‫‪Principles of Accounting‬‬

‫مبادىء المحاسبة‬
‫‪1 th Year‬‬
‫‪Computer Science‬‬
‫الفرقة االولى‬

‫علوم الحاسب‬

‫اعداد‬

‫الدكتور‪ /‬كمال منصور‬ ‫د‪ /‬محمد سالم الباز‬

‫بقسم المحاسبة باألكاديمية‬

‫‪0200/0202‬‬
 ‫رؤية برنامج علوم الحاسب‬
.‫تحقيق التميز في مجال عموم الحاسب محميا و إقميميا و دوليا في إطار جودة التعميم‬
PROGRAM VISION
The program vision is to achieve excellence in the fields of computer
science locally, regionally and internationally within education quality frame.

‫رسالة برنامج علوم الحاسب‬
‫يمتزم برنامج عموم الحاسب باألكاديمية الحديثة لعموم الكمبيوتر و تكنولوجيا اإلدارة بتقديم خدمات‬
‫تعميمية مطورة تواكب معايير جودة التعميم بما يسهم في إعداد خريج متميز له القدرة عمى المنافسة في‬
‫ و لديه القدرة عمى إجراء أبحاث عممية متقدمة و تقديم خدمات فعالة‬,‫تخصص عموم الحاسب‬
. ‫لممجتمع و البيئة المحيطة‬
PROGRAM MISSION
The computer science program is committed to provide updated educational
services that match the standards of the quality of education, in order to
prepare a distinguished graduate having the ability to complete in the field of
computer science conduct advanced scientific researches and provide
effective services to the society and surrounding environment.
 Contents :
Page no.

Chapter 1 : Introducing Accounting and Financial Statements ……………….3

Chapter 2 : Generally Accepted Accounting Principles ……………………………52

Chapter 3 : Financial Statement Analysis ………………………………………………..66

Chapter 4 : Merchandising & Manufacturing Companies ……………………….86

Chapter 5 : Managerial Accounting ……………………………………………………….120

Chapter 6 : Auditing ………………………………………………………………………………138

Chapter 7 : International Accounting …………………………………………………….151

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3
What Is Accounting?

The purpose of accounting is to provide information that will help you

make correct financial decisions. Your accountant’s job is to give you the

information you need to run your business as efficiently as possible while

maximizing profits and keeping costs low.

Accounting is the language of business. It is the process of recording,

classifying, and summarizing economic events through certain documents

or financial statements. Like any other language, accounting has its own

terms and rules. To understand how to interpret and use the information

accounting provides, you must first understand this language.

Understanding the basic concepts of accounting is essential to success in

business.

Who Uses Accounting Information?

In the world of business, accounting plays an important role to aid in making

critical decisions. The more complex the decision, the more detailed the
information must be. Individuals and companies need different kinds of
information to make their business decisions. Users of accounting information are
generally divided into two categories: internal and external. Internal users are
those within an organization who use financial information to make day-to-day
decisions. Internal users include managers and other employees who use financial
information to confirm past results and help make adjustments for future
activities. External users are those outside of the organization who use the
financial information to make decisions or to evaluate an entity’s performance. For
example, investors, financial analysts, loan officers, governmental auditors, such as
IRS agents, and an assortment of other stakeholders are classified as external
users, while still having an interest in an organization’s financial information.

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Managers within a business use accounting information daily to make decisions,
although most of these managers are not accountants. Some of the decisions they
might make for which they will use accounting information are illustrated below .

AREAS IN WHICH MANAGERS USE ACCOUNTING INFORMATION

• Marketing (Which line of goods should the company emphasize?)

• Production (Should the company produce its goods in the United States or open
a new plant in Mexico?)

• Research and Development (How much money should be set aside for new
product development?)

• Sales (Should the company expand the advertising budget and take money away
from some other part of the marketing budget?)

Without the proper accounting information these types of decisions would be very
difficult, if not impossible, to make.

Bankers continually use accounting information. Accounting is fundamental to

their decision-making process. Some of the decisions bankers make using
accounting information are listed below .

AREAS IN WHICH BANKERS USE ACCOUNTING INFORMATION

• Granting loans to individuals and companies

• Investing clients’ money

• Setting interest rates

• Meeting federal regulations for protecting your money

Financial Statements

Accountants supply information to people both inside and outside the firm by
issuing formal reports that are called financial statements. The financial
statements are usually issued at least once a year. In many cases they are issued
quarterly or more often where necessary.

A set of rules, called Generally Accepted Accounting Principles, govern the

preparation of the financial statements. Generally Accepted Accounting Principles

5
(GAAP) has been defined as a set of objectives, conventions, and principles to
govern the preparation and presentation of financial statements. These rules can
be found in volumes of documents issued by the American Institute of Certified
Public Accountants (AICPA), the Financial Accounting Standards Board (FASB), the
Internal Revenue Service (IRS), the Securities and Exchange Commission (SEC), and
other regulatory bodies. In chapter 2 we look at some of the overriding principles
of accounting as they apply to all businesses and individuals.

The Basic Financial Statements

Accountants create what are known as financial statements. Financial statements

are reports that communicate the financial performance and financial position of
the organization. In essence, the overall purpose of financial statements is to
evaluate the performance of a company. Virtually every activity and event that
occurs in a business has an associated cost or value and is known as a transaction.
Part of an accountant’s responsibility is to quantify these activities or events and
prepare financial reports that summarize what has already occurred in an
organization . Each financial statement we examine has a unique function, and
together they provide information to determine whether a company generated a
profit or loss for a given period (such as a month, quarter, or year).

Before exploring the specific financial statements, it is important to know why

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

The four financial statements that perform these functions and the order in which
we prepare them are:

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1. Income Statement

2. Statement of Owner’s Equity

3. Balance Sheet

4. Statement of Cash Flows.

1- The Income Statement

It shows all of the Revenues of the company less the Expenses, to arrive at the
“bottom line,” the Net Income. The Income Statement can also be visualized by
the formula: Revenue – Expenses = Net Income/(Loss).

Revenue is the value of goods and services the organization sold or provided to
customers for a given period of time. In our current example, Chris’s landscaping
business, the “revenue” earned for the month of August would be $1,400. It is the
value Chris received in exchange for the services provided to her clients.

Expense is a cost associated with providing goods or services to customers. In our

opening example, the expenses that Chris incurred totaled $1,150 (consisting of
$100 for brakes, $50 for fuel, and $1,000 for insurance).

Recall that revenue is the value of goods and services a business provides to its
customers and increase the value of the business. Expenses, on the other hand,
are the costs of providing the goods and services and decrease the value of the
business. When revenues exceed expenses, companies have net income. This
means the business has been successful at earning revenues, containing expenses,
or a combination of both. If, on the other hand, expenses exceed revenues,
companies experience a net loss. This means the business was unsuccessful in

7
earning adequate revenues, sufficiently containing expenses, or a combination of
both. While businesses work hard to avoid net loss situations, it is not uncommon
for a company to sustain a net loss from time-to-time. It is difficult, however, for
businesses to remain viable while experiencing net losses over the long term.

2- Statement of Owner’s Equity

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

The statement of owner’s equity, which is the second financial statement created
by accountants, is a statement that shows how the equity (or value) of the
organization has changed over time. Similar to the income statement, the
statement of owner’s equity is for a specific period of time, typically one year.
Recall that another way to think about equity is net worth, or value. So, the
statement of owner’s equity is a financial statement that shows how the net
worth, or value, of the business has changed for a given period of time.

We have addressed the owner’s value in the firm as capital or owner’s equity.
However, later we switch the structure of the business to a corporation, and
instead of owner’s equity we begin using stockholder’s equity, which includes
account titles such as common stock and retained earnings to represent the
owners’ interests. The corporate treatment is more complicated because
corporations may have a few owners up to potentially thousands of owners
(stockholders).

8
3. The Balance Sheet

It is a statement that lists what the organization owns (assets), what it owes
(liabilities), and what it is worth (equity) on a specific date. Notice the change in
timing of the report. The income statement and statement of owner’s equity
report the financial performance and equity change for a period of time. The
balance sheet, however, lists the financial position at the close of business on a
specific date.

Assets : are resources used to generate revenue. An asset can be categorized as a

short-term asset or current asset (which is typically used up, sold, or converted to
cash in one year or less) or as a long-term asset or noncurrent asset (which is not
expected to be converted into cash or used up within one year). Long-term assets
are often used in the production of products and services. Examples of short-term
assets that businesses own include cash, accounts receivable, and inventory, while
examples of long-term assets include land, machinery, office furniture, buildings,
and vehicles.

An asset can also be categorized as a tangible asset or an intangible asset. Tangible

assets have a physical nature, such as trucks or many inventory items, while
intangible assets have value but often lack a physical existence or corpus, such as
insurance policies or trademarks.

Liabilities : are amounts owed to others (called creditors). A liability can also be
categorized as a short-term liability (or current liability) or a long-term liability (or
noncurrent liability), similar to the treatment accorded to assets. Short-term
liabilities are typically expected to be paid within one year or less, while long-term
liabilities are typically expected to be due for payment more than one year past
the current balance sheet date. Common short-term liabilities or amounts owed by
businesses include amounts owed for items purchased on credit (also called
accounts payable), taxes, wages, and other business costs that will be paid in the

9
future. Long-term liabilities can include such liabilities as long-term notes payable,
mortgages payable, or bonds payable.

Equity : refers to book value or net worth or the capital .

Stated differently, it is important for employees, managers, and other interested

parties to understand what a business owns, owes, and is worth at any given point.
This provides stakeholders with valuable financial information to make decisions
related to the business.

4. Statement of Cash Flows

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

Under cash basis accounting, transactions (i.e., a sale or a purchase) are not
recorded in the financial statements until there is an exchange of cash. This type of
accounting is permitted for nonprofit entities and small businesses that elect to
use this type of accounting. Under accrual basis accounting, transactions are
generally recorded in the financial statement when the transactions occur, and not
when paid, although in some situations the two events could happen on the same
day.

10
None of these financial statements alone can tell the whole story about a
company. We need to know how to read, understand, and analyze these
statements as a package in order to make any kind of decisions about the
company. In addition to the financial statements, you must understand the
industry you are operating in and the type of business they are used in. In general
there are three forms of business operating —proprietorships, partnerships, and
corporations.

How Different Business Entities Present Accounting Information

Proprietorships are businesses with a single owner . These types of businesses

tend to be small retail businesses started by entrepreneurs. The accounting for
these proprietorships includes only the records of the business—not the personal
financial records of the proprietor of the business.

Partnerships are very similar to proprietorships, except that instead of one owner,
there are two or more owners. In general most of these businesses are small to
medium-sized. However, there are some exceptions, such as large national or even
international accounting or law firms that may have thousands of partners. As with
the proprietorships, accounting treats these organizations’ records as separate and
distinct from those of the individual partners.

Finally, there are corporations. These are businesses that are owned by one or
more stockholders. These owners may or may not have a managerial interest in
the company. Many of these stockholders are simply private citizens who have
money invested in the company by way of stocks that they have purchased. In a
corporation a person becomes an owner by buying shares in the company and thus
becomes a stockholder. The stockholders may or may not have a vote in the
company’s long-term planning depending on the type of stock they have

11
purchased. However, simply by being stockholders (owners), they do not have
decision-making authority in the day-to-day operations. These investors (or
stockholders) are not much different than the bankers that loan money to a
proprietorship or a partnership. These bankers have a financial interest in the
business, but no daily managerial decision making power. As is the case with the
stockholders who have invested money into the corporation, in general they have
a non managerial interest in the business. As with the other two types of business
organizations discussed here, the accounting records of the corporation are
maintained separately from those of the individual stockholders or owners.

The accounting records of a proprietorship are less complex than those of a

corporation in that there is a simple capital structure and only one owner. In the
case of a corporation, there are stockholders who buy a piece of the ownership of
a company by buying stock. As we will discuss later, because of this stock
ownership, the financial statements become more complex. Some of the basic
differences between these three types of businesses are shown in Figure 1.

The Accounting Equation

A simple example of a home loan , assume a family purchased a home valued at

$200,000 and made a down payment of $25,000 while financing the remaining
balance with a $175,000 bank loan. This example demonstrates one of the most
important concepts in the study of accounting: the accounting equation, which is:
In our example, the accounting equation would look like this:

$200,000 = $175,000 + $25,000

12
As you continue your accounting studies and you consider the different major
types of business entities available (sole proprietorships, partnerships, and
corporations), there is another important concept for you to remember. This
concept is that no matter which of the entity options that you choose, the
accounting process for all of them will be predicated on the accounting equation. It
may be helpful to think of the accounting equation from a “sources and claims”
perspective. Under this approach, the assets (items owned by the organization)
were obtained by incurring liabilities or were provided by owners. Stated
differently, every asset has a claim against it—by creditors and/or owners.

To continue our exploration of the accounting equation, focusing on the equity

component, in particular, recall that we defined equity as the net worth of an
organization. It is helpful to also think of net worth as the value of the
organization. Recall, too, that revenues (inflows as a result of providing goods and
services) increase the value of the organization. So, every dollar of revenue an
organization generates increases the overall value of the organization. Likewise,
expenses (outflows as a result of generating revenue) decrease the value of the
organization. So, each dollar of expenses an organization incurs decreases the
overall value of the organization. The same approach can be taken with the other
elements of the financial statements: • Gains increase the value (equity) of the
organization. • Losses decrease the value (equity) of the organization. •
Investments by owners increase the value (equity) of the organization. •
Distributions to owners decrease the value (equity) of the organization. • Changes
in assets and liabilities can either increase or decrease the value (equity) of the
organization depending on the net result of the transaction.

To help accountants prepare and users better understand financial statements, the
profession has outlined what is referred to as elements of the financial statements,
which are those categories or accounts that accountants use to record transactions

13
and prepare financial statements. There are ten elements of the financial
statements, and we have already discussed most of them.

• Revenue—value of goods and services the organization sold or provided.

• Expenses—costs of providing the goods or services for which the organization

earns revenue.

• Gains—gains are similar to revenue but relate to “incidental or peripheral”

activities of the organization.

• Losses—losses are similar to expenses but related to “incidental or peripheral”

activities of the organization.

• Assets—items the organization owns, controls, or has a claim to.

• Liabilities—amounts the organization owes to others (also called creditors).

• Equity—the net worth (or net assets) of the organization.

• Investment by owners—cash or other assets provided to the organization in

exchange for an ownership interest.

• Distribution to owners—cash, other assets, or ownership interest (equity)

provided to owners.

The General Journal

Some time after a business transaction occurs it is recorded in a book called the
general journal. While there are many different kinds of journals, it is most
important to focus on the general journal. A general journal is often referred to as
the book of original entry because this journal is the book in which a transaction is
first recorded. If a company were to buy land for cash, the pages of a general
journal will look like the one shown below :

14
Journal Entries

The standard accounting rule is that Assets, or the left side of the equation, are
increased with debits, and decreased with credits, while the right side of the
equation, the Liabilities and the Owner’s Equity items are just the opposite; that is,
they are increased with credits, and decreased with debits. When you increase or
decrease the debits, by the same amount as you increase or decrease the credits
on each transaction, you make sure that the debits always equal the credits, a key
goal of bookkeeping. If the debits do not equal the credits at the end of the period,
(month, quarter, or year), it indicates that a mistake was made somewhere along
the line and one of the transactions was entered improperly. By using this system,
the Accounting Equation always stays in balance after each transaction is recorded
since you are increasing or decreasing both sides of the equation by equal
amounts. There is a standard way of dealing with debits and credits assigned to
Assets, Liabilities, Owner’s Equity, Revenues, and Expenses. The figure below
summarizes this concept:

15
 It is important to remember that every single transaction in the journal must be
recorded as both a debit and a credit. First, Sam invested $60,000 in her bicycle
company. This transaction would be recorded as shown:

You already know that whenever the owner of a business invests cash into his or
her business, cash is increased and so is the Owner’s Investment (part of Owner’s
Equity). If cash (an Asset) increases, this is shown as a debit in the journal; the
increase in Owner’s Equity is listed as a credit.

In the next transaction, the company buys a building, land, and a truck for
$43,000. Since the bicycle shop does not have sufficient cash to pay for all of these
Assets, the owner needs to borrow $20,000 and pays the remainder in cash
($23,000). This transaction would be recorded in the general journal as shown:

Notice in the above journal entry, DEBITS were used to increase the Assets (land,
building, and truck), while CREDITS were used to decrease Asset (cash), but to
increase the Liability Mortgage Payable. Thus, depending upon which side of the
accounting equation the account appears, this will determine if it is recorded as a
debit or a credit.

16
On January 4 , the company purchased inventory of 10 bicycles for a total $1000
for cash . The inventory increased so it is DEBIT and the cash decreased so it is
CREDIT .

Jan 4 Inventory $1000

Cash $1000

( purchase inventory for cash )

On January 5, the bicycle company sold two bicycles for a total of $500. First, it
increased the Revenue account called “Sales” by $500, and second, it increased an
Expense account called “Cost of Goods Sold” by the cost of these two bicycles or
$200. Remember also that at the same time that this transaction is causing a
change to the Income Statement, it is also causing the Balance Sheet to change in
several ways. These bicycles were sold for cash; thus, the Asset cash would
increase by $500. The Asset Inventory would decrease by their cost of $200 (since
the bicycles (Inventory) do not belong to the company any longer). These two
transactions would be recorded in the general journal as seen below:

Referring back to the Accounting Equation, A = L + OE, the sales transaction has
increased the left side (the Asset Cash) by $500, and increased the right side,
Owner’s Equity by the same amount. The second part of this transaction that
reduces the Inventory also keeps the accounting equation in balance, the Expense
of the bikes (the debit), and the decrease in Inventory (the credit). In both of these
transactions, the debits to record these transactions are equal to the credits.

17
On January 7, Solana Beach Bicycle Company pays Sam her first week’s pay of
$100. This transaction would be recorded in the General Journal as shown :

This transaction has decreased the left side of the accounting equation, Assets or
Cash by $100, and has also decreased the right side Owner’s Equity with an
Expense by the same amount. Once again, the debits equal the credits.

On Jan 10 , the company made some repairs services for $500 on account . This
transaction will be recorded as follows :

Jan 10 A/R $500

Repairs Revenue $500

( performing repairs on account )

On Jan. 14 , Solana Beach Bicycle Company repairs some bicycles for $375. The
parts for these repairs cost the company $105, paid for in cash. This transaction is
recorded in the General Journal as follows :

Once again, notice that in the first part of this transaction, the left side of the
accounting equation is increased by $375, and the right side, Owner’s Equity (via a

18
Revenue item), is increased by the same amount. In the second part of the
transaction, the right side is decreased with a credit to an Asset (cash) by $105,
and the left side is decreased with a debit to an Owner’s Equity account (Repairs
Expense). Thus the equation (A = L + OE) stays in balance, and the debits equal the
credits.

The General Ledger

During the month, the journal entries made to record the January transactions
would be posted from the general journal to the general ledger. The general ledger
is a book containing a record of each account. Posting is simply the process of
transferring the information from the general journal to the individual account
pages in the general ledger. The cash account, which probably is the first page (or
pages) in the general ledger, would look like the example in the figure below :

Jan 5 Sales $500 Jan 3 Purch. Assets $23000

Jan 14 Repairs Rev. $375 Jan 4 Inventory $1000
Jan 7 Salary Expense $100
Jan 14 Repairs Exp. $105
Ending Balance $36,670
Total $60,875 Total $60,875

If you add the debit and credit sides of the cash account, you will find that the
debits total $60,875 and the credits total $24,205. The difference between these
two figures is $36,670. You could say that the cash account has a debit balance at
the end of January. Remember, in order to increase an Asset, we record a debit. If
at the end of the period there is a debit balance in an Asset account, that means
that there is a positive balance, or in this case with cash, “money in the bank.”
Debits and credits will generally not be equal for each individual account; but once
all the accounts are considered together, the debits and credits should be equal.
This is reflected on the trial balance . A discussion of the trial balance follows
below.

19
Trial Balance

Typically, accountants and bookkeepers will prepare a trial balance from the
general ledger after all transactions have been recorded and posted. A trial
balance is merely a list of all accounts in the general ledger that have a balance
other than zero, with the balance in each account shown and the debits and
credits totaled. A trial balance of Solana Beach Bicycle Company at January 31,
would look like the one below :

SOLANA BEACH BICYCLE COMPANY

Trial Balance (Before Adjusting & Closing Entries) January 31,
Debits Credits
Cash $36,670
Accounts Receivables 500
Inventory 800
Truck 8,000
Building 25,000
Land 10,000
Mortgage Payable (Long-Term) 20,000
Owner’s Investment (Capital) 60,000
Sales 500
Repair Revenue 875
Cost of Goods Sold 200
Expenses (Salary) 100
Repair Expense 105
Total $81,375 $81,375

A trial balance is prepared by first turning through the pages of the general ledger
and locating each account with a balance other than zero, as the cash account had
a debit balance of $36,670. Once it is determined what the balance in each

20
account is, this is noted on the Trial Balance . Generally speaking, the trial balance
is prepared for two reasons: the first reason is to determine whether the total
debits equal the total credits. If they do not equal, some kind of error has been
made either in the recording of the journal entries or in the posting of the general
ledger. In either case, the error must be located and corrected. The second reason
is to facilitate the preparation of adjusting entries (discussed in the next section),
which are necessary before the financial statements can be prepared. You should
note that if Solana Beach Bicycle Company had been in operation prior to this year,
a Retained Earnings figure would appear on the present trial balance. The Retained
Earnings account will show the beginning Retained Earnings until the accountant
closes the accounts that affect the Retained Earnings by the amount of the profit
or loss for the period (month, quarter, or year).

Adjusting Journal Entries

The accrual basis accounting prescribes that revenues and expenses must be
recorded in the accounting period in which they were earned or incurred, no
matter when cash receipts or payments occur. It is because of accrual accounting
that we have the revenue recognition principle and the expense recognition
principle (also known as the matching principle). The accrual method is considered
to better match revenues and expenses and standardizes reporting information for
comparability purposes. Having comparable information is important to external
users of information trying to make investment or lending decisions, and to
internal users trying to make decisions about company performance, budgeting,
and growth strategies.

Accounting records are not kept up to date at all times. To do so would be a waste
of time, effort, and money because much of the information is not needed for day-
to-day decisions. When a company reaches the end of a period, it must update
certain accounts that have either been left unattended throughout the period or
have not yet been recognized. Adjusting entries update accounting records at the
end of a period for any transactions that have not yet been recorded. Adjusting
entries is a step taken to recognize financial events that have occurred prior to the
financial statements’ issuance date but which have not been recorded in the
journal. These are not transactions with a particular date attached, but they are
financial realities which require documentation in order to maintain accurate
records and realize the matching principle of revenues and expenses . There are
five items that need to be adjusted at the end of each month:

1- Prepaid Expenses
2- Accumulated Depreciation on the fixed assets as building or truck,
3- Interest on the mortgage, and
4- the portion of account receivables that the company does not believe it
will ever be able to collect (bad debts).

21
 5- Accrued Expenses ( expenses incurred but not recorded , ex. Salaries due
but not recorded or paid, or interest expense , or income tax not paid yet )
6- Unearned Revenues
7- Accrued Revenues

After the adjusted journal entries are recorded in the journal, they must be posted
to the accounts in the general ledger, just like the earlier journal entries.

Prepaid Expenses

This is listed on the Balance Sheet as an Asset when for example Solana Beach
Bicycle Company bought a three year insurance policy for $1,500 in advance of
using it. By the end of January, one of thirty-sixth of the three-year policy had
been used up and became an Expense. To recognize the “using up” of this Asset
(called Prepaid Insurance), an Expense called Insurance Expense is increased by
$41.67 ($1,500/36 months). The Asset itself is no longer worth the full amount
paid, since it now only represents the remaining thirty-five months. If you think
back to the accounting equation again—A = L + OE—the left-hand side of the
equation is reduced by $41.67 (because the Asset called Prepaid Insurance has
decreased), and the right side is also reduced by the same amount because of
insurance Expense (which causes a reduction in Owner’s Equity). An adjustment
for this amount will be made in the journal.

Jan 1 Prepaid Insurance $1,500

Cash $1500

(purchase of insurance policy )

Jan 31 Insurance Expense $41.67

Prepaid Insurance $41.67

( adjusting prepaid insurance )

Some common examples of prepaid expenses are supplies, depreciation,

insurance, and rent.

When a company purchases supplies, it may not use all supplies immediately, but
chances are the company has used some of the supplies by the end of the period.
It is not worth it to record every time someone uses a pencil or piece of paper
during the period, so at the end of the period, this account needs to be updated

22
for the value of what has been used. Let’s say a company paid for supplies with
cash in the amount of $400. At the end of the month, the company took an
inventory of supplies used and determined the value of those supplies used during
the period to be $150. The following entry occurs for the initial payment.

When the company recognizes the supplies usage, the following adjusting entry
occurs.

Depreciation Expense

Long-Term Assets like the building and truck have a finite life. Their original
(historical) cost is therefore spread over their useful lives. This process is called
depreciation. In order to depreciate these two Assets, you need to know what the
life expectancy of each is, that is how long these Assets will produce income for
the business. In our example, you can assume that the building has a life
expectancy of twenty-five years, and the truck of five years. To depreciate these
two Assets, you can divide the historical cost by the life expectancy.

Truck: $8,000 (historical cost)/5 years (life expectancy) = $1,600 Depreciation

per year

Building: $25,000 (historical cost)/25 years (life expectancy) = $1,000

Depreciation per year

Since you are only looking for the depreciation adjustment for these two
Assets for the month of January, each number would be divided by twelve
(months) to arrive at depreciation adjustment for the month of January :

Truck = $1,600 (depreciation per year)/12 (months per year) = $133.33 per
month

Building = $1,000 (depreciation per year)/12 (months per year) = $33.33 per

month

23
Jan 31 Depreciation Expense- Truck $133.33

Accumulated Depreciation-Truck $133.33

Depreciation Expense- Building $33.33

Accumulated Depreciation-Building $33.33

( adjusting for depreciation expenses )

Land, even though it is a Long-Term Asset, does not depreciate and does not have
an accumulated depreciation contra-Asset account.

Accrued Expense

As you remember, Solana Beach Bicycle Company has to pay interest on the
mortgage that it took out on the land and building. Suppose the mortgage was for
$20,000 for ten years at 9 percent per year. The total interest per year is $1,800
($20,000 x 9 percent).Therefore, each month the business owes the mortgage
company one-twelfth of the year’s total interest or $150 ($1,800/12 months).
Since the cash is not owed until the end of the year, Solana Beach Bicycle Company
has created another Liability called Interest Payable that is due at the end of the
year. The amount of this Liability is the same as the Interest Expense of $150 for
the month of January.

Jan 31 Interest Expense $150

Interest Payable $150

( adjusting interest expense )

Accounts Receivable Write-Offs

At the end of January, the company assumed that it was not going to be able to
collect $50 from some of the customers that had promised to pay. (This was a
guesstimate or assumption, since the company will not know until next month who
is going to pay and who is not.) In order to recognize this assumption on the

24
financial statements, an Expense category called Bad Debts Expense is created. The
other half of this entry is to increase an account called “Allowance for Doubtful
Accounts.” This account is called a “contra-Asset”; it is a reduction to Accounts
Receivable that factors in the expectation that certain Accounts Receivable will not
be paid and keeps the Balance Sheet in balance. You should note that even though
the Bad Debt Expense does not use cash, it reduces the Net Income in the same
way as other Expenses that do use cash. In the case of Bad Debt Expense, the Asset
reduced is Accounts Receivable (rather than cash).

Jan 31 Bad Debts $50

Allowance for Doubtful Accounts $50

( adjusting for bad debts )

Unearned Revenues

The unearned revenue represents a customer’s advanced payment for a product

or service that has yet to be provided by the company. Since the company has not
yet provided the product or service, it cannot recognize the customer’s payment as
revenue. At the end of a period, the company will review the account to see if any
of the unearned revenue has been earned. If so, this amount will be recorded as
revenue in the current period. For example, let’s say the company is a law firm.
During the year, it collected retainer fees totaling $48,000 from clients. Retainer
fees are money lawyers collect in advance of starting work on a case. When the
company collects this money from its clients, it will debit cash and credit unearned
fees. Even though not all of the $48,000 was probably collected on the same day,
we record it as if it was for simplicity’s sake.

At the end of the year after analyzing the unearned fees account, 40% of the
unearned fees have been earned. This 40% can now be recorded as revenue. Total
revenue recorded is $19,200 ($48,000 × 40%).

25
Accrued Revenues

Accrued revenues are revenues earned in a period but have yet to be recorded,
and no money has been collected. Some examples include interest, and services
completed but a bill has yet to be sent to the customer ( when a company provides
a service but did not yet bill the client for the work and the customer has also not
yet paid for services) . Interest had been accumulating during the period and needs
to be adjusted to reflect interest earned at the end of the period. Note that this
interest has not been paid at the end of the period, only earned. This aligns with
the revenue recognition principle to recognize revenue when earned, even if cash
has yet to be collected. For example, assume that a company has one outstanding
note receivable in the amount of $100,000. Interest on this note is 5% per year.
Three months have passed, and the company needs to record interest earned on
this outstanding loan. The calculation for the interest revenue earned is $100,000
× 5% × 3/12 = $1,250. The following adjusting entry occurs.

Trial Balance After Adjustments

After the adjusting entries are posted to the ledgers, the accountant may prepare
another trial balance to help in the preparation of the actual financial statements,

26
 SOLANA BEACH BICYCLE COMPANY
Trial Balance (Before Adjusting & Closing Entries) January 31,
Debits Credits
Cash $35,170
Accounts Receivables 500
Allowance for Doubtful Accounts (50)
Inventory 800
Truck 8,000
Accumulated Depreciation-Truck (133.33)
Building 25,000
Accumulated Depreciation-Building (33.33)
Land 10,000
Prepaid Insurance 1,458.33
Mortgage Payable (Long-Term) 20,000
Interest Payable 133.33
Owner’s Investment (Capital) 60,000
Sales 500
Repair Revenue 875
Cost of Goods Sold 200
Expenses (Salary) 100
Repair Expense 105
Insurance Expense 41.67
Depreciation Expense 166.66
Interest Expense 133.33
Bad Debt Expense 50.00

Total $81,508.33 $81,508.33

27
Closing Journal Entries

In general, accounting records are closed at the end of the year. Each Revenue and
Expense account is closed (brought to a zero balance) by

(1) determining the balance of the account and

(2) placing this amount (the account balance) on the opposite side of the account;
that is, a debit balance for an account is balanced out on the credit side of the
journal, and a credit balance is balanced out on the debit side.

The income summary account is an intermediary between revenues and expenses,

and the Retained Earnings account. It stores all of the closing information for
revenues and expenses, resulting in a “summary” of income or loss for the period.
The balance in the Income Summary account equals the net income or loss for the
period. This balance is then transferred to the Retained Earnings account.

After the closing journal entries have been made and posted, all the Income
Statement accounts (also called temporary accounts vs. permanent accounts
which are the balance sheet accounts ) begin the new year with a zero balance. For
example, next year we want to accumulate and show in the sales account the total
sales made during that year and that year only; to do this, the sales account must
have a zero balance at the beginning of the year so the figures from the previous
year don’t carry over. When Solana Beach Bicycle Company decides to make the
financial statements for the end of the month, the accountant would make the
following entries in the general journal to close the records for January,

Sales 500
Repair Revenue 875
Cost of Goods Sold 200
Expenses (Salary) 100
Repair Expense 105
Insurance Expense 41.67
Depreciation Expense 166.66
Interest Expense 133.33
Bad Debt Expense 50.00
Income Summary 578.34

28
 Then the Income Summary is closed to the Retained Earnings account. To get a
zero balance in the Income Summary account, there are guidelines to consider.

• If the balance in Income Summary before closing is a credit balance, you will
debit Income Summary and credit Retained Earnings in the closing entry. This
situation occurs when a company has a net income.

• If the balance in Income Summary before closing is a debit balance, you will
credit Income Summary and debit Retained Earnings in the closing entry. This
situation occurs when a company has a net loss.

Jan 31 Income Summary $578,84

Retained Earnings $578,84

( closing income summary )

The last closing entry requires Dividends ( distributions to owners ) to close to the
Retained Earnings account. Example , suppose a $200 dividends are declared
Jan 31 Retained Earnings $200

Dividends $200

( closing dividends )

Why was income summary not used in the dividends closing entry? Dividends are
not an income statement account. Only income statement accounts help us
summarize income, so only income statement accounts should go into income
summary. Remember, dividends are a contra stockholders’ equity account. It is
contra to retained earnings. If we pay out dividends, it means retained earnings
decreases. Retained earnings decreases on the debit side.

29
Financial Statements for a Sample Company

Now it is time to bake the cake (i.e., prepare the financial statements). We have all
of the ingredients (elements of the financial statements) ready, so let’s now return
to the financial statements themselves. Let’s use as an example a fictitious
company named Cheesy Chuck’s Classic Corn. This company is a small retail store
that makes and sells a variety of gourmet popcorn treats. It is an exciting time
because the store opened in the current month, June. The financial information (as
of June 30) for Cheesy Chuck’s is as follows .

1- Income Statement

To create the income statement is to determine the amount of net income or net
loss for Cheesy Chuck’s. Since revenues ($85,000) are greater than expenses
($79,200), Cheesy Chuck’s has a net income of $5,800 for the month of June.

30
 2- The statement of owner’s equity

So how much did the value of Cheesy Chuck’s change during the month of June?
You are correct if you answered $16,850. Since this is a brand-new store, the
beginning value of the business is zero. During the month, the owner invested
$12,500 and the business had profitable operations (net income) of $5,800. Also,
during the month the owner withdrew $1,450, resulting in a net change (and
ending balance) to owner’s equity of $16,850. Shown in a formula:

Beginning Balance + Investments by Owners ± Net Income (Net Loss) –

Distributions, or $0 + $12,500 + $5,800 – $1,450 = $16,850

31
 3- Balance Sheet

Let’s create a balance sheet for Cheesy Chuck’s for June 30. To begin, we look at
the accounting records and determine what assets the business owns and the
value of each. Cheesy Chuck’s has two assets: Cash ($6,200) and Equipment
($12,500). Adding the amount of assets gives a total asset value of $18,700.

Next, we determine the amount of money that Cheesy Chuck’s owes (liabilities).
There are also two liabilities for Cheesy Chuck’s. The first account listed in the
records is Accounts Payable for $650. Accounts Payable is the amount that Cheesy
Chuck’s must pay in the future to vendors (also called suppliers) for the ingredients
to make the gourmet popcorn. The other liability is Wages Payable for $1,200. This
is the amount that Cheesy Chuck’s must pay in the future to employees for work
that has been performed. Adding the two amounts gives us total liabilities of
$1,850.

Finally, we determine the amount of equity the owner, Cheesy Chuck, has in the
business. The amount of owner’s equity was determined on the statement of
owner’s equity in the previous step ($16,850). Can you think of another way to
confirm the amount of owner’s equity? Recall that equity is also called net assets
(assets minus liabilities). If you take the total assets of Cheesy Chuck’s of $18,700
and subtract the total liabilities of $1,850, you get owner’s equity of $16,850.
Using the basic accounting equation, the balance sheet for Cheesy Chuck’s as of
June 30 is shown

32
From what we have learned in this chapter we can summarize the accounting
cycle in the following figure :

33
 REVIEW QUESTIONS
Multiple Choice

1. Accounting is sometimes called the “language of _____.”

A. Wall Street

B. business

C. Main Street

D. financial statements

2. Financial accounting information ________.

A. should be incomplete in order to confuse competitors

B. should be prepared differently by each company

C. provides investors guarantees about the future

D. summarizes what has already occurred

3. External users of financial accounting information include all of the following

except ________.

A. lenders such as bankers

B. governmental agencies such as the IRS

C. employees of a business

D. potential investors

4. Which of the following is not considered a stakeholder of an organization?

A. creditors

B. lenders

C. employees

D. community residents

34
E. a business in another industry

5. Which of these statements is not one of the financial statements?

A. income statement

B. balance sheet

C. statement of cash flows

D. statement of owner investments

6. Stakeholders are less likely to include which of the following groups?

A. owners

B. employees

C. community leaders

D. competitors

7. Identify the correct components of the income statement.

A. revenues, losses, expenses, and gains

B. assets, liabilities, and owner’s equity

C. revenues, expenses, investments by owners, distributions to owners

D. assets, liabilities, and dividends

8. The balance sheet lists which of the following?

A. assets, liabilities, and owners’ equity

B. revenues, expenses, gains, and losses

C. assets, liabilities, and investments by owners

D. revenues, expenses, gains, and distributions to owners

9. Assume a company has a $350 credit (not cash) sale. How would the transaction
appear if the business uses accrual accounting?

35
A. $350 would show up on the balance sheet as a sale.

B. $350 would show up on the income statement as a sale.

C. $350 would show up on the statement of cash flows as a cash outflow.

D. The transaction would not be reported because the cash was not exchanged.

10. Which of the following statements is true?

A. Tangible assets lack physical substance.

B. Tangible assets will be consumed in a year or less.

C. Tangible assets have physical substance.

D. Tangible assets will be consumed in over a year.

11. Owners have no personal liability under which legal business structure?

A. a corporation

B. a partnership

C. a sole proprietorship

D. There is liability in every legal business structure.

12. The accounting equation is expressed as ________.

A. Assets + Liabilities = Owner’s Equity

B. Assets – Noncurrent Assets = Liabilities

C. Assets = Liabilities + Investments by Owners

D. Assets = Liabilities + Owner’s Equity

13. Which of the following decreases owner’s equity?

A. investments by owners

B. losses

C. gains

36
D. short-term loans

14. Exchanges of assets for assets have what effect on equity?

A. increase equity

B. may have no impact on equity

C. decrease equity

D. There is no relationship between assets and equity.

15. All of the following increase owner’s equity except for which one?

A. gains

B. investments by owners

C. revenues

D. acquisitions of assets by incurring liabilities

16. Which of the following is not an element of the financial statements?

A. future potential sales price of inventory

B. assets

C. liabilities

D. equity

17. Which of the following is the correct order of preparing the financial
statements?

A. income statement, statement of cash flows, balance sheet, statement of

owner’s equity

B. income statement, statement of owner’s equity, balance sheet, statement of

cash flows

C. income statement, balance sheet, statement of owner’s equity, statement of

cash flows

37
D. income statement, balance sheet, statement of cash flows, statement of
owner’s equity

18. The three heading lines of financial statements typically include which of the
following?

A. company, statement title, time period of report

B. company headquarters, statement title, name of preparer

C. statement title, time period of report, name of preparer

D. name of auditor, statement title, fiscal year end

19. Which financial statement shows the financial performance of the company on
a cash basis?

A. balance sheet

B. statement of owner’s equity

C. statement of cash flows

D. income statement

20. Which financial statement shows the financial position of the company?

A. balance sheet

B. statement of owner’s equity

C. statement of cash flows

D. income statement

21. Which of these accounts is a liability?

A. Accounts Receivable

B. Supplies

C. Salaries Expense

D. Accounts Payable

38
22. ________ takes all transactions from the journal during a period and moves the
information to a general ledger (ledger).

A. Hitching

B. Posting

C. Vetting

D. Laxing

23. What is the impact on the accounting equation when a current month’s utility
expense is paid?

A. both sides increase

B. both sides decrease

C. only the Asset side changes

D. neither side changes

24. Which of these transactions requires a debit entry to Cash?

A. paid balance due to suppliers

B. sold merchandise on account

C. collected balance due from customers

D. purchased supplies for cash

25. What is the impact on the accounting equation when a payment of account
payable is made?

A. both sides increase

B. both sides decrease

C. only the Asset side changes

D. neither side changes

39
26. What is the impact on the accounting equation when an accounts receivable is
collected?

A. both sides increase

B. both sides decrease

C. only the Asset side changes

D. the total of neither side changes

27. What is the impact on the accounting equation when a sale occurs?

A. both sides increase

B. both sides decrease

C. only the Asset side changes

D. neither side changes

28. What is the impact on the accounting equation when stock is issued, in
exchange for assets?

A. both sides increase

B. both sides decrease

C. only the Asset side changes

D. neither side changes

29. Which of the following accounts is increased by a debit?

A. Common Stock

B. Accounts Payable

C. Supplies

D. Service Revenue

30. Which of the following accounts does not increase with a debit entry?

A. Retained Earnings

40
B. Buildings

C. Prepaid Rent

D. Electricity Expense

31. Which of the following pairs increase with credit entries?

A. supplies and retained earnings

B. rent expense and unearned revenue

C. prepaid rent and common stock

D. unearned service revenue and accounts payable

32. Which of the following pairs of accounts are impacted the same with debits
and credits?

A. Cash and Unearned Service Revenue

B. Electricity Expense and Office Supplies

C. Accounts Receivable and Accounts Payable

D. Buildings and Common Stock

33. Which of the following accounts will normally have a debit balance?

A. Common Stock

B. Fees Earned

C. Supplies

D. Accounts Payable

34. What type of account is prepaid insurance?

A. Stockholders’ Equity

B. Expense

C. Liability

41
D. Asset

35. Which of the following financial statements should be prepared first?

A. Balance Sheet

B. Income Statement

C. Retained Earnings Statement

D. Statement of Cash Flows

36. Rent collected in advance is an example of which of the following?

A. accrued expense

B. accrued revenue

C. deferred expense (prepaid expense)

D. deferred revenue (unearned revenue)

37. Rent paid in advance is an example of which of the following?

A. accrued expense

B. accrued revenue

C. deferred expense (prepaid expense)

D. deferred revenue (unearned revenue)

38. Salaries owed but not yet paid is an example of which of the following?

A. accrued expense

B. accrued revenue

C. deferred expense (prepaid expense)

D. deferred revenue (unearned revenue)

39. Revenue earned but not yet collected is an example of which of the following?

A. accrued expense

42
B. accrued revenue

C. deferred expense (prepaid expense)

D. deferred revenue (unearned revenue)

40. What adjusting journal entry is needed to record depreciation expense for the
period?

A. a debit to Depreciation Expense; a credit to Cash

B. a debit to Accumulated Depreciation; a credit to Depreciation Expense

C. a debit to Depreciation Expense; a credit to Accumulated Depreciation

D. a debit to Accumulated Depreciation; a credit to Cash

41. Which of these transactions requires an adjusting entry (debit) to Unearned

Revenue?

A. revenue earned but not yet collected

B. revenue collected but not yet earned

C. revenue earned before being collected, when it is later collected

D. revenue collected before being earned, when it is later earned

42. What critical purpose does the adjusted trial balance serve?

A. It proves that transactions have been posted correctly

B. It is the source document from which to prepare the financial statements

C. It shows the beginning balances of every account, to be used to start the new
year’s records

D. It proves that all journal entries have been made correctly.

43. Which of the following accounts is considered a temporary or nominal

account?

A. Fees Earned Revenue

B. Prepaid Advertising

43
C. Unearned Service Revenue

D. Prepaid Insurance

44. Which of the following accounts is considered a permanent or real account?

A. Interest Revenue

B. Prepaid Insurance

C. Insurance Expense

D. Supplies Expense

45. Which of these accounts is included in the post-closing trial balance?

A. Sales Revenue

B. Salaries Expense

C. Retained Earnings

D. Dividends

Questions

1. Identify the four financial statements and describe the purpose of each.

2. Define the term stakeholders. Identify two stakeholder groups, and explain how
each group might use the information contained in the financial statements.

3. Identify one similarity and one difference between revenues and gains. Why is
this distinction important to stakeholders?

4. Identify one similarity and one difference between expenses and losses. Why is
this distinction important to stakeholders?

5. Explain the concept of equity, and identify some activities that affect equity of a
business.

6. Explain the difference between current and noncurrent assets and liabilities.
Why is this distinction important to stakeholders?

44
7. Identify/discuss one similarity and one difference between tangible and
intangible assets.

8. Name the three types of legal business structure. Describe one advantage and
one disadvantage of each.

9. What is the “accounting equation”? List two examples of business transactions,

and explain how the accounting equation would be impacted by these
transactions.

10. Identify the order in which the four financial statements are prepared, and
explain how the first three statements are interrelated.

11. Explain how the following items affect equity: revenue, expenses, investments
by owners, and distributions to owners.

12. Explain the purpose of the statement of cash flows and why this statement is
needed.

13. What do the terms “debit” and “credit” mean? What is a journal? And , What
is the general ledger?

14. Why is the adjusting process needed? Name two types of adjusting journal
entries that are commonly made before preparing financial statements? Explain,
with examples.

15. What is the purpose of the closing entries?

Exercises

1. For each independent situation below, calculate the missing values.

2. For each independent situation below, calculate the missing values for owner’s
equity

45
3. For each independent situation below, calculate the missing values.

4. For each independent situation below, place an (X) by the transactions that
would be included in the statement of cash flows.

Transaction Included :

Sold items on account

Wrote check to pay utilities

Received cash investment by owner

Recorded wages owed to employees

Received bill for advertising

5. Forest Company had the following transactions during the month of December.
What is the December 31 cash balance?

46
6. Here are facts for the Hudson Roofing Company for December. Assuming no
investments or withdrawals, what is the ending balance in the owners’ capital
account?

7. Prepare an income statement using the following information for DL Enterprises

for the month of July 2018.

8. Prepare a statement of owner’s equity using the information provided for Pirate
Landing for the month of October 2018.

9. Prepare a balance sheet using the following information for the Ginger Company
as of March 31,

47
10. Cromwell Company has the following trial balance account balances, given in
no certain order, as of December 31, 2018. Using the information provided,
prepare Cromwell’s annual financial statements (omit the Statement of Cash
Flows).

Supplies $ 865

Fees Earned 22,850

Accounts Receivable 2,580

Accounts Payable 1,945

Office Furniture 12,685

Rent Expense 12,240

Retained Earnings 3,600

Cash 4,695

Electricity Expense 1,380

Capital 10,000

Miscellaneous Expenses 1,450

Distributions to Owner 2,500

11. Prepare journal entries to record the following transactions.

A. March 1, purchased land for cash, $20,000

48
B. March 11, purchased merchandise inventory, on account, $18,500

C. March 15, Sold merchandise to customer for cash, $555

12. Prepare journal entries to record the following transactions that occurred in
March:

A. on first day of the month, purchased building for cash, $75,000

B. on fourth day of month, purchased inventory, on account, $6,875

C. on eleventh day of month, billed customer for services provided, $8,390

D. on nineteenth day of month, paid current month utility bill, $2,000

E. on last day of month, paid suppliers for previous purchases, $2,850

13. Reviewing insurance policies revealed that a single policy was purchased on
August 1, for one year’s coverage, in the amount of $6,000. There was no previous
balance in the Prepaid Insurance account at that time. Based on the information
provided:

A. Make the December 31 adjusting journal entry to bring the balances to correct.

B. Show the impact that these transactions had.

14. On July 1, a client paid an advance payment (retainer) of $5,000 to cover future
legal services. During the period, the company completed $3,500 of the agreed-on
services for the client. There was no beginning balance in the Unearned Revenue
account for the period. Based on the information provided,

A. Make the December 31 adjusting journal entry to bring the balances to correct.

B. Show the impact that these transactions had.

15. Reviewing payroll records indicates that employee salaries that are due to be
paid on January 3 include $3,575 in wages for the last week of December. There
was no previous balance in the Salaries Payable account at that time. Based on the
information provided, make the December 31 adjusting journal entry to bring the
balances to correct.

49
16. Supplies were purchased on January 1, to be used throughout the year, in the
amount of $8,500. On December 31, a physical count revealed that the remaining
supplies totaled $1,200. There was no beginning of the year balance in the
Supplies account. Based on the information provided:

A. Create journal entries for the original transaction

B. Create journal entries for the December 31 adjustment needed to bring the
balances to correct

C. Show the activity, with ending balance

17. Prepare journal entries to record the following adjustments.

A. Insurance that expired this period, $18,000

B. Depreciation on assets, $4,800

C. Salaries earned by employees but unpaid, $1,200

18. Prepare adjusting journal entries, as needed, considering the account balances
excerpted from the unadjusted trial balance and the adjustment data.

A. depreciation on fixed assets, $ 8,500

B. unexpired prepaid rent, $12,500

C. remaining balance of unearned revenue, $555

19. The following accounts and normal balances existed at year-end. Make the
journal entries required to close the books:

50
20. Identify which of the following accounts would not be listed on the company’s
Post-Closing Trial Balance.

51
52
It is important that you understand the concepts of Generally Accepted Accounting
Principles (GAAP), which form the basis of accounting and are part of the language
of accounting and business. This chapter will introduce the agencies responsible
for standardizing the accounting principles that are used in the United States and it
will describe those principles in full detail. Once you understand these guiding
principles, you will have a solid foundation on which to build a complete set of
accounting skills. It is useful and necessary that whether an international company
is reporting to its stockholders or a proprietor is presenting information to a bank
for a loan, these reports follow a consistent set of rules that everyone understands
and agrees to.

Who Are the SEC, AICPA, and the FASB?

Congress created the Securities and Exchange Commission (SEC) in 1934.At that
time, the Commission was given the legal power to prescribe the accounting
principles and practices that must be followed by the companies that come within
its jurisdiction. Generally speaking, companies come under SEC regulations when
they sell securities to the public, list their securities on any one of the securities
exchanges (New York Stock Exchange or American Exchange for example), or when
they become greater than a specified size as measured by the firm’s Assets and
number of shareholders. Thus, since 1934, the SEC has had the power to
determine the official rules of accounting practice that must be followed by almost
all companies of any significant size.

Instead, for the most part, the SEC assigned the responsibility of identifying or
specifying GAAP to the American Institute of Certified Public Accountants (AICPA).
That role has now been transferred to the Financial Accounting Standards Board
(FASB). All rulings from the FASB are considered to be GAAP. The FASB is currently
collaborating on a project with the International Accounting Standards Board to
make it easier for companies to report financial statements, so that separate
statements are not needed for U.S. and international markets.

A firm must adopt the accounting practices recommended by the FASB or the SEC
unless they can identify an alternative practice that has “substantial authoritative
support.” Even when a company can find “substantial authoritative support” for a
practice it uses which differs from the one recommended, the company must
include in the financial statement footnotes (or in the auditor’s report) a
statement indicating that the practices used are not the ones recommended by
GAAP. Where practicable, the company must explain how its financial statements

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would have been different if the company had used Generally Accepted
Accounting Principles.

Generally Accepted Accounting Principles (GAAP)

Financial statements must present relevant, reliable, understandable, sufficient,

and practicably obtainable information in order to be useful.

Relevant Information

Relevant information is that information which helps financial statement users

estimate the value of a firm and/or evaluate how well the firm is being managed.
The financial statements must be stated in terms of a monetary unit, since money
is our standard means of determining the value of a company.

In the United States, accountants use the stable monetary unit concept, which
means that even though the value of the dollar changes over time (due to
inflation), the values that appear on the financial statements normally are
presented at historical cost. Historical cost presents the information on the
financial statements at amounts the individual or company paid for them or
agreed to pay back for them at the time of purchase. This method of accounting
ignores the effect of inflation. In many other countries throughout the world, the
accounting profession does account for inflation.

Not all information about a firm is relevant for estimating its value or evaluating its
management. For example, you don’t need the information of how many
individuals over forty years of age work for the company, or what color the

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machinery is painted in order to make financial decisions about a company. Even
some financial information is not relevant, like how much money the owner of a
corporation has in the bank, because as we reviewed in chapter 1, the business’s
accounting records are kept separate from its owner’s, and the owner’s financial
information is irrelevant to the business.

Reliable Information

Reliable information is key in accounting. Sufficient and objective evidence should

be available to indicate that the information presented is valid. In addition, the
information must not be biased in favor of one statement user or one group of
users to the detriment of other statement users. The need for reliable information
has caused the federal government to pass laws requiring public companies to
have their records and financial statements examined (audited) by independent
auditors who will make sure that what companies report is accurate.

Verifiable Information

The need for verifiable information does not preclude the use of estimates and
approximation. If you were to eliminate from accounting all estimates, the
resulting statements would not be useful primarily because the statements would
not provide sufficient information. The approximations that are used, however,
cannot be “wild guesses.” They must be based on sufficient evidence to make the
resulting statements a reliable basis for evaluating the firm and its management.

One example of a place in the financial statements where we estimate the value is
with depreciation. Once we purchase a Long-Term Asset (anything that the
company owns that will last longer than one year; for example, a building), we
then need to spread the cost of this building over the life of the Asset. This is called
depreciation. In order to do this we must estimate the life of that particular Asset.
We can’t know exactly how long that will be, but since we do have experience with
these types of Assets, we can estimate the Asset’s life. We assume that the
building will be useable for say twenty years and depreciate (or spread) the cost of
the building (the Asset) over twenty years (the estimated life).

For example, if we buy this building for $100,000 and assume that it is going to
last twenty years, the annual depreciation would be $5,000 per year
($100,000/20). This $5,000 becomes one of the Expenses for the company and is
shown on the Income Statement along with the other Expenses.

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Understandable Information

To be understandable, the financial information must be comparable. Any item on

the Balance Sheet that an accountant labels as an Asset or Liability, users of the
financial statements should also call Assets and Liabilities. Statement users must
compare financial statements of various firms with one another, and they must
compare statements of an individual firm with prior years’ statements of that
same firm in order to make valid decisions. Thus, the accounting practices that a
firm uses for a particular transaction should be the same as other firms use for the
identical transaction. This practice should also be the same practice the firm used
in previous periods. This concept is called Consistency. Together, information that
is comparable and consistent becomes understandable to the users of the
financial information.

Quantifiable Information

Information is easier to understand and use if it is quantified. Most information

that accountants and users of financial information use is represented by
numbers.The information that is presented in the financial statements is presented
in a numerical form; however, where that is impossible, the information (if it is
relevant, reliable, understandable, and practicably obtainable) will be presented in
narrative form, usually in a footnote to the statements. Accountants include
narrative information along with the quantifiable information because of the need
for adequate or full disclosure; statement users must have sufficient information
about a firm. An example of non-quantifiable information that might be included in
the footnotes to the financial statements would be details of an outstanding
patent infringement lawsuit against the company, which would be considered a
contingent Liability.

Obtainable Information

Furthermore, to be useful, information must be reasonably easy to obtain. This

fits into the concept of cost vs. benefit. The information must be worth more than
what it will cost to obtain it and must be secured on a timely basis. Financial
statements must be prepared at least once a year (in many cases, quarterly or
monthly) and attempting to incorporate unobtainable information could seriously
delay these schedules. An example of obtainable information is the number of
shares sold by the corporation during the year. Another example would be the

56
amount of sales by the business during the year. An example of information that
might not be considered obtainable would be the nitty-gritty details of the pension
plan systems used in each of the subsidiaries of a multinational corporation. A
more reasonable and easily obtainable piece of data might be the total amount of
money that is being spent on the company’s pensions around the world.

The Conceptual Framework

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

The conceptual framework sets the basis for accounting standards set by rule-
making bodies that govern how the financial statements are prepared. Here are a
few of the principles, assumptions, and concepts that provide guidance in
developing GAAP.

Revenue Recognition Principle

The revenue recognition principle directs a company to recognize revenue in the

period in which it is earned; revenue is not considered earned until a product or
service has been provided. This means the period of time in which you performed
the service or gave the customer the product is the period in which revenue is
recognized. There also does not have to be a correlation between when cash is
collected and when revenue is recognized. A customer may not pay for the service
on the day it was provided. Even though the customer has not yet paid cash, there
is a reasonable expectation that the customer will pay in the future. Since the
company has provided the service, it would recognize the revenue as earned, even
though cash has yet to be collected.

For example, Lynn Sanders owns a small printing company, Printing Plus. She
completed a print job for a customer on August 10. The customer did not pay cash
for the service at that time and was billed for the service, paying at a later date.
When should Lynn recognize the revenue, on August 10 or at the later payment
Lynn should record revenue as earned on August 10. She provided the service to
the customer, and there is a reasonable expectation that the customer will pay at
the later date.

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Expense Recognition (Matching) Principle

The expense recognition principle (also referred to as the matching principle)

states that we must match expenses with associated revenues in the period in
which the revenues were earned. A mismatch in expenses and revenues could be
an understated net income in one period with an overstated net income in another
period. There would be no reliability in statements if expenses were recorded
separately from the revenues generated. For example, if Lynn earned printing
revenue in April, then any associated expenses to the revenue generation (such as
paying an employee) should be recorded on the same income statement. The
employee worked for Lynn in April, helping her earn revenue in April, so Lynn must
match the expense with the revenue by showing both on the April income
statement.

Cost Principle

The cost principle, also known as the historical cost principle, states that virtually
everything the company owns or controls (assets) must be recorded at its value at
the date of acquisition. For most assets, this value is easy to determine as it is the
price agreed to when buying the asset from the vendor. There are some
exceptions to this rule, but always apply the cost principle unless FASB has
specifically stated that a different valuation method should be used in a given
circumstance. The primary exceptions to this historical cost treatment, at this time,
are financial instruments, such as stocks and bonds, which might be recorded at
their fair market value. This is called mark-to-market accounting or fair value
accounting and is more advanced than the general basic concepts underlying the
introduction to basic accounting concepts; therefore, it is addressed in more
advanced accounting courses. Once an asset is recorded on the books, the value of
that asset must remain at its historical cost, even if its value in the market changes.
For example, Lynn Sanders purchases a piece of equipment for $40,000. She
believes this is a bargain and perceives the value to be more at $60,000 in the
current market. Even though Lynn feels the equipment is worth $60,000, she may
only record the cost she paid for the equipment of $40,000.

Full Disclosure Principle

The full disclosure principle states that a business must report any business
activities that could affect what is reported on the financial statements. These
activities could be nonfinancial in nature or be supplemental details not readily

58
available on the main financial statement. Some examples of this include any
pending litigation, acquisition information, methods used to calculate certain
figures, or stock options. These disclosures are usually recorded in footnotes on
the statements, or in addenda to the statements.

Separate Entity Concept

The separate entity concept prescribes that a business may only report activities
on financial statements that are specifically related to company operations, not
those activities that affect the owner personally. This concept is called the
separate entity concept because the business is considered an entity separate and
apart from its owner(s). For example, Lynn Sanders purchases two cars; one is used
for personal use only, and the other is used for business use only. According to the
separate entity concept, Lynn may record the purchase of the car used by the
company in the company’s accounting records, but not the car for personal use.

Conservatism

This concept is important when valuing a transaction for which the dollar value
cannot be as clearly determined, as when using the cost principle. Conservatism
states that if there is uncertainty in a potential financial estimate, a company
should err on the side of caution and report the most conservative amount. This
would mean that any uncertain or estimated expenses/losses should be recorded,
but uncertain or estimated revenues/gains should not. This understates net
income, therefore reducing profit. This gives stakeholders a more reliable view of
the company’s financial position and does not overstate income.

Monetary Measurement Concept

In order to record a transaction, we need a system of monetary measurement, or

a monetary unit by which to value the transaction. In the United States, this
monetary unit is the US dollar. Without a dollar amount, it would be impossible to
record information in the financial records. It also would leave stakeholders unable
to make financial decisions, because there is no comparability measurement
between companies. This concept ignores any change in the purchasing power of
the dollar due to inflation.

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Going Concern Assumption

The going concern assumption assumes a business will continue to operate in the
foreseeable future. A common time frame might be twelve months. However, one
should presume the business is doing well enough to continue operations unless
there is evidence to the contrary. For example, a business might have certain
expenses that are paid off (or reduced) over several time periods. If the business
will stay operational in the foreseeable future, the company can continue to
recognize these long-term expenses over several time periods. Some red flags that
a business may no longer be a going concern are defaults on loans or a sequence
of losses.

Time Period Assumption

The time period assumption states that a company can present useful information
in shorter time periods, such as years, quarters, or months. The information is
broken into time frames to make comparisons and evaluations easier. The
information will be timely and current and will give a meaningful picture of how
the company is operating. For example, a school year is broken down into
semesters or quarters. After each semester or quarter, your grade point average
(GPA) is updated with new information on your performance in classes you
completed. This gives you timely grading information with which to make decisions
about your schooling. A potential or existing investor wants timely information by
which to measure the performance of the company, and to help decide whether to
invest. Because of the time period assumption, we need to be sure to recognize
revenues and expenses in the proper period. This might mean allocating costs over
more than one accounting or reporting period.

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REVIEW QUESTIONS
Multiple Choice

1. That a business may only report activities on financial statements that are
specifically related to company operations, not those activities that affect the
owner personally, is known as which of the following?

A. separate entity concept

B. monetary measurement concept

C. going concern assumption

D. time period assumption

2. That companies can present useful information in shorter time periods such as
years, quarters, or months is known as which of the following?

A. separate entity concept

B. monetary measurement concept

C. going concern assumption

D. time period assumption

3. The system of using a monetary unit, such as the US dollar, to value the
transaction is known as which of the following?

A. separate entity concept

B. monetary measurement concept

C. going concern assumption

D. time period assumption

4. Which of the following terms is used when assuming a business will continue to
operate in the foreseeable future?

A. separate entity concept

B. monetary measurement concept

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C. going concern assumption

D. time period assumption

5. The independent, nonprofit organization that sets financial accounting and

reporting standards for both public- and private-sector businesses that use
generally accepted accounting principles (GAAP) in the United States is which of
the following?

A. Financial Accounting Standards Board (FASB)

B. generally accepted accounting principles (GAAP)

C. Securities and Exchange Commission (SEC)

D. conceptual framework

6. The standards, procedures, and principles companies must follow when

preparing their financial statements are known as which of the following?

A. Financial Accounting Standards Board (FASB)

B. generally accepted accounting principles (GAAP)

C. Securities and Exchange Commission (SEC)

D. conceptual framework

7. These are used by the FASB, and it is a set of concepts that guide financial
reporting.

A. Financial Accounting Standards Board (FASB)

B. generally accepted accounting principles (GAAP)

C. Securities and Exchange Commission (SEC)

D. conceptual framework

8. This is the independent federal agency protecting the interests of investors,

regulating stock markets, and ensuring companies adhere to GAAP requirements.

A. Financial Accounting Standards Board (FASB)

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B. generally accepted accounting principles (GAAP)

C. Securities and Exchange Commission (SEC)

D. conceptual framework

9. Which of the following is the principle that a company must recognize revenue
in the period in which it is earned; it is not considered earned until a product or
service has been provided?

A. revenue recognition principle

B. expense recognition (matching) principle

C. cost principle

D. full disclosure principle

10. Which of the following is the principle that a business must report any business
activities that could affect what is reported on the financial statements?

A. revenue recognition principle

B. expense recognition (matching) principle

C. cost principle

D. full disclosure principle

11. Also known as the historical cost principle, ________ states that everything the
company owns or controls (assets) must be recorded at their value at the date of
acquisition.

A. revenue recognition principle

B. expense recognition (matching) principle

C. cost principle

D. full disclosure principle

12. Which of the following principles matches expenses with associated revenues
in the period in which the revenues were generated?

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A. revenue recognition principle

B. expense recognition (matching) principle

C. cost principle

D. full disclosure principle

13. A company purchased a building twenty years ago for $150,000. The building
currently has an appraised market value of $235,000. The company reports the
building on its balance sheet at $235,000. What concept or principle has been
violated?

A. separate entity concept

B. recognition principle

C. monetary measurement concept

D. cost principle

Questions

Match the correct term with its definition.

A. cost principle

B. full disclosure principle

C. separate entity concept

D. monetary measurement concept

E. conservatism

F. revenue recognition principle

G. expense recognition principle

i. if uncertainty in a potential financial estimate, a company should err on the side

of caution and report the most conservative amount

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ii. also known as the historical cost principle, states that everything the company
owns or controls (assets) must be recorded at their value at the date of acquisition

iii. (also referred to as the matching principle) matches expenses with associated
revenues in the period in which the revenues were generated

iv. business must report any business activities that could affect what is reported
on the financial statements

v. system of using a monetary unit by which to value the transaction, such as the
US dollar

vi. period of time in which you performed the service or gave the customer the
product is the period in which revenue is recognized

vii. business may only report activities on financial statements that are specifically
related to company operations, not those activities that affect the owner
personally.

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Financial Statement
Analysis

66
Using Short-Term Ratios
Financial statements can be extremely useful for evaluating a company’s future in
the near-term (usually defined as one to twelve months) as well as beyond the
near-term. The most important question to be answered when evaluating a
company’s near-term future is whether or not the company will be able to pay its
debts when they come due. If the firm cannot, it may be forced into bankruptcy or
perhaps even forced to cease operations. As you learned earlier, even a profitable
company can become short on cash and place its future in jeopardy. Certain
financial statement users will be particularly interested in the short-term prospects
of a company. Bankers, for example, who have made or are contemplating making
short-term loans (thirty-day, sixty-day, or even six month loans) are mainly
concerned with determining whether the borrowing company will be able to repay
their loans when they come due. These statement users will attempt to forecast
the company’s cash flow for the period of time during which their loans are
expected to be outstanding. For this reason, the cash flow statement discussed
before becomes very important. Even those users who are mostly interested in
the short-term, will also have an interest in the long-term. Again taking banks as an
example, bankers must be aware of what is happening now and what the future
looks like for all of their customers in order to decide to whom they can loan
money and in order to estimate their own future cash flows.

Key short – term ratios are illustrated in the following figure :

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And the following figure will show how each ratio is used :

Current and Quick Ratios

To figure out whether a company is going to survive in the short-term, you should
look first at the Balance Sheet. Compare the company’s Current Assets with their
Current Liabilities (debts that must be paid within twelve months) using the
current ratio.

Current Ratio = Current or Short-Term Assets/Current or Short-Term Liabilities

Also widely used is the comparison of the firm’s quick Assets—those Current
Assets that can be quickly turned into cash—to the Current Liabilities. Usually
quick Assets include cash, current receivables, and marketable securities, or in
other words, Currents Assets minus Inventory and prepaid items. This ratio of
quick Assets to Current Liabilities is referred to as the quick (or acid test) ratio.

Quick Asset Ratio = Quick Assets/Current or Short-Term Liabilities

Suppose the ShortTerm Assets on December 31, 2006, of $50,385 and the Short-
Term Liabilities on the same day of $4,000 , then the current ratio would be 12.6.
And suppose the quick Assets on December 31, 2006, was $26,385 and the
Current Liabilities of $4,000 , then the quick ratio for this company would be 6.6.
But what do these numbers mean? Before you can decide whether a firm has
sufficient Current Assets or quick Assets to cover their Current Liabilities, you need
to know what the current and quick ratios were in the preceding periods. The rule

68
of thumb is that the current ratio should be greater than 2.0. What this means is
that the Current Assets available to the company to pay their debts are at least
double their Current Liabilities. The quick Asset ratio rule of thumb is that this ratio
should be 1.5 or larger. These ratios vary from industry to industry, and therefore
your company’s current ratio should not only be compared to prior years and to
the rule of thumb figure, but should also be compared to similar companies in the
same industry.

In general, the larger the current and quick ratios are the greater the probability
that a company will be able to pay its debts in the near term. In the case of the
above example , the current and quick ratios are well above the rule of thumb,
which means the business is in a very good position to be able to pay its Current
Liabilities.

Working Capital

Another important factor to consider in the short-term in addition to these two

ratios is the firms’ working capital. This is calculated by subtracting the Current
Liabilities from the Current Assets.

Working Capital = Current or Short-Term Assets – Current or ShortTerm Liabilities

Working capital is a cushion. It allows management to make errors in its estimate

of future cash receipts and disbursements and still be able to pay its debts when
they fall due. For example, if management estimates both cash receipts and
disbursements for the next thirty days to be $30,000, and for some reason receipts
only total $25,000 and disbursements total $35,000, the firm must have either
sufficient working capital at the beginning of the month to cover the shortfall or
good credit with its bankers. If this is not the case it will find itself unable to settle
its debts and possibly be out of business or with the creditors taking control.

In addition, it is necessary to compare the working capital to the cash flow of the
firm. How much working capital a firm should have depends upon its cash flow. It
makes sense that a business that receives and/or disburses an average of
$7,000,000 per week, should have a larger working capital balance than a firm that
receives and/or disburses $7,000 per week because the first business’ needs for
cash are higher.

In the case of our example company, the working capital cushion is very good. It is
$46,385 (Current Assets of $50,385 minus the Current Liabilities of $4,000).

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Efficiency Ratios

Efficiency shows how well a company uses and manages their assets. Areas of
importance with efficiency are management of sales, accounts receivable, and
inventory. A company that is efficient typically will be able to generate revenues
quickly using the assets it acquires. Let’s examine four efficiency ratios: accounts
receivable turnover, total asset turnover, inventory turnover, and days’ sales in
inventory.

Accounts Receivable Turnover

Accounts receivable turnover measures how many times in a period (usually a

year) a company will collect cash from accounts receivable. A higher number of
times could mean cash is collected more quickly and that credit customers are of
high quality. A higher number is usually preferable because the cash collected can
be reinvested in the business at a quicker rate. A lower number of times could
mean cash is collected slowly on these accounts and customers may not be
properly qualified to accept the debt. The formula for accounts receivable turnover
is:

Many companies do not split credit and cash sales, in which case net sales would
be used to compute accounts receivable turnover. Average accounts receivable is
found by dividing the sum of beginning and ending accounts receivable balances
found on the balance sheet. The beginning accounts receivable balance in the
current year is taken from the ending accounts receivable balance in the prior
year.

Total Asset Turnover

Total asset turnover measures the ability of a company to use their assets to
generate revenues. A company would like to use as few assets as possible to

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generate the most net sales. Therefore, a higher total asset turnover means the
company is using their assets very efficiently to produce net sales. The formula for
total asset turnover is:

Average total assets are found by dividing the sum of beginning and ending total
assets balances found on the balance sheet. The beginning total assets balance in
the current year is taken from the ending total assets balance in the prior year.

Inventory Turnover Ratio

Inventory turnover ratio is calculated by dividing Cost of Goods Sold by the average
Inventory.

Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory

Average Inventory = (beginning Inventory balance + ending Inventory balance)/2.

This represents the number of times that the Inventory “turned over” (was sold
during a particular period of time). If a business sells and replaces its stock of
Inventory at a rapid rate, turnover is high; if items sit without being sold for long
periods, Inventory turnover is low. There is no widely used rule of thumb available.
To decide whether the Inventory turnover figure for a firm is desirable, you must
look at previous turnover figures of the firm, turnover figures of other similar
firms, and industry wide averages.

A relatively high turnover figure would suggest that sales are being lost due to
shortage of Inventory; a low turnover figure may suggest that demand for the
goods is falling, that some of the Inventory cannot be sold, or that prices must be
reduced. A low turnover figure may also indicate that as of the Balance Sheet date
too much cash has been invested in Inventory items. In a grocery store, you would
expect to see an Inventory turnover of one to two days because the Inventory is
perishable. In a fur coat boutique, on the other hand, you would expect this ratio

71
to be one or two months since fur coats are bought much less frequently and in
much smaller quantities than foodstuffs. It is critical to know and understand the
industry you are analyzing in order to be able to evaluate the ratios.

For example , suppose that for a bicycle company the cost of goods sold was
$14,200 , Inventory on December 31, 2006, is $23,000, and the company was first
year in business then, beginning inventory was zero. Now to calculate the average
Inventory of beginning ($0) and ending ($23,000), we add these two numbers
together and divide by two.

Thus, average Inventory is $11,500. To arrive at Inventory turnover, we divide Cost

of Goods Sold ($14,200) by average Inventory ($11,500) and arrive at 1.24. What
does this mean? Well, it means that Inventory is turning over on the average of
1.24 times per year. That is about every twelve months. Not good! The bicycles are
being built and/or bought, and then not sold for twelve months. If this ratio is not
improved, the company is going to have a lot of money tied up in Inventory, since
it’s not getting it back for a long time—nearly one year. They may need a better
marketing plan. Or it may be that there is just too much Inventory in the shop for
what can be sold at this location. What other possibilities do you see?

Days’ Sales in Inventory

Days’ sales in inventory expresses the number of days it takes a company to turn
inventory into sales. This assumes that no new purchase of inventory occurred
within that time period. The fewer the number of days, the more quickly the
company can sell its inventory. The higher the number of days, the longer it takes
to sell its inventory. The formula for days’ sales in inventory is:

Average Collection Period

To determine whether the balance in Accounts Receivable is too large (or too
small), you can calculate the average collection period.

Average collection period = Accounts receivable/average sales per day

Average sales per day = Annual Sales/365 days.

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You must rely more on the firm’s previous average collection period figures in
evaluating the result and less on the figures of other firms and industry-wide
figures in this case because firms’ credit policies and their mix of cash sales and
sales on account differ widely. If the average collection period has been increasing,
it may indicate the firm’s increasing difficulty in collecting its receivables as they
come due. If for example the Accounts Receivable is $9,000 (This is net receivables:
Accounts Receivable minus allowance for doubtful accounts.) and the sales for the
year are $35,500.

To arrive at average sales per day, we divide $35,500 by 365 days and get $97.26.
To arrive at the average collection period we divide the Accounts Receivable
$9,000 by the average sales per day of $97.26 and get a number of 92.5.

This means that it is taking the company ninety-two and one-half days to collect
their receivables. Suppose that this Company has a policy that generally gives
customers thirty to sixty days to pay. The fact that the average collection period is
longer than this means that it is taking the company too long to collect their
money and be able to use it again in the activities of the business. This is not a
good sign. The company must figure out how to get the customers to pay them
sooner or stop giving them credit at all.

Once you decide that the company is going to survive in the near future, you can
turn to estimating its long-term future prospects. As you begin to look beyond the
short-term success of a company, the main focus of your attention shifts from
information presented on the Balance Sheet to information presented on the
Income Statement in order to look at past performance and project any trends into
the future. The long-term future of a company depends, to a very large extent,
upon the capability of the company’s employees. One of your main goals is to
determine how well the employees have done in the past and how well they are
doing now. The information that you have already gathered at the beginning of
this chapter with regard to the short-term future prospect gives you valuable clues
as to current performance. However, this is not sufficient to draw a reliable
conclusion about the long-term prospects of the company.

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Using Long – term ratios
Quality of Earnings

In analyzing financial statements, it is important to keep in mind the “quality of

earnings” of the company being analyzed. But what is quality of earnings? In
general, companies with a high quality of earnings have a strong history of
earnings and strong ratios for both the short- and long-terms, and thus are
considered to be in a good position to maintain higher earnings in the future. The
“quality of earnings” concept is used by both creditors and investors who
understand that the bottom line of all organizations is not equal. Companies with
higher quality of earnings receive higher credit limits, lower interest costs, and
higher stock prices. The following figure shows what produces a higher quality of
earnings for a business.

There are also several ratios that need to be reviewed and evaluated to
understand the long-term strength of a company. These are the long term ratios
used to evaluate the company :

1. Rate of return on investment

2. Net profit as a percentage of sales

3. Percentage of various Expenses to sales

4. Rate of growth of sales

5. Earnings per share

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6. Extraordinary gains and losses

7. Price/earnings ratio

8. Number of times interest and preferred stock dividends were earned

9. Total Liabilities to total Assets

10. Dividend payout ratio

Rate of Return on Investment

The rate of return on investment is probably the single most important financial
statistic. It comes as close as any figure can to reflecting how well a company has
done. Return on Investment (ROI) is usually calculated as follows:

Rate of return (as a ratio) = Net Income/Average Stockholders’ or Owner’s Equity

Rate of return (as a percentage) = Net Income/Average Stockholders’ or Owner’s
Equity (x 100)

This ratio depicts how much money was earned as compared to the amount the
owners invested in the business. As an example , Sam had invested $60,000 into
the business on January 1. Since the beginning Owner’s Equity was $0 on January
1, and the ending Owner’s Equity was $70,385 on December 31, the average for
the year was $35,193. Since Net Income for 2006 was $10,385, the owner earned
29.5 percent on her investment. ($10,385/$35,193)

Is 29.5 percent a good return on the Owner’s Investment? The only way to answer
this question is to know what alternative investments an investor might consider.
Can the owner invest his money elsewhere and make more money? If the answer
is no, then the return is a good one. This analysis should be made on an ongoing
basis in order to continually determine where to invest one’s money. Having said
this, there are exceptions. In the early years of a new company, the owner may not
make a great return or any return. But he or she may be “betting” on the future, in
the belief that the returns will outpace other alternatives. In addition, a company
should consider how well it does in the current year as compared to the previous
year by comparing the rate of return figure for each of the two years. Comparing
one company’s results to those of another company in the same industry is also a
useful indicator of how the company is doing in comparison to the competition.

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Profitability Ratios

Profitability considers how well a company produces returns given their

operational performance. The company needs to leverage its operations to
increase profit. To assist with profit goal attainment, company revenues need to
outweigh expenses. Let’s consider three profitability measurements and ratios:
profit margin, return on total assets, and return on equity.

Profit Margin

Profit margin represents how much of sales revenue has translated into income.
This ratio shows how much of each $1 of sales is returned as profit. The larger the
ratio figure (the closer it gets to 1), the more of each sales dollar is returned as
profit. The portion of the sales dollar not returned as profit goes toward expenses.
The formula for profit margin is:

Return on Total Assets

The return on total assets measures the company’s ability to use its assets
successfully to generate a profit. The higher the return (ratio outcome), the more
profit is created from asset use. Average total assets are found by dividing the sum
of beginning and ending total assets balances found on the balance sheet. The
beginning total assets balance in the current year is taken from the ending total
assets balance in the prior year. The formula for return on total assets is:

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Return on Equity

Return on equity measures the company’s ability to use its invested capital to
generate income. The invested capital comes from stockholders investments in the
company’s stock and its retained earnings and is leveraged to create profit. The
higher the return, the better the company is doing at using its investments to yield
a profit. The formula for return on equity is:

Average stockholders’ equity is found by dividing the sum of beginning and ending
stockholders’ equity balances found on the balance sheet. The beginning
stockholders’ equity balance in the current year is taken from the ending
stockholders’ equity balance in the prior year. Keep in mind that the net income is
calculated after preferred dividends have been paid.

Earnings Data

The earnings per share figure (EPS) and the price/earnings ratio (P/E) are, along
with the rate of return on investment ratio, the most widely used information
about corporations.

The price/earnings ratio is calculated by dividing the market price per share of that
company’s stock by the earnings per share of the company.

Price/Earnings Ratio = Market Price Per Share/Earnings Per Share

The price/earnings ratio can give you some very useful ideas about what other
people expect for the future of a company. For example, when a company’s stock
is selling for fifty times earnings (P/E ratio of fifty to one) and the average P/E ratio
for most stocks in that industry is fifteen to one, you may conclude that:

(1) the company’s earnings are going to increase considerably in the future or

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 (2) the price of the stock is going down between now and the time the
present buyers will want to sell the stock.

In general, when the P/E ratio of a company’s stock is significantly higher than
average, the buyers of the stock expect that the company will prosper; when
the ratio is lower than average, buyers are not optimistic about the company’s
future. After calculating EPS, you will want to compare the earnings per share
figures of a company for a period of five to ten years and should compare the
EPS figures with those of other companies.

When looking at Net Income for a company, you must also consider the
makeup of that number. Often, there are extraordinary gains or losses
included. These are gains/losses from the sale of items that are not considered
to be recurring. Since you want to project the past into the future, you want to
eliminate from the past data those gains and losses that are not expected to
occur again in the future. Therefore, the figure that you will find most useful is
the EPS before extraordinary gains and losses when the earnings figure used in
the calculation does not include gains or losses that are considered an anomaly
or highly unusual in some way. However, you should be sure to look carefully
at the extraordinary items and determine the likelihood that they may occur
again in the future.

Solvency Ratios

Solvency implies that a company can meet its long-term obligations and will likely
stay in business in the future. To stay in business the company must generate
more revenue than debt in the long-term. Meeting long-term obligations includes
the ability to pay any interest incurred on long-term debt. Two main solvency
ratios are the debt-to-equity ratio and the times interest earned ratio.

Debt to Equity Ratio

The debt-to-equity ratio shows the relationship between debt and equity as it
relates to business financing. A company can take out loans, issue stock, and retain
earnings to be used in future periods to keep operations running. It is less risky and
less costly to use equity sources for financing as compared to debt resources. This
is mainly due to interest expense repayment that a loan carries as opposed to
equity, which does not have this requirement. Therefore, a company wants to
know how much debt and equity contribute to its financing. Ideally, a company

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would prefer more equity than debt financing. The formula for the debt to equity
ratio is:

Although some people believe that a company that borrows money is not as good
or as well managed as a company that operates without borrowing. This is not
necessarily true. Often, by borrowing money, a company can increase the Net
Income for the stockholders without increasing the stockholders’ investment. For
example, say that Company A, whose Assets total $100,000, Liabilities total
$10,000, and Stockholders’ Equity totals $90,000, expects a Net Income next year
of $9,000. This represents a return on investment of 10 percent. Now assume that
management is considering the purchase of $40,000 worth of Assets. These Assets
will produce additional annual Net Income (before interest Expense) of $4,000.
The company has two choices. First it can borrow the $40,000 at 6 percent interest
or it can have the investors put the additional $40,000 into the business.

In scenario one, Company A borrows the needed $40,000. Company A’s Net
Income next year would be $10,600 ($9,000 + $4,000 – $2,400) before Income
Taxes. The $2,400 reduction to Net Income is the interest on the loan ($40,000
x 6 percent). Thus, the return on investment would be 11.7 percent
($10,600/$90,000 = 11.7 percent).

In scenario two, instead of borrowing the $40,000, the owners invest their
own money. Net income would still increase by $4,000 to $13,000 ($9,000 +
$4,000). There would be no interest Expense, and the Return on Stockholders’
Equity would be $13,000/$130,000 (the original $90,000 + the additional
$40,000). Thus, its Return on investment remains at 10 percent. As you can
see, scenario one, where Company A borrowed the additional $40,000, and
ended up with a return on investment of 11.7 percent was a more favorable
outcome.

One way to help you determine if a company has put itself into a risky position is
to calculate two ratios: the number of times interest was earned and the ratio of
total Liabilities to total Assets. To calculate the number of times that interest was
earned, divide the interest Expense into the Net Income before interest Expense

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and before Income Taxes. You use the income figure before Income Taxes because
interest Expense is deductible for Income Tax purposes.

Number of Times Interest Was Earned

= Net Income before Interest and Taxes/Interest Expense

The larger this ratio, the easier it is for the company to meet its interest payments,
and the less likely it is that the company will default on its loans.

To calculate the ratio of Liabilities to Assets, you divide total Liabilities by total
Assets.

Ratio of Liabilities to Assets = Total Liabilities/Total Assets

The idea here is that the larger the ratio, the more risky the company. Of course, a
company with a large Liability to Asset ratio may prosper while a company without
any debt at all may fail. The Liability to Asset ratio, as well as any ratio, only gives
you a part of the total picture and must be analyzed along with other ratios and
outside information about the company, the industry, and the economy

Dividend Data

Additional information about a company can be obtained by looking at the cash

dividends that it has paid over the past several years and calculating the dividend
payout ratio, the total cash dividends declared during the year divided by the Net
Income for the year.

Dividend Payout Ratio = Dividends Declared/Net Income

If the ratio is large, the company is paying out to the stockholders a large portion
of the funds earned and not reinvesting them in the company. If this ratio is small
or if the company pays no dividends whatsoever, the company may be growing
rapidly and using the funds to finance this growth. Which is better? This is
completely determined by your personal investment needs if you are a stockholder
or the goals of the business if you are part of management.

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REVIEW QUESTIONS

Multiple Choice
1.Working capital is an indication of the firm’s ________.

A. asset utilization

B. amount of noncurrent liabilities

C. liquidity

D. amount of noncurrent assets

2.If current assets are $112,000 and current liabilities are $56,000, what is the
current ratio?

A. 200 percent

B. 50 percent

C. 2.0

D. $50,000

3. If current assets are $100,000 and current liabilities are $42,000, what is the
working capital?

A. 200 percent

B. 50 percent

C. 2.0

D. $58,000

4.Which of the following best represents a positive product of a lower number of

days’ sales in receivables ratio?

A. collection of receivables is quick, and cash can be used for other business
expenditures

B. collection of receivables is slow, keeping cash secured to receivables

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C. credit extension is lenient

D. the lender only lends to the top 10% of potential creditors

5. South Rims has an accounts receivable balance at the end of 2018 of $357,470.
The net credit sales for the year are $769,346. The balance at the end of 2017 was
$325,300. What is the accounts receivable turnover rate for 2018 (rounded to two
decimal places)?

A. 2.02 times

B. 2.25 times

C. 2.15 times

D. 1.13 times

6. What information can best be elicited from a receivable ratio?

A. company performance with current debt collection

B. credit extension effect on cash sales

C. likelihood of future customer bankruptcy filings

D. an increase in future credit sales to current customers

7. Ancient Grains Unlimited has an accounts receivable turnover ratio of 3.34

times. The net credit sales for the year are $567,920. What is the days’ sales in
receivables ratio for 2018 (rounded to the nearest whole number)?

A. 190 days

B. 109 days

C. 110 days

D. 101 days

8. Which of the following indicates a positive trend for inventory management?

A. increasing number of days’ sales in inventory ratio

B. increasing inventory turnover ratio

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C. increasing cost of goods sold

D. increasing sales revenue

Exercises
1.The following historical information is from Assisi Community Markets. Calculate
the working capital and current ratio for each year. What observations do you
make, and what actions might the owner consider taking?

2.Using the following Balance Sheet summary information, calculate for the two
years presented: A. working capital B. current ratio.

3. Using the following account balances, calculate for the two years presented:
A. working capital B. current ratio

4. Using the following Balance Sheet summary information, calculate for the two
companies presented: A. working capital B. current ratio

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Then: A. evaluate which company’s liquidity position appears stronger, and why.

5.Using the following account balances, calculate:

A. working capital B. current ratio

6. Using the following select financial statement information from Black Water
Industries, compute the number of days’ sales in receivables ratios for 2018 and
2019 (round answers to two decimal places). What do the outcomes tell a
potential investor about Black Water Industries?

7. Millennial Manufacturing has net credit sales for 2018 in the amount of
$1,433,630, beginning accounts receivable balance of $585,900, and an ending
accounts receivable balance of $621,450. Compute the accounts receivable
turnover ratio and the number of days’ sales in receivables ratio for 2018 (round
answers to two decimal places). What do the outcomes tell a potential investor
about Millennial Manufacturing if industry average is 2.6 times and number of
day’s sales ratio is 180 days?

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8. Compute Altoona Company’s (a) inventory turnover ratio and (b) number of
days’ sales in inventory ratio, using the following information.

5. Bastion Corporation earned net income of $200,000 this year. The company
began the year with 10,000 shares of common stock and issued 5,000 more on
April 1. They issued $7,500 in preferred dividends for the year. What is the EPS for
the year for Bastion?

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Merchandising &
Manufacturing
Companies

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Comparison of Merchandising Transactions versus Service Transactions

Some of the biggest differences between a service company and a merchandising

company are what they sell, their typical financial transactions, their operating
cycles, and how these translate to financial statements.

A service company provides intangible services to customers and does not have
inventory. Some examples of service companies include lawyers, doctors,
consultants, and accountants. Service companies often have simple financial
transactions that involve taking customer deposits, billing clients after services
have been provided, providing the service, and processing payments. These
activities may occur frequently within a company’s accounting cycle and make up a
portion of the service company’s operating cycle.

An operating cycle is the amount of time it takes a company to use its cash to
provide a product or service and collect payment from the customer. Completing
this cycle faster puts the company in a more stable financial position. A typical
operating cycle for a service company begins with having cash available, providing
service to a customer, and then receiving cash from the customer for the service.

The income statement format is fairly simple as well . Revenues (sales) are
reported first, followed by any period operating expenses. The outcome of sales
less expenses, which is net income (loss), is calculated from these accounts.

A merchandising company resells finished goods (inventory) produced by a

manufacturer (supplier) to customers. Merchandising companies have financial
transactions that include: purchasing merchandise, paying for merchandise, storing
inventory, selling merchandise, and collecting customer payments. A typical

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operating cycle for a merchandising company starts with having cash available,
purchasing inventory, selling the merchandise to customers, and finally collecting
payment from customers .

Their income statement format is a bit more complicated than for a service
company. Note that unlike a service company, the merchandiser, also sometimes
labeled as a retailer, must first resolve any sale reductions and merchandise costs,
known as Cost of Goods Sold, before determining other expenses and net income
(loss). A simple retailer income statement is shown below.

Compare and Contrast Perpetual versus Periodic Inventory Systems

There are two ways in which a company may account for their inventory. They can
use a perpetual or periodic inventory system. Let’s look at the characteristics of
these two systems.

Characteristics of the Perpetual and Periodic Inventory Systems

A perpetual inventory system automatically updates and records the inventory

account every time a sale, or purchase of inventory occurs. You can consider this
“recording as you go.” The recognition of each sale or purchase happens
immediately upon sale or purchase.

A periodic inventory system updates and records the inventory account at certain,
scheduled times at the end of an operating cycle. The update and recognition
could occur at the end of the month, quarter, and year. There is a gap between the
sale or purchase of inventory and when the inventory activity is recognized.
Generally Accepted Accounting Principles (GAAP) do not state a required inventory
system.

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There are some key differences between perpetual and periodic inventory
systems. When a company uses the perpetual inventory system and makes a
purchase, they will automatically update the Merchandise Inventory account.
Under a periodic inventory system, Purchases will be updated, while Merchandise
Inventory will remain unchanged until the company counts and verifies its
inventory balance. This count and verification typically occur at the end of the
annual accounting period, which is often on December 31 of the year. The
Merchandise Inventory account balance is reported on the balance sheet while the
Purchases account is reported on the Income Statement when using the periodic
inventory method. The Cost of Goods Sold is reported on the Income Statement
under the perpetual inventory method.

A purchase return or allowance under perpetual inventory systems updates

Merchandise Inventory for any decreased cost. Under periodic inventory systems,
a temporary account, Purchase Returns and Allowances, is updated. Purchase
Returns and Allowances is a contra account and is used to reduce Purchases.

When a purchase discount is applied under a perpetual inventory system,

Merchandise Inventory decreases for the discount amount. Under a periodic
inventory system, Purchase Discounts (a temporary, contra account), increases for
the discount amount and Merchandise Inventory remains unchanged.

When a sale occurs under perpetual inventory systems, two entries are required:
one to recognize the sale, and the other to recognize the cost of sale. For the cost
of sale, Merchandise Inventory and Cost of Goods Sold are updated. Under
periodic inventory systems, this cost of sale entry does not exist. The recognition
of merchandise cost only occurs at the end of the period when adjustments are
made and temporary accounts are closed.

When a sales return occurs, perpetual inventory systems require recognition of

the inventory’s condition. This means a decrease to COGS and an increase to
Merchandise Inventory. Under periodic inventory systems, only the sales return is
recognized, but not the inventory condition entry.

A sales allowance and sales discount follow the same recording formats for either
perpetual or periodic inventory systems.

Adjusting and Closing Entries for a Perpetual Inventory System

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You have already explored adjusting entries and the closing process in prior
discussions, but merchandising activities require additional adjusting and closing
entries to inventory, sales discounts, returns, and allowances. Here, we’ll briefly
discuss these additional closing entries and adjustments as they relate to the
perpetual inventory system. At the end of the period, a perpetual inventory system
will have the Merchandise Inventory account up-to-date; the only thing left to do
is to compare a physical count of inventory to what is on the books. A physical
inventory count requires companies to do a manual “stock-check” of inventory to
make sure what they have recorded on the books matches what they physically
have in stock. Differences could occur due to mismanagement, shrinkage, damage,
or outdated merchandise.

Shrinkage is a term used when inventory or other assets disappear without an

identifiable reason, such as theft. For a perpetual inventory system, the adjusting
entry to show this difference follows. This assumes that the merchandise inventory
is overstated in the accounting records and needs to be adjusted downward to
reflect the actual value on hand. If a physical count determines that merchandise
inventory is understated in the accounting records, Merchandise Inventory would
need to be increased with a debit entry and the COGS would be reduced with a
credit entry. To sum up the potential adjustment process, after the merchandise
inventory has been verified with a physical count, its book value is adjusted
upward or downward to reflect the actual inventory on hand, with an
accompanying adjustment to the COGS.

Not only must an adjustment to Merchandise Inventory occur at the end of a

period, but closure of temporary merchandising accounts to prepare them for the
next period is required. Temporary accounts requiring closure are Sales, Sales
Discounts, Sales Returns and Allowances, and Cost of Goods Sold. Sales will close
with the temporary credit balance accounts to Income Summary. Sales Discounts,
Sales Returns and Allowances, and Cost of Goods Sold will close with the
temporary debit balance accounts to Income Summary.

Note that for a periodic inventory system, the end of the period adjustments
require an update to COGS. To determine the value of Cost of Goods Sold, the
business will have to look at the beginning inventory balance, purchases, purchase
returns and allowances, discounts, and the ending inventory balance.

The formula to compute COGS is:

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where:

Once the COGS balance has been established, an adjustment is made to

Merchandise Inventory and COGS, and COGS is closed to prepare for the next
period.

The following table summarizes the differences between the perpetual and
periodic inventory systems.

Basic Analysis of Purchase Transaction Journal Entries Using the Perpetual

Inventory System

To better illustrate merchandising activities, let’s follow California Business

Solutions (CBS), a retailer providing electronic hardware packages to meet small
business needs. Each electronics hardware package contains a desktop computer,
tablet computer, landline telephone, and a 4-in-1 desktop printer with a printer,

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copier, scanner, and fax machine. CBS purchases each electronic product from a
manufacturer. The following are the per-item purchase prices from the
manufacturer.

On April 1, CBS purchases 10 electronic hardware packages at a cost of $620 each.

CBS has enough cash-onhand to pay immediately with cash. The following entry
occurs.

On April 7, CBS purchases 30 desktop computers on credit at a cost of $400 each.

The credit terms are n/15 with an invoice date of April 7. The following entry
occurs.

On May 1, CBS purchases 67 tablet computers at a cost of $60 each on credit. The
payment terms are 5/10, n/ 30, and the invoice is dated May 1. The following entry
occurs. Merchandise Inventory-Tablet Computers increases (debit) in the amount
of $4,020 (67 × $60). Account

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These credit terms include a discount opportunity (5/10), meaning, CBS has 10
days from the invoice date to pay on their account to receive a 5% discount on
their purchase. On May 10, CBS pays their account in full. The following entry
occurs.

Since CBS paid on May 10, they made the 10-day window and thus received a
discount of 5%. Cash decreases (credit) for the amount owed, less the discount.
Merchandise Inventory-Tablet Computers decreases (credit) for the amount of the
discount ($4,020 × 5%). Merchandise Inventory decreases to align with the Cost
Principle, reporting the value of the merchandise at the reduced cost. Let’s take
the same example purchase with the same credit terms, but now CBS paid their
account on May 25. The following entry would occur instead.

Purchase Returns and Allowances Transaction Journal Entries

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

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On June 8, CBS discovers that 60 more phones from the June 1 purchase are
slightly damaged. CBS decides to keep the phones but receives a purchase
allowance from the manufacturer of $8 per phone. The following entry occurs for
the allowance.

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

Recording a Retailer’s Sales Transactions

Record the journal entries for the following sales transactions by a retailer.

Jan. 5 Sold $2,450 of merchandise on credit (cost of $1,000), with terms 2/10,
n/30, and invoice dated January 5.

Jan. 9 The customer returned $500 worth of slightly damaged merchandise to the
retailer and received a full refund. The retailer returned the merchandise to its
inventory at a cost of $130.

Jan. 14 Account paid in full.

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Solution

Multi-Step Income Statements for Merchandising Companies

Merchandising companies prepare financial statements at the end of a period that

include the income statement, balance sheet, statement of cash flows, and
statement of retained earnings. The presentation format for many of these
statements is left up to the business. For the income statement, this means a
company could prepare the statement using a multi-step format or a simple
format (also known as a single step format). Companies must decide the format
that best fits their needs.

A multi-step income statement is more detailed than a simple income statement.

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

Operating expenses are daily operational costs not associated with the direct
selling of products or services. Operating expenses are broken down into selling
expenses (such as advertising and marketing expenses) and general and
administrative expenses (such as office supplies expense, and depreciation of
office equipment). Deducting the operating expenses from gross margin produces
income from operations.

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 Following income from operations are other revenue and expenses not obtained
from selling goods or services or other daily operations. Other revenue and
expenses examples include interest revenue, gains or losses on sales of assets
(buildings, equipment, and machinery), and interest expense. Other revenue and
expenses added to (or deducted from) income from operations produces net
income (loss).

A simple income statement is less detailed than the multi-step format. A simple
income statement combines all revenues into one category, followed by all
expenses, to produce net income. There are very few individual accounts and the
statement does not consider cost of sales separate from operating expenses.

Demonstration of the Multi-Step Income Statement Format

Manufacturing Organizations

A manufacturing organization is a business that uses parts, components, or raw

materials to produce finished goods . These finished goods are sold either directly
to the consumer or to other manufacturing firms that use them as a component
part to produce a finished product. For example, Diehard manufactures
automobile batteries that are sold directly to consumers by retail outlets such as

96
AutoZone, Costco, and Advance Auto. However, these batteries are also sold to
automobile manufacturers such as Ford, Chevrolet, or Toyota to be installed in
cars during the manufacturing process. Regardless of who the final consumer of
the final product is, Diehard must control its costs so that the sale of batteries
generates revenue sufficient to keep the organization profitable .

Manufacturing firms are more complex organizations than merchandising firms

and therefore have a larger variety of costs to control. For example, a
merchandising firm may purchase furniture to sell to consumers, whereas a
manufacturing firm must acquire raw materials such as lumber, paint, hardware,
glue, and varnish that they transform into furniture. The manufacturer incurs
additional costs, such as direct labor, to convert the raw materials into furniture.
Operating a physical plant where the production process takes place also
generates costs. Some of these costs are tied directly to production, while others
are general expenses necessary to operate the business. Because the
manufacturing process can be highly complex, manufacturing firms constantly
evaluate their production processes to determine where cost savings are possible.

Manufacturing organizations account for costs in a way that is similar to that of

merchandising firms. However, as you will learn, there is a significant difference in
the calculation of cost of goods sold. At first it appears that there is no difference
between the income statements of the merchandising firm and the manufacturing
firm. However, the difference is in how these two types of firms account for the
cost of goods sold. Merchandising firms determine their cost of goods sold by
accounting for both existing inventory and new purchases. It is typically easy for
merchandising firms to calculate their costs because they know exactly what they
paid for their merchandise.

Unlike merchandising firms, manufacturing firms must calculate their cost of goods
sold based on how much they manufacture and how much it costs them to
manufacture those goods. This requires manufacturing firms to prepare an
additional statements before they can prepare their income statement. This
additional statement is the Cost of Goods Manufactured statement. One thing
manufacturing firms must consider in their cost of goods manufactured is that, at
any given time, they have products at varying levels of production: some are
finished and others are still process. The cost of goods manufactured statement
measures the cost of the goods actually finished during the period, whether or not
they were started during that period.

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Before examining the typical manufacturing firm’s process to track cost of goods
manufactured, you need basic definitions of three terms in the schedule of Costs
of Goods Manufactured: direct materials, direct labor, and manufacturing
overhead.

Direct materials are the components used in the production process whose costs
can be identified on a per item-produced basis. For example, if you are producing
cars, the engine would be a direct material item. The direct material cost would be
the cost of one engine.

Direct labor represents production labor costs that can be identified on a per item-
produced basis. Referring to the car production example, assume that the engines
are placed in the car by individuals rather than by an automated process. The
direct labor cost would be the amount of labor in hours multiplied by the hourly
labor cost.

Manufacturing overhead generally includes those costs incurred in the production

process that are not economically feasible to measure as direct material or direct
labor costs. Examples include the production factory’s utilities. Since there are so
many possible costs that can be classified as manufacturing overhead, they tend to
be grouped and then allocated in a predetermined manner to the production
process. Following is an example of the calculation of the Cost of Goods
Manufactured for Koeller Manufacturing. It demonstrates the relationship
between cost of goods manufactured and cost of goods in progress and includes
the three main types of manufacturing costs.

As you can see, the manufacturing firm takes into account its work-in-process
(WIP) inventory as well as the costs incurred during the current period to finish not

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only the units that were in the beginning WIP inventory, but also a portion of any
production that was started but not finished during the month. Notice that the
current manufacturing costs, or the additional costs incurred during the month,
include direct materials, direct labor, and manufacturing overhead. Direct
materials are calculated as:

All of these costs are carefully tracked and classified because the cost of
manufacturing is a vital component of the schedule of cost of goods sold. To
continue with the example, Koeller Manufacturing calculated that the cost of
goods manufactured was $95,000, which is carried through to the Schedule of Cost
of Goods Sold :

Now when Koeller Manufacturing prepares its income statement, the simplified
statement will appear as shown below :

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So, even though the income statements for the merchandising firm and the
manufacturing firm appear very similar at first glance, there are many more costs
to be captured by the manufacturing firm. Figure 2.11 compares and contrasts the
methods merchandising and manufacturing firms use to calculate the cost of
goods sold in their income statement.

Identify and Apply Basic Cost Behavior Patterns

Now that we have identified the three key types of businesses, let’s identify cost
behaviors and apply them to the business environment. In managerial accounting,
different companies use the term cost in different ways depending on how they
will use the cost information. Different decisions require different costs classified
in different ways. For instance, a manager may need cost information to plan for
the coming year or to make decisions about expanding or discontinuing a product
or service. In practice, the classification of costs changes as the use of the cost data
changes. In fact, a single cost, such as rent, may be classified by one company as a
fixed cost, by another company as a committed cost, and by even another
company as a period cost. Understanding different cost classifications and how
certain costs can be used in different ways is critical to managerial accounting.

Major Cost Behavior Patterns

Any discussion of costs begins with the understanding that most costs will be
classified in one of three ways: fixed costs, variable costs, or mixed costs. The costs
that don’t fall into one of these three categories are hybrid costs, which are
examined only briefly because they are addressed in more advanced accounting
courses. Because fixed and variable costs are the foundation of all other cost
classifications, understanding whether a cost is a fixed cost or a variable cost is
very important.

Fixed versus Variable Costs

A fixed cost is an unavoidable operating expense that does not change in total over
the short term, even if a business experiences variation in its level of activity. The
table below illustrates the types of fixed costs for merchandising, service, and
manufacturing organizations.

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We have established that fixed costs do not change in total as the level of activity
changes, but what about fixed costs on a per-unit basis? Let’s examine Tony’s
screen-printing company to illustrate how costs can remain fixed in total but
change on a per-unit basis. Tony operates a screen-printing company, specializing
in custom T-shirts. One of his fixed costs is his monthly rent of $1,000. Regardless
of whether he produces and sells any T-shirts, he is obligated under his lease to
pay $1,000 per month. However, he can consider this fixed cost on a per-unit basis,
as shown below:

Tony’s information illustrates that, despite the unchanging fixed cost of rent, as
the level of activity increases, the per-unit fixed cost falls. In other words, fixed
costs remain fixed in total but can increase or decrease on a per-unit basis.

A variable cost is one that varies in direct proportion to the level of activity within
the business. Typical costs that are classified as variable costs are the cost of raw
materials used to produce a product, labor applied directly to the production of
the product, and overhead expenses that change based upon activity. For each
variable cost, there is some activity that drives the variable cost up or down. A cost
driver is defined as any activity that causes the organization to incur a variable
cost. Examples of cost drivers are direct labor hours, machine hours, units
produced, and units sold.

Unlike fixed costs that remain fixed in total but change on a per-unit basis, variable
costs remain the same per unit, but change in total relative to the level of activity

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in the business. Revisiting Tony’s T-Shirts, the figure below shows how the variable
cost of ink behaves as the level of activity changes.

Remember that the reason that organizations take the time and effort to classify
costs as either fixed or variable is to be able to control costs. When they classify
costs properly, managers can use cost data to make decisions and plan for the
future of the business.

Functions of Cost Equations

The cost equation is a linear equation that takes into consideration total fixed
costs, the fixed component of mixed costs, and variable cost per unit. Cost
equations can use past data to determine patterns of past costs that can then
project future costs, or they can use estimated or expected future data to estimate
future costs. Recall the mixed cost equation:

Y = a + bx
where Y is the total mixed cost, a is the fixed cost, b is the variable cost per unit,
and x is the level of activity.

Let’s take a more in-depth look at the cost equation by examining the costs
incurred by Eagle Electronics in the manufacture of home security systems, as
shown below :

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By applying the cost equation, Eagle Electronics can predict its costs at any level of
activity (x) as follows:

1. Determine total fixed costs: $50,000 + $75,000 = $125,000

2. Determine variable costs per unit: $50 + $20 = $70

3. Complete the cost equation: Y = $125,000 + $70x

Using this equation, Eagle Electronics can now predict its total costs (Y) for any
given level of activity (x), as follows :

Basic Inventory Valuation Methods

Accounting for inventory is a critical function of management. Inventory

accounting is significantly complicated by the fact that it is an ongoing process of
constant change, in part because

(1) most companies offer a large variety of products for sale,

(2) product purchases occur at irregular times,

(3) products are acquired for differing prices, and

(4) inventory acquisitions are based on sales projections, which are always
uncertain and often sporadic.

Merchandising companies must meticulously account for every individual product

that they sell, equipping them with essential information, for decisions such as
these:

• What is the quantity of each product that is available to customers?

• When should inventory of each product item be replenished and at what

quantity?

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• How much should the company charge customers for each product to cover all
costs plus profit margin?

• How much of the inventory cost should be allocated toward the units sold (cost
of goods sold) during the period?

• How much of the inventory cost should be allocated toward the remaining units
(ending inventory) at the end of the period?

• Is each product moving robustly or have some individual inventory items’ activity
decreased?

• Are some inventory items obsolete?

The company’s financial statements report the combined cost of all items sold as
an offset to the proceeds from those sales, producing the net number referred to
as gross margin (or gross profit). This is presented in the first part of the results of
operations for the period on the multi-step income statement. The unsold
inventory at period end is an asset to the company and is therefore included in the
company’s financial statements, on the balance sheet, as shown :

Inventory costing is accomplished by one of four specific costing methods:

(1) specific identification : tracking the actual cost of the item being sold and is
generally used only on expensive items that are highly customized

(2) first-in, first-out, (FIFO) : records costs relating to a sale as if the earliest
purchased item would be sold first.

(3) last-in, first-out, (LIFO) : records costs relating to a sale as if the latest
purchased item would be sold first.

(4) weighted-average cost methods : requires a calculation of the average cost of

all units of each particular inventory items.

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All four methods are techniques that allow management to distribute the costs of
inventory in a logical and consistent manner, to facilitate matching of costs to
offset the related revenue item that is recognized during the period, in accordance
with GAAP expense recognition and matching concepts. Note that a company’s
cost allocation process represents management’s chosen method for expensing
product costs, based strictly on estimates of the flow of inventory costs, which is
unrelated to the actual flow of the physical inventory. A critical issue for inventory
accounting is the frequency for which inventory values are updated. There are two
primary methods used to account for inventory balance timing changes: the
periodic inventory method and the perpetual inventory method.

Once the methods of costing are determined for the company, that methodology
would typically be applied repeatedly over the remainder of the company’s history
to accomplish the generally accepted accounting principle of consistency from one
period to another. It is possible to change methods if the company finds that a
different method more accurately reflects results of operations, but the change
requires disclosure in the company’s notes to the financial statements, which
alerts financial statement users of the impact of the change in methodology.

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REVIEW QUESTIONS
Multiple Choice

1. Which of the following is an example of a contra revenue account?

A. sales

B. merchandise inventory

C. sales discounts

D. accounts payable

2. What accounts are used to recognize a retailer’s purchase from a manufacturer

on credit?

A. accounts receivable, merchandise inventory

B. accounts payable, merchandise inventory

C. accounts payable, cash

D. sales, accounts receivable

3. Which of the following numbers represents the discount percentage applied if a

customer pays within a discount window and credit terms are 3/15, n/60?

A. 3

B. 15

C. 60

D. 3 and 15

4. If a customer purchases merchandise on credit and returns the defective

merchandise before payment, what accounts would recognize this transaction?

A. sales discount, cash

B. sales returns and allowances, cash

C. accounts receivable, sales discount

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D. accounts receivable, sales returns and allowances

5. Which of the following is a disadvantage of the perpetual inventory system?

A. Inventory information is in real-time.

B. Inventory is automatically updated.

C. It allows managers to make current decisions about purchases, stock, and sales.

D. It is cost-prohibitive.

6. Which of the following is an advantage of the periodic inventory system?

A. frequent physical inventory counts

B. cost prohibitive

C. time consuming

D. real-time information for managers

7. Which of the following is not a reason for the physical inventory count to differ
from what is recognized on the company’s books?

A. mismanagement

B. shrinkage

C. damage

D. sale of services to customers

8. Which of the following is not included when computing Net Purchases?

A. purchase discounts

B. beginning inventory

C. purchase returns

D. purchase allowances

9. Which of the following accounts are used when recording a purchase?

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A. cash, merchandise inventory

B. accounts payable, merchandise inventory

C. A or B

D. cash, accounts payable

10. A retailer pays on credit for $650 worth of inventory, terms 3/10, n/40. If the
merchandiser pays within the discount window, how much will the retailer remit in
cash to the manufacturer?

A. $19.50

B. $630.50

C. $650

D. $195

11. A retailer returns $400 worth of inventory to a manufacturer and receives a

full refund. What accounts recognize this return before the retailer remits
payment to the manufacturer?

A. accounts payable, merchandise inventory

B. accounts payable, cash

C. cash, merchandise inventory

D. merchandise inventory, cost of goods sold

12. A retailer obtains a purchase allowance from the manufacturer in the amount
of $600 for faulty inventory parts. Which of the following represents the journal
entry for this transaction if the retailer has already remitted payment?

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13. Which of the following accounts are used when recording the sales entry of a
sale on credit?

A. merchandise inventory, cash

B. accounts receivable, merchandise inventory

C. accounts receivable, sales

D. sales, cost of goods sold

14. A customer pays on credit for $1,250 worth of merchandise, terms 4/15, n/30.
If the customer pays within the discount window, how much will they remit in cash
to the retailer?

A. $1,250

B. $1,200

C. $50

D. $500

15. A customer returns $870 worth of merchandise and receives a full refund.
What accounts recognize this sales return (disregarding the merchandise condition
entry) if the return occurs before the customer remits payment to the retailer?

A. accounts receivable, sales returns and allowances

B. accounts receivable, cash

C. sales returns and allowances, merchandise inventory

D. accounts receivable, cost of goods sold

16. A customer obtains a purchase allowance from the retailer in the amount of
$220 for damaged merchandise. Which of the following represents the journal
entry for this transaction if the customer has not yet remitted payment?

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17. A multi-step income statement ________.

A. separates cost of goods sold from operating expenses

B. considers interest revenue an operating activity

C. is another name for a simple income statement

D. combines cost of goods sold and operating expenses

18. Which of the following accounts would be reported under operating expenses
on a multi-step income statement?

A. sales

B. advertising expense

C. sales returns and allowances

D. interest expense

19. A simple income statement ________.

A. combines all revenues into one category

B. does not combine all expenses into one category

C. separates cost of goods sold from operating expenses

D. separates revenues into several categories

20. Which of the following accounts would not be reported under revenue on a
simple income statement?

A. interest revenue

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B. net sales

C. rent revenue

D. operating expenses

21. Which of the following accounts are used when recording a purchase using a
periodic inventory system?

A. cash, purchases

B. accounts payable, sales

C. accounts payable, accounts receivable

D. cash, merchandise inventory

22. A retailer obtains a purchase allowance from the manufacturer in the amount
of $600 for faulty inventory parts. Which of the following represents the journal
entry for this transaction, assuming the retailer has already remitted payment?

23. Customer returns $690 worth of merchandise and receives a full refund. What
accounts recognize this sales return, assuming the customer has not yet remitted
payment to the retailer?

A. accounts receivable, sales returns and allowances

B. accounts receivable, cash

C. sales returns and allowances, purchases

D. sales discounts, cost of goods sold

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24. A customer obtains an allowance from the retailer in the amount of $450 for
damaged merchandise. Which of the following represents the journal entry for this
transaction, assuming the customer has not remitted payment?

25. Which of the following is the primary source of revenue for a service business?

A. the production of products from raw materials

B. the purchase and resale of finished products

C. providing intangible goods and services

D. the sale of raw materials to manufacturing firms

26. Which of the following is the primary source of revenue for a merchandising
business?

A. the production of products from raw materials

B. the purchase and resale of finished products

C. the provision of intangible goods and services

D. the sale of raw materials to manufacturing firms

27. Which of the following is the primary source of revenue for a manufacturing
business?

A. the production of products from raw materials

B. the purchase and resale of finished products

C. the provision of intangible goods and services

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D. both the provision of services and the sale of finished goods

28. Which of the following represents the components of the income statement
for a service business?

A. Sales Revenue – Cost of Goods Sold = gross profit

B. Service Revenue – Operating Expenses = operating income

C. Sales Revenue – Cost of Goods Manufactured = gross profit

D. Service Revenue – Cost of Goods Purchased = gross profit

29. Which of the following represents the components of the income statement
for a manufacturing business?

A. Sales Revenue – Cost of Goods Sold = gross profit

B. Service Revenue – Operating Expenses = gross profit

C. Service Revenue – Cost of Goods Manufactured = gross profit

D. Sales Revenue – Cost of Goods Manufactured = gross profit

30. Which of the following represents the components of the income statement
for a merchandising business?

A. Sales Revenue – Cost of Goods Sold = gross profit

B. Service Revenue – Operating Expenses = gross profit

C. Sales Revenue – Cost of Goods Manufactured = gross profit

D. Service Revenue – Cost of Goods Purchased = gross profit

31. Fixed costs are expenses that ________.

A. vary in response to changes in activity level

B. remain constant on a per-unit basis

C. increase on a per-unit basis as activity increases

D. remain constant as activity changes

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32. Variable costs are expenses that ________.

A. remain constant on a per-unit basis but change in total based on activity level

B. remain constant on a per-unit basis and remain constant in total regardless of

activity level

C. decrease on a per-unit basis as activity level increases

D. remain constant in total regardless of activity level within a relevant range

33. Total costs for ABC Distributing are $250,000 when the activity level is 10,000
units. If variable costs are $5 per unit, what are their fixed costs?

A. $240,000

B. $200,000

C. $260,000

D. Their fixed costs cannot be determined from the information presented.

34. Which of the following would not be classified as manufacturing overhead?

A. indirect materials

B. indirect labor

C. direct labor

D. property taxes on factory

35. In the cost equation Y = a + bx, Y represents which of the following?

A. fixed costs

B. variable costs

C. total costs

D. units of production

36. If a company has four lots of products for sale, purchase 1 (earliest) for $17,
purchase 2 (middle) for $15, purchase 3 (middle) for $12, and purchase 4 (latest)
for $14, which cost would be assumed to be sold first using LIFO costing?

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A. $17

B. $15

C. $12

D. $14

37. When inventory items are highly specialized, the best inventory costing
method is ________.

A. specific identification

B. first-in, first-out

C. last-in, first-out

D. weighted average

38. On which financial statement would the merchandise inventory account

appear?

A. balance sheet

B. income statement

C. both balance sheet and income statement

D. neither balance sheet nor income statement

39. When would using the FIFO inventory costing method produce higher
inventory account balances than the LIFO method would?

A. inflationary times

B. deflationary times

C. always

D. never

40. Which type or types of inventory timing system (periodic or perpetual) requires
the user to record two journal entries every time a sale is made.

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A. periodic

B. perpetual

C. both periodic and perpetual

D. neither periodic nor perpetual

Exercises

1. Match each of the following terms with the best corresponding definition.

A. Sales allowance

B. Purchase return

C. Sales discount

D. Purchase discount

E. Sales return

F. Trade discount

G. Purchase allowance

i. A customer returns merchandise for a full refund

ii. A retailer receives a partial refund but keeps the defective merchandise

iii. A customer receives a partial refund but keeps the defective merchandise

iv. A customer pays their account in full within the discount window

v. A type of purchase discount negotiated between a manufacturer and a retailer

before settlement on a final price

vi. A retailer returns merchandise for a full refund

vii. A retailer pays their account in full within the discount window

2. The following is selected information from Mars Corp. Compute net purchases,
and cost of goods sold for the month of March.

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3. On April 5, a customer returns 20 bicycles with a sales price of $250 per bike to
Barrio Bikes. Each bike cost Barrio Bikes $100. The customer had yet to pay on
their account. The bikes are in sellable condition. Prepare the journal entry or
entries to recognize this return if the company uses

A. the perpetual inventory system

B. the periodic inventory system

4. On April 20, Barrio Bikes purchased 30 bicycles at a cost of $100 per bike. Credit
terms were 4/10, n/30, with an invoice date of April 20. On April 26, Barrio Bikes
pays in full for the purchase. Prepare the journal entry or entries to recognize the
purchase and subsequent payment if Barrio Bikes uses:

A. the perpetual inventory system

B. the periodic inventory system

5. Pharmaceutical Supplies sells medical supplies to customers. Review the

following transactions and prepare the journal entry or entries if Pharmaceutical
Supplies uses:

A. the perpetual inventory system

B. the periodic inventory system

Jul. 9 A customer purchases 50 pairs of crutches at a sales price of $20 per pair.
The cost to Pharmaceutical Supplies per pair is $8.00. The terms of the sale are
5/10, n/30, with an invoice date of July 9.

Jul. 12 The customer who made the July 9 purchase returns 9 of the pairs to the
store for a full refund, claiming they were the wrong size. The crutch pairs were
returned to the store’s inventory at $8.00 per pair.

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Jul. 18 The customer pays in full for the remaining crutches, less the return.

6. The following select account data is taken from the records of Reese Industries
for 2019.

A. Use the data provided to compute net sales for 2019.

B. Prepare a simple income statement for the year ended December 31, 2019.

C. Compute the gross margin for 2019.

D. Prepare a multi-step income statement for the year ended December 31, 2019.

7. Suppose that a company has fixed costs of $18 per unit and variable costs $9 per
unit when 15,000 units are produced. What are the fixed costs per unit when
12,000 units are produced?

8. Flip or Flop is a retail shop selling a wide variety of sandals and beach footwear.
In 2019, they had gross revenue from sales totaling $93,200. Their operating
expenses for this same period were $34,000. If their Cost of Goods Sold (COGS)
was 21% of gross revenue, what was their net operating income for the year?

9. Pocket Umbrella, Inc, is considering producing a new type of umbrella. This new
pocket-sized umbrella would fit into a coat pocket or purse. Classify the following
costs of this new product as direct materials, direct labor, manufacturing
overhead, or selling and administrative.

A. Cost of advertising the product

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B. Fabric used to make the umbrellas

C. Maintenance of cutting machines used to cut the umbrella fabric so it will fit the
umbrella frame

D. Wages of workers who assemble the product

E. President’s salary

F. The salary of the supervisor of the people who assemble the product

G. Wages of the product tester who stands in a shower to make sure the umbrellas
do not leak

H. Cost of market research survey

I. Salary of the company’s sales managers

J. Depreciation of administrative office building

10. Hicks Contracting collects and analyzes cost data in order to track the cost of
installing decks on new home construction jobs. The following are some of the
costs that they incur. Classify these costs as fixed or variable costs .

A. Lumber used to construct decks ($12.00 per square foot)

B. Carpenter labor used to construct decks ($10 per hour)

C. Construction supervisor salary ($45,000 per year)

D. Depreciation on tools and equipment ($6,000 per year)

E. Selling and administrative expenses ($35,000 per year)

F. Rent on corporate office space ($34,000 per year)

G. Nails, glue, and other materials required to construct deck (varies per job)

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Managerial Accounting

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Define Managerial Accounting and Identify the Three Primary Responsibilities of
Management

Financial accounting process provides a useful level of detail for external users,
such as investors and creditors, but it does not provide enough detailed
information for the types of decisions made in the day-today operation of the
business or for the types of decisions that guide the company long term.

Managerial accounting is the process that allows decision makers to set and
evaluate business goals by determining what information they need to make a
particular decision and how to analyze and communicate this information. Let’s
explore the role of managerial accounting in several different organizations and at
different levels of the organization, and then examine the primary responsibilities
of management. There are many types of information that a company needs to
make business decisions to move the company forward with its strategic plan.
Some decisions will be more clearly appropriate for higher-level management that
would need detailed financial information in order to make such decisions. A
company’s financial statements aggregate information for the company as a
whole, but for most managerial decisions, information must be gathered in a
timely manner at a product, customer, or division level. Throughout your study of
managerial accounting, you will learn about the types of information needed to
make these decisions, as well as techniques for analyzing this information. Most of
the job responsibilities of a manager fit into one of three categories: planning,
controlling, or evaluating. The Figure below sums up the three primary
responsibilities of management and the managerial accountant’s role in the
process. As you can see from the model, the function of accomplishing an entity’s
mission statement is a circular, ongoing process.

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Distinguish between Financial and Managerial Accounting

Now that you have a basic understanding of managerial accounting, consider how
it is similar to and different from financial accounting. Managerial accounting is
much different from financial accounting. Also known as management accounting
or cost accounting, managerial accounting provides information to managers and
other users within the company in order to make more informed decisions. The
overriding roles of managers (planning, controlling, and evaluating) lead to the
distinction between financial and managerial accounting. The main objective of
management accounting is to provide useful information to managers to assist
them in the planning, controlling, and evaluating roles.

Unlike managerial accounting, financial accounting is governed by rules set out by

the Financial Accounting Standards Board (FASB), an independent board made up
of accounting professionals who determine and publicize the standards of financial
accounting and reporting in the United States. Larger, publicly traded companies
are also governed by the US Securities and Exchange Commission (SEC), in the
form of the generally accepted accounting principles (GAAP), the common set of
rules, standards, and procedures that publicly traded companies must follow when
they are composing their financial statements. Financial accounting provides
information to enable stockholders, creditors, and other stakeholders to make
informed decisions. This information can be used to evaluate and make decisions
for an individual company or to compare two or more companies. However, the
information provided by financial accounting is primarily historical and therefore is
not sufficient and is often synthesized too late to be overly useful to management.

Managerial accounting has a more specific focus, and the information is more
detailed and timelier. Managerial accounting is not governed by GAAP, so there is
unending flexibility in the types of reports and information gathered. Managerial
accountants regularly calculate and manage “what-if” scenarios to help managers
make decisions and plan for future business needs. Thus, managerial accounting
focuses more on the future, while financial accounting focuses on reporting what
has already happened. In addition, managerial accounting uses nonfinancial data,
whereas financial accounting relies solely on financial data.

There are important differences in the financial and managerial accounting and
reporting functions. Those differences are detailed in the following figure :

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Describe How and Why Managers Use Budgets

Implementation of a company’s strategic plan often begins by determining

management’s basic expectations about future economic, competitive, and
technological conditions, and their effects on anticipated goals, both long-term
and short-term. Many firms at this stage conduct a situational analysis that
involves examining their strengths and weaknesses and the external opportunities
available and the threats that they might face from competitors. This common
analysis is often labeled as SWOT (Strength Weakness Opportunities Threats ).
After performing the situational analysis, the organization identifies potential
strategies that could enable achievement of its goals. Finally, the company will
create, initiate, and monitor both long-term and short-term plans.

An important step in the initiation of the company’s strategic plan is the creation
of a budget. A good budgeting system will help a company reach its strategic goals
by allowing management to plan and to control major categories of activity, such
as revenue, expenses, and financing options. Planning involves developing future
objectives, whereas controlling involves monitoring the planning objectives that
have been put into place.

There are many advantages to budgeting, including:

• Communication

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 ◦ Budgeting is a formal method to communicate a company’s plans to its internal
stakeholders, such as executives, department managers, and others who have an
interest in—or responsibility for—monitoring the company’s performance.

◦ Budgeting requires managers to plan for both revenues and expenses.

• Planning

◦ Preparing a budget requires managers to consider and evaluate :

▪ The assumptions used to prepare the budget.

▪ Long-term financial goals.

▪ Short-term financial goals.

▪ The company’s position in the market.

▪ How each department supports the strategic plan.

◦ Preparing a budget requires departments to work together to :

▪ Determine realizable sales goals.

▪ Compute the manufacturing or other requirements necessary to meet the sales

goals.

▪ Solve bottlenecks that are predicted by the budget.

▪ Allocate resources so they can be used effectively to meet the sales and
manufacturing goals.

▪ Compare forecasted or flexible budgets with actual results.

• Evaluation

◦ When compared to actual results, budgets are early alerts and they forecast:

▪ Cash flows for various levels of production.

▪ When loans may be required or when loans may be reduced.

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◦ Budgets show which areas, departments, units, and so forth, are profitable or
meet their appropriate goals. Similarly, they also show which components are
unprofitable or do not reach their anticipated goals.

◦ Budgets set defined benchmarks that may be used for evaluating company and
management performance, including raises and bonuses, as well as negative
consequences, such as firing.

All budgets are quantitative plans for the future and will be constructed based on
the needs of the organization for which the budget is being created. Depending on
the complexity, some budgets can take months or even years to develop. The most
common time period covered by a budget is one year, although the time period
may vary from strategic, long-term budgets to very detailed, short-term budgets.
Generally, the closer the company is to the start of the budget’s time period, the
more detailed the budget becomes. Management begins with a vision of the
future. The long-term vision sets the direction of the company. The vision develops
into goals and strategies that are built into the budget and are directly or indirectly
reflected on the master budget.

Most organizations will create a master budget—whether that organization is large

or small, public or private, or a merchandising, manufacturing, or service company.
A master budget is one that includes two areas, operational and financial, each of
which has its own sub-budgets. The operating budget spans several areas that help
plan and manage day-to-day business. The financial budget depicts the
expectations for cash inflows and outflows, including cash payments for planned
operations, the purchase or sale of assets, the payment or financing of loans, and
changes in equity. Each of the sub-budgets is made up of separate but interrelated
budgets, and the number and type of separate budgets will differ depending on
the type and size of the organization. For example, the sales budget predicts the
sales expected for each quarter. The direct materials budget uses information from
the sales budget to compute the number of units necessary for production. This
information is used in other budgets, such as the direct materials budget, which
plans when materials will be purchased, how much will be purchased, and how
much that material should cost. You will review some specific examples of
budgeting for direct materials in Prepare Operating Budgets. The figure below
shows how operating budgets and financial budgets are related within a master
budget.

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An operating budget consists of the sales budget, production budget, direct
material budget, direct labor budget, and overhead budget. These budgets serve
to assist in planning and monitoring the day-to-day activities of the organization by
informing management of how many units need to be produced, how much
material needs to be ordered, how many labor hours need to be scheduled, and
the amount of overhead expected to be incurred. The individual pieces of the
operating budget collectively lead to the creation of the budgeted income
statement.

Example for some of the budgets prepared :

Big Bad Bikes estimates it will sell 1,000 trainers for $70 each in the first quarter
and prepares a sales budget to show the sales by quarter. Management
understands that it needs to have on hand the 1,000 trainers that it estimates will
be sold. It also understands that additional inventory needs to be on hand in the
event there are additional sales and to prepare for sales in the second quarter. This

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information is used to develop a production budget. Each trainer requires 3.2
pounds of material that usually costs $1.25 per pound.

Knowing how many units are to be produced and how much inventory needs to be
on hand is used to develop a direct materials budget. The direct materials budget
lets managers know when and how much raw materials need to be ordered. The
same is true for direct labor, as management knows how many units will be
manufactured and how many hours of direct labor are needed. The necessary
hours of direct labor and the estimated labor rate are used to develop the direct
labor budget. While the materials and labor are determined from the production
budget, only the variable overhead can be determined from the production
budget. Existing information regarding fixed manufacturing costs are combined
with variable manufacturing costs to determine the manufacturing overhead
budget. The information from the sales budget is used to determine the sales and
administrative budget. Finally, the sales, direct materials, direct labor, fixed
manufacturing overhead budget, and sales and administrative budgets are used to
develop a pro-forma income statement.

1- Sales Budget

Big Bad Bikes used information from competitor sales, its marketing department,
and industry trends to estimate the number of units that will be sold in each
quarter of the coming year. The number of units is multiplied by the sales price to
determine the sales by quarter as shown :

2- Production Budget

Estimating sales leads to identifying the desired quantity of inventory to meet the
demand. Management wants to have enough inventory to meet production, but
they do not want too much in the ending inventory to avoid paying for
unnecessary storage. Management often uses a formula to estimate how much
should remain in ending inventory. Management wants to be flexible with its

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budgeting, wants to create budgets that can grow or shrink as needed, and needs
to have inventory on hand. So the amount of ending inventory often is a
percentage of the next week’s, month’s, or quarter’s sales.

After management has estimated how many units will sell and how many units
need to be in ending inventory, it develops the production budget to compute the
number of units that need to be produced during each quarter. The formula is the
reverse of the formula for the cost of goods sold.

Big Bad Bikes requires a target ending inventory of 30% of the next quarter’s sales.
Unfortunately, they were unable to manufacture any units before the end of the
current year, so the first quarter’s beginning inventory is 0 units. As shown in the
sales budget, sales in quarter 2 are estimated at 1,000 units; since 30% is required
to be in ending inventory, the ending inventory for quarter 1 needs to be 300
units. With expected sales of 1,000 units for quarter 2 and a required ending
inventory of 30%, or 300 units, Big Bad Bikes needs to have 1,300 units available
during the quarter. Since 1,300 units needed to be available and there are zero
units in beginning inventory, Big Bad Bikes needs to manufacture 1,300 units, as
shown below in the production budget :

The ending inventory from one quarter is the beginning inventory for the next
quarter and the calculations are all the same. In order to determine the ending

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inventory in quarter 4, Big Bad Bikes must estimate the sales for the first quarter of
the next year. Big Bad Bikes’s marketing department believes sales will increase in
each of the next several quarters, and they estimate sales as 3,500 for the first
quarter of the next year and 4,500 for the second quarter of the next year. Thirty
percent of 3,500 is 1,050, so the number of units required in the ending inventory
for quarter 4 is 1,050. The number of units needed in production for the first
quarter of the next year provides information needed for other budgets such as
the direct materials budget, so Big Bad Bikes must also determine the number of
units needed in production for that first quarter. The estimated sales of 3,500 and
the desired ending inventory of 1,350 (30% of the next quarter’s estimated sales of
4,500) determines that 4,850 units are required during the quarter. The beginning
inventory is estimated to be 1,050, which means the number of units that need to
be produced during the first quarter of year 2 is 3,800.

3- Direct Materials Budget

From the production budget, management knows how many units need to be
produced in each budget period. Management is already aware of how much
material it needs to produce each unit and can combine the direct material per
unit with the production budget to compute the direct materials budget. This
information is used to ensure the correct quantity of materials is ordered and the
correct amount is budgeted for those materials. Similar to the production budget,
management wants to have an ending inventory available to ensure there are
enough materials on hand. The direct materials budget illustrates how much
material needs to be ordered and how much that material costs. The calculation is
similar to that used in the production budget, with the addition of the cost per
unit. If Big Bad Bikes uses 3.2 pounds of material for each trainer it manufactures
and each pound of material costs $1.25, we can create a direct materials budget.
Management’s goal is to have 20% of the next quarter’s material needs on hand as
the desired ending materials inventory. Therefore, the determination of each
quarter’s material needs is partially dependent on the following quarter’s
production requirements. The desired ending inventory of material is readily
determined for quarters 1 through 3 as those needs are based on the production
requirements for quarters 2 through 4. To compute the desired ending materials
inventory for quarter 4, we need the production requirements for quarter 1 of
year 2. Recall that the number of units to be produced during the first quarter of
year 2 is 3,800. Thus, quarter 4 materials ending inventory requirement is 20% of

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3,800. That information is used to compute the direct materials budget shown as
follows :

4- Direct Labor Budget

Management uses the same information in the production budget to develop the
direct labor budget. This information is used to ensure that the proper amount of
staff is available for production and that there is money available to pay for the
labor, including potential overtime. Typically, the number of hours is computed
and then multiplied by an hourly rate, so the total direct labor cost is known. If Big
Bad Bikes knows that they need 45 minutes or 0.75 hours of direct labor for each
unit produced, and the labor rate for this type of manufacturing is $20 per hour,
the computation for direct labor simply begins with the number of units in the
production budget. As shown in Figure 7.10, the number of units produced each
quarter multiplied by the number of hours per unit equals the required direct labor
hours needed to be scheduled in order to meet production needs.

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 5- Cash Budget

The cash budget is the combined budget of all inflows and outflows of cash. It
should be divided into the shortest time period possible, so management can be
quickly made aware of potential problems resulting from fluctuations in cash flow.
One goal of this budget is to anticipate the timing of cash inflows and outflows,
which allows a company to try to avoid a decrease in the cash balance due to
paying out more cash than it receives. In order to provide timely feedback and
alert management to short-term cash needs, the cash flow budget is commonly
geared toward monthly or quarterly figures.

Because the cash budget accounts for every inflow and outflow of cash, it is
broken down into smaller components. The cash collections schedule includes all
of the cash inflow expected to be received from customer sales, whether those
customers pay at the same rate or even if they pay at all. The cash collections
schedule includes all the cash expected to be received and does not include the
amount of the receivables estimated as uncollectible. The cash payments schedule
plans the outflow or payments of all accounts payable, showing when cash will be
used to pay for direct material purchases. Both the cash collections schedule and
the cash payments schedule are included along with other cash transactions in a
cash budget. The cash budget, then, combines the cash collection schedule, the
cash payment schedule, and all other budgets that plan for the inflow or outflow of
cash. When everything is combined into one budget, that budget shows if
financing arrangements are needed to maintain balances or if excess cash is
available to pay for additional liabilities or assets.

To illustrate, let’s return to Big Bad Bikes. They believe cash collections for the
trainer sales will be similar to the collections from their bicycle sales, so they will
use that pattern to budget cash collections for the trainers. In the quarter of sales,
65% of that quarter’s sales will be collected. In the quarter after the sale, 30% will
be collected. This leaves 5% of the sales considered uncollectible.

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Explain How Budgets Are Used to Evaluate Goals

As you’ve learned, an advantage of budgeting is evaluating performance. Having a

strong understanding of their budgets helps managers keep track of expenses and
work toward the company’s goals. Companies need to understand their revenue
and expense details to develop budgets as a tool for planning operations and cash
flow. Part of understanding revenue and expenses is evaluating the prior year. Did
the company earn the expected profit? Could it have earned a higher profit? What
expenses or revenues were not on the budget? Critically evaluating the actual
results versus the estimated budgetary results can help management plan for the
future. Variance analysis helps the manager analyze its results. It does not
necessarily find a problem, but it does indicate where a problem may exist. The
same is true for favorable variances as well as unfavorable variances. A favorable
variance occurs when revenue is higher than budgeted or expenses are lower than
budgeted. An unfavorable variance is when revenue is lower than budgeted or
expenses are higher than budgeted.

It is easy to understand that an unfavorable variance may be a problem. But that is

not always true, as a higher labor rate may mean the company has a higher quality
employee who is able to waste less material. Likewise, having a favorable variance
indicates that more revenue was earned or less expenses were incurred but
further analysis can indicate if costs were cut too far and better materials should
have been purchased.

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Review Questions
Multiple Choice

1. The managers of an organization are responsible for performing several broad

functions. They are ________.

A. planning, controlling, and selling

B. directing, controlling, and evaluating

C. planning, evaluating, and manufacturing

D. planning, controlling, and evaluating

2. Managerial accounting produces information:

A. to meet the needs of external users

B. that is often focused on the future

C. to meet the needs of investors

D. that follows the rules of GAAP

3. Management accounting:

A. emphasizes special-purpose information

B. relates to the company as a whole

C. is limited to strictly cost figures

D. is controlled by GAAP

4. Internal users of accounting information would not include ________.

A. managers

B. employees

C. creditors

D. officers

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5. External users of accounting information would include ________.

A. employees

B. managers

C. investors

D. supervisors

6. Which of the following is not a part of budgeting?

A. planning

B. finding bottlenecks

C. providing performance evaluations

D. preventing net operating losses

7. Which of the following is an operating budget?

A. cash budget

B. production budget

C. tax budget

D. capital budget

8. Which of the following is a finance budget?

A. cash budget

B. production budget

C. direct materials purchasing budget

D. tax budget

9. The most common budget is prepared for a ________.

A. week

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B. month

C. quarter

D. year

10. Which of the operating budgets is prepared first?

A. production budget

B. sales budget

C. cash received budget

D. cash payments budget

11. The direct materials budget is prepared using which budget’s information?

A. cash payments budget

B. cash receipts budget

C. production budget

D. raw materials budget

12. Which of the following is not an operating budget?

A. sales budget

B. production budget

C. direct labor budget

D. cash budget

13. Which of the following statements is not correct?

A. The sales budget is computed by multiplying estimated sales by the sales price.

B. The production budget begins with the sales estimated for each period.

C. The direct materials budget begins with the sales estimated for each period.

D. The sales budget is typically the first budget prepared.

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14. The units required in production each period are computed by which of the
following methods?

A. adding budgeted sales to the desired ending inventory and subtracting

beginning inventory

B. adding beginning inventory, budgeted sales, and desired ending inventory

C. adding beginning inventory to budgeted sales and subtracting desired ending

inventory

D. adding budgeted sales to the beginning inventory and subtracting the desired
ending inventory.

15. The cash budget is part of which category of budgets?

A. sales budget

B. cash payments budget

C. finance budget

D. operating budget

Exercises
1. Blue Book printing is budgeting sales of 25,000 units and already has 5,000 in
beginning inventory. How many units must be produced to also meet the 7,000
units required in ending inventory?

2. How many units are in beginning inventory if 32,000 units are budgeted for
sales, 35,000 units are produced, and the desired ending inventory is 9,000 units?

3. Navigator sells GPS trackers for $50 each. It expects sales of 5,000 units in
quarter 1 and a 5% increase each subsequent quarter for the next 8 quarters.
Prepare a sales budget by quarter for the first year.

4. One Device makes universal remote controls and expects to sell 500 units in
January, 800 in February, 450 in March, 550 in April, and 600 in May. The required
ending inventory is 20% of the next month’s sales. Prepare a production budget for
the first four months of the year.

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5. Sunrise Poles manufactures hiking poles and is planning on producing 4,000
units in March and 3,700 in April. Each pole requires a half pound of material,
which costs $1.20 per pound. The company’s policy is to have enough material on
hand to equal 10% of the next month’s production needs and to maintain a
finished goods inventory equal to 25% of the next month’s production needs.
What is the budgeted cost of purchases for March?

6. Given the following information from Rowdy Enterprises’ direct materials

budget, how much direct materials needs to be purchased?

7. Each unit requires direct labor of 2.2 hours. The labor rate is $11.50 per hour
and next year’s direct labor budget totals $834,900. How many units are included
in the production budget for next year?

8. How many units are estimated to be sold if Skyline, Inc., has a planned
production of 900,000 units, a desired beginning inventory of 160,000 units, and a
desired ending inventory of 100,000 units?

9. Cash collections for Wax On Candles found that 60% of sales were collected in
the month of the sale, 30% was collected the month after the sale, and 10% was
collected the second month after the sale. Given the sales shown, how much cash
will be collected in January and February?

10. The budgeted production cost for a waterproof phone case is $7 per unit and
fixed costs are $23,000 per month. How much is the favorable or unfavorable
variance if 5,500 units were produced for a total of $61,000?

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Auditing

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What Is an Audit?

One of the rules that the Securities Exchange Commission (SEC) has issued is that
the financial statements of public companies (those companies selling stock to the
public) must be examined by an independent public accountant through the
process of an audit. This rule means that an accountant, who is not an employee of
the company and who is licensed to practice as a public accountant by the state
where the financial statements are being prepared, must audit (or examine) the
records of the company and must determine whether or not the financial
statements are in accordance with the rules of Generally Accepted Accounting
Principles (GAAP). In addition, the auditor has the responsibility to give reasonable
assurance that the financial statements are free of any material misstatement.

The American Accounting Association defines auditing as “a systematic process of

objectively obtaining and evaluating evidence regarding assertions about
economic actions and events to ascertain the degree of correspondence between
those assertions and established criteria and communicating the results to
interested users.” (From American Accounting Association Committee on Basic
Auditing Concepts, A Statement of Basic Auditing Concepts; Sarasota, FL, American
Accounting Association, 1973.)

When auditors issue their reports they must follow a set of rules known as
Generally Accepted Auditing Standards (GAAS). These standards are made up of :

1) the ten Generally Accepted Auditing Standards,

2) the Statements on Auditing Standards (SASs), and

3) the Interpretations of these Standards.

These standards have been the jurisdiction of the American Institute of Certified
Public Accountants and their Auditing Standards Board. With the passage of the
Sarbanes-Oxley Act of 2002, Congress has now taken the responsibility for creating
standards for public companies and created the Public Company Accounting
Oversight Board (PCAOB) for this purpose. The board has the additional
responsibility to make sure that audit quality is not compromised and that auditor
performance meets public expectations.

In addition to the auditing standards, CPAs are expected to follow the Code of
Ethics established by the profession. By establishing and adhering to such a code,

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this ensures the auditor’s independence—the major attribute the auditor has to
sell to the public.

A typical auditor’s report (known as the unqualified report) is issued when the
financial statements are in accordance with GAAP. This report is written and issued
by the auditors and is submitted to the public with the financial statements.
Remember that the financial statements are prepared by and are the responsibility
of the management of the company and not the auditors. Since the major
corporate failures of the 1990s and early 2000s, the Sarbanes-Oxley Act of 2002
requires company management to sign a letter stating that the financial
statements are presented fairly in accordance with Generally Accepted Accounting
Principles, just as the auditors must.

The Importance of Auditing

It can be said that the function of auditing is to lend credibility to the financial
statements. The financial statements are the responsibility of management and
the auditor’s responsibility is to lend them credibility. By the audit process, the
auditor enhances the usefulness and the value of the financial statements, but he
also increases the credibility of other non-audited information released by
management.

Accounting Versus Auditing

As we have discussed in previous chapters, accounting is the process of recording,

classifying, and summarizing economic events in a process that leads to the
preparation of financial statements. Auditing, on the other hand, is not concerned
with the preparation of the accounting data, but with the evaluation of this data to
determine if it is properly presented in accordance with the rules of accounting
(GAAP) and whether it properly reflects the events that have occurred during the
period in question.

Types of Auditors

An auditor is an individual who checks the accuracy and fairness of the accounting
records of a company and determines whether the financial statements are in
accordance with the Generally Accepted Accounting Principles. Three different
types of auditors are described below.

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 1- The External Auditor or the Certified Public Accountant (CPA)

The Independent External Auditor have primary responsibility to the performance

of the audit function on published financial statements of publicly traded
companies and non-public companies. Some countries have several classes of
auditors who have different functions. Independent auditors are typically certified
either by a professional organization or a government agency. Certified Public
Accountants (CPAs) are auditors who serve the needs of the general public by
providing auditing, tax planning and preparation, and management consulting
services. CPAs can work as individuals or as employees of a firm; these firms range
in size from one individual to international partnerships with more than two
thousand partners. The largest of these firms have offices worldwide and are
referred to as the “Big Four.” Even though they only employ about 12 percent of
all of the CPAs in the United States, they actually perform the audits of about 85
percent of the largest corporations in the world. These four companies are:
Deloitte & Touche, Ernst & Young, KPMG, and PricewaterhouseCoopers.

Those individuals who act as independent auditors must be licensed to perform

audits by the state in which they practice. The laws vary from state to state as to
the requirements that must be met in order to obtain such licenses. However, to
be issued a license to practice as a CPA, all states require the individual to pass a
uniform examination, which is prepared and graded by the American Institute of
CPAs (AICPA). In addition to passing this examination, most states require an
individual to have some experience working with another CPA prior to being
licensed. Most states also require that after being licensed to practice as a public
accountant, CPAs must take at least a certain minimum amount of continuing
education coursework each year in order to have their license renewed.

2- Internal Auditors

Internal auditors are employed by companies to audit the companies’ own records
and to establish a system of internal control. The functions of these auditors vary
greatly, depending upon the needs and expectations of management. In general,
the work includes compliance audits (to make sure the accounting is in compliance
with the rules of the company and the laws under which they operate) and
operational audits (a review of an organization’s operating procedures for
efficiency and effectiveness). Operational Audits review the business for efficient
use of resources; they are meant to help management make decisions that will
make the company more profitable.

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 As with CPAs, many internal auditors are also certified by passing a nationally
prepared examination. This examination is for the Certificate of Internal Auditing
and is prepared by the Institute of Internal Auditors. Internal auditors generally
must report to the highest level of responsibility within the company; this may
include the Board of Directors or the Audit Committee of the Board of Directors.
This is important because it gives the internal auditors more independence from
the management team that they are reporting on. During a company’s audit,
internal auditors work closely with whatever external auditors (CPAs) have been
hired by the company in order to reduce the amount of time that the outside
auditor needs to spend with the company. Given the size of the internal audit staff
and their independence within the company, they may be asked to perform
several of the tasks that would have been prepared by the external auditors. The
external auditors still have the ultimate responsibility to determine if the financial
statements are presented in accordance with Generally Accepted Accounting
Principles, and they are the ones who sign the report that is presented to the
public. Using internal auditors is simply meant to reduce the number of detailed
procedures that would otherwise have to be performed by the external auditors.

3- Governmental Auditors

As you would expect, governmental auditors are individuals who perform the audit
function within or on behalf of a governmental organization. As with the other two
types of auditors described above, these individuals also must be independent
from the individuals or groups that they are auditing. The different governmental
organizations that most commonly hire and use auditors include the United States
General Accounting Office (GAO). The major function of this group is to perform
the audit function for Congress.( This is similar to the Central Auditing Agency in
Egypt auditing governmental organizations and companies ). Several other
governmental organizations hire auditors to ensure that the regulations affecting
those entities under their jurisdictions are met. Some of these include: the Bureau
of Alcohol, Tobacco, and Firearms (ATF), the Drug Enforcement Agency (DEA), and
the Federal Bureau of Investigation (FBI). Rather than following Generally
Accepted Accounting Principles, government audits are done in accordance with a
set of accounting rules established by the Governmental Accounting Standards
Board (GASB).

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Types of Audits

Audits are typically classified into three types: audits of financial statements,
operational audits, and compliance audits.

■ Audits of Financial Statements

Audits of financial statements examine financial statements to determine if they

give a true and fair view or fairly present the financial statements in conformity
with specified criteria. The criteria may be International Financial Reporting
Standards (IFRS), generally accepted accounting principles (GAAP) as in the USA, or
national company laws as in Egypt . This book primarily discusses audits of financial
statements.

■ Operational Audits

An operational audit is a study of a specific unit of an organization for the purpose

of measuring its performance. Operational audits review all or part of the
organization’s operating procedures to evaluate effectiveness and efficiency of the
operation. Effectiveness is a measure of whether an organization achieves its goals
and objectives. Efficiency shows how well an organization uses its resources to
achieve its goals. Operational reviews may not be limited to accounting. They may
include the evaluation of organizational structure, marketing, production methods,
computer operations or whatever area the organization feels evaluation is needed.
Recommendations are normally made to management for improving operations.
Because the criteria for effectiveness and efficiency are not as clearly established
as accepted accounting principles and laws, an operational audit tends to require
more subjective judgment than audits of financial statements or compliance
audits.

■ Compliance Audits

A compliance audit is a review of an organization’s procedures to determine

whether the organization is following specific procedures, rules or regulations set
out by some higher authority. A compliance audit measures the compliance of an
entity with established criteria. The performance of a compliance audit is
dependent upon the existence of verifiable data and of recognized criteria or
standards, such as established laws and regulations, or an organization’s policies
and procedures. Accounting personnel, for example, may be evaluated to
determine if they are following the procedures prescribed by the company

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controller. Other personnel may be evaluated to determine if they follow policies
and procedures established by management. Results of compliance audits are
generally reported to management within the organizational unit being audited.
Compliance audits are usually associated with government auditors – for example,
the tax authority, the government internal auditing arm, or audit of a bank by
banking regulators. An example of a compliance audit is an audit of a bank to
determine if they comply with capital reserve requirements. Another example
would be an audit of taxpayers to see if they comply with national tax law .
Compliance audits are quite common in not-for-profit organizations funded at
least in part by government. Many government entities and non-profit
organizations that receive financial assistance from the federal government must
arrange for compliance audits. Such audits are designed to determine whether the
financial assistance is spent in accordance with applicable laws and regulations.

The Audit Process

No matter what subject matter the audit is designed to evaluate, the audit process
is a well-defined methodology to help the auditor accumulate sufficient competent
evidence. A four-phase standard audit process model is used, based on the
scientific empirical cycle. The phases of the audit are:

1- Client Acceptance (pre-planning)

The process of client acceptance involves evaluation of the client’s background,

and selecting personnel for the audit . The audit firms must investigate the
business background, financial statements, and industry of the client.

2- Planning and Design of an audit approach

The audit firm must plan its work to enable it to conduct an effective audit in an
efficient and timely manner. Plans should be based on knowledge of the client’s
business. Plans are developed after obtaining a basic understanding of the
business background, control environment, control procedures, the client’s
accounting system, and after performing analytical procedures. The second part of
the planning process is to determine the riskiness of the engagement and set
materiality levels. Finally, the auditor prepares an audit program which outlines
the nature, timing and extent of audit procedures required to gather evidence.

3- Tests for Evidence

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The audit should be performed and the report prepared with due professional care
by persons who have adequate training, experience, and competence in auditing.
The auditor should also be independent of the audit and keep the results of the
audit confidential, as required by international ethics. “Due professional care”
means that the auditor is a professional responsible for fulfilling his duties
diligently and carefully. Due care includes the completeness of the working papers,
the sufficiency of the audit evidence and the appropriateness of the audit report.
The testing and evidence-gathering phase of the audit requires first testing any
controls that the auditor expects to rely upon, determine what kind of tests (the
nature), when they should be done (timing), and what the number (extent) of the
tests should be.

4- Completion of the audit and Issuance of an audit report.

The auditor should review and assess the conclusions drawn from audit evidence
on which he will base his opinion on the financial information. This review and
assessment involves forming an overall conclusion and writing an audit report .

The Standard Audit Opinion Illustrated

The most common document issued by auditors as part of their reports is the
standard unqualified audit opinion. It is issued under the following situations:

1. All financial statements have been examined by the auditor.

2. It is determined that these financial statements were prepared in accordance

with GAAP.

3. The auditor has gathered sufficient evidence to give an opinion on these

statements.

4. The auditor is independent of the company being audited.

5. The auditor has followed the generally accepted rules of auditing called
Generally Accepted Auditing Standards (GAAS).

The Generally Accepted Auditing Standards that auditors must follow are spelled
out in the rules of the auditing profession in a set of standards that is always
changing. The rules come from two sources, the AICPA and the SEC. With the
standards always changing, this provides an example of how the SEC and the AICPA
complement and support each other to help ensure that the financial statements

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issued to the public present useful information that is relevant, reliable,
understandable, and sufficient for use in making decisions about firms and their
management.

When all of these conditions are met, a report like the one shown below will be
issued. Notice that the report is issued on a comparative basis, and therefore the
management of the company must attach two years’ of financial statements.

The report has three basic segments: 1) the introductory paragraph,

2) the scope paragraph, and 3) the opinion paragraph.

The Parts of the Report

There are seven parts to every standard audit report. They include:

1. The report title—“Independent Auditor’s Report”

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2. The audit report address—“To the Stockholder’s…”

3. Introductory paragraph—“We have audited…”

4. Scope paragraph—“We conducted our audits…”

5. Opinion paragraph—“In our opinion…”

6. Signature of CPA firm—“Sydney and Maude, CPAs”

7. Audit report date—“March 17, 2007. This date represents when the work on the
audit was completed, not the date the report was issued.

Depending on the size of the company being audited, the review of the evidence
may take two to three months. The wording on this report may vary slightly from
auditor to auditor; however, the overall structure and meaning remain the same.

Other Types of Audit Reports

Below is a brief overview of three other types of audit reports that you might
encounter when reviewing financial statements and with which you should be
familiar.

1-A qualified audit report is issued by the auditor when they conclude that the
financial statements are presented in accordance with GAAP, except for some
specified items being different.

2- An adverse audit report is issued by auditors when they conclude that the
financial statements are not presented fairly in accordance with the rules of
accounting (GAAP).

3-A disclaimer audit report is issued by auditors when they do not have enough
information to determine whether the financial statements are in accordance with
the accounting rules. Auditors would also issue this type of report if they were not
independent of the company being audited.

Why Audits Are Useful to You

As the business world becomes more global and complex, so do the financial
reports that companies issue. The information provided and the rules that govern
their presentation have exploded in number and complexity during the past
twenty years. Today it is becoming more and more difficult for the layperson (non-

147
accountants) to fully understand these presentations. The auditor’s report of a
company’s financial statements gives the reader and user of these financial
statements an assurance that this information is in accordance with an established
set of rules (GAAP) and reviewed by the auditor who is independent of
management. The use of an independent audit can generally assure the user that
the information contained in a company’s financial statements is free of material
errors and fraud. This assurance supports the user in making investment and
analytical decisions about the company being reviewed.

Review Questions
1-Which of the following statements is correct concerning an auditor’s
responsibilities regarding financial statements?

(A) Making suggestions that are adopted about the form and content of an entity’s
financial statements impairs an auditor’s independence.

(B) An auditor may draft an entity’s financial statements based on information

from management’s accounting system.

(C) The fair presentation of audited financial statements in conformity with GAAP
is an implicit part of the auditor’s responsibilities.

(D) An auditor’s responsibilities for audited financial statements are not confined
to the expression of the auditor’s opinion.

2- Evaluate this quote: “Every international business, large or small, should have an
annual audit by an independent auditor.” Why should an auditor review the
financial statements of a company each year?

3-What is the objective of an audit? What is the general definition of an audit?

Briefly discuss the key component parts of the definition.

4-How many types of audits are there? Name each and briefly define them?

5- What are the three types of auditors? Briefly define them.

6- What are the four phases of an audit process model? Briefly describe each.
7- . Each of the following represents tasks that auditors frequently perform:

1 -Compilation of quarterly financial statements for a small business that does not
have any accounting personnel capable of preparing financial statements.

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2- Review of tax return of corporate president to determine whether she has
included all taxable income.

3- Review of the activities of the receiving department of a large manufacturing

company, with special attention to the efficiency of the materials inspection.

4 -Evaluation of a company’s computer system to determine whether the

computer is being used effectively.

5- Examination on a surprise basis of Topanga Bank. Emphasis placed on

verification of cash and loans receivable and observation of the California banking
code.

6 -Examination of vacation records to determine whether employees followed

company policy of two weeks’ paid vacation annually.

7- Audit of a small college to determine that the college had followed

requirements of a bond indenture agreement.

8- Examination of financial statements for use by stockholders when there is an

internal audit staff.
9- Audit of a German government agency to determine if the agency has
followed policies of the German government.
10- Audit of annual financial statements to be filed with the SEC.
11- Examination of a French government grant to a private company to determine
whether it would have been feasible to accomplish the same objective at less
cost elsewhere.
12- Audit of a statement of cash receipts and disbursements to be used by a
creditor.

Required: For each of the above, identify the most likely type of auditor
(independent, government, or internal) and the most likely type of audit
(financial, compliance, or operational).

13- When financial statements contain a departure from IFRS because, due to
unusual circumstances, the statements would otherwise be misleading, the
auditor should explain the unusual circumstances in a separate paragraph and
express an opinion that is:

(A) Unqualified.

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(B) Qualified.

(C) Adverse.

(D) Qualified or adverse, depending on materiality.

14-An auditor concludes that a client’s illegal act, which has a material effect on
the financial statement, has not been properly accounted for or disclosed.
Depending on the materiality of the effect on the financial statements, the auditor
should express either:

(A) An adverse opinion or a disclaimer of opinion.

(B) A qualified opinion or an adverse opinion.

(C) A disclaimer of opinion or an unqualified opinion with a separate explanatory

paragraph.

(D) An unqualified opinion with a separate explanatory paragraph or a qualified

opinion.

15- What elements make up an audit report? Briefly discuss each.

16- What are the four different opinions an auditor can issue? Briefly discuss each.

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International
Accounting

151
FOREIGN CURRENCY TRANSACTIONS AND HEDGING
FOREIGN EXCHANGE RISK

Foreign Currency-Based Transactions

A transaction that requires payment or receipt (settlement) in a foreign
currency is called a foreign currency transaction. Foreign currency
transactions are those transactions whose terms are denominated in a
currency other than the entity‟s functional currency. A transaction with
a foreign company that is to be settled in Egyptian pounds is not a
foreign currency transaction to an Egyptian firm because the number of
pounds to be received or paid to settle the account is fixed and remains
unaffected by subsequent changes in the exchange rate. Thus, a
transaction of an egyptian firm with a foreign entity to be settled in
Egyptian pound is accounted for in the same manner as if the
transaction had been with an Egyptian company.

A foreign currency transaction will be settled in a foreign currency,

and the egyptian firm is exposed to the risk of unfavorable changes in
the exchange rate that may occur between the date the transaction is
entered into and the date the account is settled. A firm may hedge, that
is, protect itself against an unfavorable change in the exchange rate by
using derivatives.

Foreign currency transactions may result in receivables or payables

fixed in terms of the amount of foreign currency to be received or paid.
When companies in different countries engage in activities with one
another, the activities often involve the use of different currencies. For
example, the egyptian currency is L.E., the United States currency is
the dollar, while the British currency is the pound, and the French
currency is the euro. The relationship between the currencies of
different countries changes over time. As such, transaction gains and
losses are reported in the income statement.

An exchange rate is the ratio between a unit of one currency and the
amount of another currency for which that unit can be exchanged at a
particular time. A direct exchange quotation is one in which the
exchange rate is quoted in terms of how many units of the domestic
currency can be converted into one unit of foreign currency. For
example, a direct quotation of Egyptian pound for one US dollar of 18
152
means that L.E. 18 could be exchanged for one US dollar. To translate
dollars into L.E., the number of dollars is multiplied by the direct
exchange rate expressed in L.E. per dollar. Exchange rates are also
stated in terms of converting one unit of the domestic currency into
units of a foreign currency, which is called an indirect quotation. In
the example above, one L.E. could be converted into 0.056 U.S. dollar
(1/18). To translate dollars into L.E., the number of dollars could also
be divided by the indirect exchange rate.

Exchange rates may be quoted either as a spot rate or a forward rate.

The spot rate is the rate currencies can be exchanged today. The
forward or future rate is the rate the currencies can be exchanges at
some future date. The forward rate is an exchange rate established at
the time a forward exchange contract is negotiated. A forward
exchange contract is a contract to exchange at a specified rate (the
forward rate) currencies of different countries on a stipulated future
date. Before the currencies are exchanged, the spot rate may move
above or below the contracted forward exchange rate, but this has no
effect on the forward rate established when the forward exchange
contract was negotiated.

Similarly, Exchange rates may also be quoted either as official (fixed)

rates or floating rates. The official rate is the rate the country maintains
the actual exchange rate of its currency within 2% of the official rate.
The floating rate is the currency‟s exchange rate that is determined by
supply and demand factors, which increases risk to companies doing
business with a foreign company.

Foreign Currency Transactions

Foreign currency transactions take place when a company:
1. buys or sells on credit goods or services the prices of which are
denominated in foreign currencies;
2. borrows or lends funds, and the amounts payable or receivable are
denominated in a foreign currency;
3. is a party to an unperformed forward exchange contract; and
4. acquires or disposes of assets, or incurs or settles liabilities
denominated in foreign currencies.

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Transactions are normally measured and recorded in terms of the
currency in which the reporting entity prepares its financial statements.
This currency is usually the domestic currency of the country in which
the company is domiciled and is called the reporting currency.
Exposure to foreign exchange risk exists when a payment to be made
or received is denominated in terms of a foreign currency.
Appreciation in a foreign currency will result in a foreign exchange
gain on a foreign currency receivable and a foreign exchange loss on a
foreign currency payable. Conversely, a decrease in the value of a
foreign currency will result in a foreign exchange loss on a foreign
currency receivable and a foreign exchange gain on a foreign currency
payable. Transaction losses differ from translation losses, which do not
influence taxable income.

The Impact of Fluctuation on Foreign Currency on the Receiver

and Payer
Foreign Foreign Currency Foreign Currency Payable
Currency Receivable
Exchange Asset Value Foreign Liability Value Foreign
Rate Exchange Exchange
Increases Increases Gain Increases Loss
Decreases Loss Decrease Gain
Decreases

A company is long in a foreign currency if the value of their foreign-

currency-denominated assets exceeds the value of its foreign-currency-
denominated liabilities. A company is short in a foreign currency if the
value of their foreign-currency-denominated assets is less than the
value of its foreign-currency-denominated liabilities.

Types of Foreign Currency Risks

All organizations that invest in, sell into or source from economies
which have a currency other than their domestic currency will be
exposed to foreign currency (FC) risk. There are three main types of
FC risk namely:
1. Translation: Impairment in Balance Sheet value of foreign
assets/investments between year-end dates due to adverse
foreign exchange rate movements.

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 2. Transaction: Transaction impairment as a result of adverse
foreign exchange rate movements between the date of inception
and completion. A company expecting receipts in foreign
currency units has the risk that the value of the foreign currency
units will drop. This results in devaluing the foreign currency
relative to the local currency. If a company is expecting to have
obligations in foreign currency units, there is risk that the value
of the foreign currency will raise and it will need to buy the
currency at a higher price.
3. Economic: Broad risk of reduced international competitiveness
on which foreign exchange rates can impact significantly.

Under IAS 21, foreign exchange gains and losses on foreign currency
balances are recorded in income in the period in which an exchange
rate change occurs; this is an accrual approach. Foreign currency
balances must be revalued to their current domestic currency
equivalent using current exchange rates whenever financial statements
are prepared. This approach violates the conservatism principle when
unrealized foreign exchange gains are recognized as income.
Techniques of Hedging Foreign Exchange Risks
Many organizations choose not to accept foreign transaction risk and
will endeavour to hedge to reduce their exposure thereto. Foreign
exchange risk can be neutralized or hedged by a change in the asset
and liability position in the foreign currency. Hedging is the process of
reducing exposure (asset or liability) by offsetting foreign currency
assets with foreign currency liabilities and foreign currency liabilities
with foreign currency assets. In other words, hedging involves
establishing a price today at which a foreign currency to be received in
the future can be sold in the future or at which a foreign currency to be
paid in the future can be purchased in the future. This can be achieved
through both internal and external techniques.

Internal Techniques
Ideally, in the first instance organizations will attempt to manage
foreign currency transaction risk internally using mechanisms such as:
(i) Netting: Netting implies offsetting exposures in one currency
with exposure in the same or another currency, where exchange
rates are expected to move high in such a way that losses or gains

155
 on the first exposed position should be offset by gains or losses
on the second currency exposure. It is of two types bilateral
netting & multilateral netting. In bilateral netting, each pair of
subsidiaries nets out their own positions with each other. Flows
are reduced by the lower of each company‟s purchases from or
sales to its netting partner.
(ii) Matching: The netting is typically used only for inter company
flows arising out of groups receipts and payments. As such, it is
applicable only to the operations of a multinational company
rather than exporters or importers. In contrast, matching applies to
both third parties as well inter-company cash flows. It can be used
by the exporter/importer as well as the multinational company. It
refers to the process in which a company matches its currency
inflows with its currency outflows with respect to amount and
timing. Receipts generated in a particular currency are used to
make payments in that currency and hence, it reduces the need to
hedge foreign exchange risk exposure. Hedging is required for
unmatched portion of foreign currency cash flows. The aggressive
company may decide to take forward cover on its currency
payables and leave the currency receivables exposed to exchange
risk; if forward rate looks cheaper than the expected spot rate. In
matching operation, the basic requirement is a two-way cash flow
in the same foreign currency. This kind of operation is referred to
as natural matching. Parallel matching is another possibility. In
parallel matching, gains in one foreign currency are expected to
be offset by losses in another, if the movements in two currencies
are parallel. In parallel matching, there is always the risk that if
the exchange rates move in opposite direction to expectations,
both sides of the parallel match leads to exchange losses or gains.
(iii) Leading and Lagging: It refers to the adjustment of
intercompany credit terms, leading means a prepayment of a trade
obligation and lagging means a delayed payment. It is basically
intercompany technique whereas netting and matching are purely
defensive measures. Intercompany leading and lagging is a part of
risk-minimizing strategy or an aggressive strategy that maximizes
expected exchange gains. Leading and lagging requires a lot of
discipline on the part of participating subsidiaries. Multinational

156
 companies which make extensive use of leading and lagging may
either evaluate subsidiary performance in a pre-interest basis or
include interest charges and credits to overcome evaluation
problem. Another important complicating factor in leading &
lagging is the existence of local minority interests. If there are
powerful local shareholders in the „losing‟ subsidiary, there will
be strong objections because of the added interest cost and lower
profitability which results from the consequent local borrowing
Government by implementing credit and exchange controls
may restrict such operations.
(iv) Pricing Policy: In order to manage foreign exchange risk
exposure, there are two types of pricing tactics: price variation
and currency of invoicing policy. One way for companies to
protect themselves against exchange risk is to increase selling
prices to offset the adverse effects of exchange rate fluctuations.
Selling price requires the analysis of Competitive situation,
Customer credibility, Price controls and Internal delays.
(v) Trading or Financing Pattern: Intercompany or transfer price
variation refers to the arbitrary pricing of intercompany transfer
of goods and services at a higher or lower rate than the market
price. In establishing international transfer prices, one tries to
satisfy a number of objectives. The firms want to minimize taxes
and at the same time win approval from the Government of the
host country. Yet, the basic objectives of profit maximization and
performance evaluation are also significant. Often, it is not
possible to satisfy all these objectives simultaneously, so a
company must decide which objectives are more important . As a
result, particular transfer price may be established arbitrarily to
fulfill the objective involving international considerations. For the
strong currency exporter, the defensive approach is the only
option available for export invoicing since the home currency is
probably the strongest currency acceptable to the customer. For
the weak currency exporter, however, there may be significant
gains from an aggressive currency-of-invoicing policy. In such
circumstances foreign currency invoicing may be attractive to the
exporter in expectation that the home currency equivalent sales
proceeds would be changed by a foreign currency appreciation

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 over the credit period. However, there are risks involved in
switching from a weak currency to a stronger one. The relative
strengths of the two currencies could reverse themselves in the
future and hence currency of invoicing cannot be changed
regularly. Price list adjustment & loss of customers credibility are
hindrances in changing currency of billing.
(vi) Asset and Liability Management: This technique can be used to
manage balance sheet, income statement and cash flow
exposures. It can also be used aggressively or defensively. They
aggressive approach reflects to increase exposed assets, revenues,
and cash inflows denominated in strong currencies and to increase
exposed liabilities, expenses, and cash outflows in weak
currencies. The defensive firm will seek to minimize foreign
exchange gains and losses by matching the currency
denomination of assets/liabilities, revenues/expenses and cash
inflows/outflows, irrespective of the distinction between strong
and weak currencies. To archive these objectives, variables are
grouped. Operating variables includes trade receivables and
payables, inventory & fixed assets and financial variables cash,
short-term investments and debt. The currency denomination of
operating variables is determined by intrinsic business conditions,
production and marketing factors. Financial variables can be used
for exposure management purpose and thus corporate financial
management has more discretion over currency denomination.
The scarcity of currency finance is often a major problem. The
parent company would borrow the weak currency for long term
while the subsidiary is usually restricted to short term borrowing.
This is because (a) most subsidiaries are not individually listed on
a stock exchange, so that the public issue of debt instruments is
very difficult, hence, the bulk of long-term loans taken out by
foreign subsidiaries are private placements; (b) many foreign
subsidiaries are relatively small and not well known to the local
financial community; and (c) host governments may be reluctant
to allow term borrowing by expatriate subsidiaries.
External Techniques
External techniques are used by both exporters and importers as well
as by multinational companies. The costs of the external exposure
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management methods are fixed and predetermined. Where internal
hedging techniques are not possible and/or fail to achieve acceptable
hedging efficiency, an organization will typically resort to external
hedging mechanisms. The main external exposure management
techniques are forward exchange contracts, short term borrowing,
discounting, forfeiting & government exchange risk guarantees.
1. Forward Exchange Contracts: A forward contract is a binding
agreement to exchange currencies at a predetermined future rate.
The forward exchange contract is a commitment to buy or sell, at
a specified future date, one currency for a specified amount of
another currency (at a specified exchange rate). This can be a
hedge against changes in exchange rates during a period of
contract or exposure to risk from such changes. A company can
(1) buy foreign exchange forward contracts to cover payables
denominated in a foreign currency and (2) sell foreign exchange
forward contracts to cover receivables denominated in a foreign
currency. This way, any gain or loss on the foreign receivables or
payables due to changes in exchange rates is offset by the gain or
loss on the forward exchange contract.

Forward cover can be used to hedge purchases as well as sales. It

may be two types namely forward purchases cover & forward
sales cover. Forward purchase cover is extended to have terms
and conditions related to export of goods & services. Period of
delivery of currency should not be beyond seven days of the
probable date of receipt as per the purchases forward cover. It can
be extended for purchases of proceeds of foreign currency notes
from licensed full fledged money changers, provided that the
currency notes were exported through the bank, for realisation
and credit to the bank‟s account. All other requirements related to
export can be hedged by it. Forward sales cover imports of goods
& services in India, where the import is permissible as per the
Import Control Regulation and repayment of foreign currency
loans, approval from RBI for availing such loan must have been
obtained. Such approval should contain the details of currency,
amount of interest and the repayment procedure. The forward
contract would have to provide for repayment in accordance with
settled terms & conditions. Repayment liabilities under such loans

159
 would be carried forward for several years and it would not be
possible to fix the forward rate for such future dates as the market
would not predict rate beyond six to seven months.

2. Foreign currency options: Options are rights & not obligations

to make buy and sell decision. An option is a contract between
two parties known as the buyer and the seller or writer. The buyer
pays a price or premium to the seller for the right but not the
obligation to buy or sell a certain amount of a specified quantity
of one currency in exchange at a fixed price for a specified period
of time. The right to buy is a call option and the right to sell is a
put option. An option gives the buyer the right, but not the
obligation, to exchange currencies at a predetermined rate. A
foreign currency put option is the right to sell a specific amount
of a foreign currency at a predetermined price, known as the
strike price. In general, a put option will be exercised when the
strike price exceeds the spot rate. A put option will not be
exercised when the strike price is less than the spot rate. Foreign
currency options can be purchased or sold in three different types
of markets: (1) options on the physical currency, purchased on the
over-the-counter (interbank) market; (2) options on the physical
currency on organized exchanges, such as the Nigeria Stock
Exchange; and (3) options on futures contracts, purchased on the
International Monetary Market (IMM).
3. Futures: Futures are contracts to buy or sell financial
instruments, for forward delivery or settlement on standardized
terms and conditions. Future contacts are similar to forward
contracts but are more liquid as these are traded on recognized
exchanges. The difference between using a futures contract and
using an option on a futures contract is that with a futures
contract, the company must deliver one currency against another,
or reverse the contract on the exchange, while with an option the
company may abandon the option and use the spot (cash) market
if that is more advantageous. IAS 39 requires derivative financial
instruments to be reported on the balance sheet at their fair value.
Under hedge accounting, gains and losses on the hedging
instrument are reported in net income in the same period as gains
and loss on the item being hedged.

160
4. Swaps: Swaps refer to a contract between two parties, termed as
counter-parties, who exchange payments between them for an
agreed period of time according to certain specified rules. It is
defined as a financial transaction involving two counter-parties
who agreed terms to exchange streams of payments or cash flows
overtime on the basis of agreed at the beginning of the contract.
Swap is like a series of forward contracts. Swaps involve a series
of exchanges at specific futures dates between counter parties.
For example, suppose a U.S.-based company needs to acquire
L.E. and an Egyptian -based company needs to acquire U.S.
dollars. These two companies could arrange to swap currencies
by establishing an interest rate, an agreed upon amount and a
common maturity date for the exchange. Currency swap
maturities are negotiable for at least 10 years, making them a very
flexible method of foreign exchange.

5. Short term Borrowing: Another alternative to hedge risks in the

forward market is the short-term borrowing technique. A
company can borrow either dollar or some other foreign currency
or the local currency. Through short term borrowing techniques,
two major difficulties of the settlement dates and the continuing
stream of foreign currency are easily solved. Short-term
borrowing has some advantages over forward cover. The cost of
short-term borrowing cover is the home currency amount which
would have been received if the exposed receivable has been
measurable. The foreign currency converted into home currency
at the settlement dateless spot rate is the amount which the short-
term borrowing technique yielded.
6. Discounting: This technique is used to resolve the problems of
continuing foreign currency exposures and uncertain settlement
dates. The discounting technique for covering receivables
exposures is very similar to short term borrowing. In discounting
techniques, the effective discount rate less the home currency
deposit rate rather that the foreign currency borrowing rate less
the home currency rate as is short term borrowing techniques, is
the cost. The basic aim in discounting is to convert the proceeds
from the foreign currency receivable into the home currency as
soon as possible.

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7. Forfeiting: Forfeiting can be used as a means of covering export
receivables. When the export receivable is to be settled on open
account except by bill of exchange, the receivables can be
assigned as collateral for selected bank financing. In forfeiting
one simply sells his export receivables to the factor and receives
home currency in return. The cost involved include credit risks
the customers, default risk, the cost of financing if the exporter
wants to receive payment before the receivable maturity date and
the cost of covering the exchange risk by the forward discount or
premium. Forfeiting, therefore, tends to be expensive means of
covering exposure. There may be offsetting benefits such as
obtaining export finance and reducing sales accounting and credit
collection costs.
8. Government Exchange Risk Guarantee: Government agencies
in many countries provide insurance against export credit risk and
introduces special export financing schemes for exporters in order
to promote exports. In recent years a few of these agencies have
begun to provide exchange risk insurance to their exporters and
the usual export credit guarantees. The exporter pays a small
premium on his export sales and for this premium the government
agency absorbs all exchange losses and gains beyond a certain
level. Initially, such exchange risk guarantee schemes were
introduced to aid capital goods exports where receivable
exposures were of long-term nature. Government exchange risk
guarantees are also given to cover foreign currency borrowing by
public bodies.
9. Money Market Hedges: The money markets are markets for
wholesale (large-scale) lending and borrowing, or trading in
short-term financial instruments. Many companies are able to
borrow or deposit funds through their bank in the money markets.
Instead of hedging a currency exposure with a forward contract, a
company could use the money markets to lend or borrow, and
achieve a similar result. The basic idea is to avoid future
exchange rate uncertainty by making the exchange at today's spot
rate instead. This is achieved by depositing/borrowing the foreign
currency until the actual commercial transaction cash flows occur.
Since forward exchange rates are derived from spot rates and
money market interest rates, the end result from hedging should
be roughly the same by either method.
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Setting up the hedge

In effect a foreign currency asset is set up to match against a future

liability (and vice-versa).
If you are hedging a future payment:
(i) buy the present value of the foreign currency amount today at
the spot rate ;
(ii) the foreign currency purchased is placed on deposit and accrues
interest until the transaction date;

163
(iii) the deposit is then used to make the foreign currency payment.

If you are hedging a receipt:

(i) borrow the present value of the foreign currency amount today
(ii) the foreign loan accrues interest until the transaction date
(iii) the loan is then repaid with the foreign currency receipt

All the various exposure management techniques are not available in

all circumstances. This is mainly because of limitation imposed by the
market-place and by regulatory authorities. Similarly, the availability
of internal techniques is largely a function of the international
involvement of each company.

TRANSLATION OF FOREIGN CURRENCY FINANCIAL

STATEMENTS
An entity may carry on foreign activities in two ways – transactions
and translation. In addition it may present its financial statements in a
foreign currency. IAS 21 prescribes how transactions and foreign
operations should be accounted and how to translate financial
statements into a presentation currency. In preparing consolidated
financial statements on a worldwide basis, the foreign currency
financial statements prepared by foreign operations must be translated
into the parent company‟s reporting currency.
A. The two major issues related to the translation of foreign
currency financial statements are: (1) which method should be
used, and (2) where should the resulting translation adjustment
be reported in the consolidated financial statements.
B. Translation methods differ on the basis of which accounts are
translated at the current exchange rate and which are
translated at historical rates. Accounts translated at the
current exchange rate are exposed to translation adjustment
(balance sheet exposure).
C. Different translation methods give rise to different concepts of
balance sheet exposure and translation adjustments of
differing sign and magnitude.

164
Under the current rate method, all assets and liabilities are translated at
the current exchange rate giving rise to a balance sheet exposure equal
to the foreign subsidiary‟s net assets. Stockholders‟ equity accounts
are translated at historical exchange rates. Income statement items are
translated at the average exchange rate for the current period.
A. Appreciation of the foreign currency results in a positive
translation adjustment; depreciation of the foreign currency
results in a negative translation adjustment.
B. Translating all assets and liabilities at the current exchange
rate maintains the relationships that exist in the foreign
currency financial statements.
B. Translating assets carried at historical cost at the current
exchange rate results in amounts being reported on the
parent‟s consolidated balance sheet that have no economic
meaning.

Under the temporal method, assets are carried at current or future value
(cash, marketable securities, receivables) and liabilities are remeasured
at the current exchange rate. Assets carried at historical cost and
stockholders‟ equity accounts are remeasured at historical exchange
rates. Expenses related to assets remeasured at historical exchange
rates are remeasured using the same rates. Other income statements
items are remeasured using the average exchange rate for the period.
A. When liabilities are greater than the sum of cash, marketable
securities, and receivables, a net liability balance sheet
exposure exists. Appreciation of the foreign currency results
in a remeasurement loss; depreciation of the foreign currency
results in a remeasurement gain.
B. Remeasuring assets carried at historical cost at historical
exchange rates maintains the underlying valuation method
used by the foreign operation in preparing its financial
statements.
C. Remeasuring some assets at historical exchange rates and
other assets at the current exchange rate distorts the
relationships that exist among account balances in the foreign
currency financial statements.

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The appropriate combination of translation method and disposition of
translation adjustment is determined under IAS 21 by identifying the
functional currency of a foreign operation.
A. The financial statements of a foreign operation whose
functional currency is different from the parent‟s reporting
currency are translated using the current rate method, with the
resulting translation adjustment deferred in stockholders‟
equity until the foreign entity is disposed of. Upon disposal of
the foreign operation, the accumulated translation adjustment is
recognized as a gain or loss in net income.
B. The financial statements of foreign operations whose
functional currency is the same as the parent‟s reporting
currency are remeasured using the temporal method with the
resulting remeasurement gain or loss reported immediately in
net income.

Translation rules between IAS 21 relates to foreign operations that

report in the currency of a hyperinflationary economy.
A. IAS 21 requires a restate-translate method in translating the
financial statements of foreign operations located in a
hyperinflationary economy. The foreign financial statements
are first restated for foreign inflation using rules in IAS 29,
and then are translated into parent company currency using the
current rate method.
C. A country is considered highly inflationary if its cumulative
three-year inflation rate exceeds 100%.

Some companies hedge their balance sheet exposures to avoid

reporting remeasurement losses in income and/or negative translation
adjustments in stockholder‟s equity. In addition to derivative financial
instruments, such as forward contracts and options, companies often
use foreign currency borrowings to hedge their net investment in a
foreign operation.
A. IAS 39 provides that the gain or loss on a hedging instrument
that is designated and effective as a hedge of the net
investment in a foreign operation should be reported in the
same manner as the translation adjustment being hedged.

166
 B. The paradox in hedging balance sheet exposure is that by
avoiding an unrealized translation adjustment or
remeasurement gain/loss, realized foreign exchange gains and
losses can arise.

Example 1
BUK an Egyptian multinational company whose functional currency is
Egyptian pound ( L.E. ) with an accounting year-end of 31st December of
each year purchased raw materials on credit from Smart Inc. of the United
States of America invoiced at $10,000 on 2nd April 2020, when the exchange
rate was L.E.17= US$ 1. BUK settled its account on 30th July 2020 when the
exchange rate was L.E. 18=US$1. You are required to show the foreign
currency gain(s) or losse(s) to BUK by way of journal entries.

Solution to Example 1

In the Books of BUK PLC

General Journal
Particulars Dr. Cr.

Purchases 170,000
Smart Inc. 170,000
Being credit purchases for US$10,000 at exchange rate of
L.E.17= US$ 1
Smart Inc. 170,000
Profit & Loss (exchange loss) 10,000
Bank 180,000
Being payment for credit purchases for US$10,000 at exchange
rate of L.E.18= US$ 1

ADDITIONAL INTERNATIONAL FINANCIAL REPORTING

ISSUES
The three main additional international financial reporting issues are:
(i) Inflation accounting
(ii) Business combinations and consolidated financial
statements, and
(iii) Segment reporting

8.1 Inflation Accounting

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Preparing financial statements using historical cost accounting in a
period of inflation results in a number of problems. Assets are
understated, and income generally is overstated; using historical cost
income as the basis for taxation and dividend distributions can result in
cash flow difficulties; and comparing the performance of foreign
operations exposed to different rates of inflation can be misleading.

Two methods of accounting for changing prices (inflation) have been

used in different countries: general purchasing power (GPP)
accounting and current cost (CC) accounting. GPP is also referred to as
General Price-Level Adjusted Historical Cost Accounting (GPLAHC).
The General Price Level Index (GPLI) used in GPP is usually
developed by the central bank. CC is also referred to as Current
Replacement Cost accounting (CRC). Under GPP accounting,
nonmonetary assets and stockholders' equity accounts are restated for
changes in the general price level. Cost of goods sold and
depreciation/amortization are based on restated asset values, and the
net purchasing power gain/loss on the net monetary liability/asset
position is included in income. GPP income is the amount that can be
paid as a dividend while maintaining the purchasing power of capital.
Under CC accounting, nonmonetary assets are revalued to current cost,
and cost of goods sold and depreciation/amortization are based on
revalued amounts. CC income is the amount that can be paid as a
dividend while maintaining the productive capacity of physical capital.

Several Latin American countries, including Brazil, Chile and Mexico,

have used GPP accounting in the past to overcome the limitations of
historical cost accounting. Presently, a number of them have
abandoned inflation accounting. Prior to the introduction of IFRS, the
Netherlands allowed, but did not require, the use of CC accounting.
IAS 29 (Financial reporting in hyper inflation economies) requires the
use of GPP accounting by firms that report in the currency of a
hyperinflationary economy. IAS 21 (effect of changes in foreign
exchange) requires the financial statements of a foreign operation
located in a hyperinflationary economy to first be adjusted for inflation
in accordance with IAS 29 before translation into the parent company's
reporting currency.

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In some countries (including US and UK) providing GPP and CC
accounting disclosure presently is optional and only few companies
provide it. Similarly, a number of countries have experienced low rates
of inflation and therefore do not need to provide GPP or CC
accounting information.

IAS 15, information reflecting the effects of changing prices was

issued in 1981 but has been withdrawn due to lack of support. The
relevant standard now is IAS 29, financial reporting in hyper
inflationary economies, which is applicable in an environment where
cumulative inflation in three consecutive years to be approaching 100
per cent or exceeds it.

In a hyperinflationary economy, money loses purchasing power at a

high rate making the comparison of amounts from transactions and
other events that have occurred at different times or even within the
same accounting period misleading. IAS 29 has instituted a
methodology of restatement of accounting information using suitable
price indices to make the financial statements of different periods
comparable and the accounting indicators for the same accounting
period useful for users‟ decision making.
IAS 29 is applicable to the financial statements, including the
consolidated financial statements, of any entity whose functional
currency is the currency of a hyperinflationary economy. An entity
shall apply this standard from the beginning of the reporting period in
which it identifies the existence of hyperinflation in the country in
whose currency it reports. IAS 29 requires presentation of financial
statements restated in accordance with the
measuring unit current at the end of the reporting period. The restated
financial statements are not to be presented as a supplement to
unrestated financial statements. Moreover, separate presentation of the
financial statements before restatement is discouraged.

Hyperinflationary economy is an economy that is inter alia

characterized by the following:
(i) The general population prefers to keep its wealth in nonmonetary
assets or in a relatively stable foreign currency. Amounts of local
currency held are immediately invested to maintain purchasing
power;
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(ii) The general population regards monetary amounts not in terms of
the local currency but in terms of a relatively stable foreign
currency. Prices may be quoted in that currency;
(iii) Sales and purchases on credit take place at prices that compensate
for the expected loss of purchasing power during the credit
period, even if the period is short;
(iv) Interest rates, wages, and prices are linked to a price index; and
(v) The cumulative inflation rate over three years is approaching, or
exceeds, 100%.

Monetary items that are either assets or liabilities expressed in terms

of money held and items to be received or paid in money.

Restatement of Financial Statements: All financial statement

elements, whether they are based on a historical cost approach or a
current cost approach, are stated in terms of the measuring unit current
at the end of the reporting period. The corresponding figures for the
previous period required by IAS 1, Presentation of Financial
Statements, and any information in respect of earlier periods, shall also
be stated in terms of the measuring unit current at the end of the
reporting period.

For the purpose of presenting comparative amounts in a different

presentation currency, paragraphs 42(b) and 43 of IAS 21, The Effects
of Changes in Foreign Exchange Rates, are
also applied. The measuring unit current at the end of the reporting
period is determined using a general price index that reflects changes
in general purchasing power. IAS 29 prefers that all entities belonging
to the same hyperinflationary economy should use the same general
index. Therefore, a hyperinflationary economy that follows IFRSs
should notify a general price index to be followed by the entities for
the purpose of presentation of financial statements. The measuring unit
current at a particular measurement date is determined by applying a
conversion factor: Index on the reporting date
Index on the measurement date
This means the conversion factor for all items measured using the
currency of hyperinflationary economy on the reporting date is 1.
Items measured using the currency of a hyperinflationary economy at a

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date earlier than the reporting date are converted applying a conversion
factor that is greater than 1.

Business Combinations and Consolidated Financial Statements

Multinational corporations (MNCs) often operate as groups, and there
is a need for consolidated financial statements reflecting their financial
position and performance. IFRS 3 (business combinations-which
replaces IAS 22 (business combination) and modifies IAS 27). defines
group as a parent and its subsidiaries, and requires groups to prepare
consolidated financial statements. IAS 27 (consolidated financial
statements and accounting for investment in subsidiaries) requires a
parent to consolidate all subsidiaries, foreign and domestic, unless the
subsidiary was acquired with the intention to be disposed of within 12
months and management is actively seeking a buyer.

Business combinations are primary mechanism used by MNCs for

expansion, where acquiree remains a separate legal entity as a
subsidiary of the acquired (parent). Sometimes the acquiree ceases to
exist. Accounting for parent and one or more subsidiaries is often
called group accounting.

Full consolidation involves aggregation of 100 per cent of the

subsidiary‟s financial statement elements, using either purchase
method or pooling of interest method, with the excess of purchase
price over the fair value of the net assets recognized as goodwill. When
a subsidiary is not 100 per cent owned, the non-owned portion is
presented as a separate item called minority interest.

Significant variation exists internationally in accounting for goodwill.

US, Nigeria, IFRS and most other countries require goodwill to be
capitalised as an assets. Some countries require amortization over a
period of up to 40 years. US, Canada and IFRS do not require
amortization but do require an annual impairment test, while Japan
allows immediate expensing of goodwill.

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Segment Reporting
The aggregation of all of a company's activities into consolidated totals
masks the differences in risk and potential existing across different
lines of business and in different parts of the world. To provide
information that can be used to evaluate these risks and potentials,
companies disaggregate consolidated totals and provide disclosures on
a segment basis. Segment reporting is an area in which considerable
diversity exists internationally. Segments are defined both by line of
business and geographic area under IFRS 8 (segment reporting).

IAS 14 (financial reporting by segment), which was originally issued

in 1981, requires disclosures by both business segment and geographic
segment, one of which is designated as the primary reporting format. A
business segment or a geographic segment is reportable if a majority of
its revenues are generated from external customers and it meets any
one of three significance tests of revenue, profit or loss and assets. A
segment is reportable if it equals or exceeds 10 per cent on any one of
these test.

Both standards require disclosure of revenues and noncurrent assets (or

long-lived assets) for the domestic country, all foreign countries in
which the company operates, and each individual country in which a
material amount of revenues or assets is located. There is a significant
lack of convergence internationally in the area of segment reporting
and in a number of countries; segment reporting is not required if
deemed to be competitive dis-advantage by the company.

As a result of the International Accounting Standards Board‟s (IASB)

joint short-term convergence project with the U.S. Financial
Accounting Standards Board (FASB), a project
was launched with the primary objective of reducing differences
between IFRS and U.S. GAAP and, based on research, was carried on
by both standard setters. The IASB adopted
the approach of the U.S. standard on segmental reporting; namely,
SFAS 131, Disclosures About Segments of an Enterprise and Related
Information, and revised its standard on segment reporting.

In November 2006, the IASB issued IFRS 8, Operating Segments,

effective for annual periods beginning on or after January 1, 2009.
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IFRS 8 replaced IAS 14 and with this new standard on segmental
reporting, the emphasis has shifted to disclosing segmental information
(for external reporting purposes), based on internal reporting within the
entity, to its Chief Operating Decision Maker (CODM). The IASB
believes that by requiring entities to report segmental information
using the approach prescribed by IFRS 8 (i.e., a management
approach) it allows the financial statement user to review segmental
information from the “eyes of the management” as opposed to a risks-
and-rewards approach that was the cornerstone of the IASB standard
on segment reporting (IAS 14). Furthermore, by adopting this new
approach under IFRS 8, the cost and time needed to produce segmental
information is greatly reduced since most, if not all, of this information
is already available within the entity. In the case of public companies
that are required to report on a quarterly basis, this is a distinct
advantage.

Scope of IFRS 8
IFRS 8 applies to both the separate or individual financial statements
of an entity and to consolidated financial statements of a group within
which the entity is the parent:
(i) Whose debt or equity instruments are publicly listed; or
(ii) That files, or is in the process of filing, its financial
statements with a securities commission or other regulatory
authority for the purpose of issuing any class of instruments
in a public market.
The standard clarifies that when both the parent‟s separate (stand-
alone) financial statements and its consolidated financial statements are
presented in the same financial report, segment information, as
required by IFRS 8, needs to be presented only for the consolidated
financial statements. Upon first adoption of IFRS 8, comparatives, as
reported under IAS 14, are required to be restated.

Core Principle of IFRS 8

According to the core principle of IFRS 8, an entity should disclose
information to enable users of its financial statements to evaluate the
nature and financial effects of the types of business activities in which
it engages and the economic environments in which it operates.

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Chief Operating Decision Maker (CODM): The chief operating
decision maker, or the CODM, as it is sometimes referred to, could be
the chief operating officer, or the chief executive officer, or the board
of directors, or an executive committee comprising two or three board
members, depending on who within the organization is responsible for
the allocation of resources and assessing the performance of the
entity‟s operating segments. In most organizations, the highest ranking
individual would qualify as the CODM. However, since the term
CODM does not always refer to an individual, but to a function, in the
case of a complex organizational and reporting setup (where decision-
making responsibilities are split amongst the top management
personnel), it could make the assessment of who the CODM is
difficult. In such a case, where it is difficult to determine the CODM,
other factors, such as who decides the management bonuses or who
approves the financial information presented to the Board of Directors,
may need to be considered as well.

Example
Exuberance Inc. is a company listed on a well-known international
stock exchange. It has three major lines of business; namely, retail,
wholesale, and export. Each major line of business has a chief
operating officer (COO) who is the responsible for the business
component‟s profitability. The company has a chief executive officer
(CEO) who is overall in charge of the entire business of the entity and
reports to the Board of Directors (Board) on the results of operations of
Exuberance Inc. The CEO has the authority from the Board to decide
on the performance bonus of each COO, for which the CEO has set
key performance indications (KPIs) against which they are evaluated
each year by the CEO. Discrete financial information for each of the
major lines of business of Exuberance Inc. is available.

The CEO has been entrusted by the Board to allocate funds for the
day-to-day operations of the three lines of business, which he does
based on criteria such as their comparative profitability, size of
business generated, and cash flows from operations. Based on the
aforementioned details about the functioning of Exuberance Inc. and
other relevant information provided, who is the Chief Operating
Decision Maker (CODM) for the purposes of IFRS 8? Is it the Board,

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the CEO, or each COO for the line of business that he or she is
responsible for?

Solution
First, a COO of any line of business of Exuberance Inc. is only
responsible for the results of the line of business he or she is
responsible for, but is certainly not responsible for the overall business
of the entity and thus cannot qualify as the Chief Operating Decision
Maker (CODM). Second, while the Board is the highest authority in
the hierarchy, the CEO has been given the required powers by the
Board, that is, the power of allocation of resources and the power to
assess the performance of the three major lines of business of the
company. In accordance with the requirements of IFRS 8, the CODM
is not the Board, but is the CEO.

References :
1- DR. WAYNE A. LABEL, CPA, 2005 , “Accounting for Non-Accountants , The
fast and easy way to learn the basics ”, Station Casinos, Inc.
2- MITCHELL FRANKLIN, PATTY GRAYBEAL, DIXON COOPER, 2019 , “Principles
of Accounting, Volume 1: Financial Accounting ” , OpenStax Rice
University.
3- MITCHELL FRANKLIN, LE MOYNE COLLEGE (FINANCIAL ACCOUNTING)
PATTY GRAYBEAL, UNIVERSITY OF MICHIGAN-DEARBORN (MANAGERIAL
ACCOUNTING) DIXON COOPER, OUACHITA BAPTIST UNIVERSITY , 2019 ,
“Principles of Accounting, Volume 2: Managerial Accounting ” , OpenStax
Rice University.
4- Rick Hayes , Roger Dassen , Arnold Schilder , Philip Wallage KPMG, 2005,
“PRINCIPLES OF AUDITING: An Introduction to International Standards on
Auditing ”, Second Edition , Pearson Education Limited.
5- Kabir Tahir Hamid , 2015 , “ International Accounting Lectures” ,
Gombe State University.

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