0 THE COSTS AND BENEFITS OF SELLING ON CREDIT

RECEIVABLES: You already know that receivables arise from a variety of claims against customers and others, and are generally classified as current or noncurrent based on expectations about the amount of time it will take to collect them. The majority of receivables are classified as trade receivables, which arise from the sale of products or services to customers. Such trade receivables are carried in the Accounts Receivable account. Nontrade receivables arise from other transactions and events, including advances to employees and utility company deposits.

CREDIT SALES: To one degree or another, many business transactions result in the extension of credit. Purchases of inventory and supplies will often be made on account. Likewise, sales to customers may directly (by the vendor offering credit) or indirectly (through a bank or credit card company) entail the extension of credit. While the availability of credit facilitates many business transactions, it is also costly. Credit providers must conduct investigations of credit worthiness, and monitor collection activities. In addition, the creditor must forego alternative uses of money while credit is extended. Occasionally, a creditor will get burned when the borrower refuses or is unable to pay. Depending on the nature of the credit relationship, some credit costs may be offset by interest charges. And, merchants frequently note that the availability of credit entices customers to make a purchase decision.

CREDIT CARDS: Banks and financial services companies have developed credit cards that are widely accepted by many merchants, and eliminate the necessity of those merchants maintaining separate credit departments. Popular examples include MasterCard, Visa, and American Express. These credit card companies earn money off of these cards by charging merchant fees (usually a formula-based percentage of sales) and assess interest and other charges against the users. Nevertheless, merchants tend to welcome their use because collection is virtually assured and very timely (oftentimes same day funding of the transaction is made by the credit card company). In addition, the added transaction cost is offset by a reduction in the internal costs associated with maintaining a credit department.

The accounting for credit card sales depends on the nature of the card. Some bank-card based transactions are essentially regarded as cash sales since funding is immediate. Assume that Bassam Abu Rayyan Company sold merchandise to a customer for $1,000. The customer paid with a bank card, and the bank charged a 2% fee. Bassam Abu Rayyan Company should record the following entry:

cash debit
service charges debit
sales credit

then

account receivable debit
sales credit

cash debit
service charges debit
account receivable credit

Notice that the entry to record the collection included a provision for the service charge. The estimated service charge could (or perhaps should) have been recorded at the time of the sale, but the exact amount might not have been known. Rather than recording an estimate, and adjusting it later, this illustration is based on the simpler approach of not recording the charge until collection occurs. This expedient approach is acceptable because the amounts involved are not very significant.

ACCOUNTING FOR UNCOLLECTIBLE RECEIVABLES

UNCOLLECTIBLE RECEIVABLES: Unfortunately, some sales on account may not be collected. Customers go broke, become unhappy and refuse to pay, or may generally lack the ethics to complete their half of the bargain. Of course, a company does have legal recourse to try to collect such accounts, but those often fail. As a result, it becomes necessary to establish an accounting process for measuring and reporting these uncollectible items. Uncollectible accounts are frequently called "bad debts."

DIRECT WRITE-OFF METHOD: A simple method to account for uncollectible accounts is the the direct write-off approach. Under this technique, a specific account receivable is removed from the accounting records at the time it is finally determined to be uncollectible. The appropriate entry for the direct write-off approach is as follows:

2-10-X7
Uncollectible Accounts Expense 500 debit
Accounts Receivable 500 credit
To record the write off of an uncollectible account from Jones

Notice that the preceding entry reduces the receivables balance for the item that is deemed uncollectible. The offsetting debit is to an expense account: Uncollectible Accounts Expense.

While the direct write-off method is simple, it is only acceptable in those cases where bad debts are immaterial in amount. In accounting, an item is deemed material if it is large enough to affect the judgment of an informed financial statement user. Accounting expediency sometimes permits "incorrect approaches" when the effect is not material. Recall the discussion of nonbank credit card charges above; there, the service charge expense was recorded subsequent to the sale, and it was suggested that the approach was lacking but acceptable given the small amounts involved. Again, materiality considerations permitted a departure from the best approach. But, what is material? It is a matter of judgment, relating only to the conclusion that the choice among alternatives really has very little bearing on the reported outcomes.

You must now consider why the direct write-off method is not to be used in those cases where bad debts are material; what is "wrong" with the method? One important accounting principle is the notion of matching. That is, costs related to the production of revenue are reported during the same time period as the related revenue (i.e., "matched"). With the direct write-off method, you can well understand that many accounting periods may come and go before an account is finally determined to be uncollectible and written off. As a result, revenues from credit sales are recognized in one period, but the costs of uncollectible accounts related to those sales are not recognized until another subsequent period (producing an unacceptable mismatch of revenues and expenses).

To compensate for this problem, accountants have developed "allowance methods" to account for uncollectible accounts. Importantly, an allowance method must be used except in those cases where bad debts are not material (and for tax purposes where tax rules often stipulate that a direct write-off approach is to be used). Allowance methods will result in the recording of an estimated bad debts expense in the same period as the related credit sales. As you will soon see, the actual write off in a subsequent period will generally not impact income.

ALTERNATIVE APPROACHES FOR UNCOLLECTIBLES

ALLOWANCE METHODS: Having established that an allowance method for uncollectibles is preferable (indeed, required in many cases), it is time to focus on the details. Let's begin with a consideration of the balance sheet. Suppose that Ito Company has total accounts receivable of $425,000 at the end of the year, and is in the process or preparing a balance sheet. Obviously, the $425,000 would be reported as a current asset. But, what if it is estimated that $25,500 of this amount may ultimately prove to be uncollectible? Thus, a more correct balance sheet presentation would appear as shown at right:

The total receivables are reported, along with an allowance account (which is a contra asset account) that reduces the receivables to the amount expected to be collected. This anticipated amount to be collected is often termed the "net realizable value."

DETERMINING THE ALLOWANCE ACCOUNT: In the preceding illustration, the $25,500 was simply given as part of the fact situation. But, how would such an amount actually be determined? If Ito Company's management knew which accounts were likely to not be collectible, they would have avoided selling to those customers in the first place. Instead, the $25,500 simply relates to the balance as a whole. It is likely based on past experience, but it is only an estimate. It could have been determined by one of the following techniques:

AS A PERCENTAGE OF TOTAL RECEIVABLES: Some companies anticipate that a certain percentage of outstanding receivables will prove uncollectible. In Ito's case, maybe 6% ($425,000 X 6% = $25,500).
VIA AN AGING ANALYSIS: Other companies employ more sophisticated aging of accounts receivable analysis. They will stratify the receivables according to how long they have been outstanding (i.e., perform an aging), and apply alternative percentages to the different strata. Obviously, the older the account, the more likely it is to represent a bad account. Ito's aging may have appeared as follows:


Both the percentage of total receivables and the aging are termed "balance sheet approaches." In both cases, the allowance account is determined by an analysis of the outstanding accounts receivable on the balance sheet. Once the estimated amount for the allowance account is determined, a journal entry will be needed to bring the ledger into agreement. Assume that Ito's ledger revealed an Allowance for Uncollectible Accounts credit balance of $10,000 (prior to performing the above analysis). As a result of the analysis, it can be seen that a target balance of $25,500 is needed; necessitating the following adjusting entry:

Uncollectible Accounts Expense15,500 debit
Allow. for Uncollectible Accounts15,500 credit

You should carefully note two important points: (1) with balance sheet approaches, the amount of the entry is based upon the needed change in the account (i.e., to go from an existing balance to the balance sheet target amount), and (2) the debit is to an expense account, reflecting the added cost associated with the additional amount of anticipated bad debts.

Rather than implement a balance sheet approach as above, some companies may follow a simpler income statement approach. With this equally acceptable allowance technique, an estimated percentage of sales (or credit sales) is simply debited to Uncollectible Accounts Expense and credited to the Allowance for Uncollectible Accounts each period. Importantly, this technique merely adds the estimated amount to the Allowance account. To illustrate, assume that Pick Company had sales during the year of $2,500,000, and it records estimated uncollectible accounts at a rate of 3% of total sales. Therefore, the appropriate entry to record bad debts cost is as follows:

Uncollectible Accounts Expense debit 75,000
Allow. for Uncollectible Accounts credit 75,000
To add 3% of sales to the allowance account ($2,500,000 X 3% = $75,000)

This entry would be the same even if there was already a balance in the allowance account. In other words, the income statement approach adds the calculated increment to the allowance, no matter how much may already be in the account from prior periods.

WRITING OFF UNCOLLECTIBLE ACCOUNTS: Now, we have seen how to record uncollectible accounts expense, and establish the related allowance. But, how do we write off an individual account that is determined to be uncollectible? This part is easy. The following entry would be needed to write off a specific account that is finally deemed uncollectible:

3-15-X3
Allow. for Uncollectible Accounts debit 5,000
Accounts Receivable credit 5,000
To record the write-off of an uncollectible account from Aziz

Notice that the entry reduces both the allowance account and the related receivable, and has no impact on the income statement. Further, consider that the write-off has no impact on the net realizable value of receivables, as shown by the following illustration of a $5,000 write-off:

COLLECTION OF AN ACCOUNT PREVIOUSLY WRITTEN OFF: On occasion, a company may collect an account that was previously written off. For example, a customer that was once in dire financial condition may recover, and unexpectedly pay an amount that was previously written off. The entry to record the recovery involves two steps: (1) a reversal of the entry that was made to write off the account, and (2) recording the cash collection on the account:

6-16-X6
Accounts Receivable 1,000
Allow. for Uncollectible Accounts 1,000
To reestablish an account previously written off via the reversal of the entry recorded at the time of write off

6-16-X6
Cash 1,000
Accounts Receivable 1,000
To record collection of account receivable

It may trouble you to see the allowance account being increased because of the above entries, but the general idea is that another as yet unidentified account may prove uncollectible (consistent with the overall estimates in use). If this does not eventually prove to be true, an adjustment of the overall estimation rates may eventually be indicated.

MATCHING ACHIEVED: Carefully consider that the allowance methods all result in the recording of estimated bad debts expense during the same time periods as the related credit sales. These approaches satisfy the desired matching of revenues and expenses.

MONITORING AND MANAGING ACCOUNTS RECEIVABLE: A business must carefully monitor its accounts receivable. This chapter has devoted much attention to accounting for bad debts; but, don't forget that it is more important to try to avoid bad debts by carefully monitoring credit policies. A business should carefully consider the credit history of a potential credit customer, and be certain that good business practices are not abandoned in the zeal to make sales. It is customary to gather this information by getting a credit application from a customer, checking out credit references, obtaining reports from credit bureaus, and similar measures. Oftentimes, it becomes necessary to secure payment in advance or receive some other substantial guarantee such as a letter of credit from an independent bank. All of these steps are normal business practices, and no apologies are needed for making inquiries into the creditworthiness of potential customers. Many countries have very liberal laws that make it difficult to enforce collection on customers who decide not to pay or use "legal maneuvers" to escape their obligations. As a result, businesses must be very careful in selecting parties that are allowed trade credit in the normal course of business.

Equally important is to monitor the rate of collection. Many businesses have substantial dollars tied up in receivables, and corporate liquidity can be adversely impacted if receivables are not actively managed to insure timely collection. One ratio that is often monitored is the accounts receivable turnover ratio. That number reveals how many times a firm's receivables are converted to cash during the year. It is calculated as net credit sales divided by average net accounts receivable:

Accounts Receivable Turnover Ratio = Net Credit Sales/Average Net Accounts Receivable
To illustrate these calculations, assume Shoztic Corporation had annual net credit sales of $3,000,000, beginning accounts receivable (net of uncollectibles) of $250,000, and ending accounts receivable (net of uncollectibles) of $350,000. Shoztic's average net accounts receivable is $300,000 (($250,000 + $350,000)/2), and the turnover ratio is "10":

10 = $3,000,000/$300,000

A closely related ratio is the "days outstanding" ratio. It reveals how many days sales are carried in the receivables category:

Days Outstanding = 365 Days/Accounts Receivable Turnover Ratio

For Shoztic, the days outstanding calculation is:

36.5 = 365/10

By themselves, these numbers mean little. But, when compared to industry trends and prior years, they will reveal important signals about how well receivables are being managed. In addition, the calculations may provide an "early warning" sign of potential problems in receivables management and rising bad debt risks. Analysts carefully monitor the days outstanding numbers for signs of weakening business conditions. One of the first signs of a business downturn is a delay in the payment cycle. These delays tend to have ripple effects; if a company has trouble collecting its receivables, it won't be long before it may have trouble paying its own obligations.

NOTES RECEIVABLE

NOTES RECEIVABLE: A written promise from a client or customer to pay a definite amount of money on a specific future date is called a note receivable. Such notes can arise from a variety of circumstances, not the least of which is when credit is extended to a new customer with no formal prior credit history. The lender uses the note to make the loan more formal and enforceable. Such notes typically bear interest charges. The maker of the note is the party promising to make payment, the payee is the party to whom payment will be made, the principal is the stated amount of the note, and the maturity date is the day the note will be due.

Interest is the charge imposed on the borrower of funds for the use of money. The specific amount of interest depends on the size, rate, and duration of the note. In mathematical form: Interest = Principal X Rate X Time. For example, a $1,000, 60-day note, bearing interest at 12% per year, would result in interest of $20 ($1,000 X 12% X 60/360). In this calculation, notice that the "time" was 60 days out of a 360 day year. Obviously, a year normally has 365 days, so the fraction could have been 60/365. But, for simplicity, it is not uncommon for the interest calculation to be based on a presumed 360-day year or 30-day month. This presumption probably has its roots in olden days before electronic calculators, as the resulting interest calculations are much easier with this assumption in place. But, with today's technology, there is little practical use for the 360 day year, except that it tends to benefit the creditor by producing a little higher interest amount -- caveat emptor (Latin for "let the buyer beware")! The following illustrations will preserve this archaic approach with the goal of producing nice round numbers that are easy to follow.

ACCOUNTING FOR NOTES RECEIVABLE: To illustrate the accounting for a note receivable, assume that Butchko initially sold $10,000 of merchandise on account to Hewlett. Hewlett later requested more time to pay, and agreed to give a formal three-month note bearing interest at 12% per year. The entry to record the conversion of the account receivable to a formal note is as follows:

6-1-X8
Notes Receivable 10,000
Accounts Receivable 10,000
To record conversion of an account receivable to a note receivable
When the note matures, Butchko's entry to record collection of the maturity value would appear as follows:

8-31-X8
Cash 10,300
Interest Income 300
Notes Receivable 10,000
To record collection of note receivable plus accrued interest of $300 ($10,000 X 12% X 90/360)

A DISHONORED NOTE: If Hewlett dishonored the note at maturity (i.e., refused to pay), then Butchko would prepare the following entry:

8-31-X8

Accounts Receivable 10,300
Interest Income 300
Notes Receivable 10,000
To record dishonor of note receivable plus accrued interest of $300 ($10,000 X 12% X 90/360)

The debit to Accounts Receivable in the above entry reflects the hope of eventually collecting all amounts due, including the interest, from the dishonoring party. If Butchko anticipated some difficulty in collecting the receivable, appropriate allowances would be established in a fashion similar to those illustrated earlier in the chapter.

NOTES AND ADJUSTING ENTRIES: In the above illustrations for Butchko, all of the activity occurred within the same accounting year. However, if Butchko had a June 30 accounting year end, then an adjustment would be needed to reflect accrued interest at year-end. The appropriate entries illustrate this important accrual concept:

Entry to set up note receivable:

6-1-X8
Notes Receivable 10,000
Accounts Receivable 10,000
To record conversion of an account receivable to a note receivable
Entry to accrue interest at June 30 year end:

6-30-X8
Interest Receivable 100
Interest Income 100
To record accrued interest at June 30 ($10,000 X 12% X 30/360 = $100)
Entry to record collection of note (including amounts previously accrued at June 30):

8-31-X8
Cash 10,300
Interest Income 200

Interest Receivable 100
Notes Receivable 10,000
To record collection of note receivable plus interest of $300 ($10,000 X 12% X 90/360); $100 of the total interest had been previously accrued

The following drawing should aid your understanding of these entries:

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0 Inventory and Costs of Goods Sold

Goods sold to customers are assets called inventory. Inventory measurements can be surprisingly difficult. Different inventory measurement approaches can lead to wide variations in reported profits or losses.

Buy Low, Sell High
The difference between a product’s sale price and its cost is called the gross margin or gross profit. Obviously, the higher the margin, the better. The cost of the product is called cost of goods sold. We would hope that computing gross profit would involve a simple subtraction of the total cost of goods sold from total sales. Alas, things turn out to be more complicated.
Adding total sales generally poses no great measurement problem, but calculating the cost of goods sold is not as straightforward. The basic difficulty arises when a business does not completely sell all its goods during the accounting period. In fact, most firms finish their year with unsold inventory. Valuing the unsold year end inventory is the primary source of complexity in figuring out the cost of goods sold.

Example. Janis buys and sells a silicon gel compound used in the production of cosmetic surgery implants. Assume that Janis can sell an ounce of compound for $500 that costs her $250. Let’s say Janis bought and sold precisely 100 ounces of compound during the year. What is her gross profit?

Now change the scenario and assume she bought 150 ounces of compound, but sold only 100 ounces during 2004. This means she has 50 ounces left at the end of the year. What is her gross profit now?

The $37,500 cost of goods sold is derived by multiplying 150 times $250. But this does not make sense because the unsold compound on hand at the end of the year should not be treated as an expense. Treating unsold year-end inventory as an expense violates the matching concept and common sense. Instead, the computation of the cost of goods sold is complicated by taking into account ending inventory as follows:
Cost of Goods Sold = Beginning Inventory + Purchases - Ending inventoryWhat would Janis’ cost of goods sold look like, assuming she had no beginning inventory, using the above formula?

This matches our previously computed cost of goods sold figure. To arrive at the $12,500 ending inventory figure, the 50 unsold ounces was multiplied by the purchase price of $250 per ounce. In this example, all Janis’ purchases were made at the same price, $250 per ounce. In the real world, the per ounce cost is likely to fluctuate. Also, Janis, like many businesses, may offer more than one type of product with fluctuating prices. In order to accurately compute the cost of goods sold, Janis has to be able to get an accurate count of unsold inventory on hand and she also has to assign the “correct” costs to these products.
In assigning a cost to unsold inventory you would expect to use its actual cost. This is not as easy as you might think. For Janis to use the actual cost paid she must be able to identify the cost associated with the batches of compound on hand at the end of the period. However, these batches might come from more than one purchase, each with a different purchase price.

Assume Janis stores her purchases in one big storage tank. Also assume that purchase prices fluctuated during the year. Because she keeps her product in one tank she cannot physically tell which batches go with which costs. She can certainly measure the amount of compound she has on hand at the end of the year, but how does she know the unit price to assign to her ending inventory?

In order to assign a cost to her ending inventory Janis will have to make assumptions about the flow of compound in and out of her tank. One plausible flow assumption is called FIFO, standing for first in, first out. Under this assumption, ending inventory is associated with costs from the most recent deliveries. An alternative flow assumption is called LIFO, standing for last in, first out. Under this flow assumption, ending inventory is associated with the oldest purchase costs. Alternatively, Janis might avoid making any flow assumption by simply using the weighted average cost of deliveries to value ending inventory.
The Effect of Different Flow Assumptions on Reported Gross Profit
You may think the choice of flow assumptions in assigning costs to ending inventory is a relatively minor issue. However, the choice of inventory flow assumption can dramatically affect the reported cost of goods sold, gross profit, and net income.
Example. Assume that Janis received four shipments during the year as follows:

If she has 50 ounces of compound unsold at the end of the year, different flow assumptions will yield different ending inventory figures. If she uses a FIFO approach, she will assume that the remaining inventory comes from the two most recent purchases:

If she uses a LIFO approach, she will assume that the remaining inventory derives from the oldest two purchases:

Alternatively, Janis could use a weighted average cost approach:

You can see that the three different approaches lead to a range of $7,900-17,000 in ending inventory value. The following table shows the variation in computed gross profit:

Because the example uses relatively small dollar amounts, the dollar variation in gross profits under the different flow assumptions may not seem extreme. The gross profit percentages reveal more startling differences. Gross profit is reported as 59% of sales using FIFO, but only 41% of sales using LIFO. If you are looking at a company with millions in sales you can see just how dramatic an impact inventory flow assumption can have on reported earnings.
GAAP: Do Your Own Thing
Does GAAP stipulate the specific flow assumption a business has to use? Actually, GAAP allows a business to use any flow assumption it chooses, as long as it does so on a consistent basis. This means that the flow assumption used in one year must be used in the next.
Allowing different inventory flow assumptions means that two businesses with identical operating results can report dramatically different amounts of profit. To avoid this possibility, GAAP would have to require that all firms use the same inventory flow assumptions. As desirable as it might be for GAAP to reduce the number of acceptable, but widely divergent inventory flow assumptions, this is not likely to happen any time soon. This means that financial statement users must be aware of the effect of these flow assumptions in comparing one firm’s performance to another

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0 The Statement of Owner’s Equity

The income statement represents those changes in an owner’s equity derived from the selling and buying activities of the business. Changes in owner’s equity also reflect cash contributions from, and distributions to, the owners. The Statement of Owner’s Equity reflects a summary of all components of the changes in owner’s equity during the year. The Statement of Owner’s Equity for Joint Ventures follows.

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0 The Statement of Cash Flows: Show Me the Money!

Many businesses use accrual accounting to reflect a reasonably complete picture of their economic performance over the accounting period. Nonetheless, at some point all accrual assets and liabilities must be reducible to cash. Assets that could not be converted into cash would have limited value. A firm’s ability to convert assets to cash is critical to its long-term survival. Because of the importance of cash flow, GAAP requires that companies prepare a financial statement that shows cash flows for the accounting period. Joint Ventures’ Statement of Cash Flow follows.

The statement divides cash flows into three components: cash flows from operations, cash flows from investing activities and cash flows from financing activities.
Operating activities are the ordinary buying and selling activity of a business. Investing activities comprise the purchase and retirement of fixed assets, as well as investments in other businesses. Financing activities are cash flows derived from the issuance and repayment of long-term debt, and cash flows from equity contributions and draws from owners.

These cash flow categories prevent the users of financial statements from drawing false conclusions about a business, simply because of the net cash increase or decrease over the accounting period. A business always seeks a positive cash flow, particularly from operating activities. However, short-term negative cash flows from operating activities do not necessarily mean that a business is unhealthy.

In fact, during periods of rapid expansion it is not uncommon for

companies to experience negative cash flow, because as credit sales increase, so do accounts receivable. Similarly, economic growth often is accompanied by increases in inventory, which also uses up cash. For these reasons, a user of financial statements must be careful not to jump to conclusions about the meaning of positive or negative cash flows.

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0 Classified balance sheets

A CLOSER LOOK AT THE BALANCE SHEET: The balance sheet reveals the assets, liabilities, and equity of a company. In examining a balance sheet, you should always be mindful that the components listed in a balance sheet are not necessarily at fair value. Many assets are carried at historical cost, and other assets are not reported at all (such as the value of a company's brand name, patents, and other internally developed resources). Nevertheless, careful examination of the balance sheet is essential to analysis of a company's overall financial condition. To facilitate proper analysis, accountants will often divide the balance sheet into categories or classifications. The result is that important groups of accounts can be identified and subtotaled. Such balance sheets are called "classified balance sheets."

ASSETS: The asset side of the balance sheet may be divided into as many as five separate sections (when applicable), in the following order:

Current Assets are those assets that will be converted into cash or consumed in a relatively short period of time; specifically, those assets that will be converted into cash or consumed within one year or the operating cycle, whichever is longer. The operating cycle for a particular company is the period of time it takes to convert cash back into cash (i.e., purchase inventory, sell the inventory on account, and collect the receivable); this is usually less than one year. In listing assets within the current section, the most liquid assets should be listed first (i.e., cash, short-term investments, and receivables). These are followed with inventories and prepaid expenses.
Long-term Investments include land purchased for speculation, funds set aside for a plant expansion program, funds redeemable from insurance policies (e.g., cash surrender value of life insurance), and investments in other entities.
Property, Plant, and Equipment includes the land, buildings, and equipment productively in use by the company.
Intangible Assets lack physical existence, and include items like purchased patents and copyrights, "goodwill" (the amount by which the price paid to buy another entity exceeds that entity's identifiable assets), and similar items.
Other Assets is the section used to report asset accounts that just don't seem to fit elsewhere, such as a special long-term receivable.
LIABILITIES: Just as the asset side of the balance sheet may be divided, so too for the liability section. The liability section is customarily divided into:

Current Liabilities are those obligations that will be liquidated within one year or the operating cycle, whichever is longer. Normally, current liabilities are paid with current assets.
Long-term Liabilities relate to any obligation that is not current, and include bank loans, mortgage notes, and the like. Importantly, some long-term notes may be classified partially as a current liability and partially as a long-term liability. The portion classified as current would be the principal amount to be repaid within the next year (or operating cycle, if longer). Any amounts due after that period of time would be shown as a long-term liability.
EQUITY: The appropriate financial statement presentation for equity depends on the nature of the business organization for which it is prepared. The illustrations in this book generally assume that the business is incorporated. Therefore, the equity section consists of:

Capital Stock includes the amounts received from investors for the stock of the company. The investors become the owners of the company, and that ownership interest is represented by shares that can be transferred to others (without further involvement by the company). In actuality, the legalese of stock issues can become quite involved, and you are apt to encounter expanded capital stock related accounts (such as preferred stock, common stock, paid-in-capital in excess of par, and so on). Those advanced issues are covered in subsequent chapters.
Retained Earnings is familiar to you, representing the accumulated income less the dividends. In essence, it is the profit that has been retained and plowed back (reinvested) into expansion of the business.
ILLUSTRATION OF CLASSIFIED BALANCE SHEET


OTHER ENTITY FORMS: There is nothing that requires that a business activity be conducted through a corporation. A sole proprietorship is an enterprise owned by one person. If the illustration above was instead being prepared for a sole proprietorship, it would look the same except that the equity section would consist of a single owner's capital account (instead of capital stock and retained earnings). If several persons are involved in a business that is not incorporated, it is likely a partnership. Again, the balance sheet would be unchanged except for the equity section; the equity section would be divided into separate accounts -- one for each partner (representing each partner's residual interest in the business). Recent years have seen a spate of legislation creating variants of these entity forms (limited liability companies/LLC, limited liability partnerships/LLP, etc.), but the overall balance sheet structure is relatively unaffected. The terminology used to describe entity forms and equity capital structure also varies considerably around the world, but there is very little substantive difference in the underlying characteristics or the general appearance and content of the balance sheet.

NOTES TO THE FINANCIAL STATEMENTS: Financial statements, by themselves, may not tell the whole story. Many important details about a company cannot be described in money on the balance sheet. Notes are used to describe accounting policies, major business events, pending lawsuits, and other facets of operation. The principle of full disclosure means that financial statements result in a fair presentation and that all facts which would influence investors' and creditors' judgments about the company are disclosed in the financial statements or related notes.

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0 T-ACCOUNTS

T-ACCOUNTS: A useful tool for demonstrating certain transactions and events is the "t-account." Importantly, one would not use t-accounts for actually maintaining the accounts of a business. Instead, they are just a quick and simple way to figure out how a small number of transactions and events will impact a company. T-accounts would quickly become unwieldy in an enlarged business setting. In essence, t-accounts are just a "scratch pad" for account analysis. They are useful communication devices to discuss, illustrate, and think about the impact of transactions. The physical shape of a t-account is a "T," and debits are on the left and credits on the right. The "balance" is the amount by which debits exceed credits (or vice versa). At right is the t-account for Cash for the transactions and events of Xao Corporation. Carefully compare this t-account to the actual running balance ledger account which is also shown (notice that the debits in black total to $33,800, the credits in red total to $7,500, and the excess of debits over credits is $26,300 -- which is the resulting account balance shown in blue).

COMPREHENSIVE T-ACCOUNT ILLUSTRATION: This link jumps to an "animation" of the process for preparing t-accounts and a trial balance. The animation is summarized by the following diagram illustrating the flow of transactions from a general journal to a set of t-accounts. It may look rather "busy" but it is actually quite simple. The debits/credits for each entry can be traced to the corresponding accounts. Once all of the entries are transferred, the resulting balances for each account can be carried forward to form the trial balance.



CHART OF ACCOUNTS: A listing of all accounts in use by a particular company is called the chart of accounts. Individual accounts are often given a specific reference number. The numbering scheme helps keep up with the accounts in use, and helps in the classification of accounts. For example, all assets may begin with "1" (e.g., 101 for Cash, 102 for Accounts Receivable, etc.), liabilities with "2," and so forth. A simple chart of accounts for Xao Corporation might appear as follows:

No. 101 Cash
No. 102 Accounts Receivable
No. 103 Land
No. 201 Accounts Payable
No. 202 Notes Payable
No. 301 Capital Stock
No. 401 Service Revenue
No. 501 Advertising Expense
No. 502 Utilities Expense
The assignment of a numerical account number to each account assists in data management, in much the same way as zip codes help move mail more efficiently. Many computerized systems allow rapid entry of accounts by reference number rather than by entering a full account description.

CONTROL AND SUBSIDIARY ACCOUNTS: Some general ledger accounts are made of many sub-components. For instance, a company may have total accounts receivable of $19,000, consisting of amounts due from Compton, Fisher, and Moore. The accounting system must be sufficient to reveal the total receivables, as well as amounts due from each customer. Therefore, sub-accounts are used. For instance, in addition to the regular general ledger account, separate auxiliary receivable accounts would be maintained for each customer, as shown in the following illustration:

The total receivables are the sum of all the individual receivable amounts. Thus, the Accounts Receivable general ledger account total is said to be the "control account" or control ledger, as it represents the total of all individual "subsidiary account" balances.

The company's chart of accounts will likely be based upon some convention such that each subsidiary account is a sequence number within the broader chart of accounts. For instance, if Accounts Receivable bears the account number 102, you would expect to find that individual customers might be numbered as 102.001, 102.002, 102.003, etc. It is simply imperative that a company be able to reconcile subsidiary accounts to the broader control account that is found in the general ledger. Here, computers can be particularly helpful in maintaining the detailed and aggregated data in perfect harmony.

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0 COMPUTERIZED PROCESSING SYSTEMS

ACCOUNTING SOFTWARE: You probably noticed that much of the material in this chapter involves rather mundane processing. Once the initial journal entry is prepared, the data are merely being manipulated to produce the ledger, trial balance, and financial statements. No wonder, then, that some of the first business applications that were computerized many years ago related to transaction processing. In short, the only "analytics" relate to the initial transaction recordation. All of the subsequent steps are merely mechanical, and are aptly suited to computerization.

HOW MUCH DOES IT COST: Many companies produce accounting software. These packages range from the simple to the complex. Some basic products for a small business may be purchased for under $100. In large organizations, millions may be spent hiring consultants to install large enterprise-wide packages. Recently, some software companies have even offered accounting systems maintained on their own network, with the customers utilizing the internet to enter data and produce their reports.

WHAT DO THEY LOOK LIKE: As you might expect, the look, feel, and function of software-based packages varies significantly. Each company's product must be studied to understand its unique attributes. But, in general, accounting software packages:

Attempt to simplify and automate data entry (e.g., a point-of-sale terminal may actually become a data entry device so that sales are automatically "booked" into the accounting system as they occur).
Frequently divide the accounting process into modules related to functional areas such as sales/collection, purchasing/payment, and others.
Attempt to be "user-friendly" by providing data entry blanks that are easily understood in relation to the underlying transactions.
Attempt to minimize key-strokes by using "pick lists," automatic call-up functions, and auto-complete type technology.
Are built on data-base logic, allowing transaction data to be sorted and processed based on any query structure (e.g., produce an income statement for July, provide a listing of sales to Customer Smith, etc.)
Provide up-to-date data that may be accessed by key business decision makers.
Are capable of producing numerous specialized reports in addition to the key financial statements.
Following is a very typical data entry screen. It should look quite familiar. After the data are input, the subsequent processing (posting, etc.) is totally automated.


Despite each product's own look and feel, the persons primarily responsible for the maintenance and operation of the accounting function must still understand accounting basics such as those introduced in this chapter: accounts, debits and credits, journal entries, etc. Without that intrinsic knowledge, the data input decisions will quickly go astray, and the output of the computerized accounting system will become hopelessly trashed. So, while it is safe to assume that you will probably be working in a computerized accounting environment, it equally true to say that you should first come to understand the basic processing described in this and subsequent chapters. These principles will clearly guide you toward successful implementation and use of most any computerized accounting product, and the reports they produce.

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0 THE TRIAL BALANCE

TRIAL BALANCE: After all transactions have been posted from the journal to the ledger, it is a good practice to prepare a trial balance. A trial balance is simply a listing of the ledger accounts along with their respective debit or credit balances. The trial balance is not a formal financial statement, but rather a self-check to determine that debits equal credits. At right is the trial balance prepared from the general ledger of Xao Corporation.

DEBITS EQUAL CREDITS: Since each transaction was journalized in a way that insured that debits equaled credits, one would expect that this equality would be maintained throughout the ledger and trial balance. If the trial balance fails to balance, an error has occurred and must be located. It is much better to be careful as you go, rather than having to go back and locate an error after the fact. You should also be aware that a "balanced" trial balance is no guarantee of correctness. For example, failing to record a transaction, recording the same transaction twice, or posting an amount to the wrong account would produce a balanced (but incorrect) trial balance.

FINANCIAL STATEMENTS FROM THE TRIAL BALANCE: In the next chapter you will learn about additional adjustments that may be needed to prepare a truly correct and up-to-date set of financial statements. But, for now, you can probably see that a tentative set of financial statements could be prepared based on the trial balance. The basic process is to transfer amounts from the general ledger to the trial balance, then into the financial statements:

In reviewing the following financial statements for Xao, notice that blue italics were used to draw attention to the items taken directly from the trial balance above. The other line items and amounts simply relate to totals and derived amounts within the statements. These statements would appear as follows:

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