Principles of Accounting, Volume 1: Financial Accounting

Preface

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About *Principles of Accounting*

*Principles of Accounting* is designed to meet the scope and sequence requirements of a two-semester accounting course that covers the fundamentals of financial and managerial accounting. This book is specifically designed to appeal to both accounting and non-accounting majors, exposing students to the core concepts of accounting in familiar ways to build a strong foundation that can be applied across business fields. Each chapter opens with a relatable real-life scenario for today’s college student. Thoughtfully designed examples are presented throughout each chapter, allowing students to build on emerging accounting knowledge. Concepts are further reinforced through applicable connections to more detailed business processes. Students are immersed in the “why” as well as the “how” aspects of accounting in order to reinforce concepts and promote comprehension over rote memorization.

Additional resources

About the authors

**Senior contributing authors**

Role of Accounting in Society

Why It Matters

Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting

Identify Users of Accounting Information and How They Apply Information

Characteristics, Users, and Sources of Financial Accounting Information

Organizations measure financial performance in monetary terms. In the United States, the dollar is used as the standard measurement basis. Measuring financial performance in monetary terms allows managers to compare the organization’s performance to previous periods, to expectations, and to other organizations or industry standards.

Characteristics, Users, and Sources of Managerial Accounting Information

As you’ve learned, managerial accounting information is different from financial accounting information in several respects. Accountants use formal accounting standards in financial accounting. These accounting standards are referred to as generally accepted accounting principles (GAAP) and are the common set of rules, standards, and procedures that publicly traded companies must follow when composing their financial statements. The previously mentioned Financial Accounting Standards Board (FASB), an independent, nonprofit organization that sets financial accounting and reporting standards for both public and private sector businesses in the United States, uses the GAAP guidelines as its foundation for its system of accepted accounting methods and practices, reports, and other documents.

Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities

For-Profit Businesses

As the name implies, the primary purpose or mission of a for-profit business is to earn a profit by selling goods and services. There are many reasons why a for-profit business seeks to earn a profit. The profits generated by these organizations might be used to create value for employees in the form of pay raises for existing employees as well as hiring additional workers. In addition, profits can be reinvested in the business to create value in the form of research and development, equipment upgrades, facilities expansions, and many other activities that make the business more competitive. Many companies also engage in charitable activities, such as donating money, donating products, or allowing employees to volunteer in the communities. Finally, profits can also be shared with employees in the form of either bonuses or commissions as well as with owners of the business as a reward for the owners’ investment in the business. These issues, along with others, and the associated accounting conventions will be explored throughout this course.

Governmental Entities

A governmental entity provides services to the general public (taxpayers). Governmental agencies exist at the federal, state, and local levels. These entities are funded through the issuance of taxes and other fees.

Not-for-Profit Entities

To be fair, the name “not-for-profit” can be somewhat confusing. As with “for-profit” entities, the name refers to the primary purpose or mission of the organization. In the case of for-profit organizations, the primary purpose is to generate a profit. The profits, then, can be used to sustain and improve the business through investments in employees, research, and development, and other measures intended to help ensure the long-term success of the business.

Explain Why Accounting Is Important to Business Stakeholders

Stockholders

A stockholder is an owner of stock in a business. Owners are called stockholders because in exchange for cash, they are given an ownership interest in the business, called stock. Stock is sometimes referred to as “shares.” Historically, stockholders received paper certificates reflecting the number of stocks owned in the business. Now, many stock transactions are recorded electronically. Introduction to Financial Statements discusses stock in more detail. Corporation Accounting offers a more extensive exploration of the types of stock as well as the accounting related to stock transactions.

Creditors and Lenders

In order to provide goods and services to their customers, businesses make purchases from other businesses. These purchases come in the form of materials used to make finished goods or resell, office equipment such as copiers and telephones, utility services such as heating and cooling, and many other products and services that are vital to run the business efficiently and effectively.

Governmental and Regulatory Agencies

Publicly traded companies are required to file financial and other informational reports with the Securities and Exchange Commission (SEC), a federal regulatory agency that regulates corporations with shares listed and traded on security exchanges through required periodic filings [link]. The SEC accomplishes this in two primary ways: issuing regulations and providing oversight of financial markets. The goal of these actions is to help ensure that businesses provide investors with access to transparent and unbiased financial information.

Customers

Depending on the perspective, the term *customers* can have different meanings. Consider for a moment a retail store that sells electronics. That business has customers that purchase its electronics. These customers are considered the end users of the product. The customers, knowingly or unknowingly, have a stake in the financial performance of the business. The customers benefit when the business is financially successful. Profitable businesses will continue to sell the products the customers want, maintain and improve the business facilities, provide employment for community members, and undertake many other activities that contribute to a vibrant and thriving community.

Managers and Other Employees

Employees have a strong interest in the financial performance of the organizations for which they work. At the most basic level, employees want to know their jobs will be secure so they can continue to be paid for their work. In addition, employees increase their value to the organization through their years of service, improving knowledge and skills, and accepting positions of increased responsibility. An organization that is financially successful is able to reward employees for that commitment to the organization through bonuses and increased pay.

Describe the Varied Career Paths Open to Individuals with an Accounting Education

Personal Attributes

While it is true that accountants often work independently, much of the work that accountants undertake involves interactions with other people. In fact, accountants frequently need to gather information from others and explain complex financial concepts to others, making excellent written and verbal communication skills a must. In addition, accountants often deal with strict deadlines such as tax filings, making prioritizing work commitments and being goal oriented necessities. In addition to these skills, traditionally, an accountant can be described as someone who

Education

Entry-level positions in the accounting profession usually require a minimum of a bachelor’s degree. For advanced positions, firms may consider factors such as years of experience, professional development, certifications, and advanced degrees, such as a master’s or doctorate. The specific factors regarding educational requirements depend on the industry and the specific business.

Related Careers

An accounting degree is a valuable tool for other professions too. A thorough understanding of accounting provides the student with a comprehensive understanding of business activity and the importance of financial information to make informed decisions. While an accounting degree is a necessity to work in the accounting profession, it also provides a solid foundation for other careers, such as financial analysts, personal financial planners, and business executives. The number of career options may seem overwhelming at this point, and a career in the accounting profession is no exception. The purpose of this section is to simply highlight the vast number of options that an accounting degree offers. In the workforce, accounting professionals can find a career that best fits their interests.

Major Categories of Accounting Functions

It is a common perception that an accounting career means preparing tax returns. While numerous accountants do prepare tax returns, many people are surprised to learn of the variety of career paths that are available within the accounting profession. An accounting degree is a valuable tool that gives accountants a high level of flexibility and many options. Often individual accountants apply skills in several of the following career paths simultaneously. [link] illustrates some of the many career paths open to accounting students.

Major Categories of Employers

Now that you’ve learned about the various career paths that accountants can take, let’s briefly look at the types of organizations that accountants can work for. [link] illustrates some common types of employers that require accountants. While this is not an all-inclusive list, most accountants in the profession are employed by these types of organizations.

Potential Certifications for Accountants

As previously discussed, the study of accounting serves as a foundation for other careers that are similar to accounting, and the certifications described here reflect that relationship.

Introduction to Financial Statements

Why It Matters

Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate

Types of Business Structure

As you learned in Role of Accounting in Society, virtually every activity that occurs in a business has an associated cost or value. Part of an accountant’s role is to quantify these activities, or transactions.

The Four Financial Statements

Are you a fan of books, movies, or sports? If so, chances are you have heard or said the phrase “spoiler alert.” It is used to forewarn readers, viewers, or fans that the ending of a movie or book or outcome of a game is about to be revealed. Some people prefer knowing the end and skipping all of the details in the middle, while others prefer to fully immerse themselves and then discover the outcome. People often do not know or understand what accountants produce or provide. That is, they are not familiar with the “ending” of the accounting process, but that is the best place to begin the study of accounting.

Purpose of Financial Statements

Before exploring the specific financial statements, it is important to know why these are important documents. To understand this, you must first understand who the users of financial statements are. Users of the information found in financial statements are called stakeholders. A stakeholder is someone affected by decisions made by a company; this can include groups or individuals affected by the actions or policies of an organization, including investors, creditors, employees, managers, regulators, customers, and suppliers. The stakeholder’s interest sometimes is not directly related to the entity’s financial performance. Examples of stakeholders include lenders, investors/owners, vendors, employees and management, governmental agencies, and the communities in which the businesses operate. Stakeholders are interested in the performance of an organization for various reasons, but the common goal of using the financial statements is to understand the information each contains that is useful for making financial decisions. For example, a banker may be interested in the financial statements to decide whether or not to lend the organization money.

The Income Statement

The first financial statement prepared is the income statement, a statement that shows the organization’s financial performance *for a given period of time*. Let’s illustrate the purpose of an income statement using a real-life example. Assume your friend, Chris, who is a sole proprietor, started a summer landscaping business on August 1, 2020. It is categorized as a service entity. To keep this example simple, assume that she is using her family’s tractor, and we are using the *cash basis* method of accounting to demonstrate Chris’s initial operations for her business. The other available basis method that is commonly used in accounting is the *accrual basis* method. She is responsible for paying for fuel and any maintenance costs. She named the business Chris’ Landscaping. On August 31, Chris checked the account balance and noticed there is only \$250 in the checking account. This balance is lower than expected because she thought she had been paid by some customers. Chris decides to do some research to determine why the balance in the checking account is lower than expected. Her research shows that she earned a total of \$1,400 from her customers but had to pay \$100 to fix the brakes on her tractor, \$50 for fuel, and also made a \$1,000 payment to the insurance company for business insurance. The reason for the lower-than-expected balance was due to the fact that she spent (\$1,150 for brakes, fuel, and insurance) only slightly less than she earned (\$1,400)—a net increase of \$250. While she would like the checking balance to grow each month, she realizes most of the August expenses were infrequent (brakes and insurance) and the insurance, in particular, was an unusually large expense. She is convinced the checking account balance will likely grow more in September because she will earn money from some new customers; she also anticipates having fewer expenses.

Statement of Owner’s Equity

Equity is a term that is often confusing but is a concept with which you are probably already familiar. In short, equity is the value of an item that remains after considering what is owed for that item. The following example may help illustrate the concept of equity.

Balance Sheet

Once the statement of owner’s equity is completed, accountants typically complete the balance sheet, a statement that lists what the organization owns (*assets*), what it owes (*liabilities*), and what it is worth (*equity*) on a *specific date*. Notice the change in timing of the report. The income statement and statement of owner’s equity report the financial performance and equity change for a period of time. The balance sheet, however, lists the financial position at the close of business on a specific date. (Refer to [link] for the balance sheet as of August 31, 2020, for Chris’ Landscaping.)

Statement of Cash Flows

The fourth and final financial statement prepared is the statement of cash flows, which is a statement that lists the cash inflows and cash outflows for the business *for a period of time.* At first glance, this may seem like a redundant financial statement. We know the income statement also reports the inflows and outflows for the business for a period of time. In addition, the statement of owner’s equity and the balance sheet help to show the other activities, such as investments by and distributions to owners that are not included in the income statement. To understand why the statement of cash flows is necessary, we must first understand the two bases of accounting used to prepare the financial statements. The changes in cash within this statement are often referred to as sources and uses of cash. A source of cash lets one see where cash is coming from. For example, is cash being generated from sales to customers, or is the cash a result of an advance in a large loan. Use of cash looks at what cash is being used for. Is cash being used to make an interest payment on a loan, or is cash being used to purchase a large piece of machinery that will expand business capacity? The two bases of accounting are the cash basis and the accrual basis, briefly introduced in Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate.

Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses

Why Does Current versus Noncurrent Matter?

At this point, let’s take a break and explore why the distinction between current and noncurrent assets and liabilities matters. It is a good question because, on the surface, it does not seem to be important to make such a distinction. After all, assets are things owned or controlled by the organization, and liabilities are amounts owed by the organization; listing those amounts in the financial statements provides valuable information to stakeholders. But we have to dig a little deeper and remind ourselves that stakeholders are using this information to make decisions. Providing the amounts of the assets and liabilities answers the “what” question for stakeholders (that is, it tells stakeholders the value of assets), but it does not answer the “when” question for stakeholders. For example, knowing that an organization has \$1,000,000 worth of assets is valuable information, but knowing that \$250,000 of those assets are current and will be used or consumed within one year is more valuable to stakeholders. Likewise, it is helpful to know the company owes \$750,000 worth of liabilities, but knowing that \$125,000 of those liabilities will be paid within one year is even more valuable. In short, the *timing* of events is of particular interest to stakeholders.

Equity and Legal Structure

Recall that equity can also be referred to as net worth—the value of the organization. The concept of equity does not change depending on the legal structure of the business (sole proprietorship, partnership, and corporation). The terminology does, however, change slightly based on the type of entity. For example, investments by owners are considered “capital” transactions for sole proprietorships and partnerships but are considered “common stock” transactions for corporations. Likewise, distributions to owners are considered “drawing” transactions for sole proprietorships and partnerships but are considered “dividend” transactions for corporations.

The Accounting Equation

Recall the simple example of a home loan discussed in Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate. In that example, we assumed a family purchased a home valued at \$200,000 and made a down payment of \$25,000 while financing the remaining balance with a \$175,000 bank loan. This example demonstrates one of the most important concepts in the study of accounting: the accounting equation, which is:

Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet

Elements of the Financial Statements

When thinking of the relationship between the elements and the financial statements, we might think of a baking analogy: the elements represent the ingredients, and the financial statements represent the finished product. As with baking a cake (see [link]), knowing the ingredients (elements) and how each ingredient relates to the final product (financial statements) is vital to the study of accounting.

Financial Statements for a Sample Company

Now it is time to bake the cake (i.e., prepare the financial statements). We have all of the ingredients (elements of the financial statements) ready, so let’s now return to the financial statements themselves. Let’s use as an example a fictitious company named Cheesy Chuck’s Classic Corn. This company is a small retail store that makes and sells a variety of gourmet popcorn treats. It is an exciting time because the store opened in the current month, June.

Liquidity Ratios

In addition to reviewing the financial statements in order to make decisions, owners and other stakeholders may also utilize financial ratios to assess the financial health of the organization. While a more in-depth discussion of financial ratios occurs in Appendix A: Financial Statement Analysis, here we introduce *liquidity ratios*, a common, easy, and useful way to analyze the financial statements.

Analyzing and Recording Transactions

Why It Matters

Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements

Accounting Principles, Assumptions, and Concepts

In Introduction to Financial Statements, you learned that the Financial Accounting Standards Board (FASB) is an independent, nonprofit organization that sets the standards for financial accounting and reporting, including generally accepted accounting principles (GAAP), for both public- and private-sector businesses in the United States.

The Conceptual Framework

The FASB uses a conceptual framework, which is a set of concepts that guide financial reporting. These concepts can help ensure information is comparable and reliable to stakeholders. Guidance may be given on how to report transactions, measurement requirements, and application on financial statements, among other things.[footnote]

Financial Accounting Standards Board. “The Conceptual Framework.” http://www.fasb.org/jsp/FASB/Page/BridgePage&cid=1176168367774

The Accounting Equation

Introduction to Financial Statements briefly discussed the accounting equation, which is important to the study of accounting because it shows what the organization owns and the sources of (or claims against) those resources. The accounting equation is expressed as follows:

Double-Entry Bookkeeping

The basic components of even the simplest accounting system are *accounts* and a *general ledger*. An account is a record showing increases and decreases to assets, liabilities, and equity—the basic components found in the accounting equation. As you know from Introduction to Financial Statements, each of these categories, in turn, includes many individual accounts, all of which a company maintains in its general ledger. A general ledger is a comprehensive listing of all of a company’s accounts with their individual balances.

Debits and Credits

Each account can be represented visually by splitting the account into left and right sides as shown. This graphic representation of a general ledger account is known as a T-account. The concept of the T-account was briefly mentioned in Introduction to Financial Statements and will be used later in this chapter to analyze transactions. A T-account is called a “T-account” because it looks like a “T,” as you can see with the T-account shown here.

Normal Balance of an Account

The normal balance is the expected balance each account type maintains, which is the side that increases. As assets and expenses increase on the debit side, their normal balance is a debit. Dividends paid to shareholders also have a normal balance that is a debit entry. Since liabilities, equity (such as common stock), and revenues increase with a credit, their “normal” balance is a credit. [link] shows the normal balances and increases for each account type.

Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions

Expanded Accounting Equation

The expanded accounting equation breaks down the equity portion of the accounting equation into more detail. This expansion of the equity section allows a company to see the impact to equity from changes to revenues and expenses, and to owner investments and payouts. It is important to have more detail in this equity category to understand the effect on financial statements from period to period. For example, an increase to revenue can increase net income on the income statement, increase retained earnings on the statement of retained earnings, and change the distribution of stockholder’s equity on the balance sheet. This may be difficult to understand where these changes have occurred without revenue recognized individually in this expanded equation.

Chart of Accounts

Recall that the basic components of even the simplest accounting system are accounts and a general ledger. Accounts shows all the changes made to assets, liabilities, and equity—the three main categories in the accounting equation. Each of these categories, in turn, includes many individual accounts, all of which a company maintains in its general ledger.

Breaking Down the Expanded Accounting Equation

Refer to the expanded accounting equation ([link]). We begin with the left side of the equation, the assets, and work toward the right side of the equation to liabilities and equity.

Define and Describe the Initial Steps in the Accounting Cycle

First Four Steps in the Accounting Cycle

The first four steps in the accounting cycle are (1) identify and analyze transactions, (2) record transactions to a journal, (3) post journal information to a ledger, and (4) prepare an unadjusted trial balance. We begin by introducing the steps and their related documentation.

Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements

Reviewing and Analyzing Transactions

Let us assume our business is a service-based company. We use Lynn Sanders’ small printing company, Printing Plus, as our example. Please notice that since Printing Plus is a corporation, we are using the Common Stock account, instead of Owner’s Equity. The following are several transactions from this business’s current month:

Use Journal Entries to Record Transactions and Post to T-Accounts

Journals

Accountants use special forms called *journals* to keep track of their business transactions. A journal is the first place information is entered into the accounting system. A journal is often referred to as the book of original entry because it is the place the information originally enters into the system. A journal keeps a historical account of all recordable transactions with which the company has engaged. In other words, a journal is similar to a diary for a business. When you enter information into a journal, we say you are journalizing the entry. Journaling the entry is the second step in the accounting cycle. Here is a picture of a journal.

Recording Transactions

We now return to our company example of Printing Plus, Lynn Sanders’ printing service company. We will analyze and record each of the transactions for her business and discuss how this impacts the financial statements. Some of the listed transactions have been ones we have seen throughout this chapter. More detail for each of these transactions is provided, along with a few new transactions.

Posting to the General Ledger

Recall that the general ledger is a record of each account and its balance. Reviewing journal entries individually can be tedious and time consuming. The general ledger is helpful in that a company can easily extract account and balance information. Here is a small section of a general ledger.

Calculating Account Balances

When calculating balances in ledger accounts, one must take into consideration which side of the account increases and which side decreases. To find the account balance, you must find the difference between the sum of all figures on the side that increases and the sum of all figures on the side that decreases.

Posting to the T-Accounts

The third step in the accounting cycle is to post journal information to the ledger. To do this we can use a T-account format. A company will take information from its journal and post to this general ledger. Posting refers to the process of transferring data from the journal to the general ledger. It is important to understand that T-accounts are only used for illustrative purposes in a textbook, classroom, or business discussion. They are not official accounting forms. Companies will use ledgers for their official books, not T-accounts.

Prepare a Trial Balance

Locating Errors

Sometimes errors may occur in the accounting process, and the trial balance can make those errors apparent when it does not balance.

The Adjustment Process

Why It Matters

Explain the Concepts and Guidelines Affecting Adjusting Entries

Accrual Accounting

Public companies reporting their financial positions use either US generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS), as allowed under the Securities and Exchange Commission (SEC) regulations. Also, companies, public or private, using US GAAP or IFRS prepare their financial statements using the rules of accrual accounting. Recall from Introduction to Financial Statements that accrual basis accounting prescribes that revenues and expenses must be recorded in the accounting period in which they were earned or incurred, no matter when cash receipts or payments occur. It is because of accrual accounting that we have the *revenue recognition principle* and the *expense recognition principle* (also known as the *matching principle*).

The Accounting Period

As we discussed, accrual accounting requires companies to report revenues and expenses in the accounting period in which they were earned or incurred. An accounting period breaks down company financial information into specific time spans, and can cover a month, a quarter, a half-year, or a full year. Public companies governed by GAAP are required to present quarterly (three-month) accounting period financial statements called 10-Qs. However, most public and private companies keep monthly, quarterly, and yearly (annual) period information. This is useful to users needing up-to-date financial data to make decisions about company investment and growth. When the company keeps yearly information, the year could be based on a fiscal or calendar year. This is explained shortly.

The Fiscal Year and the Calendar Year

A company may choose its yearly reporting period to be based on a calendar or fiscal year. If a company uses a calendar year, it is reporting financial data from January 1 to December 31 of a specific year. This may be useful for businesses needing to coincide with a traditional yearly tax schedule. It can also be easier to track for some businesses without formal reconciliation practices, and for small businesses.

Interim Periods

An interim period is any reporting period shorter than a full year (fiscal or calendar). This can encompass monthly, quarterly, or half-year statements. The information contained on these statements is timelier than waiting for a yearly accounting period to end. The most common interim period is three months, or a quarter. For companies whose common stock is traded on a major stock exchange, meaning these are *publicly traded* companies, quarterly statements must be filed with the SEC on a Form 10-Q. The companies must file a Form 10-K for their annual statements. As you’ve learned, the SEC is an independent agency of the federal government that provides oversight of public companies to maintain fair representation of company financial activities for investors to make informed decisions.

Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries

Why Some Accounts Have Incorrect Balances on the Trial Balance

The unadjusted trial balance may have incorrect balances in some accounts. Recall the trial balance from Analyzing and Recording Transactions for the example company, Printing Plus.

The Need for Adjusting Entries

Adjusting entries update accounting records at the end of a period for any transactions that have not yet been recorded. These entries are necessary to ensure the income statement and balance sheet present the correct, up-to-date numbers. Adjusting entries are also necessary because the initial trial balance may not contain complete and current data due to several factors:

Types of Adjusting Entries

Adjusting entries requires updates to specific account types at the end of the period. Not all accounts require updates, only those not naturally triggered by an original source document. There are two main types of adjusting entries that we explore further, deferrals and accruals.

Deferrals

Deferrals are prepaid expense and revenue accounts that have delayed recognition until they have been used or earned. This recognition may not occur until the end of a period or future periods. When deferred expenses and revenues have yet to be recognized, their information is stored on the balance sheet. As soon as the expense is incurred and the revenue is earned, the information is transferred from the balance sheet to the income statement. Two main types of deferrals are prepaid expenses and unearned revenues.

Accruals

Accruals are types of adjusting entries that accumulate during a period, where amounts were previously unrecorded. The two specific types of adjustments are accrued revenues and accrued expenses.

Accrued Expenses

Accrued expenses are expenses incurred in a period but have yet to be recorded, and no money has been paid. Some examples include interest, tax, and salary expenses.

Record and Post the Common Types of Adjusting Entries

Recording Common Types of Adjusting Entries

Recall the transactions for Printing Plus discussed in Analyzing and Recording Transactions.

Posting Adjusting Entries

Once you have journalized all of your adjusting entries, the next step is posting the entries to your ledger. Posting adjusting entries is no different than posting the regular daily journal entries. T-accounts will be the visual representation for the Printing Plus general ledger.

Use the Ledger Balances to Prepare an Adjusted Trial Balance

Prepare Financial Statements Using the Adjusted Trial Balance

Income Statement

An income statement shows the organization’s financial performance for a given period of time. When preparing an income statement, revenues will always come before expenses in the presentation. For Printing Plus, the following is its January 2019 Income Statement.

Statement of Retained Earnings

The statement of retained earnings (which is often a component of the statement of stockholders’ equity) shows how the equity (or value) of the organization has changed over a period of time. The statement of retained earnings is prepared second to determine the ending retained earnings balance for the period. The statement of retained earnings is prepared before the balance sheet because the ending retained earnings amount is a required element of the balance sheet. The following is the Statement of Retained Earnings for Printing Plus.

Balance Sheet

The balance sheet is the third statement prepared after the statement of retained earnings and lists what the organization owns (*assets*), what it owes (*liabilities*), and what the shareholders control (*equity*) on a specific date. Remember that the balance sheet represents the accounting equation, where assets equal liabilities plus stockholders’ equity. The following is the Balance Sheet for Printing Plus.

Ten-Column Worksheets

The 10-column worksheet is an all-in-one spreadsheet showing the transition of account information from the trial balance through the financial statements. Accountants use the 10-column worksheet to help calculate end-of-period adjustments. Using a 10-column worksheet is an optional step companies may use in their accounting process.

Completing the Accounting Cycle

Why It Matters

Describe and Prepare Closing Entries for a Business

Introduction to the Closing Entries

Companies are required to close their books at the end of each fiscal year so that they can prepare their annual financial statements and tax returns. However, most companies prepare monthly financial statements and close their books annually, so they have a clear picture of company performance during the year, and give users timely information to make decisions.

Temporary and Permanent Accounts

All accounts can be classified as either permanent (real) or temporary (nominal) ([link]).

Journalizing and Posting Closing Entries

The eighth step in the accounting cycle is preparing closing entries, which includes journalizing and posting the entries to the ledger.

Prepare a Post-Closing Trial Balance

Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity

Cash Basis versus Accrual Basis Accounting

There are several reasons accrual-basis accounting is preferred to cash-basis accounting. Accrual-basis accounting is required by US generally accepted accounting principles (GAAP), as it typically provides a better sense of the financial well-being of a company. Accrual-based accounting information allows management to analyze a company’s progress, and management can use that information to improve their business. Accrual accounting is also used to assist companies in securing financing, because banks will typically require a company to provide accrual-basis financial income statements. The Internal Revenue Service might also require businesses to report using accrual basis information when preparing tax returns. In addition, companies with inventory must use accrual-based accounting for income tax purposes, though there are exceptions to the general rule.

The Classified Balance Sheet

A classified balance sheet presents information on your balance sheet in a more informative structure, where asset and liability categories are divided into smaller, more detailed sections. Classified balance sheets show more about the makeup of our assets and liabilities, allowing us to better analyze the current health of our company and make future strategic plans.

Using Classified Balance Sheets to Evaluate Liquidity

Categorizing assets and liabilities on a balance sheet helps a company evaluate its business. One way a company can evaluate its business is with financial statement ratios. We consider two measures of liquidity, working capital, and the current ratio. Let’s first explore this idea of liquidity.

Appendix: Complete a Comprehensive Accounting Cycle for a Business

Merchandising Transactions

Why It Matters

Compare and Contrast Merchandising versus Service Activities and Transactions

Comparison of Merchandising Transactions versus Service Transactions

Some of the biggest differences between a service company and a merchandising company are what they sell, their typical financial transactions, their operating cycles, and how these translate to financial statements.

Characteristics of Merchandising Transactions

Merchandising transactions are separated into two categories: purchases and sales. In general, a purchase transaction occurs between a manufacturer and the merchandiser, also called a retailer. A sales transaction occurs between a customer and the merchandiser or retailer. We will now discuss the characteristics that create purchase and sales transactions for a retailer. A merchandiser will need to purchase merchandise for its business to continue operations and can use several purchase situations to accomplish this.

Compare and Contrast Perpetual versus Periodic Inventory Systems

Characteristics of the Perpetual and Periodic Inventory Systems

A perpetual inventory system automatically updates and records the inventory account every time a sale, or purchase of inventory, occurs. You can consider this “recording as you go.” The recognition of each sale or purchase happens immediately upon sale or purchase.

Advantages and Disadvantages of the Perpetual Inventory System

The perpetual inventory system gives real-time updates and keeps a constant flow of inventory information available for decision-makers. With advancements in point-of-sale technologies, inventory is updated automatically and transferred into the company’s accounting system. This allows managers to make decisions as it relates to inventory purchases, stocking, and sales. The information can be more robust, with exact purchase costs, sales prices, and dates known. Although a periodic physical count of inventory is still required, a perpetual inventory system may reduce the number of times physical counts are needed.

Advantages and Disadvantages of the Periodic Inventory System

The periodic inventory system is often less expensive and time consuming than perpetual inventory systems. This is because there is no constant maintenance of inventory records or training and retraining of employees to upkeep the system. The complexity of the system makes it difficult to identify the cost justification associated with the inventory function.

Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System

Basic Analysis of Purchase Transaction Journal Entries

To better illustrate merchandising activities, let’s follow California Business Solutions (CBS), a retailer providing electronic hardware packages to meet small business needs. Each electronics hardware package (see [link]) contains a desktop computer, tablet computer, landline telephone, and a 4-in-1 desktop printer with a printer, copier, scanner, and fax machine.

Cash and Credit Purchase Transaction Journal Entries

On April 1, CBS purchases 10 electronic hardware packages at a cost of \$620 each. CBS has enough cash-on-hand to pay immediately with cash. The following entry occurs.

Purchase Discount Transaction Journal Entries

On May 1, CBS purchases 67 tablet computers at a cost of \$60 each on credit. The payment terms are 5/10, n/30, and the invoice is dated May 1. The following entry occurs.

Purchase Returns and Allowances Transaction Journal Entries

On June 1, CBS purchased 300 landline telephones with cash at a cost of \$60 each. On June 3, CBS discovers that 25 of the phones are the wrong color and returns the phones to the manufacturer for a full refund. The following entries occur with the purchase and subsequent return.

Summary of Purchase Transaction Journal Entries

The chart in [link] represents the journal entry requirements based on various merchandising purchase transactions using the perpetual inventory system.

Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System

Basic Analysis of Sales Transaction Journal Entries

Let’s continue to follow California Business Solutions (CBS) and their sales of electronic hardware packages to business customers. As previously stated, each package contains a desktop computer, tablet computer, landline telephone, and a 4-in-1 printer. CBS sells each hardware package for \$1,200. They offer their customers the option of purchasing extra individual hardware items for every electronic hardware package purchase. [link] lists the products CBS sells to customers; the prices are per-package, and per unit.

Cash and Credit Sales Transaction Journal Entries

On July 1, CBS sells 10 electronic hardware packages to a customer at a sales price of \$1,200 each. The customer pays immediately with cash. The following entries occur.

Sales Discount Transaction Journal Entries

On August 1, a customer purchases 56 tablet computers on credit. The payment terms are 2/10, n/30, and the invoice is dated August 1. The following entries occur.

Sales Returns and Allowances Transaction Journal Entries

On September 1, CBS sold 250 landline telephones to a customer who paid with cash. On September 3, the customer discovers that 40 of the phones are the wrong color and returns the phones to CBS in exchange for a full refund. CBS determines that the returned merchandise can be resold and returns the merchandise to inventory at its original cost. The following entries occur for the sale and subsequent return.

Summary of Sales Transaction Journal Entries

The chart in [link] represents the journal entry requirements based on various merchandising sales transactions.

Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods

The Basics of Freight-in Versus Freight-out Costs

Shipping is determined by contract terms between a buyer and seller. There are several key factors to consider when determining who pays for shipping, and how it is recognized in merchandising transactions. The establishment of a transfer point and ownership indicates who pays the shipping charges, who is responsible for the merchandise, on whose balance sheet the assets would be recorded, and how to record the transaction for the buyer and seller.

Discussion and Application of FOB Destination

As you’ve learned, the seller and buyer will establish terms of purchase that include the purchase price, taxes, insurance, and shipping charges. So, who pays for shipping? On the purchase contract, shipping terms establish who owns inventory in transit, the point of transfer, and who pays for shipping. The shipping terms are known as “free on board,” or simply FOB. Some refer to FOB as the point of transfer, but really, it incorporates more than simply the point at which responsibility transfers. There are two FOB considerations: FOB Destination and FOB Shipping Point.

Discussion and Application of FOB Shipping Point

If FOB shipping point is listed on the purchase contract, this means the buyer pays the shipping charges (freight-in). This also means goods in transit belong to, and are the responsibility of, the buyer. The point of transfer is when the goods leave the seller’s place of business.

Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies

Similarities and Differences between the Multi-Step and Simple Income Statement Format

A multi-step income statement is more detailed than a simple income statement. Because of the additional detail, it is the option selected by many companies whose operations are more complex. Each revenue and expense account is listed individually under the appropriate category on the statement. The multi-step statement separates cost of goods sold from operating expenses and deducts cost of goods sold from net sales to obtain a gross margin.

Demonstration of the Multi-Step Income Statement Format

To demonstrate the use of the multi-step income statement format, let’s continue to discuss California Business Solutions (CBS). The following is select account data from the adjusted trial balance for the year ended, December 31, 2018. We will use this information to create a multi-step income statement. Note that the statements prepared are using a perpetual inventory system.

Demonstration of the Simple Income Statement Format

We will use the same adjusted trial balance information for CBS but will now create a simple income statement.

Final Analysis of the Two Income Statement Options

While companies may choose the format that best suits their needs, some might choose a combination of both the multi-step and simple income statement formats. The multi-step income statement may be more beneficial for internal use and management decision-making because of the detail in account information. The simple income statement might be more appropriate for external use, as a summary for investors and lenders.

Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System

Merchandise Purchases

The following example transactions and subsequent journal entries for merchandise purchases are recognized using a periodic inventory system.

Merchandise Sales

The following example transactions and subsequent journal entries for merchandise sales are recognized using a periodic inventory system.

Accounting Information Systems

Why It Matters

Define and Describe the Components of an Accounting Information System

Manual and Computerized Accounting Information Systems

Interestingly, the term *accounting information system* predates computers. Technically, an AIS is a system or set of processes for collecting data about accounting transactions; recording, organizing, and summarizing the data; and culminating with the preparation of financial statements and other reports for internal and external users. These systems or processes can exist as a series of paper ledgers, computer databases, or some combination of the two. Examples of external users include banks that might lend the company money, investors, and the Securities and Exchange Commission (SEC), which requires that publicly traded companies submit audited financial statements. Since business enterprises needed to produce financial statements long before computers existed, they used manual accounting systems to gather the data needed. Data is the term for parts of accounting transactions that constitute the input to an AIS. You have examined many forms of data in this course, for example, the cash received upon the sale of an item is one data point, the reduction of the inventory account related to that specific sold item is another data point, and both the revenue and the cost of goods sold would be additional data points associated with that single transaction of a sale. These data points are summarized and aggregated (in other words “processed”) into more meaningful and useful numbers that appear in the financial statements, and all this data is typically referred to as financial information. A company that may have used a manual AIS years ago likely uses a computerized AIS today. It is important to remember that a computerized accounting system does not change *what* we do with accounting transactions, it only changes *how* we do it, and how we can present the information to different users.

Inputting/Entering Data

A source document is the original document that provides evidence that a transaction occurred. If you hire a company to paint your house, it will most likely provide a document showing how much you owe. That is the company’s sales document and your invoice. When you pay, your check or digital transaction record is also a source document for the company that provided the service, in this case, the home painter.

Processing Data

Companies need the accounting system to process the data that has been entered and transform it into useful information. In manual accounting systems, employees process all transaction data by journalizing, posting, and creating financial reports using paper. However, as technology has advanced, it became easier to keep records by using computers with software programs specifically developed for accounting transactions. Computers are good at repetition and calculations, both of which are involved in accounting, and computers can perform these calculations and analyses more quickly, and with fewer errors, thus making them a very effective tool for accounting from both an input and an output standpoint.

Output: Presenting Information

An AIS should provide a way to present system output (printed page, screen image, e-transmission). Any accounting software application such as that used by large companies (an ERP system) or one used by smaller businesses (QuickBooks) can easily print financial statements and other documents as well as display them on the screen.

Storing Data

Data can be stored by an AIS in paper, digital, or cloud formats. Before computers were widely used, financial data was stored on paper, like the journal and ledger shown in [link].

Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders

Special Journals

Instead of having just one general journal, companies group transactions of the same kind together and record them in special journals rather than in the general journal. This makes it easier and more efficient to find a specific type of transaction and speeds up the process of posting these transactions. In each special journal, all transactions are totaled at the end of the month, and these totals are posted to the general ledger. In addition, instead of one person entering all of the transactions in all of the journals, companies often assign a given special journal’s entries to one person. The relationship between the special journals, the general journal, and the general ledger can be seen in [link].

Subsidiary Ledgers

In addition to the four special journals, there are two special ledgers, the accounts receivable subsidiary ledger and the accounts payable subsidiary ledger. The accounts receivable subsidiary ledger gives details about each person who owes the company money, as shown in [link]. Each colored block represents an individual’s account and shows only the amount that person owes the company. Notice that the subsidiary ledger provides the date of the transaction and a reference column to link the transaction to the same information posted in one of the special journals (or general journal if special journals are not used)—this reference is usually a code that references the special journal such as SJ for the sales special journal, as well as the amounts owed in the debit column and the payments made in the credit column. The amounts owed by all of the individuals, as indicated in the subsidiary ledger, are added together to form the accounts receivable control total, and this should equal the Accounts Receivable balance reported in the general ledger as shown in [link]. Key points about the accounts receivable subsidiary ledger are:

Analyze and Journalize Transactions Using Special Journals

The Sales Journal

The sales journal is used to record sales on account (meaning sales on credit or credit sale). Selling on credit always requires a debit to Accounts Receivable and a credit to Sales. Because every credit sales transaction is recorded in the same way, recording all of those transactions in one place simplifies the accounting process. [link] shows an example of a sales journal. Note there is a single column for both the debit to Accounts Receivable and the credit to Sales, although we need to post to both Accounts Receivable and Sales at the end of each month. There is also a single column for the debit to Cost of Goods Sold and the credit to Merchandise Inventory, though again, we need to post to both of those. In addition, for companies using the perpetual inventory method, there is another column representing a debit to Cost of Goods Sold and a credit to Merchandise Inventory, since two entries are made to record a sale on account under the perpetual inventory method.

The Cash Receipts Journal

When the customer pays the amount owed, (generally using a check), bookkeepers use another shortcut to record its receipt. They use a second special journal, the cash receipts journal. The cash receipts journal is used to record all receipts of cash (recorded by a debit to Cash). In the preceding example, if Baker Co. paid the \$1,450 owed, there would be a debit to Cash for \$1,450 and a credit to Accounts Receivable. A notation would be made in the reference column to indicate the payment had been posted to Baker Co.’s accounts receivable subsidiary ledger. After Baker Co.’s payment, the cash receipts journal would appear as in [link].

The Cash Disbursements Journal

Many transactions involve cash. We enter all cash received into the cash receipts journal, and we enter all cash payments into the cash disbursements journal, sometimes also known as the cash payments journal. Good internal control dictates the best rule is that all cash received by a business should be deposited, and all cash paid out for monies owed by the business should be made by check. Money paid out is recorded in the cash disbursements journal, which is generally kept in numerical order by check number and includes all of the checks recorded in the checkbook register. If we paid this month’s phone bill of \$135 with check #4011, we would enter it as shown in [link] in the cash disbursements journal.

The Purchases Journal

Many companies enter only purchases of inventory on account in the purchases journal. Some companies also use it to record purchases of other supplies on account. However, in this chapter we use the purchases journal for purchases of inventory on account, only. It will always have a debit to Merchandise Inventory if you are using the perpetual inventory method and a credit to Accounts Payable, or a debit to Purchases and a credit to Accounts Payable if using the periodic inventory method. It is similar to the sales journal because it has a corresponding subsidiary ledger, the accounts payable subsidiary ledger. Since the purchases journal is only for purchases of inventory on account, it means the company owes money. To keep track of whom the company owes money to and when payment is due, the entries are posted daily to the accounts payable subsidiary ledger. Accounts Payable in the general ledger becomes a control account just like Accounts Receivable. If we ordered inventory from Jones Mfg. (account number 789) using purchase order #123 and received the bill for \$250, this would be recorded in the purchases journal as shown in [link].

General Journal

Why use a general journal if we have all the special journals? The reason is that some transactions do not fit in any special journal. In addition to the four special journals presented previously (sales, cash receipts, cash disbursements, and purchases), some companies also use a special journal for Sales returns and allowances and another special journal for Purchase returns and allowances if they have many sales returns and purchase returns transactions. However, most firms enter those transactions in the general journal, along with other transactions that do not fit the description of the specific types of transactions contained in the four special journals. The general journal is also necessary for adjusting entries (such as to recognize depreciation, prepaid rent, and supplies that we have consumed) and closing entries.

Prepare a Subsidiary Ledger

Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems

Fraud, Internal Controls, and Cash

Why It Matters

Analyze Fraud in the Accounting Workplace

Define and Explain Internal Controls and Their Purpose within an Organization

The Role of Internal Controls

The accounting system is the backbone of any business entity, whether it is profit based or not. It is the responsibility of management to link the accounting system with other functional areas of the business and ensure that there is communication among employees, managers, customers, suppliers, and all other internal and external users of financial information. With a proper understanding of internal controls, management can design an internal control system that promotes a positive business environment that can most effectively serve its customers.

Environment Leading to the Sarbanes-Oxley Act

Internal controls have grown in their importance as a component of most business decisions. This importance has grown as many company structures have grown in complexity. Despite their importance, not all companies have given maintenance of controls top priority. Additionally, many small businesses do not have adequate understanding of internal controls and therefore use inferior internal control systems. Many large companies have nonformalized processes, which can lead to systems that are not as efficient as they could be. The failure of the SCICAP Credit Union discussed earlier is a direct result of a small financial institution having a substandard internal control system leading to employee theft. One of the largest corporate failures of all time was Enron, and the failure can be directly attributed to poor internal controls.

Major Accounting Components of the Sarbanes-Oxley Act

As it pertains to internal controls, the SOX requires the certification and documentation of internal controls. Specifically, the act requires that the auditor do the following:

Describe Internal Controls within an Organization

Elements of Internal Control

A strong internal control system is based on the same consistent elements:

Purposes of Internal Controls within a Governmental Entity

Internal controls apply not only to public and private corporations but also to governmental entities. Often, a government controls one of the most important assets of modern times: data. Unprotected financial information, including tax data, social security, and governmental identifications, could lead to identity theft and could even provide rogue nations access to data that could compromise the security of our country. Governmental entities require their contractors to have proper internal controls and to maintain proper codes of ethics.

Purposes of Internal Controls within a Not-for-Profit

Not-for-profit (NFP) organizations have the same needs for internal control as many traditional for-profit entities. At the same time, there are unique challenges that these entities face. Based on the objectives and charters of NFP organizations, in many cases, those who run the organizations are volunteers. As volunteers, leaders of NFPs may not have the same training background and qualifications as those in a similar for-profit position. Additionally, a volunteer leader often splits time between the organization and a full-time career. For these reasons, internal controls in an NFP often are not properly implemented, and there may be a greater risk of control lapse. A control lapse occurs when there is a deviation from standard control protocol that leads to a failure in the internal control and/or fraud prevention processes or systems. A failure occurs in a situation when results did not achieve predetermined goals or meet expectations.

Identify and Apply Principles of Internal Controls to the Receipt and Disbursement of Cash

Cash can be a major part of many business operations. Imagine a Las Vegas casino, or a large grocery store, such as Publix Super Markets, Wegmans Food Markets, or ShopRite; in any of these settings, millions of dollars in cash can change hands within a matter of minutes, and it can pass through the hands of thousands of employees. Internal controls ensure that all of this cash reaches the bank account of the business entity. The first control is monitoring. Not only are cameras strategically placed throughout the store to prevent shoplifting and crime by customers, but cameras are also located over all areas where cash changes hands, such as over every cash register, or in a casino over every gaming table. These cameras are constantly monitored, often offsite at a central location by personnel who have no relationship with the employees who handle the cash, and all footage is recorded. This close monitoring makes it more difficult for misuse of cash to occur.

Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries

Demonstration of Typical Petty Cash Journal Entries

Petty cash accounts are managed through a series of journal entries. Entries are needed to (1) establish the fund, (2) increase or decrease the balance of the fund (replenish the fund as cash is used), and (3) adjust for overages and shortages of cash. Consider the following example.

Discuss Management Responsibilities for Maintaining Internal Controls within an Organization

Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries

Fundamentals of the Bank Reconciliation Procedure

The balance on a bank statement can differ from company’s financial records due to one or more of the following circumstances:

Demonstration of a Bank Reconciliation

A bank reconciliation is structured to include the information shown in [link].

Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements

How Companies Cook the Books to Misrepresent Their Financial Condition

One of the most common ways companies cook the books is by manipulating revenue accounts or accounts receivables. Proper revenue recognition involves accounting for revenue when the company has met its obligation on a contract. Financial statement fraud involves early revenue recognition, or recognizing revue that does not exist, and receivable accountings, used in tandem with false revenue reporting. HealthSouth used a combination of false revenue accounts and misstated accounts receivable in a direct manipulation of the revenue accounts to commit a multibillion-dollar fraud between 1996 and 2002. Several chief financial officers and other company officials went to prison as a result.[footnote]

Melinda Dickinson. “Former HealthSouth Boss Found Liable for \$2.9 Billion.” *Reuters*. June 18, 2009. https://www.reuters.com/article/us-healthsouth-scrushy/former-healthsouth-boss-found-liable-for-2-9-billion-idUSTRE55H4IP20090618

Sarbanes-Oxley Act Compliance Today

The Enron scandal and related financial statement frauds led to investors requiring that public companies maintain better internal controls and develop stronger governance systems, while auditors perform a better job at auditing public companies. These requirements, in turn, led to the regulations developed under SOX that were intended to protect the investing public.

Accounting for Receivables

Why It Matters

Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions

Accounting Principles and Assumptions Regulating Revenue Recognition

The main revenue recognition objective is to recognize revenue after the company’s performance obligation. This performance obligation is the performance of services or the delivery of goods being carried out in return for an amount of consideration (often cash) the company expects to receive from the customer. To know exactly when and how much revenue to recognize, companies follow FASB’s five-step revenue recognition process in which revenue is recognized at the fifth step. This may not necessarily be when cash is collected, as will be illustrated in a later example. Revenue can be recognized when all of the following criteria have been met:

Short-Term Revenue Recognition Examples

As mentioned, the revenue recognition principle requires that, in some instances, revenue is recognized before receiving a cash payment. In these situations, the customer still owes the company money. This money owed to the company is a type of receivable for the company and a payable for the company’s customer.

Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches

Fundamentals of Bad Debt Expenses and Allowances for Doubtful Accounts

Bad debts are uncollectible amounts from customer accounts. Bad debt negatively affects accounts receivable (see [link]). When future collection of receivables cannot be reasonably assumed, recognizing this potential nonpayment is required. There are two methods a company may use to recognize bad debt: the direct write-off method and the allowance method.

Income Statement Method for Calculating Bad Debt Expenses

The income statement method (also known as the percentage of sales method) estimates bad debt expenses based on the assumption that at the end of the period, a certain percentage of sales during the period will not be collected. The estimation is typically based on credit sales only, not total sales (which include cash sales). In this example, assume that any credit card sales that are uncollectible are the responsibility of the credit card company. It may be obvious intuitively, but, by definition, a cash sale cannot become a bad debt, assuming that the cash payment did not entail counterfeit currency. The income statement method is a simple method for calculating bad debt, but it may be more imprecise than other measures because it does not consider how long a debt has been outstanding and the role that plays in debt recovery.

Balance Sheet Method for Calculating Bad Debt Expenses

The balance sheet method (also known as the percentage of accounts receivable method) estimates bad debt expenses based on the balance in accounts receivable. The method looks at the balance of accounts receivable at the end of the period and assumes that a certain amount will not be collected. Accounts receivable is reported on the balance sheet; thus, it is called the balance sheet method. The balance sheet method is another simple method for calculating bad debt, but it too does not consider how long a debt has been outstanding and the role that plays in debt recovery. There is a variation on the balance sheet method, however, called the aging method that does consider how long accounts receivable have been owed, and it assigns a greater potential for default to those debts that have been owed for the longest period of time.

Balance Sheet Aging of Receivables Method for Calculating Bad Debt Expenses

The balance sheet aging of receivables method estimates bad debt expenses based on the balance in accounts receivable, but it also considers the uncollectible time period for each account. The longer the time passes with a receivable unpaid, the lower the probability that it will get collected. An account that is 90 days overdue is more likely to be unpaid than an account that is 30 days past due.

Determine the Efficiency of Receivables Management Using Financial Ratios

Basic Functions of the Receivables Ratios

Receivables ratios show company performance in relation to current debt collection, as well as credit policy effect on sales growth. One receivables ratio is called the accounts receivable turnover ratio. This ratio determines how many times (i.e., how often) accounts receivable are collected during an operating period and converted to cash (see [link]). A higher number of times indicates that receivables are collected quickly. This quick cash collection may be viewed as a positive occurrence, because liquidity improves, and the company may reinvest in its business sooner when the value of the dollar has more buying power (time value of money). The higher number of times may also be a negative occurrence, signaling that credit extension terms are too tight, and it may exclude qualified consumers from purchasing. Excluding these customers means that they may take their business to a competitor, thus reducing potential sales.

Accounts Receivable Turnover Ratio

The ratio to determine accounts receivable turnover is as follows.

Number of Days’ Sales in Receivables Ratio

The ratio to determine number of days’ sales in receivables is as follows.

Discuss the Role of Accounting for Receivables in Earnings Management

Apply Revenue Recognition Principles to Long-Term Projects

Explain How Notes Receivable and Accounts Receivable Differ

Characteristics of Notes Receivable

Notes receivable have several defining characteristics that include principal, length of contract terms, and interest. The principal of a note is the initial loan amount, not including interest, requested by the customer. If a customer approaches a lender, requesting \$2,000, this amount is the principal. The date on which the security agreement is initially established is the issue date. A note’s maturity date is the date at which the principal and interest become due and payable. The maturity date is established in the initial note contract. For example, when the previously mentioned customer requested the \$2,000 loan on January 1, 2018, terms of repayment included a maturity date of 24 months. This means that the loan will mature in two years, and the principal and interest are due at that time. The following journal entries occur at the note’s established start date. The first entry shows a note receivable in exchange for a product or service, and the second entry illustrates the note from the point of view that a \$2,000 loan was issued by a financial institution to a customer (borrower).

Illustrated Examples of Notes Receivable

To illustrate notes receivable scenarios, let’s return to Billie’s Watercraft Warehouse (BWW) as the example. BWW has a customer, Waterways Corporation, that tends to have larger purchases that require an extended payment period. On January 1, 2018, Waterways purchased merchandise in the amount of \$250,000. BWW agreed to lend the \$250,000 purchase cost (sales price) to Waterways under the following conditions. First, BWW agrees to accept a note payable issued by Waterways. The conditions of the note are that the principal amount is \$250,000, the maturity date on the note is 24 months, and the annual interest rate is 12%. On January 1, 2018, BWW records the following entry.

Appendix: Comprehensive Example of Bad Debt Estimation

Inventory

Why It Matters

Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions

Fundamentals of Inventory

Although our discussion will consider inventory issues from the perspective of a retail company, using a resale or merchandising operation, inventory accounting also encompasses recording and reporting of manufacturing operations. In the manufacturing environment, there would be separate inventory calculations for the various process levels of inventory, such as raw materials, work in process, and finished goods. The manufacturer’s finished goods inventory is equivalent to the merchandiser’s inventory account in that it includes finished goods that are available for sale.

Data for Demonstration of the Four Basic Inventory Valuation Methods

The following dataset will be used to demonstrate the application and analysis of the four methods of inventory accounting.

Additional Inventory Issues

Various other issues that affect inventory accounting include consignment sales, transportation and ownership issues, inventory estimation tools, and the effects of inflationary versus deflationary cycles on various methods.

Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method

Information Relating to All Cost Allocation Methods, but Specific to Periodic Inventory Updating

Let’s return to the example of The Spy Who Loves You Corporation to demonstrate the four cost allocation methods, assuming inventory is updated at the end of the period using the periodic system.

Specific Identification

The specific units assumed to be sold in this period are designated as follows, with the specific inventory distinction being associated with the lot numbers:

First-in, First-out (FIFO)

The first-in, first-out method (FIFO) of cost allocation assumes that the earliest units purchased are also the first units sold. For The Spy Who Loves You, considering the entire period, 300 of the 585 units available for the period were sold, and if the earliest acquisitions are considered sold first, then the units that remain under FIFO are those that were purchased last. Following that logic, ending inventory included 210 units purchased at \$33 and 75 units purchased at \$27 each, for a total FIFO periodic ending inventory value of \$8,955. Subtracting this ending inventory from the \$16,155 total of goods available for sale leaves \$7,200 in cost of goods sold this period.

Last-in, First-out (LIFO)

The last-in, first-out method (LIFO) of cost allocation assumes that the last units purchased are the first units sold. For The Spy Who Loves You, considering the entire period together, 300 of the 585 units available for the period were sold, and if the latest acquisitions are considered sold first, then the units that remain under LIFO are those that were purchased first. Following that logic, ending inventory included 150 units purchased at \$21 and 135 units purchased at \$27 each, for a total LIFO periodic ending inventory value of \$6,795. Subtracting this ending inventory from the \$16,155 total of goods available for sale leaves \$9,360 in cost of goods sold this period.

Weighted-Average Cost (AVG)

Weighted-average cost allocation requires computation of the average cost of all units in goods available for sale at the time the sale is made. For The Spy Who Loves You, considering the entire period, the weighted-average cost is computed by dividing total cost of goods available for sale (\$16,155) by the total number of available units (585) to get the average cost of \$27.62. Note that 285 of the 585 units available for sale during the period remained in inventory at period end. Following that logic, ending inventory included 285 units at an average cost of \$27.62 for a total AVG periodic ending inventory value of \$7,872. Subtracting this ending inventory from the \$16,155 total of goods available for sale leaves \$8,283 in cost of goods sold this period. It is important to note that final numbers can often differ by one or two cents due to rounding of the calculations. In this case, the cost comes to \$27.6154 but rounds up to the stated cost of \$27.62.

Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method

Information Relating to All Cost Allocation Methods, but Specific to Perpetual Inventory Updating

Let’s return to The Spy Who Loves You Corporation data to demonstrate the four cost allocation methods, assuming inventory is updated on an ongoing basis in a perpetual system.

Specific Identification

For demonstration purposes, the specific units assumed to be sold in this period are designated as follows, with the specific inventory distinction being associated with the lot numbers:

First-in, First-out (FIFO)

The first-in, first-out method (FIFO) of cost allocation assumes that the earliest units purchased are also the first units sold. For The Spy Who Loves You, using perpetual inventory updating, the first sale of 120 units is assumed to be the units from the beginning inventory, which had cost \$21 per unit, bringing the total cost of these units to \$2,520. Once those units were sold, there remained 30 more units of beginning inventory. The company bought 225 more units for \$27 per unit. At the time of the second sale of 180 units, the FIFO assumption directs the company to cost out the last 30 units of the beginning inventory, plus 150 of the units that had been purchased for \$27. Thus, after two sales, there remained 75 units of inventory that had cost the company \$27 each. The last transaction was an additional purchase of 210 units for \$33 per unit. Ending inventory was made up of 75 units at \$27 each, and 210 units at \$33 each, for a total FIFO perpetual ending inventory value of \$8,955.

Last-in, First-out (LIFO)

The last-in, first-out method (LIFO) of cost allocation assumes that the last units purchased are the first units sold. For The Spy Who Loves You, using perpetual inventory updating, the first sale of 120 units is assumed to be the units from the beginning inventory (because this was the only lot of good available, so it represented the last purchased lot), which had cost \$21 per unit, bringing the total cost of these units in the first sale to \$2,520. Once those units were sold, there remained 30 more units of beginning inventory. The company bought 225 more units for \$27 per unit. At the time of the second sale of 180 units, the LIFO assumption directs the company to cost out the 180 units from the latest purchased units, which had cost \$27 for a total cost on the second sale of \$4,860. Thus, after two sales, there remained 30 units of beginning inventory that had cost the company \$21 each, plus 45 units of the goods purchased for \$27 each. The last transaction was an additional purchase of 210 units for \$33 per unit. Ending inventory was made up of 30 units at \$21 each, 45 units at \$27 each, and 210 units at \$33 each, for a total LIFO perpetual ending inventory value of \$8,775.

Weighted-Average Cost (AVG)

Weighted-average cost allocation requires computation of the average cost of all units in goods available for sale at the time the sale is made for perpetual inventory calculations. For The Spy Who Loves You, the first sale of 120 units is assumed to be the units from the beginning inventory (because this was the only lot of good available, so the price of these units also represents the average cost), which had cost \$21 per unit, bringing the total cost of these units in the first sale to \$2,520. Once those units were sold, there remained 30 more units of the inventory, which still had a \$21 average cost. The company bought 225 more units for \$27 per unit. Recalculating the average cost, after this purchase, is accomplished by dividing total cost of goods available for sale (which totaled \$6,705 at that point) by the number of units held, which was 255 units, for an average cost of \$26.29 per unit. At the time of the second sale of 180 units, the AVG assumption directs the company to cost out the 180 at \$26.29 for a total cost on the second sale of \$4,732. Thus, after two sales, there remained 75 units at an average cost of \$26.29 each. The last transaction was an additional purchase of 210 units for \$33 per unit. Recalculating the average cost again resulted in an average cost of \$31.24 per unit. Ending inventory was made up of 285 units at \$31.24 each for a total AVG perpetual ending inventory value of \$8,902 (rounded).[footnote]

Note that there is a \$1 rounding difference due to the rounding of cents inherent in the cost determination chain process.

Comparison of All Four Methods, Perpetual

The outcomes for gross margin, under each of these different cost assumptions, is summarized in [link].

Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet

Fundamentals of the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet

Understanding this interaction between inventory assets (merchandise inventory balances) and inventory expense (cost of goods sold) highlights the impact of errors. Errors in the valuation of ending merchandise inventory, which is on the balance sheet, produce an equivalent corresponding error in the company’s cost of goods sold for the period, which is on the income statement. When cost of goods sold is overstated, inventory and net income are understated. When cost of goods sold is understated, inventory and net income are overstated. Further, an error in ending inventory carries into the next period, since ending inventory of one period becomes the beginning inventory of the next period, causing both the balance sheet and the income statement values to be wrong in year two as well as in the year of the error. Over a two-year period, misstatements of ending inventory will balance themselves out. For example, an overstatement to ending inventory overstates net income, but next year, since ending inventory becomes beginning inventory, it understates net income. So over a two-year period, this corrects itself. However, financial statements are prepared for one period, so all this means is that two years of cost of goods sold are misstated (the first year is overstated/understated, and the second year is understated/overstated.)

Calculated Income Statement and Balance Sheet Effects for Two Years

Let’s return to The Spy Who Loves You Company dataset to demonstrate the effects of an inventory error on the company’s balance sheet and income statement. Example 1 (shown in [link]) depicts the balance sheet and income statement toggle when no inventory error is present. Example 2 (see [link]) shows the balance sheet and income statement inventory toggle, in a case when a \$1,500 understatement error occurred at the end of year 1.

Examine the Efficiency of Inventory Management Using Financial Ratios

Fundamentals of Inventory Ratios

Inventory ratio analysis relates to how well the inventory is being managed. Two ratios can be used to assess how efficiently management is handling inventory. The first ratio, inventory turnover, measures the number of times an average quantity of inventory was bought and sold during the period. The second ratio, number of days’ sales in inventory, measures how many days it takes to complete the cycle between buying and selling inventory.

Calculating and Interpreting the Inventory Turnover Ratio

Inventory turnover ratio is computed by dividing cost of goods sold by average inventory. The ratio measures the number of times inventory rotated through the sales cycle for the period. Let’s review how this works for The Spy Who Loves You dataset. This example scenario relates to the FIFO periodic cost allocation, using those previously calculated values for year 1 cost of goods sold, beginning inventory, and ending inventory, and assuming a 10% increase in inventory activity for year 2, as shown in [link].

Calculating and Interpreting the Days’ Sales in Inventory Ratio

Number of days’ sales in inventory ratio is computed by dividing average merchandise inventory by the average daily cost of goods sold. The ratio measures the number of days it would take to clear the remaining inventory. Let’s review this using The Spy Who Loves You dataset. The example scenario relates to the FIFO periodic cost allocation, using those previously calculated values for year 1 cost of goods sold, beginning inventory, and ending inventory, and assuming a 10% increase in inventory activity for year 2, as in [link].

Long-Term Assets

Why It Matters

Distinguish between Tangible and Intangible Assets

Tangible Assets

An asset is considered a tangible asset when it is an economic resource that has physical substance—it can be seen and touched. Tangible assets can be either short term, such as inventory and supplies, or long term, such as land, buildings, and equipment. To be considered a long-term tangible asset, the item needs to be used in the normal operation of the business for more than one year, not be near the end of its useful life, and the company must have no plan to sell the item in the near future. The useful life is the time period over which an asset cost is allocated. Long-term tangible assets are known as fixed assets.

Intangible Assets

Companies may have other long-term assets used in the operations of the business that they do not intend to sell, but that do not have physical substance; these assets still provide specific rights to the owner and are called intangible assets. These assets typically appear on the balance sheet following long-term tangible assets (see [link].)[footnote] Examples of intangible assets are patents, copyrights, franchises, licenses, goodwill, sometimes software, and trademarks ([link]). Because the value of intangible assets is very subjective, it is usually not shown on the balance sheet until there is an event that indicates value objectively, such as the purchase of an intangible asset.

Apple, Inc. U.S. Securities and Exchange Commission 10-K Filing. November 3, 2017. http://pdf.secdatabase.com/2624/0000320193-17-000070.pdf

Analyze and Classify Capitalized Costs versus Expenses

Property, Plant, and Equipment (Fixed Assets)

Why are the costs of putting a long-term asset into service capitalized and written off as expenses (depreciated) over the economic life of the asset? Let’s return to Liam’s start-up business as an example. Liam plans to buy a silk-screening machine to help create clothing that he will sell. The machine is a long-term asset, because it will be used in the business’s daily operation for many years. If the machine costs Liam \$5,000 and it is expected to be used in his business for several years, generally accepted accounting principles (GAAP) require the allocation of the machine’s costs over its useful life, which is the period over which it will produce revenues. Overall, in determining a company’s financial performance, we would not expect that Liam should have an expense of \$5,000 this year and \$0 in expenses for this machine for future years in which it is being used. GAAP addressed this through the *expense recognition* (*matching*) principle, which states that expenses should be recorded in the same period with the revenues that the expense helped create. In Liam’s case, the \$5,000 for this machine should be allocated over the years in which it helps to generate revenue for the business. Capitalizing the machine allows this to occur. As stated previously, to capitalize is to record a long-term asset on the balance sheet and expense its allocated costs on the income statement over the asset’s economic life. Therefore, when Liam purchases the machine, he will record it as an asset on the financial statements.

Investments

A short-term or long-term asset that is not used in the day-to-day operations of the business is considered an investment and is not expensed, since the company does not expect to use up the asset over time. On the contrary, the company hopes that the assets (investment) would grow in value over time. Short-term investments are investments that are expected to be sold within a year and are recorded as current assets.

Repair and Maintenance Costs of Property, Plant, and Equipment

Long-term assets may have additional costs associated with them over time. These additional costs may be capitalized or expensed based on the nature of the cost. For example, Walmart’s financial statements explain that major improvements are capitalized, while costs of normal repairs and maintenance are charged to expense as incurred.

Explain and Apply Depreciation Methods to Allocate Capitalized Costs

Fundamentals of Depreciation

As you have learned, when accounting for a long-term fixed asset, we cannot simply record an expense for the cost of the asset and record the entire outflow of cash in one accounting period. Like all other assets, when purchasing or acquiring a long-term asset, it must be recorded at the historical (initial) cost, which includes all costs to acquire the asset and put it into use. The initial recording of an asset has two steps:

Straight-Line Depreciation

Straight-line depreciation is a method of depreciation that evenly splits the depreciable amount across the useful life of the asset. Therefore, we must determine the yearly depreciation expense by dividing the depreciable base of \$48,000 by the economic life of five years, giving an annual depreciation expense of \$9,600. The journal entries to record the first two years of expenses are shown, along with the balance sheet information. Here are the journal entry and information for year one:

Units-of-Production Depreciation

Straight-line depreciation is efficient, accounting for assets used consistently over their lifetime, but what about assets that are used with less regularity? The units-of-production depreciation method bases depreciation on the actual usage of the asset, which is more appropriate when an asset’s life is a function of usage instead of time. For example, this method could account for depreciation of a printing press for which the depreciable base is \$48,000 (as in the straight-line method), but now the number of pages the press prints is important.

Double-Declining-Balance Depreciation

The double-declining-balance depreciation method is the most complex of the three methods because it accounts for both time and usage and takes more expense in the first few years of the asset’s life. Double-declining considers time by determining the percentage of depreciation expense that would exist under straight-line depreciation. To calculate this, divide 100% by the estimated life in years. For example, a five-year asset would be 100/5, or 20% a year. A four-year asset would be 100/4, or 25% a year. Next, because assets are typically more efficient and “used” more heavily early in their life span, the double-declining method takes usage into account by doubling the straight-line percentage. For a four-year asset, multiply 25% (100%/4-year life) × 2, or 50%. For a five-year asset, multiply 20% (100%/5-year life) × 2, or 40%.

Summary of Depreciation

[link] compares the three methods discussed. Note that although each time-based (straight-line and double-declining balance) annual depreciation expense is different, after five years the total amount depreciated (accumulated depreciation) is the same. This occurs because at the end of the asset’s useful life, it was expected to be worth \$10,000: thus, both methods depreciated the asset’s value by \$48,000 over that time period.

Partial-Year Depreciation

A company will usually only own depreciable assets for a portion of a year in the year of purchase or disposal. Companies must be consistent in how they record depreciation for assets owned for a partial year. A common method is to allocate depreciation expense based on the number of months the asset is owned in a year. For example, a company purchases an asset with a total cost of \$58,000, a five-year useful life, and a salvage value of \$10,000. The annual depreciation is \$9,600 ([\$58,000 – 10,000]/5). However, the asset is purchased at the beginning of the fourth month of the fiscal year. The company will own the asset for nine months of the first year. The depreciation expense of the first year is \$7,200 (\$9,600 × 9/12). The company will depreciate the asset \$9,600 for the next four years, but only \$2,400 in the sixth year so that the total depreciation of the asset over its useful life is the depreciable amount of \$48,000 (\$7,200 + 9,600 + 9,600 + 9,600 + 9,600 + 2,400).

Special Issues in Depreciation

While you’ve now learned the basic foundation of the major available depreciation methods, there are a few special issues. Until now, we have assumed a definite physical or economically functional useful life for the depreciable assets. However, in some situations, depreciable assets can be used beyond their useful life. If so desired, the company could continue to use the asset beyond the original estimated economic life. In this case, a new remaining depreciation expense would be calculated based on the remaining depreciable base and estimated remaining economic life.

Fundamentals of Depletion of Natural Resources

Another type of fixed asset is natural resources, assets a company owns that are consumed when used. Examples include lumber, mineral deposits, and oil/gas fields. These assets are considered natural resources while they are still part of the land; as they are extracted from the land and converted into products, they are then accounted for as inventory (raw materials). Natural resources are recorded on the company’s books like a fixed asset, at cost, with total costs including all expenses to acquire and prepare the resource for its intended use.

Fundamentals of Amortization of an Intangible

Recall that intangible assets are recorded as long-term assets at their cost. As with tangible assets, many intangible assets have a finite (limited) life span so their costs must be allocated over their useful lives: this process is amortization. Depreciation and amortization are similar in nature but have some important differences. First, amortization is typically only done using the straight-line method. Second, there is usually no salvage value for intangible assets because they are completely used up over their life span. Finally, an accumulated amortization account is not required to record yearly expenses (as is needed with depreciation); instead, the intangible asset account is written down each period.

Describe Accounting for Intangible Assets and Record Related Transactions

Fundamentals of Intangible Assets

Intangibles are recorded at their acquisition cost, as are tangible assets. The costs of internally generated intangible assets, such as a patent developed through research and development, are recorded as expenses when incurred. An exception is legal costs to register or defend an intangible asset. For example, if a company incurs legal costs to defend a patent it has developed internally, the costs associated with developing the patent are recorded as an expense, but the legal costs associated with defending the patent would be capitalized as a patent intangible asset.

Copyrights

While copyrights have a finite life span of 70 years beyond the author’s death, they are amortized over their estimated useful life. Therefore, if a company acquired a copyright on a new graphic novel for \$10,000 and estimated it would be able to sell that graphic novel for the next ten years, it would amortize \$1,000 a year (\$10,000/ten years), and the journal entry would be as shown. Assume that the novel began sales on January 1, 2019.

Patents

Patents are issued to the inventor of the product by the federal government and last twenty years. All costs associated with creating the product being patented (such as research and development costs) are expensed; however, direct costs to obtain the patent could be capitalized. Otherwise, patents are capitalized only when purchased. Like copyrights, patents are amortized over their useful life, which can be shorter than twenty years due to changing technology. Assume Mech Tech purchased the patent for a new pump system. The patent cost \$20,000, and the company expects the pump to be a useful product for the next twenty years. Mech Tech will then amortize the \$20,000 over the next twenty years, which is \$1,000 a year.

Trademarks

Companies can register their trademarks with the federal government for ten years with the opportunity to renew the trademark every ten years. Trademarks are recorded as assets only when they are purchased from another company and are valued based on market price at the time of purchase. In this case, these trademarks are amortized over the expected useful life. In some cases, the trademark may be seen as having an indefinite life, in which case there would be no amortization.

Goodwill

From an accounting standpoint, goodwill is internally generated and is not recorded as an asset unless it is purchased during the acquisition of another company. The purchase of goodwill occurs when one company buys another company for an amount greater than the total value of the company’s net assets. The value difference between net assets and the purchase price is then recorded as goodwill on the purchaser’s financial statements. For example, say the London Hoops professional basketball team was sold for \$10 million. The new owner received net assets of \$7 million, so the goodwill (value of the London Hoops above its net assets) is \$3 million. The following journal entry shows how the new owner would record this purchase.

Describe Some Special Issues in Accounting for Long-Term Assets

Revision of Remaining Life or Salvage Value

As you have learned, depreciation is based on estimating both the useful life of an asset and the salvage value of that asset. Over time, these estimates may be proven inaccurate and need to be adjusted based on new information. When this occurs, the depreciation expense calculation should be changed to reflect the new (more accurate) estimates. For this entry, the remaining depreciable balance of the net book value is allocated over the new useful life of the asset. To work through this process with data, let’s return to the example of Kenzie Company.

Obsolescence

Obsolescence refers to the reduction in value and/or use of the asset. Obsolescence has traditionally resulted from the physical deterioration of the asset—called physical obsolescence. In current application—and considering the role of modern technology and tech assets—accounting for functional obsolescence is becoming more common. Functional obsolescence is the loss of value from all causes within a property *except* those due to physical deterioration. With functional obsolescence, the useful life still needs to be adjusted downward: although the asset physically still works, its functionality makes it less useful for the company. Also, an adjustment might be necessary in the salvage value. This potential adjustment depends on the specific details of each obsolescence determination or decision.

Sale of an Asset

When an asset is sold, the company must account for its depreciation up to the date of sale. This means companies may be required to record a depreciation entry before the sale of the asset to ensure it is current. After ensuring that the net book value of an asset is current, the company must determine if the asset has sold at a gain, at a loss, or at book value. We look at examples of each accounting alternative using the Kenzie Company data.

Current Liabilities

Why It Matters

Identify and Describe Current Liabilities

Fundamentals of Current Liabilities

A current liability is a debt or obligation due within a company’s standard operating period, typically a year, although there are exceptions that are longer or shorter than a year. A company’s typical operating period (sometimes called an operating cycle) is a year, which is used to delineate current and noncurrent liabilities, and current liabilities are considered short term and are typically due within a year or less.

Examples of Current Liabilities

Common current liabilities include accounts payable, unearned revenues, the current portion of a note payable, and taxes payable. Each of these liabilities is current because it results from a past business activity, with a disbursement or payment due within a period of less than a year.

Analyze, Journalize, and Report Current Liabilities

Accounts Payable

On August 1, Sierra Sports purchases \$12,000 of soccer equipment from a manufacturer (supplier) on credit. Assume for the following examples that Sierra Sports uses the perpetual inventory method, which uses the Inventory account when the company buys, sells, or adjusts the inventory balance, such as in the following example where they qualified for a discount. In the current transaction, credit terms are 2/10, n/30, the invoice date is August 1, and shipping charges are FOB shipping point (which is included in the purchase cost).

Unearned Revenue

Sierra Sports has contracted with a local youth football league to provide all uniforms for participating teams. The league pays for the uniforms in advance, and Sierra Sports provides the customized uniforms shortly after purchase. The following situation shows the journal entry for the initial purchase with cash. Assume the league pays Sierra Sports for twenty uniforms (cost per uniform is \$30, for a total of \$600) on April 3.

Current Portion of a Noncurrent Note Payable

Sierra Sports takes out a bank loan on January 1, 2017 to cover expansion costs for a new store. The note amount is \$360,000. The note has terms of repayment that include equal principal payments annually over the next twenty years. The annual interest rate on the loan is 9%. Interest accumulates each month based on the standard interest rate formula discussed previously, and on the current outstanding principal balance of the loan. Sierra records interest accumulation every three months, at the end of each third month. The initial loan (note) entry follows.

Taxes Payable

Let’s consider our previous example where Sierra Sports purchased \$12,000 of soccer equipment in August. Sierra now sells the soccer equipment to a local soccer league for \$18,000 cash on August 20. The sales tax rate is 6%. The following revenue entry would occur.

Define and Apply Accounting Treatment for Contingent Liabilities

Two Financial Accounting Standards Board (FASB) Requirements for Recognition of a Contingent Liability

There are two requirements for contingent liability recognition:

Four Potential Treatments for Contingent Liabilities

If the contingency is probable and estimable, it is likely to occur and can be reasonably estimated. In this case, the liability and associated expense must be journalized and included in the current period’s financial statements (balance sheet and income statement) along with note disclosures explaining the reason for recognition. The note disclosures are a GAAP requirement pertaining to the full disclosure principle, as detailed in Analyzing and Recording Transactions.

Prepare Journal Entries to Record Short-Term Notes Payable

Recording Short-Term Notes Payable Created by a Purchase

A short-term notes payable created by a purchase typically occurs when a payment to a supplier does not occur within the established time frame. The supplier might require a new agreement that converts the overdue accounts payable into a short-term note payable (see [link]), with interest added. This gives the company more time to make good on outstanding debt and gives the supplier an incentive for delaying payment. Also, the creation of the note payable creates a stronger legal position for the owner of the note, since the note is a negotiable legal instrument that can be more easily enforced in court actions.

Recording Short-Term Notes Payable Created by a Loan

A short-term notes payable created by a loan transpires when a business incurs debt with a lender [link]. A business may choose this path when it does not have enough cash on hand to finance a capital expenditure immediately but does not need long-term financing. The business may also require an influx of cash to cover expenses temporarily. There is a written promise to pay the principal balance and interest due on or before a specific date. This payment period is within a company’s operating period (less than a year). Consider a short-term notes payable scenario for Sierra Sports.

Record Transactions Incurred in Preparing Payroll

Employee Compensation and Deductions

As an employee working in a business, you receive compensation for your work. This pay could be a monthly salary or hourly wages paid periodically. The amount earned by the employee before any reductions in pay occur is considered gross income (pay). These reductions include involuntary and voluntary deductions. The remaining balance after deductions is considered net income (pay), or “take-home-pay.” The take-home-pay is what employees receive and deposit in their bank accounts.

Journal Entries to Report Employee Compensation and Deductions

We continue to use Sierra Sports as our example company to prepare journal entries.

Employer Compensation and Deductions

At this point you might be asking yourself, “why am I having to pay all of this money and my employer isn’t?” Your employer also has a fiscal and legal responsibility to contribute and match funds to certain payroll liability accounts.

Journal Entries to Report Employer Compensation and Deductions

In addition to the employee payroll entries for Billie Sanders, Sierra Sports has an obligation to contribute taxes to federal unemployment, state unemployment, FICA Social Security, and FICA Medicare. They are also responsible for 60% of Billie’s health insurance premium payment. Assume Sierra Sports receives the FUTA credit and is only taxed at the rate of 0.6%, and SUTA taxes are \$100. August is Billie Sanders’ first month of pay for the year. The following entry represents the employer payroll liabilities and expense for the month of August. The second entry records the health insurance premium liability.

Long-Term Liabilities

Why It Matters

Explain the Pricing of Long-Term Liabilities

Types of Long-Term Funding

If a company needs additional funding for a major expenditure, such as expansion, the source of funding would typically be repaid over several years, or in the case of equity-based financing, over an indefinite period of time. With equity-based financing, the company sells an interest in the company’s ownership by issuing shares of the company’s common stock. This financing option is equity financing, and it will be addressed in detail in Corporation Accounting. Here, we will focus on two major long-term debt-based options: long-term loans and bonds.

Fundamentals of Bonds

Now let us look at bonds in more depth. A bond is a type of financial instrument that a company issues directly to investors, bypassing banks or other lending institutions, with a promise to pay the investor a specified rate of interest over a specified period of time. When a company borrows money by selling bonds, it is said the company is “issuing” bonds. This means the company exchanges cash for a promise to repay the cash, along with interest, over a set period of time. As you’ve learned, bonds are formal legal documents that contain specific information related to the bond. In short, it is a legal contract—called a bond certificate (as shown in [link]) or an indenture—between the issuer (the business borrowing the money) and the lender (the investor lending the money). Bonds are typically issued in relatively small denominations, such as \$1,000 so they can be placed in the market and are accessible to a greater market of investors compared to notes. The bond indenture is a contract that lists the features of the bond, such as the amount of money that will be repaid in the future, called the principal (also called face value or maturity value); the maturity date, the day the bond holder will receive the principal amount; and the stated interest rate, which is the rate of interest the issuer agrees to pay the bondholder throughout the term of the bond.

Fundamentals of Interest Calculation

Since interest is paid on long-term liabilities, we now need to examine the process of calculating interest. Interest can be calculated in several ways, some more common than others. For our purposes, we will explore interest calculations using the simple method and the compounded method. Regardless of the method involved, there are three components that we need when calculating interest:

Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method

Pricing of Long-Term Notes Payable

When a consumer borrows money, she can expect to not only repay the amount borrowed, but also to pay interest on the amount borrowed. When she makes periodic loan payments that pay back the principal and interest over time with payments of equal amounts, these are considered fully amortized notes. In these timed payments, part of what she pays is interest. The amount borrowed that is still due is often called the principal. After she has made her final payment, she no longer owes anything, and the loan is fully repaid, or amortized. Amortization is the process of separating the principal and interest in the loan payments over the life of a loan. A fully amortized loan is fully paid by the end of the maturity period.

Bonds Payable

As you’ve learned, each time a company issues an interest payment to bondholders, amortization of the discount or premium, if one exists, impacts the amount of interest expense that is recorded. Amortization of the discounts increases the amount of interest expense and premiums reduce the amount of interest expense. There are two methods used to amortize bond discounts or premiums: the effective-interest method and the straight-line method.

Prepare Journal Entries to Reflect the Life Cycle of Bonds

Issuance of Bonds

Since the process of underwriting a bond issuance is lengthy and extensive, there can be several months between the determination of the specific characteristics of a bond issue and the actual issuance of the bond. Before the bonds can be issued, the underwriters perform many time-consuming tasks, including setting the bond interest rate. The bond interest rate is influenced by specific factors relating to the company, such as existing debt balances and the ability of the company to repay the funds, as well as the market rate, which is influenced by many external economic factors.

First and Second Semiannual Interest Payment

When a company issues bonds, they make a promise to pay interest annually or sometimes more often. If the interest is paid annually, the journal entry is made on the last day of the bond’s year. If interest was promised semiannually, entries are made twice a year.

Retirement of Bonds When the Bonds Were Issued at Par

At some point, a company will need to record bond retirement, when the company pays the obligation. Often, they will retire bonds when they mature. For example, earlier we demonstrated the issuance of a five-year bond, along with its first two interest payments. If we had carried out recording all five interest payments, the next step would have been the maturity and retirement of the bond. At this stage, the bond issuer would pay the maturity value of the bond to the owner of the bond, whether that is the original owner or a secondary investor.

Appendix: Special Topics Related to Long-Term Liabilities

Brief Comparison between Equity and Debt Financing

Although we briefly addressed equity versus debt financing in Explain the Pricing of Long-Term Liabilities, we will now review the two options. Let’s consider Maria, who wants to buy a business. The venture is for sale for \$1 million, but she only has \$200,000. What are her options? In this situation, a business owner can use debt financing by borrowing money or equity financing by selling part of the company, or she can use a combination of both.

Effect of Interest Points and Loan Term in Years on a Loan

A mortgage loan is typically a long-term loan initiated by a potential home buyer through a mortgage lender. These lenders can be banks and other financial institutions or specialized mortgage lenders. [link] shows some examples of the major categories of loans. The table demonstrates some interesting characteristics of home loans.

Summary of Bond Principles

As we conclude our discussion of bonds, there are two principles that are worth noting. The first principle is there is an inverse relationship between the market rate of interest and the price of the bond. That is, when the market interest rate increases, the price of the bond decreases. This is due to the fact that the stated rate of the bond does not change.[footnote] As we discussed, when the market interest rate is higher than the stated interest rate of the bond, the bond will sell at a discount to attract investors and to compensate for the interest rate earned between similar bonds. When, on the other hand, the market interest rate is lower than the stated interest rate, the bond will sell at a premium, which also compensates for the interest rate earned between similar bonds. It may be helpful to think of the inverse relationship between the market interest rate and the bond price in terms of analogies such as a teeter-totter in a park or a balance scale, as shown in [link].

Another reason for the inverse relationship between the market interest rate and bond prices is due to the time value of money.

Corporation Accounting

Why It Matters

Explain the Process of Securing Equity Financing through the Issuance of Stock

The Organization of a Corporation

Incorporation is the process of forming a company into a corporate legal entity. The advantages of incorporating are available to a corporation regardless of size, from a corporation with one shareholder to those with hundreds of thousands of shareholders. To issue stock, an entity must first be incorporated in a state.

Advantages of the Corporate Form

Compared to other forms of organization for businesses, corporations have several advantages. A corporation is a separate legal entity, it provides limited liability for its owner or owners, ownership is transferable, it has a continuing existence, and capital is generally easy to raise.

Disadvantages of the Corporate Form

As compared to other organizations for businesses, there are also disadvantages to operating as a corporation. They include the costs of organization, regulation, and taxation.

Financing Options: Debt versus Equity

Before exploring the process for securing corporate financing through equity, it is important to review the advantages and disadvantages of acquiring capital through debt. When deciding whether to raise capital by issuing debt or equity, a corporation needs to consider dilution of ownership, repayment of debt, cash obligations, budgeting impacts, administrative costs, and credit risks.

How Stocks Work

The Securities and Exchange Commission (SEC) (www.sec.gov) is a government agency that regulates large and small public corporations. Its mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”[footnote] The SEC identifies these as its five primary responsibilities:

U.S. Securities and Exchange Commission. “What We Do.” June 10, 2013. https://www.sec.gov/Article/whatwedo.html

Capital Stock

A company’s corporate charter specifies the classes of shares and the number of shares of each class that a company can issue. There are two classes of capital stock—common stock and preferred stock. The two classes of stock enable a company to attract capital from investors with different risk preferences. Both classes of stock can be sold by either public or non-public companies; however, if a company issues only one class, it must be common stock. Companies report both common and preferred stock in the stockholders’ equity section of the balance sheet.

Analyze and Record Transactions for the Issuance and Repurchase of Stock

Typical Common Stock Transactions

The company plans to issue most of the shares in exchange for cash, and other shares in exchange for kitchen equipment provided to the corporation by one of the new investors. Two common accounts in the equity section of the balance sheet are used when issuing stock—Common Stock and Additional Paid-in Capital from Common Stock. Common Stock consists of the par value of all shares of common stock issued. Additional paid-in capital from common stock consists of the excess of the proceeds received from the issuance of the stock over the stock’s par value. When a company has more than one class of stock, it usually keeps a separate additional paid-in capital account for each class.

Treasury Stock

Sometimes a corporation decides to purchase its own stock in the market. These shares are referred to as treasury stock. A company might purchase its own outstanding stock for a number of possible reasons. It can be a strategic maneuver to prevent another company from acquiring a majority interest or preventing a hostile takeover. A purchase can also create demand for the stock, which in turn raises the market price of the stock. Sometimes companies buy back shares to be used for employee stock options or profit-sharing plans.

Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits

The Nature and Purposes of Dividends

Stock investors are typically driven by two factors—a desire to earn income in the form of dividends and a desire to benefit from the growth in the value of their investment. Members of a corporation’s board of directors understand the need to provide investors with a periodic return, and as a result, often declare dividends up to four times per year. However, companies can declare dividends whenever they want and are not limited in the number of annual declarations. Dividends are a distribution of a corporation’s earnings. They are not considered expenses, and they are not reported on the income statement. They are a distribution of the net income of a company and are not a cost of business operations.

Dividend Dates

A company’s board of directors has the power to formally vote to declare dividends. The date of declaration is the date on which the dividends become a legal liability, the date on which the board of directors votes to distribute the dividends. Cash and property dividends become liabilities on the declaration date because they represent a formal obligation to distribute economic resources (assets) to stockholders. On the other hand, stock dividends distribute additional shares of stock, and because stock is part of equity and not an asset, stock dividends do not become liabilities when declared.

Cash Dividends

Cash dividends are corporate earnings that companies pass along to their shareholders. To pay a cash dividend, the corporation must meet two criteria. First, there must be sufficient cash on hand to fulfill the dividend payment. Second, the company must have sufficient retained earnings; that is, it must have enough residual assets to cover the dividend such that the Retained Earnings account does not become a negative (debit) amount upon declaration. On the day the board of directors votes to declare a cash dividend, a journal entry is required to record the declaration as a liability.

Property Dividends

A property dividend occurs when a company declares and distributes assets other than cash. The dividend typically involves either the distribution of shares of another company that the issuing corporation owns (one of its assets) or a distribution of inventory. For example, Walt Disney Company may choose to distribute tickets to visit its theme parks. Anheuser-Busch InBev, the company that owns the Budweiser and Michelob brands, may choose to distribute a case of beer to each shareholder. A property dividend may be declared when a company wants to reward its investors but doesn’t have the cash to distribute, or if it needs to hold onto its existing cash for other investments. Property dividends are not as common as cash or stock dividends. They are recorded at the fair market value of the asset being distributed. To illustrate accounting for a property dividend, assume that Duratech Corporation has 60,000 shares of \$0.50 par value common stock outstanding at the end of its second year of operations, and the company’s board of directors declares a property dividend consisting of a package of soft drinks that it produces to each holder of common stock. The retail value of each case is \$3.50. The amount of the dividend is calculated by multiplying the number of shares by the market value of each package:

Comparing Small Stock Dividends, Large Stock Dividends, and Stock Splits

Companies that do not want to issue cash or property dividends but still want to provide some benefit to shareholders may choose between small stock dividends, large stock dividends, and stock splits. Both small and large stock dividends occur when a company distributes additional shares of stock to existing stockholders.

Stock Dividends

Some companies issue shares of stock as a dividend rather than cash or property. This often occurs when the company has insufficient cash but wants to keep its investors happy. When a company issues a stock dividend, it distributes additional shares of stock to existing shareholders. These shareholders do not have to pay income taxes on stock dividends when they receive them; instead, they are taxed when the investor sells them in the future.

Stock Splits

A traditional stock split occurs when a company’s board of directors issue new shares to existing shareholders in place of the old shares by increasing the number of shares and reducing the par value of each share. For example, in a 2-for-1 stock split, two shares of stock are distributed for each share held by a shareholder. From a practical perspective, shareholders return the old shares and receive two shares for each share they previously owned. The new shares have half the par value of the original shares, but now the shareholder owns twice as many. If a 5-for-1 split occurs, shareholders receive 5 new shares for each of the original shares they owned, and the new par value results in one-fifth of the original par value per share.

Compare and Contrast Owners’ Equity versus Retained Earnings

Three Forms of Business Ownership

Businesses operate in one of three forms—sole proprietorships, partnerships, or corporations. Sole proprietorships utilize a single account in owners’ equity in which the owner’s investments and net income of the company are accumulated and distributions to the owner are withdrawn. Partnerships utilize a separate capital account for each partner, with each capital account holding the respective partner’s investments and the partner’s respective share of net income, with reductions for the distributions to the respective partners. Corporations differ from sole proprietorships and partnerships in that their operations are more complex, often due to size. Unlike these other entity forms, owners of a corporation usually change continuously.

Characteristics and Functions of the Retained Earnings Account

Retained earnings is the primary component of a company’s earned capital. It generally consists of the cumulative net income minus any cumulative losses less dividends declared. A basic statement of retained earnings is referred to as an analysis of retained earnings because it shows the changes in the retained earnings account during the period. A company preparing a full set of financial statements may choose between preparing a statement of retained earnings, if the activity in its stock accounts is negligible, or a statement of stockholders’ equity, for corporations with activity in their stock accounts. A statement of retained earnings for Clay Corporation for its second year of operations ([link]) shows the company generated more net income than the amount of dividends it declared.

Statement of Stockholders’ Equity

The statement of retained earnings is a subsection of the statement of stockholders’ equity. While the retained earnings statement shows the changes between the beginning and ending balances of the retained earnings account during the period, the statement of stockholders’ equity provides the changes between the beginning and ending balances of each of the stockholders’ equity accounts, including retained earnings. The format typically displays a separate column for each stockholders’ equity account, as shown for Clay Corporation in [link]. The key events that occurred during the year—including net income, stock issuances, and dividends—are listed vertically. The stockholders’ equity section of the company’s balance sheet displays only the ending balances of the accounts and does not provide the activity or changes during the period.

Prior Period Adjustments

Prior period adjustments are corrections of errors that appeared on previous periods’ financial statements. These errors can stem from mathematical errors, misinterpretation of GAAP, or a misunderstanding of facts at the time the financial statements were prepared. Many errors impact the retained earnings account whose balance is carried forward from the previous period. Since the financial statements have already been issued, they must be corrected. The correction involves changing the financial statement amounts to the amounts they would have been had no errors occurred, a process known as restatement. The correction may impact both balance sheet and income statement accounts, requiring the company to record a transaction that corrects both. Since income statement accounts are closed at the end of every period, the journal entry will contain an entry to the Retained Earnings account. As such, prior period adjustments are reported on a company’s statement of retained earnings as an adjustment to the beginning balance of retained earnings. By directly adjusting beginning retained earnings, the adjustment has no effect on current period net income. The goal is to separate the error correction from the current period’s net income to avoid distorting the current period’s profitability. In other words, prior period adjustments are a way to go back and correct past financial statements that were misstated because of a reporting error.

Discuss the Applicability of Earnings per Share as a Method to Measure Performance

Calculating Earnings per Share

Earnings per share is the profit a company earns for each of its outstanding common shares. Both the balance sheet and income statement are needed to calculate EPS. The balance sheet provides details on the preferred dividend rate, the total par value of the preferred stock, and the number of common shares outstanding. The income statement indicates the net income for the period. The formula to calculate basic earnings per share is:

Measuring Performance with EPS

EPS is a key profitability measure that both current and potential common stockholders monitor. Its importance is accentuated by the fact that GAAP requires public companies to report EPS on the face of a company’s income statement. This is only ratio that requires such prominent reporting. If fact, public companies are required to report two different earnings per share amounts on their income statements—basic and diluted. We’ve illustrated the calculation of basic EPS. Diluted EPS, which is not demonstrated here, involves the consideration of all securities such as stocks and bonds that could potentially dilute, or reduce, the basic EPS.

Partnership Accounting

Why It Matters

Describe the Advantages and Disadvantages of Organizing as a Partnership

Characteristics of a Partnership

Just like a corporation, a partnership is a legal entity. It can own property and can be held legally liable for its actions. It is a separate entity from its owners, the partners. Partnerships have several distinct characteristics that set them apart from other entity types. The most common characteristics of a partnership are the following:

Advantages of Organizing as a Partnership

When it comes to choosing a legal structure or form for your business, the most common options are sole proprietorships, partnerships, and different forms of corporations, each with advantages and disadvantages. Partnerships have several advantages over other forms of business entities, as follows:

Disadvantages of Organizing as a Partnership

While partnerships carry some clear advantages, there are also several disadvantages to consider. For example, due to unlimited liability, each partner in a general partnership is equally and personally liable for all the debts of the partnership. Following are some of the disadvantages of the partnership form of business organization:

Types of Partnerships

A general partnership is an association in which each partner is personally liable to the partnership’s creditors if the partnership has insufficient assets to pay its creditors. These partners are often referred to as general partners. A limited partnership (LP) is an association in which at least one partner is a general partner but the remaining partners can be limited partners, which means they are liable only for their own investment in the firm if the partnership cannot pay its creditors. Thus, their personal assets are not at risk.

Dissolution of a Partnership

Dissolution occurs when a partner withdraws (due to illness or any other reason), a partner dies, a new partner is admitted, or the business declares bankruptcy. Whenever there is a change in partners for any reason, the partnership must be dissolved and a new agreement must be reached. This does not preclude the partnership from continuing business operations; it only changes the document underlying the business. In some cases, the new partnership may also require the revaluation of partnerships assets and, possibly, their sale. Ideally, the partnership agreement has been written to address dissolution.

Describe How a Partnership Is Created, Including the Associated Journal Entries

Creation of a Partnership

Ideally, the agreement to form a partnership should be in the form of a written contract. This partnership agreement details the partners’ roles, the way profits and losses are shared, and the contributions each partner makes to the partnership. It also should contain basic information such as the business’s name, its location, its purpose or mission, the names of the partners, and the date of inception. Even more importantly, it should outline the following information. There is no legal requirement for a written partnership agreement. In fact, individuals can end up in court after forming a partnership agreement by accident with no written documentation. It is strongly suggested that any business relationship has a written agreement. A properly drafted agreement will often contain the following details:

Formation of the Partnership

Each partner’s initial contribution is recorded on the partnership’s books. These contributions are recorded at the fair value of the asset at the date of transfer. All partners must agree to the valuation being recorded.

Compute and Allocate Partners’ Share of Income and Loss

Allocation of Income and Loss

Just like sole proprietorships, partnerships make four entries to close the books at the end of the year. The entries for a partnership are:

Income Allocations

Not every partnership allocates profit and losses on an even basis. As you’ve learned, the partnership agreement should delineate how the partners will share net income and net losses. The partnership needs to find a methodology that is fair and will equitably reflect each partner’s service and financial commitment to the partnership. The following are examples of typical ways to allocate income:

Prepare Journal Entries to Record the Admission and Withdrawal of a Partner

Admission of New Partner

There are two ways for a new partner to join a partnership. In both, a new partnership agreement should be drawn up because the existing partnership will come to an end.

Withdrawal of Partner

Now, let’s explore the opposite situation—when a partner withdraws from a partnership. Partners may withdraw by selling their equity in the business, through retirement, or upon death. The withdrawal of a partner, just like the admission of a new partner, dissolves the partnership, and a new agreement must be reached. As with a new partner, only the economic effect of the change in ownership is reflected on the books.

Discuss and Record Entries for the Dissolution of a Partnership

Fundamentals of Partnership Dissolution

The liquidation or dissolution process for partnerships is similar to the liquidation process for corporations. Over a period of time, the partnership’s non-cash assets are converted to cash, creditors are paid to the extent possible, and remaining funds, if any, are distributed to the partners. Partnership liquidations differ from corporate liquidations in some respects, however:

Recording the Dissolution Process

As discussed above, the liquidation or dissolution of a partnership is synonymous with closing the business. This may occur due to mutual partner agreement to sell the business, the death of a partner, or bankruptcy. Before proceeding with liquidation, the partnership should complete the accounting cycle for its final operational period. This will require closing the books with only balance sheet accounts remaining. Once that process has been completed, four steps remain in the accounting for the liquidation, each requiring an accounting entry. They are:

Statement of Cash Flows

Why It Matters

Explain the Purpose of the Statement of Cash Flows

Approaches to Preparing the Statement of Cash Flows

The statement of cash flows can be prepared using the indirect approach or the direct approach. The indirect method approach reconciles net income to cash flows by subtracting noncash expenses and adjusting for changes in current assets and liabilities, which reflects timing differences between accrual-based net income and cash flows. A noncash expense is an expense that reduces net income but is not associated with a cash flow; the most common example is depreciation expense. The direct method lists net cash flows from revenue and expenses, whereby accrual basis revenue and expenses are converted to cash basis collections and payments. Because the vast majority of financial statements are presented using the indirect method, the indirect approach will be demonstrated within the chapter, and the direct method will be demonstrated in Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method.

Differentiate between Operating, Investing, and Financing Activities

Cash Flows from Operating Activities

Cash flows from operating activities arise from the activities a business uses to produce net income. For example, operating cash flows include cash sources from sales and cash used to purchase inventory and to pay for operating expenses such as salaries and utilities. Operating cash flows also include cash flows from interest and dividend revenue interest expense, and income tax.

Cash Flows from Investing Activities

Cash flows from investing activities are cash business transactions related to a business’ investments in long-term assets. They can usually be identified from changes in the Fixed Assets section of the long-term assets section of the balance sheet. Some examples of investing cash flows are payments for the purchase of land, buildings, equipment, and other investment assets and cash receipts from the sale of land, buildings, equipment, and other investment assets.

Cash Flows from Financing Activities

Cash flows from financing activities are cash transactions related to the business raising money from debt or stock, or repaying that debt. They can be identified from changes in long-term liabilities and equity. Examples of financing cash flows include cash proceeds from issuance of debt instruments such as notes or bonds payable, cash proceeds from issuance of capital stock, cash payments for dividend distributions, principal repayment or redemption of notes or bonds payable, or purchase of treasury stock. Cash flows related to changes in equity can be identified on the Statement of Stockholder’s Equity, and cash flows related to long-term liabilities can be identified by changes in long-term liabilities on the balance sheet.

Prepare the Statement of Cash Flows Using the Indirect Method

Prepare the Operating Activities Section of the Statement of Cash Flows Using the Indirect Method

In the following sections, specific entries are explained to demonstrate the items that support the preparation of the operating activities section of the Statement of Cash Flows (Indirect Method) for the Propensity Company example financial statements.

Add Back Noncash Expenses

Net income includes deductions for noncash expenses. To reconcile net income to cash flow from operating activities, these noncash items must be added back, because no cash was expended relating to that expense. The sole noncash expense on Propensity Company’s income statement, which must be *added back*, is the depreciation expense of \$14,400. On Propensity’s statement of cash flows, this amount is shown in the Cash Flows from Operating Activities section as an adjustment to reconcile net income to net cash flow from operating activities.

Reverse the Effect of Gains and/or Losses

Gains and/or losses on the disposal of long-term assets are included in the calculation of net income, but cash obtained from disposing of long-term assets is a cash flow from an investing activity. Because the disposition gain or loss is not related to normal operations, the adjustment needed to arrive at cash flow from operating activities is a reversal of any gains or losses that are included in the net income total. A gain is subtracted from net income and a loss is added to net income to reconcile to cash from operating activities. Propensity’s income statement for the year 2018 includes a gain on sale of land, in the amount of \$4,800, so a reversal is accomplished by *subtracting* the gain from net income. On Propensity’s statement of cash flows, this amount is shown in the Cash Flows from Operating Activities section as Gain on Sale of Plant Assets.

Decrease in Noncash Current Assets

Decreases in current assets indicate lower net income compared to cash flows from (1) prepaid assets and (2) accrued revenues. For decreases in prepaid assets, using up these assets shifts these costs that were recorded as assets over to current period expenses that then reduce net income for the period. Cash was paid to obtain the prepaid asset in a prior period. Thus, cash from operating activities must be increased to reflect the fact that these expenses reduced net income on the income statement, but cash was not paid this period. Secondarily, decreases in accrued revenue accounts indicates that cash was collected in the current period but was recorded as revenue on a previous period’s income statement. In both scenarios, the net income reported on the income statement was lower than the actual net cash effect of the transactions. To reconcile net income to cash flow from operating activities, *add* decreases in current assets.

Determining Net Cash Flow from Operating Activities (Indirect Method)

Net cash flow from operating activities is the net income of the company, adjusted to reflect the cash impact of operating activities. Positive net cash flow generally indicates adequate cash flow margins exist to provide continuity or ensure survival of the company. The magnitude of the net cash flow, if large, suggests a comfortable cash flow cushion, while a smaller net cash flow would signify an uneasy comfort cash flow zone. When a company’s net cash flow from operations reflects a substantial negative value, this indicates that the company’s operations are not supporting themselves and could be a warning sign of possible impending doom for the company. Alternatively, a small negative cash flow from operating might serve as an early warning that allows management to make needed corrections, to ensure that cash sources are increased to amounts in excess of cash uses, for future periods.

Prepare the Investing and Financing Activities Sections of the Statement of Cash Flows

Preparation of the investing and financing sections of the statement of cash flows is an identical process for both the direct and indirect methods, since only the technique used to arrive at net cash flow from operating activities is affected by the choice of the direct or indirect approach. The following sections discuss specifics regarding preparation of these two nonoperating sections, as well as notations about disclosure of long-term noncash investing and/or financing activities. Changes in the various long-term assets, long-term liabilities, and equity can be determined from analysis of the company’s comparative balance sheet, which lists the current period and previous period balances for all assets and liabilities.

Prepare the Completed Statement of Cash Flows Using the Indirect Method

Review Problem: Preparing the Virtual Co. Statement of Cash Flows

**Additional Information**

Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency

Free Cash Flow

Free cash flow calculations start with cash flows from operating activities, reduced by planned capital expenditures and planned cash dividend payments. In the example case demonstrated, free cash flow would be as follows:

Cash Flows to Sales

The cash flows to sales ratio is computed by dividing free cash flow by sales revenue. In the Propensity Company case, free cash flow had a negative outcome, so the calculation would not be useful in this case.

Cash Flows to Assets

The cash flows to assets ratio is computed by dividing free cash flow by total assets. Again, when the free cash flow had a negative outcome, as it did in the Propensity Company example scenario, the calculation would not be useful

Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method

Cash Collected from Customers

Cash collected from customers is different from the sales revenue that is recorded on the accrual basis financial statements. To reconcile the amount of sales revenue reported on the income statement to the cash collected from sales, calculate the maximum amount of cash that could have been collected this period (potential cash collected) by combining (a) the amount that was due from customers on the first day of the period (beginning accounts receivable) and (b) total sales revenue recorded this period. If there were no outstanding accounts receivable balance at the end of the period, then one could reasonably assume that this total was collected in full during this period. Thus, the amount collected for sales can be determined by subtracting the ending accounts receivable balance from the total potential cash that could have been collected.

Cash Paid to Suppliers for Inventory

Cash paid for inventory is different from the cost of goods sold that is recorded on the accrual basis financial statements. To reconcile the amount of cost of goods sold reported on the income statement to the cash paid for inventory, it is necessary to perform two calculations. The first part of the calculation determines how much inventory was purchased, and the second part of the calculation determines how much of those purchases were paid for during the current period.

Cash Paid for Salaries

Cash paid for salaries is different from the salaries expense that is recorded on the accrual basis financial statements. To reconcile the amount of salaries expense reported on the income statement to the cash paid for salaries, calculate the maximum amount of cash that could have been paid for salaries this period (total obligation to pay salaries) by combining (a) the amount that was due to employees on the first day of the period (beginning salaries payable) and (b) total salaries expense recorded this period. If there were no outstanding salaries payable balance at the end of the period, then one could reasonably assume that this total was paid in full during this current period. Thus, the amount paid for salaries can be determined by subtracting the ending salaries payable balance from the total obligation to pay salaries that could have been paid.

Cash Paid for Insurance

Cash paid for insurance is different from the insurance expense that is recorded on the accrual basis financial statements. To reconcile the amount of insurance expense reported on the income statement to the cash paid for insurance premiums, calculate the maximum amount of cash that could have been paid for insurance this period (total insurance premiums expended) by combining (a) the amount of insurance premiums that were prepaid on the last day of the period (ending prepaid insurance) and (b) total insurance expense recorded this period. If there were no prepaid insurance balance at the beginning of the period, then one could reasonably assume that this total was paid entirely during the current period. Thus, the amount paid for insurance this period can be determined by subtracting the beginning prepaid insurance balance from the total insurance premiums that had been recorded as expended.

Financial Statement Analysis

Financial Statement Analysis

Financial statement analysis reviews financial information found on financial statements to make informed decisions about the business. The income statement, statement of retained earnings, balance sheet, and statement of cash flows, among other financial information, can be analyzed. The information obtained from this analysis can benefit decision-making for internal and external stakeholders and can give a company valuable information on overall performance and specific areas for improvement. The analysis can help them with budgeting, deciding where to cut costs, how to increase revenues, and future capital investments opportunities.

Horizontal Analysis

Horizontal analysis (also known as trend analysis) looks at trends over time on various financial statement line items. A company will look at one period (usually a year) and compare it to another period. For example, a company may compare sales from their current year to sales from the prior year. The trending of items on these financial statements can give a company valuable information on overall performance and specific areas for improvement. It is most valuable to do horizontal analysis for information over multiple periods to see how change is occurring for each line item. If multiple periods are not used, it can be difficult to identify a trend. The year being used for comparison purposes is called the base year (usually the prior period). The year of comparison for horizontal analysis is analyzed for dollar and percent changes against the base year.

Vertical Analysis

Vertical analysis shows a comparison of a line item within a statement to another line item within that same statement. For example, a company may compare cash to total assets in the current year. This allows a company to see what percentage of cash (the comparison line item) makes up total assets (the other line item) during the period. This is different from horizontal analysis, which compares across years. Vertical analysis compares line items within a statement in the current year. This can help a business to know how much of one item is contributing to overall operations. For example, a company may want to know how much inventory contributes to total assets. They can then use this information to make business decisions such as preparing the budget, cutting costs, increasing revenues, or capital investments.

Overview of Financial Ratios

Financial ratios help both internal and external users of information make informed decisions about a company. A stakeholder could be looking to invest, become a supplier, make a loan, or alter internal operations, among other things, based in part on the outcomes of ratio analysis. The information resulting from ratio analysis can be used to examine trends in performance, establish benchmarks for success, set budget expectations, and compare industry competitors. There are four main categories of ratios: liquidity, solvency, efficiency, and profitability. Note that while there are more ideal outcomes for some ratios, the industry in which the business operates can change the influence each of these outcomes has over stakeholder decisions. (You will learn more about ratios, industry standards, and ratio interpretation in advanced accounting courses.)

Advantages and Disadvantages of Financial Statement Analysis

There are several advantages and disadvantages to financial statement analysis. Financial statement analysis can show trends over time, which can be helpful in making future business decisions. Converting information to percentages or ratios eliminates some of the disparity between competitor sizes and operating abilities, making it easier for stakeholders to make informed decisions. It can assist with understanding the makeup of current operations within the business, and which shifts need to occur internally to increase productivity.

Time Value of Money

Present Value of \$1 Table

Present Value of an Ordinary Annuity Table

Future Value of \$1 Table

Future Value of an Ordinary Annuity Table

Suggested Resources

Sample Financial Statements

The following income statements and balance sheets show the finances of companies representing the manufacturing, retail, and service industries.

Accounting Software and Tools

The resources listed offer a variety of tutorials, training videos, and practice activities using software and tools common in accounting.

Personal Finance

These resources can assist you with personal financial planning.

Accounting-Related Organizations

A number of organizations are dedicated to regulating and supporting the variety of work undertaken in the discipline of accounting.

Accounting Exams and Certificates

These sites provide information on exams and professional certifications.