Rutgers MBA Accounting
What are adjusting entries?
Adjusting entries are entered into the accounting system in the same way as the previous items, but there is a difference in their cause. Up to now, we have been dealing with transactions, where the company engaged in an exchange with another party. But there are some accounting entries that are driven by the passage of time or the arrival of new information. These are adjusting entries, and they are made at the end of every reporting period (e.g., the end of every quarter). Usually one part of the entry adjusts the value of an asset or liability, while the other half of the entry affects the Income Statement
What if, of total sales of $2,500,000, $500,000 is for cash and the remainder on account, i.e., the customer promise to pay Orphan Brands later? F irst, enter the inflows of resources into the Accounting Equation. Then go to the next screen to record the outflows of resources.
Again, this transaction is an exchange between Orphan Brands and its customers. There has been an inflow of cash and accounts receivable, and the Income Statement reflects these resource inflows from the company's operations. Note that the Revenue number on the Income Statement does not depend on whether customers paid in cash today or promised to pay cash in the future. It reflects a longer-term view of resource flows than the Statement of Cash Flows
What is an "Account Receivable"?
An Account Receivable represents another party's obligation to pay the company in the future. Usually receivables arise from sales to customers on credit, but there are other types as well. For instance, a company might make a loan to an employee.
When should the purchase of an asset be recognized?
Assets are recognized when the company acquires (in a transaction) a resource that will provide future benefits and those benefits can be estimated with a reasonable degree of certainty. The specifics may depend on the customs of a given business, but an asset is most commonly recognized by the purchaser when it is shipped from the seller.
Describe Income statement T-accounts vs Income Summary vs Income Statement
But this isn't balanced.
What is the difference between cash and retained earnings?
Cash is an asset, so it is listed on the left side of the Balance Sheet. In contrast, retained earnings are not an asset. It is the lifetime earnings of the company that have been retained and reinvested in the business to buy more assets or pay bills. It's a part of owners' equity and is listed on the right-hand side of the Balance Sheet. You might think that retained earnings is the same as cash, because "retained" sounds like a resource and "earnings" sounds like cash. But as you will see very soon, earnings and cash are not the same.
Do you increase a LIABILITY or OWNER'S EQUITY with a debit or credit?
Credit (right-sided entry) thus, you decrease liability or owner's equity with a DEBIT (left-sided entry)
Do you increase an ASSET T-account with a debit or credit?
Debit (left-sided entry) thus, you decrease an asset T-account with a right-sided entry (credit)
show how the liability and owners' equity accounts are effected by the trademark purchase. Remember that the package of consideration included $4,500,000 in cash, $500,000 in debt, and $1,000,000 in common stock.
In addition to the $4,500,000 in cash that you entered on the previous screen, Orphan Brands gave the promise of a future cash payment of $500,000, and $1,000,000 in equity. These additional entries to the right side of the Accounting Equation balance the total $6,000,000 purchase of the trademark.
As you translate this transaction into the language of financial accounting, recall that we've already (in transaction #5) recognized the revenue from the sales that totaled $2,500,000. And in that same transaction, we also recognized the cost of goods sold expense and the related reduction of inventory. None of those accounts is affected here. All we're doing now is completing the payment cycle on $1,500,000 of the initial purchase of $2,000,000 of inventory.
Orphan Brands has $1,500,000 less cash after this transaction and it has reduced its obligation to CPX by the same amount. Reducing an asset and a liability by the same amount keeps the Accounting Equation in balance. There is no expense at this point; the cost of the inventory is being "stored" in the Inventory account. Once the product is sold - and the resulting revenue is recognized - then the cost will be removed from "storage" in Inventory and recognized as cost of goods sold expense that is matched with the revenue for the period.
First show how the asset side of the Accounting Equation is affected. Start with the addition of the new asset - the brand - whose account is called "Purchased Trademark" and whose value is $6,000,000. The package of consideration included $4,500,000 in cash, $500,000 in debt, and $1,000,000 in common stock.
Orphan Brands has acquired an intangible asset called Purchased Trademark in exchange for a cash payment, the promise of a future cash payment, and equity. This entry shows how the asset Purchased Trademark increased and Cash decreased. Note: If a company develops its own valuable trademark through marketing and advertising, it does NOT recognize an asset because of the difficulty in verifying the value to assign to the asset as it is being developed. But when a company purchases a trademark transaction, the agreed-upon price can serve as a verifiable value for the intangible asset. In that case, an asset should be recognized on the Balance Sheet of the purchasing company.
How would you account for this transaction using the T-account method? Orphan Brands spent $48,000 on equipment to get their business started.
Orphan Brands has changed its mix of assets. We depict the new office equipment with a debit (left side entry) to a new T-account labeled Office Equipment. And Orphan Brands acquired these assets by paying cash. We depict that outflow of resources, i.e., the decrease in Cash, with a credit (right side entry) to the Cash T-account.
What if, instead of getting free rent for a year, Orphan Brands had to enter into a lease for its office space on terms that required rent at an annual rate of $50,000, with the first six months payable in advance? How would you use the Accounting Equation method to depict the first payment of rent?
Orphan Brands has exchanged cash for an intangible asset - a contract that provides the right to use the office space for the next six months. Note that Orphan Brands would not recognize the office building itself as an asset because it has only acquired the right to use the space for a limited time. Prepaid Rent would be a current asset, because its expected benefits (the use of the office space) will occur within the next year.
What if a particular customer wanted a quantity of ReallyKleen to be provided with special packaging? Let's assume that Orphan Brands charges the customer $75,000 for this order, and the customer pays $40,000 up-front, even though the goods will not be shipped for two months. Orphan Brands' cost on this order will be $30,000. How would you account for the receipt of the order and the receipt of $40,000 in cash? (Hint: This hypothetical question is similar to the second one that followed transaction # 5.)
Orphan Brands has received cash of $40,000, and it now has an obligation to the customer to ship the ordered product or to return the $40,000. The $40,000 liability is an example of a non-monetary liability for which the company has no obligation to pay, but rather an obligation to provide a good or a service. Note that this entry does not yet recognize revenues, expenses and profit; the order has yet to be delivered to the customer.
What if the interest expense were paid in cash at the end of the quarter instead of being accrued for payment at the end of the year? How would you account for that using the T-account method?
Orphan Brands incurred an interest cost of $15,000 for its use of CPX's capital for this quarter, and it has reduced cash to pay that interest. This transaction doesn't require an adjusting entry. Remember, adjusting entries involve accruals, and this (cash) transaction needs no accrual to place the expense within the accounting period.
Recall in transaction # 4 that, as part of its payment of $6 million for the brand Trademark, Orphan Brands gave CPX a promissory note of $500,000. How do we treat the interest expense that is associated with that loan?
Regardless of whether the interest is paid in cash, it makes sense to recognize interest expense now (by debiting the Interest Expense T-account). Orphan Brands has had the use of the $500,000 of loan proceeds for the quarter and should recognize an expense for the cost of using that capital for the period. The interest payments aren't due as cash payments until the end of the year, but in the meantime, Orphan Brands' obligation to pay interest to CPX increases every period by the amount of the interest accrual. That obligation takes the form of the Interest Payable account, which we increase with the credit of $15,000.
Now the assets should equal $1,050 whereas the Owners Equity and Liabilities = $1,000. What is missing?
Retained Earnings of $50
When are revenues recognized?
Revenues are recognized when they are earned, which usually means when products are shipped or services are provided. If you think about it, this corresponds to the rule where assets are recognized when we acquire the right to them. For example, when we bought inventory, we recognized the asset as the vendor sent it to us. At the same time, the vendor probably recognized revenues on his financial statements. The two usually go together, and the linkage is delivery to the customer.
Are wage costs reflected differently on the Income Statement versus the Statement of Cash Flows?
Sure. Do you remember in transaction # 5 we had credit sales and reported them as revenues on the Income Statement? The credit sales won't materialize as cash on the Statement of Cash Flows until we collect the receivables (transaction # 7). Well, that same difference between accruals and cash occurs here. Let's say our reporting period is ending on a Wednesday and we pay our employees on Fridays. On the Income Statement, we accrue wage expenses through Wednesday. Our offset is an increase in wages payable, not a reduction in cash. Cash won't go down until Friday, when we pay the employees, reduce the payable, and see the cash effect on the Statement of Cash Flows.
What are the 3 financial statements?
The Income Statement reports the company's profit or loss, a summary of all the firm's sales and related expense activity from the beginning to the end of a period of time. The Balance Sheet reports the amount of a company's assets, liabilities, and owner's equity. It represents a snapshot of the firm's financial situation at a specific moment in time. And the Statement of Cash Flows reports why the company's cash balance changed over a given period of time.
What is the Matching Principle of accounting?
The Matching Principle guides the recognition of expenses in the Income Statement. When a company incurs a cost, it does so for a purpose - to receive a benefit (e.g., revenue). The Matching Principle states that the cost should be recognized as an expense in the SAME PERIOD as the benefit is recognized. So, when an investor looks at the Income Statement, he or she is getting a pretty complete picture of the resources that were necessary to generate the revenues for the period. This practice should make it easier to judge the long-term value-added performance of the company. (Note that the Conservatism Principle discussed above can disrupt the matching of costs with the benefits they produce.)
What is a depreciation expense?
The account on the income statement where the expense for depreciation on an asset is recorded. ie. equipment purchased with a life-span of 2 years
record the effect of this transaction on the T-accounts for liabilities and owners' equity. Remember, the package of consideration included $4,500,000 in cash, the promise to pay CPX $500,000 in the future, and $1,000,000 of Orphan Brands common stock. (Remember that the total debits and total credits from this screen and the previous screen need to match!)
In addition to using the $4,500,000 in cash that we recorded on the previous screen, Orphan Brands funded this acquisition by incurring a new liability (Notes Payable) of $500,000. We depict this new claim on the company's assets with a credit (right-hand side entry) to its T-account. Next, they issued CPX $1,000,000 worth of Orphan Brands common stock. Note that this part of the transaction makes CPX not just a creditor of Orphan Brands, but a shareholder too. So now total debits ($6,000,000 to the Trademark T-account) equal total credits ($4,500,000 to the Cash T-account, $500,000 to Notes Payable T-account, and $1,000,000 to the Common Stock T-account).
What triggers the recognition of revenue?
In most cases, revenue (and profit) is recognized when the product is shipped to the customer because at that point, the company has fulfilled its share of the sales transaction. There are a couple of cases in which we might delay revenue recognition to a later date. First, it may be that we cannot make a reasonably certain estimate of the amount we will receive from the customer. (This is an uncommon event, because most companies try to avoid selling to such customers.) Or, it may be that we have promised to deliver more to the customer following shipment (installation, upgrades, support service, etc.) In that case, "shipment" is not really "delivery" of the promised goods and services.
Would Orphan Brands recognize a sale before it receives cash from its customers? Why?
In most cases, yes. We recognize assets when we have a future benefit that we have acquired (or earned) and when that benefit can be estimated with a reasonable degree of certainty. When Orphan Brands ships the product to a customer, it has an asset - an Account Receivable - that it did not have before. This inflow of assets is balanced by the recognition of revenue. In the great majority of cases, recognition of revenue is tied to delivery of the product or service to the customer, not to the receipt of cash from the customer.
How is interest expense classified in the financial statements?
Interest expense, which is the cost of using borrowed money, is accrued for the period and reported on the Income Statement. It's classified as a part of financing costs, which are reported separately from operating costs. However, on the Statement of Cash Flows, interest payments are reported as part of operating activity.
Use the T-account method to depict this transaction in which Orphan Brands acquired inventory in exchange for a promise to pay in the future. You should begin to see the close similarities between this method and the Accounting Equation method.
Inventory increased by $2 million, and we depict an increase in its T-account with an entry on the left-hand side, i.e., the debit side. And Accounts Payable increased by the same $2 million amount. And since Accounts Payable represents a claim on the company's assets, we depict an increase in its T-account with an entry on the right-hand side, i.e., the credit side.
What is a contra account?
It is an account that serves to reduce the value of another account. On the Balance Sheet, a contra-asset account has a credit balance and a contra-liability (or contra-owners' equity) account has a debit balance. A contra account is always associated with another specific account.
What if a customer informs Orphan Brands that, due to cash flow tightness that won't ease for another six months, it will have to defer its payment of an outstanding $50,000 that it owes Orphan Brands from an earlier purchase. Orphan Brands has confidence in this customer, who demonstrates his sincerity by signing a promissory note, due in six months, to document the $50,000 liability. To compensate Orphan Brands for the deferral in payment, the customer will pay $3,000 in interest, in addition to the $50,000 principal, at the end of 6 months. How would you account for this?
It's possible that this change will not be observable to the financial statement reader if Notes Receivable and Accounts Receivable accounts are aggregated into a single account. However, within the accounting system, the change from a non-interest-bearing receivable to an interest-bearing receivable would be recorded.
How do increases in credit sales affect profitability and liquidity?
Let's imagine that our revenues from credit sales grow quickly and cause a build-up in receivables. What happens if we don't collect those receivables very fast? Profitability would increase as we continue to report all those revenues. But liquidity would decrease: We'd have a lot of "money" tied up in receivables, and at the same time, we'd have vendors and employees who have to get paid on time. That could create a serious problem. In fact, did you know that the most common reason why new companies go out of business is not because they don't have sales or reported profits? It's because they run out of cash.
What if, in addition to paying $1,500,000 of the balance from the initial purchase of inventory, Orphan Brands also decided to replenish its inventory by placing an order with CPX for another $1,000,000 of ReallyKleen to be delivered in 30 days? How would you account for this order?
No entry The order for more inventory would be entered into Orphan Brands' information systems but would not yet influence the financial statements. In general, accounting systems do not recognize "unexecuted contracts," i.e., agreements on which neither party has yet performed. Orphan Brands does not yet control the inventory, and it has no obligation to pay CPX until CPX sends notification that the inventory has been delivered to a section of the warehouse that is reserved for Orphan Brands' inventory.
Assume that many years ago, Coca Cola Inc. invested (hypothetically) $20,000,000 to develop the formula for Coke. In the meantime, Coke has become a global brand and trademark with earning power that supports a valuation in the stock market of well over $100,000,000,000. How would you use the T-account method to recognize the increase in the value of that asset? How would the accounting system recognize the increase in the value of that asset in the T-accounts?
No entry. Accountants' conservatism does not allow a company to recognize an increase in the value of an asset except in the case of marketable securities. (Note that this rule is not always followed in other countries where inflation is high.) Companies with self-developed intangible assets like trademarks and patents do not recognize the value of these resources on their balance sheets. Instead, the expenditures that produced these assets are expensed in the period in which they occur.
Translate this activity into the language of financial accounting. Be sure to match the $2,500,000 million amount of sales (i.e., Revenue) with an equal-sized entry to another account to record the inflow of resources to Orphan Brands. Then, on the next screen, match the $1,000,000 million reduction of Inventory with an entry to another account to record the outflow of resources.
Note how the inflow of resources from the customer, as represented by the increase (debit entry) in Accounts Receivable, is matched by the increase (credit entry) in the Revenues T-account. Note also that this transaction does not reflect any cash receipts. (We'll see the cash collections shortly in transaction # 7). Now that we've correctly reported the inflow of resources, we need to correctly report the corresponding outflow of resources.
Are Costs of Goods Sold always recognized when revenue is recognized?
Yes, and that becomes clear when you look at the term closely. We recognize revenues when there's a sale of goods, and the goods that are sold have a cost. Hence, "cost of goods sold." Accounting uses the matching principle which says "Match costs with the revenues that they helped produce." Then, by definition, the answer to your question is "Yes."
Direct vs indirect method for statement of cash flows
both the Direct Method and the Indirect Method arrive at the same answer for Cash from Operations. It's true that the Direct Method is easier to understand, and the accounting standards setters have encouraged companies to present it. However, almost all companies in the U.S. use the Indirect Method, so it's important to learn how to interpret it.
What is an "accrued expense"?
refers to an expense that is recognized on the Income Statement, when the associated cash outflow won't occur until SOME TIME IN THE FUTURE. For instance, let's suppose that Orphan Brands ran a product promotion during this quarter, and they received an invoice for the advertising that is due just after the end of the quarter. At the point they receive the invoice, does Orphan Brands have a liability that should be recognized? Should the cost of the advertising be matched against this quarter's revenues in assessing the firm's performance? The answer to both questions is yes, and in the accounting system, we would recognize a liability and an expense.
What is an expense? How do you balance an accounting entry to recognize an expense?
represent the resources (actually net resources) that were used by the company to generate the revenues for the period. So, whenever we make an accounting entry to recognize an expense, there is a balancing entry that reduces assets or increases liabilities.
What is an income statement?
shows a company's revenues, expenses, gains and losses for a PERIOD OF TIME ending with a NET INCOME for that period. Reflects the flow of resources.
What is a Cash Flow Statement?
shows why a company's cash balance changed during a given time period; specifies if a company's activities (operations, investing, financing) generated cash and which activities used cash
What is a balance sheet?
statement of financial positions that shows the company's: total assets = total liabilities + owner's equity (the accounting equation) A = L + OE provides a snapshot of a company's mix of resources and obligations at a point in time
How do you organize the previous table into the income statement?
three transactions that affect the Income Statement for this period, and they're all captured in the Expense columns of the Accounting Equation. These entries, for Depreciation, Amortization and Interest Expense can all be reformatted as part of the Income Statement, as indicated above
What does it mean to "buy on account"? How is it related to Accounts Payable and Accounts Receivable?
to "buy on credit," though the payment horizon is usually very short (e.g., days or weeks). It is very common for companies to purchase goods or services on account from suppliers (giving rise to a liability called Accounts Payable) and to sell goods or services on account to customers (giving rise to an asset called Accounts Receivable).
What does amortized mean?
to expense in equal quarterly amounts over the asset's estimated useful life It's a rather general term that is used in a variety of contexts to assign a cost or value to a period of time. For instance, the costs of intangible assets are "amortized" in a fashion that is very like depreciation. In fact, depreciation is regarded as a special case of amortization. In addition, we will see how liability values for debt can be amortized, i.e., their cost assigned to a particular period of time.
As you translate this item into the language of financial accounting, note that we've introduced another contra account as an offset to the Purchased Trademark account. Can you figure out how it works and what its purpose is? Remember that Orphan Brands paid $6,000,000 for the brand and that it has a useful life of 25 years. The cost of the brand will be expensed quarterly.
The accrual accounting system "matches" the $6,000,000 cost of the purchased trademark to the periods that are expected to benefit. We might think that the ReallyKleen trademark would provide benefits forever if Orphan Brands were careful to maintain it. But current accounting convention requires that such assets have a maximum accounting life of 40 years. In this case, we are amortizing the brand over 25 years. We also see another contra-asset - called Accumulated Amortization - that appears among the assets but that has a negative balance (a credit balance in the T-account system). Its purpose is the same as the Accumulated Depreciation account for property and equipment.
We're introducing a new kind of account on the asset side of the equation. Accumulated Depreciation is a "contra account," (i.e., it's an offset to the Equipment account). So, if the Equipment account has a debit balance, what kind of balance (debit versus credit) do you suppose the contra account has?
The accrual system "matches" the $48,000 cost of office equipment to each of eight quarters, usually in a "straight-line" fashion. In each of the eight quarters after the equipment's acquisition, a Depreciation Expense of $6,000 will be charged for a total of $48,000. A new account - a contra-asset called Accumulated Depreciation - is displayed in assets with a negative balance. It reduces the book value of the office equipment asset that maintains the original cost of $48,000. "Office Equipment, net" appears in the Balance Sheet at quarter end with a value of $42,000. Preserving details in two separate accounts helps the reader track cumulative investments and estimate age of assets.
What are the 4 transactions of startups? What are the 4 transactions that reflecting operating activities? What are the 3 adjusting entries?
What are the 4 transactions of startups? 1) initial capital 2) inventory purchase 3) equipment purchase 4) determining trademark value What are the 4 transactions that reflecting operating activities? 1) sales 2) compensation 3) accounts receivable 4) accounts payable What are the 3 adjusting entries? 1) Accumulated depreciation 2) Trademark amortization 3) Interest expense
What is the basis for the estimate of a two-year useful life, and why do I care?
When companies make significant asset purchases, they assess the amount and timing of the benefits that should be generated by the asset. The useful life is important for planning purposes because we must plan for another purchase (and another cash outflow) in two years. This two year life will also affect the depreciation calculation in a later entry to communicate to the investors how fast the company is using up its resources.
What is the role of a T-account?
A balance sheet is just a snapshot report of the mix of a company's resources and claims as of a particular reporting date, but levels of resources and claims can change between balance sheets. A T-account can track those interim changes.
When should a liability be recognized?
A liability should be recognized when a company receives goods or services and, in exchange, promises to pay the provider of the goods a (reasonably) definite amount at a (reasonably) definite future time. The payment is usually in cash but may be in goods or services.
Do you remember transaction #5, which depicted sales on account (credit sales that totaled $2.5 million for the period)? Let's look at the back end of that transaction. Assume that it's time for Orphan Brands to collect the cash from a portion of those sales. As you translate this transaction into the language of financial accounting, recall that we've already (in transaction #5) recognized the revenue and expense from the sales that totaled $2,500,000. All we're doing now is completing the collection cycle on $1,600,000 of those sales.
Accounts Receivable represents customers' promises to pay. When customers fulfill that promise, Cash goes up and the Accounts Receivable balance goes down. Note that until these collections, Orphan Brands has seen its cash account diminish significantly from the starting level, even though its operations have been profitable in the meantime. It's good that Orphan Brands has a cash cushion, and providing that cushion is one of the roles of long-term capital. But ultimately the company must generate cash flow from its operations to maintain its financial health. We'll explore that further at the end of the course.
What triggers the recognition of a liability?
If we're on the receiving end of a shipment, the asset (inventory or equipment) will be recognized when it's shipped, and the balancing entry would be a liability (payables).
How are income statements and statement of cash flows affected by depreciation?
Depreciation expense has no corresponding cash outflow. It's strictly an accrual. We paid the cash up front when we bought the asset. All we're doing now is allocating that cost over the asset's useful life. Therefore, depreciation expense is reported in the Income Statement and REDUCES PROFITABILITY, but it doesn't reduce the cash balance or change the results of the Statement of Cash Flows.
COMPENSATION EXPENSE is one of the many types of expense that a company incurs as it operates the business. As we saw in the prior transaction, the Accounting Equation matches expenses with revenues beneath the Owners' Equity heading. Keep in mind that the amount of expense recognized is not the same as the amount of cash paid. Rather, it is the cost that was incurred to produce the revenues for the current period. Orphan Brands paid wages of $740,000. Unpaid wages for the partial pay period accumulated to $60,000.
During the quarter, Orphan Brands paid $740,000 to its employees and promised to pay (Wages Payable liability) another $60,000 for work done between pay periods at the end of the quarter. These are operating resource flows and they are reflected as Compensation Expense in the Income Statement. Another way of looking at this entry is that the Income Statement should take a longer-term view of the resources required to produce the $2,500,000 in sales recorded in the previous transaction.
As part of the business arrangement between CPX and Orphan Brands, CPX agrees to ship the ReallyKleen product directly from its factory on behalf of Orphan Brands to Orphan Brands' customers. A customer makes a purchase and CPX immediately ships the products to the customers. CPX then informs Orphan Brands of the purchase and charges Orphan Brands $10,000 for the deliveries. CPX requests that Orphan Brands pay the $10,000 within 30 days. How would Orphan Brands account for the $10,000 delivery expense?
Even though Orphan Brands doesn't yet have to pay for the delivery service, it has nonetheless incurred the associated $10,000 cost to achieve its Sales Revenue of $2,500,000 during the quarter. In the accrual accounting system, "matching" requires that this cost be recognized as an expense during the same period in which the revenue is recognized.
Use the Accounting Equation method to depict Orphan Brands' purchase of $2 million of ReallyKleen inventory, an asset. Remember Orphan Brands agreed to pay CPX within three months.
Even though Orphan Brands has not taken physical possession of the ReallyKleen inventory, this transaction gives Orphan Brands control over that property. Therefore, the Inventory account increases. In addition, this transaction creates an obligation that Orphan Brands did not have before; CPX has a claim on the resources of Orphan Brands, and Orphan Brands must acknowledge the existence of that claim by recognizing an Accounts Payable liability. The $2,000,000 increase in assets and in liabilities keeps the Accounting Equation in balance.
What is "Cost of Goods Sold (COGS)"?
Every sales transaction involves an exchange. The company gets something (cash or a receivable) and it gives something (product from its inventory). Cost of Goods Sold Expense is an Income Statement account that shows the value of the inventory that was given to the customer. It is subtracted from Revenue to determine Gross Profit and, ultimately, Net Income.
What is "Gross Profit," and where does it appear in this transaction?
Gross Profit appears in the Income Statements of companies that sell products (and sometimes services) to customers. It is defined as: Revenues - Cost of Goods Sold Expense Note that there is no "Gross Profit" column in the Accounting Equation or "Gross Profit" T-account: rather it is a subtotal that is inserted in the INCOME STATEMENT presentation for the convenience of the reader.
What is the "collection cycle"?
The collection cycle refers to the number of days between delivery of the product or service to a customer and the collection of cash from that customer.
How is the income statement related to the balance sheet?
The income statement records a company's profit and losses between 2 balance sheets. We track these results with T-accounts for Revenues and Expenses --> which are related to RETAINED EARNINGS on the balance sheet
Use the T-accounts to translate this activity into the language of financial accounting. Remember that an increase in a liability or owners' equity account is shown on the right (i.e., credit) side of the T-account, and the same is true for the Revenue account (which this transaction does not affect). In contrast, an Expense has the opposite effect of Revenue. That's why an increase in an expense is shown on the left (i.e., debit) side of the T-account.
The most obvious part of this transaction is the reduction of Cash by the amount ($740,000) paid out to employees. But the offset is somewhat less obvious (although it has parallels to the accrual in the prior transaction). Here, we recognize the full amount ($800,000) of compensation that employees earned for their work during the period. Of that, Orphan Brands paid $740,000 in cash and, for the period between the payday and the end of the period, accrued another $60,000 as Wages Payable to those employees. This keeps the system in balance and acknowledges that this portion of compensation expense has yet to be paid.
using the T-account method, record the outflow of the resources for this sales transaction.
The outflow of resources associated with the transfer of product to customers is depicted by the decrease (credit entry) in Inventory. And the offsetting debit entry to the Cost of Goods Sold account is the method for recognizing an expense for the reporting period in an amount that is equal to the decrease in the Inventory account.
How do the income statement and balance sheet relate to each other?
The profit from the income statement can be used as the Retained Earnings in the balance sheet to keep it balanced
What relationship exists between profitability and liquidity? Which financial statement does which?
The two main goals of any business are to make adequate profits over the long-term while keeping enough cash to pay the bills on time during the short term. Each of these goals is worth focusing on, and that's why we report a Balance Sheet, an Income Statement and a Statement of Cash Flows. The Balance Sheet portrays the current mix of resources and obligations. The Income Statement reports profitability. It's all about accrual accounting, the matching principle, and smoothing out the effects of cash inflows and outflows. In contrast, the Statement of Cash Flows is about liquidity. It ignores all those accruals and focuses on when cash actually is collected or paid. It's kind of like a checkbook that shows why the company's cash balance changes from one transaction to the next, and from one Balance Sheet date to the next.
Remember that the Orphan Brands shipped $1,000,000 worth of their inventory in this transaction. How would you book the OUTFLOW of resources for this transaction.
This transaction is an exchange between Orphan Brands and its customers. They had an outflow of resources (inventory) and an inflow of resources (accounts receivable - a promise of future cash receipts). We use Income Statement accounts to reflect these resource flows from the company's operations. The inflow of $2,500,000 is reported as Sales Revenue in the Income Statement. We booked this part of the transaction on the previous screen. The outflow of $1,000,000 of inventory is reported as Cost of Goods Sold. This $1,000,000 cost is "matched" against revenues of $2,500,000. Showing this allows for precise projections of future profitability.
Orphan Brands sells $1.6M worth of product to its customers. These customers still owe $900,000 from their most recent purchase (accounts receivable). How would you book the INFLOW of resources for this transaction.
This transaction represents an exchange between Orphan Brands and its customers. There has been an inflow of resources (accounts receivable - which represent a promise of future cash receipts) and an outflow of resources (inventory) which we will address on the next screen. We use the Income Statement accounts to reflect these resource flows from the company's operations. The inflow of $2,500,000 is reported as Sales Revenue in the Income Statement.
try to translate this transaction into the language of financial accounting using T-accounts. And as you do, recall that we've already (in transaction #5) recognized the Revenue and Cost of Goods Sold Expense from the sales that totaled $2,500,000 millio
This transaction simply completes the collection cycle for the sale of product in transaction #5. Orphan Brands has already reported the revenues and expenses from this sale. Now the initial form of the inflow of resources, i.e., the accounts receivable, is being converted into cash upon the receipt of the payment from the customer.
