Preparation of Trading and Profit and Loss account (a/c)

The "Trading and Profit & Loss a/c" is a ledger account. Like all ledger accounts, the postings in this ledger account also flow from the journal. "No Journal No Ledger".

• Transactions making up the Trading and Profit & Loss a/c

The transactions relating to the journal entries that would go into the "Trading and Profit & Loss a/c" are not ones that are take place in the ordinary course of business. These are transactions that are specifically meant to create this "Trading and Profit & Loss a/c". Consider the above formula for ascertaining the profit or loss,
Profit = Sum of balances in Nominal accounts with a Credit Balance
− Sum of balances in Nominal accounts with a Debit Balance .

» For Ascertaining the sum of balances in Nominal Accounts with a Debit Balance

This is done by transferring the balances in the nominal accounts with a debit balance, to an account by name "Trading and Profit & Loss a/c".

Transferring a debit balance from one account to a second results in the second account being debited and the first account being credited.

Therefore the Journal Entry would be

Journal in the books of M/s __ for the period from ____ to _____
Date	V/R No.	Particulars		L/F	Debit Amount (in Rs)	Credit Amount (in Rs)
March 31st	–	Trading and Profit & Loss a/c       To Nominal a/c [with a debit balance]	Dr	– –	xxxx	xxxx
		[For the debit balances in the nominal accounts transferred to the "Trading and Profit & Loss a/c" for the purpose of ascertaining the profits on the last day of the accounting period ]

» For Ascertaining the sum of balances in Nominal Accounts with a Credit Balance

This is done by transferring the balances in the nominal accounts with a credit balance to an account by name "Trading and Profit & Loss a/c".

Transferring a credit balance from one account to a second results in the second account being credited and the first account being debited.

Therefore the Journal Entry would be

Journal in the books of M/s __ for the period from ____ to _____
Date	V/R No.	Particulars		L/F	Debit Amount (in Rs)	Credit Amount (in Rs)
March 31st	–	Nominal a/c [with a credit balance]       To Trading and Profit & Loss a/c	Dr	– –	xxxx	xxxx
		[For the credit balances in the nominal accounts transferred on the last day of the accounting period to the "Trading and Profit & Loss a/c" for the purpose of ascertaining the profits.]

• Trading and Profit and Loss Account (a/c)

Thus the "Trading and Profit & Loss a/c" would appear as follows

Dr

Trading and Profit & Loss a/c

Cr

Date	Particulars	J/F	Amount (in Rs)	Date	Particulars	J/F	Amount (in Rs)
31/03/06 31/03/06 31/03/06 31/03/06 31/03/06	To Nominal a/c 1 [Dr] To Nominal a/c 2 [Dr] To Nominal a/c 3 [Dr] ... ...	– – – – –	xxx xxx xxx xx xxx	31/03/06 31/03/06 31/03/06 31/03/06 31/03/06	By Nominal a/c 1 [Cr] By Nominal a/c 2 [Cr] ... ...	–	xxx xxx xxx xxx xxx
	sub-total		3,24,000		sub-total		5,80,000
31/03/06	To Bal (Profit)	–	2,56,000
	Total		5,80,000		Total		5,80,000

Thus the "Trading and Profit & Loss a/c", is nothing but a consolidated account formed by transferring the balances in the nominal accounts.

Ascertaining the how much of Profit/Loss

• Profit = Total (Incomes + Gains) − Total (Expenses + Losses)

Using this relation, a positive profit figure indicates a profit and a negative profit figure indicates a loss.

• Math of Ascertainment of Profit/Loss

Nominal accounts are related to incomes/gains and expenses/losses. Thus the information relating to the aspects that would define the profit or loss made by the organisation is contained in the Nominal accounts.

» Nominal Accounts with Debit balances

Those ledger accounts which have a debit balance in them represent expenses or losses The total (sum) of balances in all the nominal (ledger) accounts with a debit balance indicates the total (expense + losses).

» Nominal Accounts with Credit balances

Those ledger accounts which have a credit balance in them represent incomes or gains. The total (sum) of balances in all the nominal (ledger) accounts with a credit balance indicates the total (incomes + gains).

If the total of (expense + losses) and (incomes + gains) are set off, we would be able to arrive at the profit or loss made.
Thus the relation to ascertain the profit or loss can be written as

Profit = Sum of balances in Nominal accounts with a Credit Balance
− Sum of balances in Nominal accounts with a Debit Balance .

Accounting Period

Accounting Period is that period for which the organisation ascertains the profit or loss. If the organisation is trying to ascertain the profits made over a year, then the accounting period is a year. If it is trying to ascertain the profits made over a six months period, then the accounting period is six-months.
There are two aspects relating to an accounting period. The length of the period as well as the being/end dates of the period. These can be ascertained from the way the accounting period is stated.
For example, where the accounting period of an organisation is stated as

• From 1st July to 31st December,
  This implies that the length of the accounting period is 6 months.
• One year and starts on 1st January every year.
  This implies that the accounting period is from 1st January to 31st December and is one year long.

• What Accounting Period to Follow?

What accounting period an organisation follows is dependent on the informational as well as statutory needs of the organisation. The most common period followed all over the world is a period of 1 year which starts from either 1st January or 1st April.

» Statutory Requirements

The need of the organisation to comply with the various laws that it has to adhere to would also influence the decision relating to the accounting period. Say in India, the Income Tax Act, needs organisations to calculate and present their business profits for the period from 1st April to the following 31st March. Therefore, the organisations would follow the same accounting period so that their accounting would serve their informational needs as well as enable them to easily present the information that has to be presented to the Income Tax Department.

When is the information relating to profits & position collected/derived

Information needs vary from organisation to organisation. Even the information relating to profits and position would also be derived for such periods and on such dates respectively depending on the organisations need or this information.

» Period for which profits are ascertained

The information relating to profits is something that is needed by the organisation periodically. For what period do we try to ascertain profits. Do we think of profits made every day or over a week or over a month or over a six month period or over a year? This is dependent on the information needs of the organisation.
Though theoretically it is possible to derive this information's for any time period, conventionally it is derived for a year. That is in most cases, information relating to profits is derived over a year. We think of profits made over a year.

» Day on which position is ascertained

The information relating to the position may be needed by the organisation at many points of time. Theoretically this is also capable of being derived at any point of time we need it. However, conventionally it is derived at a point which indicates the end of the period for which the profits are ascertained. Say if we think of profits made for the period from 1st April 2005 to 31st March 2006, we think of deriving the position as on 31st March 2006.

Debtors (Assets) and Creditors (Liabilities)

• Assets

Real accounts and Personal accounts are capable of being called assets. Any element (account) that is capable of being liquidated (that is capable of being converted to cash by giving it away) indicates an asset. Machinery, Furniture, Cash, etc are real accounts that can be called assets.

» Debtors represent Assets

Debtors represent the persons and organisation who owe to the organisation. They would clear their dues by paying out either in cash or in some other form. Thus Debtors get liquidated and as such can be called assets.

• Liabilities

All elements representing liabilities are Personal accounts. An element that is capable of being cleared by paying out indicates a liability.

» Creditors represent Liabilities

Creditors represent the persons and organisation to whom the organisation owes. The organisation would clear its due by paying them either in cash or in some other form. Thus creditors are cleared by paying out and as such can be called liabilities.

How is the Additional Information obtained?

• Information relating to Profits

The ledger accounts relating to the organisation are classified into three types. Personal, Real and Nominal.

» Nominal Accounts

Nominal accounts are related to expenses, losses, incomes and gains.

Since ascertaining profits or losses involves dealing with incomes, gains, expenses and losses we can conclude that all the nominal accounts together would give us the information relating to the profits or losses made by the organisation.

» Trading and Profit and Loss Accounts

To derive the information relating to profits from these nominal accounts a ledger account by name "Trading and Profit & Loss a/c" is prepared.

Almost in all cases, we use two separate ledger accounts "Trading a/c" and "Profit and Loss a/c" to derive information relating to profits with a greater detail. [The more the information we need, the more the accounting heads we need to maintain].

Preparation of these ledger accounts requires us to think beyond just transferring the information in the nominal accounts into these accounts.

• The Position of the organisation

The ledger accounts maintained within an organisational accounting system are classified into three as Personal, Real and Nominal.

» Real Accounts

Real accounts are related to tangible aspects. In general we can identify that all asset accounts are real accounts.

» Personal Accounts

Personal accounts are related to persons and organisations. These are persons/organisation which owe the organisation or to whom the organisation owes. In effect they either form creditors (liabilities) or debtors (assets).

Since all the nominal accounts have been dealt with in deriving the information relating to profits and we are left with only the real and personal accounts which represent either assets or liabilities we can conclude that all the real and personal accounts together give us the information relating to the position of the organisation.

» Balance Sheet

To derive the information relating to the position of the organisation from these real and personal accounts a statement by name "Balance Sheet" is prepared. However preparing the Balance sheet need us to think a bit beyond just listing out the information relating to the personal and real accounts in the statement.

Additional Information Needed by the Organisation

Apart from the information relating to the various elements (ledger accounts) that an organisation collects, there is other information that is needed by the organisation. In general, in accounting we can identify two important pieces of information that the organisation needs.
The ledger accounts collect information relating to each element. All the elements (account heads) are classified into three types. Personal accounts (relating to persons and organisations), Real accounts (relating to tangible aspects) and Nominal accounts (relating to incomes/gains and expenses/losses).

• Profits made by the organisation

As and when an element is effected by a transaction, the ledger account is posted to with the information. This keeps on happening continuously. The information thus collected in the form of ledger accounts does not say anything about the profits made by the organisation. The organisation periodically would be interested in knowing the amount of profit that it has made over the period.

» Involvement of a Period

When it comes to thinking about profits there is a period involved in the thought. We think of profits made over a period and not at a particular instance. For example, We think of Profits made

• From 1st April to 31st April or
• During April or
• During the 6 months ending 30th June
• For the year from 1st April, 2005 to 31st March 2006.

• Position of the Organisation

The ledger accounts are periodically balanced to obtain the balances in the accounts. The act of balancing is done at such periods as is needed by the organisation. For example, where the organisation needs the information relating to cash balance daily, therefore Cash a/c is balanced daily.

» Assets and Liabilities indicate a persons Position

What is it that comes to our mind when we think of a persons position? It is the value of his/her property and the liabilities he/she has. Even in accounting, in trying to ascertain the position of a business entity, this is what we think of. The position of a business is indicated by the value of its assets and liabilities.
The organisation at times would be interested in knowing its position as at a particular point of time.

» Position at an instance

When it comes to thinking about the position there is an instance involved in the thought. We think of the position as at a point of time and not a period. For example, We think of the position

• As on 24th June or
• As at the end of a period i.e. on the last day of the period

Tasks Involved in the accounting process

Including the tasks of recording the transactions and posting them into the ledger, these are the tasks that we generally come across and assume to be the tasks involved in accounting.

• Creating a Proof of the Transaction

Whenever a transaction takes place in an organisation, more so, in the case of transactions relevant to accounting, a proof is created in the form of either a voucher or a receipt or an invoice or any other document that gives the details relating to the transaction. Strictly speaking, this task is not a part of the accounting process. It is only a task which would enable the accomplishment of the accounting process or tasks.

• Actual Accounting Tasks

» Recording

The first accounting task is "Preparing the Journal based on the proof of the transaction". This is called Recording the transaction.

» Posting

The second accounting task is "Preparing the Ledger based on the information in the Journal". This is called Posting the Journal Entry into the Ledger.

» Preparing a Trial Balance

Preparing a trial balance is one other task that we come across in accounting. A trial balance is a statement of ledger account balances as at a particular instance. It can be prepared at any instance as and when needed. It is a statement and not a ledger account.

• Purpose!!

A Trial Balance is prepared to check the mathematical/arithmetic accuracy of accounting. This is the main and most important purpose of preparation of the Trial Balance and nothing else. However, since it is anyhow prepared for an important purpose, it is used for other purposes wherever possible. Just because it is being used for other purposes (like in the preparation of final accounts), we cannot say that the trial balance is prepared for those other purposes.

• Trial Balance » Not a part of the actual Accounting Process!!

True, the trial balance enables the organisation to ensure the mathematical/arithmetic accuracy of accounting. However, preparation of a Trial Balance is not a necessity, unlike the Journal and the Ledger. The Ledger gives the information that we need and we cannot prepare a ledger without a journal (No Journal No Ledger). But, we can think of the existence of the accounting system and process without the trial balance.

Journal (Recording) » Ledger (Posting) : Regular Tasks

The place where the information relating to an element is collected/available is a Ledger. Each accounting element has a specific identity in the ledger and is known as a ledger account.
Every Ledger posting should have a journal support i.e. the information flows into the ledger from/through a journal. There is no ledger without a journal.
Recording the accounting transactions into the journal and posting them into the ledger form the core tasks carried on regularly in relation to the accounting process. However these are not the only tasks that exist in relation to an accounting system/process.

Basic Purpose of Accounting

The basic purpose of accounting is derivation of information. The double entry system of accounting enables an organisation to derive the information that it needs in relation to accounting elements called account heads or ledger accounts. This double entry system of accounting, enables the collection of all the information relating to an element (account) at a single place.
For example

• To know the value of Furniture with the organisation a "Furniture a/c" is maintained.
• ...
• ...
• To know the amount of expenditure incurred on account of salaries a "Salaries a/c" is maintained.
• ...

The organisation's informational need defines the elements in the accounting system of the organisation. The more the information needed by the organisation the more the elements (accounting heads) that are to be maintained by the organisations'.

Final » Accounts/Accounting

» Final

• Meaning
  1. Occurring at or forming an end or termination
  2. Conclusive in a process or progression
• Synonyms
  • last, concluding, finishing, closing, ending

» Final Accounts/Accounting

In its simplest sense, final accounts/accounting should be understood as the accounting activity that is carried on generally towards the end of a period called accounting period.

ECB holds key interest rate at record low of 0.75%; euro rises

FRANKFURT (Germany): The European Central Bank leaves its benchmark interest rate unchanged at 0.75 percent, holding off on further stimulus for the slowing eurozone economy.

Markets and analysts are focused instead on bank President Mario Draghi's news conference later on Thursday, where he is expected to give further details about the bank's efforts to lower borrowing costs for heavily indebted governments.

The bank has said it is willing to buy up the government bonds of struggling countries such as Spain and Italy, this would lower their borrowing costs. But the ECB expects them to first ask for help from the eurozone bailout fund. Markets want to know other key details, such as how big the purchases could be, and what kind of conditions would come attached to the help.

The euro rose on Thursday after the European Central Bank left interest rates unchanged, but gains looked fragile on concerns the bank's plan to stem the debt crisis, set to be announced later in the day, may fall short of expectations.

The single currency rose to $1.2652, its highest since early July, from around $1.2615. Some in the market had been bracing for an interest rate cut by the ECB to support flagging growth in the euro zone.

"This is the conventional reaction since there were people who were expecting a rate cut," said Daragh Maher, strategist at HSBC. "No rate cut means a higher currency and a few stops got cleared at $1.2640. But the market is really waiting for what Draghi has to say."

The euro rallied on Wednesday after a string of leaks from euro zone officials made markets more confident that the ECB President Mario Draghi will back up his pledge to do "whatever it takes" to save the euro.

Two central bank sources told Reuters on Wednesday Draghi would give no details of planned amounts or explicit targets for spreads or interest rates.

Most market players saw limited gains for the euro even if the ECB gave more details than expected. The single currency has risen from a two-year low of $1.2042 struck in late July on speculation Draghi will unveil a new bond-buying programme to curb high Spanish and Italian borrowing costs.

But with expectations running high, many market players warned there was scope for profit taking and disappointment, given Draghi may be unable to disclose specifics of the plan.

"I think Draghi will disappoint in the respect he will not give us a fully-fledged list of details which would allow us to asses the risks or the chances of his programme," said Ulrich Leuchtmann, head of FX research at Commerzbank. "But I don't think we will see a collapse in the euro or a collapse in the Spanish bond market because we are only missing details."

Double Declining Balance Method Example 2

Double Declining Balance Method Example 2

1. double declining balance method

Cost of asset = $800,000
Estimated residual value = 10% of the cost
Estimated useful life of asset = 5 years

Depreciation rate = (1/useful life) x 200%
= 1/5 x 200% = 20% x 2 = 40%


Example 2 Summary

Year	Cost	Depreciation Rate	Depreciation	Accumulated Depreciation	Book Value
1	$800,000	40%	$320,000	$320,000	$480,000
2		40%	$192,000	$512,000	$288,000
3		40%	$115,200	$627,200	$172,800
4		40%	$69,120	$696,320	$103,680
5		40%	$23,680 (*)	$720,000	$80,000

(*) depreciation stops when book value = residual value

$800,000 x 40% = $320,000
$800,000 - $320,000 = $480,000

$480,000 x 40% = $192,000
$320,000 + $192,000 = $512,000
$800,000 - $512,000 = $288,000

$288,000 x 40% = $115,200
$512,000 + $115,200 = $627,200
$800,000 - $627,000 = $172,800

$172,800 x 40% = $69,120
$627,200 + $69,120 = $696,320
$800,000 - $696,320 = $103,680

$103,680 - $80,000 = $23,680
$696,320 + $23,680 = $720,000
$800,000 - $720,000 = $80,000

Double Declining Balance Method Example 1

Double Declining Balance Method Example 1

1. double declining balance method

Cost of asset = $100,000
Estimated residual value = $10,000
Estimated useful life of asset = 5 years

Depreciation rate = (1/useful life) x 200%
= 1/5 x 200% = 20% x 2 = 40%


Example 1 Summary

Year	Cost	Depreciation Rate	Depreciation	Accumulated Depreciation	Book Value
1	$100,000	40%	$40,000	$40,000	$60,000
2		40%	$24,000	$64,000	$36,000
3		40%	$14,400	$78,400	$21,600
4		40%	$8,640	$87,040	$12,960
5		40%	$2,960 (*)	$90,000	$10,000

(*) depreciation stops when book value = residual value


[Year 1]
Depreciation amount for year 1
= beginning book value x depreciation rate
= $100,000 x 40% = $40,000

Accumulated depreciation at the end of year 1 = $40,000
Book value at the end of year 1
= $100,000 - $40,000 = $60,000

[Year 2]
Depreciation amount for year 2
= beginning book value x depreciation rate
= $60,000 x 40% = $24,000

Accumulated depreciation at the end of year 2
= $40,000 + $24,000 = $64,000

Book value at the end of year 2
= $100,000 - $64,000 = $36,000

[Year 3]
Depreciation amount for year 3
= beginning book value x depreciation rate
= $36,000 x 40% = $14,400

Accumulated depreciation at the end of year 3
= $40,000 + $24,000 + $14,400 = $78,400

Book value at the end of year 3
= $100,000 - $78,400 = $21,600

[Year 4]
Depreciation amount for year 4
= beginning book value x depreciation rate
= $21,600 x 40% = $8,640

Accumulated depreciation at the end of year 4
= $40,000 + $24,000 + $14,000 + $8,640 = $87,040

Book value at the end of year 4
= $100,000 - $87,040 = $12,960

[Year 5]
Depreciation amount for year 5
= beginning book value x depreciation rate
= $12,960 x 40% = $5,184 ??

[NOTE]
For year 5, depreciation amount will not be $5,184.

If $5,280 is depreciated,
--> book value = $13,200 - $5,184 = $7,776
--> book value < residual value

Depreciation stops when book value = residual value
--> depreciation amount for year 5 = $2,960
--> book value = $12,960 - $2,960 = $10,000

Straight Line Depreciation Examples

Straight Line Depreciation Examples

Example 1

1. straight line depreciation

Cost of asset = $100,000
Estimated residual value = $10,000
Estimated useful life of asset = 5 years = 60 months

Depreciation base = cost - residual value
= $100,000 - $10,000 = $90,000

Depreciation amount for each year
= (cost - residual value) x 1 / useful life
= ($100,000 - $10,000) x 1 / 5 years
= $90,000 / 5 = $18,000 per year

Depreciation amount for each month
= (cost - residual value) x 1 / useful life
= ($100,000 - $10,000) x 1 / 60 months
= $90,000 / 60 = $1,500 per month


Example 2

2. straight line depreciation

Cost of asset = $800,000
Estimated residual value = 10% of the cost
Estimated useful life of asset = 10 years = 120 months

Depreciation base = cost - residual value
= $800,000 - $80,000 = $720,000

Depreciation amount for each year
= (cost - residual value) x 1 / useful life
= ($800,000 - $80,000) x 1 / 10 years
= $720,000 / 10 = $72,000 per year

Depreciation amount for each month
= (cost - residual value) x 1 / useful life
= ($800,000 - $80,000) x 1 / 60 months
= $720,000 / 120 = $6,000 per month

Depreciation of Property, Plant and Equipment

Depreciation of Property, Plant and Equipment

1. Depreciation is a process of allocating the cost of a long-lived asset.

2. If an asset is used for more than one accounting period
--> the cost of an asset is allocated to each period

3. Depreciation method should be
--> systematic and rational

4. Depreciation methods
(1) straight line depreciation
(2) double declining balance method
(3) sum-of-the-years'-digits method
(4) production based method

5. straight line depreciation
(1) depreciation base is equally allocated to each period
(2) depreciation base = cost - residual value
(3) depreciation amount = (cost - residual value) x 1/useful life of an asset

6. double declining balance method
(1) depreciation amount = beginning book value x depreciation rate
(2) book value = cost of an asset - accumulated depreciation
(3) beginning book value
= balance of book value at the beginning of period
= equals to book value at the end of previous period
(4) depreciation rate = (1/useful life) x 200%
--> because 200% is multiplied
--> this method is called "double" declining balance method

7. 150% declining balance method
(1) depreciation rate = (1/useful life) x 150%

8. sum-of-the-years'-digits method
(1) depreciation amount
= (cost - residual value) x depreciation rate for that period

(2) depreciation rate is determined as follows:

If the useful life of an asset is N periods
--> Sum-of-the-years'-digits
= 1 + 2 + 3 + ... + N
= N x (N+1) / 2

If useful life is 5 years
--> Sum-of-the-years'-digits
= 1 + 2 + 3 + 4 + 5
= 5 x (5 + 1) / 2
= 30 / 2 = 15

depreciation rate
--> for period 1 = 5 / 15
--> for period 2 = 4 / 15
--> for period 3 = 3 / 15
--> for period 4 = 2 / 15
--> for period 5 = 1 / 15

9. Production based method
(1) If an asset is designed to produce certain number of product units
--> depreciation amount = (cost - residual value) x (A) / (B)
--> (A) = number of products produced during the period
--> (B) = total number of product units expected from an asset

(2) If an asset is designed to be used for certain number of usage hours
--> depreciation amount = (cost - residual value) x (C) / (D)
--> (C) = number of hours used during the period
--> (D) = total number of usage hours expected from an asset

Inventory measurement: Lower of Cost or Market

Inventory measurement: Lower of Cost or Market

1. Lower of Cost or Market (LCM)
--> If market value of inventory is lower than the cost
--> inventory is measured at market

2. Market = current replacement cost

3. Upper limit and lower limit
Upper limit = net realizable value (NRV)
Lower limit = net realizable value - normal profit margin

4. Net realizable value = (A) - (B)
(A) Selling price
(B) Estimated cost of completion and disposal

5. If Lower limit < Upper limit < Current replacement cost
--> Market = upper limit = net realizable value

6. If Current replacement cost < Lower limit < Upper limit
--> Market = lower limit = net realizable value - normal profit margin

7. If Lower limit < Current replacement cost < Upper limit
--> Market = Current replacement cost


Example 1

Cost of inventory = $5,000
Current replacement cost of inventory = $4,500
Selling price = $5,200
Cost of completion and disposal = $400
Normal profit margin = 20% of selling price

8. Net realizable value
= selling price - cost of completion and disposal
= $5,200 - $400 = $4,800

9. Upper limit = net realizable value = $4,800

10. Lower limit
= net realizable value - normal profit margin
= $4,800 - ($5,200 x 20%)
= $4,800 - $1,040 = $3,760

11. Market = current replacement cost = $4,500
Because
Current replacement cost = $4,500
--> is below upper limit ($4,800)
--> and above lower limit (3,760)

12. Inventory is measured at market ($4,500)
Because
Market ($4,500) is lower than the cost ($5,000)
--> Lower of cost or market

Inventory: Cost flow assumptions

Inventory: Cost flow assumptions

1. If unit costs of inventory items vary over time
--> cost of goods sold and inventory amount will depend on
--> which specific items are sold

2. Example 1
January 1, 2011
--> Entity A had 100 units of merchandise in inventory at $10 per unit cost

January 15, 2011
--> Entity A purchased 300 units of merchandise at $12 per unit cost

January 20, 2011
--> Entity A sold 50 units of merchandise $16 per unit price

Sales revenue = 50 units x $16 = $800
What is the amount of cost of goods sold?

3. Specific identification method
--> if each unit can be identified
--> Entity A can specify which 50 units are sold and
--> decide the cost of each specific unit

4. If inventory items are identical and pooled together
--> Entity A has to decide which 50 units were sold on January 20, 2011

5. If the units in the beginning inventory
--> cost per unit is $10

6. If the units purchased on January 15, 2011
--> cost per unit is $12

7. This is the reason why cost flow assumptions are made
--> when specific identification method is not used

8. Cost flow assumptions
(1) First-in, First-out (FIFO)
--> items purchased first are assumed to be sold first

(2) Last-in, First-out (LIFO)
--> items purchased last are assumed to be sold first

(3) Weighted average
--> weighted average cost of all previous purchases is used
--> to determine the cost of goods sold

9. Example 1, continued
January 1, 2011
--> Entity A had 100 units of merchandise in inventory at $10 per unit cost

January 15, 2011
--> Entity A purchased 300 units of merchandise at $12 per unit cost

January 20, 2011
--> Entity A sold 50 units of merchandise $16 per unit price

Sales revenue = 50 units x $16 = $800
What is the amount of cost of goods sold?

10. First-in, First-out (FIFO)
--> Beginning inventory at January 1, 2011 is assumed to be sold first
--> cost of 50 units sold: $10 per unit
--> 50 units x $10 = $500

11. Last-in, First-out (LIFO)
--> the most recent purchase on January 15, 2011 is assumed to be sold first
--> cost of 50 units sold: $12 per nit
--> 50 units x $12 = $600

12. Weighted average
--> weighted average cost
= (100 x $10 + 300 x $12) / (100 + 300) units
= ($1,000 + $3,600) / 400 units
= $4,600 / 400 = $11.50

Cost of 50 units sold
= 50 units x $11.50 = $575

13. Cost of goods sold summary
(1) FIFO
--> 50 units x $10 = $500

(2) LIFO
--> 50 units x $12 = $600

(3) Weighted average
--> 50 units x $11.50 = $575

13. Inventory
(1) FIFO
--> 50 units x $10 + 300 units x $12
= $500 + $3,600 = $4,100

(2) LIFO
--> 100 units x $10 + 250 units x $12
= $1,000 + $3,000 = $4,000

(3) Weighted average
--> 350 units x $11.50 = $4,025

14. Quick comparison of FIFO and LIFO

--> If the cost of later purchase is higher than those of previous purchases

--> Cost of goods sold
FIFO < Weighted average < LIFO
--> earlier cost (lower cost) is charged for FIFO
--> later cost (higher cost) is charged for LIFO

--> Inventory
LIFO < Weighted average < FIFO
--> later cost (higher cost) stays in inventory for FIFO
--> earlier cost (lower cost) stays in inventory for LIFO

Recording Inventory Transactions

Recording Inventory Transactions

1. Two methods of recording inventory transactions
(1) Perpetual inventory system
(2) Periodic inventory system

2. Perpetual inventory system
--> records purchases to inventory account
--> each time transaction occurs
--> inventory account is updated continuously during the period

3. Periodic inventory system
--> records purchases to purchases account
--> inventory account is updated only at the end of the period
--> based on the results of physical inventory taking

[Example 1]

January 1, 2011
Entity A had 400 units of merchandise in inventory at $10 per unit cost

5. January 10, 2011
Entity A purchased 500 units of merchandise at $10 per unit price on credit

Journal entry for perpetual inventory system

debit credit Merchandise inventory 5,000         Accounts payable   5,000 Journal entry for periodic inventory system

debit credit Purchases 5,000         Accounts payable   5,000 6. January 20, 2011 Entity A purchased 600 units of merchandise at $10 per unit price on credit Journal entry for perpetual inventory system

debit credit Merchandise inventory 6,000         Accounts payable   6,000 Journal entry for periodic inventory system

debit credit Purchases 6,000         Accounts payable   6,000 7. January 25, 2011 Entity A sold 700 units of merchandise at $15 per unit price on credit Journal entry for perpetual inventory system To record sale s revenue

debit credit Accounts receivable 10,500         Sales   10,500 To record cost of goods sold

debit credit Cost of goods sold 7,000         Merchandise inventory   7,000 Journal entry for periodic inventory system To record sale s revenue

debit credit Accounts receivable 10,500         Sales   10,500 No journal entry is prepared to record cost of goods sold during the period --> cost of goods sold is recorded only at the end of the period 8. January 31, 2011 Entity A took physical inventory and counted 800 units of merchandise inventory Journal entry for perpetual inventory system --> no journal entry is prepared --> inventory and cost of goods sold accounts are updated --> continuously during the period Journal entry for periodic inventory system Beginning inventory = 400 units x $10 = $4,000 Purchases = 500 unit x $10 + 600 units x $10 = $11,000 Cost of goods sold = 700 units x $10 =$7,000 Ending inventory = 800 units x $10 = $8,000 Beginning inventory and purchases are redistributed --> to cost of goods sold and ending inventory

	debit	credit
Cost of goods sold	7,000
Merchandise inventory	8,000
Merchandise inventory		4,000
Purchases		11,000

9. Gross profit is same for both methods of inventory recording
Sales revenue - Cost of goods sold
= $10,500 - $7,000 = $3,500

Consigned goods

1. Consignment contract
--> Consignor sends goods to consignee
--> Consignor continues to own consigned goods

2. Physical location of consigned goods
--> Consigned goods are located in the warehouse of consignee

3. Ownership of consigned goods
--> Ownership of consigned goods belongs to consignor

4. Inventory counting
--> Consignor should include consigned goods in the inventory
--> even if consigned goods are currently located in the warehouse of consignee

5. Consignee should exclude consigned goods from the inventory
--> even if consigned goods are currently located in the warehouse of consignee

6. Example 1
On December 20, 2011
--> Entity A sent 200 units of its products to Entity B for consignment sales

On December 31, 2011
-->Entity A counted 500 units of its products in their warehouses

What is the number of units to be reported as Entity A's inventory at December 31, 2011?
Answer: 700 units (500 units on hand + 200 units of consigned goods)

7. Example 2
On December 20, 2011
--> Entity A sent 200 units of its products to Entity B for consignment sales

On December 31, 2011
--> Entity B counted 500 units of products in their warehouses, including consigned goods

What is the number of units to be reported as Entity B's inventory at December 31, 2011?
Answer: 300 units (500 units on hand - 200 units of consigned goods)

Goods in transit

Goods in transit

1. Goods in transit
--> ownership of goods in transit is determined by the terms of shipping agreement

2. Free on board (F.O.B.) shipping point
--> ownership of goods is transferred when they are on board
--> at the departing port

3. Free on board (F.O.B.) destination
--> ownership of goods is transferred when they arrive at the destination port

4. Example 1
Entity A sold 5,000 units of goods to Entity B, with FOB shipping point
All 5,000 units of goods were shipped on December 30, 2011,
and arrived at the destination on January 5, 2012.

Which entity should report 5,000 units of goods as inventory at December 31, 2011?
Answer: Entity A

5. Example 2
Entity A sold 5,000 units of goods to Entity B, with FOB destination
All 5,000 units of goods were shipped on December 30, 2011,
and arrived at the destination on January 5, 2012.

Which entity should report 5,000 units of goods as inventory at December 31, 2011?
Answer: Entity B

Classification of inventory

Classification of inventory

Inventory items are classified based on
--> where they are in the production process

1. Merchandise
--> goods purchased from other entities
--> for the purpose of reselling to customers

2. Raw materials
--> materials and parts purchased from other entities
--> for the purpose of using them in the production process

3. Work in process
--> materials and parts currently in the production process

4. Finished goods
--> goods that completed the productions process
--> goods that are ready for sale to customers

Notes receivable and imputation of interest

Notes receivable and imputation of interest


1. If (A) > (B), the difference is recognized as discount on note receivable
(A) face amount of note receivable
(B) present value of note receivable

2. Example 1:
On August 1, 2011, Entity A loaned $100,000 cash to Entity B
--> and received a promissory note of $112,000 from Entity B
--> note is due on July 31, 2012

Face amount = $112,000
Present value = $100,000
Discount = $112,000 - $100,000 = $12,000

3. Discount on note receivable is amortized
--> and recognized as interest income

4. Interest income for 2011 (August 1 - December 31)
--> $12,000 x 1/12 x 5 months = $5,000

5. Interest income for 2012 (January 1 - July 31)
--> $12,000 x 1/12 x 7 months = $7,000

6. Journal entry on August 1, 2011

debit credit Notes receivable 112,000         Cash   100,000       Discount on notes receivable   12,000 7. Journal entry on December 31, 2011 To record interest income for August 1, 2011 - December 31, 2011

debit credit Discount on notes receivable 5,000         Interest income   5,000 8. Journal entry on July 31, 2012 To record interest income for January 1, 2012 - July 31, 2012

debit credit Discount on notes receivable 7,000         Interest income   7,000 9. Journal entry on July 31, 2012

	debit	credit
Cash	112,000
Notes receivable		112,000

Accounts receivable and allowance for doubtful accounts

Accounts receivable and allowance for doubtful accounts

Accounts receivable
--> "Allowance for doubtful accounts" is subtracted from accounts receivable balance
--> "Allowance for doubtful accounts" is a contra-asset account
--> a contra-asset account is subtracted from an asset account balance

[Example 1]

1. Entity A has accounts receivable balances from three customers as follows:
Customer 1: $100,000 --> 25 days old
Customer 2: $250,000 --> 35 days old
Customer 3: $200,000 --> 70 days old

2. Expected bad debts rate
--> Aging schedule method
--> estimate bad debts based on the aging of balances

--> following rates are assumed:
0 - 30 days: 0%
31 - 60 days: 2%
61 - 90 days: 5%
over 90 days: 10%

3. Estimated bad debts amount
= $250,000 x 2% + $200,000 x 5%
= $5,000 + $10,000 = $15,000

4. Journal entry to record bad debts expense

debit credit Bad debts expense 15,000         Allowance for doubtful accounts   15,000 5. Accounts receivable = $100,000 + $250,000 + $200,000 = $550,000 6. Allowance for doubtful accounts = $15,000 7. Accounts receivable less allowance for doubtful accounts = $550,000 - $15,000 = $535,000

Assets: Definition and Classification

Assets: Definition and Classification

Definition of assets
--> Assets represent future economic benefits.
--> Future benefits should be probable.
--> Past transactions created future benefits.
--> Future benefits are controlled by an entity.

Assets: Classification

1. Current assets and noncurrent assets
--> current assets will be converted into cash within one year
--> noncurrent assets will be converted into cash after one year

[Example]
On March 1, 2011, Entity A loaned $100,000 to Entity B. The loan is due on September 1, 2012.
Is this a current or noncurrent asset on the Statement of Financial Positions as of December 31, 2011?
--> Since the loan is due within a year from December 31, 2011, it is reported as a current asset.

2. Cash and receivables
--> Cash is a financial asset.
--> Receivables include accounts receivable and notes receivable.

[Example]
On April 1, 2011, Entity A sold 200 units of product to Entity B at $10 per unit on credit.
April 20, 2011, Entity B paid $2,000 to Entity A.
Prepare journal entries for these transactions.

April 1, 2011
To record the sale of products on credit

debit credit Accounts receivable 2,000         Sales   2,000 April 20, 2011 To record the collection of accounts receivable

debit credit Cash 2,000         Accounts receivable   2,000 3. Inventories and prepaid expenses Inventories include: --> merchandise --> raw materials --> work in process --> finished goods Prepaid expenses include: --> prepaid rent --> prepaid insurance Prepaid expenses are assets, because the entity will receive economic benefits from the amount of expenses paid in advance. [Example] On November 1, 2011, Entity A paid $60,000 cash as a rent for six months from November 1, 2011 to April 30, 2012. Prepare journal entries for these transactions. November 1, 2011 To record prepaid rent expense

debit credit Prepaid rent 60,000         Cash   60,000 December 31, 2011 To record rent expense for the period from November 1 to December 31, 2011

debit credit Rent expense 20,000         Prepaid rent   20,000 April 30, 2010 To record rent expense for the period from January 1 to April 30, 2012

	debit	credit
Rent expense	40,000
Prepaid rent		40,000

4. Investments in debt and equity securities
--> Trading securities
--> Available for sale securities
--> Held to maturity securities

5. Property, plant and equipment
--> Land
--> Buildings
--> Machinery
--> Equipment

6. Intangible assets
--> Intangible assets do not have physical substance
--> Patents
--> Trademarks
--> Copyright
--> Goodwill

Examples of Asset Accounts

1. Assets = current assets + noncurrent assets

2. Current assets
Assets that are expected to be converted into cash within (A) or (B), whichever is longer
(A) one year
(B) normal operating cycle

3. Noncurrent assets
Assets that are expected to be converted into cash after (A) or (B), whichever is longer
(A) one year
(B) normal operating cycle

4. Examples of current assets

Cash
Accounts receivable, due within one year
Notes receivable, due within one year
Prepaid expenses

Inventories
Short-term loans, due within one year
Current portion of long-term loans

Trading securities
Available for sale securities, to be sold within one year
Held to maturity securities, due within one year

5. Examples of noncurrent assets

Accounts receivable, due after one year
Notes receivable, due after one year
Long-term loans, due after one year

Available for sale securities, to be sold after one year
Held to maturity securities, due after one year

Property, plant and equipment
Intangible assets

Elements of Financial Statements

Elements of Financial Statements

1. Statement of financial position, Balance sheet
--> Assets
--> Liabilities
--> Shareholders' equity

2. Statement of comprehensive income, Income statement
--> Revenue
--> Expenses

[U.S. GAAP]
Net income = revenue - expenses
Comprehensive income = net income + other comprehensive income

[IFRS]
Profit or loss = revenue - expenses
Comprehensive income = profit or loss + other comprehensive income

3. Statement of cash flows
--> Cash flows from operating activities
--> Cash flows from investing activities
--> Cash flows from financing activities

4. Statement of changes in equity, Statement of shareholder equity
--> Beginning balances of the components of shareholders' equity
--> Changes in the components of shareholders' equity
--> Ending balances of the components of shareholders' equity

Financial Statements Overview

1. Complete set of financial statements by IFRS

[IAS 1.10]
(1) Statement of financial position
(2) Statement of comprehensive income
(3) Statement of changes in equity
(4) Statement of cash flows
(5) Notes

2. Financial statements by U.S. GAAP

[Codification Topic]
210 Balance sheet
225 Income statement
230 Statement of cash flows
215 Statement of shareholder equity
235 Notes to financial statements

Journal Entries for Merchandise Transactions

1. March 1, 2011
Purchased 200 units of merchandise at $10 per unit in cash.

debit credit Merchandise 2,000         Cash   2,000 2. March 5, 2011 Purchased 500 units of merchandise at $10 per unit on credit.

debit credit Merchandise 5,000         Accounts payable   5,000 3. March 10, 2011 Sold 300 units of merchandise at $15 per unit on credit. Journal entry to record sales revenue.

debit credit Accounts receivable 4,500         Sales   4,500 Journal entry to record cost of goods sold.

	debit	credit
Cost of goods sold	3,000
Merchandise		3,000

4. Merchandise in inventory

700 units purchased - 300 units sold = 400 units in inventory
400 units x $10 per unit = $4,000

5. Gross profit
= Sales - Cost of goods sold
= $4,500 - $3,000 = $1,500

Double-entry method

1. Accounting transactions are recorded by preparing journal entries.

2. Journal entries have at least one entry on each of (A) and (B).
(A) debit side
(B) credit side

3. Debit side refers to the left side of a journal entry.

4. Credit side refers t the right side of a journal entry.

5. An example of journal entry

Transaction
--> $100,000 cash was invested to start a business.

	debit	credit
cash	100,000
owner's equity		100,000

This journal entry records an increase in cash of $100,000 and an increase in owner's equity of $100,000.

6. Asset accounts, such as cash, have normal balances on debit side.
--> an increase in asset accounts is recorded on debit side

7. Equity accounts, such as owner's equity, have normal balances on credit side.
--> an increase in equity accounts is recorded on credit side

8. Liability accounts, such as borrowings, have normal balances on credit side.
--> an increase in liability accounts is recorded on credit side

9. For all journal entries, total on debit side should be equal to total on credit side.
--> a journal entry balances when debit = credit

10. Accounting equation
--> assets = liabilities + equity

11. Revenue accounts, such as sales, have normal balances on credit side.
--> an increase in revenue accounts is recorded on credit side

12. Expense accounts, such as cost of sales, have normal balances on debit side.
--> an increase in expense accounts is recorded on debit side

13. An expanded version of accounting equation
--> assets + expenses = liabilities + equity + revenue
--> assets = liabilities + equity + revenue - expenses

14. Ending balance of equity = (C) + (D) - (E)
(C) Beginning balance of equity
(D) Revenue
(E) Expenses

15. Net income = revenue - expenses

16. An expanded version of accounting equation
--> assets = liabilities + equity + revenue - expenses
--> assets = liabilities + equity + net income

17. An example of accounting equation

Assets = $100,000
Liabilities = $30,000
Beginning balance of equity = ??
Revenue = $110,000
Expenses = $90,000
Net income = ???

assets = liabilities + equity + revenue - expenses
100,000 = 30,000 + ?? + 110,000 - 90,000

Beginning balance of equity = ?? = 50,000
net income = revenue - expenses = 110,000 - 90,000 = 20,000

assets = liabilities + equity + revenue - expenses
100,000 = 30,000 + 50,000 + 110,000 - 90,000 = 100,000

Ending balance of equity = beginning balance of equity + net income
= 50,000 + 20,000 = 70,000

Qualitative characteristics of accounting information

1. What is the most important quality of accounting information?
--> Decision usefulness
--> The objective of accounting is to provide useful information to the users

2. What the two primary decision-specific qualities to make information useful for decisions?
--> Relevance and Reliability
--> To make information useful, information should be relevant to the decision and reliable.

3. What are the ingredients of relevance?
--> timeliness, predictive value, feedback value

4. What are the ingredients of reliability?
--> verifiability, representational faithfulness

5. What are the secondary qualities applicable for both relevance and reliability?
--> comparability

6. What is the secondary quality for reliability?
--> neutrality

7. Qualities of accounting information:

100. Decision usefulness
110. Relevance
111. timeliness
112. predictive value
113. feedback value
114. comparability

120. Reliability
121. verifiability
122. representational faithfulness
123. neutrality
124. comparability

8. To make information useful for decisions, information should be:
(A) relevant
(B) reliable

9. To make information relevant, information should have the following qualities:
(C) timeliness
(D) predictive value
(E) feedback value
(F) comparability

10. To make information reliable, information should have the following qualities:
(G) verifiability
(H) representational faithfulness
(I) neutrality
(J) comparability

11. In providing information, what is a pervasive constraint?
--> the benefits of information should be greater than the costs of information

12. What is the user-specific quality of information to be useful?
--> understandability
--> information should be understandable to be useful

13. What is the threshold for recognizing the elements of accounting information?
--> materiality
--> material items are recognized
--> items that are not material do not require recognition

14. What is materiality?
--> Information (AA) is material,
--> if the omission or misstatement of (AA)
--> probably changes or influences
--> the judgment of a reasonable person who relies on (AA)

What's the difference between income and revenue?

Revenue is the total amount earnd during sales of goods and services. While income is the total amount earned after all other expenses and tax have been deducted which will be seen as net profit.

How would depreciation affect the balance sheet?

Depreciation only affects the value of an asset on the balance sheet.

On the profit/loss statement it's counted as an expense, because you're technically losing money. It counts toward the total expenses, and therefore lowers earnings on the balance sheet.

How would you post in a journal? Performed services for $30,000; received $14,000 in cash and the rest is payable in 60 days?

(DR ) cash $ 14,000
(DR) accounts receivable $ 16,000
(CR) service revenue $ 30,000

How do you record profits?

You don't record profits. You record income and expense. Profits (or losses) are calculated by subtracting expenses from income.

How do you classify cost of inventory?

There are multiple methods: LIFO, FIFO, Average, Standard, Last, or Serialized. Each has pros and cons.

Accounting Terms

Retained Earnings – the amount of net profit retained and not paid out to shareholders over the life of the business
Revenue - total income before expenses.
Shareholder Equity - the capital and retained earnings in an entity attributed to the shareholders
Single-Entry Bookkeeping - system of accounting in which transactions are entered into one account
Statement of Account - a summary of amounts owed to a vendor, lender, etc.
Subsidiary Accounts – the subaccounts that are totaled on the financial statement under “master accounts;” i.e. “Cash-ABC Bank” might be one of several subsidiary accounts that are subtotaled under “Cash”
Supplies – assets purchased to be consumed by the entity
Treasury Stock – shares purchased by the entity from shareholders, reducing shareholder equity
Write-down/Write-off – an accounting entry that reduces the value of an asset due to an impairment of that asset; i.e. the account receivable from the bankrupt customer

Accounting terms

Fixed Asset - long-term tangible property; building, land, computers, etc.
General Ledger - a record of all financial transactions within an entity
Goodwill – an intangible asset reflecting the value of an entity in excess of its tangible assets
Income Statement - a summary of income and expenses
Inventory – merchandise purchased for resale at a profit
Inventory Valuation – the method to set the book value of unsold inventory: i.e. “LIFO,” last in, first out; “FIFO,” first in, first out; “average,” an average cost over a given period, “last cost,” the cost based on the last purchase; “standard,” a “deemed” amount related to but not tied to a specific purchase, “serialized,” based on a uniquely identifiable serial number or character of each inventory item
Invoice – the original billing from the seller to the buyer, outlining what was purchased and the terms of sale, payment, etc.
Job Costing - system of tracking costs associated with a job or project (labor, equipment, etc) and comparing with forecasted costs
Journal - a record where transactions are recorded, also known as an "account"
Liability - money owed to creditors, vendors, etc
Liquid Asset - cash or other property that can be easily converted to cash
Loan - money borrowed from a lender and usually repaid with interest
Master Account – an account on the general ledger that subtotals the “subsidiary accounts” assigned to it; i.e. Cash might be the master account for a list of depository accounts at banks
Net Income - money remaining after all expenses and taxes have been paid
Non Cash Expense - recognizing the decrease in the value of an asset; i.e. depreciation and amortization
Non-operating Income - income generated from non-recurring transactions; ie: sale of an old building
Note - a written agreement to repay borrowed money; sometimes used in place of "loan"
Operating Income - income generated from regular business operations
Other Income - income generated from other than regular business operations, i.e. interest, rents, etc.
Payroll - a list of employees and their wages
Posting – the process of entering then permanently saving or “archiving” accounting data
Profit - see "net income"
Profit/Loss Statement - see "income statement"
Reconciliation – the process of matching one set of data to another; i.e. the bank statement to the check register, the accounts payable journal to the general ledger, etc.