Home News FORM THREE BOOK KEEPING STUDY NOTES TOPIC 7-10

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/x2 as of 12/31/x1
ASSETS
Current assets
Cash and cash equivalents $270,000 $215,000
Trade receivables 147,000 139,000
Inventories 139,000 128,000
Other current assets 15,000 27,000
Total current assets 571,000 509,000
Fixed assets
Furniture and fixtures 551,000 529,000
Leasehold improvements 82,000 82,000
Office equipment 143,000 143,000
Total non-current assets 776,000 754,000
Total assets $1,347,000 $1,263,000
LIABILITIES AND EQUITY
Current liabilities
Trade and other payables $217,000 $198,000
Short-term borrowings 133,000 202,000
Current portion of long-term borrowings 5,000 5,000
Current tax payable 26,000 23,000
Accrued expenses 9,000 13,000
Total current liabilities 390,000 441,000
Long-term liabilities
Long-term debt 85,000 65,000
Deferred taxes 19,000 17,000
Total non-current liabilities 104,000 82,000
Total liabilities 494,000 523,000
Shareholders’ Equity
Capital $100,000 $100,000
Additional paid-in capital 15,000 15,000
Retained earnings 738,000 625,000
Total equity 853,000 740,000
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 materials xxxx
Add purchase of raw materials xxxxx
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 materials xxxx
Cost of Direct Materials xxxxxxx
Add Direct labour xxxxxxx
Add Direct expenses (Eg: royalties) xxxxxxx
Prime Cost xxxxxxx
Add Factory overhead expenses
Factory lighting xxxxxx
Factory heating xxxxxx
Factory insurance xxxxxx
Factory rent xxxxxx
Factory maintenance xxxxxx
Factory indirect wages xxxxxx
Factory supervisor’s wages xxxxxx ( + )
Depreciation on plant & machinery xxxxxx
Depreciation on factory building xxxxxx
Depreciation on factory furniture xxxxxx
Depreciation on factory motor van xxxxxx
Depreciation on other factory fixedassets xxxxxx XXXXXXX
XXXXXXX
Add Opening stock of work in progress xxxxxx
XXXXXXX
Less Closing stock of work in progress xxxxxx
Cost of production XXXXXXX
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 $485,000 Liabilities $ 285,000
Shareholders’ Equity $200,000
Total Assets $485,000 Total 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
Assets Liabililities
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
ASSETS LIABILITIES
Current Assets Current Liabilities
Cash $ 50,000 Accounts Payable $ 60,000
Accounts receivable (net of allowance for bad debts of $5,000) $175,000 Notes payable (including current portion of long-term debt) $ 40,000
Inventory (FIFO) $125,000 Income taxes payable $ 25,000
Total current assets $350,000 Total current liabilities $125,000
Non-current Assets Long Term Liabilities
Plant $ 50,000 5-year notes payable $160,000
Property $ 75,000 Total Liabilities $285,000
Equipment $ 50,000
Fixed assets $175,000 SHAREHOLDERS’ EQUITY
Less: Accumulated depreciation ($ 50,000) Common stock ($1.00 par value; 1,000 shs authorized, issued + outstanding) $ 1,000
Net fixed assets $125,000 Paid-in capital in excess of par value $ 49,000
Intangibles (patents) $ 10,000 Retained earnings $150,000
Total non-current assets $ 135,000 Total Shareholders’ Equity $200,000
Total Assets $485,000 Total 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.
Quantity Cost per item Total Cost
Jan. Purchase 100 $ .60 $ 60
Mar. Purchase 500 .70 $350
June Purchase 300 .80 $240
Sep. Purchase 100 .90 $ 90
Total purchases 1,000 $740
Less sales 700
Ending inventory 300 ?? ??
  • 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?
Year Depreciation Depreciation
Straight-line Double-declining
1 (50,000 – 10,000) / 5 = $ 8,000 50,000 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 materials Less
Returns outwards of raw materials
Less Closing stock of raw materials
Equals Cost 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/f X Balance b/f X
Credit sales (SDB) X Sales returns (SRDB) X
Bank (CB) X
Bank (CB) dishonoured cheques X Irrecoverable debts (journal) X
Bank (CB) refunds of credit balances X Discounts allowed X
Interest charged X Contra X
Balance c/f X Balance c/f X
____ ____
X X
____ ____
Balance b/f X Balance b/f X
Balance b/f X Balance b/f X
Bank (CB) X Credit purchases (PDB) X
Purchases returns (PRDB) X Bank (CB) refunds of debit balances X
Discounts received X
Contra X
Balance c/f X Balance c/f X
____ ____
X X
____ ____
Balance b/f X Balance b/f X
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 debtors Debtor accounts in sales ledger
Credit sales Sales daybook
Returns inwards Returns inwards daybook
Money received from customers Cashbook
Discounts allowed General ledger or cashbook (3rd column)
Closing balance of debtors Debtor accounts n sales ledger
Information for purchases ledger control account
Information needed: Information located:
Opening balance of creditors Creditor accounts in purchases ledger
Credit purchases Sales daybook
Returns outwards Returns outwards daybook
Money received from customers Cashbook
Discounts received General ledger or cashbook (3rd column)
Closing balance of creditors Creditor 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 start Cash/cheques received
Credit sales made during period Returns 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 paid Balance owing by us at start
Returns outwards Credit 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 type Suspense account involved?
1 Omission– a transaction is not recorded at all No
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 $100
No
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 round
No
6 Addition errors –figures are incorrectly added in a ledger account Yes
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 $1,000
Yes
8 Trial balance errors– a balance is omitted, or incorrectly extracted, in preparing the trial balance Yes
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 discovered
Yes, 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 examiner X Adjustments for errors X
Adjustments for errors X Revised balance c/f X
–– ––
X X
$
Balance as extracted from list of receivables X
Adjustments for errors X/(X)
–––––
Revised total agreeing with balance c/f on control account X
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
 
SHARE