Section 4:) Accrual vs. Cash Basis of Accounting
As you dig further into accounting, you will see that there is more than just one way to maintain bookkeeping. The method used depends on the ultimate purpose. For example, a company may need to keep records for tax reporting, for internal reporting, and perhaps to meet other external requirements. In addition, the methods and principles used may sometime depend on the type of company and the regulations that they have to abide by. If a company is publicly traded on United States Stock Exchanges, they are required to abide by United States Generally Accepted Accounting Principles (GAAP).
US GAAP requires the use of the accrual basis of accounting, versus the cash basis of accounting. This section discusses the differences. Under the cash basis of accounting, revenues are recorded when the cash is received, regardless of whether that is before or after the corresponding sale or service. Likewise, expenses are recorded when the cash is paid, regardless of when the event that the expense relates to occurred. Although this method is very straightforward, there is a risk that the results are misleading.
For one example, if 2 years’ worth of insurance is paid in advance, the cash basis of accounting would record all 2 years of insurance expense in year 1. This is improper, as the insurance benefits the company for two years. Likewise, if we are the insurance company, we would count all of that money as insurance revenue, even though we would be providing a service (coverage) over the two-year period.
Under the accrual basis of accounting, we are more concerned with when revenue is “earned” and when expense is “incurred”, rather when the cash changes hands.
To be considered “earned”, the service or product generating the revenue must be completed, and the likelihood of collection should be reasonably assured. In some cases, earning occurs over time. Some examples of this may be rental income, insurance income, interest income, etc.
To be considered “incurred”, the benefit related to the item that is generating the expense must have been used up. For example, if the benefit comes from employees that have worked for us, the salaries expense would be incurred when they work, not when payday occurs. In the case of interest expense, the expense is recognized as the time passes and the borrowed cash remains used.
There are two main concepts behind the accrual basis of accounting:
1.) The revenue recognition principle states that revenue should be recognized in the period earned, regardless of when the cash is received.
2.) The expense recognition principle (aka the matching principle) states that all costs that are used to generate revenue are recorded as expenses in the period the revenue is recorded.
The understanding of the accrual basis of accounting will help as we continue into the next section covering adjusting entries. Adjusting entries are the way that a company converts from the cash basis of accounting back to the accrual basis of accounting for certain transactions.
This below video goes through the difference between the accrual and cash bases of accounting.
Section 5:) Adjusting Journal Entries
Adjusting Entries
At the end of the accounting period, before issuing financial statements, accountants often have to record adjustments to certain accounts to reflect accrual accounting. You can think of this as an adjustment from the cash basis of accounting to the accrual. This is essentially the opposite of what we were doing with the cash flow statement.
There are a few special types of accounts that need to be defined in order to fully understand accrual accounting:
1.) Accounts Receivables – This is an asset that generally represents a sale to a customer where cash has not yet been received. When the sale is generated, the asset is increased (just like cash would have been increased if the sale was for cash.) When the cash is eventually collected, the accounts receivable will be decreased, and the cash will be increased.
2.) Notes Receivables – This is an asset very similar to Accounts Receivables, except that it generally occurs when money is lent to someone (vs. earning money from customer sales.) Notes Receivables generally have a longer period to collect, are more formal, and accrue interest over time.
Note: There are a variety of different receivable accounts you may see (e.g., interest receivable, etc. These are all assets.
3.) Accounts Payable – This is a liability that represents the purchase of a product or service from another company, where money is not paid immediately, but rather due in the future. When the cash is eventually paid, the cash will be decreased and the accounts payable will be decreased as well.
4.) Notes Payable – This is a liability that generally represents the borrowing of money to be paid over a slightly longer period of time. This is similar to the Accounts Payable, but Notes Payables generally have a longer period to pay, are more formal, and accrue interest over time.
Note: There are a variety of different payable accounts you may see (etc., utilities payable, interest payable, salaries payable, etc.) These are all liabilities.
5.) Accumulated Depreciation – This is an account that relates to the usage of a long-term asset over time (e.g., equipment.) Under the matching principle, we cannot record all of the expense for the asset up front when it is purchased. Instead, we must expense it bit by bit over time as the equipment is used to generate revenue. The debit to that journal entry will be depreciation expense (to increase the expense.) However, instead of crediting the asset itself to decrease it, we credit this accumulated depreciation account, which will eventually show up as an offset to the asset’s value on the balance sheet. This allows us to keep track of the original cost of the asset, as well as what it is currently worth after accounting for how much of it has been used over time. See the example of this entry later.
6.) Prepaid Expense – Although the word “expense” may sometimes appear in this account name, it is actually an asset. The fact that it is prepaid means that we have already spent the cash to purchase the “benefit” of using this item later. Some examples of this may include prepaid rent expense, prepaid insurance expense, etc. Supplies are also a form of prepaid expense, even though the word expense generally does not show up in the name of this asset. In all cases, we have traded one benefit (cash) for another, and at some point in time these prepaids will be used up and actually converted to the corresponding expense. For example, the prepaid expense asset will eventually be used up and converted to rent expense, supplies will be converted to supplies expense, etc. See the reclassification/deferral adjusting entry examples later.
7.) Unearned Revenue - Although the word “revenue” may sometimes appear in this account name, it is actually a liability. This reflects a cash payment that has been made to our company even before we have provided the service or delivered the product to earn the money. As such, we cannot call it a revenue yet. We have received the cash, and thus we owe the customer something (the product, the service, or perhaps their money back down the road.) Once we have earned the money, we will reduce the unearned revenue liability and convert it to actual revenue. See the reclassification/deferral adjusting entry examples later.
Two main categories of adjustments
Accruals- This is when the company has not yet received cash, but we want to force recognition of the revenue or expense to reflect accrual accounting. As such, we accrue the transaction and will handle the cash payment/receipt in the next period.
Reclassifications (aka deferrals) – This is where the company has received cash, but it does not yet meet the rules for recognition as expense or revenue under accrual method. As such, we have to defer the recognition of the expense or revenue and temporarily reclassify the transaction as something else (generally an asset or liability that can be converted into revenue or expense at a later time.)
These two main categories can be broken down further into the following four main types of adjustments:
1a. Accrued Revenue (aka Accrued Assets) - Example would be revenue that has been earned even though we haven’t formally completed the transaction yet. For example, if we have earned revenue from providing service but haven’t yet billed the customer by the end of the period. Since it has been earned, we need to count it in this period.
With accruals, there will also be a subsequent transaction that takes place in the next period. This is to reflect the eventual cash transaction.
1b. Accrued Expense (aka Accrued Liability) – An example of this is when we owe our employees money by the end of the period even though the related paychecks won’t be issued until after the period is over. Since the expense has been incurred, we need to report it in this period.
With accruals, there will also be a subsequent transaction that takes place in the next period. This is to reflect the eventual cash transaction.
2a. Deferred Revenue (aka Unearned Revenue) – An example of this is when we are the landlord and we have received a year’s worth of rental income from a tenant. We cannot count this all as income yet because we have to wait for the year to pass. Until that time, we still owe a “service” (i.e., letting the tenant stay in the rental.)
2b. Deferred Expense (aka Prepaid Expense) - An example of this is when we are the tenant and we have paid a year’s worth of rent to the landlord. We cannot count this all as an expense yet because we have to wait for the year to pass. Until that time, we will count it as an asset. It is a benefit to us because the rent has already been paid and it is an asset we can “use up” over time by staying in the rental.
Note: One example of a prepaid expense is the purchase and eventual use of supplies. The only difference is that the asset in the above example will generally be called “supplies” without the word “prepaid” in front of it.
Yet another example of a prepaid expense is the purchase of long-term assets that will be used over time. This entry looks different than a normal prepaid expense because the asset itself is not directly reduced. Instead, an account known as “accumulated depreciation” is used. This account (known as a contra-asset) will be discussed further in a later chapter on long-term assets. See the example below for the purchase and use of the equipment.
Note both names for each type of transaction as it will often help you with the related entry. In the case of the accruals, the two different names will tell you both sides to the transaction. For example, accrued revenues will always have an entry to a revenue account and an asset account.
Very Important: There are two rules that come into play here.
Generally, every adjustment will affect a balance sheet account and an income statement account. The one exception to this is the adjustment for declared dividends that were not paid in the period and need to be carried over to the next period. In this case, the dividends account takes the place of the income statement (expense) account. Throughout accounting
Generally, although the original transaction may involve cash, an adjustment transaction will not. The one exception to this is the adjusting entry that may need to be made after a bank reconciliation.
Once adjusting entries are entered, they would then be posted to the ledger (just like the initial entries.) The balances would then be carried forward to the adjusted trial balance. Those amounts are then used to create the financial statements.
Example of a Trial Balance
The below videos go through the accrual and deferral categories of adjusting entries.
Accrual
Deferral
The below videos go through practice examples for the different types of adjusting entries.
Practice #1-
Practice #2 –
Practice #3 –
Section 6.) Closing Journal Entries
Once the initial and adjusting entries have been completed and posted to the T accounts (general ledger), the financial statements will be completed. Then, the temporary accounts (revenues, expenses, and dividends) will be closed out to retained earnings, while the permanent accounts (the balance sheet accounts) will keep a running balance.
There are two options for the closing entries. The first is using a very temporary account known as “income summary” to close out revenues and expenses. Then the “income summary” account gets closed to retained earnings. The second option is to close revenues and expenses out straight to retained earnings (not using the income summary account.)
Note that “closing” an account is done by identifying what the final balance is and then entering the opposite entry. For example, if an account had a $500 debit balance, then the entry would be to credit that account for $500. Just like all journal entries, there must be an opposite entry to offset it. Debits and credits must balance.
Option 1:
Close Revenues to “Income Summary” account
Close Expenses to “Income Summary” account
Close “Income Summary” account to Retained Earnings
Close Dividends account to Retained Earnings
Option 2:
Close Revenues to Retained Earnings account
Close Expenses to Retained Earnings account
Close Dividends to Retained Earnings account
Note that this entire process very closely resembles the retained earnings statement itself, as these same activities were used to determine the final retained earnings amount.
The income summary account is called a clearing account as it is only used to summarize your net income (revenue minus expenses) for the year in order to close it to retained earnings. Remember from the statement of owner’s equity that net income increases the owner’s equity.
This below video goes through the topic of the closing entries.
Wrap-Up:
There are quite a few things to keep track of this week. The biggest thing is understanding the normal balance rules. Then, understand the rule of formatting journal entries (debits must go first and must equal credits that are indented to the right.) Practicing the initial and adjusting journal entries is important as well. Finally, understand how to carry over the amount from a journal entry over to the T account (general ledger) and then eventually to the trial balance.
Section 1.) Accounting Cycle
A large portion of this chapter is dedicated to the discussion of journal entries. These are the basis for accounting now and into the future weeks. To understand journal entries, we first need to discuss the accounting cycle. This is the process that the company goes through each period from the time the transaction occurs to the time when the financial statements are issued and beyond that.
The life of a company is broken into various financial periods so that users can see how well the company is doing from time to time instead of having to wait until the end of the company’s life. Some companies choose to produce financial statements or other reports on a monthly basis. Others may only choose to do them on an annual basis.
If a company is publicly traded on the stock market, it must file quarterly and annual financial statements to meet the requirements of the Securities and Exchange Commission (SEC.)
In order to prepare these financial statements, a company goes through what is known as the Accounting Cycle. This lecture will discuss the various steps of the accounting cycle. It should be noted that different textbooks and different courses may discuss these in different levels of depth, merging some steps, or expanding on others. Below are the various steps of the accounting cycle as laid out in this text.
Step 1: Analyze Transactions
In this step, we are reviewing the source documents that have accumulated throughout the period (receipts, invoices, etc.) to identify what transactions have taken place. Then, we identify what accounts they belong in, whether they were increased or decreased, etc. This step goes back to the accounting equation exercises that we worked on in week 1.
Step 2: Journalize (Recording Journal Entries)
Once we have an idea what accounts were impacted by the various transactions, we can create the journal entry. The journal entry is a chronological record of the transactions that have occurred throughout the period. The journal entry requires at least one debit and at least one credit. The number/quantity of debits and credits in each entry do not necessarily have to balance out. However, the total dollar amounts of debits and credits must balance out.
Step 3: Post to the Ledger
Once the journal entries have been created, each piece of every journal entry is posted to its corresponding account in the general ledger. For example, if the journal entry required a debit to cash and credit to revenue, then we would take the debit to cash and post it to the cash account itself. This will adjust the cash balance and eventually will provide us with a running total.
Step 4: Prepare Unadjusted Trial Balance
After all of the transactions have been journalized and posted, the final balances from each of the accounts will be brought forward to an unadjusted trial balance, the first of three trial balances. The purpose of this is to give a concise report of all accounts and their debit/credit balances. Furthermore, it allows us to ensure that the total debit balances equal the total credit balances.
Step 5: Prepare and Post Adjusting Entries
As part of the accrual basis of accounting, entries are needed at the end of the period to reflect what prepaid assets have been used up during the period, what unearned revenue has been earned, what expenses/liabilities have been accrued throughout the period, and what revenues/assets have been accrued. More detail on adjusting entries is available later in this section.
Step 6: Prepare Adjusting Trial Balance
Once all of the adjusting entries have been journalized and posted, a second trial balance is created. Although the same basic purposes as the unadjusted trial balance are present, there is also an added purpose of using the adjusted trial balance to prepare the financial statements.
Step 7: Prepare Financial Statements
This step requires us to prepare each of the four financial statements; the income statement, retained earnings statement, balance sheet, and cash flow statement. Most of the amounts come straight from the adjusted trial balance, with the exception of the various subtotals and grand totals.
Step 8: Prepare and Post Closing Entries
The main purpose of the accounting cycle is to prepare financial statements. At the end of the period, many of the accounts must be closed to a zero balance to start the next year fresh. The closing process is discussed in more detail in another lecture.
Step 9: Prepare Post Closing Trial Balance
Once the closing entries have been prepared and posted, the third trial balance (post-closing trial balance) is prepared to ensure that debits and credits still balance out and that only the permanent accounts (balance sheet accounts) still have a balance.
Step 10: Prepare and Post Reversing Entries (Optional)
This final step is completely optional, and relatively few companies use it. The reversing entries basically reverse the adjusting entries. The only purpose of the adjusting entries is to get accurate balances for the purposes of the financial statements. Once the financial statements are completed it really doesn’t matter what the company does with the adjusting entries. Reversing entries essentially allow the provider to revert back to the cash basis of accounting, reflecting the balances of the various accounts before any adjusting entries were applied. Of course, the adjusting entries would again need to be made before the next set of financial statements.
This below video goes through the various steps in the accounting cycle.
Section 2.) Normal Balances
Before you can record a journal entry you must understand the meaning of debit and credit and what it means to each specific account. A debit would increase one account while a credit would decrease it. Another account may be increased by a credit and decreased by a debit. Understanding how a debit or credit impacts an account is critical.
Another word for this is normal balance. Specifically, the normal balance of account represents the entry that increases a particular account. Some accounts have a normal debit balance. Others have a normal credit balance. The normal balance of an account is also the side we need it to be on to be positive. If it is on the opposite side (the abnormal balance) then it would be a negative amount.
To understand this term “normal balance”, we first must understand how to calculate the balance of an account in general. One way to understand the calculation of the balance is by using a T account. A T account is a visual representation of the general ledger for an account. It is an informal way of showing a running balance after a series of transactions.
The T account for the cash account is shown below. In this case, there were $250 of debits and $100 of credits. The balance is the difference between the two and it would be on the side that had the highest amount. In other words, there are $150 more in debits than credits, so the balance would be $150 debit.
For cash this is a good thing, because as we will see shortly, cash (an asset) has a normal debit balance. That means that the cash account is positive. In reality, virtually all accounts end up with their normal balance. Very few accounts can even logically go negative and even then, it is only temporary. Think of the example of a company’s checking account. In the unfortunate situation that they overdrew their account, it would be negative temporarily and that would be a credit balance for cash.
In a T account, the only thing that is consistent across every account is that the left-hand side is a Debit (abbreviated DR) and the right side is a Credit (abbreviated CR.) Before considering whether debit or credit means positive or negative you have to know the type (classification) of account
Classifications of accounts and the normal balance
One way to remember the debit/credit rules is to use the DEAD mnemonic to remember those accounts that have a normal debit balance.
A normal balance simply states that this type of account should normally have this type of balance (DR or CR). When an account has its normal balance, this means it is reflecting a positive balance. For example, an asset will normally have a debit balance. If the current balance of the account is debit, then it is positive, if it is credit then it is a negative balance. In addition, to increase an account you will always report the entry on its normal balance side. To decrease an account, you will always report the entry on the opposite of its normal balance side.
Use the DEAD mnemonic to remember those accounts that have a normal debit balance.
Use the CLRC mnemonic to remember those accounts that have a normal credit balance.
It is extremely important to understand these normal balances rules before proceeding on to journal entries.
The two videos below go through the topic of normal balances in more detail.
This video goes through a practice exercise with the normal balances.
Section 3.) Initial Journal Entries
Once you understand the normal balance rules for accounts you can proceed on to recording the actual journal entry. A journal is a chronological record of the various business transactions within a company. A journal entry shows both sides of the transaction. This is where the concept of “double entry accounting” comes from. Every journal entry must have at least two pieces to it (at least one debit and at least one credit) but there may be more than two. No matter what, the sum of all of the debits in a journal entry must match the sum of all of the credits.
Another way to think of a journal entry is that each piece helps to explain the other. For example, if a journal entry shows that the company purchased supplies for cash, then that explains what the cash payment was for, and it also explains how the supplies were purchased.
Journal Entry Format:
Note that the debits will always go first followed by credits, which are right indented for both the account name and the amount.
To summarize the journal entry rules:
1.) The total dollar amount of debits in a journal entry must match the total dollar amount of credits. This does not mean that the quantity of debits entries must match the quantity of credit entries though. For example, there can be two debits and one credit, as long as the sum of the dollar amounts matches.
2.) Debits always go first (aligned to the left)
3.) Credits always go last (indented to the right)
4.) If you are using the normal balance of an account, that means you are increasing it. If you are using the opposite of the normal balance, then you are decreasing it.
Note also that some journal entries end up increasing both accounts, some end up decreasing both accounts, and some increase one account and decrease another.
Ledgers/T-Accounts:
A ledger is a collection of accounts. Each side of the journal entry will be posted to its respective account in the ledger. This allows us to calculate a balance of that account after all of our journal entries up to that point in time. Although within a journal entry debits must always equal credits, within an individual account the debits seldom equal credits. The difference between the debits and credits of an account is the balance of the account. For example, if there are $200 in debits to the cash account and $150 in credits, then the difference of $50 is called the debit balance.
Chart of Accounts:
The chart of accounts lists out all of the accounts for a company. It contains no dollar amounts or debits/credits at all. It simply lists the name of an account and also an account number (internal and specific to the company.)
See the below example of a chart of accounts.
Examples of Journal Entries:
For simplicity, every entry example will be $1,000. These are just example entries to help explain the process. There are many other journal entries that can exist and many of them are discussed in the YouTube videos linked later in the text.
Example #1 – Using cash to purchase supplies (or any other asset)
In this case, the asset that is being purchased is debited to increase it. This is because an asset has a normal debit balance, thus needs to be debited to increase it.
The cash asset is being credited to decrease it, since a credit is the opposite of the normal balance.
This is an example of an entry where one account is increased, and one is decreased.
Example #2 – Borrowing and receiving cash
In this case, the cash asset is debited to increase it. This is because an asset has a normal debit balance, thus needs to be debited to increase it.
The notes payable liability is being credited to increase it, since a credit is the normal balance for a liability account.
This is an example of an entry where both accounts are increased.
Example #3 – Earning revenue, but not collecting it right away
In this case, the accounts receivables asset is debited to increase it. This is because an asset has a normal debit balance, thus needs to be debited to increase it.
The revenue account is being credited to increase it, since a credit is the normal balance for a revenue account.
This is an example of an entry where both accounts are increased.
Example #4 – Collecting the money earned from the earlier revenue.
In this case, the cash asset is debited to increase it. This is because an asset has a normal debit balance, thus needs to be debited to increase it.
The accounts receivables account is being credited to decrease it, since a debit is the normal balance for an asset account, and we need to decrease it with the opposite.
This is an example of an entry where one account is increased, and one is decreased.
Example #5 – Paying an Expense with Cash
In this case, the expense account is debited to increase it. This is because an expense has a normal debit balance, thus needs to be debited to increase it.
The cash account is being credited to decrease it, since a debit is the normal balance for an asset account, and we need to decrease it with the opposite.
This is an example of an entry where one account is increased, and one is decreased.
Once the journal entries are completed, each piece will be carried forward to the corresponding T account to show us the overall balance.
Example of T Accounts
Example of a Trial Balance
This below video goes through the topic of source documents and journal entries.
The below three videos go through various practice journal entries.
Practice #1
Practice #2
https://youtu.b Section 2.) Different Classifications of Accounting and Careers Within Them When people first think of an accountant, they may have a pre-conceived image of what that career/profession entails. Most likely they are either thinking of just the standard bookkeeping profession or possibly even a tax accountant. In reality, accounting is a very broad and expanding field. Although many students in this course may not initially be interested in an accounting career, it doesn’t hurt to know what is out there. Financial Accounting: This area of accounting refers to the process of preparing and reporting financial statements. Although created and used to some extent by internal users, the information is generally more focused on the needs of external users. The information is in a uniformly prescribed format that we will discuss in a later section. Financial accounting also must follow Generally Accepted Accounting Principles (GAAP). This is just a formal name for the “rule of accounting.” Bookkeepers, Controllers, Certified Public Accountants (CPAs) and others fall under this type of accounting. This type of accounting is more focused on historical results. This is the section of accounting we spend the first two thirds of the course on. Managerial Accounting: Managerial accounting refers to the creation of information that is used by management to make decisions on running the company. Cost accounting is a subset of managerial accounting that deals specifically with determining the cost of products and activities for future planning. Certified Managerial Accountants (CMAs), Certified Financial Managers (CFMs), and others fall under this category. This type of accounting is more focused on future results. This type of accounting is what we spend the final third of the course on. External Auditing: An external auditor reviews the financial statements that were discussed above and gives an opinion as to whether they are fairly reported in conformance with Generally Accepted Accounting Principles (GAAP). They follow Generally Accepted Auditing Standards (GAAS) to do this work. Although this is not an auditing course, we do introduce a few important concepts throughout the text. Auditor independence, in fact and in appearance, is extremely important to ensure that the public can fully trust the information that the auditor reports on. Auditors do not guarantee that the company will do well or that it is a good investment. Instead, they only report whether the company is fairly reporting their information, good or bad. Internal Auditing: These auditors perform work similar to the external auditor, but they are employed by the company, thus do not appear to outsiders to be independent. This does not mean that internal auditors cannot be trusted. They are professionals and their work in many cases assists external auditors and also assists management. However, since there is an “appearance” that they are not objective (they work for the company that they would be reporting on) there must be an outside external auditor in charge of the report. Government and Not-For-Profit: This area of accounting is an offshoot of Financial Accounting, but it is specialized to the needs of entities whose main purpose is not profit. Instead, these entities are more concerned with providing benefits to beneficiaries (citizens or whoever is a designated focus of the group) and tracking where the funds are spent. The rules for reporting information are substantially different under G&NFP accounting. Income Tax Accounting: This area of accounting is often the one most familiar to people because as soon as you get your first job you start dealing with income taxes. The main goal of an income tax accountant is in filling out the income tax returns (Federal and State) according to regulations that have been set by the Internal Revenue Service. Although the starting point for a company’s income tax return is the income statement, there are many adjustments that need to be made due to the different rules between GAAP and IRS Tax Code. One of the main differences is that the income statement under financial accounting is reported under the “accrual basis of accounting.” This basically means that revenues are reported when they are earned (even if the money hasn’t been received yet.) Expenses are reported when they are “incurred”, even if the money hasn’t been paid yet. We will dig more into this in later weeks. Income tax is most commonly reported using the “cash basis of accounting.” This means that both revenues and expenses are reported only when the cash changes hands. The focus of income tax accounting is in following the regulations to properly determine taxable income. Other Careers in Accounting Education – Education is a career option in virtually any field. In order for more people to learn a profession, someone needs to teach. Often educators in accounting come from another accounting career to gain experience. Fraud or Forensic Accounting – This is a growing field where professionals help to identify errors in financial accounting records. This may be to fix the company’s internal controls or potentially to identify and solve crimes to hold criminals accountable. See the below link for more information on various accounting careers that are available. https://www.accounting.com/careers/ Section 3.) History of Accounting Now that we’ve talked a little about the reason for accounting, and what types of accounting exist, let’s back up a bit and talk about the history. You may be a bit surprised to learn that the basic accounting model we use today is over twice as old as the United States of America. Luca Pacioli, often referred to as the Father of Accounting, developed the first double entry bookkeeping system in 1494. His model created the same basic concepts and framework that we use today. This includes the debit/credit and self-balancing models we will discuss later. It should be noted that accounting in general has existed even further back than that, just not in the same model. Accounting in general has been found in civilizations as far back as 7,000 years ago. Although the double-entry accounting model has existed since 1494, it was mainly used for internal purposes up until around the Industrial Revolution. At that time, the rapid growth led to companies requesting more capital investments from investors. Before investors would invest, they needed to be able to trust the information that company was presenting to them. Since they would be choosing between multiple companies to invest in, the information from each company had to be reported in a consistent way to allow them to compare results between the companies and across time. This led to the development and use of standard accounting procedures. Accounting Professionals organized in the early 1900’s, but broad principles were not created until around 1932-34. These are in large part a response to the stock market crash and subsequent Great Depression. Between 1932-1934, the American Institute of Accountants (predecessor of the current American Institute of Certified Public Accountants - AICPA) and the New York Stock Exchange agreed on five broad principles. The Stock Market Crash of 1929 led to this agreement as the importance of reliable, consistent, comparable, and high-quality financial information was realized. The Securities Act of 1933 and Securities Exchange Act of 1934 created the standard setting body known as the Securities Exchange Commission (SEC). This government agency was initially granted the authority to create accounting standards, but they have delegated it over the years. The SEC first delegated this authority to the Committee on Accounting Procedure (CAP.) This was a committee within the American Institute of Accountants discussed above. Between 1939-1959 the CAP issued 51 Accounting Research Bulletins. These bulletins dealt with very specific accounting issues that arose and did not create any “general” concepts. From 1959-1972, the Accounting Principles Board (APB) replaced the Committee on Accounting Procedure (CAP). The APB was an arm of the newly formed AICPA. The APB issued 39 “opinions” on specific accounting procedures, but they failed to issue any general concepts. The APB, being an arm of the AICPA, was thought to not be independent enough. In other words, there were concerns about the group of accounting professionals creating the standards that they are to be bound by. In 1973, the Financial Accounting Foundation (FAF) was created as a more independent entity. They established the Financial Accounting Standards Board (FASB) as authoritative standard setting body within the accounting profession. The FASB embarked on a project called Conceptual Framework of Financial Accounting and Reporting. They are still in existence and still working on this through the present day. Eight Statements of Financial Accounting Concepts (SFAC’s) have been issued between 1973 and August 2018. These are more general guidelines, rather than specific principles. The FASB uses these concepts for future principles development and the public can use these to determine the “spirit” of an accounting requirement. Check out the FASB’s website to learn more about them. See the below YouTube video for a review of the history of accounting standard setting. The FASB currently sets accounting standards that apply to company’s reporting on the Stock Exchanges in the United States. Historically, many other countries either had their own sets of standards or followed the United States’ GAAP. However, over the past few decades this has been changing quickly. The International Accounting Standards Board (IASB) and its predecessor the International Accounting standards Committee (IASC) was created in 1973 around the same time as the FASB. The ultimate goal of the IASB is to bring accounting standards from various countries closer together so that information can be more easily compared globally. In a world where companies are often global/multi-national, global investments are also more common. Being able to compare results from different companies regardless of what country they operate out of is increasingly more important. Check out the IASB’s website to learn more about them. https://www.ifrs.org/groups/international-accounting-standards-board/ There are other accounting standard boards outside of the FASB. These generally apply to areas of accounting other than financial accounting. The Cost Accounting Standards Board (CASB) issues standards for cost accounting (a subset of managerial accounting.) For cost accounting issues that are not specifically addressed, the FASB standards should be used. We will not delve into these standards in this course. The Governmental Accounting Standards Board (GASB) issues standards that apply to the unique situations found within these types of non-profit entities. It should be noted that the FASB’s GAAP is often a starting point for these rules, with the GASB standards applying when there is something unique that is not addressed in FASB GAAP. In addition to Accounting Standard Boards, there are also Auditing Standard Boards that set the rules for how auditors should perform the work in reviewing a company’s financial statements. Although accountants and auditors are often thought of as one in the same, it is perhaps more accurate to think of auditors as accountants that review the initial accounting work performed by others. Although they share the same initial skill set, auditors must also learn additional skills and follow additional standards in the work they perform. The Auditing Standards Board (ASB) is a technical committee within the AICPA. The standards set by this group historically were used by both publicly traded companies and non-publicly traded companies, but as discussed in the next section a new board was implemented in 2002 for publicly traded companies. The ASB standards still apply to non-publicly traded companies, and in many cases the standards were carried over and implemented by the new board with minor if any changes. In 2002, Congress passed the Sarbanes Oxley Act (SOX) as a response to the massive corporate accounting scandals and fraud that was occurring at the time. This SOX legislation also created the Public Companies Accounting Oversight Board (PCAOB), which has the authority to create auditing standards for public companies. The concern was that the AICPA (the society of accounting professionals) was regulating their own profession with no real external oversight being exercised. Section 4: Accounting Concepts and Principles In order to proceed in the mechanics of accounting we first must understand some of the basic principles that accounting relies on. Note that in this course we will not be trying to memorize specific standard numbers. Instead, we are trying to understand the basic concepts and principles. Different textbooks, courses, etc. may refer to these with slightly different names, so many of the multiple names have been included below. One thing to note is that different textbooks, courses, etc. also sometimes refer to these differently. Sometimes one will be called a principle, another time a concept, and yet another time an assumption. Don’t get hung up on these particular words, and instead focus on the name as a whole. Whether something is a concept, or principle, or assumption really doesn’t matter. Accounting Entity Principle - This principle states that a business entity's financial transactions must be able to be separate from its owners and from other entities. Going Concern Concept - This concept states that we should make the assumption that this company is not going to be going out of business any time soon. Without this assumption we would have to value the assets differently (if they were to be sold at clearance prices, etc.) Furthermore, we would not be able to take a longer-term view of the company and spread certain costs out across the years (see the depreciation discussion in future weeks.) Unit of Measurement (Monetary Unit) - This principle states that we must report all income, costs, etc. at their current dollar value (or whatever currency is being used), without taking any change in the value of the dollar (i.e., inflation) into consideration. Furthermore, it tells us that for financial statement purposes we will not be measuring anything in hours, units of product, pounds of materials, etc. Everything is a dollar (or unit of currency) value. Cost Principle (Historical Cost Principle) – This requires companies to record all assets at their historical cost rather than any current market value. There are exceptions made for marketable securities which are “marked to market”. There are also exceptions made for inventory which are reported at the lower of cost or market. Objectivity Principle - This states that, whenever possible, we want to base our reporting on facts and objective statements, rather than management’s judgment. In some cases, this may not be possible, and estimates may need to be used. Accrual Concept - This tells us that we will report income and expenses in the period they are earned or incurred, regardless of when the cash is received or spent. The revenue recognition and matching principles below are key to accrual accounting. Revenue Recognition Concept - This tells us that we record revenue when it is earned and realizable, regardless of when the cash is received. Matching Concept - This tells us that we want to try to report expenses in the same period as the revenues they helped to produce. We expend funds for the sole purpose of trying to create revenue. We want to match the two when possible. Consistency - Whenever possible a company should report transactions similarly from one year to the next. In other words, they should follow the same rules each period. If any method of accounting for an item changes from one year to the next it must be fully disclosed so that users of the financial statements understand why the amounts may vary so drastically. Full disclosure - This states that management must disclose any information that is relevant to the financial statements or that may cause users to view the statements differently. This doesn’t mean that all corporate trade secrets are to be disclosed, but instead that the company shouldn’t be hiding information that an investor needs to understand the financial status of the company. Materiality – Contrary to popular belief, accounting is not an exact science and is not intended to be. Transactions are not always reported to the penny. When deciding on how accurate the reporting should be, a professional needs to determine whether a higher level of precision would benefit the user and whether that additional benefit is worth the additional cost in measurement. It should be noted that the size of the company often comes into these materiality decisions. A $10,000 difference in a transaction may be relevant and material to a smaller company, but that same $10,000 difference may not be material at all for a multi-billion-dollar company. Conservatism – This concept requires accountants to use the figure that will result in the less “positive” effect, when estimates must be made. For income statement items, this means they should report the lower of two revenue estimates or the higher of two expense estimates, when exact amounts aren’t known. Essentially, accountants should err on the side of caution. They should not paint too rosy of a picture for investors unless there are facts to support it. See the below YouTube video for a review of the various principles discussed above. Qualitative Characteristics of Accounting Information The overarching requirement in accounting is that the information that is produced is useful in making decisions (known as decision usefulness). All of the principles and concepts are geared towards that end result. GAAP breaks down this decision usefulness into a tree as shown below. The two primary qualities that must be met are relevance and representational faithfulness (formerly known simply as reliability.) The ingredients of each of these primary qualities is as follows: Relevance - In order for the information to be relevant to users in making a decision, it has to have some (or hopefully all) of the following qualities. · Predictive Value – This simply means that the information can be used to help make a prediction about what may happen in the future. · Feedback Value – This means that the information can help the user determine whether a previous prediction came true, or how far off it was. · Timeliness – In order for information to be relevant, it must be timely. Untimely information is simply not relevant anymore, because the window of opportunity for acting on a decision has passed. Representational Faithfulness/Reliability- In order for the information to be reliable and deemed to faithfully represent what it purports to represent, the information must have some (or hopefully all) of the following qualities. · Verifiability – This means that a third party should be able to gather and recalculate the information and come up with the same results. This is often assured by the external auditors, who have access to the books of the company while they are auditing it. · Neutrality – This means that there is no inherent bias or conflict of interest apparent in the development of the information. In other words, there is no spin on the information and it is presented fairly. Again, the external auditor often performs the function of ensuring that the information is neutral. There are two secondary qualities of information that become important in decision usefulness as well. These two work hand in hand and you really can’t have one without the other. Comparability – This is the ability for a user to compare financial statements of one period to those of another period and accurately determine how the company has improved or declined from one period to the next. Consistency – This means that the company has applied the same measurement techniques from one period to the next, or at least has clearly disclosed how they changed methods and why. The use of consistent accounting techniques leads to the ability for the periods to be comparable. Another criterion that comes into play is that of understandability. The information must be presented in such a way that a reasonably experienced user of financial statement data can read the financial statements and disclosures and understand the results for that period. Companies that have tried to hide fraud or other negative issues sometimes do so by making the transactions and disclosures look so complicated that a user may not even know where to begin in asking questions. Finally, when understanding decision usefulness, it is important to understand that the cost/benefit and materiality constraints come into play. In general, a company is not expected to go to great lengths to perfectly measure every thing that happens in the company. There may be some errors that make it through. As long as those errors are not material (i.e., do not matter) to the decision maker, then it is not worth expending the extra cost to try to achieve perfection since that additional cost will not provide additional benefit to the user. See the below YouTube video for a review of the Qualitative Characteristics of Accounting Information Section 5.) Four Core Financial Statements in Order of Creation: Now that we have a basic understanding of the principles and concepts that underlie accounting, we will start discussing the financial statements that are the ultimate result of all of the accounting transactions. Every year (and possibly every quarter) a company must publish these four financial statements so that investors can see the company’s results and make decisions about continued investment. We will introduce these four financial statements here. But will return to discuss them in more detail in later chapters as well. 1.) Income Statement This statement shows the profitability of a company over time. Revenues minus expenses equals net income. The income statement is reported for a period of time (i.e., how much income has been made by this company over a set period of time?) There are also items called gains and losses, which are similar to revenues and expenses, but they relate to non-operating activities that are generally somewhat rare in occurrence. For example, when a company sells one of its pieces of equipment after having used it for a couple of years it may make a gain or loss on the sale. Unless the company is in the business of selling that type of asset it should not be a common occurrence. It is important to report these separately so that investors don’t assume this type of income will continue year after year. 2.) Statement of Changes in Owner’s Equity (AKA Statement of Changes in Capital Stock, Statement of Changes in Retained Earnings, Retained Earnings Statement, etc.) This statement is also for a period of time. It shows how much has been invested by the owners or withdrawn by the owners over a period of time. It also shows what net income has been added to the company’s capital and what dividends have been paid out to the owners. Note that the final balance (the total owner’s equity) carries over from year to year, unlike the net income from the income statement. The ending balance of owner’s equity from one year becomes the beginning balance for the next year. Owner’s Equity is comprised of two major portions: A.) Paid in Capital (amounts directly invested by owners) If stock has a par value or a stated value, this paid in capital will also be broken down further into common stock and additional paid in capital. Note that par value has no direct relationship with the market value; it just tells us how to categorize whatever amount the stock is sold for. This concept is discussed more in later sections. For example, if the par value of stock was $10 and it was sold for $15, $10 of that would go into the common stock account and the remaining $5 would be reported as additional paid in capital. If coincidentally the sale of the stock was for $10 (the same value as the par value), the entire amount would be reported as common stock, and nothing would be reported as additional paid in capital. This split has to do with legal capital, which is the amount that is available to protect a creditor’s rights in a company. The legal capital is the amount of stockholders' equity that cannot be reduced by the payment of dividends (see below). B.) Retained Earnings (sometimes referred to as earned capital) This refers to the amounts of income earned and retained by the company over its life. It can also be thought of as the amount of earnings reinvested into the company. If this is a negative amount, indicating that the company has had large losses that have reduced their retained earnings below zero, then this is called an accumulated deficit or just a deficit. Dividends are the payment of retained earnings out to the owners. If the company has retained large amounts of earnings over the years, they may use it for future investments in production or they may choose to give it out to the owners if the company has no good needs for the cash at the time. Either way, the shareholder has a right to the asset, it is just a matter of whether they get it in cash now or whether it will help to increase the value of their stock later. 3.) Balance Sheet This statement lists the organization’s assets, liabilities, and owner’s equity at a point in time (usually the end of the period.) This means that all of the transactions from the beginning of this company’s life, up to this point in time, have created the balances that we now see. The equation Assets = Liabilities + Owner’s Equity is often referred to as the basic accounting equation or the balance sheet equation. There are NO exceptions to this rule!! Memorize this and consider all of the ways you can mathematically manipulate this. For example, if you know liabilities and assets, you can figure out the owner’s equity, etc. Assets must equal the total of liabilities plus owner’s equity. · Assets are defined as probable future economic benefits obtained or controlled by a particular entity as a result of past economic transactions or events. Another way of thinking about this is that they are resources owned by the company. Think about all of the things that can be considered assets. Cash, Buildings, Equipment, Investments in other companies are only a few examples. Accounts Receivable (which is a customer’s promise to pay an amount in the future) is also considered an asset because the company can expect it to turn into cash later on. · Liabilities are defined as probable future sacrifices of economic benefits arising from present obligations of an entity to transfer assets or provide services to other entities as the result of past transactions or events. Liabilities are amounts owed by one company to another entity. The liabilities represent the creditors’ claim to the assets owned by the company. Their claims come before the owner’s claims. · Owner’s Equity represents the owner’s share of whatever assets are left after considering the creditors’ claims. Note that you may hear owner’s equity called a few different things depending on the company. It may be called stockholder’s equity, capital, shareholder’s equity, etc. They all mean the same thing. Owner’s Equity is what is left for the owners after deducting the creditors’ share of the assets. These are sometimes referred to as net assets (i.e., assets minus liabilities). Both assets and liabilities may be broken into current and long-term categories. A one-year timeframe is generally the cut-off point for current. Either the amount will be converted to cash or paid with cash within one year to be a current asset or liability respectively. 4.) Statement of Cash Flows: This statement identifies the sources and uses for cash during the year. In other words, where did the company get their cash from and where did they spend it? The cash flow statement is also for a period of time like the income statement and statement of owner's equity. This reflects how much cash has transferred in or out of the company over a period of time. Note that cash flow does not necessarily equal income or loss for the year. However, cash flow is extremely important for a company. Just because a company has high amounts of income doesn’t necessarily mean it is healthy. They must have some cash coming in from that income so that they can pay the bills. The difference between net income and cash flows is a timing difference. For example, we may count something as net income this period, and then not receive the cash flows until next period. The Cash Flow Statement is broken down into three types of cash flows. These are also the three types of business activities in a company: · Operating Activities · Investing Activities · Financing Activities Cash Flows from Operating Activities This section relates to cash flow from transactions that are the core of the business’s operations. In other words, this is what they are in the business for, whether that be building and selling a product or providing a service. There are two different ways to report the operating section of the cash flow statement. These are the direct and the indirect method. The direct method directly identifies transactions that impacted cash and reports the increases or decreases. The indirect method starts with the net income figure from the income statement (reported under the accrual basis of accounting). It then adjusts certain things up or down based on whether or when they actually related to a cash flow. The details of these methods will be discussed in later weeks. Cash Flows from Investing Activities: This section relates to cash flow from the purchase or sale of long-term assets. The company “invests” in these assets to help them grow production, etc. We simply need to determine how much cash was actually spent on these types of assets or obtained from their sale. Cash Flows from Financing Activities: This section related to cash flows from the purchase or sale of long-term debt and common stock and payment of common stock dividends. The reason for breaking these cash flow statements into three types of activities is that we want to know specifically what types of activities are causing the cash account to increase or decrease. If the cash inflow is mostly from operating activities, that is generally good because it is sustainable. If the cash inflows are mostly from borrowing, the sale of stock, or the sale of the company’s long-term assets, that may not be as good because they generally cannot be sustainable for long periods of time. Such a situation may be acceptable for the initial growth stages of a company, but not necessarily a good thing for a company later down the road. Summary of the order and flow of the financial statements: Income Statement: This is the first financial statement, which shows us the revenues and expenses for a period of time. This is sometimes referred to as the Profit/Loss Statement. The net income from this statement carries forward to the statement of changes in the owner’s equity. Statement of Changes in Owner’s Equity: This statement shows us investments and distributions by/to the owners for a period of time. Net income from the income statement adds to the owner’s equity. The ending balance of equity carries forward to the balance sheet. Balance Sheet: This shows the company’s financial position at the end of the period (Assets, Liabilities, and Equity). The ending balance of one of those assets (cash) carries forward to the statement of cash flows. Statement of Cash Flows: This shows us how cash was obtained or used during a period of time. Note that cash flows may not relate directly to revenues or expenses in that same period. See the below YouTube video for a review of the various financial statements. Section 6.) Basic and Expanded Accounting Equation In the balance sheet section above, we discussed the equation Assets = Liabilities + Owner’s Equity. This is a hard and fast rule that is at the root of the “double entry” model created back in the 1400’s. There are two main ways to think of this. One is that whatever assets that company has had to have been financed by either borrowing money (creating liabilities) or by owner investments (meaning some owner now has equity in the company.) Another way of explaining this is that some party has to have a claim to all assets of the company. Creditors have a claim to certain assets based on the money they lent the company (liabilities.) Owners have a claim (called equity) to whatever assets are left after the company pays off their liabilities. Equity is often referred to as net assets because it represents the assets that are left over after paying off the liabilities. Although the equation starts out as Assets = Liabilities + Equity, there are many ways to restate this mathematically. Often this is done based on what information you know. If you know assets and liabilities, you can determine what equity must be by subtracting liabilities from both sides of the equation. Assets – Liabilities = Equity If you instead know Assets and Equity you can determine what liabilities must be by subtracting equity from both sides. Assets – Equity = Liabilities Note that the accounting equation must always remain in balance no matter what transactions occur. As such, if you add $1,000 to assets for some transaction, there must be some offsetting $1,000 transaction (or combination of transactions) that would keep it in balance. There might be a $1,000 decrease to a different asset, or there may be a $1,000 increase to either liabilities or equity. In a separate example, if you know that Assets in total increased by $15,000 and Equity increased by $8,000, you know that Liabilities must have increased by $7,000 to keep the accounting equation in balance. Double entry accounting requires that every transaction impacts at least two separate accounts. These accounts may both be on one side of the accounting equation, with one increasing and the other decreasing. Alternatively, they may be on separate sides of the accounting equation, where both would increase or both would decrease to remain in balance. Expanded Accounting Equation When reporting accounting transactions, we don’t just report things broadly in these three buckets. Instead, there are many different types of assets and liabilities we will talk about throughout the course. Furthermore, there are different elements of equity that deserve our attention. We can break these equity elements out to give us what is known as the expanded accounting equation. Specifically, Equity is broken out into Paid in Capital and Retained Earnings. Retained Earnings is calculated by taking beginning retained earnings (the ending balance from last period) and adding the revenues, subtracting the expenses, and subtracting the dividends. Understanding this expanded accounting equation is important as we begin the next week, because it will lead to the classifications of accounts that we use for our actual transactions and entries. Below are a few tips to help you understand this concept. These issues will all be discussed in greater detail next week but will be helpful this week for the assignment. First, note that when you increase either expenses or dividends it actually decreases retained earnings, which decreases equity. As such, for the accounting equation an increase to either dividends or expense is reflected as a negative (to balance out what is often a decrease to cash on the other side.) Second, there are a couple of terms that we need to understand. Accounts receivables reflect money that the company will eventually receive from a customer for services that have already been provided. Those services can be recorded as revenue now, even though there is not a cash increase now. Instead of increasing cash, it would be accounts receivable (another asset) that is increased. Third, when the phrase “on account” is used, that means that no cash is changing hands at that time. If someone is purchasing something from the company on account, this means it will be recorded as an accounts receivable (AR.) If the company is purchasing something from another entity, that means they will record an accounts payable (AP), which is a liability. That just means that they may be recording either an asset (if they purchased something) or an expense (if something was being used up immediately) and the other side would be an increase to accounts payable (i.e., they owe money later.) When the eventual payment is made that decreases either the accounts payable or accounts receivable, depending on what the initial transaction was. It also decreases the cash asset at the same time. When the company borrows money, this is often reported as a Notes Payable. Both accounts payable and notes payable are liabilities. When an asset (like supplies of equipment) is used up, it requires you to decrease the asset and generally increase an expense account for the amount used. Expenses generally refer to the usage of an asset, although we will see more situations where they occur next week. Examples of accounting equation transactions: • Increase asset 1 by $500, decrease asset 2 by $500 • Increase asset by $750, increase liability by $750 • Increase revenue by $1,000, decrease liability by $1,000 • Increase asset by $5,000, increase liability by $2,500, increase equity by $2,500 • Decrease asset by $800, increase expense by $800 (which is reflected as a negative amount, since it decreases equity.) • Decrease assets by $450, increase dividend by $450 (which is reflected as a negative amount, since it decreases equity.) See the below YouTube video for a review of the accounting equation. The video below goes through an example exercise for reporting transactions in the accounting equation format. The below video goes through an example exercise of a number puzzle identifying how to determine missing pieces of the accounting equation. Wrap-Up The first three sections of this week are largely informational. Although they are helpful as we begin the course, most of it is not necessary to build on in future weeks. However, you should at least retain an understanding of the difference between financial and managerial accounting. In section 4, we discuss the various principles of accounting. These are important terms that will come up throughout the rest of the course. It is not necessary to memorize the exact definition from this text. Instead, just retain a basic understanding of what it means and why it is important. We will apply the concept many times in later weeks. In section 5, we introduce the financial statements. These are important concepts that we will use multiple times throughout the course. You should understand the order of the four statements, an example of what they look like, and how one leads to the next. You should also understand that the balance sheet reflects one point in time (the end of the period) whereas the other three statements all reflect periods of time. In section 6, we discussed the basic and expanded accounting equation. This is perhaps the most critical section of week 1, as everything from this point on builds from this accounting equation. You should understand what it means, how to mathematically restate it, and how to solve for one item if you know the other two. Section 1.) Introduction to Accounting – History and Needs of Users Before we dig into the history and principles of accounting it is important to understand why we are learning accounting in the first place and how/why it is used by companies and individuals. Many students of this particular course come in without an intent to pursue an accounting degree or career. Instead, they are pursuing other subfields within business. Naturally, a common question is why non-accounting business students must still learn accounting. The response to this question is that anyone working within a company at any sort of management level needs to be able to understand the results of the company. Accounting is often referred to as the language of business because it is the way business decisions and results are presented. Continuing the language analogy, if you are planning to visit another country that doesn’t speak English, it is probably wise to at least brush up on some of the basics of that language. You don’t need to be an expert at it necessarily, but you should have a basic level of working knowledge. On the other hand, if you are going to be living and working in that country for an extended period of time, it may be wise to become more of an expert on the language. The same thing can apply to accounting. Accounting business majors need to gain more expertise in accounting, but non-accounting business majors may just need to learn the basics. This course and this text cover those necessary basics. What is Accounting? The next question that comes up is, what exactly is accounting? Most people taking this course start out with some level of familiarity with the term as we all use it to some level in our personal finances. However, we will see that it takes on an even deeper meaning when applied to companies. A formal definition would state that accounting is “the process of identifying, measuring, and communicating economic information about an entity for decisions and informed judgments.” In other words, we are identifying what information is relevant to business decisions. Then, we determine the best way to measure it and perform those measurements. Finally, we communicate the information to users to make those decisions. The identification and measurement generally come in the “bookkeeping” portion of accounting. The communication generally relates to the financial statements and annual reports that will be discussed later. Differences and Similarities Between Financial and Managerial Accounting There are many differences and similarities between financial and managerial accounting. First, an important similarity is that the data generally comes from the same transaction recording system itself. The “bookkeeping” aspect of accounting is used to record transactions in a standardized way that we will discuss in the next module. The differences arise from who uses the information, what types of reports are generated with the data, what types of standards apply to the collection and communication of the data, and what time periods are used for reporting. a.) Who uses the information To understand the decisions we introduced before, we have to understand who exactly is using the accounting information and what decisions they may need to make. This course is broken up into two main parts, financial accounting and managerial accounting. We will see that financial accounting is mainly for external users and managerial accounting is generally for internal users. External Users: The following are generally considered external users. Investors/Shareholders: These external users need the information to make decisions on whether to invest in a company. Financial accounting is often focused on these users. Creditors/Suppliers: These external users need information to make decisions as to whether to lend to a company. Government Agencies (SEC, taxing authorities, etc.): These external users need information to ensure the company’s compliance with regulations. One of their main goals is to protect the interests of the investors who have no other way of verifying the information they are being given. Employees (non-management): Although one may often think of employees as internal users, those in non-management positions may not have much more information than investors or other external users. Employees may be relying on the same information to predict their job security, opportunities for promotions, etc. Internal Users: Generally, when we think of the internal users, we think of management levels within the company. These internal users need this information to make decisions about how to run the business. As we will see in later sections of the course, management has access to a lot more information than will be available to investors and other external users. Furthermore, the same stringent standards do not apply. b.) What types of reports are generated In financial accounting, the accounting data is used to ultimately generate four core financial statements. These include the income statement, statement of changes in owner’s equity, cash flow statement, and balance sheet. These will all be discussed in later sections of this course. In addition, supplementary data is often generated in the form of footnotes and disclosures that help to further support and explain the financial statements. There are some very limited alternatives that can be selected regarding the format of a report, however for the most part the design of a financial statement from one company will look very similar to the design of a financial statement from another company. In managerial accounting, there may be several more types of reports generated, and they may be different from one company to the next. It is all dependent upon what the management of that particular company thinks they need to make the best decisions about how to run the company. There are many different software suites that provide choices for these reports that management may need. Often, the reports are heavily customizable. c.) What types of time periods are used for the reports With financial accounting companies are mainly concerned with quarterly and annual financial statements. The annual statements are audited in the case of a publicly traded company, though the quarterly statements are not required to go through such a process. Companies may have informal monthly financial statements, though they would generally be for internal use only. With managerial accounting, the reporting will run from annual reports, all the way down to hourly or even real time reports in some cases. The big difference is that management needs to know things on a much more frequent basis to be able to make actual changes to the operations. One example would be a supervisor working at a restaurant running an hourly labor report. The number of staff on hand for the evening would have been determined/predicted based on the expected amount of sales. If those sales are actually coming in much lower than expected (i.e., it is not as busy that evening) then people may be asked to leave their shift early to keep the labor cost percentage down. d.) What types of accounting standards (i.e., rules) guide the collection and communication of the data When dealing with financial accounting, it is important to remember that this information is being used by external parties that have no other way of accessing information about the company. As such, they trust that the information being given to them is complete, accurate, and reliable. Although in a perfect world trust would be enough, in reality there are many that might look to take advantage of that. For this reason, over the years several standards have been established that are collectively referred to as Generally Accepted Accounting Principles (GAAP.) Many of these concepts are discussed in more detail, but for this section it is important to note that financial/external accounting is required to abide by those standards when the companies are publicly traded. Managerial accounting on the other hand is for internal users, who often have other ways to access information about the company. They are using this data to make decisions about how to run the company. There is generally no incentive for them to “lie to themselves”, and there is no need for external parties to protect management from themselves. For this reason, managerial accounting is generally not subject to stringent standards. That being said, there are some situations where managerial accounting information is used by outside parties. One example is from my particular career in Medicare Cost Report Auditing. We rely heavily on internal information from hospitals when reviewing their Medicare Cost Reports and determining how much the Medicare program owes them. As such, these hospitals are subject to Medicare regulations and policies when developing and communicating their internal information to us. Another example would be when insurance companies are relying on internal costing information to determine a proper reimbursement. In these cases, Cost Accounting Standards sometimes apply. For our purposes in this section, the important thing to remember is that external financial accounting information is subject to stringent standards whereas internal managerial accounting is generally not. See the below link for a YouTube video covering the differences between managerial and financial accounting in more detail.
Practice #3
Another group of current assets would be the same ones that we talked about last week, with supplies, prepaid rent, prepaid insurance, etc. These are almost always short term, because most companies do not buy more than a year’s worth of supplies. Also, they do not generally prepay insurance or prepay rent for more than a year. This is not to say that it cannot happen, but it is very rare. For this reason, prepaid assets/expenses are considered short term/current. Eventually they will generally be used up, though it is possible some could be returned for cash.
Section 4:) Accounts Receivables and Bad Debts
Accounts receivables are amounts owed to the company by customers. These relate to services provided by the company to those customers or for products sold to them. They are considered a current asset because they are generally very short term (usually 30-60 days.)
There are similar assets known as notes receivables that can be either short term or long term. These are more formal (requiring a signed promissory note) and generally accrue interest.
With accounts receivables, generally a company has some sort of relationship or performs some sort of credit check on a customer before extending credit to them. Generally, accounts receivable gives the customer around 30-60 days to pay their bill. When the customer does not pay on time a question arises as to whether the customer will ever pay the bill.
An accounts receivable is an asset because it has a reasonable expectation of future benefit. If that expectation ever becomes unreasonable (due to the questions raised above) then the company must determine whether to reduce the value of the accounts receivable asset on their book. This will eventually lead to the recognition of a bad debt.
According to accounting principles, accounts receivable must be recorded at their net realizable value (i.e., how much is actually expected to be collected overall.)
From time-to-time companies must adjust these values based on an analysis of their bad debts. They reduce some of the accounts receivable asset amount and convert it into bad debt. The lost revenue is essentially a cost of doing business. Such a valuation adjustment reduces the carrying value of the accounts receivable asset down to its “net realizable value.”
Similar to fixed assets and depreciation expense that we briefly discussed last week, the accounts receivable asset itself is not reduced with this value adjustment. Instead, the reduction is done through what is known as the “allowance for doubtful accounts” account. This is a contra asset that reduces the value of the accounts receivable account. Note that a contra account is one that helps us to value the net amount of a particular account. It will always have the opposite normal balance from that main account. This allows us to offset its value, without touching the main account.
The reason we cannot directly reduce accounts receivable is we don’t know for sure which specific customers won’t pay, just the fact that some of them may not. Although we have been discussing accounts receivable as one main account up to this point, in reality it is comprised of a subaccount for every specific customer. Once we have reason to believe that a specific customer is not going to pay then we can directly write it off of the customer’s specific accounts receivable account.
Historically, once an account was converted into a bad debt, it was done by reducing the accounts receivable asset and increase a bad debt expense account. That expense would then reduce overall net income on the income statement. Recent changes in GAAP that are still being implemented instead require that the company offset the revenues directly by using what is known as a “contra-revenue” account (instead of using an expense account.) The impact to net income is the same.
This contra revenue account relies on the concept that if the company knows they will only collect a certain percentage of their accounts receivable, then they have likely already built that into their price. As such, it makes sense to reduce it out of the revenues immediately to reflect the actual amount they expect to collect. Although this is what GAAP is currently converting to, for the remainder of this discussion we will revert back to the traditional GAAP requirement (using bad debts expense) for simplicity.
Below is an example of this bad debt valuation adjustment using bad debts expense.
Note that in accounting courses focused on accounting majors, more detail is discussed on how to come up with the amount for the valuation adjustment. In some cases, management determines that a percentage of the current sales will end up as bad debts. In other cases, management determines that a certain percentage of the current accounts receivable balance will end up as bad debts (possibly based on the length of time they have already been past due. Due to the managerial focus of this class, the adjustment amount is given to you, and we will focus on the two entries. However, if you are interested you will find more information and examples in the videos link below. None of that information will be on the quiz though.
Write off entry
Once a specific account is actually determined to be uncollectible, it will be removed from the accounts receivable record. The below entry debits the allowance for doubtful accounts (which decreases this contra-asset.) Remember, that any “contra” account has the opposite normal balance of the account it is contra to.
This is all you need to know about accounts receivables for this particular course with a managerial focus. However, if you are interested in learning more, there is additional information included in some of the videos below.
This below video goes through an example of an accounting equation video practice exercise that is similar to the one we are doing for our assignment this week.
AR and Bad Debts
BD Practice Exercise #1
BD Practice Exercise #2
Section 5.) Inventory and Cost of Goods Sold
As discussed earlier, the cutoff between current and long term (for either assets or liabilities) is generally one year. If the company’s operating cycle (see definition below) is longer than one year, then this becomes the cutoff between current and long term. In other words, if an asset is cash or if it is expected to be converted into cash or if the benefit is expected to be used up within one year’s time, then it is considered current. If you recall the definition of an asset was any resource that represented a benefit to the company. The “using up” of that benefit is considered an expense. In other words, assets eventually are used up and converted into expenses.
Operating Cycle
This concept reflects the average time it takes a company to convert an investment in inventory back into cash, which is in turn used to buy even more inventory, etc. As you can see this cycle continues throughout the life of the company. The goal of a company is to make a profit through each operating cycle, thus increasing their overall profits.
- If a company operates strictly on cash (all payments due immediately) then this cycle has two components: Purchase of inventory and sale of inventory.
- If a company allows credit payments, then the cycle has three components:
1. Purchase of inventory
2. Sale of inventory on credit
3. Later receipt of cash from the above sale
The more efficiently a company manages their operating cycle, the quicker they can turn more profit, and the less inventory they must store on hand.
Inventory:
Inventory is defined as any item that a company purchases for the purpose of selling to customers. Inventory is an asset; when it is sold to the customer it is “used up” for the purpose of generating revenue. In other words, it is converted to an expense. This expense is known as cost of goods sold or COGS.
When inventory is purchased, the entry is as follows:
When the inventory is sold it is recorded as follows:
Periodic vs. Perpetual Inventory Systems
A company that has inventory has two main ways they can keep track of their inventory (periodically or perpetually.)
A periodic inventory system means that the company does not track the inventory amounts and the cost of goods sold after each transaction. Instead, they do not know this until they perform a physical inventory at the end of each period. At that time, they take the beginning inventory balance (i.e., the ending balance from last period), they add in the purchases of inventory from the period to determine what amount of inventory they have that they “could” sell throughout the year. Then, they subtract out the ending inventory balance (because they obviously did not sell that.) That leaves them with the balance they must have sold.
Cost of Goods Sold Calculation
Beginning Inventory
Plus: Purchases
Equals: Cost of Goods Available for Sale
Minus: Ending Inventory
Equals: Cost of Goods Sold
A perpetual inventory system means that the company can track the cost and inventory amounts after each sale. They generally do this by bar code scanning and computerized inventory systems.
In a perpetual inventory system, there are always two sets of transactions during a sale
To take the inventory out and record a cost of goods sold
To account for the sale and collection of cash or the set-up of the accounts receivable. This second entry would exist in either a perpetual or periodic system.)
Inventory Costing Methods
(FIFO/LIFO/Weighted Average/Specific ID)
When determining what cost to assign to a particular piece of inventory when we sell it, we need to consider the inventory cost flow assumption that management has chosen. There are four common methods:
Specific Identification
Weighted Average
FIFO (First In First Out)
LIFO (Last In First Out)
The idea between inventory flow is that we have inventory that we have purchased at different costs over time, we need to figure out which of those costs to use for the journal entry when we sell a product.
Let’s assume that we have the following items of a particular inventory product:
9 units at $23 per unit (that we had from beginning inventory)
10 units at $25.00 per unit (that we purchased on January 1st)
15 units at $26.25 per unit (that we purchased on February 3rd)
8 units at $26.50 per unit (that we purchased on February 20th)
Note that the above costs are NOT prices that we sell the product at. Generally, we would sell at a higher price. Also, note that the drastic cost increases over a two-month period are for example purposes only.
Now, if we decided to sell 17 units, the question is what cost we would record. Would we use $23 per unit? Would we use $26.50 per unit? The answer is generally that we would use some of each. For example, we only have 9 units at $23, so there is no way we could use $23 for all 17 units. One option we could use is to use 9 units at $23 and the remaining 8 units we need at $25. That would give us that 17 units we need. Since we started with the oldest (first) units, that is the “first in-first out” method.
Physical Flow vs. Cost Flow
We are focusing on cost flow assumptions, which do not always need to match the actual physical flow of the product. Physical flow of most products is FIFO, as that allows for rotation of the stock to keep it fresh. Think of a milk cooler in a grocery store. It is loaded from the back so that the first product purchased (the oldest product) is available for the customer to pick up and buy first. If every customer tried to reach to the back of the shelf to pick up the newest milk instead, this would essentially be LIFO (the last milk that the store purchased would be the first that the customer bought.)
The “in” and “out” of first in-first out, is “in” to the inventory balance and “out” of inventory to the cost of goods sold.
These assumptions determined what amount is taken out of the inventory account and converted to expense for each sale.
Although LIFO is not a common method used for physical flow, one example of this would be a rock pile where the new inventory is loaded to the top and purchased inventory is also pulled from the top.
Description of each method:
- With Specific Identification, we have rather unique items, and we can easily track the cost that the item was purchased at so that we can remove that exact same amount from inventory when we sell it.
- With Weighted Average, we take the total cost of the items up to that point (of sale) and divide it by the total number of units we have at that point. This gives us an average cost that we will then assign to each unit we are selling.
- With FIFO we take the cost of the first units that we put into inventory, and we use that cost to take it out of inventory. It is important to note that we must consider the quantity of items we have available at each level. We are essentially emptying out “the earlier cost layers” of the inventory. Since we are removing the first costs (and converting them to expenses) the last costs are left in the inventory balance.
- With LIFO we take the cost of the last units that we put into inventory, and we use that cost to take it out of inventory. It is important to note that we must consider the quantity of items we have available at each level. We are essentially emptying out “the later cost layers” of the inventory. Since we are removing the later costs (and converting them to expense) the first costs are left in the inventory balance.
Consider how these different methods would affect both income and inventory balances in periods of increasing or decreasing costs.
The below videos go through the different inventory and cost of goods sold concepts. There are also examples of the journal entries and calculations. Some of these topics go deeper than we are going into for this accounting course focused on accounting majors, but it provides opportunities for students to dig a little deeper if they want. Feel free to ask any questions you may have.
Intro to Inventory and Cost of Goods Sold
Periodic vs. Perpetual Inventory
Inventory Costing Methods
Practice Exercise for Inventory and Cost of Goods Sold
Wrap-Up
There are a lot of subtopics related to current assets. The main one you will see in your assignment this week is cash and the bank reconciliation. However, you will see some questions related to accounts receivables and inventory in the quiz. All of the videos will provide extra practice and examples on the topics at hand, but feel free to ask if you have any remaining questions.
Next week, we move on to the topic of long-term assets, mainly fixed assets and depreciation.
Section 1.) Current Assets and Overview
This week we discuss current assets on the balance sheet. The term “current” is another word for short term. Specifically, this refers to assets that are going to be used up (or converted to cash) in less than one year from the balance sheet date. A long-term asset (or non-current asset) on the other hand would take more than one year to be used up completely. We will discuss the long-term assets next week.
The current assets we discuss this week include cash, accounts receivable, inventory and various prepaid assets (like rent, insurance, supplies, etc.) The assignment for this week is based on the bank reconciliation for cash. For the other topics, we keep them at a relatively high level, though they would be discussed in much more detail in a financial accounting course for accounting majors.
Certain balance sheets, known as “classified balance sheets,” separate the current and non-current assets into their own groups with their own subtotals. A “non-classified” balance sheet just lists all assets out under one group. Although both are allowable, a classified balance sheet can help investors to understand which assets are short lived, and thus may have to be replaced more quickly.
Section 2.) Cash and Bank Reconciliation
The most current of all assets is cash. Remember that a current asset is one that is either used up or converted to cash within a year. Cash is already cash immediately. The benefit of cash is that it can be used to purchase anything else. On the other hand, assets like inventory must be sold, accounts receivable must be collected, etc. before they can be used.
Cash also carries unique risks because it is a much higher risk for thieves and fraudsters. Once they steal it is easy for them to use and hard to track.
There are two issues we will discuss regarding cash. The first is the concept of petty cash. The second is the bank reconciliation process.
Petty Cash:
Petty Cash is the idea that most companies have a small amount of cash set aside in a safe in the office or something so that it can be used for very small purchases without having to go through the normal in-depth approval procedures that are used for larger purchases. For example, if a company has to buy a booklet of stamps, they don’t want to have to go through a lengthy approval process first. On the other hand, if they are buying an expensive piece of equipment, that in-depth approval process seems appropriate.
Although having any purchases outside of the approval process does carry risks, the risk of this petty cash fund is seen as minimal when compared with the efficiency that is gained.
Petty cash is a subset of the cash account. Both cash and petty cash are assets and would show up on the balance sheet under the current asset section.
When a petty cash fund is established, money is moved out of the main cash account and over to the petty cash account. Generally, this involves the main cashier writing a check to the petty cashier. That petty cashier will then take the check and cash it. The cash will then be stored in a safe or other protected location.
The journal entry to establish the petty cash initially would be as follows. The petty cash is increased with a debit, while the cash account is decreased with a credit.
When petty cash is used throughout the period, the petty cashier gives the employee cash and in return gets a receipt back. No entry is needed at that time. However, at the end of the period, the petty cash fund must be replenished with another cash transfer from the main cash account.
Interestingly, the journal entry to replenish the petty cash account does not even involve the petty cash account. Instead, all of the expense related to the original purchases are debited (to increase them) and the main cash account gets credited (to decrease it, since the cash is being paid to the petty cashier.)
The third type of petty cash entry is when the petty cashier wants to increase or decrease the overall maximum level of the fund. For example, we started with a $500 fund. If they want to increase it to $700 (add $20) they would have to create another entry that looks very similar to the initial establishment entry, only it would be for $200.
Bank Reconciliation:
One of the most important internal controls over cash is simply the monthly bank reconciliation. This allows the cash account to be constantly reviewed to ensure that the balance the company has in their books matches what the bank says they have. Without a proper bank reconciliation, it may be possible for cash to be stolen and not noticed for several months.
The goal of the bank reconciliation is to compare the cash account balance per the company’s books with the cash account balance per the bank. Because there may be several transactions in process at the time that we obtain those balances, there may be several adjustments that need to be made to back into the proper balances. At the end, the goal is to ensure that the adjusted balances of both bank and book match. When we refer to the “book” balance, we are referring to the company’s own records (as opposed to the bank statement.)
Examples of Adjustments:
Deposits in Transit - These deposits have already been recorded in the company’s cash account, but they have not yet been added into the banks’ balance on the bank statement, because they did not know about it at the time of cutoff. To adjust for this, we need to add the amount into the bank side of the reconciliation.
Outstanding Checks - These are checks that have been sent and recorded in the company’s cash account, but it has not yet made it into the banks’ balance on the bank statement, because they did not know about it. To adjust for this, we need to subtract the amount from the bank side of the reconciliation.
Bank Account Interest Earned - This is income that has been added into the company’s bank account balance, but the company themselves did not know about it before the bank statement was issued so they did not add it into their cash account balance. To adjust for this, we need to add this into the book side of the reconciliation.
Bank Service Charges - These are expenses that have already been subtracted out of the bank account balance, but the company did not know about them before the statement was issued, so they did not subtract them out of their books yet. We need to subtract this amount from the book side of the reconciliation.
NSF Check Charges - This is a prior deposit that we made from a customer’s check that has now bounced. Since it is not a valid check, the bank has reversed that portion of the deposit. The company didn’t know about it before the statement was issued so they did not have a chance to reverse it in the company’s cash account. We need to subtract this amount from the book side of the reconciliation. Then the company needs to collect payment from the customer that gave them the bad check. This last item is outside of the bank reconciliation process though.
Collections by the bank on behalf of the customer (Lockbox arrangements) – In some cases, a company will have an agreement with the bank whereby the customers send their payments directly to the bank. The bank then handles the processing of the account. The bank knows about the payment before the company. That means that the bank statement balance will already have the amount incorporated into the final balance. The company then needs to take that information and adjust the amount into their cash account as part of the reconciliation.
Bank or book errors – In some cases, an actual error was noted with the way the bank handled something or the way the company handled something. For example, the bank may have erroneously included someone else’s deposit or check into this company’s account. That needs to be reconciled out of whichever side was in error. In some cases, the bank makes an error with the amount they record for a transaction. If the amount was higher than it should have been, they need to reverse the entry for that additional amount. If it was lower than it should have been, they need to add the additional back in through the same entry.
There may be other items as well. When faced with a different item, simply consider the effect, which side it has been accounted for in, and make the appropriate adjustment to the opposite side so that the handling is identical to the other side.
Once the bank reconciliation has been completed, adjusting entries (different from the type we learned about last week) need to be made to update the company’s cash account. These entries would ONLY need to be made for the reconciling items on the “book” side of the equation. Without those entries, the company’s records would never get updated.
No entries need to be made to the bank side of the reconciliation, as we cannot (and don’t need to) get into the bank’s accounts to update them. The bank will handle those updates themselves once they become aware of the information. For example, once the bank receives the deposit, they will update it. Once the outstanding checks have cleared, the bank will update it. The bank reconciliation items are generally just timing differences. At worst, if the company continues to see outstanding items by the next bank statement period, they may want to contact the bank to notify them of the potential issue.
The below videos go through the topics in more detail. The final one is a practice exercise that is similar to the one we are doing for our assignment this week.
Cash and Internal Controls
Petty Cash Exercise
Practice Exercise for Bank Reconciliation
Section 1.) Accounts Payable vs. Notes Payables (and Misc. Liabilities)
What Are Liabilities?
Liabilities are the “probable future sacrifices of economic benefits arising from present obligations of a particular entity arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.”
In other words, some transaction we had in the past has caused us to owe another company something in the future. One thing to note about the above definition is that the future sacrifice of benefits may be us giving up an asset (i.e., cash or something else) or it may be us providing services to the other entity.
Liabilities can either be short term (aka current) or long term (aka non-current). This is determined by whether the debt is due within one year (current) or more than a year (long term.)
In some cases, a company may buy goods on credit from another vendor. In these cases, the amount due is recorded in an “accounts payable.” It is important to note that accounts payable generally arise from purchasing goods or services from suppliers or customers. Generally, accounts payables DO NOT arise from borrowing money or purchasing fixed assets (property, plant, and equipment.) Amounts borrowed are more commonly considered notes payables, due to the promissory note that is signed.
Short term debts that are more formal than accounts payable are known as “notes payable.” These generally have a legal contract backing them and they also accrue interest. They tend to be slightly longer periods of time as well, though still short term (less than one year.)
In summary, the main differences between Accounts Payable are that Notes Payable tend to be longer in term than accounts payable, notes payables tend to accrue interest, and notes payables are more formal.
Again, generally the accounts payable arises when you buy a product and the notes payable arises when you borrow money. However, there are some cases where you a buy a product and need a longer period of time to pay for it. That could indeed be considered as a notes payable if the seller asks you to sign a promissory note for the amount. That promissory note and the corresponding interest is what makes the notes payables more formal than the accounts payable.
An example of a journal entry might be the purchase of inventory on account (or on credit.) This would result in the debit to inventory to increase that asset, and a credit to accounts payable to increase that liability. Other common entries would include a debit to supplies, or debits to various expenses, for anything purchased on account.
Interest Accrual – Simple Interest
As discussed above, only the notes payables generally accrue interest. In the financial world, interest rates are always given in an Annual Percentage Rate (APR) form, even if the borrowing period itself isn’t for a full year. Interest is calculated by taking the principal of the loan (amount borrowed) multiplied by the annual interest rate percentage, multiplied by the percentage of the year in question. As such, for a $100,000 note with a 12% annual rate that we are borrowing for 9 months out of the 12 months in a year, we would take:
$100,000 X .12 X (9/12) = $9,000
Financial Statements
As a liability, both the Accounts Payable and Notes Payable will show up on the balance sheet. Liabilities have a normal credit balance, which means that they are increased with a credit and decreased with a debit. Furthermore, liabilities carry their balance forward from year to year, instead of being closed out and zeroed out automatically at the end of the period.
Unearned Revenues
Another liability that we have dealt with in the previous adjusting entries discussion is “unearned revenue.” As you may recall, this exists when a customer pays us in advance, before the services are rendered, or before the product is delivered. When the customer first prepaid, the unearned revenue account is increased with a credit for the amount paid. This liability represents the fact that we owe the customer something in the future (i.e., the product/service or their money back.) When services are provided or a product is actually delivered, the unearned revenue liability account is decreased with a debit.
Short Term Maturities of Long-Term Debt
An important issue for either assets or liabilities is the proper classification of current vs long-term. Debt that matures (becomes due) in more than a year is known as long term debt. However, there are commonly situations where a portion of the debt is due each year. Take a home mortgage for example. It is certainly a long-term debt (15 or 30 years), but a certain amount is due each and every month/year.
Any portion of that long term debt that becomes due within the next year is considered a “current portion of a long-term debt” and is recorded in the current asset section of the balance sheet. Each period, a new portion of the long debt will be carved off and moved into the current asset section.
Purchases and Purchase Discounts
Although accounts payables can be created anytime any purchase is made (supplies, etc.) it is frequently discussed in accounting courses in conjunction with the purchase of inventory.
When a purchase is made on account, the seller often gives a discount for early payments. This is known as a purchase discount. At the time of the purchase, it is not known for sure whether the discount will be taken (i.e., whether it will be paid early).
Discount terms (or credit terms) are often written in the format of 2/10, N/30. This means that there is a 2% discount available for any amounts paid within 10 days and the “net” amount (i.e., whatever is left) would be due within 30 days. Of course, any of these elements could be different from company to company.
Of course, you won’t know for sure whether the buyer receives the discount or not until they actually pay the bill. Even the purchaser themselves won’t know that, though they may have policies in place where they always try to pay early to get a discount.
Because of the unknown, there two different ways to record the purchase; the “Gross” method and the “Net” method
Gross Method: The “gross method” has the buying company recording the purchase at the full price initially and then later adjusting at the time of payment if the discount is indeed taken. This is often used when there are no policies in place to require the company to pay early, and as such there is a lot of risk that they won’t get the discount.
Example:
$10,000 worth of inventory is sold under credit terms of 2/10, N/30 indicating that if the amount is paid within 10 days a 2% discount will be available. On day one when the purchase is recorded, it is unknown whether the discount will be taken or not. If the gross method is used, the entry on day 1 would look like this.
If the discount was not taken, then it would simply require a debit to accounts payable for the full $100,000 to clear it from the books and a credit to cash for $100,000 to reflect payment as shown below:
On the other hand, if the discount was eventually taken by paying within 10 days, the journal entry to adjust for it would look like the one below.
-The debit to accounts payable represents the fact that a total of $100,000 is being removed from the accounts payable, since nothing will be left due after this payment.
-The credit to inventory reduces that account by the $2,000 discount. This is because inventory (as an asset) can only be recorded at cost. We thought that the cost was the full $100,000 on day 1, but when we realized we took the discount, we had to adjust the inventory down by $2,000 so it is ultimately reported at the cost ($98,000.)
-The credit to cash for $98,000 is to reduce cash because we are spending that amount in payment.
Net Method - The “net method” has the purchasing company recording the purchase at the discounted price and then later adjusting if the discount is not taken. This method is often used when the purchasing company expects all payments to be made early enough to take the discount, and as such wants to be able to track when their employees do not pay things soon enough (thus losing the discount.)
Example:
$10,000 worth of inventory is sold under credit terms of 2/10, N/30 indicating that if the amount is paid within 10 days a 2% discount will be available. On day one when the purchase is recorded, we are assuming that the discount will ultimately be taken, thus we are recording it at the discounted amount. If the net method is used, the entry on day 1 would look like this.
If the discount was eventually taken as assumed, the journal entry to adjust for it would look like the one below. This debits the accounts payable for the $98,000 to zero it out, and a credit to cash for the same $98,000 to reflect payment.
On the other hand, if the discount was NOT taken, then a special entry is needed to record the “lost discount”. Though different companies may use different titles for this account, it basically reflects the fact that the company wants to track any discounts that are lost. Their use of the net method implies that they plan to take advantage of discounts whenever possible. If they are not doing so, they want to track it for later follow-up.
The below entry shows a debit to accounts payable for the $98,000 that was originally recorded, a debit to the “discounts lost” account (which is essentially a type of miscellaneous expense.) There is also a credit to cash for the $100,000 total payment.
Cost of Lost Discounts?
Though a 2% discount may not seem like much, keep in mind that this is not an annual rate. Instead, it is a 20-day rate (i.e., they had to pay 20 days earlier than expected to get it.)
Annualized, this ends up being 36.73%
This is calculated as:
(Discount Rate/100%-Discount Rate) * 360/ (Full Credit Period – Discount Period.)
Loss of discounts can be expensive. You may ask, why does a selling company offer such a lucrative discount? First, it incentivized the company to pay them first, before other vendors that do not offer discounts. This significantly reduces the risk of non-payment. Second, it allows them to take that money and purchase more inventory to sell again. Receiving their money from the customer sooner means there is less money they have to borrow to keep their operations going.
See the below YouTube video for a review of the accounts payables and purchase discounts discussed above.
Section 2.) Payroll
Although some small firms operate with the owner as the only employee, most companies eventually have to start hiring employees. This requires the use of a certain area of accounting known as payroll accounting. It is not as easy as just paying your employees a certain amount of money. Instead, this requires the collection and payment of certain types of taxes, both on the employee side, as well as the employer side.
You may be familiar with these types of taxes from your own employment experience, but there are additional things that apply to employers that you may have not been aware of. Let’s discuss the various types of taxes below.
FICA – Social Security
First off, the acronym FICA stands for Federal Insurance Contributions Act. This is an act that has been around since the 1930’s, when Social Security itself was enacted. This requires the withholding of a certain percentage of an employee’s earnings, which will then be deposited into the Social Security fund. This is a retirement fund for the elderly, as well as a fund to aid with disability income. FICA covers both Social Security and Medicare, but each are treated differently.
Social Security is withheld at a certain percentage (currently 6.2%). The big difference with Social Security is that the amount of earnings that are taxed are capped at a level that increases each year. For 2020 it was $137,700 and for 2021 it is $142,800. Generally speaking, most accounting courses do not require that you memorize these percentages or caps, but rather that you know how to calculate them when the percent and cap is given to you in a problem.
FICA – Medicare
The Medicare program has been around since 1966 to provider a single payor for health insurance to the elderly or disabled. Medicare is also funded under the FICA contributions. The difference with Medicare is that the tax rate is much lower (currently 1.45%) and there is (currently) no capped level of earnings that are taxed.
Federal Income Taxes
While Social Security and Medicare are taxed at a specific percentage, the Federal Income Tax is a progressive tax, which means that the more money you earn the higher your tax rate will be for those extra dollars. For example, a single taxpayer in 2021 will have their first $9,950 of taxable income taxed at a rate of 10%. The next $30,575 of income is taxed at 15% and the next $45,850 is taxed at 25%. There are additional tax brackets for higher income individuals as well. A common misconception is that once you enter a new tax bracket your entire income is subject to that higher rate. That is incorrect. It is just the “incremental” amount of income subject to that higher tax rate.
Another thing to consider is that not all of your income is taxable. There are various deductions and exemptions from your total income before you arrive at the taxable income. This concept is covered further in classes on income tax.
Whatever the amount of Federal Income Tax that is due, the employer makes an estimate of that amount and withholds it from your paycheck and pays it to the Internal Revenue Service. This estimate is based in part on what the employer reports on their W-4 form, documenting the number of withholdings based on marriage status, number of dependents, etc.
State and Local Income Taxes
Not all States or Localities have income taxes, but for those that due they are treated largely the same as Federal Income Taxes. The main difference is what agency the money is sent to (i.e., State taxing authority versus Federal Internal Revenue Service.)
Other Voluntary Deductions
In some cases, employees may also voluntarily have funds withheld from their paycheck for a variety of reasons (e.g., health insurance, retirement 401k, gym membership, charities, etc.)
Employer Side Journal Entries
The employee themselves is likely most concerned with the net income they will receive in their direct deposit. In the example below, that net pay that they have earned is $68,550. This is reflected in a credit to the salaries payable liability, showing the amount the company owes directly to the employee.
However, as you can see there is quite a bit more to the entry for the employer. They have to reflect the overall salaries expense (gross pay), as well as the various entities they owe the money to. As discussed above, a large part of the money is owed directly to the employee, but there are also amounts that have been withheld from the employee’s paycheck to be paid to the various taxing authorities, insurance companies, retirement plans, etc.
Assume that the below is a journal entry for 10 employees making $1,000 per month.
Employer Side Deductions
In addition to withholding the appropriate percentages for the two FICA taxes (Social Security and Medicare), employers also must pay a matching amount to the government. In addition, the employers must pay an extra tax related to unemployment insurance. These are required by the Federal Unemployment Tax Act (FUTA) and State Unemployment Tax Act (SUTA). No amount of the State or Federal Unemployment tax is paid by the employees themselves or withheld from their paychecks. It all comes from the employer.
The FUTA tax is 6.2% of the first $7,000 of annual earnings, though the employer gets a credit for whatever the State tax rate is (up to 5.4%.) This would leave the FUTA rate at .08%.
See the below YouTube video for a review of the payroll taxes discounts discussed above. The second video is a practice exercise.
Section 3.) Warranties
Many companies offer guarantees to their customers that when they buy their product it will work defect free for a specified period of time. This is referred to as a warranty. If you are given two nearly identical companies where the only difference is that one offers a two-year warranty for their product and the other offers nothing, generally the company that offers the warranty will either have a higher sales price or will experience higher sales volume.
Although they may generate higher revenues, they will also generate an expense due to the fact that eventually some customers will likely have a warranty claim. The matching principle of accounting requires that we record the expenses in the same period as the revenues of the product that the warranty relates to. This is similar to the treatment of bad debts expenses discussed in earlier sections.
Returning to the example of the two-year warranty, you can see the problem with matching because we may not know when or how many of the products are going to be returned until the two-year period is up. Obviously, this is too far out to be able to record the expenses in the first year when the product is sold.
Due to this issue, we estimate how much warranty expense we expect to have when the product is sold. This estimate is often based on either on prior experience or some sort of industry standard. It is just an estimate and is not expected to be perfect. This estimate will be refined over time.
Assume that a product is sold in the amount of $40,000 and management estimates that warranty expense will be 5% of sales.
When the product is sold the journal entry to record the warranty expense would be as follows:
Note that throughout the period of sales, this estimated warranty liability would continue to be credited, which increases that account. This sets up a “fund” of sorts to later be used when a warranty claim comes through.
Let’s say on 2/15/xx, a customer that bought this product in last year returns it due to defect. In some cases, a company may pay the customer a set fee. In other cases, they may replace their product altogether. In other cases, they may simply repair it.
Let’s look at each of the three examples.
Cash Payment of $1,500
Replacement of inventory worth $1,500
Repair of product using up $400 of supplies and $1,100 of labor
Over time, more and more warranty expense would be credited to the liability account, setting up a “cushion” against future claims. Then, whenever an actual warranty claim comes through it would be debited. The company should strive to keep the warranty liability account to a minimal level, but on the credit side. That being said, there is the potential for a company to underestimate the expected warranties. This would cause them to end up with a debit balance (negative) for the estimated warranty liability. An example of this is shown below.
If the estimated warranty liability continues to increase over time, the company may need to reduce their estimated warranty percentage. If the estimated warranty liability is negative on a regular basis, then the company may need to increase their estimated warranty percentage. There is no need for them to close this account out or correct for any misestimates each year. The “adjustments” are just made on a go forward basis with revisions to the estimated warranty percentage.
In summary, the liability for product warranty claims is an example of a liability that has been calculated using estimates, for the purpose of better matching revenues and expenses. In the period of the estimate itself, an expense will be generated (even before any claims are submitted.) This expense will reduce net income in that period.
See the below YouTube video for a review of the warranty concepts discussed above.
Section 4.) Contingent Liabilities
Under Generally Accepted Accounting Principles, a liability is the “probable future sacrifices of economic benefits arising from present obligations of a particular entity arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.”
To record a liability, it must be probable, but that doesn’t have to be 100% guaranteed. In some situations, there are liabilities that are based on past events, but we are not sure whether it will lead to an actual liability in the future.
There are three classic situations:
1.) Lawsuits based on something that was done in the past
2.) Warranty Claims
3.) Guarantees of Debt (i.e., co-signing a note payable for another party)
In each of these situations, it is possible that the company may owe something in the future depending on the outcome of some event in the future. For example, how likely is it that we will lose the lawsuit and what amount will we owe? How likely is it that the person we cosigned for will not pay their debt, thus pushing the liability to pay to us?
In order to record an actual liability, we must be able to reasonably estimate the amount, and it must be “probable” that we will actually owe that amount. In any other situation, we will either not record it at all, or simply disclose it in the footnotes to the financial statements.
Possible Scenarios:
- If the likelihood is “probable” and the amount is “reasonably estimable”, we will record a liability AND disclose it in the footnotes.
- If the likelihood is “remote” (i.e., very unlikely to happen), it doesn’t matter whether we know the amount or not, we will not need to record a liability, or disclose it in the footnotes.
- If the likelihood is “probable”, but we cannot reasonably estimate the amount, we cannot record it as a liability, but should instead disclose whatever information we do have on it in the footnotes to the financial statements.
- If the likelihood is just “reasonably possible” we will just disclose what we do know about it in the footnotes to the financial statements.
See the below YouTube video for a review of the contingent liability concepts discussed above.
Section 5.) Bonds Payable
Noncurrent (Long-Term) Liabilities
In order to begin and/or expand operations, a company must obtain financing of some sort. The two typical ways of doing this are by borrowing money or by issuing stock in exchange for ownership interest in the company. For the purposes of this section, we will focus on borrowing money (by issuing debt such as a bond.)
Although at first glance it may appear that a company is better off without having any debt, this may not actually be the case.
When a company obtains equity financing (i.e., issues stock) for financing they must share any of the profits with the new owners. This is a downside. One of the upsides is that there is no set payment that must be made on a regular basis because dividends are generally only paid when there are earnings.
When a company obtains debt financing (i.e., borrows money by issuing/selling bonds), they do not have to share any of the profits with the lenders, however they do have a set amount of interest to pay each period. This creates risk because the payment is due regardless of whether they are doing well financially that period. If they fail to pay, the lenders could in extreme cases force them into bankruptcy.
Note that if a company is able to borrow money at a relatively low rate and then use it to run their business and generate a higher profit, this is a good use of debt financing. The difference between the company’s return on investment (ROI) (the return considering all money available to them, regardless of financing method) and the return on equity (ROE) (the return considering only the money that stockholders have invested) is known as leverage. These ratios will be discussed in later sections of the course.
Bonds Overview
Bonds are a common way for larger companies (or even governments) to obtain debt financing. With a Notes Payable, the company is borrowing a large amount from one investor. With Bonds Payables, the company is borrowing smaller amounts from several investors to ultimately receive the same total amount overall. There is less risk to each individual investor, thus the interest rates tend to be lower.
Individuals are willing to lend money to the company by purchasing their bonds because of the potential return they will receive from those bonds. The company attracts investors to purchase the bonds in return for a set interest payment and a promise to repay the face amount (par value) at a later time (called the maturity date.) Although there is a set face value for the bond, and a set interest rate, the amount that the investor pays to the company varies depending on the current market rate for similar bonds.
The stated interest rate on the bond often differs from the average market rate effective on that same date. This is in part because sometimes there may be a time delay between when the company prints the bonds and when they are actually purchased. Regardless of how the stated interest rate compared to the market rate, the bond will be equally valuable to the investor for reasons discussed below.
Three issuance options
-If the stated interest on the bond happens to match the current market rate the bond will be issued at the face value (known as par.)
-If the stated interest rate on the bond is less than the current market rate, this means that the investor would get less interest payments if they purchased the bond than they would otherwise get by investing in other bonds on the market. Because of this the bond must be issued at a discount, and the investor will pay less money to purchase the low interest bond. None of this changes the “face value” of the bond, which represents what they will be repaid in the future when the bond comes due. This means that the investor will pay less now than they will actually get repaid in the future. This lower price makes up for the fact that they will get less interest over time.
-If the stated interest rate on the bond is more than the current market rate, this means that the investor would get more money if they purchased the bond than they would otherwise get by investing in other bonds on the market. Because of this the bond will be issued at a premium, and the investor will pay more money up front to purchase the higher interest bond. None of this changes the “face value” of the bond, which represents what they will be repaid in the future when the bond comes due. This means that the investor will pay more now than they will actually get repaid in the future. This higher price makes up for the fact that they will receive more interest over time.
Bond Journal Entries – Initial Issuance
The entry that is made at the bond issuance and at the time of each interest payment will be determined by whether it was issued at a discount or premium. Depending on whether the bond is issued at par, discount, or premium, the entries will look like the ones below. Assume that this is a 5-year bond, with a 10% stated interest rate.
In the case of the issuance at par, note that the bonds payable amount exactly equals the cash amount received.
In the case of the issuance at discount, note that the bonds payable amount is still the full $100,000, but the cash debit only reflects the actual amount received ($95,000.) The remaining $5,000 is recorded as a debit to a “discount” account. This account is a contra-liability account, offsetting the carrying value of the bond on the balance sheet, as shown in the illustration below. A “discount” account (as a contra-liability account) has the opposite normal balance as the account it is contra to. As such, since the liability account has a normal credit balance, the contra-liability account (discount) has a normal debit balance. It is increased by debits and decreased by credits.
At the time of each subsequent interest journal entry, this discount debit balance must be offset by credits, until eventually the total amount of all of those credit entries will offset the original debit balance, thus zeroing out the account. This process is known as amortization and is similar to the calculations for straight line depreciation.
In the case of the issuance at premium, note that the bonds payable amount is still the full $100,000, but the cash debit reflects the higher amount actually received ($105,000.) The extra $5,000 is recorded as a credit to a “premium” account. This account is an “adjunct-liability” account, which adds to the carrying value of the bond on the balance sheet, as shown in the illustration below. Adjunct accounts work the exact opposite way from contra accounts. They add to the original account, thus they have the exact same normal balance.
At the time of each subsequent interest journal entry, this premium credit balance must be offset by debits. This process is known as amortization and is similar to the calculations for straight line depreciation.
The premium or the discount must be amortized over the life of the bond. Depending on whether it is a premium or a discount this will either reduce or increase the amount of interest expense accrued in a given period, as compared with the amount of cash actually paid out in interest. It is important to note that both bond premiums and discounts are amortized across all periods. They impact interest expense in opposite ways though as discussed in the next section.
Note: There are many other examples in accounting where contra and adjunct accounts are used, and they all follow the same rules. These two types of accounts are often referred to as “valuation” accounts, because they help to generate a net value of an account like bonds payables.
Bond Journal Entries – Interest Expense
When a company records bond interest expense each period, they will record a credit to cash for the amount actually paid. This is the par value of the bond multiplied by the “stated” interest rate. If the bond was issued at par, then the debit to interest expense will be the same amount as the credit to cash.
If the bond was issued at a discount or premium, the interest expense will be higher or lower than the cash interest payment.
Specifically, when a company issues a bond at a discount, the cash interest payment is less than what the investor would receive from a similar bond with a market average rate. However, the company will have to report an interest expense that is higher than that cash amount, because the discount itself is similar to prepaid interest, which gets expensed across the periods.
On the other hand, when a company issues a bond at a premium, the investor will get more cash interest than the market average, but the company will report a lower interest expense across the periods. This is because they are paying the same amount of interest, but on a higher borrowed amount.
See the below example journal entries for each scenario.
In this case, the debit to interest expense is the same amount as the credit to cash.
In this case, the debit to interest expense is more than the cash interest paid. This is because we also needed a credit to the discount account (amortizing and reducing the original debit balance to that discount account.) The debit to interest expense must match the sum of the two credits to balance out.
In this case, the debit to interest expense is less than the cash interest paid. This is because we also needed a debit to the premium account (amortizing and reducing the original credit balance to that premium account.) The debit to interest expense can’t be as high, since the total debits (to interest expense or premium) cannot exceed the total credit to cash.
Excerpt from Balance Sheet
Below is an excerpt of how a discounted bond would fit into the balance sheet. The net carrying value of the bond is similar to the idea of the net book value for a fixed asset. It is the amount that the bond is technically valued at this time.
Amortization Schedules
Companies generally keep track of an amortization schedule, which shows how the discount or premium is decreasing over time. This also tracks the entry that will be needed for interest expense and cash.
In the discount example below, you can see that the ending carrying value started below the par value of the bond, but it works its way up to a higher amount over time. At the end, it should exactly equal the par value (within a rounding variance.)
In the premium example below, you can see that the ending carrying value started above the par value of the bond, but it works its way down to a lower amount over time. At the end, it should exactly equal the par value (within a rounding variance.)
There are other important concepts related to bonds that are outside of the scope of this course. This would include how to calculate the price of a bond, and how to handle situations where bonds are sold/paid off prior to maturity. In that case, you may have a gain or loss to record upon sale/liquidation of the bond.
Although these are not discussed in this text, you can see videos for them below.
See the below YouTube video for a review of the bond concepts discussed above. Some of these videos go into more depth than what we normally do for this course, but I have included them here for your information if you are interested.
Bond Terminology - https://youtu.be/DjXAg2PBC2M
Bond Initial Journal Entries - https://youtu.be/GSGR5NcTmxI
Bond Interest Expense – Straight Line - https://youtu.be/H-wCBW2vhco
Bond Interest Expense – Effective Interest Method (not discussed in the text) – https://youtu.be/n6UySnKYGn4
Bond Amortization Practice Exercise – https://youtu.be/_lk1AqXvjHU
Bond Pricing – Not Discussed in Text - https://youtu.be/fowNLWw___w
Bond Pricing Practice Exercise – https://youtu.be/QbV_i2d8x9E
Bond Retirement – Gains/Losses – Not Discussed in Text - https://youtu.be/jqf8dlHH2Ow
Wrap-Up
The main topics for this week were accounts vs. notes payables, payroll, warranties, and bonds payable. It is important to be familiar with the terminology, concepts, warranty calculations and entries, and issuance/interest expense entries for bonds payable. There are several videos that have been included in this week’s materials. Some of them are beyond the normal coverage for this course, but I have included them for anyone that may be interested in learning more about the topics.
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