Accounting Aleks Review

corporate income statement

-The corporate income statement has two major sections: the top half, income from continuing operations, and the bottom half, consisting of "special" items. -Special items are nonrecurring, unique items, such as discontinued operations, and the cumulative effect of a change in accounting principle. -Note: Since income tax expense appears in the top half of the income statement, all of these special items must be shown net of tax in the bottom half of the income statement.

Balance Sheet Items

Assets: -cash -marketable securities -notes receivable -accounts receivable -inventories -supplies -prepaid expenses Liabilities: -accounts payable -notes payable -deferred revenue -wages payable Total Stockholder's Equity -capital stock -(ending) retained earnings pg 1 notes

Income Statement

DEFINITION -(Sometimes referred to as a Single-step Income Statement) - the financial statement typically included first in the annual report. The income statement lists all the revenue and expense accounts and their balances, as well as the net income/loss for a specific period of time, such as one year.

Conservatism

DEFINITION -A concept that recognizes that accounting measurements sometimes take place in a context of uncertainty. When faced with uncertainty related to the measurement of assets, conservatism suggests that the accounting for that uncertainty should tend toward understatement rather than overstatement of assets and income. -The concept's influence can also be found in generally accepted accounting principles such as the requirement to report inventories at the lower of cost or market value. As with inventory, when accounting for contingencies, probable losses are to be recognized, but probable gains must not be anticipated.

Allowance for Uncollectible Accounts

DEFINITION -A contra-asset account (also called Allowance for Doubtful Accounts or Allowance for Bad Debts) that contains the estimated amount of uncollectible accounts receivable. The name Allowance for... stems from the fact that a provision is made for possible future uncollectible amounts. The amount held in the Allowance account is based on estimation of uncollectible amounts, using either a percentage of accounts receivable (see aging of accounts receivable) or a percentage of net credit sales. -In the balance sheet, accounts receivable are reported under current assets, less allowance for uncollectible accounts, to arrive at the net realizable value.

stock dividend

DEFINITION -A distribution of a company's own stock to its stockholders. A company may decide to pay a stock dividend instead of a cash dividend if it prefers to keep the cash for other purposes. Another reason to pay a stock dividend is to maintain a tradition of paying dividends at a time when cash is not available. -When the board of directors announces a stock dividend, the declaration does not create a liability for the company because it is not obligated to pay cash. To pay a stock dividend, a company issues new shares and distributes them to the existing shareholders. Each shareholder ends up owning a larger number of shares, but the investment value of each shareholder's total investment remains the same. -A corporation may issue a small stock dividend (less than 20%-25% of a company's issued stock) or a large stock dividend (more than 20%-25%). A small stock dividend is normally recorded at its current market price, while a large stock dividend is recorded at par or stated value. Usually, small stock dividends do not materially affect the market price per share, while large stock dividends decrease the market price, an effect similar to that of a stock split.

Bank Reconciliation

DEFINITION -A document prepared monthly to prove the accuracy of the cash balance per books and the cash balance per bank statement. A bank reconciliation starts with the balance per bank statement on one side of the reconciliation form and the balance per books on the other side. Usually the two balances are not equal. Items responsible for the difference, often called reconciling items, are then added to or subtracted from the balance per bank statement and the balance per books in order to arrive at the adjusted balance per bank statement and the adjusted balance per books. These adjusted balances should be equal in order to prove the accuracy of the records as kept independently by the company and by its bank. -Once the bank reconciliation is completed and the accuracy of the cash balance is verified, any needed journal entries are prepared. The purpose of these journal entries is to record the reconciling items (on the books side of the bank reconciliation) in the company books to bring the records to date. -Once these journal entries are posted, the balance of the cash account and the other accounts involved will be current. The Cash account balance will change from $11,680 to $15,870, the adjusted balance. Reconciling items, on the bank side of the bank reconciliation, will eventually be recorded by the bank to update its own records. These items will be reflected on next month's bank statement. EXPLANATION -A bank reconciliation is prepared by an entity to account for transactions that were not accounted for on either the bank statement or the entity's books at the time of the reconciliation. The purpose of the bank reconciliation is to compare what the bank has recorded with what the entity has recorded to insure that the records match. There are two basic rules to be followed: -Ask the question, "Which party, the bank or the entity, did not know about the item and therefore has not recorded it?" The item must now be included on the bank reconciliation on the side (bank or entity) that did not record it. -In the case of errors, errors are corrected on the bank reconciliation on the side (bank or entity) that made the error.

Statement of Changes in Retained Earnings

DEFINITION -A financial statement that provides a summary of the changes to Retained Earnings that occurred during a specific period. It starts with a beginning balance, to which is added net income for the period. If there is a net loss instead of net income, then Retained Earnings will be reduced by the amount of the net loss. Dividends also reduce the balance in retained earnings. -The ending balance of the Statement of Changes in Retained Earnings represents cumulative net income from previous periods that has not been distributed and is available for reinvestment in the business. This ending balance in the retained earnings statement also appears on the balance sheet under stockholders' equity.

statement of changes in retained earnings

DEFINITION -A financial statement that provides a summary of the changes to Retained Earnings that occurred during a specific period. It starts with a beginning balance, to which is added net income for the period. If there is a net loss instead of net income, then Retained Earnings will be reduced by the amount of the net loss. Dividends also reduce the balance in retained earnings. -The ending balance of the Statement of Changes in Retained Earnings represents cumulative net income from previous periods that has not been distributed and is available for reinvestment in the business. This ending balance in the retained earnings statement also appears on the balance sheet under stockholders' equity.

equipment

DEFINITION -A fixed asset (plant asset) account used for recording the cost of equipment purchased for use by the business. The asset's costs include the purchase price of the equipment, sales taxes, broker's commission, freight costs, and insurance costs during shipping, as well as the costs of installation and special training needed to ready the asset for its intended use. -Since equipment is purchased for use in the business, and the life of the asset is usually longer than one year, the matching principlerequires that its cost be allocated to the periods benefiting from its use. This process of expensing the acquisition cost over the estimated useful life is called depreciation. -Equipment is reported at book value, cost less accumulated depreciation, under the property, plant, and equipment section of the balance sheet. Equipment is depreciated in a systematic and rational manner over the estimated useful life of the asset.

liquidity

DEFINITION -A measure of how quickly and easily an asset can be converted into cash. On the balance sheet, current assets are listed in the order of their liquidity, starting with cash. Liquidity determines a company's ability to meet its short-term obligations.

Gross Profit Ratio

DEFINITION -A measure of profitability of a merchandising business before operating expenses are deducted. Gross profit is computed by subtracting cost of goods sold from net sales. The gross profit ratio is calculated by dividing gross profit by net sales. -The trends in gross profit amount and the gross profit percentage are watched and carefully compared to past performance and to industry averages. An increase in the amount of gross profit may be due to an increase in sales, an increase in selling prices, or a decrease in the costs to buy (or produce) products. The increase in the gross profit percentage may indicate that sales prices have risen compared to costs or that costs have decreased compared to sales prices. These are issues that should be addressed when considering an increase in sales price or implementing a cost-cutting strategy. Raising prices may result in loss of sales. Reducing costs may make the business more efficient. This in turn may lead to a sales price reduction and increased sales and market share. FORMULAS Gross profit = Net sales - Cost of goods sold Gross profit ratio= Gross profit / Net sales

Balance Sheet Approach

DEFINITION -A method of accounting for uncollectible accounts receivable that utilizes the allowance method and bases estimates of uncollectible accounts on the balance of accounts receivable. This method is called the balance sheet approach because it focuses on accounts receivable, which is a balance sheet account. This method often uses an aging of accounts receivable to compute the estimated uncollectible accounts and assigns a different percentage rate of bad debts expense to groups of accounts based on the length of time that each group has been outstanding. For more details see aging of accounts receivable.

Aging of Accounts Receivable Method

DEFINITION -A method of classifying accounts receivable by age, according to the period they have been past due. An aging report is prepared periodically to keep track of accounts receivable, and to assist in the estimation of uncollectible amounts, also called bad debts. -The aging of accounts receivable is based on the premise that the older a receivable is, the more uncollectible it becomes. Once receivables have been grouped by age, a certain percentage of each group is assumed uncollectible based on past experience. The older the receivable, the higher the percentage that is estimated to be uncollectible. The total amount deemed to be uncollectible should equal the balance in the Allowance for Doubtful Accounts account after the adjusting entry at the end of the period. -Aging of accounts receivable is one application of the balance sheet method for estimating bad debts expense. Based on past experience, some companies use one weighted average percentage rate that applies to total receivables rather than aging accounts receivable. In the example above, Samara, Inc. above may choose not to prepare an aging report but instead use 5% of its total receivables as an estimate of bad debts.

percentage of sales method

DEFINITION -A method of estimating the amount of bad debts using a percentage of net sales for the period. -also known as income statement approach

income statement approach

DEFINITION -A method of recognizing bad debts by estimating bad (uncollectible) debts using a percentage of net credit sales. It is called the income statement approach because it focuses on the amount of bad debts expense to be reported on the income statement. Also called Allowance for Bad Debts, Using a Percentage of Net Sales. -The amount of estimated bad debts is treated as a selling expense for the period during which sales were recognized, consistent with thematching principle. An Allowance for Bad Debts account, a contra-asset, is also set up with a balance against which future write-offs of bad debts can be made. The name Allowance for Bad Debts stems from the fact that a provision is made for possible future uncollectible amounts.

straight-line method of depreciation

DEFINITION -A method that allocates the depreciable cost of an asset equally over its useful life.

Revenue Recognition

DEFINITION -A principle which states that revenues must be recognized (recorded) in the period in which they were earned, regardless of when cash is received. Revenue is earned when products are delivered to, or when services are performed for, a customer.

Matching Principle

DEFINITION -A principle, required by the accrual system of accounting, that states that for an accounting period, all the expenses incurred to generate revenues should be recognized (recorded) in the same accounting period as those revenues are recorded, regardless of when cash was received or paid. The matching principle requires the implementation of the expense recognition principle, which utilizes adjusting entries at year-end to insure that all expenses have been accounted for by the end of the period.

Cost-Benefit Rule

DEFINITION -A rule that holds that for an activity or a program to be worth pursuing, its benefits should be equal to or greater than its costs. If costs are greater than benefits, profit will suffer. Since the goal of every business is to maximize profit, it follows that only activities that help maximize profit are worth pursuing. -A sophisticated accounting system using a computer and an accounting software package especially tailored to the needs of a business can be very expensive. The cost of such a system includes more than the cost of a computer network and special accounting software. Other costs include hiring specialists to maintain, update, and operate the system in order to obtain useful and timely information. -To some small companies, computerizing the accounting system may be too burdensome in terms of costs and required skills. Other companies may utilize commercially available software whose cost is low and would be easily offset by the benefits obtained from using it.

Income Tax Expense

DEFINITION -A tax on the income (profit) of a business that is paid yearly to the government. Income tax expense is calculated by multiplying the income by the tax rate. If income before taxes is $80,000 and the tax rate is 25%, then the income tax expense is $20,000. -Income tax expense is reported on the income statement as a deduction from income before income taxes, to yield net income. EXAMPLE Income tax expense = $80,000 × 25% = $20,000

horizontal analysis

DEFINITION -A technique for analyzing data contained in financial statements with the goal of establishing a trend over two or more accounting periods. Horizontal analysis measures the amount and percentage change in financial data. For example, business decision-makers are interested in whether net sales and net income are increasing over time. The actual change and the percentage change (increase or decrease) is also compared with industry averages and competitors' financial statements. -Horizontal analysis of financial statements compares values in a certain period to values in prior periods and computes the dollar and percentage change horizontally on each line. For example, on the income statement, net sales or cost of goods sold for the current period may be compared to those in the previous period or periods in various ways. -Horizontal analysis compares the values from a number of periods and computes the value of each year as a percentage of the base year. This is often called trend analysis. -Horizontal analysis can be used with any financial statement. Business decision-makers use horizontal analysis to assess the soundness and performance of a company based on detected trends of increase and decrease. These trends are also used to project future performance and financial position. -It is desirable to have an increase in gross profit, which generally translates into increasing net income. An increase in gross profit is due to either higher prices or a lower cost of goods sold. -It is not wise to achieve higher gross profit by raising prices when higher prices may result in loss of sales. On the other hand, an increase in gross profit that is achieved by lowering the cost of goods sold is generally very desirable. -Wal-mart sells at lower prices than its competitors, which gives it a lower gross profit margin than the competition. Wal-mart, however, is quite efficient in keeping operating costs lower than those of its competition, thereby ending up with a higher rate of net income.

FOB (Free-On-Board) Destination

DEFINITION -A term of sale between the seller and the buyer of merchandise whereby the seller agrees to ship the merchandise at the seller's own expense to the shipping destination. Destination usually means the address of the buyer. FOB destination also indicates that the ownership of the goods passes from the seller to the buyer when the goods arrive at the shipping destination. -Determining who owns the merchandise, especially when the merchandise is in transit, is very important in the calculation of the cost of inventory. FOB destination means that goods in transit continue to be owned by the seller and should be counted in the seller's ending inventory.

FOB (Free-On-Board) Shipping Point

DEFINITION -A term of sale between the seller and the buyer of merchandise, whereby legal title to the goods transfers from the seller to the buyer at point of shipment and the buyer is responsible for the shipping costs. -Example: If the goods are shipped FOB shipping point from Los Angeles (shipping point) to New York (destination), it means that the buyer is responsible for the shipping expenses from Los Angeles to New York. FOB shipping point also means that the ownership of the goods passes from the seller to the buyer when the goods leave the shipping point. -Determining who owns the merchandise, especially when the merchandise is in transit, is very important in the calculation of the cost of inventory. FOB shipping point means that goods in transit, though not yet at the buyer's store, are owned by the buyer and should be counted in the buyer's ending inventory as soon as the goods leave the shipping point.

Cost of Goods Sold

DEFINITION -Also called Cost of Sales. Typically the largest single expense of a merchandising or manufacturing business. COGS is the cost of inventory that the business has sold to its customers during the accounting period. On a classified income statement,net sales is reduced by the amount of COGS to arrive at gross profit.

Gross Profit

DEFINITION -Also called Gross Margin. The excess of net sales over cost of goods sold (COGS). Gross profit is income before deduction of operating expenses and other revenues and expenses. Gross profit is usually reported on the multiple-step income statement of a merchandising or manufacturing business.

Net Income (Profit)

DEFINITION -Also called net earnings or net profit, net income is the excess of total revenues over total expenses. If total expenses exceed total revenues, a company will have a net loss instead of a net income. Net income/loss is the last item that appears on an income statement. Business activities go through a cost benefit analysis, and implementation of the activity follows when benefits exceed costs.

double declining balance method

DEFINITION -An accelerated depreciation method that uses double the straight-line rate in the calculation of the annual depreciation amount. The rate is applied to book value, and salvage value is initially disregarded. EXTRA INFO -When estimates used to calculate the depreciation of an asset are revised and the company uses the straight-line method of depreciation, the following three elements are used: current book value, remaining useful life, and the revised salvage value.

cash basis accounting

DEFINITION -An accounting method that records revenues when cash is received and records expenses when cash is paid. Cash basis does not utilize the matching principle and can be manipulated to show different amounts of profits or losses in a certain period. -Example: A customer is asked to make a down payment now on a service to be released in the next accounting period. The effect of this (under the cash basis) will be an increase in cash receipts and, therefore, in revenues and net income for the current period. If a payment to a supplier can be delayed until after year-end, then expenses for the current year would be less, and net income would be more. -Generally accepted accounting principles (GAAP) require that a business use the accrual basis and not the cash basis.

cash

DEFINITION -An asset that includes currency (paper money and coins), checks, and money orders as well as deposits in bank accounts and other financial institutions. For bank deposits to be considered cash, these deposits must be available for unrestricted withdrawal and use. -Cash is the most liquid asset, and as such it is reported on the balance sheet as the first account among current assets. Some entities report cash and cash equivalents together. Cash is also reported on the statement of cash flows. -Sound principles of internal control require that cash receipts be deposited at least once every day. Also, except for minor disbursements handled through a petty cash fund, all cash payments should be made by check. The cash account is reconciled monthly to the bank statement.

useful life

DEFINITION -An estimated period, usually expressed in years, during which an asset would be used by a business. The cost of an asset is spread over its useful life in a systematic and rational way so that the cost is expensed during the periods benefitted by the asset. EXAMPLE -Furniture was purchased in January for $6,000 with an estimated useful life of 5 years. If the cost is allocated using the straight-line depreciation method, then each year $1,200 will be recorded as Depreciation Expense ($6,000 / 5):

Capital Expenditure

DEFINITION -An expenditure that is added to the cost of an asset (capitalized) because it increases the benefit of the asset by extending its useful life or enhancing its performance. Capital expenditures are usually non-recurring, with benefit that extends beyond the current accounting period. -Capital expenditures are divided into additions, betterments, and extraordinary repairs. Additions are capital expenditures to extend or expand an existing asset. An example of additions is building an extension to an existing building, which increases its function or capacity. Betterments enhance the quality or performance of an asset, such as installing an air-conditioning unit for a building. Extraordinary repairs extend the useful life of an asset. An example of an extraordinary repair is a major engine overhaul.

Bad Debts Expense

DEFINITION -An expense account (also called Doubtful Accounts Expense or Uncollectible Accounts Expense) that accumulates estimates of uncollectible accounts receivable. Some customers who buy on account may not pay when the balance is due. A business treats these amounts as bad credit expenses and writes them off using the direct write-off method or the allowance method. Under the direct write-off method, bad debts expense is recognized when the account becomes clearly uncollectible and is written off.

Periodic Inventory System

DEFINITION -An inventory accounting system that does not keep perpetual records of inventory items and transactions. A physical count at the end of an accounting period is used as the basis for computing the cost of inventory on hand (ending inventory) and the cost of goods sold for the period.

FIFO

DEFINITION -An inventory cost flow assumption that presumes that the first items purchased (in) are the first items sold (out). Under FIFO, the cost of ending inventory would be made up from the latest purchases of goods. During periods of increasing costs, using FIFO results in a higher cost of ending inventory than it would have been if other inventory methods were used. A higher ending inventory means a lower cost of goods sold (an expense) and in turn a higher net income and a higher tax liability.

LIFO

DEFINITION -An inventory cost flow assumption that presumes that the last items purchased (in) are the first items sold (out). Under LIFO, the assumed cost of ending inventory would be made up from beginning inventory and the earliest purchased goods. During periods of increasing costs, using LIFO will result in the cost of ending inventory being lower (and cost of goods sold being higher) than they would have been if other inventory methods had been used, especially FIFO. A higher cost of goods sold (an expense) means lower net income and, therefore, lower taxes.

weighted average method

DEFINITION -An inventory cost flow assumption that uses the weighted average unit cost (the cost that is weighted by the number of units purchased at various prices) in the allocation of cost of goods available to both ending inventory and cost of goods sold. The weighted-average unit cost is calculated by dividing cost of goods available by the number of units available.

Income from operations

DEFINITION -Appears on the income statement and is equal to gross profit less operating expenses. Operating income is an important statistic because it indicates how profitable a business is from its primary business operations. To arrive at net income, add other revenues and gains to operating income, and subtract other expenses and losses, including income tax expense.

paid-in capital

DEFINITION -Corporate capital that is contributed as investment money by the stockholders, also called contributed capital. Paid-in capital is usually received in cash when common or preferred stock is issued. When the issued stock sells at a price that is higher than its par value, the difference is credited to Paid-in Capital in Excess of Par. -Additional paid-in capital, typically a significant part of stockholders' equity, includes the following: paid-in capital in excess of par - preferred stock, paid-in capital in excess of par - common stock, paid-in capital - treasury stock, etc. -All paid-in capital in excess of par from issuing preferred and common stock is reported on the stockholders' equity section of the balance sheet as additional paid-in capital.

Retained Earnings

DEFINITION -Cumulative net income of a corporation that has not been distributed as dividends. Retained Earnings represents a corporation's capital that has been earned through profitable operations. -Future profits, if not distributed as dividends, will add to the amount of retained earnings. Net loss and dividend distribution will reduce the balance of retained earnings. The Retained Earnings account is used to keep track of changes to retained earnings; its balance reflects the ending balance on the retained earnings statement, which also appears on the balance sheet under stockholders' equity.

retained earnings

DEFINITION -Cumulative net income of a corporation that has not been distributed as dividends. Retained Earnings represents a corporation's capital that has been earned through profitable operations. Future profits, if not distributed as dividends, will add to the amount of retained earnings. Net loss and dividend distribution will reduce the balance of retained earnings. The Retained Earnings account is used to keep track of changes to retained earnings; its balance reflects the ending balance on the retained earnings statement, which also appears on the balance sheet under stockholders' equity. CORRECTION OF ERROR: -Revenue and expense items are closed into Retained Earnings during the closing process. Thus, any errors related to revenue and expense items from a prior period(s) will have to be adjusted through Retained Earnings. -The effect of these errors is shown net of tax and adjusts beginning retained earnings on the retained earnings statement. -To compute the amount of the correction (of the error), net of tax, first calculate the tax effect of the error. An increase in income will also increase tax. Thus, there is additional tax associated with this error. NET INCOME -Net income increases Retained Earnings and will be listed in the retained earnings statement after adjusted beginning retained earnings. CASH DIVIDENDS DECLARED -When dividends are declared, Retained Earnings is reduced. Cash dividends declared will reduce Retained Earnings and will follow net income on the retained earnings statement. CASH DIVIDENDS PAID -When cash dividends are paid, Dividends Payable is reduced and Cash is reduced. However, this transaction does not affect Retained Earnings. Retained Earnings is decreased when dividends are declared, not paid. ACCUMULATED DEPRECIATION -Accumulated depreciation is a contra-asset that is reported on the balance sheet in the property, plant, and equipment section. It does not affect Retained Earnings, and it will not be found on the retained earnings statement.

cash dividend

DEFINITION -Distribution of earnings to stockholders. A dividend must be declared before it is paid, and a dividend declaration creates a liability for the corporation. This liability is settled by paying cash to the stockholders. The declaration and payment of a cash dividend reduces assets (cash) and stockholders' equity (retained earnings). -The board of directors may declare a cash dividend if there is a favorable balance in Retained Earnings and if there is sufficient cash available. The board of directors may also declare stock dividends, but cash dividends are more prevalent than stock dividends.

dividend

DEFINITION -Distribution of retained earnings (profit) to the stockholders, the owners of a corporation. In order for a corporation to pay dividends, it usually must have adequate retained earnings as well as cash in the bank, since dividends are typically paid in cash. -The management of a corporation decides if and when to pay dividends. Dividends are normally declared by the corporate board of directors and are paid to stockholders based on the number of shares owned. -Example: ABC Co. has 1,000,000 shares issued. On December 31 the board of directors declared a $ .30 per share dividend that will be distributed on January 15 to shareholders of record on January 1. If on January 1, Richard Holly owned a stock certificate representing 400 shares of ABC Co., what amount of dividends would Richard receive on January 15? Answer: $ .30 per share × 400 shares = $ 120

Revenue Expenditure

DEFINITION -Expenditures that are recognized (expensed) in the same accounting period as that in which they were incurred. Revenue expenditures are debited to various expense accounts, such as Wages Expense and Rent Expense, as they occur.

Generally Accepted Accounting Principles (GAAP)

DEFINITION -Generally accepted rules and practices developed by the financial community to provide guidelines for the recording, reporting, and interpretation of financial information. -The Securities Exchange Commission (SEC) is the U.S. government agency that oversees the setting of accounting standards for publicly traded entities. The primary accounting standard-setting body in the United States is the Financial Accounting Standards Board (FASB). -The primary goal of GAAP is the generation of the most useful information for decision making. For information to be useful, it must be relevant, reliable, timely, comparable, and prepared in a consistent manner.

(Merchandise) Inventory

DEFINITION -Goods awaiting sale (finished goods), goods in the course of production (work in process), and goods to be consumed directly or indirectly in production (raw materials). Inventory for a wholesale or retail company, merchandise inventory consists of only finished goods, but the inventory of a manufacturer will include all three types of goods. In a perpetual inventory system, the Merchandise Inventory account is updated with every sale and purchase of inventory. Returns, discounts, and freight-in are all recorded directly to Merchandise Inventory. -In a periodic inventory system, Merchandise Inventory is updated only at the end of the accounting period. -Merchandise inventory is reported on the balance sheet under current assets. Methods for reporting inventory include first-in-first-out (FIFO), last-in-first-out (LIFO), and the average method. The conservatism principle dictates that businesses report inventory using the lower of cost or market (LCM) method.

Purchase Discount (Gross Method)

DEFINITION -In the gross method, when merchandise is purchased, the full amount of the purchase invoice (gross) is debited to Merchandise Inventory. Merchandise Inventory is later credited with the amount of the cash discount if the discount is taken.

Revenue

DEFINITION -Income earned by selling goods and services to customers. Revenue increases stockholders' equity and appears at the beginning of the income statement. Revenue is earned when the product is delivered to the customer or when a service has been performed.

Inventory Shrinkage

DEFINITION -Loss of inventory items due to theft by employees, shoplifting, errors in the physical count or recording of inventory, and other causes. Inventory shrinkage is discovered following a physical count of inventory items on hand and comparing the results to the perpetual inventory records. Shrinkage means that inventory on hand is less than it should be, as per the inventory records. Periodically, inventory records are adjusted to show the actual quantities, as per the physical count. In the perpetual system of accounting for inventory, the amount of shrinkage (loss) is usually written off as an expense. In the periodic system of accounting for inventory, inventory shrinkage does not exist as a separate account but is included in cost of goods sold.

discontinued operations

DEFINITION -Major divisions or segments of a business that are disposed of. From time to time, management may sell significant parts of its operations because they are not profitable or as part of an effort to downsize the business. -The net income or loss of operating the discontinued operation is reported, net of tax, in the lower part of the income statement after income from continuing operations. Also, the gain or loss from disposal of the discontinued operations is reported, net of tax, in the lower part of the income statement.

preferred stock

DEFINITION -One kind of stock that a corporation can issue to raise capital (the other being common stock). Preferred stock typically gives its owners a preference over the owners of common stock in dividend distribution and assets upon liquidation. Preferred stockholders are not guaranteed a dividend; a company must make profit and declare dividends first. -When a corporation pays a cash dividend, preferred stockholders are paid their annual dividend requirement before common shareholders are paid anything. Dividends paid to preferred stockholders generally are a fixed dollar amount per share (example, $3 per share) or a percentage of the stock's par value (example, 10% of $30 par value). -Preferred stock may be issued at par or no-par.

direct write-off method

DEFINITION -One of two methods used to account for uncollectible accounts receivable and the related write-off. The other method is the allowance method. Under the direct write-off method, bad debts expense may not be recorded in the period of the sale. Instead, whenever an account is deemed to be uncollectible, Bad Debt Expense is debited and Accounts Receivable is credited to record the bad debts expense and write off the account. To write off a debt is to close a customer's account and to assume its balance as a business expense (loss). Writing off a debt usually follows failed attempts to collect the amount due from a customer. -The direct write-off method violates both the matching and conservatism principles and does not conform to GAAP. The direct write-off method is mostly used by companies with few sales on account and, therefore, few or no credit losses. In such cases its use is permitted because of the materiality concept. -In this method, no provision is made in advance for possible uncollectible accounts receivable.

Allowance Method

DEFINITION -One of two methods used to write off uncollectible accounts receivable (bad debts). Under the allowance method, an estimate of uncollectible amounts is made in advance and recorded in an account called Allowance for Uncollectible Accounts. Then, this account is used to write off accounts receivable when they become uncollectible. To write off a debt is to close a customer's account and to assume its balance as a business expense (loss). Writing off a debt usually follows failed attempts to collect the amount due from a customer. -The allowance method is the more accepted method and the one recognized by GAAP because it adheres to the matching principles. The matching principle requires that revenues reported for an accounting period be matched with all the expenses incurred to generate that revenue. The allowance method recognizes bad debt expense in the same period during which the sale was recognized. -The allowance method presents accounts receivable on the balance sheet, less allowance for uncollectible accounts to arrive at net (cash) realizable value.

goods in transit

DEFINITION -Products en route from a seller to a buyer, sold FOB shipping point or FOB destination. At the end of an accounting period, each business conducts a physical count of inventories on hand to determine the correct balance of its inventoryaccount. -Legal title (ownership) of goods shipped FOB shipping point goes from the seller to the buyer at the shipping point. Goods in-transit at year-end shipped FOB shipping point belong to the buyer, who should include them in ending inventories. The seller should not include them. -On the other hand, goods in-transit (at year-end) sold FOB destination are the property of the seller, who should include them in ending inventories. The buyer should not include them.

Freight Out

DEFINITION -The account used to record shipping costs on goods sold FOB destination, whereby the seller pays for the shipping costs. Freight-out is reported separately on the income statement under selling expenses. Freight-Out is sometimes called transportation-out or delivery expense. (Note that there may be circumstances when Freight-out is actually reported as part of Cost of Goods Sold.)

distribution date

DEFINITION -The date on which dividends are distributed (paid, in the case of a cash dividend) to the stockholders. There are two other dates relating to declaration and distribution of dividends that precede the distribution date: the declaration date and the date of record. On the declaration date, the board of directors formally announces its intention to distribute dividends to owners of record as of a specific date, the date of record. -The vast majority of dividends distributed are cash dividends, although a few are stock dividends. When a cash dividend is declared, a liability is created. A journal entry debiting (decreasing) Retained Earnings and crediting (increasing) Dividends Payable records the transaction. (Alternately, instead of debiting Retained Earnings, one can debit a Dividends account, which is then closed to Retained Earnings at the end of the year.) On the distribution date, the stockholders are paid their cash dividend, and the transaction is recorded by debiting (decreasing) Dividends Payable and crediting (decreasing) Cash.

salvage value

DEFINITION -The estimated cash amount to be received from selling the asset at the end of its useful life. Also called Salvage Value or Scrap Value. In the calculations of annual depreciation, residual value is subtracted from the cost of an asset to arrive at the depreciable cost. -The depreciable cost is then allocated to the various periods in an asset's useful life using an acceptable method of depreciation such asstraight line, double declining balance, or units of production. FORMULA Depreciable cost = Acquisition cost - Residual value

Net Loss

DEFINITION -The excess of a company's total expenses over its total revenues. If total revenues exceed total expenses, a company will have a net income instead of a net loss. Net income/loss is usually the last item that appears on an income statement.

Net Sales

DEFINITION -The excess of sales revenue over sales returns and allowances and sales discounts. Often referred to as the "top-line" of the income statement. -Net sales= Sales revenue - Sales return and allowances - Sales discounts. -Net sales is reported on the multiple-step income statement of a merchandising or manufacturing business.

Multi-Step Income Statement

DEFINITION -The income statement presentation that provides more detailed information than a single-step income statement. A multiple-step income statement highlights the components of net income and provides information on net sales, cost of goods sold, gross profit, and income from operations.

common stock

DEFINITION -The most basic type of stock issued by a corporation as evidence of investment by the stockholders. Common stock gives its owners the right to vote in the annual shareholders meeting and to receive dividends if the corporation chooses to declare them. A private corporation normally issues common stock directly to the investors. A public corporation issues common stock and sells it to investors indirectly in a public exchange through a broker, such as the New York Stock Exchange. -Besides common stock, a corporation may also issue preferred stock. Holders of preferred stock normally do not have voting rights but are entitled to receive declared dividends before holders of common stock.

stockholder's equity

DEFINITION -The net shareholders' claims against the assets of a corporation are comprised of paid-in capital and retained earnings. Paid-in capital represents the shareholders' investment when stock was issued. Retained earnings represents accumulated profits retained (not paid as dividends) from current and previous periods. -Stockholders' equity is reported on the balance sheet in a section by itself, following liabilities.

legal capital

DEFINITION -The par value of the stock issued, obtained by multiplying the number of shares issued by the par value per share. -The par value per share is usually stated in the corporate charter, which also specifies the maximum number of shares a corporation can issue, i.e., authorized shares. -For the protection of creditors, many states require that corporations maintain a minimum amount of stockholders' equity, called legal capital. FORMULA -Legal capital = Total number of shares issued × Par value per share EXAMPLE -If a corporation issues 1,000 shares of $5 par common stock for $17 per share, the total amount in the Common Stock account, also known as legal capital, will be the total par value of the issued shares: 1,000 shares × $5 par = $5,000

capitalization

DEFINITION -The recording of an expenditure as an asset instead of recording it as an expense. Capital expenditures benefit future accounting periods, so their costs are expensed over their entire useful life rather than in only the current accounting period, in accordance with the matching principle. The periodic allocation of cost to expense accounts is called depreciation for fixed assets, amortization for intangible assets, and depletion from natural resources.

Materiality

DEFINITION -The relative importance of an item or a transaction. If the item is material, then it could influence the actions of a decision maker. If an item is immaterial, it would not influence the decisions of the users of accounting information and it may be accounted for in the easiest manner. -Materiality of an item generally can be assessed by comparing that item to total assets or total revenues. For example, if a company with total revenues of $4 billion makes a mistake of $200 in recording and reporting sales revenue, this mistake is considered immaterial. -The issue of materiality arises, for example, when recording the purchase of tools or small equipment. The matching principle dictates that such purchases be capitalized, i.e., charged to a plant asset account, and the cost allocated (depreciated) to the periods in the asset's useful life. The materiality principle, however, permits the recording of these purchases as expenses to be absorbed by the current accounting period. This would be more efficient, and since the amount is not material, it would not make a difference in decision making. -The concept of materiality also permits use of the direct write-off method of accounting for bad debts if they are immaterial.

Accrual Basis Accounting

DEFINITION -The system of accounting under GAAP (generally accepted accounting principles) that recognizes revenueswhen they are earned (not necessarily when the cash is received) and expenses as they are incurred (not necessarily when the cash is paid). The cash basis of accounting is not acceptable by GAAP because it only recognizes revenues and expenses when cash is received and paid.

vertical analysis

DEFINITION -The use of ratios in the comparison and analysis of financial information that is presented vertically (in a column) on a financial statement. In the (partial) income statement for Falcon Motor Company, the values for the current year 2020 are presented in the first column. A second column is used to compute each of the values as a percentage of Gross Sales. In this example, Gross Sales is used as the base for comparison, and has a value of 100%. In another situation, Net Sales could be used as the base for comparison and would be given a value of 100%. -Vertical analysis of financial statements is used to show the relationship of each individual component as a percentage of the total within a single statement. In a vertical analysis of an income statement, each item is typically stated as a percentage of net sales. In a vertical analysis of a balance sheet, each item is typically stated as a percentage of total assets. -Vertical analysis, also called common size analysis, uses percentages to compare the financial statements of two or more companies of any size. In the income statement, the comparison then focuses on each income statement item as a percentage of net sales. -Vertical analysis is also useful in comparing the current period percentages with those of prior periods for the same company to discern a trend.

change in accounting principle

DEFINITION -Using a different generally accepted accounting principle than the one used in the past year, such as LIFO instead of FIFO for inventory valuation, or straight-line instead of double-declining balance for depreciation. Using the same principle (method) consistently is essential to producing comparable information over a number of accounting periods. ---When a change in accounting principle occurs, the cumulative effect on the net income of prior years from having used the previous method rather than the new method must generally be reported. This cumulative effect must be disclosed, net of tax, at the end of the current year's income statement. -To maintain comparability from period to period, income statements are prepared in two parts. The first part ends with income from continuing operations after income taxes. The second part starts, where the first part ends, with income from operations after tax and includes any results of discontinued operations, extraordinary items, and the cumulative effect of a change in accounting principle, all shown net-of-tax. EXAMPLE -Starting this year, Tustin Sporting, Inc. changed the method of depreciation for its depreciable assets from straight-line to double-declining-balance. The cumulative effect on prior years' income statements is an increase in depreciation expense in the amount of $60,000. This means that pre-tax income also decreases by $60,000. The net-of-tax effect of the change is the decrease in pre-tax income less the applicable tax at the rate of 25%. The effect of the change in accounting principle is calculated as follows: Cumulative effect of change in accounting principle: Increase in depreciation expense and, therefore, decrease in pre-tax income by $60,000. Tax reduction (savings) resulting from decrease in pre-tax income=$60,000×25%=$15,000 Cumulative effect of change, net-of-tax = Decrease in income -Tax effect = $60,000 - $15,000 = $45,000

Statement of Cash Flows

DEFINITION -a financial statement prepared at the end of an accounting period, together with the other three financial statements: the income statement, the statement of retained earnings and the balance sheet. Unlike the other three financial statements, which are prepared from an adjusted trial balance, the preparation of the statement of cash flows uses information included in the current year's income statement and the comparative balance sheet. Also, schedules detailing transactions that affect cash are prepared to assist in the preparation of the statement of cash flows. -The purpose of the statement of cash flows is to report cash receipts and cash payments, changes in the cash balance, and the reasons for these changes. Business decision-makers utilize the information in the statement of cash flows to assess the liquidity of a company and to predict its ability to generate cash in the future. Cash is needed to pay for many things including bills, employees' salaries and to purchase inventories. Investors and creditors are especially interested in the reasons for changes in cash. Also of interest are the investing and financing activities reported on the statement of cash flows. -The statement of cash flows reports activities that affect cash in three sections: operating activities, investing activities and financing activities. Most companies use the indirect method to prepare the statement of cash flows, because it is easier and because it reveals less information to competition. The Financial Accounting Standards Board (FASB), prefers the direct method, but allows the use of the indirect method. -Both the direct and indirect methods arrive at the same results, and report cash receipts and cash payments in three activities: operating, investing and financing. The two methods differ in the way operating activities are reported. Specifically they differ in the way they convert net income from the accrual basis to the cash basis.

statement of cash flows

DEFINITION -a financial statement prepared at the end of an accounting period, together with the other three financial statements: the income statement, the statement of retained earnings and the balance sheet. Unlike the other three financial statements, which are prepared from an adjusted trial balance, the preparation of the statement of cash flows uses information included in the current year's income statement and the comparative balance sheet. Also, schedules detailing transactions that affect cash are prepared to assist in the preparation of the statement of cash flows. -The purpose of the statement of cash flows is to report cash receipts and cash payments, changes in the cash balance, and the reasons for these changes. Business decision-makers utilize the information in the statement of cash flows to assess the liquidity of a company and to predict its ability to generate cash in the future. Cash is needed to pay for many things including bills, employees' salaries and to purchase inventories. Investors and creditors are especially interested in the reasons for changes in cash. Also of interest are the investing and financing activities reported on the statement of cash flows. -The statement of cash flows reports activities that affect cash in three sections: operating activities, investing activities and financing activities. Most companies use the indirect method to prepare the statement of cash flows, because it is easier and because it reveals less information to competition. The Financial Accounting Standards Board (FASB), prefers the direct method, but allows the use of the indirect method. -Both the direct and indirect methods arrive at the same results, and report cash receipts and cash payments in three activities: operating, investing and financing. The two methods differ in the way operating activities are reported. Specifically they differ in the way they convert net income from the accrual basis to the cash basis. Below is a skeleton statement of cash flows with the main sections highlighted.

Accounts Receivable Turnover Ratio

DEFINITION -a liquidity ratio that compares net credit sales to average net receivables to compute the number of times, on average, that receivables are collected (turned) during a period. The more times that receivables are collected, the shorter the average collection period, and the more liquid the receivables. -A decrease in the Receivables Turnover Ratio means that receivables are collected less frequently (it takes a longer period to collect) indicating lower liquidity. The adequacy of a company's liquidity is also assessed in a comparison with industry averages. -if no beginning balance is provided for earlier year, we have to use the year-end balance for receivables as the average. -The accounts receivable turnover ratio measures the number of times an entity collects its receivables during the year. It shows the relationship between credit sales and accounts receivable. In general, it is desirable to collect receivables as promptly as possible. The cash collected from receivables improves solvency. Prompt collection also lessens the risk of loss from uncollectible accounts. FORMULA -Receivables turnover ratio = Net credit sales / Average net receivables -Net credit sales = sales on account - (sales discounts + sales returns and allowances) -Average net receivables = (total of beginning + ending balances of Accounts Receivable) / 2 -Net receivables = Accounts Receivable - Allowance for Bad Debts.

investing activities

DEFINITION -a section of the statement of cash flows which reports cash transactions relating to the purchase and sale of fixed assets, equity and debt investments, as well as lending and collection of loans. -However, related revenues such as interest revenue and dividends received from investments are reported in the operating activities section of the statement of cash flows. -Investing activities include the purchase and sale of non-current assets, investments (excluding trading securities), and the lending and collection of loans. These transactions involve the purchase and sale of assets (not including merchandise inventory, trading securities, and cash equivalents). Examples include proceeds from the sale of, or cash used to purchase equipment, long-term investments, and buildings.

Perpetual Inventory System

DEFINITION -an accounting system that requires records of each inventory item be kept, maintained, and continuously (perpetually) updated with every inventory purchase and sale. Under a Perpetual Inventory System, the balances of Merchandise Inventory and Cost of Goods Sold accounts continuously reflect the cost of inventory on hand and the cost of inventory that has been sold during the period, respectively.

financing activities

DEFINITION -one of the three sections of the statement of cash flows. The financing activities section reports cash transactions relating to the issuance and retirement of bonds and other debt securities, as well as the issuance of stock and payment of cash dividends. -Financing activities include the issuance of stock, issuance and retirement of bonds, long-term debt and current non-operating debt, dividends paid to stockholders, and treasury stock transactions. These transactions involve the issuance and retirement of debt and equity and the return of resources to the stockholders (repurchase of treasury stock and payment of dividends). Examples include issuance of common stock, preferred stock, bonds and other debt; purchase of treasury stock; retirement of debt; and payment of dividends.

operating activities

DEFINITION -transactions involving cash that are related to an entity's principal business activity and operations. On the statement of cash flows, business activities are grouped into operating, investing and financing activities. -Operating activities that produce cash inflows include sales, and the receipt of interest and dividends from investments. Operating activities with cash outflows include payments for inventories, operating expenses, interest, and taxes. -A statement of cash flows is prepared using either the direct method or the indirect method. The presentation of the operating activities section is different under each method, but cash flows from both investing and financing activities are presented in an identical way under both the direct and the indirect methods. Operating activities are reported first on the statement of cash flows because of their importance. -An analysis of cash provided by operating activities can help to answer fundamental questions about whether the company will be able to generate enough cash from its main business activity to survive and expand in the future. -Operating activities include cash provided by or used within the normal income-producing (operational) activities. These transactions involve cash and are related to transactions that are reported on the income statement. Examples include cash received from customers (from sales or service revenue), cash paid to suppliers (for the purchase of inventory), cash paid for operating expenses (including salaries, rent, insurance, and others), cash paid for interest, and cash paid for taxes.

Declaration Date (dividends)

DEFINITION The date on which the board of directors announces that a dividend is promised to the stockholders, to be distributed on a future date (the distribution date). The declaration of a cash dividend creates a liability for the corporation; the liability is recorded by debiting (decreasing) Retained Earnings and crediting (increasing) Dividends Payable. (Alternatively, instead of debiting Retained Earnings, a Dividends account may be debited on the declaration date and then closed to Retained Earnings at the end of the year.) Dividends Payable is a current liability account that is debited on the distribution date, the date on which cash is paid to the shareholders.

income statement classification

DEFINTION -A corporate income statement may include any or all of the following categories: -Change in accounting estimate -Change in accounting principle -Discontinued operations -Operating expense -Other expenses -Other revenues -Prior period adjustments

Annual Report

DEFINTION -A document issued by management to the shareholders of a company and other potential users that presents financial information and results of operations for the last fiscal year. Included in the annual report is a letter from the chief executive officer (CEO) to the shareholders highlighting major achievements during the last accounting period and outlining plans of action for the forthcoming period. The annual report also includes financial statements, notes to financial statements, management's discussion and analysis of financial condition, operations, and cash flows, as well as the auditor's report.

Date of record

DEFINTION -The date used to establish ownership of stock for the purpose of paying dividends. Owners of record are stockholders who owned the stock on the date of record and will receive a dividend payment on the date of distribution.