FORM THREE BOOK KEEPING STUDY NOTES TOPIC 7-10

TOPIC 7: FINANCIAL STATEMENTS
General Purpose Financial Statements
Describe general purpose financial statements
Financial Statements
Definition: Financial statements are a collection of reports about an organization's financial results, financial condition, and cash flows. They are useful for the following reasons:
  • To determine the ability of a business to generate cash, and the sources and uses of that cash.
  • To determine whether a business has the capability to pay back its debts.
  • To track financial results on a trend line to spot any looming profitability issues.
  • To derive financial ratios from the statements that can indicate the condition of the business.
  • To investigate the details of certain business transactions, as outlined in the disclosures that accompany the statements.
The standard contents of a set of financial statements are:
  • Balance sheet. Shows the entity's assets, liabilities, and stockholders'equity as of the report date. It does not show information that covers a span of time.
  • Income statement. Shows the results of the entity's operations and financial activities for the reporting period. It includes revenues, expenses, gains, and losses.
  • Statement of cash flows. Shows changes in the entity's cash flows during the reporting period.
  • Supplementary notes. Includes explanations of various activities, additional detail on some accounts, and other items as mandated by the applicable accounting framework, such asGAAP or IFRS.
Why General Purpose Financial Statements must follow Generally Accepted Accounting Principles
Explain why general purpose financial statements must follow generally accepted accounting principles
If a business plans to issue financial statements to outside users (such as investors or lenders), the financial statements should be formatted in accordance with one of the major accounting frameworks. These frameworks allow for some leeway in how financial statements can be structured, so statements issued by different firms even in the same industry are likely to have somewhat different appearances.
If financial statements are issued strictly for internal use, there are no guidelines, other than common usage, for how the statements are to be presented.
At the most minimal level, a business is expected to issue an income statement and balance sheet to document its monthly results and ending financial condition. The full set of financial statements is expected when a business is reporting the results for a full fiscal year, or when a publicly-held business is reporting the results of its fiscal quarters.
Example Trial Balance:
The trial balance ensures that the debits equal the credits.It is important to note that just because the trial balance balances, does not mean that the accounts are correct or that mistakes did not occur.There might have been transactions missed or items entered in the wrong account – for example increasing the wrong asset account when a purchase is made or the wrong expense account when a payment is made.Another potential error is that a transaction was entered twice.Nevertheless, once the trial balance is prepared and the debits and credits balance, the next step is to prepare the financial statements.
Income Statement
Describe an income statement
The income statement is prepared using the revenue and expense accounts from the trial balance.If an income statement is prepared before an entity’s year-end or before adjusting entries (discussed in future lessons) it is called an interim income statement.The income statement needs to be prepared before the balance sheet because the net income amount is needed in order to fill-out the equity section of the balance sheet.The net income relates to the increase (or in the case of a net loss, the decrease) in owner’s equity.
Preparation of a Balance Sheet
Prepare a balance sheet
Now that the net income for the period has been calculated, the balance sheet can be prepared using the asset and liability accounts and by including the net income with the other equity accounts.
When preparing balance sheets there are two formats you can use.The format above is called the Report form and the Account form lists assets on the left side and liabilities and equity on the right side.

 TOPIC 8: BALANCE SHEET (CLASSIFIED)
Meaning of Each Asset and Liability Classification Appearing on a Balance Sheet
Define each asset and liability classification appearing on a balance sheet
A classified balance sheet presents information about an entity's assets, liabilities, and shareholders' equity that is aggregated (or "classified") into subcategories of accounts. It is extremely useful to use classifications, since information is then organized into a format that is more readable than a simple listing of all the accounts that comprise a balance sheet. When information is aggregated in this manner, a balance sheet user may find that useful information can be extracted more readily than would be the case if an overwhelming number of line items were presented.
The most common classifications used within a classified balance sheet are:
  • Current assets
  • Long-term investments
  • Fixed assets (or Property, Plant, and Equipment)
  • Intangible assets
  • Other assets
  • Current liabilities
  • Long-term liabilities
  • Shareholders' equity
The sum of these classifications must match this formula:Total assets = Total liabilities + Shareholders' Equity
The classifications used can be unique to certain specialized industries, and so will not necessarily match the classifications shown here. Whatever system of classification is used should be applied on a consistent basis, so that balance sheet information is comparable over multiple reporting periods.
Balance Sheet Items
Classify balance sheet items
There is no specific requirement for the classifications to be included in the balance sheet. The following items, at a minimum, are normally included in the balance sheet:
Current Assets:
  • Cash and cash equivalents
  • Trade and other receivables
  • Prepaid expenses
  • Investments
  • Inventories
  • Assets held for sale
Long-Term Investments:
  • Investments in other companies
Fixed Assets:
  • Computer hardware
  • Computer software
  • Furniture and fixtures
  • Leasehold improvements
  • Office equipment
  • Production equipment
  • Accumulated depreciation
Intangible Assets:
  • Intangible assets
  • Accumulated amortization
  • Goodwill
Current Liabilities:
  • Trade and other payables
  • Accrued expenses
  • Current tax liabilities
  • Current portion of loans payable
  • Other financial liabilities
  • Liabilities held for sale
Long-Term Liabilities:
  • Loans payable
  • Deferred tax liabilities
  • Other non-current liabilities
Shareholders' Equity:
  1. Capital stock
  2. Additional paid-in capital
  3. Retained earnings
Preparation of Classified Balance Sheet
Prepare a classified balance sheet
Here is an example of a classified balance sheet, where the classifications are listed in bold in the first column:
Holystone Dental Corp. Statement of Financial Position
(000s)as of 12/31/x2as of 12/31/x1
ASSETS

Current assets

Cash and cash equivalents$270,000$215,000
Trade receivables147,000139,000
Inventories139,000128,000
Other current assets15,00027,000
Total current assets571,000509,000



Fixed assets

Furniture and fixtures551,000529,000
Leasehold improvements82,00082,000
Office equipment143,000143,000
Total non-current assets776,000754,000



Total assets$1,347,000$1,263,000



LIABILITIES AND EQUITY

Current liabilities

Trade and other payables$217,000$198,000
Short-term borrowings133,000202,000
Current portion of long-term borrowings5,0005,000
Current tax payable26,00023,000
Accrued expenses9,00013,000
Total current liabilities390,000441,000



Long-term liabilities

Long-term debt85,00065,000
Deferred taxes19,00017,000
Total non-current liabilities104,00082,000



Total liabilities494,000523,000



Shareholders’ Equity

Capital$100,000$100,000
Additional paid-in capital15,00015,000
Retained earnings738,000625,000
Total equity853,000740,000



Total liabilities and equity$1,347,000$1,263,000

TOPIC 9: MANUFACTURING ACCOUNT
Manufacturing Account
Difference in Accounting for Stocks between Manufacturing Companies and Merchandising Companies
Explain the difference in accounting for stocks between manufacturing companies and merchandising companies
The businesses which produce and sell the items prepare the following accounts at the end of its accounting year:-
  • The Manufacturing account (to calculate the total cost of production)
  • The Trading and profit & loss account (to find out the net profit or loss)
  • The balance sheet.(to show the financial position of the business)
The total cost of production = Prime cost + Factory overhead
The Prime cost = Direct material + Direct labour + Direct expenses
Direct material cost = Opening stock of raw materials + purchase of raw materials + carriage inwards – returns outwards – closing stock of raw materials.
Factory overhead expenses = All expenses related to the factory (indirect expenses)
The format of a manufacturing account
Manufacturing account for the year ended . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Opening stock of raw materialsxxxx
Add purchase of raw materialsxxxxx
Add carriage inwards ( if any )Xxxx
Xxxxx
Less Returns outwards (of raw materials)xxxx
Xxxxx
Less Goods drawings ( if any )xxxx
xxxxx
Less Closing stock of raw materialsxxxx
Cost of Direct Materialsxxxxxxx
Add Direct labourxxxxxxx
Add Direct expenses (Eg: royalties)xxxxxxx
Prime Costxxxxxxx
Add Factory overhead expenses
Factory lightingxxxxxx
Factory heatingxxxxxx
Factory insurancexxxxxx
Factory rentxxxxxx
Factory maintenancexxxxxx
Factory indirect wagesxxxxxx
Factory supervisor’s wagesxxxxxx( + )
Depreciation on plant & machineryxxxxxx
Depreciation on factory buildingxxxxxx
Depreciation on factory furniturexxxxxx
Depreciation on factory motor vanxxxxxx
Depreciation on other factory fixedassetsxxxxxxXXXXXXX
XXXXXXX
Add Opening stock of work in progressxxxxxx
XXXXXXX
Less Closing stock of work in progressxxxxxx
Cost of productionXXXXXXX
The Three Basic Types of Manufacturing Cost
Describe the three basic types of manufacturing cost
Manufacturing costs are the costs necessary to convert raw materials into products. Allmanufacturing costsmust be attached to the units produced for external financial reporting under USGAAP. The resulting unit costs are used forinventory valuationon the balance sheet and for the calculation of thecost of goods soldon the income statement.
Manufacturing costs are typically divided into three categories:
  1. Direct materials. This is the cost of the materials which become part of the finished product. For example, the cost of wood is a direct material in the manufacture of wooden furniture.
  2. Direct labor. This is the cost of the wages of the individuals who are physically involved in converting raw materials into a finished product. For example, the wages of the person cutting wood into the specified lengths and the wages of the assemblers are direct labor costs in a furniture factory.
  3. Factory overhead ormanufacturing overhead. Factory overhead refers to all other costs incurred in the manufacturing activity which cannot be directly traced to physical units in an economically feasible way. The wages of the person who inspects the completed furniture and thedepreciationon the factory equipment are part of the factory overhead costs. Factory overhead is also described as indirect manufacturing costs.
Difference between Indirect and Direct Manufacturing Costs
Distinguish between indirect and direct manufacturing costs
When you're determining the price of a product, it's obvious that you need to charge more than the total cost of producing it. But production costs go beyond the materials and equipment — you also need to factor in workers' salaries, marketing campaigns, overall company maintenance, and the like. Taken all together, these expenses make up the direct and indirect costs of running your business.
It is easy to classify the basic difference between direct and indirect costs. Direct costs are immediately associated with the production of a product or service, while indirect costs include such things as rent — which may be associated with many products — or they may be several steps back in the production process. Though it is tempting to ignore the nuances of this accounting principle, spending some time correctly allocating your costs can improve your accounting ledger — and your clout with potential investors.
Direct costs
Direct costs are expenses that a company can easily connect to a specific "cost object," which may be a product, department or project. This includes items such as software, equipment, labor and raw materials. If your company develops software and needs specific pregenerated assets such as purchased frameworks or development applications, those are direct costs.
Labor and direct materials, which are used in creating a specific product, constitute the majority of direct costs. For example, to create its product, an appliance maker requires steel, electronic components and other raw materials.
Companies typically track the cost of the finished raw materials as a direct cost. Two popular ways of tracking these costsinclude last in, first out (LIFO) or first in, first out (FIFO).
While salaries tend to be a fixed cost, direct costs are frequently variable. Variable expenses increase as additional units of a product or service are created, whereas an employee's salary remains constant throughout the year. For example, smartphone hardware is a direct, variable cost because its production depends on the number of units ordered.
Indirect costs
Indirect costs go beyond the costs associated with creating a particular product to include the price of maintaining the entire company. These overhead costs are the ones left over after direct costs have been computed, and are sometimes referred to as the "real" costs of doing business.
The materials and supplies needed for the company's day-to-day operations are examples of indirect costs. These include items such as cleaning supplies, utilities, office equipment rental, desktop computers and cell phones. While these items contribute to the company as a whole, they are not assigned to the creation of any one service.
Indirect labor costs make the production of cost objects possible, but aren't assigned to a specific product. For example, clerical assistants who help maintain the office support thecompany as a whole instead of just one product line. Thus, their labor can becounted as an indirect cost.
Other common indirect costs include advertising and marketing, communication, "fringe benefits" such as an employee gym, and accounting and payroll services.
Much like direct costs, indirect costs can be both fixed and variable. Fixed indirect costs include things like the rent paid for the building in which a company operates. Variable costs include the ever-changing costs of electricity and gas.
Difference between Product Costs and Period Costs
Distinguissh between product costs and period costs
The key difference between product costs and period costs is that products costs are only incurred if products are acquired or produced, and period costs are associated with the passage of time. Thus, a business that has no production or inventory purchasing activities will incur no product costs, but will still incur period costs.
Examples of product costs are direct materials, direct labor, and allocated factory overhead. Examples of period costs are general and administrative expenses, such as rent, office depreciation, office supplies, and utilities.
Product costs are sometimes broken out into the variable and fixed subcategories. This additional information is needed when calculating the break even sales level of a business. It is also useful for determining the minimum price at which a product can be sold while still generating a profit.
A Schedule of Cost of Finished Goods Manufactured
Prepare a schedule of cost of finished goods manufactured
Thecost of goods manufactured scheduleis used to calculate the cost of producing products for a period of time. The cost of goods manufactured amount is transferred to the finished goods inventory account during the period and is used in calculating cost of goods sold on the income statement. The cost of goods manufactured schedule reports the total manufacturing costs for the period that were added to work‐in‐process, and adjusts these costs for the change in the work‐in‐process inventory account to calculate the cost of goods manufactured.
The cost of goods manufactured for the period is added to the finished goods inventory. To calculate the cost of goods sold, the change in finished goods inventory is added to/subtracted from the cost of goods manufactured
The Cost of Work in Process Stocks and the Costs of Finished Goods Stocks
Determine the cost of work in process stocks and the costs of finished goods stocks
Work in process is goods in production that have not yet been completed. These goods are situated between raw materials and finished goods in the production process flow.
Inventory in this classification typically involves the full amount of raw materials needed for a product, since that is usually included in the product at the beginning of the manufacturing process. During production, the cost of direct labor and overhead is added in proportion to the amount of work done. From the perspective of valuation, a WIP item is more valuable than a raw materials item (since processing costs have been added), but is not as valuable as a finished goods item (to which the full set of processing costs have already been added).
In prolonged production operations, there may be a considerable amount of investment in work in process. Conversely, the production of some products occupies such a brief period of time that the accounting staff does not bother to track WIP at all; instead, the items in production are considered to still be in the raw materials inventory. In this latter case, inventory essentially shifts directly from the raw materials inventory to the finished goods inventory, with no separate work in process accounting at all.
Work in progress accounting involves tracking the amount of WIP in inventory at the end of an accounting period and assigning a cost to it for inventory valuation purposes, based on the percentage of completion of the WIP items.
WIP accounting can be incredibly complex for large projects that are in process over many months. In those situations, we use job costing to assign individual costs to projects. See thejob costingarticle for more information.
In situations where there are many similar products in process, it is more common to follow these steps to account for work in progress inventory:
  1. Assign raw materials. We assume that all raw materials have been assigned to work in process as soon as the work begins. This is reasonable, since many types of production involve kitting all of the materials needed to construct a product and delivering them to the manufacturing area at one time.
  2. Compile labor costs. The production staff can track the time it works on each product, which is then assigned to the work in process. However, this is painfully time-consuming, so a better approach is to determine the stage of completion of each item in production, and assign a standard labor cost to it based on the stage of completion. This information comes from labor routings that detail the standard amount of labor needed at each stage of the production process.
  3. Assign overhead. If overhead is assigned based on labor hours, then it is assigned based on the labor information compiled in the preceding step. If overhead is assigned based on some other allocation methodology, then the basis of allocation (such as machine hours used) must first be compiled.
  4. Record the entry. This journal entry involves shifting raw materials from the raw materials inventory account to the work in process inventory account, shifting direct labor expense into the work in process inventory account, and shifting factory overhead from the overhead cost pool to the WIP inventory account.
It is much easier to usestandard costsfor work in process accounting. Actual costs are difficult to trace to individual units of production, unless job costing is being used. However, standard costs are not as precise as actual costs, especially if the standard costs turn out to be inaccurate, or there are significant production inefficiencies beyond what were anticipated in the standard costs.
Closing Entries for a Manufacturing Company
Prepare closing entries for a manufacturing company
Some companies use one account, factory overhead, to record all costs classified as factory overhead. If one overhead account is used, factory overhead would be debited in the previous entry instead of factory depreciation.
At the end of the cycle, the closing entries are prepared. For a manufacturing company that uses the periodic inventory method, closing entries update retained earnings for net income or loss and adjust each inventory account to its period end balance. A special account called manufacturing summary is used to close all the accounts whose amounts are used to calculate cost of goods manufactured. The manufacturing summary account is closed to income summary. Income summary is eventually closed to retained earnings. The manufacturing accounts are closed first. The closing entries that follow are based on the accounts included in the cost of goods manufactured schedule and income statement for Red Car, Inc.
The following T‐accounts illustrate the impact of the closing entries on the special closing accounts and retained earnings.
The Basic Differences in the Financial Statements of Manufacturing Companies and Merchandising Companies
Describe the basic differences in the financial statements of manufacturing companies and merchandising companies
The most significant difference between a manufacturing company and a merchandising business is that a manufacturer makes goods to sell and a merchandiser buys or acquires goods for resale. In developing a small business, it is critical to understand whether your strengths, available resources and environmental factors contribute to a manufacturing or merchandising setup.
  • Expertise: Given their primary functions of either making or acquiring goods for resale, expertise is a core difference between manufacturing and merchandising. A successful manufacturing business features expertise in developing an operation that produces high-quality, efficient or high-value goods and then distributing them. A merchandiser owns strengths in acquiring goods, increasing their value and marketing them to buyers. A distributor buys items and then resells to retailers, consumers or business buyers. A retailer buys goods and then resells to consumers.
  • Relationship: Manufacturers and merchandisers also have different roles in their interrelationship within a traditional distribution channel. The distribution or trade channel represents the flow of goods from manufacturer through distribution, retailer and on to the final customer. The manufacturer makes goods and traditionally sells them to the distributor or retailer. Wholesaling merchandisers are the traditional direct buyer of manufacturers, although retailers may buy directly from manufacturers as well.
  • Marketing Strategies: Manufacturers typically use a combination of "push" and "pull" marketing strategies. Pull marketing occurs when the manufacturer promotes its brands to end customers. The idea it to create market demand and pull the products through the distribution process. Push marketing occurs when a manufacturer promotes goods directly to trade buyers, or merchandisers. This includes a mix of communicating benefits and offering trade incentives or discounts. Retailer merchandising businesses focus on promoting their company and product brands to targeted customers. They must attract customers to make sales.
  • Inventory: For manufacturers, production inventory includes raw materials used in producing finished goods. Low costs and efficient use of raw inventory is key in manufacturing profitability. Once raw materials are converted, the manufacturer possesses a finished-goods inventory. A reseller buys finished goods and either holds its new inventory in a distribution center or in storage areas in stores. When floor inventory or merchandise grows low, stock is replenished by retail associates.
The procedure Inherent in a General Accounting System for a Manufacturing Company
Describe the procedure inherent in a general accounting system for a manufacturing company
Understanding the JD Edwards EnterpriseOne Manufacturing Accounting System
This two-part flowchart illustrates the manufacturing accounting processes:
Manufacturing Accounting process flow
Integration with General Accounting
To remain competitive in a changing business environment, companies must integrate all aspects of their operations. This integration includes identifying operations that reduce lead times, expedite speed-to-market, and reduce operating costs. The objective is to reduce costs to remain a competitive market player.
After a company defines item costs and identifies how each cost is derived, it transfers these cost records into the accounting records. Using a manufacturing accounting system enables you to track the costs that are associated with each activity within the manufacturing process. As material is received into inventory, issued to a manufacturing order, and used at various stages of the manufacturing cycle, the company maintains detailed accounting records that reflect debits and credits to predetermined financial accounts. These records can be transferred to the general ledger throughout the manufacturing cycle.
The ability to perform standard costing (comparisons based on frozen costs) or actual costing (comparison of expected cost versus actual cost) enables companies to accurately account for the cost of manufacturing. Comparisons identify specific costs that deviate from the original cost expectations. This information enables managers to make better informed decisions and to implement a course of action that reflects current costs in the ultimate cost of the products. Work in process and on-hand inventory can be revalued to reflect these updated costs.
In volatile and dynamic industries such as electronics and other technologies, changes in technology and customer demand, product configuration, and production processes must be monitored constantly. Changes must be integrated and reflected throughout product life cycles as quickly as possible. Industries remain competitive in the global marketplace only if they minimize the time to market for new products and reduce costs.
This flowchart illustrates the interaction between the JD Edwards EnterpriseOne Manufacturing Accounting system and the JD Edwards EnterpriseOne General Accounting system:
Integration between Manufacturing Accounting and General Accounting systems
Different Accounts that Appear on a Manufacturing Company’s Books
List the different accounts that appear on a manufacturing company’s books
The balance sheet is a snapshot of a company's:
  • assets(what it owns)
  • liabilities(what it owes)
  • owners' equity(net worth - what's left over for the owners)
The balance sheet shapshot is at a particular point in time, such as at the close of business on December 31. The simplest corporate balance sheet possible, showing only totals and leaving out all detail, might look like this.
ALBEGA CORPORATIONBalance SheetDecember 31, 20xx
Assets$485,000Liabilities$ 285,000
Shareholders' Equity$200,000
Total Assets$485,000Total Liabilities and Shareholders' Equity$485,000
Balance sheet equation.Assets are always equal to the liabilities plus equity. You can see the balance sheet as a statement of what the company owns (assets) and the persons having claims to the assets (creditors and owners). Here is the balance sheet equation:
Assets = Liabilities + Shareholders' Equity
AssetsLiabililities
Shareholders' Equity
The equation reflects how information is organized on the balance sheet, with assets listed on the left and liabilities and equity on the right. Like the equation, the two sides of the balance sheet must balance.
Double entry bookkeeping.The balance sheet equation also reflects the way information is recorded in the company records. Too keep the equation in balance, company transactions are recorded using "double entry bookkeeping." Every transaction will cause two changes on the accounting statements -- that is, a transaction that affects one side of the equation will also affect the other side, unless there are two offsetting entries on one side. For example, a $2,000 increase in assets will also result in either:
  • an offsetting decrease in assets (if the new $2,000 asset was purchased with $2,000 cash)
  • an increase in liabilities (if the company borrowed the $2,000 to buy the asset)
  • an increase in equity (if the $2,000 came from contributions by the company's owners).
Reading balance sheet.Let's read a more detailed version of our balance sheet:
ALBEGA CORPORATIONBalance SheetDecember 31, 20xx
ASSETSLIABILITIES
Current AssetsCurrent Liabilities
Cash$ 50,000Accounts Payable$ 60,000
Accounts receivable (net of allowance for bad debts of $5,000)$175,000Notes payable (including current portion of long-term debt)$ 40,000
Inventory (FIFO)$125,000Income taxes payable$ 25,000
Total current assets$350,000Total current liabilities$125,000
Non-current AssetsLong Term Liabilities
Plant$ 50,0005-year notes payable$160,000
Property$ 75,000Total Liabilities$285,000
Equipment$ 50,000

Fixed assets$175,000SHAREHOLDERS' EQUITY
Less: Accumulated depreciation($ 50,000)Common stock ($1.00 par value; 1,000 shs authorized, issued + outstanding)$ 1,000
Net fixed assets$125,000Paid-in capital in excess of par value$ 49,000
Intangibles (patents)$ 10,000Retained earnings$150,000
Total non-current assets$ 135,000Total Shareholders' Equity$200,000
Total Assets$485,000Total Liabilities and Shs' Equity$485,000
What the Accounts in a Manufacturing Company’s Books Represent
State what the accounts in a manufacturing company’s books represent
Assets
The assets accounts show how the company has used the money it has obtained from lenders, investors, and company earnings. Technically, according to GAAP, assets are resources with "probable future economic benefits obtained or controlled by an entity resulting from pasttransactionsor events." This leads to some non-intuitive results. Importantresources like intellectual property or longstanding business relationships, though valuable to a business, are generally not reflected on the balance sheet.
Assets are grouped as monetary (cash and accounts receivables), liquid (whether they can easily be converted to cash), tangible or intangible.
In our example the asset categories are:
  • Current assets:cash and those items, such as accounts receivable, that are normally expected to be converted into cash within one year.
  • Non-current assets:Fixed assets: the company's more or less permanent physical assets, such as its land, buildings, machinery and equipment; Intangible assets: goodwill, trademarks, copyrights, patents (reader beware!)
Current Assets
Cash. - This includes not only currency, which a company might keep in "petty cash," but also bank deposits, U.S. Treasury notes, money market accounts, and other "cash equivalents." If the company had to pay a ransom, how much could it pay today?
Accounts Receivable. - If a company sells goods or services on credit, the amounts owed to the company by customers are "accounts receivable." The company must, however, anticipate that some of the accounts receivable will not be received. An account, such as "allowance for bad debts," is set-off (subtracted) from the accounts receivable shown in the balance sheet. The allowance, often based on a percentage, is usually based on the company's past collection experience. This presents a fairer picture of how much the company will likely receive from its sales on credit.
Inventory. - For a manufacturing company, inventory includes goods used in the business at various stages of production: raw materials, work in process and finished goods. Other companies have other types of inventory. For example, a retail store has in inventory only the purchased goods it sells. Service companies have no inventory. The generally accepted method of inventory valuation is to record the inventory at its cost or market value, whichever is lower (here "market value" is not retail value, but what it would cost the company to replace the inventory).
Inventory
Things get trickier for the cost of goods in various stages of the manufacturing process. Two common ways to measure the "cost" of inventory purchased at different times and at varying prices are:
  • First-in, first-out ("FIFO "). Under the FIFO method of valuation, inventory items purchased first are deemed to be sold first. Under this method, the most recent purchase prices are deemed to represent the cost of the items remaining. For example, suppose that the purchases and sales of a particular item are as follows:Under FIFO, the cost of the ending inventory (300 items) would be $250 ($.90 each for 100 and $.80 each for 200). When prices are rising, FIFO results in inventory being shown on the balance sheet at the highest possible amount.

QuantityCost per itemTotal Cost
Jan. Purchase100$ .60$ 60
Mar. Purchase500.70$350
June Purchase300.80$240
Sep. Purchase100.90$ 90
Total purchases1,000
$740
Less sales700

Ending inventory300????
  • Last-in, first-out ("LIFO "). Under LIFO, the items of inventory purchased last are deemed to be sold first -- so the cost of the ending inventory is deemed the cost of the items purchased first. In our example, the cost of the ending inventory (300 items) would be $200 ($.60 for each 100 items and $.70 each for 200 items)
Non-current Assets - Fixed Assets
Fixed assets -- such as land, buildings, machinery and equipment -- are typically shown on the balance sheet at their cost, less accumulated depreciation.
Historical cost.How are assets valued for purposes of the balance sheet? There are several possibilities:
  • historical cost (how much the company paid to acquire it)
  • current market value
  • value in use
  • liquidation value based on its sale after use.
Assets are typically recorded on financial statements at theirhistorical costexpressed in dollars.
Depreciation. What is depreciation / depletion / amortization? these are all terms that refer to alloocating the cost of along-lived asset to consecutive accounting periods as expenses until the full cost is fully accounted for.
  • "Depreciation" describes the allocation of the cost of certain fixed assets over their estimated useful lives. (Land is not depreciated, since its useful life for accounting purposes is unlimited.)
  • "Depletion" describes the case of "wasting assets," such as oil and gas fields.
  • "Amortization" is used for intangible assets, such as patents or trademarks. Amortization of R&D expenses is controversial. Under GAAP such expenses are expensed currently, even though they may have long-term payoffs.
When a fixed asset is depreciated, the cost of the asset is allocated over its expected useful life, and each annual installment of depreciation is added to an account called "accumulated depreciation. " On the balance sheet, accumulated depreciation is set-off against the total fixed assets (shown at their total cost at time of purchase).
Notice that the balance sheet does not reflect appreciation in the value of assets, such as when there is inflation.
How is depreciation calculated? There are two common methods:
  • Straight-line method.- The straight line depreciation method, the most common, calculates depreciation by dividing the cost of the asset, less its salvage value, by its estimated useful life.
  • Double declining balance method. - The double declining balance method calculates depreciation by takingtwicethe straight-line depreciation percentage rate and multiplying this percentage rate by the initial cost of the asset (in the first year) or by each declining balance amount (in succeeding years). The asset is not depreciated below a reasonable salvage value.
The double declining balance method is a kind ofaccelerated depreciationsince it produces more depreciation in the initial years of an asset's life than does the straight-line method. For tax purposesaccelerateddepreciationhas the advantage ofreducing taxable income during early years of asset;s life -- and as we know, tax savings now are worth more than tax savings later.
Example 1
A wine press purchased for $50,000 has an estimated useful life of 5 years and a salvage value of $10,000. What is its annual depreciation using a straight-line method? a double-declining balance method?
YearDepreciationDepreciation

Straight-lineDouble-declining
1(50,000 - 10,000) / 5 = $ 8,00050,000 x 40% = $ 20,000
2(50,000 - 10,000) / 5 = $ 8,000(50,000-20,000) x 40% = $12,000
3(50,000 - 10,000) / 5 = $ 8,000(30,000-12,000) x 40% = $7,200
4(50,000 - 10,000) / 5 = $ 8,000$ 800
5(50,000 - 10,000) / 5 = $ 8,000$0
Annual %20%varies
The annual depreciation using a straight-line method is $8,000 -- that is, 20% per year,
The annual depreciation using a double-declining method varies. After three years, the cumulative depreciation is $39,200. Assuming a salvage value of $10,000, the last depreciation amount of $800 comes in the fourth year when the salvage figure is reached.
Intangible Assets
This item has become more important as intellectual property (patents, trademarks, copyrights) has become the darlings of the information age. Typically, IP is carried at its acquisition or development cost.
Vapor. But intangible assets, particularly goodwill, raise tricky issues. Are these unseen, untouchable assets just vapor? On the one hand, it is easy to overstate their value, particularly since there usually is no ready market to compare. On the other hand, intangible assets may represent an importan part of the company's overall business value. (For example, some business valuatiors hav calculated that the Coca-Cola trademark -- forget the secret formula -- is worth a real $80 billion.) exists
Goodwill. What about goodwill -- that is, the value the business derives from brand names, reputation, management quality, customer loyalty or recognized location? Typically, goodwill is not accounted for. Classified as an intangible asset, goodwill is recorded on a company's books only when it is acquired in a business acquisition. Sometimes, goodwill is valued as the difference between the price paid for a company as a going concern and the fair market value of its assets minus liabilities.
Liabilities
The second portion of the balance sheet consists of the company's liabilities -- usually separated into current liabilities and long-term liabilities. Liabilities can be understood as the opposite of assets -- they represent obligations of the business. Not all obligations to make a payment in the future are reflected on the balance sheet. For example, an obligation to pay employees' rising health care costs may be a signficant commitment , it might not be represented on the balance sheet if sufficiently uncertain. Or the prospect of paying clean-up fees for a toxic site owned by the business may not make it to the balance sheet, though it may be described in a note.
  • Current liabilities: those debts that are to be paid within 12 months. These include accounts payable, short-term notes payable and income taxes payable. Also included are accrued expenses payable, such as for employees wages and salaries, insurance premiums, attorney fees, and taxes due.
  • Long-term liabilities: any debt that is not due within one year, such as long-term debts and notes. In the case of a debt that is partially due within one year and partially due in future years, the portion of the debt payable within one year is shown as a current liability and the rest as a long-term liability.
One important potential drain on a business are contingent liabilities, such as possible products liability claims or securities fraud exposure. These are not carried on the balance sheet.
Owners' Equity
The third and final portion of a balance sheet represents the owners' equity. In a sole proprietorship (a business with one owner), the ownership account is known as "proprietor's equity"; in a partnership, the ownership account is "partners' capital."
In a corporation, the ownership accounts are divided into three categories, reflecting accounting conventions found in state corporation statutes. Accountants, however, use their own nomenclature for these accounts [the corporation statutory term in in brackets]
  • Common stock [stated capital]. This is calculated by multiplying the number of shares of stock outstanding by the par value of each share. In our balance sheet above, the par value of the corporation's common stock is $1.00 per share and 1,000 shares have been issued, yielding a stated capital of $1,000. (Par value is an arbitrary dollar figure assigned to stock to determine stated capital; some corporation statutes -- particularly Delaware's -- restrict a corporation's distributions based on stated capital.)
  • Paid-in capital in excess of par [capital surplus]. This is the difference between what shareholders paid the corporation for their stock and the stock's par value. In our example, the corporation sold 1,000 shares of common stock for $50 each -- $1,000 shown in common stock and $49,000 shown in paid-in capital in excess of par value. (Some corporation statutes also restrict distributions based on capital surplus).
  • Retained earnings [earned surplus]. This shows the total profits and losses of the corporation since its formation, decreased by any dividends paid the shareholders. If the corporation has had losses rather than profits, retained earnings is negative (indicated by placing the number in parenthesis). That is, as the business makes or loses money, this is the item that gets adjust (up or down) to balance the "balance sheet."
One way to see equity is aspermanentnon-debt capitalization of the business -- that is, captal assets and accumulated profitsless anydistributionsto the owners. Each year the equity account changes with the ebb and flow of revenuesand expenses -- creating a link between theincome statementand balance sheet.
The Purpose of Manufacturing Account
Explain the purpose of a manufacturing Account
The purpose of a Manufacturing Account is to ascertain Cost of Production ( ).Cost of Production = Prime Cost + Factory Overheads + Opening Work in Progress – Closing Work in Progress
How a Manufacturing Account is Composed
Explain how a manufacturing Accounts is composed
A manufacturing account shows the cost of producing the goods that are sold during an accounting period. It is split into the following sections:
  • Prime cost- Direct costs of physically making the products (e.g. raw materials)
  • Overhead cost- Other indirect costs associated with production but not in a direct manner
The cost of manufacturing the products will be the total of the prime cost and the overhead cost added together. This total factory cost (or production cost) will then be transferred to the trading account where it will appear instead of the 'normal' purchases figure.
Prime cost
The prime cost covers all the costs involved in physically making the products and other costs that are directly related to the level of output. These are usually known as direct costs and common examples would include:
  • Direct materials
  • Direct labour/wages
  • Other direct costs (e.g. packaging, royalties)
Cost of raw materials consumed
Within the prime cost adjustments will have to be made for opening and closing stocks of raw materials. There may also be carriage inwards charged on the raw materials and returns outwards of materials sent back to their original supplier. The overall charge for materials is referred to as cost of raw materials consumed, this should be highlighted when drawing up a manufacturing account and it is calculated as follows:
-Opening stock of raw materials
-Purchases of raw materials
Add
Carriage inwards on raw materialsLess
Returns outwards of raw materials
LessClosing stock of raw materials
EqualsCost of raw materials consumed
A true direct cost will vary directly with the level of output. If the output level doubles, then we would expect a direct cost to also double. If the cost does not behave in this manner then it may be an indirect cost and not a direct cost.
Royalties
Royalties is sometimes included within the prime cost. These are a cost that is paid to the owner of a copyrighted process. Usually a fee is paid for each product that uses this process and therefore the total royalty cost will be directly proportional to the level of output.
Overhead cost
This section includes all other expenses concerned with the production of output but not in a direct manner.This means that if the level of production increased, then these expenses may also increase but not by the same proportion. These are sometimes known as indirect costs, factory overheads or indirect manufacturing costs. Common examples of overhead costs would include:
  • Factory rent
  • Indirect labour
  • Depreciation of factory plant and equipment
Depreciation of fixed assets should be included in this section only if it is depreciation on assets included for production. For example, depreciation of machinery would appear as an overhead cost but depreciation of office equipment would appear in the profit and loss account as an expense as would be expected in a non-manufacturing organisation.
Once the overhead costs have been calculated they will need adding to the total of the prime cost. This will give us the production cost of the goods. However, the production cost will need adjusting for goods which are not yet finished. 

TOPIC 10: CONTROL ACCOUNT 
 
Control Account from Subsidiary Records
Construct control account from subsidiary records
Definition: A control account is a summary-level account in the general ledger. This account contains aggregated totals for transactions that are individually stored in subsidiary-level ledger accounts. Control accounts are most commonly used to summarize accounts receivable and accounts payable, since these areas contain a large volume of transactions, and so need to be separated into subsidiary ledgers, rather than cluttering up the general ledger with too much detailed information. The balance in a control account should match the total for the related subsidiary ledger. If the balance does not match, it is possible that a journal entry was made to the control account that was not also made in the subsidiary ledger.
The typical level of activity in a control account is on a daily basis. For example, all payables entered during one day will be aggregated from the subsidiary ledger and posted as a single summary-level number into the accounts payable control account. Posting into all control accounts must be completed before the books can be closed at the end of a reporting period; otherwise, transactions may be stranded in a subsidiary ledger.
If anyone wants to see detailed transactional information for accounts payable, they can review the detail located in the subsidiary ledger, since it is not located in the general ledger.
Control accounts are most commonly used by large organizations, since their transaction volume is very high. A small organization can typically store all of its transactions in the general ledger, and so does not need a subsidiary ledger that is linked to a control account.
Preparation of Control Accounts from Account Balance
Prepare control accounts from account balance
Whilst maintaining control accounts most businesses will maintain what is referred to as a 'memorandum.' This is a separate list of individual receivable and payable amounts due from each customer and to each supplier, respectively. This simple 'list of balances' is used as a record so that companies know how much each customer is due to pay and how much they are due to pay each supplier. This assists with credit control and cash flow management.
A key control operated by a business is to compare the total balance on the control account at the end of the accounting period with the total of all the separate memorandum balances. In theory they should be identical. This is referred to as acontrol account reconciliation.
Balance b/fXBalance b/fX
Credit sales (SDB)XSales returns (SRDB)X


Bank (CB)X
Bank (CB) dishonoured chequesXIrrecoverable debts (journal)X
Bank (CB) refunds of credit balancesXDiscounts allowedX
Interest chargedXContraX
Balance c/fXBalance c/fX

____
____

X
X

____
____
Balance b/fXBalance b/fX
Balance b/fXBalance b/fX
Bank (CB)XCredit purchases (PDB)X
Purchases returns (PRDB)XBank (CB) refunds of debit balancesX
Discounts receivedX

ContraX
Balance c/fXBalance c/fX

____
____

X
X

____
____
Balance b/fXBalance b/fX
How a Control Ledger and its Subsidiary Ledger Operate
Explain how a control ledger and its subsidiary ledger operate
Two of the most common Control Accounts are Sales Ledger Control Accounts and Purchases Ledger Control Accounts. After posting all transactions the balance of the Control Account and the sum of the detailed records in the Subsidiary Ledger should always be the same. In other words, a control account deals with summarized information while a subsidiary ledger deals with detailed information. Because the control accounts contain summarized information they are also called total accounts. Therefore a control account for a Sales Ledger can be called a Sales ledger Control accounts or Total Debtors Account. A control account for a Purchases Ledger can be called a Purchases Ledger Control account or a Total Creditors Account.
The Rule for Posting to a Subsidiary Ledger and its Controlling Account
Give the rule for posting to a subsidiary ledger and its controlling account
The closing balances on the sales ledger control accounts should be equal to the sum total of the closing balances on the individual debtor accounts in the sales ledger. It follow as well that the closing balances on the purchases ledger control accounts should be equal to the sum total of the closing balances on the individualcreditor accounts in the purchases ledger. If the respective balances are not in agreement then it would suggest some form of irregularity in the records which would need investigation.
Example 1
The information for constructing each control accounts are taken from both the personal accounts of debtors and creditors, as well as information form the main daybooks (e.g. sales daybook for total of credit sales). The main sources of information are found in the following locations:
Information for sales ledger control account
Information needed:Information located:
Opening balance of debtorsDebtor accounts in sales ledger
Credit salesSales daybook
Returns inwardsReturns inwards daybook
Money received from customersCashbook
Discounts allowedGeneral ledger or cashbook (3rd column)
Closing balance of debtorsDebtor accounts n sales ledger
Information for purchases ledger control account
Information needed:Information located:
Opening balance of creditorsCreditor accounts in purchases ledger
Credit purchasesSales daybook
Returns outwardsReturns outwards daybook
Money received from customersCashbook
Discounts receivedGeneral ledger or cashbook (3rd column)
Closing balance of creditorsCreditor accounts in purchases ledger
A control account will appear as if it is a personal account - with amounts relating topurchases and sales, returns, discounts as well as payments made and received. The examples below are to remind you of what a debtor and what a creditor account looks like:
Debtor accounts
Balance owing to us at startCash/cheques received
Credit sales made during periodReturns inwards
-Discounts allowed
-Balance owing to us at end (*1)
(*1 this is a debit balance but it is initially carried down from the credit side when the account is balanced off)
Creditor accounts
Cash/Cheques paidBalance owing by us at start
Returns outwardsCredit purchases made during period
Discounts received-
Balance owing to by at end (*2)-
(*2 this is a credit balance but it is initially carried down from the debit side when the account is balanced off)
Recording Corrections in the Control and Suspense Accounts
Record corrections in the control and suspense accounts
A suspense account is a temporary resting place for an entry that will end up somewhere else once its final destination is determined. There are two reasons why a suspense account could be opened:
  1. a bookkeeper is unsure where to post an item and enters it to a suspense account pending instructions
  2. there is a difference in a trial balance and a suspense account is opened with the amount of the difference so that the trial balance agrees (pending the discovery and correction of the errors causing the difference). This is the only time an entry is made in the records without a corresponding entry elsewhere (apart from the correction of a trial balance error.
Types of error
Before we look at the operation of suspense accounts in error correction, we need to think about types of error - not all types affect the balancing of the records and hence the suspense account.
Types of error
Error typeSuspense account involved?
1 Omission- a transaction is not recorded at allNo
2 Error of commission- an item is entered to the correct side of the wrong account (there is a debit and a credit here, so the records balance)No
3 Error of principle- an item is posted to the correct side of the wrong type of account, as when cash paid for plant repairs (expense) is debited to plant account (asset)(errors of principle are really a special case of errors of commission, and once again there is a debit and a credit)No
4 Error of original entry- an incorrect figure is entered in the records and then posted to the correct accountExample: Cash $1,000 for plant repairs is entered as $100; plant repairs account is debited with $100No
5 Reversal of entries- the amount is correct, the accounts used are correct, but the account that should have been debited is credited and vice versaExample: Factory employees are used for plant maintenance:Correct entry:Debit: Plant maintenanceCredit: Factory wagesEasily done the wrong way roundNo
6 Addition errors -figures are incorrectly added in a ledger accountYes
7 Posting errora an entry made in one record is not posted at allb an entry in one record is incorrectly posted to anotherExamples: cash $10,000 entered in the cash book for the purchase of a car is:a not posted at allb posted to Motor cars account as $1,000Yes
8 Trial balance errors- a balance is omitted, or incorrectly extracted, in preparing the trial balanceYes
9 Compensating errors- two equal and opposite errors leave the trial balance balancing (this type of error is rare, and can be because a deliberate second error has been made to force the balancing of the records or to conceal a fraud) Yes, to correct each of the errors as discoveredYes, to correct each of the errors as discovered
Correcting errors
Errors 1 to 5, when discovered, will be corrected by means of a journal entry between the accounts affected. Errors 6 to 9 also require journal entries to correct them, but one side of the journal entry will be to the suspense account opened for the difference in the records. Type 8, trial balance errors, are different. As the suspense account records the difference, an entry to it is needed, because the error affects the difference. However, there is no ledger entry for the other side of the correction - the trial balance is simply amended.
Some hints on preparing suspense accounts
  • Does a correction involve the suspense account? The type of error determines this. Practice, and study of Table 1 should ensure that you see immediately which errors affect the balancing of the records and hence the suspense account.
  • Which side of the suspense account must an entry go? This is one of the most awkward problems in preparing suspense accounts. The best way of solving it is to ask yourself which side the entry needs to be on in the other account concerned. The suspense account entry is then obviously to the opposite side.
  • Look out for errors with two aspects. In the illustrative question earlier, error 1 is a case in point. An entry has been made to the wrong account, but also to the wrong side of the wrong account. Both errors must be corrected. It is very easy to fall into the trap of correcting only one of the errors, especially when working quickly under examination conditions.
Reconciling the Sales and Purchases Ledger Control Accounts with the Individual Balances
Reconcile the sales and purchases ledger control accounts with the individual balances
The reconciliation is a working to ensure that the entries in the sales and purchase ledgers(the memorandums, or list of individual balances) agree with the entries in thecontrol accounts. The totals in each should be exactly the same. If not it indicates an error in either the memorandum account or the control account. All discrepancies should be investigated and corrected.
The format of a control account reconciliation, in this case for receivables, is as follows:
Reconciliation of individual receivables balances with control account balance
Receivables ledger control account

$
$
Balance given by the examinerXAdjustments for errorsX
Adjustments for errorsXRevised balance c/fX

––
––

X
X

$
Balance as extracted from list of receivablesX
Adjustments for errorsX/(X)

–––––
Revised total agreeing with balance c/f on control accountX
Illustration – Preparing a control account reconciliation
Alston's payables ledger control account is an integral part of the double entry system. Individual ledger account balances are listed and totalled on a monthly basis, and reconciled to the control account balance. Information for the month of March is as follows:
  1. Individual ledger account balances at 31 March have been listed out and totalled $19,766.
  2. The payables ledger control account balance at 31 March is $21,832.
  3. On further examination the following errors are discovered:
  • The total of discount received for the month, amounting to $1,715, has not been entered in the control account but has been entered in the individual ledger accounts.
  • On listing-out, an individual credit balance of $205 has been incorrectly treated as a debit.
  • A petty cash payment to a supplier amounting to $63 has been correctly treated in the control account, but no entry has been made in the supplier's individual ledger account.
  • The purchases day book total for March has been undercast (understated) by $2,000.
  • Contras (set-offs) with the receivables ledger, amounting in total to $2,004, have been correctly treated in the individual ledger accounts but no entry has been made in the control account.
Step 1:The total of discount received in the cash book should have been debited to the payables ledger control account and credited to discount received. Thus, if the posting has not been entered in either double entry account it clearly should be. As this has already been entered into the individual ledger accounts, no adjustment is required to the list of balances.
Step 2:Individual credit balances are extracted from the payables ledger. Here, this error affects the ledger accounts balance. No adjustment is required to the control account, only to the list of balances.
Step 3:The information clearly states that the error has been made in the individual ledger accounts. Amendments should be made to the list of balances. Again, no amendment is required to the control accounts.
Step 4:The total of the purchases day book is posted by debiting purchases and crediting payables ledger control account. If the total is understated, the following bookkeeping entry must be made, posting the $2,000 understatement:Dr Purchases;Cr Payables ledger control account
As the individual ledger accounts in the payables ledger are posted individually from the purchases day book, the total of the day book being understated will not affect the listing of the balances in the payables ledger.
Step 5:Here it is clear that the error affects the control account, not the payables ledger. Correction should be made by the bookkeeping entry: Dr Payables ledger control account; Cr Receivables ledger control account
 

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