Tender Coconut

The following month when the customer picks up the computer and pays for it, the company will record the receipt of payment as follows.

Date	Account	Debit	Credit
Mar-31	Accounts Receivable	$200
	Computer Repair Revenue		$200
	To accrue revenue from repairs made during the month.

Date	Account	Debit	Credit
Apr-15	Cash	$200
	Accounts Receivable		$200
	To record receipt of payments on account.

This is a generalized example of a journal entry. Many companies use an accounts receivable subsidiary ledger to keep track of each individual customer.

Example - Accrued Expense (accounts payable)

ComputerRx installs computer networks. They often hire an independent contractor to run cables for the network. They are billed twice a month at a rate of $1.50 per foot of installed cable, including parts and labor. At the end of the month they estimate the contractor installed 500 feet of cable that they had not been billed for.

The company should record an accounts payable for $750 ($1.50 x 500 ft).

The following month when the company pays the installer, they will record the payment, as follows.

Date	Account	Debit	Credit
Mar-31	Installation Expense	$750
	Accounts Payable		$750
	To accrue installation expense at end of month.

Date	Account	Debit	Credit
Apr-10	Accounts Payable	$750
	Cash		$750
	To record payment on account.

Note, in both examples above, the revenue or expense is recorded only once, and in the correct month. The second journal entry reflects the receipt or payment of cash to clear the account receivable or payable.

Deferrals

- money has changed hands, but conditions are not yet satisfied to record a revenue or expense.

Prepaid Expenses - insurance, rent, advertising paid in advance but the expense shows up on future income statements.

Unearned Revenue - subscriptions, maintenance contracts paid in advance but the revenue shows up on future income statements.

These are recorded before financial statements are prepared, so the statements reflect all revenue earned, and expenses incurred. Let's look at a time line and see how it works.

Deferrals are often referred to as allocations. Costs are spread over a number of months using a reasonable method of allocation. In the example below, we use the straight line method - an equal amount is allocated to each month. Other reasonable methods can be used as well.

Example - Deferred Expense

The company has an option of paying its insurance policy once per year, twice a year (2 installments) or monthly (12 installments). They decide to pay it twice a year, in January and July. To get a proper matching of expense to the period we spread each 6-month payment equally over the period the insurance policy covers. The effect of this is to 1) match the appropriate expense with the month it relates to, and 2) eliminate

Month>	Jan	Feb	Mar	Apr	May	Jun	total
$ spent>	$600	$0	$0	$0	$0	$0	$600
Expense taken	$100	$100	$100	$100	$100	$100	$600

Money is spent only once each 6 months, but the expense is allocated to each month by enter an adjusting journal entry in the books. Here's how the first journal entry would look.

And the entry to record January insurance expense at the end of the month.

Date	Account	Debit	Credit
Jan-2	Prepaid Insurance	$600
	Cash		$600
	To record payment of 6 months insurance policy

Date	Account	Debit	Credit
Jan-31	Insurance Expense	$100
	Prepaid Insurance		$100
	To record one month insurance policy

And finally, the Ledger accounts.

General Ledger

Prepaid Insurance

Date	Description	Debit	Credit	Balance
Jan-2		$600		$600
Jan-31			$100	$500

Prepaid Insurance declines each month as the expense is transferred from the Balance Sheet to the Income Statement.

Insurance Expense

Date	Description	Debit	Credit	Balance
Jan-31		$100		$100

Example - Deferred Revenue

American Artist sells subscriptions to their magazine, published 12 times a year. A subscription costs $36 per year. People can subscribe at any time during the year. They record unearned subscription revenue when payment is received for a subscription.

Each month, as issues of the magazine are mailed, the company recognizes subscription revenue. How do they calculate their total subscription revenue? Each subscription earns them $3 per month ($36/12 issues). Last month they mailed out 3000 copies of the magazine. They will recognize $9,000 in subscription revenue
($3 x 3000 copies).

Date	Account	Debit	Credit
Apr-2	Cash	$36
	Unearned Subscription revenue		$36
	To record 1 year subscription received

In both examples above, the company is transferring a deferred cost or revenue from the balance sheet to the income statement. We call this articulation.

Date	Account	Debit	Credit
Apr-30	Unearned Subscription revenue	$9,000
	Subscription revenue		$9,000
	To record 1 year subscription received

Depreciation

Depreciation is an exaple of a deferred expense. In this case the cost is deferred over a number of years, rather than a number of months, as in the insurance example above.

In 2000 the company buys a delivery truck for 12,000. They expect the truck to last 5 years. They decide to use the straight line method, with a salvage value (SV) of $2,000. The depreciable value is $10,000 ($12,000 cost - $2,000 SV). The annual depreciation expense is $2,000 ($10,000/ 5 years).

Year>	2001	2002	2003	2004	2005	total
$ spent>	$12,000	$0	$0	$0	$0	$12,000
Expense taken	$2,000	$2,000	$2,000	$2,000	$2,000	$10,000
Salvage Value						$2,000

At the end of 5 years, the company has expensed $10,000 of the total cost. The $2,000 salvage value remains on the books.

The straight line method is only one method used to calculate depreciation. The subject will be covered more in Chapter 9.

Date	Account	Debit	Credit
Jan-2	Delivery Trucks	$12,000
	Cash		$12,000
	To record purchase of delivery truck

Dec-31	Depreciation Expense	$2,000
	Accumulated Depreciation		$2,000
	To record depreciation expense for the year

General Ledger

Delivery Trucks

Date	Description	Debit	Credit	Balance
2001	To record purchase of truck	$12,000		$12,000

Accumulated Depreciation

Date	Description	Debit	Credit	Balance
2001	To record annual depreciation		$2,000	$2,000
2002	To record annual depreciation		$2,000	$4,000
2003	To record annual depreciation		$2,000	$6,000
2004	To record annual depreciation		$2,000	$8,000
2005	To record annual depreciation		$2,000	$10,000

Book Value & Salvage Value

Book value is the difference between the cost of an asset, and the related accumulated depreciation for that asset.

Book Value = Cost - Accumulated Depreciation

Book Value = ($12,000 - $10,000) = $2,000

The company will stop depreciating the truck after the end of the fifth year. The truck cost $12,000, but only $10,000 in depreciation expense was taken. The remaining book value is equivalent to the salvage value established when the vehicle was purchased. Book value will be used to calculate any gain or loss when the truck is sold or traded (Chapter 9).

Adjusting Journal Entries

All companies must make adjusting entries at the end of a year, before preparing their annual financial statements. Some companies make adjusting entries monthly, to prepare monthly financial statements.

Adjusting entries fall outside the routine daily journal entries and activities of special departments, such as purchasing, sales and payroll. Accountants make adjusting and reversing journal entries in a way that does not interfere with the efficient daily operations of these essential departments.

Adjusting entries should not be confused with correcting entries, which are used to correct an error. That should be done separately from adjusting entries, so there is no confusion between the two, and a clear audit trail will be left behind in the books and records documenting the corrections.

In practice, accountants may find errors while preparing adjusting entries. To save time they will write the journal entries at the same time, but students should be clearly aware of the difference between the two, and the need to keep them separate in our minds.

Adjusting entries don't involve the Cash account. Any adjustments to Cash should be made in with the bank reconciliation (Chapter 7), or as a correcting entry.

Adjusting entries involve a balance sheet account and an income statement account. Here are some common pairs of accounts and when you would use them.

Income Statement Account	Balance Sheet Account	Adjustment to be made
Sales Revenue (cr)	Accounts Receivable (dr)	Accrue unrecorded sales
Earned Revenue (cr)	Unearned Revenue (dr)	Recognize earned revenue
Depreciation Expense (dr)	Accumulated Depreciation (cr)	Recognize depreciation expense
Insurance Expense (dr)	Prepaid Insurance (cr)	Apportion prepaid expense
Interest Expense (dr)	Interest Payable (cr)	Accrue interest expense
Supplies Expense (dr or cr)	Supplies (dr to increase, or cr to decrease account)	Recognize supplies used as an expense, and/or adjust Supplies account
Cost of Goods Sold (dr or (cr, as needed to offset Inventory adjustment)	Inventory (dr to increase, cr to decrease balance)	Adjust Inventory account to match year-end physical count

Legend: dr = debit; cr = credit; these are general rules of thumb. In all adjustments you should make the entry that is needed.

Notice most examples follow general rules: Revenues are credited, Expenses are debited, receivables are debited, payables are credited.

The Supplies or Inventory accounts need to be adjusted to reflect the physical amount of inventory or supplies at the end of the year. With Supplies we will count the physical items, for instance: 3 boxes of paper, 4 dozen pens, etc. and calculate a total value for supplies on hand, based on what we paid for the items originally. The Supplies account will be increased or decreased, as needed, to bring it to the correct balance.

Correcting entries

A correcting entry should be entered whenever an error is found. If errors are found at the end of the year, while preparing financial statements, accountants usually go ahead and correct the error at that time. There are various reasons a correction might be needed. A wrong account or dollar amount might have been entered. The entry could have used a debit, when a credit should have been entered.

Errors will carry through to the financial statements, so it is important to detect and correct them. The type of error should be noted, and brought to management's attention, if the accountant feels the error might be intentional. Intentional errors are called "falsifications" and are an indication there might be fraud.

Reclassifications

A reclassification is a correction entry used to correct a mis-classification or to change the classification of an entry. This might be necessary if an entry is made without complete information. For instance, the company might purchase a building and land for a single price. The two assets need to be entered separately. The company may have to wait for an appraisal, and will make a journal entry to record the purchase, then reclassify a portion of the purchase price to allocate the correct values to the land and building.

Reversing entries

A reversing entry is a very special type of adjusting entry. They can be extremely useful and should be used where necessary. A reversing entry comes in two parts: the original adjusting entry, and the reverse, or opposite entry. The second entry is written by simply reversing the position of all debits and credits. Ultimately, the end result on the books is zero, but the adjusting entry serves to correctly allocate an expense, so the financial statements are correct.

Let's look at an example. X Company has a payroll department, and cuts checks every two weeks after tabulating hours, and calculating net pay. A large number of allocations have to be made to various withholding accounts. The accountants don't want to interfere with the operations of the payroll department. And the employees also want the department to run efficiently so they can get their pay checks on time.

At the end of the year the accountants need to appropriately allocate payroll expenses, plus taxes due and payable. Rather than interfere with the payroll department the calculation is made on paper (or computer), and entered as an adjusting entry. It is marked to be reversed. After the closing entries are made, the first entries of the new year are the reversing entries. They undo the effects of the adjusting entry.

If the adjusting entry is not reversed, the books will not be correct. Both the accountants and payroll department will be making entries related to payroll. The reversing entry effectively allows the accountants to make adjusting entries without causing the books to be incorrect; the payroll department continues to make routine entries, and doesn't need to make any special entries or allocations.

Until you actually work with reversing entries they seem strange. Here's how the numbers play out. Let's look at a really simple example.

X Company's payroll expense is $1,500 per week; they pay salaries every two weeks. Assume that December 31 falls at the end of the week, and in the middle of the pay period. The payroll expense for the two week period needs to be split between two years, with $1,500 in year 1 and $1,500 in year 2.

Total for 2 week payroll = $3000

This is how the expense should be allocated:

Dec 31

Last week of year 1	First week of year 2
$1500	$1500

This is the journal entry the payroll department will make

Dec 31

Last week of year 1	First week of year 2
$0	$3000

At the end of the first week in January the payroll department will make its journal entry to record the two week payroll. But that journal entry will be for $3000, and not $1500 as it should be. Two things need to happen: 1) $1500 needs to be accrued in the year 1 financial statements; 2) the first week of year 2 needs to be adjusted, because it will record too much payroll expense.

If this adjusting entry is made, the year 1 payroll expense will be correct:

Adjusting Entry

Date	Account	Debit	Credit
Dec-31	Payroll Expense	$1500
	Accrued Payroll Expense		$1500
	To record payroll for last week of the year

Reversing Entry

Date	Account	Debit	Credit
Jan-1	Accrued Payroll Expense	$1500
	Payroll Expense		$1500
	To reverse payroll accrual

After the books are closed for the year the reversing entry is made, dated the first day of the new year. The Payroll Expense account carries a credit balance, which is not the normal balance for an expense account, and would normally indicate an error in posting or classifying the transaction. But for a reversing entry this is correct.

General Ledger

Payroll Expense

Date	Description	Debit	Credit	Balance
Jan-1	Reversing entry		$1500	($1500)
Jan-7	2-week payroll expense	$3000		$1500

After the payroll department post the 2-week payroll the Payroll Expense account will be correct. The balance is a debit of $1500, which is exactly what the Payroll Expense account should have for one week's payroll. If the reversing entry had not been made, the Payroll Expense account would need to be adjusted, because it would be overstated by $1500.

Chapter 5

Reporting Financial Results

The Accounting Cycle

The Trial Balance

Articulation in Financial Statements

Closing the books at the end of the year

Chapter 5 brings together what you have learned in the previous chapters. In this chapter we review the overall accounting process and accounting cycle. The weekly exam is replaced with a midterm exam covering the first 4 week's material.

Preparing Financial Statements

The ultimate purpose of the accounting process is to prepare financial statements. Everything else, all the routine journal entries & posting, corrections and adjusting entries finally culminate in an organized set of information that follows a set of rules known as GAAP.

GAAP gives us guidance as to what should be included in the financial statements, and how things should be reported and disclosed. The financial statements must include three specific reports, and notes that describe and disclose certain additional information.

The required elements of financial statements:
The Income Statement
The Balance Sheet
The Statement of Cash Flows
Notes to the Financial Statements

Optional (but recommended) financial statements:
The Statement of Retained Earnings
The Statement of Stockholders' Equity
[Only one optional statement will be included in a set of financial statements]

Although GAAP gives us guidance, it also allows for a considerable amount of flexibility in presenting financial information. The Notes must accompany the other financial information, and includes disclosure about accounting principles, lawsuits, lease obligations, concentrations of receivables, and other information the FASB considers necessary for adequate disclosure of important information.

The Accounting Cycle revisited

1) Capture and Record business transactions,
2) Classify transactions into appropriate Accounts,
3) Post transactions to their individual Ledger Accounts,
4) Summarize and Report the balances of Ledger Accounts in financial statements.
5) Post adjusting and closing journal entries.
6) Prepare a post-closing trial balance

Page 191 of your text has a good illustration of the accounting cycle.

The Trial Balance (TB)

The Trial Balance is a list of the balance in all accounts. The balances are separated into debit and credit columns, and the columns are totaled (footed) to be sure the financial system is in balance. Just because the system is in balance doesn't mean everything is correct, or that financial statements can be prepared. First we must make any necessary adjusting entries to bring our books into alignment with GAAP.

The Trial Balance Worksheet

The TB Worksheet provides accountants with a tool to organize the process of preparing adjusting entries and financial statements. A completed worksheet is presented on p. 192 of your text. It lets us organize the entire set of books on one or two pages of paper, so we can easily see all the balances and calculate the net profit for the year.

After completing the TB Worksheet, all that is left to do is transfer the information from the Income Statement and Balance Sheet columns to their respective financial statements, in the correct format. The worksheet greatly simplifies the process of preparing financial statements. It is also used by auditors when conducting an examination or review of a company's books.

Articulation and Preparing the Financial Statements

The textbook shows how information flows back and forth between the Income Statement and Balance Sheet. This is called articulation. There are some very important articulations to watch when preparing financial statements. The financial statements should be prepared in the correct order, so the information articulates (flows) correctly.

The Income Statement should be prepared first. Net Income or Net Loss flows to the Statement of Retained Earnings (or Statement of Stockholders' Equity). The ending balance of Retained Earnings flows to the Stockholder's Equity section of the Balance Sheet.

How information articulates between financial statements

Income Statement	Retained Earnings Stmt	Balance Sheet
Net Income or Loss ==>	Retained Earnings ===>	Stockholders' Equity

Because of articulation, financial statements must be prepared in this order.

Closing the books at the end of the year

At the end of each year, the books are closed. What this means is that certain account balances are reset to zero, in preparation of a new year. Since the Income Statement reports information on a yearly basis, the income statement accounts are the ones that will be closed.

Have you ever seen an automobile odometer that had a trip odometer, with a button you can push to set the trip odometer to zero? When you want to measure your mileage you can press the button, reset the odometer to zero, then drive to your destination. The trip odometer will tell you how far you've driven. Then you can reset it again for the next trip.

Closing the accounts is very similar. We close the income statement accounts so we can start counting again for a new year. These accounts are all the revenue and expense accounts, and they make up the total we call Net Income.

How to close an account
You close an account by looking at its balance, then entering a journal entry that is the exact opposite of its account balance. For instance, if an account has a $1000 debit balance, we would enter a $1000 credit to bring the account to zero.

General Ledger

Insurance Expense

Date	Description	Debit	Credit	Balance
Dec-31	year end balance			$1000
Dec-31	year end closing entry		$1000	$0

Here we see the Insurance Expense ledger account. It has a debit balance of $1000. The closing entry credits the account, and brings the balance to zero. The account is now ready to begin entering transactions for the new year.

We will close all revenue and expense accounts. We will leave all balance sheet accounts alone, except for the dividend accounts, which closes directly to Retained Earnings.

The Income Summary Account
Income Summary is an account used for a single purpose to close the books at the end of the year. All income statement accounts are closed to the Income Summary account.

All revenues accounts are debited, and the Income Summary account is credited for the total of the debits. Then all expense accounts are credited, and the Income Summary account is debited for the total of all credits. At this point all revenue and expense accounts have a zero balance. The balance in Income Summary is equal to the Net Income or Net Loss for the year.

Finally the Income Summary account has to be closed. We make the entry necessary to bring that account to zero, and post the opposite side of the entry to the Retained Earnings account. The last entry is to close all dividend accounts to Retained Earnings. And we are done for the year.

We usually prepare a Post-Closing Trial Balance to make sure all revenue and expense accounts were closed out to zero, and none remain with a balance. We also check to see that all the account balances are correct, and match with the TB Worksheet and financial statements we have just prepared. If all is well, we are done for the year, and can begin entering transactions for the new year.

At this point I usually tell my students about life as an accountant. Since many companies close their books on December 31, all accountants have to stay and work late on New Year's Eve, and make sure all the adjusting and closing entries have been made so business can start up on January 1. And if you believe that story I have a bridge located right on the Mississippi river I'd like to sell you.

Actually, most accountants like to take New Year's Eve off, and they are usually sleeping in late on January 1 as well. In the real world, financial statements are prepared after the close of the year, often several months later. It is a time consuming process, and many things need to be done before financial statements can be prepared.

Inventories must be counted and valued. Missing information has to be found. Depreciation and various other accruals and deferrals must be calculated. Companies with many branches, or those that do business on a global scale, must gather up the information from all parts of their company, before financial statements can be prepared. So don't worry, you won't have to work late on New Year's Eve if you become an accountant. Now, tax season.... well, that's another story. And we'll save it for another day.

The textbook gives some good illustrations that show the basic mechanics of the closing process, and the final outcome. All that's left to do is analyze the financial information, and see what kind of year the company had.

Your text shows a few financial ratios on p. 189. Most chapters from now on will show some financial ratios, that relate to the specific chapter topics. Chapter 14 of the text recaps all the financial ratios presented in the text. you can see them all on pp 628-29.

These ratios are used by investors and financial analysts on a daily basis. These are nothing new, and are not difficult to use. All you have to do is carefully follow the instructions and formula. Financial ratios can help you understand how your business is doing from year to year, and can also help you compare one business to another.

Financial statements have these elements:

A proper heading, consisting of
The body of the statement presenting financial information, in correct format.
Totals and subtotals, specific to each financial statement.
Articulation of balances and totals between statements.
Notes disclosing additional information according to GAAP

Chapter 6

Merchandising Activities

Accounts Used

Physical Inventory

Adjusting the Inventory Account

Inventory Shrinkage

Special Sales and Purchase Accounts

Freight In vs Delivery Expense

Chapter 6

Merchandising means selling products to retail customers. Merchandisers, also called retailers, buy products from wholesalers and manufacturers, add a markup or gross profit amount, and sell the products to consumers at a higher price than what they paid. When you go to the mall, all the stores there are retailers, and you are a retail customer.

Retailers deal with an inventory: all the goods (products) they have for sale. They account for inventory purchases and sales in one of two ways: Periodic and Perpetual. As the names suggest these methods refer to how often the inventory account balances are updated.

In a Periodic system, inventory account balances are updated once a year (some companies may do it more often, but all must do so at least once per year).

In a Perpetual system, inventory account balances are updated after each sale. This type of system is much more complex. Scanning cash registers, bar coded merchandise, and similar devices are used to update the inventory records after each sale. Obviously, this type of system is very expensive, but it gives managers a high degree of control over inventory, helps purchasing agents order replacement merchandise in time, detects and deters theft and helps identify other problems relating to inventory.

The main differences between the two relate to the journal entries used to record purchases and sales. The system a company chooses should be cost effective and provide the desired levels of inventory management. Special journals are often used to record sale and purchase transactions.

Accounts Used

You can usually tell whether a company is using the Periodic or Perpetual system by the accounts they use to record inventory purchases. Here's a chart that shows the differences:
[COGS = Cost of Goods Sold]

Method >>>	Periodic	Perpetual
Account used to record inventory purchases:	Purchases	Inventory
Appears on:	Income Statement	Balance Sheet
When a sale is made:	No adjustment to inventory is necessary; merchandise cost is already on the Income Statement	Merchandise cost is transferred from Inventory to Cost of Goods Sold -an Income Statement account
Year-end procedures:	Adjust Inventory balance to agree with year-end physical count and merchandise value	Adjust Inventory balance to agree with year-end physical count and merchandise value
Other procedures:	Transfer Purchases balance to Cost of Goods Sold	Balances should now be correct

Physical Inventory

The "physical inventory" simply means the actual, real, tangible, touchable stuff the company has for resale. In the case of a manufacturing company, the physical inventory includes raw materials, the value of goods in the process of production, and the value of finished goods (Chapter 16).

Taking a physical inventory means counting the number of units of stuff you have for sale. This is usually done at the end of the year, so the balance sheet Inventory amount accurately reflects the true value of the ending physical inventory.

If you run a grocery store, you would count all the cans, packages and containers of food, and everything else you have available for sale. You would then have to assign a value to everything: it's cost to you when you bought each item. A small piece of your inventory records might look something like the one below.

Quantity is the number of units on the shelf, and also in boxes in storage; this is the amount we counted in taking the physical inventory. Unit Cost is what was paid for each unit of product. The extension column is the total cost of each item.

Item	Quantity	Unit Cost	Extension
soup, tomato, can, 8 oz	65	.24	15.60
soup, chicken noodle, can, 8 oz	79	.21	16.59
soup, cream of mushroom, can, 8 oz	53	.16	8.48

Once all items are counted, priced and extended, the total cost is the ending value for Inventory.

Adjusting the Inventory Account

The Inventory account usually does not agree with the physical count. If the Periodic method is being used, the Inventory account has the balance as adjusted at the end of the prior year. If the Perpetual method is being used, the Inventory account should be close to the physical value calculated from the physical inventory count. There will always be a difference, and the accounts must be adjusted so the Inventory account agrees with the physical count and valuation. You will study valuation methods more in Chapter 8.

The Inventory account is adjusted to agree with the physical count and valuation. Let's look at an example of how the adjustment is made. The Inventory account has a balance of $12,500. You take a physical count and calculate the correct inventory value is $11,975. You will decrease inventory by $525 to adjust the Inventory account the equal the actual physical inventory value.

General Ledger

Inventory

[a Balance Sheet account]

Date	Account	Debit	Credit
Dec-31	Cost of Goods Sold	$525
	Inventory		$525
	To adjust Inventory to year-end physical count and valuation

Date	Description	Debit	Credit	Balance
Jan-1	Beginning balance forward	12,500		12,500
Dec-31	Year-end adjustment		525	11,975

Cost of Goods Sold

[an Income Statement account]

Date	Description	Debit	Credit	Balance
Dec-31	Balance			100,000
Dec-31	Year-end Inventory adjustment	525		100,525

The adjusting entry correctly uses an Income Statement account and a Balance Sheet account. The additional merchandise cost is transferred to the Income Statement in this case, but the reverse adjustment could just as easily be made.

Inventory Shrinkage

If you throw a good wool sweater in a washing machine full of hot water, what will happen? You ladies already know the answer to that question. If you're a guy you may need to ask you wife, girlfriend, sister, or mother. Go ahead.... we'll wait.......

OK, now that you know the sweater will shrink, or get smaller. Guys, if you do this to your wife's favorite cashmere sweater we'll be forwarding your mail to the doghouse for the next month or so.

Well, inventory also shrinks. But not because we washed it in hot water. In fact inventory shrinkage occurs for a number of reasons, and it is just as it sound - inventory gets smaller. But how should this happen? Things happen to merchandise while the store has it available for sale. Here are some of the things:

Theft - by employees or customers
Spoilage - milk, meat, vegetables, past the expiration date
Obsolescence - computers, software, clothing (last year's styles)
Display - merchandise put on display often can't be sold later or must be discounted
Grazing - customers or employees eating food available for sale
Damage - broken bottles, bent cans, frozen foods left out of the freezer

The sum total of all these items contributes to the difference between the Inventory account and the physical count. There might also have been errors made in the Inventory account during the year, adding to the difference.

A true story about grazing

I used to live in Tucson, Arizona and went to school at the University there. I lived on North Park, pretty far up the road near the north end of town. Near me was a Lucky grocery store, where I shopped a couple of times each week. Every time I would go there I would see people wandering around the store posing as customers. They would push a cart down the aisles, collecting a few items along the way.

A typical scenario I have observed with my own eyes:

take a couple of slices of bread (leave the rest of the loaf on the shelf, opened
open a package of cold cuts, take a few slices, leave the package
tear off a couple of pieces of lettuce, leave the rest of the head behind
get one plastic knife from a package of 20, ditch the other 19 somewhere
put some mayo and mustard on the sandwich, return jars to the shelf
get a beverage and have lunch
top it off with a piece of fruit for dessert

The cart is abandoned, along with the empty beverage container, and the grazer leaves the store. This may sound extreme, but I've seen this done on a regular and repeated basis. It is a real problem is many areas, especially in cities and in large stores. Grazing is a form of theft. If you pop a grape in your mouth, you are grazing too.

Special Sales and Purchase Accounts

Merchandisers use a few special accounts. When a sale is made, sometimes the customer returns merchandise for a refund. We do not reduce the sales revenue account. We enter the refund in a different account. This is done to help track the number and dollar amount of these types of transactions.

Sales accounts deal with customers and sale transactions

Sales Returns and Refunds
Sales Allowances
Sales Discounts

Purchase accounts deal with suppliers and purchase transactions

Purchase Returns and Refunds
Purchase Allowances
Purchase Discounts

Notice the close similarity between the account titles. They are almost identical, but apply on opposite sides of the purchase and sales cycles. Sales accounts are used in conjunction with selling merchandise and dealing with customers. Purchase accounts are used in conjunction with buying merchandise and dealing with suppliers.

By tracking these types of transactions in their own account managers have the opportunity to better understand their business. Are too many refunds being given? Why? Are we buying defective merchandise from a certain supplier? Are Sales Allowances cutting into our gross profit too much? Are we taking advantage of our Purchase Discounts when available?

The key to business profits is to identify each and every item that can be improved, and then improve it. Managers can raise prices. But they can also cut costs, reduce waste, increase efficiency, take discounts when available, and many other things to improve the profitability of their business.

Freight In vs Delivery Expense

Freight In is the cost to have merchandise shipped to your store. Freight In is a cost of purchasing merchandise, and becomes part of Cost of Goods Sold in the Income Statement. Sometimes a company has to pay a separate charge for Freight In. At other times the cost may be included in the cost of merchandise from the supplier. In any case, the cost of Freight In is added to the cost of the merchandise.

example:
XYZ, Co. buys 100 units of Product R for $7500. The trucking company charges $500 for the shipment. The total cost of the merchandise is $8000. Each unit costs $8000 / 100 = $80. They should set their selling price based on a cost of $80.

Delivery Expense is the cost to ship or deliver merchandise to your customer after a sale. Delivery Expense is a Selling Expense, and is included under that caption in the Income Statement.

Chapter 7

Financial Assets

Bank Reconciliation

Short Term Investments

Accounts Receivable

Uncollectible Accounts

Writing Off Bad Debts

Financial Analysis

Chapter 7 discusses financial assets: Cash, Accounts Receivable, Short Term Investments.

What are financial assets

Financial assets include Cash, and those assets that can be converted to cash in a reasonably short period of time - one year at most, but less time in many cases. We will study the following financial assets:

Cash
Cash Equivalents
Short Term Investments
Accounts Receivable

Valuation of financial assets

Financial assets are valued as of balance sheet date, when financial statements are prepared. They are valued at the equivalent of their current Cash value - what they would be worth if we could convert them to cash now. In the case of Cash, it is already at it's current value. Short Term Investments are reported at their current market value. Accounts Receivable are adjusted for possible bad debts.

Cash and Cash Equivalents

Cash is just as the word suggests. It includes cash money including paper and coins, checks and money orders to be deposited, money deposited in bank accounts that can be accessed quickly. The term liquid refers to Cash, and the ease or difficulty of converting an asset into Cash.

Cash Equivalents are highly liquid short term investments that can be turned into Cash very quickly. These include US Treasury bills, money market accounts and high grade commercial paper. When corporations need to borrow money for a very short time, they often sell commercial paper. These come due within a few months at most, and pay a higher interest rate than other investments.

Bank Reconciliation

Banks send statements to their depositors each month. A bank reconciliation compares the information in the bank statement with the company's Cash account, and finds any discrepancies. These are recorded or dealt with as needed. The process is fairly simple.

The bank balance and book Cash balance are listed on a piece of paper (now we often use computers). Some items show up on the bank statement, but have not been reflected in the books yet. These items will be added to or subtracted from the book balance.

Some transactions have been recorded in the books, but have not yet cleared the bank. These include deposits in transit, which are not yet posted in the bank's records - those made after the date of the bank statement. And outstanding checks - those which have been written and mailed, but haven't cleared the bank yet. These items are added to or subtracted from the bank balance.

Once all items have been included, the adjusted bank and book balances should be equal. If they are not, the reconciliation needs to be reviewed and corrected until the two amounts are equal.

Bank Reconciliation

Adjustments to Bank Balance	Adjustments to Book Balance
Add Deposits in transit	Add anything on bank statement that increases cash balance, but has not been recorded in the books: bank collections, interest earned
Subtract Outstanding checks	Subtract anything on bank statement that decreases cash balance, but has not been recorded in the books: bank charges and fees, bad checks, interest charges
Bank errors (add or subtract as needed); notify bank of error; these don't happen very often, but we need to watch for them	Add or subtract for accounting errors relating to deposits or checks.
Do not record any of these adjustments in the books.	These adjustments must be entered as journal entries, so the books agree with the bank balance.

Short Term Investments

Short Term Investments include stocks and bonds that the company intends to hold only for a short time, and then sell and convert back to Cash. We consider it a good practice to convert unneeded cash to an investment account, where it can earn interest, dividends or show capital gains. These are shown on the balance sheet at their current market value, even if that is higher than the price paid for the investments. This is one of the few times we increase a balance sheet item above it's historic cost.

Accounts Receivable

Companies often sell to their customers on credit. The amount the customers owe is called Accounts Receivable (AR). We would record AR at the same time the sale is made, deducting any cash paid at the time of purchase, etc. When customers pay, we subtract the payment from their accounts receivable balance.

Most companies use an Accounts Receivable Subsidiary Ledger, which is similar to the General Ledger. The subsidiary ledger contains detailed information about each customer's account - purchases, payments, returns, adjustments, etc. Most companies send statements at the of each month, listing the monthly transactions and ending balance due from each customer.

Uncollectible Accounts

When businesses sell on credit, they run the risk that some customers will not pay their bill. Legitimate complaints, errors in billing , etc. are dealt with in an appropriate manner, and the books are adjusted as needed to correct any errors, or show returns and allowances (price adjustments). Still, some customers don't pay their bill, for any of a variety of reasons, and we must have a way to deal with this in the books, and on the financial statements.

We do this by setting up an account that is a companion to Accounts Receivable. It is called the Allowance for Uncollectible Accounts (or something similar - Allowance for Doubtful Accounts is often used click here for funny true accounting story).

Allowance for Doubtful Accounts is called a contra-asset account. It is a companion to Accounts Receivable, and has an opposite balance. When we net the two balances, we get the amount we expect to collect from customers, allowing for those who don't pay.

The allowance account is established each year, at balance sheet date. We usually prepare an Accounts Receivable aging report, which gives us a history of customers accounts tabulated in columns, each column representing one month. We can quickly see which customers are late paying their bills by 30 day, 60 days, 90 days, etc. We would expect that if a customer hadn't paid their bill after 90 days there is a good chance they won't pay at all. The risk of loss goes up as accounts go unpaid for longer periods of time.

Companies use the aging report to make a dollar estimate of how much they will lose in unpaid account balances. At that time we have no way to know exactly which customers won't pay. But by tracking its business history a company can estimate a dollar amount that they believe is reasonable.

When the allowance account is established, an expense account is also debited. That account is called Uncollectible Accounts Expense, Bad Debt Expense, Provision for Bad Debt, or something similar. So the loss due to bad debts is recognized as a normal business expense on the Income Statement.

Writing Off Bad Debts

Periodically, and no less than once a year, a company must review it's accounts receivable and identify any customers who have not paid their bill for a very long time, generally over 90 days. Information is gathered about these customers, and attempts at collection should be made. However, the customer may be out of business, bankrupt, etc. and it is unlikely the company will be paid by these customers.

When this happens, the debt is no good and should be removed from the books. We do that by making an entry to both Accounts Receivable and the allowance account, reducing the balance in both accounts. Writing off bad debt should be done with management's approval. Potentially collectible accounts should be pursued; only legitimately uncollectible accounts should be written off.

The allowance method is acceptable for accounting, and correct under GAAP. However, no allowance expense is permitted for tax returns. Only accounts actually written off can be expensed on a tax return, and then only in the year the account is deemed uncollectible.

Financial Analysis

Financial statements contain valuable information, but it must be analyzed to make relevant and correct decisions. Certain ratios are commonly used by investors and analysts. These are not difficult. All the information you need is already in the financial statements, as required by GAAP. And these ratios are used by thousands of people on a daily basis. No college degree or great math skills are required to use financial ratios.

Ratios can be used to evaluate a company's performance over a number of years. It can also be used to compare several different companies. Bankers often use ratios when considering a loan application. And investors calculate ratios to decide which stocks to buy or sell.

Chapter 8

Inventories and Cost of Goods Sold

Using a Cost Flow Assumption

Specific Identification

FIFO

LIFO

Average Cost

The importance of time when working with inventory methods

Estimating Inventory

Inventory Turnover

How Turnover relates to Gross Profit

Inventory Management - a delicate balance

Chapter 8

Manufacturing companies have three types of inventory: materials, work in process and finished goods. Retailers have one inventory: merchandise. In all cases, inventory is something the company will re-sell to someone else. Inventory cost is an asset until it is sold; after merchandise is sold, the cost becomes an expense, called Cost of Goods Sold (COGS). A journal entry transfers costs from the Balance Sheet to the Income Statement.

Chapter 8 focuses on inventories of merchandise, those inventories held by retailers for sale to their customers. This would include grocery stores, clothing stores, in fact all the stores you would visit in the mall, or shop at on a regular basis, are retailers. That covers a large and broad group of businesses.

There are several important points, or events, in the life on an inventory item. The company must first order and buy the item. It then holds the item on a shelf or warehouse, until a customer wants to but the item. Once the item is sold, the cost is transferred to COGS. So the three important times in an item's life are buying, holding and selling.

Let's think for a moment about a hypothetical inventory item, we'll call it Item X. If you buy, hold and sell Item X all in the same year, say 2002, the entire transaction relating to Item X will be a completed and realized transaction. If the customer has paid for Item X there will be absolutely no accounting left to do, except show the sale and related COGS on the 2002 Income Statement. Nothing about Item X will affect the company in the future. Everything about Item X relates only to the past.

If Item X costs you $40, and you sell it for $65, you made a Gross Profit on the item of $25.

Income Statement 2002

Selling Price of Item X	$ 65.00
Less: Cost of Item X	40.00
Gross Profit from selling Item X	$25.00

This is the information that will be included in the 2002 Income Statement. Nothing will be left on the Balance Sheet.

Now let's think for a moment about Item Z. Assume you buy Item Z for late in 2002, and you are still holding it. There will be no sale to report, so the cost will remain on the Balance Sheet. If Item Z cost $50 that is the amount that will be shown on the Balance Sheet.

Balance Sheet Dec. 31, 2002

Inventory at December 31, 2002
Cost of Item Z	$50.00

If Item Z is sold in 2003, the cost will flow to the Income Statement for 2003, and the gross profit will be reported on that income statement.

Inventory Valuation

In the example above, you determined a value for Item Z at the end of the year. It is important for companies to count the physical inventory at the end of the year (Chapter 6). They must also place a dollar value on that inventory. The inventory value will be reported on the Balance Sheet at the end of the year.

It is also important to know the correct value of merchandise sold. That is the cost used to determine Gross Profit. Without enough Gross Profit a company can't pay it's operating expenses, such as salaries and wages, rent and utilities, etc. We will discuss Gross Profit a little more later in this section.

There are four methods commonly used to calculate a value for ending inventory. A company should select and use the method that best matches their merchandise and how it is sold.

4 methods of inventory valuation

Inventory method	How it works	When used
Specific Identification	the cost of each individual inventory item is tracked separately; the exact cost of each item is used in the value of ending inventory	auto sales, gems and jewelry, works of art, unique, one of a kind items
First In, First Out (FIFO)	cost of earliest purchases flow to COGS; we assume that the items remaining at the end are the last ones bought in the year	eggs, milk, meat, produce; this is the default flow assumption, unless a different method is specified
Last In, First Out (LIFO)	cost of last purchases flow to COGS; we assume that the items remaining at the end are the earliest ones bought in the year	clothing, seasonal items; a highly specialized method of retail inventory
Average Cost	cost of items bought are averaged across the year; the average cost is used at the end of the year; a moving weighted average is sometimes used	lumber, nails, nuts and bolts (simple average); gasoline (moving average)

Using a Cost Flow Assumption

must meet cost-benefit rule
accounts for quantities of homogeneous products
matches the physical flow of goods
can be used with either Periodic or Perpetual costing system

Specific Identification

The Specific Identification method assumes that each inventory item is special enough, unique enough, and costly enough to merit tracking one at a time. But does that apply to each and every item? What about a ream (500 sheets) of typing paper. Is it necessary to place a value on each and every sheet of paper?

Most business would answer "No" to that question. The cost of keeping that much detailed information would exceed the usefulness, or benefit, of the information. We call that the cost-benefit rule. The cost of an accounting system (or any other venture) should be outweighed by the benefits, or it is not cost-effective to follow that course of action.

For most companies, the Specific Identification method is far too costly and the additional information that could be gained is of little value. Most companies use a cost flow assumption. This simply means that the flow of inventory follows a certain pattern. Companies will buy merchandise in a manner consistent with the merchandise itself.

FIFO

For instance, a grocery store will buy only the amount of milk it can sell in a week. Because milk spoils quickly, the store will buy small amounts each week, and make sure the milk it has for sale is the freshest milk available.

Further, one gallon of milk is basically the same as the next gallon (with only minor differences). We say that milk is a homogeneous product. All the milk can be viewed as a single product group, that follows an almost identical weekly sales and spoilage pattern.

The grocery will use a flow assumption to value its milk inventory at the end of the year. They will use FIFO, assuming that the milk on hand is the last milk that was bought during the year.

The LIFO method would assume that the milk bought in the first week of the year is the same milk on the shelf at the end of the year. Obviously year old milk will probably be coagulated into a solid, stinking block of green muck. So we know that LIFO would be an incorrect flow assumption for milk. So when will the LIFO assumption will be valid?

LIFO

Let's now picture a clothing store. There are basically 4 clothing seasons: Winter, Spring, Summer and Autumn. There is a line of clothing for each season. Further, clothing styles change each year. Except for a few items (socks, handkerchiefs, belts) customers will prefer to buy this year's fashions, rather than last year's fashions. Here's how that works into the LIFO method.

At the end of the year the clothing store looks at its merchandise. If their year ends in December, they have Winter clothes in the show room. But when they look in the storage room, most of the clothes there are from earlier seasons that year. So Last In, First Out means, the most current seasons clothes (Last In) are the ones that people want now (First Out). After all, you wouldn't be buying last summer's clothes in the middle of winter, would you? Most people will wait until the following year and buy clothes in style in the coming summer.

Average Cost

Some merchandise is nearly identical and is carried in large quantities, like lumber, nails, nuts and bolts or gasoline. If you have a tank on gasoline with say 50 gallons in it, and you add 200 more gallons, you can't separate the first 50 gallons out from the rest of it. It all just becomes on take with 250 gallons of gasoline in it. So companies use the average cost method to account for things like this.

If you run a gas station, your costs will change every week. You will always have some left in the tank from the week before, and the delivery truck will dump more gas in your tank at this week's prices. Gas stations use a moving average method - they take the moving average from last week, and calculate a new moving average after adding this weeks batch of gasoline to the tank. So a moving average updates the cost frequently, and applies that particular average cost to that week's gasoline sales. Next week they will calculate a new moving average and apply it to next week's gasoline sales, etc.

At one time my office was next to a company that sold nuts, bolts, screws, nails, washers and other types of small hardware items. They bought directly from the manufacturers, mostly foreign. Their goods came packed in small wooden barrels. Believe me, a small wooden barrel full of nails is heavy!

They repackaged the items into small plastic bags for resale to stores, and ultimately to end consumers. They had a very sophisticated set of scales that would accurately weigh out the pieces into the desired quantity. For instance ,they could weigh out 10 flat washers accurately, and drop them into a small plastic bag. It was much quicker and easier than counting pieces manually.

How do you think they counted and valued their ending inventory? They weighted all the opened containers (no need to weigh a full, unopened one), and used their cost per pound, to calculate the value of their ending inventory. This may seem a bit unconventional, but it is a very good method, and entirely acceptable.

Some bulk products and how they might be measured for average costing:

product	measurement
gasoline, oil, milk, orange juice	gallon, liter
crude oil	barrel
natural gas	cubic yard, cubic meter
nails, nuts and bolts	pound, kilo
wheat, oats, corn, other grains	bushel
electric, telephone or TV cable	foot, meter

The importance of time when working with inventory methods

When it comes to inventory values, time is of the essence. That's a legal term, and means that time is more than just important, it is essential. You can't sell something you don't have, right? You can sell only what you have on hand in your inventory. Once an item is sold we have to determine how much cost to transfer from the Inventory account to the COGS account.

Using the Periodic system

If you use a Periodic inventory system, you value your inventory only once a year - at the end of the year! So the job is fairly easy, and you should have little problem making the calculation. You apply a cost flow assumption once at the end of the year, and it pertains only to the physical merchandise still on hand at the end of the year.

It doesn't matter when sales take place, or when inventory is purchased. We ignore all that when we use the Periodic system. All we have to care about is what inventory is on hand at the end of the year.

Using the Perpetual System

If you use the Perpetual system you have to track each and every purchase and sale of inventory. Time is definitely of the essence. We will use a cost flow and apply it continuously, updating the Sales, Inventory and COGS accounts daily, as merchandise is purchased and sold.

This can be a daunting task, and usually is done by sophisticated and expensive computerized systems. When you go to a grocery or department store, notice that all the products have a bar code, which is scanned by an electronic cash register. All the merchandise is scanned into the the computer inventory records when it arrives at the store, and is scanned out as it is sold. The inventory records are continuously updated, along with the inventory value.

The type of system a company uses will depend on how much it can afford to spend. Obviously, not all companies can or need to spend $50,000 to $100,000 for each scanning cash register, plus the cost of the computer and software itself. Installing such a system can easily cost $1 million or more per store. That's a high price tag, so most companies use a Periodic system, and update their inventory only once a year.

Estimating Inventory

Let's say a company uses the Periodic system. In the middle of the year they go to the bank seeking a loan for expansion. The banker asks to see a set of financial statements. Taking a complete physical inventory can be a huge, time-consuming task. The company may simply not have time to drop everything and take a physical inventory at this time. Do they have any options?

In fact, they do. They can estimate the inventory on hand. They can reconstruct the inventory based on their purchase and sales records for the year to date. There are a couple of methods used to do this. They are both similar.

The Gross Profit method is one method. The store needs to know it's gross profit rate or cost ratio (the inverse of gross profit rate). They start with the beginning inventory balance, add purchases, and deduct for sales made using the cost ratio. The result is an estimate of the merchandise on hand.

This method is especially useful when there has been a loss due to theft, fire, flood and so forth. The Gross Profit or Retail methods can be used to substantiate an insurance claim for loss in these situations.

Inventory Turnover

Inventory turnover is not some sort of exotic pastry. It also does not mean we physically pick up our inventory and turn it over or upside down. Having dispensed with those misconceptions, just what is inventory turnover?

Each time you sell your entire inventory, you are said to have "turned" or "turned over" your inventory. We measure this as the number of times per year that this happens. We also measure it in a dollar amount, not by the actual physical objects. A store might have a year-old can of "Uncle Simon's Nasty Stuff That Only Your Aunt Ethel Will Eat". Not selling that can will have not effect on inventory turnover, in the larger sense of the word.

[Managers are definitely interested in micro-inventory management: looking at the sales pattern of individual items. Walmart has been an aggressive pioneer in this area. Right now we are dealing with macro-inventory management: looking at the dollar value of the entire inventory, taken as a whole.]

Earlier I discussed how a grocery store stocks milk. The buy enough for one week. There are 52 weeks in a year, so we would expect their inventory turnover, for milk, to be roughly 52. We usually calculate this using dollars, rather than tracking actual cartons of milk.

Number of Days in Inventory is the concept expressed in number of days. It tells us how many days, on average, inventory stays on a shelf before it is sold. Since there are 365 days in a year, we can divide 365 by the inventory turnover rate and get the number of days in inventory.

365 / 52 = 7 (rounded) or roughly 1 week

There are 52 weeks in the year, and the store wants to stock enough for 1 week at a time. Their weekly milk inventory is sold 52 times a year (turnover), or once every 7 days (days in inventory).

Let's look at a table and see some typical correlation's. Notice the inverse relationship between turnover rate and days in inventory. As one goes up, the other goes down.

Turnover Rate	Days in Inventory	Frequency
52	7	weekly
12	30.4	monthly
6	60.8	2 months
4	91.25	quarter (3 months)
2	182.5	half year
1	365	one year

What I'm hoping you'll get from this is a little common sense. Eggs would not have a turnover rate of 4. Perishable items will have a high turnover rate and low number of days in inventory.

Automobiles, diamond rings, and works of art would probably not have a turnover rate of 52. It can take much longer to sell these expensive items. They will have a low turnover rate, and a high number of days in inventory.

How Turnover relates to Gross Profit

Profits depend on several things. One of the most important is the relationship between turnover and gross profit. Higher turnover brings greater profit. Lets look at a simple example.

A store buys Item X for $20, and sells it for $30. The Gross Profit from each item is $10.

Annual Turnover Rate	Sales	COGS	GP
1	30	20	10
2	60	40	20
4	120	80	40

Guess what, we can just multiply the annual turnover rate and the GP per unit ($10). That would be an easier calculation!

Annual Turnover Rate	$GP x TO Rate	Total $GP
1	$10 x 1	$10
2	$10 x 2	$20
4	$10 x 4	$40
6	$10 x 6	$60
12	$10 x 12	$120
52	$10 x 52	$520

If you sell 1 unit per year, you will only make $10 per year.
If you sell 1 unit per week you make $520 per year.

Which is better?

(I sincerely hope you chose $520 per year. If not, please consult a physician. You may need professional help.)

Turnover is essential to profits. Higher turnover = higher profits.

Let's look at an example

Jim buys pocket knives from the manufacturers and resells them on e-bay. He buys by the case and pays $5 for each knife. At the both the start and end of the year he had 30 knives on hand (to make this example a little easier).

Jim bought and sold 800 knives during the year. He had 32 knives on hand at the start and end of the year, so his average inventory is 32 (32+32/2 = 32).

Cost Component	Units	$ Cost
COGS @ $5	800	$ 4,000
Avg Inventory @ $5	32	$ 160
Results
Turnover rate	$4000 / $160 =	25
Days in inventory	365 / 25 =	14.6

What this is telling us:

His average inventory was 32 knives last year.
He sells 32 knives every 25 days.
Each batch of 32 knives is in inventory 14.6 days.
If he sells 800 knives every year, that's about 800 / 365 = 2.19 knives per day.
This is consistent with our results. 32 knives / 14.6 days = 2.19 knives per day.
He sells about 2 x 32 = 64 knives each month (avg 66.6 knives per month).

Inventory Management - a delicate balance

By now you should be seeing the correlation between Gross Profit and sales. No matter what your gross profit is, making more sales will always mean making more GP. Since each and every unit of product you sell earns you a GP, you will always do better selling more, rather than less.

Inventory turnover is a measure of ow often your average inventory is sold. Since business managers have access to all the detailed operating information of their company, they can manage inventory on a product by product basis. They can effectively look at the turnover of a single product, and more accurately gauge their real average inventory held for that item.

There is one very important thing that all businesses have to deal with: carrying the right amount of inventory - not too much, not too little.

If you carry too little inventory you will lose sales, and that will reduce your GP.

If you carry too much inventory the surplus will tie up your cash flow. You will have to warehouse, protect and insure the excess inventory. And you run a high risk of spoilage, obsolescence, theft and damage.

A company will maximize its profits by carrying the correct amount of each item in its inventory. This amount is determined by careful analysis and tracking of customer's buying patters. Stores have to pay attention to the seasonal and cyclic buying trends their customers display. Effective inventory management requires both day-to-day attention, and ongoing analysis of customer preferences and buying habits.

Chapter 9

Plant Assets and Depreciation

Chapter 9

In earlier chapters you learned the basics of depreciation. This chapter explains a little more about how depreciation expense is calculated. It also shows the other significant events in the life of plant assets: the purchase and retirement of those assets.

Depreciation expense spreads the cost of major equipment and assets over a period of time that spans a number of years. Amortization is used to allocate the cost of intangible assets, such as patents, copyrights, trademarks, and franchises. Depletion is used to record the cost of natural resources extracted from the earth.

There are three main events in the life of any asset:

acquisition
useful life
disposal or retirement

We will make journal entries for each of these events. Over the useful life we will enter depreciation expense. At the end of the life we will record any gain or loss at the time of disposal or retirement of the asset. Sometimes assets are traded for other assets, and that must be accounted for in the same manner as a disposal or retirement.

Fixed asset acquisition

Fixed asset accounts are debited for the actual cost of fixed assets. The correct account should be debited. Some companies use a Fixed Asset Subsidiary Ledger and show a control account on the Balance Sheet, called Property, Plant and Equipment (PPE) or something similar. In these cases all fixed assets acquisitions debit PPE and the subsidiary ledger carries the details pertaining to the asset.

Depreciable cost

Buildings, equipment, vehicles, computers, furniture and fixtures are all examples of depreciable assets. We will depreciate the depreciable cost of assets. This includes the purchase price paid, sales tax, shipping and installation costs, and possibly incidental costs if they are material. Cost of fixing damage caused during shipping and installation is treated as a Repair Expense.

Some costs are incidental to buying new equipment. A specialist might be hired to install a large printing press, or other specialized, complex piece of manufacturing equipment. This type of cost is included in the depreciable cost of the asset.

Sometimes employees have to be trained. The cost of training may be considered part of the depreciable cost, it the amount is material to the purchase of the asset. A brief training session for one or two machine operators will probably be an immaterial amount.

The cost of training the entire company's personnel when a new computer system is installed would probably be a material amount, especially in a large company. Every employee might require a day's training or more in the new system. The loss of productivity would be a material amount, and should be classified as part of the depreciable cost of the asset.

Recording Asset Acquisitions

If a company buys land, building, equipment etc. all at the same time, the total purchase price has to be divided correctly among the various assets.

Land is a non-depreciable asset. It falls into its own category in the books and on the Balance Sheet. Don't include land costs with other fixed asset costs, such as buildings. They must always be entered separately. Buildings will be depreciated; land will not be depreciated.

The Useful Life of an asset, is the period of time the company expects to use the asset in the business. It is also important that the asset be used as it is intended, and for the production of income. For instance, a computer that is being used as a doorstop is not contributing to the production of income, and it is also not being used as it was intended.

Date	Account	Debit	Credit
Apr-15	Land	$5,000
	Building	$45,000
	Cash		$10,000
	Mortgage Note Payable		$40,000
	To record purchase of land and building

Apr-30	Manufacturing Equipment	$7,000
	Computers and peripherals	$10,000
	Computer software	$3,000
	Accounts Payable		$20,000
	To record purchase of equipment, computers and software

[Of course, at this point some very clever student will say something like, "What if the computer is used as part of an art project displayed in the foyer of an office building? It's not being used as intended nor in the production of income." Well, young Einstein, objects d'art are Investments, not depreciable plant assets. Nice try, but no banana for the monkey.]

Why do assets depreciate?

For Federal Income Tax purposes, depreciation is referred to as cost recovery. The government allows you to use the cost of plant assets to offset income. You recover your cost a little bit at a time, over a number of years. Each year you reduce your income tax expense, by an amount relative to the cost recovery amount for that year. It's a slightly strange concept if you're not involved in preparing income taxes. But it does make sense if you think about it a bit.

For financial statement purposes, depreciation reflects a number of different influences that each affect an asset over its useful life.

recognize physical deterioration
recognize obsolescence
recognize a reduction in market value
recognize benefits derived from using the asset
apply a logical, systematic cost allocation over a relevant period of time
apply the matching principle

Each of these is important to a company. When assets are purchased, the cost is reflected in the Balance Sheet. Depreciation expense transfers that cost to the Income Statement in order to reflect the effect of the items listed above, in the financial statements.

Usually, at this point, students are a showing a slight glaze over their eyes. I then reiterate that depreciation expense reduces income, which in turn cuts income taxes. Cutting our taxes, that's something most of us can relate to. So depreciation is a good thing, an important thing, a joyous and wonderful thing.

[you may now take a few moments to celebrate the joys of depreciation ...ahhhhh.]

Depreciation Methods

We will study a couple of depreciation methods. There are other methods. If you study international accounting, you will find that other countries deal with these issues in a very different way than we do in the US. But we're #1, so we must be right (hee, hee).

Depreciation Method	my silly comments
Straight-Line Method	causes problems with my spell checker because of the hyphenated word
Declining-Balance Method	oh, no. another hyphenated word. my spell checker is not happy today
MACRS (income tax method)	US congress made up this word. its not in my spell checker dictionary either. whatever they were drinking that night, I want a bottle of it.

OK, let's try this again.

Depreciation Method	my serious comments
Straight-Line Method	an easy method that allocates an equal amount of depreciation to each time period; salvage value is used
Declining-Balance Method (200% & 150% DB)	allocates more depreciation expense to the early years of an asset's life, when it is new; since there should be less down-time and fewer repairs in the early years, the company should get more use out of the asset in the beginning of it's life; no salvage value is used.
MACRS (income tax method)	uses the double-declining balance method, but you only take one-half year's depreciation in the first year, and then you switch to the straight-line method in the middle of the asset's life, so a 5 year asset takes 6 years to depreciate. salvage value? salvage value? we don't need no stinking salvage value!! I still want a bottle of whatever they were drinking when they dreamed this one up.

[It is a little known fact that the US congress is responsible for the rapid growth of the computer industry during the 1980s and 1990s. The MACRS depreciation rules were so complex everyone had to buy computers just to do the calculations each year. Millions of computers were sold, just to calculate MACRS depreciation ........ OK, I'm just kidding. You didn't really think I was serious, did you?. Hey, this is week 8, we're almost done.]

Selling or disposing of Fixed Assets

After selling or disposing of fixed assets, the company no longer has the asset. This requires a journal entry to remove everything in the accounting records relating to the asset.

The depreciable cost and accumulated depreciation relating to the asset must both be removed, or reversed. There might be a gain or loss when disposing of assets. There might also be incidental costs relating to disposing of the asset. All these things should be included in the journal entry recording the disposal.

Let's assume on September 1, the ledger shows these balances for a piece of equipment.

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward	$7000		$7000

Removing these amounts from the books with a journal entry

When assets disposed of there might be a gain, loss or a wash (no gain or loss). In either case all such journal entries will start from the same place, removing the related asset cost and accumulated depreciation. This journal entry does not balance; is the beginnings of a journal entry, and must be completed when all the information is available.

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward		$5600	($5600)

Notice the exact opposite of the account balances is entered for each account. This causes the account balances to go to zero after this journal entry is posted.

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600


	Equipment		$7,000
	To record disposal of equipment

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward	$7000		$7000
Sep-15	Disposal of asset		$7000	$0

The asset and related accumulated depreciation have both been removed from the books.

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward		$5600	($5600)
Sep-15	Disposal of asset	$5600		$0

Calculating Book Value

Book Value is the difference between the asset cost and accumulated depreciation:

Equipment cost	$ 7,000
Less: accumulated depreciation	-5,600
Book Value before sale	$ 1,400

Gains and losses are calculated using the Book Value.

Equipment sold for a Gain

If the equipment is sold for more than its book value there will be a gain. Gains are similar to revenues, and will be recorded with a credit entry. Let's say the equipment is sold on September 15 for $2,000. The gain will be:

Selling Price	$ 2,000
Less: Book Value	- 1,400
Gain	$ 600

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

The journal entry is now in balance. Did you notice what I did? I started the journal entry with what I already knew - the cost and accumulated depreciation. I left 2 lines blank in the middle of the journal entry, so the sales price and gain or loss could be recorded.

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Cash	$2,000
	Gain on disposal of equipment		$ 600
	Equipment		$7,000
	To record disposal of equipment

Equipment sold for a Loss

If the equipment is sold for less than its book value there will be a loss. Losses are similar to expenses, and will be recorded with a debit entry. Let's say the equipment is sold on September 15 for $1,000. The loss will be:

Selling Price	$ 1,000
Less: Book Value	- 1,400
Loss	($ 400)

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

Equipment sold for a Wash

If the equipment is sold equal to its book value there will be a wash. Let's say the equipment is sold on September 15 for $1,400.

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Cash	$1,000
	Loss on disposal of equipment	$ 400
	Equipment		$7,000
	To record disposal of equipment

Selling Price	$ 1,400
Less: Book Value	- 1,400
Wash	$ 0

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places. In this case there is a wash, so no gain or loss is recorded. The equipment is simply removed from the books.

Equipment Junked

If the equipment is junked there will be a loss equal to its book value. We call this abandonment. The item is usually just thrown in the trash, or hauled to the dump. Sometimes a company will have to pay to have the item hauled away. Incidental costs are revenue expenditures, and are not included in calculating the capital gain or loss.

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Cash	$1,400
	Equipment		$7,000
	To record disposal of equipment

Selling Price	$ 0
Less: Book Value	- 1,400
Loss	($ 1,400)

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

Intangible Assets

Intangibles are assets that have no physical existence. They are legal assets or accounting assets, such as copyrights, patents, trademarks or goodwill. We use a simple form of amortization, usually straight-line, to allocate the cost of these items to expenses.

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Loss on abandonment of equipment	$1,400
	Equipment		$7,000
	To record abandonment of equipment

Chapter 9

Plant Assets and Depreciation

There are three main events in the life of any asset:

acquisition
useful life
disposal or retirement

Recording Asset Acquisitions

If a company buys land, building, equipment etc. all at the same time, the total purchase price has to be divided correctly among the various assets.

For financial statement purposes, depreciation reflects a number of different influences that each affect an asset over its useful life.

Date	Account	Debit	Credit
Apr-15	Land	$5,000
	Building	$45,000
	Cash		$10,000
	Mortgage Note Payable		$40,000
	To record purchase of land and building

Apr-30	Manufacturing Equipment	$7,000
	Computers and peripherals	$10,000
	Computer software	$3,000
	Accounts Payable		$20,000
	To record purchase of equipment, computers and software

recognize physical deterioration
recognize obsolescence
recognize a reduction in market value
recognize benefits derived from using the asset
apply a logical, systematic cost allocation over a relevant period of time
apply the matching principle

[you may now take a few moments to celebrate the joys of depreciation ...ahhhhh.]

Depreciation Method	my silly comments
Straight-Line Method	causes problems with my spell checker because of the hyphenated word
Declining-Balance Method	oh, no. another hyphenated word. my spell checker is not happy today
MACRS (income tax method)	US congress made up this word. its not in my spell checker dictionary either. whatever they were drinking that night, I want a bottle of it.

OK, let's try this again.

Depreciation Method	my serious comments
Straight-Line Method	an easy method that allocates an equal amount of depreciation to each time period; salvage value is used
Declining-Balance Method (200% & 150% DB)	allocates more depreciation expense to the early years of an asset's life, when it is new; since there should be less down-time and fewer repairs in the early years, the company should get more use out of the asset in the beginning of it's life; no salvage value is used.
MACRS (income tax method)	uses the double-declining balance method, but you only take one-half year's depreciation in the first year, and then you switch to the straight-line method in the middle of the asset's life, so a 5 year asset takes 6 years to depreciate. salvage value? salvage value? we don't need no stinking salvage value!! I still want a bottle of whatever they were drinking when they dreamed this one up.

Let's assume on September 1, the ledger shows these balances for a piece of equipment.

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward	$7000		$7000

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward		$5600	($5600)

Notice the exact opposite of the account balances is entered for each account. This causes the account balances to go to zero after this journal entry is posted.

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600


	Equipment		$7,000
	To record disposal of equipment

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward	$7000		$7000
Sep-15	Disposal of asset		$7000	$0

The asset and related accumulated depreciation have both been removed from the books.

Date	Description	Debit	Credit	Balance
Sep-1	Balance forward		$5600	($5600)
Sep-15	Disposal of asset	$5600		$0

Calculating Book Value

Book Value is the difference between the asset cost and accumulated depreciation:

Equipment cost	$ 7,000
Less: accumulated depreciation	-5,600
Book Value before sale	$ 1,400

Gains and losses are calculated using the Book Value.

Selling Price	$ 2,000
Less: Book Value	- 1,400
Gain	$ 600

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Cash	$2,000
	Gain on disposal of equipment		$ 600
	Equipment		$7,000
	To record disposal of equipment

Selling Price	$ 1,000
Less: Book Value	- 1,400
Loss	($ 400)

Equipment sold for a Wash

If the equipment is sold equal to its book value there will be a wash. Let's say the equipment is sold on September 15 for $1,400.

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Cash	$1,000
	Loss on disposal of equipment	$ 400
	Equipment		$7,000
	To record disposal of equipment

Selling Price	$ 1,400
Less: Book Value	- 1,400
Wash	$ 0

We'll begin with the journal entry we started above, and add the additional information, the selling price and gain or loss, in the right places.

Date	Account	Debit	Credit
Sep-15	Accumulated Depreciation	$5,600
	Cash	$1,400
	Equipment		$7,000
	To record disposal of equipment

Selling Price	$ 0
Less: Book Value	- 1,400
Loss	($ 1,400)