Section 3.) Prepaid Expenses/Assets
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
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