First & Second Chapter Accounting is the art of measuring, summarizing and communicating the results of business operations.
Types of Businesses 1. Services Business 2. Merchandising Business 3. Manufacturer Business
Users of Accounting Information. 1. External Users e.g. Owners, Creditors, Labor unions, Governmental agencies, Suppliers, Customers, Trade associations, General public have financial interest in the business and are not involved in day to day operations of the business entity. 2. Internal Users e.g. Managers, Production supervisors, Finance directors, and Company officers, who plan, organize and run business.
Types of Accounting Information 1. Financial Accounting has 4 major parts i.e. Balance Sheet, Income Statements, Statement of Changes of equity and statement of cash accounts. It is basically about recording and classifying the transactions of the business. 2. Cost Accounting is the process of tracking, recording and analyzing costs associated with the activity of an organization, where cost is defined as 'required time or resources'. Costs are measured in units of currency. 3. Managerial Accounting is the accounting information that aids in decision making. It mostly is a mixture of accounting financial information and other factors such as politics and fashions etc.
Transactions: Any event or dealing which causes a change in the firm’s financial position and can be measured in monetary terms is called Transaction. Transactions are the inputs.
Transactions
Accounting Process
Financial Statements
Assets: All economic resources which are owned by the business and can benefit the future operations of the business are called Assets. There are two types of assets.
1. Current Assets are the assets that are converted into cash or used up within one year. E.g. Cash, marketable securities (investments), notes receivable, bill receivable, inventory (stock), prepaid expenses etc. 2. Fixed Assets are the assets which are used up or give benefit to the business for more than one year. Fixed assets are also known as plant assets, long lived assets and non current assets.
Capital: Capital is the residual claim or the right of the owner on business assets. It is obtained by the equation called Balance Sheet equation or Accounting equation. It states that: Assets -
Liabilities = Capital (Owner’s Equity) OR Assets = Liabilities + Owner’s Equity (Capital) It increases by 2 ways. 1. By additional investment of the owner. 2. By earning revenue or income. It decreases by 2 ways. 1. By withdrawal by owner. 2. By expenses or losses.
Expenses:
The cost price of the goods and services consumed in the process of earning revenue e.g. rent, salaries, supplies etc. The amount or resources paid or consumed by the business.
Revenue: Sale price of goods and the services sold to customer during a specific period is called revenue. The amount (all the) consumers paid during an accounting period. There are two conditions for the realization of revenues. 1. Good or services should have been delivered to the customer (Transaction should be completed). 2. Liability for the goods has been accepted by the customer.
In a case of services business, revenue’s name is services revenue or a name relevant to the types of services being offered (e.g. medical fees, legal free, and/or commission revenue). In a case of merchandising/manufacturer business, the revenue’s name is the same i.e. Sales revenue.
Balance Sheet: A statement which shows the financial position of the business on a particular day (at a particular time).
Account Format of Balance Sheet ABC (Company) Balance Sheet As on 31st Dec, 2004 ASSETS Cash Marketable Securities Notes Receivable Supplies Prepaid Expenses Land Building Equipment
LIABILITIES & OWNER’S EQUITY Rs. 10,000 Rs. 15,000 Rs. 20,000 Rs. 5,000 Rs. 2,000 Rs. 20,000 Rs. 30,000 Rs .5,000
Total
Rs. 112,000
Liabilities Note Payables Account Payables Salaries Payable Long term Bank Loan Subtotal
Rs. 5,000 Rs. 10,000 Rs. 5,000 Rs. 15,000 Rs. 30,000
Owner’s Equity Mr. A’s Capital
Rs. 82,000
Total
Rs. 112,000
NOTE: There are 3 orders in which account-titles are listed in the balance sheet. 1. Liquidity means nearness to cash. While making balance sheet, liquidity order is observed. 2. Permanence order is the opposite of liquidity order. Some officials use permanence order. 3. Mixed order is used by banks. Assets are listed in liquidity order and liabilities are listed in permanence order.
Income Statements: A statement which represents the results of business operations for a specific period in the form of net income or net loss. The income statements equation is All Revenues – All Expenses = Net Income/Loss
ABC (A Law Firm) Income Statement For the year ended on Dec 31st, 2004 Revenues Legal Fees (Revenue)
Rs. 50,000
Expenses Rent Expenses Salaries Expenses Supplies Expenses Utility Expenses Misc. Expenses
Rs. 10,000 Rs. 5,000 Rs. 2,000 Rs. 5,000 Rs. 3,000 Total Expenses
Rs. 25,000
Net Income
Rs. 25,000
Statement of Cash Flows: A statement which summarizes the cash collections and cash payments made during the same period as covered by the income statement (for the same accounting period). These cash flows can be categorized into 3 forms. 1. Operating Cash Flows are the cash flows associated with the revenues or expenses and increase or decrease takes places in current assets and current liabilities except for Bank loans. 2. Investing Cash Flows are the cash flows associated with the sale and purchase of fixed assets. 3. Financing Cash Flows are the cash flows associated with the financing of the business. These include acquiring or retiring bank loans (short of long term) and additional investment or drawing by the owner.
Business Name Statement of Cash Flows For the period April 1 – 6, 2004
Cash Flows from Operation Activities Cash revenue Cash Expense
5,500 (4,000) Cash from Operation Activities
1,500
Cash Flows from Investing Activities Bought Land
(66,000) Cash from Investing Activities
(66,000)
Cash Flows from Financing Activities Additional Investment by owner
80,000
Cash from Financing Activities
80,000
Net increase Beginning Cash Balance
15,500 300,000
Ending Cash Balance
315,500
Statement of Owner’s Equity: A statement which summarizes owner’s net worth. ABC (Company) Statement of Owner’s Equity For the year ended Dec 31, 2003 Beginning Capital (as on Jan 1, 2003) Add: Net Income Additional Investment
100,000 20,000 10,000 30,000
Subtotal Less:
Drawings
Ending Capital (as on Dec 31, 2003)
130,000 15,000 115,000
GAAP (Generally Accepted Accounting Principles) Cost Principle (Historic Cost Principle) All assets (especially fixed assets) are recorded in the accounting records and financial statements at their original cost less (if any) accumulative depreciation.
Business Entity Principle It states that from accounting’s point of view, business is a separate entity from its owner(s). That means business's assets; liabilities and operations are kept separate from owner’s personal assets, liabilities and operations.
Going Concern Principle A business will continue its operations indefinitely. Thus, the assets it uses to run the business are not for sale, and their market values are irrelevant to decision making.
Stable Currency Principle The value of the currency used to measure accounting transactions does not fluctuate much from period to period. If it does fluctuate, the fluctuation is ignored.
Realization Principle A business records revenues when it ships goods or completes a service; in short, when it has done everything needed to complete its part of the transaction.
Matching Principle Expenses incurred in generating revenues must be recorded in the same time period that the revenues are recorded.
Consistency Principle An organization must persistently use the same accounting procedures period after period or inform the user that a procedure has changed.
Adequate Disclosures This GAAP states that all the information that is required for proper interpretation of financial statements should accompany them while keep in view the costs for producing that information.
Concept of Materiality It means that significance of an item should be considered when it is reported in the financial statements.
Principle of Consistency It states that a business must use the same method of accounting throughout and should notify of any changes.
Order of Making of Financial Statements
Income statement Statement of owner’s equity Balance sheet Statement of cash flows
Third Chapter Ledger: A book which contains all the accounts of the business at one place. Ledger Account: An account is a record which is used to summarize the changes taking places in a particular financial statement item. I.e. any assets, liability, capital, revenue or expense item E.g. Cash, Accounts Receivables etc Account Title Dr.
Cr. Debit Side
Credit Side “T Account Version” (Simplified)
Account Title Account No. Dr. Date Particulars
J. F
Amount
Date
Particulars
J. F
Page No. Cr. Amount
“T Account Version” (Detailed)
Page No.
Account Title Date
Particulars
J.F.
Debit
Credit
Balance
Running Balance Account
Types of Accounts: There are 5 types of accounts. 1. 2. 3. 4.
Assets Accounts Liability Accounts Capital Accounts Revenue Accounts
5. Expense Accounts
Debit & Credit Rules 1. For Assets Accounts Increase in assets are recorded as Debit Decrease in assets is recorded as Credit.
2. For Liabilities Accounts Increase in liabilities are recorded as Credit Decrease in liabilities is recorded as Debit.
3. For Capital Accounts Increase in capital is recorded as Credit Decrease in capital is recorded as Debit
4. For Revenue Accounts Increase in revenue is recorded as Credit Decrease in revenue is recorded as Debit
5. For Expense Accounts Increase in expense is recorded as Debit Decrease in expense is recorded as Credit Debit
Credit
Increase in Assets Increase in Expense
Increase in Liabilities Increase in Capital Increase in Revenue
Journal: A book of original entry in which transactions are recorded in chronological order. Transactions are first recorded in the journal, showing which accounts have been debited and which have been credited. The journal is then used to update the respective ledger accounts.
Journal Format Date
Account Title and Explanation
Ledger Folio
Debit
Credit
Accounting Cycle: The sequence of recording, classifying and summarizing the business transactions is named as accounting cycle. It starts from recording the transaction in the Journal and its end product is the preparation of Financial Statements. There are 8 steps in the Accounting cycle.
1. 2. 3. 4. 5. 6.
Journalizing the transaction Posting the transaction into ledger accounts Preparation of a trial balance Making adjusting entries Preparation of adjusted trail balances Preparing financial statements (Income statement, Statement of owner’s equity, balance sheet, statement of cash flows) 7. Making Closing entries 8. Preparation of after-closing (post-closing) trial balances.
Trial Balance: A trail balance is a two column schedule prepared at the end of the period with account titles and account balances in order to check the equality of debits and credits before preparing the financial statements. For explanation of Accounting Cycle, problem 3.5 was solved. (On page number 134)
1st Step: Journalizing the Transaction. Date Account Titles L.F
Debit
June 1
60,000
June 2 June 4 June 15 June 15 June 18 June 25 June 30 June 30 June 30 June 30
Cash Pat Campbell, Capital Aircraft Cash Notes Payable Rent Expense Cash A/c Receivable Crop-Dusting Revenue Salaries Expense Cash Maintenance Expense Cash Cash A/c Receivable A/c Receivable Services Revenue Salaries Expense Cash Fuel Expense A/c Payable Pat Campbell, Drawing
Credit 60,000
220,000 40,000 180,000 2500 2500 8320 8320 5880 5880 1890 1890 4910 4910 16450 16450 6000 6000 2510 2510 2000
Cash
2000
2nd Step: Posting Into Ledger Accounts. CASH Dr.
Cr.
June 1 June 25
6,000 4910
June 2 June 4 June15 June 18 June30 June 30
64910 6640
40,000 2500 5880 1890 6000 2000 58270
3rd Step: Preparation of a Trial Balance. Campbell Crop Dusting Trail Balance
As on Dec 30, 2001 Account Titles Cash A/c Receivable Aircraft Notes Payable A/c Payable Capital Drawing Revenue Salaries Expense Fuel Expense Rent Expense Repair Expense
Dr. Balance
Cr. Balance
6,640 19,860 220,000 180,000 2510 60,000 2000 24770
TOTAL
11880 2510 2500 1890 267280
267280
Note: Liquidity Order is observed in making trail balances. Balance Sheet accounts come before Income statement accounts.
4th Step: Making Adjusting Entries.
Entries made at the end of the period in order to update certain ledger accounts are named as Adjusting Entries. Adjusting Entries are firstly recorded in the Journal and then posted to the Ledger. The purpose of making adjusting entries is to allocate, to each period, the appropriate amount of revenue and expenses.
5th Step: Adjusted Trial Balance. A trial balance which is prepared after recording and posting of the adjusting entries is called Adjusted Trial Balance. Income statement, statement of owner’s equity and balance sheet are prepared directly from the adjusted trial balance
6th Step: Preparing Financial Statements. 7th Step: Closing Entries. Entries made at the end of the accounting period to close the temporary accounts are called Closing Entries. By temporary accounts we mean accounts for revenue, expenses and drawing (or dividends in case of Corporation.) Assets, liabilities and capital accounts are permanent. There are 4 closing entries. General formats of each have been given.
1. Entries to close the revenue account(s). Date st
31 Dec
Account Title
Dr.
Revenue Account Income Summary Account6 (Profile & Loss Account)
xxx
Cr. xxx
2. Entries to close the expense accounts Date
Account Title
Dr.
31st Dec
Income Summary Account (Profile & Loss Account) Expense Account
xxx
Cr. xxx
3. Entry to close the Income Summary Account(s) 6. (i) In Case of Profit Date Account Title
Dr.
31st Dec
xxx
Income Summary Account Capital Account
xxx
(ii) In Case of Loss Date Account Title
Dr.
31st Dec
xxx
Capital Account
Cr.
Cr.
Income Summary Account
xxx
4. Entry to close the Drawing or Dividends Account(s). Date
Account Title
Dr.
31st Dec
Capital Account Drawing Account
xxx
Cr. xxx
8th Step: Post-Closing Trial Balance A trial balance prepared after the closing entries are recorded in Journal and posted to their respective ledger accounts, is called Post-Closing Trial Balance. This trial balance contains only assets, liabilities and capital accounts.
Depreciation = Expenses
[Cost of Asset – Residual Value1 (Salvage Value)] ------------------------------------------------------------Useful Life of Asset2
ADEQUATE DISCLOSURES FOR CHAPTER 3:
1. 2. 3.
If residual value is not given, then it is assumed zero.
4.
Accumulated Depreciation is a contra-asset account shown below the related asset account as a deduction from that asset account. The depreciation through-out the life of an asset is called Accumulated Depreciation.
5.
Income Summary A/c is the account in the ledger into which revenue and expense accounts are closed. Credit balance of this account means net income or profit, Debit balance means net loss. This account is later closed into the Capital account.
6.
Adequate disclosures establish that information necessary for proper interpretation of the financial statements should accompany them. E.g. accounting system used, due dates of liabilities, depreciation policy, Lawsuits pending on the business etc. Adequate disclosures are based on facts and reasonable estimates and not optimistic assumptions.
If life is given in months, then depreciation expense is also taken in per month. The double entry system of accounting is the system in which 2 entries are made for each business transaction. One for debiting certain account(s) and the other for crediting the corresponding account(s). The amount by which account(s) are debited is equal to the amount by each corresponding accounts are credited. This system makes possible the measurement of net income and also the use of error-detecting devices. (E.g. trial balance)
Fourth Chapter Adjusting Entries
Adjusting entries are made for internal adjustments. The basis of adjusting entries are two GAAP i.e. Matching principle and Realization principle. These are fundamentally based on the accrual basis of accounting. By accrual, we mean revenues or expenses that have grown or accumulated over time. Accrued revenues need to be collected whereas accrued expenses need to be paid off. Cash isn’t mostly involved in adjusting entries because adjustment is made in our accounting records only. There are four types of Adjusting Entries.
1. 2. 3. 4.
Entries to apportion the recorded cost. Entries to apportion the unearned revenues. Entries to apportion the unrecorded expenses. Entries to apportion the unrecorded revenues.
1. Entries to apportion the recorded cost There are some costs which are firstly recorded as an asset as their benefit extends beyond one accounting period. At the end of the period, it is necessary to allocate some portion of the recorded cost (which has expired) to expense. E.g. deprecation expense, supplies expense, prepaid expenses, unexpired insurance etc. For this adjustment, expense account is debited and asset or contra-asset account is credited.
Date
Account Title
Dr.
Jan 1
Depreciation Expense: Furniture Accumulated Depreciation1: Furniture Rent Expense Prepaid Rent Expense
xxx
Apr 6 (2nd exp)
Cr. xxx
xxx xxx
2. Entries to record the unrecorded expenses (Accrued expenses) There are some expenses which are still unrecorded at the end of the accounting period but the business has consumed those expenses. E.g. salaries are given at the 15th of each month but the accounting period ends on the 30th or 31st. E.g. Depreciation expense, salaries expense, Interest expense. For this adjustment, Expense account is debited and a liability account is credited.
Date
Account Title
Dr.
Cr.
Jan 1 Apr 6 (2nd exp)
Salaries Expense Salaries Payable Interest Expense Interest Payable
xxx xxx xxx xxx
3. Entries to apportion the unearned revenue Sometimes the business may collect, in advance, cash from its customers, against which goods or services are to be delivered in the future. This advance is the liability of the business named as Unearned Revenue or deferred revenue (a liability account). E.g. advance payments of airline tickets. For adjustment purposes, the unearned revenue account is debited and the revenue account is credited.
Date
Account Title
Dr.
Apr 6
Unearned Revenue Revenue
xxx
Cr. xxx
4. Entries to record the Accrued Revenue (Unrecorded Revenue) There are some revenues which the business has earned during the period but still has not billed the customers or still has not recorded it into its accounting records. E.g. interest revenue. For adjustment of this type, Account receivables are debited and the appropriate revenue account is credited .
Date
Account Title
Dr.
Apr 6
Accounts Receivables Revenue
xxx
Cr. xxx
Workshit: A spreadsheet which displays the balances on the unadjusted trial balance, proposed adjusting entries and the effects which adjusting entries will make on financial statements. OR A multicolumn schedule showing the relationships among items in trial balance, proposed adjusting entries and the financial statements that would result if those adjustments are made. It is prepared at the end of the period before adjusting entries are recorded into accounting records. It is useful for accountants as they can see the effects of adjusting entries on financial statement’s items. Thus, errors could be corrected or estimated amounts could be altered accordingly. It also enables the internal users to preview the financial statements before they are made. A worksheet also enables the preparation of interim financial statements4. The preparation of Worksheet involves 5 steps.
1. Enter the ledger account balance in the Trial Balance columns. 2. Enter the adjustments in the Adjustments Column. 3. Prepare an Adjusted Trial Balance
4. Enter balances from the Adjusted Trial balance column to their respective financial statement columns. 5. Total the financial statement columns
ABC(Business Name) Worksheet For the year ended Dec 31, 2005
Trial Balance Adjustments
Adjusted Trial Balance
Dr.
Dr.
Cr.
Dr.
Cr.
Cr.
Income Statement Dr.
Balance Sheet
Cr.
Dr.
Cr.
Balance Sheet Accounts:
Cash A/c Receivables Supplies Prepaid expenses Land Building Acc. Dep.: Building Tools Acc. Dep.: Tools Notes Payable Interest Payable Wages Payable Unearned Revenue Capital Drawing
29,250 6500 6600 2300 123000 420000
29,250 6500 6600 2300 123000 420000 6600
57000
29,250 6500 6600 2300 123000 420000 6600
6600
57000
57000
7000 24000 5200 16000 600
7000 24000 5200 16000 6000
7000 24000 5200 16000 6000
86000
86000
86000
23000
23000
23000
Income Statement Accounts:
Revenue Advertising Expense Wages Expense Supplies Expense Dep. Exp.: Building Dep. Exp: Tools Interest Expense
162960
162960
162960
3460
3460
3460
44269 3590 450
44269 3590 450
44269 3590 450
890 200 XXX
890 200 YYY
890 200 ZZZ XYY XYZ
XXX
Net Income
YYY
ZZZ
XXY
XYZ
XYX
…….. XXY XYY XYX
Layout of a Worksheet Sample Only
ADEQUATE DISCLOSURES FOR CHAPTER 4:
1. 2. 3. 4.
Accumulative depreciation is only for assets whose volume doesn’t change. They are mostly fixed assets. Prepaid expenses are our assets and Unearned Revenue is our liability. Principle x Rate of Interest x Time Period ( P x R x T) is the interest equation Interim financial statements are the financial statements an organization makes at various points during a fiscal year.
Fifth Chapter Merchandising Business
Merchandising Business: A business that is selling goods, which are purchased by the business in ready-to-sell condition, to generate revenue. The revenue in merchandising business is called Sales Revenue. Goods or inventory, bought for sale, is relatively a liquid asset that is usually sold within days or weeks. For this reason, inventory appears near the top of the balance sheet immediately below Accounts Receivables. For services and merchandising business, the supplies are the same as inventories or stock. For manufacturers business, raw material, semi-finished goods and finished goods are the stock/inventory.
MERCHANDISING BUSINESS WHOLE SELLERS RETAILERS CONSUMERS Whole sellers purchase goods in bulk from the manufacturer and sell to secondary whole sellers or distributors. Retailers purchase goods from whole sellers or distributors and sell to the final consumers.
Operating Cycle of Merchandising Business: The sequence of activities through which revenues and cash receipts are generated is called the operating cycle of merchandising business. There are 3 steps in the operating cycle of merchandising business. 1. Purchase of Inventory/Stock. 2. Selling of merchandise or inventory on account. 3. Collection of accounts receivable.
The time (in days) used to collect money is called average collection period. The length of operating cycle is specified in days. Length of operating cycle is inversely proportional to the strength of the business. The time taken to sell goods is called inventory transit time. The cost of goods sold is the largest cost in merchandising business.
NOTE: Gross profit = Sale price of goods – direct expenses such as labor salaries, transportation expenses etc. Net profit = Sale price of goods – all expense (direct or indirect) such as stationary, phone bills etc. Inventory = Stock = Goods = Merchandise; they all mean the same.
Income statement for Merchandising Business ABC (Company) Income Statement For the period ended Dec 31, 2004 Sales Cost of goods sold Gross Profit Less: Other expenses: Net Income Less:
Note:
Rs. 100,000 Rs. 60,000 Rs. 40,000 Rs. 15,000 Rs. 25,000
The Cost of Goods Sold A/c is an expense account. It is the largest cost or expense or item appearing in the income statement of a merchandising business. Gross profit is also called Gross Margin.
Subsidiary Ledger: A book or a register which contains a separate account for each item in the general ledger. For example, Inventory ledger, Customer book, Supplier register etc.
Control Account: The account in the general ledger for which a subsidiary ledger is kept is called a Control Account. Also called Controlling Account, it summarizes the total of all of its relevant subsidiary accounts. The balances of all subsidiary accounts add up to give the balance of their control account..
Subsidiary Account: A subsidiary ledger account is a separate and detailed account for each item in its control account.
Inventory Subsidiary Ledger (Inventory Ledger): An inventory ledger is a subsidiary ledger that keeps a separate account for each item or product in the inventory. It maintains the records for inventory bought, sold and the result of that change in inventory in the balance column.
Customer book: A book having the names, addresses and summaries of transactions or dealings of all the customers in one place
Supplier book: A register having the names, addresses and summaries of transactions of all the suppliers in one place.
Inventory Systems: There are two approaches for recording the merchandising transaction Periodic Inventory System
Perpetual Inventory System
Periodic Inventory System: Under this system, the inventory records are only updated at the end of the accounting period by taking a complete physical inventory. No effort is made to keep the CGS or Inventory account up-to-date. An inventory subsidiary ledger is optional under periodic inventory system. If maintained, it is kept in units only.
Purchases of merchandise are recorded by debiting the Purchases account and crediting the cash or accounts payable account.
Date
Account Titles & Descriptions Purchases Cash/Acc. Payable
Debit xxx
Credit xxx
Sale of inventory requires only one entry, the entry to recognize the sales revenue.
Date
Account Titles & Descriptions Cash/Acc. Receivables Sales Revenue
Debit xxx
Credit xxx
A physical inventory determines the amount of inventory appearing in the balance sheet. The cost of goods sold for the whole year is determined at the end of the period by the following schedule. Costs of goods sold Beginning Inventory (Year 2005) Add Purchases (During Year 2005) Cost of goods available for sale Less Ending Inventory (End of Year 2005)200 Cost of good sold (For Year 2005)
100 500 600 400
Note: The beginning inventory of Year 2005 is the ending inventory of last year (i.e. 2004. Cost of goods available for sale is the amount that was available for sale during 2000.
Closing Process: For closing process in periodic inventory system, a CGS account is created. After the creation of a CGS account, the closing is done in the same method as in Perpetual inventory system. A Cost of Goods Sold account is created by two entries. The first entry is to create the CGS account by bringing together the costs which contribute towards the CGS. The costs contributing towards the CGS are Beginning inventory and purchases which are both closed into the CGS account. The second entry adjusts its balance by debiting the Ending Inventory account and crediting the CGS account. Date Sep 28
Account Titles & Descriptions Cost of Goods Sold Inventory (Beginning)
Debit xxx
Credit xxx
Sep 28
Purchases Inventory (Ending) Cost of Goods Sold
xxx xxx xxx
Perpetual Inventory System: Under perpetual inventory system, the stock books/ledger accounts and/or inventory records are updated perpetually or continuously as the transaction occur. Under this system, inventory subsidiary ledger is also maintained.
Purchase of merchandise is recorded by debiting an asset account, called inventory (stock), and crediting Cash or A/c Payable account(s).
Date
Debit xxx
Credit xxx
The sale of merchandise requires two entries. One entry to recognize the revenue earned and the other to recognize the related cost of goods sold. This second entry also reduces the balance of inventory account to reflect the sale of some of the company’s stock.
Date
Account Titles & Descriptions Inventory Cash/Acc. Payable
Account Titles & Descriptions Cash/Acc. Receivables Sales Revenue Cost of goods sold Inventory
Debit xxx
Credit xxx
xxx xxx
The entry for collection of accounts receivables is as follows. Cash is debited whereas accounts receivables is credited.
Date
Account Titles & Descriptions Cash Accounts Receivable
Debit xxx
Credit xxx
Layout of Inventory Subsidiary Ledger Item: 21” TV’s Description: LG Flatron Location: Store room #5 Date
(A.K.A Order Point)
Purchased Unit
Unit Cost
Supplier: Farooq Electronics Max Level: 500 Min Level: 20
Sold Total Cost
Unit
Unit Cost
Balance Total Cost
Unit
Unit Cost
Total Cost
Jan 1
50
100
5000
Jan 2
10
Control Account for Inventory Dr. Inventory 5000
100
1000
50
100
5000
40
100
4000
Cr. 1000
Journal Entry Date
Account Titles & Descriptions
Jan 1
Inventory Cash (A/c Payable) Cash Sales Revenue
Purchase
Jan 12 Sale entry 1
Debit
Credit
5000 5000 1500 1500
(This new price includes our profit)
Jan 12 Sale entry 2
Cost of goods sold Inventory
1000 1000
(This is the price on which we bought the stock)
Taking Physical Inventory: When physical inventory is taken, management uses the inventory ledger to determine on a product-by-product basis whether inventory on hand corresponds to the amount indicated in inventory ledger. The lessening of inventory on hand is called Inventory Shrinkage. It refers to unrecorded decreases in inventory resulting from factors such as breakage, spoilage, theft or shoplifting. The process of taking physical inventory is done usually once a year near the year-end. After taking physical count, the per unit costs in inventory ledger determine the balance of Inventory Account. The Inventory account is then adjusted in accordance with Inventory Shrinkage. The adjusting entry to record shrinkage of inventory is as follows:
Date
Account Titles & Descriptions
Apr 6
Cost of Goods Sold Inventory
Debit
Credit
xxx xxx
(To adjust perpetual inventory records to reflect inventory shrinkage)
If a large amount of inventory shrinkage occurs through events such as fire or earthquake or theft, the cost of missing or damaged goods can be debited to a Special Loss A/c. In the income statement, a loss is deducted from the revenue in the same manner as an expense.
Special Journal: An accounting record designed to keep record of specified types of routine transactions quickly and efficiently.
Sales Return & Allowances: The journal entry for returned goods is the opposite of the entry for selling merchandise. The first entry if goods are returned or an allowance is given is as follows.
Date
Account Titles & Descriptions
Apr 6
Sales Return & Allowances* Acc. Receivables/Cash
Debit
Credit
xxx* xxx
*Sales Return & Allowances is a contra-revenue account. It is deducted from gross sales when determining net sales.
The second entry, only if goods are returned, is as follows.
Date
Account Titles & Descriptions
Apr 6
Inventory Cost of Goods sold
Debit
Credit
xxx xxx
Sales Discounts: If goods are sold on credit, an incentive given by the manufacturers for the customer to encourage an early payment is called a Discount. The term n/30 means that full(net) payment is due in 30 days. 10eom means within 10 days after the end of this month. 2/10 n/30 means a 2% discount is available if payment is made within 10 days but full payment is due in 30 days. It is read as 2, 10 net 30. The period for which a discount is available is called the Discount period. For buyers, the cash discount is called Purchase discount and sellers refer it as Sales Discount. Initially, the seller records the sale and the related account receivables at the invoiced price. If payment is made after the discount period, no extra entries are required. However, if the payment is made within the discount period, the following entry is made.
Date
Account Titles & Descriptions
Apr 6
Cash Sales Discount* Accounts Receivables
Debit
Credit
xxx xxx xxx
*Sales Discount is a Contra-Revenue Account. Contra asset accounts are deducted from Revenue for computing net sales and have debit balances.
Sales Taxes: Sales tax is only applicable on the price offered to the final consumer. It is not applicable on the transactions between manufacturer and whole-seller or distributor. Sales tax is collected from the consumer himself and given to the government by the selling organization. The entry for sales tax may be recorded at the sale of merchandise for which the entry is as specified.
Date
Account Titles & Descriptions
Apr 6
Cash/Acc. Receivables Sales Sales Tax Payable
ADEQUATE DISCLOSURES FOR CHAPTER 5:
Debit
Credit
xxx xxx xxx
1. 2. 3. 4.
Cost of an asset includes all expenses to bring it into use. E.g. transportation expenses, licensing fee. Contra-Revenue A/c are closed into P&L account in the same manner as expense accounts. If the seller pays for Delivery expenses, the cost is debited to a Delivery Expenses account. Gross profit margin or gross profit ratio or gross profit rate is ratio of gross profit to net sales.
Seventh Chapter Financial Assets
Financial Assets: Financial assets mean cash or highly liquid assets that can be converted into a know amount of cash. There are three types of financial assets. 1. Cash 2. Short Term Investments or Marketable Securities 3. Receivables The value of cash is its face amount. The value of Marketable Securities may change daily based upon different factors such as interest rates, stock prices etc. That is the reason why Short Term Investments appear in the balance sheet at their current market value. Accounts Receivables are stated at the amount which is expected to be received. Thus, Accounts Receivables are recorded at their Net Realizable Value.
Cash: It is defined as the money on deposit in the bank and any items that banks will accept for deposit including coin, paper money, cheques, money orders and travelers cheques. Cash is listed on the top of all assets because it is the most liquid. The Cash account is usually combined with cash equivalents and listed as Cash & Cash Equivalents. Cash Equivalents include some short-term investments e.g. money market funds, treasury bills. To qualify for a Cash Equivalent, an investment must be very safe, have a stable market value and mature within 90 days from the date of acquisition. Restricted Cash is the cash that is not available for paying current liabilities thus is not a current asset. It is written directly after current assets as Investments & Funds. Line of Credit is an agreement of the organization with its bank that the bank will let the business lend any amount of money up to a specified limit. Money can be drawn using cheques . Liability arises as soon as a portion of credit line is used. The unused Line of Credit is not an Asset. It just increases a business’s solvency and is revealed in Adequate Disclosures. Bank Reconciliation is a schedule explaining differences between the balance shown on bank statement and the balance shown in customer’s accounting records. The need for reconciliation arises usually when both the accounting records are not updated evenly or because of outstanding cheques or due to deposits in transit. Conflicts may also arise when the customer has not yet recorded the services charges that the bank has deducted from the account. Petty Cash is the small amount of cash a business keeps at hand for miscellaneous expenses.
Marketable Securities/Short-Term Investments: A company having extra cash can invest its reserves temporarily so that it generates revenue in the form of interest or dividend. Marketable Securities mostly consist of investments in bonds and in stocks of publicly owned corporations. Stocks are traded on daily basis in Stock Exchanges. Short-Term Investments are highly liquid i.e. they can be sold immediately for cash at their quoted price. Short term investments in marketable securities appear in the balance sheet at their current market value as on the date of the balance sheet. There are three types of marketable securities. Available for sale securities, trading securities and held to maturity securities. This classification is based upon manager’s intent. The value of marketable securities are adjusted to their market value on the balance-sheet-date. This principle is called Mark to Market. The profit or loss due to adjustment of Mark to Market principle is settled in an account called Unrealized Holding Gain or Unrealized Holding Loss. This account appears as a special equity account in the balance sheet.
Accounts Receivable: Accounts Receivable are relatively liquid assets that are converted into cash within a period of 30 – 60 days depending on the company’s policies. Therefore, accounts receivable appear in the balance sheet directly after cash and marketable securities. Accounts receivable that require more than one year to be fully collected are also listed as current assets.6 Accounts receivables are listed in the balance sheet at their Net Realizable Value i.e. the receivables that are expected to be recovered. A part of accounts receivable that has become doubtful is no longer an asset. The amount of accounts receivables termed uncollectible are debited to an expense account called Uncollectible Accounts Expense. The entry when a portion of accounts receivable becomes doubtful is as follows:
Date
Account Titles & Descriptions
Apr 6
Uncollectible Accounts Exp. Allowance for doubtful accounts
Debit
Credit
xxx xxx
The Allowance for Doubtful Accounts appears in the balance sheet as a deduction from the face amount of Accounts Receivables. It reduces the Accounts Receivables to their net realizable value. The Allowance for Doubtful Accounts is a contra asset account. It has a credit balance which is offset against the Accounts Receivables in the balance sheet. The estimate of uncollectible accounts is made before preparation of financial statements. It depends upon professional judgment and circumstances like political, social, economic conditions. Writing Off of Uncollectible Accounts is done when we are sure that the amount will not be received. It is done by the following journal entry.
Date
Account Titles & Descriptions
Apr 6
Allowance for doubtful accounts Accounts Receivables
Debit
Credit
xxx xxx
In this second entry, the balance reduced from Accounts Receivables is the same as balance reduced from Allowance for Doubtful Accounts account.
Writing off of debit consists of two different entries. The first is done when the debit becomes doubtful and the second is done when we are sure that receivables wouldn’t be recovered.
Accounts Receivables that were previously written off could be recovered. The journal entry for recoveries of bad debt is as follows.
Date
Account Titles & Descriptions
Apr 6
Accounts Receivables Allowance for doubtful accounts
Debit
Credit
xxx xxx
A separate entry is required to debit cash and credit A/c receivables. Different methods are used for estimating credit loses.
1. Balance Sheet Approach: Estimates of bad debts are predictable based on aging the account receivables. An aging schedule is prepared in this method. It is useful for the management in reviewing credit-worthiness. Based on professional judgment, management estimate the percentage of credit losses likely to occur in each age group. This percentage when applied gives the estimated amount of uncollectible accounts. 2. Income Statement Approach: Based on experience, a certain percentage of credit sales for an accounting period is considered to be uncollectible. Direct Write Off is a fast and simple method of writing off uncollectible accounts. No estimates are made whatsoever. When an account is sure to be uncollectible. It is written off by debiting Uncollectible Accounts Expense and crediting Accounts Receivables. Accounts Receivables Turnover Rate tells us how many times the company’s average investment in receivables was converted into cash during the year. The ratio is computed by dividing annual net sales by average accounts receivables. The higher the turnover rate, the more liquid the company’s receivables. Another method of judging a company’s solvency is to convert the accounts receivable turn over rate to the number of days required to collect account receivables. It is found by 365 days divided by turnover rate. ADEQUATE DISCLOSURES FOR CHAPTER 7:
1. 2. 3. 4. 5. 6. 7.
Cash is recorded at its face amount, marketable securities at their market value and A/c Receivables at Net Realizable value. Cash is usually a control account. Cash Ledger may contain accounts for different bank accounts. Transactions involving bank cards are not credit sales but cash sales. Transfer of money between bank accounts does not appear in Statement of Cash Flows as the amount of money remains constant. The valuation of Marketable Securities are exempt from Cost Principle. The period used to define current assets is one year or the company’s operating cycle, whichever is longer. The normal period of time required to convert cash into inventory, inventory to a/c receivables and a/c receivables back into cash is called the Operating Cycle.
Depreciation is recorded in Income Statement and Accumulated Depreciation is recorded in Balance Sheet.
