced by
the fees paid to credit card companies. You may face monthly fees as well as
fees per transaction; however, each company sets up individual arrangements
with its bank regarding these fees. Sales volume impacts how much you pay
in fees, so when researching bank services, be sure to compare credit card
­transaction fees to find a good deal. A company records these fees in a credit
card fee expense account.
Selling on Credit
Many businesses decide to sell to customers on direct credit, meaning credit
offered by the business and not through a bank or credit card provider.
This approach offers more flexibility in the type of terms you can offer your
­customers, and you don’t have to pay bank fees. However, it involves more
work for you, the bookkeeper, and more risk if a customer doesn’t pay what
he or she owes.
If you accept a customer’s bank-issued credit card for a sale and the c
­ ustomer
doesn’t pay the bill, you get your money, and the bank is responsible for
­
collecting from the customer and takes the loss if he or she doesn’t pay.
That’s not the case if you decide to offer credit to your customers directly.
If a c
­ ustomer doesn’t pay, your business takes the loss.
Deciding whether to offer store credit
The decision to set up your own store credit system depends on what your
competition is doing. For example, if you run an office supply store and
all other office supply stores allow store credit to make it easier for their
­customers to get supplies, you probably need to offer store credit to stay
competitive.
If you want to allow your customers to buy on store credit, the first thing you
need to do is set up some ground rules. You have to decide
Chapter 3: Counting Your Sales
83
✓ How you plan to check a customer’s credit history
✓ What the customer’s income level needs to be to be approved for credit
✓ How long you give the customer to pay the bill before charging interest
or late fees
✓ What maximum dollar amount you plan to give the customer as a credit
limit
The harder you make it to get store credit and the stricter you make the
bill-paying rules, the less chance you have of a taking a loss. However, you
may lose customers to a competitor with less restrictive credit rules. Keep
in mind that if you loosen your qualification criteria and bill-paying requirements, you have to carefully monitor your customer accounts to be sure
they’re not falling behind. The key risk you face is selling product for which
you’re never paid.
Recording store credit transactions
in the books
When sales are made on store credit, you have to enter specific information
into the accounting system. In addition to inputting information regarding
cash receipts (see “Collecting on Cash Sales” earlier in this chapter), you
update the customer accounts to be sure each customer is billed and the
money is collected. You debit the accounts receivable account, an asset
account shown on the balance sheet (see Book IV), which shows money due
from customers.
Here’s how a journal entry of a sale made on store credit looks:
Debit
Accounts receivable
Sales
Sales tax collected
Cash receipts for April 25, 2015
Credit
$84.80
$80.00
4.80
In addition to making this journal entry, you enter the information into the
customer’s account so that accurate customer statements can be sent out
at the end of the month. When the customer pays the bill, you update the
­individual customer’s record to show that payment has been received and
enter the following into the bookkeeping records:
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Book II: Recording Accounting Transactions
Debit
Cash
Accounts receivable
Payment from S. Smith on invoice 123.
Credit
$84.80
$84.80
You’ll send the customer an invoice (a bill). You see in the previous table
that S. Smith was sent invoice #123. Most of the information on the invoice
is ­similar to the sales receipt form (see “Collecting on Cash Sales”), but the
invoice also has space to enter a different address for shipping (the “ship to”
field) and includes payment terms (the “terms” field).
An automated accounting system uses the information on the invoice form to
update the following accounts:
✓ Accounts receivable
✓ Inventory
✓ The customer’s account
✓ Sales tax collected
When the time comes to bill the customer at the end of the month, your
accounting system can generate statements for all customers with outstanding invoices (unpaid bills). You can easily generate statements for
specific customers or all customers on the books.
When you receive payment from a customer (as you do earlier in the chapter
with the S. Smith invoice), here’s what happens:
1. Accounts receivable is reduced by crediting.
2. Cash is increased with a debit.
3. The customer’s individual account is updated to reflect the payment.
If your company uses a point of sale program that’s integrated into the
­computerized accounting system, recording store credit transactions is even
easier for you. Sales details feed into the system as each sale is made, so you
don’t have to enter the detail at the end of day. These point of sale programs
save a lot of time.
Even if customers don’t buy on store credit, point of sale programs provide
businesses with an incredible amount of information about their customers and what they like to buy. This data can be used in the future for direct
­marketing and special sales to increase return business.
Chapter 3: Counting Your Sales
85
Proving Out the Cash Register
To ensure that cashiers don’t pocket a business’s cash, at the end of each
day, cashiers must prove out cash. This is a process to show that the cashier
has the correct amount of cash in the register. The cash balance changes
based on the sales transactions during the day. The balance is also affected
by the amount of cash, checks, and charges that the cashier took in during
the day.
This process of proving out a cash register actually starts at the end of the
previous day, when cashier John Doe and his manager agree to the amount of
cash left in John’s register drawer. Cash sitting in cash registers or cash drawers is recorded as part of the cash on hand account.
When John comes to work the next morning, he starts out with the amount
of cash left in the drawer. At the end of the business day, either he or his
manager runs a summary of activity on the cash register for the day to
produce a report of the total sales taken in by the cashier. John counts
the amount of cash in his register as well as totals the checks, credit card
receipts, and store credit charges. He then completes a cash-out form that
looks something like this:
Cash Register: John Doe, 4/25/2015
Receipts
Beginning cash
Cash sales
Credit card sales
Store credit sales
Total sales
Sales on credit
Cash received
Total cash in register
Sales
Total
$100
$400
800
200
1,400
1,000
400
500
A store manager reviews John Doe’s cash register summary (produced by
the actual register) and compares it to the cash-out form. If John’s ending
cash (the amount of cash remaining in the register) doesn’t match the cashout form, he and the manager try to pinpoint the mistake. If they can’t find a
mistake, they fill out a cash-overage or cash-shortage form. Some businesses
charge the cashier directly for any shortages; others take the position that
the cashier’s fired after a certain number of shortages of a certain dollar
amount (say, three shortages of more than $10). Most companies post cash
shortages to a shortage expense account.
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Book II: Recording Accounting Transactions
The store manager decides how much cash to leave in the cash drawer or
register for the next day and deposits the remainder. He does this task for
each of his cashiers and then deposits all the cash and checks from the
day in a night deposit box at the bank. He sends a report with details of the
deposit to the bookkeeper so that the data makes it into the accounting
system. The bookkeeper enters the data on the cash receipts form (see the
previous table) if a computerized accounting system is being used or into the
cash receipts journal if the books are being kept manually.
Tracking Sales Discounts
Most businesses offer discounts at some point in order to generate more
sales. Discounts are usually in the form of a sale with 10 percent, 20 percent,
or even more off purchase price.
When you offer discounts to customers, it’s a good idea to track your sales
discounts in a separate account so you can keep an eye on how much you
discount sales in each month. If you find you’re losing more and more money
to discounting, look closely at your pricing structure and competition to find
out why it’s necessary to frequently lower your prices in order to make sales.
You can track discount information very easily by using the data found on a
standard sales register receipt. The following receipt from a bakery includes
sales discount details.
Sales Receipt 4/25/2015
Item
Quantity
Price
Total
White Serving Set
Cheesecake, Marble
Cheesecake, Blueberry
1
1
1
$40
20
20
$40
20
20
80.00
Sales Discount @ 10%
(8.00)
Sales Tax @ 6%
4.32
Cash Paid
Change
80.00
3.68
72.00
76.32
From this example, you can see clearly that the stores take in less cash when
discounts are offered. When recording the sale in the cash receipts journal,
you record the discount as a debit. This debit increases the sales discount
account, which is subtracted from the sales account to calculate the net
Chapter 3: Counting Your Sales
87
sales. (Book IV, Chapter 2 walks you through all these steps and calculations
as it discusses preparing the income statement.) Here’s the bakery’s entry for
this particular sale in the cash receipts journal:
Debit
Cash in checking
Sales discounts
Sales
Sales tax collected
Cash receipts for April 25, 2015
Credit
$76.32
8.00
$80.00
4.32
Book II
If you use a computerized accounting system, add the sales discount as a line
item on the sales receipt or invoice, and the system automatically adjusts the
sales figures and updates your sales discount account.
Recording Sales Returns and Allowances
Most stores deal with sales returns on a regular basis. Instituting a no-return
policy is guaranteed to produce unhappy customers, so to maintain good
customer relations; you should generally allow sales returns.
Sales allowances (sales incentive programs) are becoming more popular with
businesses. Sales allowances are most often in the form of a gift card. A gift
card that’s sold is actually a liability for the company because the company
has received cash, but no merchandise has gone out. For that reason, gift
card sales are entered in a gift card liability account.
When a customer makes a purchase at a later date by using the gift card, the
gift card liability account is reduced (debited) and inventory is also reduced
(with a credit). Monitoring the gift card liability account allows businesses to
keep track of how much is yet to be sold without receiving additional cash.
Accepting sales returns can be a more complicated process than accepting
sales allowances. Usually, a business posts a set of rules for returns that may
include:
✓ Returns will be allowed within only 30 days of purchase.
✓ You must have a receipt to return an item.
✓ If you return an item without a receipt, you can receive only store credit.
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Book II: Recording Accounting Transactions
You can set whatever rules you want for returns. For internal control
­ urposes, the key to returns is monitoring how your staff handles them. In
p
most cases, you should require a manager’s approval on returns. Also, be sure
your staff pays close attention to how the customer originally paid for the
item being returned. You certainly don’t want to give a customer cash if she
paid on store credit — that’s just handing over your money! After a return’s
approved, the cashier returns the amount paid by either cash or credit card.
Customers who bought the items on store credit don’t get any money back.
That’s because they didn’t pay anything when they purchased the item, but
expected to be billed later. Instead, a form is filled out so that the amount
of the original purchase can be subtracted from the customer’s store credit
account.
You use the information collected by the cashier who handled the return to
input the sales return data into the books. For example, a customer returns
a $40 item that was purchased with cash. You record the cash refund in the
cash receipts journal like this:
Debit
Sales returns and allowances
Sales tax collected @ 6%
Cash in checking
To record return of purchase, 4/30/2015.
Credit
$40.00
2.40
$42.40
If the item had been bought with a discount, you’d list the discount as well
and adjust the price to show that discount.
In this journal entry,
✓ The sales returns and allowances account increases. This account
normally carries a debit balance and is subtracted from sales when
­preparing the income statement, thereby reducing revenue received
from customers.
✓ The debit to the sales tax collected account reduces the amount in that
account because sales tax is no longer due on the purchase.
✓ The credit to the cash in checking account reduces the amount of cash.
Chapter 3: Counting Your Sales
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Monitoring Accounts Receivable
Making sure customers pay their bills is a crucial responsibility of the
­bookkeeper. Before sending out the monthly bills, you should prepare an
aging summary report that lists all customers who owe money to the c
­ ompany
and how old each debt is.
If you keep the books manually, you collect the necessary information from
each customer account. If you keep the books in a computerized accounting
system, you can generate this report automatically. Either way, your aging
summary report should look similar to this example report from a bakery:
Aging Summary — As of April 30, 2015
Customer
Current
31–60 Days
S. Smith
J. Doe
H. Harris
M. Man
Totals
$84.32
$46.15
61–90 Days
>90 Days
$65.78
89.54
173.86
46.15
65.78
$125.35
125.35
The aging summary quickly tells you which customers are behind in their
bills. In this example, customers are cut off from future purchases when their
payments are more than 60 days late, so J. Doe and M. Man aren’t able to buy
on store credit until their bills are paid in full.
Give a copy of your aging summary to the sales manager so he can alert staff
to problem customers. He can also arrange for the appropriate collections
procedures. Each business sets up its own collections process, but usually it
starts with a phone call, followed by letters, and possibly even legal action, if
necessary.
Accepting Your Losses
You may encounter a situation in which a customer never pays your business, even after an aggressive collections process. In this case, you have no
choice but to write off the purchase as a bad debt and accept the loss.
Most businesses review their aging reports monthly and decide which
accounts need to be written off as bad debt. Accounts written off are tracked
in a general ledger account called bad debt. (See Book I, Chapter 3 for more
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Book II: Recording Accounting Transactions
information about the general ledger.) The bad debt account appears as an
expense account on the income statement. When you write off a c
­ ustomer’s
account as bad debt, the bad debt account increases (debit), and the
accounts receivable account decreases (credit).
To give you an idea of how you write off an account, assume that one of your
customers never pays the $105.75 due. Here’s what your journal entry looks
like:
Debit
Bad debt
Accounts receivable
Credit
$105.75
$105.75
In a computerized accounting system, you enter the information by using
a customer payment form and allocating the amount due to the bad debt
expense account. Finally, make a note of the bad debt on each customer’s
individual account. Going forward, you’ll know which customers didn’t pay
an invoice. That information will help you make a decision about doing
­business with the customer going forward.
Chapter 4
Processing Employee Payroll
and Benefits
In This Chapter
▶ Hiring employees
▶ Collecting and depositing employee taxes
▶ Keeping track of benefits
▶ Preparing and recording payroll
U
nless your business has only one employee (you, the owner), you’ll
most likely hire employees, and that means you’ll have to pay them,
offer benefits, and manage a payroll.
Responsibilities for hiring and paying employees usually are shared among
the human resources staff and the bookkeeping staff. As the bookkeeper, you
must be sure that all government tax-related forms are completed and handle
all payroll responsibilities including paying employees, collecting and paying
employee taxes, collecting and managing employee benefit contributions,
and paying benefit providers. This chapter examines the various employee
staffing issues that bookkeepers need to be able to manage.
Staffing Your Business
After you decide that you want to hire employees for your business, you
must be ready to deal with a lot of government paperwork. In addition to
paperwork, you face many decisions about how employees will be compensated and who will be responsible for maintaining the paperwork required by
state, local, and federal government entities.
Knowing what needs to be done to satisfy government bureaucracies isn’t
the only issue you must consider before hiring your first employee; you also
must decide how frequently you’ll pay employees and what type of wage and
salary scales you want to set up.
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Book II: Recording Accounting Transactions
Completing government forms
Even before you sign your first employee, you need to start filing government
forms related to hiring. If you plan to hire staff, you must first apply for an
Employer Identification Number, or EIN. Government entities use this number
to track your employees, the money you pay them, and any taxes collected
and paid on their behalf.
Before employees start working for you, they must fill out forms including
the W-4 (tax withholding form), I-9 (citizenship verification form), and W-5
(for employees eligible for the Earned Income Credit). The following sections
explain each of these forms as well as the EIN.
Employer Identification Number (EIN)
Every company must have an EIN to hire employees. If your company is
incorporated (see Book VI, Chapter 2 for the lowdown on corporations and
other business types), which means you’ve filed paperwork with the state
and become a separate legal entity, you already have an EIN. Otherwise, to
get an EIN you must complete and submit Form SS-4, which you can see in
Figure 4-1.
Luckily, the government offers four ways to submit the necessary information
and obtain an EIN. The fastest way is to call the IRS’s Business & Specialty Tax
Line at 800-829-4933 and complete the form by telephone. IRS officials assign
your EIN over the telephone. You can also apply online at www.irs.gov, or
you can download Form SS-4 at www.irs.gov/pub/irs-pdf/fss4.pdf
and submit it by fax or by mail.
In addition to tracking pay and taxes, state entities use the EIN number to
track the payment of unemployment taxes and workers’ compensation taxes,
both of which the employer must pay (see Chapter 5 for details).
W-4
Every person you hire must fill out a W-4 form called the “Employee’s
Withholding Allowance Certificate.” You’ve probably filled out a W-4 at least
once in your life, if you’ve ever worked for someone else. You can download
this form and make copies for your employees at www.irs.gov/pub/
irs-pdf/fw4.pdf.
This form, shown in Figure 4-2, tells you, the employer, how much to take
out of your employees’ paychecks in income taxes. On the W-4, employees
indicate whether they’re married or single. They can also claim additional
allowances if they have children or other major deductions that can reduce
their tax bills. The amount of income taxes you need to take out of each
employee’s check depends upon how many allowances he or she claimed
on the W-4.
Chapter 4: Processing Employee Payroll and Benefits
93
Book II
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Figure 4-1:
You must
file IRS
Form SS-4
to get an
Employer
Identification
Number
before hiring
employees.
Courtesy of IRS
94
Book II: Recording Accounting Transactions
Figure 4-2:
IRS Form
W-4
should be
completed
by all
employees
when
they’re hired
so that you
know how
much to
take out
of their
paychecks
for taxes.
Courtesy of IRS
It’s a good idea to ask an employee to fill out a W-4 immediately, but you can
allow the employee to take the form home if he or she wants to discuss allowances with a spouse or an accountant. If an employee doesn’t complete a W-4,
you must take income taxes out of his or her check based on the highest possible amount for that person. See “Collecting Employee Taxes” later in this chapter.
An employee can always fill out a new W-4 to reflect life changes that impact
the tax deduction. For example, if the employee was single when he started
working for you and gets married a year later, he can fill out a new W-4 and
claim his spouse, lowering the amount of taxes that must be deducted from
his check. Another common life change that can reduce an employee’s tax
deduction is the birth or adoption of a child.
I-9
All employers in the United States must verify that any person they intend
to hire is a U.S. citizen or has the right to work in the United States. As an
employer, you verify this information by completing and keeping on file an I-9
form from U.S. Citizenship and Immigration Services (USCIS). The new hire fills
out Section 1 of the form by providing information, including name and address,
birth history, Social Security number, and U.S. Citizenship or work permit.
You fill out Section 2, which requires you to check for documents that establish identity and prove employment eligibility. Workers can provide a driver’s
license; a military ID, student ID, or official state ID; or a Social Security card,
birth certificate, or U.S. passport. Instructions provided with the form list all
acceptable documents you can use to verify work eligibility. You must complete Section 2 of the I-9; making copies of the employment eligibility documents (IDs) for your files isn’t enough.
Chapter 4: Processing Employee Payroll and Benefits
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Figure 4-3 shows a sample I-9 form. You can download the form and its
instructions from the U.S. Citizenship and Immigration Services website
at www.uscis.gov/files/form/i-9.pdf.
Book II
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Figure 4-3:
U.S.
employers
must verify
a new hire’s
eligibility
to work in
the United
States by
completing
Form I-9.
Courtesy of U.S. Citizenship and Immigration Services
96
Book II: Recording Accounting Transactions
W-5
Some employees you hire may be eligible for the Earned Income Credit (EIC),
which is a tax credit that refunds some of the money the employee would
otherwise pay in taxes, such as Social Security or Medicare. In order to get
this credit, the employee must have a child and meet other income qualifications that are detailed on the form’s instructions.
The government started the EIC credit, which reduces the amount of tax
owed, to help lower-income people offset increases in living expenses and
Social Security taxes. Having an employee complete Form W-5 allows you to
advance the expected savings of the EIC to the employee on his paycheck
each pay period rather than make him wait to get the money back at the
end of the year after filing tax forms. The advance amount isn’t considered
income, so you don’t need to take out taxes on this amount.
As an employer, you aren’t required to verify an employee’s eligibility for the
EIC tax credit. The eligible employee must complete a W-5 each year to indicate that he still qualifies for the credit. If the employee doesn’t file the form
with you, you can’t advance any money to the employee. If an employee qualifies for the EIC, you calculate his paycheck the same as you would any other
employee’s paycheck, deducting all necessary taxes to get the employee’s net
pay. Then you add back in the EIC advance credit that’s allowed.
Any advance money you pay to the employee can be subtracted from the
employee taxes you owe to the government. For example, if you’ve taken out
$10,000 from employees’ checks to pay their income, Social Security taxes, and
Medicare taxes and then returned $500 to employees who qualified for the EIC,
you subtract that $500 from the $10,000 and pay the government only $9,500.
You can find out more about form W-5 and its instructions at www.irs.gov.
Picking pay periods
Deciding how frequently you’ll pay employees is an important point to work
out before hiring staff. Most businesses choose one or more of these four pay
periods:
✓ Weekly: Employees are paid every week, and payroll must be done
52 times a year.
✓ Biweekly: Employees are paid every two weeks, and payroll must be
done 26 times a year.
✓ Semimonthly: Employees are paid twice a month, commonly on the 15th
and last day of the month, and payroll must be done 24 times a year.
✓ Monthly: Employees are paid once a month, and payroll must be done
12 times a year.
Chapter 4: Processing Employee Payroll and Benefits
97
You can choose to use any of these pay periods, and you may even decide to
use more than one type. For example, some companies pay hourly employees
(employees paid by the hour) weekly or biweekly and pay salaried employees
(employees paid by a set salary regardless of how many hours they work)
semimonthly or monthly. Whatever your choice, decide on a consistent pay
period policy and be sure to make it clear to employees when they’re hired.
For each employee who’s paid hourly, you need to have some sort of time
sheet to keep track of work hours. These time sheets are usually completed by
the employees and approved by their managers. Completed and approved
time sheets are then sent to the bookkeeper so that checks can be calculated
based on the exact number of hours worked.
Determining wage and salary types
You have a lot of leeway regarding the level of wages and salary you pay
your employees, but you still have to follow the rules laid out by the U.S.
Department of Labor. When deciding on wages and salaries, you have to first
categorize your employees. Employees fall into one of two categories:
✓ Exempt employees are exempt from the Fair Labor Standards Act
(FLSA), which sets rules for minimum wage, equal pay, overtime pay,
and child labor laws. Executives, administrative personnel, managers, professionals, computer specialists, and outside salespeople can
all be exempt employees. They’re normally paid a certain amount per
pay period with no connection to the number of hours worked. Often,
exempt employees work well over 40 hours per week without extra pay.
✓ Nonexempt employees must be hired according to rules of the FLSA,
meaning that companies within certain parameters must pay a minimum hourly wage. Any nonexempt employee who works more than 40
hours in a seven-day period must be paid a higher hourly rate for the
additional hours worked, often called overtime. Minimum wage doesn’t
have to be paid in cash. The employer can pay some or all of the wage in
room and board provided it doesn’t make a profit on any noncash payments. Also, the employer can’t charge the employee to use its facilities
if the employee’s use of a facility is primarily for the employer’s benefit.
For details about who can be designated an exempt employee, visit the
U.S. Department of Labor’s website at www.dol.gov.
Federal and state minimum wage laws change over time, so be sure to check
with your state department of labor to be certain you’re meeting the wage
guidelines.
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If you plan to hire employees who are under the age of 18, pay attention to
child labor laws. Federal and state laws restrict what kind of work children can
do, when they can do it, and how old they have to be to do it, so be sure you
become familiar with the laws before hiring employees who are younger than
18. For minors below the age of 16, work restrictions are even tighter than for
teens aged 16 and 17. (You can hire your own child without worrying about
these restrictions.)
You can get a good summary of all labor laws at the Business Owner’s Toolkit
online at www.toolkit.cch.com/text/p05_4037.asp.
Collecting Employee Taxes
In addition to following wage and salary guidelines set for your business,
when calculating payroll, you, the bookkeeper, must also be familiar with how
to calculate the employee taxes that must be deducted from each employee’s
paycheck. These taxes include Social Security; Medicare; and federal, state,
and local withholding taxes.
Sorting out Social Security tax
Employers and employees share the Social Security tax equally: Each must
pay a certain percentage of her income toward Social Security up to a specified cap per year per person. The amount an employee earns above the cap
may not be subject to Social Security tax. The federal government adjusts the
cap each year based on salary level changes in the marketplace. Essentially,
the cap gradually increases as salaries increase.
The calculation for Social Security taxes is relatively simple. For example, for
an employee who makes $1,000 per pay period, assuming a rate of 6.2 percent
for Social Security, you calculate Social Security tax this way:
$1,000 × 0.062 = $62
The bookkeeper deducts $62 from this employee’s gross pay, and the company also pays the employer’s share of $62. Thus, the total amount submitted
in Social Security taxes for this employee is $124.
Making sense of Medicare tax
Employees and employers also share Medicare taxes. However, unlike Social
Security taxes, the federal government places no cap on the amount that
must be paid in Medicare taxes. So even if someone makes $1 million per
Chapter 4: Processing Employee Payroll and Benefits
99
year, the Medicare tax percentage is calculated for each pay period and paid
by both the employee and the employer. Here’s an example of how you calculate the Medicare tax for an employee who makes $1,000 per pay period,
assuming a Medicare tax rate of 1.45 percent:
$1,000 × 0.0145 = $14.50
The bookkeeper deducts $14.50 from this employee’s gross pay, and the company also pays the employer’s share of $14.50. Thus, the total amount submitted in Medicare taxes for this employee is $29.
Figuring out federal withholding tax
To avoid dealing with nearly all withholdings from pay, you can hire a payroll
company to handle the task. ADP and Paychex are two large providers of payroll services. You may find that the rate you pay an outside company is far less
than the time and expense of performing this task yourself.
For bookkeepers and accountants, deducting federal withholding taxes is a
much more complex task than deducting Social Security or Medicare taxes.
You not only have to worry about an employee’s tax rate, but also must consider the number of withholding allowances the employee claimed on her
W-4 and whether the employee is married or single. Generally speaking, the
first so many thousands of dollars are taxed at one low rate. As an individual
or couple earns more, that income may bump them into higher tax brackets,
meaning that extra income gets taxed at a higher rate.
Trying to figure out taxes separately for each employee based on his or her
tax rate and number of allowances would be an extremely time-consuming
task, but luckily, you don’t have to do that. The IRS publishes tax tables
in Publication 15, “Employer’s Tax Guide,” that let you just look up an
­employee’s tax obligation based on the taxable salary and withholdings.
You can access the IRS Employer’s Tax Guide online at www.irs.gov/­
publications/p15/index.html. You can find tables for calculating
­withholding taxes at www.irs.gov/publications/p15/ar03.html.
The IRS’s tax tables give you detailed numbers for levels of withholding
allowances. Table 4-1 shows a sample tax table with only seven allowances
because of space limitations. But even with seven allowances, you get the
idea — just match the employee’s wage range with the number of allowances
he or she claims, and the box where they meet contains the amount of that
employee’s tax obligation. For example, if you’re preparing a paycheck for
an employee whose taxable income is $1,000 per pay period, and he claims
three withholding allowances — one for himself, one for his wife, and one
for his child — then the amount of federal income taxes you deduct from his
pay is $106.
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Book II: Recording Accounting Transactions
Table 4-1
Portion of an IRS Tax Table for Employers
If Wages Are:
And the Number of Allowances Claimed Is:
At
Least
But Less
Than
1
2
3
4
5
6
7
$1,000
$1,010
$144
$125
$106
$91
$80
$68
$57
1,010
1,020
146
127
109
92
81
70
59
1,020
1,030
149
130
111
94
83
71
60
Settling up state and local
w­ithholding taxes
In addition to the federal government, most states have income taxes, and
some counties and cities even have local income taxes. You can find all
state tax rates and forms online at www.payroll-taxes.com. If your
state, county, or city has income taxes, they need to be taken out of each
­employee’s paycheck.
Determining Net Pay
Net pay (commonly referred to as take-home pay) is the amount a person is
paid after subtracting all tax and benefit deductions.
After you figure out all the necessary taxes to be deducted from an employee’s paycheck, you can calculate the check amount. Here’s the equation and
an example of how you calculate the net pay amount:
Gross pay – (Social Security + Medicare + Federal withholding tax + State
withholding tax + Local withholding tax + Benefit deductions) = Net pay
1,000 – (62 + 14.50 + 106 + 45 + 0 + 0) = 772.50
Many businesses offer their employees health, retirement, and other benefits
but expect the employees to share a portion of those costs. The fact that some
of these benefits are tax deductible and some aren’t makes a difference in
when you deduct the benefit costs. If an employee’s benefits are tax deductible and taken out of the check before federal withholding taxes are calculated,
the federal tax rate may be lower than if the benefits are deducted after calculating federal withholding taxes. Many states follow the federal government’s
lead on tax-deductible benefits, so the amount deducted for state taxes will be
lower as well.
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Surveying Your Benefits Options
Benefits include programs that you provide your employees to better their
lives, such as health insurance and retirement savings opportunities. Some
benefits are tax-exempt, which means that the employee isn’t taxed for them.
However, some benefits are taxable, so the employee has to pay taxes on the
money or the value of the benefits received. This section reviews the different tax-exempt and taxable benefits you can offer your employees.
Tax-exempt benefits
Some benefits are tax-exempt (not taxed). In some cases, healthcare and
retirement benefits are tax-exempt. You may have a flexible spending plan at
work, for example. Your company provides tax-exempt payments that you
can use to pay for medical expenses. In fact, accident and health benefits
and retirement benefits make up the largest share of employers’ pay toward
employees’ benefits. If the benefits are tax-exempt, anything an employee
pays toward them is deducted from the gross pay, so the employee doesn’t
have to pay taxes on that part of his salary or wage. The rules change frequently, so check with a tax advisor.
For example, if an employee’s share of tax-exempt health insurance is $50 per
pay period and he makes $1,000 per pay period, his taxable income is actually
$1,000 minus the $50 health insurance premium contribution, or $950. As the
bookkeeper, you calculate taxes in this situation on $950 rather than $1,000.
Employee contributions to the retirement plan you offer may be tax deductible, too. Here’s an example, assuming the tax deduction is allowed: If an
employee contributes $50 per pay period to your company’s 401(k) retirement plan, that $50 can also be subtracted from the employee’s gross pay
before you calculate net pay. So if an employee contributes $50 to health
insurance and $50 to retirement, the $1,000 taxable pay is reduced to only
$900 taxable pay.
You can offer a myriad of other benefits to employees, as well, including:
✓ Adoption assistance: You can provide up to a certain cap per child that
an employee plans to adopt without having to include that amount in
taxable gross income. The value of this benefit must be included when
calculating Social Security and Medicare taxes, however.
✓ Athletic facilities: You can offer your employees the use of a gym on
premises your company owns or leases without having to include the
value of the gym facilities in gross pay. In order for this benefit to qualify
as tax-exempt, the facility must be operated by the company primarily
for the use of employees, their spouses, and their dependent children.
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✓ Dependent care assistance: You can help your employees with dependent care expenses, which can include children and elderly parents, provided you offer the benefit in order to make it possible for the employee
to work.
✓ Education assistance: You can pay employees’ educational expenses
up to a certain amount without having to include that payment in gross
income.
✓ Employee discounts: You can offer employees discounts on the company’s products without including the value of the discounts in their gross
pay, provided the discount isn’t more than 20 percent less than what’s
charged to customers.
✓ Group term life insurance: You can provide group term life insurance
up to a specified coverage level to your employees without including the
value of this insurance in their gross pay. Premiums for coverage above the
cap may be added to calculations for Social Security and Medicare taxes.
✓ Meals: Meals that have little value (such as coffee and doughnuts) don’t
have to be reported as taxable income. Also, occasional meals brought
in so employees can work late don’t have to be reported in employees’
income.
✓ Moving expense reimbursements: If you pay moving expenses for
employees, you don’t have to report these reimbursements as employee
income as long as the reimbursements are for items that would qualify
as tax-deductible moving expenses on an employee’s individual tax
return. Employees who have been reimbursed by their employers can’t
deduct the moving expenses for which the employer paid.
Again, check with a tax professional on the deductibility and taxability of
these benefits.
Taxable benefits
You may decide to provide some benefits that are taxable. These benefits may
include the personal use of a company automobile, life insurance premiums
for coverage over the cap, and benefits that exceed allowable maximums.
Dealing with cafeteria plans
Cafeteria plans are benefit plans that offer employees a choice of benefits
based on cost. Employees can pick and choose from those benefits and put
together a benefit package that works best for them within the established
cost structure.
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Cafeteria plans are becoming more popular among larger businesses, but
not all employers decide to offer their benefits this way. Managing a cafeteria plan can be much more time consuming for the bookkeeping and human
resources staff. Many small businesses that offer a cafeteria plan for benefits
do so by outsourcing benefit management services to an outside company
that specializes in managing cafeteria plans.
For example, a company tells its employees that it will pay up to $5,000 in
benefits per year and values its benefit offerings this way:
Health insurance
Retirement
Child care
Life insurance
$4,600
1,200
1,200
800
Joe, an employee, then picks from the list of benefits until he reaches $5,000.
If Joe wants more than $5,000 in benefits, he pays for the additional benefits
with a reduction in his paycheck.
The list of possible benefits could be considerably longer, but in this case, if
Joe chooses health insurance, retirement, and life insurance, the total cost is
$6,600. Because the company pays up to $5,000, Joe needs to copay $1,600,
a portion of which is taken out in each paycheck. If Joe gets paid every two
weeks for a total of 26 paychecks per year, the deduction for benefits from his
gross pay (with rounding) is $61.54 ($1,600 ÷ 26).
Preparing Payroll and Posting
It in the Books
When you know the details about your employees’ withholding allowances
and their benefit costs, you can then calculate the final payroll and post it to
the books.
Calculating payroll for hourly employees
When you’re ready to prepare payroll for nonexempt (hourly) employees,
the first thing you need to do is collect time records from each person who
is paid hourly. Some companies use time clocks, and some use time sheets
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to produce the required time records. Whatever method is used, the m
­ anager
of each department usually reviews the time records for each employee
supervised. After the manager’s review, he or she sends those time records
to you, the bookkeeper.
With time records in hand, you have to calculate gross pay for each
employee. For example, if a nonexempt employee worked 45 hours and is
paid $12 an hour, you calculate gross pay like so:
40 regular hours × $12 per hour = $480
5 overtime hours × $12 per hour × 1.5 overtime rate = $90
$480 + $90 = $570
In this case, because the employee isn’t exempt from the FLSA (see
“Determining wage and salary types” earlier in this chapter), overtime
must be paid for any hours worked over 40 in a seven-day workweek. This
employee worked five hours more than the 40 hours allowed, so assume he
needs to be paid at time plus one-half (the hourly rate paid over 40 hours
may change).
Doling out funds to salaried employees
In addition to preparing payroll for hourly employees, you also must prepare payroll for salaried employees. Paychecks for salaried employees are
relatively easy to calculate — all you need to know are their base salaries
and their pay period calculations. For example, if a salaried employee makes
$30,000 per year and is paid twice a month (totaling 24 pay periods), that
employee’s gross pay is $1,250 for each pay period.
Totaling up for commission checks
Running payroll for employees paid based on commission can involve complex calculations. To show you a number of variables, this section calculates
a commission check based on a salesperson who sells $60,000 of product
during one month.
For a salesperson on a straight commission of 10 percent, you calculate pay
by using this formula:
Total amount sold × Commission percentage = Gross pay
$60,000 × 0.10 = $6,000
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For a salesperson with a guaranteed base salary of $2,000 plus an additional
5 percent commission on all products sold, you calculate pay by using this
formula:
Base salary + (Total amount sold × Commission percentage) = Gross pay
$2,000 + ($60,000 × 0.05) = $5,000
Although this employee may be happier having a base salary he can count on
each month, he actually makes less with a base salary because the commission rate is so much lower. By selling $60,000 worth of products, he earned
only $3,000 in commission at 5 percent. Without the base pay, he would have
made 10 percent on the $60,000 or $6,000. The salesperson actually got paid
$1,000 less with a base pay structure that includes a lower commission pay
rate.
If he has a slow sales month of just $30,000 worth of products sold, his pay
would be:
$30,000 × 0.10 = $3,000 on straight commission of 10 percent
and
$30,000 × 0.05 = $1,500 plus $2,000 base salary, or $3,500
For a slow month, the salesperson would make more money with the base
salary than with the higher commission rate.
There are many other ways to calculate commissions. One common way is
to offer higher commissions on higher levels of sales. Using the figures in the
next example, this type of pay system encourages salespeople to keep their
sales levels over $30,000 to get the best commission rate.
With a graduated commission scale, a salesperson can make a straight commission of 5 percent on his first $10,000 in sales, then 7 percent on his next
$20,000, and finally 10 percent on anything over $30,000. Here’s what his
gross pay calculation looks like, using this commission pay scale:
($10,000 × 0.05) + ($20,000 × 0.07) + ($30,000 × 0.10) = $4,900 Gross pay
One other type of commission pay system involves a base salary plus tips.
This method is common in restaurant settings in which servers receive
between $2.50 and $5 per hour plus tips.
Businesses that pay less than minimum wage must prove that their employees
make at least minimum wage when tips are accounted for. Today, that’s relatively easy to prove because most people pay their bills with credit cards and
include tips on their bills. Businesses can then come up with an average tip
rate by using that credit card data.
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Employees must report tips to their employers on an IRS Form 4070, Employee’s
Report of Tips to Employer, which is part of IRS Publication 1244, Employees
Daily Record of Tips and Report to Employer. If your employees receive tips
and you want to supply the necessary paperwork, you can download it at
www.irs.gov/pub/irs-pdf/p1244.pdf. The publication provides details
about what the IRS expects you and your employees to do if they work in an
environment where tipping is common.
As an employer, you must report an employee’s gross taxable wages based
on salary plus tips. Here’s how you calculate gross taxable wages for an
employee whose earnings are based on tips and wages:
Base wage + Tips = Gross taxable wages
($3 × 40 hours per week) + $300 = $420
If your employees are paid by using a combination of base wage plus tips,
you must be sure that your employees are earning at least the minimum wage
rate. Checking this employee’s gross wages, the hourly rate earned is $10.50
per hour.
Hourly wage = $10.50 ($420 ÷ 40)
Taxes due are calculated on the base wage plus tips, so the check you prepare
for the employee in this example is for the base wage minus any taxes due.
Putting it together to prepare payroll
After calculating paychecks for all your employees, you prepare the payroll,
make up the checks, and post the payroll to the books. In addition to cash,
many accounts are impacted by payroll, including:
✓ Accrued federal withholding payable, where you record the liability for
future federal tax payments.
✓ Accrued state withholding payable, where you record the liability for
future state tax payments. Many companies have withholding accounts
for FICA, Medicare, local taxes, and other categories.
✓ Accrued employee medical insurance payable, where you record the
liability for future medical insurance premiums.
✓ Accrued employee elective insurance payable, where you record the
liability for miscellaneous insurance premiums, such as life or accident
insurance.
When you post the payroll entry, you indicate the withdrawal of money from
the cash account as well as record liabilities for future cash payments that
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107
will be due for taxes and insurance payments. As an example of the proper
setup for a payroll journal entry, assume the total payroll is $10,000 with
$1,000 set aside for each type of withholding payable. In reality, your numbers will be much different, and your payables will probably never be all the
same. Here’s what your journal entry for posting payroll should look like:
Salaries and wages expense
Accrued federal withholding payable
Accrued state withholding payable
Accrued medical insurance payable
Accrued elective insurance payable
Cash
To record payroll for May 27, 2015.
Debit
$10,000
Credit
$1,000
1,000
1,000
1,000
6,000
In this entry, you increase the expense account for salaries and wages as
well as all the accounts in which you accrue future obligations for taxes and
employee insurance payments.
When cash payments are made for the taxes and insurance payments, you
post those payments in the books. Here’s an example of the entry you would
post to the books after making the federal withholding tax payment:
Debit
Accrued federal withholding payable
$1,000
Cash in checking
To record the payment of May federal taxes for employees.
Credit
$1,000
Depositing Employee Taxes
Any taxes collected on behalf of employees must be deposited in a financial
institution authorized to collect those payments for the government or in
the Federal Reserve Bank in your area. Most major banks are authorized to
collect these deposits; check with your bank to see whether it is or to get a
recommendation of a bank you can use. IRS Form 8109, Federal Tax Deposit
(FTD) Coupon, is the coupon businesses use to deposit taxes. You can’t
get a copy of this form online; it’s available only from the IRS or a bank that
­handles your deposits.
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Form 8109 can be used to deposit many different kinds of federal payments,
including:
✓ Form 941, Employer’s Quarterly Federal Tax Return (includes federal
withholding taxes, Social Security taxes, and Medicare taxes)
✓ Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return
✓ Form 1120, U.S. Corporation Income Tax Return
When depositing funds by using Form 8109, be sure to include the EIN and
name of the company on the coupon as well as the form number related to the
payment. The IRS tracks payments by EIN number and form number filed.
For the purposes of tax payments collected from employees for the federal
government, you must complete Form 941, which is shown in Figure 4-4. This
form summarizes the tax payments made on behalf of employees. You can get
instructions and Form 941 online at www.irs.gov — just search on the site
for the term “Form 941.” (For more about the various forms employers must
file, see Chapter 5.)
During the first year as an employer, the company will have to make monthly
deposits of employee taxes. Monthly payments must be made by the 15th
day of the month following when the taxes were deducted. For example, taxes
collected from employees in April must be paid by May 15. If the date the
deposit is due falls on a weekend or bank holiday, the payment is due on the
next day the banks are open.
As your business grows, you may need to make more frequent deposits. You
can also make employee tax payments electronically by using the Electronic
Federal Tax Payment System (EFTPS). To find out more, check out IRS
Publication 15 at www.irs.gov.
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Figure 4-4:
Employers
must file
Form 941 to
report taxes
collected
on behalf of
employees.
110
Book II: Recording Accounting Transactions
Figure 4-4:
(continued)
Courtesy of IRS
Chapter 5
Computing and Reporting
Payroll Taxes
In This Chapter
▶ Tallying the employer’s share of Social Security and Medicare
▶ Filing and paying unemployment taxes
▶ Figuring out workers’ compensation
▶ Keeping accurate employee records
A
fter your company hires employees, you need to complete regular
reports for the government regarding the taxes you must pay toward
the employees’ Social Security and Medicare, as well as unemployment taxes.
In most states, employers also are required to buy workers’ compensation
insurance based on employees’ salary and wages.
This chapter reviews the federal, state, and local government reporting
requirements for employers as well as the records you, the accountant, must
keep in order to complete these reports. You also find out about the requirements for buying workers’ compensation insurance.
Paying Employer Taxes on Social
Security and Medicare
In the United States, both employers and employees must contribute to
the Social Security and Medicare systems. In most cases, employers share
equally with employees the tax obligation for both Social Security and
Medicare.
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As discussed in Chapter 4, the employer and the employee each must pay
a certain percentage of an employee’s compensation for Social Security.
Employer and employee must also pay a percentage of wages toward
Medicare.
When you finish calculating payroll checks, you calculate the employer’s portion of Social Security and Medicare. When you post the payroll to the books,
you set aside the employer’s portion of Social Security and Medicare in an
accrual account.
Filing Form 941
Each quarter you must file federal Form 941, Employer’s Federal Tax Return,
which details the number of employees who received wages, tips, or other
compensation for the quarter. In Chapter 4, you can see what the form looks
like. Table 5-1 shows you what months are reported during each quarter and
when the reports are due.
Table 5-1
Filing Requirements for Employer’s Quarterly
Federal Tax Return (Form 941)
Months in Quarter
Report Due Date
January, February, March
On or before April 30
April, May, June
On or before July 31
July, August, September
On or before October 31
October, November, December
On or before January 31
The following key information must be included on Form 941:
✓ Number of employees who received wages, tips, or other compensation
in the pay period
✓ Total of wages, tips, and other compensation paid to employees
✓ Total tax withheld from wages, tips, and other compensation
✓ Taxable Social Security and Medicare wages
✓ Total paid out to employees in sick pay
✓ Adjustments for tips and group-term life insurance
✓ Amount of income tax withholding
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113
✓ Advance earned income credit payments made to employees (see
Chapter 4 for an explanation)
✓ Amount of tax liability per month
Knowing how often to file
As an employer, you file Form 941 on a quarterly basis, but you may have to
pay taxes more frequently. Most new employers start out making monthly
deposits for taxes due by using Form 8109 (shown in Chapter 4), which is a
payment coupon that your company can get from a bank approved to collect
deposits or from the Federal Reserve branch near you. Others make deposits
online by using the IRS’s Electronic Federal Tax Payment System (EFTPS). For
more information on EFTPS, go to www.eftps.gov.
Employers on a monthly payment schedule (usually small companies) must
deposit all employment taxes due by the 15th day of the following month.
For example, the taxes for the payroll in April must be paid by May 15. Larger
employers must pay taxes more frequently, depending on the number of
workers employed and the dollar amount of payroll.
Completing Unemployment Reports and
Paying Unemployment Taxes
As an employer, you’re responsible for paying a share of unemployment compensation based on your record of firing and laying off employees. The fund
you pay into is known as the Federal Unemployment Tax Act (FUTA) fund. For
FUTA, employers pay a percentage rate based on each employee’s earnings.
The employee earnings are capped at a certain dollar amount. So, even
though each employee earns a different level of salary, FUTA taxes are calculated only on the first dollars each employee earns. As of this writing, the cap
for FUTA taxes is on the first $7,000 of income.
States also collect taxes to fill their unemployment fund coffers. The federal
government allows you to subtract a portion of the state unemployment payments from your federal contributions. Essentially, the amount you pay to
the state can serve as a credit toward the amount you must pay to the federal
government.
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Each state sets its own unemployment tax rate. Many states also charge additional fees for administrative costs and job-training programs. You can check
out the full charges for your state at payroll-taxes.com.
How states calculate the FUTA tax rate
States use four different methods to calculate how much you may need to
pay in FUTA taxes:
✓ Benefit ratio formula: The state looks at the ratio of benefits collected
by former employees to your company’s total payroll over the past three
years. States also adjust your rate depending upon the overall balance in
the state unemployment insurance fund.
✓ Benefit wage formula: The state looks at the proportion of your company’s
payroll that’s paid to workers who become unemployed and receive benefits, and then divides that number by your company’s total taxable wages.
✓ Payroll decline ratio formula: The state looks at the decline in your
company’s payroll from year to year or from quarter to quarter.
✓ Reserve ratio formula: The state keeps track of your company’s balance in the unemployment reserve account, which gives a cumulative
representation of its use by your former employees who were laid off
and paid unemployment. This recordkeeping dates back from the date
you were first subject to the state unemployment rate. The reserve
account is calculated by adding up all your contributions to the account
and then subtracting total benefits paid. This amount is then divided by
your company’s total payroll. The higher the reserve ratio, the lower the
required contribution rate.
These formulas can be very complicated, so your best bet is to contact your
state’s unemployment office to review how your company’s unemployment
rate will be set. In addition to getting a better idea of what may impact your
FUTA tax rate, you can also discuss how best to minimize that rate.
Calculating FUTA tax
After you know what your rate is, calculating the actual FUTA tax you owe
isn’t difficult. Here’s what you do:
1. Multiply $7,000 by the federal unemployment tax rate to determine
how much you owe per employee in federal unemployment. That
$7,000 is the cap on earnings, which was discussed earlier.
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2. Multiply the result from Step 1 by the number of employees to determine the total federal unemployment tax you owe. If the state rate is
lower than the federal rate, you’re done. You pay the federal program
the federal calculation, less the amount you pay into the state unemployment fund. If the state rate is higher than the federal rate, proceed
to Step 3.
3. Subtract the state rate from the federal rate.
4. Multiply the result from Step 3 by $7,000 to determine the additional
amount of state unemployment tax you must pay per employee.
5. Multiply the result from Step 4 by the number of employees.
6. Add the amounts from Steps 2 and 5.
Here’s an example, assuming a state tax rate of 2.7 percent and a federal rate
of 6.2 percent:
State unemployment taxes:
$7,000 × 0.027 = $189 per employee
$189 × 10 employees = $1,890
Federal unemployment taxes:
$7,000 × 0.062 = $434
$434 × 10 employees = $4,340
Because the federal rate is higher than the state rate, you can subtract the
amount in state unemployment tax you owe from the total. In this case, you
would pay $1,890 to the state, and $2,450 ($4,340 – $1,890) to the federal
unemployment fund.
Each year, you must file IRS Form 940 Federal Unemployment (FUTA) Tax
Return, shown in Figure 5-1. You can find Form 940 online at www.irs.gov/
pub/irs-pdf/f940.pdf.
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Figure 5-1:
Employers
report their
FUTA tax on
Form 940.
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Figure 5-1:
(continued)
Courtesy of IRS
You can pay taxes for Form 940 by using the same coupon (Form 8109) used
to pay Form 941 taxes (see “Filing Form 941” earlier in this chapter for an
­explanation). Most employers pay unemployment taxes quarterly.
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Filing and paying unemployment taxes
to state governments
Many states collect their unemployment taxes on a quarterly basis, and most
states allow you to pay your unemployment taxes online. Check with your
state to find out how to file and make unemployment tax payments.
Unfortunately, the filing requirements for state unemployment taxes may be
more difficult to complete than those for federal taxes (see the discussion of
Federal Form 940 in the previous section). States require you to detail each
employee by name and Social Security number. The state must know how
much an employee was paid each quarter in order to determine his or her
unemployment benefit, if the need arises. Some states also require you to
report the number of weeks an employee worked in each quarter because the
employee’s unemployment benefits are calculated based on the number of
weeks worked.
Each state has its own form and filing requirements. Some states require a
detailed report as part of your quarterly wage and tax reports. Other states
allow a simple form for state income tax and a more detailed report with your
unemployment tax payment.
Carrying Workers’ Compensation
Insurance
Taxes aren’t the only thing you need to worry about when figuring out your
state obligations after hiring employees. Nearly every state requires employers to carry workers’ compensation insurance, which covers your employees
in case they’re injured on the job.
If an employee gets hurt on the job, workers’ compensation covers costs of
lost income, medical expenses, vocational rehabilitation, and, if applicable,
death benefits. Each state sets its own rules regarding how much medical
coverage you must provide. If the injury also causes the employee to miss
work, the state determines the percentage of the employee’s salary you must
pay and how long you pay that amount. If the injury results in the employee’s
death, the state also sets the amount you must pay toward funeral expenses
and the amount of financial support you must provide the employee’s family.
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Each state makes up its own rules about how a company must insure itself
against employee injuries on the job. Some states create state-based workers’
compensation funds to which all employers must contribute. Other states
allow you the option of participating in a state-run insurance program or
buying insurance from a private company. A number of states permit employers to use HMOs, PPOs, or other managed-care providers to handle workers’
claims.
If your state doesn’t have a mandatory state pool, you have some other
resources to obtain workers’ compensation insurance coverage. States set
the requirements for coverage, and either a national rating bureau called the
National Council on Compensation Insurance (NCCI) or a state rating bureau
establishes the premiums. For the lowdown on NCCI and workers’ compensation insurance, visit www.ncci.com.
You may find lower rates over the long term if your state allows you to buy
private workers’ compensation insurance. Many private insurers give discounts to companies with good safety standards in place and few past claims.
So the best way to keep your workers’ compensation rates low is to encourage safety and minimize your company’s claims.
Your company’s rates are calculated based on risks identified in two areas:
✓ Classification of the business: These classifications are based on historic rates of risk in different industries. For example, if you operate a
business in an industry that historically has a high rate of employee
injury, such as a construction business, your base rate for workers’
compensation insurance is higher than that of a company in an industry
without a history of frequent employee injury, such as an office that sells
insurance.
✓ Classification of the employees: The NCCI publishes classifications of
hundreds of jobs in a book called the Scopes Manual. Most states use
this manual to develop the basis for their classification schedules. For
example, businesses that employ most workers at desk jobs pay less in
workers’ compensation than businesses with a majority of employees
operating heavy machinery.
Be careful how you classify your employees. Many small businesses pay
more than needed for workers’ compensation insurance because they
misclassify employees. Be sure you understand the classification system
and properly classify your employee positions before applying for workers’ compensation insurance. Be sure to read the information at www.
ncci.com before classifying your employees.
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When computing insurance premiums for a company, the insurer (whether
the state or a private firm) looks at employee classifications and the rate of
pay for each employee. For example, consider the position of an administrative assistant who earns $25,000 per year. If that job classification is rated at
29 cents per $100 of income, the workers’ compensation premium for that
employee is:
($25,000 ÷ 100) × 0.29 = $72.50
Most states allow you to exclude any overtime paid when calculating workers’
compensation premiums. You may also be able to lower your premiums by
paying a deductible on claims. A deductible is the amount you would have to
pay before the insurance company pays anything. Deductibles can lower your
premium by as much as 25 percent, so consider that as well to keep your
upfront costs low.
Maintaining Employee Records
When you consider all the state and federal filing requirements for employee
taxes that you must keep, it’s clear that you must have very good employee
records. Otherwise, you’ll have a hard time filling out all the necessary forms
and providing detail on your employees and your payroll. The best way to
track employee information is to set up an employee journal and create a
separate journal page for each employee. You can set this up manually, or
through an automated accounting system.
The detailed individual records you keep on each employee should include
this basic information, most of which is collected or determined as part of
the hiring process:
✓ Name, address, phone number, and Social Security number
✓ Department or division within the company
✓ Start date with the company
✓ Pay rate
✓ Pay period (weekly, biweekly, semimonthly, or monthly)
✓ Whether hourly or salaried
✓ Whether exempt or nonexempt
✓ W-4 withholding allowances
✓ Benefits information
✓ Payroll deductions
✓ All payroll activity
Chapter 5: Computing and Reporting Payroll Taxes
121
If an employee asks to change the number of withholding allowances and file a
new W-4 or asks for benefits changes, his or her record must be updated to
reflect such changes.
The personal detail that doesn’t change each pay period should appear at
the top of the journal page. Then, you divide the remaining information into
­columns. Here’s a sample showing what the top of an employee’s journal
page may look like.
Name:
SS#:
Address:
Tax Info: Married, 2 WH
Pay Information: $8 hour, nonexempt, biweekly
Benefits: None
Book II
Recording
Accounting
Transactions
The following is an example of the body of the journal page. It contains columns for date of check, taxable wages, Social Security and Medicare tax (in
one total), federal tax withholding, state tax withholding, and the net check
amount.
Date
4/8/2015
4/22/2015
Taxable Wages
$640
640
SS & Med
$39.68
38.68
Fed WH
$9.28
9.28
State WH
$8.62
8.62
Check
$582.42
582.42
You may want to add other columns to your employee journal to keep track
of things such as
✓ Non-taxable wages
Examples include health or retirement benefits that are paid before
taxes are taken out.
✓ Benefits
If the employee receives benefits, you need at least one column to track
any money taken out of the employee’s check to pay for those benefits.
In fact, you may want to consider tracking each benefit in a separate
column. Check out Chapter 4 for more on benefits.
✓ Sick time
✓ Vacation time
122
Book II: Recording Accounting Transactions
Clearly, these employee journal sheets can get very lengthy very quickly.
That’s why many small businesses use computerized accounting systems to
monitor both payroll and employee records. Figures 5-2 and 5-3 show you
how a new employee is added to the QuickBooks system.
Figure 5-2:
New
employee
personal
and contact
information can be
added in
QuickBooks
to make
it easier
to keep
track of
employees.
Figure 5-3:
QuickBooks
enables
you to track
salary and
deduction
information,
as well as
information
about sick
time and
vacation
time.
Book III
Adjusting and Closing Entries
Check out www.dummies.com/extras/accountingaio for specifics on how
to adjust your accounting records with accruals and deferrals.
In this book…
✓ Choose the best depreciation method for your long-term
assets. Assets are used to generate revenue, and depreciation
expenses the cost of the asset as it’s used in business.
✓ Account for interest your business pays or receives. If your
business borrows or lends money, it pays or collects interest.
Either way, you need to account for that interest.
✓ Prove out the cash to ensure that what’s on paper matches the
real dollar amounts in a store or office. Your cash account typically has a lot of transactions. As a result, you need to carefully
account for cash to ensure that all the activity is properly
recorded.
✓ Reconcile accounts and confirm that your journals and general
ledger are correct. Reconciling your books is a great way to
check your work, correct any errors, and even spot signs of
fraud!
✓ Double-check your books by running a trial balance, correct
any errors, and prepare a financial statement worksheet. A trial
balance lists all your accounts and their dollar balances.
✓ Adjust the books in preparation of preparing financial reports.
Trial balances are adjusted before being used to create financial statements to ensure accuracy in financial reports.
Chapter 1
Depreciating Your Assets
In This Chapter
▶ Understanding depreciation: What you do and why you do it
▶ Exploring depreciation methods
▶ Looking at depreciation’s tax impact
A
ll businesses have fixed assets — equipment, furnishings, and vehicles
that last more than a year. Although they may last longer than other
assets, even fixed assets eventually wear out or become obsolete and
need replacing.
Of course, fixed assets, like other assets, are an expense, but because fixed
assets last longer, you have options in how you account for those expenses.
For example, you may choose to deduct the entire cost of a fixed asset the
year you purchase it. Another option is to use a method called depreciation
to write off the cost of the asset over several years or perhaps even over the
life of that asset. Each option has its benefits and drawbacks.
This chapter introduces you to the various ways you can depreciate your
assets and explains how to choose a depreciation method, calculate depreciation, and reap its tax benefits. Changes in the tax law may also impact
your decisions about depreciation.
Defining Depreciation
Accountants use depreciation as a way to allocate the costs of a fixed
asset over the period in which the asset is useable to the business. You,
the accountant, normally record the full cost of the asset when the asset is
purchased. Subtracting a portion of that value as a depreciation expense
each year gradually reduces the value of the asset.
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Book III: Adjusting and Closing Entries
Depreciation expenses don’t involve the exchange of cash; they’re solely
done for accounting purposes . . . and to reap tax benefits. Most companies
enter depreciation expenses into the books once a year just before preparing
their annual reports, but others calculate depreciation expenses monthly
or quarterly.
One key reason to write off assets is to lower your tax bill, so the IRS gets
involved in depreciation, too. As a business owner, you probably won’t be
able to write off the cost of all major purchases in one year. The IRS has strict
rules about how you can write off assets as tax-deductible expenses. For
more about the IRS’s rules, see “Tackling Taxes and Depreciation,” later in
this chapter.
Knowing what you can and
can’t depreciate
Businesses don’t depreciate all assets. Low-cost items or items that aren’t
expected to last more than one year are expensed immediately. In other
words, these items aren’t recorded as assets. For example, office supplies
are expense items and not depreciated, but that office copier, which you’ll
use for more than one year, is recorded in the books as a fixed asset and
depreciated each year over the course of its expected useful life.
Lifespan isn’t the deciding factor for depreciation, however. Some assets that
last many years are never depreciated. One good example is land; you can
always make use of land, so its value never depreciates. You also can’t depreciate any property that you lease or rent. If you make improvements to leased
property, however, you can depreciate the cost of those improvements. In
that case, you write off the lease or rent as an expense item and depreciate
the lease improvements over their estimated useful life.
You can’t depreciate any items that you use outside your business, such as
your personal car or home computer. If you use these assets for both personal
needs and business needs, you can depreciate a portion of them based on the
percentage of time or other measurement that proves how much you use the
car or computer for business.
For example, the portion of a car that can be depreciated can be based on the
miles driven for business versus the miles driven for personal use. If you drive
your car a total of 12,000 miles in a year and have records showing that 6,000
of those miles were for business purposes, you can depreciate 50 percent of
the cost of the car. That percentage is allocated over the anticipated useful
life of the car.
Chapter 1: Depreciating Your Assets
127
Another example of depreciation of a dual-usage asset is a room in your
home designated exclusively for your business. You may be able to depreciate a portion of your home’s cost as part of your business expenses. The
amount you can depreciate is based on the portion of your home used for
business.
Figuring out the useful life of a fixed asset
You’re probably wondering how you figure out the useful life of a fixed asset.
Well, the IRS has done the dirty work for you by creating a chart that spells
out the recovery periods allowed for business equipment (see Table 1-1).
Recovery periods are the anticipated useful lifespan of a fixed asset. For
example, cars generally have a five-year recovery period because the IRS
anticipates that they’ll have a useful lifespan of five years. Although the car
will probably run longer than that, you’re not likely to continue using that car
for business purposes after the first five years. You’re more likely to trade it
in and get a new car.
Table 1-1
Depreciation Recovery Periods for Business Equipment
Property Class Recovery Period
Business Equipment
Book III
3-year property
Tractor units and horses over two years old
5-year property
Cars, taxis, buses, trucks, computers, office
machines (faxes, copiers, calculators),
research equipment, and cattle
Adjusting
and Closing
Entries
7-year property
Office furniture and fixtures
10-year property
Water transportation equipment, singlepurpose agricultural or horticultural structures
15-year property
Land improvements, such as shrubbery,
fences, roads, and bridges
20-year property
Farm buildings that aren’t agricultural or
horticultural structures
27.5-year property
Residential rental property
39-year property
Nonresidential real estate, including a home
office but not including the value of the land
128
Book III: Adjusting and Closing Entries
Delving into cost basis
In order to calculate depreciation for an asset, you need to know the cost
basis of that asset. Cost basis represents all the costs you incur to use the
asset in your business. You use assets to make money — to make a product
or service to sell. The equation for cost basis is:
Cost of the fixed asset + Sales tax + Shipping and delivery costs +
Installation charges + Other costs = Cost basis
✓ Cost of the fixed asset: What you paid for the equipment, furniture,
structure, vehicle, or other asset.
✓ Sales tax: What you were charged in sales tax to buy the fixed asset.
✓ Shipping and delivery costs: Any shipping or delivery charges you paid
to get the fixed asset.
✓ Installation charges: Any charges you paid in order to have the
equipment, furniture, or other fixed asset installed on your
business’s premises.
✓ Other costs: Any other charges you need to pay to make the fixed asset
usable for your business. For example, if you buy a new computer and
need to set up certain hardware in order to use that computer for your
business, those setup costs can be added as part of the cost basis of
the fixed asset (the computer). Training costs may also be part of
your cost basis.
For additional details on how to determine which costs can be included in
depreciation, see Book VIII, Chapter 1.
Evaluating Your Depreciation Options
For the purposes of this book, you may choose from among four methods of
depreciation. Three are based on time: straight-line, declining balance, and
sum-of-the-years’-digits. The fourth method, units-of-production, is based on
actual physical usage of the fixed asset. Here’s a brief explanation of each:
✓ Straight-line method: This method spreads out the cost of the fixed
asset evenly over its useful life.
✓ Declining balance method: This is an accelerated method of depreciation, meaning the depreciation expense is higher in the earlier years
of ownership.
Chapter 1: Depreciating Your Assets
129
✓ Sum-of-the-years’-digits method: This is another accelerated method
of depreciation. With this method, you figure depreciation expense by
assigning numbers (in declining order) to each year of the fixed asset’s
expected useful life. For example, an asset used for three years would
require this calculation: 3 + 2 + 1 = 6. Your depreciation rate for any given
year is the year’s assigned number divided by that sum, so the year 1
rate would be 3/6 (or 1/2).
✓ Units-of-production method: Using this method, you compare the
total estimated number of units the fixed asset will produce over its
expected useful life to the number of units produced in the current
accounting period.
Depletion, which is the annual expense for the use of natural resources, is also
based on actual physical usage. Examples of natural resources subject to
depletion are oil, timber, and minerals.
Don’t worry; the sections that follow walk you through a detailed example of
each of the previously listed methods of depreciation. And to show how the
choice of a depreciation method affects the amount of depreciation expense
taken each year, each example uses the same asset facts and circumstances.
For the purposes of calculating depreciation in this chapter, here are the
facts and circumstances for your sample fixed asset — a delivery van that the
company buys on January 1, 2015:
✓ The cost basis of the asset: The earlier section “Delving into cost basis,”
explains which costs to include in the cost basis — the total cost of the
fixed asset. The cost base of the delivery van is $30,000.
✓ How long the company anticipates being able to use the fixed asset:
The company may measure the length in years, in production hours,
or in miles driven. For this example, the business anticipates using the
delivery van for 5 years or 50,000 miles.
✓ The value of the asset after the company is done using it (known as its
salvage value): The salvage value is an estimate that management makes
for how much the fixed asset will be worth when it’s retired. When the delivery van is replaced, the company anticipates receiving $3,000 in trade-in
value. Cost basis less the salvage value equals depreciable base. Consider
depreciable base to be the dollar amount you use to compute depreciation.
✓ The depreciation method the company uses: The method the business
uses to depreciate should be appropriate for the asset. Accountants
apply the matching principle to match revenue with the expense incurred
to generate the revenue. For financial accounting, the standard of appropriateness is met if the company uses the method that most closely
matches expenses to revenue.
Book III
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and Closing
Entries
130
Book III: Adjusting and Closing Entries
A business can’t arbitrarily switch methods after using one depreciation
method for an asset. To do so would be a change in accounting method.
If you do choose to change an accounting method, you need to justify
the change (see Book I, Chapter 4 for more on selecting accounting
methods).
✓ Date of purchase and whether the company is on a calendar or fiscal
year-end: The date is when the fixed asset is ready for use. Calendar
year-end is on December 31. A fiscal year ends on the last day of any
other month of the company’s choosing during the year. For example, a
fiscal year can be April 1 through March 31. This business has a calendar
year-end of December 31. The delivery van is purchased on January 1.
Ready? Well, start your engines and let’s depreciate this delivery van!
Walking through the straight-line method
When using the straight-line method, the salvage value reduces the depreciable base. So the cost of the delivery van ($30,000) less its salvage value
($3,000) gives you a depreciable base of $27,000.
The expected useful life is 5 years. So depreciation expense for the van is
$27,000/5 or $5,400 depreciation expense per year for each of the 5 years.
Book value at the end of year 5 is $3,000.
Accelerating by using declining balance
To depreciate an asset more quickly during the earlier years of its use (than
by using the straight-line method), you can use a declining balance method.
Several declining-balance methods are available, but the double-declining balance method is used most often. It enables you to depreciate an asset at twice
the rate of the straight-line method. The double-declining balance method is
ideal for assets whose primary usefulness is in the early years of life.
To calculate depreciation by using the double-declining balance method, use
this formula:
2 × ( 1 ÷ Estimated useful life) × Book value at the beginning of the year
= Depreciation expense
Chapter 1: Depreciating Your Assets
131
Note that double-declining balance calculates depreciation on cost ($30,000), not
depreciable base ($27,000). Also, the straight-line method spreads depreciation
evenly over 5 years, or 20 percent a year. Double-declining balance multiplies
the cost by 40 percent — twice the 20 percent rate.
The calculation for the van’s depreciation expense in the first year, using the
declining balance method, is:
2 × (1 ÷ 5) × $30,000 = $12,000
At the beginning of the second year, you need to reduce the value of the
asset by the year one depreciation amount; in this example, $30,000 – $12,000
= $18,000. $18,000 is your new book value. In other words, $18,000 is the
amount you plug into the formula to get year two depreciation. Plug that
number into the formula, and you get:
2 × (1 ÷ 5) × $18,000 = $7,200
Perform the same calculation for the remaining years of useful life, and the
five-year depreciation looks like this:
✓ Year 1: $12,000
✓ Year 2: $7,200
Book III
✓ Year 3: $4,320
Adjusting
and Closing
Entries
✓ Year 4: $2,592
✓ Year 5: $888
If you add the 5 years of depreciation in this example, the total is $27,000.
You’ve seen the number before: $30,000 cost less $3,000 salvage value. Your
total depreciation using double-declining balance can’t be more than cost
less salvage value. When you reach salvage value, you sell the asset. So,
depreciation stops at that point.
Figure 1-1 shows how to figure double-declining balance depreciation.
Note that in year 5, the 40 percent depreciation rate doesn’t matter
because you have to limit the depreciation to salvage value. Because
the ending net book value is $3,888 in year 4, depreciation is limited to
$888 in year 5.
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Book III: Adjusting and Closing Entries
Figure 1-1:
A doubledeclining
balance
depreciation
calculation.
©John Wiley & Sons, Inc.
Calculating sum-of-the-years’-digits
Like all methods of depreciation, the sum-of-the-years’-digits method of
depreciation bases the depreciation rate on the useful life of the asset, but
with a twist. Using this method, you depreciate the asset by adding the useful
life years together (5 + 4 + 3 + 2 + 1 = 15) to get the denominator for the rate
fraction. The numerator is the number of years remaining in the depreciation
schedule. In year one, your multiplier is 5/15 (1/3); in year two, the multiplier
is 4/15; and so on. As with straight-line depreciation, you back out the salvage
value before you start, so in this example, you start with $30,000 – $3,000 =
$27,000. The depreciation expense for the first year is:
$27,000 × 5/15 or 1/3 = $9,000
So here’s how sum-of-the-years’-digits depreciation expense plays out for the
delivery van over 5 years:
✓ Year 1: $27,000 × 5/15 = $9,000 depreciation expense
✓ Year 2: $27,000 × 4/15 = $7,200 depreciation expense
✓ Year 3: $27,000 × 3/15 = $5,400 depreciation expense
✓ Year 4: $27,000 × 2/15 = $3,600 depreciation expense
✓ Year 5: $27,000 × 1/15 = $1,800 depreciation expense
Check the math: Adding up all five years of depreciation expense equals
$27,000, which is the cost of the delivery van less the salvage value!
Chapter 1: Depreciating Your Assets
133
Using the units-of-production method
The units of production (UOP) method of depreciation works well primarily
in a manufacturing environment because it calculates depreciation based on
the number of units produced in a year. Companies whose machinery usage
varies greatly each year depending on the market and the number of units
needed for sale make use of this depreciation method. Finally, this method
helps you match an expense (depreciation expense) with revenue (sales of the
items produced). The matching principle is mentioned earlier in this chapter.
The formula for calculating depreciation by using units of production is a
two-step process:
1. Find the UOP rate by using this formula:
(Cost – Salvage value) ÷ Estimated number of units to be produced
during estimated useful life = UOP rate
2. Find the depreciation expense by using this formula:
Units produced during the year × UOP rate = Depreciation expense
You need to use the units-of-production depreciation method only if you’re
manufacturing the products you sell and the usage of your equipment fluctuates widely from year to year.
Here’s how this method works with the delivery van purchase example: The
business anticipates using the delivery van for 50,000 miles over the course of
the 5 years when a depreciation expense is to be deducted. First, find the cost of
the delivery van less salvage value: $30,000 – $3,000 = $27,000. Divide this figure
by your anticipated usage: $27,000/50,000 miles equals $0.54 per mile. If the van
travels 8,000 miles in any given year, the depreciation expense for that year is:
8,000 × $0.54 = $4,320
In essence, using this method for the delivery van is giving you a standard
mileage rate. If you’ve ever done your own tax return and had to figure your
mileage expense for charitable work you’ve done, it’s the same concept.
Seeing how the methods compare
Just for fun, Figure 1-2 shows how the different depreciation methods result
in a different amount of depreciation expense per year. Notice that over the
entire 5-year useful life, total depreciation is $27,000 regardless of the method
Book III
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and Closing
Entries
134
Book III: Adjusting and Closing Entries
used. Thus, the different methods result in different depreciation expense
amounts in each of the years but not in a difference in total depreciation over
the life of the asset.
Figure 1-2:
Comparison
of
depreciation
expense
among
methods.
©John Wiley & Sons, Inc.
Pretty cool, huh?! Depending on the depreciation method the company uses
for the fixed asset, depreciation expense can be all over the map. A business
can use a different depreciation method for different types of assets as long
as the depreciation method fairly shows the use of the asset over time.
More depreciation expense in an accounting period results in less net income,
and vice versa.
Chapter 1: Depreciating Your Assets
135
Figuring partial year depreciation
The delivery van example was neat and clean because the company purchased the van on January 1 (the first day of its fiscal year). What happens
if the company buys a fixed asset mid-year? How do you figure depreciation
expense for a partial year?
Here’s the solution: You prorate the depreciation expense among the
accounting periods involved. For example, if the sample company buys a
delivery van on June 1, the first year of depreciation is prorated by using the
fraction 7/12 (because seven months remain in the fiscal year). Any leftover
depreciation is taken in year 6.
Consider the delivery van while using the straight-line method. Depreciation
expense in year 1 is now $3,150 ($5,400 × 7/12). For years 2 through 5, the
depreciation expense remains $5,400. In year 6, you finish up by expensing
the remaining $2,250 ($5,400 × 5/12).
The journal entry (see Book I, Chapter 3) to book depreciation is to debit
depreciation expense and credit accumulated depreciation.
Tackling Taxes and Depreciation
Depreciation calculations for tax purposes are a completely different animal
from the calculations used to record depreciation for accounting purposes.
You can use straight-line depreciation to calculate your depreciation expense
for book (accounting record) purposes. Many businesses, however, use
an accelerated method of depreciation for tax purposes. These companies
prefer to write off the highest expense legally permissible and reduce their
tax bills by the greatest amount as soon as possible.
Accountants reconcile differences between the accounting records (“book”)
and the tax return (“tax”). You may hear accountants discussing book versus
tax issues. One issue that causes these differences is the treatment of depreciation. The reconciliation process isn’t discussed in this book, but you should
keep this concept in mind.
In addition to straight-line depreciation, two other acceptable IRS methods for writing off assets are: Section 179 and Modified Accelerated Cost
Recovery System (MACRS). The big advantage of the Section 179 Deduction
is that you can write off up to 100 percent of the cost basis of qualifying
property. If the property doesn’t qualify under Section 179, many businesses
choose to use MACRS rather than straight-line depreciation. (The following
sections describe Section 179 and MACRS depreciation in greater detail.)
Book III
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136
Book III: Adjusting and Closing Entries
Section 179
Section 179, which gets its name from a section of the tax code, is a great
boon for companies. Businesses can write off up to 100 percent of the full
purchase price of the property.
The primary reason for this part of the tax code is to encourage businesses to
buy new property in order to stimulate the economy. That’s why only certain
types of property are included, and the tax code limits the amount that can be
deducted for some types of property.
Basically, Section 179’s qualifying property includes tangible property such
as machines, equipment, and furniture. In addition, some storage facilities
qualify. Cars and SUVs between 6,000 and 14,000 pounds can be partially
written off under Section 179.
You can get full details about Section 179 by ordering a copy of IRS Publication
946, How to Depreciate Property, from the IRS or accessing it online at
www.irs.gov. If you’re a business owner, work with your accountant to
determine what’s eligible and how much of the cost basis is eligible for the
Section 179 deduction.
MACRS
The most common type of depreciation write-off used by businesses is
Modified Accelerated Cost Recovery System, or MACRS. The recovery period
shown in Table 1-1 is the basis for this depreciation method. After you know
what type of property you have (three-year, five-year, and so on), you use the
MACRS table in IRS Publication 946, How to Depreciate Property, to figure out
the depreciation expense you can write off. If you’re a business owner, you
can leave MACRS calculations for your accountant to do when he prepares
your business tax forms.
Chapter 2
Paying and Collecting Interest
In This Chapter
▶ Understanding interest calculations
▶ Making the most of interest income
▶ Calculating loan interest
F
ew businesses are able to make major purchases without taking out loans.
Whether loans are for vehicles, buildings, or other business needs, businesses must pay interest, a percentage of the amount loaned, to their lenders.
Some businesses also loan money to borrowers and receive interest payments
as income. In fact, a savings account can be considered a type of loan because
by placing your money in the account, you’re giving the bank the opportunity
to loan that money to others. That interest is income for your company.
This chapter reviews different types of loans and how to calculate and record
interest expenses for each type. It also explains how you calculate and record
interest income in your business’s books.
Deciphering Types of Interest
Any time you make use of someone else’s money (whether that someone else
is an individual or a bank), you have to pay interest for that use — whether
you’re buying a house, a car, or some other item you want. The same is true
when someone else is using your money. For example, when you buy a corporate bond or deposit money in a money market account, you’re paid interest
for allowing someone to use your funds.
The financial institution that has your money will likely combine your money
with that of other depositors and loan it to other people to make more interest than it’s paying you. A corporation will use the proceeds from the bond
issue to finance its business’s expansion. The company wants to generate
more in earnings than it will pay in interest expense.
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Book III: Adjusting and Closing Entries
Financial institutions use two types of interest calculations:
✓ Simple interest is calculated only on the principal amount of the loan.
✓ Compound interest is calculated on the principal and on the interest
previously earned.
Simple interest
Simple interest is simple to calculate. Here’s the formula for calculating
simple interest:
Principal × Interest rate × n = Interest
The n in the equation stands for number of periods. To understand how interest
is calculated, assume that someone deposited $10,000 in the bank in a
money market account earning 3 percent (0.03) interest for three years. So
the interest earned over three years is $10,000 × 0.03 × 3 = $900.
Compound interest
Compound interest is computed on both the principal and any interest
earned. You must calculate the interest each year and add it to the balance
before you can calculate the next year’s interest payment, which will be
based on both the principal and the interest earned.
Here’s how you would calculate compound interest:
Principal × Interest rate
(Principal + Year one interest earned) × Interest
rate
(Principal + Years one and two interest earned) ×
Interest rate
=
=
Interest for year one
Interest for year two
=
Interest for year three
You repeat this calculation for all years of the deposit or loan. Compound
interest assumes that interest payments are reinvested and earn additional
interest. Compounding means that you’re earning interest on a larger investment amount.
To understand how compounding interest impacts your earnings, notice how
the amount of interest changes from one year to the next on a three-year
deposit of $10,000 at 3 percent (0.03):
Chapter 2: Paying and Collecting Interest
$10,000 × 0.03
($10,000 + 300) × 0.03
($10,000 + 300 + 309) × 0.03
Total interest earned
=
=
=
=
139
$300.00 (Year one interest)
$309.00 (Year two interest)
$318.27 (Year three interest)
$927.27
You can see that you earn an extra $27.27 during the first three years of the
deposit if interest is compounded. When working with much larger sums or
higher interest rates for longer periods of time, compound interest can make
a big difference in how much you earn or how much you pay on a loan.
The Rule of 72 is a tool you can use to remember how compound interest
works. Seventy-two divided by the rate of compound interest gives you the
number of years it will take for your money to double. For example, if the rate
of compound interest is 6 percent, your money will double in 72 ÷ 6, or 12
years. The higher the compound interest rate, the faster your money will
double. At 12 percent, your money doubles in 72 ÷ 12, or 6 years.
Ideally, you want to find a savings account, certificate of deposit, or other savings instrument that earns compound interest. But if you want to borrow
money, look for a simple interest loan (see the previous section).
Also, not all accounts that earn compound interest are created equally. Watch
carefully to see how frequently the interest is compounded. The preceding
example assumes that interest is compounded annually. But if you can put
your money into an account that compounds interest monthly, the interest
you earn will be even higher.
Monthly compounding means that interest earned is calculated each month
and added to the principal each month before calculating the next month’s
interest, which results in a lot more interest than a bank that compounds
interest just once a year. Likewise, opt for loans that compound interest
annually instead of quarterly or monthly.
Handling Interest Income
The income that your business earns from its savings accounts, certificates
of deposits, or other investment vehicles is called interest income. As the
bookkeeper, you’re rarely required to calculate interest income by using the
simple interest or compounded interest formulas described in the earlier
sections of this chapter. In most cases, the financial institution sends you a
monthly, quarterly, or annual statement that has a separate line item
reporting interest earned.
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When you get your monthly statement, you then reconcile the books — your
accounting records. Reconciliation is a process in which you prove out whether
your bank balance (on the bank statement) is equal to the cash balance in your
accounting records. For more about reconciling bank accounts, see Chapter 4.
One step in the reconciliation process involves recording any bank activity
that may not be posted to your books. Often, companies wait until they get
the bank statement to post certain bank transactions. Two common transactions are interest earned and bank fees. You may post these entries after you
receive the monthly bank statement.
If you’re keeping the books manually, a journal entry to record interest
income would look similar to this:
Debit
Cash
Interest income
To record interest income from American Savings Bank.
Credit
$100
$100
To record bank fees, you would debit (increase) an expense account and
credit cash (a decrease). You pay bank fees in cash via your bank account.
When preparing financial statements, you show interest income on the
income statement in a section called other income (see Book IV, Chapter 2
for more information about the income statement). Other income includes
any income your business earned that wasn’t directly related to your primary
business activity — selling your goods or services.
Delving into Loans and Interest Expenses
Businesses borrow money for both short-term periods (less than 12 months)
and long-term periods (more than 12 months). Short-term debt usually
involves some form of credit card debt or line-of-credit debt. Long-term debt
can include a five-year car loan, 20-year mortgage, or any other type of debt
paid beyond one year.
Short-term debt
Any money due in the next 12-month period is shown on the balance sheet as
short-term or current debt. Any interest paid on that money is shown as an
interest expense on the income statement.
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For the purposes of this book, a current asset represents cash or items that will
be converted to cash within one year. Current liabilities will be paid in cash
within one year.
In most cases, you don’t have to calculate your interest due. The financial
institution sending you a bill gives you a breakdown of the principal
and interest to be paid.
Calculating credit card interest
When you get a credit card bill at home, a line always shows you new
charges, the amount to pay in full to avoid all interest, and the amount of
interest charged during the current period on any money not paid from the
previous bill. If you don’t pay your credit card in full, interest on most cards
is calculated by using a daily periodic rate of interest, which is compounded
each day based on the unpaid balance. When not paid in full, interest is calculated on the unpaid principal balance plus any unpaid interest. Table 2-1
shows what a typical interest calculation looks like on a credit card.
Table 2-1
Credit Card Interest Calculation
Average
Daily
Balance
Daily
Periodic
Rate
Corres-­
­ponding
Annual Rate
Finance Charges
Daily
Rate
Transaction
Fees
Purchases
$1,000
0.033973%
12.40%
$0.34
$50
Cash
$200
0.045178%
16.49%
$0.09
$20
On many credit cards, you start paying interest on new purchases immediately, if you haven’t paid your balance due in full the previous month. When
opening a credit card account for your business, be sure you understand how
interest is calculated and when the bank starts charging on new purchases.
Some issuers give a grace period of 20 to 30 days before charging interest.
In Table 2-1, the finance charges include the daily rate charged in interest based
on the daily periodic rate plus any transaction fees. For example, if you take a
cash advance from your credit card, many credit card companies charge a
transaction fee of 2 to 3 percent of the total amount of cash taken. This fee may
also apply when you transfer balances from one credit card to another.
Although the company entices you with an introductory rate of 1 or 2 percent
to get you to transfer the balance, be sure to read the fine print. You may
have to pay a 3 percent transaction fee on the full amount transferred, which
makes the introductory rate much higher.
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Using credit lines
As a small-business owner, you generally get better interest rates by using
a line of credit with a bank than with a credit card. Interest rates are usually
lower on lines of credit. Typically, a business owner uses a credit card for
purchases, but if he can’t pay the bill in full, he draws money from his line of
credit rather than carry over the credit card balance.
When the money is first received from the credit line, you record the cash
receipt and the liability. Just to show you how this transaction works, here’s
a sample journal entry for the receipt of a credit line of $1,500:
Debit
Cash
Credit line payable
To record receipt of cash from credit line.
Credit
$1,500
$1,500
In this entry, you increase the cash account and the credit line payable
account balances.
When you make your first payment, you must record the use of cash, the
amount paid on the principal of the loan, and the amount paid in interest.
Here is what that journal entry looks like:
Debit
Credit line payable
Interest expense
Cash
To make monthly payment on credit line.
Credit
$150
$10
$160
This journal entry reduces the amount due in the credit line payable account,
increases the amount paid in the interest expense account, and reduces the
amount in the cash account.
If you’re using a computerized system, you simply complete a check form and
indicate which accounts are impacted by the payment. The system updates
the accounts automatically.
When you prepare the check for printing in an automated system, you can
add the accounts that are impacted by the payment. Your accounting system
can then print the check and update all affected accounts. You don’t need to
do any additional postings to update your books.
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Long-term debt
Most companies take on some form of long-term debt — debt to be paid over
a period longer than 12 months. This debt may include car loans, mortgages,
or promissory notes. A promissory note is a written agreement stating that
you agree to repay someone a set amount of money at some point in the
future at a particular interest rate. The term can be monthly, yearly, or some
other period specified in the note. Most installment loans are types of
promissory notes.
Recording a debt
When the company first takes on a long-term debt, it’s recorded in the books
in much the same way as a short-term debt:
Debit
Cash
Notes payable
To record receipt of cash from American Bank promissory note.
Credit
$500
$500
Book III
Payments are also recorded in a manner similar to short-term debt:
Debit
Notes payable
Interest expense
Cash
To record payment on American Bank promissory note.
Credit
$100
$5
$105
Although the way you enter the initial information isn’t very different, a big
difference exists between how short- and long-term debts appear on the
financial statements. All short-term debt appears in the current liability section of the balance sheet.
Long-term debt is split and appears in different line items. The portion of
the debt due in the next 12 months appears in the current liabilities section,
which is usually a line item named something like “current portion of longterm debt.” The remaining balance of the long-term debt due beyond the next
12 months appears in the long-term liability section of the balance sheet as
notes payable.
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Considering major purchases and long-term debt
Sometimes a long-term liability is set up at the same time as you make a
major purchase. You may pay some portion of the amount due in cash
as a down payment and the remainder as a note. To see how to record
such a transaction, assume that a business has purchased a truck for $25,000,
made a down payment of $5,000, and signed a five-year (60 month) promissory
note at an interest rate of 6 percent for $20,000. Here’s how you record this
purchase in the books:
Debit
Vehicles
Cash
Notes payable – vehicles
To record payment for the purchase of the blue truck.
Credit
$25,000
$5,000
$20,000
You then record payments on the note in the same way as you do on any
other loan payment:
Debit
Notes payable – vehicles
Interest expense
Cash
To record payment on the purchase of the blue truck.
Credit
$2,000
$300
$2,300
Separating principal and interest
When recording the payment on a long-term debt for which you have a set
installment payment, you may not get a breakdown of interest and principal
with every payment. For example, when you take out a car loan, you may
receive a coupon book with just the total payment due each month. Each
payment includes both principal and interest, but you don’t get any breakdown detailing how much goes toward interest and how much goes toward
principal, which may change with each payment. (With many loans, you pay
a greater portion of interest earlier in the term, so banks can collect their
interest earlier, and a greater portion of the principal with later payments.)
In order to record long-term debt for which you don’t receive a breakdown
each month, you need to ask the bank that gave you the loan for an amortization schedule, create your own amortization schedule, or enter the details of
the loan into your accounting program. An amortization schedule lists the total
payment, the amount of each payment that goes toward interest, the amount
that goes toward principal, and the remaining balance to be paid on the note.
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Some banks provide an amortization schedule automatically when you sign
all the paperwork for the note. If your bank can’t give you one, you can easily
generate one online by using an amortization calculator. BankRate.com has a
good one at www.bankrate.com/brm/amortization-calculator.asp.
Using that calculator, an amortization schedule is generated for the entire
60-month term of the loan showing the principal and interest breakdown for
each payment. Table 2-2 displays payment information for each of the first
six months. As you can see, the amount paid to principal on a long-term note
gradually increases, while the amount of interest paid gradually decreases as
the note balance is paid off.
Table 2-2
Six-Month Amortization Chart for Truck Payments
Total Payment
Principal
Interest
Remaining Note Balance
$386.66
$286.66
$100.00
$19,713.34
$386.66
$288.09
$98.57
$19,425.25
$386.66
$289.53
$97.13
$19,135.72
$386.66
$290.98
$95.68
$18,844.75
$386.66
$292.43
$94.22
$18,552.32
$386.66
$293.89
$92.76
$18,258.42
Book III
Looking at the six-month amortization chart, here is what you would need to
record in the books for the first payment on the truck:
Debit
Notes payable – vehicles
Interest expense
Cash
To record payment on note for blue truck.
Credit
$286.66
$100.00
$386.66
In reading the amortization chart in Table 2-2, notice how the amount paid
toward interest is slightly less each month as the balance on the note still
due is gradually reduced. By the time you start making payments for the final
year of the loan, interest costs drop dramatically because the principal
balance is so much lower.
As you lower your principal balance, much less of your payment goes toward
interest and much more goes toward reducing principal. That’s why many
financial specialists advise you to pay down principal as fast as possible if you
want to reduce the term of a loan and, more importantly, the total amount you
end up paying in interest.
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Book III: Adjusting and Closing Entries
Chapter 3
Proving Out the Cash
In This Chapter
▶ Understanding the purpose of closing out the cash
▶ Counting your company’s cash
▶ Finalizing the cash journals
▶ Using temporary posting journals
A
ll business owners — whether the business is a small, family-owned
candy store or a major international conglomerate — like to p
­ eriodically
verify how well their businesses are doing. They also want to be sure that the
numbers in their accounting systems actually match what’s p
­ hysically in their
stores and offices. After they check out what’s in the books, these business
owners can prepare financial reports to determine the c
­ ompany’s financial
­success or failure during the last month, quarter, or year. This process of
­verifying the accuracy of your cash is called proving out the cash.
This chapter explains how to ensure the cash counts are accurate, finalize
the cash journals for the accounting period, prove out the bank accounts,
and post any adjustments or corrections to the general ledger.
Why Prove Out the Cash?
You’re probably thinking that proving out the cash is a major, time-sucking
endeavor. You’re right — it’s a big job, but it’s also a very necessary one to
do periodically so you can be sure that what’s recorded in your accounting
system realistically reflects what’s actually going on in your business.
Any accounting system is susceptible to mistakes, and, unfortunately, any
business can fall victim to incidents of theft or embezzlement. One way
to minimize the risk is to periodically prove out the cash. The process of
­proving out the cash is a big part of the accounting cycle, discussed in detail
in Book I, Chapter 1.
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The first three steps of the accounting cycle — recording transactions,
making journal entries, and posting summaries of those entries to the ­
general ledger — involve tracking cash flow throughout the accounting
period. All three steps are part of the process of recording a business’s
­financial ­activities throughout the entire accounting period.
The rest of the steps in the accounting cycle are conducted at the end of
the period and are part of the process of proving out the accuracy of your
books. They include running a trial balance and creating a worksheet (see
Chapter 5), adjusting journal entries (see Chapter 6), creating financial
­statements (see Books IV and V), and closing the books (see Chapter 4).
Most businesses prove out their books every month.
Of course, you don’t want to shut down your business for a week while you
prove out the cash, so select a day during each accounting period on which
you’ll take a financial snapshot of the state of your accounts.
The balance sheet is always generated on a specific day to provide a snapshot in time. The income statement, on the other hand, displays your profit
and loss for a period of time (month or year). If you try to generate a balance
sheet for the month of June, you’ll get an error message. Likewise, if you ask
your system to produce an income statement for June 15, you’ll get another
error message.
If you’re preparing monthly financial reports at the end of the month, you test
the amount of cash your business has on hand as of that certain time and
day, such as 6 p.m. on June 30 after your store closes for the day. The rest of
the testing process — running a trial balance, creating a worksheet, adjusting journal entries, closing the books, and creating financial statements — is
based on what happened before that point in time. When you open the store
and sell more products the next day and buy new things to run your business, those transactions and any others that follow your test become part of
the next accounting cycle.
Making Sure Ending Cash Is Right
Testing your books starts with counting your cash. Why start with cash?
Because, for most businesses, the cash account has more transactions than
any other account. More transactions in an account can mean a higher risk of
error. Cash is also the asset most susceptible to theft.
If you prove your cash balance first, you’re addressing your most difficult
account first. Before you can even begin to test whether the books are right,
you need to know whether your books have captured what’s happened to
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your company’s cash and whether the amount of cash shown in your books
actually matches the amount of cash you have on hand.
Accountants spend a lot of time looking at business transactions and
­ onsidering which accounts are affected. When mulling over a transaction,
c
ask yourself: Did anything happen to cash? Because cash is so often affected
by business activity, this approach helps you post the activity to the right
accounts.
Book II, Chapter 3 discusses how a business proves out the cash taken in by
each of its cashiers. That process gives a business good control of the point
at which cash comes in the door. The cashier accepts cash from customers
who buy the company’s products or services. Cashiers also process cash
refunds given to customers who returned items. So, proving cash handled by
cashiers is important. But the points of sale and return aren’t the only times
cash comes into or goes out of the business.
If your business sells products on store credit (see Book II, Chapter 3), you
(or the bookkeeping staff responsible for tracking customer credit accounts)
collect some of the cash from customers at a later point in time. And when
your business needs something, whether products to sell or s­ upplies
for ­various departments, you must pay cash to vendors, suppliers, and
­contractors. Sometimes you pay cash on the spot, but many times you record
the bill in the accounts payable account and pay it at a later date.
Your amount of cash on hand at any one time includes not only what’s in the
cash registers but also what’s on deposit in the company’s bank accounts.
You need to know the balances of those accounts and test those balances to
be sure they’re accurate and match what’s in your company’s books.
Some departments may also have petty cash accounts, requiring that you
total that cash as well. The total cash figure is what you report as an
asset called “cash” on the first line of your company’s balance sheet. The
balance sheet shows all that the company owns (its assets) and owes (its
­liabilities) as well as the equity the owners have in the company. (To find
out more about the balance sheet and how you prepare one, see Book IV,
Chapters 3–5.)
The actual cash you have on hand is just one tiny piece of the cash moving
through your business during the accounting period. The true detail of what
cash has flowed into and out of the business is in your cash journals. Closing
those journals is the next step in the process of figuring out how well your
business is doing.
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Closing the Cash Journals
As explained in Book I, Chapter 3, you can find a record of every transaction
that involves cash in one of two cash journals: the cash receipts journal (cash
that comes into the business) and the cash disbursements journal (cash that
goes out of the business).
If you use a computerized accounting system, you have many additional
ways to find the same information. You can run reports of sales by customer,
item, or sales representative. You can also run reports that show you all the
company’s purchases by vendor or item as well as list any purchases still on
order.
Cash receipts should be debited to increase cash. In the same way, cash disbursements are credited to reduce cash. If you identify all the cash receipts
and disbursements, you should be able to match those transactions with the
debits and credits.
A typical automated accounting system can generate purchase reports. You
can run these reports by the week, month, quarter, or year. You can also customize the reports to show a particular period of time that you’re analyzing.
For example, if you want to know what purchases occurred between June 5
and 10, you can run a report specifying those exact dates. You have the same
capability to generate sales reports.
In addition to the sales and purchase reports, you can generate other transaction detail reports, including customers and receivables; jobs, time, and
mileage; vendors and payables; inventory; employees and payroll; and
banking. One big advantage of a computerized accounting system when
you’re trying to prove out your cash is the number of different ways you can
develop reports to check for accuracy in your books if you suspect an error.
Although the ability to generate tons of information is great, try to avoid information overload. Get training on your accounting system so you can quickly
access the most meaningful and useful reports. Knowing how to generate the
most useful reports quickly will save you time. Don’t create ten sales reports if
you use only two.
Finalizing cash receipts
If all your books are up-to-date, when you summarize the cash receipts
journal to prove out your cash, you should come up with a total of all cash
received by the business at that time. Up-to-date books ensure that all cash
receipt transactions are posted to your accounting system.
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Unfortunately, in the real world of bookkeeping, things don’t always come
out so nice and neat. In fact, you probably wouldn’t even start entering the
transactions from that particular day into the books until the next day, when
you enter the cash reports from all cashiers and others who handle incoming
cash (such as the accounts receivable staff who collect money from customers buying on credit) into the cash receipts journal.
After entering all the transactions from the day in question, the books for the
period you’re looking at may still be incomplete. Sometimes, adjustments or
corrections must be made to the ending cash numbers. For example, monthly
credit card fees and interest received from the bank may not yet be recorded
in your cash journals.
As the bookkeeper or accountant, you must be sure that all bank fees are
recorded to the cash disbursement journal. Interest earned is recorded in
the cash receipts journal. After posting those entries, you can summarize the
journals for the period you’re analyzing.
Remembering credit card fees
When your company allows customers to use credit cards, you must pay fees
to the bank that processes these transactions, which is probably the same
bank that handles all your business accounts. These fees actually lower the
amount you take in as cash receipts, so the amount you record as a cash
receipt must be adjusted to reflect those costs of doing business. Monthly
credit card fees vary greatly depending upon the bank you’re using and other
factors, but here are some of the most common fees your company should
expect:
✓ Address verification service (AVS) fee is a fee companies pay if they
want to avoid accepting fraudulent credit card sales. Businesses that use
this service take orders by phone or e-mail and therefore don’t have the
credit card in hand to verify a customer’s signature. Banks charge this
fee for every transaction that’s verified.
✓ Chargeback and retrieval fees are charged if a customer disputes a
transaction and wins the dispute.
✓ Customer support fees are charged to companies that want bank
support for credit card transactions 24 hours a day, 365 days a year.
Companies such as mail-order catalogs that allow customers to place
orders 24 hours a day look for this support. Sometimes companies
even want this support in more than one language if they sell products
­internationally.
✓ Discount rate is a fee that all companies using credit cards must pay;
it’s based on a percentage of the sale or return transaction. The rate
your company may be charged varies greatly depending on the type of
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­ usiness you conduct and the volume of your monthly sales. Companies
b
that use a terminal to swipe cards and electronically send transaction
information usually pay lower fees than companies that use paper credit
card transactions, because the electronic route creates less work for the
bank and eliminates the possibility of key-entry errors by employees.
✓ Equipment and software fees are charged to your company if you lease
credit card equipment and related software from the bank. You may
have the option of buying the equipment and software for a one-time
charge instead.
✓ Monthly minimum fee is the least amount a business is required to
pay for the ability to offer its customers the convenience of using credit
cards to buy products.
✓ Secure payment gateway fee, which allows the merchant to process
transactions securely, is charged to companies that transact business
over the Internet. If your business sells products online, you can expect
to pay this fee based on a set monthly amount.
✓ Transaction fee is a standard fee charged to your business for each
credit card transaction you submit for authorization. You pay this fee
even if the cardholder is denied and you lose the sale.
Reconciling your credit card statements
Each month, the bank that handles your credit card sales will send you a
statement listing
✓ All your company’s transactions for the month.
✓ The total amount your company sold through credit card sales.
✓ The total fees charged to your account.
If you find a difference between what the bank reports was sold on credit
cards and what the company’s books show regarding credit card sales, it’s
time to play detective and find the reason for the difference. In most cases,
the error involves the charging back of one or more sales because a customer
successfully disputes the charge. In this case, the cash receipts journal is
adjusted to reflect that loss of sale, and the bank statement and company
books should match up.
For example, suppose $200 in credit card sales were disputed. The original
entry of the transaction in the books should look like this:
Sales
Cash
To reverse disputed credit card sales recorded in June.
Debit
$200
Credit
$200
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This entry reduces the total sales for the month as well as the amount of the
cash account. If the dispute is resolved and the money is later retrieved, the
sale is then reentered when the cash is received.
You also record any fees related to credit card fees in the cash disbursements
journal. For example, if credit card fees for the month of June total $200, the
entry in the books should look like this:
Credit card fees
Cash
To record credit-card fees paid for the month of June.
Debit
$200
Credit
$200
Summarizing the cash receipts journal
When you’re sure that all cash receipts as well as any corrections or
­adjustments to those receipts have been properly entered in the books
(see the previous two sections), you summarize the cash receipts journal as
explained in detail in Book I, Chapter 3. After summarizing the cash receipts
journal for the accounting period you’re analyzing, you know the total cash
that was taken into the business from sales as well as from other channels.
A customer who buys a product either pays at the time of purchase or on
credit. So, in the cash receipts journal, sales usually appear in two columns:
✓ Sales: The cash shown in the sales column is cash received when the
customer purchases the goods by using cash, check, or bank credit
card.
✓ Accounts receivable: The accounts receivable column is for sales in
which no cash was received when the customer purchased the item.
Instead, the customer bought on credit and intends to pay cash at a later
date. (For more about accounts receivable and collecting money from
customers see Book II, Chapter 3.)
After you add all receipts to the cash receipts journal, entries for items
bought on store credit can be posted to the accounts receivable journal and
the individual customer accounts. You then send bills to customers that
reflect all transactions from the month just closed as well as any payments
still due from previous months. Billing customers is a key part of the closing
process that occurs each month.
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In addition to the sales and accounts receivable columns, your cash receipts
journal should have at least two other columns:
✓ General: The general column lists all other cash received, such as owner
investments in the business.
✓ Cash: The cash column contains the total of all cash received by the
business during an accounting period.
Finalizing cash outlays
After you close the cash receipts journal (see “Summarizing the cash receipts
journal”), the next step is to close the cash disbursements journal. Any
adjustments related to outgoing cash receipts, such as bank credit card fees,
should be added to the cash disbursements journal.
Before you close the journal, you must also be certain that any bills paid at
the end of the month have been added to the cash disbursements journal.
Bills that are related to financial activity for the month being closed but that
haven’t yet been paid have to be accrued, which means recorded in the books,
so they can be matched to the revenue for the month. These accruals are necessary only if you use the accrual accounting method. If you use the cash-basis
accounting method, you need to record the bills only when cash is actually
paid. For more on the accrual and cash-basis methods, flip to Book I, Chapter 4.
You accrue bills yet to be paid in the accounts payable account. For example,
suppose that your company prints and mails flyers to advertise a sale during
the last week of the month. A bill for the flyers totaling $500 hasn’t been paid
yet. Here’s how you enter the bill in the books:
Advertising
Accounts payable
To accrue the bill from Jack’s printing for June sales flyers.
Debit
$500
Credit
$500
This entry increases advertising expenses for the month and increases the
amount due in accounts payable. When you pay the bill, the accounts payable account is debited (to reduce the liability), and the cash account is
­credited (to reduce the amount in the cash account). You make the actual entry
in the cash disbursements journal when the cash is paid out.
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When proving out the cash, also review any accounts in which expenses are
accrued for later payment, such as sales tax collected, to be sure all accrual
accounts are up-to-date. These tax accounts are actually liability accounts for
taxes that will need to be paid in the future. If you use the accrual accounting
method, the expenses related to these taxes must be matched to the revenues
collected for the month they’re incurred.
Using a Temporary Posting Journal
Some companies use a temporary posting journal to record payments that
are made without full knowledge of how the cash outlay should be posted
to the books and which accounts will be impacted. For example, a company
using a payroll service probably has to give that service a certain amount of
cash to cover payroll even if it’s not yet known exactly how much is needed
for taxes and other payroll-related costs.
In this payroll example, cash must be disbursed, but transactions can’t be
entered into all affected accounts until the payroll is done. Suppose a company’s payroll is estimated to cost $15,000 for the month of May. The company
sends a check to cover that cost to the payroll service and posts the payment
to the temporary posting journal.
After the payroll is calculated and completed, the company receives a statement of exactly how much was paid to employees and how much was paid in
taxes. After the statement arrives, allocating the $15,000 to specific accounts
such as payroll expenses or tax expenses, that information is posted to the
cash disbursements journal.
If you decide to keep a temporary posting journal to track cash coming in or
going out, before summarizing your cash disbursements journal and closing
the books for an accounting period, be sure to review the transactions listed
in the temporary posting journal that may need to be posted in the cash
­disbursements journal.
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Chapter 4
Reconciling Accounts and Closing
Journal Entries
In This Chapter
▶ Reconciling accounts and making adjustments
▶ Confirming that your journals are correct
▶ Gathering journal information for closing
▶ Posting adjustments to the general ledger
▶ Examining your journals in a computerized system
A
s the old saying goes, “The devil is in the details.” When it comes to
your bookkeeping, especially if you keep your books manually, those
details are in the accounts and journals you keep. And any errors in those
tiny details can lead to big problems down the road. To ensure accuracy, you
must reconcile your accounts and prove out your journals and close them
at the end of an accounting period, which is what this chapter is all about.
Within these pages, you also find out how to post all corrections and adjustments to the general ledger after you make them in the appropriate journal.
(To find out how to set up your journals, see Book I, Chapter 3.)
Reconciling Bank Accounts
Reconciling bank accounts involves verifying whether the cash balance in
your accounting records agrees to the cash balance on your bank statement.
Accountants use the phrase balance per book to refer to the cash balance
in the accounting records. Balance per bank refers to your cash balance
­according to the bank statement.
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Book III: Adjusting and Closing Entries
Table 4-1 walks you through the bank reconciliation process. You’ve p
­ robably
reconciled your personal checking account at least a few times over the
years, and you’ll be happy to hear that reconciling business accounts is a
similar process that goes something like this:
1. Set up bank reconciliation template. Set up a template with two columns. The bank statement column represents bank activity and the cash
account column lists information from your accounting records. Post
the beginning balances at the top. The bank balance is taken from the
bank statement. The cash balance is the ending balance from your cash
account.
2. Mark cleared transactions. Compare the transactions in your cash
accounting records with the bank statement and mark cleared transactions — transactions that appear both in the bank records and in your
records. Because your book balance (accounting records) agrees with
the bank statement, you don’t need to do anything further with these
transactions. Note, however, that you’re not finished with the reconciliation process.
3. Note deposits in transit. Deposits in your cash account that aren’t listed
in the bank statement are called deposits in transit. Post the total dollar
amount as an addition to the bank column. In Table 4-1, deposits in transit total $300.
4. Post outstanding checks. Checks that aren’t posted to the bank statement are considered outstanding checks. Post the total dollar amount as
a subtraction from the bank column. In Table 4-1, outstanding checks
total $600.
5. Review the bank activity that isn’t posted to the cash account. Some
transactions in your bank statement may not be posted to the cash
account. In Table 4-1, $20 in bank interest is added to the cash b
­ alance —
because the interest isn’t yet posted to the cash account. If you have bank
fees, you subtract those fees from the cash account column.
6. Compare the bank and cash balances. If you have properly reconciled,
the bank balance should agree with the cash balance. In the table, both
ending balances are $720. Your cash account is reconciled with the bank
statement. If the balances don’t agree, you have more reconciling items
to investigate.
Table 4-1 shows a common format for reconciling a bank account.
Table 4-1 includes three reconciling items (entries accounted for on the
­statement but not on the books or vice versa): outstanding checks, deposits
in transit, and bank interest.
Chapter 4: Reconciling Accounts and Closing Journal Entries
Table 4-1
Bank Reconciliation
Bank
Statement
Cash
Account
Starting balance
$1,020
$700
Deposits in transit (not shown on statement)
300
Outstanding checks (not shown on
statement)
(600)
Interest (on statement but not posted to
books)
Adjusted balance
159
20
720
720
Tracking down reconciling items
Often, your book balance and the bank statement balance don’t agree.
That’s okay, because reconciling items are common. You just need
to adjust for uncleared transactions. Here’s a more complete list of
­reconciling items:
✓ If the adjusted bank balance is higher than your balance, check to be
sure that all the deposits listed by the bank appear in the cash account
in your books. If you find that the bank lists a deposit that you don’t
have, do some detective work to figure out what that deposit was for
and add the detail to your accounting records. Also, make sure you’ve
recorded all outstanding debits and added those amounts (as negative
values) to the ending balance on the bank statement.
✓ If the bank balance is lower than your balance, check that all checks
listed by the bank are recorded in your cash account. You may have
missed one or two checks that were written but not properly recorded.
You also may have missed a deposit that you have listed in your cash
account but that the bank hasn’t listed on the statement yet. If you
notice a missing deposit on the bank statement, be sure you have
your proof of deposit and confirm with the bank that the cash is in the
account.
✓ If all deposits and checks are correct but you still see a difference,
your only option is to make sure all checks and deposits were entered
correctly (and not entered twice by mistake or for a different dollar
amount) and check your calculations.
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Using a computerized system
If you use a computerized accounting system, reconciliation should be much
easier than if you keep your books manually. In QuickBooks, for example,
when you start the reconciliation process, a screen pops up in which you
can enter the ending bank statement balance and any bank fees or interest
earned. Figure 4-1 shows you that screen.
Figure 4-1:
Displaying
the reconciliation
process in
QuickBooks.
Intuit.com
After you click Continue, you get a screen that lists all checks written since
the last reconciliation as well as all deposits. You put a check mark next to
the checks and deposits that have cleared on the bank statement, as shown
in Figure 4-2, and then click Reconcile Now.
QuickBooks automatically reconciles the accounts and provides reports that
indicate any differences. It also provides a reconciliation summary, shown in
Figure 4-3, that includes the beginning balance, the balance after all cleared
transactions have been recorded, and a list of all uncleared transactions.
QuickBooks also calculates what your check register should show when the
uncleared transactions are added to the cleared transactions.
Chapter 4: Reconciling Accounts and Closing Journal Entries
Figure 4-2:
To reconcile
checking
by using
QuickBooks,
you put a
check mark
next to all
the checks
and deposits that have
cleared the
account
and click
Reconcile
Now.
161
Intuit.com
Book III
Figure 4-3:
After reconciling your
accounts,
QuickBooks
automatically
provides
a reconciliation
summary.
Adjusting
and Closing
Entries
Intuit.com
Posting Adjustments and Corrections
After you close out the cash receipts and cash disbursements journals and
reconcile the bank account with your accounting system, you need to post
any adjustments or corrections that you uncover to accounts that may be
impacted by the change. For example, Table 4-1 lists a reconciling item of $20
for bank interest. That interest isn’t yet posted to your books. To post the
item, debit (increase) cash $20 and credit (increase) other income $20.
162
Book III: Adjusting and Closing Entries
If you find that several customer payments haven’t been entered in the
cash receipts journal, you need to post those payments to the cash receipts
­journal, the accounts receivable journal, and the customers’ accounts.
The same is true if you find payments on outstanding bills that haven’t
been entered into the books. In such cases, post the payments to the cash
­disbursements journal and the accounts payable journal as well as to the
individual vendors’ accounts.
Prepping to Close: Checking
for Accuracy and Tallying
Things Up
Closing the books is the process of finishing up all your accounting activity
for the period (month or year). Said another way, closing the books ensures
that your accounting records are ready to start the next accounting period.
As you prepare to close the books, you first need to total what’s in your
­journals, which is called summarizing the journals. During the process, it’s a
good idea to look for errors and be sure that the entries accurately reflect the
business transactions during the accounting period.
Even the smallest error in a journal can cause a lot of frustration when you try
to run a trial balance and close out your books, so it’s best to do a thorough
search for errors as you close out each journal for the month. Finding an error
at this point in the closing process is much easier than trying to track it back
through all your various accounts.
Paying attention to initial
transaction details
Do a quick check to be sure the transaction details in your journals are
­accurate. The prior section explains how to do this type of check with the
cash journals. When you follow the rules of accrual accounting, however, not
all transactions involve cash. In accrual accounting, noncash transactions
can include customer purchases made on store credit (which you track in the
accounts receivable journal) and bills you will pay in the future (which you
track in the accounts payable journal). You may also create other journals to
track transactions in your most active accounts, and you probably also keep
details about sales in the sales journal and payroll in the payroll journal.
Chapter 4: Reconciling Accounts and Closing Journal Entries
163
In the payroll journal, make sure that all payroll for the month has been
added with all the proper details about salaries, wages, and taxes. Also verify
that you’ve recorded all employer taxes that need to be paid. These taxes
include the employer’s portion of Medicare and Social Security as well as
unemployment taxes. (For more about payroll and payroll taxes, see Book II,
Chapters 4 and 5.)
Summarizing journal entries
When you close your books at the end of the month, you summarize all the
journals — that is, you total the columns and post the totals to the general
ledger. Journals are temporary holding accounts for transactions. Eventually,
all accounting activity must be posted to the general ledger. The general
ledger, after all, is used to create financial statements.
Summarizing a journal is a four-step process:
1. Number each journal page at the top if it isn’t already numbered.
2. Total any column that’s not titled general debit or general credit. Any
transactions recorded in the general debit or general credit columns
need to be recorded individually in the general ledger.
3. Post the totals to the general ledger account. Each transaction in the
general credit or general debit column must be posted separately. Enter
the date and journal page number as well as the amount of the debit
or credit, so you can quickly find the entry for the original transaction
if you need more details. Keep in mind that total debits in the general
ledger should equal total credits.
4. In the post reference (PR) column of the journal, record ­information
about where the entry is posted. If the entry to be posted to the
accounts is summarized and totaled at the bottom of the page, you can
just put a check mark next to the entry in the PR column. For transactions listed in the general credit or general debit columns, you should
indicate an account number for the account into which the transaction
is posted. This process helps you confirm that you’ve posted all entries
in the general ledger.
Figure 4-4 shows a summarized journal page, specifically the cash receipts
journal. You can see that entries listed in the sales credit and cash debit
columns on the cash receipts journal are just checked. Only one entry was
placed in the general credit column, and that entry has an account number
in the PR column. Although Figure 4-4 doesn’t list all the transactions for the
month, which would of course be a much longer list, it does show how you
summarize the journal at the end of the month.
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Book III: Adjusting and Closing Entries
Figure 4-4:
Summary
of cash
receipts
journal
entries after
the first five
days.
©John Wiley & Sons, Inc.
As you can see in Figure 4-4, after summarizing the cash receipts journal,
there are only four general ledger accounts (general credit, accounts receivable credit, sales credit, and cash debit) and three customer accounts
(S. Smith, J. Jones, and P. Perry) into which you need to post entries. Even
better, the entries balance: $2,900 in debits and $2,900 in credits! To verify the
credit total, add the totals at the bottom of each credit column.
The customer accounts total $500, which is good news because it’s the same
amount credited to accounts receivable. The accounts receivable account
is decreased (credited) by $500 because payments were received, as is the
amount due from the individual customer accounts.
Summarizing the accounts receivable journal gives you a grand total of all
transactions for that period that involved customer credit accounts. Figure 4-5
shows a summary of an accounts receivable journal. The accounts receivable journal includes transactions from the sales journal (where c
­ ustomer
purchases on store credit first appear) and the cash receipts journal (where
customers’ payments toward their store credit accounts first appear) as well
as any credit memos for customer returns. The example in Figure 4-5 is only
a few lines long, but, in most companies, the accounts receivable journal is
very active with transactions posted every day the business is open during the
month. When you summarize the accounts receivable journal, you get a closing
balance that shows the total of all financial activity recorded in that journal.
Figure 4-5 shows a closing balance of $2,240, which is the amount outstanding
from customers.
Chapter 4: Reconciling Accounts and Closing Journal Entries
165
Figure 4-5:
A sample
accounts
receivable
journal
summary.
©John Wiley & Sons, Inc.
Each transaction in the journal should have a reference number next to it,
which tells you where the detail for that transaction first appears in the books.
Each line item in Figure 4-5 has a journal page reference.
When you check for errors in the journal, you may need to review the original
source information used to enter some transactions in order to double-check
that entry’s accuracy. In Chapter 3, you go over how to prove out cash, which
includes a review for errors. In addition to the accounts receivable journal,
you also have individual journal pages for each customer; these pages detail
each customer’s purchases on store credit and any payments made toward
those purchases. At the end of an accounting period, accountants prepare
an aging summary detailing all outstanding customer accounts. This report
shows you what money is due from customers and how long it has been due.
(See Book II, Chapter 3 for more about managing customer accounts.)
For the purpose of proving out the books, the aging report is a quick summary that ensures that the customer accounts information matches what’s
in the accounts receivable journal. Table 4-2 shows what an aging summary
would look like as of March 31, 2015.
Table 4-2
Aging Summary: Accounts Receivable
as of March 31, 2015
Customer
Current
31–60 Days
61–90 Days
S. Smith
$300
J. Doe
H. Harris
100
$300
$200
500
240
M. Man
400
200
Total
1,300
740
200
>90 Days
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In this sample accounts receivable aging summary, the total amount
­outstanding from customers matches the balance total in the accounts
receivable journal ($2,240) in Figure 4-5. To compute the total, add the total
receivable amount in each column above ($1,300 + $740 + $200 = $2,240).
Therefore, all customer accounts have been accurately entered in the books,
and the bookkeeper shouldn’t encounter any errors related to customer
accounts when running a trial balance, as explained in Chapter 5.
If you find a difference between the information in your journal and your
aging summary, review your customer account transactions to find the problem. An error may be the result of:
✓ Recording a customer purchase in the accounts receivable journal without recording the details of that transaction in the customer’s account.
✓ Recording a customer purchase directly into the customer’s account
without adding the purchase amount to the accounts receivable journal.
✓ Recording a customer’s payment in the customer’s account without
recording the cash receipt in the accounts receivable journal.
✓ Recording a customer’s payment in the accounts receivable journal without recording the cash receipt in the customer’s account record.
The process of summarizing and closing out the accounts payable journal is
similar to that of the accounts receivable journal. For accounts payable, you
can prepare an aging summary for your outstanding bills as well. That summary should look something like Table 4-3.
Table 4-3
Aging Summary: Accounts Payable
as of March 31, 2015
Vendor
Current
American Bank
$150
Carol’s Realty
800
31–60
Days
Helen’s Paper Goods
$250
Henry’s Bakery
Supplies
500
Plates Unlimited
400
200
Total
1,350
950
61–90
Days
>90
Days
Chapter 4: Reconciling Accounts and Closing Journal Entries
167
The total of outstanding bills on the accounts payable aging summary should
match the total shown on the accounts payable journal summary for the
accounting period. If yours match, you’re ready for a trial balance. If they
don’t, you must figure out the reason for the difference before closing out the
accounts payable journal. Keep in mind that the vendor is the company that
sold you the product or service on credit. The problem may be the result of:
✓ Recording a bill due in the accounts payable journal without recording it
in the vendor’s account.
✓ Recording a bill due in the vendor’s account without recording it in the
accounts payable journal.
✓ Making a payment to the vendor in the vendor’s account without
­recording it in the accounts payable journal.
✓ Making a payment to the vendor and recording it in the accounts
­payable journal but neglecting to record it in the vendor’s account.
Correct any problems you find before closing out the journal. If you know that
you may be working with incorrect data, you don’t want to try to do a trial
­balance. A trial balance with errors can’t be used to generate accurate
­financial reports. Generating a trial balance without checking for errors is
wasted effort.
Book III
Analyzing summary results
You may be wondering how you can find problems in your records by just
reviewing a page in a journal. Well, that skill comes with experience and
practice. As you summarize your journals each month, you’ll become familiar with the expected level of transactions and the types of transaction that
occur month after month. If you don’t see a transaction that you expect to
find, take the time to research the transaction to find out why it’s missing.
Perhaps the transaction didn’t occur or someone forgot to record it.
For example, suppose that when summarizing the payroll journal, you
notice that the payroll for the 15th of the month seems lower than normal.
As you check your details for that payroll, you find that the amount paid
to hourly employees was recorded, but someone didn’t record the amount
paid to ­salaried employees. For that particular payroll, the payroll company ­experienced a computer problem after running some checks and as a
result sent the final report on two separate pages. The person who recorded
the payroll numbers didn’t realize there was a separate page for salaried
­employees, so the final numbers entered into the books didn’t reflect the full
amount paid to employees.
Adjusting
and Closing
Entries
168
Book III: Adjusting and Closing Entries
As you close the books each month, you’ll get an idea of the numbers you can
expect for each type of journal. After a while, you’ll be able to pick out
­problems just by scanning a page — no detailed research required!
Planning for cash flow
The process you go through each month as you prepare to close your books
helps you plan for future cash flow. Reviewing the accounts receivable and
accounts payable aging summaries tells you what additional cash you can
expect from customers during the next few months and how much cash
you’ll need in order to pay bills for the next few months.
If you notice that your accounts payable aging summary indicates that
more and more bills are slipping into past-due status, you may need to find
another source for cash, such as a credit line from the bank. For example, the
accounts payable aging summary reveals that three key vendors — Helen’s
Paper Goods, Henry’s Bakery Supplies, and Plates Unlimited — haven’t been
paid on time. Late payments can hurt your business’s working relationship
with vendors; they may refuse to deliver goods unless cash is paid upfront.
And if you can’t get the raw materials you need, you may have trouble filling
customer orders on time. The lesson here is to act quickly and find a way to
improve cash flow before your vendors cut you off. (For more on accounts
payable management, check out Book II, Chapter 2.)
You may also find that your accounts receivable aging summary reveals that
certain previously good customers are gradually becoming slow or nonpaying customers. For example, J. Doe’s account is past due, and at least some
portion of his account is overdue by more than 60 days. The bookkeeper
dealing with these accounts may need to consider putting a hold on that
account until payment is received in full. (For more on accounts receivable
management, check out Book II, Chapter 3.)
Posting to the General Ledger
An important part of closing your books is posting to the general ledger any
corrections or adjustments you find as you close the journals. This type of
posting consists of a simple entry that summarizes any changes you found.
For example, suppose you discover that a customer purchase was recorded
directly in the customer’s account record but not in the accounts receivable
journal. You have to research how that transaction was originally recorded.
Chapter 4: Reconciling Accounts and Closing Journal Entries
169
If the only record was a note in the customer’s account, both the sales
account and the accounts receivable account are affected by the mistake —
both ­balances are understated. The correcting entry looks like this:
Accounts receivable
Sales
To record sale to J. Doe on 3/15/2015 — corrected
3/31/2015.
Debit
$100
Credit
$100
If you find this type of error, the sales transaction record for that date of sale
isn’t accurate, which means that someone bypassed your standard bookkeeping process when recording the sale. You may want to research that part of the
issue as well because there may be more than just a recording problem behind
this incident. Someone in your company may be allowing customers to take
product, purposefully not recording the sale appropriately in your books, and
pocketing the money instead. It’s also possible that a salesperson recorded a
sale for a customer that never took place. If that’s the case and you bill the
customer, he would likely question the bill, and you’d find out about the problem at that point.
The process of proving out your journals, or any other part of your b
­ ookkeeping
records, is a good opportunity to review your internal controls as well. As you
find errors during the process of proving out the books, keep an eye out for
exceptions (probably similar errors that appear frequently) that may indicate
bigger problems than just bookkeeping mistakes.
Repeat errors may call for additional staff training to be sure your bookkeeping rules are being followed to a T. Unfortunately, such errors may
be evidence that someone in the company is deliberately recording false
­information. Whatever the explanation, you need to take corrective action.
(See Book IX, Chapter 2 for coverage of internal controls.)
Checking Out Computerized
Journal Records
Although you don’t have to close out journal pages if you keep your books
by using a computerized accounting system, running a spot-check (at the
very least) of what you have in your paper records versus what you have
on your computer is a smart move. Simply run a series of reports by using
your ­computerized accounting system and then check to be sure that those
­computer records match what you have in your files.
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Book III: Adjusting and Closing Entries
For example, in QuickBooks, go to the Report Navigator and click on Vendors
& Payables. The first section of the navigator page, shown in Figure 4-6, is
called A/P Aging (due and overdue bills). This section offers three possible
reports: Summary, which shows how much is due for each vendor; Detail,
which gives a list of bills due and overdue; and an Accounts Payable Graph
that illustrates your outstanding bills.
Figure 4-6:
QuickBooks
allows you
to run a
number
of reports
concerning
vendors and
payables.
Essentially,
these
reports
tell you
how much
money your
company
owes to
others.
Intuit.com
Figure 4-7 shows you the kind of detail you get when you select the Detail
report. The Detail report is divided into:
✓ Current bills
✓ Bills overdue by 1 to 30 days
✓ Bills overdue by 31 to 60 days
✓ Bills overdue by 61 to 90 days
✓ Bills overdue by more than 90 days
Obviously, anything in the last two sections — overdue by more than 60 days —
is bad news. You can expect a supplier or vendor whose bills appear in these
­columns to soon cut you off from additional credit until your account is
up-to-date.
Chapter 4: Reconciling Accounts and Closing Journal Entries
171
Figure 4-7:
When you
run an
Accounts
Payable
Detail
report in
QuickBooks,
you get a
listing of all
outstanding
bills, the
dates the
bills were
received,
and the
dates
they’re due.
Intuit.com
In addition to locating your bill-paying problem areas, you can also use the
information in the Detail report to verify that the paper bills you have waiting
to be paid in vendor files match what you have on your computer. You don’t
need to check every bill, but doing a spot-check of several bills is good practice. The goal is to verify the accuracy of your records as well as make sure
that no one’s entering and paying duplicate or nonexistent bills.
When it comes to cash flow out of the business, keep tight controls on who can
actually sign checks and how the information that explains those checks is
recorded. See Book II, Chapter 2 for more about the importance of s­ eparating
duties to protect each aspect of your bookkeeping system from corruption.
You can also run reports showing the information recorded in your accounts
receivable account. Figure 4-8 shows you a list of possible reports to run
from the Customers & Receivables page. In addition to the Summary, Detail,
and Accounts Receivable Graph, you can also run a report for Open Invoices,
which lists outstanding customer invoices or statements, and Collections,
which lists not only overdue customers but also how much they owe and
their contact information.
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Figure 4-8:
In
QuickBooks,
you can run
a series of
reports that
summarize
customer
accounts.
Intuit.com
Again, running spot-checks on a few customer accounts to be sure your
paper records of their accounts match the information in your computerized
system is a good idea. There’s always a chance that a customer’s purchase
was entered in error in the computer, and you could end up sending the bill
to the wrong person.
Some companies double-check their accounts receivable bookkeeping for
accuracy by sending surveys to customers periodically (usually twice a year)
to see whether their accounts are correct. If you choose to do this, include
with the customer’s bill a postage-paid card asking whether the account is
­correct and giving the customer room to indicate any account problems
before mailing the card back to your company. You can also send a survey by
e-mail. In most cases, a customer who has been incorrectly billed will contact
you soon after getting that bill — especially if he or she has been billed for
more than anticipated.
In addition to keeping actual accounts, such as accounts payable or accounts
receivable, your computerized accounting system keeps a journal of all your
company’s transactions. This journal contains details about all your transactions over a specified time period and the accounts that were impacted by
each transaction. Figure 4-9 is a sample computerized journal page.
Chapter 4: Reconciling Accounts and Closing Journal Entries
173
Figure 4-9:
A computerized
accounting
system
keeps a
journal of
all transactions,
which you
can review
during the
closing
process.
Intuit.com
If you need to be reminded of how you recorded a transaction into your
­ omputerized accounting system, run the journal report by date, isolating all
c
transactions that took place at a particular time. Running a report by date can
be a helpful tool if you’re trying to locate the source of an error in your books;
if you find a questionable transaction, you can open the detail of that
­transaction and see how it was entered and where you can find the original
source material.
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Chapter 5
Checking Your Accuracy
In This Chapter
▶ Checking your math with a trial balance
▶ Finding and correcting errors
▶ Preparing a worksheet
▶ Generating reports from your computerized system
A
fter you close all your journals and do your best to catch any and all
errors (flip to Chapter 4 for instructions on how to do this), the time
comes to test your work. If you’ve entered all double-entry transactions into
the books correctly, the books balance out, and your trial’s a success!
Unfortunately, few bookkeepers get their books to balance on the first try. And
in some cases, the books balance, but errors still exist. This chapter explains
how you do a trial balance of your books and gives tips on finding any errors
that may be lurking. You also find out how to take your first step toward developing financial reports (see Books IV and V) by creating a worksheet.
Working with a Trial Balance
When you first start entering transactions in a dual-entry accounting system,
you may think, “This is a lot of work, and I don’t know how I’m ever going to
use all this information.” You enter all your transactions, using debits and
credits, without knowing whether they’ll actually produce useful financial
information that you can use to gauge how well your business is doing. It’s
not until after you close your journals and prepare your first set of financial
reports that you truly see the value of double-entry accounting.
The first step toward producing useable reports that help you interpret your
financial results is doing a trial balance — a worksheet prepared manually or
spit out by your computer accounting system that lists all the accounts in your
general ledger and each account balance at the end of an accounting period.
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Book III: Adjusting and Closing Entries
The purpose of the trial balance is to prove that, at least mathematically, your
debits and credits are equal. If any errors exist in your calculations or in the
way you summarized the journals or posted the summaries to the general
ledger, they’re uncovered in the trial balance when total debits and total
credits don’t come out equal.
Conducting your trial balance
If you’ve entered transactions manually, you create a trial balance by listing all the accounts with their ending debit or credit balances. (See Book I,
Chapter 2 for more about debits and credits.) After preparing the list, you
total both the debit and credit columns. If the totals at the bottom of the two
columns are the same, the trial is a success, and your books are in balance.
Following are step-by-step instructions for developing a trial balance:
1. Prepare a worksheet with three columns: one for account titles,
one for debits, and one for credits.
2. Fill in all the account titles and record their balances in the
appropriate debit or credit columns.
3. Total the dollar amounts in the debit column and write the total
at the bottom of the column.
4. Total the dollar amounts in the credit column and write the total
at the bottom of the column.
5. Compare the debit and credit column totals.
Figure 5-1 shows a sample trial balance for a company as of May 31, 2014.
Note that the debit column and the credit column both equal $57,850, making
this a successful trial balance.
A successful trial balance is no guarantee that your books are free of errors; it
just means that all your transactions have been entered in balance. The books
may still contain errors related to how you entered your transactions, including:
✓ You forgot to put a transaction in a journal or in the general ledger.
✓ You forgot to post a journal entry to the general ledger.
✓ You posted a journal entry twice in either the general ledger or in the
journal.
✓ You posted the wrong amount.
✓ You posted a transaction to the wrong account.
✓ Your account doesn’t display a normal balance, as explained in the
next section.
Chapter 5: Checking Your Accuracy
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Book III
Adjusting
and Closing
Entries
Figure 5-1:
A sample
trial
balance.
©John Wiley & Sons, Inc.
Understanding normal balances for your accounts
Every account should consistently display either a debit or credit balance,
depending on the type of account. Accountants refer to these balances as
normal balances. Asset accounts normally display debit balances. Cash, an
asset account, should have a debit balance at any point in time. Expense
accounts in the income statement also have a normal debit balance.
Liability and equity accounts have normal credit balances. Accounts payable,
a liability account, should have a credit balance. Revenue (or sales) in the
income statement also has a normal credit balance.
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Book III: Adjusting and Closing Entries
During your trial balance review, if you notice an account that doesn’t have
a normal balance, that could be the sign of an error. You should consider
making a journal entry to adjust the account. Every account should have a
normal balance, or a balance of zero.
Adjusting an account to properly reflect a normal balance
Assume that you compile your trial balance and notice that your ending balance in cash is a credit balance of $100. A normal balance for cash, an asset
account, is a debit balance. The credit balance in cash is a negative balance. If
you have a negative balance in the bank, that means the bank has given you a
loan. The negative amount (or overdraft) must be paid back to the bank.
As mentioned in the previous section, you need to post a journal entry to
adjust the cash balance to zero. In this case, you would debit cash $100 and
credit loans payable (a liability account) $100. Your cash balance is now zero,
and you have properly set up a loan balance for the amount you owe the bank.
If, by chance, the errors listed here slip through the cracks, there’s a good
chance that the discrepancy will become evident in the financial reports.
Dealing with trial balance errors
If your trial balance isn’t correct, you need to work backward in your closing
process to find the source of the mathematical error. And remember, bookkeepers and accountants work with pencils instead of pens for this reason —
pencils make correcting errors much easier. When you need to find errors
after completing a trial balance that fails, follow these four basic steps to
identify and fix the problem:
1. Check your math. Keep your fingers crossed and total the debits and
credits in your trial balance again to be sure the error isn’t just one of
addition. That’s the simplest kind of error to find. Correct the addition
mistake and re-total your columns.
2. Compare your balances. Double-check the balances on the trial balance
worksheet by comparing them to the totals from your journals and your
general ledger. Be sure you didn’t make an error when transferring the
account balances to the trial balance. Correcting this type of problem
isn’t very difficult or time-consuming. Simply correct the incorrect balances, and total the debits and credits in your trial balance again.
Chapter 5: Checking Your Accuracy
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3. Check your journal summaries. Double-check the math in all your
journal summaries, making sure that all totals are correct and that any
totals you posted to the general ledger are correct. Running this kind of
a check, of course, is somewhat time-consuming, but it’s still better than
rechecking all your transactions. If you do find errors in your journal
summaries, correct them, reenter the totals correctly, change the numbers on the trial balance worksheet to match your corrected totals, and
retest your trial balance.
4. Check your journal and general ledger entries. Unfortunately, if Steps
1, 2, and 3 fail to fix your problem, all that’s left is to go back and check
your actual transaction entries. The process can be time-consuming, but
the information in your books isn’t useful until your debits equal your
credits.
If Step 4 is your last resort, scan through your entries looking specifically for ones that appear questionable. For example, if you see an entry
for office supplies that’s much larger or much smaller than usual, check
the original source material for that entry to be sure it’s correct. If you
carefully proved out the accounts payable and accounts receivable journals as explained in Chapters 3 and 4, you can concentrate your efforts
on accounts with separate journals. After you find and correct the
error(s), run another trial balance. If total debits and total credits still
don’t match up, repeat the steps listed here until your debits and credits
equal out.
You can always go back and correct the books and do another trial balance
before you prepare the financial reports. Don’t close the books for the
accounting period until the financial reports are completed and accepted.
See Books IV and V for more about preparing financial reports.
Testing Your Balance by Using
Computerized Accounting
Systems
If you use a computerized accounting system, it automatically generates your
trial balance for you. Because the system enables you to enter only transactions
that are in balance, the likelihood that your trial balance won’t be successful is
pretty slim. But that doesn’t mean your accounts are guaranteed error-free.
Book III
Adjusting
and Closing
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180
Book III: Adjusting and Closing Entries
Remember the saying, “Garbage in, garbage out?” If you make a mistake when
you enter transaction data into the system, even if the data’s in balance, the
information that comes out will also be in error. Although you don’t have to
go through the correction steps covered in the earlier section “Dealing with
trial balance errors” to reach a successful trial balance, you still may have
errors lurking in your data.
Accountants frequently run an automated trial balance report at the end of
every period. You’ll get in the habit of reviewing the trial balance, making
corrections, and running a new trial balance. In addition to the trial balance,
automated systems can generate a report showing the general ledger, transaction detail by account, journal detail, voided transactions, and transactions
by date. In QuickBooks, you can assess the Accountant & Taxes page, as
shown in Figure 5-2, to find these reports.
A business’s accountant is likely to use many of the report options to doublecheck that transactions were entered correctly and that no one is playing
with the numbers. In particular, the accountant may use a report option
called Audit Trail, which reveals what changes impacted the company’s
books during an accounting period and who made those changes. This type
of report is available in most automated accounting systems.
Figure 5-2:
The
Accountant
&
Taxes page
of Quick­
Books’s
Report
Navigator
provides the
option of
creating
many useful
reports.
Intuit.com
Although it doesn’t match the trial balance done manually in Figure 5-1, the
QuickBooks trial balance shown in Figure 5-3 gives you an idea of what a
computerized accounting trial balance looks like.
Chapter 5: Checking Your Accuracy
181
Figure 5-3:
A sample
trial balance
report
produced by
QuickBooks.
Intuit.com
Developing a Financial
Statement Worksheet
After your accounts successfully pass a trial balance test (see “Conducting
your trial balance” earlier in this chapter), you can take your first stab at creating financial statements, including a balance sheet and an income statement.
The first step in producing these statements is using the information from
the trial balance and its corrections to develop a worksheet that includes the
initial trial balance, the accounts that would normally appear on a balance
sheet, and the accounts that would normally appear on an income statement.
You create the worksheet that includes these seven columns:
✓ Column 1: Account list
✓ Columns 2 and 3: Trial balance (one column for debits, one column for
credits)
✓ Columns 4 and 5: Balance sheet (one column for debits, one column for
credits)
✓ Columns 6 and 7: Income statement (one column for debits, one column
for credits)
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Book III: Adjusting and Closing Entries
Figure 5-4 shows a sample of a worksheet developed from trial balance
numbers. Note that the numbers of the trial balance are transferred to the
appropriate financial statement; for example, the cash account, which is an
asset account, is shown in the debit column of the balance sheet. (See Books
IV and V for more about creating financial statements.)
Figure 5-4:
This sample
worksheet
shows the
first step in
developing
a company’s
financial
statements.
©John Wiley & Sons, Inc.
After you transfer all the accounts to their appropriate balance sheet or
income statement columns, you total the worksheet columns. Don’t panic
when you see that the totals at the bottom of your columns aren’t equal,
because the net income hasn’t been calculated yet. However, the difference
between the debits and credits in both the balance sheet and the income
statement totals should be the same. That amount should represent the net
income that will appear on the income statement. (See Book IV, Chapter 2 for
more about the income statement.)
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In Figure 5-4, the $4,500 difference for the balance sheet is shown as a credit,
representing an increase in retained earnings. The retained earnings account
reflects the profits that have been reinvested into the company’s assets in
order to grow the company. You can find more about retained earnings in
Book IV, Chapter 5.
In some companies, earnings are taken out in the form of dividends paid to stockholders. Dividends are a portion of the earnings divided among stockholders.
The board of directors of the corporation establishes that a certain amount per
share be paid to stockholders. A company must have earnings (either from the
current year or in retained earnings) to pay a dividend. If a company has no earnings at all — either in the current year or accumulated in retained earnings from
past years — payments to shareholders are considered to be return of capital.
Many other small companies that haven’t incorporated pay earnings to their
owners by using a drawing account, which tracks any cash taken out by the
owners. Each owner should have his or her own drawing account so that
you have a history of how much each owner withdraws from the company’s
resources.
Replacing Worksheets with
Computerized Reports
If you use a computerized accounting system, you don’t have to create a
worksheet. Instead, the system gives you the option of generating many different types of reports to help you develop your income statement and balance sheet.
One of the advantages of your computerized system’s reports is that you can
easily look at your numbers in many different ways. To get the report you
want, all you do is click on the report title.
A typical computerized accounting system can generate a number of different
reports within the following categories:
✓ Profit and loss (income statement): Some key reports in this section
include
• A standard report that shows how much the company made or lost
during a specific period of time
• A detail report that includes all the year-to-date transactions
• A report that compares year-to-date figures with the previous
year (provided you kept the accounts by using the computerized
system in the previous year)
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Book III: Adjusting and Closing Entries
✓ Income and expenses: Some key reports in this section include
• Income by customer (both a summary and a detailed report)
• Expenses by vendor (both a summary and a detailed report)
✓ Balance sheet and net worth: Some key reports in this section include
• A standard balance sheet showing a summary of assets, liabilities,
and equity
• A detail report of assets, liabilities, and equity
• A report that compares the assets, liabilities, and equity levels
with those of the previous year
✓ Cash flow: Some key reports in this section include
• A statement of cash flows for the year
• A forecast of cash flows during the next few weeks or months
based on money due in accounts receivable and money to be paid
out in accounts payable
Computerized accounting systems provide you with the tools to manipulate
your company’s numbers in whatever way you find useful for analyzing your
company’s results. And if a report isn’t quite right for your needs, you can
customize it. For example, if you want to see the profit and loss results for a
particular week during an accounting period, you can set the dates for only
that week and generate the report. You can also produce a report looking at
data for just one day, one month, one quarter, or any combination of dates.
Most computerized accounting systems, including QuickBooks, enable you
to custom design reports that meet your company’s unique financial information needs. Many companies customize reports to collect information by
department or division. You’re limited only by your imagination!
As you work with your computerized system, you’ll be asked for information
not easily found by using standardized reports. The first few times you pull
that information together, you may need to do so manually. But as you get
used to your computerized accounting system and its report functions, you’ll
be able to design customized reports that compile and present information in
just the way you need it.
Chapter 6
Adjusting the Books
In This Chapter
▶ Going over types of accounting adjustments
▶ Making adjustments for noncash transactions
▶ Taking your adjustments for a trial (balance) run
D
uring an accounting period, your bookkeeping duties focus on your
business’s day-to-day transactions. When the time comes to report
transactions in financial statements, you must make some adjustments to
your books. Your financial reports are supposed to report your company’s
financial condition, so your books must reflect any significant change in the
value of your assets, even if that change doesn’t involve the exchange of
cash. Those changes are adjustments.
If you use cash-basis accounting, many adjustments aren’t necessary because
you record transactions only when cash changes hands. (See Book I,
Chapter 4 to find out more about the two accounting methods: accrual and
­cash-basis.)
This chapter reviews the types of adjustments you need to make to the
books before preparing financial statements. Adjustments include calculating
asset depreciation, dividing prepaid expenses, updating inventory numbers,
­dealing with bad debt, and recognizing salaries and wages not yet paid.
Adjusting All the Right Areas
Even after testing your books by using the trial balance process explained
in Chapter 5, you still need to make some adjustments before you’re able to
­prepare accurate financial reports.
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Book III: Adjusting and Closing Entries
Adjusting entries can be grouped into four categories:
✓ Converting assets into expenses: This book defines assets as resources
you use to make money in your business. As you use assets, those dollars become expenses. Assume that your company owns a truck. When
you recognize depreciation on your truck, you make an adjusting entry
to reduce the asset’s value and post-depreciation expense.
✓ Converting liabilities into revenue: Unearned revenue is defined as
payments you receive from customers before you provide a product or
service. Unearned revenue is a liability account. If you don’t deliver the
product or service, you have to return the payment. When you pay for
a one-year magazine subscription in advance, your payment represents
unearned revenue to the magazine publisher. As the publisher delivers
magazines to you, it moves some of your payment into earned revenue.
That journal entry is an adjustment.
✓ Accruing unpaid expenses: When you owe money for an expense at
the end of an accounting period, you make an adjustment to accrue
the expense. Suppose you owe payroll to your staff for the last week of
December. Your next payroll pay date is January 5. On December 31, you
debit payroll expense and credit accrued payroll liability for December
payroll.
✓ Accruing uncollected revenue: If you’ve earned revenue, but haven’t
yet received the payment in cash, you make an adjustment to accrue
revenue. If you’ve earned interest on your bank balance, but haven’t
yet received interest from the bank, you make an adjustment. You debit
(increase) accounts receivable and credit interest income (revenue) for
the interest earned.
An adjusting entry always uses a balance sheet account and an income statement account. Keep that in mind when posting adjusting entries.
Here are three other specific adjustments you may make to your books:
✓ Prepaid expenses: Prepaid expenses are expenses incurred for benefits
to be received in the future. This adjustment matches expenses incurred
with the benefits received for a period of time. For example, if you pay
an annual insurance premium with a single payment, you should move
1/12th of that payment to insurance expense each month of the year.
✓ Bad debts: Bad debt expense is posted to acknowledge that some customers will never pay. Accountants refer to the process as writing off
a receivable account. You debit bad debt expense and credit (reduce)
accounts receivable.
✓ Supplies: Many companies perform a count of the supplies they have on
hand at the end of the month. They use that count to calculate the dollar
amount of supplies used during the month. The adjustment is to debit
supply expense and credit an asset account — supplies.
Chapter 6: Adjusting the Books
187
Depreciating assets
The largest noncash expense for many businesses is depreciation. Depreciation
is an accounting chore that’s important for every business because it reflects
the use and decline in value of assets. (For more on depreciation and why you
do it, check out Chapter 1.)
The time to adjust the books for depreciation is when you close the books for
an accounting period. Some businesses record depreciation expenses every
month to more accurately match monthly expenses with monthly revenues,
but many business owners make depreciation adjustments only once a year,
when they prepare their annual financial statements.
Depreciation doesn’t involve the use of cash. By accumulating depreciation
expenses on an asset, you’re reducing the value of the asset as shown on the
balance sheet (see Book IV, Chapter 4 for the lowdown on balance sheets).
Readers of your financial statements can get a good idea of the usefulness of
your assets by reviewing your accumulated depreciation. If a financial statement shows that assets are close to being fully depreciated, readers know
that you’ll probably need to spend significant funds on replacing or repairing
those assets sometime soon. As readers evaluate the financial health of the
company, they take that future obligation into consideration before making a
decision to loan money to the company or possibly invest in it.
Usually, you calculate depreciation for accounting purposes by using the
straight-line depreciation method. This method is used to calculate an amount
to be depreciated that will be equal each year based on the anticipated useful
life of the asset.
For example, suppose your company purchases a car that costs $25,000. You
anticipate that car will have a useful lifespan of five years and will be worth
$5,000 after five years. Using the straight-line depreciation method, you first
subtract $5,000 from the total car cost of $25,000 to find the value of the car
during its five-year useful lifespan ($20,000). $20,000 represents the depreciable base. Next, you divide $20,000 by 5 to find your depreciation expense for
the car ($4,000 per year). When adjusting the assets at the end of each year
in the car’s five-year lifespan, your entry to the books should look like this:
Depreciation expense
Accumulated depreciation: Vehicles
To record depreciation for vehicles.
Debit
$4,000
Credit
$4,000
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Book III: Adjusting and Closing Entries
This entry increases depreciation expense, which appears on the income
statement (see Book IV, Chapter 2). The entry also increases accumulated
depreciation, which is the use of the asset and appears on the balance sheet
directly below the vehicles asset line. The vehicle asset line always shows the
value of the asset at the time of purchase (cost). So, the fixed asset section of
your balance sheet after one year of vehicle depreciation would be:
Vehicle
Accumulated depreciation: Vehicles
$25,000 (Cost)
($5,000)
You see several times in this book that you debit asset accounts to increase
them. Accumulated depreciation is an exception to that rule — this account is
a contra-asset account (an account with a normal balance that is the oppo­­­site of
other accounts in the same category, as explained in Book IV, Chapter 3). In the
previous journal entry, accumulated depreciation is credited for an increase in
depreciation expense. Using a credit for accumulated depreciation allows you
to present a reduction in the asset you’re depreciating. So, the $25,000 vehicle
has $5,000 in depreciation expense. Each asset in your fixed asset listing has its
own accumulated depreciation account.
You can speed up depreciation if you believe that the asset will be used more
heavily in the early years of ownership. Book III, Chapter 1 discusses alternative depreciation methods in greater detail.
If you use a computerized accounting system as opposed to keeping your
books manually, you may not need to make this adjustment at the end of
an accounting period. If your system is set up with an asset management
feature, depreciation is automatically calculated, and you don’t have to do
it. Check with the person who set up the asset management feature before
­calculating and recording depreciation expenses.
Allocating prepaid expenses
Most businesses have to pay certain expenses at the beginning of the year
even though they’ll benefit from that expense throughout the year. Insurance
is a prime example of this type of expense. Most insurance companies require
you to pay the premium annually at the start of the year even though the
value of that insurance protects the company throughout the year.
For example, suppose your company’s annual car insurance premium is
$1,200. You pay that premium in January in order to maintain insurance
­coverage throughout the year. For accounting purposes, you need to match
the benefit you receive (insurance coverage) with the expense of that benefit
(paying insurance premiums).
Chapter 6: Adjusting the Books
189
As a first step, you record the cost as an asset called prepaid expenses, and
then you adjust the value of that asset to reflect that it’s being used up.
Prepaid expenses are assets, because they represent costs that are already
paid for. In other words, you don’t have to pay the cost later — and that’s an
asset to you. Your $1,200 annual insurance premium is actually valuable to
the company for 12 months, so you calculate the actual expense for insurance by dividing $1,200 by 12, resulting in a monthly expense of $100. At the
end of each month, you record the use of that asset by preparing an adjusting
entry that looks like this:
Insurance expenses
Prepaid expenses
To record insurance expenses for one month.
Debit
$100
Credit
$100
This entry increases insurance expenses on the income statement and
decreases the asset prepaid expenses on the balance sheet. No cash changes
hands in this entry because cash was reduced when the insurance bill was
paid, and the asset account prepaid expenses was increased in value at the
time the cash was paid.
Counting inventory
Inventory is a balance sheet asset that needs to be adjusted at the end of an
accounting period. During the accounting period, your company has several
issues related to inventory:
✓ Beginning inventory: When you open your doors at the beginning of a
period (month, year), you have a certain amount of inventory on hand,
or beginning inventory.
✓ Purchases: During the month, you make purchases. You debit inventory
and credit cash or accounts payable.
✓ Sales: When you sell inventory, you debit cash or accounts receivable and credit sales for the sale price. You also debit cost of sales (an
expense account) and credit inventory for the cost of inventory. The
­difference between sales and cost of sales is your profit.
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Book III: Adjusting and Closing Entries
At the end of the accounting period, you adjust the inventory value to
reflect your ending inventory balance. Here’s the formula to calculate ending
­inventory:
Beginning inventory + Purchases – Sales = Ending inventory
The steps for making proper adjustments to inventory in your books are as
follows:
1. Perform a physical count of ending inventory.
In addition to calculating ending inventory by using the previous
­formula, you should consider performing a physical count of inventory
to be sure that what’s on the shelves matches what’s in the books. Try
to perform the physical count as close as possible to the last day of the
accounting period, so the physical inventory on hand will be close to
your accounting record balance for the last day of the period.
2. Consider the value of your ending inventory.
The value of ending inventory varies depending on the method
your company chooses to use for valuing inventory. For more about
­inventory value and how to calculate the value of ending inventory, see
Book II, Chapter 2. As mentioned in that chapter, you should apply the
same valuation method for your inventory each year. If you choose to
change the method, you need a justification.
3. Adjust the ending inventory balance.
When you physically count the units of inventory and compute each
unit’s value, you add up the total. The total ending inventory value in the
physical count may differ from that value in your accounting records.
If the two values differ, you need to investigate. Either the accounting
records are wrong, or your count had an error. You may need to adjust
your inventory records, depending on the results of the count. That’s
another adjustment at the end of the period.
If you track inventory by using your computerized accounting system, the
system makes adjustments to inventory as you record sales and make purchases. At the end of the accounting period, the value of your company’s
ending inventory should be adjusted in the books already.
Allowing for bad debts
No company likes to accept the fact that it will never see the money owed
by some of its customers. Unfortunately, that’s what happens to most
­companies that sell items on store credit. When your company determines
Chapter 6: Adjusting the Books
191
that a customer who has bought products on store credit will never pay for
them, you record the value of that purchase as a bad debt. (For an explanation of store credit, check out Book II, Chapter 3.) To find out more about
accounting for bad debt, continue reading the sections that follow.
Using an aging report
At the end of an accounting period, you should list all outstanding customer
accounts in an aging report (see Book II, Chapter 3). This report shows which
customers owe you money, how much they owe, and for how long they’ve
owed you. After a certain amount of time, you have to admit that some customers simply aren’t going to pay. Each company sets its own determination
of how long it waits before tagging an account as a bad debt. For example,
your company may decide that when a customer is six months late with a
payment, you’re unlikely to ever see the money.
After you determine that an account is a bad debt, you should no longer
include its value as part of your assets in accounts receivable. Including its
value doesn’t paint a realistic picture of your situation for the people reading your financial reports. Because the bad debt is no longer an asset, you
reduce the value of your accounts receivable to reflect the loss of that asset.
Selecting a bad debt method
Book III
You can record bad debts (write them off) in a couple of ways:
✓ By customer: Some companies identify the specific customers whose
accounts are bad debts and calculate the bad debt expense each
accounting period based on specific customer accounts.
✓ By percentage: Other companies look at their bad-debts histories and
develop percentages that reflect those experiences. Instead of taking the
time to identify each specific account that qualifies as a bad debt, these
companies record bad debt expenses as a percentage of their accounts
receivable.
However you decide to record bad debts, you need to prepare an adjusting
entry at the end of each accounting period to record bad debt expenses.
Here’s an adjusting entry to record bad debt expenses of $1,000:
Bad debt expense
Accounts receivable
To write off uncollectible customer accounts.
Debit
$1,000
Credit
$1,000
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Book III: Adjusting and Closing Entries
You can’t have bad debt expenses if you don’t sell to your customers on store
credit. You need to deal with bad debt only if you offer your customers the
convenience of buying your products on store credit.
If you use a computerized accounting system, check the system’s instructions for how to write off bad debt. The following steps walk you through the
process of writing off a bad debt and present an example to put all the concepts in context:
1. Initial accounting entries for a sale. Suppose you sell $1,000 in goods to
Acme Painting Company. You debit accounts receivable and credit sales
for $1,000. Assume your inventory cost was $870. You make a second
entry to debit cost of sales and credit (reduce) inventory for $870. Your
profit is sales less cost of sales, or ($1,000 – $870 = $130).
2. Review your aging reports. You review an aging report for accounts
receivable each month. As time goes on, you notice that the $1,000 Acme
Painting receivable becomes older.
3. Attempt collection of the debt. Every company should have a process
for following up on past due amounts. In your case, you send Acme letters requesting collection and make phone calls.
4. Determine whether the amount is collectable. Acme Painting goes out
of business. Because the company has insufficient assets to pay its bills,
you determine that the $1,000 receivable isn’t collectible.
5. Post the bad debt expense entry. Knowing the specific debt isn’t collectible; you debit bad debt expense and credit accounts receivable for
the $1,000 Acme owed.
Consider the impact on your business. The bad debt means that you’ll collect
$1,000 less than you planned. If bad debt amounts are large, they can impact
your cash flow planning. Check out Book IV, Chapter 3 for details on planning
your cash flow.
Growing your sales and dealing with the issue of bad debt
Every company wants to grow, which means increasing sales. Selling more
usually means selling to new customers. By definition, a new customer has
no payment history, so do your homework. Many companies purchase data
that documents the creditworthiness of various businesses. The data is similar to what you’d find in a personal credit report. Set financial guidelines for
new clients. In addition to checking credit reports, insist that new customers
pay on time. Until that client builds a track record of timely payments, you
can’t take the risk of the client paying late or not at all. If a new customer
doesn’t pay or pays late, consider whether continuing to do business with
that customer is a good idea.
Chapter 6: Adjusting the Books
193
Suppose your company generates $1,000,000 in sales and has bad debts
totaling 2 percent of sales ($20,000). Next year, you’re able to grow sales by
$200,000, with bad debt on your new sales of $10,000. A $10,000 bad debt
level is 5 percent of your new sales ($10,000 ÷ $200,000). Your bad debt as a
percentage of sales for the entire $1,200,000 is $30,000, or 2.5 percent. You
sold more, but your bad debt expense (both in total dollars and as a percentage of sales) increased.
Increasing sales is good, but if your collections on the new total sales amount
decline, you have a problem. A larger bad debt expense can result in lower
profit. In the previous example, bad debt expense increased from 2 to 2.5 percent of sales. Profit declined by 0.5 percent for every dollar in sales revenue.
Recognizing unpaid salaries and wages
Not all pay periods fall at the end of a month. If you pay your employees
every two weeks, you may end up closing the books in the middle of a pay
period. For example, assume employees aren’t paid for the last week of
March until the end of the first week of April. Your fiscal period ends on
March 31, which isn’t a payroll pay date.
In this case, you need to make an adjusting entry to record the payroll
expense incurred but not yet paid, also called accrued payroll. You estimate
the amount of the adjustment based on what you pay every two weeks.
Here’s how you can accrue for payroll:
1. Calculate your daily payroll expense. Take your total payroll for the
period (both before and after the end of the period) and divide that
amount by the number of days in the pay period. Typically a pay period
is two weeks. Assume your two-week payroll is $2,800. Your daily payroll
accrual is ($2,800 ÷ 14 days = $200 per day).
2. Compute payroll accrual. Compute the number of days to be accrued.
In this case, assume you need to accrue 7 days — the last week of
March. Your payroll accrual is (7 days × $200 per day = $1,400).
3. Post your accrual entry. Here’s the entry you post on March 31 to
accrue unpaid March payroll:
Payroll expenses
Accrued payroll expenses
To record payroll expenses for the last week of March.
Debit
$1,400
Credit
$1,400
Book III
Adjusting
and Closing
Entries
194
Book III: Adjusting and Closing Entries
After the cash is actually paid out, you reverse the accrual entry. You debit
to reduce the liability account (accrued payroll expenses) and credit cash
account, to account for the payment. Doing these extra entries may seem like
a lot of extra work, but if you didn’t match the payroll expenses for March
with the revenues for March, your income statements wouldn’t reflect the
actual state of your affairs. Without the payroll accrual, your March payroll
would be understated.
Testing an Adjusted Trial Balance
In Chapter 5, you find out why and how you run a trial balance on the
accounts in your general ledger. Adjustments to your books call for another
trial balance, the adjusted trial balance, to ensure that your adjustments are
correct and ready to be posted to the general ledger. You track all the adjusting entries on a worksheet similar to the one shown in Chapter 5. You need to
use this worksheet only if you’re doing your books manually. It’s not necessary if you’re using a computerized accounting system.
The key difference in the worksheet for the adjusted trial balance is that additional columns must be added to the worksheet. Columns include
✓ Column 1: Account titles.
✓ Columns 2 and 3: Unadjusted trial balance — the trial balance before
the adjustments are made — with Column 2 for debits and Column 3 for
credits.
✓ Columns 4 and 5: Adjustments. All adjustments to the trial balance are
listed in Column 4 for debits and Column 5 for credits.
✓ Columns 6 and 7: Adjusted trial balance. A new trial balance is calculated that includes all the adjustments. Be sure that the credits equal
the debits when you total that new trial balance. If they don’t, find any
errors before posting entries to the balance sheet and income statement
columns.
✓ Other columns: Use data from the adjusted trial balance columns and
create columns for a balance sheet and an income statement.
When you’re confident that all the accounts are in balance, post your adjustments to the general ledger so that all the balances in the general ledger
include the adjusting entries. With the adjustments, the general ledger can be
used to generate financial statements. After you finalize your general ledger
for the year, you may want to make changes to your chart of accounts, which
lists all the accounts in your accounting system. You may add or subtract
accounts, depending on the activity in your business.
Book IV
Preparing Income Statements
and Balance Sheets
You can use income statements and balance sheets to prove your business’s creditworthiness to prospective lenders. Find out how by visiting www.dummies.com/
extras/accountingaio.
In this book…
✓ Understand accounting standards that govern financial reporting for businesses and nonprofit organizations. To ensure accuracy and transparency, you need to know and comply with
these standards.
✓ Prepare an income statement to disclose a company’s bottom
line — its net profit or loss. Business owners, executives, and
managers, along with investors, often head first to the bottom
line to assess an organization’s financial condition.
✓ Report the value of a company’s current assets on the balance
sheet. Assets are everything the business uses to generate a
profit. See how a business converts current assets into cash
and puts it to use within the course of a year.
✓ Disclose debt in the balance sheet’s liabilities section and distinguish short-term from long-term debt. (Hint: Short-term debt
must be repaid in less than a year. Long-term debt is repaid
over the course of a year or longer.)
✓ Calculate the dollar amount of equity in a company and report it
in the equity section of the balance sheet. Discover a business’s equity — what it would be worth if it were to sell all its
assets and pay back all its debt.
✓ Use the income statement and balance sheet in tandem to
draw conclusions about a company’s financial condition.
Viewing these sheets side-by-side reveals more than you may
imagine.
Chapter 1
Brushing Up on Accounting
Standards
In This Chapter
▶ Looking back at the origins of financial accounting standards
▶ Introducing the accountant’s code of conduct (set by the AICPA)
▶ Reviewing rules set by the Financial Accounting Standards Board (FASB)
▶ Finding out about generally accepted accounting principles (GAAP)
A
lthough accountants often ply their trade as freelancers, accounting
isn’t a free-for-all. Accountants are expected to operate according to
a professional code of conduct and practice generally accepted accounting
­principles (GAAP) — best practices for accounting in the United States.
This chapter begins with a whirlwind tour through the history of a
­ ccounting
that highlights the origins of accounting standards. Following this brief
historical account is an overview of the financial accounting code of
­professional conduct, which is set by the American Institute of Certified
Public Accountants (AICPA). These standards give you a roadmap to
follow when you’re trying to figure out how to interact with your clients or
employer. The standards also explain how to handle various accounting
transactions taking place during day-to-day business operations.
Finally, you meet the financial accounting standard-setting bodies. You find
out why publicly owned companies (those whose stock shares are traded on
a public stock exchange) abide by a different set of standards than privately
owned companies.
198
Book IV: Preparing Income Statements and Balance Sheets
Exploring the Origins of
Accounting Standards
Although the history of accounting dates back to prehistoric times, the birth
of accounting standards is fairly recent. Here’s a brief timeline that traces the
history of accounting up to the present:
✓ Human ancestors probably traded whatever they had or produced
to acquire food and other basic necessities. These trades required
some equitable method of measuring the relative value of goods, thus
­originating the concept of keeping track of — or accounting for — items.
✓ Later in history, formal accounting records were kept to make sure
people paid the required amount of taxes.
✓ The Industrial Revolution in the 18th and 19th centuries ushered in the
mass production of manufactured goods. Mass production required
a more sophisticated approach to recording the movement of goods,
­services, and money. As a result, the accounting field had to operate
with a higher level of professionalism and expertise. Many owners
needed more people to properly manage the business. Mass production
resulted in the separation of ownership from management.
✓ Accountants plied their trade in a mostly unmonitored and unregulated
environment until the stock market crash of 1929. After this horrific
event, the American Institute of Accountants, which is now the American
Institute of Certified Public Accountants, partnered with the New York
Stock Exchange to agree upon five principles of accounting.
✓ Fast-forwarding to the present, these five principles have expanded into
hundreds of principles covering every accounting topic imaginable,
from how to prepare financial statements to how to keep the books for
­different types of businesses.
If you’re just getting started in accounting, you may be wondering why
you have to record financial events in such a nit-picky fashion. You may
also wonder who the head nit-pickers are and from whence they get their
­authority. Well, read on! This chapter answers both questions and gives you
a good foundation for understanding why accountants perform certain tasks
the way they do.
Sometimes, accountants handle transactions in a certain way simply because
that’s the way it’s done. Instead of trying to understand the logic or lack
thereof, develop a general understanding of the regulatory system, as
explained in this chapter and then go with the flow. As you spend more time
working in accounting, the standards will make more sense to you.
Chapter 1: Brushing Up on Accounting Standards
199
Recognizing the Role of the American
Institute of Certified Public
Accountants (AICPA)
The American Institute of Certified Public Accountants (AICPA) is the
national professional organization for all certified public accountants (CPAs).
Through its senior technical committee, called the Auditing Standards Board
(ASB), the AICPA is responsible for establishing auditing and attestation standards for companies in the United States. To understand what that entails,
you need to know the meaning of three key terms:
✓ Auditing: The purpose of auditing is to gather evidence about a company’s financial statements and to use that evidence to determine whether
the statements are free of material (significant) misstatements. The company creates the financial statements — the auditor is an independent
entity who issues an opinion on the company’s financials.
✓ Attestation: Accountants create other reports on financial statements
that don’t provide an opinion. Those reports are considered attestation
services. For example, a company may hire you to calculate the rate of
return on the company’s investments (see Book VIII, Chapter 3), making
sure your figures match the company’s report on the same topic.
✓ Nonpublic: Nonpublic companies are privately owned. Their stock isn’t
traded on any open-to-the-public stock exchange. For example, if you
start a corporation, you aren’t required to sell any of your shares of
stock unless you want to.
Tying together regulators for audits
of publicly traded companies
Shares of publicly traded companies are available for purchase on stock
exchanges, such as the New York Stock Exchange, or over-the-counter markets, such as the NASDAQ. To issue securities to the public, companies must
register their securities with the Securities and Exchange Commission (SEC).
The Public Company Accounting Oversight Board (PCAOB) oversees audits
of publicly traded companies. The SEC has oversight over the PCAOB. The
SEC approves the PCAOB’s rules and standards and its budget.
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Book IV: Preparing Income Statements and Balance Sheets
The AICPA also enforces a code of professional conduct for its members,
which governs how accountants perform their duties. Those duties include
performing audits and attestation services. The Auditing Standards Board
(ASB) sets audit and attestation standards. This organization is a senior
­committee within the AICPA.
When the company involved is publicly traded, the PCAOB and the SEC have
oversight. As a result, auditing standards created by the ASB are adopted by
the PCAOB and approved by the SEC. If you look through the standards listed
on the PCAOB website, you’ll see a list of auditing standards from the ASB.
Establishing and adhering to accounting standards ensures that financial
reports have accurate information so investors and others can make wellinformed decisions. As an accountant, you’re responsible for serving at least
two masters: the organization that hires you to produce the financial reports
and investors who use that information to make investment decisions.
Accounting standards help to ensure that everyone is making decisions by
using timely and accurate financial information.
You don’t have to be a CPA or a member of the AICPA to perform your job ethically, or to get work as an accountant. However, membership in the AICPA has
many benefits, including automatic accounting standards updates, research
tools, and educational resources.
ASB audit and attestation standards
The ASB is a senior technical committee of the AICPA. The ASB issues the standards and procedures that accountants must follow when conducting attestation
and audit services for nonpublic companies. As explained in the prior section,
the ASB is also involved with accounting work on publicly traded companies.
The ASB also sets quality control standards to use when conducting peer
reviews, which occur when one CPA firm evaluates the operations of another
CPA firm. Most ASB members work for public accounting firms (such as
KPMG LLP), are university professors or governmental accountants, or practice in some other accounting field.
Curious about these mysterious ASB standards? They’re called Statements on
Auditing Standards (SAS). Here are just a couple of the standards, so you have
some idea of what they cover:
✓ SAS No. 1 Section 410 establishes that the auditor must state whether
the financial statements are presented in accordance with GAAP.
✓ SAS No. 85 defines the responsibilities that management of a company
has for the preparation of the financial statements. Management also
must provide written representations about financial statement
preparation to the auditors.
Chapter 1: Brushing Up on Accounting Standards
201
More information about the ASB standards and procedures is available free of
charge on the AICPA website at www.aicpa.org. From the home page, select
Research and then Standards. You can access all sorts of good financial
­accounting info on the topics of audit, attest, compilation, and review standards.
A compilation occurs when an accountant prepares financial statements for a
company by using only data received from company management. A review
occurs when the accountant gives limited assurance that no material modifications need to be made to financial statements prepared by company management.
AICPA Code of Professional Conduct
The AICPA’s Code of Professional Conduct contains six principles of professional conduct by which its members must abide: responsibilities, serving
the public interest, integrity, objectivity and independence, taking due care,
and the scope and nature of services.
Following are brief definitions of the six principles:
✓ Responsibilities: As an accountant, you hold yourself to high moral and
ethical standards in order to maintain the public’s confidence in your
financial reporting. For example, accountants have the responsibility to
participate in self-governance by performing peer reviews of other CPA/
financial accounting firms’ work to check for accuracy and consistency
among the profession.
✓ Serving the public interest: An accountant’s public interest is the company for whom she is preparing the financial statements, as well as the
users of the financial statements (such as people thinking about purchasing shares of the company stock).
The public interest also includes banks and other businesses that are
considering granting credit to the company, governmental agencies
such as the Internal Revenue Service (which measures the company’s
compliance with the tax code), current and prospective investors, and
other members of the business and financial community who rely on the
objectivity and integrity of CPAs.
✓ Integrity: Having this characteristic means you’re honest when dealing
with others. In the world of accounting, integrity means that you serve
the company for whom you’re preparing the financial statements to
the best of your ability. Keep in mind that this may not be the same as
completely agreeing with the way the company wants its financial statements prepared. You can’t be worried that business management is
going to be mad at you or fire you if you disagree with them.
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Book IV: Preparing Income Statements and Balance Sheets
✓ Objectivity and independence: When you’re objective, you’re neutral
and unbiased in all decision-making processes. You base your opinions
only on facts and not on any preconceived notions you may have. You
interpret rules and policies, such as GAAP, in a truthful and sincere
manner — staying true to both the form and spirit of the particular
­principle or regulatory issue.
Accountants who provide auditing and other attestation services must
be independent in both fact and appearance. Being independent means
you have no special relationship to or financial interest with the company that would cause you to disregard evidence and facts when evaluating the company. For example, preparing the financial statements for
a business owned by a close relative can justifiably cause those reading
your report to doubt your objectivity.
✓ Taking due care: In a nutshell, this principle means you have the education and experience to perform the work at hand. You must be both
competent and diligent. In addition, due care means you plan and supervise adequately any professional activity for which you’re responsible.
✓ Scope and nature of services: All the principles in this list lead up to
this final one. Accountants consider all the preceding principles when
determining whether they can provide specific services in individual
­circumstances.
For more about these six principles, visit www.aicpa.org/About/code/
sec50.htm.
If being a member of the AICPA isn’t mandatory in order to get a job as an
accountant, you may wonder why its code of conduct is such a big deal. Well,
if you want to be an accountant practicing as a CPA, you must be licensed by
your state, which recognizes the authority of the AICPA. State and federal
courts consistently hold that all practicing CPAs, regardless of membership in
the AICPA, must follow the professional ethical standards contained in the
AICPA’s Code of Professional Conduct.
Checking Out the U.S. Securities and
Exchange Commission (SEC)
In addition to the AICPA, other organizations give accountants official guidance on how to prepare financial statements. Public and nonpublic corporations have different agencies that monitor their activities. Perhaps the
best known of the regulating agencies is the U.S. Securities and Exchange
Commission (SEC). The earlier section “Tying together regulators for audits
of publicly traded companies” tells you that the SEC has oversight over
auditors of public companies.
Chapter 1: Brushing Up on Accounting Standards
203
In response to the stock market crash of 1929 and the ensuing Great
Depression, Congress passed the Securities Exchange Act of 1934, which
led to the formation of the SEC. The SEC’s mission is to make sure publicly
traded companies tell the truth about their businesses and treat investors
in a fair fashion by putting the needs of the investor before the needs of the
company.
The SEC is run by five commissioners who are appointed to five-year terms
by the President of the United States. Their terms are staggered, and no more
than three commissioners can be from the same political party at the same
time. These commissioners ride herd over the SEC’s power to license and
regulate stock exchanges, the companies whose securities are traded on the
exchanges, and the brokers and dealers who conduct the trading and sell
securities to investors.
The enforcement authority given by Congress allows the SEC to bring
civil enforcement actions against individuals or companies alleged to
have ­committed accounting fraud, provided false information, or engaged
in insider trading or other violations of the securities law. The SEC also
works with criminal law enforcement agencies to prosecute individuals and
­companies alike for offenses that include criminal violations.
As an accountant, your exposure to the regulatory authority of the SEC will be
limited unless you work for a company whose shares of stock are publicly
traded or you work for a CPA firm conducting financial statement audits for
publicly traded companies.
Getting to Know the Financial Accounting
Standards Board (FASB)
The Financial Accounting Foundation (FAF ) was established as a nonprofit
corporation in June 1972. FAF was created in response to congressional
­criticism of the standard-setting work being done by the American Institute
of Certified Public Accountants (AICPA).
The FAF in turn established the Financial Accounting Standards Board (FASB),
which is the private sector body establishing GAAP for all nongovernmental
entities. FAF also established the Governmental Accounting Standards Board
(GASB). Governmental entities follow GASB procedures.
The FASB has five full-time members, who are selected by FAF. All are
required to have knowledge of accounting, finance, and business. For more
info about the FASB, accounting standards, and FAF, check out the FASB
­website at www.fasb.org.
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Income
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Sheets
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Book IV: Preparing Income Statements and Balance Sheets
In 1984, the FASB formed the Emerging Issues Task Force (EITF ) to help identify accounting issues in need of standardization. The EITF is composed of
accounting professionals who meet regularly to mull over current economic,
business, and industrial developments.
Understanding generally accepted
accounting principles (GAAP)
Generally accepted accounting principles (GAAP) defines the acceptable
practices in the preparation of financial statements in the United States.
Specifically, GAAP tells accountants exactly how financial data must be presented on the income statement, balance sheet, and statement of cash flows.
For example, GAAP states that assets, liabilities, and equity must be posted
on the balance sheet and not on the income statement. GAAP is also pretty
darn picky as to how these accounts are arranged on the balance sheet
(you find out more about the balance sheet starting in Chapter 3). In addition, GAAP gives specific rules for separating operating revenue (which is
related to the business purpose) from non-operating revenue (non-businessrelated revenue, such as profit from selling a company asset), as explained in
Chapter 3. Some of this detail is also explained in the footnotes of the financial statements. Check out Book V, Chapter 4 for more on footnotes.
Like most rules, the rule that all businesses must follow GAAP has exceptions.
Some businesses, including airlines, franchisors, and healthcare entities, can
deviate from GAAP. However, these companies are required to justify their
deviation from GAAP in their financial statements.
Is GAAP the same for public and nonpublic companies? For now, yes. The
SEC has the statutory authority to set accounting standards for publicly held
companies, but historically it has relied on private sector bodies to set those
standards.
As explained earlier in this chapter the SEC oversees the PCAOB in regard to
audits. However, the auditing standards listed by the PCAOB are nearly all
written by the AICPA’s Auditing entity. The AIPCA is the private sector body
setting standards — and the SEC relies on those standards.
But hold onto your hats! How accountants view GAAP changed with the adoption of FASB Accounting Standards Codification. FASB Accounting Standards
Codification (ASC) became the single source of authoritative GAAP in the
United States. Before you get in a dither, keep in mind that the ASC doesn’t
change GAAP; the FASB didn’t rewrite all the accounting rules. Instead, the
ASC organizes GAAP in a more user-friendly fashion and (mercifully) uses a
consistent format across the board for all GAAP topics.
Chapter 1: Brushing Up on Accounting Standards
205
Looking online for FASB standards
The FASB allows free, limited access to the Accounting Standards
Codification. To check it out, visit asc.fasb.org. After you complete the
login procedure, you can browse the topics to see how to apply GAAP for
accounting topics such as revenue, assets, liabilities and equity, and presentation. Each topic allows you to drill down to more detailed information. For
example, if you select Equity, you can further select Treasury Stock to find
out how to account for treasury stock under GAAP.
For better search functions that allow for a fully functional view of the codification, you can upgrade to ASC’s professional version for an annual subscription cost. If you’re still in school, ask your accounting instructor whether your
school has academic access.
Pick a standard: Domestic
or international
For many years, the size of a company — and whether it was public or private —
wasn’t considered germane for the accounting and financial reporting standards
that should be used by a business. The business world in the United States was
under the dominion of one set of accounting and financial reporting standards,
GAAP, which applied to all businesses. GAAP was considered the gold standard
and good for the rest of the world as well.
In recent years, the movement toward adopting international standards
gained momentum. Companies using U.S. GAAP may also be affected by international financial reporting standards (IFRS). If you do business outside the
U.S., ask your accounting firm whether any IFRS rules affect your business.
Serious efforts have arisen to simplify accounting and financial reporting
for private businesses. The Private Company Council (PCC), established by
FAF, is tasked with making recommendations to the FASB for modifying and
making exceptions to GAAP to alleviate the burden on private companies in
complying with complex GAAP standards.
A movement is underway within the AICPA to allow small- and medium-sized
owner-managed entities to deviate even further from GAAP under a frame of
reference called Other Comprehensive Basis of Accounting. Where this movement is heading is anyone’s guess, but change seems inevitable. Stay tuned.
Book IV
Preparing
Income
Statements
and
Balance
Sheets
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Book IV: Preparing Income Statements and Balance Sheets
Chapter 2
Preparing an Income Statement
and Considering Profit
In This Chapter
▶ Getting a grip on what profit is and isn’t
▶ Designing the income statement and deciding what to disclose
▶ Recognizing how profit affects a business and its financial condition
▶ Handling unusual gains and losses in the income statement
▶ Correcting misconceptions about profit
A
n income statement shows in black and white how much money a business earned and spent over any given period along with a bottom-line
figure — net profit or loss. As an accountant, you create income statements
for your company and other users, including investors. Business owners and
managers use income statements to determine the overall financial condition
of their business and to make informed decisions. Investors and lenders may
also refer to a company’s income statements when deciding whether to buy
or sell shares in the company or loan the company money.
This chapter begins with the components that make up the income statement. It
then moves on to disclosures and income statement presentation and leads you
through the process of deciding how much information a financial statement
reader needs. This chapter also explains extraordinary gains and losses. Finally,
you find out about common misconceptions surrounding the calculation and
reporting of profit.
Understanding the Nature of Profit
Profit doesn’t have just one universal meaning or definition. Generally, you
can separate profit into three categories:
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Book IV: Preparing Income Statements and Balance Sheets
✓ Selling an asset for a gain: You profit when you buy something and sell
it for a gain. Real estate and investment companies are in the business of
buying assets that appreciate in value.
✓ Selling a product: Manufacturers make a product and sell it for a profit.
Retailers buy products as inventory and make a profit when the inventory is sold. Both types of companies sell a product for more than their
total costs.
✓ Providing a service: Plumbers, carpenters, and electricians provide a
service for a fee. If the total fees generated are more than the total costs,
the business earns a profit.
For more about the various ways a business generates profits and reports
those profits, keep reading.
Throughout this book, asset is defined as a resource you use to generate
profit. Businesses need to raise capital to invest in assets. Chapter 4 explains
how companies raise money by using debt. If you’re wondering about selling
stock (equity) in your business, check out Chapter 5.
Profit is a calculated number equal to the difference between revenue and
expenses. Revenue is on one side of the scale, expenses are on the other
side, and profit is the measure of how much the revenue side outweighs the
expense side. To locate profit, you must trace the effects of revenue and
expenses.
Suppose a business collects cash for all its sales and pays cash for all its
expenses during the year. You need to look to only one place — its cash
account — to find the business’s profit. However, a business may make credit
sales and not collect cash from all its sales during the year. Furthermore, the
typical business doesn’t pay all its expenses during the year and pays some
expenses before the start of the year. In short, sales and expenses affect several
assets, including cash and liabilities.
Choosing the Income Statement Format
The bottom-line profit (or loss) in an income statement draws the most attention, but the income statement is really about revenue and expenses. A business can’t make profit without revenue and expenses.
An income statement reports three basic items of information, in the following
order:
✓ Revenue
✓ Expenses
✓ Profit or loss
Chapter 2: Preparing an Income Statement and Considering Profit
209
Income statements are reported in two basic formats (although in actual
practice, you see many variations of them):
✓ Multi-step format: This format typically presents four measures of
profit — gross margin, operating earnings, earnings before income tax,
and net income (see Figure 2-1 for an example). One revenue line and
four profit lines are presented. One purpose of this format is to disclose
gross margin, which is a key determinant in the bottom-line profit
performance of businesses that sell products. Gross margin is the
revenue less cost of goods sold. Any slippage in gross margin as a
percent of sales revenue is viewed with alarm.
✓ Single-step format: In this format, all expenses are added and their total
is deducted from revenue (see Figure 2-2 for an example). Unlike the
multi-step format, the single-step format presents only one profit line,
which is bottom-line net income.
Figure 2-1:
Example of
multi-step
income
statement
format.
©John Wiley & Sons, Inc.
Book IV
Figure 2-2:
Example of
single-step
income
statement
format.
Preparing
Income
Statements
and
Balance
Sheets
©John Wiley & Sons, Inc.
The income statement examples shown in Figures 2-1 and 2-2 are simplified
versions compared to actual income statements in external financial reports.
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Deciding What to Disclose
in the Income Statement
After a business decides on the format for reporting its income statement
(multi-step or single-step, as explained in the preceding section), the next
decision concerns how much information to disclose about its expenses.
Considering expense disclosure
Accountants work with different requirements for expense disclosure,
depending on whether the company is public or private.
Public companies are subject to financial disclosure rules issued by the
United States Securities and Exchange Commission (SEC). A publicly owned
business has no choice but to abide by these rules. Otherwise, trading in its
stock shares could be suspended by the SEC — the kiss of death for a public
company.
Income statement disclosure standards for nonpublic businesses (that
is, those not subject to the SEC’s jurisdiction) are less specific. Generally
accepted accounting principles (GAAP) provide broad guidance on how
much information should be disclosed about expenses in the income statement. (For more about GAAP and other accounting standards, see Chapter 1.)
Generally speaking, businesses that sell products report their cost of goods
sold expenses, and almost all businesses report their interest and income tax
expenses. However, generalizing about the disclosure of other expenses is
much more difficult.
Figures 2-1 and 2-2 disclose only one large operating expense category: selling
and general expenses. Some businesses disclose only this expense because
they’re reluctant to reveal any more detail about their operating expenses. Other
businesses report five or ten operating expenses in their income statements.
Presenting the right amount
of expense information
When deciding how much expense disclosure to include in income statements, consider the following three factors:
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✓ Confidentiality: Many businesses don’t want to reveal the compensation
of the officers of the business, for example. They argue that this information is private and personal.
✓ Materiality: Most businesses don’t see any point in reporting expense
information that’s relatively insignificant and would only clutter the
income statement.
✓ Practicality: Businesses limit the income statement contents to what fits
on one page. A business can put additional detail about expenses in the
footnotes to its financial statements, but many argue that shareowners
and lenders have only so much time to read financial statements and putting too much information in their financial reports is counterproductive.
If you’re a major outside shareowner in a business, you may request information about four expenses: repairs and maintenance, advertising, pension and
profit-sharing plans, and employee benefit plans. The information could be
reported in the income statement itself or in the footnotes to the financial
statements. Why these four? Repairs and maintenance expense can be manipulated by management to push profit up or down for the year. Advertising is a
discretionary expense that you may want to compare to sales revenue.
Pension and profit-sharing plans and employee benefit plans can be large
encumbrances on a business.
Examining How Sales and Expenses
Change Assets and Liabilities
In a financial report, the income statement may seem disconnected from the balance sheet and the statement of cash flows. Nothing is further from the truth.
The three financial statements are interdependent and interconnected. For
example, if sales revenue or one of the expenses had been just $10 different from
the amount reported in the income statement, a $10 difference would appear
somewhere in the balance sheet and statement of cash flows. The following sections explain how income statement activity is connected to the balance sheet
and how the two together reflect the financial condition of a business.
Sizing up a business’s financial condition
Financial condition is the status of the firm’s assets, liabilities, and equity at a
certain point in time. For this book, financial condition refers to the amounts
presented in the balance sheet. This section explains how income statement
activity is connected to the balance sheet.
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As explained earlier in this chapter, in the section “Choosing the Income
Statement Format,” an income statement reports revenue, expenses, and profit
(or loss). But an income statement doesn’t report how revenue and expenses
change the financial condition of the business. For example, in Figure 2-1,
$26,000,000 revenue is reported in the annual income statement of a business.
The business also reports $24,310,000 total expenses for the year (the sum of
the four expense line items). How did the sales revenue and expenses change
its financial condition? The income statement doesn’t answer that question.
The balance sheet does, as explained in Chapters 3 to 5.
Business managers rely on their accountants to explain how sales and
expenses change the assets and liabilities of their businesses. Business lenders and shareowners also need to understand these effects in order to assess
the health of a business.
Noting how accounting transactions affect
the income statement and balance sheet
Typical accounting transactions — accounting entries that many businesses
make every month — affect income statement activity that relates to balance
sheet accounts.
Suppose you’re the chief accountant of the business whose income statement
is presented in Figure 2-1. The president asks you to explain the financial
effects of revenue and expenses reported in its latest annual income statement at the next meeting of its board of directors.
To help organize your thoughts for the presentation, you decide to prepare
summary revenue and expense journal entries for the year. Based on your
analysis, you prepare the following summary journal entries for revenue and
expenses reported in the income statement:
Revenue and receivables
Account
Cash
Accounts receivable
Sales revenue
Debit
$25,000,000
$1,000,000
Credit
$26,000,000
The business makes credit sales. When recording a credit sale, the asset
account accounts receivable is debited (increased). When the customer pays,
accounts receivable is credited (a decrease). The business initially collected
$25,000,000 in cash payments from customers. The accounts receivable
­balance for the period increased by $1,000,000.
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Cost of goods sold expense and inventory
Account
Cost of goods sold expense
Inventory
Cash
Accounts payable
Debit
$14,300,000
$2,000,000
Credit
$14,500,000
$1,800,000
The business purchases $16,300,000 of product during the year. Of that
total, $14,300,000 represents cost of goods sold. The remaining $2,000,000
in purchases remained in inventory. The company didn’t pay cash for all
its $16,300,000 in purchases. Its accounts payable for inventory purchases
increased $1,800,000. Therefore, cash outlay for purchases during the year
was $14,500,000 ($16,300,000 – $1,800,000).
Selling and general expenses and payables
Account
Selling and general expenses
Prepaid expenses
Cash
Accounts payable
Accrued expenses payable
Accumulated depreciation
Debit
$8,700,000
$300,000
Credit
$6,900,000
$850,000
$725,000
$525,000
Selling and general expenses is a somewhat complicated entry because operating expenses involve several balance sheet accounts. The business added
$300,000 to its prepaid expenses balance during the year. It recorded $525,000
depreciation expense for the year. In this instance, depreciation expense is
included in the selling and general expenses debit amount reported in its
income statement. That same amount is credited to accumulated depreciation, as shown in the previous table.
Not all expenses were paid for by the end of the year; unpaid expenses
caused an $850,000 increase in accounts payable and a $725,000 increase in
accrued expenses payable.
Interest expense and payables
Account
Interest expense
Cash
Accrued expenses payable
Debit
$400,000
Credit
$350,000
$50,000
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The business paid $350,000 interest during the year. The amount of unpaid
interest at year-end increased $50,000. A general liability account for accrued
expenses is shown in this entry. (The business may credit a more specific
account, such as accrued interest payable.)
Income tax expense and payables
Account
Income tax expense
Cash
Accrued expenses payable
Debit
$910,000
Credit
$830,000
$80,000
At the end of last year, the business didn’t owe any income tax. During the
year, it made $830,000 installment payments toward its estimated income tax.
Based on the final determination of its income tax for the year, the business
still owes $80,000, which it will pay when it files its tax return. The general
liability account for accrued expenses is shown in this entry. (The business
may credit a more specific account, such as income tax payable.)
Considering the Diverse Financial
Effects of Making a Profit
Making sales and incurring expenses cause a multitude of effects on the
assets and liabilities of a business. In other words, making profit causes many
changes in the financial condition of a business. It would be convenient if a $1
profit caused a $1 cash increase and nothing more, but the effects of making
profit are much broader and reach throughout the balance sheet.
This section introduces a tool, called a T-account, to explain how profit
affects the entire balance sheet.
Introducing T-accounts
The journal entries in the preceding section summarize the effects of sales
and expenses on a business’s assets and liabilities. Figure 2-3 shows these
changes in T-accounts for the assets and liabilities. T-accounts aren’t the official, formal accounts of a business. Rather, T-accounts are like scratch paper
that accountants use to analyze and “think out” the effects of transactions.
A T-account has two columns: debits are always put in the left column and
credits in the right column. The rules for debits and credits are explained in
Book II, Chapter 1.
Chapter 2: Preparing an Income Statement and Considering Profit
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Figure 2-3:
Changes in
assets and
liabilities
caused by
sales and
expenses.
©John Wiley & Sons, Inc.
Figure 2-3 uses seven asset and liability accounts to illustrate the recording of revenue and expenses for the year. Even a relatively small business may have 100 or more
asset and liability accounts in its chart of accounts (see Book I, Chapter 2). However,
the seven asset and liability accounts in the example are sufficient to illustrate the
effects of revenue and expenses on the financial condition of a business.
Combining activity into one journal entry
In order to help you understand what profit consists of, the activity in
Figure 2-3 is combined into one comprehensive journal entry. In this entry,
the $1,690,000 profit for the year is shown as an increase in the retained earnings owners’ equity account.
Comprehensive Journal Entry that Summarizes Changes in Assets and
Liabilities from Profit-Making Activities during the Year
Account
Cash
Accounts receivable
Inventory
Prepaid expenses
Accounts payable
Accrued expenses payable
Accumulated depreciation
Owners’ equity — retained earnings
Debit
$2,420,000
$1,000,000
$2,000,000
$300,000
Credit
$2,650,000
$855,000
$525,000
$1,690,000
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The totals for each balance sheet account represent the totals in the
T-accounts in Figure 2-3. Simply add the amounts you see in each T-account.
The cash total, however, is a little more complicated. For cash, take the
$25,000,000 debit and subtract the sum of the credit entries ($22,580,000) to
arrive at the $2,420,000 balance in cash.
Profit improves the net worth of a business. Net worth, another name for the
owners’ equity, equals total assets minus total liabilities. In this example, the
business makes a profit, and the effect on the balance sheet is that assets
increase more than liabilities, which is the typical profit effect. To figure out
how to calculate retained earnings, head over to Chapter 5.
Explaining additional transactions
related to profit
The profit-making activities of a business include more than just recording
revenue and expenses. Additional transactions are needed, which take place
before or after revenue and expense are recorded. You see some common
transactions in the “Noting how accounting transactions affect the income
statement and balance sheet” section, earlier in this chapter. This section
offers a more generic explanation of before-and-after transactions. These
explanations apply to dozens of accounting entries in your business.
✓ Collecting cash from customers for credit sales made to them. The cash
is collected after recording the sales revenue.
✓ Purchasing (or manufacturing) products that are put in inventory and
held there until the products are sold sometime later. When a sale
occurs, the cost of products sold is charged to expense in order to
match costs with the revenue from the sale.
✓ Paying for products bought on credit and for other items that aren’t
charged to expense until sometime after the purchase. These purchased
items are considered assets until they’re used (expensed).
✓ Paying for expenses that have been recorded sometime earlier.
✓ Making payments to the government for income tax expense that has
already been recorded.
Only revenue and expenses are reported in the income statement, but the
other transactions change assets and liabilities, and they definitely affect
cash flow. See Book V, Chapter 2 for more about cash flow.
Chapter 2: Preparing an Income Statement and Considering Profit
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Reporting Extraordinary
Gains and Losses
When accountants refer to extraordinary transactions, they mean activity
that’s not related to your day-to-day business. Assume you manufacture blue
jeans. You incur costs to buy denim material. You pay labor costs and collect cash from sales. If you happened to sell your headquarters building for
a gain, that transaction would be out of the ordinary (extraordinary). After
all, you’re in the business of making blue jeans — not selling real estate. Any
profit from the sale of the building would be an extraordinary gain.
Segregating the income statement
Extraordinary gains and losses require an income statement that’s split into
two distinct sections.
Many businesses report unusual, extraordinary gains and losses in addition to
their usual revenue, income, and expenses. Remember that recording a gain
increases an asset or decreases a liability. And recording a loss decreases an
asset or increases a liability. When a business records an extraordinary gain
or loss during the period, its income statement is divided into two sections:
✓ The first section presents the ordinary, continuing sales, income, and
expense operations of the business for the year.
✓ The second section presents any unusual, extraordinary, and nonrecurring gains and losses that the business recorded in the year.
Considering business disruptions
The road to profit is anything but smooth and straight. Every business experiences an occasional discontinuity — a serious disruption that comes out of
the blue, doesn’t happen regularly or often, and can dramatically affect its
bottom-line profit. In other words, a discontinuity is something that disrupts
operations or the regular flow of profit-making activities.
Here are some examples of discontinuities:
✓ Downsizing and restructuring the business: Layoffs may require severance pay or trigger early retirement costs; major segments of the business may be disposed of, causing large losses.
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✓ Abandoning product lines: When leadership decides to discontinue
selling a line of products, the business loses at least some of the money
it paid to obtain or manufacture the products, because it either sells the
products below cost or writes off products it can’t sell as a loss.
✓ Settling lawsuits and other legal actions: Paying damages or fines or receiving
awards from favorable rulings are nonrecurring extraordinary losses or gains.
✓ Writing down (also called writing off) damaged and impaired assets:
If products become damaged and unsellable, or fixed assets need to be
replaced unexpectedly, you need to remove these items from the assets
accounts. Even when certain assets are in good physical condition, if they
lose their ability to generate future sales or other benefits to the business,
accounting rules say that the assets have to be taken off the books or at
least written down to lower book values (see Book III, Chapter 1).
✓ Changing accounting methods: A business may decide to use a different
method for recording revenue and expenses than it did in the past, in some
cases because the accounting rules (set by the authoritative accounting
governing bodies — see Chapter 1) have changed. Often, the new method
requires a business to record a one-time cumulative effect caused by the
switch in accounting method. These special items can be huge.
✓ Correcting errors from previous financial reports: If a business discovers that a past financial report had an accounting error, it must make a
correction entry, recording a loss or gain that had nothing to do with the
performance of the business in the current year.
According to financial reporting standards, a business must make these onetime losses and gains very visible in its income statement. So in addition to
the main part of the income statement that reports normal profit activities, a
business with unusual, extraordinary losses or gains must add a second layer
to the income statement to disclose these out-of-the-ordinary happenings.
If a business has no unusual gains or losses in the year, its income statement
ends with one bottom line, usually called net income, as shown in Figures 2-1
and 2-2. When an income statement includes a second layer, the net income
line becomes net income from continuing operations before unusual gains and
losses. Below this line, each significant, nonrecurring gain or loss appears.
Suppose a business suffered a relatively minor loss from ending a product
line and a very large loss from a major lawsuit whose final verdict went
against the business. The second layer of the business’s income statement
would look something like the following:
Net income from continuing operations
Discontinued operations, net of income taxes
Earnings before effect of legal verdict
Loss due to legal verdict, net of income taxes
Net earnings (loss)
$267,000
($20,000)
$247,000
($456,000)
($209,000)
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The gains and losses reported in the second layer of an external income statement are generally complex and may be quite difficult to spot. When looking
for extraordinary gains or losses, answer the following questions:
✓ Why wasn’t the loss or gain recorded on a more piecemeal and gradual
year-by-year basis instead of as a one-time charge?
✓ Was the loss or gain really a surprising and sudden event that couldn’t
have been anticipated?
✓ Is such a loss or gain likely to occur again in the future?
Questioning whether activity
is truly unusual
Every company that stays in business for more than a couple of years experiences a discontinuity of one sort or another. But beware of a business that
takes advantage of discontinuities in the following ways:
✓ Discontinuities become continuities: A successful business makes consistent profits from continuing operations. It’s the day-to-day business
that drives profit. Beware of a business that makes an extraordinary loss
or gain a regular feature on its income statement. Suppose that every
year or so, the business loses a major lawsuit, abandons product lines,
or restructures itself. It reports “nonrecurring” gains or losses on a
recurring basis. You should question whether the company’s core business could be profitable without all the unusual transactions.
✓ A discontinuity is used as an opportunity to record all sorts of writedowns and losses: When recording an unusual loss (such as the cost of
settling a lawsuit), the business opts to record other losses at the same
time and writes off everything but the kitchen sink (and sometimes
that, too). According to this big-bath strategy, you may as well take a big
bath now in order to avoid taking little showers in the future. Consider
whether all the write-offs truly relate to the event that occurred or
whether the company is taking advantage of the situation to expense
unrelated items.
A business may just have bad (or good) luck regarding extraordinary events
that its managers couldn’t have predicted. If a business is facing a major,
unavoidable expense this year, cleaning out all its expenses in the same year
so it can start fresh next year can be a clever, legitimate accounting tactic.
But where do you draw the line between these accounting manipulations and
fraud? Staying alert to these potential problems is an important first step.
The subject of fraud is covered in Book IX, Chapter 7.
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Book IV: Preparing Income Statements and Balance Sheets
Correcting Common Misconceptions
about Profit
To wrap up this chapter, consider some misconceptions about profit. It’s
critical that an accountant understand these issues. The first section covers
misconceptions generally. The second discussion focuses on your firm’s
profit compared with profit standards in your industry. Finally, you consider
an analysis of credit sales and bad debt.
The purpose of this section is to remind business owners to stop and consider what their level of profit really means to the business.
Clearing up profit misconceptions
Many accountants find themselves clearing up these misconceptions for
other people in the organization:
✓ Profit does not increase cash by the same amount. Book III, Chapter 6
explains the difference between cash- and accrual-basis accounting. Most
companies use the accrual method, which matches revenue earned with
expenses incurred to earn the revenue. Using this method, you may post
revenue and record expenses without cash moving in or out of your business. As a result, a $20,000 profit doesn’t mean your cash account is
immediately $20,000 higher.
✓ Some revenue and expense entries are based on estimates. Another
misconception about profit is that the numbers reported in the income
statement are precise. Many journal entries are based on estimates,
which require using judgment. Recognizing bad debt expense, for
example, often requires an estimate of the percentage of customers who
won’t pay. The expense may be adjusted later, when the actual amount
of bad debt is known. (For more on bad debt expense, see “Waving the
red flag when you see revenue and credit sales increase,” later in this
chapter.) Profit calculations are partially based on estimates.
✓ A high level of profit doesn’t mean that the balance sheet is necessarily
attractive to investors. Consider how a company acquires and uses assets
to generate a profit. Assume a company borrows heavily to meet high
customer demand. The plan works, and the firm generates a high level of
profit. If sales levels go down, profit may decline. The business will have
less in revenue to make the larger debt payments. Ramping up spending
to meet high demand may become a drag on profits if sales decline. An
investor may shy away from investing in a company with a high debt load
and declining sales.
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Comparing to industry standards
When considering your level of profit, comparing your profit to that of other
companies in your industry may be useful. Here are some points to mull over.
The percentages used are profit margin percentages (net income divided by
sales):
✓ Reasonableness: Your shop sells sporting goods to hikers, mountain
bike riders, and other outdoor sports participants. You earn what you
believe to be an unusually high level of profit of 25 percent for the year.
After some research, you find that similar shops had profits in the same
range. Turns out that great weather increased demand for outdoor
sporting goods. You conclude that the profit — which is higher than you
expected — is reasonable, based on the industry average.
✓ Sustainable level of profit: Assume your grocery store has a 10 percent
profit for the year. Stores in your industry typically have an annual profit
of 2 percent. You do research to determine whether the 10 percent profit
is sustainable. After all, your profits should be in line with the industry’s
profit levels over time. You find that your high profit level was due to
more demand, due to a nearby grocery store closing. You decide to plan
future sales and costs based on the industry’s 2 percent profit.
✓ Adding a product line: You manage a roofing company, which installs
and repairs roofs for the residential market. You’re considering adding
siding installation to your business. To estimate a profit margin for your
new venture, you can consider the industry profit averages. Assume
that your roofing business generates a 12 percent profit and the siding
industry averages a 5 percent profit. You can consider how your total
company profit would look, after you add the new product line.
Your goal is to plan and manage your business based on a reasonable, sustainable level of profit. Industry standards should be part of your analysis.
Waving the red flag when you see
revenue and credit sales increase
When comparing income statements from different periods for the same business, watch out for this common big red flag: an increase in revenue that’s tied
to an increase in credit sales. (See Book V, Chapter 3 for additional guidance
on analyzing financial statements.)
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Credit sales mean that you’re selling a product that will be paid for at a later
date. When a business increases its credit sales, it needs to consider how
much of those sales are credit sales to new customers. New customers, by
definition, don’t have a track record of making timely payments on credit
sales. You may find that credit sales are increasing, but that bad debt expense
is increasing even faster. A business needs to perform some analysis to determine whether sales to new customers will be profitable over the long term.
Here’s an example. You note these results from the prior year:
Prior year results: Credit sales $1,200,000, bad debt expense $24,000
(2% of credit sales)
The profit on the credit sales includes all expenses — including bad debt
expense.
In the current year, you note an increase in credit sales. You also see that bad
debt expense increased to 3.5 percent of credit sales. Here are the current
year results:
Current year results: Credit sales $1,500,000, bad debt expense $52,500
(3.5% of credit sales)
Bad debt expense increases by $28,500 ($52,500 less $24,000). You can see
how this additional expense would eat away at profit. Assuming everything
else remained the same, this higher bad debt expense would reduce the
profit margin. Every dollar increase in credit sales generates a higher dollar
amount of bad debt, compared to the prior year. If you own or run the business, you must consider whether the new customers are worth the risk of
bad debt. Book III, Chapter 6 has more information on bad debt expense.
Chapter 3
Assessing the Balance
Sheet’s Asset Section
In This Chapter
▶ Sticking with an asset’s historic cost
▶ Listing common current assets
▶ Distinguishing between tangible and intangible assets
▶ Preparing the asset section of a balance sheet
A
balance sheet reports a company’s assets, liabilities (claims against
those assets), and equity (the amount of money left when you sell
what you own and pay what you owe). This chapter gets the party started
by focusing on assets; Chapter 4 walks you through the liabilities section,
and Chapter 5 covers equity.
Assets are resources a company owns and uses to generate revenue.
Businesses have many different types of assets, which are categorized as
either current or noncurrent. Current assets (such as checking accounts,
accounts receivable, and inventory) are liquid, which means they either
are cash or can quickly be turned into cash.
Noncurrent assets aren’t liquid; converting them to cash may take time.
Converting these assets to cash may result in a loss or a gain on sale.
Examples of noncurrent assets include tangible assets (things you can touch)
such as a company’s cars, computers, office buildings, or factories.
Not every noncurrent asset is tangible. For example, consider a company’s
patents and trademarks, as well as investments that a business makes in
other companies — these are all intangible assets. Another intangible asset,
goodwill, is created when a business buys another company.
Current? Noncurrent? Tangible? Intangible? The topic of assets may seem a little
overwhelming at first because so many kinds of assets exist. But this chapter
gives you a straightforward, easy-to-understand tutorial on the ABCs of assets.
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Homing in on Historic Cost
Before exploring typical business assets, you need to understand how the
value of most assets normally shows up on the balance sheet. Most assets
are valued on the balance sheet at their original historic cost — the cost of the
item when it was acquired plus any other costs to prepare the asset for use.
Historical cost isn’t fair market value, which is what a buyer is willing to pay
for the asset in an open marketplace.
Here’s an example: Suppose a company buys a building for $200,000 in 1999.
That $200,000 is the building’s historic cost. In 2015, the fair market value of
that building is $400,000, but the value of the asset on the balance sheet stays
at $200,000 — the historical cost. Book value is defined as cost minus accumulated depreciation. If you consider buying an asset, the “true value” of the
asset is its book value. Check out Book III, Chapter 1 for more on book value
and depreciation.
Record marketable securities — securities that the company purchases to sell in
the short term — at their fair market value. See “Short-term investments,” later
in this chapter, for details. Keep in mind that some assets, such as marketable
securities, use fair market value as the asset’s value on the balance sheet.
Discovering What Makes
an Asset Current
For this book, current assets include cash and any asset that a company
anticipates converting to cash within a 12-month period from the date of the
balance sheet. On the balance sheet, you should list current assets in order
of liquidity. Because cash is the most liquid (it’s already cash), it shows up
on the balance sheet first. Other common current assets are short-term
investments, accounts receivable, notes receivable, inventory, and prepaid
expenses. The following sections cover each type in turn.
Cash
Cash consists of paper bills, coinage, and accounts backed by cash. For
example, when you go to the grocery store and use your debit card to pay for
your groceries, that debit transaction is the same as paying with cash. That’s
because when you swipe your card and enter your PIN, you attest to the fact
that funds in your checking account are sufficient and immediately available
to cover the cost of your groceries.
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Depending on the size of the business, it may organize and manage its
revenue and bill paying in one or more types of cash accounts. For example,
a retail business probably has a separate operating account and merchant
account (an account where credit card transactions deposit). A large service
business may have a separate operating account and payroll account. Some
companies have cash accounts for which they earn interest income.
You may be wondering why a company complicates its bookkeeping with
different bank accounts to pay expenses and accept revenue. In some cases,
having different bank accounts creates a safer business environment. For
example, having a dedicated payroll account allows payroll disbursing
employees to do their job (process payroll paper checks and electronic
transfers) while having access to a limited, defined amount of cash.
But with cash accounts, it’s really the Wild West out there in the business
world. Some small businesses have more accounts than they actually need,
and some large businesses have only one.
In terms of the balance sheet, the most important point to remember about
cash accounts is that they’re included in the current section of the balance
sheet. However, understanding the business purpose for different types of
cash accounts is also important — so here they are, with brief descriptions:
✓ Operating checking account: A business usually earmarks a particular
checking account, which it calls its operating account, to handle business activities such as depositing revenue and paying bills.
✓ Payroll checking account: Many companies have a checking account
used only to pay employees. The company calculates the total dollar
amount of checks or transfers going to pay employees and transfers that
amount from its operating account to cover the payroll checks. Often,
businesses hire a payroll service to perform these tasks. Head to Book II,
Chapters 4 and 5 for more on payroll.
✓ Merchant account: If a business allows customers to pay by credit
card, it probably has a dedicated merchant account into which the
only deposits are from its merchant provider: the company that helps it
process customer credit card transactions. Normally, withdrawals from
this account go to the operating cash account to cover bill-paying
withdrawals.
✓ Petty cash account: Most companies have a cash box to pay for small
daily expenses. This account is also known as an imprest account, which
means it always carries the same balance. Anytime the cash box is
checked, it should contain cash or receipts equaling the petty cash fund
amount. So if the fund balance is $300, cash and receipts in the box must
equal $300.
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✓ Sweep account: A sweep account is a way for the company to ­automatically
earn investment income. Each evening, any extra cash in the
company’s operating account is gathered up and transferred (swept)
into investment accounts.
Money from many different companies is pooled into a bigger pot,
thereby providing the advantage of a higher rate of return. Then as the
company needs the money in order to clear checks and withdrawals, the
money is swept back into the operating account.
A negative (credit) balance in a cash account is considered a loan. If you have
a negative balance, your account is overdrawn. That means that you owe the
bank money. This situation requires an adjustment at the end of an accounting
period. You should debit cash (to adjust the account to zero) and credit a loan
or payable account. A credit entry increases a liability account.
Short-term investments
A business may make short-term investments by purchasing securities issued
by other companies to the public. These investments can be equity (stock)
and debt (bond) securities that a company uses to invest any idle cash and
earn a return. (For more about bonds, see Chapter 4. Stocks are covered
in Chapter 5.) Instead of investing idle cash in a bank account, a company
invests idle cash in stocks and bonds.
To classify these investments as short-term (current assets), the company
must be planning to sell them within 12 months of the balance sheet date.
Two types of common short-term investments are trading and available-forsale securities, which the following sections describe.
Trading securities
Trading securities are debt and equity securities that a business purchases to
sell in the short term to make a profit. You record trading securities on the
balance sheet initially at cost. Then, as their value fluctuates, you record
them at fair market value with any unrealized gain or loss going to the income
statement. Unrealized means the gain or loss is only on paper. You won’t
have realized gain or loss until you actually sell the securities.
You must have a buy and a sell to have a realized gain or loss. An unrealized
gain or loss on a security means that a gain or loss would occur if you were to
sell the security. Until you sell the asset, the gain or loss is unrealized.
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For example, suppose your company buys 100 shares of common stock in
ABC Corp. for $1,000. To record this transaction, the balance sheet’s trading
securities account is increased by $1,000 and cash is decreased by the
same amount.
Sadly, at the end of the month after purchase, these 100 shares are now worth
only $900. To adjust the current asset section of the balance sheet, you need
to credit (reduce) trading securities by the $100 drop in value. Then you
also debit (increase) other losses on the income statement (see Chapter 2)
by $100.
As explained previously in the chapter, historic cost isn’t used on the balance
sheet when you’re dealing with marketable securities. In this example of ABC
Corp. stock dropping in value, the value of ABC Corp. stock on the balance
sheet is reflected at less than historic cost.
Available-for-sale securities
Available-for-sale securities are debit and equity investments that a company opts not to classify as trading securities. The difference is important
because unrealized fluctuations in the value of available-for-sale securities do not show up on the income statement as gain or loss. Instead, any
changes (net of tax) go onto the balance sheet as accumulated other
comprehensive income.
Here’s how to handle an available-for-sale transaction: Suppose Reeves
Corporation buys 2,000 shares of common stock for $5,000, deciding to classify the stock as available-for-sale. At the end of the month, the fair value of
the shares is $6,000. Woohoo! That’s an unrealized gain of $1,000!
To record this transaction, you increase (debit) the value of the security on
the balance sheet by $1,000 (from $5,000 to $6,000) and increase (credit)
accumulated other comprehensive income by $1,000.
Accounts receivable
Accounts receivable (A/R) is the amount of money that customers owe a
business for merchandise or services they purchased from the business on
credit. Many companies sell products and services on credit, because the
practice encourages customers to do business. As a result, many companies
have accounts receivable balances.
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Assume you perform a service and give a client an invoice for $500. A couple
weeks later, your client mails you a check for payment in full. In that two-week
period between when you performed the service and received the payment,
that $500 is on your books as an accounts receivable.
Unfortunately, some customers who buy on credit don’t pay their bills. Under
generally accepted accounting principles (GAAP; see Chapter 1), you have
to make a valuation adjustment for such uncollectible accounts, called bad
debt. If you determine that a customer isn’t going to pay, the receivable balance should be recorded as bad debt expense.
If you extend credit to customers, GAAP requires that you estimate your
uncollectible accounts. Companies usually base their estimate on their past
experiences with bad debt.
For example, a company finds that 2 percent of all credit sales over the past
5 years were never collected. Those balances were written off as bad debt
expense. That history of bad debt experience (2 percent of sales) can be used
to estimate bad debt in the current period.
Using the allowance method for bad debt expense
The allowance method enables you to estimate the amount of bad debt
expense, based on some percentage of credit sales. In the previous example,
you estimate that 2 percent of credit sales will be uncollectible.
Suppose sales on account are $50,000. Using the 2 percent figure, the estimate for uncollectible accounts is $1,000 ($50,000 × 0.02). The journal entry
to record this amount is to debit (increase) bad debt expense $1,000. Bad
debt expense is an income statement account. You also credit (increase)
allowance for doubtful accounts $1,000. Allowance for doubtful accounts is
considered a contra account.
A contra account carries a balance opposite to the account’s normal balance.
Because the normal balance for an asset is a debit, the normal balance for a
contra-asset account, such as allowance for doubtful accounts, is a credit.
The amount of money you expect to collect from credit sales is defined as net
receivables. Here’s the formula:
Net receivables = Accounts receivable – Allowance for doubtful accounts
Allowance for doubtful accounts tells the financial statement reader the dollar
amount of credit sales you estimate as bad debt. Until the company is reasonably sure that a customer on account won’t cough up the cash, the journal
entry is just an estimate not tied to any particular customer.
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When you determine that a particular customer’s account is uncollectible
(maybe the company declares bankruptcy), your next step is to remove
the amount from both allowance for doubtful accounts and the customer
accounts receivable balance. After all, the mystery is over — you know the
customer won’t be paying.
For example, Newbury Supplies owes you $1,000. You send it a past-due
notice that the post office returns as undeliverable with no forwarding
address. After following up, you have no success at locating Newbury.
You must make a journal entry to debit (decrease) allowance for doubtful accounts for $1,000 and credit (reduce) Accounts Receivable–Newbury
Supplies for $1,000.
Now, what if the owner of Newbury Supplies sends you a check for the $1,000
after you’ve written off the balance due? Then you record the payment by
debiting cash and crediting allowance for doubtful accounts. Keep in mind
that you already removed (credited) the receivable when you determined the
amount was uncollectible. So, when you collect on a receivable that has been
written off already, you don’t post an entry to accounts receivable.
The allowance method for bad debt adheres to the accounting principle of
conservatism. The principle is discussed throughout this book. When in
doubt, the principle instructs the accountant to err on the side of conservatism. That means that you should delay recognizing revenue until you’re
certain about your estimate. You should also recognize expense sooner
rather than later. The principle helps you generate financial statements
that aren’t overly optimistic.
The allowance method posts bad debt expense early. The bad debt entry is
based on your estimate of bad debt. When you’re certain that a customer
won’t pay, you reduce (debit) the allowance account and reduce (credit)
accounts receivable.
Going over the direct write-off method
Using the direct write-off method, you post bad debt only when you’re certain
that you won’t be paid. It doesn’t use an allowance account to estimate uncollectible balances, so it doesn’t meet GAAP requirements. When an account is
determined to be uncollectible, the direct write-off method requires you to
debit (increase) bad debt expense and credit (reduce) accounts receivable.
For more about the direct write-off method, see Book III, Chapter 6.
Note the difference between the allowance and direct write-off methods. The
allowance method posts bad debt when you estimate uncollectible balances.
The direct write-off method posts the bad debt only when you’re certain that
you won’t be paid. Because the allowance method posts bad debt sooner, the
approach is more conservative, thus conforming to GAAP.
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Notes receivable
A note receivable is a short-term debt that someone owes you, meaning it
comes due within 12 months of the balance sheet date. In many cases this
current asset arises from a trade receivable: money your customer owes you
for the purchase of goods or services you rendered. This situation can arise
if the customer has cash flow problems that prevent it from paying for a
purchase. The customer goes to its vendor and asks for extended terms in a
formal written document, which replaces the less formal agreement to pay
for the goods or services — the invoice.
A note receivable has three major components:
✓ Principal: The amount owed to the company by the debtor.
✓ Rate: The amount of interest the debtor pays on the principal. It’s
almost always stated as an annual rate, even if the note is for a period
shorter than one year.
✓ Time: The period in which the debtor has to pay back the note.
If you ever have to convert an accounts receivable to a note receivable, you
can breathe a sigh of relief because it’s a simple journal entry (see Book I,
Chapter 3). You increase (debit) notes receivable and decrease (credit) the
customer’s accounts receivable.
A note receivable appears in the current asset part of the balance sheet only
for the debt you anticipate will be paid back within 12 months of the balance
sheet date. Any portion of the note receivable extending past that 12-month
period gets put in the long-term asset section of the balance sheet.
Inventory
Inventory is another current asset you need to account for in the asset section of the balance sheet. You need to account for two different types of
inventory. The first is retail inventory, which is merchandise available for sale
in stores and shops. The second, used by manufacturers, is product inventory,
which includes direct materials: work in process and finished goods.
Book VIII, Chapter 2 is devoted entirely to inventory. The following two
sections give you brief descriptions and examples of inventory terms.
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Retail (or merchandise) inventory
Accounting for retail inventory is easier than accounting for manufacturing
inventory because a merchandising company, such as a retail store, has only
one class of inventory to keep track of: goods the business purchases from
various manufacturers for resale (the goods on the store’s shelves).
Here’s an example of how a retailer handles an inventory purchase: The
associate in charge of lawn mower inventory at a major home improvement
store notices that the department is running low on a certain type of mower.
He informs the department manager. The manager follows the department
store’s purchasing process, and the department receives a shipment of
mowers from its vendor. This transaction is a purchase, which is part of
inventory (an asset account). When the mowers are sold, the inventory is
reclassified as cost of goods sold (an expense account).
Manufacturing inventory
Because a manufacturing company doesn’t simply buy finished goods for
resale to customers, it has a more complicated inventory with three major
components:
✓ Direct material inventory: Also known as raw materials, this inventory
reflects all materials the company owns that it will use to make a product. For the lawn mower manufacturer, raw materials include the steel to
form the body, leather or fabric for the seat, and all the other gizmos and
parts that make the mower work. In essence, any materials that you can
directly trace back to making the mower are direct material inventory.
✓ Work-in-process inventory: At any point in time during the manufacturing process, the company probably has items that are in the process
of being made but aren’t yet complete, which is work in process. With
a lawn mower manufacturer, this category includes any mowers that
aren’t completely assembled at the end of the financial period. The company values its work-in-process inventory based on the mower’s percentage of completion. If the mower is 70 percent complete, the mower’s
cost is likely to include 70 percent of the costs incurred.
✓ Finished goods: These are costs you associate with goods that are
ready for sale to customers but haven’t yet been sold. For the lawn
mower manufacturer, this category consists of mowers not yet sold
to retailers, such as hardware stores. Finished goods can end up in
two places: If you sell the goods, the cost is posted to cost of sales
(an expense account). If you don’t sell the finished goods, the cost is
included in ending inventory — an asset account.
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Companies can use many different methods to place a dollar value on ending
inventory. See Book VIII, Chapter 2 for details.
Prepaid expenses
Rounding out the discussion of current assets are prepaid expenses, which
are expenses the business pays before they’re due. Many companies pay
six months’ worth of business insurance in advance. In a similar way,
your car insurance policy requires insurance premium payments before
your coverage starts. Companies may also pay rent in advance. Prepaid
expenses are considered an asset, because you don’t have to pay for the
expense later.
For example, assume a company pays an invoice for $1,200 that covers 12
months of car insurance for the company vehicle. You originally book this
amount as an increase (debit) to prepaid expense and a credit (reduction) to
cash. Then, as each month goes by, you move the portion of the insurance
cost from the balance sheet to the income statement. Each month, you debit
(increase) insurance expense for $100 ($1,200/12 months) and credit (reduce)
prepaid expense for the same amount. See Book III, Chapter 6 for additional
coverage of prepaid expenses.
Keeping Track of Noncurrent
(Long-Term) Assets
Recall that assets are used to make money in your business. You classify an
asset as noncurrent or long-term if the asset will be used up over the course
of more than 12 months after the date of the balance sheet. For example,
any part of a note receivable that the company expects to receive after the
12-month cutoff date is classified as noncurrent. Natural resources such as
coal, oil, and timber are also noncurrent assets. So are mineral deposits, such
as gold and diamonds.
This section focuses on the most common types of noncurrent assets
you’ll encounter, starting with tangible assets and then moving on to
intangibles.
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Meeting the tangibles: Property,
plant, and equipment (PP&E)
Tangible assets, also called fixed assets, include property, plant, and
equipment (PP&E) — a category that includes land, buildings, equipment,
furniture, and fixtures. The following sections describe the various
tangible assets included in PP&E.
Land
Land, also called real property, is the earth on which the company’s office
buildings or manufacturing facilities sit. The cost of the land plus any improvements the company has to make to the land to use it for business operations
is your total cost. Land is posted to the balance sheet at historic cost.
Four types of costs are included in the land account:
✓ Contract price: The purchase price for the land.
✓ Closing costs: Expenses to exchange the title of the land from buyer to
seller. These costs include real estate broker commissions, legal fees,
and title insurance.
✓ Survey costs: Costs for a land surveyor to give you a professional opinion
as to where the boundaries of the property lie.
✓ Land improvements: Expenses the company incurs to get the land
ready for use, which include the cost of clearing the land if necessary
to build the manufacturing plant or adding sidewalks and fences to an
existing property.
Because land isn’t considered to be “used up” the way that other PP&E is, land
is never depreciated.
If a company buys land as an investment, you record it in the investment section of the balance sheet rather than PP&E. Wondering whether it would go
in the current or long-term section? Well, that classification depends on how
long the company plans on owning the land. If it anticipates selling the land
within 12 months of the balance sheet date, it’s a current asset. Otherwise,
record it as noncurrent (long-term).
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Buildings
This category covers the company-owned structures in which the company
conducts business operations. It includes office buildings, manufacturing
facilities, and retail shops. If the business owns off-site storage facilities or
warehouses, these assets go in the buildings category too.
Unlike land, buildings are depreciable (see Book III, Chapter 1). Also, when
preparing a balance sheet, make sure you list land and buildings separately
because doing so is a GAAP requirement.
To figure out the cost of the land and buildings separately, do one of
the following:
✓ If the business purchased the land and buildings together, hire an
appraiser to determine the value of the land and the value of the building.
✓ If the business purchased a piece of raw land and constructed its own
building, use the purchase agreement to determine the value of the land
and all invoices related to erecting the building to determine its value.
Equipment
This category is quite broad, encompassing any equipment a company uses
to make the products it sells to customers. For example, a manufacturing
company such as a bread baker includes all the mixers, ovens, and packaging
machines it uses to turn the yeast and flour into loaves of bread and package
them to ship to grocery stores.
A merchandising company (a retailer, which doesn’t make any products)
includes in this category any office computer equipment it owns, plus
forklifts or mechanized ladders to move inventory around. Retail shops
categorize their cash registers as equipment.
Furniture and fixtures
Last up in the parade of PP&E are furniture and fixtures, which include desks,
chairs, and filing cabinets. Add to these three very common examples any
other furniture items you see in an office setting: credenzas, conference
tables, area rugs — the list goes on and on.
A merchandiser has fixtures to present wares for sale, such as glass display
cases and display racks. Mannequins are also considered fixtures and, depending on their quality, can be a very high dollar item on the balance sheet.
If the company leases any of its PP&E, the leased items may not be considered
company property and don’t show up in the PP&E section of the balance
sheet. However, if the lease has aspects of ownership that pass the GAAP sniff
test, you do record the leased asset on the balance sheet as a capitalized
lease. For more about leases, see Book V, Chapter 4.
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Investigating intangible assets
The big difference between tangible and intangible assets is that intangible
assets (usually) don’t have a physical presence. When you really dig into
the subject, you’ll probably find intangibles a lot more interesting than
steel desks and swivel chairs. The following sections describe the types of
intangible assets and explain how to write off intangible assets and generate
intangible assets internally.
Identifying patents, trademarks, and other intangible assets
The first type, which is the most common, includes long-lived assets such as
patents, trademarks, and copyrights:
✓ Patents: Patents provide licensing for inventions or other unique
processes and designs. Items that patents can protect run the
gamut from pharmaceuticals to automobile circuitry to unique
jewelry designs.
✓ Copyrights: Securing a copyright means that someone can’t use the
company’s printed work (such as books or articles) or recorded work
(such as musical scores or movies) without permission.
✓ Trademarks: When a company has a trademarked name or symbol
(for example, Xerox), no other company can use it without getting
permission from the trademark owner.
See “Writing off intangibles by using amortization,” later in this chapter, for
details on how to determine the value of these intangible assets and account
for them on the balance sheet.
Introducing goodwill
The second category of intangibles, goodwill, comes into play only when
one business purchases another for a price greater than the fair market
value of the net assets acquired during the sale. (Net assets are total assets
less total liabilities.) For example, ABC Corp. buys XYZ Corp. for $250,000.
XYZ’s net assets are $175,000. ABC Corp. acquires $75,000 ($250,000 –
$175,000) of goodwill in the transaction. Goodwill is posted as an asset on
ABC’s books.
Consider the logic of paying more than the fair market value of the net assets
when purchasing a company. Net assets represents the true value of the company. If you sell all the assets and use the cash to pay off all the liabilities, you’re
left with net assets (equity). So consider why someone would pay more than the
net assets.
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The buyer — who pays more than the net asset value — believes that the
company has assets or other opportunities not fully valued in the financials.
For example, the buyer is willing to pay more for the company’s brand name
and reputation in the marketplace. Maybe the company has a customer list,
and the buyer believes that he can generate more business from that list.
Those are reasons to pay more than the value of net assets.
Writing off intangibles by using amortization
Amortization is similar to depreciation (see Book III, Chapter 1) because you
use amortization to move the cost of intangible assets from the balance sheet
to the income statement. Both amortization and depreciation are expenses.
Most intangibles are amortized on a straight-line basis, using their expected
useful life. Assume, for example, that the U.S. government grants patent
protection for a period of 20 years. Unless the patent has become obsolete,
20 years would probably be the expected useful life the business uses for
its patent amortization. An obsolete patent has no value. The cost would be
immediately expensed.
What about the balance sheet cost of intangibles? Leasehold improvements
are easy: The amount is the actual cost for any improvements the company
makes. The useful life for leasehold improvements is usually the term of
the underlying lease. Patents, trademarks, and copyrights the business purchases are treated similarly: You have the cost of purchase as a basis for the
amount you amortize.
Generating intangible assets for company use
The cost of developing an intangible asset in-house can be minimal. For
example, maybe some employees were just spit-balling in a meeting and came
up with a catch phrase that eventually became very valuable because of the
success of the product associated with the phrase.
In this case, the company can include the legal costs to file the trademark
with the federal government in a trademark asset account. Legal expenses
incurred to defend the trademark against infringement (unauthorized use)
can also be added to the trademark asset account. Keep in mind, however,
that most research and development costs to create an intangible asset are
expensed as incurred. Those costs aren’t posted to an asset account.
The second category of intangibles, goodwill, is never amortized. Accountants
test goodwill yearly for impairment. The company determines whether any
goodwill has declined in value and writes off (removes) that value from the
balance sheet.
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Exploring the Asset Section
of the Balance Sheet
To wrap up this chapter, Figure 3-1 shows what the asset section of the
­balance sheet looks like. Liabilities and equity are each merely a line
item in Figure 3-1. Check out Chapter 4 to see the liability section and
Chapter 5 to see the equity section of a balance sheet fully developed.
Figure 3-1:
The asset
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Book IV
©John Wiley & Sons, Inc.
Current assets are always shown first, in order of liquidity, followed by any
long-term assets, which typically include notes receivable (notes due more
than 12 months past the balance sheet date).
The company’s PP&E appears next with the accumulated and amortization
shown as a separate line item at the bottom of the section. Appearing at the
end are any nonphysical intangibles — usually net of amortization, which
means that amortization is subtracted before listing the intangibles’ values
on the balance sheet.
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Chapter 4
Digging for Debt in the Balance
Sheet’s Liabilities Section
In This Chapter
▶ Discovering how a company raises cash
▶ Identifying current liabilities
▶ Finding out about long-term debt
▶ Knowing when loss contingencies are reportable
▶ Accounting for bonds
N
obody likes debt, but it’s often an inevitable part of a company keeping
its doors open for business. This chapter covers both current and longterm debt, collectively known as liabilities. You discover the types of current
liabilities that help a business manage its day-to-day operations. You also find
out about long-term debt obligations that businesses use to acquire assets.
This chapter discusses basic long-term debt — such as mortgages and notes
payable — and bonds, focusing on the many facets of this complicated topic.
A third type of liability — loss contingencies — also gets some space in
this chapter. These liabilities aren’t always included in financial accounting
reports; you get the lowdown on when and how to include them.
Seeing How Businesses
Account for Liabilities
Liabilities are claims on company assets (cash) by other businesses or its
employees. Because a company uses assets to pay liabilities, accountants
refer to liabilities as a “claim on assets.” Examples include:
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Book IV: Preparing Income Statements and Balance Sheets
✓ Accounts payable: Money a company owes to its vendors for services
and products it purchased.
✓ Unearned revenues: Money received from clients before the business
provides goods or services to the customer. When you pay for a oneyear magazine subscription, your payment is unearned revenue to the
magazine publisher. The revenue isn’t earned until the publisher starts
to deliver magazines to you.
✓ Salaries payable: Wages the company owes to employees.
Generally accepted accounting principles (GAAP, discussed in Chapter 1)
dictate that when you prepare the liability section of the balance sheet,
any claims against the company have to be broken out between current and
long-term obligations. For this book, the dividing line between the two is the
one-year mark: All liabilities that are due within one year of the balance sheet
date are considered current. All others are considered long-term.
If a company refinances a current liability, that new liability may be treated as
long-term. For example, a company may replace an accounts payable balance
with a note payable (a formal loan document to pay the balance — possibly
owed over several years). See Chapter 2 for details.
Book I, Chapter 1 introduces the fundamental accounting equation, which is:
Assets = Liabilities + Owners’ equity
Based on the order of elements in this equation, liabilities show up on the
balance sheet after total assets but before equity accounts, with current
liabilities first, followed by long-term liabilities. (Current and long-term assets
receive similar treatment; see Chapter 3.)
Using the accrual method of accounting (explained in Book I, Chapter 4), all
revenue must be matched with expenses incurred during the production of
that revenue. So if a company incurs costs but money doesn’t change hands, a
liability shows up on the balance sheet to reflect the amount that eventually
has to be paid. For example, the company may make a purchase from a vendor
without immediately paying for it. That item will appear in accounts payable,
which is a current liability.
Figure 4-1 shows a simple liability section of the balance sheet, with all asset
and equity accounts consolidated to a single line item each (the two shaded
lines). Check out Chapter 3 for a more formal presentation of all sections of
the balance sheet. Also note that each account’s chart of account number is
included. (See Book I, Chapter 2 for more info about the chart of accounts.)
A formal balance sheet usually won’t include chart of account numbers.
Chapter 4: Digging for Debt in the Balance Sheet’s Liabilities Section
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Figure 4-1:
The liability
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©John Wiley & Sons, Inc.
Keeping Current Liabilities under Control
This section introduces nearly every type of current liability you’re likely
to encounter. It even tosses in some journal entries, so you can see how the
transactions get into the accounting records (see Book I, Chapter 3). But
before you start, you need to understand the reason why breaking out current from long-term liabilities is so important. GAAP requires the division so
the user of the financial statements can easily glean the information necessary to compute several important financial ratios.
Liquidity ratios measure how well a company is prepared to pay short-term
liabilities (bills due in less than a year) with assets available in the short
term. One important liquidity ratio is working capital, which is current assets
minus current liabilities. A variation on working capital is the current ratio,
which is current assets divided by current liabilities. These ratios are important to many users of financial reports, who may be investors, banks, or
anyone else with an interest in the company’s financial health.
These financial ratios and tools (spelled out in Book V, Chapter 3) give the
user specific criteria for deciding how well the company is performing. For
example, a bank’s loan officer deciding whether to loan a business money
wants to gauge the expectation of being paid back on time. Working capital
and the current ratios are very helpful in that arena.
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For this reason, netting current assets with current liabilities is rarely okay
under GAAP. To do so would eliminate the ability to use any sort of ratio
­analysis involving current asset or liability accounts. For example, if you purchase inventory on account (on credit), both the inventory and accounts payable accounts increase.
Accounts payable
Accounts payable (A/P) includes money a company owes its vendors for
services and products it has purchased. Accounts payable is a current liability, because the company anticipates paying the liability in the short term.
For example, the company purchases inventory from a manufacturer. The
transaction originally goes in the purchases journal, which shows purchases
on account, with a debit going to whatever cost or expense account is most
applicable and a credit going to accounts payable.
Per GAAP, A/P is always assumed to be a current liability. However, a transaction originally entered as A/P could eventually be reclassified as a long-term
debt. This change may happen if the company couldn’t pay the vendor and
the vendor agreed to convert the short-term A/P to a long-term note (a formal
document showing an amount owed and a mutually acceptable interest rate
and payback period spanning more than a year).
Note that the terms accounts payable and trade payables are often used synonymously. But technically, trade payables generally refer to vendors from which
a company buys business supplies and direct materials — items it uses to manufacture products for sale (see Book VII, Chapter 4). Accounts payable
includes all vendors you intend to pay within a year. Some accounting systems
may include both categories simply as accounts payable.
Many vendors selling on credit give a discount to customers who pay their
balances early. For example, the terms of the purchase may call for full payment in 30 days but a discount of 2 percent if the customer pays the bill
within 10 days. Accountants refer to this type of arrangement as 2/10 net 30.
If the company got a 1 percent discount for paying in 15 days with the total
amount due in 45 days, it looks like this: 1/15 net 45. The seller is willing to
accept a smaller payment (by offering a discount) in order to collect the payment sooner. Collecting payments quickly provides the business more cash
to operate. Figure 4-2 illustrates the debiting and crediting for $1,000 of
inventory purchased on account with discount terms of 2/10 net 30 and
the subsequent payment.
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Figure 4-2:
Inventory
purchase on
account and
payment
within
discount
period.
©John Wiley & Sons, Inc.
Payroll and taxes
The nature of the beast is that most companies accrue payroll and related
payroll taxes. With an accrual, the business recognizes a liability that hasn’t
yet been paid. At the end of many accounting periods, a company may owe
payroll to employees. This concept is easy to understand if you think about
the way an employer has paid you in the past.
Most companies have a built-in lag time between when employees earn
their wages and when the paychecks are cut. For example, Penway
Manufacturing pays its employees on the 1st and 15th of every month with
15 days of wages in arrears. This means that when the employees get their
paychecks on July 15, the paychecks compensate work they did from June
16 through June 30.
To match expenses to revenue when preparing financial statements for the
one-month period ending June 30, the gross wages earned but not yet paid
as of June 30 have to be added to the balance sheet as a current liability. You
also have to account for any payroll taxes or benefits that will be deducted
from the employees’ paychecks when the checks are finally cut. Book II,
Chapters 4 and 5 provide details on these topics.
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Book IV: Preparing Income Statements and Balance Sheets
Unearned revenue
Unearned revenue is a liability that arises when a company receives payment
for goods or services rendered before it has actually provided the goods or
services. Because the business has an obligation to deliver the product or
service, the unearned revenue is a liability until the company completes its
end of the transaction. Unearned revenue can be a short-term (a year or less)
or a long-term liability.
To record revenue, it has to be earned and realizable. If the customer pays in
advance, the revenue is realized. However, the revenue isn’t earned until the
product or service is delivered to the client.
Suppose you pay a $1,200 deposit to a cabinet maker to build customized
cabinets for your office building. Until the cabinet maker delivers the cabinets to your office, your payment isn’t 100 percent earned revenue for the
cabinet maker. The way this works on the cabinet maker’s end is that it
debits cash and credits unearned revenue for your payment of $1,200. After
delivering the completed cabinets, it records revenue by debiting (reducing)
unearned revenue and crediting (increasing) gross sales for $1,200.
Other short-term liabilities
Other short-term liabilities include items such as loan payments that are
payable within 12 months. Current debt can originate as short-term bank
loans, or it can be the portion of a long-term debt that’s due within the next
12 months. Another type of current liability you’re likely to encounter is estimated warranty, which reflects how much money a company may have to pay
to repair or replace products sold to customers.
Here’s more information on short-term bank loans, current maturities of
long-term debt, and estimated warranty expense:
✓ Short-term bank loans: When a company takes out a loan, it doesn’t
always have to be for an extensive period (such as a 30-year mortgage).
Frequently, a company anticipates getting paid for a job it has performed
and just needs a brief influx of cash to pay expenses such as payroll.
A good example of this situation is a working capital loan, which a bank
makes with the expectation that the loan will be paid back from collection of accounts receivable. As long as the loan is due in full fewer than
12 months after the balance sheet date, you classify borrowed funds as
current liabilities.
Chapter 4: Digging for Debt in the Balance Sheet’s Liabilities Section
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Short-term debt is important to examine when determining the financial
health of a company because it indicates whether a cash flow issue
could arise in the future. If the short-term debt is unreasonably high,
the company may not have the excess money to make the loan
payments.
A company can also have a revolving line of credit, which is a loan with
a preset limit on how much the company can withdraw at any one time.
This type of financing is considered a current liability. This sort of
­current debt is much more flexible than a loan because the company
borrows against it only when necessary.
✓ Current maturities of long-term debt: Suppose a company has a 30-year
mortgage on its land and building, and it’s in the third year of paying
off the loan. To properly reflect this mortgage on the balance sheet,
the principal amount the company owes in the next 12 months has to
be recorded as a current liability. The rest of the mortgage payable is a
long-term liability, a subject covered in the next section.
You can use an amortization schedule, which shows how much of each
mortgage payment goes to principal versus interest, to figure out the
current portion of the long-term debt.
✓ Estimated warranty liability: Warranties on products may be included
in the purchase price of a product or something the purchaser elects to
buy separately — usually at the time of purchase. A great example is the
guarantee of performance relating to the purchase of a computer from
an electronics retail shop. For example, the computer comes with a sixmonth warranty from the manufacturer covering numerous performance
and repair issues. If the computer breaks down within the six-month
warranty period, the purchaser can send it back to be fixed, free of
charge. The company has to take two steps in this situation to ensure its
financial reports are complete:
• Provide a disclosure about the warranty in a footnote to its
­financial statements (see Book V, Chapter 4)
• Calculate and book an estimate of how much it costs the company
to fulfill the terms of the warranty
A popular way to estimate warranty expense is to use a percentage
of sales. This percentage is normally figured historically. If in the past
the company has incurred an actual warranty expense of 4 percent,
that same percentage should be the current year’s estimate until the
facts change.
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Here are the steps to estimate and record warranty expense:
1. Compute the total dollar amount of sales under warranty.
2. Calculate the dollar amount of warranty expense. Use a percentage
of total sales based on your experience with warranty expenses in past
years.
3. Post an entry to debit estimated warranty expense and credit accrued
warranty liability for the warranty estimate.
4. Debit accrued warranty liability and credit cash for actual payments
for warranty expenses.
5. Compare your estimate of warranty expense with your actual payments
for warranty expenses (cash payments). Consider whether the warranty
estimates should be increased or decreased to accurately reflect your
warranty expenses going forward.
Ready to see how to journalize these transactions? Figure 4-3 gives you the
lowdown on the entry to book the estimate and record actual warranty
expense.
Figure 4-3:
Recording
accrued
and actual
warranty
expense.
©John Wiley & Sons, Inc.
Planning for Long-Term Obligations
If you own a car you financed, you’re probably all too familiar with long-term
debt — loans that won’t be paid off within the next 12 months. Companies
have long-term debt, too. Although a company usually uses current liabilities
(loans) as a vehicle to meet short-term obligations such as payroll, it may
incur long-term debt for the financing of company assets.
Chapter 4: Digging for Debt in the Balance Sheet’s Liabilities Section
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Financing asset purchases
with debt versus equity
Corporations raise money to purchase assets in one of two ways: debt or
equity. Debt means the company borrows money with an obligation to pay
the borrowed funds back. Equity means the company sells shares of its own
stock to investors. If you issue debt, you have creditors. If you issue stock,
the purchasers of your stock are owners.
What makes equity investing appealing is that the company may not be under
any obligation to buy back the shares of stock from the investors. However, it
also means that equity investors have some say in the decisions of your business, including voting rights on major corporate decisions. Equity investors
also want a return on investment, possibly in the form of a dividend.
Oddly enough, debt can end up making a company money. This situation
is called financial leverage, and it takes place when the borrowed money is
expected to earn a higher return than the cost of interest payable on the
debt. Additionally, interest expense on debt is normally a tax deduction while
dividends payable to investors are not.
Here’s an example: You borrow funds at 6 percent to purchase a new machine
to manufacture a product. The new machine operates more efficiently. You
incur less repair and maintenance cost, and you’re able to produce more
product each month. As a result, your company earnings increase by 8 percent. Your 8 percent growth in earnings more than offsets your 6 percent
borrowing cost. Book VIII, Chapter 4 provides more insight on this concept.
Managing long-term debt
If the company needs to raise cash and decides to do so by accumulating
debt, the most common types are mortgages, notes payable, capitalized
leases, and bonds. Following is your accounting guide to the first three of
these categories of long-term debt. Bonds are a much more complicated
subject, covered later in this chapter in the section “Accounting for
Bond Issuances.”
Any type of debt instrument between a lender and a borrower specifies principal
(the amount borrowed), rate (how much interest the company pays to borrow
the money), and term (the duration of the note). A portion of each payment is
applied to principal and the other portion to interest.
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Book IV: Preparing Income Statements and Balance Sheets
Mortgages
Mortgages are used to finance the purchase of real property assets (building and land, for example). The property collateralizes the mortgage, which
means that the property is held as security on the mortgage. If the borrower
defaults on the mortgage, the lending institution seizes the property and sells
it to recoup as much of the borrowed money as possible.
Notes payable
Notes payable are formal written documents that spell out how money
is being borrowed. The earlier section “Other short-term liabilities”
explains that the part of a note payable that’s going to be paid off within
the 12 months of the balance sheet date is classified as short-term debt.
The remainder of the note is considered a long-term debt.
Capitalized leases
Another type of long-term debt involves capitalized leases. A company
doesn’t always buy its fixed assets (see Chapter 3); sometimes it leases them.
Leasing often makes sense for any fixed asset that’s replaced frequently. For
example, leasing computers makes sense for businesses that need to stay
current with computer technology.
Capital leases have characteristics of ownership, which means the cost of the
leased capital asset goes on the balance sheet as a depreciable asset. This
book offers a full discussion of accounting for leases in Book V, Chapter 4.
Anticipating contingent liabilities
A contingent liability is a liability that may cause a future loss depending
on events that may or may not occur. Here are two examples of common
contingent liabilities:
✓ Pending litigation: A company is actively involved in a lawsuit that
hasn’t been settled.
✓ Guarantee of obligations: A business agrees to step in and satisfy the
debt of another borrower if need be. A company may guarantee the
debt of a supplier if the supplier’s product is critical to the company’s
production process. Perhaps the supplier can’t operate without a loan,
and the lender insists on a co-signer for the loan to be approved.
You typically record contingent liabilities in the footnotes to the financial
statements (see Book V, Chapter 4) rather than as a dollar amount in the
­financial statements. However, if a loss due to a contingent liability meets the
Chapter 4: Digging for Debt in the Balance Sheet’s Liabilities Section
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following two criteria, it should be accrued and reported in the company’s
financial statements as a dollar amount:
✓ The chance of the loss event happening is probable — likely to occur.
Consider the guarantee of obligation example: If the debtor business
(the supplier) has gone out of business and the owners have disappeared into the night, the lender will probably come after the back-up
guarantor to pay off the loan balance.
✓ The amount of the loss can be reasonably estimated, which means you
can come up with an accurate dollar amount of the loss. Continuing with
the guarantee of obligation example, the loss is reasonably estimated
because it should be the remaining balance on the loan, interest owed,
and any additional charges tacked on by the lender in accordance with
the obligatory note.
If the loss contingency meets these two standards for accrual, the journal
entry involves a debit to a relevant loss account (an expense) and a credit
to a liability account. For example, the company could take the debit to “loss
on guaranteed debt” and to some sort of liability account such as “amount
due on guaranteed obligation.”
Accounting for Bond Issuances
Bonds are long-term lending agreements between borrowers and lenders. For
example, a municipality (such as a city or village) may issue bonds to finance
the building of new roads or a hospital. Corporations generally issue bonds
to raise money for capital expenditures, operations, and acquisitions.
The person who purchases a bond receives interest payments at the bond’s
stated interest rate during the bond’s term or for as long as he holds the
bond. When the bond matures (the term of the bond expires), the company
pays the bondholder back the bond’s face value, or principal amount.
A bond is either a source of financing or an investment, depending on which
side of the transaction you’re looking at. The company issuing the bond incurs
the long-term liability. The person or company acquiring the bond views it as
an investment; for a business, this investment is an asset.
Mulling over bond basics
Bonds are normally issued at face amount (the principal amount printed on
the bond, as explained in the following list). When a bond is issued, it’s sold
to the public for the first time. After issuance, a bond may be bought and sold
between many investors over time, based on the market price for the bond.
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The market price of a bond can be expressed in one of three ways:
✓ Face amount (also known as par value): The principal amount printed
on the bond, typically in denominations of $1,000
✓ A discount: Less than face value
✓ A premium: More than face value
When considering bond prices and rates of return, consider the following:
✓ Principal repayment: The bond issuer is obligated to repay the face
amount at maturity regardless of the price the investor paid for the
bond. For example, if the bond’s face amount is $1,000, the bond issuer
must pay back $1,000.
✓ Interest payments: Most bonds pay interest monthly or semi-annually
(twice a year). Bonds issued by corporations typically pay interest
semi-annually.
✓ Yield to maturity: An investor has two cash flows that impact his or her
total return. One cash flow is the interest payments, which are based
on the stated, fixed interest rate. Investors may also have a gain or loss,
depending on whether they bought the bonds at a premium or a discount.
The interest income plus the gain or loss is the yield to maturity. You can
view yield to maturity as the total return on the bond investment.
Examining sample bond transactions
To get a handle on bond prices and yield to maturity, consider an example of
a bond purchased at a discount, and then an example of a bond bought at a
premium.
Buying a bond at a discount
A $1,000, 6-percent, 10-year face amount bond is originally issued at $1,000.
One year later, an investor purchases the bond at $920. Because the purchase
price is less than the face amount, the bond is purchased at a discount. That
investor has two cash flows:
✓ Annual interest payments of $60 ($1,000 × 6 percent)
✓ The principal amount paid at maturity, less the cost of the bond ($1,000 –
$920 = $80)
The investor’s yield to maturity (total return) is more than 6 percent.
That’s because the investor earns $80 when the bond matures, along with
the 6 percent interest rate. When you buy a bond at a discount, you earn
more than the stated interest rate of the bond.
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Investing in a bond at a premium
Using the same numbers, assume a 6-percent, 10-year face amount bond is
originally issued at $1,000. One year later, an investor purchases the bond at
$1,050. Because the purchase price is more than the face amount, the bond is
purchased at a premium. That investor has two cash flows:
✓ Annual interest payments of $60 ($1,000 × 6 percent)
✓ The principal amount paid at maturity, less the cost of the bond ($1,000 –
$1,050 = –$50)
The investor’s yield to maturity (total return) is less than 6 percent, because
the investor loses $50 when the bond matures. When you buy a bond at a
premium, you earn less than the stated interest rate of the bond.
Kicking around the logic of paying a premium
Given the fact that paying a premium for a bond reduces the net interest
earned, you may wonder why an investor would pay a premium for a bond.
Bonds are priced at a premium because the stated interest rate on the bond
is higher than the interest rate of bonds currently being issued (for the same
maturity and credit quality).
Consider the example in the previous section. Assume 10-year maturity
bonds of similar creditworthiness are being issued at a 5-percent interest
rate. An investor may pay $1,050 for the 6-percent bond, because current
bonds being issued have a stated rate of less than 6 percent. The investor
is willing to pay an extra $50 to earn more interest income.
This discussion also explains why bonds are priced at a discount. If a bond’s
stated interest rate is less than similar bonds currently being issued, the
market price of the bond is less than the face amount. If bonds are being
issued at 5 percent, an existing 4-percent interest rate bond sells at a
discount.
Book IV
Journaling bond transactions
When a company issues a bond and when the bond is purchased (at a
premium or a discount), the company must make a journal entry to record
the activity, as explained in the following sections.
Issuing a bond
As mentioned in a previous section, bonds are most often issued at face
amount (par value). If a bond is issued at par value of $1,000, the entry
is to debit cash $1,000 and credit bond payable (a liability account) for $1,000.
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Book IV: Preparing Income Statements and Balance Sheets
Issuing a bond means that the company is selling the bond to an investor. As
a result, the company receives cash from the buyer. Issuing a bond at a premium or discount doesn’t happen that often, so you don’t need to concern
yourself with those scenarios.
Accounting for a bond purchased at a premium
Assume a buyer purchases a $1,000 bond for $1,020. Because the buyer pays
more the $1,000, the bond was purchased at a premium. The buyer debits
bond investment for $1,000 (the face amount). Premium on bond investment is debited for $20, and cash is credited for $1,020. The premium of $20
is amortized, meaning the bond premium is moved into an expense account
over time until the bond matures. The premium is an extra cost to the buyer.
Handling a bond purchased at a discount
Assume the buyer purchases a $1,000 bond for $980. Because the buyer pays
less than the $1,000, the bond is purchased at a discount. The buyer debits
bond investment for $1,000 (the face amount). Note that the bond investment
is debited for $1,000 — regardless of whether the bond is bought at a
premium or discount.
Discount on bond investment is credited for $20, and cash is credited for
$980. The discount of $20 is also amortized. In this case, the bond discount
is moved into an income account over time until the bond matures. So, the
bond discount is extra income to the buyer.
Considering the bond seller’s entries
Now consider the seller of the bond and the related entries. When selling
a bond at a premium, the seller receives more than the face amount. The
premium must be amortized over time into an income account. On the other
hand, when selling at a discount, the seller receives less than face amount.
That discount must be amortized into an expense account.
What you should notice is that additional expense for the buyer generates
income for the seller. The reverse is also true: Additional income for the
buyer results in more expense for the seller.
Understanding debt and other liabilities is a critical area for a business
owner. Debt is one of the two ways an owner can raise capital to run the
business. A manager needs to understand repayment terms and the total
liabilities on the balance sheet in order to make well-informed business
decisions.
Chapter 5
Explaining Ownership in the Equit y
Section of the Balance Sheet
In This Chapter
▶ Meeting the three types of business entities and two types of stock ownership
▶ Investigating paid-in capital and retained earnings
▶ Checking out reductions in stockholder’s equity
▶ Understanding how corporations pay their investors
T
his chapter gets into the nitty-gritty of how the owners’ interest in the
business shows up on the balance sheet. Equity (also referred to as net
assets) is the combined total of each owner’s investment in the business.
Both terms refer to the difference between assets (resources a company
owns) and liabilities (claims against the company).
Understanding How Owner Equity
Varies among Business Entities
Depending on the type of business entity, the owners’ equity section of the
balance sheet can range from bare-boned to quite elaborate, as explained in
the following sections. For more about different business entities in general
and the pros and cons of each, check out Book VI, Chapter 2.
Sole proprietorship
Sole proprietorships (one-owner businesses) have an equity account called
owner capital. Cash and other contributions that the owner makes to the
business, such as equipment, increase the owner capital account. Business
earnings (net income) also increase the owner capital account.
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Book IV: Preparing Income Statements and Balance Sheets
The owner draw account shows money and other assets the owner takes
from the business to convert to personal use. Owner draw reduces the
owner capital account. Although owner draws are accounted for in a unique
account, keep in mind that you need to keep track of owner draw activity to
calculate owner capital.
Here’s a formula to calculate an owner’s capital balance:
Owner’s capital balance = Beginning capital balance + Owner capital
contributions + Year-to-date net income – Capital draws
Figure 5-1 shows the owner’s equity section of the sole proprietorship for
Penway Manufacturing owned by Mike Penway.
Figure 5-1:
A statement
of owner’s
equity for a
sole propri­
etorship.
©John Wiley & Sons, Inc.
Partnership
Partnerships (businesses owned by two or more people) mimic sole proprietorships in that the equity section on the balance sheet has capital and
draw accounts. Figure 5-2 shows the partner equity section of the DoubleTrouble Partnership, whose partners, Tom and Dottie Double, each own
50 percent of the business.
The amount of draws and income distributions a partner is allowed to take
can differ from that person’s partnership interest (ownership interest). So
even though you have two equal partners, that doesn’t mean they have to
take the same draw amount. Hence the differences in beginning and ending
partners’ capital accounts between partners in Figure 5-2.
If one 50-percent owner takes a higher draw each year, his capital account
declines faster over time (everything else being equal). That’s why Tom’s
capital account balance is lower than Dottie’s ($12,000 versus $17,000).
Chapter 5: Explaining Ownership in the Equity Section of the Balance Sheet
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Figure 5-2:
A statement
of partners’
equity.
©John Wiley & Sons, Inc.
Corporation
Unlike sole proprietorships and partnerships, corporations are owned by stockholders. The balance sheet section called “stockholders’ equity” represents
the claim shareholders of the corporation have to the company’s net assets.
Stockholders’ equity is made up of four components: capital stock, paid-in
capital, treasury stock, and retained earnings. Capital stock, paid-in capital,
and treasury stock involve transactions dealing with the corporate stock
issuances and repurchases. Retained earnings contain income and dividend
transactions. The sections that follow give each of these components their due,
but first you need to know a little something about the differences in capital stock.
Distinguishing between Two
Types of Capital Stock
To sell ownership in a corporation, the corporation issues stock that investors
can purchase. According to general accepted accounting principles (GAAP),
all stock transactions must be reported on the balance sheet. The following
sections describe the types of stock covered in this book (common and preferred), and show how to record stock transactions on the balance sheet.
Preferred stock
Preferred stock has two advantages over common stock (discussed next).
First, preferred stock shareholders receive their dividends before common
stock shareholders. If earnings are insufficient to pay both common and preferred dividends, only the preferred dividend is paid. The preferred dividend
is a specific amount, stated as a percentage or a dollar amount.
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If a corporation sells its assets and closes its doors, preferred shareholders
receive their portion of the sales before common shareholders receive theirs.
In other words, in the event a company liquidates, preferred shareholders are
more likely to recoup all or a portion of their investment in the company.
Common stock
Common stock shareholders also may earn a dividend. However, the amount
of the dividend is at the discretion of the corporation (the dividend amount
isn’t stated). The dividend may be higher or lower than last year — or even
zero for the year.
In the unfortunate event a corporation is liquidated, a common shareholder’s
claim on assets comes after preferred shareholders’ claims are paid. In fact,
common stock claims on assets are last in line — after bondholders, creditors, and preferred stockholders.
Recording stock transactions
on the balance sheet
GAAP dictates that you properly describe stock transactions on the balance
sheet. Figure 5-3 shows the proper balance sheet descriptions for common
and preferred stock. Note the following terms:
Figure 5-3:
Capital
stock
balance
sheet
descrip­
tions.
©John Wiley & Sons, Inc.
Chapter 5: Explaining Ownership in the Equity Section of the Balance Sheet
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✓ Par value: The value per share that’s posted to the stock account balance.
Note the difference in par values for common and preferred stock.
Common stock has a par value of $5; preferred stock is $200.
✓ Authorized shares: The maximum number of shares the corporation
can issue, according to its articles of incorporation. When a company is
formed, the owners determine how many shares they want to authorize.
✓ Issued shares: Authorized shares sold to the public.
✓ Outstanding shares: Authorized and issued shares held by the public.
If the corporation repurchases issued shares, they’re considered treasury stock. Treasury stock shares aren’t outstanding. (See “Buying back
shares: Treasury stock,” later in this chapter, for details.)
✓ Dividend: As you see in the prior section, the preferred stock dividend
is a stated amount: 5 percent in this case. The 5 percent is based on the
$200 par value. So the dividend is 5 percent × $200, or $10 per share.
The common stock doesn’t have a stated dividend amount.
Defining Paid-In Capital
Paid-in capital represents money invested in the business (contributed capital).
Paid-in capital has two components:
✓ Par value of common or preferred stock: The par value of the stock
purchased (either common or preferred) multiplied by the number of
shares purchased. If you buy 100 shares of $5 par value common stock,
you would post $500 (100 × $5) to the common stock line in the balance
sheet.
✓ Additional paid-in capital: Additional paid-in capital is the dollar amount
you pay for the stock above its par value. “Additional” in this case refers
to “more than par value.” Consider the previous example. Assume you
spend $700 to buy 100 shares of the $5 par value common stock. $500 is
posted to common stock. The remaining $200 ($700 purchase price less
$500 par value) is posted to additional paid-in capital.
For additional details about how to issue stock shares, see Book VI,
Chapter 1.
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Recording Retained Earnings
The retained earnings account lists the sum of all net income earned by the
company since inception less all dividends paid to shareholders since the
company opened for business. These transactions change the retained
earnings balance:
✓ Net income: Net income (profit) for the current year increases retained
earnings. A net loss reduces retained earnings.
✓ Dividends: Earnings distributed to shareholders. If a company pays a
dividend, the payment reduces retained earnings.
Consider this formula for year-end retained earnings:
Year-end retained earnings = Beginning retained earnings
+ Current year net income – Current year dividends
For example, assume your company opens its doors on January 2, 2015. On
January 2, retained earnings are 0 because the company didn’t previously
exist. From January 2 to December 31, 2015, your company has a net income
of $20,000 and pays out $5,000 in dividends.
On January 1, 2016, the retained earnings amount balance is $15,000 ($20,000 –
$5,000). To compute retained earnings as of December 31, 2016, you start with
$15,000 and add or subtract the amount of income the company made or lost
during 2016. You also subtract any dividends paid during the year. Book IV,
Chapter 2 discusses how balance sheet accounts (such as retained earnings)
are related to the income statement.
Spotting Reductions to
Stockholders’ Equity
Three accounting transactions reduce stockholders’ equity: incurring a net
loss (as explained in the previous section), paying dividends, and repurchasing treasury stock. (The following sections explain how paying dividends and
repurchasing treasury stock result in reductions to stockholders’ equity.
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Paying dividends
Dividends are distributions of company earnings to the shareholders in the
form of cash (yeah!) or additional stock. For most investors, receiving stock
dividends isn’t quite as exciting as getting a check in the mail. However, stock
dividends can be quite profitable in the long run, especially if the stock’s
price rises, because the investor has more shares to sell.
Companies pay dividends only to shareholders of record — investors who own
their shares on a specific date referred to as the record date. In other words,
an investor can’t simply purchase stock the day before dividends are paid,
collect the dividends the next day, and then sell the stock.
Calculating dividends
Whether your company decides to pay cash dividends or stock dividends,
you need to know how to calculate the amount to pay investors of record.
Here’s an explanation of both cash and stock dividend calculations:
✓ Cash dividends: Shareholders of record receive cash dividends based
upon how many shares of stock they own. For a company to pay cash
dividends, two conditions have to be met:
• The company has net income for the current period or retained
earnings from prior periods.
• The company has enough ready cash to pay the dividends.
For example, assume an investor owns 1,500 shares of common stock in
Penway Manufacturing Corporation. Penway has both a surplus of cash
and a retained earnings balance, so the board of directors decides to
pay a cash dividend of $12 per share. The investor’s dividend is $18,000
(1,500 shares times $12).
✓ Stock dividends: As the name implies, a stock dividend means that
shareholders of record receive additional shares of stock, not cash. The
additional shares received are based on the number of shares the investor already owns. This type of dividend is expressed as a percentage
rather than a dollar amount. For example, if an investor receives a stock
dividend of 5 percent on 1,500 Penway shares, the investor receives an
additional 75 shares of stock (1,500 × 0.05).
Posting dividends to the accounting records
Now that you know the amount of cash or number of shares paid as a dividend, you can post journal entries. (Recording the stock dividend is slightly
more complex than the cash dividend entry.)
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Book IV: Preparing Income Statements and Balance Sheets
Dividends are not an expense of doing business. They’re a balance sheet
transaction only, serving to reduce both cash (in the case of cash dividends)
and retained earnings.
The reduction to retained earnings for a cash dividend is straightforward:
You reduce (debit) retained earnings by the amount of the dividend and
credit cash to reduce that account for the payment.
Posting the stock dividend is more complex:
1. Determine the fair market value of the stock on the declaration date —
the date on which the board of directors decides to pay a dividend.
2. Calculate the total number of shares to be paid as a stock dividend. As
explained in the prior section, multiply the stock dividend percentage by
the number of shares outstanding.
3. Multiply the fair market value per share by the number of stock dividend
shares. This total represents the fair market value of the stock dividend in
total dollars.
4. Debit retained earnings for the fair market value in dollars.
5. Credit common stock dividends distributable for the par value of the
stock dividend shares.
6. Credit additional paid-in capital for the fair market value of the stock
that is greater than the par value.
Here’s an example of a stock dividend transaction:
Penway declares a 5 percent stock dividend at a time when it has
30,000 shares of $10 par value common stock outstanding. At the date
of declaration of the stock dividend, the fair market value (FMV) of the
stock is $15.
The stock dividend totals 1,500 shares (5 percent × 30,000 shares). The net
effect is to decrease retained earnings by $22,500 (1,500 × FMV of $15 per
share) and increase common stock dividends distributable by $15,000
(par value of $10 × 1,500 shares). Additional paid-in capital increases by the
difference between the two: $7,500. This entry reduces retained earnings and
shifts the dollar amount ($22,500) to common stock and paid-in capital.
When Penway issues the stock dividend, common stock increases by $15,000
and the common stock dividends distributable is adjusted to zero.
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Corporations may issue stock dividends when they’re low in operating cash
but still want to throw the investors a bone. The investors stay happy because
they feel they’re getting more of a return on their investment.
Buying back shares: Treasury stock
Treasury stock represents shares of stock that a corporation issued (sold) to
investors and then bought back. You record treasury stock on the balance
sheet as a contra stockholders’ equity account. Contra accounts carry a
balance opposite to the normal account balance. Because equity accounts
normally have a credit balance, a contra equity account weighs in with a
debit balance, because company equity is reduced by treasury stock. For
more about contra accounts, see Book IV, Chapter 3.
Your journal entry to record the purchase of treasury stock is to debit treasury stock and credit cash (for payments to the sellers of stock). In accordance with GAAP, don’t record any gain or loss on treasury stock transactions.
One reason a corporation buys back shares of its own stock is to prevent a
hostile takeover. The fewer shares trading in the open market, the smaller the
chance that another company can purchase controlling interest.
Exploring Stock Splits
One other type of stock transaction that doesn’t reduce retained earnings is a
stock split, which increases the number of shares outstanding while decreasing the price per share proportionally. A company typically performs a stock
split when it believes the share price is too high to attract investors.
For example, Penway Manufacturing Corporation stock is trading for $100,
and the company thinks the price is too high to attract the average investor.
To get the price of the stock down to $25 per share, the company issues a
4-for-1 split. Every outstanding share now equals four shares, each of which
is worth $25. The logic here is that one share worth $100 is equal to four
shares worth $25.
The common stock caption, which is the descriptive line on the balance
sheet, changes to reflect the split on the books. If the caption originally read
“Common stock, 1,000 shares at $100 par,” it now reads “Common stock,
4,000 shares at $25 par.” Note that the total dollar value remains the same —
$100,000 — no reduction to retained earnings.
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Book IV: Preparing Income Statements and Balance Sheets
Computing Earnings per Share
Earnings per share (EPS) is calculated as net income divided by shares of
common stock outstanding. (Although variations exist, this is the basic formula most often used to calculate EPS.) Potential investors like to see the
EPS calculation so they can make educated investment decisions; earnings
per common share is a frequently used measure of profitability. The following
sections explain how to calculate EPS for a simple capital structure and give
you basic information on EPS in a complex capital structure.
Simple capital structure
If a company issues only common stock — or common stock with nonconvertible preferred stock outstanding — it has a simple capital structure. The
following sections define convertible securities, so you know what nonconvertible stock is, and explain how to calculate the EPS for a corporation that
has a simple capital structure.
Understanding convertible securities
A simple capital structure assumes that the company has no convertible
securities outstanding. Convertible securities are those that can be converted
into common stock; for example, convertible bonds, convertible preferred
stock, stock options, warrants, and rights.
Computing EPS for weighted average shares
To calculate EPS for a corporation with a simple capital structure, divide
income available to common shareholders by the weighted-average number of
common shares outstanding for the period. The weighted-average is figured by
multiplying the number of shares outstanding by the fraction of the period in
which they’re outstanding. For example, if the company has 10,000 shares of
stock outstanding in January, February, and March, its weighted average for
the year (12 months) is 2,500 (10,000 × 3⁄12).
Suppose ABC Manufacturing Corporation has net income of $473,400. During
the year, the corporation has 38,000 outstanding shares of $4.50, $70 par
value preferred stock, and the weighted-average number of common shares
outstanding totals 205,000. The owners of the 38,000 shares of preferred
stock get a dividend of $4.50 per share first, which equals $171,000
(38,000 shares × $4.50 per share).
This figure has to be subtracted from net income before figuring the EPS of
common stock ($473,400 – $171,000 = $302,400). Dividing $302,400 by the shares
of common stock outstanding (205,000) equals $1.48 EPS of common stock.
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If net income includes items such as extraordinary gains or losses, a separate
EPS is required for each major component of income, as well as for net
income. See Chapter 2 for more information on gains and losses.
Complex capital structure
If items that could cause a potential dilution to EPS exist, the company’s
capital structure is complex. Dilution refers to the idea that total earnings
are spread out over more shares of stock. Convertible securities mentioned
in the prior section are potential sources of dilution. Accountants say potential source, because the owner of each security can choose to convert the
security to common stock. When the potential for dilution exists, you have
to show both basic and diluted EPS.
To figure diluted EPS, use the number of common shares outstanding
that would be issued if every potentially dilutive share were converted to
common stock.
Presenting the diluted EPS gives the user of the financial statements the
worst-case scenario for EPS, relating to any exercise of existing options
or the conversion of existing securities. In other words, diluted EPS displays
the lowest possible EPS figure.
Check out Figure 5-4 for an abbreviated income statement showing how basic
EPS looks, including extraordinary items. Note that the figure includes a line
item reflecting diluted EPS.
Figure 5-4:
Showing
EPS and
diluted
EPS on the
income
statement.
Book IV
©John Wiley & Sons, Inc.
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Book IV: Preparing Income Statements and Balance Sheets
Chapter 6
Coupling the Income Statement
and Balance Sheet
In This Chapter
▶ Seeing connections between the income statement and balance sheet
▶ Fitting key pieces into the balance sheet puzzle with operating ratios
▶ Adding assets to the balance sheet
▶ Examining debt versus equity on the balance sheet
E
very time you record a sale or expense entry by using double-entry
accounting, you see the connections between the income statement and
balance sheet (see Book I, Chapter 2 for more about double-entry accounting
and the rules for debits and credits). A sale increases an asset or decreases a
liability, and an expense decreases an asset or increases a liability. Therefore,
one side of every sales and expense entry is in the income statement, and the
other side is in the balance sheet. You can’t record a sale or an expense without affecting the balance sheet. The income statement and balance sheet are
inseparable, but they aren’t reported that way!
To properly interpret financial statements — the income statement, the balance
sheet, and the statement of cash flows — you need to understand the links
between the three statements. Unfortunately, the links aren’t obvious. Each
financial statement appears on a separate page in the annual financial report,
and nothing highlights connections between related items on the different
statements. In reading financial reports, non-accountants — and even some
accountants — usually overlook these connections.
Chapter 2 presents the income statement, and Chapters 3 to 5 cover the balance sheet. This chapter stitches these two financial statements together and
marks the connections between sales revenue and expenses (in the income
statement) and their corresponding assets and liabilities (in the balance
sheet). Book V, Chapter 2 explains the connections between the amounts
reported in the statement of cash flows and the other two financial statements.
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Book IV: Preparing Income Statements and Balance Sheets
Rejoining the Income Statement
and Balance Sheet
When reading financial statements, you should “see,” in your mind’s eye,
lines connecting related amounts on the income statement and balance
sheet. Because financial reports don’t offer a clue about these connections,
actually drawing the lines, as done in the next section, may help you see the
connections.
Seeing connections between accounts
Here’s a quick summary explaining the lines of connection between items on
the income statement and balance sheet, as shown in Figure 6-1, starting from
the top and working down:
✓ Making sales (and incurring expenses for making sales) requires a business
to maintain a working cash balance.
✓ Making sales on credit generates accounts receivable.
✓ Selling products requires the business to carry an inventory (stock) of
products. When inventory is sold, the inventory cost is posted to cost
of goods sold — an expense account.
✓ Acquiring inventory items on credit generates accounts payable.
✓ Prepaying expenses (such as insurance premiums) creates an asset
account balance.
✓ Depreciation expense is recorded for the use of fixed assets (long-term
operating resources).
✓ Depreciation is also recorded in the accumulated depreciation contra
account (instead of decreasing the fixed asset account). (For more about
contra accounts, see Book IV, Chapter 3.)
✓ Amortization expense is recorded for limited-life intangible assets.
✓ Operating expenses is a broad category of costs encompassing selling,
general, and administrative expenses:
• Some of these operating costs are prepaid before the expense is
recorded, and until the expense is recorded, the cost stays in the
prepaid expenses asset account.
• Some of these operating costs involve purchases on credit that
generate accounts payable.
• Some of these operating costs are from recording unpaid expenses
in the accrued expenses payable liability.
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✓ Borrowing money on notes payable generates interest income for the
lender and interest expense for the borrower.
✓ Net income results in income tax expense. A portion of income tax
expense for the year may be unpaid at year-end. The unpaid balance
is recorded in the accrued expenses payable liability.
✓ Earning net income increases retained earnings, which also increases
the equity section of the balance sheet.
Figure 6-1:
Connections
between
income
statement
and balance
sheet
accounts.
©John Wiley & Sons, Inc.
Book IV
Using transactions to explain
the connections
Figure 6-1 provides a nice visual tool to connect balance sheet and income
statement accounts. Keep that tool in mind as you consider some common
accounting transactions, as explained in the following sections.
Estimating a receivable balance at year-end
Figure 6-1 shows how the sales account (in the income statement) is connected to accounts receivable in the balance sheet. An accountant can use
historical trends in these two accounts to project an accounts receivable
balance at year-end.
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Book IV: Preparing Income Statements and Balance Sheets
Suppose for the year just ended, a business reports $5,200,000 sales revenue,
as shown in Figure 6-2. All sales are made on credit (to other businesses).
Historically, the company’s year-end accounts receivable balance equals
about five weeks of annual sales revenue; in other words, an amount equal to
five weeks of annual sales revenue is not yet collected at the end of the year.
Figure 6-2:
Income
statement of
a business
for the year
just ended.
©John Wiley & Sons, Inc.
Sales are level throughout the year. To determine the amount of accounts
receivable to expect in the business’s year-end balance sheet, divide the
$5,200,000 by 52 weeks to get $100,000 per week. After that, multiply by
5 weeks to get $500,000 of sales revenue in accounts receivable.
Projecting ending inventory balance and accounts payable
If historical trends allow you to project accounts receivable, you may also
be able to forecast an ending balance in inventory and a year-end accounts
payable figure.
Assume the same business has an annual cost of goods sold expense of
$3,120,000 (refer to Figure 6-2), and its ending inventory balance historically
equals about 13 weeks of annual sales. You can expect the amount of inventory in its year-end balance sheet to be: $3,120,000 ÷ 52 weeks = $60,000
average cost of goods sold per week × 13 weeks = $780,000.
Historically, the business’s accounts payable for inventory purchases
equals about four weeks of annual cost of goods sold. (Note: The accounts
payable balance also includes an amount from purchases of supplies and
services on credit, but this example concerns only the amount of accounts
payable from inventory purchases.) Here’s how you calculate the amount
of accounts payable for inventory purchases you’d expect to see in its
year-end balance sheet: $3,120,000 ÷ 52 weeks = $60,000 average cost of
goods sold per week × 4 weeks = $240,000.
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Accruing other year-end expenses
A company has other expenses in addition to cost of goods sold. You may be
able to estimate the amount of other expenses that are accrued at year-end
(see Book I, Chapter 3 for more about accruals).
Assume a business has annual operating expenses of $1,378,000 (which
excludes depreciation, amortization, interest, and income tax expenses).
Historically, its year-end balance of accrued expenses payable equals about
six weeks of its annual operating expenses. Ignoring accrued interest payable and income tax payable, you’d expect the amount of accrued expenses
payable in its year-end balance sheet to be: $1,378,000 ÷ 52 weeks = $26,500
average operating expenses per week × 6 weeks = $159,000.
For this same business, the average amount borrowed on notes payable
during the year was $1,500,000. The average annual interest rate on these
notes was 6.5 percent. To determine the amount of interest expense you’d
find in the business’s income statement for the year: $1,500,000 average
notes payable × 6.5 percent interest rate = $97,500.
Introducing Operating Ratios
One way to connect a balance sheet account to the income statement is to
use a ratio. Accountants use a variety of ratios to measure financial performance. This section explains the use of operating ratios.
An operating ratio expresses the size of an asset or liability on the basis of
sales revenue or an expense in the annual income statement. A normative
operating ratio refers to how large an asset or liability should be relative to
sales revenue or its related expense. You can use operating ratios to judge
how a business is performing compared to its own past performance and
to the performance of other companies in the same industry.
Comparing expected with actual
operating ratios
To manage businesses, managers compare expected performance with actual
results. As explained previously, a normative operating ratio is a benchmark.
It’s a result that’s expected or planned. Your actual ratio may differ. The process of evaluating the difference between planned and actual results is called
variance analysis.
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Book IV: Preparing Income Statements and Balance Sheets
Suppose a business, Company X, makes all its sales on credit and offers
its customers one month to pay. Very few customers pay early, and some
customers are chronic late-payers. To encourage repeat sales, the business
tolerates some late-payers. As a result, its accounts receivable balance equals
five weeks of annual sales revenue. Thus, its normative operating ratio of
accounts receivable to annual sales revenue is 5 (weeks) divided by
52 weeks, which equals 9.615 percent of sales revenue.
The 5:52 operating ratio is the normative ratio between accounts receivable and
annual sales revenue; it’s based on the sales credit policies of the business
and how aggressive the business is in collecting receivables when customers
don’t pay on time. When you consider actual results, minor deviations from the
normative ratios are harmless. However, significant variances deserve serious
management attention and follow-up. Check out Book VII, Chapter 4 for more
on variances.
Generating balance sheet amounts
by using ratios
Figure 6-2 presents the annual income statement of Company X. From the
sales revenue and expenses reported in the income statement, you can determine the balances of several asset and liability accounts by using the
normative operating ratios for the business.
Presenting ratios used for balance sheet calculations
Operating ratios can be expressed in terms of a number of weeks in a 52-week
year or as percentages of annual sales revenue or annual expense. The
normative operating ratios for the business whose income statement is
presented in Figure 6-2 are as follows (expressed as weeks in a year):
✓ Cash: 7/52 or seven weeks of annual sales revenue
✓ Accounts receivable: 5/52 or five weeks of annual sales revenue
✓ Inventory: 13/52 or 13 weeks of annual cost of goods sold
✓ Prepaid expenses: 4/52 or four weeks of annual selling and general
expenses
✓ Accounts payable for inventory acquisitions: 4/52 or four weeks of
annual cost of goods sold
Chapter 6: Coupling the Income Statement and Balance Sheet
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✓ Accounts payable for supplies and services bought on credit: 4/52 or
four weeks of annual selling and general expenses
✓ Accrued expenses payable for operating expenses: 6/52 or six weeks
of annual selling and general expenses
Calculating balance sheet amounts
Using the operating ratios for Company X, whose income statement appears
in Figure 6-2, you can determine the balances for the assets and liabilities
driven by its sales revenue and expenses. Take the following steps:
1. Determine the revenue or expense account to be used for the
operating ratio.
2. Divide the revenue or expense dollar amount by 52 weeks to compute
a weekly level of activity.
3. Multiply the fraction you calculated in Step 2 by the total dollar
amount of revenue or expense. The result is the dollar amount in the
balance sheet account.
Using the operating ratios presented in the earlier section, “Presenting ratios
used for balance sheet calculations,” you can calculate dollar amounts for the
balance sheet accounts:
Assets
7/52 × $5,200,000 sales revenue = $700,000 Cash
5/52 × $5,200,000 sales revenue = $500,000 Accounts receivable
13/52 × $3,120,000 cost of goods sold = $780,000 Inventory
4/52 × $1,430,000 selling and general expenses = $110,000 Prepaid
expenses
Liabilities
(4/52 × $3,120,000 cost of goods sold) + (4/52 × $1,430,000 selling and
general expenses) = $350,000 Accounts payable
6/52 × $1,430,000 selling and general expenses = $165,000 Accrued
expenses payable
These asset and liability balances are normative, not the actual balances
that would be reported in the business’s balance sheet. See the section,
“Comparing expected with actual operating ratios” earlier in this chapter
for additional guidance.
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Tackling other balance sheet issues
You may find the list of ratios to be straightforward. Calculating other
amounts in the balance sheet requires more explanation. These balance
sheet accounts aren’t typically derived by using an operating ratio.
Consider these points:
✓ Intangible assets: The business doesn’t own intangible assets and therefore
doesn’t have amortization expense. An intangible asset, such as a patent or
trademark, isn’t usually derived by using an operating ratio.
✓ Accrued interest payable: This year-end liability typically is a relatively small balance compared with the major assets and liabilities of a
business. Also, the expense that drives this balance isn’t an operating
expense. The year-end balance of accrued interest payable depends on
the terms for paying interest on the business’s debt.
✓ Accrued income tax payable: Income tax payable is similar to interest
payable. This balance is typically smaller than the other amounts in the
balance sheet. The expense that drives this balance is the income tax
status of the business and its policies regarding making installment payments toward its annual income tax during the year. Income tax expense
isn’t considered an operating expense.
✓ Fixed assets: The ratio of annual depreciation expense to the original
cost of fixed assets can’t be normalized. Different fixed assets are depreciated over different estimated useful life spans. Some fixed assets are
depreciated according to the straight-line method and others according
to an accelerated depreciation method. (See Book III, Chapter 1 for more
about these and other depreciation methods.)
In Figure 6-3, you can see a partial balance sheet that presents only the assets
and liabilities determined in the preceding example. Later in the chapter, you
fill in the remainder of this balance sheet, including fixed assets, long-term
debt, and owners’ equity (see Figure 6-4, which is also a partial balance sheet).
A complete balance sheet is displayed in Figure 6-5.
Figure 6-3:
Partial
balance
sheet with
asset and
liability
balances.
©John Wiley & Sons, Inc.
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Adding Fixed Assets, Depreciation,
and Owners’ Equity
One asset is obviously missing in the partial balance sheet shown in
Figure 6-3: the fixed assets of the business. Fixed assets are usually physical,
tangible assets you use to make money in your business (see Chapter 3).
Virtually every business needs these long-lived economic resources to carry
on its profit-making activities. This section adds fixed assets, depreciation,
and owners’ equity to the balance sheet detail.
Dealing with fixed assets and depreciation
Unfortunately, you can’t use an operating ratio method to determine the balance sheet amount for fixed assets or depreciation expenses for two reasons:
✓ Different fixed assets are depreciated over different estimated useful life
spans, using different depreciation methods (such as straight-line and
accelerated), so you can’t simply divide total depreciation expense by
the original costs of the fixed assets to compute a consistent ratio for
expensing fixed assets.
✓ Generalizing about the cost of fixed assets relative to annual sales
revenue is very difficult. As a ballpark estimate for this ratio, you
could say that annual sales revenue of a business is generally
between two to four times the total cost of its fixed assets, but
this ratio varies widely from industry to industry and even among
companies in the same industry.
The cost and accumulated depreciation of a business’s fixed assets depend
on these factors:
✓ The type of depreciation method used
✓ When the assets were purchased (recently or many years ago)
✓ Whether the business leases or owns these assets
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Fitting in fixed assets and depreciation to the balance sheet
Next, you see where fixed assets and depreciation fit into the balance sheet.
Take a look at the partial balance sheet shown in Figure 6-4. Notice the
following:
✓ The total current asset number ($2,090,000) is the same number you see
in Figure 6-3.
✓ Figure 6-4 adds three numbers to the asset column. Note that these three
numbers are below current assets. That means that the added numbers
are long-term assets — assets that will be used over several years.
✓ Total assets in Figure 6-4 are $3,855,000. Note that this total doesn’t
balance with total liabilities and equity ($350,000 + $165,000). In fact,
the right column doesn’t list any equity. That issue is addressed in the
“Tacking on owners’ equity” section later in the chapter.
✓ Book I, Chapter 1 explains the fundamental accounting equation, which
dictates that Assets = Liabilities + Owners’ equity. Because that isn’t the
case in Figure 6-4, this balance sheet is incomplete. You fill in the remaining balance sheet numbers as you move through the chapter.
Calculating depreciation
Now that you see where fixed assets and depreciation show up in the balance
sheet, you can go over the calculation of depreciation. Book III, Chapter 1
covers deprecation in detail. This section gives a more general discussion.
Figure 6-4:
A partial
balance
sheet that
includes
assets and
liabilities.
©John Wiley & Sons, Inc.
Chapter 6: Coupling the Income Statement and Balance Sheet
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Here are the accounts related to fixed assets in Figure 6-4:
$2,450,000 property, plant, and equipment – $685,000 accumulated
depreciation = $1,765,000 cost less depreciation
Accumulated depreciation is the total of all depreciation expense since the
asset was purchased. Property, plant, and equipment is a common term for
fixed assets.
If all the assets were bought on the same day, and no depreciation had
been expensed, the total property, plant, and equipment balance would be
($2,450,000 + $685,000 = $3,135,000). As you see in the earlier section “Dealing
with fixed assets and depreciation,” there is no single method for calculating depreciation. So, the $685,000 is a combination of different depreciation
methods. Some methods recognize depreciation evenly each year; others
record more depreciation expense in the early years. For this chapter,
assume that the $685,000 accumulated depreciation is a combination
of different methods.
Tacking on owners’ equity
At this point, you’ve seen all the components that make up the total assets
(refer to Figure 6-4). In the right column of the figure, you see two liability
numbers — but no data for owners’ equity.
You can use the fundamental accounting equation to calculate total equity.
As explained in Book I, Chapter 1, the fundamental accounting equation looks
like this:
Assets = Liabilities + Owners’ equity
or
Assets – Liabilities = Owners’ equity
Using the numbers from the balance sheet shown in Figure 6-4, you can
calculate owners’ equity.
$3,855,000 assets – $515,000 liabilities = $3,340,000 owners’ equity
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Book IV: Preparing Income Statements and Balance Sheets
Completing the Balance Sheet with Debt
If you own Company X, whose balance sheet is depicted in Figure 6-4, how
should you raise the $3,340,000 in capital? You can debate this question until
the cows come home, because no answer is right or best. The two basic
sources of business capital are interest-bearing debt and equity (more precisely, owners’ equity). Company management decides what percent of capital
is raised by using debt, and how much from equity.
Many businesses use debt for part of their capital needs. This practice makes
sense as long as the business doesn’t overextend its debt obligations.
Going over the debt section
of the balance sheet
Figure 6-5 presents the complete balance sheet for Company X, including its
debt and owners’ equity accounts. These are the final pieces of the balance
sheet puzzle (if you start at the beginning of this chapter, this is what you’re
working toward).
Figure 6-5:
Complete
balance
sheet of
Company X.
©John Wiley & Sons, Inc.
Chapter 6: Coupling the Income Statement and Balance Sheet
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The business has borrowed $500,000 on short-term notes payable (due in
one year or less) and $1,000,000 on long-term notes payable (due in more
than one year). Interest rates and other relevant details of debt contracts
are disclosed in the footnotes to the financial statements. For example, debt
covenants (conditions prescribed by the debt contract) may limit the amount
of cash dividends the business can pay to its shareowners. (See Book V,
Chapter 4 for a discussion of footnotes.)
Tying in the new equity section
Note that Figure 6-5 displays a more detailed equity section than the simple
equity total presented in Figure 6-4. The following sections describe the
sources of these details.
Bringing up common stock
The shareowners in Company X invested $750,000, for which they received
10,000 shares of capital stock. Typically, a footnote is necessary to fully
explain the ownership structure of a business corporation.
As a general rule, private business corporations don’t have to disclose
owners — the owners of their capital stock. In contrast, public business
corporations are subject to many disclosure rules regarding the stock ownership,
stock options, and other stock-based compensation benefits of their officers and
top-level managers. Stroll over to Chapter 5 for more on equity topics.
Addressing retained earnings
Retained earnings represent the sum of all net income earned by the company since inception, less all dividends paid to shareholders since the
business started. For more, head over to Chapter 2.
Over the years, the business in this scenario retained $1,090,000 of its yearly
profits (see retained earnings in Figure 6-5). Two details aren’t explained in
the retained earnings line item:
✓ You can’t determine how much of the cumulative total is from any single
year’s net income.
✓ Retained earnings don’t reveal how much of the company’s $255,125
profit for the year just ended (see Figure 6-2) was distributed as a cash
dividend to shareowners during the year just ended.
One purpose of the statement of cash flows (explained in Book V, Chapter 2)
is to report the cash dividends paid from net income to shareowners during
the year.
Book IV
Preparing
Income
Statements
and
Balance
Sheets
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Book V
Reporting on Your Financial
Statements
To gauge how profitable an investment is likely to be, visit www.dummies.com/
extras/accountingaio for guidance on calculating present and future values.
In this book…
✓ Use the balance sheet to assess and report the financial condition of a business, as measured by its assets, liabilities, and
equity.
✓ Produce a cash flow statement and summarize changes in
stockholders’ equity. Use the cash flow statement to explain
how your business raised funds and how it used cash to generate profit. Use the stockholders’ equity report to reveal
changes in earnings, dividends, and company ownership.
✓ Read and interpret financial statements to evaluate a business’s financial health. Assess your own business’s financial
fitness and size up other businesses you’re thinking of doing
business with.
✓ Make sense of explanatory notes and disclosures you’re likely
to find in a corporation’s annual financial report. Reading this
extra data may change your opinion about the company’s plans
for growth.
✓ Pick out valuable pieces of financial information from a company’s report to its shareholders. You may find additional disclosures that clarify the company’s financial performance.
Chapter 1
Presenting Financial Condition
and Business Valuation
In This Chapter
▶ Valuing assets in balance sheets
▶ Using the balance sheet to estimate the value of a business
▶ Considering methods to value an entire business
T
he balance sheet, also called the statement of financial condition, gives a
snapshot of a business’s financial health at a point in time. It presents the
assets of a business on the one hand and the liabilities and equity sources of
the business on the other hand, reflecting the balance sheet equation:
Assets = Liabilities + Equity
This chapter considers how to value (estimate the monetary worth of) the
assets and liabilities in the balance sheet. Traditionally, a business values
assets at historical cost. In this chapter, you find out how to use other methods to value assets and how to compute a valuation for an entire business.
This chapter also explores the various uses for valuations and touches on the
field of performing valuations as an occupation. You finish the chapter with a
discussion of business valuations based on earnings and cash flow.
Clarifying the Values of Assets
in Balance Sheets
The evidence is pretty strong that readers of financial reports aren’t entirely
clear about the dollar amounts reported for assets in a balance sheet. Other
than cash — the value of which is clear — the amounts reported for assets in
a balance sheet aren’t at all obvious to non-accountants.
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Of course, accountants should be clear about the valuation of every asset
reported in the balance sheet. In preparing a year-end balance sheet, an accountant should do a valuation check on every asset. Recent authoritative pronouncements on financial accounting standards have been moving in this direction.
Accountants now must check at the end of the accounting year to see
whether the value of any asset has been impaired (diminished in economic
value to the business), and if so, write down (decrease) the book value of the
asset. Book value is the cost of the asset less accumulated depreciation. Head
over to Book III, Chapter 1 for more on depreciation.
Considering options for balance
sheet ­valuation
If you need to value assets in the balance sheet, you may consider using historical cost, a value below cost, or a balance sheet value above cost:
✓ Historical cost: Most of the assets in a typical balance sheet are valued
at historical cost (original cost). That value should be your starting point.
✓ Impairment: Accountants are required to write down impaired assets.
The value of an impaired asset is typically below cost.
✓ Increase in market value of asset: In some cases, the value of the asset
is above cost. Short-term investments in marketable securities held for
sale may have an adjusted value above cost. The recorded values of
nearly all other assets aren’t written up (increased) to recognize appreciation in the replacement value or market value of the asset. One reason
is because assets you use in your business (buildings, equipment) aren’t
held for sale. Also, these assets are likely to be used for many years. It’s
not your intention to sell assets you use in your business.
Looking at balance sheet valuation entries
The dollar amounts reported for assets in a balance sheet are the amounts that
were recorded in the original journal entries made when recording the asset
transactions. These journal entries could have been recorded last week, last
month, last year, or 20 years ago for some assets. Here are some examples:
✓ The balance of the asset accounts receivable is from amounts entered
in the asset account when credit sales were recorded. These sales are
recent, probably within the few weeks before the end of the year.
✓ The balance in the inventory asset account is from the costs of
manufacturing or purchasing products. These costs could be from
the last two or three months.
Chapter 1: Presenting Financial Condition and Business Valuation
✓ The costs of fixed assets reported in the property, plant, and equipment
asset account in the balance sheet may go back five, ten, or more years —
these economic resources are used for a long time.
Connecting balance sheet values and expenses
As you see earlier in this chapter, most balance sheet assets are valued at
historical cost. The amount of cost used to value the asset depends partly on
how expenses are treated.
Merchandisers (retailers) purchase inventory and sell those goods to the
public. Inventory is an asset. Accounting rules dictate that the cost of inventory should be the price paid for the asset plus any other costs incurred to
prepare the goods for sale. Those other costs may include shipping, storage,
and even costs to build display racks.
The additional costs to prepare the good for sale are not immediately
expensed. Instead, the costs are posted to inventory. Those costs become
expenses when the inventory item is sold. At that point, all the costs are
posted to cost of sales (or cost of goods sold).
If you buy jeans for your retail shop, for example, the shipping costs you pay
to get the jeans to your shop are considered part of inventory. If you need to
build displays racks by the front window, those costs are part of inventory,
too. (For more about inventory, see Book II, Chapter 2.)
Another example to connect expenses with balance sheet values is the area
of leasehold improvements — changes made to a leased space to meet a tenant’s needs. Instead of immediately expensing this amount, accountants
capitalize the cost as an asset. The asset is usually depreciated over the
remaining life of the lease.
Assume you lease a factory building to a manufacturer. To accommodate
truck shipments for the manufacturer/tenant, you need to widen the road
approaching the factory. The spending on the road isn’t immediately
expensed. Instead, the cost is posted to an asset account called leasehold
improvements. (See Book V, Chapter 4 for more about lease-related financial
disclosures.)
Comparing two balance sheet valuations
Consider two different valuations for the same asset, and how the difference
impacts the balance sheet. Refer to the balance sheet in Figure 1-1. The business uses the straight-line depreciation method, by which an equal amount of
depreciation is allocated to each year of a fixed asset’s estimated useful life
(see Book III, Chapter 1 for more about depreciation methods).
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Figure 1-1:
Balance
sheet for a
company
that uses
straight-line
depreciation.
©John Wiley & Sons, Inc.
Assume the business had used an accelerated depreciation method for its
fixed assets instead. In this case, $700,000 more in depreciation would be
expensed, using the accelerated method. The change in depreciation method
results in several changes in the balance sheet, as shown in Figure 1-2:
Figure 1-2:
Balance
sheet for
the same
company,
using
accelerated
depreciation.
©John Wiley & Sons, Inc.
Chapter 1: Presenting Financial Condition and Business Valuation
✓ Depreciation expense over the years would be $700,000 higher. As a
result, accumulated depreciation is $700,000 higher ($2,100,000
versus $1,400,000 in Figure 1-1).
✓ Using accelerated depreciation reduces the total value of assets. With
that method, total assets are $7,300,000, compared with $8,000,000 total
assets by using straight-line depreciation.
✓ The higher amounts of depreciation expense reduce cumulative net
income by $700,000. Lower net income means that retained earnings
is also lower ($1,500,000 versus $2,200,000 in Figure 1-1).
Introducing Business Valuation
The previous section shows how different valuation methods affect various
items on the balance sheet, including inventory, leasehold improvements,
and depreciation.
You can also use different valuation methods to estimate the dollar worth
of the entire company. The following sections present the uses of business
valuations and explain the Certified Valuation Analyst (CVA) designation for
anyone interested in making a career of performing business valuations.
Grasping the practical applications
of business valuations
Accountants don’t perform business valuations simply to stick a dollar figure
on a business. They do valuations for clients who need a general idea of how
much money a business is worth in order to make well-informed decisions
regarding that business. The following sections introduce a few of the more
practical applications of business valuations.
Negotiating a business purchase
The most basic reason to place a dollar figure on a business is to help sellers
or buyers determine what they think is a reasonable price for the business.
Imagine if you were considering buying a pizza restaurant. You’d probably
want to take a look at the ovens, equipment, and furniture — and consider
how soon those fixed assets would need to be replaced. That analysis would
help you determine what the business is truly worth to you, and how much
you’d be willing to pay for it.
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Securing a bank loan
Commercial loan officers work with loans to businesses. The loan officer is concerned about the company’s ability to generate enough earnings to make the
interest payments on the loan and repay the principal amount borrowed. If a valuation based on earnings shows the company’s earnings are trending higher, the
business is likely to be in a better position to make loan payments in the future.
Say, for example, that your firm has a $2,000 monthly interest payment on a loan.
The interest payment would be less of a burden if your earnings were $50,000 a
month versus $5,000 a month. See the later section “Using future earnings and
cash flow” to find out more about business valuations based on earnings.
Explaining a company’s value to investors
Businesses often raise money by selling shares of the business to investors who want to know the value of what they’re getting for their money.
Unfortunately, the balance sheet may fail to reflect the true value of a
­particular asset or exclude the value of certain assets. For example, suppose a company purchases a time-saving machine that will eventually save
it far more than the cost of that machine; the machine is worth more than
the dollar amount the company paid for it. Assets that don’t even appear on
the balance sheet are customers or clients. A business may have strong longterm relationships with certain clients that generate significant sales and
earnings, but the value can’t be posted to the balance sheet as an asset. A
business valuation takes this important asset into account.
Considering a CVA designation
The demand for business valuations and valuation analysis has resulted in
a designation called a Certified Valuation Analyst (CVA). If you find business
valuation fascinating and want to pursue it as a career, you may want to consider getting your CVA designation. The following sections show you how to
get started and highlight other professions that do business valuations.
Visiting the NACVA website
The CVA designation is offered through the National Association of Certified
Valuators and Analysts (NACVA), which you can find on the web at www.
nacva.com. NACVA trains and certifies Certified Valuators and Analysts. The
website explains that a primary requirement to become a CVA is to hold a
valid license as a Certified Public Accountant.
Understanding other professionals and valuations
Many other professionals perform work that may be classified a business
­valuation, even though the work they produce isn’t considered a certified
Chapter 1: Presenting Financial Condition and Business Valuation
valuation. When a business is subject to litigation, an attorney may perform
some analysis on a firm’s balance sheet and income statement. If the owners
of a firm are in a legal dispute about the value of each owner’s share of the
business, for example, an attorney may perform an analysis. Appraisers perform value analysis of commercial property to estimate its current worth.
Although other professionals may perform similar analysis, a CVA may be
brought in to perform a certified valuation. Your accounting skills along with
CVA training and designation ensure that you’re up to the task.
Comparing Business Valuation Methods
Just as you can use different valuations to estimate the dollar value of assets
listed on the balance sheet, you can use different methods to perform business valuations. And different methods lead to different conclusions. Keep
in mind, however, that the values calculated for a valuation may not be the
amounts listed on the balance sheet. A valuation may use concepts inconsistent with generally accepted accounting principles (GAAP). See Chapter 1 for
more on GAAP and other accounting standards.
The question of whether determining the market value of a business is more
of an art or a science is open to debate. One school of thought is that business valuation should be based on a complicated, multi-factor, formula-driven
model — a scientific approach in which a business’s dollar value can be
quantified. The opposite camp argues that in buying a business you’re buying
a future stream of earnings, not merely a collection of assets. Their argument
is that you’re just as well off using a simple method, but this simple method
requires forecasting future earnings, which is notoriously difficult, not to
mention unreliable. Both sides agree on one point: The profit performance
track record of the business (reported in its recent income statements) and
its present financial condition (reported in its latest balance sheet) are absolutely essential for the valuation of a business. The debate concerns how you
should analyze and use that information. The following sections present two
common approaches to performing business valuations.
Replacing assets: Replacement value
One measurement of a business’s worth in dollars is its book value — the
cost of all assets less all accumulated depreciation. The following sections
consider the cost of replacing assets used in a business.
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Pairing fixed asset accounts
Most companies pair each fixed asset account with its own accumulated
depreciation account, both of which are included in the company’s Chart
of Accounts (see Book I, Chapter 2). Your office furniture asset account, for
example, is paired with an account called accumulated depreciation- office furniture. The asset account less the accumulated depreciation equals the office
furniture’s book value. Note: Accounting systems commonly give each fixed
asset account its own accumulated depreciation account; those account titles
usually include a dash like the one in accumulated depreciation- office furniture.
Forecasting spending on fixed assets
Suppose you’re in the market for a car repair shop. The big assets on the
books are large pieces of equipment, such as hydraulic lifts for vehicles, and
lots of other tools and equipment. All these items are listed as fixed assets on
the balance sheet, each with its own accumulated depreciation account.
A potential buyer most likely wants to buy the business and use it to generate earnings over many years. Big considerations include when each asset
needs to be replaced and how much the replacement asset will cost. The prospective buyer can scan the fixed asset listing and make a judgment on each
asset. Assets with a large amount of cost posted to accumulated depreciation
probably need to be replaced soon.
An analyst can estimate each asset’s replacement cost and the year of
replacement. That list represents the required cash flow to maintain the
assets needed to operate the business. The listing’s total dollar amount, plus
the initial purchase price of the business, is the total investment required
to buy and maintain the business. At that point, the investor can decide
whether the business is worth the investment.
Using future earnings and cash flow
Although asset value provides a snapshot of a company’s current value, it
doesn’t provide much insight into the company’s potential future value. Taking
into account the replacement value of assets, as explained in the previous
section, is one way to project the company’s future value. Another approach
is to look at the company’s ability to produce earnings and cash flow into the
future. Several tools are available for measuring a company’s potential profit.
Book III, Chapter 6 explains the difference between cash basis accounting
and the accrual basis. Nearly all companies use the accrual method, which
requires that they recognize revenue when it’s earned rather than when they
actually receive payment. The accrual method also posts expenses when
they’re incurred instead of waiting until the bills are actually paid. As a result,
the earnings using the accrual method differ from the cash method.
Chapter 1: Presenting Financial Condition and Business Valuation
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Earnings first
Book V
Your first approach to determine future value may be potential earnings.
Take a look at the firm’s past financial performance. Next, consider how your
industry knowledge could help increase sales. Mull over the firm’s reputation
and customer list.
Reporting
on Your
Financial
Statements
Maybe you’re considering buying an ad agency. The firm has a stable group
of clients that have used the company for advertising for years. Your purchase price includes retention bonuses to motivate current key employees
to stay with the company. Based on your long experience in the industry,
you conclude that you can generate a 15 percent profit margin — or a 15-cent
profit on every dollar in sales (see Book IV, Chapter 2 for more on profit
­measurements).
Every investment has an opportunity cost associated with it. Opportunity cost
is cash you invest in the purchase that you can’t use for some other purpose.
Assume you invest $500,000 in a greeting card shop instead of investing the
same amount in a convenience store. The profit earned by the convenience
store owner is given up — that’s the opportunity cost of investing in the greeting card shop.
Moving to cash flow
Earnings are important, but a better measure of a company’s value may be
the cash flow it generates. If you decide to invest in a company, you use cash.
That cash has to come from somewhere. Consider these points:
✓ If you borrow funds, you stand to pay interest expense on the loan.
✓ Investors that issue stock expect a return on their investment, possibly
in the form of a dividend.
✓ If you use cash from your existing company’s operations, you’ll have a
tougher time meeting the cash flow needs of your business.
A business needs to recover its cash investment as soon as possible. Given
these considerations, a potential buyer may look at future cash flows of the
new business to determine a company’s value.
Assume you’re looking at a $600,000 investment in a bookstore. Based on
your analysis, you determine that the business will generate $100,000 in cash
inflow per year. The calculation you need to use is payback period:
Payback period = Initial investment ÷ Cash inflow per period
In this case, the payback period is 6 years ($600,000 ÷ $100,000). You can
make a judgment as to whether or not 6 years is a reasonable period to
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recover your original cash investment. See Book VIII, Chapter 4 for more
about making purchase decisions.
Putting a present value on cash flows
Many analysts add a present value assumption into cash flow analysis
because of inflation, which is broadly defined as a rise in the general level of
prices for goods and services. In other words, today’s dollar is likely to buy
you more than a dollar will buy you five years from today.
Inflation impacts the value of the cash flows you receive from the business
you purchase. The cash inflows should be adjusted to their present value
(the current worth of a future sum of money). You should consider the
­present value of the cash flows you receive, because that amount represents the current purchasing power of those dollars.
Your annual cash inflows in the prior section total $100,000 per year. Assume
a 3 percent inflation rate. You’re interested in the present value of the payment received at the end of year 5. You need to multiply the cash inflow by
a present value factor of 3 percent per period for 5 periods. You can find
numerous versions of present value tables online.
When you find a table, the period “n” is 5 (five years). After you find the n
value for 5, scroll over to the 3 percent column. The table should show 0.863
(depending on rounding in your table). You can multiply this present value
factor by the cash inflow amount:
Present value of $100,000 at 3 percent, end of year 5
= $100,000 × 0.863 = $86,300
If you find a present value factor for all payments, you can compute the present value of all cash inflows. Use the sum of the cash inflows to judge the
value of the business.
Chapter 2
Laying Out Cash Flows and
Changes in Equity
In This Chapter
▶ Separating cash from profit
▶ Connecting the dots with the statement of cash flows
▶ Presenting cash flow by using the direct and indirect methods
▶ Summarizing changes in stockholders’ equity
W
hile accounting is all about the accrual method, which means revenue
is recorded when it’s earned and expenses are recorded when they’re
incurred, the missing piece of the puzzle is cash changing hands. For the users
of financial statements to get a total picture of the health of the business, cash
payments and receipts have to be reconciled with accrual transactions.
You accomplish this reconciliation by preparing a statement of cash flows. In
this chapter, you find out about the three sections of the statement of cash
flows — operating, investing, and financing — and what types of accounting
information are reported in each. This chapter also brings you up to speed
on the two acceptable ways to prepare the statement of cash flows — by
using the direct or indirect method — and concludes with a brief explanation
of the statement of changes in stockholders’ equity.
Understanding the Difference
between Cash and Profit
As explained in Book I, Chapter 4, the accrual method records revenue when
it’s earned, regardless of whether money changes hands. You also record
expenses when you incur them, regardless of whether they’re paid. Book I,
Chapter 4 also introduces another accounting method — the cash method —
which uses the criteria of cash changing hands to determine when revenue
and expense transactions are recorded. The cash method is simply posting
revenue and expenses by using your checkbook checks, debits, and deposits.
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Recognizing accounting transactions doesn’t hinge on cash being exchanged. As
a result, you can expect to see a difference between a company’s cash balances
and profit shown on the income statement (see Book IV, Chapter 2). Not all costs
are immediately expenses, and until a cost is an expense, it doesn’t appear on
the income statement. In the same way, not all cash receipts are immediately
revenue. If a customer pays you in advance, you don’t recognize revenue until
you provide the product or service to the client. This section first shows you
how noncash transactions influence a company’s net income. It then illustrates
the difference between costs and expenses.
Seeing how noncash transactions
affect profit
The statement of cash flows homes in on the difference between two amounts:
✓ Ending balance in cash for the period
✓ Net income for the period
Differences exist because net income factors in revenue earned but not yet
collected from customers and expenses incurred but not yet paid — rather
than reflecting only transactions involving cash. In other words, net income
is computed by using the accrual method of accounting. The accrual method
means that a business is likely to have a balance in accounts receivable (for
credit sales) and accounts payable (for purchases it hasn’t yet paid for).
For example, suppose that in June a company deposits $2,000 into its
checking account and writes checks to pay bills for $1,800. If you look only
at the cash flowing in and out of the business, the company spent $200 less
than it brought in, so it shows a profit of $200. But what if, in June, the company also used a credit card it doesn’t intend to pay for until August to pay
monthly bills in the amount of $1,000? Taking this transaction into account,
the company actually spent more than it made, resulting in a loss of $800
($2,000 in deposits less $2,800 in checks and credit card usage).
Distinguishing costs from expenses
When using the accrual method of accounting, one of the big distinctions
you need to make and keep in mind is that costs aren’t the same as expenses.
Take a look at the differences:
✓ Costs: A cost is the money the company uses to produce or buy
something — money that’s not available to use anymore. Costs are a use
of company cash, be it to purchase inventory, make investments, or pay
back debt.
Chapter 2: Laying Out Cash Flows and Changes in Equity
✓ Expenses: Expenses are costs directly applied to revenue-producing
activities during a financial period. When spending is applied (or
matched) with revenue, the spending becomes an expense. Book I,
Chapter 4 explains the matching principle for revenue and expenses.
Suppose a company buys a shipment of aluminum for $25,000 cash in order
to manufacture lawn mowers to sell to customers. The aluminum is a raw
material, which appears on the balance sheet as an inventory account. When
the company buys the aluminum, the price it pays, or promises to pay, is a
cost. The company uses the aluminum to manufacture lawn mowers. When
the lawnmower is sold, the cost of the aluminum used is reclassified as an
expense (cost of goods sold). If the company uses half of the aluminum in
production during the accounting period — and the lawn mowers produced
are sold — the cost is $25,000, but the expense is only $12,500. The remaining
$12,500 stays in inventory until it’s needed to produce the product and the
product is sold. Check out Book II, Chapter 2 for more on inventory.
The statement of cash flows is so important; it ties together the costs shown
on the balance sheet with the expenses shown on the income statement.
Realizing the Purpose of the
Statement of Cash Flows
The primary purpose of the statement of cash flows is to show a company’s
cash sources and uses during the financial period. Although cash can come
from many different sources, such as customer payments, loans, and sales of
assets, uses of cash directly trace back to costs. This information is interesting to the external users of the company’s financial statements, who aren’t
privy to the day-to-day operations of the business, because it provides a
basis for understanding how wisely a company manages its cash.
A company can be a real go-getter in the business world, but if cash is thrown
around like chewing gum, the business may not be able to give prospective
investors a reasonable return on their investment. Also, poor cash management may hinder a company’s ability to make timely payments of principal
and interest on a loan.
The statement of cash flows provides guidance for the following questions:
✓ Does the company have the ability to generate positive cash flow in
the future? You don’t want to invest in a one-hit wonder. Viewing a
current statement of cash flows gives a hint as to the company’s future
prospects. Investors look for companies that can generate positive cash
flow year after year.
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✓ Does the company have enough cash to make loan or dividend
payments? If you’re a potential investor or lender for a corporation,
letting the business use your money for free probably isn’t very smart.
You want to check out the statement of cash flows to see how the
business manages its money and gauge the probability of the company
having enough cash to satisfy its loan obligations and pay dividends.
✓ Is the reason for the difference between net income and cash
transactions indicative of a healthy business? All cash is not created
equal. Cash a company brings in from gross receipts is a lot more
exciting to a potential investor than cash the company has left over
because it sold some assets. After all, the business can own only a finite
number of assets, while the sky’s the limit for bringing in revenue from
operations, assuming the business is managed well.
You ferret out this information by reviewing the different sections of the
statement of cash flows. Each section ties back to how accounting transactions
affect the income statement and balance sheet. So you’re not looking at new
information; instead, you’re looking at the same information presented in a
different way.
Walking through the Cash Flow Sections
A statement of cash flows has the following three sections:
✓ Operating: The sources and uses of cash in this section come from dayto-day business operations: cash received from sales to customers, and
cash paid out for payroll, inventory, and other common costs.
✓ Investing: The investing section is all about buying and selling assets.
This section shows sources and uses of cash from investment purchases
and sales. The section also includes purchases and sales of property,
plant, and equipment (PP&E).
✓ Financing: This section involves raising money to run a business and
paying it back. This section includes cash inflows from loans and cash
outflows for principal payments. It also includes equity related items
(the sale of company stock and payment of dividends).
If some of these terms are unfamiliar to you, don’t worry. By the time you
finish reading the rest of this section, you’ll be an old pro on cash flow.
Most of a company’s cash transactions are in the operating section of the cash
flow statement, because operations represent the common, day-to-day activity
of the business. If you’re reviewing cash activity, find the investing and financing
transactions first. When you finish, any cash activity that remains unassigned
should be posted to the operating section.
Chapter 2: Laying Out Cash Flows and Changes in Equity
Figuring cash operating results
Generally accepted accounting principles (GAAP) has a guide to what shows
up in the operating section: The operating section contains transactions not
listed as investing or financing transactions. The following sections offer
examples of operating sources and uses of cash. (See Book IV, Chapter 1 for
details on GAAP.)
Operating sources of cash
Here are examples of operating sources of cash:
✓ Cash receipts from the sale of goods or services: This source is the
cash that customers pay the company when the sale occurs. When the
company collects cash from accounts receivable, that cash inflow is also
from operations. For example, you go into Target and buy a new DVD
player for $65. You fork over the cost of the purchase plus sales tax in
cash. Target records this receipt as a source of cash.
On the flip side, let’s say that on October 12, you go into an appliance
warehouse to buy a new washer and dryer. The warehouse is holding
a “90 days same as cash” promotion, which means that as long as you
cough up the cash for the washer and dryer within 90 days, you pay no
interest. On October 12, the appliance warehouse has no cash source
from you, and it won’t have that source until you pay for your purchase
on or before January 12. The appliance warehouse can’t record the sale
as a source of cash until it receives your payment.
✓ Trading portfolio sales: Trading securities are assets a business purchases
to make a profit in the short term. The intention is to trade the securities
(buy and sell them). Assume a business has spare cash lying around that
it doesn’t need access to in the immediate future. Rather than leaving the
cash in the bank earning little or no interest, the company buys highly
liquid (easily convertible to cash) stocks, bonds, or loans.
The business tries to invest in something that won’t drop in value during
the holding period. Then, when the company sells the investment, the
cash it receives goes on the statement of cash flows in the operating
section rather than investing. The key here for operating section placement is that the investment is short term. See Book IV, Chapter 3 for more
information about short-term investments.
✓ Interest and dividends: If the company makes loans to other businesses
or individuals, any interest income it receives on those loans goes in the
operating section. An example is a loan to a shareholder who is also an
employee and needs cash beyond what she’s receiving in her paycheck.
This situation happens often in a closely held corporation.
Also, some companies make loans to key vendors needing a short-term
infusion of cash to keep their doors open. A company takes this step if it’s
in the company’s best interest to keep an essential vendor in business.
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After all, if you like to buy your widgets from Joe’s Widget Shop and Joe
goes out of business, you’ll have to find another widget vendor, and maybe
you won’t like working with that vendor (or paying its prices) as much as
you liked working with Joe.
As reported on the income statement, dividends are income paid to
shareholders based on their proportional ownership of the corporation. For example, ABC Corp. owns 2,000 shares of XYZ, Inc. stock. ABC
receives dividends from XYZ at $2 per share totaling $4,000 ($2 × 2,000
shares); this amount is posted to the operating section as a source of
cash. You can find out more about the process behind declaring and
paying dividends in Book IV, Chapter 5.
Operating uses of cash
Cash uses also show up in the operating section of a statement of cash flows.
The cash outflows are kind of the flip side of the cash inflows. For example,
accounts receivable from customers is an inflow, and accounts payable paid
to vendors is an outflow.
Here are the operating cash outflows you’re likely to encounter:
✓ Satisfying accounts payable: Accounts payable is the amount a company
owes vendors for services and products purchased. When the original
purchase takes place, no money changes hands between the customer
and the supplier. Rather, the transaction contains a promise to pay
within a certain amount of time.
For example, suppose you order $500 of office supplies from Folders
Office Supply, and Folders immediately invoices your company for $500.
Your company doesn’t record this amount as a cash outlay, because
Folders wasn’t paid yet; it merely has your promise to pay within 10
days (or 30 days, or whatever). This $500 becomes a cash outlay only
after you sign and mail the payment check to Folders.
✓ Trading portfolio purchases: Just as sales of trading securities are a
cash source, the amount of money the company pays to buy any trading
security is a use of cash. No securities other than trading securities go in
the operating section of the statement of cash flows. Again, the key here
for operating section placement is that the investment is short term. See
Book IV, Chapter 3 for more information about short-term investments.
✓ Payments for other business expenses: This category includes any
cash outlays to buy inventory, pay employees, remit income taxes due,
or pay any other suppliers (such as utility providers or the telephone
company). You can find out more information about inventory purchases in Book II, Chapter 2.
✓ Interest payments: Any cash paid to lenders in the form of interest
also goes in the operating section. The purpose or source of the loan
doesn’t make any difference. So interest paid to a related party, such
Chapter 2: Laying Out Cash Flows and Changes in Equity
as a shareholder, for an operating capital loan (cash made available for
day-to-day business functions) is treated the same as interest paid to a
vehicle financing company for the note on the company car.
When a company borrows funds to operate, the cash inflow from the loan represents cash flow from financing. However, interest payments on the loan are
an operating activity. Keep this difference in mind.
The main thrust of the operating section of the statement of cash flows is
to reconcile the cash versus accrual treatment of income statement items.
Because paying dividends to shareholders isn’t a business expense, dividend
payments don’t show up on the income statement, so they’re not an operating use of cash.
Showing cash investing transactions
Investing transactions involve the purchase and sale of noncurrent assets (see
Book IV, Chapter 3). Noncurrent assets are assets the company anticipates
owning for more than one year past the date of the balance sheet. Examples
of noncurrent assets are long-term debt and equity investments; property,
plant, and equipment; and intangible assets such as patents and copyrights.
What exactly are debt and equity investments?
✓ Common stock is an example of an equity investment. Equity refers to
ownership in a company. Suppose you buy AT&T common stock. As a
shareholder, you’re an investor who gets paid back for the purchase of
the stock only if you sell it to someone else.
✓ Bonds are debt investments. Corporations generally issue bonds to raise
money for capital expenditures, operating expenses, and acquisitions.
Because the investors are owed the principal amount they invest with
the company, they’re company creditors. For example, a municipality
sells bonds to the public for the purpose of financing a new hospital.
Bondholders receive interest payments at the bond’s stated interest
rate. When the bond matures, the company pays the bondholder the
face amount of the bond.
Investing sources of cash
Investing transactions show up as sources of cash in the following ways:
✓ Long-term debt sales and collection: A company’s investments in debt
may fall into three categories: loans, held-to-maturity debt investments,
and available-for-sale debt portfolios. Here’s how they differ:
• Loans are easy to understand; they’re merely money the company
loans to others that won’t be repaid within 12 months of the
balance sheet date. You know from your own personal debts (such
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as car loans) that when you owe money, you periodically have to
make payments on the principal portion of the loan. The same
holds true with businesses. So any collection of principal on loans
is a cash source for the company lending the money.
• Held-to-maturity debt investments are those the company anticipates holding onto until the debt matures. For example, ABC
Corp. buys five-year bonds issued by the city of Orlando to build a
new sports arena. When the bonds mature, the cash proceeds go in
the investing section. See Book IV, Chapter 4 for details on bonds.
• Available-for-sale debt investments are one of those accounting topics
defined by what they aren’t rather than what they are. They don’t
fall into the held-to-maturity or trading category. However, as with
the held-to-maturity investments, any cash the company receives
from their sale or collection of principal at maturity reflects as a cash
source in the investing section of the statement of cash flows.
✓ Sales of equity investments: If the company sells stock it owns in other
corporations, the cash it receives is an investing source. So suppose
your company owns 500 shares of ABC Corp. common stock, and you
decide to sell all 500 shares. Any money you receive for the sale of your
shares goes in the investing section.
✓ Sales of property, plant, and equipment (PP&E) and intangibles: The
cash proceeds from any PP&E the corporation sells (such as cars, buildings, and equipment) is an investing source of cash. Ditto if the company
sells an intangible asset such as a patent. (A patent provides licensing for
inventions or other unique processes and designs.)
Investing uses of cash
Here are the potential uses of cash that appear in the investing section of the
statement of cash flows:
✓ Loans and debt purchases: Any cash the company loans to another company is a cash outlay. So is any cash the company uses to buy bonds.
✓ Purchase of equity investments: This category includes any cash the
company uses to buy stock in another corporation.
✓ Purchase of PP&E: If the business pays cash for any fixed asset acquisition or an intangible asset, this outlay of cash must appear in the
investing section.
Accounting for financing activities
Financing activities show transactions with lenders such as long-term liabilities
(paying or securing loans beyond a period of 12 months from the balance sheet
date) and equity items (the sale of company stock and payment of dividends).
Sound familiar from the investing section?
Chapter 2: Laying Out Cash Flows and Changes in Equity
The one main financing cash source is cash proceeds if a business issues its
own stock or debt. For example, ABC Corp. sells $3,000 of its own stock to
XYZ, Inc. The cash ABC receives from XYZ for this transaction is a financing
source of cash on ABC’s statement of cash flows.
Short-term and long-term debt the company issues is included in the financing
section. How long the creditor plans to hold the debt determines whether it’s
recorded on the creditor’s books as short- or long-term debt.
Now, here are the uses of cash that would appear in the financing section of
the statement of cash flows:
✓ Treasury stock transactions: Treasury stocks are shares of corporate
stock that were previously sold and have since been bought back by
the issuing corporation. The use of the cash is to buy back stock from
shareholders. See Book IV, Chapter 5 for more information about
treasury stock.
✓ Cash dividend payments: Cash dividends are earnings paid to
shareholders based on the number of shares they own. Dividends can
also come in the form of stock dividends, which don’t involve cash
changing hands. So remember, only cash dividends go in the financing
section. You find more about cash and stock dividends, plus some info
on stock splits (also a noncash transaction), in Book IV, Chapter 5.
✓ Paying back debt: Any principal payment a company makes on bonds
or loans is a financing activity.
Recognizing Methods for Preparing
the Statement of Cash Flows
Two methods are available to prepare a statement of cash flows: the indirect
and direct methods. The Financial Accounting Standards Board (FASB; see
Book IV, Chapter 1) prefers the direct method, while many businesses prefer
the indirect method. Regardless of which method you use, the bottom-line
cash balance is the same, and it has to equal the amount of cash you show on
the balance sheet.
The last step in compiling the statement of cash flows is to verify that the
ending balance in the cash flow statement equals the ending balance in the
cash account on the balance sheet. If they don’t agree, there must be a mistake
or missing cash transactions in the cash flow statement. This is the process
used for both the direct and indirect method.
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The following figures show you what the statement of cash flows looks like
when you use both the direct and indirect methods of preparation. Figure 2-1
is the statement of cash flows using the direct method, and Figure 2-2 is the
statement of cash flows using the indirect method. As you look at both, note
that the cash balance on 12/31/2015 is the same for both methods.
Figure 2-1:
A direct
method
statement of
cash flows.
©John Wiley & Sons, Inc.
Chapter 2: Laying Out Cash Flows and Changes in Equity
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Figure 2-2:
An indirect
method
statement of
cash flows.
©John Wiley & Sons, Inc.
Using the direct method
The direct method of preparing the statement of cash flows shows the net cash
from operating activities. This section shows all operating cash receipts and
payments. Some examples of cash receipts you use for the direct method are
cash collected from customers, as well as interest and dividends the company
receives. Examples of cash payments are cash paid to employees and other suppliers and interest paid on notes payable or other loans (see Book IV, Chapter 4).
Here are three key facts to remember about the direct method:
✓ You present cash received and paid — not net income or loss as shown
on the income statement (see Book IV, Chapter 2).
✓ Any differences between the direct versus the indirect method are
located in the operating section of the statement of cash flows. The
financing and investing sections are the same regardless of which
method you use.
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✓ The FASB prefers the direct method because it believes the direct
method gives the users of the financial statements a more complete
picture of the health of the business.
Starting indirectly with net income
When you use the indirect method of preparing the statement of cash flows,
the operating section starts with net income from the income statement. You
then adjust net income for any noncash items hitting the income statement.
One typical adjustment is for depreciation, which is a noncash transaction
(see Book III, Chapter 1).
Other common items requiring adjustment are gains and losses from the
sale of assets (see Book IV, Chapter 2). This is because the gains or losses
shown on the income statement for the sale will rarely if ever equal the cash
a company receives. In other words, gain or loss is based on the difference
between the asset’s net book value, which is cost less accumulated depreciation, and the amount the item sold for — not how much cash the buyer
hands over to the seller.
Assume a business has a machine it no longer uses. Because it no longer
needs the machine, the business sells it to another company for $1,500. The
cash received is $1,500, but what about gain or loss on disposal? Consider
these facts:
✓ The company originally paid $3,000 to purchase and install the machine.
✓ The asset was depreciated, meaning that the asset’s cost was gradually
posted to depreciation expense over the machine’s useful life. The total
amount depreciated over time (accumulated depreciation) was $2,000.
Check out Book III, Chapter 1 for more on depreciation.
✓ Book value for the machine on the date of sale was $1,000 ($3,000 cost –
$2,000 accumulated depreciation).
✓ The company debits (increases) cash for $1,500 and debits (reduces)
accumulated depreciation for $2,000. When the asset is sold, the
accumulated depreciation account is adjusted to zero. Debits
total $3,500.
✓ The asset is credited (reduced) by $3,000, which is the original cost.
✓ Gain on disposal is a credit for $500, which is the difference between
$3,500 total debit and the $3,000 credit. After the gain is posted, total
debits and credits both equal $3,500.
Chapter 2: Laying Out Cash Flows and Changes in Equity
You see that the cash received ($1,500) differs from the gain on disposal
($500). These are the types of transactions that are reconciled in the statement
of cash flows. The net income change ($500 gain) doesn’t match the $1,500
cash inflow. Book IV, Chapter 2 goes into more detail in gains and losses.
Interpreting the Statement
of Cash Flows
Users of the statement of cash flows are primarily interested in whether the
company has positive cash flows from operations. As a general rule, a company should be covering its costs by the cash it brings in from the day-to-day
running of the business, rather than from borrowed funds.
A potential investor or creditor wants to see that cash the company brings in
through operations exceeds any cash brought in by selling assets or borrowing money. This is because selling assets or borrowing money can never be
construed as a continuing event, such as bringing in cash from selling goods
or services. Book IV, Chapter 2 explains this concept in more detail.
A company may issue stock or bonds in order to expand its operations. On a
nonrecurring basis, that situation can be okay because successful expansion
is a good thing for investors and creditors. Successful expansion leads to more
sales and higher overall profits. However, unless cash from operations
exceeds cash from other sources with some consistency, a company will be
paying back debt with either more debt or equity being issued, which is
decidedly not a good thing.
Here’s how investors and lenders use the statement of cash flows:
✓ Investor: An investor wants to make sure the corporation has enough
cash flow to pay an adequate return on investment. In other words, can
the investor anticipate getting a cash dividend each year? Also important
is using the statement of cash flows to evaluate how well the company
is managing its cash because investors may eventually sell their shares
of stock. If the company mismanages its cash to such a point that it goes
out of business, there won’t be any buyers for the company’s stock —
the stock may be worthless.
✓ Creditor: The creditor also has a vested interest in making sure the
company has sound cash management. After all, in addition to the
interest expense the debtor pays for the use of the loan, the creditor
wants to make sure it also gets paid back the principal portion of the
loan. It’s never a good sign if a business is paying back debt by assuming
more debt or issuing more equity.
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Looking Quickly at the Statement of
Changes in Stockholders Equity
Larger businesses generally have more complicated ownership structures
than smaller and medium-sized companies. Larger businesses are most often
organized as a corporation in contrast to other forms of legal structures. (See
Book VI, Chapter 2 for more about the legal structure of a business.)
Corporations can issue more than one class of stock shares, and many do. One
class, preferred stock, has certain perks that the other class, called common
stock, doesn’t. Also, a corporation may have both voting and non-voting stock
shares. And corporations can buy back their own stock shares (treasury stock)
for a variety of reasons. Book IV, Chapter 5 addresses these transactions.
The point is that many businesses, especially larger public companies, engage
in activities that change their owners’ equity components. These owners’
equity activities tend to get lost from view in a comparative balance sheet and
in the statement of cash flows. Yet the activities can be important. Therefore,
the business prepares a separate statement of changes in stockholders’
equity covering the same period as its income statements. The statement
of changes in stockholders’ equity is where you find certain technical gains
and losses that increase or decrease owners’ equity but that are not reported
in the income statement. You have to read this summary of changes in the
owners’ equity accounts to find out whether the business had any such gains
or losses. Look in a column headed comprehensive income for these gains and
losses, which are very technical.
The general format of the statement of changes in stockholders’ equity
includes columns for each class of stock, additional paid in capital, treasury
stock, retained earnings, and the comprehensive income element of owners’
equity. Professional stock analysts have to pore over these statements.
Average financial report readers probably quickly turn the page when they
see this statement. But it’s worth a quick glance if nothing else.
Many financial reports include a statement of changes in stockholders’
equity in addition to their three primary financial statements. It’s not really a
full-fledged financial statement. Rather, it serves as a columnar footnote for
the various owners’ equity accounts in the balance sheet. For more about
changes in owners’ equity, see Book IV, Chapter 5.
Chapter 3
Analyzing Financial Statements
In This Chapter
▶ Evaluating a business’s financial health
▶ Categorizing business transactions
▶ Connecting revenue and expenses with their assets and liabilities
▶ Focusing on profitability and activity measures
▶ Preparing vertical and horizontal analyses
S
takeholders in a business are naturally curious about the financial
condition of a company, as reported in its financial statements.
Stakeholders include everyone who may be affected by the financial success
or failure of the business — owners, investors, lenders, the CEO and other
executives, managers, employees, and even vendors.
This chapter offers practical tips to help investors, lenders, or anyone who
has a financial stake in a business glean important insights from financial
statements. These tips also help anyone else with an interest in the financial
condition of a business.
Judging Solvency and Liquidity
Solvency and liquidity both measure the ability of an entity to pay its debts.
Solvency has a long-term focus, while liquidity addresses short-term
payments.
Solvency refers to the ability of a business to pay its liabilities on time.
Solvency measures whether or not a company is viable — a business that can
generate sufficient cash flow to operate over the long-term (multiple years).
Liquidity, on the other hand, refers to the ability of a business to keep its cash
balance and cash flows at adequate levels so that operations aren’t disrupted
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by cash shortfalls. When considering liquidity, the focus is on the next six
months or the next year. For more on this important topic, check out Cash
Flow For Dummies by Tage C. Tracy and John A. Tracy (Wiley).
Understanding the risks of late payments
Delays in paying liabilities on time can cause serious problems for a business. Customers may shy away from doing business with a company that has
financial problems. Vendors may not be willing to sell the company product
because of the risk of not being paid. Customers and vendors may hear about
a company’s financial issues through media reports (newspaper, TV, web).
In extreme cases, a business can be thrown into involuntary bankruptcy. In
a bankruptcy, a court-appointed trustee may take substantial control over
the business and its decisions about debt payment. Even the threat of bankruptcy can cause serious disruptions in the normal operations of a business.
Recognizing current assets and liabilities
Short-term, or current, assets include:
✓ Cash
✓ Marketable securities that can be immediately converted into cash
✓ Assets expected to be converted into cash within one year
The operating cycle is the process of converting current assets (largely
inventory and accounts receivable) into cash. The term operating cycle refers
to the repetitive process of putting cash into inventory, holding products
in inventory until they’re sold, selling products on credit (which generates
accounts receivable), and collecting the receivables in cash. In other words,
the operating cycle is the “from cash — through inventory and accounts
receivable — back to cash” sequence. The operating cycles of businesses
vary from a few weeks to several months, depending on how long inventory
is held before being sold and how long it takes to collect cash from sales
made on credit.
Short-term, or current, liabilities include non-interest-bearing liabilities that
arise from the operating (sales and expense) activities of the business. A typical business keeps many accounts for these liabilities — a separate account
for each vendor, for instance. In an external balance sheet you usually find
only three or four operating liabilities. It’s assumed that the reader knows
Chapter 3: Analyzing Financial Statements
that these operating liabilities don’t bear interest (unless the liability is
seriously overdue and the creditor has started charging interest because of
the delay in paying the liability).
The balance sheet example shown in Figure 3-1 discloses three operating
liabilities: accounts payable, accrued expenses payable, and income tax
payable. The terminology for these short-term operating liabilities varies
from business to business.
Figure 3-1:
Typical
comparative
balance
sheet for
a product
business at
the end of
its two most
recent years
(in vertical,
or portrait
format).
©John Wiley & Sons, Inc.
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In addition to operating liabilities, interest-bearing notes payable that have
maturity dates one year or less from the balance sheet date are included in
the current liabilities section (see short-term notes payable in Figure 3-1). The
current liabilities section may also include certain other liabilities that must be
paid in the short run (which are too varied and technical to discuss here).
Notice the following points in Figure 3-1 (dollar amounts refer to year-end 2015):
✓ The first four asset accounts (cash, accounts receivable, inventory, and
prepaid expenses) are added to give the $8,815,000 subtotal for current
assets.
✓ The first four liability accounts (accounts payable, accrued expenses
payable, income tax payable, and short-term notes payable) are added
to give the $4.03 million subtotal for current liabilities.
✓ The total interest-bearing debt of the business is separated between $2.25
million in short-term notes payable (those due in one year or sooner) and
$4 million in long-term notes payable (those due after one year).
Brushing up on current and quick ratios
If current liabilities become too high relative to current assets — which constitute the first line of defense for paying current liabilities — managers should
move quickly to resolve the problem. A perceived shortage of current assets
relative to current liabilities could sound the sirens in the minds of the company’s creditors and owners. The current and quick ratios measure this risk.
Making a judgment about the ratios you compute depends on your industry.
However, a current ratio of at least 1.0 is considered a minimum expectation
for company liquidity (see the earlier section on liquidity). At that ratio, you
have at least $1 in current assets to pay each dollar of current liabilities.
Business managers know that acceptable ratios also depend on general
practices in the industry for short-term borrowing. Some businesses do well
with current ratios less than 2.0 and quick ratios less than 1.0; so take these
benchmarks with a grain of salt. Lower ratios don’t necessarily mean that the
business won’t be able to pay its short-term (current) liabilities on time.
Applying the current ratio
Current assets are the first source of money to pay current liabilities when
these liabilities come due. Remember that current assets consist of cash and
assets that will be converted into cash in the short run. Ideally, a company
will use current assets as a payment source, rather than additional borrowing
or other financing.
Chapter 3: Analyzing Financial Statements
To size up current assets against total current liabilities, the current ratio is
calculated. Using information from the company’s balance sheet (refer to
Figure 3-1), you compute its year-end 2015 current ratio as follows:
$8,815,000 current assets ÷ $4,030,000 current liabilities = 2.2 current ratio
Generally, businesses don’t provide their current ratio on the face of their
balance sheets or in the footnotes to their financial statements — they leave
it to the reader to calculate this number. On the other hand, many businesses
present a financial highlights section in their financial report, which often
includes several financial ratios.
Moving to the quick ratio
The quick ratio is more restrictive than the current ratio. Only cash and
assets that can be immediately converted into cash are included, which
excludes inventory. In some businesses, it may take many months to sell
inventory. Here is the adjusted asset number you use for the quick ratio
(refer to Figure 3-1):
$8,815,000 current assets – $3,450,000 inventory = $5,365,000 assets for
quick ratio
You compute the quick ratio as follows:
$5,365,000 assets for quick ratio ÷ $4,030,000 current liabilities = 1.3 quick
ratio
Wrapping up with working capital
The same data used to calculate current and quick ratios is used to compute
working capital. Here’s the formula:
Working capital = Current assets – Current liabilities
A current ratio of at least 1.0 is considered reasonable for liquidity purposes.
That’s because the ratio displays at least $1 in current assets for each dollar
of current liabilities.
Assume that current assets and current liabilities each total $1,500,000. The
current ratio is 1.0 ($1,500,000 ÷ $1,500,000). Put the same data in the working
capital formula. Working capital would be zero ($1,500,000 less $1,500,000).
Negative working capital would mean that current assets are less than current liabilities. So, the minimum expectation of 1.0 for a current ratio is the
same as a $0 working capital calculation.
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Understanding That Transactions
Drive the Balance Sheet
A balance sheet is a snapshot of the financial condition of a business at
an instant in time. If the fiscal, or accounting, year of a business ends on
December 31, its balance sheet is prepared at the close of business at midnight
December 31. (A company should end its fiscal year at the close of its natural business year or at the close of a calendar quarter — September 30, for
example.) This freeze-frame nature of a balance sheet may make it appear that
a balance sheet is static. Nothing is further from the truth. A business doesn’t
shut down to prepare its balance sheet. The financial condition of a business is
in constant motion because the activities of the business go on nonstop.
Analyzing three types of balance
sheet transactions
Transactions change the makeup of a company’s balance sheet — that is, its
assets, liabilities, and owners’ equity. The transactions of a business fall into
three basic types. Notice that these three types match up with the three categories of cash flow in the statement of cash flows (see Chapter 2):
✓ Operating activities: This category refers to making sales and incurring
expenses, and also includes accompanying transactions that relate to
the recording of sales and expenses. For example, a business records
sales revenue when sales are made on credit, and then, later, records
cash collections from customers. The transaction of collecting cash is
the indispensable follow-up to making the sale on credit. For another
example, a business purchases products that are placed in its inventory
(its stock of products awaiting sale), at which time it records an entry for
the purchase. The expense (the cost of goods sold) isn’t recorded until
the products are actually sold to customers. Keep in mind that the term
operating activities includes the associated transactions that precede or
are subsequent to the recording of sales and expense transactions.
✓ Investing activities: This term refers to making investments in assets
and (eventually) disposing of the assets when the business no longer
needs them. The primary examples of investing activities for businesses that sell products and services are capital expenditures. A capital
expenditure is an amount spent to modernize, expand, or replace the
long-term operating assets of a business. A business may also invest in
financial assets, such as bonds and stocks or other types of debt and
equity instruments. Purchases and sales of financial assets are also
included in this category of transactions.
✓ Financing activities: These activities include securing money from debt
and equity sources of capital, returning capital to these sources, and
Chapter 3: Analyzing Financial Statements
distributing profit to owners. For instance, when a business pays cash
dividends to its stockholders the distribution is treated as a financing
transaction. The decision whether or not to distribute some of its profit
depends on whether the earnings generated are needed to operate the
business. If the company distributes earnings by paying a dividend, the
equity section of the balance sheet is reduced. (See Book VIII, Chapter 1
for more about accounting for financing activities.)
Reviewing changes in balance sheet
accounts
Figure 3-2 presents a summary of changes in assets, liabilities, and owners’
equity during the year. Notice the middle three columns in Figure 3-2, for each
of the three basic types of business transactions discussed in the prior section.
One column is for changes caused by its revenue and expenses and their connected transactions during the year, which collectively are called operating activities. The second column is for changes caused by its investing activities during
the year. The third column is for the changes caused by its financing activities.
Figure 3-2:
Summary
of changes
in assets,
liabilities,
and owners’
equity
during
the year
according to
basic types
of transactions.
©John Wiley & Sons, Inc.
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Note: Figure 3-2 doesn’t include subtotals for current assets and liabilities.
(The formal balance sheet for this business is presented in Figure 3-1.)
The summary of changes in assets, liabilities, and owners’ equity isn’t a
required financial statement for external users (stakeholders). The purpose
of Figure 3-2 is to demonstrate how the three major types of transactions
change the assets, liabilities, and owners’ equity accounts during the year.
Tying in profit
Figure 3-2 lists a $1.69 million increase in owners’ equity–retained earnings
account. See the operating activities column. The increase represents net
income earned for the year.
The operating activities column in Figure 3-2 is worth lingering over for a
few moments because the financial outcomes of making profit appear in this
column. Most people see a profit number, such as the $1.69 million in this
example, and stop thinking any further about the financial outcomes of making
the profit. This is like going to a movie because you like its title, but you don’t
know anything about the plot and characters. You probably noticed that the
$1,515,000 increase in cash in this column differs from the $1,690,000 net
income figure for the year. The cash effect of making profit (which includes the
associated transactions connected with sales and expenses) almost always
differs from the net income amount for the year. Book V, Chapter 2 explains
this difference.
Managing balance sheet activity
The summary of changes presented in Figure 3-2 gives a sense of the b
­ alance
sheet in motion, or how the business got from the start of the year to the end
of the year. Having a good sense of how transactions propel the balance sheet
is important. A summary of balance sheet changes, such as those shown
in Figure 3-2, can be helpful to business managers who plan and c
­ ontrol
changes in the assets and liabilities of the business. They need a clear understanding of how the three basic types of transactions change assets and liabilities. Also, Figure 3-2 provides a useful platform for the statement of cash
flows explained in Book V, Chapter 2.
Measuring Profitability
In addition to having a handle on how well a company covers its current debt
with current assets, just about all financial statement users want to be able to
evaluate the relative robustness of a company’s income over a series of years
or financial periods. Looking at a company’s performance over a long period
of time is called trend analysis.
Chapter 3: Analyzing Financial Statements
This section explains how trend analysis works and why it’s so important
when evaluating profitability. It then moves on to explain two profitability
measures: return on investment and return on equity.
Understanding trend analysis
A single profitability measure standing alone doesn’t really tell you much
about a company or how it’s performing compared to its competitors.
This is true for two reasons:
✓ The company may have had an exceptionally good or bad year. Unless
a company’s performance is static from year to year, looking at only one
year of financial statement results is misleading. The statement user
sees an inaccurate vision of the company’s performance over time.
Consider a personal example. Suppose you win $50,000 in the lottery this
year, making your total income (after adding in your earnings from your
part-time job) $62,000. The next year and the year after that, you don’t
have any winning lottery tickets (darn it!), and your average income is
$33,000 per year. Clearly, looking at your income for only the year you won
the lottery gives an inaccurate indication of your typical annual income,
because that year’s income includes an unusual, nonrepeating event.
✓ Under generally accepted accounting principles (GAAP), companies are
allowed to use various methods to estimate some expenses. If a financial
statement user is trying to compare Company A to Company B by applying
a single set of profitability ratios, he’s not going to see the whole picture.
For example, two equally profitable companies using different inventory
valuation methods (see Book VIII, Chapter 2) may report big differences
in net income. The same holds true for depreciation of long-term assets,
discussed in Book III, Chapter 1. Different options are also available
for booking an estimate for bad debt expense, which is the money the
company reckons it won’t be able to collect from credit customers (see
Book III, Chapter 6). Many more differences may arise by using allowable
GAAP methods, but you get the picture.
Trend analysis gives much more meaningful information to the financial statement user because differences in accounting methods tend to
smooth out over time. For example, although the method a company
uses for depreciation affects the amount of depreciation expense by
year, it never affects original cost. In other words, an asset costing
$1,000 can never be depreciated for more than $1,000. After the asset is
fully depreciated, total depreciation expense is the same, regardless of
the method used. Analyzing ratios over a period of several years should
be somewhat consistent, which permits the financial statement user to
do some useful trend comparisons.
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Using trend analysis means looking at profitability ratios over a number of
years. Doing so is usually more helpful to the financial statement user than
any single ratio is because everything is relative. Seeing how profitability
ratios go up and down (when comparing current performance to past performance and when comparing the company with other companies in the same
industry) is more meaningful than just looking at one stand-alone ratio. Most
investors consider at least five years — sometimes up to ten.
Focusing on return on investment
Return on investment (ROI) is a measuring tool investors use to see how
well their investment in a particular company is faring — and to help them
make that important decision to sell a stock and move on or to stick with it.
Potential investors also use ROI when trying to make a decision among different companies in which to plunk their spare cash.
Investors want to see how well company management is using the company
assets to make money. This information gives the investor some idea of the
competency of management and the relative profitability of a business when
compared to others the investor is considering.
Investors can calculate ROI, which is expressed as a percentage, a few
­different ways. All the methods involve using some form of comparing
income to assets. Here are two common methods:
✓ Net income divided by average total assets: Net income (see Book VIII,
Chapter 1) is the bottom-line total of what’s left over after you deduct
all business expenses and losses from all revenue and gains for the
same financial period. Assets are all the resources a company owns. So
if a company has net income of $100,000 and average total assets of
$2,700,000, its ROI is 3.7 percent ($100,000 ÷ $2,700,000).
To determine the average of any account, add the account balance at the
beginning of the financial period to the ending balance and divide that
figure by two. So, if total liabilities are $50,000 on January 1 and $75,000
on December 31, average total liabilities is $125,000 ÷ 2 = $62,500.
✓ Operating income divided by average operating assets: This form of
ROI calculation starts with income before income taxes and interest and
divides it by average operating assets, which are long-lived assets such
as property, plant, and equipment. So if a company’s operating income
is $82,000 and its average operating assets are $1,200,000, ROI using this
method is 6.83 percent ($82,000 ÷ $1,200,000).
In real life, it doesn’t make any difference which method an investor uses. As
long as the chosen method is used consistently, trend analysis using any ROI
method will give the investor a significant resource for making a decision as
to which company to invest in.
Chapter 3: Analyzing Financial Statements
Homing in on return on equity
As explained in the prior section, return on investment measures how well you
generate profits from company assets. Return on equity (ROE) measures the
profit earned for each dollar invested in a company’s stock. You figure it by
dividing net income by average owners’ equity (see Book IV, Chapter 5), which is
what’s left over in the business after all liabilities are subtracted from all assets.
The higher the ROE ratio, the more efficient management is at utilizing its
equity base. This measurement is important to stockholders and potential
investors because it compares earnings to owners’ investments (equity).
Because this calculation takes into account retained earnings — the company’s
cumulative net income less dividends — it gives the investors much-needed
data as to how effectively their capital is being used. Having net income grow
in relation to increases in equity presents a picture of a well-run business.
Take a walk through a quick calculation. If a company’s net income is $35,000
and the average owners’ equity is $250,000, ROE is 14 percent ($35,000 ÷
$250,000). Once again, to make wise investment decisions, users of this information look at ROE as it trends over a series of years and compare it to the
ROE of other companies.
Exploring Activity Measures
This section discusses activity measures that quantify the relationship
between a company’s assets and sales. Accounting textbooks usually mention a few activity measures. This section discusses the ones most commonly
used: those that measure accounts receivable and inventory activity.
For many companies, accounts receivable and inventory represent the largest account balances in the balance sheet. As a result, performing analysis on
these accounts is an important indicator of financial performance.
Ratio analysis that studies activity shows you how well a company is using
its assets to make money. This calculation is an expansion of the return on
investment (ROI) measurement. The premise is that how well a company
uses its assets to generate revenue goes a long way toward telling the tale
of its overall profitability. Presumably, a business that’s effectively and efficiently operated, which activity measures show, will generally be more successful than its less effective and efficient competitors.
Asset turnover analysis shows how well you use assets to generate sales. A
higher ratio means more sales per dollar of assets, which is the goal. In other
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words, efficiently turning over assets indicates a well-run business. The basic
formula to calculate asset turnover is this:
Asset turnover = Sales ÷ Average assets
The two most important current assets for the majority of businesses are
accounts receivable and inventory. The following sections explain each turnover ratio.
Accounts receivable turnover
Accounts receivable turnover shows the average number of times accounts
receivable is turned over during the financial period. In this case, turned over
means how often a receivable is posted to the books and then received in
cash. Here’s the formula:
Accounts receivable turnover = Net credit sales ÷ Average accounts
receivable
Net credit sales represent sales made on credit, less any sales returns and
discounts. See Book I, Chapter 3 for more detail on receivables. Average
accounts receivable is simply the beginning receivable balance for the period
plus the ending receivable balance divided by two. See “Focusing on return
on investment,” earlier in this chapter for instructions on how to compute an
average balance.
The sooner a company collects receivables from its customers, the sooner
the cash is available to take care of the needs of the business. This turnover
rate is a big deal, because the more cash the company brings in from operations, the less it has to borrow for timely payment of its liabilities.
Here’s an example of how to figure accounts receivable turnover: Village
Shipping has net credit sales of $35,000 for the year. Accounts receivable
(A/R) was $2,500 at January 1 and $1,500 at December 31. The average A/R is
($2,500 + $1,500) ÷ 2 = $2,000. The accounts receivable turnover is $35,000 ÷
$2,000 = 17.5, or 17.5 times.
Another often-used accounts receivable activity measure is the average collection period for accounts receivable, also called day’s sales outstanding. This
measure calculates the average number of days that credit sales remain in
accounts receivable — a valuable aid in helping companies develop credit
and collection policies. The average collection period for accounts receivable
is figured by dividing accounts receivable as of the last day of the financial
period by the average day’s sales (all sales in the financial period divided by
Chapter 3: Analyzing Financial Statements
365 days or 366 days in a leap year). This calculation assumes that a business
is open each day of the year. It may not be realistic, but it allows the formula
to be compared among businesses.
Inventory turnover
Inventory turnover shows how efficiently the company is handling inventory
management and replenishment. The less inventory a company keeps on
hand, the lower the costs are to store and hold it, thus lowering the cost of
inventory having to be financed with debt or by selling equity to investors.
However, keep in mind that running out of inventory hurts business. Low
inventory levels can cause lost sales and late deliveries and perhaps strain
the company’s relationship with its customers. Also, running low on inventory may cause the company to panic and buy the same inventory for a
higher price to get it right now. Too much of that sort of mismanagement can
play havoc with the bottom line.
Here’s the formula for inventory turnover:
Inventory turnover = Cost of goods sold ÷ Average inventory value
You calculate average inventory the same way you compute the average for
accounts receivable in the prior section. If cost of goods sold are $35,000, and
average inventory is $8,500, inventory turnover is $35,000 ÷ $8,500 = 4.12, or
4.12 times.
Comparing Horizontal and
Vertical Analysis
A good way to do some ratio and trend analysis work is to prepare both
horizontal and vertical analyses of the income statement. Both analyses
involve comparing income statement accounts to each other in dollars
and in percentages.
Understanding horizontal and vertical analysis is essential for managerial
accounting, because these types of analyses are useful to internal users
of the financial statements (such as company management), as well as to external users. If analysis reveals any unexpected differences in income statement
accounts, management and accounting staff at the company should isolate
the reasons and take action to fix the problem(s).
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You can do the same types of analyses for balance sheet accounts. For a
horizontal analysis, you compare like accounts to each other over periods of
time — for example, accounts receivable (A/R) in 2014 to A/R in 2015. To prepare a vertical analysis, you select an account of interest (comparable to
total revenue) and express other balance sheet accounts as a percentage. For
example, you may show merchandise inventory or accounts receivable as a
percentage of total assets.
Using horizontal analysis
Horizontal analysis compares account balances and ratios over different time
periods. For example, you compare a company’s sales in 2014 to its sales in 2015.
Figure 3-3 is an example of how to prepare a horizontal analysis for two years.
For useful trend analysis, you need to use more years (most investors use
five), but this example gives you all the info you need to prepare a horizontal
analysis for an unlimited number of years.
Figure 3-3:
Income
statement
horizontal
analysis for
2014 and
2015.
©John Wiley & Sons, Inc.
The analysis computes the percentage change in each income statement
account at the far right. The first number you might consider is the change
in profit. Net income declined by 42.29 percent. Consider these two numbers
and how they contributed to the decline:
✓ Repairs expense increased by 39.76 percent
✓ Sales declined by 5 percent
Chapter 3: Analyzing Financial Statements
To isolate the reason for the net income decline, look at the change in total
dollars, as well as the percentage change. The repair expense is the largest
percentage change — an increase in costs. But note that the dollar amount of
change is only $1,650 ($4,150 to $5,800). On the other hand, the sales decline
was $25,000 ($500,000 to $475,000). The decrease in sales has a bigger impact
on the net income decline, when dollars are considered.
Implementing vertical analysis
Vertical analysis restates each amount in the income statement as a percentage of sales. This analysis gives the company a heads up if cost of goods
sold or any other expense appears to be too high when compared to sales.
Reviewing these comparisons allows management and accounting staff at the
company to isolate the reasons and take action to fix the problem(s).
Figure 3-4 is an example of how to prepare a vertical analysis for two years.
As with the horizontal analysis, you need to use more years for any meaningful trend analysis. This figure compares the difference in accounts from 2014
to 2015, showing each account as a percentage of sales for each year listed.
Figure 3-4:
Income
statement
vertical
analysis for
2014 and
2015.
©John Wiley & Sons, Inc.
At the bottom of the analysis, note that net income, as a percentage of sales,
declined by 2.62 percentage points (6.67 percent to 4.05 percent). As a dollar
amount, net income declined by $14,096 ($33,333 to $19,237). As mentioned
in the prior section, management should consider both the percentage
change and the dollar amount change.
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Using Common Size Financial Statements
One way to visually zero in on potential problems and missteps taking place
within a business is to prepare and study common size financial statements.
Common size financial statements get rid of the dollars and cents, reflecting
account balances as percentages. For example, with the vertical analysis of
income statement items, all income statement items are shown as a dollar
amount and percentage of total sales. With a common size income statement,
you omit any references to the dollar figures.
The big deal about common size financial statements is that the distraction of the
dollar amounts is taken away. Cleaning up the statements this way allows
the user to compare different companies in the same industry in a more
equitable manner.
For example, just because one company has higher total revenue than
another doesn’t necessarily make it a better company to invest in or loan
money to. Showing accounts as a percentage of another account of interest
rather than a dollar amount really allows you to see the big picture of how
the business is doing rather than obsessing about the difference in dollar
amounts.
Chapter 4
Reading Explanatory Notes
and Disclosures
In This Chapter
▶ Touching on corporate governance
▶ Studying the characteristics of a corporation
▶ Finding out more about a company by reading its notes and disclosures
▶ Figuring out who is responsible for full disclosure
T
his chapter begins with a quick overview of corporate governance and
ends by shedding light on the explanatory notes and other information
found in most corporate annual reports. For a complete picture of corporate
annual reports, see Chapter 5. Annual reports educate the shareholders
about corporate operations for the past year.
Also in this chapter, you find out how a business becomes a corporation,
and you review the four characteristics of a corporation: continuity, easy
transferability of shares, centralized management, and (the biggie) limited
liability.
The complete list of notes and disclosures that may appear on a corporate
annual report is quite long, so this chapter can’t cover them all. Instead, it
focuses on the most common explanatory notes and disclosures popping up
on corporate annual reports.
Realizing How Corporations Should
Govern Themselves
Simply put, corporate governance is the framework under which a corporation
operates. At its core, this framework involves establishing financial controls
(policies and procedures that govern how the company’s finances are handled),
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showing accountability to the shareholders, and making sure corporate
management acts in the best interest of the shareholders and the community
in which it operates. Financial controls and accountability are covered in
depth in the upcoming section “Reviewing Common Explanatory Notes.”
Part of a corporation’s self-regulation includes fully disclosing information on
its financial statements. Hence the focus on corporate governance in a chapter
about financial statement notes and disclosures.
The subject of corporate governance could fill an entire book. But here are
just a couple examples of ways that corporations need to self-regulate:
✓ Acting in the best interests of the shareholders: The corporation
should operate so that the shareholders can expect a reasonable rate
of return. For example, the corporation doesn’t pay excessive bonuses
to corporate officers that reduce cash flow to such a point the business
can’t effectively operate.
✓ Being sensitive to environmental concerns: The corporation shouldn’t
pollute or cause health issues through its business waste or other byproducts for those living in the communities in which the business
operates.
Identifying Corporate Characteristics
Many people have only a murky understanding of how a business becomes a
corporation and what being a corporation means. This section quickly walks
you through the process and explains the characteristics of a corporation
to provide a broader context for understanding corporate governance and
financial statement disclosures.
Incorporation — the process of turning a regular old business into a
corporation — is governed by state statute. If a company wants to set up
shop as a corporation, it must play by the rules of the state in which it
operates. For more about incorporating, see Book VI, Chapter 1.
In most states, the incorporation process kicks off when the company files
a corporate charter or articles of incorporation with the Secretary of State.
This document contains all pertinent facts about the new corporation,
including its name, address, and information about the type and number of
stock shares it’s authorized to issue. The corporation must name a registered
agent: the person the Secretary of State contacts with questions about the
corporation. After the charter is accepted by the Secretary of State, parties
interested in purchasing shares of stock in the business hold a meeting.
These new shareholders then elect a board of directors, and the corporation
is off and running!
Chapter 4: Reading Explanatory Notes and Disclosures
This is a very simplified version of the incorporation process, which can vary
by state. An initial public offering (IPO) — when a company offers shares of
common stock to the public for the first time — is much more complicated
than the previous paragraph may lead you to believe.
Every corporation has four characteristics:
✓ Limited liability: This term means that investors in a corporation
normally can’t be pursued for corporate debt. If a vendor, a lender, or
some other entity to which it owes money sues the corporation, the
individual investors are generally off the hook.
However, you may encounter exceptions to this general rule, which
hinge on the corporation managing itself according to state statute. Also,
the federal government and state departments of revenue can go after
shareholders or corporate officers for certain types of unpaid taxes. One
example is the trust fund portion of the payroll taxes, which includes
the employee portion of federal withholding tax, Federal Insurance
Contributions Act (FICA) tax, and Medicare.
✓ Easy transferability of shares: This characteristic means that if a person
has the money, he can purchase shares of stock in a corporation — with
the expectation of selling the shares in the future if he needs the money.
However, for closely held corporations (those with few shareholders),
this characteristic doesn’t quite ring true. If you’re the majority
shareholder in a private corporation, you don’t have to sell shares to
just anyone.
Easy transferability of shares applies more to the purchase and
sale of shares of publicly traded stock. Publicly traded stocks trade
on exchanges, which are set up to connect buyers and sellers. For
example, if you want to buy shares of AT&T stock, you don’t have to
get permission from good ole’ Ma Bell. You just call up your friendly
neighborhood stockbroker — or go online. In either case, you make
the trade through an exchange.
✓ Centralized management: The management of a corporation shouldn’t
be divided among many different groups. For the corporation to function
at full efficiency, shareholders give up the right to chime in on every
decision it makes. The shareholders elect the board of directors, who
oversee the corporate operations and choose officers to handle the
day-to-day business operations.
✓ Continuity: Until the corporation is formally dissolved, it’s assumed to
have unlimited life, continuing out into perpetuity. The members of the
board of directors can change, corporate officers can change, or there
can be a different mix of shareholders, but the corporation just rolls on
and on.
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Reviewing Common Explanatory Notes
As noted earlier in this chapter, one aspect of corporate self-governance is
giving financial statement users the complete information they need in order
to accurately gauge the company’s performance and financial health. Some of
that information comes in the form of explanatory notes.
Leveling the playing field among
financial statements
Explanatory notes are discussions of items accompanying the financial
statements; they contain important disclosures that aren’t presented in the
financial statements themselves. The financial statements are the income
statement (see Book IV, Chapter 2), balance sheet (see Book IV, Chapters
3 to 5 and Book V, Chapter 1), and statement of cash flows (see Book V,
Chapter 2).
Another term for an explanatory note is footnote or just note. This chapter
uses all three terms so you get used to seeing them used interchangeably.
Such notes are essential to fulfill the needs of the external users of the
financial statements: people like you who may be interested in investing
in the business, banks thinking about loaning the company money, or
governmental agencies making sure the company has complied with
reporting or taxation issues. External users don’t work for the company,
so they aren’t privy to the day-to-day accounting transactions taking place
within the business.
Information that can’t easily be gleaned from reviewing the financial
statements has to be spelled out in notes and disclosures, which explain
how or why a company handles a transaction a certain way. Full disclosure
allows external users to understand what’s going on at the company and
creates a level playing field so an external user can compare the financial
statements of one company with those of another company.
Such notes are part of the corporate annual report (see Chapter 5), which
provides shareholders with both financial and nonfinancial information
about the company’s operations in past years.
The notes come after the financial statements in the corporate annual report
and are ordered to mirror the presentation of the financial statements. In
other words, notes for income statement accounts come first, followed by
balance sheet notes, and then items reflecting on the statement of cash flows.
Chapter 4: Reading Explanatory Notes and Disclosures
The U.S. Securities and Exchange Commission (SEC), introduced in Book IV,
Chapter 1, requires certain explanatory notes specifically for publicly traded
companies. However, as a best practice, many preparers of financial statements for private companies follow SEC guidelines.
Explaining significant accounting policies
This section explains the explanatory notes commonly addressed in financial
accounting textbooks. Most of these subjects are presented elsewhere in this
book in more detail, so you get just a brief overview here and a reference to
let you know where you can find more info.
Keep in mind that each of these explanatory notes is just a light-bite
(truncated) version. Depending on the company and the complexity of the
underlying accounting transaction, explanatory notes can be long and boring
to wade through for all but the most diligent and experienced investor. Each
type of note is accompanied by a simple version of what you see in real life.
The first order of business when a company prepares its explanatory notes
is to describe in general the business and its significant accounting policies.
Some businesses break the two broad topics into different notes. The
first could be called “Basis for Presentation” and the second “Accounting
Policies.” Alternatively, the company could have just one note called
“Summary of Business and Accounting Policies.”
Taking this first step creates a fairer presentation of the financial statements.
Information about accounting policies helps financial readers to better
interpret the statements. A footnote is needed for each significant accounting
choice the company makes.
At the very least, the explanatory notes should include what depreciation
methods are in use, how a company values its ending inventory, its basis of
consolidation, how it accounts for income taxes, information about employee
benefits, and accounting for intangible assets. The following sections touch on
each of these subjects in turn.
Note also that explanatory notes may explain the time period and payments
due on a capital lease. Leases aren’t covered in detail in this book, but keep
in mind that you may see leases in the notes section.
Reviewing depreciation and inventory valuation methods
Depreciation (see Book III, Chapter 1) consists of spreading the cost of a
long-term asset over its useful life, which may be years after the purchase.
Inventory valuation methods detail how a business may value its ending
inventory (see Book VIII, Chapter 2).
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The methods a company opts to use for both depreciation expense and
inventory valuation can cause wild fluctuations for the amount of assets
shown on the balance sheet and the amount of net income (or loss) shown
on the income statement. Because of this fluctuation, the financial statement
user needs to know which methods the company uses in order to more fairly
compare one company’s financial statement figures to another’s. Differences
in net income could merely be a function of depreciation or valuation
methodology — a fact the user would be unaware of without the footnote.
Assuming that depreciation and inventory are addressed in note 1, here’s a
truncated example of how such a note looks:
NOTE: SUMMARY OF BUSINESS AND ACCOUNTING POLICIES
We compute inventory on a first-in, first-out basis. The valuation of
inventory requires we estimate the value of obsolete or damaged
inventory.
We compute depreciation for financial reporting purposes using the
straight-line method, generally using a useful life of 2 to 5 years for all
machinery and equipment.
Consolidating financial statements
Consolidation is what happens when companies merge or when a larger
company (called a parent company) acquires one or more smaller ones
(subsidiaries). In the context of generally accepted accounting principles
(GAAP), consolidation refers to the aggregation of financial statements of two
or more companies so those statements can be presented as a whole. In this
section of the footnotes, the company confirms the fact that the consolidated
financial statements do indeed contain the financial information for all its
subsidiaries. Any deviations from including all subsidiaries must
be explained.
Here’s a truncated example of a note addressing consolidation:
NOTE: SUMMARY OF BUSINESS AND ACCOUNTING POLICIES
Our consolidated financial statements include our parent account and
all wholly owned subsidiaries. Intercompany transactions have been
eliminated, and we use the equity method, which means we report the
value based on our proportionate ownership, to account for investments
in which we own common stock.
Accounting for income taxes
Financial statements prepared by using GAAP and those prepared for
tax purposes differ. The former are created by using what’s called book
accounting, and the latter are created by using tax accounting. Temporary
and permanent differences can exist between the book and tax figures. Keep
reading for a brief explanation of each difference.
Chapter 4: Reading Explanatory Notes and Disclosures
Here’s an example of a permanent difference: Using book accounting, assume
a business can expense 100 percent of meals and entertainment costs it incurs
in the normal course of business. For tax purposes, however, it can expense
at most 50 percent of that same cost. This is a permanent difference because
under the Internal Revenue tax code, the business is never able to expense
100 percent. The difference between book and tax expenses is permanent.
The most common temporary difference relates to depreciation. Assume
that, for book purposes, a company uses straight-line depreciation and for
tax purposes a more accelerated method. In the short run, there will be a
difference in depreciation expense. Eventually, over time, the amount of
depreciation the company expenses for an asset will balance out so that
under either method the total amount of depreciation is the same. The
difference in depreciation expense is only temporary.
The company must address the differences between book and tax, called
deferred tax assets and liabilities, in the footnotes to the financial statements.
Here’s a truncated example of how such a note may look:
NOTE: TAXES
Income before taxes was $7.68M, and the provision for federal taxes
was $2.78M, an effective tax rate of 36.2 percent. Deferred income taxes
reflect the net tax effects of temporary differences between the carrying
amounts of assets and liabilities for financial reporting versus for tax
reporting purposes.
Spelling out employee benefits
Details about the company’s expense and unpaid liability for employees’
retirement and pension plans are also spelled out in the footnotes. The
obligation of the business to pay for postretirement health and medical
costs of retired employees must also be addressed.
Accounting for employee benefits is a somewhat advanced accounting
topic. Just remember that employee benefits require an explanatory note,
and you’ll be fine.
Here’s a truncated example of how such a note looks:
NOTE: RETIREMENT BENEFIT PLANS
We provide tax-qualified profit sharing retirement plans for the benefit
of our eligible employees, former employees, and retired employees.
As of December 31, 2015, approximately 80% of our profit sharing fund
was invested in equities with the rest in fixed-income funds. We have
independent external investment managers.
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Walking through intangibles
Intangible assets aren’t physical in nature as is a desk or computer. Two
common examples of intangibles are patents, which license inventions or
other unique processes and designs, and trademarks, which are unique signs,
symbols, or names that the company uses. (See Book IV, Chapter 3 for more
information about intangibles.) Besides explaining the different intangible
assets the company owns via an explanatory note, the business also needs
to explain how it has determined the intangible asset’s value posted to the
balance sheet.
Here’s a truncated example of how such a note looks:
NOTE: INTANGIBLE ASSETS
We classify intangible assets with other long-term assets. As of December
31, 2015, our intangible assets consisted of the following: patents,
copyrights, and goodwill. They are generally amortized on a straight-line
basis. We perform a yearly review to determine whether useful life is
properly estimated, and to determine whether the value of the intangible
asset has been impaired.
Looking for important event disclosures
A company must also provide information in its annual report explaining the
following topics: accounting changes, business combinations, contingencies,
events happening after the balance sheet date, and segment reporting.
The topic of event disclosure is usually discussed separately from the topic
of explanatory notes that accompany financial statements. But keep in mind
that event disclosure information goes in the footnotes to the financial
statements right along with the accounting method information described
in the previous section.
Accounting changes
A company may have up to three types of accounting changes to report: a
change in accounting principle, a change in an accounting estimate, or a change
in a reporting entity. Narrative descriptions about accounting changes go in the
explanatory notes to the financial statements very early in the game — usually
in the first or second note.
Chapter 4: Reading Explanatory Notes and Disclosures
Following is an explanation of each type of accounting change:
✓ Accounting principles guide the way the company records its
accounting transactions. Under GAAP, a company is usually allowed
different ways to account for transactions; for example, GAAP allows
companies to use different depreciation methods to expense the cost of
long-lived assets.
For financial statements, changes in accounting principle have to be
shown by retrospective application to all affected prior periods (unless
doing so isn’t practical). This process involves three steps:
• Adjust the carrying amounts of affected assets and liability
accounts for the cumulative effect of the change.
• Take any offset (difference in amounts) to beginning retained
earnings. In other words, the difference in carrying amounts either
increases or decreases beginning retained earnings.
• If the financial report shows multiple years for comparison, show the
effect of the new accounting principle in each of the reported years.
✓ Accounting estimates are numbers a company enters into the financial
records to reflect its best guesses as to how certain transactions will
eventually shake out. For example, going back to the depreciation
example, consider the estimate for salvage value, which is how much a
company assumes it will be able to get for a long-lived asset when the
time comes to dispose of it. If something happens to make you believe
your original estimate of salvage value was wrong and you change it,
that’s a change in accounting estimate.
A change in accounting estimate has to be recognized currently and
prospectively. For example, if salvage value is recalculated, the current
and future financial statements show the salvage value as corrected. No
change is made to prior period financial statements.
✓ Reporting entities reflect which business combinations are shown
on the financial statements, also known as consolidated financial
statements. When a business owns more than 50 percent of another
business, the investor business is called a parent and the investee is
the subsidiary. If something changes in the way the subsidiaries show
up on the financial statements, that’s a change in reporting entity.
Changes in reporting entities are shown retrospectively to the financial
statements of all prior periods. This means you have to show the dollar
amount effect of the change of reporting entities in the balances of all
related assets and liabilities. Any offsetting amount goes to the
beginning balance of retained earnings.
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Business combinations
Accounting textbooks typically cover basic business combinations, which
include these three:
✓ Mergers: Two or more companies combine into a single entity. Mergers
are usually regarded as friendly combinations — not hostile takeovers.
✓ Acquisitions: One company acquires another business. The business
doing the acquiring takes over, and in essence the target (acquired)
company ceases to exist. Acquisitions usually aren’t quite as friendly as
mergers.
✓ Dispositions: A company transfers, sells, or otherwise gets rid of a
portion of its business. For example, a shoe manufacturer makes dress
shoes, slippers, and tennis shoes and decides to sell its slipper division
to another company.
If a company involves itself in any of these three activities during the financial
reporting period, it has to explain the transaction and spell out the effect of
the business combination on the financial statements. Business combination
information goes in the explanatory notes to the financial statements very
early in the game; it first crops up in the first or second note, and then it’s
addressed as needed in subsequent notes.
If a company is involved in a disposition, GAAP dictates that it disclose not
only the facts and circumstances surrounding the disposition but also any
anticipated operational losses from getting rid of a portion of its business.
The losses are calculated net of tax, which means you factor in any increase
or decrease in tax due because of the disposition. The company must also
show any loss or gain on the sale of that portion of the business (also net
of tax) on the income statement. These results are pulled out and reported
separately because they won’t continue into the future. This activity is
typically posted to an account called income (or loss) from discontinued
operations.
Contingencies
A contingent liability exists when an existing circumstance may cause a loss in
the future depending on other events that have yet to happen (and, indeed,
may never happen). For example, the company is involved in an income tax
dispute. Disclosing this contingent liability is a requirement if the company
will owe a substantial amount of additional tax penalties and interest should
the unresolved examination end up in the government’s favor. See Book IV,
Chapter 4 for a general discussion about contingencies.
Here’s a truncated example of a contingency note:
NOTE: COMMITMENTS AND CONTINGENCIES
Chapter 4: Reading Explanatory Notes and Disclosures
As of December 31, 2015, we were contingently liable for guarantees of
indebtedness owed by third parties in the amount of $3 million. These
guarantees relate to third-party vendors and customers and have arisen
through the normal course of business. The amount represents the
maximum future payments that we could be responsible to make under
the guarantees; however, we do not consider it probable that we will be
required to satisfy these guarantees.
A contingent liability needs to be reported not only as a disclosure via a
footnote to the financial statements but also in the financial statements if it’s
probable and the amount of loss can be reasonably estimated. This disclosure
specifically states that the company doesn’t consider the loss contingency
probable, so footnote disclosure without inclusion in the financial statements
is all that’s required for this example.
Events happening after the balance sheet date
The company also must address any subsequent events happening after
the close of the accounting period but before the financial statements are
released. Like contingent liabilities, depending on their nature, subsequent
events may just need a disclosure in the footnotes to the financial
statements, or they may require both a disclosure and an adjustment to the
figures on the financial statements to reflect the dollar amount effect of the
subsequent event.
How the company handles the event happening after the balance sheet date
depends on whether the event is classified as a Type I or Type II event:
✓ Type I events: These events affect the company’s accounting estimates
reflecting on the books but not confirmed as of the balance sheet date.
(See the earlier section “Accounting changes” for an explanation of
accounting estimates.) A good example is the estimate for uncollectible
accounts. This estimate exists on the books at the balance sheet date,
but the company can’t be sure of the resolution of the estimate until
a subsequent event occurs, such as a customer filing for bankruptcy.
At that point, the company confirms that the amount is actually
uncollectible.
If the confirming event (such as the bankruptcy) occurs after the
balance sheet date but before the financial statements are finalized, the
company has to adjust its financial statements. Footnote disclosure can
be used to explain the event as well.
✓ Type II events: These events aren’t on the books at all before the
balance sheet date and have no direct effect on the financial statements
under audit. The purchase or sale of a division of the company is a
classic example of a Type II event.
These events are also called nonrecognized events. This means that if
they’re material, they have to be disclosed in footnotes to the financial
statements, but the financial statements don’t have to be adjusted.
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Here’s a truncated example of a note on an event taking place after the
balance sheet date:
NOTE: SUBSEQUENT EVENT
On February 1, 2015, we entered into an agreement to sell our ownership
interests in our ABC division to XYZ Manufacturing for approximately
$5 million in cash. The transaction is subject to certain regulatory
approvals. We expect the transaction to close in the 4th quarter of 2015.
Segment reports
Business segments are components operating within a company. For example,
a clothing manufacturer makes dresses, blouses, pants, and sweaters; these
are all business segments. If a business has various segments, it must disclose
info about each segment — such as its type, geographic location, and major
customer base — so that the users of the financial statements have sufficient
information. Here’s a truncated example of how such a note looks:
NOTE: SEGMENT REPORTING
As of December 31, 2015, our organizational structure consisted of the
following operating segments: North America and Europe. Our North
American segments derive the majority of their revenue from the sale
of finished clothing. Our European segment derives the majority of its
revenue from the sale of fabric and notions to other European companies.
Putting the Onus on the Preparer
The explanatory notes and disclosures, like the financial statements
themselves, are the responsibility of the company’s management and its
accounting staff. Management and the internal accounting staff prepare the
explanatory notes and disclosures by using the applicable American Institute
of Certified Public Accountants (AICPA) disclosure checklist. All GAAP guides
contain a comprehensive appendix listing the full AICPA disclosure checklist.
After management prepares the financial statements and explanatory
notes and disclosure information, the company often hires an independent
certified public accountant (CPA) to evaluate management’s work. The
CPA is independent, which means she has no special relationship to or
financial interest in the company. The CPA may or may not be required to be
independent, depending on the work the CPA performs for the client.
Chapter 4: Reading Explanatory Notes and Disclosures
CPAs perform three major types of financial statement work:
✓ Audits: Auditing is the process of investigating information that’s
prepared by someone else, usually company management and the
accountants the company employs, in order to determine whether
the financial statements are fairly stated. CPAs performing audits
must investigate the assertions that a company makes on its financial
statements, including any notes and disclosures.
Financial statement assertions often relate to how the company
conducts business, such as how it makes and spends money and how it
records financial information about its property, plant, and equipment;
its long-term liabilities and equity; and its cash and investments.
An audit provides a reasonable level of positive assurance, which means
the financial statements are free of material errors and are stated in
accordance with GAAP. An audit does not, however, provide an absolute
guarantee that the financial statements contain no errors. Also, an audit
isn’t designed or performed to detect all fraud.
Although accountants employed by the business prepare the financial
statements (including the notes and disclosures), only an independent
CPA can audit them. If auditing is a subject that interests you, check out
Auditing For Dummies by Maire Loughran (Wiley).
✓ Reviews: When a CPA conducts a review, she looks at the company’s
documents and provides negative assurance, which means the CPA finds
no reason to believe the information prepared by company management
is incorrect. For example, the CPA looks over the company’s financial
statements, noting whether they’re of proper appearance. For
example, do the statements contain appropriate explanatory notes and
disclosures per the AICPA disclosure checklist? Do they conform to
GAAP? Reviews are usually performed for privately owned companies
when the users of the financial statements require some sort of
assurance about the financial statements’ assertions but don’t require a
full-blown audit.
✓ Compilations: If a CPA is hired to do a compilation, she can compile financial statements (using information provided by company
management) that omit footnote disclosures required by GAAP or that
use another comprehensive basis of accounting, such as cash-basis
accounting (see Book III, Chapter 6). Preparing the statements this way
is okay as long as omitting the explanatory notes and disclosures
is clearly indicated in the report without intent to mislead users.
When footnote disclosures have been omitted, CPAs add a paragraph
to the compilation report stating that management has elected to omit
disclosures. This paragraph lets the user know that if the financial
statements did contain the explanatory notes or disclosures, that
information may affect their conclusions.
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Here’s an example of the language used when a company is omitting
compilation disclosures:
Management has elected to omit substantially all the disclosures
required by generally accepted accounting principles. If the
omitted disclosures were included in the financial statements,
they might influence the users’ conclusions about the company’s
financial position, results of operations, and its cash flows.
Accordingly, these financial statements are not designed for
those who are not informed about such matters.
Chapter 5
Studying the Repor t
to the Shareholders
In This Chapter
▶ Staying private or going public: Why annual reports differ among companies
▶ Identifying the three purposes of a corporate annual report
▶ Recognizing common sections in an annual report
▶ Analyzing Form 10-K
M
ost of the chapters in Books IV and V are devoted to explaining how
to prepare financial statements (the income statement, balance sheet,
and statement of cash flows). But what happens to these statements after
they’re done? Do they just get filed away in case anyone asks to see them?
Absolutely not! The financial statements become the heart of a company’s
annual report to its shareholders. An annual report is a document that the
company can share with its current owners, potential investors, creditors,
the media, and so on; it can be an important public relations tool that shows
the outside world how the company is doing. For many companies, the
report is also a regulatory requirement.
This chapter explains the ins and outs of a corporate annual report, including the three key purposes it serves. Here you also find out about Form 10-K,
an annual filing that the U.S. Securities and Exchange Commission (SEC)
requires from most publicly traded companies.
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Why Private and Public Companies
Treat Annual Reports Differently
A corporate annual report (which may also be called the annual report or the
annual report to shareholders) may look different depending on whether the
company in question is private or public.
The corporate annual report for a private company — one whose stock isn’t
traded on the open market — is usually a bare-bones document that gives
users just the mandatory information about how the company performed in
the past year. You don’t find many bells and whistles in a private company’s
report. That’s because most private companies are closely held (they have a
small number of owners), so they aren’t too concerned about how a larger
audience will react to the report. On the other hand, a public company’s
report is often loaded with bells and whistles, such as marketing material
designed to tout the company to potential investors and creditors.
Another key difference between the annual reports of private and public companies is that private companies don’t always have their financial statements
audited, while public companies do. A private company usually has its financial
statements audited only if doing so is required to fulfill a business purpose.
(Perhaps a creditor or an insurer providing bonding — compensation to customers in case the company doesn’t fulfill its obligations — requires an audit.)
As explained later in this chapter, public companies’ financial statements
must always be audited in order to fulfill regulatory requirements. What does
it mean for the statements to be audited? After the company creates the statements, it employs an independent certified public accountant (CPA) to gather
sufficient information to express an opinion on whether the statements are
materially correct. (In other words, they don’t contain any misstatements
that could significantly impact the decisions made by the financial statement
users.) See Book IX for a more detailed explanation of auditing.
Only after a public company’s financial statements are audited can they be
included in the company’s annual report to the shareholders.
This chapter focuses on the annual reports that large public companies prepare to show you what the most elaborate reports look like. You can access
the corporate annual report for just about any publicly traded corporation
online. Go to the home page of any company in which you have an interest.
Look for an “Investor” link on the home page, and click it. Voilà! Chances
are you’re looking at the annual report. If you can’t easily find the “Investor”
link, don’t spin your wheels. Just search the web by using the key phrase
“[Company name] corporate annual report.” You’ll likely locate it easily.
Chapter 5: Studying the Report to the Shareholders
Fulfilling Three Purposes
This section spells out the three distinct goals of the annual report for
a public corporation: to promote the company, to display its financial
­performance and goals, and to meet regulatory requirements.
Something to keep in mind: Going forward, large public corporations will
undoubtedly turn more and more toward electronic media to distribute their
annual reports. Doing so is a cost-saver and demonstrates a corporation’s
commitment to using resources wisely.
Serving a marketing and PR function
A substantial portion of a corporate annual report is devoted to the company’s bragging about what it has accomplished during the preceding year and
where it expects to go in the coming year. The language can be full of hyperbole and puffery. The purpose of this marketing and public relations material
is to keep existing shareholders pumped up about the wisdom of their investment and to attract new shareholders to the fold.
Stating financial performance and goals
Less flashy but of decidedly more interest to serious investors are the
sections addressing the corporation’s financial performance in the past year.
The information in these sections indicates how closely the company came
to hitting projected revenue figures. Additionally, the company addresses
how it intends to improve financial performance going forward.
Here are some examples of financial goals:
✓ Increasing revenue by expanding into global markets.
✓ Becoming regarded as a premier employer.
✓ Managing operations for the greatest effectiveness.
✓ Increasing brand awareness. Brand awareness is a fancy way of saying
the company wants to make sure consumers recognize the company and
its signature products. The purpose of brand awareness is also tied to
making the company’s products preferred over similar ones marketed
by the competition.
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Meeting regulatory requirements
Most large companies would produce an annual report even if the U.S.
­government didn’t require them to. That’s because an annual report is such
a crucial marketing and PR tool. However, because publicly traded companies must adhere to stringent regulatory requirements, not issuing an annual
report isn’t an option.
Companies that issue publicly traded securities — as well as companies
that meet certain other criteria — have to file annual reports with the U.S.
Securities and Exchange Commission (SEC). The specific report required by
the SEC is called Form 10-K. The final section of this chapter explains which
companies have to file this form and what exactly it entails.
To avoid having to create two separate types of annual reports, some companies include in their reports to shareholders all the information that the
SEC requires be included in Form 10-K. SEC and other regulatory bodies are
addressed in Book IV, Chapter 1.
Reading the Annual Report
to Shareholders
This section takes you through the sections that you most often find in a
corporate annual report. With the exception of the audited financial statements, the sections are put together in an effort to draw the external reader
into the inner workings of the business in an attempt to raise the users’ comfort with and confidence in the company. Audited financial statements, on the
other hand, require a specific presentation.
Writing the narrative for a corporate annual report is an art. Many times,
the report is contracted out to professionals rather than produced in-house,
although the company’s chief executive or managing director always has a
say in the format of the report.
Keep in mind that this section contains just a brief overview of what you may
expect to see in a corporate annual report. Especially if a company is large, it
may include a plethora of additional information.
If you have the time, check out Reading Financial Reports For Dummies by Lita
Epstein (Wiley). While the following sections touch on the fundamentals, this
book walks you through reviewing financial reports from A to Z.
Chapter 5: Studying the Report to the Shareholders
Meeting the chair of the board of directors
Most casual investors in a corporation have absolutely no idea who the
chairperson of the board of directors is or what that person does. Although
the duties of the chairperson are similar from company to company, the individual holding the position is unique to the particular company.
The chairman of the board of directors is the head honcho who oversees
the board of directors (and is usually elected by the other members of the
board). The board of directors consists of individuals elected by the shareholders to guide the company based on the firm’s mission or vision.
The board of directors doesn’t handle the day-to-day activities of any business; that’s management’s job. However, approving the hiring of upper management personnel, such as the chief executive officer (CEO), is a function of
the board of directors.
In the corporate annual report, you meet the chairman via a letter whose salutation is something like “Dear Fellow Shareholder.” The letter gives the company’s top management team a chance to review all the accomplishments
the company achieved during the preceding year. The letter also summarizes
goals for the future. It ends by thanking the shareholders for their support
and offering a firm promise to work tirelessly to continue earning the trust of
the shareholders and growing their value in the company stock.
Highlighting key financial data
In the beginning of the annual review, the company gives the shareholders a
condensed version of how well the company performed during the preceding
year. This condensed info provides the more casual readers with what the company perceives as the main points of interest. At the least, this section contains
a summary of operations, earnings per share data, and balance sheet data:
✓ Summary of operations: This summary shows the company’s bottom
line net income for at least three years (and preferably five to ten years).
Net income is the excess of revenue and gains over expenses and losses
during a financial period.
✓ Earnings per share (EPS): This calculation shows the net income per
outstanding share of common stock. Read on for an explanation of this
formula. Many investors focus on this figure, comparing it to their other
investments and to other companies’ EPS in the same industry. For
example, an investor may compare the EPS of The Coca-Cola Company
to the EPS of PepsiCo to gauge the value of one company’s stock over
the other, given that these companies are in the same industry.
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Three calculations you may see in an annual review are basic EPS,
diluted EPS, and cash dividends (see Book IV, Chapter 5 for additional
details on all three). Here’s an example of each:
• Basic EPS: To figure basic EPS, take net income for the financial
period and divide it by the weighted average number of shares of
common stock outstanding. The weighted average factors in the
fluctuations of stock outstanding during the entire year instead of
just taking stock outstanding at January 1 and stock outstanding at
December 31 and dividing it by two.
If ABC Corp. has net income of $100,000, and the weighted average
number of shares of common stock outstanding is 21,833, basic
EPS is $100,000 ÷ 21,833 = $4.58.
• Diluted EPS: If the company has issued stock options or convertible debt or convertible preferred stock that the investor has the
option to convert into common stock, the company has to show
diluted EPS, which is a complicated calculation. (Stock options
are benefits allowing employees to purchase a certain number of
shares of company stock at a pre-determined date and price.)
Diluted EPS calculates earnings per share by estimating how many
shares could theoretically exist after all stock options and convertible securities have been exercised into common stock shares. So if
ABC Corp.’s weighted average of common stock outstanding after
adding in these extras is 24,989, its diluted EPS is $100,000 ÷ 24,989 =
$4.00.
• Cash dividends: This calculation is the amount per share paid to
shareholders of record. The company must have earnings to pay a
dividend, because dividends are a payment of earnings. The board
of directors determines the dividend paid, if any, to shareholders
of record.
✓ Balance sheet data: This section shows selected figures from the balance sheet in which the company believes the shareholders have an
interest. For example, the company may show total assets, which are all
assets (current and long-term) that the company owns as of the balance
sheet date. The company may also show long-term debt, which is any
debt the company won’t have paid off within 12 months of the balance
sheet date.
Even though these figures are compressed, they’re based upon — and must
reconcile with — the audited financial statements.
Figure 5-1 shows an example of this condensed financial data.
Chapter 5: Studying the Report to the Shareholders
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Figure 5-1:
Select
financial
information.
©John Wiley & Sons, Inc.
Touting company achievements
In this section, which has a distinct public relations purpose, the company
expands upon any facts the chairman of the board discusses in his letter to
the shareholders. For example, this section may break out how the company
has increased growth per capita, which is the average per person living in an
area the company serves. Per capita growth could mean that the company
sold more products to existing consumers or expanded its sales base into
new markets or countries. Companies want to emphasize that they’re attracting new customers while still maintaining a bond with existing customers.
Looking into the future
In its annual report, a company also addresses where it sees itself in the future —
both short-term and long-term. Although the business may not provide specific
financial targets (like total sales or new customers), it gives the reader its strategy
for moving forward. Doing so addresses any concerns that an investor may have
that the business is a going concern: that it will be able to stay in business for at
least 12 months beyond the balance sheet date, generating or raising enough
cash to pay its operating expenses and make appropriate payments on debt.
Obviously, investors aren’t going to get all fired up about their ownership
in the company stock if they believe the company will be around for only a
couple more years. Therefore, annual reviews normally give a three-to-fiveyear plan on growth methodology. Often, companies associate their growth
predictions with social and economic transitions — for example, changes in
population demographics such as aging and income.
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Getting to know key management
and board members
This section of the annual report introduces other members of the board of
directors, the management team for each division of the company, and committee members (such as members of the audit committee). Most likely, the
report includes pictures of all of them posed at the company headquarters.
Walking through Form 10-K
The U.S. Securities and Exchange Commission (SEC) requires that all companies registered with it annually file Form 10-K shortly after the end of the
company’s fiscal year. The SEC also requires that Form 10-Q must be filed
each fiscal quarter. Companies that have a certain class of securities, a certain level of assets or number of holders, and/or which are publicly traded
must register with the SEC:
✓ Class of securities: Any company issuing securities traded publicly on
a stock exchange or in the over-the-counter market (where dealers buy
from and sell to interested investors for their own accounts via the
phone or computer) must register with the SEC.
✓ Assets or holders: Any company with more than $10 million in assets
and 500 or more holders of any class of equity, such as common or preferred stock, must register as well.
✓ Publicly traded: Any company whose equity (stock) or debt (bonds) is
publicly sold pursuant to a registration statement must register with
the SEC.
A registration statement is filed with the SEC when a company wants to
issue securities to the public. It includes a full and fair disclosure of the
securities being issued, info about the company and what it does, the
company’s financial position, and what the company plans to do with
the proceeds from the issuance. The company submitting the filing is
referred to as the registrant.
Registration with the SEC doesn’t mean the SEC is giving the company a
stamp of approval. It merely means the company has provided all documents
required for registration.
Form 10-K consists of a facing page and four additional parts: business,
market/financial, management/corporate governance, and exhibits/financial
statement schedules. The following sections explain each part in turn.
Chapter 5: Studying the Report to the Shareholders
Facing page: Identifying
the affected company
The facing page of Form 10-K gives basic info about the company (the SEC
registrant), including its name, address, telephone number, and the fiscal year
in question. It also lists the title and class of securities (equity and debt) that
are registered with the SEC and the number of shares outstanding. Some more
advanced information appears on the facing page as well, such as whether
the company is required to file certain reports or has done so voluntarily.
Part I: Finding out more
about the registrant
Part I contains information about the company, including an overview of
what the company does and any risk factors surrounding it. An example of a
risk factor may be heightened competition hurting the core business or a significant depletion of the raw materials needed to make its products.
This section requires the following additional info:
✓ The year the company organized
✓ Its form of organization
✓ Any bankruptcy proceedings, business combinations, or changes in the
method of conducting its business
For example, the registrant may state, “We were incorporated in February
1945 under the laws of the State of Delaware and succeeded to the business
of a New York corporation.”
The Part I information can be incorporated by reference from the annual
report to the stockholders if that report contains the required disclosures.
If the company opts to do this, it must cross-reference Form 10-K to the
annual report showing what was incorporated and from which pages in
the annual report. For example, the company could write, “See page 10
of the 2015 annual report for this information.”
Part II: Revealing the company’s
financial performance
Part II is really the meat of Form 10-K because it reveals a company’s financial performance in the past year. This part features information about
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where the company’s stock is traded, analysis and discussion from company
­management, and the audited financial statements.
Market information and financial highlights
In Part II, the company tells the SEC in which market the company’s common
stock lists and trades. Two U.S. examples are the New York Stock Exchange
and NASDAQ.
The company also lists the high and low common stock market prices and
dividends declared for the year in question. More than likely, the company
will also include its key financial data from the annual report to stockholders.
(See the earlier section “Highlighting key financial data.”)
Management discussion and analysis
Part II also includes a management discussion and analysis section. Normally,
management recaps business operations and discusses significant financial
trends within the company during the past couple years. For example, for a
fast-food restaurant, management would probably discuss how government
regulations to combat obesity are expected to affect the business.
Audited financial statements
The audited financial statements, critical accounting policies, estimates, and
explanatory notes and disclosures also appear in Part II. Accounting policies
include how a company recognizes revenue and expenses and where these
figures show up on the financial statements. An example of an estimate is the
allowance for uncollectible accounts, which is what the company anticipates
it won’t be able to collect from customers who have purchased on credit;
see Book IV, Chapter 3. For additional guidance on explanatory notes and disclosures, see Chapter 4.
Auditing is the process of systemically gathering enough evidence to support
the facts a company is showing in the financial statements. The results of an
audit are communicated to all interested users in a format that they can both
understand and use for their intended purposes.
The goal of a financial statement audit is for the auditor to form an opinion
regarding whether the financial statements are or aren’t free of material misstatement. Auditors aren’t responsible for preparing the financial statements
they’re auditing. In fact, they can’t prepare them; to do so would violate the
concept of independence.
Therefore, the items under audit are company management’s responsibility. In
other words, the financial statements contain management assertions —
management’s assurance that the information provided is materially correct. A
company accountant uses these assertions to produce the financial statements.
Chapter 5: Studying the Report to the Shareholders
After conducting the audit of the financial statements, the auditor can
express one of four basic options:
✓ Unqualified: An unqualified opinion is the best the client can get! It
means that the audit has been conducted in accordance with generally
accepted auditing standards (GAAS) and that the financial statements
conform with generally accepted accounting principles (GAAP) in all
material aspects.
✓ Qualified: An auditor may have to issue a qualified opinion when the
company doesn’t use GAAP consistently, or circumstances may have
prevented the auditor from getting enough evidence to be able to issue
an unqualified opinion. When the end user (a potential investor, for
example) sees this opinion, she knows she can’t rely on the information
in the financial report as much as she could if the auditor offered an
unqualified opinion. Qualified opinions are referred to as “except for”
opinions, because the language in the audit report often uses the phrase
“except for” to explain why the report is qualified.
✓ Adverse: As you can probably guess, an adverse opinion isn’t good! The
auditor issues an adverse opinion if the financial statements don’t present the client’s financial position, results of operations, and cash flows
in conformity with GAAP. This type of opinion is issued only when the
financial statements contain material departures from GAAP. (Book IV,
Chapter 1 defines materiality and how it applies to financial statements.
For now, just realize that what is material for one business may not be
material for another.)
✓ Disclaimer of opinion: This happens when the auditor can’t form an
opinion on a client’s financial statements. For example, a disclaimer may
be issued in cases when the auditor isn’t independent.
Book IX, Chapter 1 displays a standard unqualified audit opinion. That report
gives you some idea of the language used.
Part III: Identifying management
and corporate governance
Yippee! You’ve successfully navigated the more detailed parts of Form 10-K.
Heading toward the finish line, next up is a discussion of management and
governance. In this short section, the company lists its directors and executive officers — most likely with a reference back to Part I of Form 10-K (if that
section has already provided sufficient information).
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For example, Part III may read as follows: “See Item X in Part I of this report
for information regarding executive officers of the corporation.” Otherwise,
the company lists here each individual’s name, title/office, and any other
relevant information (such as whether the individual is associated with
another unrelated organization).
Now, what about corporate governance? Some of the issues corporate
governance addresses are ethical business behavior, responsibility for the
community in which the company operates, and equitable treatment of the
shareholders. For example, corporate governance demands full and fair
disclosure associated with the financial statements so investors can make
informed decisions. For a manufacturing company, this section may note that
it takes care not to pollute the drinking water of adjacent cities with illegal
dumping of factory runoff.
Most companies state that they have a Code of Business Conduct for both
employee and nonemployee directors. If the code isn’t included in Form 10-K,
the form will at least provide information as to where on the company
website this information resides. See Chapter 4 for more about corporate
governance.
Part IV: Exhibits, financial statement
schedules, and signature
This section merely lists the documents that are part of Form 10-K and gives
the exhibit number where each document can be found. This section can go
on interminably, listing such exhibits as “Exhibit No. 6.8.5: 2005 Stock Option
Plan of the Company: amended and restated through December 31, 2015.”
Pretty exciting stuff!
Finally, the last page contains the signature of the chairman of the board of
directors, the chief executive officer, the chief financial officer, the principal
accounting officer, all directors, and the attorney-in-fact (the individual holding power of attorney) attesting to the fact the report doesn’t contain any
untrue statement of a material fact or omit any necessary material facts.
Book VI
Planning and Budgeting for
Your Business
Managing inventory can boost profits. Discover various strategies for managing inventory cost-effectively by visiting www.dummies.com/extras/accountingaio
for free guidance.
In this book…
✓ Structure a business to attract capital and issue stock shares
to raise capital. Find out more about what potential investors
really want to see in a company’s financials.
✓ Choose the appropriate legal structure for a business —
sole-proprietorship, partnership, LLC, C-corp., S-corp., or
something else. The right legal structure provides valuable
legal protection and potential tax savings.
✓ Draft a business plan that increases your chances of securing
loan approval or attracting eager investors. Tell your company’s
growth story to prospective shareholders.
✓ Build a budget to help executives and managers make better
business decisions and boost their organization’s bottom line.
Budgeting not only keeps your business on track financially but
also helps inform spending decisions so you get the most bang
for your buck.
✓ Tweak your budget to accommodate different levels of production and other potential variables. Play “what-if” with different
production and product-development scenarios to plan production and sales and maximize profit.
✓ Get a handle on long-term debt to reduce interest and improve
cash flow. Make informed decisions about how much cash
your business needs to operate and how much of that cash
you’ll generate through debt.
Chapter 1
Incorporating Your Business
In This Chapter
▶ Structuring the business to attract capital
▶ Taking stock of the corporate legal structure
▶ Issuing and managing stock shares
T
he obvious reason for investing in a business rather than putting your
money in a safer type of investment is the potential for greater rewards.
Note the word potential. As an owner of a business, you’re entitled to your
fair share of its profit, as are the other owners. At the same time, you’re
subject to the risk that it could go down the tubes, taking your money with it.
Ignore the risks for a moment and look at just the rosy side of the picture:
Suppose the doohickeys that your business sells become the hottest products of the year. Sales are booming, and you start looking at buying a fivebedroom mansion with an ocean view. Don’t make that down payment just
yet — you may not get as big a piece of the profit pie as you’re expecting.
Some claims to that profit may rank higher than yours, and you may not see
any profit after all these claims are satisfied, because the way the profit is
divided among owners depends on the business’s legal structure. This
chapter shows how legal structure determines your share of the profit —
and how changes beyond your control can make your share less valuable.
Securing Capital: Starting with Owners
Every business needs capital. Capital provides money for the assets a business needs to manufacture products, make sales, and carry on operations.
Common examples of assets are the working cash balance a business needs
for day-to-day activities, products held in inventory for sale, and long-life
operating assets (buildings, machines, computers, office equipment,
and so on).
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Assume a typical business in your industry needs capital equal to one-half
of annual sales revenue. You would plan your financing efforts to raise that
amount of capital. Of course, this ratio varies from industry to industry.
Many manufactures need a high ratio of capital to sales, so they’re described
as being capital intensive.
One of the first questions that providers of business capital ask is how the
business entity is organized legally. That is, which specific form or legal
structure is the business using? The different types of business legal entities
present different risks and potential rewards to business capital providers.
Whatever its legal structure, a business gets the capital it needs from two basic
sources: debt and equity. Debt refers to the money borrowed by a business, and
equity refers to money invested in the business by owners plus profit earned and
retained in the business (instead of being distributed to its owners). No matter
which type of legal entity form it uses, every business needs a foundation of ownership (equity) capital. Owners’ equity is the hard-core capital base of a business.
In starting a new business from scratch, its founders typically must invest a lot
of sweat equity, which refers to the grueling effort and long hours to get the
business off the ground and up and running. The founders don’t get paid for
their sweat equity, and it doesn’t show up on the balance sheet.
Contrasting two sources of equity
Every business — regardless of how big it is, whether it’s publicly or privately
owned, and whether it’s just getting started or is a mature enterprise — has
owners. Virtually no business can get all the capital it needs by borrowing.
Your firm can obtain equity financing from two sources:
✓ Investors: Outside investors can provide the business with both start-up
and a continuing base of capital, or equity.
✓ Owners: The firms’ founders may provide their own capital in exchange
for equity.
Without the foundation of equity capital, a business wouldn’t be able to get
credit from its suppliers and couldn’t borrow money. As they say in politics,
the owners must have some skin in the game.
Considering what investors want
The equity capital in a business always carries the risk of loss to its owners.
So, what do the owners expect and want from taking on this risk? Their
expectations include the following:
✓ Share in profits: They expect the business to earn profit on their equity
capital in the business and to share in that profit by receiving cash
distributions from profit and from increases in the value of their
ownership shares, with no guarantee of either.
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✓ Participate in management: They may expect to directly participate in
the management of the business, or they may plan to hire someone else
to manage the business. In smaller businesses, an owner may be one of
the managers and may sit on the board of directors. In very large businesses, however, you’re just one of thousands of owners who elect a
representative board of directors to oversee the managers of the
business and protect the interests of the non-manager owners.
✓ Share in sales proceeds: Looking down the line to a possible sale of the
business or a merger with another business, they expect to receive a
proportionate share of the proceeds if the business is sold or to receive
a proportionate share of ownership when another company buys or
merges with the business. Or they may end up with nothing in the event
the business goes kaput and nothing’s left after paying off the creditors.
When owners invest money in a business, the accountant records the amount
of money as an increase in the company’s cash account. And, using doubleentry accounting, the amount invested in the business is recorded as an
increase in an owners’ equity. (See Book I, Chapter 2 to find out about doubleentry accounting.) Owners’ equity also increases when a business makes
profit. See Book IV, Chapter 2 for more on why earning profit increases the
amount of assets minus liabilities, which is called net worth, and how this
increase in net worth (due to profit) is balanced by recording the increase in
owners’ equity.
Dividing owners’ equity
Certain legal requirements often come into play regarding the minimum
amount of owners’ capital that a business must maintain for the protection
of its creditors. Therefore, the owners’ equity of a business is divided into
two separate types of accounts:
✓ Invested capital: This type of owners’ equity account records the
amounts of money that owners have invested in the business, which
could have been many years ago. Owners may invest additional capital
from time to time, but generally speaking they can’t be forced to put
additional money in a business (unless the business issues assessable
ownership shares, which is unusual). Depending on the legal form of the
entity and other factors, a business may keep two or more accounts for
the invested capital from its owners.
✓ Retained earnings: The profit a business earns over the years that has
been retained and not distributed to its owners is accumulated in the
retained earnings account. If all profit is distributed every year, retained
earnings has a zero balance. (If a business loses money, its accumulated
loss causes retained earnings to have a negative balance, which generally is called a deficit.) If none of the annual profits of a business are
distributed to its owners, the balance in retained earnings is the
cumulative profit the business has earned since it opened its doors
(net of any losses along the way).
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Whether to retain part or all of annual net income is one of the most important
decisions that a business makes; distributions from profit have to be decided
at the highest level of a business. A growing business needs additional capital
for increasing its assets, and increasing the debt load of the business usually
can’t supply all the additional capital. So, the business plows back some of its
profit for the year into the business, rather than distributing it to its owners.
In the long run, this may be the best course of action, because it provides
additional capital for growth.
Leveraging equity capital with debt
Leverage refers to the idea of using debt to add capital to your business.
Leverage is a good strategy if the company can generate more in earnings
than it pays in interest expense and fees on the debt. If a business is interested in leverage, the first consideration is how much of the balance sheet
should include debt.
Suppose a business has $10 million in total assets. ( You find assets in the balance sheet of a business — see Book IV, Chapter 3.) The balance sheet equation (in Book I, Chapter 1) is Assets less Liabilities equals Equity. $10 million
in total assets doesn’t mean that the company has $10 million of equity. You
have to subtract liabilities from assets to compute equity. Assuming the business has a good credit rating, it probably has some amount of trade credit
extended for purchases, which is recorded in the accounts payable liability
account (see Book IV, Chapter 4). Other kinds of operating liabilities may also
come into play. Suppose its accounts payable and other operating
liabilities total $2 million.
At this point, you’ve identified $10 million in total assets, less $2 million in
liabilities. That leaves $8 million to account for. The $8 million could
represent other liabilities. Some of the $8 million may be equity. In a sense,
you’re filling in the numbers in the balance sheet equation:
$10 million total assets – $2 million liabilities = $8 million to be identified
(either more liabilities or equity)
Some businesses depend on debt for more than half of their total capital. In
contrast, others have virtually no debt at all. You find many examples of both
public and private companies that have no borrowed money. But as a general
rule, most businesses carry some debt (and therefore, have interest expense).
The debt decision isn’t really an accounting responsibility as such; although
once the decision is made to borrow money, the accountant is very involved
in recording debt and interest transactions. Deciding on debt is the responsibility of the chief financial officer and chief executive officer of the business.
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In medium-sized and smaller businesses, the chief accounting officer
(controller) may also serve as the chief financial officer. In larger businesses,
two individuals hold the top financial and accounting positions.
The loan contract between a business and its lender may prohibit the business from distributing profit to owners during the period of the loan. Or the
loan agreement may require that the business maintain a minimum cash balance. Generally speaking, the higher the ratio of debt to equity, the more likely
a lender is to charge higher interest rates and insist on tougher conditions.
That’s because the lender has higher risk that the business may default on the
loan. A high debt-to-equity ratio means the company has more debt for every
dollar of equity.
When borrowing money, the president (or another officer in his or her
capacity as an official agent of the business) signs a note payable document
to the lender. In addition, the lender may ask the major investors in a smaller,
privately owned business to guarantee the note payable of the business
as individuals in their personal capacities — and it may ask their spouses to
guarantee the note payable as well. The individuals may endorse the note
payable, or a separate legal instrument of guarantee may be used.
The individuals promise to pay the note if the business can’t make payments.
You should definitely understand your personal obligations if you’re inclined
to guarantee a note payable of a business. You take the risk that you may
have to pay some part or perhaps the entire amount of the loan from your
personal assets if the business is unable to honor its obligation.
Recognizing the Legal Roots
of Business Entities
The U.S. legal system enables entities to be created for conducting business
activities. These entities are separate and distinct from the individual owners
of the business. Business entities have many of the rights of individuals; for
example, the rights to own property and enter into contracts. In starting
a business venture, one of the first tasks the founders must attend to is to
select the type of legal structure to use — which usually requires the services
of a lawyer who knows the laws of the state in which the business is
organized.
A business may have one or more owners. A one-owner business may choose
to operate as a sole proprietorship, a limited liability company, or a corporation; a multi-owner business must choose to be a partnership, a limited
liability company, or a corporation. The most common type of business is a
corporation (although the number of sole proprietorships would be larger
if part-time, self-employed people were included in this category). No legal
structure is inherently better than another; which one is right for a particular
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Book VI: Planning and Budgeting for Your Business
business is something that the business’s managers and founders need to
decide when starting the business. The following discussion focuses on the
basic types of legal entities that owners can use for their business.
Incorporating a Business
The law views a corporation as a real, live person. Like an adult, a corporation is treated as a distinct and independent individual who has rights and
responsibilities. (A corporation can’t be sent to jail, but its officers can be put
in the slammer if they’re convicted of using the corporate entity for carrying
out fraud.) A corporation’s “birth certificate” is the legal form that it files with
the Secretary of State of the state in which the corporation is created (incorporated). A corporation must also have a legal name. You’re not allowed to
use certain names, such as the State Department of Motor Vehicles. Consult a
lawyer when choosing a name for your corporation.
The corporate legal form offers several important advantages. A corporation has unlimited life; it stays alive until the shareowners vote to terminate
the entity. The ownership interests in a corporation, specifically the shares
of stock issued by the corporation, are generally transferable. You can sell
your shares to another person or bequeath them in your will to your grandchildren. You don’t need the approval of the other shareholders to transfer
ownership of your shares. Each ownership share typically has one vote in the
election of directors of a business corporation. In turn, the directors hire and
fire the key officers of the corporation. This provides a practical way to structure the management of a business.
Just as an adult child is an entity separate from his or her parents, a corporation is separate from its owners. For example, the corporation is responsible
for its own debts. Assuming you didn’t cosign for one of your parents’ loans,
the bank can’t come after you if your parents default on their loan, and the
bank can’t come after you if the corporation you invested money in goes
belly up. If a corporation doesn’t pay its debts, its creditors can seize only
the corporation’s assets, not the assets of the corporation’s owners.
This important legal distinction between the obligations of the business entity
and its individual owners is known as limited liability — that is, the limited liability of the owners. Even if the owners have deep pockets, they have no legal
exposure for the unpaid debts of the corporation (unless they’ve used the corporate entity to defraud creditors). The legal fence between a corporation and
its owners is sometimes called the “corporate shield” because it protects the
owners from being held responsible for the debts of the corporation. So when
you invest money in a corporation as an owner, you know that the most you
can lose is the amount you put in. You may lose every dollar you put in, but
the corporation’s creditors can’t reach through the corporate entity to grab
your assets to pay off the business’s liabilities. (But to be prudent, you should
check with your lawyer on this issue to be sure.)
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Issuing stock shares
When raising equity capital, a corporation issues ownership shares to people
who invest money in the business. These ownership shares are documented
by stock certificates, which state the name of the owner and the number of
shares. (An owner can be an individual, another corporation, or any other
legal entity.) The corporation has to keep a register of how many shares
everyone owns. Many public corporations use an independent agency to
maintain their ownership records. Stock shares are commonly issued in
book entry form, which means you get a formal letter (not a stock certificate)
attesting to the fact that you own so many shares. Your legal ownership is
recorded in the official books, or stock registry of the business.
The owners of a corporation are called stockholders because they own stock
shares issued by the corporation. The stock shares are negotiable, meaning
the owner can sell them at any time to anyone willing to buy them without
having to get the approval of the corporation or other stockholders. Publicly
owned corporations are those whose stock shares are traded in public markets, such as the New York Stock Exchange and NASDAQ.
The stockholders of a private business have the right to sell their shares,
although they may enter into a binding agreement restricting this right. For
example, suppose you own 20,000 of the 100,000 stock shares issued by
the business. You have 20 percent of the voting power in the business (one
share, in this case, has one vote). You may agree to offer your shares to the
other shareowners before offering the shares to someone outside the present
group of stockholders. Or you may agree to offer the business itself the right
to buy back the shares. In these ways, the continuing stockholders of the
business control who owns the stock shares of the business.
Offering different classes of stock shares
Before you invest in stock shares, you should ascertain whether the corporation has issued just one class of stock shares. A class is one group, or type, of
stock shares all having identical rights; every share is the same as every other
share. A corporation can issue two or more classes of stock shares. For example, a business may offer Class A and Class B stock shares, giving Class A
stockholders a vote in elections for the board of directors but not granting
voting rights to Class B stockholders.
State laws generally are liberal in allowing corporations to issue different
classes of stock shares. A whimsical example is that holders of one class
of stock shares could get the best seats at the annual meetings of the
stockholders. But whimsy aside, differences between classes of stock shares
are significant and affect the value of the shares of each class of stock.
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Common stock and preferred stock are two classes of corporate stock shares
that are fundamentally different. Here are two basic differences:
✓ Fixed dividend amount: Preferred stockholders are promised (though
not guaranteed) a certain amount of cash dividends each year, but the
corporation makes no such promises to its common stockholders.
(The company must generate earnings to pay any type of dividend,
including dividends on preferred stock.) Each year, the board of
directors must decide how much, if any, cash dividends to distribute
to its common stockholders.
✓ Claims on assets: Common stockholders have the most risk. A business
that ends up in deep financial trouble is obligated to pay off its liabilities
first and then its preferred stockholders. By the time the common stockholders get their turn to collect, the business may have no money left to
pay them. In other words, the common shareholders are last in line to
make a claim on assets.
Neither of these points makes common stock seem very attractive. But
consider the following points:
✓ Preferred stock shares are promised a fixed (limited) dividend per year
and typically don’t have a claim to any profit beyond the stated amount
of dividends. (Some corporations issue participating preferred stock,
which gives the preferred stockholders a contingent right to more
than just their basic amount of dividends. This topic is too technical to
explore further in this book.)
✓ Preferred stockholders may not have voting rights. They may not get to
participate in electing the corporation’s board of directors or vote on
other critical issues facing the corporation.
The advantages of common stock, therefore, are the ability to vote in corporation elections and the unlimited upside potential: After a corporation’s obligations to its preferred stock are satisfied, the rest of the profit it has earned
accrues to the benefit of its common stock. Although a corporation may
keep some earnings as retained earnings, a common stock shareholder may
receive a much larger dividend than a preferred shareholder receives.
Here are some important points to understand about common stock shares:
✓ Each stock share is equal to every other stock share in its class. This
way, ownership rights are standardized, and the main difference
between two stockholders is how many shares each owns.
✓ The only time a business must return stockholders’ capital to them is
when the majority of stockholders vote to liquidate the business in part
or in total. Otherwise, the business’s managers don’t have to worry about
stockholders withdrawing capital. If one investor sells common stock to
another shareholder, the company’s capital balance is unchanged.
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✓ A stockholder can sell his or her shares at any time, without the
approval of the other stockholders. The stockholders of a privately
owned business, however, may agree to certain restrictions on this right
when they first become stockholders in the business.
✓ Stockholders can put themselves in key management positions, or they
may delegate the task of selecting top managers and officers to the
board of directors, which is a small group of people selected by the
stockholders to set policies and represent stockholders’ interests.
Now don’t get the impression that if you buy 100 shares of IBM you can
get yourself elected to its board of directors. On the other hand, if you
have the funds to buy 100 million shares of IBM, you could very well get
yourself on the board. The relative size of your ownership interest is
key. If you put up more than half the money in a business, you can put
yourself on the board and elect yourself president of the business.
That may not be the most savvy business decision, but it’s possible.
The stockholders who own 50 percent plus one share constitute the
controlling group that decides who’s on the board of directors.
Note: The all-stocks-are-created-equal aspect of corporations is a practical
and simple way to divide ownership, but its inflexibility can be a hindrance.
Suppose the stockholders want to delegate to one individual extraordinary
power, or to give one person a share of profit out of proportion to his or her
stock ownership. The business can make special compensation arrangements
for key executives and ask a lawyer for advice on the best way to implement
the stockholders’ intentions. Nevertheless, state corporation laws require
that certain voting matters be settled by a majority vote of stockholders.
If enough stockholders oppose a certain arrangement, the other stockholders
may have to buy them out to gain a controlling interest in the business.
(The limited liability company legal structure permits more flexibility in
these matters.)
Determining market value of stock shares
When you consider selling your shares of stock in a company, you probably
want to know the market value of each of your shares. There’s a world of
difference between owning shares of a public corporation and owning shares
of a private corporation.
Public means an active market exists for the stock shares of the business; the
shares are liquid. You can convert your shares into cash in a flash by calling
your stockbroker or going online to sell them. You can check a daily financial
newspaper — such as The Wall Street Journal — for the current market prices
of many large publicly owned corporations. Or you can go to one of many
websites (such as finance.yahoo.com) that provide current market prices.
But stock shares in privately owned businesses aren’t publicly traded, so
you need to take a different approach to determine the value of your shares.
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Stockholders of a private business rarely worry about putting a precise
market value on their shares — until they’re serious about selling their shares
or something else happens that demands putting a value on the shares. When
you die, the executor of your estate has to put a value on the shares you own
for estate tax purposes. If you divorce your spouse, a value is needed for the
stock shares you own, as part of the divorce settlement. When the business
itself is put up for sale, a value is put on the business; dividing this value by
the number of stock shares issued by the business gives the value per share.
Other than during events like these, which require that a value be put on
the stock shares, the shareowners of a private business get along quite well
­without knowing a definite value of their shares. This doesn’t mean they have
no idea regarding the value of their business and what their shares are worth.
They read the financial statements of their business, so they know its profit
performance and financial condition. In the backs of their minds they should
have a reasonably good estimate regarding how much a willing buyer may
pay for the business and the price they would sell their shares for. So even
though they don’t know the exact market value of their stock shares, they’re
not completely in the dark about that value.
Generally speaking, the value of ownership shares in a private business
depends on the recent profit performance and the current financial condition
of the business, as reported in its latest financial statements. The financial
statements may have to be trued up, as they say, to bring some of the historical cost values in the balance sheet up to current replacement values.
For more about performing business valuations, see Book V, Chapter 1.
Business valuation is highly dependent on the specific circumstances of each
business. The present owners may be very eager to sell, and they may be willing to accept a low price instead of taking the time to drive a better bargain.
The potential buyers of the business may see opportunities that the present
owners don’t see or aren’t willing to pursue. Even Warren Buffett, who has a
well-deserved reputation for knowing how to value a business, admits that
he’s made some real blunders along the way.
Keeping alert for dilution of share value
Watch out for developments that cause a dilution effect on the value of your
stock shares — that is, that cause each stock share to drop in value.
Specifically, dilution means that your earnings per common stock share have
declined. If this earnings per share figure declines, investor interest in the
common stock also is likely to decline. The most basic level of measuring
earnings per share involves common stock, as explained in this section.
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Sometimes the dilution effect may be the result of a good business decision,
so even though your earnings per share decreases in the short term, the
long-term profit performance of the business (and, therefore, your value
of the common stock shares) may benefit. But you need to watch for these
developments closely. The following situations cause a dilution effect:
✓ Issuing additional shares: A business issues additional stock shares at
the going market value but doesn’t really need the additional capital —
the business is in no better profit-making position than it was before
issuing the new stock shares. For example, a business may issue new
stock shares in order to let a newly hired chief executive officer buy
them. The immediate effect may be a dilution in the value per share.
Total earnings are the same, but those earnings are spread over more
common stock shares. Over the long term, however, the new CEO may
turn the business around and lead it to higher levels of profit that
increase the stock’s value.
✓ Offering additional shares at a discount: A business issues new
stock shares at a discount below its stock shares’ current value. For
example, the business may issue a new batch of stock shares at a price
lower than the current market value to employees who take advantage
of an employee stock-purchase plan. Issuing stock shares — at any
price — has a dilutive effect on the market value of the shares. But in
the grand scheme of things, the stock-purchase plan may motivate its
employees to achieve higher productivity levels, which can lead to
superior profit performance of the business. Finally, keep in mind that
issuing shares at a discount means that you don’t raise as much capital for the business.
Now here’s one for you: The main purpose of issuing additional stock shares
is to deliberately dilute the market value per share. For example, a publicly
owned corporation doubles its number of shares by issuing a two-for-one
stock split. Each shareholder gets one new share for each share presently
owned, without investing any additional money in the business. As you would
expect, the market value of the stock drops in half — which is exactly the
purpose of the stock split. The lower stock price may attract more investors.
After all, 100 shares of a $20 stock cost less than 100 shares of a $40 stock.
Note that a stock split doesn’t change the total market value of the company.
When the number of shares is doubled in a two-for-one stock split, the value of
each share is cut in half. As a result, the total market value stays the same.
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Recognizing conflicts between
stockholders and managers
Stockholders are primarily concerned with the profit performance of the
business; the dividends they receive and the value of their stock shares
depend on it. Managers’ jobs depend on living up to the business’s profit
goals. But whereas stockholders and managers have the common goal of
optimizing profit, they have certain inherent conflicts of interest:
✓ Manager compensation: The more money that managers make in wages
and benefits, the less stockholders see in bottom-line net income.
Stockholders obviously want the best managers for the job, but they
don’t want to pay any more than they have to.
Most public business corporations establish a compensation committee
consisting of outside directors that sets the salaries, incentive bonuses,
and other forms of compensation of the top-level executives of the
organization. An outside director is one who has no management
position in the business and who, therefore, should be more objective
and shouldn’t be beholden to the chief executive of the business. This
scenario is good in theory, but it may not work out all that well in
practice — particularly if the top-level executive of a large public
business has the dominant voice in selecting the people to serve on its
board of directors. Being a director of a large public corporation is a
prestigious position, to say nothing of the annual fees that can be fairly
substantial at many corporations.
✓ Control over the business: The question of who should control the
business — managers who are hired for their competence and are
intimately familiar with the business, or stockholders who may have no
experience relevant to running this business but whose money makes it
tick — can be tough to answer. Ideally, the two sides respect each other’s
contributions to the business and use this tension constructively. Of
course, the real world is far from ideal, and in some companies, managers
control the board of directors rather than the other way around.
As an investor, be aware of these issues and how they affect the return on
your investment in a business. If you don’t like the way your business is run,
you can sell your shares and invest your money elsewhere. (However, if the
business is privately owned, there may not be a ready market for its stock
shares, which puts you between a rock and a hard place.)
Chapter 2
Choosing a Legal Structure
for a Business
In This Chapter
▶ Partnering with others in business
▶ Gaining legal protections with an LLC
▶ Looking out for number one in a sole proprietorship
▶ Considering the tax ramifications of your choices
F
orming a business can be easy as pie or extremely complicated, depending on the type of business entity being created. If you’re flying solo,
you’re a business unto yourself and really don’t need to do anything to establish yourself as a sole proprietorship. Unless you say otherwise, the IRS considers your business a sole proprietorship. With a little extra effort, you can
establish your business as a partnership, to share duties and profits among
owners, or create a limited liability company (LLC) to provide your business
with some extra legal protection. With a little more effort, and a lot more
paperwork, you can establish your business as a full-fledged corporation.
This chapter presents the ABCs of the three types of business entities: partnerships, LLCs, and corporations. First, you get a brief overview of sole proprietorships and partnerships. Then you find out all you need to know about
the different types of corporations — C corporations and S corporations —
and the tax considerations for each.
Differentiating between Partnerships
and Limited Liability Companies
Suppose you’re starting a new business with one or more other owners, but
you don’t want it to be a corporation. You can choose to create a partnership
or a limited liability company (LLC ), which are the main alternatives to the
corporate form of business.
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A partnership is also called a firm. You don’t see this term used to refer to a
corporation or limited liability company nearly as often as you do to a partnership. The term firm connotes an association of a group of individuals working
together in a business or professional practice.
Compared with the relatively rigid structure of corporations, the partnership and LLC forms of legal entities allow the division of management
authority, profit sharing, and ownership rights among owners to be very
flexible. The following sections highlight the key features of these two
legal structures.
Partnerships
Partnerships avoid the double-taxation feature that corporations are subject
to (see “Choosing the Right Legal Structure for Income Tax,” later in this
chapter for details), because all profits and losses “pass through” the business to its partners. Partnerships also differ from corporations with respect
to owners’ liability:
✓ General partners are subject to unlimited liability. If a business can’t pay
its debts, its creditors can reach into general partners’ personal assets.
General partners have the authority and responsibility to manage the
business. They’re roughly equivalent to the president and other highlevel managers of a business corporation. The general partners usually
divide authority and responsibility among themselves, and often they
elect one member of their group as the senior general partner or elect a
small executive committee to make major decisions.
✓ Limited partners escape the unlimited liability that the general partners
have hanging around their necks. Limited partners aren’t responsible,
as individuals, for the liabilities of the partnership entity. These junior
partners have ownership rights to the business’s profit, but they don’t
generally participate in the high-level management of the business. A
partnership must have one or more general partners; not all partners
can be limited partners.
Many large partnerships copy some of the management features of the corporate
form — for example, a senior partner who serves as chair of the general
partners’ executive committee acts in much the same way as the chair of
a corporation’s board of directors.
In most partnerships, an individual partner can’t sell his interest to an outsider without the consent of all the other partners. You can’t just buy your
way into a partnership; the other partners have to approve your joining the
partnership. In contrast, you can buy stock shares and thereby become part
owner of a corporation without the approval of the other stockholders.
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Limited liability company (LLC)
The LLC is an alternative type of business entity. An LLC is like a corporation
regarding limited liability, and it’s like a partnership regarding the flexibility
of dividing profit among the owners. An LLC can elect to be treated either as
a partnership or as a corporation for federal income tax purposes. Consult a
tax expert if you’re facing this choice.
The key advantage of the LLC legal form is its flexibility, especially regarding
how profit and management authority are determined. For example, an LLC
permits the founders of the business to put up, say, only 10 or 20 percent of
the money to start a business venture but to keep all management authority
in their hands. The other investors share in profit but not necessarily in
proportion to their invested capital.
LLCs have a lot more flexibility than corporations, but this flexibility can have
a downside. The owners must enter into a very detailed agreement that spells
out the division of profit, the division of management authority and responsibility, their rights to withdraw capital, and their responsibilities to contribute
new capital as needed. These schemes can get very complicated and difficult
to understand, and they may end up requiring a lawyer to untangle them. If
the legal structure of an LLC is too complicated and too far off the beaten
path, the business may have difficulty explaining itself to a lender when
applying for a loan, and it may have difficulty convincing new shareholders
to put capital into the business.
Limiting liability: Professional
corporations and LLPs
Professional partnerships — physicians, CPAs, lawyers, and so on — may choose
to become professional corporations (PCs), which are a special type of legal structure that state laws offer to professionals who otherwise would have to operate
under the specter of unlimited partnership liability. States also permit limited
liability partnerships (LLPs) for qualified professionals (such as doctors, lawyers,
CPAs, and dentists), in which all the partners have limited liability.
These types of legal entities were recently created in reaction to large
damage awards in malpractice lawsuits against partners. The professionals
pleaded for protection from the unlimited liability of the partnership form
of organization, which they had traditionally used. Until these types of legal
entities came along, the code of professional ethics of the various professions
required that practitioners operate as a partnership (or as sole practitioners/
proprietors). Today, almost all professional associations are organized as
PCs or LLPs. They function very much as partnerships do but without the
unlimited liability feature, which is like having the best of both worlds.
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Understanding how partnerships
and LLCs distribute profits
A partnership treats salaries paid to partners (at least to its general partners)
as distributions from profit. In other words, profit is determined before the
deduction of partners’ salaries. LLCs are more likely to treat salaries paid to
owner-managers as an expense (as a corporation does). Accounting for compensation and services provided by the owners in an LLC and the partners in
a partnership gets rather technical and is beyond the scope of this book.
The partnership or LLC agreement specifies how to divide profit among the
owners. Whereas owners of a corporation receive a share of profit directly
proportional to the number of common stock shares they own, a partnership or LLC doesn’t have to divide profit according to how much each owner
invested. Invested capital is only one of three factors that generally play into
profit allocation in partnerships and LLCs:
✓ Treasure: Owners may be rewarded according to how much of the treasure — invested capital — they contributed. So if Jane invests twice as
much as Joe, her cut of the profit may be twice as much as his.
✓ Time: Owners who invest more time in the business may receive more
of the profit. Some partners or owners, for example, may generate more
billable hours to clients than others, and the profit-sharing plan reflects
this disparity. Some partners or owners may work only part-time, so the
profit-sharing plan takes this factor into account.
✓ Talent: Regardless of capital and time, some partners bring more to the
business than others. Maybe they have better business contacts, or
they’re better rainmakers (they have a knack for making deals happen),
or they’re celebrities whose names alone are worth a special share of
the profit. However their talent impacts the business, they contribute
much more to the business’s success than their capital or time suggests.
A partnership needs to maintain a separate capital (ownership) account for
each partner. The total profit of the entity is allocated into these capital
accounts, as spelled out in the partnership agreement. The agreement also
specifies how much money each partner can withdraw from his or her capital
account. For example, partners may be limited to withdrawing no more than
80 percent of their anticipated share of profit for the coming year, or they may
be allowed to withdraw only a certain amount until they’ve built up their capital accounts. The capital that remains in the partnership is used to operate
the business.
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Going It Alone: Sole Proprietorships
A sole proprietorship is basically the business arm of an individual who
decides not to do business as a separate legal entity (as a corporation,
partnership, or LLC). It’s the default when you don’t establish a legal entity.
Describing a sole proprietorship
A sole proprietorship isn’t a separate entity; it’s like the front porch of a
house — attached to the house but a separate and distinct area. You may
be a sole proprietor of a business without knowing it! An individual may do
house repair work on a part-time basis or be a full-time barber who operates
on his own. Both are sole proprietorships. Anytime you regularly provide
services for a fee, sell things at a flea market, or engage in any business activity whose primary purpose is to make profit, you’re a sole proprietor. If you
carry on business activity to make profit or income, the IRS requires that you
file a separate Schedule C “Profit or Loss From Business” with your annual
individual income tax return. Schedule C summarizes your income and
expenses from your sole proprietorship business.
Understanding liability and
financial reporting
As the sole owner (proprietor), you have unlimited liability, meaning that if
your business can’t pay all its liabilities, the creditors to whom your business
owes money can come after your personal assets. Many part-time entrepreneurs may not know this or may put it out of their minds, but this is a big risk
to take. Some part-time business consultants operate their consulting businesses as sole proprietorships. If they’re sued for giving bad advice, all their
personal assets are at risk — though they may be able to buy malpractice
insurance to cover these losses.
Obviously, a sole proprietorship has no other owners to prepare financial
statements for, but sole proprietors should still prepare these statements to
know how their businesses are doing. Banks usually require financial statements from sole proprietors who apply for loans.
One other piece of advice for sole proprietors: Although you don’t have to
separate invested capital from retained earnings as corporations do, you
should still keep these two separate accounts for owners’ equity — not only
for the purpose of tracking the business but also for the benefit of any future
buyers of the business.
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Choosing the Right Legal Structure
for Income Tax
When deciding which type of legal structure is best for securing capital and
managing their business, owners should also consider the income tax factor.
They should know the key differences between the two alternative kinds of
business entities from an income tax point of view:
✓ Taxable-entity, C corporations: These corporations are subject to
income tax on their annual taxable income. Plus, their stockholders pay
a second income tax on cash dividends that the business distributes to
them from profit, making C corporations and their owners subject to
double taxation. The owners (stockholders) of a C corporation include
in their individual income tax returns the cash distributions from the
after-tax profit paid to them by the business.
✓ Pass-through entities — partnerships, S corporations, and LLCs:
These entities don’t pay income tax on their annual taxable income;
instead, they pass through their taxable income to their owners, who
pick up their shares of the taxable income on their individual tax
returns. Pass-through entities still have to file tax returns with the IRS,
even though they don’t pay income tax on their taxable income. In their
tax returns, they inform the IRS how much taxable income is allocated
to each owner, and they send each owner a copy of this information to
include with his or her individual income tax return.
Most LLCs opt to be treated as pass-through entities for income tax purposes.
But an LLC can choose instead to be taxed as a C corporation and pay income
tax on its taxable income for the year, with its individual shareholders paying a
second tax on cash distributions of profit from the LLC. Why would an LLC
choose double taxation? Keep reading. The following sections explain the differences between the two types of legal structures in terms of income taxes. These
examples assume that the business uses the same accounting methods in preparing its income statement that it uses for determining its taxable income — a
realistic assumption, though there are many technical exceptions to this general
rule. To keep this discussion simple, the examples focus on differences in federal income tax, which is much larger than any state income tax that may apply.
C corporations
A corporation that doesn’t qualify as an S corporation (explained in the next
section) or that doesn’t elect this alternative if it does qualify, is referred to as
a C corporation in the tax law. A C corporation is subject to federal income tax
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based on its taxable income for the year, keeping in mind that a host of special
tax credits (offsets) could reduce or even eliminate the amount of income tax
a corporation has to pay. Suppose a business is taxed as a C corporation. Its
abbreviated income statement for the year just ended is shown in Figure 2-1.
(See Book IV, Chapter 2 for more about income statements.)
Figure 2-1:
Abbreviated
annual
income
statement
for a C
corporation.
Book VI
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Given the complexity and changing nature of the income tax law, the following
discussion avoids going into details about income tax form numbers and the
income tax rates used to determine the income tax amounts in each example.
By the time you read this section, the tax rates probably will have changed,
but the following discussion does use realistic income tax numbers.
Refer to the C corporation income statement example again (Figure 2-1).
Based on its $2.2 million taxable income for the year, the business owes
$748,000 income tax — assuming a 34 percent tax rate for this level of corporate taxable income. (Most of the annual income tax should have been paid in
installments to the IRS before year-end.) The income tax is a big chunk of the
business’s hard-earned profit before income tax. Finally, don’t forget that net
income means bottom-line profit after income tax expense.
Being a C corporation, the business pays $748,000 income tax on its profit
before tax, which leaves $1,452,000 net income after income tax. Suppose
the business distributes $500,000 of its after-tax profit to its stockholders
as their just rewards for investing capital in the business. The stockholders
include the cash dividends as income in their individual income tax returns.
Assuming that all the individual stockholders have to pay income tax on this
additional layer of income, as a group they would pay $75,000 in income tax
to Uncle Sam (based on a 15 percent rate on corporate dividends).
A business corporation isn’t legally required to distribute cash dividends, even
when it reports a profit and has good cash flow from its operating activities.
But paying zero cash dividends may not go over well with all the stockholders.
If you’ve persuaded your Aunt Hilda and Uncle Harry to invest some of their
money in your business, and if the business doesn’t pay any cash dividends,
they may be very upset.
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S corporations
A business that meets the following criteria (and certain other conditions)
can elect to be treated as an S corporation:
✓ It has issued only one class of stock.
✓ It has 100 or fewer people holding its stock shares.
✓ It has received approval for becoming an S corporation from all its
stockholders.
Suppose that the business example presented in the previous section qualifies
and elects to be taxed as an S corporation. Its abbreviated income statement
for the year is shown in Figure 2-2. An S corporation pays no income tax itself,
as you see in this abbreviated income statement. But it must allocate its $2.2
million taxable income among its owners (stockholders) in proportion to the
number of stock shares each owner holds. If you own one-tenth of the total
shares, you include $220,000 of the business’s taxable income in your individual income tax return for the year regardless of whether you receive any cash
distribution from the profit of the S corporation. That’s likely to push you into
a high income tax rate bracket.
Figure 2-2:
Abbreviated
annual
income
statement
for an S
corporation.
©John Wiley & Sons, Inc.
Considering the pros and cons
When its stockholders read the bottom line of this S corporation’s annual
income statement, it’s a good news/bad news thing. The good news is that
the business made $2.2 million net income and doesn’t have to pay any corporate income tax on this profit. The bad news is that the stockholders must
include their respective shares of the $2.2 million on their individual income
tax returns for the year.
The total amount of individual income tax that would be paid by the stockholders as a group is tough to pin down. Each investor’s tax situation is different. An S corporation could distribute cash dividends to its stockholders,
which would provide them with the money to pay the income tax on their
shares of the company’s taxable income.
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Choices regarding taxation
The main tax question concerns how to minimize the overall income tax
burden on the business entity and its stockholders. Should the business be
an S corporation (assuming it qualifies) and pass through its taxable income
to its stockholders, which generates taxable income to them? Or should the
business operate as a C corporation (which always is an option) and have its
stockholders pay a second tax on dividends paid to them in addition to the
income tax paid by the business?
Here’s another twist: In some cases, stockholders may prefer that their S
corporation not distribute any cash dividends. They’re willing to finance the
growth of the business by paying income tax on the taxable profits of the
business — without taking a distribution from the S corporation. This strategy relieves the business of making cash distributions to pay the income tax.
Many factors come into play in choosing between an S and C corporation.
Choosing the best option isn’t easy. Consult a CPA or other tax professional
before making your final decision.
Partnerships and LLCs
The LLC type of business entity borrows some features from the corporate
form and some features from the partnership form. The LLC is neither fish
nor fowl; it’s an unusual blending of features that have worked well for many
business ventures. A business organized as an LLC has the option to be a
pass-through tax entity instead of paying income tax on its taxable income.
A partnership doesn’t have an option; it’s a pass-through tax entity by virtue
of being a partnership.
Following are the key income tax features of partnerships and LLCs:
✓ Pass-through tax entity: A partnership is a pass-through tax entity, just
like an S corporation.
When two or more owners join together and invest money to start a
business and don’t incorporate and don’t form an LLC, the tax law treats
the business as a de facto partnership. Most partnerships are based on
written agreements among the owners, but even without a formal, written agreement, a partnership exists in the eyes of the income tax law
(and in the eyes of the law in general).
✓ Making a choice: An LLC has the choice between being treated as a
pass-through tax entity and being treated as a taxable entity (like a C
corporation). All you need to do is check off a box in the business’s tax
return to make the choice. Many businesses organize as LLCs because
they want to be pass-through tax entities (although the flexible structure of the LLC is also a strong motive for choosing this type of legal
organization).
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The partners in a partnership and the shareholders of an LLC pick up their
shares of the business’s taxable income in the same manner as the stockholders of an S corporation. They include their shares of the entity’s taxable income in their individual income tax returns for the year. For example,
suppose your share of the annual profit as a partner, or as one of the LLC’s
shareholders, is $150,000. You include this amount in your personal income
tax return.
Summing up the legal structure issue
Choosing the best legal structure for a business is a complicated affair that
goes beyond just the income tax factor. You need to consider many other factors, such as the number of equity investors who will be active managers in
the business, state laws regarding business legal entities, ease of transferring
ownership shares, and so on. After you select a particular legal structure,
changing it later isn’t easy. Asking the advice of a qualified professional is
well worth the money and can prevent costly mistakes.
Sometimes the search for the ideal legal structure that minimizes income tax
and maximizes other benefits is like the search for the Holy Grail. Business
owners shouldn’t expect to find the perfect answer — they have to make
compromises and balance the advantages and disadvantages. In its external
financial reports, a business has to make clear which type of legal entity it is.
The type of entity is a very important factor to the lenders and other creditors of the business, and to its owners of course.
One other thing bears mentioning here. In this Internet age, many people
form their own entities, whether it be a corporation or an LLC, through the
assistance of online software and websites, with the assumption that they
now have the limited liability asset protection afforded that entity. However,
forming an entity and keeping it legal can be a complex task, and every state
has different rules. One little misstep can make it easy for the corporate
shield to be pierced in the event of a lawsuit. Hire a competent business
attorney to make sure you’re protected. Consider it a form of insurance.
Chapter 3
Drawing Up a Business
Plan to Secure Cash
In This Chapter
▶ Examining the four basic parts of a business plan
▶ Creating a business plan, from idea through development
▶ Including reliable third-party info in your business plan
▶ Remembering to use data that’s complete, accurate, reliable, and timely
W
hether a business is a start-up or a mature operation, a clear and concise business plan is an essential tool to assist businesses with securing cash, managing their operations, and protecting their interests.
This chapter provides the basic understanding and tools needed to develop a
viable business plan, which is translated into economic value via the production of financial forecasts and projections. The planning process described
in this chapter includes numerous elements. This chapter discusses obtaining current market information (on the potential demand for a new product
and what price the market will support) and evaluating personnel resources
(to ensure that proper professionals are available to support a business).
Another issue addressed is determining how great operational constraints
(such as manufacturing space availability or environmental regulations) may
be in terms of expanding into a new location.
Outlining the Basic Business Plan
All too often companies proceed with strategies anchored in the past instead
of evaluating and investigating the markets in which they operate and looking
to the future. Management’s reason for doing something a certain way often
sounds like this: “We’ve always done it like that” or “This is how the industry
has operated for the past umpteen years.” Developing a business plan
compels management to be more future focused.
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A solid business plan should represent management’s foundation and justification for birthing, growing, operating, and/or selling a business based on
present economic and market conditions and future projections. Without a
solid plan, a business is destined to operate by trial and error — an approach
that often leads to failure.
Business plans come in a variety of shapes, sizes, forms, and structures and
often take on the characteristics of the business founder(s). It may resemble
its creators by emphasizing certain traits or areas of expertise the founders
have. For instance, a type-A personality may use a number of bold adjectives
to describe the massive, huge, unlimited, exceptional potential of a future
market opportunity. As for unique areas of expertise, different sections of
the business plan may be developed in depth, whereas other sections may
be presented in quasi-summary format because the needed information isn’t
readily available (for presentation).
Herein lies the first lesson of developing a business plan: The business plan
should be built from the outside looking in so that any reasonable party can
clearly and quickly understand the business concept.
The business plan can come in a multitude of formats and include all types
of information, data, graphs, charts, analyses, and more. The basis of every
business plan, however, is in four main sections, as explained in the
following sections.
The executive summary
The executive summary is a brief overview of the business concept in terms
of the market opportunity, the operational logistics required to bring a product and/or service to market, the management team that’s going to make it
happen, the amount of capital needed to execute the plan, and the potential
economic return. This section of the business plan is really nothing more than
a condensed summary of the entire business concept, presented in a neat and
tidy overview of five pages or (hopefully) fewer. The general idea is that the
executive summary should capture the critical content of each of the three
primary areas of the business plan in an efficient and easy to digest manner.
Although the meat of the business plan resides in the remainder of the
document, this section is the most critical in terms of attracting interest from
capital sources and/or management. The reader of the business plan must
be able to conceptualize, understand, and justify the business concept from
the information presented in the executive summary. This section must gain
the reader’s interest, generate some type of excitement, and move him with
a sense of urgency to pursue the business opportunity at hand.
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Although the executive summary is the first section of the business plan,
consider writing it last, so you can draw information from the other sections
of the plan. If you write it first, you’re probably going to need to rewrite it
later to make it consistent with information in the remaining sections.
The market assessment
The market assessment substantiates the present or future need for a product
or service that’s not being met in the current marketplace. Although this section of the business plan isn’t necessarily more important than the others,
it takes precedence because without a market for the product or service, a
business has no reason to provide it.
You support the business concept by quantifying the size of the market
in coordination with qualifying the market need, but that step is only
half the battle (and often the easier of the two halves). Beyond providing
information and supporting data on the market size, characteristics, and
trends, the market assessment must also present a clear understanding
of the business’s competitive niche, target market, and specific marketing
strategies. Identifying the specific niche and target market and developing
an effective marketing strategy to capitalize on the opportunity present is
often more challenging and critical to the future success of the business
venture. And to top it all off, locating reliable and meaningful data
essential to supporting your conclusions on the market opportunity
can often be difficult.
All marketing sections should include a summary of the competition that
savvy entrepreneurs or business managers can use to their advantage in
several ways:
✓ By including an overview of the competition, the business establishes
credibility with the readers (because it indicates that you’ve done your
homework).
✓ By reading in-depth competitor assessments, managers may identify
weaknesses in competitors’ plans that can be exploited.
✓ By evaluating competitors’ strengths and weaknesses, managers can
better understand business risks.
For more about competitive analysis, check out Competitive Intelligence For
Dummies by Jim Underwood (Wiley).
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The operational overview
Following the market segment of the business plan is a well-developed
company operating overview. This segment of the business plan addresses
a number of operational issues, including personnel requirements, technological needs, locations (for offices, production/manufacturing, warehouses/
distribution centers, and so on), company infrastructure requirements,
international considerations, professional/expert counsel resources, and the
like. This segment drives various business-operating elements in terms of the
resources needed to implement and execute the business plan. For example,
if a company is planning on expanding into new foreign markets where the
local government still “influences” the distribution channels, then the operating segment needs to address how the product will be distributed and which
international partners will be essential to the process.
Business plans often dedicate a large portion of the operational overview
to providing an overview of the management team. The overview covers
the members’ past credentials as well as their responsibilities with the new
business concept. The market may be ripe and capital plentiful, but without
a qualified management team, the business concept will sink more times
than not. In today’s challenging economic environment, management qualifications and credibility have taken on an entirely new level of importance,
given the heightened sensitivity to management accountability and
transparency.
The management team responsible for executing the business plan is a key
component of the business plan. Initially, financing and capital sources are
lured in by business plans and may turn over any concept in the plan to a
slew of professionals for further due diligence, reviews, evaluations, and critique. For example, if a capital source has concerns over the technological
basis within a biomedical company, then medical- or technology-based professionals can be brought in to complete additional research and analysis
and either approve or dismiss the idea. However, the management team
standing behind the business plan and its execution is really what the capital
and financing sources invest in. The integrity, experience, determination,
passion, commitment, and competence of the management team are of
utmost importance. Any weakness in this area is likely to drive away
investors and their capital.
The financial summary: Performance
and required capital
In a sense, the financial summary brings all the elements of the business plan
together from an accounting and financing perspective. In the financial summary, financial forecasts project the anticipated economic performance of
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the business concept based on the information and data presented earlier in
the business plan:
✓ The market segment drives the revenue portion of the forecasts,
because the information accumulated and presented there substantiates
items such as potential unit sales growth (in relation to market size),
pricing, and revenue sources by product and service.
✓ The operational overview drives the expense element of the forecast,
because it addresses the business cost structure in terms of personnel,
assets, company infrastructure, and so on.
You can look at the financial summary as a projected financial report that
includes a forecasted income (profit and loss) statement, balance sheet, and
cash flow statement. All this information quantifies the capital required to
execute the business plan.
Developing a Business Plan
Accounting is more art than science, especially when it comes to developing
a business plan. Nobody can tell you precisely what to put into your business
plan, but the following sections provide valuable guidance and tools
to explain the process and get you started.
Business plans shouldn’t be reserved for new companies just starting out or
an existing business looking at launching new products. All companies should
implement formal business-planning processes to ensure that their business
interests are properly managed and protected.
Recognizing the evolution of business
plans: BOTE, WAG, and SWAG
The real start of developing any business plan is coming up with the initial
concept, idea, or thought. Over time, the plan evolves usually in line with
the following progression:
✓ BOTE: Back of the envelope
✓ WAG: Wild-ass guess
✓ SWAG: Scientific wild-ass guess
These acronyms on developing business plans and projections are presented
somewhat in jest, but at the same time, they do help you understand the
evolution of a business plan and projection model from how an idea is
born to how it’s communicated in financial language to various parties.
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Whether you apply these acronyms and follow this logic or rely on another
creation and development cycle, the same key concept holds. Business plans
and projection models should continue to evolve, improve, and strengthen
over time as more and more effort is invested to bring the idea to life.
BOTE
BOTE usually represents the very first financial projection developed for a
business plan: back of the envelope (or back of a napkin at a restaurant). Yes,
even the majority of the most astute and experienced business professionals and entrepreneurs can attest to jotting down the basic concepts, needs,
potential sales, costs, and profits of a business idea or concept on a random
piece of paper (or with a simple mobile communication device application).
Sometimes you need to get it out of your head and down in writing just to
see whether it makes any sense to begin with. You’d be amazed at how often
BOTE estimates are used.
WAG
If the idea passes the BOTE test, the next step in the evolution of the planning
process is the ever-present WAG (or wild-ass guess). The WAG is somewhat more
sophisticated than the BOTE in that it tends to incorporate more thought and
some basic research. WAGs are usually produced by using software tools such
as Microsoft Excel and incorporate the basic economic structure of the business,
starting with sales and then moving through the remainder of the income statement by capturing costs of sales, operating expenses, and overhead or general
and administrative costs. You can then draw two simple conclusions:
✓ How profitable the idea will be
✓ More importantly, how much capital or cash the idea needs in order to
achieve success
These conclusions aren’t overly sophisticated, but they’re an early attempt
to assign numbers to the idea.
SWAG
If your idea has passed both the BOTE and WAG stages, congratulations
are in order because you now can use the much more powerful tool, SWAG
(scientific wild-ass guess) to further the development of your business plan.
In other words, the business plan and supporting projection model are actually getting some serious attention and logical consideration. You can begin
to use external sources (or third-party data/information) to actually start to
substantiate and corroborate the idea’s potential. The first real form to the
business plan and projection models are taking shape. You may be incorporating the use of technology tools to draft the business plan (for example,
Microsoft Word), to build version 1.0 of the projection model (perhaps with
Microsoft Excel), and to begin to prepare a presentation to summarize the
plan (for example, with Microsoft PowerPoint).
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Getting the process going
After the business’s executive management teams or new company founders have decided that the concept for the new business endeavor has merit
(which is by no means a small task), you can begin drafting the business
plan. You can prepare a draft by following four simple steps:
1. Delve into historical business information. In order to start the budgeting process, you should have a good understanding of your company’s
prior financial and operating results. Review as much history as is available and relevant to the current idea, whether it stretches back three
months, one year, five years, or longer. Of course if you’re planning an
entirely new business, the availability of internal historical information
is limited, but plenty of external information is usually available from
similar businesses.
Remember that although the history of a company may provide a basic
foundation on which to develop a budget, by no means is it an accurate
predictor of the future.
2. Involve key management. You must ensure that all key management
team members are involved in the planning process, covering all critical
business functions, to produce a reliable projection. The accounting and
financial departments actively participate in the planning (and rightfully so, as these are the people who understand the numbers the best)
and they produce the final forecast. Critical business data comes from
numerous parties and sources, and all of that data must be included in
the planning process to produce the most reliable projections possible.
3. Gather reliable data. The availability of quality market, operational, and
accounting data represents the basis of the budget. A good deal of this
data often comes from internal sources. For example, salespeople may
pick up on customer needs that aren’t being met in the marketplace or
a company executive may hear about pending legislation that’s likely to
lead to new opportunities. With this information and some research, you
can begin to determine sales volumes, personnel levels, wages rates,
commission plans, and so on.
The internal information is certainly of value, but it represents only
half of what you need, because external information and data are just
as critical. Having access to quality and reliable external third-partyproduced information is absolutely essential to the overall business
planning process and the production of reliable forecasts. Market
forces and trends that aren’t apparent in internal data may be occurring and set to impact your new business, product, or service over the
next 24 months. (For more about gathering information from external
sources, see “Incorporating Third-Party Information into Your Plan”
later in this chapter.)
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4. Coordinate the start of the planning process. Most companies tend to
start the planning process for the next year in the fourth quarter of their
current calendar year. This way, they have access to recent financial
results on which to support the budgeting process moving forward.
The closer the date of the financial data is to when the projection is made,
the more detailed the information and results being produced. If you prepare a budget for the coming fiscal year, then you can reasonably include
monthly financial statement forecasts (with more detailed support available). Looking two or three years out, you can produce quarterly financial
statement projections (with more summarized assumptions), and so on.
When preparing your company’s budgets, try to use information that’s as
complete, accurate, reliable, and timely as possible. Though you can’t be 100
percent sure about the data and information gathered for your plan (because
by definition, you’re attempting to predict the future with a projection), with
proper resources (including appropriate internal management, external subject-matter experts or consultants, and allocating financial resources to secure
critical information that’s not readily available or free), you can avoid large
information “black holes.”
What worked two years ago may not provide management with the necessary
information today on which to make appropriate business decisions. Just ask
any retailer that formerly relied on brick-and-mortar stores and print-based
advertising campaigns how the Internet and e-commerce have reshaped their
business models. Although management has put forth the effort to restructure
the company’s operations in a changing market environment, a plan based on
an old projection model with outdated assumptions doesn’t capture the
essence of the new market realities. Remember, the planning process represents a living, evolving thing that must constantly be updated and adapted to
changing market conditions.
Analyzing and streamlining information
with SWOT and KISS
If you’re not careful, the data-accumulation process can engulf the entire
planning effort. And if you get too much data, you can’t digest it or draw any
type of meaningful conclusion. Fortunately two simple but powerful planning
tools are available to make sense of the data and present it in an easily accessible format: SWOT and KISS.
The SWOT analysis
Strengths, weaknesses, opportunities, and threats: A SWOT analysis is an effective planning and budgeting tool used to keep businesses focused on critical
issues that may lead to wonderful successes or horrible failures. The SWOT
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analysis should be as comprehensive as possible and capture both relevant
information for the specific idea as well as incorporating more broad-based data
about the company, the industry, and the competition. The simple SWOT analysis (or matrix) in Figure 3-1 provides a better understanding of how it works.
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Figure 3-1:
A simple
SWOT
analysis.
©John Wiley & Sons, Inc.
A SWOT analysis is usually broken down into a matrix containing four
segments. Two of the segments are geared toward positive attributes (for
instance, a company’s strengths and its opportunities) and two are geared
toward negative attributes (weaknesses and threats). In addition to illustrating these categories, Figure 3-1 makes reference to the terms internal
versus external. This distinction highlights the fact that certain attributes
tend to come from internal company sources (namely, strengths and weaknesses) and other attributes from external sources (typically opportunities
and threats).
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Used correctly, a SWOT analysis not only provides invaluable information to
support the planning process but also (and more importantly) helps identify
the type of management a business has in place. The success of any business
plan hinges on having the right leaders driving the bus to take the opportunity
from a concept to reality. A frontline manager in need of direction can assist
with this process but generally isn’t qualified to lead. You need a bona fide
businessperson to lead the charge.
A variety of different parties may conduct SWOT analysis. In a larger or wellestablished business, the management team assigned to complete a project
or pursue an opportunity may take the lead. The SWOT analysis is then evaluated and interpreted by the company’s executives, who consider whether
it’s viable and whether the right people are in place. On the other hand, two
founders just starting a business may complete a SWOT analysis. When the
SWOT is complete, company executives may ask a third-party consultant to
review the document. An outside expert can provide management with an
unbiased view on whether the analysis is realistic.
Remember to KISS
You know what KISS stands for: Keep it simple, stupid. Used in the marketing world for years, the concept of KISS also applies to business plans. When
developing a business plan, be as clear and direct as possible. Summarize the
data, use images and graphs wherever necessary to illustrate points, and present clear directives for moving forward. And follow the credo “When in doubt,
leave it out.” That is, if information isn’t essential to making a point, omit it.
Don’t make the end user of the business plan sift through it to extract meaning.
If you’re an executive or owner of a business, you must be able to understand the
big picture and the key economic drivers of your company’s success in order to
prepare proper business plans, strategies, and, ultimately, forecasts. The ability
to understand and positively affect the key economic drivers of your business
and empower the management team to execute the business plan represents the
end game. Getting lost in excessive amounts of detail (“Why did you spend an
extra $500 on the trip to Florida?”) generally isn’t the best use of senior management’s time, because every level of detail adds more and more complexity to the
plan, which can get overwhelmed with TMI (too much information).
Incorporating Third-Party Information
into Your Plan
When building reliable and credible business plans, don’t underestimate the
importance of accumulating data and information from reliable independent
third parties (including various trade and industry sources). The following
sections explain how and where to gather the information you need and the
importance of starting with solid data.
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Gathering the info
Not so long ago, valuable third-party market, industry, and technological
information was gathered via archaic methods such as researching in a
library, subscribing to trade journals and magazines, and attending seminars or educational trade shows. Today, most of the information you need is
available electronically over the World Wide Web, which has improved the
efficiency of accumulating information significantly. Most industries’ trade
organizations now regularly produce and provide content via the web, but
you have to be prepared to pay for it, because reliable information costs
money.
Incorporate trade shows, seminars, and educational events into your efforts
to accumulate third-party data. These events can not only offer a great source
of information, but also (and potentially more importantly) be places to make
contacts with potential future employees, vendors, customers, and funding
sources that can assist with the execution of the business plan.
The third-party information you gather should cover multiple aspects of
your business. Following are three examples of data sources for a jewelry
­company:
✓ The World Gold Council provides an excellent overview of consumer
gold-buying trends and patterns by price points, types of jewelry, and
different sales channels. This information can support the marketing
segment of the business plan.
✓ If the production of jewelry is required, then information on available
manufacturing sources is needed. Because a large majority of jewelry is
produced globally (from Southeast Asia to Europe to Central America),
the company needs to make sure that it has a good handle on the political, social, and economic stability of any foreign suppliers.
✓ In addition, if the jewelry company is going to sell products through
retail storefronts, then an overview of commercial real estate rental
rates, trends, and so on can be incorporated (for a specific geographical
area) to support a critical expense driver in the business.
Riding the CART concept: Complete,
­accurate, reliable, and timely
During the planning process, evaluate your data to make sure it’s complete,
accurate, reliable, and timely (CART). Actually, you should apply the concept
of CART to all business segments; whether you’re developing a business plan,
analyzing periodic operating results, or evaluating an employee benefit plan.
Business owners and managers must have complete, accurate, reliable, and
timely information to make savvy business decisions. Whether the information
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and data is coming from internal or external sources, from the marketing or
manufacturing departments, the basis of the budget is having access to
complete, accurate, reliable, and timely information.
✓ Complete: Financial statements include a balance sheet, income statement, and a statement of cash flows (see Books IV and V for more on
these statements). All three are needed in order to understand the entire
financial picture of a company. If a projection model is incorporating an
expansion of a company’s manufacturing facility in a new state (to keep
up with rising demand), all information related to the new facility needs
to be accumulated to prepare the budget. This info includes the cost of
the land and facility, utility costs in the area, potential environmental
issues, whether a trained workforce is available, and so on. Overkill isn’t
the objective; having access to all “material” information and data is.
✓ Accurate: Incorporating accurate data is absolutely essential for preparing the business plan. Every business plan needs to state the price your
company charges for the goods or services it sells, how much employees are paid, what the monthly office rent is, what evolving patterns
exist in sales channels, and every other relevant detail. Accumulating
accurate information, whether from internal sources or external third
parties, represents a critical and ongoing management endeavor.
✓ Reliable: The concepts of reliability and accuracy are closely linked, but
they differ as well. A piece of information may be accurate without being
reliable. For example, you may conduct some research and find that the
average wage for a paralegal in San Diego, California, is $24 per hour.
This data sounds accurate, but if the business model you’re developing
requires paralegals with special training who demand $37 per hour, the
information isn’t reliable.
✓ Timely: Finally, the information and data must be accumulated in a
timely fashion. Data provided six months after it was needed doesn’t do
management much good. Companies live and die by having access to
real-time information on which to make business decisions and change
course (and forecasts) if needed.
An old phrase that’s often quoted, “Don’t put the cart before the horse,”
means you shouldn’t buy a cart before you have a horse to pull it; in other
words, you should do things in the proper order. However, the CART principle is a case in which the “cart” always needs to come first. You must put
the CART information and data before the horse (the business plan). If you
attempt to offer a business plan that hasn’t been created through CART data,
the end result will be nothing short of disastrous.
Chapter 4
Budgeting for a Better Bottom Line
In This Chapter
▶ Getting up to speed on budgeting fundamentals
▶ Gathering accurate information and projections
▶ Drawing up a budget — the essential budget documents
Y
ou need accurate information to make smart decisions about your
­business. A well-planned budget may be the most important piece
of information you use. Budgeting is a proactive process. It’s the thinking
­person’s accounting. You anticipate future outcomes and can maximize them.
You anticipate problems and may be able to minimize or eliminate them.
That’s a lot better than operating in ignorance and reacting to events as they
arise. In this chapter, you look at budgets, consider how to anticipate costs,
and work through some essential budget documents.
Brushing Up on Budgeting Basics
A budget is a financial plan that includes both financial and non-financial
­information. Its most obvious features are revenue and expense projections —
how much you anticipate earning and spending. The budget can also contain
non-financial information, such as how many employees you think you need.
A budget is a forecasting document, but businesses also use it as a financial
control tool to monitor activities in their business. One control is to review
spending and ensure that you don’t exceed your budgeted spending. Often,
a company (or a division or a department within it) isn’t allowed to spend
more than has been budgeted. Budgets cover a specific period of time, most
commonly a year, and they look into the future. Although you use historical
information to develop a budget, the activities you plan happen in the future.
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Meeting the master budget
The master budget is a comprehensive picture of your plans for the future
and how the plans will be accomplished. It’s a summary of your financial and
operating plans:
✓ The financial plan (financial statements, really) is what you share with
outside parties who need your budgeted information, including lenders,
stockholders, and perhaps even government regulatory agencies.
✓ The operating plan (also known as the operating budget) is used internally, mostly by managers, to set sales goals and develop their own
budgets. You hand out the operating plan to each manager, and the managers implement the plan.
Operating plans can contain non-financial information. Decisions about production, hiring, and selling efforts are components of operating plans.
Understanding key budgeting concepts
Budgeting forces you to plan how to use your assets wisely to generate revenue. (Assets are resources, including cash, buildings, machinery, office equipment, and anything else your businesses uses to conduct business.) As you
develop your budget, keep the following key concepts in mind:
✓ Depreciation: Long-term assets, such as trucks and machinery, depreciate; that is, they wear out and are worth a little less every day as you
use them up. You need to budget for operating costs and depreciation,
so you have sufficient cash to replace these assets when they’re used
up or no longer useful. (Head over to Book III, Chapter 1 for more on
depreciation.)
Milk all the revenue you can from an asset before disposing of it, unless
maintenance of that asset exceeds the cost of replacing it or a newer
model would improve efficiency to the point of at least paying for itself.
✓ Opportunity cost: When you use an asset to manufacture product A, you
give up the opportunity to use that asset to produce product B, which
would have generated revenue, too. When developing a budget, consider
opportunity cost, and make choices on how to use assets that minimize
these costs.
✓ Cash flow: When you conduct business, cash flows through your business. It flows in as revenue and flows out as expenses. One of your primary goals when developing a budget is to make sure you have at least
as much cash flowing in as you do flowing out. Book V, Chapter 2 goes
into more detail on cash flow.
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Planning strategically
Whether you’re starting a new business, launching a new division or a new
product line, or simply preparing for the future, you need to develop a strategic plan — your business’s road map to the future. The plan reminds you,
your employees, and third parties what you do, how you do it, the customers
you do it for, and maybe even how you’ll do it in a superior way. Your strategic plan summarizes where your business is, where it wants to go, and how
it’s going to get there.
Your budget, of course, is an important part of strategic planning. The budgeting process forces you to think, make decisions, and come up with reasonable forecasts. You can’t sidestep potential negatives, either. That would be
like a farmer overlooking the possibility of a drought.
If you’re trying to attract financing to fuel your business venture, you’d better
have a strategic plan (business plan) in place that lays out exactly how the
business is going to generate sufficient revenue to cover its bills and either
make payments on its loans or produce a return on any investments in the
business. Nobody will lend money or invest in a business without seeing how
that business plans to make money.
Strategic planning methods exist in abundance and seem to be a thriving cottage industry. They contain more letters than ten cans of alphabet soup, and
include SWOT, PEST, STEER, EPISTEL, ATM, and RCA. Be cautious, and use
common sense before embracing a planning methodology. For additional guidance in developing a strategic plan, check out Strategic Planning For Dummies
by Erica Olsen ( Wiley).
Recognizing Factors That Impact
Your Budgeting Process
Whether you’re developing a budget for a business or a household, one of
the biggest challenges is coming up with good ballpark estimates. Consulting
a fortune teller or staring into a crystal ball probably won’t help. Useful information comes from your experience, what you know about timing, the facts
and figures your staff supplies, and your own sales projections.
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Experience counts
Business owners with little experience in an industry often plan poorly, in
part because they don’t have much personal history to go on. Also, some
people have trouble accepting the reality of their business prospects.
For example, they really want the business to grow 30 percent and can’t
accept the fact that 10 percent is more realistic.
Consider three brothers who were opening a pizza-parlor franchise. The franchise was successful in other parts of the county. The brothers were opening
a store in a new area of town. All good. None of the brothers had any restaurant industry experience. Two of the brothers sold business envelopes, and
the third was a professional golfer. Not so good.
The brothers performed an analysis and determined that the profit margin
was only 5 percent, barely enough to pay each of them a meager salary. They
went forward with the business anyway. Perhaps they thought that 5 percent
figure was wrong or that they could somehow increase it. Within a few years,
the brothers closed the business. If the brothers had experience in the pizza
business, they probably wouldn’t have bought the parlor, or they would have
at least had more realistic expectations.
Timing is everything
Different business decisions have different timelines that depend, in part, on
the dollar amount of the decision you’re making. Understanding your timeline
helps you make intelligent decisions about spending.
For example, if you decide to use a different supplier for your materials, you
could start buying materials from that company immediately. No problem.
On the other hand, completing a move into a newly constructed building may
take a year or more. You need to consider timelines for your more expensive
business decisions. If you’re building a new office, determine how long the
construction will take. Based on the timeline, you can plan your payments for
the building and how you’ll generate cash to make the payments.
Explain your timeline in your business plan. If you’re providing financial
statements (discussed later in this chapter) for one year, you may need
to explain payments for a building (asset) that isn’t yet completed. It’s
­perfectly reasonable to expect a business to pay for major assets over a
long period. Just be sure to explain it to your investors or lenders. You
may have a one-year operating budget, along with a capital ­expenditure
budget for three to five years. The capital expenditure budget is the
­big-things-I’ll-buy-and-pay-for-long-term budget. This budget helps you
and others v
­ isualize your long-term plans and spending.
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People get you headed in the
right ­direction
The budgeting process isn’t only about numbers; it also involves people. A
budget is something that a group of people typically reviews and eventually
comes to an agreement on. Involve people, consider their opinions, and get
their buy-in on the budget. If the company’s managers don’t generally agree
on where you’re headed in your budget, you may need to revise it.
Talk to your staff. If you’re concerned about wasting material in the manufacturing process, talk to people on the factory floor. Maybe you’ll find out that
poor quality is the reason some material is wasted during production. Maybe
some denim you use to make jeans tears too easily, and you need to find a
new supplier. You may never find out about that if you don’t spend some time
on the factory floor.
Talk with the sales staff to plan sales for the year. Good salespeople know
their clients. They may know about a client’s purchasing plans for next year.
They may even know a client’s budget to buy your product! Also, a good
salesperson knows the customer’s financial condition. If the customer’s business is growing, he or she may buy more from you. If the business is in financial trouble, sales may decline.
Have a conversation with the accountant during planning. She knows how
cash flow turned out last year. You can look at the data on how quickly you
collected cash for sales. Also, your attorney may remind you of any legal
issues that could possibly generate expenses during the year. There may be
costs for legal services or costs to settle litigation. Those costs require cash,
and you need to include them in your plan.
When your budget is in good shape, present it to your staff and explain where
the company is headed. They’ll feel more confident knowing the company’s
direction and prospects, especially if they played a role in developing the
budget.
Sales projections pay off
Sales projections help answer the question of how you earn a reasonable
level of profit. Of course, the answer is complicated if competitors are selling the same product or service, because it suggests you may have to lower
prices to stay competitive. If you want to cut prices to attract business, you
need to plan your costs so your profit level remains reasonable. Another
­possibility is to improve the design of your products and not change prices.
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If you do that, you add the cost of design to product costs. But increased
sales without cutting prices may offset the cost of design.
Good planning is useful, and poor planning leads to projections (of profit, sales,
and company growth) that aren’t useful. If you base decisions on inaccurate
projections, you’re likely to use assets in ways that won’t maximize your profits. Simply put, you end up spending time and money on the wrong activities.
Coming up with accurate sales projections often begins with market research.
Suppose you’re selling running shoes in the United States, and you discover
that 10 million people buy running shoes each year in the U.S. On average,
they spend $80 for a pair. Fortunately, you’ve priced your shoes at $78, so
you’re right around the average.
Next, you estimate that your firm can capture 10 percent of the U.S. runningshoe market. That means a total sales volume of 10 percent of a 10 millionunit market, or 1 million units sold in a year. At $78 a pair, you project your
sales to be $78 million. Finally, you consider whether the market is growing
or shrinking. If the running-shoe market is growing at 10 percent per year,
you could reasonably increase your sales projection by 10 percent each year,
also. Of course, market growth is impacted by the overall economy and the
specific industry (sporting goods, in this case). Competitors may also impact
your growth. You’d need to project all these contingencies before coming up
with a reasonable sales forecast.
The sales growth rate drives decisions about spending, employee hiring, and
cash planning. If you’re selling 30 percent more, you can plan to increase
your spending and hire employees to manufacture 30 percent more of your
product. You also probably can expect a 30 percent increase in cash inflow as
a result of growth.
But wait! If a more careful review indicates 10 percent growth, your 30 p
­ ercent
projection creates some problems for you. You increased your spending and
hiring assuming the 30 percent level, but the sales and cash inflows will only
come in at 10 percent. Put simply, you’re planning on spending 20 percent too
much. Whether you’re building homes or selling running shoes, the numbers
still apply.
The Nuts and Bolts of Budgeting
Begin the budgeting process by deciding which company entities require a
budget and how detailed it needs to be. You may decide to develop a budget
for the entire company or for each division or department within it.
In budgeting, you begin with some assumptions. The assumptions are called
standard costs and are the specific planned levels of cost and activity. For
example, you may assume a standard labor rate (cost) of $20 per hour for
Chapter 4: Budgeting for a Better Bottom Line
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a sewing-machine operator. You may assume a standard material rate of $75
per square foot for marble for kitchen countertops.
When you create your budget (based on reasonable assumptions) and start the
year’s business, you have actual costs and levels of activity to review.
A ­difference between an actual cost and standard cost is a variance. A ­variance
is a scorecard that tells you how close your budget assumptions were to actual
results. Fortunately, you can make modifications to your budget to deal with
variances. (See Book VII, Chapter 4 for more about variance a
­ nalysis.)
Understanding the budgeting financials
Your budget becomes a set of pro forma financial statements. Pro formas
are what-if statements, filled with budgeted, planned, and forecasted items.
Unless you have a crystal ball, your budget is always a collection of educated
best guesses about the future.
To keep things simple, a budget uses three basic financial statements: the
balance sheet, the income statement, and the statement of cash flow (head
over to Books IV and V for more on financial statements). Another aspect is
an explanation of your source of funds.
Source of funds
Your budget determines whether you have enough funds to run your business. Hopefully, you get all the money you need from selling products or services, but that’s not always the case.
The financial plan (also loosely called the business plan) explains the source
of funds to run the business. You can raise money by borrowing cash (debt)
or by offering investors ownership in the business (equity) in exchange for
cash. (See Chapter 1 for guidance on raising funds.) For now, consider how
you budget for the process.
If you borrow, you repay a creditor the original amount borrowed (principal)
and interest on the loan, usually on a written schedule. The interest cost and
principal repayment must be included in the budget.
You can also raise funds by selling ownership in your business, offering investors equity. Equity investors are rewarded in two ways: stock appreciation and
dividends.
The most common way to sell ownership is to sell common stock. Investors
expect you to explain (through your budget) how you plan to generate a
profit for the year. If the company is profitable, the value of their ownership in your business increases. They could eventually sell their ownership
­interest to someone else for a profit.
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You also need to consider whether to pay dividends. Dividends are a share
of the profits earned by the company paid to equity investors. Of course,
­without any company earnings, you can’t pay dividends.
Using the balance sheet
The balance sheet lists the company’s assets, liabilities, and equity (essentially
the difference between assets and liabilities) as of a certain date. Think of the
actual balance sheet as a snapshot in time; think of the budgeted balance
sheet as a pretty good estimate of the actual financial statement.
Liabilities are claims on your assets. A liability means that you owe ­someone
money. Liabilities include items such as unpaid utility bills and payroll costs
you haven’t yet paid. Future interest and principal payments on a loan are
also liabilities. When you pay a liability, you use an asset (cash, in most
cases) to make payments.
This gets you to the balance sheet equation, introduced in Book I, Chapter 1:
Assets – Liabilities = Equity
Consider this scenario: Assume you own a little shop. You sell all your
assets — your inventory, furniture, and your building. You use the cash you
receive to pay off all your liabilities — utility bills, payroll, and bank loan.
Whatever cash remains after you pay off your liabilities is your equity. Equity
is the true value of your business. So now you can see the logic behind the
balance sheet formula: Assets less liabilities equals equity.
Working with the income statement
The income statement shows revenue, expenses, and net income (profit) or
loss. For most business owners, the income statement is the most important
report. It shows whether a business was profitable over a period of time
(such as a month, quarter, or year), whereas the balance sheet shows assets,
liabilities, and equity as of a specific date. The nice thing about modern
accounting software is that it can generate an income statement almost
instantly. Think of the budgeted income statement as a pretty good projection of your company’s sales, expenses, and profit.
The income statement formula is incredibly simple:
Revenue – Expenses = Net income or loss
Analyzing the statement of cash flows
The statement of cash flows analyzes sources of cash (cash inflows) and uses
of cash (cash outflows) over a period of time. Stroll over to Book V, Chapter 2
for more on cash flows. Cash flows are grouped into three categories:
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operating, financing, and investing activities. When an accountant puts
together a cash flow statement, she reviews every transaction that affected
cash. A very simple model is what’s in your checkbook. If inflows are good,
you probably have enough cash to operate. If the checkbook shows that
you’re overdrawn, outflows have exceeded inflows, and you’ve got trouble.
The goal is to assign every cash transaction to one of three categories,
although most of your cash activity is in the operating activities section.
To simplify the process, find the financing and investing activities first —
because they represent fewer transactions. The remaining transactions are
operating activities.
The three cash flow categories are:
✓ Operating activities occur when you run your business each day. You
buy material, pay for labor, ship goods, pay interest on loans, and collect
cash from customers.
✓ Financing activities occur when you raise money for your business,
and when you pay lenders or investors. You receive cash when you sell
equity, and you receive cash when you borrow. You pay cash when you
pay dividends, and you pay cash when you pay down a loan (pay back
some of the principal).
✓ Investing activities occur when you buy or sell assets. Writing a check
for a new vehicle and receiving cash when you sell equipment are
­investing activities.
The statement of cash flows lists the beginning cash balance; all the cash
activity for the period, grouped into three categories; and the ending cash
balance:
Ending cash balance = Beginning cash balance +/– Net cash flow of
­ perating activities +/– Net cash flow of financing activities +/– Net
o
cash flow of investing activities
A simpler formula is
Ending cash balance = Beginning cash balance + Cash inflows for the
period – Cash outflows for the period
The ending cash balance in the statement of cash flows equals the cash
­balance in the balance sheet (well, it’s supposed to, anyway). For example,
if the statement of cash flows is for March, the ending cash balance should
equal the balance sheet cash balance for the last day of March.
When you create your budget, it should include all three financial statements
(balance sheet, income statement, and statement of cash flows).
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Reviewing revenue and production b­ udgets
Revenue and production budgets, put simply, forecast how many units you
plan to produce and how many units you plan to sell.
Say you’re budgeting to manufacture garage doors. You need to forecast how
many sales you expect. Then consider how many garage doors you already
have in inventory and plan how many you need to manufacture to meet the
sales forecast. Ta da! When you know the number of doors you need to make,
you can budget for material and labor costs. Material and labor costs are considered direct costs, because they can be traced directly to your product.
Indirect costs are those that can’t be directly traced to the product. Repair
and maintenance costs for a machine, for example, are indirect costs. You
may assign these costs by dividing the total cost incurred by the number
of hours the machine ran during the month. That would give you a rate per
machine hour. If you incur two hours of machine time to make one unit of
product, you would multiply two hours by the machine rate per hour. That
indirect cost total would be added to the unit of product.
Revenue, production, inventory, direct materials, direct labor, indirect costs
(overhead), and cost of goods sold all are budgeted items.
Applying the revenue formula
Suppose you forecast selling 200 garage doors in March. Consider how many
garage doors you need to manufacture. Assuming a sales price of $300 per
door, here’s your revenue budget:
Revenue budget = 200 units × $300
Revenue budget = $60,000
Using the inventory formula
And now for the famous inventory formula:
Ending inventory = Beginning inventory + Production – Sales
Your production will change based on how many garage doors you already
have in inventory. So if you already have 75 completed garage doors in
­beginning inventory, you won’t need to manufacture all 200 units you plan
to sell. (For more about inventory, see Book II, Chapter 2.)
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But wait! Do you want any garage doors in ending inventory? If you think
you’ll have orders during the first few days of the next month, you probably
want to have at least a few garage doors left at the end of this month. So
maybe you decide on an ending inventory of 50 garage doors.
Take the inventory formula and calculate the garage door production you
need. Assume x is production in units, and solve for x:
Ending inventory = Beginning inventory + Production – Sales
50 = 75 + x – 200
50 – 75 + 200 = x
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x = 175
This simple algebra problem shows that production should be 175 units.
Table 4-1 shows a production budget.
Table 4-1
Garage Door Production Budget
Cost
Quantity
Price
Total
Direct material (wood)
80 square feet
$1 per square foot
$80
Direct labor (labor)
2 hours
$25 per hour
$50
Indirect costs allocated
1 hour
$15 per hour
$15
Cost per unit
Production cost
$145
Units
Unit cost
Total cost
175
$145 (above)
$25,375
The production budget includes direct materials, direct labor, and indirect
costs (overhead). In this example, the indirect cost is allocated based on
machine hours. Add the costs to get a unit cost. Then multiply units to be
produced by the cost per unit. That amount is the total cost of production of
$25,375.
Assessing cost of goods sold
The goods you produce for customers end up in one of two places: You either
sell them (cost of goods sold), or they’re still on the shelf (finished goods
inventory). Beginning inventory and production don’t matter.
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What costs should be attached to the goods you sell? How much did they
cost to produce? (If you’re a retailer, how much did they cost to get?) To
­continue with the garage door manufacturing example, assume the first
goods you sell are from beginning inventory. Because all 75 units of
beginning inventory are sold, use a formula to determine how many
units of the March production are sold:
March production sold = Total sales – Beginning inventory
March production sold = 200 – 75
March production sold = 125
Assume also that the cost per unit of beginning inventory is $143. That cost is
different from the March production cost of $145. (Why the change? Because
the costs of materials and labor to make a garage door rose.) Table 4-2 displays the cost of goods sold budget.
Table 4-2
Garage Door Cost of Goods Sold Budget
Units
Cost Per Unit
Total Cost
Beginning inventory
75
$143
$10,725
March production sold
125
$145
$18,125
Total
200
$28,850
The total cost of goods sold is higher ($28,850) than total production cost
in Table 4-1 ($25,375). That makes sense, because Table 4-1 deals only with
producing 175 units. You sold 200 units, but 75 units were from inventory.
Because of adjustments for beginning and desired ending inventory, you
don’t always need to produce in a month the number of units you sell in a
month.
One more calculation. (There’s always one more calculation.) Now calculate
your ending inventory budget:
Ending inventory budget = Units × Per unit cost
Ending inventory budget = 50 × $145
Ending inventory budget = $7,250
You’ve planned revenue, production, and inventory. Great! Now you need
to figure out how to pay for it all. If you don’t have a budget for an adequate
cash amount to operate, you can’t do business. See Chapter 5 for guidance.
Chapter 5
Mastering and Flexing
Your Budgeting
In This Chapter
▶ Applying accrual accounting to the budget process
▶ Producing a budgeted income statement and balance sheet
▶ Creating a flexible budget
Y
ou can master budgeting basics and figure out how to budget for sales
and production in Chapter 4. Then you’re ready to tackle more detailed
aspects of budgeting, weigh the pros and cons of budgeting with cash-basis
or accrual accounting, and develop a flexible budget.
This chapter explains how to use the information from your budget for sales
and production to create a budgeted income statement and balance sheet. It
also reveals how to put together a flexible budget that accommodates different levels of production. But the first order of business is to understand why
accountants use accrual rather than cash-basis accounting to create budgets.
Budgeting with Cash or Accrual
Accounting
Nearly every large corporation uses accrual accounting both to record
transactions and to budget. Small businesses have a choice: They can use
cash basis accounting or accrual basis accounting:
✓ Cash basis accounting posts revenue and expenses to the financial
statements based solely on cash transactions. Nothing happens until
you take cash in or pay it out. It’s a simple way of doing things — no
accounts receivable and no accounts payable.
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✓ Accrual basis accounting states that expenses are matched with revenue,
regardless of when cash moves in or out of the checkbook. The accrual
basis is a better method to account for profits, because revenue and
expenses are matched more precisely. See the section “I accrue, you
accrue, we all accrue with accrual accounting.”
You can use either method to produce a budget, but accrual is better and is
used by all large organizations. (See Book I, Chapter 4 for more about cash
and accrual accounting.) This section discusses these concepts in the context
of the budgeting process.
A useful budget uses accrual accounting, which matches revenue with expenses.
Using the cash method — budgeting based on cash inflows and outflows —
doesn’t provide an accurate picture of your budgeted profit level.
Cash basis accounting: Using your
checkbook to budget
On a very basic level, your cash budget is a reflection of your checkbook.
It’s the sum of the deposits you make (revenue) and the checks you write
(costs). The budgeting result of cash basis accounting is a cash budget.
Such a budget assumes that all your customers pay for sales in cash during
the month of sale and that you pay all costs during the month that the goods
are sold. This scenario is highly unlikely for most businesses.
It’s more likely that you write a check in February for materials for a product
you sell in April. Similarly, you may pay an employee in December for work to
make a product that’s sold in January.
Assume you own a shop that sells greeting cards, flowers, and gifts. Your
beginning cash balance for the month is $100,000. Table 5-1 displays a cash
budget for a gift shop.
Table 5-1
Gift Shop Cash Budget — Month of March
Amount
Beginning cash balance
Add customer payments for sales
$100,000
$50,000
Less:
Inventory purchases
$20,000
Chapter 5: Mastering and Flexing Your Budgeting
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Amount
Payroll costs
$10,000
Utilities costs
$1,000
Lease cost
$3,000
Ending cash balance
$116,000
This cash budget has a $16,000 increase in cash during the month ($116,000 –
$100,000). You had $50,000 in sales. If you hadn’t collected any cash from customers during March, your cash balance would decrease by $34,000, the total
of all the cash outflows. If that happened, you’d start the next month with
$34,000 less cash. You need to consider whether your April cash budget (next
month) would work with a lower beginning balance in cash. You don’t want
to start in the red.
If you don’t think you’ll have enough cash for a period, you can consider
how to get it.
The cash budget is similar to the statement of cash flows. Table 5-2 shows an
example statement of cash flows for the gift shop.
Table 5-2
Gift Shop Budgeted Statement of Cash Flows
Amount
Beginning cash balance
Cash flow from operations
$100,000
$16,000
Cash flow from financing
$0
Cash flow from investing
$0
Ending cash balance
$116,000
Note that the beginning and ending cash balances in Table 5-2 agree with the
cash budget ($100,000 at the beginning and $116,000 at the end). The cash
flow calculation from operations is
Net cash inflow from operations = Customer payments – Cash outflows
Net cash inflow from operations = $50,000 – $34,000
Net cash inflow from operations = $16,000
All the cash flows for the gift shop are related to day-to-day operations.
None of the cash activity is related to financing or investing.
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I accrue, you accrue, we all accrue
with accrual accounting
An effective budget applies the matching principle. The principle states
you should match the timing of the expenses of creating and delivering
your product or service with the timing of getting revenue from the sale.
This is accrual basis accounting (as opposed to cash basis accounting).
Accrual accounting ensures that revenue is more precisely matched with the
expenses incurred to generate revenue.
With accrual accounting, when you create an invoice, the accounts receivable
(A/R) system generates a receivable, even though the customer may not pay
for, say, 30 days. When the payment arrives, the receivable is adjusted to zero,
meaning it’s been satisfied by the payment. Accrual accounting is considered
to provide a more accurate reflection of business activity than cash accounting.
By the way, the system still allows for straight cash sales — where you sell now
and the customer pays now.
The same is true of purchases you make. When you buy now and pay later, you
create a payable. When the bill comes and you pay it, the payable is adjusted
to zero. Of course, the system allows you to make straight cash purchases —
where you buy and pay your vendor now.
Suppose you manage a catering business. The food, preparation cost, and
delivery expenses related to the Jones family reunion should be matched
with the revenue from the Jones family. Ideally, you want the expense and
the revenue to be posted in the same time period. You wouldn’t want the
Jones expenses posted in March and the Jones revenue posted when they
paid (say, in April). That’s not the best reflection of your business activity.
The downside of accrual accounting is that your income statement revenue
and expenses rarely match your cash inflows and outflows. You can be rich
in receivables and darned poor in cash. But most companies still prepare a
cash flow statement even if they’re using accrual accounting.
Budgeting to Produce the Income
Statement and Balance Sheet
A final step in the budgeting process is to create a budgeted balance sheet
and budgeted income statement. Your balance sheet and income statement,
whether budgeted or actual, are the two great financials. They reflect the
bottom line, showing how the business is doing.
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The well-balanced balance sheet
Your balance sheet is a fine indicator of business health. Table 5-3 shows a
healthy balance sheet.
Table 5-3
Budgeted Balance Sheet
Amount
Assets
$100,000
Less liabilities
$50,000
Book VI
Equals equity
$50,000
Planning
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As you review your balance sheet budget, keep in mind the goal is to maintain
enough assets to run your business, which includes production (if you make
things), buying inventory (if you’re a retailer), or employing people (for
manufacturing, retailing, or service businesses).
The balance sheet should include assets needed for selling and distributing your
products. Managing your business generates liabilities, too (accounts payable,
long-term debt, and so forth). That’s okay, as long as you have a plan to pay them.
If revenue doesn’t supply you enough of the best asset — cash — you need
a plan to raise capital. Capital represents an investment in your business. If a
business owner invests $20,000 into his business, the $20,000 is considered
capital for the business. That means you’re probably either issuing debt
(taking out a loan) or selling equity (shares of the company) to stockholders.
The incredible income statement
Most business owners are most interested in the income statement. The
owner typically plans this budget document first.
Table 5-4 shows a budgeted income statement that projects a healthy
net income.
Table 5-4
Budgeted Income Statement
Amount
Revenue
$50,000
Less expenses
$25,000
Equals net income
$25,000
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Book VI: Planning and Budgeting for Your Business
Here’s the thought process: You figure out how much revenue the company
can generate. Then you subtract likely expenses from the revenue, and the
result is your net income. After that, think about how cash will “move” (the
cash flow statement) and where your company will get sufficient assets to
operate (the balance sheet).
As you move forward in managing your business, don’t be surprised if cash
flow becomes the most important budget item for you. Without enough cash
flow, not much happens.
Flexing Your Budget: When
Plans Change
Regardless of how carefully you budget, plans may change. Assume you plan a
cross-country family camping trip. You diligently create a budget spreadsheet
based on your research and assumptions. Unfortunately, nearly everything
costs more than you estimated.
A 30-percent increase in the price of gas adds more than $1,000 to the cost of
the trip. And although you timed the trip to drive 600 miles per day, you don’t
take into account stops for coffee, restrooms, or motion sickness.
As the road trip attests, budgets don’t have to be set in stone. This section
explains how to use flexible budgets to manage your business’s operations.
Controlling your business
Budgeting helps you plan your business’s operations. However, you also need
to control your business — to monitor what’s actually happening. Controlling
involves constantly comparing actual activity to your budget and carefully
analyzing and understanding any differences. To accomplish this task, you
need budget reports that compare your budgets (what should have happened) to what actually happened.
For example, suppose your company budgeted $100,000 for sales in the
first quarter. Actual sales for the quarter fall short, at only $70,000. First,
call the sales manager to find out what happened. (Maybe a computer snafu
accidentally canceled customer orders.) Then, take corrective action. (Fix
your computer and call your customers to apologize.) Finally, adjust your
future plans. (Cut next quarter’s production estimates.)
Chapter 5: Mastering and Flexing Your Budgeting
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Chapter 4 provides the basic template for budgeting, offering projections for
sales, expenses, production levels, and cash flows to help you plan for future
periods. However, its major flaw is that it’s static — it projects only one scenario
based on a single set of sales estimates. It can’t change.
Therefore, a $30,000 difference throws off more than just your sales budget. It
also necessitates changing your production, purchases, direct labor, overhead
costs, and selling and administrative expenses, ruining the entire planning
process and making it impossible for you to make future comparisons
between your budgets and actual results.
Enter the flexible budget. As activity levels change, you can easily adjust a
flexible budget and continue to use it to plan and control your business.
Dealing with budget variances
One of the benefits of flexible budgeting is that it helps you to understand the
reasons for your company’s variances, the differences between actual and
budgeted amounts. Chapter 4 introduces the concept of a variance. The next
section gives you the lowdown on the flexible budgeting process, but first
you should delve a little deeper into the issue of variances.
Always indicate whether a variance is favorable or unfavorable. A variance is
usually considered favorable if it improves net income and unfavorable if it
decreases income. Therefore, when actual revenues exceed budgeted amounts,
the resulting variance is favorable. When actual revenues fall short of budgeted
amounts, the variance is unfavorable. On the other hand, when actual expenses
exceed budgeted expenses, the resulting variance is unfavorable; when actual
expenses fall short of budgeted expenses, the variance is favorable.
Management should investigate the cause of significant budget variances.
Here are some possibilities:
✓ Changes in conditions: For example, a supplier may have raised prices,
causing the company’s costs to increase.
✓ The quality of management: Special care to reduce costs can result in
favorable variances. On the other hand, management carelessness can
drive up unfavorable variances.
✓ Lousy budgeting: An unrealistically ambitious budget is likely to cause
unfavorable variances.
Many managers use a system called management by exception. They investigate
the largest variances, whether favorable or unfavorable, and ignore the rest.
This strategy helps managers prioritize potential problem areas in operations.
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Implementing a flexible budget
To compute variances that can help you understand why actual results differed from your expectations, creating a flexible budget is helpful. A flexible
budget adjusts the budget for your actual sales or production volume. For
example, your budget may have assumed that you’d produce 5,000 units;
however, you actually produce 5,100 units. The flexible budget accommodates this new number, making all the appropriate adjustments to sales and
expenses based on the unexpected change in volume.
To prepare a flexible budget, you need to have a budget, really understand
cost behavior, and know the actual volume of goods produced and sold.
Consider Kira, president of the fictional Skate Company, which manufactures
roller skates. Kira’s accountant, Steve, prepares the overhead budget shown
in Figure 5-1.
Figure 5-1:
Skate’s
static
overhead
budget.
©John Wiley & Sons, Inc.
Skate had a great year; actual sales came to 125,000 units. However, much to
the disappointment of Steve and Kira, the overhead budget report, shown
in Figure 5-2, reports major overruns. For each category of overhead, Steve
computes a variance, identifying unfavorable variances in indirect materials,
indirect labor, supervisory salaries, and utilities.
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Figure 5-2:
Skate’s
overhead
budget
report.
©John Wiley & Sons, Inc.
Skate’s total overhead exceeds budget by $25,000. Steve makes the elementary
mistake of treating variable costs as fixed. After all, portions of overhead, such
as indirect materials, appear to be variable costs. If Skate increases production
from 100,000 units to 125,000 units, these variable costs should also increase.
In other words, comparing the $60,000 actual indirect cost of making 125,000
units to the $50,000 budgeted indirect cost of making just 100,000 units makes
no sense. You’re comparing apples and oranges. Different levels of activity
(units) generate a different level of variable costs (indirect costs).
Instead, Steve should flex the budget to determine how much overhead he
should have, assuming that the company makes more or less than the
budgeted number of units. The following sections show you how.
Separating fixed and variable costs
Some costs are variable — they change in response to activity levels — while
other costs are fixed and remain the same, regardless of activity level. For
example, direct materials are variable costs because the more goods you
make, the more materials you need. On the other hand, some overhead costs,
such as rent, are fixed; no matter how many units you make, these costs
stay the same. To determine whether a cost is variable or fixed, think about
whether or not the total cost changes when the level of activity changes.
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For Skate, an analysis indicates that indirect materials, indirect labor, and
utilities are variable costs. On the other hand, supervisory salaries, rent, and
depreciation are fixed. Steve recomputes variable costs with the assumption
that the company makes 125,000 units, as shown in Figure 5-3.
Figure 5-3:
Flexing
variable
overhead
costs.
©John Wiley & Sons, Inc.
In the original budget, making 100,000 units results in total variable costs of
$130,000. Dividing total cost of each category by the budgeted production
level results in variable cost per unit of $0.50 for indirect materials, $0.40 for
indirect labor, and $0.40 for utilities.
To compute the value of the flexible budget, multiply the variable cost per
unit by the actual production volume. Figure 5-3 indicates that the variable
costs of producing 125,000 should total $162,500 (125,000 units × $1.30).
Comparing the flexible budget to actual results
The final step is to combine the variable and fixed costs in order to prepare
a new overhead budget report, inserting the new flexible budget results into
the overhead budget report as shown in Figure 5-4.
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Figure 5-4:
Skate’s
flexible
overhead
budget.
©John Wiley & Sons, Inc.
Look at that! After you adjust for the change in production level, Skate’s
variance is suddenly favorable. Actual overhead of $355,000 was $7,500
less than the $362,500 flexible budget.
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Chapter 6
Planning for Long-Term
Obligations
In This Chapter
▶ Discovering how a company raises cash
▶ Identifying long-term liabilities
▶ Accounting for notes payable
▶ Reporting gain or loss on debt extinguishment
▶ Considering bonds
I
f you own a car or house you financed, you’re probably all too familiar
with long-term debt: loans that won’t be paid off by the end of the next
12-month period. Well, companies have long-term debt, too. A company usually uses current debt as a vehicle to meet short-term obligations like payroll
and incurs long-term debt to finance company assets.
This chapter gives you the lowdown on two types of long-term debt: notes
and bonds payable. Notes payable are debt a company takes on typically
through lending institutions, such as banks, to finance asset purchases. Asset
purchases include cars, equipment, and buildings. Bonds payable are typically issued by hospitals and municipalities to fund expansion (although corporations can issue them too). Here you find out all you need to know about
this complicated topic.
Managing Long-Term Debt
An immutable fact of running a business is that at some point the company
will have to take on long-term debt to grow its operations. After all, unless the
business owners are running the business just for fun, they want to expand
operations in the hopes of making more money.
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The way you structure long-term debt affects the expense of borrowing the
money. When you finance a vehicle or home purchase, you probably shop
around for interest rates and evaluate the options of financing the loan for a
shorter or longer term. Businesses do the same, but they may carry millions
of dollars of debt on their balance sheet, and they have to service this debt.
Debt service is the process of making principal and interest payments on
debt. Managing the debt service is crucially important because minute differences in terms can have a large effect on interest and the bottom line.
A company may raise cash to purchase assets, expand existing operations,
or maybe even buy another company. If the firm decides to do so by accumulating long-term debt, management evaluates the relative merits of available forms of long-term debt. The most common types of long-term debt are
mortgages, notes payable, and bonds payable. The next few sections discuss
mortgages and notes payable. See “Accounting for Bonds,” later in this chapter, for coverage of bonds.
The many faces of notes payable
Notes payable are formal written documents that spell out how money is
being borrowed. This type of agreement between a lender and a borrower
specifies principal (amount borrowed), rate (interest percentage the company
pays to borrow the money), frequency of payments, and term (the amount of
time the company has to pay off the loan).
Notes payable are issued in three different ways: face; no-face, no-interest;
and no-face, interest. These terms may make lending and borrowing seem like
a silly game of peek-a-boo, so take a look at their definitions in the following
sections.
Keep in mind that face refers to face amount — a specific dollar amount stated
on the face of the note payable. It represents the principal amount that the
borrower must repay. The note payable document should list everything that
the borrower and lender need to know about the liability, including the principal amount owed.
Face
Face is the easiest type of note to account for. With this type of note, the present value of the note payable is the same as its face, which is the amount stated
on the note. (For more about present value, check out Book V, Chapter 1.) This
sameness results because the effective interest rate, which is the market interest rate, and the stated interest rate (what’s printed on the face
of the note payable) are the same.
Chapter 6: Planning for Long-Term Obligations
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Market is the interest rate for a note of similar risk. The level of risk refers to
the creditworthiness of the borrower — the ability to repay principal (face
amount) and interest on time. For example, if one company loans another
company $5,000 at an effective and stated rate of 10 percent due in three
years, the journal entry for the borrower to record issuance of the note is
to debit cash and credit notes payable for $5,000.
Each year, the borrower records interest expense at $500 ($5,000 × 0.10).
The journal entry is to debit interest expense and credit cash for $500.
When the company pays off the debt at the end of the three years, the
borrower records a credit to cash and a debit (reduction) to notes
payable for $5,000.
No-face, no-interest
A no-face, no-interest note payable is issued for the present value of the
amount the borrower receives from the lender, which is less than the face
value (future value) of the note. The difference between the face value and
present value of the note is called a discount, which represents the total interest to be paid over the life of the loan.
To determine the present value of the amount borrowed and figure the discount,
use a present value of $1 table. This table assumes a single payment and that
you need to compute the present value of that payment. Search the web to find
present value tables for a single payment and for multiple payments (annuities).
Take the following steps, which assume a single payment:
1. Using a present value of $1 table, find the factor at the intersection of
the loan percentage and period, as shown in Table 6-1. For example,
for a five-year loan at 8 percent annual interest, skim down the Periods
column (on the left) until you find 5, and then follow that row to the
right until you hit the 8.00% column. In this case, the factor inside
the intersection of row 5 and column 8.0% is 0.6805. If the decimal is
extended one more place, the more precise factor is 0.68058. Use that
more precise factor for this analysis.
2. Multiply the present value factor you found in Step 1 by the future value
of the loan amount to find the present value. In this example, the face
amount (future value) of the loan amount is $20,000, so to find the present
value of $20,000, take $20,000 × 0.68058 = $13,611.60 (rounded to $13,612).
This is the present value of $20,000, discounted at 8 percent for five years.
3. Subtract the present value from the future value to determine the
discount. The discount is $20,000 face amount (future value) – $13,612
(present value) = $6,388.
Figure 6-1 shows how to journalize this transaction.
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Table 6-1
Present Value of $1 Lookup Table
Periods
7.0%
7.5%
8.0%
8.5%
1
0.9345
0.9302
0.9259
0.9216
2
0.8734
0.8653
0.8573
0.8494
3
0.8162
0.8049
0.7938
0.7829
4
0.7628
0.7488
0.7350
0.7215
5
0.7129
0.6965
0.6805
0.6650
Figure 6-1:
Journalizing
a zero-rateinterestbearing note
payable.
©John Wiley & Sons, Inc.
The discount on a notes payable account is a contra liability account. It
follows the note payable, amortized over the five-year life. The process
of amortization moves the discount balance (in the balance sheet) to the
income statement via interest expense by using the effective interest method.
Figure 6-2 gives you a bird’s-eye view on how this works, assuming that the
effective interest rate is 8 percent.
Journalize the first year by debiting interest expense for $1,089 and crediting
discounts on notes payable for the same amount. For the second year, debit
interest expense for $1,176 and credit discounts on notes payable for the
same amount — and so on for the remaining three years. Note these points
regarding amortization:
✓ The carrying amount of the note increases to face amount ($20,000) over
the life of the note payable (five years).
✓ The entire discount balance ($6,388) is moved to interest expense over
the same five-year life of the note payable.
No-face, interest bearing
Now that you’ve tackled zero-interest-bearing notes payables, you can dig into
interest-bearing notes. Going back to the $20,000 example from the “No-face,
no-interest” section, assume the note payable has a stated (face) interest rate
of 6 percent. At that stated rate, interest is $1,200 per year ($20,000 × 0.06).
The borrower pays interest to the lender at the end of each year.
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Figure 6-2:
Discount
amortization
schedule:
zero-rateinterestbearing
note.
©John Wiley & Sons, Inc.
Note that the stated interest rate on the note payable is 6 percent. However,
both the cash interest payments ($1,200 per year) and the principal amount
are discounted based on an 8-percent rate.
You know that the present value of the principal is $13,612. However, you
also need to figure out the present value of the interest portion of the note.
Use Table 6-2 to find the present value of an annuity of $1 table. Because the
interest paid is a series of payments for the same amount, the payments are
referred to as an annuity. When you calculate the present value of the note
payable (Table 6-1), it’s the present value of a single amount.
Table 6-2
Present Value of an Annuity $1 Lookup Table
Periods
6%
8%
10%
1
0.9434
0.9259
0.9091
2
1.8334
1.7833
1.7355
3
2.6730
2.5771
2.4869
4
3.4651
3.3121
3.1699
5
4.2124
3.9927
3.7908
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The factor at the intersection of 8 percent and five years in the present value
of an annuity of $1 table is 3.9927. The present value of the interest is $4,791
(rounded) ($1,200 × 3.9927). Add the two present value figures to get the carrying
value of the note, which is $18,403 ($13,612 + $4,791). Subtract $18,403 from the
face value of the note payable to get the discount of $1,597 ($20,000 – $18,403).
Figure 6-3 shows how to journalize this transaction, and Figure 6-4 gives you
the lowdown on the amortization table used to prepare the journal entry.
Figure 6-3:
Recording
discounted
note
payable.
©John Wiley & Sons, Inc.
Figure 6-4:
Discount
amortization
schedule:
interestbearing note
payable.
©John Wiley & Sons, Inc.
Chapter 6: Planning for Long-Term Obligations
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To record the borrower’s interest payment at the end of each year, journalize
the first year by crediting discounts on notes payable for $272 and debiting
interest expense for $1,472. The credit goes to cash for $1,200. For the second
year, you credit discounts on notes payable for $294, debit interest expenses
for $1,494, and credit cash for $1,200 — and so on for the remaining
three years.
Discussing mortgages payable
The most common type of note payable is a mortgage, which is used to
finance the purchase of real property assets such as land and buildings. The
property collateralizes the mortgage, which means the property is held as
security on the mortgage. If the company defaults on the mortgage, the
lending institution seizes the property and sells it in an attempt to recover
as much of the loan balance as possible.
Mortgages require a formal closing procedure that’s typically done at the
offices of a title company, an independent middleman that coordinates the
rights and obligations during the sale for the buyer, seller, and mortgage
company. As in the purchase of a personal residence, reams of paperwork
(such as the mortgage document and the transfer of the property’s title) are
passed back and forth among the buyer, seller, and closing agent for approval
and signature.
Another type of long-term debt involves capitalized leases. A company doesn’t
always buy its fixed assets — sometimes it leases them. In this scenario, the
lessee, the person leasing the property, records the capital lease as both a
leased asset and a leased liability. Read more about accounting for leases in
Book VIII, Chapter 4.
Treasury bonds defined
Treasury bonds are debt the government of the United States issues to
pay for government projects. As with any bond, repayment of principal is
­accompanied by a fixed (or variable in some new, inflation-proof U.S. bonds)
interest rate.
Treasury bonds have nothing to do with treasury stock, which is corporate
stock the issuing corporation buys back from investors. See Book IV, Chapter
5 for more about treasury stock. To understand how to account for corporate
bond debt, see the “Accounting for Bonds” section in this chapter.
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The dark side of debt-free
If a company pays off a debt (whether a note or a bond) early, the company
must determine whether a gain or loss was incurred on the transaction.
(Paying off a debt early is also referred to as debt extinguishment.) With an
early payoff, any unamortized discount or premium on the debt payable is
removed from the books. Because the debt is removed, any remaining discount or premium related to the debt should also be removed. This transaction may generate a gain or loss.
When computing a gain or loss related to an early payoff, keep these points
in mind:
✓ The liability is always debited (reduced) for the face amount of the debt.
✓ Cash is credited (reduced) for the amount paid to remove the debt.
✓ An unamortized discount is credited to adjust the remaining balance to
zero.
✓ After you post the first three entries, consider the remaining amount
you need in the journal entry to balance debits and credits. If you need a
debit, it’s a loss on bond extinguishment. A credit entry would be posted
as a gain.
Imagine that a company repurchases a note payable for $104,000; the face
value is $100,000. It was issued at a discount, and $3,000 of the discount isn’t
yet amortized at the date of repurchase. Here’s the journal entry:
✓ Debit bond payable $100,000 and loss on bond extinguishment $7,000
✓ Credit cash (paid to lender) $104,000 and discount on bond payable $3,000
Remember that a business can remove the debt from its balance sheet only if
one of the following occurs:
✓ The debtor pays the creditor and is totally relieved of the obligation. For
example, the debt was for $10,000 and the debtor paid the creditor the
full $10,000 plus all required interest.
✓ The creditor legally releases the debtor from any further obligation. For
example, the creditor agrees to cancel a portion of the debt.
This chapter doesn’t discuss troubled debt restructuring, which is an
advanced financial accounting topic. This takes place when terms of the debt
are modified for market or legal reasons. A good example is when the financial
institution lowers the interest rate. Another example is a short sale of a home,
in which the lender allows the homeowners to sell the home for less than the
balance due on the loan, so the homeowners can get out from under a home
they can’t afford and the borrower can recoup a portion of the principal.
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Accounting for Bonds
Bonds are long-term lending agreements between a borrower and a lender.
For example, when a municipality (such as a city, county, town, or village)
needs to build new roads or a hospital, it issues bonds to finance the project.
Corporations generally issue bonds to raise money for capital expenditures,
operations, and acquisitions.
The selling price of bonds, like publicly traded stock, is normally set by what
the market will bear. The issuer of the bond sets the interest rate, which is
known as the stated, coupon, face, or nominal rate. All four terms mean the
same thing — the interest rate stated in the bond indenture.
A bond indenture is similar to any type of legal financing document that you
may have signed to finance a house or car. It describes the key terms of the
bond issuance, including maturity date and interest rate.
The people who purchase a bond receive interest payments during the
bond’s term (or for as long as they hold the bond) at the bond’s stated interest rate. When the bond matures (the term of the bond expires), the company
pays back the bondholder the bond’s face value.
A bond is either a source of financing or an investment, depending on which
side of the transaction you’re looking at. Because this is a chapter on longterm liabilities, most of the text looks at this transaction from the source of
financing viewpoint.
Valuing bonds payable
A company can issue bonds either at face value (also known as par value),
which is the principal amount printed on the bond; at a discount, which is
less than face value; or at a premium, which means the bond sells for more
than its face value. Usually face value is set in denominations of $1,000.
Understanding premiums, discounts, and yields
To understand the value placed on a bond, you need to know the relationship
between bonds prices and yield to maturity. Yield to maturity can be thought of
as an investor’s total return on a bond. The total return has two components:
✓ Interest income earned on the bond.
✓ If the bond is purchased at a discount, the investor is paid the face
amount at maturity. The difference between the discount and the face
amount is a gain. The gain adds to the total return on the bond. A bond
purchased at premium results in a loss when the investor is paid the
face amount. The loss reduces the investor’s total return on the bond.
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Going over the effective interest rate
Generally accepted accounting principles (GAAP) prefers the effective interest method when accounting for bonds issued at a discount or a premium.
When using the effective interest method, you amortize by using the carrying value of the bonds, which is face amount plus unamortized premium or
minus unamortized discount.
You see the effective interest method used to amortize the no-face, no-interest
note payable (see “No-face, no-interest” earlier in this chapter). In that instance,
the discount represents the interest earned by the lender over time. Check
out Figure 6-2. The carrying amount started as the cash received by the issuer
when the note payable was issued. That amount can also be stated as the face
amount less the unamortized discount, or $20,000 – $6,388 = $13,612.
Over time, the carrying amount is increased by the discount amortization
each year. At the note’s maturity, the carrying amount is equal to the face
amount, $20,000. If you’re the borrower, the amortization of the discount
generates more interest expense to you (see Figure 6-2). For the investor,
amortization of the discount generates more interest income. In either case,
amortization increases the carrying amount until it equals the face amount.
GAAP allows the straight-line method if the result is materially the same:
straight-line method versus effective interest rate method. Keep in mind that
International Financial Accounting Standards (IFRS) requires use of the
effective interest method.
Figuring out the present value of a bond
In many ways, this present value process is the same as the concepts used
for notes payable. Assume a company issues a $100,000 bond due in four
years paying seven percent interest annually at year-end. Here are the steps
to compute the present value of the bond:
1. Compute annual interest expense. The interest expense is $100,000 ×
0.07 = $7,000 interest expense per year.
2. Find the market interest rate for similar bonds. You can check a financial publication, such as The Wall Street Journal, for current market rates
on bonds. The market interest rate may differ from the rate actually being
paid. You want the market rate, because in the next step you use the
market rate to look up the present value factor for the interest payments.
Assume that the market rate for similar bonds is 11 percent. Specifically,
similar bonds (with similar credit rating, stated interest rate, and maturity date) are priced to yield 11 percent. Because the stated rate is 7 percent, the bond must be priced at a discount. The discount is amortized
into income, which increases the yield to maturity (see “Understanding
premiums, discounts, and yields” earlier in this chapter for details).
Chapter 6: Planning for Long-Term Obligations
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3. Find the present value factors for the face value of the bond and interest payments. Use the present value of $1 table to find the present value
factor for the bond’s face amount. Use the present value of an annuity
table to find the present value factor for the interest payments. In each
case, find the factor for four periods (years) at 11 percent interest. In
this example, the present value factor for the bond’s face amount is
0.65873, and the present value factor of the interest payments is 3.1025.
Search the web to find a present value of $1 table and a present value of
an annuity table. Look for tables that list the factors out to the fifth decimal place.
4. Use the present value factors to calculate the present value of each
amount in dollars. The present value of the bond is $100,000 × 0.65873 =
$65,873. The present value of the interest payments is $7,000 × 3.10245 =
$21,717, with rounding.
5. Add the present value of the two cash flows to determine the total
present value of the bond. In this example, $65,873 + $21,717 = $87,590.
Issuing at face value
This one is the easiest type of bond transaction to account for. The journal
entry to record bonds that a company issues at face value is to debit cash
and credit bonds payable. So if the corporation issues bonds for $100,000
with a five-year term, at 10 percent, the journal entry to record the bonds is
to debit cash for $100,000 and to credit bonds payable for $100,000.
Face value (or face amount) refers to the amount of debt stated on the face of
the bond certificate. It represents the amount that must be repaid at maturity.
For bonds, par value has the same meaning as face value. This section uses
the term face value, because that term refers to the amount stated on the
bond certificate.
Mulling over bond pricing
Bond prices are expressed as a percentage of par value (face amount). A
bond with a face amount of $1,000 may have a bond price of 100, or 100 percent of par value ($1,000). Bonds issued at a premium have a bond price of
more than 100. For example, a price of 102 means 102 percent of par value. In
this case, a $1,000 bond’s price would be $1,020. A bond priced at 98 (a discount), would have a price of $980 per $1,000 bond.
Calculating interest payments
Interest payments don’t change, regardless of whether the bond is priced
at par, a premium, or a discount. To calculate interest payments on a bond,
multiply the principal amount by the interest rate stated on the face of the
certificate (stated rate). For example, suppose the stated rate of a bond
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is 10 percent, interest is to be paid semiannually (every six months), the
bonds are issued on July 1, and the first interest payment isn’t due until
December 31. The interest payment is principal multiplied by interest rate
multiplied by time; in this case, $100,000 × 0.10 × ½ = $5,000. So your journal entry on December 31 is to debit bond interest expense for $5,000 and
credit cash for $5,000. The interest expense may change, depending on
whether the bond is priced at a premium or a discount. However, the cash
payment for interest is fixed.
See Book IV, Chapter 4 for examples of issuing bonds at both a premium and a
discount.
Book VII
Making Savvy Business
Decisions
Discover ways to fix bottlenecks, increase efficiency, and lower production costs at
www.dummies.com/extras/accountingaio.
In this book…
✓ Estimate production cost by using job costing and process
costing and use either of those values to ballpark a profitable
price to charge for a product. Set the right price from the
get-go.
✓ Calculate the product cost based on activities that go into manufacturing and selling the product, so your cost per product
and pricing are more accurate. Find out what peanut-butter
costing is and why and how to avoid it.
✓ Analyze a product’s break-even point, target profit, and margin
of safety. Savvy business owners use these tools to plan production and sales levels.
✓ Calculate variance into the pricing equation to avoid any nasty
surprises. Variance analysis compares budgeting plans with
actual results.
✓ Survey various pricing models to make smart pricing decisions.
Decide which pricing method will cover all your costs and generate a reasonable profit.
✓ Size up the financial condition of your business and recognize
the most common early warning signs of financial trouble. Use
the results to improve your business.
Chapter 1
Estimating Costs with Job Costing
In This Chapter
▶ Going over how job costing works
▶ Identifying cost objects
▶ Using job costs to price a product or service
▶ Reviewing the flow of costs through a manufacturing system
J
ob costing is a methodology you use when the costs to manufacture a
product or provide a service vary according to each customer’s unique
needs. Job costing allows you to provide detailed price estimates based on
the product or service provided. A roofing business, for example, uses job
costing, because the cost varies according to the customer’s needs. The
amount of material depends on the type of roof and the square footage.
Labor time varies, depending on the roof’s size, pitch, and unique angles.
A cost object is the product, activity, or process that causes your company
to incur costs. In this chapter, you see how to assign costs to the cost object.
You also find out how to follow the flow of manufacturing costs as a product
moves through the production process.
Understanding How Job Costing Works
For some businesses, nearly every customer job has different costs, and
that’s where job costing asserts its value. You need a job costing estimate in
order to get the customer’s business, and you need to track costs accurately
so you generate a reasonable profit.
The different costs for different jobs are often self-evident. Material costs,
labor hours, mileage cost, and type of equipment used are likely to vary. For
example, a tree trimming company incurs more costs to remove a 30-foot tree
than to remove a small stump. The big tree takes more labor and different
equipment.
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Some factors could lower costs and make a business more competitive in
price (or improve its bottom line). For example, a tree trimming company
working on a job in a certain neighborhood may distribute a flyer offering
free estimates to other homes in the neighborhood. It’s a smart business
move. If the tree-trimming services already stands to incur the cost to locate
its employees and equipment in a certain area, why not perform as much
work as possible while it’s there? The business can spread some costs (mileage, for example) over several jobs. As a result, its cost per job in that neighborhood is lower, boosting its profit.
The business lesson is that a little bit of flyer can go a long way.
Cost objects: The sponges
that absorb money
A cost object is anything that causes you to incur costs. Think about a cost
object as a sponge that absorbs your money. The object can be a customer,
job, product line, or company division. Carefully identifying cost objects
helps you cost your product or service accurately.
Assume you manage a group of plumbers. You’re reviewing the month’s mileage expense (the equivalent of gasoline) for your staff and notice a 20 percent
increase from the prior month. Why? You start asking questions. As it turns
out, the customer demand for plumbing work required your staff to drive
more miles. The average customer lived farther away.
You grumble, “That driving ran up a lot of costs!” Yes, it did, and you do the
driving to meet the needs of your customers. In this example, the cost object
was the group of customers for the month. Without any customers, you
wouldn’t have paid for all the gas. (Well, you wouldn’t have had any income
either, but never mind that.) No cost object means no costs incurred.
Direct costs are traced to the cost object, and indirect costs are allocated to
the cost object.
Indirect costs can be fixed or variable. Insurance costs on vehicles are a
fixed indirect cost. The premiums are fixed, and the cost is indirect to the job
because you can’t trace the vehicle insurance cost directly to a specific job.
Utility costs for the office (such as heating and cooling) are variable indirect
costs. Costs vary with the weather, but as with the insurance premiums, you
can’t trace them directly to any one job.
Chapter 1: Estimating Costs with Job Costing
423
Here’s how fixed and variable costs are assigned to cost objects:
✓ Direct costs
Variable direct costs, such as denim material, where denim jeans are
the cost object
Fixed direct costs, such as a supervisor salary at an auto plant,
where an automobile produced is the cost object
✓ Indirect costs
Variable indirect costs, such as utility costs for a television plant,
where a television produced is the cost object
Fixed indirect costs, such as insurance for a plumbing vehicle, where
a plumbing job is the cost object
Charging customers for direct
and indirect costs
To bill a customer and calculate a profit, you add up all the costs for that
­customer, whether they’re direct or indirect costs.
Book VII
If, for example, you manufacture kitchen countertops, you include all direct
and indirect costs of a custom countertop installation in order to bill the
customer. A direct cost may be marble (for material). To find the total cost
of material for the job, you compute direct material cost as Marble × Square
footage used × Cost per square foot.
Indirect costs are different. If your kitchen countertop business makes lease
payments on an office building, the cost is indirect. You can’t know the exact
amount of indirect costs for the client. You also can’t trace the cost directly
to a specific customer, but you can allocate it by using a cost allocation base.
For job costs to be accurate, you need to collect information before you bill
the client. You also need to consider the difference between your cost estimate and the final bill. Your client needs to understand how costs higher than
the estimate will be handled. Should the customer expect to pay it, or will you
absorb the cost (and lower your profit)? If this isn’t handled correctly, the
customer may be upset. Unforeseen things happen, of course, and you should
explain when you hand the customer the estimate that the final bill may be
different. A customer is likely to accept additional labor costs. That’s because
the exact cost of labor is probably hard for you to predict.
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Allocating indirect costs
Think about allocating indirect costs this way: You need to allocate a dollar
amount of cost (say, $100). You spread that cost over a group of customers,
a level of production, or some other activity level. In this section, you see
how that may work.
A carpenter owns trucks that require repair and maintenance expense. That
cost can’t be traced to specific customers; instead, these indirect costs are
allocated to a cost object. You find a “best” method to assign repair and
maintenance expense to clients, perhaps labor hours worked for the
customer.
The logic is that if you work more hours for a specific customer, you probably
use your truck more. If you use the truck more, that customer should absorb
more of your truck’s repair and maintenance cost.
Tracing the repair and maintenance cost of the truck back to a specific
c­ustomer is virtually impossible. So you make your best educated guess to
distribute the cost.
Defining cost allocation
Cost allocation is the process of connecting an indirect cost to a cost object.
A cost pool is a grouping of similar costs. You can think of a cost pool as a
bunch of similar cost objects thrown together. In this case, the cost object is
a specific job.
A cost driver is an item that changes the total costs. If you drive the trucks
more, they require more repair and maintenance. An activity (driving to see
customers) drives up your costs (repair and maintenance).
Just to clarify: The cost object is the “sponge” that absorbs the cost. The cost
driver adds to the size of the sponge. A bigger sponge absorbs more cost.
Assume the total repair and maintenance expense for three carpentry trucks
is $3,000. During the month, your workers provide service to 300 clients.
Each customer is allocated $10 of repair and maintenance expense
($3,000 ÷ 300 clients).
If the cost driver increases to 400 clients per month, the carpenters drive
more miles. As a result, the trucks require more maintenance and possibly
repairs. Your monthly repair and maintenance expense is higher.
At 400 customers for the month, assume total repair and maintenance
expense for three carpentry trucks is $3,600. Now each customer is allocated
repair expense of $9 ($3,600 ÷ 400 clients). The cost driver increase
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(number of customers) changes your total cost to $3,600. Because you also
have an increase in total customers (400), the $3,600 is spread over a larger
group. The total cost increases, but the cost allocated per customer declines.
You can see how the cost allocation process can get complicated.
Grouping similar costs into the same cost pool is often beneficial when the
cost driver is the same. Consider a cost pool for the indirect costs for the carpentry trucks. In addition to repair and maintenance expense, the company
pays for insurance and depreciation on the three trucks. None of these costs
can be traced to a specific customer; instead, you need to allocate these
costs. A good cost pool includes depreciation, insurance, and repair costs on
the trucks. This cost pool can be allocated in the same way as the repair and
maintenance costs in the previous example.
Implementing job costing in manufacturing:
An example
To implement job costing in a manufacturing company, first think about
dividing your costs into two piles: direct costs and indirect costs. In a manufacturing setting, you have direct materials and direct labor you can trace
directly to any given job. So far, so good. Next, think about what’s driving
indirect costs. You spread those indirect costs to the work you perform.
As an example, Reliable Fencing manufactures and installs wooden fences for
the residential market. Reliable has a manufacturing component and a service component.
Reliable provides the customer a cost estimate. The estimate is based on the
type of fence, fence height and length, and labor hours needed for installation. Because nearly every job has a different set of costs, Reliable Fencing
uses job costing. This system allows Reliable to compute costs accurately.
And from that, Reliable can calculate a selling price that generates a reasonable profit.
Imagine that you’re the manager of Reliable Fencing. The Johnsons have
requested an estimate for a fence in their backyard. To provide the estimate,
you discuss the fence models and types with them. You measure the length
needed for the fence and the height requested. Finally, you consider any
extra labor costs you may incur. For example, the Johnsons want the fence to
jog around several trees so the fence doesn’t damage the tree trunks.
The Johnsons’ fence is the cost object. Reliable will incur costs if the client
orders a fence and work starts on the project. But before getting an order,
you have to provide a cost estimate.
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Figuring out direct costs
Reliable combines the cost of wood, paint, and a waterproofing treatment for
the wood. That combined cost represents direct materials. As the manager,
you compute direct material costs:
Direct materials = Quantity of materials × Unit price paid for material
You buy material measured in square feet. The unit cost is the price per
square foot. Here’s the amount of material needed and the cost:
Direct materials = 600 square feet of material needed × $5 per square foot
Direct materials = $3,000
Your other direct cost is direct labor. Your staff must cut the wood, paint it,
waterproof it, and build the fence. Thinking through it further, your staff must
measure and dig postholes. They then fill the area around the posts and nail
the fence boards onto the posts, all while keeping everything level. Not easy!
It takes real skill and planning. As a result, the owners of Reliable Fencing
know it’s best to hire skilled people and pay them a reasonable hourly rate.
Your experience as Reliable’s manager allows you to estimate the labor time
needed based on several factors. You consider the square footage of material
needed; the length and height of the fence; and any extra work, such as going
around those tree trunks. Here’s your formula for direct labor costs:
Direct labor = Hours of labor × Rate paid for labor
Note a difference in terms: Price is used for materials, and rate is the term used
for labor. That distinction comes up in the world of cost variances.
You estimate that 2 people working 20 hours can complete the job. Using
these numbers, you determine the labor cost:
Direct labor = Number of workers × Hours of labor per worker × Hourly
rate paid for labor
Direct labor = 2 workers × 20 hours × $20 per hour
Direct labor = $800
Consider one more direct cost. You see a discussion of mileage expense earlier in chapter. That formula is also used here:
Cost per mile = Cost per gallon of gas ÷ Miles per gallon for the vehicle
Mileage costs = Miles needed for client × Cost per mile
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You calculate 15 miles (round trip) from your office to the job site. However,
the work will be completed over several days, so you estimate 45 total miles.
Your trucks get 20 miles to the gallon, and your fuel cost is $4 per gallon. It’s
not much, but here is the direct cost for mileage:
Cost per mile = $4 gallon of gas ÷ 20 miles per gallon
Cost per mile = $0.20 per mile
Mileage costs = 45 miles needed for client × $0.20 per mile
Mileage costs = $9.00
So you have three direct costs: materials, labor, and mileage. They’re direct
costs because they can be traced to the cost object: the Johnsons’ fence.
Calculating indirect costs
To allocate indirect costs, you decide on two cost pools. One pool is your
vehicle and equipment costs, which includes depreciation, maintenance,
repair, and insurance costs. The other pool is office cost, which includes
salary, benefits, accounting costs, and legal costs for your company. The cost
object for allocating these indirect costs is the customer base:
Vehicle and equipment costs
Office cost
Customers serviced
$4,000
$7,000
200
After you resolve how to allocate costs, try to keep it simple. You combine
the indirect costs into one amount: $4,000 + $7,000 = $11,000. You then divide
the indirect cost total by the number of clients for the month:
Indirect cost allocation rate = $11,000 ÷ 200 customers = $55 per customer
Indirect cost allocation rate = $55 per customer
Your office assistant asks a question: “Is that really fair? What if one client
has a $3,000 job, and another’s project is only $500? Should we be charging
the same amount of costs to both?” You think about the issue over lunch.
After lunch, you stop by your office assistant’s desk and say: “You know, a
client should expect that if we show up for a job of any size we’re going to
incur some office and vehicle costs. I don’t think a client will be surprised
by those fees.”
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The assistant thinks for a minute. “Yeah, that’s fair. If they showed up at my
house for a job, those indirect costs seem okay. I guess I’d expect to pay for it
somehow. As long as the cost charged to a small job isn’t huge, I think charging a rate per customer is reasonable.”
The discussion with your office assistant may convince you that your indirect
cost allocation should be more specific. If you could show the client how the
specific job generates indirect costs, he or she would be more inclined to
agree with your billing.
You need to weigh the cost and time needed to allocate costs with the benefit
of knowing more specific information. If customers generally accept the
$55 allocation rate as reasonable, great. Probably no reason to dig further
into your indirect costs.
If the majority of your customers have a problem with the rate, you should
consider more detailed analysis and present a more detailed indirect cost
billing. If not, you may lose the opportunity to do more work with the same
group of clients.
Presenting total job costs
Table 1-1 shows the total costs for the Johnsons’ fence job.
Table 1-1
Job Cost Sheet — Johnson Fence Job
Cost Type
Amount or Quantity
Price or Rate
Total Cost
Direct material
600 square feet
$5 per square foot
Direct labor
40 hours
$20 per hour
Mileage
45 miles
$0.20 per mile
$9
Indirect costs
1 customer
$55 allocation
$55
Total job costs
$3,000
$800
$3,864
Taking a Closer Look at Indirect Costs
by Using Normal Costing
In this section, you apply indirect costs to your product or service. You also
plan direct and indirect costs by using a normal costing system. Actual costs
represent what comes out of your checkbook. You determine actual costs
after the work is completed. Normal costing instead uses budgeted data,
which is generated before the work is completed. Normal costing uses a budgeted price or rate multiplied by the actual quantity used.
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Planning your work without some budgeted rates of cost is difficult. Normal
costing creates budgeted rates that you can use to plan your work. Although
normal costs may not equal your actual costs, they do give you a basis for
planning your spending each period.
Suppose you operate a landscaping company. Changes in costs can make
planning difficult. Maybe the costs you pay for materials, labor, and other
costs change as the year progresses. The cost of grass seed may go up,
increasing your material costs. Or your labor costs decline because the economy slows. More people with the needed skills are looking for landscaping
work, so you can offer a lower pay rate.
If you use actual costs, which change over time, pricing your product to
generate a reasonable profit is difficult. For example, if you had a 15 percent
profit above costs, a cost increase would eat away at your profit. Maybe
higher costs lower your profit to 10 percent.
Planning your cash needs is also more challenging. If you need to buy $10,000
of grass seed in the next 30 days, what if the price goes up? Maybe a shortage increases your grass seed cost to $12,000. That means that the check you
need to write will be $12,000, not $10,000. Now you need to have $2,000 more
cash available.
Budgeting and cash management is similar to planning a vacation. First, you
determine the costs (airline, car rental, hotel, gas). Next, you plan your cash
flow to pay for the vacation cost. If the prices are constantly fluctuating, planning is difficult. Many people try to book a vacation trip well in advance, so at
least airfare and lodging costs are fixed for the trip!
Budgeting for indirect costs
When you budget for indirect costs, you spread those costs to cost objects
based on a cost driver (refer to the section “Cost objects: The sponges that
absorb money”). Before you spread the indirect cost, you come up with a
rate to allocate the costs to the product or service. The indirect cost rate
allows you to price your product to produce a reasonable profit.
As the manager for the landscaping company, you decide on a cost pool
for indirect costs. Your only indirect cost is for vehicles and equipment
(depreciation, insurance, and repair costs). Your company is new, with
virtually no office costs to consider yet.
Many companies have planning meetings around the end of their fiscal
(­business) year. In the meetings, they make assumptions about many issues,
including next year’s costs. This is when a company plans predetermined or
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budgeted indirect cost rate. The predetermined overhead rate depends on
total indirect costs and the cost driver you select. Indirect costs are also
referred to as overhead costs.
During a planning session, you consider the prices and rates you paid last
year. You think about how prices and rates have changed and consider your
estimates of miles driven each month. Based on that analysis, here is your
budgeted indirect cost rate:
Predetermined or budgeted indirect cost rate = $7,500 ÷ 1,400 miles
= $5.36 per mile
Not until the end of the year does the company know what the actual total
indirect costs and the actual miles driven will be. Here’s the actual indirect
cost rate for the vehicles and equipment (using miles driven for the month as
the cost object). The formula is explained in the section “Computing direct
costs and indirect costs”:
Indirect cost allocation rate = $8,000 ÷ 1,300 miles = $6.15 per mile
Predetermined or budgeted means planned in advance. Your budgeted monthly
rate has a lower monthly cost level ($7,500 versus $8,000) but more monthly
miles (1,400 versus 1,300). As a result, the budgeted overhead rate is lower.
You use this rate to apply indirect costs to every job during the year.
At the end of the year, you realize that you didn’t allocate enough costs to
your jobs. As a result, your actual profit will be lower than what you budgeted. Because actual costs aren’t known until the end of the year, you almost
always have a difference between budgeted and actual results.
Following a normal job costing system
Put together your budgeting process for indirect costs with a plan for direct
costs. Think of the combined process as normal costing. This chapter keeps
hammering away at this point, but it’s important: You trace direct costs and
allocate indirect costs.
Normal costing combines indirect cost rate with actual production. The
­process gets you closer to actual total costs for your product.
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Computing direct costs and indirect costs
To implement normal costing, you compute direct and indirect costs:
✓ Direct costs: Traced to the cost object by multiplying actual prices and/
or rates × actual quantity for a specific job object
✓ Indirect costs: Allocated to the cost object by multiplying predetermined or budgeted indirect cost rate × actual quantity for a specific job
object
Note that both direct and indirect costs use actual quantity in the formula.
While you come up with an indirect cost rate in planning, the rate is multiplied by actual quantities. In this case, the quantity is jobs for the month.
Introducing the job cost sheet
A job cost sheet lists every cost incurred for a particular job, including direct
material, direct labor, and all indirect costs. The job cost sheet is your basis
for computing your sale price and your profit. You use this document to
prepare a cost estimate for a client. Table 1-2 shows a job cost sheet using
normal costing for a landscaping job. Because some job costs are based on
budgets and estimates, many businesses round the calculations. You see that
total costs are rounded in Table 1-2.
Table 1-2
Normal Job Cost Sheet — Landscaping Job
Cost Type
Amount or Quantity
Price or Rate
Direct material
100 square feet of grass
seed
$12 per square
foot
Direct labor
15 hours of labor
$15 per hour
Mileage
30 miles driven
$0.18 per mile
$5
Indirect costs
30 miles driven
$5.36 per mile
$161
Total job costs
Total Cost
(Rounded)
$1,200
$225
$1,591
The indirect cost calculation (vehicle and equipment costs) uses the actual
quantity (miles driven) and the estimated rate per mile. The other direct
costs on the job sheet use actual quantities and actual prices/rates.
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Following the Flow of Costs through
a Manufacturing System
Costs flow through a manufacturing system, from buying materials for a product all the way to the customer sale. When you envision the flow of costs,
you find it easier to collect all the product costs you need to price a product.
When you know all the steps, you remember all the costs related to those
steps!
The manufacturing process described in the following sections assumes the
company uses process costing. Process costing assumes that each product
manufactured is similar to the others, maybe even identical. As a result, you
can track costs as they move from one production department to another.
You don’t need to track costs by each customer or each customer job.
Control starts with control accounts
Control accounts are temporary holding places for costs. Managing costs has
to start somewhere, and in accounting, that process most often starts with
control accounts.
Labor, materials, and indirect costs start off in control accounts. It may
sound strange, but these accounts and their balances don’t appear in the
financial statements. That’s because the balances are eventually moved to
other accounts. All the checks you write for manufacturing costs are posted
first to control accounts.
For many manufacturers and retailers, inventory is the biggest investment;
more cash is spent on inventory than any other asset. Because of that, a big
part of operating a profitable business is to control the costs of inventory.
Inventory is an asset you eventually sell to someone. (That’s a little different,
of course, from buildings and equipment.) For manufacturers, inventory has
three components: raw materials, work-in-process, and finished goods, whereas
retailers just have finished goods. Raw materials inventory is, broadly, products not yet started; work-in-process inventory is partially completed products; and finished goods inventory is completed products.
The three kinds of inventory are assets, because you eventually sell the goods
to a customer. When you do, the inventory asset becomes an expense — cost
of goods sold. Managing inventory starts in a control account.
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Following are the three major categories of control accounts. The amounts in
each of these accounts are eventually moved into production.
✓ Materials: You buy materials (such as wood for making kitchen cabinets)
in advance of making your products. Materials control is the term for the
control account for material costs.
✓ Labor: Consider labor costs. Employees report the hours they work on
time cards each week. Those cards list hours worked on various projects. For custom cabinets, the time cards list customer jobs that employees completed, and the hours worked. Wages payable control is the term
for the control account for labor.
✓ Indirect costs: A business (such as the kitchen cabinet business) has
indirect costs (for example, machine repair and maintenance). Your firm
has some method to allocate those costs to clients (see “Budgeting for
indirect costs”). However, you may not get to the allocation until after
you write checks for the cost. Overhead control is the term for the control account for indirect costs.
Control accounts (materials, labor, and overhead), work-in-process, and finished goods are inventory accounts, which are assets. Cost of goods sold
(COGS) is an expense account. When you make a sale to a customer, you “use
up” the asset. The asset becomes an expense. Debiting increases all these
accounts, and crediting decreases all these accounts. The balance for any of
these accounts is equal to debit balance less credit balance. For more about
debits and credits, see Book I, Chapter 2.
Walking through a manufacturing cost
example
Say you’re the manager of Homewood Custom Cabinets. You order $20,000
in lumber. You then take $5,000 of the lumber and start making cabinets for a
customer.
When you buy the lumber, cash (an asset) goes down, but the material control account (as asset) goes up. The material control account is increased
(debited) when you buy the lumber.
The material control account balance is decreased (credited) when you take
$5,000 in lumber to start using the material for a customer. Now how does
your material control account look?
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Material control account
Debit
$20,000
Credit
$5,000
If the month ends with no other activity, the ending material control balance
is $15,000 ($20,000 – $5,000).
But the $5,000 doesn’t just vanish. When you put materials into production,
you reduce (credit) the material control account and increase (debit) the
work-in-process control account.
Work-in-process control account
Debit
$5,000
Credit
You reduce one asset (material control account) and increase another asset
(work-in-process control account).
Now assume that the people on the shop floor finish some cabinets and move
$2,000 of the $5,000 work-in-process to finished goods.
Work-in-process control account
Debit
$5,000
Credit
$2,000
You reduce one asset (work-in-process control account) and increase another
asset (finished good control account). If the month ends with no other activity, the ending balance in work-in-process is $3,000 ($5,000 – $2,000).
Again, no money disappears. The “other side” of the transaction hits the finished goods control account.
Finished goods control account
Debit
$2,000
Credit
So one more time, you reduce one asset (work-in-process control account)
and increase another asset (finished goods control account).
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At some point, you sell what you made. You have $2,000 in finished goods.
Because you make custom cabinets, you have one customer identified as the
buyer. That customer “raised her hand” and placed an order. The finished
goods control account shows this:
Finished goods control account
Debit
$2,000
Credit
$2,000
You’re almost home. When goods are sold, you reduce (credit) the finished
goods account and increase (debit) cost of goods sold. And that’s an expense
account. At last!
Cost of goods sold
Debit
$2,000
Credit
The difference between your sale price and the cost of goods sold is your
profit.
The reason you do this exercise is to fully track where your inventory money
is. For custom cabinets, it can be a big deal if you’re building for, say, 20 customers at once. For off-the-shelf cabinets, it can be a very big deal. You may
be delivering 2,000 cabinets per month.
The flow lets you see where the inventory money is and spot production
logjams. Too much in the material control account suggests that you’re
overbuying or not producing at the rate you expected. Too much in the
work-in-process control account suggests that you’re not producing
completed product as planned. Too much in the finished goods control
account suggests that you’re not selling and you have “dead inventory.”
Applying the methodology
to other control accounts
Use the same flow process for labor and indirect costs. Labor costs accumulate in the control account until they’re traced to a customer or product
line. At that point, the cost moves to work-in-process. When the goods are
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completed, the costs move to finished goods. When goods are sold, the cost
moves to cost of goods sold. The labor cost process mirrors the system for
material costs described in the previous section.
For more about cost allocation see the “Budgeting for indirect costs” section
earlier in this chapter. For example, you’re recognizing depreciation expense
and repair costs on vehicles. Those costs are in an overhead account. You
plan a budgeted rate to apply indirect costs to products. As those costs are
incurred, the overhead control account is increased (debited).
When you allocate indirect costs to a customer or product line, you reduce
(credit) the overhead account and increase (debit) work-in-process c
­ ontrol
account. After that, the process is the same as with the other control
accounts. Costs move from work-in-process to finished goods to cost of sales.
Chapter 2
Performing Activity-Based Costing
In This Chapter
▶ Understanding peanut butter costing
▶ Designing and implementing an activity-based costing system
▶ Using activity-based costing to increase profits in the budgeting process
A
s a business owner or manager, you can always use more useful information — information that helps you make informed decisions. Chapter
1 introduces two widely used costing methods: job costing and process costing. Now dig deeper for better information on costs. Pull apart your product
or service and find out more about the activities that create cost. The result
is an activity-based costing system.
With activity-based costing (ABC) you incur costs when production and sales
happen. When you take an order over the phone, manufacture a product,
or place a box on a delivery truck, the activities generate costs. The activity
becomes the focus to assign costs. Because you’re connecting cost to the
activity that creates the cost, your cost per product is more accurate, and so
is your pricing.
Avoiding the Slippery Slope
of Peanut Butter Costing
Despite the benefits of ABC costing, many business managers use cost
smoothing, or peanut butter costing, instead, which spreads costs over a
broad range of cost objects. When you spread peanut butter, you smooth it
over the entire slice of bread. You don’t pay much attention to how much
cost is assigned to any particular part of the bread. Likewise, cost smoothing spreads the cost without paying too much attention to how much cost is
assigned to any particular cost object. The trouble is, costs aren’t assigned
as accurately as they should be.
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Cost allocation is the process of allocating indirect costs to products and services. The cost allocation base is the level of activity you use to assign costs.
Maybe you use 1,000 machine hours or 200 labor hours. Also, keep in mind
that direct costs are traced to products and services, not allocated. Stroll over
to Chapter 1 for more.
To understand the benefits of ABC, you need to see the slippery slope of
peanut butter costing. Here’s the setup: Say you’re a food distributor. You
have five restaurant clients that order meat, fish, and poultry every day. You
take orders, package them, and deliver the food to these businesses every
day. Your restaurant clients have high expectations; they expect high-quality,
fresh food to be delivered quickly so they can prepare their meals.
Your order manager handles the details of order processing. Her salary, benefits, and other costs total $5,000 per month, an indirect cost. The cost must
be charged to the restaurant clients. You can’t trace the cost of the order
manager to your service. Instead, you need to allocate it.
The following sections explain how to allocate indirect costs by using one
type of activity. You can see that using single indirect cost allocation can lead
to errors in assigning costs.
Recognizing a single indirect
cost allocation
A single indirect cost allocation uses one cost pool. (Chapter 1 defines cost
pools.) The food distribution setup uses one pool of costs — order manager
costs. With ABC, you end up dividing the costs of order management into
more cost pools, and you’re better off for it.
Everybody pretty much starts by creating a predetermined or budgeted overhead rate (described in Chapter 1). When you plan at the beginning of the
year, using a single indirect cost pool, you come up with an overhead rate for
the order manager’s cost, such as the following:
Annual budgeted indirect cost rate = Cost ÷ orders
= $60,000 ÷ 1,250 = $48 per order
The order manager’s cost of $5,000 per month amounts to $60,000 per year.
The five restaurants order nearly every business day of the year. You figure
that total orders will be 1,250 — 250 orders per year from five customers. (Isn’t
it great that in samples all customers order exactly the same number of times?)
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The single indirect cost allocation spreads the cost (order manager)
­uniformly over the cost object (orders). That’s $48 dollars per order.
This is an example of peanut butter costing, where all services receive
the same or similar amounts of cost.
A fly in the peanut butter: Dealing with
different levels of client activity
If some customers or activities eat up more costs than others, peanut
butter costing isn’t a true reflection of the costs. A customer or activity that
demands more effort should get a larger cost allocation. So companies that
use peanut butter costing miss the chance to allocate costs more precisely.
You no doubt know from experience that some customer orders are usually
smooth as glass. Other orders, from problem customers, often require your
staff to jump through extra hoops. For example, say you notice that your
order manager is spending a lot of time with two customers in particular. The
Steak Place and Riverside Fishery are making big demands.
They change their orders at the last minute at least once a week. When they
make this change, the order manager has to cancel the original invoice (the
bill), make a new one, and e-mail it. Then she has to change the shipping
instructions document; you don’t want the wrong goods put on the truck and
sent to the restaurant. So the order manager cancels the original shipping
instructions and makes new instructions.
“It’s really frustrating,” the manager says. “Sometimes they call so late that I
have to call the driver and tell him not to leave the dock. We unload the truck
and start over.” Well, no doubt you want to be known for your high level of
customer service, but this is getting ridiculous.
Another issue is that when the invoice and shipping orders change, the goods
coming out of inventory also change. Your pickers are taking products off the
shelf, putting them back, and then taking different products. These constant
changes eventually lead to mistakes in inventory. A picker may move a product in or out and not record it in the accounting records.
And here’s another point to consider: Your business supplies meat, fish, and
poultry — items that aren’t known for having a long shelf life. The excesses of
The Steak Place and Riverside Fishery may leave you with heaps of spoiled
product.
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You decide to take another run at allocating the office-manager cost. “Why
don’t we track the time spent on each client? Let’s try that for three months
and see how your time shakes out. It sounds like we should assign more
costs to the two customers you mentioned.” You change the cost allocation
from orders placed to time spent per customer.
After three months, you review the time spent per customer. Fortunately,
you’ve been tracking time carefully, and you’re using an excellent spreadsheet program.
The office manager works 24 days per month, 8 hours per day. Her total
monthly hours are 192 hours (24 days × 8 hours). Table 2-1 shows the
­breakdown.
Table 2-1
Order Manager — Monthly Hours Per Customer
Restaurant Customer
Hours for Month
Percent of Total
Apple Core Diner
30
15.6
Blue Lantern
30
15.6
Meadowbrook Grill
30
15.6
Riverside Fishery
56
29.2
The Steak Place
Total hours
46
24.0
192
100.0
Aha! The situation is just as the order manager described, but now you have
some metrics. Half the costing battle is measuring reality to confirm your
instincts.
With peanut butter costing, you spread the cost evenly. You assigned 20 percent of order-manager costs to each customer. Now you see that two customers account for more than 50 percent (!!!) of the order manager’s effort. The
time to reallocate the cost has arrived.
Undercosting and overcosting
If you use cost smoothing, you’re likely to incur product undercosting
or product overcosting.
✓ Product undercosting occurs when a product or service uses more
resources (costs) than you assign.
✓ Product overcosting occurs when a product or service uses fewer
resources (costs) than you assign.
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If either of these costing errors occurs, the cost of the product isn’t accurate,
and your profit calculation is incorrect.
Discussing product-cost cross-subsidization
Undercosting or overcosting creates product-cost cross-subsidization, meaning
that if you undercost one product, you will overcost another. It’s common
sense and simple math. You have a fixed amount of cost to assign. If you’re
“over” in one product, you’ll be “under” in another. That situation throws off
your cost and profit calculations.
Say you have two products, A and B. (Obviously, your marketing department
needs to come up with better product names.) The total cost to be allocated
is $100. You allocate $50 of costs to product A and $50 to product B. If you
overcost product A by $10, you allocate $10 too much. That means you
undercost product B by $10. In other words, the actual costs should be $40
for product A and $60 for product B. You start with $100 in your “bucket” of
costs. When you allocate too much for product A, too little remains to allocate to product B.
Undercosting or overcosting direct costs is relatively easy to figure out and
fix. How do you catch mistakes? You trace direct costs, so you can determine
the exact cost of material used in production. Undercosting or overcosting of
indirect costs is harder to catch. Allocating indirect costs is less precise than
tracing direct costs.
For example, allocating utility costs in a factory is a bit difficult, but you
can do it. The cost accounting “secret” is to invest time investigating the
activities that result in utility costs. For example, if one of the manufacturing
machines runs twice as long as another, that activity is probably consuming
twice as much electricity. The higher machine activity should result in twice
as much utility expense.
Table 2-1 shows that investigation pays off. Two customers are chewing up
more than 50 percent of the order manager’s effort by requiring more hours
of her time. The investigation of the activity produces metrics, which form the
basis of a better cost allocation plan. For the tools and techniques, see the
section “Designing an Activity-Based Costing System,” later in this chapter.
Underallocating or overallocating messes up pricing
Underallocating or overallocating costs impacts your product price and your
profit. If your product costs aren’t accurate, you can’t price your product
­correctly.
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Say you overallocate costs for retailing a men’s dress shirt. You think total
shirt cost is $31 in direct and indirect costs, and you want a $10 profit per
shirt. You therefore price your shirts at $41. But that may not be correct! If
the true cost of the shirt is only $30, $1 is overallocated. As a result, your
profit is $11 ($41 – $30).
Well, what’s wrong with that? You’d prefer to make $11 a shirt instead of $10.
But with that higher price, you may lose some sales. Most people have a
price point — a maximum price they’re willing to pay based on the value they
perceive. Because the apparel industry is highly price-driven, you could be
losing sales, which would hurt your bottom line.
If a lot of customers say to themselves, “The most I would pay for that shirt is
$40,” you may lose sales by charging $41. Although you make another dollar
per shirt at $41, your sales may decline to the point where you make less
total profit.
A bigger pricing problem may be when a product’s cost is underallocated.
Assume that you underallocate another men’s dress shirt by $5. You think the
total cost is $50. To make a $10 profit per shirt, you set the sale price at $60,
so everything’s fine, right? Wrong! If costs are allocated correctly, the real
profit is $5 ($60 – $55). Underallocation has resulted in a sale price that’s too
low, and that reduces profit.
You can’t make up this deficiency through volume sales. Usually, shirts selling
for $60 don’t go flying off the display table.
Designing an Activity-Based
Costing System
If your ABC system is well designed, you allocate costs more precisely. This
section helps you carefully separate costs between direct costs and indirect
costs. You also consider the specific activities that drive the indirect costs
higher. Finally, the indirect costs are allocated to the activities that cause
those costs to be incurred.
Refining your approach
ABC is a refined costing system, or a more specific way to assign costs to cost
objects. The system avoids using big, generic categories, such as splitting
a cost evenly between divisions. Instead, it allocates indirect costs to the
Chapter 2: Performing Activity-Based Costing
443
activities that generate those costs. The result is likely to be more accurate
costing and product pricing.
The refined costing system requires you to perform the following three tasks:
✓ Direct cost tracing: Review your direct costs and categorize more costs
as direct costs, if possible.
✓ Cost pools: Review cost pools and create more pools, if necessary.
✓ Cost-allocation bases: Decide on cost-allocation bases by using causeand-effect criteria.
Direct costs are traced to cost objects. As a result, the amount of cost is fairly
easy to determine. For example, determining the amount of leather used to
make the leather handbags is easy.
Cost pools should be homogeneous; that is, each of the costs has the same
cost allocation base. The costs have a similar cause-and-effect relationship.
Therefore, if you have more than one allocation base, you should have more
than one cost pool. A good example is a cost pool combining vehicle depreciation, repair and maintenance, and fuel costs. The costs all increase when
your vehicles drive more miles. The cost allocation base should be mileage,
and you simply allocate a dollar amount of indirect cost per mile driven.
Grouping costs by using a cost hierarchy
A cost hierarchy groups costs into cost pools based on cost drivers or cost
allocation bases. A cost hierarchy has levels, which explain how broadly you
look at costs and activities. Here are levels you may use in a cost hierarchy:
✓ Unit-level costs are cost activities performed on an individual unit,
whether a product or service. If you make blue jeans, your unit is one
pair of jeans. An individual tax return is a unit, if you prepare tax returns
for clients.
✓ Batch-level costs are cost activities that generate costs at the batch
level. For example, when an automobile plant changes from one car
model to another, it’s changing batches and incurring setup costs. The
plant is “retooling,” which may include moving machinery, and certainly
includes changing out the dies and reprogramming the welding robots.
✓ Customer-level costs are cost activities generated for one customer. If
you’re remodeling a kitchen, your labor costs, materials used, and overhead costs incurred for a specific customer are all customer-level costs.
Customer-level costs may include multiple orders from the same client.
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✓ Product-sustaining costs are cost activities that support a particular
product or service line, regardless of the number of units produced.
A product-sustaining cost extends the life of a product; technology
products are good examples. To stay relevant with customers, software
companies come out with endless new versions of software. Extending a
product’s life is supposed to keep customers buying it. Design costs can
be product-sustaining costs. To keep the technology product current,
you change the design. You can allocate product-sustaining costs to a
product or to an entire product line (sometime called a “product family”
in high tech).
✓ Facility-sustaining costs are cost activities that support the overall
company, such as legal and accounting activities. The rent, insurance,
and maintenance on the company’s building are facility-sustaining costs,
because the building is essential to keeping the entire company running. The costs should be allocated over the entire company. Companies
with multiple buildings sometimes cost allocate for each building to see
whether a building is too expensive to occupy.
If you use a fine-enough granularity, you can get really precise costing. On the
other hand, too much granularity will make you crazy. The financial benefit of
precise costing should be greater than the time and expense to track the cost
information. The financial benefit is more accurate product costs and more
precise profit calculations.
Testing your ABC design
The following example begins by separating direct and indirect costs. You
also see descriptions of the activities that generate indirect costs. This example allocates indirect costs and calculates the full cost of the product.
For this example, assume you manage a company that makes and installs
automobile windshields. You have a forward-looking product called a smart
windshield, which uses lasers, infrared sensors, and a camera to help drivers
with vision problems drive well. You sell two products: sedan windshields
and van windshields. The company wants to implement activity-based costing for indirect costs. Ready, set, go!
Dealing with direct costs
You begin by sitting down with the production manager to get a handle on
direct costs. You produce 1,500 windshields each year (750 for sedans and
750 for vans). You trace $300 of direct materials per windshield and $500 in
direct labor per unit. Table 2-2 shows direct costs.
Chapter 2: Performing Activity-Based Costing
Table 2-2
445
Windshield Direct Costs
Type of Cost
Units × Cost
Total
Direct material
1,500 units × $300
$450,000 ($225,000 per type)
Direct labor
1,500 units × $500
$750,000 ($375,000 per type)
Diving into the cost pools
Next, you and the production manager list the indirect cost activities to manufacture and install windshields. Your goal is to pull apart the cost pools. In
other words, you make sure that each cost pool is based on a specific activity. The more specific the cost pool, the more likely you’re allocating costs
to products correctly. Table 2-3 shows the indirect costs for producing and
installing windshields.
Table 2-3
Indirect Cost Activities — Windshield Production
and Installation
Activity
Description
Molding setup
Install mold in machine to create a windshield
Machine operation
Run machine to convert material in mold to a windshield
Quality inspection
Review product for defects
Packaging and delivery
Pack windshield; load into truck for delivery to client
Installation
Install windshield at client location
You review to see whether any of these costs are direct costs. That would be
good, because it gets you out of the cost allocation business. Using a direct
cost traced to a product results in greater precision than using an indirect
cost allocated to a product.
Applying indirect costs by using a cost allocation base
The next step is to link the indirect costs to the cost pools (the activities) by
using a cost allocation base. At the start, you agree that labor hours should
be used to allocate indirect costs for each activity, except for machine operation. The machine cost is allocated based on machine hours. Table 2-4 allocates each cost pool (activity) based on the total hours required to complete
each activity. You perform this analysis for all products.
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Table 2-4
Cost Allocation Rates
Activity
Allocation
Base
Molding setup
Labor hours
Machine operation
Machine
hours
Quality inspection
Labor hours
Packaging and
delivery
Installation
Total
Cost
Total
Hours
Allocation
Rate/Hour
$20,000
150
$133/hour
$500,000
5,700
$88/hour
$100,000
1,050
$95/hour
Labor hours
$50,000
525
$95/hour
Labor hours
$30,000
900
$33/hour
Allocate and celebrate: Assigning the cost
allocation rates to the products
You have the allocation rate per hour (either machine hours or labor hours).
Now decide how many hours to use to apply the rate. The goal is to tie the
cost allocation to the activity as closely as possible.
Each product has a different mold. Your company changes the windshield
being produced by changing the mold. Because of the sedan windshield’s
curve, more labor hours are required to set up the sedan’s mold.
More machine hours are required to produce the van windshield, simply
because the van windshield is bigger. The van’s larger windshield also
requires more time to inspect, package, and deliver.
Installation costs are the same for both products. Table 2-5 lists the cost
­allocation for each product and the percentage of the total hours for each
activity.
Table 2-5
Cost Allocation as a Percentage of Total Hours
Activity
Allocation
Rate/Hour
Sedan Cost and
(Percent Hours)
Van Cost and
(Percent Hours)
Molding setup
$133
$13,333 (67%)
$6,667 (33%)
Machine
­operation
$88
$236,842 (47%)
$263,158 (53%)
Quality
­inspection
$95
$42,857 (43%)
$57,143 (57%)
Chapter 2: Performing Activity-Based Costing
Activity
Allocation
Rate/Hour
Sedan Cost and
(Percent Hours)
Van Cost and
(Percent Hours)
Packaging and
delivery
$95
$21,429 (43%)
$28,571 (57%)
Installation
$33
$15,000 (50%)
$15,000 (50%)
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At long last, you review the total product costs for sedan and van windshields (see Table 2-6).
Table 2-6
Total Costs by Type — Sedan and Van Windshields
Type of Costs
Sedan (750
Units)
Van (750
Units)
Total (1,500
Units)
Direct material
$225,000
$225,000
$450,000
Direct labor
$375,000
$375,000
$750,000
Molding setup
$13,333
$6,667
$20,000
Machine operation
$236,842
$263,158
$500,000
Quality inspection
$42,857
$57,143
$100,000
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Packaging and
delivery
$21,429
$28,571
$50,000
Installation
$15,000
$15,000
$30,000
Total costs
$929,461
$970,539
$1,900,000
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Cost per windshield
$1,239.28
$1,294.05
The cost per van windshield ($1,294.05) is slightly higher than the cost per
sedan windshield. The higher cost for vans makes sense. You can use the
total costs in Table 2-4 and the percentages in Table 2-5 to assign costs.
You get the same cost allocation that’s calculated by using the rates per hour
in Table 2-5. You need the cost allocation rates to easily assign costs to all of
your production. That’s why the rates per hour are important.
Take a look at indirect costs. Installation costs are evenly split, so disregard
that cost pool. Consider the other indirect costs. Other than molding setup,
all the remaining indirect cost pools have a larger allocation to the van. That’s
reasonable, because the van windshield is bigger than the sedan windshield.
It costs more to run it through a machine, to inspect it, and to package it.
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Using Activity-Based Costing to Compute
Total Cost, Profit, and Sale Price
The only constant is change. Demand for your product is probably always
changing. Material costs may increase (they rarely go down). Increased competition may force you to lower your prices to prevent sales from slipping.
Luckily for you, activity-based costing is a tool to manage indirect cost allocations effectively as conditions change.
Take a look at the following example, which shows how to use cost allocation to compute total cost, profit, and a sale price. Say you operate a lawn
care business that provides two services: flower bed planting and care, and
lawn planting and care. You plan and price your work based on a 25-squarefoot area. One unit for your business is 25 square feet, whether it’s a lawn or
flower bed. You refer to one unit as one customer yard. Table 2-7 shows a
summary of the cost objects for the business.
Table 2-7
Flower Bed and Lawn Care Costs
Type of Costs
Flower Bed
Lawn Care
Direct materials
Mulch and fertilizer
Sod, grass seed, and
fertilizer
Direct labor
Clear area, plant, or
install material
Clear area, plant, or
install material
Estimator cost (indirect
cost)
Flower bed inspection
and analysis
Lawn inspection and
analysis
Transportation cost
(indirect cost)
Depreciation,
i­nsurance for vehicles,
and ­mileage
Depreciation, insurance
for vehicles, and mileage
Office cost (indirect
cost)
Costs for dispatcher/
accountant
Costs for dispatcher/
accountant
In planning, you determine that your business will service 500 units in the
upcoming year. Assume that the sales will be evenly split between the two
services (250 yards each).
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Allocating indirect costs evenly by product
Initially, you allocate indirect costs by splitting the indirect costs between
the product types. Table 2-8 shows an even allocation of indirect costs. The
direct costs are traced to each service you provide, either flower bed work or
lawn care.
Table 2-8 Costs and Profit by Product — Flower Bed and Lawn Care
Cost (250 Units of Each Product)
Flower Bed
Lawn Care
Total
Direct material
$25,000
$30,000
$55,000
Direct labor
$37,500
$25,000
$62,500
Estimator cost (indirect cost)
$15,000
$15,000
$30,000
$7,500
$7,500
$15,000
Office cost (indirect cost)
$12,500
$12,500
$25,000
Total costs
$97,500
$90,000
$187,500
Transportation cost (indirect cost)
Add: Profit (10 percent of cost)
$9,750
$9,000
$18,750
$107,250
$99,000
$206,250
Cost per unit (yard)
$390
$360
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Sale price per unit
$429
$396
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Total sales
Estimator cost, transportation cost, and office cost are evenly split. Now
think about profit as a percentage of total costs. In Table 2-8, the flower
bed profit calculation is $9,750, or 10 percent of costs ($97,500 × 0.10). To
compute your sale price for flower beds, add the total cost to profit. That’s
$107,250. Finally, divide both the total cost and total sales by 250 yards. That
provides cost per unit of $390 and sale price per unit of $429 for flower beds.
Analyzing and reallocating cost activities
A key point of activity-based costing is basing each cost pool on a specific
activity. This puts you on the road to more accurate costing of your product.
To find out more, ask your staff in detail about their activities.
The estimator’s job is to discuss each project with the client. She assesses
the current condition of the yard and the labor and materials needed for the
project. Finally, she supervises the work to completion. You ask your estimator to track the amount of time she spends on each type of product. It’s
simple: She will post her time to a flower bed column or a lawn column on a
spreadsheet.
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After a few months, you find that the estimator spends 70 percent of her time
on flower bed projects. “Flower beds take more time to discuss with the
client,” she says. “Most of time, we’re dealing with an existing flower bed. The
customer decides what to keep and what to throw out. Lawns are easier. You
don’t have much to discuss, other than the current condition of the grass.”
Based on this discussion, clearly you should assign 70 percent of the estimator’s cost to the flower bed product.
At the same time, the estimator tracks mileage on the trucks and vehicles.
“If you look at this map, you’ll see that most of our flower bed work is in the
wealthier area of town. That’s farther from our office than most of the lawn
work.” She looks through her mileage log. “I calculated that 60 percent of our
drive time and mileage is spent on flower bed work.” Okay, more progress!
You probably should allocate 60 percent of the transportation costs (vehicle
depreciation, insurance, and fuel) to the flower bed product.
Your last stop is your office assistant’s desk. “You know we get a lot of cancellations and rescheduled work for lawn care.” He pauses for a minute. “I think
because the work isn’t complicated, and we have a lot of competitors, people
don’t take it as seriously. They change and cancel without much thought.”
Well, a cancellation or rescheduling fee would reduce the problem, but
that’s a cost story for another day. For now, just consider the activities that
generate office costs. The office assistant’s cost (salary, office supplies, and
computer) can be allocated based on his time. When a customer cancels or
reschedules, the office assistant spends time on the phone with customers,
the estimator, and employees. In addition, the paperwork for the project has
to be changed. After more analysis, the two of you decide that 60 percent of
the office assistant cost should be allocated to lawn work.
Changing allocations to cost pools
You investigate indirect costs and make some changes. Table 2-9 shows the
cost allocation changes to the three indirect cost pools. The direct costs
don’t change, because they’re traced directly, not allocated. Total costs are
still $187,500. That makes sense, because activity-based costing changes cost
allocations, not cost totals. Costs change by product but not in total for the
company. Sales are still $206,250.
Because the per unit sale prices stay the same, the profit calculations change.
Profit for flower beds is now $4,750 ($107,250 – $102,500). Profit for lawn care
is now $14,000 ($99,000 – $85,000).
Chapter 2: Performing Activity-Based Costing
Table 2-9
Activity-Based Costing by Product — Flower
Bed and Lawn Care
Cost (250 Units of Each Product)
Flower Bed
Lawn Care
Total
Direct material
$25,000
$30,000
$55,000
Direct labor
$37,500
$25,000
$62,500
Estimator cost (indirect cost)
$21,000
$9,000
$30,000
Transportation cost (indirect cost)
Office cost (indirect cost)
Total costs
Profit (total sales less total costs)
$9,000
$6,000
$15,000
$10,000
$15,000
$25,000
$102,500
$85,000
$187,500
$4,750
$14,000
$18,750
$107,250
$99,000
$206,250
Cost per unit (yard)
$410
$340
Sale price per unit
$429
$396
Total sales
451
In Table 2-9, the flower bed total cost increases by $5,000 (from $97,500 to
$102,500). As a result, profit for flower beds declines by $5,000 (from $9,750
to $4,750). ABC has the opposite effect on the lawn care business. Lawn care
costs go down by $5,000 (from $90,000 to $85,000). Profit increases by $5,000
(from $9,000 to $14,000).
Changing prices after ABC
You overcosted lawn care and undercosted flower beds. When you reallocate
that from lawn care to flower beds, the change throws off your profit calculation! You want a profit of 10 percent for each product, but flower beds are
producing only a 4.6 percent profit ($4,750 profit ÷ $102,500 in sales). The
lawn care profit produces a 16.5 percent profit ($14,000 ÷ $85,000). See the
explanation for the profit and sales numbers earlier in the chapter.
Here’s the problem: 4.6 percent may be too small a profit margin. You’re spinning your wheels for a bunch of petunias. Calculate the new sale price for
flower beds, based on the ABC and a 10 percent profit, as shown in Table 2-10.
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Table 2-10
Calculating a New Sale Price for Flower Beds
Cost (250 Units of Each Product)
Flower Beds
Total costs in Table 2-9
$102,500
Profit (10 percent of total cost)
Total sales
$10,250
$112,750
Cost per unit (yard)
$410
Sale price per unit
$451
The original price per unit for flower beds was $429. The new flower bed unit
price is $451, which is $22 higher than before ($451 to $429). To make a
10 percent profit, change the flower bed sale price to $451 per unit.
At the old price, you weren’t making your desired profit. Now you will. And
that’s the value of using ABC. You could make up for the lower profit on
flower beds by earning more on lawn care. But really, you should assess each
product on its own and price each one to produce the correct profit.
Chapter 3
Examining Contribution Margin
In This Chapter
▶ Figuring contribution margin
▶ Meeting income goals with cost-volume-profit analysis
▶ Analyzing your break-even point, target profit, and margin of safety
▶ Exploring operating leverage
W
hen you have to make a business decision about what to sell, how
much of it to sell, or how much to charge, you first need to understand how your decision is likely to affect net income — your profit. Suppose
you sell one refrigerator for $999.95. How does that sale affect your net
income? Now suppose you sell 1,000 of the same make and model at this
price. How does that sales volume affect net income?
Contribution margin simplifies these decisions. In this chapter, you find out
how to calculate contribution margin and how to apply it to different business decisions, using both graphs and formulas. You also find out how to
prepare something called a cost-volume-profit analysis, which explains how
the number of products sold affects profits. And you discover how to prepare
a break-even analysis, which indicates exactly how many products you must
sell in order to break even and start earning a profit.
Suppose you set a target profit — a goal for net income this period. This
chapter shows you how to estimate the number of units you need to sell in
order to meet your target profit. It also explains how to measure something
called margin of safety, or how many sales you can afford to lose before your
profitability drops to zero. Finally, this chapter explains and demonstrates
operating leverage, which measures a company’s riskiness.
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Computing Contribution Margin
Contribution margin measures how sales affects net income or profits. To compute contribution margin, subtract variable costs of a sale from the amount of
the sale itself:
Contribution margin = Sales – Variable costs
For example, if you sell a gadget for $10 and its variable cost is $6, the contribution margin for the sale is $10 – $6 = $4. Selling this gadget increases your
profit by $4, before considering fixed costs. Your contribution margin less
fixed costs equals your profit.
When computing contribution margin, subtract all variable costs, including
variable manufacturing costs and variable selling, general, and administrative
costs. Don’t subtract any fixed costs. You compute gross profit by subtracting
cost of goods sold from sales. Because cost of goods sold usually includes a
mix of fixed and variable costs, gross profit doesn’t equal contribution margin.
You can calculate contribution margin in three forms, as discussed in the
following sections: in total, per unit, or as a ratio.
Contribution margin, in any of its forms, explains how different factors in
the company — sales price, sales volume, variable costs, and fixed costs —
interact. This understanding helps you make better decisions when planning
sales and costs.
Figuring total contribution margin
Total contribution margin measures the amount of contribution margin earned
by the company as a whole. You calculate it by using this formula:
Total contribution margin = Total sales – Total variable costs
To determine overall profitability, subtract total fixed costs from total
contribution margin. Net income equals the excess of contribution margin
over fixed costs.
You can use total contribution margin to create something called a contribution margin income statement. This document differs from a multi-step income
statement (shown in Figure 3-1), where you first subtract cost of goods sold
from sales and then subtract selling, general, and administrative costs.
Chapter 3: Examining Contribution Margin
455
Figure 3-1:
Multi-step
income
statement.
©John Wiley & Sons, Inc.
A contribution margin income statement first subtracts the variable costs
and then subtracts fixed costs, as shown in Figure 3-2. Here, variable costs
include variable costs of both manufacturing and selling. Likewise, fixed
costs include more manufacturing and selling costs.
Figure 3-2:
Contribution
margin
income
statement.
©John Wiley & Sons, Inc.
The contribution margin income statement makes understanding cost behavior and the way sales will affect profitability easier. In Figure 3-2, the company
earns $1,000 in sales, $400 of which goes toward variable costs. This scenario
results in $600 of contribution margin.
These amounts — sales, variable costs, and contribution margin — change in
proportion to each other. If sales increase by 10 percent, then variable costs
and contribution margin also increase by 10 percent; $1,100 in sales increases
variable costs to $440 and contribution margin to $660. On the other hand,
fixed costs always remain the same: The $300 in fixed costs is $300 regardless
of any increase or decrease in sales and contribution margin.
The contribution margin income statement presents the same net income
figure as a traditional income statement. However, the contribution margin
income statement isn’t in accordance with generally accepted accounting
principles (GAAP). (See Book IV, Chapter 1 for more about GAAP.) Managers
can internally use a contribution margin income statement to better
understand their own companies’ operations.
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Calculating contribution margin per unit
Contribution margin per unit measures how the sale of one additional unit
affects net income. You calculate it by subtracting variable costs per unit from
sales price per unit, as in this formula:
Contribution margin per unit = Sales price per unit – Variable costs per unit
Say a company sells a single gadget for $100, and the variable cost of making
the gadget is $40. Contribution margin per unit on this gadget equals
$100 – $40 = $60. Therefore, selling the gadget increases net income by $60,
assuming no change in fixed costs.
Increasing the sales price doesn’t affect variable costs because the number
of units manufactured, not the sales price, is what usually drives variable
manufacturing costs. Therefore, if the gadget company raises its sales price
to $105, the variable cost of making the gadget remains at $40, and the contribution per unit increases to $105 – $40 = $65 per unit. The $5 increase in sales
price goes straight to the bottom line as net income. Again, this assumes that
fixed costs don’t change.
Working out contribution margin ratio
Contribution margin ratio measures the percentage of each sales dollar that
represents net income. To calculate it, divide contribution margin by sales,
either in total or per unit:
Contribution margin ratio = Total contribution margin ÷ Total sales
or
Contribution margin ratio = C
ontribution margin per unit ÷
Sales price per unit
Suppose a gadget selling for $100 per unit brings in $40 per unit of
contribution margin. Its contribution margin ratio is 40 percent:
Contribution margin ratio = $40 ÷ $100 = 0.40 or 40%
To find out how sales affect net income, multiply the contribution margin
ratio by the amount of sales. In this example, $1,000 in gadget sales increases
net income by $1,000 × 0.40 = $400 (before considering fixed costs).
Chapter 3: Examining Contribution Margin
457
Preparing a Cost-Volume-Profit Analysis
Contribution margin indicates how sales affects profitability. When running a
business, a decision-maker needs to consider how four different factors affect
net income:
✓ Sales price
✓ Sales volume
✓ Variable cost
✓ Fixed cost
Cost-volume-profit analysis helps you understand different ways to meet your
net income goals. The following sections explain cost-volume-profit analysis
by using graphical and formula techniques. These sections pay special attention to computing net income based on different measures of contribution
margin: total contribution margin, contribution margin per unit, and the
contribution margin ratio.
The graphs provide a helpful way to visualize the relationship among cost,
volume, and profit. However, when solving problems, you’ll find that plugging
numbers into formulas is much quicker and easier.
Book VII
Drafting a cost-volume-profit graph
Making
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Decisions
Figure 3-3 visually describes the relationship among cost, volume, and profit
for a company called Pemulis Basketballs. It sells its basketballs for $15 per
basketball. The variable cost of the basketballs is $6. Pemulis has total fixed
costs of $300 per year.
In this figure, the fixed costs of $300 are represented by a horizontal line
because regardless of the sales volume, fixed costs stay the same. Total variable costs are a diagonal line, starting at the origin (the point in the lowerleft corner of the graph where sales are zero). Total costs (the sum of total
variable costs and total fixed costs) are a diagonal line starting at the
$300 mark because when the company makes and sells zero units, total
costs equal the fixed costs of $300. Total costs then increase with volume.
Finally, total sales forms a diagonal line starting at the origin and increasing
with sales volume.
Figure 3-4 shows when the company will earn net income or incur a loss.
When the sales curve exceeds total costs, the company earns net income
(represented by the shaded right side of the X in Figure 3-4). However, if total
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Figure 3-3:
Costvolumeprofit graph.
©John Wiley & Sons, Inc.
sales are too low to exceed total costs, then the company incurs a net loss
(the shaded left side of the X). The higher the sales volume — that is, the
more sales volume moves to the right of the graph — the higher the company’s net income.
Figure 3-4:
Identifying
net income
and loss
in a costvolumeprofit graph.
©John Wiley & Sons, Inc.
Dropping numbers into the chart shows exactly how much income can be
earned at different sales levels. Assuming Pemulis has a sales price of $15 per
unit, a variable cost per unit of $6, and total fixed costs of $300, what happens if Pemulis sells 60 basketballs? Total sales come to 60 units × $15 = $900.
Total variable costs multiply to 60 units × $6 = $360. Add these total variable
costs to total fixed costs of $300 to get total costs of $660.
Figure 3-5 illustrates these amounts. Total sales of $900 sits on the Total sales
line. Total costs of $660 sits on the Total cost line. The difference between these
amounts of $240 represents the net income from selling 60 units.
Chapter 3: Examining Contribution Margin
459
Figure 3-5:
Applying
a costvolumeprofit graph
to a specific
case.
©John Wiley & Sons, Inc.
Trying out the total contribution
margin formula
The following formula, based on total contribution margin, follows the same
structure as the contribution margin income statement. (Flip to the earlier section “Figuring total contribution margin” for details on total contribution
margin and its related income statement.)
Net income = Total contribution margin – Fixed costs
Assume that Pemulis Basketballs sells 60 units for $15 each for total sales
of $900 (see the preceding section for more on the origins of this example).
The variable cost of each unit is $6 (so total variable costs come to $6 × 60 =
$360), and total fixed costs are $300. Using the contribution margin approach,
you can find the net income in two easy steps:
1. Calculate total contribution margin.
Use the formula provided earlier in the chapter to compute total contribution margin, subtracting total variable costs from total sales:
Total contribution margin = Total sales – Total variable costs
= (60 × $15) – (60 × $6) = $900 – $360 = $540
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This total contribution margin figure indicates that selling 60 units
increases net income by $540 (before considering fixed costs).
2. To calculate net income, subtract the fixed costs from the total
contribution margin.
Just plug in the numbers from Step 1:
Net income = Total contribution margin – Fixed costs = $540 – $300 = $240
Subtracting fixed costs of $300 from total contribution margin of $540
gives you net income of $240.
Practicing the contribution margin
per unit formula
If you know the contribution margin per unit (see “Calculating contribution
margin per unit” earlier in this chapter), the following approach lets you use
that information to compute net income. Here’s the basic formula equating
net income with contribution margin per unit:
Net income = (Sales volume × Contribution margin per unit) – Fixed costs
Say Pemulis Basketballs now wants to use this formula. It can simply plug in
the numbers — 60 units sold for $15 each, variable cost of $6 per unit, fixed
costs of $300 — and solve. First compute the contribution margin per unit:
Contribution margin per unit = Sales price per unit – Variable costs per unit
= $15 – $6 = $9
Next, plug contribution margin per unit into the net income formula to figure
out net income:
Net income = (Sales volume × Contribution margin per unit) – Fixed costs
= (60 × $9) – $300 = $540 – $300 = $240
Eyeing the contribution
margin ratio formula
If you want to estimate net income but don’t know total contribution margin and
can’t find out the contribution margin per unit, you can use the contribution
margin ratio to compute net income.
Chapter 3: Examining Contribution Margin
461
As noted in the earlier section “Working out contribution margin ratio,” you
can compute contribution margin ratio by dividing total contribution margin
by total sales. So if your contribution margin is $540 and your sales is $900,
your contribution margin ratio is 60 percent:
Contribution margin ratio = Total contribution margin ÷ Total sales
= Contribution margin per unit ÷ Sales price per unit = $540 ÷ $900
= 0.60 = 60%
This means that 60 cents of every sales dollar increases net income, after
considering fixed costs. After you know the contribution margin ratio, you’re
ready for the net income formula:
Net income = ( Sales volume in units × Contribution margin per unit)
– Fixed costs
To calculate net income for the earlier example company, plug the
­contribution margin ratio of 60 percent into the formula:
Net income = ( Sales volume in units × Contribution margin per unit)
– Fixed costs = ($900 × 0.60) – $300 = $540 – $300 = $240
Generating a Break-Even Analysis
How much do you need to sell in order to break even? The break-even point
(BE) is the amount of sales needed to earn zero profit — enough sales to
avoid a loss, but insufficient sales to earn a profit. This section shows
you a couple of different ways — graphs and formulas — to locate your
break-even point.
Plotting the break-even point
In a cost-volume-profit graph, the break-even point is the sales volume where
the total sales line intersects with the total costs line. This sales volume is
the point at which total sales equals total costs.
Suppose that, as with the basketball example earlier in the chapter, a company
sells its products for $15 each, with variable costs of $6 per unit and total fixed
costs of $300. The graph in Figure 3-6 indicates that the company’s break-even
point occurs when the company sells 34 units.
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Figure 3-6:
Plotting the
break-even
point.
©John Wiley & Sons, Inc.
For many products (such as basketballs), you can sell only whole units.
Therefore, if you sell whole units, the break-even point must always be a whole
number. If break-even analysis results in some fractional volume of sales (such
as 33.33333 units), always round up (in this case, to 34 units), even if the fraction is closer to the lower whole number than the higher number. If your
break-even point equals 33.0001, round it up to 34. If you round down
(to 33 units), then the actual sales volume is below the break-even point,
and at this volume level, your company reports a net loss.
Using the formula approach
When you need to solve actual problems, drawing graphs isn’t always practical.
For a quicker approach, you want to rely on the three formulas that use contribution margin to measure net income. (See “Preparing a Cost-Volume-Profit
Analysis” earlier in the chapter.)
The break-even point is where net income is zero, so just set net income
equal to zero, plug whatever given information you have into one of the equations, and then solve for sales or sales volume. Better yet: At the break-even
point, total contribution margin equals fixed costs.
Suppose a company has $30,000 in fixed costs. How much total contribution
margin does it have to generate in order to break even?
Chapter 3: Examining Contribution Margin
463
Net income = Total contribution margin – Fixed costs
0 = Total contribution marginBE – Fixed costs
0 = Total contribution marginBE – $30,000
$30,000 = Total contribution marginBE
Here, too, at the break-even point, total contribution margin equals fixed costs
of $30,000. Now suppose a company has contribution margin per unit of
$6 and fixed costs of $600. What’s the break-even point in units?
Net income = (Sales volume × Contribution margin per unit) – Fixed costs
0 = (Sales volumeBE × Contribution margin per unit) – Fixed costs
0 = (Sales volumeBE × $6) – $600
$600 = Sales volumeBE × $6
$600 ÷ $6 = 100 units
Another company has a contribution margin ratio of 40 percent and fixed
costs of $1,000. Sales price is $1 per unit. What’s the break-even point
in dollars?
Net income = (Sales × Contribution margin ratio) – Fixed costs
0 = (SalesBE × Contribution margin ratio) – Fixed costs
0 = (SalesBE × 0.40) – $1,000
$1,000 = SalesBE × 0.40
$1,000 ÷ 0.40 = SalesBE
$2,500 = SalesBE
You can express break-even point in units or dollars. If your formula gives
you units and you want dollars, multiply the number of units by the sales
price. If your formula gives you dollars and you want units, just divide by
the sales price.
Shooting for Target Profit
If you’ve set a specific goal for net income, contribution margin analysis
can help you figure out the needed sales. This goal for net income is called
target profit.
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To compute target profit, just adapt one of the three net income formulas.
(Head to the earlier section “Preparing a Cost-Volume-Profit Analysis” to see
these formulas.) Then plug target profit into one of these formulas as net
income. For example, say a company is pushing to earn $20,000 in profit and
has to pay $10,000 in fixed costs. How much total contribution margin does
the company need to generate in order to make its target profit of $20,000?
Net income = Total contribution margin – Fixed costs
$20,000 = Total contribution marginTarget – $10,000
$30,000 = Total contribution marginTarget
Total contribution margin of $30,000 will result in $20,000 worth of net
income. Now suppose a company has set its target profit for $2,000, earns
contribution margin per unit of $5, and incurs fixed costs of $500. How many
units must the company sell?
Net income = (Sales volume × Contribution margin per unit) – Fixed costs
$2,000 = (Sales volumeTarget × Contribution margin per unit) – Fixed costs
$2,000 = (Sales volumeTarget × $5) – $500
$2,500 = Sales volumeTarget × $5
$2,500 ÷ $5 = Sales volumeTarget
500 units = Sales volumeTarget
If the company wants to earn $2,000 in profit, it needs to sell 500 units.
Consider another company with a contribution margin ratio of 40 percent
and fixed costs of $1,000. The company is looking to earn $600 in net income.
How much does that company need in sales?
Net income = (Sales × Contribution margin ratio) – Fixed costs
$600 = (SalesTarget × Contribution margin ratio) – Fixed costs
$600 = (SalesTarget × 0.40) – $1,000
$1,600 = SalesTarget × 0.40
$1,600 ÷ 0.40 = SalesTarget
$4,000 = SalesTarget
Don’t confuse dollars with units. The formula that uses contribution margin
per unit gives you sales in units. However, the formula that uses contribution
margin ratio gives you sales in dollars. To translate between these units, just
multiply or divide by the sales price as described at the end of the previous
section. Also be sure to label the numbers in your analysis, so you don’t
confuse terms. For example, use a dollar sign for dollars and the word
“units” when dealing with units.
Chapter 3: Examining Contribution Margin
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Observing Margin of Safety
Margin of safety is the difference between your actual or expected profitability
and the break-even point. It measures how much breathing room you have —
how much you can afford to lose in sales before your net income drops to
zero. When budgeting, compute the margin of safety as the difference between
budgeted sales and the break-even point. Doing so will help you understand
the likelihood of incurring a loss. Turn to Book VI, Chapters 4 and 5 for more
about budgeting.
Using a graph to depict margin of safety
Figure 3-7 shows you how to visualize margin of safety with a graph. In this
example, margin of safety is the difference between current or projected sales
volume of 60 units and break-even sales volume of 34 units, which is 26 units.
Sales would have to drop by 26 units for existing net income of $240 to completely dry up.
Book VII
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Figure 3-7:
Graphing
margin of
safety.
©John Wiley & Sons, Inc.
Calculating the margin of safety
To compute margin of safety directly, without drawing pictures, first calculate
the break-even point and then subtract it from actual or projected sales. You
can use dollars or units:
Margin of safety (in dollars) = SalesActual – SalesBE
Margin of safety (in units) = Unit salesActual – Unit salesBE
For guidance on finding the break-even point, check out the earlier section
“Generating a Break-Even Analysis.”
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You can compute margin of safety either in sales dollars or in units, but be
consistent. Don’t subtract break-even sales in units from actual sales
in dollars!
Taking Advantage of Operating Leverage
Operating leverage measures how changes in sales can affect net income. For a
company with high operating leverage, a relatively small increase in sales
can have a fairly significant impact on net income. Likewise, a relatively
small decrease in sales for that same company will have a devastating effect
on earnings.
Operating leverage is typically driven by a company’s blend of fixed and
variable costs. The larger the proportion of fixed costs to variable costs, the
greater the operating leverage. For example, airlines are notorious for their
high fixed costs. Airlines’ highest costs are typically depreciation, jet fuel,
and labor — all costs that are fixed with respect to the number of passengers
on each flight. Their most significant variable cost is probably just the cost of
the airline food, which, judging from some recent flights couldn’t possibly be
very much. Therefore, airlines have ridiculously high operating leverage and
unspeakably low variable costs. A small drop in the number of passengermiles can have a dreadful effect on an airline’s profitability.
Graphing operating leverage
In a cost-volume-profit graph (see Figure 3-3 earlier in the chapter), operating
leverage corresponds to the slope of the total costs line. The more horizontal
the slope of this line, the greater the operating leverage. Figure 3-8 compares
the operating leverage for two different entities, Safe Co., which has lower
operating leverage, and Risky Co., which has higher operating leverage.
Figure 3-8:
How
operating
leverage
increases
risk.
©John Wiley & Sons, Inc.
Chapter 3: Examining Contribution Margin
467
In this example, Risky Co. has higher fixed costs and lower variable costs
per unit than Safe Co. Therefore Risky’s total cost line is more horizontal
than Safe’s total cost line. Accordingly, Risky has the potential to earn much
higher income with the same sales volume than Safe does. Because its fixed
costs are so high, Risky also has the potential to incur greater losses than
Safe does.
Looking at the operating leverage formula
The formula for operating leverage is
Operating leverage = Total contribution margin ÷ Net income
Suppose that Safe Co. and Risky Co. each earn sales of $400 on 50 units.
Assume that on these sales, Safe Co. has $150 in contribution margin and Risky
has $300 in contribution margin. Safe Co. has fixed costs of $50, while Risky Co.
has fixed costs of $200. Safe’s net income comes to $100 ($150 – $50). At this
volume level, Risky’s net income also works out to be $100. Here’s the math:
Operating leverage = Total contribution margin ÷ Net income
Operating leverageSafe Co. = $150 ÷ $100 = 1.5
Operating leverageRisky = $300 ÷ $100 = 3.0
According to these measures, Risky Co. has twice the operating leverage of
Safe Co. Although a 10-percent increase in sales boosts Safe Co.’s net income
by 15 percent, a similar 10-percent increase in sales for Risky Co. increases
that company’s net income by 30 percent!
That said, high operating leverage can work against you. For Safe Co., a
10-percent decrease in sales cuts income by 15 percent; for Risky, a
10-percent decrease in sales reduces net income by 30 percent.
Because automation replaces labor with machines, it usually replaces the variable costs (from direct labor) with fixed overhead (associated with running
equipment). As such, automation tends to increase operating leverage.
However, outsourcing usually has the opposite effect. Companies that close
factories and pay other companies to make goods for them replace fixed costs
(needed to run factories) with variable costs (used to pay other companies to
make the goods).
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Chapter 4
Accounting for Change with
Variance Analysis
In This Chapter
▶ Understanding and setting standard costs
▶ Figuring out direct materials prices and direct labor rates
▶ Using formulas to compute variances
▶ Exploiting a shortcut for calculating direct material and direct labor variances
▶ Identifying variances that require further investigation
W
hen things don’t go according to plan, inevitably you’re left asking
“Why?” To find the answer, examine the factors under your control. For
example, suppose you don’t like to diet. As an accountant, you should enjoy
counting calories. But maybe you don’t. Maybe you don’t like to exercise either.
That said, if you weigh yourself only to find that you’re gaining rather than
losing weight, you may ask “Why?” You thought you were being so careful this
week. Why did you gain three pounds? It all comes down to three factors under
your control: what you eat and drink, how much you eat and drink, and how
much you exercise. Examining each of these factors helps you change your
routine so that you can more successfully manage your weight in the future.
Variance analysis plays a similar role for business. When things go wrong, or
even when they go more right than expected, variance analysis explains why.
What caused higher-than-expected profits? What about unexpected losses?
You can use all this information to improve future operations.
Setting Up Standard Costs
You can’t measure variances without first setting standard costs or standards —
predetermined unit costs of materials, labor, and overhead. Standards are really
the building blocks of budgets; budgets predict total costs (as explained in
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Book VI, Chapters 4 and 5), but standards predict the cost of each unit of direct
materials, direct labor, and overhead. Standard costs provide a number of
important benefits for managers. For example, they
✓ Help managers budget for the future.
✓ Help employees focus on keeping costs down.
✓ Help set sales prices.
✓ Give managers a benchmark for measuring variances and identifying
related problems.
✓ Simplify collecting and managing the cost of inventory.
✓ Provide useful information for variance analysis (as explained in
this chapter).
Implementing standards often forces managers to face a critical dilemma:
Should standards be aspirational or realistic?
✓ Ideal or aspirational standards can encourage employees to work hard
to achieve rigorous goals. However, overly aggressive standards can
unduly pressure employees, causing them to report false information
or to just give up on the standards out of frustration, deeming them
unattainable.
✓ Realistic standards provide more accurate cost information and are
less likely to lead to the kind of unfavorable variances that result in
lower-than-expected income. However, realistic standards don’t always
encourage employees to “go the extra mile” to improve cost control
and productivity.
Therefore, the first step in variance analysis is to set up expectations: your
standards. These standards must include both the cost and the quantity
needed of direct materials and direct labor, as well as the amount of
overhead required.
After you establish standards, you can use them to compute variances.
Whenever actual performance strays from expectations, variances help
you identify the reasons why.
Establishing direct materials standards
Direct materials are raw materials traceable to the manufactured product,
such as the amount of flour used to make a cake. To compute the direct materials standard price (SP), consider all the costs that go into a single unit of
direct materials. Because several different kinds of direct materials are often
necessary for any given product, you need to establish separate direct materials standard prices and quantities for every kind of direct materials needed.
Chapter 4: Accounting for Change with Variance Analysis
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Suppose that the Band Book Company usually pays $10 per pound for paper.
It typically pays $0.25 per pound for freight and another $0.10 per pound
for receiving and handling. Therefore, as shown in Figure 4-1, total cost per
pound equals $10.35.
Figure 4-1:
Adding
up direct
materials
standard
price (SP).
©John Wiley & Sons, Inc.
Another standard to consider is the direct materials standard quantity (SQ)
per unit. This number is the amount of direct materials needed to make a
single unit of finished product. It includes not only the direct materials actually used but also any direct materials likely to get scrapped or spoiled in the
production process.
Variance costing involves juggling many different figures and terms. To simplify matters, use abbreviations such as SP (for direct materials standard price)
and SQ (for direct materials standard quantity). Doing so makes remembering
how to calculate variances easier later in this chapter. For example, assume
that Band Book Company needs 25 pounds of paper to make a case of books.
For every case, three pounds of paper are deemed unusable because of waste
and spoilage. Therefore, the direct materials standard quantity per unit equals
28 pounds, as shown in Figure 4-2.
Figure 4-2:
Computing
direct
materials
standard
quantity
(SQ) per
unit.
©John Wiley & Sons, Inc.
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Determining direct labor standards
Direct labor is the cost of paying your employees to make products. Proper
planning requires setting standards with respect to two factors: the direct
labor standard rate and the direct labor standard hours per unit.
To compute the direct labor standard rate or SR (the cost of direct labor), consider all the costs required for a single hour of direct labor. For example, suppose Band Book usually pays employees $9 per hour. Furthermore, it pays
an additional $1 per hour for payroll taxes and, on average, $2 per hour for
fringe benefits. As shown in Figure 4-3, the direct labor standard rate equals
$12 per hour.
Figure 4-3:
Computing
the direct
labor
standard
rate (SR).
©John Wiley & Sons, Inc.
You also need to estimate the amount of direct labor time needed to make a
single unit, the direct labor standard hours (SH) per unit. This measurement
estimates how long employees take, on average, to produce a single unit.
Include in this rate the time needed for employee breaks, cleanups, and
setups.
For example, employees at Band Book Company need three hours to produce a single case of books, plus an average of 30 minutes of setup time and
30 minutes of break time. Therefore, the direct materials standard quantity
equals four hours, as shown in Figure 4-4.
Figure 4-4:
Computing
direct labor
standard
hours (SH).
©John Wiley & Sons, Inc.
Chapter 4: Accounting for Change with Variance Analysis
473
Calculating the overhead rate
Standard costs also need to account for overhead (the miscellaneous costs of
running a business) in addition to direct materials and direct labor. Overhead
is much more difficult to measure than direct materials or direct labor standards because overhead consists of indirect materials, indirect labor, and
other costs not easily traced to units produced. Therefore, measuring how
much overhead should be applied to different units produced is very challenging. To assign overhead costs to individual units, you need to compute an
overhead allocation rate.
Remember that overhead allocation entails three steps:
1. Add up total overhead.
Add up estimated indirect materials, indirect labor, and all other product costs not included in direct materials and direct labor. This amount
includes both fixed and variable overhead.
For example, assume that total overhead for Band Book Company is estimated to cost $100,000.
2. Compute the overhead allocation rate.
The allocation rate calculation requires an activity level. You choose
an activity that closely relates to the cost incurred. The most common
activity levels used are direct labor hours or machine hours. Divide total
overhead (calculated in Step 1) by the number of direct labor hours.
Assume that Band Book plans to utilize 4,000 direct labor hours:
Overhead allocation rate = Total overhead ÷ Total direct labor hours
= $100,000 ÷ 4,000 hours = $25.00
Therefore, for every hour of direct labor needed to make books, Band
Book applies $25 worth of overhead to the product.
3. Apply overhead.
Multiply the overhead allocation rate by the number of direct labor
hours needed to make each product.
Suppose a department at Band Book actually worked 20 hours on
a product. Apply 20 hours × $25 = $500 worth of overhead to
this product.
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Adding up standard cost per unit
To find the standard cost, you first compute the cost of direct materials,
direct labor, and overhead per unit, as explained in the previous sections.
Then you add up these amounts.
Figure 4-5 applies this approach to Band Book Company. To calculate the
standard cost of direct materials, multiply the direct materials standard price
of $10.35 by the direct materials standard quantity of 28 pounds per unit.
The result is a direct materials standard cost of $289.80 per case. To compute
direct labor standard cost per unit, multiply the direct labor standard rate of
$12 per unit by the direct labor standard hours per unit of 4 hours. The standard cost per unit is $48 for direct labor. Now multiply the overhead allocation
rate of $10 per hour by the direct labor standard hours of 4 hours per unit to
come to a standard cost of overhead per unit of $40.
Figure 4-5:
Summing
up standard
cost per
unit.
©John Wiley & Sons, Inc.
Add together direct materials, direct labor, and overhead to arrive at the
standard cost per unit of $289.80 + $48 + $40 = $377.80. Making a single case
of books costs Band Book $377.80.
Understanding Variances
A variance is the difference between the actual cost and the standard cost that
you expected to pay. (Standard costs are covered earlier in this chapter.) When
actual cost exceeds the standard, then the resulting variance is considered
unfavorable because it reduces net income. On the other hand, when actual
costs come in under standard costs, then the resulting variance is considered
favorable because it increases net income.
Variances can arise from direct materials, direct labor, and overhead. In fact,
the variances arising from each of these three areas, when added together,
should equal the total variance:
Total variance = D
irect materials variance + Direct labor variance
+ Overhead variance
Chapter 4: Accounting for Change with Variance Analysis
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In turn, you can further break down direct materials and direct labor variances into additional price and quantity variances to understand how changes
in materials prices, materials quantities used, direct labor rates, and direct
labor hours affect overall profitability.
Generally, you incur a variance for one of two reasons: Either you used more
or less than you planned (a quantity variance), or you paid more or less than
you planned (a price or rate variance).
Computing direct materials variances
A direct materials variance results from one of two conditions: differences in
the prices paid for materials or discrepancies in the quantities used in production. To find these variances, you can use formulas or a simple diagram
approach.
Using formulas to calculate direct materials variances
The total direct materials variance is comprised of two components: the
direct materials price variance and the direct materials quantity variance.
To compute the direct materials price variance, take the difference between
the standard price (SP) and the actual price (AP), and then multiply that
result by the actual quantity (AQ):
Direct materials price variance = (SP – AP) × AQ
To get the direct materials quantity variance, multiply the standard price by
the difference between the standard quantity (SQ) and the actual quantity:
Direct materials quantity variance = SP × (SQ – AQ)
The total direct materials variance equals the difference between total actual
cost of materials (AP × AQ) and the budgeted cost of materials, based on
standard costs (SP × SQ):
Total direct materials variance = (SP × SQ) – (AP × AQ)
Consider the Band Book Company example described in “Setting Up
Standard Costs” earlier in the chapter. Band Book’s standard price is
$10.35 per pound. The standard quantity per unit is 28 pounds of paper
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per case. This year, Band Book made 1,000 cases of books, so the
company should have used 28,000 pounds of paper, the total standard
quantity (1,000 cases × 28 pounds per case). However, the company
purchased 30,000 pounds of paper (the actual quantity), paying $9.90
per case (the actual price).
Based on the given formula, the direct materials price variance comes to a
positive $13,500, a favorable variance:
Direct materials price variance = (SP – AP) × AQ = ($10.35 – $9.90) × 30,000
= $13,500 favorable
This variance means that savings in direct materials prices cut the company’s
costs by $13,500.
The direct materials quantity variance focuses on the difference between the
standard quantity and the actual quantity, arriving at a negative $20,700, an
unfavorable variance:
Direct materials quantity variance = SP × (SQ – AQ)
= $10.35 × (28,000 – 30,000) = –$20,700 unfavorable
This result means that the 2,000 additional pounds of paper used by the company increased total costs $20,700. Now, you can plug both parts in to find
the total direct materials variance. (You could just plug in the final results,
but I show you the longer math here.) Compute the total direct materials
variance as follows:
Total direct materials variance = (SP × SQ) – (AP × AQ) = ($10.35 × 28,000)
– ($9.90 × 30,000) = $289,800 – $297,000 = –7,200 unfavorable
Diagramming direct materials variances
Figure 4-6 provides an easier way to compute price and quantity variances.
To use this diagram approach, just compute the totals in the third row: actual
cost, actual quantity at standard price, and the standard cost. The actual cost
less the actual quantity at standard price equals the direct materials price
variance. The difference between the actual quantity at standard price and
the standard cost is the direct materials quantity variance. The total of both
variances equals the total direct materials variance.
To apply this method to the Band Book example, take a look at Figure 4-7.
Start at the bottom. Direct materials actually cost $297,000, even though the
standard cost of the direct materials is only $289,800. The actual quantity of
direct materials at standard price equals $310,500.
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Figure 4-6:
Diagram of
how price
and quantity
variances
contribute
to direct
materials
variance.
©John Wiley & Sons, Inc.
To compute the direct materials price variance, subtract the actual cost of direct
materials ($297,000) from the actual quantity of direct materials at standard
price ($310,500). This difference comes to a $13,500 favorable variance, meaning
that the company saves $13,500 by buying direct materials for $9.90 rather than
the original standard price of $10.35.
To compute the direct materials quantity variance, subtract the actual quantity
of direct materials at standard price ($310,500) from the standard cost of direct
materials ($289,800), resulting in an unfavorable direct materials quantity variance of $20,700. Because the company uses 30,000 pounds of paper rather than
the 28,000-pound standard, it loses an additional $20,700.
This setup explains the unfavorable total direct materials variance of $7,200 —
the company gains $13,500 by paying less for direct materials, but loses $20,700
by using more direct materials.
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Figure 4-7:
Computing
direct
materials
variances
by using a
diagram.
©John Wiley & Sons, Inc.
Calculating direct labor variances
A direct labor variance is caused by differences in either wage rates or hours
worked. As with direct materials variances, you can use either formulas or a
diagram to compute direct labor variances.
Utilizing formulas to figure out direct labor variances
To estimate how the combination of wages and hours affects total costs,
compute the total direct labor variance. As with direct materials, the price
and quantity variances add up to the total direct labor variance. To compute
the direct labor price variance (also known as the direct labor rate variance),
take the difference between the standard rate (SR) and the actual rate (AR),
and then multiply the result by the actual hours worked (AH):
Direct labor price variance = (SR – AR) × AH
To get the direct labor quantity variance (also known as the direct labor efficiency variance), multiply the standard rate (SR) by the difference between
total standard hours (SH) and the actual hours worked (AH):
Direct labor quantity variance = SR × (SH – AH)
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The direct labor variance equals the difference between the total budgeted
cost of labor (SR × SH) and the actual cost of labor, based on actual hours
worked (AR × AH):
Total direct labor variance = (SR × SH) – (AR × AH)
Now you can plug in the numbers for the Band Book Company example from
earlier in the chapter. Band Book’s direct labor standard rate (SR) is $12 per
hour. The standard hours (SH) come to 4 hours per case. Because Band made
1,000 cases of books this year, employees should have worked 4,000 hours
(1,000 cases × 4 hours per case). However, employees actually worked
3,600 hours, for which they were paid an average of $13 per hour.
With these numbers in hand, you can apply the formula to compute the
direct labor price variance:
Direct labor price variance = (SR – AR) × AH = ($12.00 – $13.00) × 3,600
= –$1.00 × 3,600 = –$3,600 unfavorable
According to the direct labor price variance, the increase in average wages
from $12 to $13 causes costs to increase by $3,600. Now plug the numbers into
the formula for the direct labor quantity variance:
Direct labor quantity variance = SR × (SH – AH) = $12.00 × (4,000 – 3,600)
= $12.00 × 400 = $4,800 favorable
Employees worked fewer hours than expected to produce the same amount
of output. This change saves the company $4,800 — a favorable variance. To
compute the total direct labor variance, use the following formula:
Total direct labor variance = (SR × SH) – (AR × AH) = ($12.00 × 4,000)
– ($13.00 × 3,600) = $48,000 – $46,800 = $1,200 favorable
According to the total direct labor variance, direct labor costs were $1,200
lower than expected, a favorable variance.
Employing diagrams to work out direct labor variances
Figure 4-8 shows you how to use a diagram to compute price and quantity
variances quickly and easily. First, compute the totals in the third row:
actual cost, actual hours at standard rate, and the standard cost. To get
the direct labor price variance, subtract the actual cost from the actual
hours at standard. The difference between the standard cost of direct
labor and the actual hours of direct labor at standard rate equals the
direct labor quantity variance. The total of both variances equals the
total direct labor variance.
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Figure 4-8:
How price
and quantity
variances
add up to
direct labor
variance.
©John Wiley & Sons, Inc.
Take a look at Figure 4-9 to see this diagram in action for Band Book: Starting
from the bottom, the actual cost of direct labor amounts to $46,800. The
actual hours of direct labor at standard rate equals $43,200. The standard
cost of direct labors comes to $48,000.
To compute the direct labor price variance, subtract the actual hours of direct
labor at standard rate ($43,200) from the actual cost of direct labor ($46,800)
to get a $3,600 unfavorable variance. This result means the company incurs
an additional $3,600 in expense by paying its employees an average of $13 per
hour rather than $12.
To compute the direct labor quantity variance, subtract the standard cost of
direct labor ($48,000) from the actual hours of direct labor at standard rate
($43,200). This math results in a favorable variance of $4,800, indicating that
the company saves $4,800 in expenses because its employees work 400 fewer
hours than expected.
The $1,200 favorable variance arises because of two factors: the company
saves $4,800 from fewer hours worked but incurs an additional $3,600
expense by paying its employees more money per hour than planned. This
scenario begs the question “Are higher-paid workers more productive?” But
that’s a discussion for the human resources experts.
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Figure 4-9:
Computing
the direct
labor
variances
the easy
way with a
diagram.
©John Wiley & Sons, Inc.
Computing overhead variances
Whenever you see direct labor and direct materials, overhead can’t be far
behind. To compute overhead applied, multiply the overhead application rate
by the standard number of hours allowed:
Overhead applied = Overhead application rate × SH
So you can determine overhead variance by subtracting actual overhead from
applied overhead:
Overhead variance = Overhead applied – Actual overhead
Band Book Company incurs actual overhead costs of $95,000. The company’s
overhead application rate is $25 per hour. (You can find the math for that
calculation in the earlier section “Calculating the overhead rate.”) In that
prior section, you use direct labor hours as the activity level for applying
overhead. In order for Band Book’s workers to produce 1,000 cases, you can
expect them to work standard hours of 4 direct labor hours per case.
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SH equals 1,000 cases produced × 4 direct labor hours per case, or 4,000
direct labor hours. This amount results in overhead applied of $100,000:
Overhead applied = Overhead application rate × SH = $25.00 × 4,000
= $100,000
To compute the variance, subtract actual overhead from the overhead
applied:
Overhead variance =
Overhead applied – Actual overhead
= $100,000 – $95,000 = $5,000
Because actual overhead is less than overhead applied, the $5,000 variance
is favorable.
Spending too much or too little on overhead — or using overhead
inefficiently — often causes overhead variance.
Like direct labor and direct materials, overhead, too, can have price and
quantity variables. However, fixed and variable cost behaviors considerably
complicate the calculation of overhead variances. These complexities are
outside the scope of this book.
Looking past the favorable/
unfavorable label
The unfavorable and favorable labels describe variances only in terms of how
they affect income; favorable variances aren’t necessarily always good, and
unfavorable variances aren’t necessarily always bad. For example, a favorable variance may result because a company purchases cheaper direct materials of poorer quality. These materials lower costs, but they also hurt the
quality of finished goods, damaging the company’s reputation with customers. This kind of favorable variance can work against a company. On the
other hand, an unfavorable variance may occur because a department
chooses to scrap poor-quality goods. In the long run, the company benefits
from incurring a short-term unfavorable variance to provide better-quality
goods to its customers.
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Teasing Out Variances
In your business, variance analysis helps you identify problem areas that
require attention, such as
✓ Poor productivity
✓ Poor quality
✓ Excessive costs
✓ Excessive spoilage or waste of materials
Identifying and working on these problems helps managers improve production flow and profitability. Managers and accountants often talk about
management by exception — using variance analysis to identify exceptions, or
problems, where actual results significantly vary from standards. By paying
careful attention to these exceptions, managers can root out and rectify
manufacturing problems and inefficiencies, thereby improving productivity,
efficiency, and quality.
Interpreting variances in action
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The previous sections in this chapter lay out what happens to the costs of
the Band Book Company over the course of a year. Figure 4-10 summarizes
Band Book’s variances.
Figure 4-10:
Band Book’s
variances.
©John Wiley & Sons, Inc.
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A complete analysis of Band Book’s variances provides an interesting story
to explain why the company has a $1,000 unfavorable variance. The following
events transpire:
✓ The company pays less than expected for direct materials, leading to
a favorable $13,500 direct materials price variance.
✓ Perhaps because of the cheaper, lower-quality direct materials, the company uses an excessive amount of direct materials. This overage results
in a $20,700 unfavorable direct materials quantity variance.
✓ The company pays its employees a higher wage rate, resulting in an
unfavorable direct labor price variance of $3,600.
✓ The company saves money because employees work fewer hours than
expected, perhaps because they’re more productive, higher-paid
workers. The favorable direct labor quantity variance is $4,800.
✓ The company saves $5,000 in reduced overhead costs.
Focusing on the big numbers
Management by exception directs managers to closely investigate the largest
variances. For example, the two largest variances in Figure 4-10 are the direct
materials quantity variance ($20,700 unfavorable) and the direct materials
price variance ($13,500 favorable). Band Book’s managers should focus on
how the company buys and uses its direct materials.
Here, the direct materials quantity variance resulted because the company
should have used 28,000 pounds of paper but actually used 30,000 pounds
of paper. Why? Here are a few possibilities:
✓ The paper was poor quality, and much of it needed to be scrapped.
✓ The company underestimated the amount of paper needed (the standard
quantity needs to be changed).
✓ Someone miscounted the amount of paper used; 2,000 pounds of paper
are sitting in the back of the warehouse (oops).
✓ A new employee misused the machine, shredding several thousand
pounds of paper.
Management by exception directs managers to where the problem may
have occurred so that they can investigate what happened and take
corrective action.
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Now take a look at the favorable direct materials price variance of $13,500.
How did the purchasing department come to purchase direct materials for
only $9.90 a pound, rather than the $10.35 standard? Did the purchased
materials meet all of the company’s quality standards? Should the company
reduce its standard price in the future?
Consider setting control limits to determine which items are sufficiently large
to investigate. A variance exceeding its control limit takes priority over less
significant variances.
Tracing little numbers
back to big problems
Be careful! Don’t focus exclusively on the big numbers and ignore the little
numbers. Big problems can also hide in the small numbers. For example,
although many frauds (such as stealing raw materials) may trigger large variances, a well-planned fraud may be designed to manipulate variances so that
they stay low, below the radar, where managers won’t notice them.
For example, knowing the standard price of a raw material is $100 per unit,
a crooked purchasing manager may arrange to purchase the units for exactly
that price — $100 per unit — while receiving $10 per unit as a kick-back
gratuity from the supplier. This scheme results in a direct materials price
variance of zero, but it doesn’t reflect what should be the company’s actual
cost of doing business. A more scrupulous purchasing manager would have
arranged a purchase price of $90, resulting in a large positive direct materials
price variance.
To avoid these problems, managers should still investigate all variances, even
while focusing most of their time on the largest figures.
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Chapter 5
Making Smart Pricing Decisions
In This Chapter
▶ Understanding the importance of product differentiation
▶ Addressing absorption costing
▶ Using cost-plus pricing
▶ Taking risks with variable-cost pricing
▶ Aiming for target costing
H
ave you ever seen the game show The Price Is Right? The host challenges contestants to guess the prices of different merchandise.
Guessing the right price can win you cash and all sorts of valuable prizes.
Even if you get the price wrong, you still walk away with your novelty
­nametag and maybe a chance to spin a giant wheel.
The stakes get a lot higher when you’re naming prices in the real business
world. Prices that are too high scare away customers. Too low, and losses
may wipe out your business. Prices must be low enough to lure customers
but high enough to cover your costs and help you earn a profit. Therefore,
before setting a price, you must understand both market forces and the cost
structure of your business.
This chapter explains how to use your knowledge of cost behavior to make
savvy pricing decisions.
Differentiating Products
Product differentiation allows consumers to see differences among different
companies’ products, which makes them willing to spend more money for
some brands than for others. Hence, a company that successfully differentiates its products can charge a higher price than its competitors, making it a
price maker. Companies that don’t differentiate their products need to use
low prices to get a leg up on the competition. Marketers call these companies
price takers.
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Customers usually have trouble seeing any difference among the products
offered by different mainstream supermarkets. Therefore, all supermarkets —
price takers — need to price their products competitively in line with each
other. On the other hand, premium supermarkets such as Whole Foods have
done a brilliant job of differentiating themselves from competitors, so much
so that customers often pay significantly more money to shop there. Whole
Foods is a price maker.
Regardless of how well a company differentiates its products, its prices must
take into account both market forces and the company’s own cost behavior.
Taking All Costs into Account
with Absorption Costing
Absorption costing (sometimes also called full costing) is the predominant
method for costing goods that companies manufacture and sell. Generally
accepted accounting principles (GAAP) require all U.S. companies to use
absorption costing in their financial statements. International accounting
standards have similar requirements worldwide.
Absorption costs include all product costs — the costs of making products.
Product costs include a variable component that increases and decreases
with volume and a fixed component that doesn’t change regardless of how
much or how little you produce.
The costs of direct materials, raw materials that you can directly trace to the
manufactured product, are variable. After all, the more units you make, the
more direct materials you need to make them. The same goes for direct labor,
the cost of paying employees to make your products.
Overhead costs, such as the miscellaneous costs of running a factory, usually
consist of a mixture of fixed and variable costs. Absorption costing requires
you to spread out the fixed costs over all units produced. (Flip to Chapter 4
for details on direct and overhead costs.)
Suppose your factory makes T-shirts. Each T-shirt requires $8 worth of variable costs (direct materials, direct labor, and variable overhead), and your
factory pays $100,000 for fixed costs each year for rent and utilities. This
year, you plan to make 50,000 T-shirts. How much will each T-shirt cost?
According to absorption costing, the cost of a T-shirt includes both variable
and fixed components. You know that the variable component per shirt is $8.
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The fixed component of $100,000 applies to all the shirts, however, so you
need to spread it out among them. Divide the total fixed costs of $100,000
by the number of units you plan to produce (50,000) to get a fixed cost per
unit of $2. Therefore, each T-shirt includes $8 worth of variable costs and
$2 worth of fixed costs, resulting in total cost per unit of $10.
Pricing at Cost-Plus
Many retailers and manufacturers set their prices at cost-plus by adding a fixed
markup to their absorption cost. Cost-plus pricing ensures that prices are
high enough to meet profit goals. Figure 5-1 illustrates how cost-plus
pricing computes the sales price by adding markup to a product’s fixed and
variable costs.
Book VII
Figure 5-1:
Cost-plus
pricing
includes
absorption
cost of the
product plus
a markup.
Making
Savvy
Business
Decisions
©John Wiley & Sons, Inc.
Computing fixed markups
To figure out the markup for cost-plus pricing, divide total desired profit by
the number of units produced.
For example, suppose that Saint Company wants to earn $100,000 on the
production of 100 Model 51 Robots:
Desired profit ÷ Units produced = Markup = $100,000 ÷ 100 = $1,000
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Dividing the desired profit by units produced results in a planned markup
of $1,000 per unit. To set the price, add this planned markup to the cost.
Assume that Saint’s cost to produce each robot is $4,000:
Cost + Markup = Sales price = $4,000 + $1,000 = $5,000
If Saint Company wants to earn a total of $100,000, it should set the price at
$5,000 per unit.
Setting a cost-plus percentage
Because companies often sell many different products at different prices,
they commonly use a cost-plus percentage or percentage markup on cost
that applies to all their products. To figure this percentage, you divide the
markup, in dollars, by the total product cost. Then, to determine the products’ sales prices, you apply this percentage to all products, or to different
categories of products.
For example, Saint Company’s Model 51 Robot has a $1,000 markup on a cost
of $5,000.
Markup ÷ Product cost = $1,000 ÷ $4,000 = 0.25 or 25%
Here, Saint earns a 25-percent cost-plus percentage. The company can then
apply the same cost-plus percentage to set the prices of other products. For
example, another robot, Model 6, costs Saint Company $6,000 to produce.
The markup on this robot amounts to $6,000 × 0.25 percent = $1,500, pricing it
at $6,000 + $1,500 = $7,500.
Considering problems with
cost-plus pricing
Cost-plus pricing works because it’s easy to use. However, it carries a few
drawbacks. First, it ignores market factors. Just because you like to mark up
your merchandise 20 percent doesn’t necessarily mean your customers are
willing to pay this price or that your competitors will cooperate with you by
setting their prices even higher.
Second, because cost-plus pricing relies on absorption costing, it treats
fixed costs as though they were variable. Saint Company wants to sell 100
Model 51 Robots, which means it can distribute its fixed costs over 100 units.
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However, the fixed costs remain the same regardless of how many units Saint
actually sells; if the company sells only 50 robots, the fixed costs are spread
over fewer units (50 robots rather than 100), and the cost per unit rises.
Check out Figure 5-2. If production drops to 50 robots, then the cost per
unit increases to $6,000 per unit. This change puts Saint into a tight bind.
Figure 5-2 shows how this miscalculation causes Saint’s profits to vaporize
into a $50,000 loss.
Figure 5-2:
Cost-plus
pricing gone
wild.
©John Wiley & Sons, Inc.
Look on the bright side: If your sales volume is higher than you expected,
then spreading fixed costs will have a disproportionately positive effect on
income — delivering profits way beyond your wildest dreams. That’s because
you’ll spread the fixed costs over more units, which lowers the total cost per
unit sold.
Extreme Accounting: Trying
Variable-Cost Pricing
Variable-cost pricing offers an adventurous variation on cost-plus pricing (refer to the earlier section “Pricing at Cost-Plus”). Instead of adding a
markup on total cost, variable-cost pricing adds a markup on just the variable
cost. It disregards fixed costs altogether. Figure 5-3 compares variable-cost
pricing with boring old cost-plus pricing. The following sections show you
how variable-cost pricing works and point out the drawbacks of using this
system.
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Figure 5-3:
Comparing
cost-plus
(a) and
variablecost
pricing (b).
©John Wiley & Sons, Inc.
Working out variable-cost pricing
When you use variable-cost pricing, your markup must cover both the
desired profit and the expected fixed costs. Therefore, to figure out your
markup, divide the total desired profit plus expected fixed costs by the
number of units produced.
Suppose that Sparl Industries makes the Red Rover model. The entire production run of Red Rover requires $900,000 worth of fixed costs. Each unit
costs another $90,000 in variable costs. Sparl wants to earn $400,000 in profit
on the production and sale of 20 units of this model.
First, figure out how much markup you need on each unit to cover both the
desired profit and the fixed costs:
(Desired profit + Fixed costs) ÷ Units produced = Markup
= ($400,000 + $900,000) ÷ 20 = ($1,300,000) ÷ 20 = $65,000
The markup is $65,000 per unit. Now set the price at this planned markup
plus the variable cost:
Variable cost + Markup = $90,000 + $65,000 = $155,000
According to this analysis, if Sparl Industries wants to earn $400,000 in profit
and cover $900,000 worth of fixed costs by selling 20 units, it should set the
sales price at $155,000.
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Spotting the hazards of
variable-cost pricing
Variable-cost pricing is especially useful for companies pricing special orders
when they have excess capacity, meaning they have sufficient resources to
produce more goods. However, when operating at full capacity, variable-cost
pricing may be hazardous to the health of your business.
Suppose that you operate a hotel with vacant rooms. Each room has a
variable cost of $10/night, and a fixed cost of $90/night. Cost-plus pricing
requires you to base your price on a total cost of $100/night. However,
variable-cost pricing allows you to base your price on a variable cost of just
$10/night.
If your hotel has vacancies (read: excess capacity) and a customer walks in
without a reservation, offering to pay $52 for a room for the night, variable-cost
pricing indicates you should take the guy in. After all, $52 exceeds the variable
cost of $10, increasing your profits by $42. (Cost-plus pricing tells you to refuse
the offer. Each room costs $100/night. Why would you willingly lose $48?) But
if your hotel is completely booked, the only way to house the $52 customer
would be to turn away a full-price-paying customer, reducing revenue.
Variable-cost pricing poses another severe danger: To earn a profit, your sales
must exceed costs. Because variable-cost pricing doesn’t fully account for
fixed costs, it can trick managers into setting prices so low that they hurt
profits, or worse yet, cause net losses. As explained in the preceding example, occasionally selling a room for $52 may increase your profits. However,
selling too many rooms at such low prices (even if you’re never at full
capacity) causes you to lose a lot of money.
Bull’s-Eye: Hitting Your Target Cost
Many industries use price points — special “magic” price levels that customers
expect to pay. You’ve probably seen these prices in the store: $99.99, $26.99,
$19.95, and so on. Understanding customer expectations and competitor
­pricing, manufacturers design products specifically so that the products can
be produced and sold at the magic price points.
Although traditionally you first design the product and then set the price,
target costing requires you to set the price before you design the product.
After you know the price, you can engineer the product so that its cost is
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low enough to ensure that you earn the expected profit margin. Done right,
target costing avoids problems caused by products that are priced too high
for consumers or are too expensive to make. It engineers the price, the profit
margin, and the cost right into the product.
Calculating your target cost
With target costing, the company starts with market price and markup and
uses that information to figure out the product’s cost and specifications. (In
contrast, cost-plus pricing starts with the product cost and desired profit and
uses that information to set the price. You can read about cost-plus pricing
earlier in the chapter.)
To figure out the target cost, subtract the desired profit from the market price:
Market price – Desired profit = Target cost
Figure 5-4 illustrates how this process works.
Figure 5-4:
In target
costing, the
market price
determines
the
product’s
cost.
©John Wiley & Sons, Inc.
For example, suppose you head to a big-box store to buy a new desktop
computer, and you’re determined to pay no more than $750 plus tax. You discover four different desktop models, priced at $599.99, $749.99, $999.99, and
$1,299.99. You take the $749.99 model, because you want the best computer
you can get for $750 or less.
Assume that the store sets prices so that gross profit equals 10.51 percent
of the company’s sales price. An inventory item that sells for $100 typically
includes gross profit worth $100 × 0.1051 = $10.51, costing the company
$100.00 – $10.51 = $89.49. Gross profit is defined as sales less cost of sales.
Check out Chapter 3 for more detail.
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The company’s desired profit on your computer model equals $749.99 ×
0.1051 = $78.82. Plug it into the formula:
Market price – Desired profit = $749.99 – $78.82 = $671.17
The math indicates that the store should pay $671.17 for computers that it
can sell for $749.99.
Target costing works both for retailers (like that big-box store) and for manufacturers (such as the maker of your new computer). Therefore, after the
store determines that it’s willing to pay $671.17 for these computers, the
maker needs to figure out how to make computers with all the right bells and
whistles that it can sell for $671.17.
The computer maker works to earn a 22.7-percent profit margin on sales.
Therefore, the company’s desired profit equals $671.17 × 22.7 percent =
$152.36:
Market price – Desired profit = $671.17 – $152.36 = $518.81
After subtracting desired profit of $152.36 from its expected sales price of
$671.17, the computer maker works out that it needs to engineer and produce
computers that cost $518.81. Armed with this knowledge, the engineers pick
and choose various specifications and features to cook up a computer that
costs exactly this amount.
Knowing when to use
target costing
Target costing works especially well for companies whose products aren’t
well differentiated (such as electronic accessories and economy automobiles),
where price is often a key consideration for customers selecting which brand
to buy. This technique ensures that the company can sell a competitive product
with all the features — and the price — that customers expect.
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Book VIII
Handling Cash and Making
Purchase Decisions
Don’t overlook opportunity costs — the cost of missed opportunities when you allocate
money to certain business ventures. To find out more about opportunity costs and how
to account for them, visit www.dummies.com/extras/accountingaio.
In this book…
✓ Tell the difference between costs and expenses, figure out
which costs you can depreciate, and know when to recognize
revenue.
✓ Take a look at how inventory calculations impact cash flow and
other financial statements. Inventory is often your largest asset
account balance, so understanding these issues is crucial.
✓ Determine when something you’re thinking of purchasing is
likely to pay for itself. Consider the cash inflows that the new
purchase helps you generate and calculate your break-even
point.
✓ Grasp the pros and cons of taking on debt to leverage equity.
Weigh the cost of interest on a loan with a potential dividend
that you would pay a shareholder.
Chapter 1
Identifying Costs and Matching
Costs with Revenue
In This Chapter
▶ Knowing the ins and outs of costs and expenses
▶ Understanding the difference between product and period costs
▶ Figuring out which costs to depreciate
▶ Mulling over revenue recognition
T
his chapter is your introduction to a company’s tangible assets, which
you can touch and feel — they have a physical presence. Tangible assets,
also called fixed assets, include property, plant, and equipment (PP&E).
Many fixed assets are used for years, and a company relies on a mysterious
accounting tool called depreciation to keep its financial statements in line
with the reality of how long those assets stay in use.
If you read this entire chapter, depreciation won’t seem so mysterious anymore. This chapter helps you understand what depreciation is and how it
connects a business’s costs to its expenses. (Yes, costs and expenses are two
different things in the business world.) This chapter also walks you through
the information you find in a schedule of depreciation.
Because you match expenses with revenue, this chapter wraps up with a
discussion of revenue recognition — the event or transaction that determines
when revenue is posted to your accounting records.
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Defining Costs and Expenses
in the Business World
In the world of business, costs aren’t the same as expenses. Note this
­process:
✓ When a business incurs a cost, it exchanges a resource (usually cash or
a promise to pay cash in the future) to purchase a good or service that
enables the company to generate revenue.
✓ Later, when the asset is used to create a product or service, the cost of
the asset is converted into an expense.
✓ When the product or service is sold, the company generates revenue.
The revenue is matched with the expenses incurred to generate the
revenue. Businesses use this matching principle to calculate the profit or
loss on the transaction.
Here’s an example of a common business transaction that demonstrates the
process:
Suppose you’re the manager of the women’s apparel department of a major
manufacturer. You’re expanding the department to add a new line of formal
garments. You need to purchase five new sewing machines, which for this
type of business are fixed assets.
When you buy the sewing machines, the price you pay (or promise to pay) is
a cost. Then, as you use the sewing machines in the normal activity of your
business, you depreciate them: You reclassify the cost of buying the asset to
an expense. So the resources you use to purchase the sewing machines move
from the balance sheet (cost) to the income statement (expense).
Your income statement shows revenue and expenses. The difference between
those two numbers is the company’s net income (when revenue is more than
expense) or net loss (when expenses are higher than revenue).
Still wondering what the big deal is with accountants having to depreciate
fixed assets? Well, the process ties back to the matching principle, discussed
in the next section.
Satisfying the Matching Principle
In accounting, every transaction you work with has to satisfy the matching
­principle (see Book I, Chapter 4). You have to associate all revenue earned
during the accounting period to all expenses you incur to produce that ­revenue.
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The idea is that the expenses are matched with the revenue — r­ egardless
of when the expense occurs.
Continuing with the sewing machine example from the previous section, s­ uppose
the life of the sewing machine — the average amount of time the company
knows it can use the sewing machine before having to replace it — is five years.
The average cost of a commercial sewing machine is $1,500. If the company
expenses the entire purchase price (cost) of $1,500 in the year of purchase, the
net income for year one is understated and the net income for the next four
years is overstated.
Why? Because although the company laid out $1,500 in year one for a
machine, the company anticipates using the machine for another four years.
So to truly match the sales the company generates from garments made by
using the sewing machine, the cost of the machine has to be allocated over
each of the years it will be used to crank out those garments for sale.
Identifying Product and Period Costs
The way a company classifies a cost depends on the category the cost falls
into. Using generally accepted accounting principles (GAAP) as explained in
Book IV, Chapter 1, business costs fall into the two general categories in the
following list:
✓ Product costs: Any costs that relate to manufacturing or merchandising an item for sale to customers. A common example is inventory (see
Chapter 2), which reflects costs a manufacturing company incurs when
buying the raw materials it needs to make a product. For a merchandiser
(retailer), the cost of inventory is what it pays to buy the finished goods
from the manufacturer.
✓ Period costs: Costs that, although necessary to keep the business’s
doors open, don’t tie back to any specific item the company sells. You
can also think of period costs as costs you incur due to the passage
of time, such as depreciation, rent, interest on a loan, and insurance
­premiums.
Discovering Which Costs Are Depreciated
When a company purchases a fixed asset (see Book IV, Chapter 3), such as
a computer or machine, the cost of the asset is spread over its useful life,
which may be years after the purchase. Therefore, depreciation is a period
cost: As time passes, the fixed asset is used to generate revenue. The cost of
the fixed asset is converted into an expense.
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Your next question may be: “Which costs associated with purchasing a fixed
asset do you add together when figuring up the entire cost? Just the purchase
price? Purchase price plus tax and shipping? Other costs?”
Except for the allocation of cost between land and buildings (see the section,
“Allocating costs between land and buildings”), figuring depreciated cost is
straightforward. Per GAAP, the business has to record all fixed asset purchases
on its balance sheet at their original cost plus all the ordinary and necessary
costs to get the fixed asset ready to use. The total cost of the fixed asset is
referred to as its depreciable base.
For example, a company makes pencils and buys a new machine to automatically separate and shrink-wrap ten pencils into salable units. Various costs of
the machine may include the purchase price, sales tax, freight-in, and assembly of the shrink-wrapping machine on the factory floor. (Freight-in is the
buyer’s cost to get the machine from the seller to the buyer.)
Handling real property depreciation
Now, what about real property — land and buildings? Both are clearly fixed
assets, but the cost of the land a building sits on isn’t depreciated and has to
be separated from the cost of the building. Your financial statements will list
land and building as two separate line items on the balance sheet. Why? The
answer is that GAAP mandates that separation — no ifs, ands, or buts about it.
The cost of land is never depreciated either under GAAP or on the company’s
tax return. That’s because the land a building stands on is assumed to retain
its value. In other words, it won’t be used up or run down through use over
time.
So, if a company pays $250,000 to purchase a building to manufacture its pencils and the purchase price is allocated 90 percent to building and 10 percent
to land, how much of the purchase price is spread out over the useful life of
the building? Your answer is: $250,000 × 0.90 = $225,000.
Allocating costs between land
and buildings
Frequently, a company pays one price for both a building and the land that
the building sits on. Figuring out the allocation of costs between land and
building is a common challenge. The best approach is to have an appraisal
done during the purchasing process.
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An appraisal occurs when a licensed professional determines the value of real
property. If you’ve ever purchased a home and applied for a mortgage, you’re
probably familiar with property appraisals. Basically, the appraisal provides
assurance to the mortgage company that you’re not borrowing more than the
property is worth.
Even if a business doesn’t have to secure a mortgage to purchase a real
property asset, it still gets an appraisal to make sure it’s not overpaying for
the property. Alternatively, the county property tax records may show an
allocation of costs to land. However, that allocation is just for property tax
purposes; it may not be materially correct for depreciation purposes. Just
remember to subtract land cost from the total before calculating real property depreciation (depreciation on just the building).
Land improvements, such as fences, roads, and gates, are depreciable. Land
improvements should be shown as a separate line item on the balance sheet
(see Book IV, Chapter 3).
If a business purchases a piece of raw land and constructs its own building,
the accounting issue is more straightforward, because you have a sales price
for the land and construction costs for the building.
Expensing repairs and maintenance
Preventative repair and maintenance costs are expensed in the period in
which they’re incurred. For example, on June 14, a florist business has the oil
changed and purchases new tires for the flower delivery van. The cost of the
oil change and tires goes on the income statement as an operating expense
for the month of June.
The next month, the delivery van’s transmission goes completely out, stranding the driver and flowers at the side of the road. Rebuilding the transmission
significantly increases the useful life of the delivery van, so you have to add
the cost of the new transmission to the net book value of the van on the balance sheet. Net book value (or book value for short) is the difference between
the cost of the fixed asset and its accumulated depreciation at any given time.
Preparing a Depreciation Schedule
Book III, Chapter 1 explains the different methods a business can use to calculate depreciation and how the methods compare to each other. A company
may use different depreciation methods for different types of assets.
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All businesses keep a depreciation schedule for their assets showing all the
relevant details about each asset. Here is the basic information that shows up
on a depreciation schedule:
✓ Description: The type of asset and any other identifying information
about the fixed asset. For a truck, the description may include the make
and model of the truck and its license plate number.
✓ Cost: The purchase price of the asset plus any other spending that
should be added to the asset’s cost. See “Discovering Which Costs Are
Depreciated,” earlier in this chapter for an explanation of other costs
that are included with the purchase price. Although most additions to
purchase price take place when the company acquires the asset, the
fixed asset cost can be added to after the fact if material renovations are
performed. (Think about the truck transmission example from the earlier section “Expensing repairs and maintenance.”)
✓ Life: How long the company estimates it will use the fixed asset.
✓ Method: The method of depreciation the company uses for the fixed
asset.
✓ Salvage value: The estimated value of the fixed asset when the company
gets rid of or replaces it.
✓ Date purchased: The day the asset was purchased.
✓ Current depreciation: The depreciation expense booked in the current
period.
✓ Accumulated depreciation: The total amount of depreciation expensed
from the day the company placed the fixed asset in service to the date
of the financial report.
✓ Net book value: The difference between the fixed asset cost and its
accumulated depreciation.
Depending on the size of the company, the depreciation schedule may also
have the fixed asset’s identifying number, the location where the fixed asset
is kept, property tax information, and many more facts about the asset.
In order to audit fixed assets, auditors may perform a physical count of the
assets. (See Book IX for more about auditing.) If you store tools and equipment in a warehouse, for example, the auditors want to verify that each asset
on your fixed asset listing (accounting records) is actually located in the warehouse. Assigning each asset a unique number is important, so that the number
on the fixed asset listing can be matched to the same number on the asset
itself. That policy allows the audit process to go smoothly.
Chapter 1: Identifying Costs and Matching Costs with Revenue
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Having a nicely organized depreciation schedule allows the company to
keep at its fingertips a summary of activity for each fixed asset. Check out
Figure 1-1 to see the basic organization for a depreciation schedule.
Figure 1-1:
Example
of a
depreciation
schedule.
©John Wiley & Sons, Inc.
Deciding When to Recognize Revenue
The matching principle requires that you match costs incurred with the revenue a company generates. Previously in this chapter, you explore the costs
side of the matching principle. You wrap up this chapter by considering the
revenue side of the matching principle.
Going over the revenue recognition
principle
The revenue recognition principle, first mentioned in Book I, Chapter 4,
requires that, if you use the accrual basis of accounting, you recognize
­revenue by using these two criteria:
✓ Revenue is recorded when it has been earned
✓ Revenue is considered earned when the revenue generation process is
substantially complete
Generally, the revenue generation process is complete when you deliver your
product or service. So, when the clothing store receives jeans from the manufacturer, the company that produced the jeans should recognize revenue. If
you’re a tax accountant, you recognize revenue when you deliver the completed tax return to the client.
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Recognizing revenue and cash flow
With accrual accounting, you can recognize revenue prior to receiving any
payment from the client. A company recognizes revenue as soon as it delivers the goods or services.
For businesses that use accrual accounting, revenue recognized for the
month may be very different from cash inflows for sales for the same period.
Specifically, the increase in cash may not equal sales for the month. (See
Book V, Chapter 2 for more about cash flows.)
A business using cash-basis accounting recognizes revenue when the cash is
received from the client. (See Book I, Chapter 4 for more about the difference
between cash- and accrual-basis accounting.) If you review the checkbook of
a cash-basis company, the deposits for the month will match the revenue for
the month. Most businesses, however, use the accrual-basis of accounting.
Chapter 2
Exploring Inventory Cost Flow
Assumptions
In This Chapter
▶ Seeing how inventory calculations impact financial statements
▶ Comparing service companies and manufacturers
▶ Recognizing a variety of inventory types
▶ Sampling inventory valuation methods
▶ Looking at an inventory worksheet
S
ome people think that inventory is only the merchandise available for
sale in a store, commonly called retail or merchandise inventory. This
chapter covers retail inventory, but it also introduces you to other kinds of
product inventory used by manufacturers, including direct materials, work in
process, and finished goods.
You also find out in this chapter about two methods a company may use to
keep track of merchandise inventory, as well as the four methods businesses
may use to value ending inventory: specific identification; weighted average;
last-in, first-out; and first-in, first-out.
Some businesses, such as service companies, may not carry any inventory.
Although they may carry a minimal amount of office supplies, they’re in the
business of selling a service (legal advice, consulting) rather than a product.
Discovering How Inventory Valuation
Affects the Financial Statements
In accounting, you’re preparing financial statements for users outside the
business, such as investors and lenders (see Book I, Chapter 4). They need
accurate financial statements to make informed decisions on whether they
want to invest in the company or loan it money.
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Comparing merchandising and
manufacturing companies
For manufacturing companies (which make products) and merchandising
companies (which sell the products made by the manufacturers), inventory can be a big part of the balance sheet. Along with accounts receivable,
inventory may be the largest current asset account. So proper accounting for
inventory is important, and that includes the value placed on ending inventory. A company can inadvertently prepare a set of highly inaccurate financial
statements by expensing purchases rather than keeping them on the balance
sheet as inventory (an asset account).
So which costs are okay to expense directly on the income statement, and
which costs should stay on the balance sheet as assets? Here’s a quick and
dirty answer: Any item that a company buys for eventual sale to a customer
should be recorded as inventory, which appears on the balance sheet.
Connecting inventory to revenue
Inventory ties into both the revenue process and the cost of goods sold (see
Book IV, Chapter 6). Associating inventory with cost of goods sold makes
common sense — you have to buy something before you can sell it. But you
may be wondering how revenue and inventory relate to each other. Well,
remember that you need to use generally accepted accounting principles
(GAAP), introduced in Book IV, Chapter 1. GAAP’s matching principle dictates
that expenses are matched with revenue earned for the period.
How does inventory come into the revenue equation? Book IV, Chapter 6
shows how to compute cost of goods sold for both a merchandising and a
manufacturing company. Consider this process:
✓ Product costs are any costs that a company incurs when purchasing or
manufacturing an item for sale to customers. Product costs are part of
inventory (an asset account).
✓ When a sale occurs, product costs are posted to cost of goods sold (an
expense account).
✓ Any product costs for unsold inventory remain in the inventory (asset)
account at the end of the period.
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Logging Inventory for Service Companies
Although discussions of inventory focus on manufacturing and merchandising companies, you also need to consider service companies: those that don’t
provide a tangible good and normally don’t have any appreciable inventory.
However, if a service company keeps a large amount of office or other supplies on hand, it may inventory them instead of applying the cost of supplies
purchased to the supply expense each month.
Suppose a service company purchases supplies on account, which means
the company promises to pay for them at a later date. The supplies cost
$700 at the beginning of September. The $700 represents purchases. For this
example, no beginning inventory exists for September. On the last day of
September, an inventory is taken and supplies in the amount of $230 remain
in the cabinet.
Your journal entry to record the purchase is to debit supplies (an asset
account) and credit accounts payable for $700. So far you haven’t affected
the income statement.
Now at the end of the month, you have to adjust supplies inventory to the
actual on hand, which involves expensing the portion of supplies used. The
company purchased $700 of supplies and only $230 remain, so you know that
$700 – $230 = $470 of supplies were used and should be expensed for the
month of September. So your journal entry is to debit supplies expense
(an income statement account) and credit supplies (an asset account).
Classifying Inventory Types
Depending on the type of business, you’ll encounter different types of inventory. To make it easier for you to understand, this section breaks out the
subject between inventory for merchandising companies and inventory for
manufacturing companies.
Accounting for merchandising
company inventory
Accounting for merchandise inventory is generally easier than accounting for
manufacturing inventory. That’s because a merchandising company, such
as a retail store, has only one class of inventory to keep track of: goods the
business purchases from various manufacturers for resale.
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Here’s an example of the basic flow of inventory for a retailer: A linen sales
associate at a major department store tells the manager that a certain style
of linen is in low supply. The manager follows the store’s purchasing process,
and the store receives a shipment of linens from its vendor.
This transaction is a purchase (cost), but it’s not an expense until the department store sells the linens. So the business records the entire shipment of
linens on the balance sheet as an addition to both inventory and accounts
payable (see Book IV, Chapter 3). Accounts payable is used instead of cash
because the department store has payment terms with this vendor and
money has yet to change