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What is the difference between a balance sheet and a trial balance? (pg. 41)

A balance sheet is one of the main financial statements and is also known as the statement of financial position. The balance sheet is referred to as an external report because it is used outside of the company by investors, lenders, and others. The balance sheet reports on the organization's assets, liabilities, and stockholders' or owner's equity as of a point in time—for example, as of midnight of April 30, 2009. The balance sheet also shows that the total of the asset amounts is equal to the total of the amounts of liabilities and stockholders' equity. A trial balance is an internal document used only within the accounting department. Its purpose is to show that the amounts of debits and credits within the accounting system are equal. The trial balance consists of three columns: the first column lists every account title having an account balance, the second column is for account balance if it is a debit balance, and the third column is for the account balance if it is a credit balance. The amounts in the debit column are summed and the amounts in the credit column are summed. The total amount of each column should be the same.

Is it possible to have a balance sheet for a single day? (pg. 18)

A balance sheet presents the amounts of a company's assets, liabilities, and owner's equity as of an instant or moment in time within a day. Usually it is the instant as of the end of the day. In other words, you can have a balance sheet each day, but the balance sheet amounts represent the amount at the instant or moment after all of the transactions of the specified day have been recorded. We avoid saying that the balance sheet is for the day, since the amounts are not for the 24-hour period. For example, the cash amount that is reported on the balance sheet is the cash as of the end of the day. For the day, the cash balance may have been $1000 at 8 a.m., $1200 at 9 a.m., $823 at 10 a.m., $3134 at 4 p.m., etc. Similarly, account balances such as accounts receivable and accounts payable are changing during the day. If you do prepare a balance sheet as of the end of each day, you will need to make daily adjusting entries in order for the balance sheet to be meaningful. For example, each day more electricity is used and therefore each day there is an additional liability and an expense for electricity.

What is a bookkeeper? (pg. 33)

A bookkeeper is usually employed by a small to mid-size company to record its transactions such as sales, purchases, payroll, collection of accounts receivable, payment of bills, etc. A very small company might use the services of a bookkeeping firm that employees bookkeepers. Since bookkeepers typically do not have a four-year accounting degree, an accounting firm will review the financial statements prepared by a company's bookkeeper. A bookkeeper today is expected to be comfortable using accounting software.

What is a budget? (pg. 51)

A budget is a plan expressed in dollar amounts that acts as a road map to carry out an organization's objectives, strategies and assumptions. A company might have a master budget or profit plan for the upcoming year. The master budget will include a projected income statement and balance sheet. Within the master budget will be operating budgets such as a sales budget, production budget, marketing budget, administrative budget, and budgets for departments. In addition there will be a cash budget and a capital expenditures budget. It is common that the budgets prepared for the next accounting year will be detailed by quarter and/or by month. It is also typical that the annual budget will not be changed once the actual year begins. Good managers realize that a budget is a guide and that it cannot be so rigid that it prevents timely action when needed. In rare circumstances the annual budget might be revised, but only when the business environment has radically changed.

What is the difference between a budget and a standard? (pg. 50)

A budget usually refers to a department's or a company's projected revenues, costs, or expenses. A standard usually refers to a projected amount per unit of product, per unit of input (such as direct materials, factory overhead), or per unit of output. For example, a manufacturer will have budgets for its manufacturing or factory overhead departments. Let's assume that the budgeted manufacturing overhead for the upcoming year is expected to be $1,000,000 in order to produce the expected 100,000 identical units of product. The standard cost of manufacturing overhead per unit of product is $10 ($1,000,000 divided by 100,000 units). When the products are not identical, the $1,000,000 of manufacturing overhead might be divided by the expected number of machine hours required to manufacture the units of product. Assuming it will take 50,000 machine hours, the standard cost of the manufacturing overhead will be $20 per machine hour ($1,000,000 divided by 50,000 machine hours).

What is a budget variance? (pg. 21)

A budget variance results when an actual amount is different from a planned or budgeted amount. A budget variance can occur for revenues and for expenses.

How do I record an advance to an employee and the deduction? (pg. 48)

A cash advance to an employee is recorded with a debit to an account such as Advance to Employees or to Other Receivables: Advances. The credit will be to the account Cash. If the cash advance is expected to be repaid within one year, the account Advance to Employees will be a current asset account. If the cash advance is repaid through payroll withholdings, the amount withheld will be recorded as a credit to Advance to Employees. If the employee gives the company a personal check to repay the advance, the Cash account is debited and the account Advance to Employees is credited.

What is a dividend? (pg. 65)

A cash dividend is a distribution of a portion of a corporation's earnings to its stockholders. A stock dividend (as opposed to a cash dividend) is a distribution of more shares of a corporation's own stock to its stockholders.

What is a certified public accountant? (pg. 33)

A certified public accountant, or CPA, is a person who has passed the very difficult CPA Exam and has been licensed by one of the 50 U.S. states (or one of five other jurisdictions). The CPA's license is renewed if the state's requirements continue to be met including continuing professional education credits. Many certified public accountants work in the field of public accounting in CPA firms ranging from a sole practitioner to a large international CPA firm. However, many certified public accountants leave public accounting while others never enter public accounting. These CPAs can be found working as accountants in manufacturing, financial services, not-for-profit organizations, health care, government agencies, education, and so on. Most state boards of accountancy now require candidates to have 150 college credits in order to sit for the CPA Exam.

What is a learning curve? (pg. 22)

A common learning curve shows that the cumulative average time to complete a manual task which involves learning will decrease 20% whenever volume doubles. This is referred to as an 80% learning curve. Let's illustrate the 80% learning curve with a person learning to design and code websites of similar size and complexity. If the first website takes 100 hours, then after the second website the cumulative average time will be 80 hours (80% of 100 hours). The cumulative average of 80 hours consists of 100 hours for the first website plus only 60 hours for the second website resulting in a total of 160 hours divided by 2 websites. After the fourth website the cumulative average time will be 64 hours (80% of 80 hours). After the eighth website the cumulative average will be 51.2 hours (80% of 64 hours). In other words, the total time to have completed all eight websites will be 409.6 hours (8 websites times an average time of 51.2 hours). Improvements in technology can mean time and cost reductions beyond those in the learning curve. For example, software may become available to assist in the design and coding, computer processing speeds might increase, there may be lower costs of processing and storage, etc. The learning curve is important for setting standards, estimating costs, and establishing selling prices.

Where is a contingent liability recorded? (pg. 40)

A contingent liability that is both probable and the amount can be estimated is recorded as 1) an expense or loss on the income statement, and 2) a liability on the balance sheet. As a result, a contingent liability is also referred to as a loss contingency. Warranties are cited as a contingent liability that meets both of the required conditions (probable and the amount can be estimated). Warranties will be recorded at the time of a product's sale with a debit to Warranty Expense and a credit to Warranty Liability. A loss contingency which is possible but not probable, or the amount cannot be estimated, will not be recorded in the accounts. Rather, it will be disclosed in the notes to the financial statements. A loss contingency that is remote will not be recorded and will not have to be disclosed in the notes to the financial statements.

Where is a contract with a customer reported on the balance sheet? (pg. 35)

A contract to perform future services for a customer is not reported on the balance sheet of the company that will be providing the services. For example, if Company Jay and one of its customers sign a contract in December agreeing that Company Jay will deliver $20,000 of services beginning in January, the contract is not reported on Company Jay's December 31 balance sheet. (If the customer makes a deposit of $3,000 at the time of signing the contract, the $3,000 will be recorded by Company Jay in December with a $3,000 debit to Cash and a $3,000 credit to the liability account Customer Deposits or Unearned Revenues. With no downpayment or advance payment in December, there is no entry recorded.) The $20,000 contract is not reported as an asset on Company Jay's December 31 balance sheet. The reason is that Company Jay has not earned any of the contract amount and therefore does not have a right or a receivable to the $20,000 as of December 31. Similarly, Company Jay's income statement for December and its December 31 owner's equity cannot include any earnings associated with the contract.

What are the reasons for a stock dividend instead of a cash dividend? (pg. 65)

A corporation might declare a stock dividend instead of a cash dividend in order to 1) increase the number of shares of stock outstanding, 2) move some of its retained earnings to paid-in capital, and 3) minimize distributing the corporation's cash to its stockholders. If a corporation has 100,000 shares of stock outstanding and it declares a 10% stock dividend, the corporation ends up having 110,000 shares outstanding. An individual stockholder having 1,000 shares prior to the 10% stock dividend will have 1,100 shares after the stock dividend. This individual's stake in the corporation was 1% (1,000 out of 100,000 shares) prior to the stock dividend and will remain at 1% (1,100 out of 110,000 shares) after the stock dividend. Since the corporation hasn't really changed because of the stock dividend, the total market value of the corporation should not change. In other words, if the total market value of the corporation was $1 million before the stock dividend, it should be $1 million after the stock dividend. However, the market value of each share should decrease: $1,000,000 divided by 100,000 shares = $10 per share, and $1,000,000 divided by 110,000 shares = $9.0909. The total market value of the individual's holdings should also remain the same: 1,000 shares X $10 = $10,000, and 1,100 shares X $9.0909 = $10,000. If the market does not adjust for the increased number of shares, the individual stockholders will benefit.

Why aren't retained earnings distributed as dividends to the stockholders? (pg. 58)

A corporation's earnings are usually retained instead of being distributed to the stockholders in the form of dividends because the corporation is in need of money to strengthen its financial position, to expand its operations, or to keep up with the inflation in its present size of operations. The stockholders may prefer to forego dividends in order to see its stock value increase from the corporation's wise use of the retained earnings. This is especially true of U.S. individuals in high federal and state income tax brackets. These stockholders might end up paying 40% of the dividend amount in income taxes. They would rather have their stock appreciate in value with no tax payments and later sell their shares of stock at the lower capital gains tax rates.

What is a customer deposit? (pg. 47)

A customer deposit could be an amount paid by a customer to a company prior to the company providing it with goods or services. In other words, the company receives the money prior to earning it. The company receiving the money has an obligation to provide the goods or services to the customer or to return the money. For example, Ace Manufacturing Co. might agree to produce an expensive, custom-made machine for one of its customers. Ace requires that the customer pay $50,000 before Ace begins to design and construct the machine. The $50,000 payment is made in December 2008 and the machine must be finished by June 30, 2009. The $50,000 is a down payment toward the machine's price of $400,000. In December 2008, Ace will debit Cash for $50,000 and will credit Customer Deposits, a current liability account. (The customer will record the $50,000 payment with a debit to a long-term asset account such as Construction Work in Progress or Downpayment on New Equipment, and will credit Cash.)

What is a debenture? (pg. 55)

A debenture is an unsecured bond. In other words, a debenture is a bond without a lien on specific assets owned by the issuing corporation.

What is the difference between a debit and a debit balance? (pg. 55)

A debit is an entry on the left side of an account. For example, the account Cash is debited when cash is received. The account Cash will be credited when cash is paid out. (A credit is an entry on the right side of an account.) If a company's Cash account has $394,000 of debit amounts and $392,000 of credit amounts, the Cash account will have a debit balance of $2,000. Most asset accounts and expense accounts will have debit balances. If the Cash account had $394,000 of debit amounts and $395,000 of credit amounts, the Cash account will have a credit balance of $1,000. This indicates that it has a negative amount of cash—that the amount of checks written is greater than the money it has received. If a bank deposit is not made prior to its checks clearing the bank, the company's bank account will overdraw.

How do you record a deposit on utilities? (pg. 20)

A deposit on utilities is recorded with a debit to the asset account Utilities Deposit and a credit to the asset account Cash. The account Utilities Deposit will be reported as a current asset if the company expects the amount to be returned by the utilities within one year of the balance sheet date. If the deposit will not be returned within one year of the balance sheet date, it will be reported as a long-term asset.

What is the entry for the down payment from a signed contract? (pg. 43)

A down payment received before it is earned is recorded with a debit to the current asset account Cash and a credit to the current liability account Customer Deposits. When the contract is completed, the account Customer Deposits will be debited for the amount of the down payment, the sale will be recorded with a credit, and Cash or Accounts Receivable will be debited.

What is the meaning of a favorable budget variance? (pg. 19)

A favorable budget variance indicates that an actual result is better for the company (or other organization) than the amount that was budgeted. Here are three examples of favorable budget variances: 1. Actual revenues are more than the budgeted or planned revenues. 2. Actual expenses are less than the budget or plan. 3. Actual manufacturing costs are less than the amount budgeted for the period. Occasionally, a favorable budget variance for revenues will be analyzed to determine whether it was the result of higher than planned selling prices, greater quantities, or a more favorable mix of items sold. Similarly, a favorable budget variance for expenses will be analyzed to identify the cause of the lower expenses.

What is the difference between a ledger and a trial balance? (pg. 13)

A ledger is often defined as a book of accounts. Today a ledger is most likely an electronic record or file containing a group of accounts. For example, a company's general ledger is the record containing all of its asset, liability, owner equity, revenue, expense, gain, and loss accounts. Each of these accounts will contain the amounts that are pertinent to the account. A trial balance is a listing of the name and the balance of each of the accounts in the general ledger. The trial balance is not a financial statement. Rather, it is an internal report that documents which accounts have debit balances and which accounts have credit balances and proves that the total of the debit balances is equal to the total of the credit balances.

Is a money market account a current asset or a fixed asset? (pg. 44)

A money market account is a current asset unless it is restricted for a long-term purpose. The amount of an unrestricted money market account will likely be reported on the balance sheet as part of a company's cash or its cash and cash equivalents.

Is the current portion of long term debt adjusted monthly?

A monthly adjustment to the current portion of long term debt is necessary when: 1. the company issues monthly balance sheets, and 2. the amount to be paid on a loan's principal balance during the next 12 months is different from the amount presently shown as a current liability. The amount reported as a current liability plus the amount reported as a long term liability must be equal to the total amount owed on the debt.

What is a natural business year? (pg. 12)

A natural business year is the period of 12 consecutive months (or 52-53 consecutive weeks) ending at a low point of an organization's activities. For example, a school district will have a natural business year of July 1 through June 30, since classes for the school year end in early June. A retailer's natural business year might be the 52-53 consecutive weeks ending on the Saturday closest to each February 1. This is a low point of activity as it follows the retailer's holiday season and its January clearance sales. The 52-53 week periods (instead of 12 month periods) will result in an equal number of Saturdays in most of the natural business years (as well as in the 13-week quarters and in the 4-5 week months). Many companies have a natural business year of January 1 through December 31. On the other hand, some companies are required by government regulations to end their accounting years on December 31, even though it is not the end of their natural business year. The term fiscal year is associated with companies having financial reporting years that do not end on December 31.

Is a postdated check considered to be currency? (pg. 23)

A postdated check—a check with a date that is later than the current date—is not considered to be currency. Further, the postdated check should not be reported as part of the Cash account balance until the date of the check. If the postdated check was received as payment on accounts receivable, the accounts receivable balance is not reduced until the date of the check. To illustrate this, let's assume that on August 20 a company receives a $1,000 postdated check. The check is dated September 5 and represents the full payment on one of the company's accounts receivable. Since the postdated check is not considered to be money until the date of the check, the accounts receivable should not be reduced and cash should not be increased until September 5. Therefore, the company's August 31 balance sheet will report that the customer's $1,000 accounts receivable is still due.

What is a source document? (pg. 17)

A source document is the original record containing the details to substantiate a transaction entered in an accounting system. For example, a company's source document for the recording of merchandise purchased is the supplier's invoice supported by the company's purchase order and receiving ticket. A company's source documents for its weekly payroll are the employees' time cards. A manufacturer's production records will also include source documents such as materials requisition forms. In the past, source documents were printed on paper. Today many of the paper documents are being converted to an electronic format.Source documents should be retained for future reference. For instance, auditors will review a portion of a company's transactions and will need to examine the pertinent source documents.

What is a static budget? (pg. 54)

A static budget is a budget that does not change as volume changes. If a company's annual master budget is a static budget, the budget for sales commissions expense will be one amount such as $200,000 for the year. In other words, in a static budget the budgeted amount for sales commissions expense will remain at $200,000 even if the actual sales during the year are $3 million, $4 million or $5 million. In contrast to a company's static master budget, the company's sales department might have a flexible budget. In the flexible budget, the sales commissions expense budget might be expressed as 5% of sales. In that instance, the department's budget for sales commissions expense will be $200,000 when actual sales are $4 million, but it will decrease to $150,000 when actual sales are $3 million, and the budget will increase to $300,000 when actual sales are $6 million, and so on.

What is a voided check? (pg. 61)

A voided check is a check written or partially written but then canceled or deleted by the maker of the check. The notation of "void" is used because checks are prenumbered for control purposes and every check needs to be accounted for. Voided checks may require some adjustments when reconciling the bank statement. For example, if a check is written in December but is voided in January, the Cash account in the company's general ledger will need to be increased when the check is voided. (Another account will need to be credited because of double entry bookkeeping.)

Where can I find high quality business forms? (pg. 14)

AccountingCoach.com has developed 80 business forms to help you prepare financial statements or to calculate financial ratios, breakeven points, standard costing variances, and more. Each of the 80 forms comes in two formats: blank and filled-in. The business forms are professionally designed to help you learn and save time. You will reduce your frustration by filling in lines instead of staring at a blank sheet of paper.

What is the difference between receivables and accounts receivable? (pg. 60)

Accounts receivable are usually current assets that arise from selling merchandise or providing services to customers on credit. Accounts receivable are also known as trade receivables. Receivables is the term that refers to both trade receivables and nontrade receivables. Nontrade receivables are receivables other than accounts receivable. Some examples of nontrade receivables include interest receivable, income tax receivable, insurance claims receivable, and receivables from employees.

Why are accruals needed every month?

Accrual adjusting entries are needed monthly only if a company issues monthly financial statements. Two reasons for the monthly accrual adjusting entries are: 1. To report the revenues and receivables which were earned during the month, but the transactions had not been recorded in the accounts as of the end of the month, and 2. To record the expenses and liabilities which were incurred during the month, but the transactions had not been recorded in the accounts as of the end of the month. Monthly accrual, deferral, and other adjusting entries must be recorded prior to issuing monthly financial statements in order to comply with the accrual basis of accounting

What are accruals? (pg. 59)

Accruals are adjustments for 1) revenues that have been earned but are not yet recorded in the accounts, and 2) expenses that have been incurred but are not yet recorded in the accounts. The accruals need to be added via adjusting entries so that the financial statements report these amounts. An example of an accrual for revenue involves your electric utility company. The utility used coal and many employees in December to generate electricity that customers received in December. However, the utility doesn't bill the electric customers for the December electricity until the meters are read in January. To have the proper amounts on the utility's financial statements, there needs to be an adjusting entry to increase revenues that were earned in December and the receivables that the utility has a right to as of December 31. An example of an accrual involving an expense is an employee's bonus that was earned in 2008, but will not be paid until 2009. The 2008 financial statements need to reflect the bonus expense and the bonus liability. Therefore, prior to issuing the 2008 financial statements an adjusting entry is prepared to record this accrual.

Where does accrued interest on notes receivable get reported on the balance sheet? (pg. 58)

Accrued interest on notes receivable is likely to be reported as a current asset such as Accrued Interest Receivable or Interest Receivable. The accrued interest receivable is a current asset if the interest amount is expected to be collected within one year of the balance sheet date. I would expect that even a long-term note receivable that is due in five years will require that the interest on the note be paid quarterly, semiannually or annually. Hence the accrued interest will be a current asset. If the interest on the note is not expected to be received within one year of the balance sheet date, then the accrued interest receivable should be reported as a long-term asset.

How do you calculate accrued vacation pay? (pg. 46)

Accrued vacation pay is the amount of vacation pay which has been earned by the employee but has not yet been paid to the employee. To illustrate accrued vacation time and accrued vacation pay let's assume that the employee's contract guarantees 120 hours of paid vacation time per year (40 hour work week times 3 weeks). If the employee's hourly pay rate is $26 per hour, the employee is earning vacation pay of $3,120 per year (120 hours x $26), or $60 per week ($3,120 per year divided by 52 weeks). The company is also incurring vacation pay expense and a liability of $60 per week. In terms of vacation time, the employee is earning 2.31 hours of vacation time each week (120 hours per year divided by 52 weeks per year) or 2.45 hours based on 120 hours divided by the 49 weeks not on vacation. At December 31 the company has a liability for the vacation hours and vacation pay that the employee has earned and is entitled to if the company were to close. If the employee has worked 20 weeks since the employee's anniversary date with the company and the last vacation payment, then the company should report a current liability of $1,200 (20 weeks x $60 per week.)

What is an adjusted trial balance? (pg. 60)

An adjusted trial balance is a listing of all the account titles and balances contained in the general ledger after the adjusting entries for an accounting period have been posted to the accounts. The adjusted trial balance is an internal document and is not a financial statement. The purpose of the adjusted trial balance is to be certain that the total amount of debit balances in the general ledger equals the total amount of credit balances.

If an accrual adjusting entry increases an expense and a liability, how does the balance sheet remain in balance? (pg. 9)

An expense is a temporary account which reduces owner's equity or stockholders' equity. The decrease in owner's equity will offset the increase in the liability account.

How does an expense affect the balance sheet? (pg. 41)

An expense will decrease the amount of assets or increase the amount of liabilities, and will reduce the amount of owner's or stockholders' equity. For example an expense might 1) reduce a company's assets such as Cash, Prepaid Expenses, or Inventory, 2) increase the credit balance in a contra-asset account such as Allowance for Doubtful Accounts or Accumulated Depreciation, 3) increase the balance in the liability account Accounts Payable, or increase the amount of accrued expenses payable such as Wages Payable, Interest Payable, and so on. In addition to the change in the assets or liabilities, an expense will reduce the credit balance in the Owner Capital account of a sole proprietorship, or will reduce the credit balance in the Retained Earnings account of a corporation.

What is an indirect cost? (pg. 63)

An indirect cost is a cost that is not directly traceable to a cost object. Rather, the cost is common to several objects and requires an allocation. For example, the depreciation of the factory building is an indirect cost of manufacturing products. The reason is that the annual cost of the factory building is not directly traceable to a specific unit of product manufactured during the year. The depreciation will be included in manufacturing overhead which is allocated to the units of product manufactured during the year.

What is an intangible asset? (pg. 60)

An intangible asset is an asset that you cannot touch. Examples of intangible assets include copyrights, patents, mailing lists, trademarks, brand names, domain names, and so on. Often the market value of an intangible asset is far greater than the market value of a company's tangible assets such as its buildings and equipment. Accounting principles require that intangible assets be reported on a company's balance sheet at cost or less. Since many intangible assets are not purchased, they may not have a reportable cost. As a result, many valuable intangible assets are not even reported as assets on the company's balance sheet.

What is an invoice? (pg. 58)

An invoice is defined in a Webster's dictionary as "an itemized bill for goods sold or services provided, containing individual prices, the total charge, and the terms." The invoice is often referred to as the sales invoice. However, the purchaser of the goods or services might refer to the invoice received from the vendor or supplier as a purchase invoice.

What is the difference between an invoice and a statement? (pg. 25)

An invoice received from a supplier shows the items purchased, the cost per unit, the total cost or extension of each item, and the total of all the items listed on the invoice. A statement from a supplier lists all of the amounts owed on past invoices as of a specified date. For example, the statement from a supplier might indicate that as of July 31 your company owes for four invoices and a small amount from an earlier invoice. It is possible that the statement amount is not the amount currently owed. For instance, it is possible that on July 30 and on August 3 your company actually paid for two of the invoices listed on the statement. For this reason it is a wise policy to make payments only from invoices and never from statements. This policy will avoid paying twice for an invoice amount.

Why does a bond's price decrease when interest rates increase? (pg. 16)

Bond prices decrease when interest rates increase because the fixed interest and principal payments stated in the bond will become less attractive to investors. Let's illustrate this with a $100,000 bond having a stated interest rate of 9% and having a remaining life of 5 years. This bond will pay $4,500 at the end of each of the 10 remaining semiannual periods plus $100,000 at the end of the bond's life. If an investor's goal is to earn 9%, the investor will pay $100,000 for the bond. However, if the market interest rates increase to 10% the investor will now be able to earn $5,000 semiannually on a $100,000 investment. Obviously, the 9% bond paying only $4,500 semiannually will no longer be salable for $100,000. For an investor to buy the 9% bond in a 10% market, the bond's price will have to drop to an amount that will yield a 10% return over the bond's remaining life. Using our example, the investor will earn 10% only if the 9% bond can be purchased for approximately $96,000. The cash return of $4,500 every six months for five years on the $96,000 investment plus the gain of $4,000 ($100,000 in 5 years versus the investment of $96,000) will result in the required return of 10%. If market interest rates decrease, the value of a bond will increase since the bond's stated fixed interest payments will be greater than the amounts available in new bonds issued at current market interest rates. (However, be aware that a bond's call price can limit the amount of increase in market value.)

Why are bonds payable less costly than common stock? (pg. 56)

Bonds payable are less costly than common stock because the bonds issued by a corporation contain a formal contract to pay the investor a fixed amount of interest every six months and to pay the face or principal amount when the bonds mature. The contract to pay these cash amounts to the investors makes bonds a less risky investment than common stock. Less risk for the investor means the investor will earn a smaller return—and the corporation will have a smaller cost. Some bonds might also provide collateral and some bonds might require that a sinking fund be established to set aside money to pay the bondholders when the bonds come due. These features will further reduce the investor's risk and should further reduce the corporation's cost. Another reason why bonds are less costly than common stock is that the interest paid by the corporation will be deductible on the corporation's income tax return. If a corporation's combined federal and state income tax rate is 35%, then $100,000 of interest expense will save the corporation $35,000 of income taxes. This means that a corporation's ultimate or net cost of a 10% bond is only 6.5%.

What is Construction Work in Progress? (pg. 52)

Construction Work in Progress is a long-term asset account in which the costs of constructing long-term assets are recorded. The account Construction Work in Progress will have a debit balance and will be reported on the balance sheet as part of a company's Property, Plant and Equipment. The costs of a constructed asset are accumulated in the account Construction Work in Progress until the asset is placed into service. When the asset is completed and placed into service, the account Construction Work in Progress will be credited for the accumulated costs of the asset and will be debited to the appropriate Property, Plant and Equipment account. Depreciation begins after the asset has been placed into service.

What is cost allocation? (pg. 62)

Cost allocation is the assigning of a common cost to several cost objects. For example, a company might allocate or assign the cost of an expensive computer system to the three main areas of the company that use the system. A company with only one electric meter might allocate the electricity bill to several departments in the company. Allocation implies that the assigning of the cost is somewhat arbitrary. Some people describe the allocation as the spreading of cost, because of the arbitrary nature of the allocation. Efforts have been made over the years to improve the bases for allocation. In manufacturing, the overhead allocations have moved from plant-wide rates to departmental rates, from direct labor hours to machine hours to activity based costing. The goal is to allocate or assign the costs based on the root causes of the common costs instead of merely spreading the costs.

When should costs be expensed and when should costs be capitalized? (pg. 24)

Costs should be expensed when they are used up or have expired and when they have no future economic value which can be measured. For example, the August salaries of a company's marketing team should be charged to expense in August since the future economic value of their August salaries cannot be determined. Costs should be capitalized or recorded as assets when the costs have not expired and they have future economic value. For example, on November 25 a company pays $12,000 for property insurance covering the six months of December through May. The $12,000 is initially recorded as the current asset Prepaid Insurance. On November 30 the company will report this asset at $12,000 since the $12,000 has a future economic value. (It will save making future payments of cash for insurance coverage.) On December 31 the asset will be reported as $10,000—the unexpired cost. It will also report Insurance Expense for the month of December as $2,000—the cost that has expired during December. On January 31 the asset will be reported at the unexpired cost of $8,000. January's insurance expense will be $2,000—the amount that has expired during January. For personal use by the original purchaser only. Copyright © 2010 AccountingCoach.com. 24

Why are debt issue costs classified as an asset? (pg. 37)

Debt issue costs are classified as assets because of the matching principle. The idea is to match the cost of issuing debt to the periods that benefit from the debt. For example, if a corporation incurs $500,000 of issue costs associated with its 10 year bonds, it should expense $50,000 per year ($500,000 divided by 10 years). To achieve the matching principle, the corporation must initially defer the issue costs. Deferred expenses or deferred costs or prepaid costs are reported as assets on the balance sheet. In the bond example above, at the time that the corporation pays for its bond issue costs, it will debit Deferred Issue Costs for $500,000 and will credit Cash for $500,000. Then in each of the 10 years of the bond's life it will credit Deferred Issue Costs for $50,000 and will debit Bond Issue Costs Expense for $50,000. If the amount of the bond issue costs is not significant, the materiality concept allows the corporation to expense the entire amount of issue costs at the time that the bonds are issued.

What is depletion? (pg. 63)

Depletion is the movement of the cost of natural resources from a company's balance sheet to its income statements. The objective is to match on the income statement the cost of the natural resources that were sold with the revenues of the natural resources that were sold. The cost of the natural resources sold is referred to as depletion expense. Conceptually, depletion is similar to the depreciation of property, plant and equipment.

Is depreciation a direct or indirect cost? (pg. 57)

Depreciation can be either a direct cost or an indirect cost, or it can be both direct and indirect. Let's illustrate this with the depreciation of a machine used in Department 23 of a manufacturer. The depreciation on that machine is a direct cost for Department 23. It is direct because it is traceable to Department 23 without any allocation. The depreciation of this same machine will be an indirect cost of the products manufactured with that machine. It is indirect because the depreciation is allocated to the products. Perhaps the machine in Department 23 has depreciation of $50,000 per year (cost of machine of $500,000 divided by 10 years of useful life). The $50,000 of annual depreciation is then assigned or allocated to products based on the number of hours that products use the machine. For example, if the manufacture expects 20,000 machine hours of use in the current year, then it assigns or allocates $2.50 ($50,000/20,000) per machine hour to each product using the machine. If Product #189 requires one hour of this machine's time, Product #189 will have $2.50 as part of its indirect costs. Indirect manufacturing costs are also referred to as manufacturing overhead, factory overhead, or burden.

What is EOQ? (pg. 24)

EOQ is the acronym for economic order quantity. The economic order quantity is the optimum quantity of goods to be purchased at one time in order to minimize the annual total costs of ordering and carrying or holding items in inventory. EOQ is also referred to as the optimum lot size. The formula to calculate the economic order quantity is the square root of [(2 times the annual demand in units times the incremental cost to process an order) divided by (the incremental annual cost per unit to carry an item in inventory)].

What is FIFO? (pg. 66)

FIFO is the acronym for First In, First Out. FIFO is a cost flow assumption often used to remove costs from the Inventory account when an item in inventory had been purchased at varying costs. Under FIFO, the oldest cost of an item in inventory will be removed first when one of those items is sold. This oldest cost will then be reported on the income statement as part of the cost of goods sold. FIFO also means that the more recent costs of an item will remain in the Inventory account and will be reported on the balance sheet.

What is the difference between financial accounting and management accounting? (pg. 9)

Financial accounting has its focus on the financial statements which are distributed to stockholders, lenders, financial analysts, and others outside of the company. Courses in financial accounting cover the generally accepted accounting principles which must be followed when reporting the results of a corporation's past transactions on its balance sheet, income statement, statement of cash flows, and statement of changes in stockholders' equity. Managerial accounting has its focus on providing information within the company so that its management can operate the company more effectively. Managerial accounting and cost accounting also provide instructions on computing the cost of products at a manufacturing enterprise. These costs will then be used in the external financial statements. In addition to cost systems for manufacturers, courses in managerial accounting will include topics such as cost behavior, break-even point, profit planning, operational budgeting, capital budgeting, relevant costs for decision making, activity based costing, and standard costing.

What is financial leverage? (pg. 59)

Financial leverage refers to the use of debt to acquire additional assets. Financial leverage is also known as trading on equity. Below are two examples to illustrate the use of financial leverage, or simply leverage. Mary uses $400,000 of her cash to purchase 40 acres of land with a total cost of $400,000. Mary is not using financial leverage. Sue uses $400,000 of her cash and borrows $800,000 to purchase 120 acres of land having a total cost of $1,200,000. Sue is using financial leverage. Sue is controlling $1,200,000 of land with only $400,000 of her own money. If the properties owned by Mary and Sue increase in value by 25% and are then sold, Mary will have a $100,000 gain on her $400,000 investment, a 25% return. Sue's land will sell for $1,500,000 and will result in a gain of $300,000. Sue's $300,000 gain on her $400,000 investment results in Sue having a 75% return. When assets increase in value leverage works well. When assets decline in value the use of leverage works against you. Let's assume that the properties owned by Mary and Sue decrease in value by 10% from their cost and are then sold. Mary will have a loss of $40,000 on her $400,000 investment—a loss of 10% on Mary's investment. Sue will have a loss of $120,000 ($1,200,000 X 10%) on her $400,000 investment. This is a loss of 30% ($120,000 divided by $400,000) on Sue's investment.

What is the difference between a note payable and a bond payable? (pg. 34)

For accounting purposes, a note payable and a bond payable are similar. That is, both are 1) written promises to pay interest and to repay the principal amount or maturity amount on specified future dates, 2) both are reported as liabilities, and 3) interest is accrued as a current liability. If the bond or the note has its principal or maturity due within one year of the balance sheet date and the payment will cause a reduction in working capital, the bond or note will be reported as a current liability. If the bond or note will not be due within one year of the balance sheet date or if the maturity date is within one year but will not cause a reduction in working capital when it becomes due, it will be reported as a long-term liability. (For example, there may be a bond sinking fund or a formal agreement for refinancing the debt with new long-term debt or stock.) Outside of accounting, I am certain there are differences. For example, debt with an original maturity date of less than a year is likely to be a note. However, some notes can be longer than one year. Government debt securities might be bills, notes, or bonds depending on the original maturity date of the debt security. Perhaps some notes do not specify interest.

What is GAAP? (pg. 21)

GAAP is the acronym for generally accepted accounting principles. In the U.S. that means 1) the basic accounting principles and guidelines such as the cost principle, matching principle, full disclosure, etc., 2) the detailed standards and other rules issued by the Financial Accounting Standards Board (FASB) and its predecessor the Accounting Principles Board, and 3) generally accepted industry practices. GAAP must be adhered to when a company distributes its financial statements outside of the company. If a corporation's stock is publicly traded, the financial statements must also adhere to rules established by the U.S. Securities and Exchange Commission (SEC). This includes having its financial statements audited by an independent CPA firm.

Can I capitalize this year's R&D? (pg. 17)

Generally, R&D costs cannot be capitalized for U.S. financial statements according to the Statement of Financial Accounting Standards No. 2, Accounting for Research and Development Costs. The original pronouncement can be viewed at www.FASB.org. We are not able to address the second part of your question, which involved the R&D costs on the income tax returns. You will need to ask an income tax adviser or do a search on www.IRS.gov regarding the capitalization of R&D costs for income tax purposes.

What is retained earnings? (pg. 61)

Generally, retained earnings is a corporation's cumulative earnings since the corporation was formed minus the dividends it has declared since it began. In other words, retained earnings represents the corporation's cumulative earnings that have not been distributed to its stockholders. The amount of retained earnings as of a balance sheet's date is reported as a separate line item in the stockholders' equity section of the balance sheet. A negative amount of retained earnings is reported as deficit or accumulated deficit.

Why do purchases appear as expenses on an income statement? (pg. 28)

Generally, the purchases of merchandise are sold in the year they are acquired. Hence, it is logical to match the current period's purchases as expenses on the same income statement that reports the current period's sales revenues. If some of the purchases are not sold in the same period, there will be a change in inventory. An increase in the amount of inventory will appear on the income statement as a deduction to the current period's purchases. It is a deduction because some of the costs of the current period's purchases are not associated with the sales shown on the income statement. The deduction is reporting that some of the costs of purchases are being deferred to a later period when they will be sold. The deduction is necessary in order to achieve the matching principle: matching the proper amount of the costs of the goods sold with the sales revenues of the accounting period. A decrease in the amount of inventory will appear on the income statement as an addition to the cost of the purchases. This recognizes that some of the sales included some costs of purchases that were made in an earlier accounting period.

What is historical cost? (pg. 62)

Historical cost is a term used instead of the term cost. Cost and historical cost usually mean the original cost at the time of a transaction. The term historical cost helps to distinguish an asset's original cost from its replacement cost, current cost, or inflation-adjusted cost. For example, land purchased in 1992 at cost of $80,000 and still owned by the buyer will be reported on the buyer's balance sheet at its cost or historical cost of $80,000 even though its current cost, replacement cost, and inflation-adjusted cost is much higher today. The cost principle or historical cost principle states that an asset should be reported at its cost (cash or cash equivalent amount) at the time of the exchange transaction and should include all costs necessary to get the asset in place and ready for use.

What is the difference in salaries between a bookkeeper and an accountant? (pg. 30)

I estimate that a bookkeeper's salary will be less than half of an accountant's salary. For example, an accountant with a year or two of experience might earn $60,000 per year while a bookkeeper will earn less than $30,000 per year. More experienced accountants will be able to earn higher salaries but bookkeepers will not see significant salary increases. Some explanations for the salary differences are listed below. Generally, a bookkeeper's formal education will be less than a four-year college degree. Accountants generally have a 120 or 150 credit college degree including at least 30 credits of accounting courses plus 30 credits of other business courses. A bookkeeper is likely to be employed at a smaller company or organization and will process a large volume of routine transactions. An accountant is likely to be employed at a larger company and will be able to delegate the processing of the high-volume routine transactions to accounting clerks. In turn, the accountant will deal with more complicated transactions, will review the financial statements, and will assist management in the planning and control of the organization.

What is a deferred cost? (pg. 20)

I use the term deferred cost to mean a cost that has been incurred (and often already paid for) but will not appear as an expense on the income statement until a later accounting period. In the meantime, the deferred cost will be reported as an asset on the balance sheet. The justification for deferring an expense until a later accounting period is likely tied to the matching principle. A common example of a payment that is deferred for less than a year is a payment for a one-year insurance premium. The unexpired portion of the cost will be reported as a prepaid expense in the current asset section of the balance sheet. A payment that is deferred for more than one year is often reported in the long-term asset section as a Deferred Charge. For example, the payments for professional services necessary for issuing a long-term bond will likely be deferred in the balance sheet account Bond Issue Costs. Over the life of the bond this deferred cost will be amortized to expense—thereby matching these costs to the periods that the bond is outstanding. Some interest expense incurred during the self-construction of a plant asset might be deferred. This is achieved by including it as part of the cost of the asset and then expensing it as part of the depreciation expense. This is referred to as the capitalization of interest.

Are fixed assets the same as plant assets? (pg. 44)

I use the term fixed assets to mean the same as plant assets. In other words, I believe that both fixed assets and plant assets refer to the assets reported on the balance sheet as Property, Plant and Equipment.

What is solvency? (pg. 53)

I use the term solvency to mean 1) that a company is able to pay its obligations when they come due and 2) that a company is able to continue in business. Some people look to a company's working capital in deciding whether a company is solvent. They conclude that a company with a positive amount of working capital is solvent. In other words, a company that is solvent has more current assets than it has current liabilities. Stated another way a company that is solvent will have a current ratio that is greater than 1:1. Others look at a company's total assets and total liabilities in deciding whether a company is solvent. They might conclude that if a company's total assets are greater than its total liabilities, the company is solvent. I suspect that the definition of solvency varies among people in the same country and from country to country. You should check the legal system in your country to find the appropriate meaning.

What is the difference between a differential cost and an incremental cost? (pg. 36)

I use the terms differential cost and incremental cost interchangeably. In other words, I believe the terms mean the same thing: the difference in cost between two alternatives. For example, if a company determined that the annual cost of operating at 80,000 machine hours was $4,000,000 while the annual cost of operating at 70,000 machine hours was $3,800,000, then the differential cost or incremental cost of the additional 10,000 machine hours was $200,000. The term marginal cost refers to the cost of operating for one additional machine hour.

What is the difference between accounts payable and accrued expenses payable? (pg. 39)

I would use the liability account Accounts Payable for suppliers' invoices that have been received and must be paid. As a result, the balance in Accounts Payable is likely to be a precise amount that agrees with supporting documents such as invoices, agreements, etc. I would use the liability account Accrued Expenses Payable for the accrual type adjusting entries made at the end of the accounting period for items such as utilities, interest, wages, and so on. The balance in the Accrued Expenses Payable should be the total of the expenses that were incurred as of the date of the balance sheet, but were not entered into the accounts because an invoice has not been received or the payroll for the hourly wages has not yet been processed, etc. The amounts recorded in Accrued Expenses Payable will often be estimated amounts supported by logical calculations.

What is IFRS? (pg. 17)

IFRS is the acronym for International Financial Reporting Standards. IFRS is used throughout the world except in the United States where U.S. GAAP (generally accepted accounting principles) is followed. There is an urgency for the U.S. to adopt the IFRS because of the growth in global financial markets, global commerce, acquisition of U.S. companies by corporations outside of the U.S., multinational corporations having subsidiaries both inside and outside of the U.S., and so on. Since financial statements report two or three years of amounts, the amounts from earlier years will need to follow IFRS in order to be comparative. Efforts are also under way for a simplified version of IFRS that would apply for small and medium sized privately held corporations.

Where do I record the refund of a registration fee? (pg. 42)

If the registration fee refers to a fee expense that you had originally paid but the amount is now being refunded to you, I would credit the same expense account that you had originally charged or debited, and would debit Cash. If the registration fee refers to an amount you are refunding because someone had originally registered for one of your programs, I would 1) credit Cash for the amount you are paying out as the refund, and 2) debit a contra-revenue account such as Refunds of Registration Fee Revenues. This will allow you to easily track the total amounts of refunds that you make during a year. On the other hand, if it is rare for your organization to refund registration fees, you could simply 1) debit the amount you are refunding to the normal revenue account such as Registration Fee Revenues, and 2) credit Cash.

What is the entry when merchandise has been received but not the vendor's invoice? (pg. 46)

If you received merchandise, but have not received the vendor's invoice by the end of the accounting period, you need to 1) debit Purchases (periodic method) or debit Inventory (perpetual method) for the cost of the goods or merchandise received, and 2) credit Accounts Payable. You also need to include the merchandise in your physical inventory. When the vendor's invoice is received and processed, be sure to reverse (remove) the above entry.

What is accounting for price level changes? (pg. 15)

In 1979 the Financial Accounting Standards Board (FASB) issued its Statement of Financial Accounting Standards No. 33 entitled Financial Reporting and Changing Prices. (You will find the original Statement No. 33 on www.FASB.org.) In short, Statement No. 33 required large companies to report supplementary information on the effects of changing prices on its inventory and its property, plant and equipment. (In the late 1970's the U.S. was experiencing double-digit inflation rates and the SEC was advocating the reporting of replacement cost.) One disclosure required by Statement 33 was the reporting of the effects of general inflation as indicated by the change in the consumer price index. In other words, a large company had to disclose in the notes to its financial statements some key amounts after adjusting inventory and property, plant and equipment amounts for the changes in the purchasing power of the U.S. dollar. The second disclosure reported the effects of the changes in the specific prices of inventory and property, plant and equipment. In 1986 the FASB issued its Statement No. 89 which no longer required the reporting of the information. As a result, most companies stopped the calculations and reporting. Two of the factors in deciding to stop the calculations was the lack of use by financial analysts and a decline in the rates of inflation in the U.S. In other words, the accounting for price level changes failed to pass the cost/benefit test.

What is the meaning of aging? (pg. 23)

In accounting the term aging is often associated with a company's accounts receivable. Accounts receivable arise when a company provides goods or services on credit. For example, a company may allow its customers to pay for goods or services 30 days after they are delivered. If customers do not pay as agreed, the company could experience a cash problem. In order for the company to minimize its cash flow problems and potential losses from customers who are unable to pay, companies will routinely prepare an aging of accounts receivable. The aging report will list each customer's outstanding balance and will then sort the total amount into columns such as: Current, 1-30 days past due, 31-60 days past due, 61-90 days past due, 91-120 days past due, and 120+ days past due. The aging of accounts receivable allows managers to quickly see which customers are behind in meeting the agreed upon terms. An aging is usually a standard feature of accounting software. Some companies also do an aging of accounts payable. This aging sorts the accounts payable amounts by due dates.

What is stock? (pg. 31)

In accounting there are two common uses of the term stock. One meaning of stock refers to the goods on hand which is to be sold to customers. In that situation, stock means inventory. The term stock is also used to mean the ownership shares of a corporation. For example, an owner of a corporation will have a stock certificate which provides evidence of his or her ownership of a corporation's common stock or preferred stock. The owner of the corporation's common or preferred stock is known as a stockholder.

What is variance analysis? (pg. 51)

In accounting, a variance is the difference between an expected or planned amount and an actual amount. For example, a variance can occur for items contained in a department's expense report. Variance analysis attempts to identify and explain the reasons for the difference between a budgeted amount and an actual amount. Variance analysis is usually associated with a manufacturer's product costs. In this setting, variance analysis attempts to identify the causes of the differences between a manufacturer's 1) standard costs of the inputs that should have occurred for the actual products it manufactured, and 2) the actual costs of the inputs used for the actual products manufactured. To illustrate, let's assume that a company manufactured 10,000 units of product (output). The company's standards indicate that it should have used $40,000 of materials (an input), but it actually used $48,000 of materials. This unfavorable variance needs to be analyzed. A common variance analysis will divide the $8,000 into a price variance and a quantity variance. The price variance identifies whether the company paid too much for each unit of input—perhaps it paid more per pound of the input than it had planned. The quantity variance identifies whether the company used too much of the input—perhaps it used too many pounds of the raw materials for the number of products it manufactured. Variance analysis for manufacturing overhead costs is more complicated than the variance analysis for materials. However, the variance analysis of manufacturing overhead costs is very important as manufacturing overhead costs have become a very large percentage of a product's costs.

What is materiality? (pg. 64)

In accounting, the concept of materiality allows you to violate another accounting principle if the amount is so small that the reader of the financial statements will not be misled. A classic example of the materiality concept or the materiality principle is the immediate expensing of a $10 wastebasket that has a useful life of 10 years. The matching principle directs you to record the wastebasket as an asset and then depreciate its cost over its useful life of 10 years. The materiality principle allows you to expense the entire $10 in the year it is acquired instead of recording depreciation expense of $1 per year for 10 years. The reason is that no investor, creditor, or other interested party would be misled by not depreciating the wastebasket over a 10-year period. Determining what is a material or significant amount can require professional judgment. For example, $5,000 might be immaterial for a large, profitable corporation, but it will be material or significant for a small company that has very little profit.

What is a credit? (pg. 52)

In bookkeeping and accounting, a credit could refer to the entry on the right side of a T-account. A credit could also be a verb that means the act of recording an amount on the right side of a Taccount. A credit entry in an asset account will reduce the account's usual debit entry. A credit entry in a revenue, liability, or owner's equity account will increase the usual credit balance. A credit could also mean your bank has increased your bank account balance. Your bank account is a liability for your bank and when your bank account increases, your bank has a larger obligation to you. Credit can also refer to loans, such as line of credit, letter of credit, credit rating, as so on.

What is disinvestment? (pg. 29)

In business, disinvestment means to sell off certain assets such as a manufacturing plant, a division or subsidiary, or product line. Disinvestment is sometimes described as the opposite of capital expenditures. Some people use the term divestiture, or to divest when discussing disinvestment. For example, an electric generator manufacturer might sell off its consumer generator product lines and manufacturing facilities in order to raise money that can be used to expand its industrial generator product line. Another example is a consumer products company selling off a profitable division that no longer meets its long range goals. The proceeds from this disinvestment are then used to improve the company's financial position by reducing its debt.

What do overabsorbed and underabsorbed mean? (pg. 49)

In cost accounting, manufacturing overhead costs are often assigned to products by using a predetermined overhead rate. The predetermined rate is likely based on an annual manufacturing overhead budget divided by some activity such as the expected number of machine hours. Instead of saying that the manufacturing overhead is assigned, we might say it is allocated, applied or apportioned to the products manufactured during the period. We could also say that the products have absorbed the overhead. If the amount of overhead assigned to the products manufactured is greater than the amount of overhead actually incurred, the products have overabsorbed the overhead costs. If the amount of overhead assigned to the products is less than the amount of overhead actually incurred, the products have underabsorbed the overhead costs. The cause of the overabsorption or underabsorption will be some combination of 1) the quantity of products manufactured, and 2) the actual overhead costs incurred.The amounts of the overabsorbed and underabsorbed manufacturing overhead are referred to as variances.

What are sales taxes? (pg. 28)

In the United States, most of its 50 States assess a sales tax, which is a tax on sales to the end user. For example, in the state of Wisconsin a retailer must collect a 5% sales tax and perhaps another 0.5% for a county sales tax on specified goods and services. The retailer must remit the sales taxes collected within a prescribed time period.The items subject to sales tax will vary from state to state. In some states basic food items might not be taxed, but meals at restaurants will be subject to sales tax. Some services might be subject to a sales tax. Sales of raw materials to a manufacturer will be exempt if the materials will be used in products that will be manufactured and sold. When the products are sold by the manufacturer to a retailer for resale, the manufacturer will be also be exempt from collecting a sales tax. Sales by retailer to an end consumer will require the collection of sales taxes. Sales tax can be viewed as a tax on consumption. In accounting, the sales taxes collected by the seller of the goods or services are not revenues for the seller. For example, if a merchant sells an item for $100 and the item is subject to a 5% sales tax, the merchant will debit Cash for $105 and will credit Sales for $100 and will credit Sales Tax Payable for $5. Sales Tax Payable is a liability account. When the sales taxes are remitted to the state, the merchant will debit Sales Tax Payable.

What is interest expense? (pg. 53)

Interest expense is the cost of debt that has occurred during a specified period of time. To illustrate interest expense under the accrual method of accounting, let's assume that a company borrows $100,000 on December 15 and agrees to pay the interest on the 15th of each month beginning on January 15. The loan states that the interest is 1% per month on the loan balance. The interest expense for the month of December will be approximately $500 ($100,000 x 1% x 1/2 month). The interest expense for the month of January will be $1,000 ($100,000 x 1%). Since interest on debt is not paid daily, a company must record an adjusting entry to accrue interest expense and to report interest payable. Using our example above, at December 31 no interest was yet paid on the loan that began on December 15. However, the company did incur one-half month of interest expense. Therefore, the company needs to record an adjusting entry that debits Interest Expense $500, and credits Interest Payable for $500.

Why isn't land depreciated? (pg. 13)

Land is not depreciated because land is assumed to have an unlimited useful life. Other long-lived assets such as land improvements, buildings, furnishings, equipment, etc. have limited useful lives. Therefore, the costs of those assets must be allocated to those limited accounting periods. Since land's life is not limited, there is no need to allocate the cost of land to any accounting periods.

What is the entry for an employee's personal phone calls included in the company's bill? (pg. 45)

Let's assume that an employee has made personal phone calls of $20 which are included in the company's phone bill of $100. Below are two options for recording the cost of the employee's personal phone calls. If the employee is paying (reimbursing) the company immediately, you can record the entire phone bill with a debit of $100 to the company's account Telephone Expense. You will also credit Telephone Expense for $20 when you record the $20 receipt from the employee. If the employee is not paying the company immediately, you can record the $100 phone bill by debiting Telephone Expense for $80 and debiting the asset account Receivable from Employees for $20. When you receive the $20 from the employee, you will credit the account Receivable from Employees.

What is the discounted value of expected net receipts? (pg. 48)

Let's first define expected net receipts. These are future receipts after deducting any related payments. For example, if you are likely to receive $1,200 one year from today, but will have to pay a fee of $200 at the time of the receipts, the expected net receipts will be $1,000. Often we need to know the present value of amounts expected in the future. We calculate the present value by discounting the future amounts. In this situation discounting means 1) removing a specified amount of interest, or 2) adjusting for the time value of money. The concept is that receiving $1,000 in the future is less valuable than receiving $1,000 today. If we assume that the time value of money is 10% per year, a net receipt of $1,000 one year from today will have a present value of $909. In other words, we discounted the future value of $1,000 by $91. With a time value of money of 10%, the $909 can be invested today and will grow by $91 ($909 x 10%) to be $1,000 in one year. Receiving a net amount of $1,000 in two years will have a present value of only $826. The reason is that $826 invested today at a compounded rate of 10% will grow to $1,000 in two years. If all amounts are certain, you will be in the same position whether you have $826 today or you receive $1,000 in two years.

What is the amortization of premium on bonds payable? (pg. 55)

Let's use the following example to illustrate the amortization of premium on bonds payable: A corporation issues bonds having a face value of $1,000,000 and receives a premium of $60,000. The bond premium occurred because the bonds' stated interest rate was slightly greater than the interest rate required by the investors in the bond market. The corporation records the bonds as follows: debit Cash for $1,060,000; credit Bonds Payable for $1,000,000; credit Premium on Bonds Payable for $60,000. The Premium on Bonds Payable is a liability account that must be reduced to $0 by the time the bonds mature. Reducing the Premium on Bonds Payable each period by a logical amount is called amortizing the premium on bonds payable or amortizing the bond premium. Since the premium of $60,000 is related to the interest rates when the bonds were issued, the amortization of the premium involves the account Interest Expense. If we assume that the bonds will mature 20 years after they were issued, then each year the corporation will make this entry: debit Premium on Bonds Payable $3,000 and credit Interest Expense $3,000. As you can see, the $60,000 difference between the $1,060,000 it received and the $1,000,000 it must repay is reported as a reduction of interest expense over the life of the bonds. Reducing the balance in the account Premium on Bonds Payable by the same amount each period is known as the straight line method of amortization. A more precise method, the effective interest rate method of amortization, is preferred when the amount of the premium is a very large amount.

What is liquidity? (pg. 54)

Liquidity refers to a company's ability to pay its bills from cash or from assets that can be turned into cash very quickly. The quick ratio, also known as the acid-test ratio, is an indicator of a company's liquidity.

What are the top accounting schools? (pg. 32)

Many colleges and universities use their former students' pass rates from earlier CPA Exams as an indicator of being a top accounting school. I recommend that you expand the criteria for finding the accounting school that is best for you. I recommend that you consider a college that 1) is accredited by an organization such as AACSB 2) has admissions criteria that you can meet 3) is staffed by professional instructors with a passion for teaching 4) has student organizations in accounting and other areas that will allow you to gain leadership and other skills 5) has a vibrant campus placement or career services office with a track record of placing accounting students in the professional positions that you seek. Here's my point. What if many of the top performers on the CPA Exam graduated from universities that are not located near your residence and those universities have extremely high admissions standards? What if those universities allow only a small percentage of its students to enroll in the intermediate and advanced accounting courses and those courses have very strict grading standards? I suspect that the graduates of these programs will have outstanding results on the CPA Exam. Those schools can be labeled as "top" but those schools might not be what's best for you. Hence, my suggestion that you look at additional criteria. To help you identify a college accounting program that is appropriate for you, we recently expanded the AccountingCoach.com website to include an Accounting Career Center. There you will find more details on selecting a college for studying accounting, direct links to the accounting departments at 700 colleges and universities in the U.S., information on the CPA Exam, a discussion of accounting jobs and opportunities, and more.

What is the margin of safety? (pg. 63)

Margin of safety is used in break-even analysis to indicate the amount of sales that are above the break-even point. In other words, the margin of safety indicates the amount by which a company's sales could decrease before the company will become unprofitable.

What is marginal cost? (pg. 54)

Marginal cost is the cost of the next unit or one additional unit of volume or output. To illustrate marginal cost let's assume that the total cost of producing 10,000 units is $50,000. If you produce a total of 10,001 units the total cost is $50,002. That would mean the marginal cost—the cost of producing the next unit—was $2. The reason that the marginal cost was $2 instead of the previous average cost of $5 ($50,000 divided by 10,000 units) is that some costs did not increase when the additional unit was produced. For example, fixed costs such as salaries, depreciation, property taxes generally do not increase when one additional unit is produced.

Why would a company use double-declining depreciation on its financial statements? (pg. 12)

Most companies will not use the double-declining balance method of depreciation on their financial statements. The reason is that it causes the company's net income in the early years of an asset's life to be lower than it would be under the straight-line method. One reason for using double-declining balance depreciation on the financial statements is to have a consistent combination of depreciation expense and repairs and maintenance expense during the life of the asset. In other words, in the early years of the asset's life, when the repairs and maintenance expenses are low, the depreciation expense will be high. In the later years of the asset's life, when the repairs and maintenance expenses are high, the depreciation expense will be low. While this seems logical, the company will end up reporting lower net income in the early years of the asset's life (as compared to the use of straight-line depreciation). Most managers will not accept reporting lower net income sooner than required.

What does NOI stand for? (pg. 67)

NOI is the acronym for net operating income. Net operating income is also referred to as income from operations. NOI excludes discontinued operations, extraordinary items, and nonoperating (or other) items such as interest expense, interest revenues, gains, and losses.

Will every transaction affect an income statement account and a balance sheet account? (pg. 26)

No. Some transactions affect only balance sheet accounts. For example, when a company pays a supplier for goods previously purchased with terms of net 30 days, the payment will be recorded as a debit to the liability account Accounts Payable and as a credit to the asset account Cash. (No revenue account or expense account is involved.) Another example of a transaction affecting two balance sheet accounts and no income statement account is a deposit for future services. The payer will debit the asset Prepaid Expenses and will credit the asset Cash. The company receiving the payment will debit Cash and will credit a liability account such as Customer Deposits, Unearned Revenues, or Deferred Revenues. Adjusting entries are a classification of accounting entries that will affect a balance sheet account and an income statement account.

Why use normal costing instead of actual costing? (pg. 40)

Normal costing uses a predetermined annual overhead rate to assign manufacturing overhead to products. In other words, the overhead rate under normal costing is based on the expected overhead costs for the entire accounting year and the expected production volume for the entire year. Under actual costing each month's actual costs and each month's actual production volume are used to assign overhead costs. Since most companies will experience month to month fluctuations in activity, the actual monthly overhead rates will likely vary from month to month. Normal costing will result in an overhead rate that is more uniform and realistic for all of the units manufactured during an accounting year.

What is not sufficient funds? (pg. 30)

Not sufficient funds or NSF is the term used to describe a check that has been returned by the bank on which it was drawn because the checking account balance was less than the amount of the check. A check noted as not sufficient funds, NSF, or insufficient funds is also referred to as a returned check, a return item, a check that bounced, or as a rubber check since it was bounced back to the payee by the bank on which the check was drawn. Checks returned as not sufficient funds usually result in bank charges for both the payee and for the person writing the check. A check returned as not sufficient funds could be an indication that the financial condition of the maker of the check had declined. This could signal a potential credit loss if the maker of the check is a customer to which you extend credit terms on its purchases.

What is an account? (pg. 31)

One definition of an account is a record in the general ledger that is used to collect and store debit and credit amounts. For example, a company will have a Cash account in which every transaction involving cash is recorded. If the company sells merchandise for cash, the Cash account will be debited and the Sales account will be credited. Another definition of an account is a record of a customer relationship. For example, if a company sells merchandise to a customer on credit, there seller will have an account receivable and the purchaser will have an account payable. The term on account means not for cash. For example, if a company purchases merchandise with the terms net 30 days, it means the company has 30 days in which to pay.

What is the meaning of pro rata? (pg. 9)

Pro rata is a Latin term that means in proportion. Pro rata is related to prorate, a term used in cost accounting. To illustrate the term pro rata, let's assume that a company's standard costing system has an unfavorable materials price variance of $400,000. If that amount is significant, the company will prorate the $400,000 to its inventory and to its cost of goods sold. Let's also assume that the proration will be based on the company's $1 million of standard materials costs in its inventories and $9 million of standard materials costs in its cost of goods sold. On this basis the inventories' pro rata share of the variance will be $40,000 ($1 million divided by the total of $10 million = 10% times the $400,000 variance). The pro rata share of the variance assigned to the cost of goods sold will be $360,000 ($9 million divided by $10 million = 90% times the $400,000 variance).

What is process costing? (pg. 36)

Process costing is a term used in cost accounting to describe one method for collecting and assigning manufacturing costs to the units produced. Processing cost is used when nearly identical units are mass produced. (Job costing or job order costing is a method used when the units manufactured vary significantly from one another.) To illustrate process costing, let's assume that a product requires several processing operations— each of which occurs in a separate department. The costs of Department One for the month of June amount to $150,000 of direct materials and $225,000 of conversion costs (direct labor and manufacturing overhead). If the number of units processed in June in Department One is the equivalent of 100,000 units, the per unit cost of the products processed in Department One in June will be $1.50 for direct materials and $2.25 for conversion costs. These costs will then be transferred to Department Two and its processing costs will be added to the cost of the units.

How do I record a loan payment which includes paying both interest and principal? (pg. 61)

Recording a loan payment which contains both interest and principal payments will involve a debit to Interest Expense, a debit to Loan Payable, and a credit to Cash. The credit balance in your liability account Loan Payable should agree with the principal balance on your lender's records. You can confirm that your balance in Loan Payable is correct by comparing it to the loan balance shown on the loan statement furnished by your lender. If such a statement is not provided, you can phone your lender and ask for the principal balance on your loan.

Are repairs to office equipment and factory equipment period costs? (pg. 12)

Repairs to office equipment are period costs. That is, the cost of the repairs to office equipment will be reported as a selling, general and administrative (SG&A) expense in the period in which the repairs take place. Repairs to factory equipment are not period costs. Rather, the costs of repairs to factory equipment are product costs. The repair costs within the factory are part of the factory overhead (also known as manufacturing overhead) which is assigned to the products when they are manufactured. When those products are sold, the costs of the products (raw materials, direct labor, and factory overhead) will be expensed as the cost of goods sold. Until the products are sold, the products' costs will be reported as the current asset Inventory.

Are salaries and wages part of expenses on the income statement? (pg. 38)

Salaries and wages of the current accounting period are reported as expenses on a service company's current income statement. Salaries and wages of a manufacturer are more complicated. The salaries and wages of people in the administrative and selling functions are reported as expenses on the current income statement. However, the salaries and wages of people in the production departments are assigned to the products manufactured. When the products are sold, their production costs (including the manufacturing salaries and wages) will appear on the income statement as part of the cost of goods sold. The products not sold are reported as inventory on the balance sheet at their production costs (including the manufacturing salaries and wages).

Are commissions a cost of goods sold account or an expense? (pg. 32)

Sales commissions are a selling expense. Selling expenses are reported on the income statement as part of the operating expenses. Often the operating expenses will appear as selling, general and administrative expenses or SG&A. Sales commissions are not part of the cost of a product and therefore are not assigned to the cost of goods held in inventory or to the cost of goods sold.

Are sales discounts reported as an expense? (pg. 24)

Sales discounts are not reported as an expense. Rather, sales discounts are reported as a reduction of gross sales. In other words, Sales or Gross Sales minus Sales Discounts and Sales Returns and Sales Allowances = Net Sales.

What is the entry when a contract is signed? (pg. 52)

Signing a contract will not require a journal entry unless cash, a promissory note, or another asset is exchanged at the time. Signing a contract causes a commitment but does not necessarily create a liability or asset at the time of signing. For example, an electric utility may sign a contract with a coal producer for 100 million tons of coal to be delivered over a one-year period beginning in three months. On the day the two parties sign the contract, the electric utility does not own any of the coal specified in the contract and does not have a liability to the coal producer. Likewise, on the day of signing the contract, the coal producer does not have a sale of any of the coal specified in the contract nor does it have an account receivable from the electric utility. In three months, when the first trainload of coal arrives at the electric utility, the utility will record the purchase of that trainload of coal and the related account payable to the producer. Also at that time, the coal producer will record the sale of that trainload of coal and an account receivable.

Is Accounts Payable a debit or a credit or both? (pg. 11)

Since Accounts Payable is a liability account, it should have a credit balance. The credit balance indicates the amount that company or organization owes to its suppliers or vendors. The Accounts Payable account is credited when goods or services are purchased on credit terms (as opposed to being purchased for cash). Accounts Payable is debited when a payment is made to a supplier or vendor. Stated another way, a credit to Accounts Payable will increase the balance in Accounts Payable, and a debit to Accounts Payable will decrease the balance.

Are there two ABC methods in accounting? (pg. 50)

Some accountants use ABC to mean Activity Based Costing. Under this ABC a manufacturer will use many cost drivers to assign overhead costs to products. The objective of Activity Based Costing is to assign the overhead costs based on their root causes rather than merely spreading the costs on the basis of direct labor hours or production machine hours. A second use of ABC involves categorizing inventory items into "A" items, "B" items, and "C" items. The "A" items are a relatively small number of items which account for the majority of the inventory's value. For example, the "A" items might be 20% of the items in inventory which account for 70% of the inventory value. At the other extreme the "C" items might be 60% of the items in inventory but account for only 10% of the inventory value. The "B" items might be 20% of the items accounting for 20% of the inventory value. Under this system, the "A" items will receive the most attention since they account for 70% of the value. This ABC is sometimes referred to as Pareto analysis or Pareto's rule and it can be applied to more than inventory. For example, 20% of a company's customers might account for 70% of the company's sales.

Why would a balance sheet list current liabilities as negative amounts? (pg. 35)

Some accounting software will use minus signs or parentheses to indicate credit balances, while positive numbers indicate debit balances. The accounting software will usually have an option to print the liability account balances on the balance sheet without the negative signs. Look in a formatting section of the software, the balance sheet section, financial statements, or chart of accounts. If only one liability account has a negative sign, it is possible that the liability account has a debit balance. For example, if the account Interest Payable had a credit balance of $600, and subsequently a payment of $605 was recorded in the account, the account Interest Payable will have a debit balance of $5. If a balance sheet is prepared at that point, it will list Accounts Payable with a negative balance of $5 (and the other liability amounts will be positive).

What is the difference between cost and price? (pg. 44)

Some people use cost and price interchangeably. Others use the term cost to mean one component of a product's selling price. Even the same person might use the terms differently. For example, in standard costing the price variance of the raw materials refers to the difference between the standard cost and the actual cost of the materials. In other situations we define a product's selling price as: product costs + expenses + profit. As these two examples indicate, there can be different meanings for the terms cost and price.

Is standard costing GAAP? (pg. 28)

Standard costing was developed to assist a manufacturer plan and control its operations. Generally accepted accounting principles or GAAP require that a manufacturer's financial statements comply with the cost principle. This means that the inventories, the cost of goods sold, and the resulting net income must reflect the manufacturer's actual costs. Standard costing will meet the GAAP requirements if the variances between the standard costs and the actual costs are properly prorated to the inventories and to the cost of goods sold prior to issuing the financial statements.

What is the difference between stocks and bonds? (pg. 40)

Stocks, or shares of stock, represent an ownership interest in a corporation. Bonds are a form of long-term debt in which the issuing corporation promises to pay the principal amount at a specific date. Stocks pay dividends to the owners, but only if the corporation declares a dividend. Dividends are a distribution of a corporation's profits. Bonds pay interest to the bondholders. Generally, the bond contract requires that a fixed interest payment be made every six months. Every corporation has common stock. Some corporations issue preferred stock in addition to its common stock. Many corporations do not issue bonds. The stocks and bonds issued by the largest corporations are often traded on stock and bond exchanges. Stocks and bonds of smaller corporations are often held by investors and are never traded on an exchange.

What is the meaning of sundry and sundry debtors?

Sundry can mean various, miscellaneous, or diverse. Sundry debtors might refer to a company's customers who rarely make purchases on credit and the amounts they purchase are not significant. I suspect that the term sundry was more common when bookkeeping was a manual task. In other words, prior to the low cost of computers and accounting software, a bookkeeper had to add a page to the company's ledger book for every new customer. If a new page was added for every occasional customer, the ledger book would become unwieldy. It was more practical to have one page entitled sundry on which those occasional customers' small transactions were entered. With the efficiency and low cost of today's accounting systems, I believe the need for classifying customers and accounts as sundry has been greatly reduced.

What is the meaning of systematic and rational allocation? (pg. 26)

Systematic and rational allocation is a phrase often cited in the definition of depreciation. In that context it means that the annual depreciation expense should be based on a formula that is logical and acceptable to other unbiased accountants.For example, depreciating an asset over a 10-year period with the same amount of depreciation expense each year is systematic and rational. Depreciating the asset on the basis of the number of parts it produces is also systematic and rational. However, determining the annual depreciation expense based on each year's profits is not systematic and rational. Systematic and rational allocations provide for objectivity and consistency, which are important characteristics of accounting.

What is contained on a 10-column worksheet? (pg. 22)

The 10-column worksheet that I am familiar with will have the general ledger account titles in the first column followed by ten columns of amounts. There will be one debit and one credit column for each of the following five headings: 1. Trial Balance containing each account's unadjusted balance, 2. Adjustments containing any adjusting entries, 3. Adjusted Trial Balance containing the combination of the unadjusted balance and any adjustments, 4. Income Statement containing the adjusted balances for the revenue, expense, gain and loss accounts, and 5. Balance Sheet containing the adjusted balances for the asset, liability and owner's equity accounts. Under the Income Statement columns, the difference between the total of the debit column and the credit column is the amount of net income or net loss. If the total of the credit column is larger than the total of the debit column, it indicates a positive net income (revenues are greater than expenses). If the total of the debit column is larger than the total of the credit column it indicates a net loss (expenses are greater than revenues).

What is the maximum FICA tax for 2009? (pg. 66)

The FICA tax for 2009 consists of the Social Security tax of 6.20% on the first $106,800 of an employee's taxable earnings (wages, salary, cash bonus, etc.) plus the Medicare tax of 1.45% on every dollar of an employee's 2009 taxable earnings. In other words, there is no employee earnings limit on the Medicare tax. The FICA tax of 7.65% (6.20% + 1.45%) on the first $106,800 of an employee's earnings is withheld from an employee's pay and is also matched by the employer. Therefore, the total amount to be remitted by the employer is 15.3% of each employee's first $106,800 of earnings in 2009 plus the Medicare tax of 2.90% of the employee's earnings above $106,800. To illustrate the FICA tax, let's assume that a company has only one employee. During the year 2009 the employee has wages of $50,000. The FICA tax withheld from the employee will be the Social Security tax of 6.20% + the Medicare tax of 1.45% for a total of 7.65% x $50,000 = $3,825. The employer must match the $3,825 and remit a total of $7,650 for this employee. The employer's matching of $3,825 will be recorded as a payroll expense or as part of the company's fringe benefit expense. Now let's assume that another company has only one employee whose salary in 2009 is $120,000. The FICA tax withheld from this employee will consist of the Social Security tax of $6,621.60 (6.20% x $106,800) plus the Medicare tax of $1,740 (1.45% X $120,000) for a total of $8,361.60. The calculation could also be computed as: ($106,800 x 7.65% = $8,170.20) plus ($120,000 - $106,800 = $13,200 x 1.45% = $191.40) resulting in the same total of $8,361.60. The employer is required to match the $8,361.60 and must remit $16,723.20. The employer's matching of $8,361.60 becomes an additional payroll related expense for the company.

What is the Social Security tax rate for 2009? (pg. 64)

The Social Security tax rate (excluding the Medicare tax) for the year 2009 is 6.20% on the first $106,800 of an employee's taxable earnings. Taxable earnings includes items such as salaries, wages, and cash bonuses. Since the Social Security tax is withheld from employees and then matched by the employer, the total Social Security tax (excluding the Medicare tax) is 12.40% on the first $106,800 of each employee's earnings paid by the employer in the year 2009. The Medicare tax remains at 1.45% of every dollar of every employee's salaries, wages, etc. The Medicare tax is also matched by the employer resulting in the employer remitting 2.90% of every dollar of wages, salaries, etc. paid to employees in the year 2009. The combination of the Social Security tax and the Medicare tax is often referred to as FICA. Combining the information above, the FICA rate for 2009 is 7.65% withheld from the first $106,800 of each employee's earnings and 1.45% on any employee's earnings above $106,800. Since the employer matches these amounts, the employer must remit 15.3% of each employee's first $106,800 of earnings plus 2.90% of any employee's 2009 earnings that are greater than $106,800. Self-employed individuals are responsible for both the employee and employer portions of Social Security and Medicare taxes.

What is the Social Security tax rate for 2010? (pg. 14)

The Social Security tax withheld from employees during the year 2010 will be 6.2% of the first $106,800 of each employee's taxable earnings. The employee's earnings in excess of $106,800 are not subject to the Social Security tax. In addition to the Social Security tax, the entire amount of each employees' taxable earnings is subject to the Medicare tax of 1.45%. Both the Social Security tax and the Medicare tax must be matched by the employer. This means the employer must remit to the federal government 12.4% of each employee's first $106,800 of taxable earnings plus 2.9% of each employee's earnings regardless of amount. Self-employed individuals are responsible for paying both the employee and the employer portions of the Social Security tax and the Medicare tax.

Where do preferred stocks go on the P&L? (pg. 29)

The amount received from issuing preferred stock is reported on the balance sheet within the stockholders' equity section. Only the annual preferred dividend is reported on the income statement. The annual preferred dividend requirement is subtracted from a corporation's net income and the remainder is described as the Income Available for Common Stock.

Is the installation labor for a new asset expensed or included in the cost of the asset? (pg. 56)

The cost of installation is part of the cost of the asset. An asset's cost is considered to be all of the costs of getting an asset in place and ready for use. Therefore, the labor cost of installing a new machine is considered to be part of the asset's cost and not an immediate expense of the period. The cost of the installation labor will include the workers' wages and the fringe benefits applicable to those wages.The total cost of the asset, including installation costs, will be depreciated over the useful life of the asset. The concept of materiality does allow you to expense the installation cost immediately if the amount is insignificant.

What is the cost to store inventory? (pg. 25)

The cost to store, hold or carry inventory consists of 1) the cost of the space used including rent, heat, maintenance, etc., 2) the cost of the money tied up in inventory, 3) the cost of insurance and perhaps property tax, and 4) the cost of deterioration and obsolescence of the inventory items.Some of the storage costs are a function of the cost or value of the inventory, while some storage costs are dependent on the physical size of the items. The costs to store or hold inventory are often stated on an annual basis, such as $3 per unit or 15% of an item's cost. The calculation of the cost to store inventory should be based on the incremental annual costs or the company's opportunity costs. In other words, if a business has a large amount of cash, no debt, and a warehouse that is half empty, its costs to store inventory will be relatively low. Another company with little cash, much debt, and little available storage space will have relatively high costs of storing inventory. The costs to store inventory are part of the economic order quantity (EOQ) formula or model that calculates the optimum order quantity. The economic order quantity is the number of units that will minimize the total annual costs of both ordering and storing inventory.

Why are the issue costs of bonds reported as an asset? (pg. 46)

The costs associated with issuing bonds should be matched to the accounting periods that will benefit from the bonds. For example, if a corporation incurs bond issue costs of $150,000 in order to issue $5,000,000 of bonds maturing in 15 years, the corporation should report an annual Bond Issue Costs Expense of $10,000 ($150,000 divided by 15 years). Since the corporation must pay the bond issue costs of $150,000 when the bonds are issued, but can expense only $10,000 per year, the bond issue costs need to be deferred to a long-term asset account. In effect the bond issue costs are prepaid expenses, which are part of the definition of assets. (Recall, that the payment of a 6-month or 12-month insurance premium is reported as a current asset until it expires and is then expensed.) The journal entry for the bond issue costs will initially be a debit of $150,000 to Bond Issue Costs and a credit to Cash or Accounts Payable. Then each year that the bonds are outstanding there needs to be an accounting entry to credit Bond Issue Costs for $10,000 and to debit Bond Issue Costs Expense. This is referred to as amortization and it results in the balance in the longterm asset account Bond Issue Costs being reduced to $0 by the time the bonds mature.

How do you account for bond issue costs? (pg. 62)

The costs associated with issuing bonds should be recorded as a deferred charge in the long term asset section of the balance sheet under the heading of Other Assets. The account title could be Bond Issue Costs. Over the life of the bonds you will need to systematically move the bond issue cost from the balance sheet to the income statement. Accountants refer to this as amortizing the costs. Let's illustrate the amortization of bond issue costs by assuming the total of the bond issue costs were $24,000 and the bonds will mature in 10 years. Each month you would debit Bond Issue Cost Expense for $200 ($24,000 divided by 120 months) and would credit Bond Issue Cost for $200. The concept is to match the $24,000 cost to the accounting periods that are benefiting from the bonds having been issued. Our discussion pertains to financial statement reporting and we are not familiar with income tax reporting. You should discuss the income tax treatment with your tax adviser.

What are the reasons for high inventory days? (pg. 35)

The days sales in inventory is high when the inventory turnover is low. Since inventory turnover is associated with sales and average inventory, changes in either sales or inventory can cause a high amount of inventory days. For example, if a company has maintained its inventory quantities, but economic factors cause a significant drop in its sales, the company's inventory days will increase dramatically. If a retailer increases its inventory in order to generate additional sales, but sales do not increase, there will also be an increase in the number of inventory days.

What is the definition of net sales? (pg. 66)

The definition of net sales is sales minus sales discounts, sales returns, and sales allowances.

Where do dividends appear on the financial statements? (pg. 21)

The dividends declared and paid by a corporation will be reported as a use of cash in the financing section of the statement of cash flows. Dividends are also reported on the statement of changes in stockholders' equity. Dividends on common stock are not reported on the income statement since they are not expenses. Dividends on preferred stock are not expenses, but will be deducted from net income in order to report the earnings available for common stock on the income statement. Since the balance sheet reports only the ending account balances at an instant of time, the Cash and Retained Earnings amounts reflect the balances after past dividends and other transactions.

What are the elements of financial statements? (pg. 15)

The elements of financial statements are the classes of items contained in the financial statements. Examples of elements include assets, liabilities, equity or net assets, revenues, expenses, gains, and losses. You can learn more about the elements by reading the FASB's Statement of Financial Accounting Concepts No. 6, Elements of Financial Statements, at www.FASB.org.

How is petty cash reported on the financial statements? (pg. 37)

The general ledger account Petty Cash is reported on the balance sheet as a current asset. Often the balance in the Petty Cash account is combined with the balances in other cash accounts (such as checking accounts) and the total will be reported on the balance sheet as Cash. The Petty Cash account should be replenished just prior to issuing the financial statements so that the amount of currency and coins on hand is equal to the balance in the Petty Cash account. This also ensures that the recent petty cash disbursements are recorded in their appropriate accounts—often expense accounts.

What is the gross profit method of inventory? (pg. 27)

The gross profit method is a technique for estimating the amount of ending inventory. The gross profit method might be used to estimate each month's ending inventory or it might be used as part of a calculation to determine the approximate amount of inventory that has been lost due to theft, fire, or other causes. The gross profit method of estimating ending inventory assumes that we know the gross profit percentage or gross margin ratio. For example, if a company purchases goods for $80 and sells them for $100, its gross profit is $20 and it has a gross profit percentage or ratio of 20% of the selling price. When this company has sales of $50,000 it is assumed that its cost of those goods will be $40,000 ($50,000 minus 20% of $50,000; or 80% of $50,000). Let's assume we need to estimate the cost of the July 31 inventory. The last time the merchandise inventory was counted was seven months earlier on December 31 and it had a cost of $15,000. Since December 31, the company purchased merchandise with a cost of $42,000; its sales were $50,000; and the gross profit percentage has remained at 20%. We can estimate the July 31 inventory as follows: Inventory cost at December 31: $15,000 Purchases between December 31 and July 31 at cost: $42,000 Expected cost of goods available: $57,000 ($15,000 + $42,000) Cost of goods sold: $50,000 of sales x 80% = $40,000 Estimated Inventory at July 31 at cost: $17,000 ($57,000 - $40,000)

Is income tax an expense or liability? (pg. 45)

The income tax reported on the income statement is the income tax expense which pertains to the revenues and expenses shown on the income statement. The income taxes to be paid in the near future are reported as a current liability. If a corporation has overpaid its income taxes, the income taxes to be refunded by the government are reported on the corporation's balance sheet as a current asset. There are also balance sheet accounts for deferred income taxes. Deferred income taxes arise when a revenue or expense item is reported on the income tax return in a year that is different from the year the item appears on the financial statements. More information is contained in Financial Accounting Standards Board Statement No. 109, Accounting for Income Taxes. It is available for reading at www.FASB.org.

What is the maximum FICA tax for 2010? (pg. 14)

The maximum FICA tax for the year 2010 remains the same as the 2009 FICA tax: 7.65% on each employee's first $106,800 of taxable earnings (such as wages, salaries, bonuses, etc.) plus 1.45% of any employee's taxable earnings in excess of $106,800. The FICA tax is withheld from each employee's earnings and it is also matched by the employer. This means that the employer is required to remit 15.3% (employee's 7.65% + employer's 7.65%) of each employee's first $106,800 of earnings in 2010 plus 2.9% (employee's 1.45% + employer's 1.45%) of any employee's earnings greater than $106,800. The FICA tax is really two taxes: 1. The Social Security tax of 6.2% which applies only to the first $106,800 of an employee's taxable earnings (in year 2010 and in year 2009), and 2. The Medicare tax of 1.45% on every dollar of every employee's taxable earnings.

How do I record money received for an insurance claim on inventory loss? (pg. 31)

The money received from an insurance company for a claim involving a loss on inventory stock is debited to Cash. Any other proceeds from disposing of the inventory items will also be debited to Cash. In addition, the Inventory account is credited for the carrying cost of the inventory items, which is usually the original cost of the items. If the total of the debits to Cash is greater than the credits to Inventory, the difference is credited to a gain account, such as Gain from Inventory Damage. If the total of the debits to Cash is less than the credits to Inventory, the difference is a debit to a loss account, such as Loss from Inventory Damage.

In a bank reconciliation, what happens to the outstanding checks of the previous month? (pg. 10)

The outstanding checks of the previous month will have either cleared the bank in the current month or will remain on the list of outstanding checks. If an outstanding check of the previous month clears the bank (is paid by the bank) in the current month, you simply remove that check from the list of outstanding checks. If an outstanding check of the previous month does not clear the bank in the current month, the check will remain on the list of outstanding checks until the month that it does clear the bank. In the bank reconciliation process, the total amount of the outstanding checks is deducted from the balance appearing on the bank statement.

How should an interest only loan be recorded? (pg. 39)

The principal balance of an interest only loan is a liability. If none of the principal is due within 12 months of the date of the balance sheet, the entire principal balance is reported as a long-term liability. If the current month's interest is paid on the last day of each month, there will be no interest liability. Each month's payment of interest will be debited to Interest Expense and will be reported on the income statement. Under accrual accounting the interest that has occurred but has not been paid as of the date of the balance sheet, is reported as a current liability such as Interest Payable or Accrued Interest Payable and is also reported as Interest Expense on the income statement. Future interest is not reported on the financial statements.

How do you account for the rebate on an automobile? (pg. 20)

The rebate on the purchase of an automobile should be recorded as a reduction of the automobile's cost. The lower automobile cost will result in lower depreciation expense.

Is a security deposit a current asset? (pg. 57)

The security deposit paid to another entity is a current asset, if the security deposit will be returned within one year of the balance sheet date. The entity holding the security deposit will report it as a current liability, if it is to be repaid within one year of the balance sheet date. If the security deposit will not be returned within one year of the balance sheet date, the security deposit is reported as a long-term asset by the entity paying the security deposit. The party holding the security deposit will report it as a long-term liability if it will not be returned within one year of the balance sheet date.

What is separation of duties? (pg. 37)

The separation of duties is one of several steps to improve the internal control of an organization's assets. For example, the internal control of cash is improved if the money handling duties are separated from the record keeping duties. By separating these duties the likelihood of theft is reduced because it will now require two dishonest people working together to admit to each other that they are dishonest, plan the theft, and to then carry out the theft. One person will have to remove the cash and the other person will have to falsify the records. Without the separation of duties, the theft of cash is easier. One dishonest person can steal the money and enter a fictitious amount into the records—thereby concealing the theft. Another step in improving internal control over cash is to use a cash register, issue receipts, and have two people present when cash is handled.

What is bad debts? (pg. 19)

The term bad debts usually refers to accounts receivable (or trade accounts receivable) that will not be collected. However, bad debts can also refer to notes receivable that will not be collected. The bad debts associated with accounts receivable is reported on the income statement as Bad Debts Expense or Uncollectible Accounts Expense. When the allowance method is used, the journal entry to Bad Debts Expense will include a credit to Allowance for Doubtful Accounts, a contra account and valuation account to the asset Accounts Receivable. The allowance method anticipates the losses and therefore requires the use of estimates. Under the direct write-off method, the Allowance for Doubtful Accounts is not used. Rather, Bad Debts Expense will be debited when an account receivable is actually written off. The credit in this entry will be to the asset Accounts Receivable.

What is the transaction approach and balance sheet approach to measuring net income? (pg. 38)

The transaction approach to measuring net income is the traditional bookkeeping and accounting method. That is, individual transactions such as each sale, each purchase, and every expense are recorded into general ledger accounts. At any point you can go to an account such as Salaries Expense for Sales Staff and see the year to date amount of such an expense. With the use of accounting software, an enormous quantity of transactions can be recorded into many detailed accounts. I believe that the balance sheet approach is also referred to as the capital maintenance approach. Under the balance sheet approach one looks at the change in stockholders' or owner's equity to determine the amount of net income during the period between balance sheets. This approach requires that you exclude any additional capital from the owners as well as any dividends or withdrawals distributed to the owners. For example, if stockholders' equity increased by $5 million with $2 million caused by the issuance of new shares of stock, and $1 million distributed as dividends, the net income would have been $4 million. We can verify the calculation with the following: net income of $4 (an addition to equity) plus new investor money of $2 (an addition to equity) = $6 of additions to equity, minus dividends of $1 (a decrease to equity) = $5 (the net increase to equity). Under this balance sheet approach you will not have the detailed information on revenues and expenses that would be available under the transaction approach.

What is a bond? (pg. 42)

There are several business definitions for bond. 1. A bond could be a formal debt instrument issued by a corporation or government and purchased by investors. This is the meaning when we say that a public utility issued or sold bonds to help finance a new power plant. Investors talk about investing in stocks and bonds. You can learn more about this use of bonds by visiting our Explanation of Bonds Payable. 2. A bond is also used to describe a guarantee of another person's obligation. For example, an insurance company might issue a $500,000 surety bond needed by a company in order to engage in transactions on credit. This use of bond means that the insurance company is guaranteeing that it will pay up to $500,000 if the insured company does not make its required payments for its purchases. 3. We also use bond to mean that a company purchases insurance to protect itself from dishonest acts by its employees handling money. For example, some accounting textbooks state that a company's employees should be bonded. However, the cost of such protection may far exceed the expected benefits.

Can I take the CPA Exam with a bachelor's degree? (pg. 34)

To be eligible for taking the CPA Exam you must meet the requirements of the board of accountancy in the U.S. state (or jurisdiction) in which you plan to take the CPA Exam. Most states require CPA Exam candidates to have a minimum of 150 college credits including specified accounting and business courses and to have a minimum of a bachelor's degree from a college or university approved by the state's board of accountancy.

What does it mean to check the extensions and to foot an invoice? (pg. 32)

To check the extensions on a purchase invoice means to verify that the number of units of each item multiplied by its unit cost agrees with the total dollar amount for each item. For example, if 15 units of Item Q have a per unit cost of $5, the total cost for Item Q should be $75. To foot the invoice means to add up the extended costs and verify the total with the amount appearing as the total on the invoice. For example, if the invoice has extended costs of $75 for Item Q and $210 for Item Z, the invoice total should be $285.

What does it mean to reclassify an amount? (pg. 18)

To reclassify an amount often means to move an amount from one general ledger account to another general ledger account. To illustrate, let's assume that an invoice for $900 was recorded in the account Advertising Expenses. Upon review, the advertising manager informs the accountant that the amount should have been recorded in the account Marketing Supplies. If the accountant uses a journal entry to move the amount, the entry's description might be: To reclassify $900 from Advertising Expense to Marketing Supplies. In this illustration, the phrase to reclassify an amount has a gentler tone than the phrase to correct an account coding error.

What is turnover? (pg. 65)

Turnover is used in some countries to mean sales. Turnover is also used in certain financial ratios. For example, the inventory turnover ratio is calculated by dividing the cost of goods sold during a year by the average inventory during the same year. The accounts receivable turnover ratio is computed by dividing the credit sales during a year by the average balance in Accounts Receivable during the same year.

Should a company focus on cash flows or accounting profits when making a capital expenditure decision? (pg. 47)

Using the incremental cash flows and discounting them to reflect the time value of money is the preferred method. The two most common techniques involved in discounting cash flows are net present value and internal rate of return. While the discounted cash flow models are the ideal, I would also want to forecast or project the impact on the company's future financial statements. Therefore, I would also calculate and understand the effect on the accounting profits resulting from the capital expenditure.

How do you reduce the break-even point? (pg. 43)

Ways to reduce a company's break-even point include 1) reducing the amount of fixed costs, 2) reducing the variable costs per unit—thereby increasing the unit's contribution margin, 3) improving the sales mix by selling a greater proportion of the products having larger contribution margins, and 4) increasing selling prices so long as the number of units sold will not decline significantly.

Why doesn't AccountingCoach.com classify the financial ratios? (pg. 49)

We avoided classifying the financial ratios because a financial ratio may overlap several classifications, and there are several different titles for the classifications. Let's use the inventory turnover ratio as an example. During our review of several books and articles we found the inventory turnover ratio in a variety of ratio classifications including liquidity, solvency, activity, asset management, asset utilization, efficiency, and short-term creditor. Even the current ratio was listed as a liquidity ratio, a solvency ratio, a short-term solvency ratio, and a short-term creditor ratio. Rather than add to any confusion, we chose to downplay the ratio classifications.

What is the difference between accounts payable and accounts receivable? (pg. 10)

When a company purchases goods or services on credit, it will increase its accounts payable (a current liability). When a company sells goods or services on credit, it will increase its accounts receivable (a current asset). Just as one company's purchase is another company's sale, the accounts payable of one company will be the accounts receivable of another company. Some accountants refer to this as symmetry. To illustrate this, let's assume that Max Corporation receives $5,000 of goods it ordered from Super Supply Company on credit. This transaction will result in Max recording a $5,000 accounts payable (and a purchase), and Super Supply recording a $5,000 accounts receivable (and a sale).

Does a dividend reduce profit? (pg. 44)

When a corporation declares and pays a dividend, the dividend does not reduce the current accounting period's profit reported on the income statement. In other words, a dividend is not an expense. Dividends will reduce the amount of the corporation's retained earnings. Retained earnings are reported in the stockholders' equity section of the balance sheet. If a corporation has very profitable uses for its cash, its future profits might be less if it pays dividends instead of reinvesting the cash dividend amounts into profitable projects.

Why are loan costs amortized? (pg. 11)

When loan costs are significant, they must be amortized because of the matching principle. In other words, all of the costs of a loan must be matched to the accounting periods when the loan is outstanding. To clarify this, let's assume that a company incurs legal, accounting, and registration fees of $120,000 during February in order to obtain a $4 million loan at an annual interest rate of 9%. The loan will begin on March 1 and the entire $4 million of principal will be due five years later. The company's cost of the borrowed money will be $360,000 ($4 million X 9%) of interest each year for five years plus the one-time loan costs of $120,000. It would be misleading to report the entire $120,000 of loan costs as an expense of one month. Hence, the matching principle requires that each month during the life of the loan the company should report $2,000 ($120,000 divided by 60 months) of expense for the loan costs in addition to the interest expense of $30,000 per month ($4 million X 9% per year = $360,000 per year divided by 12 months per year). The combination of the amortization of the loan cost plus the interest expense will mean a total monthly expense of $32,000 for 60 months beginning on March 1.

What is the difference between gains and proceeds in terms of long-term assets? (pg. 16)

When long-term assets are sold, the amounts received are referred to as the proceeds. If the amount of the proceeds is greater than the book value or carrying value of the long-term asset at the time of the sale, the difference is a gain on the sale or disposal. If the amount received is less than the book value, the difference is a loss on the sale or disposal. Depreciation must be recorded up to the date of the disposal in order to have the asset's book value at the time of the sale. On the statement of cash flows, the proceeds from the sale of long-term assets are reported in the investing activities section, while the gain on the sale appears in the operating activities section as a deduction from net income.

How can working capital be improved? (pg. 43)

Working capital can be improved by 1) earning profits, 2) issuing common stock or preferred stock for cash, 3) replacing short-term debt with long-term debt, 4) selling long-term assets for cash, 5) settling short-term debts for less than the stated amounts, and 6) collecting more of the accounts receivables than was anticipated and then reducing the balance required in the current asset account Allowance for Doubtful Accounts. I am sure there are additional ways to increase working capital. The concept is to increase the amount of current assets and/or to decrease the amount of current liabilities.

How can I determine the inventory methods used by other companies in my industry? (pg. 25)

You can find the inventory methods used by the companies in your industry whose stock is publicly traded by reading the Summary of Significant Accounting Policies contained in each company's Form 10-K. The Form 10-K is the annual report to the Securities and Exchange Commission or SEC. The Summary of Significant Accounting Policies will appear as the first or second item in the Notes to the Financial Statements. Most publicly traded corporations will have an Investors Relations link at the bottom of their website's home page. On the Investors Relations page you will find a link to the corporation's SEC filings.