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  • 1. What is an outstanding deposit?
     

    An outstanding deposit refers to a company's receipts (cash, checks from customers, etc.) which have been recorded by the company, but the amount will appear on its bank statement at a later date. An outstanding deposit is also known as a deposit in transit.

     

    To illustrate an outstanding deposit, let's assume that on October 31 a company received cash and checks from customers in the amount of AED 800. Clearly the company should report the AED 800 as part of its cash as of October 31. However, the company did not deposit the AED 800 into its bank account until after October 31. Since the AED 800 is not on its bank statement as of October 31, the AED 800 is described as an outstanding deposit or deposit in transit as of October 31.

     

    The AED 800 outstanding deposit is pertinent to the company's bank reconciliation as of October 31. When the company reconciles the bank statement, the outstanding deposit is an addition to the balance shown on the bank statement as of October 31. (There is no adjustment to the balance per books since the AED 800 had been recorded as of October 31.)

  • 2. What is zero-based budgeting?
     

    Zero-based budgeting, or ZBB, is a rigorous budgeting process that requires every dollar of every expense to be justified even if the expense has been occurring for many years. For example, if a company has been spending AED 100,000 each year for the rent of warehouse space, the zero-based budgeting process assumes that nothing was spent previously. As a result, the warehousing activities must be reviewed, justified and documented before any amount can be included in the budget.

     

    Zero-based budgeting is in contrast to more common budgeting practices that focus on the incremental change from the current expenses and current budget. In other words, under a more typical budgeting process, the AED 100,000 of rent expense is accepted and the focus is on whether the rent for the upcoming budget should assume an inflation adjustment of AED 3,000 or some other amount.

     

    While zero-based budgeting will be far more time consuming than focusing on the incremental changes for the next budget, it can result in significant cost savings. For instance, the analysis and documentation of the warehousing activities required by zero-based budgeting could lead to a better use of space, better inventory management, etc. If those efficiencies will occur, the budget for the warehousing may need to be only AED 60,000 (instead of more than AED 100,000).

     

    Zero-based budgeting was widely discussed in the 1970s for businesses and governments. Today, it is again being discussed since a few large corporations have used ZBB budgeting process to significantly reduce unneeded expenses.

  • 3. What is a capital account?
     

    In accounting and bookkeeping, a capital account is one of the general ledger accounts used to record 1) the amounts that were paid in to the company by an investor, and 2) the cumulative amount of the company's earnings minus the cumulative distributions to the owners. The balances of the capital accounts are reported in the owner's equity, partners' equity, or stockholders' equity section of the balance sheet.

  • 4. What is a stockholder?
     

    A stockholder (also known as a shareholder) is the owner of one or more shares of a corporation's capital stock. A stockholder is considered to be separate from the corporation and as a result will have limited liability as far the corporation's obligations.

     

    The owner of a corporation's common stock is referred to as a common stockholder. The common stockholders elect the corporation's board of directors and will vote on very significant transactions such as merging the corporation with another corporation. Generally it is the common stockholders who become wealthy when a corporation becomes increasingly more successful.

     

    In addition to common stock, some corporations also issue preferred stock. An owner of these shares is known as a preferred stockholder (or preferred shareholder). A preferred stockholder usually accepts a fixed cash dividend that will be paid by the corporation before the common stockholders are paid a dividend. In exchange for this preferential treatment of dividends, the preferred stockholder will forego the potential financial gains that may occur for the common stockholder.

     

    The amounts paid by the original stockholders are reported as paid-in (or contributed) capital within the stockholders' equity section of the corporation's balance sheet.

  • 5. What is a revenue expenditure?
     

    A revenue expenditure is a cost that is expensed in the accounting year in which it is incurred. In other words, the cost will be matched with the revenues of the accounting year in which the expenditure took place. (This is in contrast to a capital expenditure in which the cost is deferred to the balance sheet and is then expensed over several accounting years.)

     

    Revenue expenditures are often discussed with costs spent on fixed assets after they have been placed in service. For example, the amount spent each year to keep an ice cream's store's equipment working efficiently is revenue expenditure. Also, the cost to repair the equipment will be revenue expenditure. In both of these situations, the amounts spent will be debited to Repairs and Maintenance Expense and will be matched with the revenues on the current year's income statement.

     

    On the other hand, if the ice cream store incurs a large cost to improve the equipment (to make it more than it had been) and/or to extend the equipment's useful life, the amount spent is considered to be a capital expenditure. As such, the amount is initially deferred to the balance sheet (capitalized) and will be expensed over the current and future years of the equipment's useful life.

  • 6. What is the difference between depreciation expense and accumulated depreciation?
     

    Depreciation expense is the amount of depreciation that is reported on the income statement. In other words, it is the amount that pertains only to the period of time indicated in the heading of the income statement.

     

    Accumulated depreciation is the total amount of depreciation that has been taken on a company's assets up to the date of the balance sheet. Accumulated depreciation is also the title of the contra asset account reported in the property, plant and equipment section of the balance sheet. The accumulated depreciation for an individual asset is subtracted from the asset's cost in determining the asset's carrying value or book value.

     

    To illustrate, let's assume that a retailer purchases new display racks at a cost of AED 84,000. This asset is estimated to have a useful life of 7 years (84 months), no salvage value, and will be depreciated using the straight-line depreciation method. Therefore, during each month of the asset's life the retailer will report depreciation expense of AED 1,000. However, the accumulated depreciation will be reported on the balance sheet at AED 1,000 after the first month, AED 2,000 after the second month, AED 3,000 after the third month, and so on until it reaches AED 84,000 at the end of 84 months.

     

    Assuming a manufacturer purchases manufacturing equipment for AED 84,000 with the same life and salvage value, the AED 1,000 of monthly depreciation will be part of manufacturing overhead (instead of being reported directly on the income statement as depreciation expense). As part of manufacturing overhead it will be allocated to the products manufactured. When the products are sold, their production costs (which include their allocated share of depreciation and other manufacturing overhead costs) will be reported on the income statement as the cost of goods sold. The accumulated depreciation will be reported on the balance sheet just as it was for the retailer

  • 7. What is a lease?
     

    A lease is usually a written agreement between an owner of property (land, building, equipment, vehicle, etc.) and a person or business that will use the property for a stated period of time at a specified series of payments.

     

    The owner of the property is known as the lessor and the person using the property is the lessee.

     

    Some leases are for short periods of time and there is no intention of transferring ownership of the asset in exchange for the rent payments. Two examples of this type of lease are 1) the lease for a one-bedroom apartment covering a 12-month period and rent payments of AED 1,100 per month, and 2) the lease of a new automobile for 24 months with payments of AED 300 per month.

     

    Other leases may be for longer periods and ownership of the asset will transfer to the lessee for a small additional payment. An example is a noncancellable lease requiring 60 monthly payments of AED 600 per month for a forklift truck. At the end of the lease period (after the 60th payment) the lessee may take ownership of the forklift truck for an additional payment of AED 500.

     

    Since leases are contracts requiring a series of payments, there is a question of how the lease and the related payments should be accounted for by the lessee and the lessor. As of September 2015, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) were close to issuing a common financial accounting reporting standard that will replace the present U.S. accounting rules.

  • 8. What is the difference between income and profit?
     

    .

    Some people intend for the terms income and profit to have the same meaning. For example, the income statement was commonly referred to as the profit and loss (P&L) statement. When a company is profitable, we mean that the company has a positive net income.

     

    To aid in understanding these terms, the word "net" is often added. Hence, we often see the terms net incomeand net profit. This communicates that the amounts are the remainder after expenses have been deducted. For example, a company's profit margin is often listed as the net profit margin (which is defined as the company's net income divided by its net sales). The word "net" also helps to distinguish a company's net profit from its gross profit, and its net profit margin from its gross profit margin.

     

    Some people use the term income to mean revenues. For example, a bank or an individual will often refer to the interest they earn on bond investments as interest income or investment income. A retailer will refer to the sales of merchandise as revenues, but the revenues from secondary activities will be reported as other income or non operating income.

     

    It is wise to keep in mind that different meanings are not unusual among people, businesses and countries

    What is comprehensive income?

    Comprehensive income for a corporation is the combination of the following amounts which occurred during a specified period of time such as a year, quarter, month, etc.:

     

    1. Net income or net loss (which is reported on the income statement), plus
    2. Other comprehensive income (if this is present, a statement of comprehensive income must be prepared)

    Examples of other comprehensive income include:

     

    • Unrealized gains/losses on available-for-sale investments
    • Unrealized gains/losses on hedge/derivative financial instruments
    • Foreign currency translation adjustments
    • Unrealized gains/losses on postretirement benefit plans

    Basically, comprehensive income consists of all of the revenues, gains, expenses, and losses that caused stockholders' equity to change during the accounting period. (The corporation's sale or purchase of its capital stock and its declaration of dividends are not a component of comprehensive income. The stock transactions and dividends are reported as separate items in the statement of stockholders' equity.)

     

    The amount of other comprehensive income for the period will be added to the accumulated other comprehensive income, which is a separate line within stockholders' equity on the end-of-the-period balance sheet. (The net income or net loss reported on the income statement will be added to retained earnings as usual.)

    What are capital expenditures?

    Capital expenditures or capex are the amounts spent for tangible assets that will be used for more than one year in the operations of a business. Capital expenditures can be thought of as the amounts spent to acquire or improve a company's fixed assets. Some examples include the purchase of machinery, equipment, furniture, building improvements, computer information systems, and leasehold improvements.

     

    The amount of capital expenditures for an accounting period is reported in the cash flow statement. The amount is an outflow of cash and is listed in the investing activities section of the statement. Sometimes the amount is listed as capital expenditures and sometimes it is listed as purchase of property and equipment.

     

    The capital expenditures will also increase the respective asset accounts which are reported in the noncurrent asset section of the balance sheet entitled property, plant and equipment. Once the assets are placed in service they are depreciated over their useful lives. The accumulated depreciation for the assets is also reported as part of the property, plant and equipment.

     

    The current period's amount of capital expenditures is often subtracted from the cash from operating activities to arrive at the company's free cash flow.

  • 9. What is DCF?
     

    In accounting, DCF refers to discounted cash flows or to the discounted cash flow techniques such as net present value or internal rate of return.

     

    DCF is a preferred method for evaluating capital expenditures (and other investments) because DCF recognizes the time value of money. In other words, it recognizes that receiving AED 10,000 of cash today is more valuable than receiving AED 10,000 of cash in the future. Similarly, AED 10,000 cash receipt in Year 10 is less valuable than a AED 10,000 cash receipt in Year 7.

     

    The recognition of the time value of money occurs by discounting the related future cash flows back to the time when cash is invested. (The date that the cash is invested is often referred to as the "present" or the very beginning of the investment's first year.)

     

    The greater the time value of money, the greater will be the amount of the discount. The smaller the time value of money, the smaller the amount of the discount. In turn, a larger discount will mean a smaller present value. A smaller discount will result in a greater present value.

     

    DCF is also useful for calculating the approximate market value of bonds payable, a product line, or entire companies.

  • 10. What is opportunity cost?
     

    Opportunity cost is the profit that was lost because of some action.

     

    To illustrate opportunity cost, let's assume that you want to add a website to your already successful business. You are confident that it will increase your company's profit by AED 1,500 each week. A highly-trusted and successful firm will complete the website in 3 weeks at a cost of AED 10,000. Your friend has offered to do the work for AED 6,500 and expects it will take 5 weeks.

     

    If you select your friend, there will be an opportunity cost of AED 3,000 since you will lose the opportunity to earn AED 1,500 per week for 2 weeks (friend's 5 weeks vs. firm's 3 weeks).

     

    Now let's assume that you have selected your friend, but it actually takes your friend 7 weeks. This means that you lost the opportunity to earn the additional AED 1,500 per week for 4 weeks (friend's 7 weeks vs. firm's 3 weeks) for a total opportunity cost of AED 6,000. This opportunity cost reveals that you would have been wiser to have paid the trusted firm AED 10,000 instead of paying your friend AED 6,500. The payment difference of AED 3,500 is less than the opportunity cost of AED 6,000 (4 weeks of lost profit at AED 1,500 per week).

  • 11. What is the operating cycle?
     

    The operating cycle is also known as the cash conversion cycle. In the context of a manufacturer the operating cycle has been described as the amount of time that it takes for a manufacturer's cash to be converted into products plus the time it takes for those products to be sold and turned back into cash. In other words, the manufacturer's operating cycle involves:

    • paying for the raw materials needed in its products
    • paying for the labour and overhead costs needed to convert the raw materials into products
    • holding the finished products in inventory until they are sold
    • waiting for the customers' cash payments for the products that have been sold

    Some calculate the operating cycle to be the sum of:

     

    • the days' sales in inventory (365 days/inventory turnover ratio), plus
    • the average collection period (365 days/accounts receivable turnover ratio)

    The above sum is sometimes reduced by the number of days in the credit terms of the accounts payable.

     

    The operating cycle has importance in classifying current assets and current liabilities. While most manufacturers have operating cycles of several months, a few industries require very long processing times. This could result in an operating cycle that is longer than one year. To accommodate those industries, the accountants' definitions of current assets and current liabilities include the following phrase: ...within one year or within the operating cycle, whichever is longer.

     

  • 12. What is a general ledger?
     

    A general ledger is a grouping of perhaps hundreds of accounts that are used to sort and store information from a company's business transactions. The general ledger is organized as follows:

    • balance sheet accounts (assets, liabilities, equity), and
    • income statement accounts (revenues, expenses, gains, losses)

     

    Under the double entry system of accounting and bookkeeping, every business transaction will have the amount of debits equal to the amount of credits. Hence, the general ledger is expected to have its debit amounts equal to its credit amounts.

     

    In a manual accounting or bookkeeping system, the general ledger was a "book" with a separate page or ledger sheet for each account. (When a significant amount of detailed information was needed for an account such as Accounts Receivable, a subsidiary ledger was used.)

     

    In a computerized system, the general ledger will be an electronic file of all the needed accounts. This also allows for the electronic preparation of the company's financial statements.

  • 13. What are gross sales?
     

    Gross sales are the amounts a company earned and recorded from the sales of its products (and perhaps its services). The amounts originate from the company's sales invoices but the total will be adjusted to the accrual basis at the end of each accounting period.

     

    The gross sales amounts from the sales invoices are recorded in a general ledger account such as Sales. (Any sales returns, sales allowances, and sales discounts should be recorded in separate contra revenue accounts in order for management to see the magnitude of these items.)

     

    Gross sales is also defined as the sales revenues before deducting the sales returns, sales allowances, and sales discounts. (Gross sales minus sales returns, sales allowances, and sales discounts is the definition of net sales.)

     

    A review of the income statement for 19 publicly-traded corporations revealed that only the net amount of sales (or revenues) appeared on the face of the income statements.

  • 14. What are sales discounts?
     

    Sales discounts (if offered by sellers) reduce the amounts owed to the sellers of products, when the buyers pay within the stated discount periods.

     

    To illustrate a sales discount let's assume that a manufacturer sells AED 900 of products and its credit terms are 1/10, n/30. This means that the buyer can satisfy the AED 900 obligation if it pays AED 891 (AED 900 minus AED 9 of sales discount) within 10 days. The alternative is for the buyer to pay AED 900 within 30 days. If the buyer pays within 10 days, the seller will record a debit to Cash for AED 891, a debit to Sales Discounts for AED 9, and a credit to Accounts Receivable for AED 900.

     

    The account Sales Discounts is referred to as a contra revenue account. Hence, its debit balance will be one of the deductions from sales (gross sales) in order to report the amount of net sales.

     

    Sales discounts are also known as cash discounts and early payment discounts.

  • 15. Why do we charge depreciation?
     

    We charge depreciation because most of the long-lived assets used in a business have 1) a significant cost, and 2) they will be useful only for a limited number of years. The matching principle (a basic underlying accounting principle) requires that the actual cost of these assets be allocated to the accounting periods in which the company will benefit from their use.

     

    The depreciation reported on a U.S. corporation's external financial statements is computed by spreading an asset's cost (less any salvage value) over the asset's service life or useful life. For example, equipment with a cost of AED 500,000 and no salvage value at the end of an assumed useful life of 10 years will likely result in matching AED 50,000 to each full accounting year. (The U.S. income tax rules allow accelerating the depreciation amounts, but the total cannot exceed the asset's cost.)

     

    Examples of the assets that must be depreciated include machinery, equipment, fixtures, furnishings, buildings, vehicles, etc. These assets are often referred to as fixed assets or plant assets, and the amounts spent are part of a corporation's capital expenditures. (Note that land is not depreciated because it is assumed to last indefinitely.)

  • 16. What are turnover ratios?
     

    In accounting, turnover ratios are the financial ratios in which an annual income statement amount is divided by the average balance of an asset (or group of assets) throughout the year. Turnover ratios include:

    • accounts receivable turnover ratio
    • inventory turnover ratio
    • total assets turnover ratio
    • fixed assets turnover ratio
    • working capital turnover ratio

    Some of the turnover ratios are also categorized as liquidity ratios, operating ratios, activity ratios, efficiency ratios, and asset utilization ratios.

     

    The larger the turnover ratio, the better. For instance, a large amount of credit sales in relationship to a small amount of accounts receivable indicates that the company was efficient and effective in collecting its accounts receivable. (Remember that ratios are averages. Hence, some of the accounts receivable could be very old, but they are "hidden" because other customers paid quickly.)

     

    Turnover ratios are more accurate when they use the asset's average balances for the year (as opposed to onebalance at the final instant of the accounting year). The reason is that an income statement amount reflects the total activity during the entire year.

     

  • 17. What are accounting ratios?
     

    Accounting ratios (also known as financial ratios) are considered to be part of financial statement analysis. Accounting ratios usually relate one financial statement amount to another. For example, the inventory turnover ratio divides a company's cost of goods sold for a recent year by the cost of its inventory on hand during that year.

     

    For a company with current assets of AED 300,000 and current liabilities of AED 150,000 its current ratio is AED 300,000 to AED 150,000, or 2 to 1, or 2:1. This ratio of 2:1 can then be compared to other companies in its industry regardless of size or it can be compared to the company's ratio from an earlier year.

     

    Other examples of accounting ratios include:

     

    • Quick ratio
    • Current ratio
    • Debt to equity ratio
    • Acid-test ratio
    • Contribution margin ratio
    • Interest coverage ratio
    • Debt to total assets ratio
    • Gross margin ratio
    • Return on assets ratio
    • Profit margin (after tax) ratio
    • Total assets turnover ratio
    • Fixed asset turnover ratio
    • Times interest earned ratio
    • Liquidity ratio
    • Working capital ratio
    • Dividend payout ratio
    • Free cash flow ratio

     

  • 18. What are sundry expenses?
     

    In accounting and bookkeeping, sundry expenses are expenses that are small in amount and do not occur often. Since these items are not significant, a company might use one general ledger account with the title Sundry Expenses for recording the debit amounts.

     

    If some items recorded in Sundry Expenses begin to occur frequently and/or become significant, the related amounts should be transferred to a new separate general ledger account.

     

    Sundry expenses could also refer to a line on a company's income statement. Often it includes the combined total of several (or many) expense accounts that have small balances.

     

    Today, you are likely to find Sundry Expenses being replaced with Miscellaneous Expenses.

  • 19. What are departmental overhead rates?
     

    Departmental overhead rates are used by many manufacturers instead of using a single, plant-wide overhead rate. The reason for departmental overhead rates is that a manufacturer is likely to produce many diverse products which use different processes (each of which has different costs).

     

    To illustrate, let's assume that a manufacturer has three operations with each occurring in a separate department:

    • Dept #1 uses a large, sophisticated machine having a cost of AED 900,000
    • Dept #2 uses a small AED 40,000 machine to refine the products coming out of Dept #1
    • Dept #3 is an additional, optional process that uses a AED 10,000 machine

    When the manufacturer divided its total manufacturing overhead for the upcoming year by the total machine hours for the upcoming year, the result was a plant-wide overhead rate of AED 30. If Product A requires 7 hours in Dept #1 and 1 hour in Dept #2, it will be assigned overhead of AED 240 [(7+1)XAED 30]. If Product B requires 2 hours in Dept #1, 2 hours in Dept #2, and 4 hours in Dept #3, it will also be assigned overhead of AED 240 [(2+2+4)XAED 30].

     

    When departmental overhead rates were computed, the manufacturing overhead rate for Dept #1 was AED 50 per machine hour (resulting from high amounts of depreciation, electricity, maintenance, etc.). The overhead rate per machine hour for Dept #2 was AED 20, and AED 15 for Dept #3. Using the more accurate departmental overhead rates Product A will be assigned overhead of AED 370 [(7XAED 50)+(1XAED 20)]. Product B will be assigned overhead of AED 200 [(2XAED 50)+(2XAED 20)+(4XAED 15)].

     

    Having multiple, departmental overhead rates will better reflect the costs of manufacturing Product A and Product B compared to using a single, plant-wide overhead rate.

  • 20. What is a predetermined overhead rate?
     

    A predetermined overhead rate is often an annual rate for assigning or allocating indirect manufacturing costs to the goods it produces. Manufacturing overhead is allocated to products for various reasons including compliance with U.S. accounting principles and income tax regulations.

     

    A predetermined annual overhead rate is likely computed shortly before the start of the accounting year in which it will be used. The computation of the rate is 1) the budgeted amount of manufacturing overhead for the upcoming year divided by 2) the budgeted or normal number of machine hours (or some other activity) for the upcoming year. Using annual amounts (and the resulting annual rate) eliminates the monthly and seasonal fluctuations which may occur.

     

    A manufacturer producing only a few similar products might use a plant-wide overhead rate. However, if the products require different processes, it is better for each process to have its own specific overhead rate. These multiple overhead rates are also known as departmental overhead rates.

  • 21. What are production costs?
     

    In managerial accounting and cost accounting, production costs are the direct materials, direct labor, and manufacturing overhead used to manufacture products. The production costs are also referred to as manufacturing costs, product costs, a manufacturer's inventoriable costs, or the costs occurring in the factory.

    Production costs are often classified as direct or indirect product costs. For example, direct materials and direct labor are direct product costs because they can be easily and economically traced to the products being manufactured. On the other hand, manufacturing overhead costs are indirect product costs because they are not easily or economically traceable directly to the products. Instead, the manufacturing overhead costs must be allocated or assigned to the products often through a predetermined overhead rate.

    Production costs can also be classified as direct or indirect as to a factory department. For example, the costs of the factory maintenance staff is a direct cost of the factory maintenance department, while at the same time being an indirect product cost.

  • 22. What is long-term debt?
     

    In accounting, long-term debt generally refers to a company's loans and other liabilities that will not become due within one year of the balance sheet date. (The amount that will be due within one year is reported on the balance sheet as a current liability.)

     

    To illustrate, let's assume that a company has a mortgage loan with a principal balance of AED 200,000 and 120 monthly payments remaining. The loan payments due in the next 12 months include AED 12,000 of principal payments. The AED 200,000 of debt should be reported on the company's balance sheet as follows:

     

    • AED 188,000 as a long-term or noncurrent liability such as Noncurrent portion of mortgage loan
    • AED 12,000 as a current liability such as Current portion of mortgage loan

    If you use the word "debt" to be interchangeable with "liabilities" (as is done in financial ratios) then other examples will include vehicle loans, bonds payable, capital lease obligations, pension and other postretirement benefit obligations, and deferred income taxes.

     

    Some long-term debt that will be due within one year can continue to be reported as a noncurrent liability if the company intends to refinance it and can prove it will be done within 12 months without reducing its working capital.

  • 23. What is the cost of goods manufactured?
     

    In managerial accounting and cost accounting, the cost of goods manufactured is a schedule, statement, or calculation of the production costs for the products that were completed in an accounting period. In other words, the cost of goods manufactured is the manufacturing costs associated with the products that moved from the manufacturing area to the finished goods inventory during the period.

     

    The formula for the cost of goods manufactured is the costs of: direct materials used + direct labor used + manufacturing overhead assigned = the manufacturing costs incurred in the current accounting period + beginning work-in-process inventory - ending work-in-process inventory.

     

    A manufacturer's cost of goods sold is computed by adding the finished goods inventory at the beginning of the period to the cost of goods manufactured and then subtracting the finished goods inventory at the end of the period.

  • 24. What is managerial accounting?
     

    Managerial accounting is also known as management accounting and it includes many of the topics found in cost accounting.

     

    Some managerial accounting topics focus on computing a manufacturer's product costs that are needed for the external financial statements. For example, the manufacturer's income statement must report the actual cost of the products sold, and its balance sheet must report the actual costs in its ending inventories. The managerial accounting topics needed for these calculations include: product vs. period costs, job order costing, process costing, allocation of manufacturing overhead, costing of joint products, and more.

     

    Other managerial accounting topics are more beneficial for planning and controlling a business and in helping management make financial decisions. These topics include:

     

    • understanding cost behavior and cost-volume-profit analysis
    • operational budgeting and capital budgeting
    • standard costing and variance analysis
    • activity based costing
    • pricing of individual products and services
    • analyzing the profitability of product lines, customers, territories, etc.

    The appropriate and relevant amounts for these topics will likely be unaudited, estimated, and future amounts (instead of the past, sunk costs found in the general ledger). Management's focus on these managerial accounting topics can make a difference in a company's profitability.

  • 25. What is a current asset?
     

    A current asset is cash and any other company asset that will be turning to cash within one year from the date shown in the heading of the company's balance sheet. (If a company has an operating cycle that is longer than one year, an asset that will turn to cash within the length of its operating cycle is considered to be a current asset.)

     

    Current assets are generally listed first on a company's balance sheet and will be presented in the order of liquidity. That means they will appear in the following order: cash (which includes currency, checking accounts, petty cash), temporary investments, accounts receivable, inventory, supplies, and prepaid expenses. (Supplies and prepaid expenses will not literally be converted to cash. They are included because they will allow the company to avoid paying cash for these items during the upcoming year.)

     

    It is important that the amount of each current asset not be overstated. For example, accounts receivable, inventories, and temporary investments should have valuation accounts so that the amounts reported will not be greater than the amounts that will be received when the assets turn to cash. This is important because the amount of company's working capital and its current ratio are computed using the current assets' reported amounts.

     

    Current assets are also referred to as short term assets.

  • 26. What is leverage?
     

    In accounting and finance, leverage refers to the use of a significant amount of debt and/or credit to purchase an asset, operate a company, acquire another company, etc.

     

    Generally the cost of borrowed money is much less than the cost of obtaining additional stockholders' equity. As a result, it is usually wise for a corporation to use some debt and leverage. Perhaps this is one of the reasons that leverage is also known as trading on equity.

     

    Financial ratios such as debt to equity and debt to total assets are indicators of a corporation's use of leverage. In these ratios debt is the total amount of all liabilities (current and noncurrent). This means that a corporation's debt includes bonds payable, loans from banks, loans from others, accounts payable, and all other amounts owed.

     

    In a related Q&A we illustrate how leverage can increase or decrease the returns on investments.

  • 27. What is the bookkeeping equation?
     

    The bookkeeping equation for a sole proprietorship is assets = liabilities + owner's equity. The bookkeeping equation for a corporation is assets = liabilities + stockholders' equity. The bookkeeping equation is also referred to as the accounting equation.

     

    In the bookkeeping equation:

     

    • assets are the resources owned by the business
    • liabilities are the amounts the business owes
    • owner's equity is the amount the owner invested plus the net income of the business minus the amounts the owner withdrew for personal use (all since the business began)

    Often it is said that the liabilities and owner's equity are the claims against the assets. It can also be said that the liabilities and the owner's equity are the sources of the assets.

     

    The bookkeeping equation should always be in balance because of double-entry bookkeeping.

     

    To learn more about the bookkeeping or accounting equation, see our Explanation, Quiz, and more.

    What is accounts payable?

    Accounts payable may refer to:

    • A section of the accounting department that is responsible for processing vendor invoices and other bills for goods and services that a company received on credit.
    • The title of the current liability account containing the amounts owed for vendor invoices and other bills that have been approved but not yet paid. The balance in Accounts Payable is expected to be a credit balance.
    • Amounts owed which did not involve a promissory note. If a promissory note is involved, the account Notes Payable will be used instead of Accounts Payable.

    If the company owes for goods and services and the amounts are not yet recorded in Accounts Payable, they must be entered with an adjusting entry at the end of the accounting period. The credit portion of the adjusting entry is likely to be recorded in a separate current liability account such as Accrued Expenses and Liabilities.

     

    Accounts payable may also be referred to as trade payables.

     

    To learn more about the various aspects of accounts payable, see our Explanation, Quiz, Q&A, and more.

  • 28. What is gross margin?
     

    Gross margin is the difference between 1) the cost to produce or purchase an item, and 2) its selling price. For example, if a company's manufacturing cost of a product is AED 28 and the product is sold for AED 40, the product's gross margin is AED 12 (AED 40 minus AED 28), or 30% of the selling price (AED 12/AED 40). Similarly, if a retailer has net sales of AED 40,000 and its cost of goods sold was AED 24,000, the gross margin is AED 16,000 or 40% of net sales (AED 16,000/AED 40,000).

     

    It is important to realize that the gross margin (also known as gross profit) is the amount before deducting expenses such as selling, general and administrative (SG&A) and interest. In other words, there is a big difference between gross margin and profit margin (or net profit margin).

  • 29. What is carriage outwards?
     

    Carriage outwards refers to the seller's cost of delivering goods to the buyer. Carriage outwards is the expense of the seller when the terms of the sale are FOB destination. Under the accrual method of accounting, the cost of carriage outwards should be reported on the income statement as an operating expense in the same period as the sale of the goods.

     

    Carriage outwards is also referred to as freight-out, transportation-out, or delivery expense.

  • 30. What is standard costing?
     

    Standard costing is an accounting technique that some manufacturers use to identify the differences or variancesbetween 1) the actual costs of the goods that were produced, and 2) the costs that should have occurred for those goods. The costs that should have occurred for the actual good output are known as standard costs.

     

    Standard costing is likely integrated with a manufacturer's budgets (profit plan, master budget) for an accounting year and involve the product costs: direct materials, direct labor, and manufacturing overhead. With standard costing, the accounts for inventories and the cost of goods sold contain the standard costs of the inputs that should have been used to make the actual good output.

     

    If the company had incurred more than the standard costs for the direct materials, direct labor, and manufacturing overhead, the company will not meet its projected net income. In other words, the variances will direct management's attention to the production inefficiencies or higher input costs. In turn, management can take action to correct the problems or seek higher selling prices.

     

    Since the external financial statements must reflect the historical cost principle, the standard costs in the inventories and the cost of goods sold will need to be adjusted for the variances. Since most of the goods manufactured will have been sold, most of the variances will be reported on the income statement as part of the cost of goods sold.

  • 31. What is carriage inwards?
     

     

    Carriage inwards refers to the transportation costs associated with the purchase of merchandise or other assets. The buyer is responsible for the cost of carriage inwards when it buys items and the prices are stated as being FOB shipping point. Carriage inwards is also known as freight-in or transportation-in.

     

    When goods or merchandise are purchased FOB shipping point and the periodic inventory method is used, the buyer will likely record the cost of the carriage inwards in the general ledger account Carriage Inwards (or Freight-in or Transportation-in). The carriage inwards costs are considered to be part of the cost of items purchased. In other words, part of the costs of carriage inwards should be assigned to the units in inventory and some should be assigned to the units that have been sold.

     

    In the case of assets other than inventory items that are purchased FOB shipping point, the buyer should add the carriage inwards cost to the asset's cost. This is necessary because accountants define an asset's cost as all of the costs that are necessary to get an asset in place and ready for use.

  • 32. What is payroll accounting?
     

    Payroll accounting involves a company's recording of its employees' compensation including:

     

    • gross wages, salaries, bonuses, commissions, and so on that have been earned by its employees
    • withholding of payroll taxes such as federal income taxes, Social Security taxes, Medicare taxes, state income taxes (if applicable)
    • withholding for the employees' portion of health insurance premiums, employees' contributions to savings plans, garnishments of salaries and wages, employees' contributions to United Way, etc.
    • employer's portion/expense for Social Security taxes, Medicare taxes, state and federal unemployment taxes
    • employer's portion/expense of fringe benefits such as health and dental insurance, paid holidays, vacations and sick days, pension and savings plan contributions, worker compensation insurance, etc.

    If employees are paid weekly or biweekly and the company has calendar month/year accounting periods, the company will have to accrue for the wages and benefits earned by the employees (but not yet paid or recorded in the general ledger accounts) as of the date of the financial statements.

     

    You can see more details including journal entries at our free Explanation of Payroll Accounting.

  • 33. What is the cash flow statement?
     

    The cash flow statement is one of the main financial statements of a business or a non profit entity. (It is also known as the statement of cash flows.) The cash flow statement reports a company's major sources and uses of cash during the same period of time as the company's income statement. In other words, it lists the major reasons for the change in a company's cash and cash equivalents reported on the balance sheets at the beginning and the end of the accounting period.

     

    The cash flow statement is needed because the income statement reports the revenues earned and the expenses incurred using the accrual method of accounting. These amounts are different from the amount of cash received and paid. Also, the company's annual income statements might report 3% of a new building's cost as depreciation expense, but the company may have paid cash for 100% of the building's cost in the year it was constructed. Since cash is critical for a company's operations and decision making, it is necessary to have the cash flow statement.

     

    The cash flow statement is organized into four major sections: cash from operating activities, cash from investing activities, cash from financing activities, and supplemental information such as interest paid, income taxes paid, and significant noncash exchanges.

  • 34. What are the limitations of the balance sheet?
     

    One limitation of the balance sheet is that only the assets acquired in transactions can be included. Therefore, some of a company's most valuable assets will not be reported on the balance sheet. For example, assume that a company developed an internet business that now attracts millions of visitors each day and has AED 10 million in annual revenues. Since the internet business was not purchased from another company and its cost to develop was not significant, the company's balance sheet will include the business's cash, receivables and some related payables. However, the company's balance sheet will not be reporting the internet business at anywhere near the AED 30 million that the company was offered for the internet business.

     

    Similarly, the immensely talented designers and content writers employed by an internet business cannot be reported as assets on the company's balance sheet since they were not acquired (and accountants are not able to compute a precise amount for these human resources). This is also the case for a company's reputation, its brand names that were developed through years of effective marketing, its customers' future demand for its unique services, etc.

     

    Another limitation of the balance sheet pertains to a company's long-term (or noncurrent) assets which have increased in value since the time they were purchased in a transaction. For instance, a company's land will be reported at an amount no greater than its cost (due to the accountant's cost principle). Its buildings will be reported at their cost minus their accumulated depreciation (due to the cost principle and the matching principle). Hence, the amounts reported on the balance sheet for a company's land and buildings could be much lower than their market value.

  • 35. What is the difference between a land improvement and a leasehold improvement?
     

    Examples of land improvements include paved parking areas, driveways, fences, outdoor lighting, and so on. Land improvements are recorded separately from land, because land improvements have a limited life and are depreciated. Land is assumed to last indefinitely and will not be depreciated.

     

    Land improvements are recorded in a general ledger asset account entitled Land Improvements. The depreciation of land improvements will result in depreciation expense on the company's income tax return. This will reduce its taxable income and will reduce a profitable company's income tax payments.

     

    An example of a leasehold improvement is the permanent improvement to a building that is being rented under a 10 year lease. For instance, the tenant might construct permanent walls and offices inside of the warehouse that it leases from the owner. The lease will likely state that all improvements to the building will belong to the owner of the building. The amount spent by the tenant to improve the building will be recorded by the tenant in its asset account Leasehold Improvements. Generally, the amount of these leasehold improvements will be depreciated by the tenant over the useful life of the improvements or over the life of the lease, whichever is shorter. The depreciation expense associated with the leasehold improvements will reduce the tenant's taxable income and its income tax payments if the company is profitable

  • 36. What are nonmanufacturing overhead costs?
     

    Nonmanufacturing overhead costs are the business expenses that are outside of a company's manufacturing operations. These are often referred to as the selling, general and administrative (SG&A) expenses plus the company's interest expense. Examples of the nonmanufacturing overhead costs include the salaries and other expenses for the following business activities: selling, distribution, marketing, finance, IT, human resources, legal, and so on.

     

    Since these costs are outside of the manufacturing function, they are not considered to be costs of the products. As a result, the nonmanufacturing costs are not allocated to the products for determining the costs for inventory or for the cost of goods sold. Instead, the nonmanufacturing costs are immediately expensed in the accounting period in which they are incurred. That is why accountants say that the nonmanufacturing costs are period costs or period expenses. (Only the manufacturing costs of direct materials, direct labor and manufacturing overhead are product costs.)

     

    While the nonmanufacturing overhead costs are not allocated to the products, the company must have its selling prices and sales revenues sufficient to cover both the product costs and the period expenses in order to avoid a negative net income.

  • 37. What are debits and credits?
     

    Debits and credits are terms used in accounting and bookkeeping (and have been used for centuries). They are a key part of the double entry system, which means that every business transaction will affect a minimum of two accounts. One of the accounts will receive a debit entry and another account will receive a credit entry. The amounts entered as debits must be equal to the amounts entered as credits.

     

    To illustrate, let's assume that a company borrows AED 10,000 from its bank. The company will record a debit of AED 10,000 in its Cash account, and a credit of AED 10,000 in its Notes Payable account. A cash sale of AED 300 will be recorded with a debit of AED 300 in the Cash account and a credit of AED 300 in the Sales account.

     

    You should think of a debit as an entry on the left side of an account, and a credit as an entry on the right side of another account. Accountants often use T-accounts to visualize the debit and credit effects on the accounts' balances.

     

    It may take some time to learn which general ledger accounts will be debited and credited, but here are some general rules:

     

    • expenses will have debit entries and will have debit balancs
    • revenues will have credit entries and will have credit balances
    • assets will have debit and credit entries, but will usually have debit balances
    • liabilities will have debit and credit entries, but will usually have credit balances
    • stockholders' equity accounts could have debit and credit entries, but the combined total for profitable corporations will be a credit
  • 38. What is a blank endorsement?
     

    In the case of a check payable to John Smith (the payee), a blank endorsement would be the signature of John Smith on the back side of the check without any other words above or below his signature.

     

    A blank endorsement is considered to be risky because the endorser is not restricting the check (or other negotiable instrument). The blank endorsement indicates that whoever is in possession of the endorsed check is considered to be the owner. To avoid such a risk, businesses and individuals should use restrictive endorsementson the checks they receive.

  • 39. What is a condensed income statement?
     
    1. A condensed income statement is one that summarizes much of the income statement detail into a few captions and amounts.

     

    For example, a retailer's condensed income statement will summarize hundreds of categories of sales into one amount with the description Net Sales. Its detailed purchases and changes in inventory will be presented as one amount with the description Cost of Goods Sold. Perhaps thousands of operating expenses will be presented as one amount with the description Selling, General and Administrative, or SG&A.

     

    The readers of a condensed income statement will be able to easily and quickly focus on the company's net income and its key components.

  • 40. What are accounting principles?
     

    Accounting principles are the common rules that must be followed when preparing financial statements that will be distributed to people outside of the company (or other organization).

     

    The accounting principles include the basic underlying guidelines and assumptions such as the cost principle, matching principle, full disclosure principle, revenue recognition principle, industry-specific regulatory rules, materiality, conservatism, consistency, and others.

     

    In the U.S. the accounting principles also include the many complex detailed rules that are established and maintained by the Financial Accounting Standards Board (FASB).

     

    The combination of the basic underlying guidelines and the complex detailed accounting rules are referred to as US GAAP or GAAP. GAAP is the acronym for generally accepted accounting principles.

  • 41. What is a blank check?
     

    A blank check often refers to a check that has been signed by an authorized check signer before the other information (date, payee, amount) has been entered on the check. For instance, a small business owner may sign three blank checks before leaving for a seven day vacation. Basically the owner is trusting that the employee holding these checks will enter the information required to make up to three business payments in the owner's absence. This is obviously poor internal control since the employee is able to issue the check for any amount and to any person. In addition these blank checks must be stored in a very secure place since anyone else could also complete the check information.

     

    A blank check could also refer to the completely blank checks that are received from a check printing company. These blank checks do not yet have an authorized signature and are sometimes referred to as check stock. These checks should be stored in a secure place until they are inserted into the company's printer in order to pay its suppliers, etc.

  • 42. What is the aging method?
     

    The aging method usually refers to the technique used for determining the credit balance needed in the account Allowance for Doubtful (or Uncollectible) Accounts. This Allowance account is a contra asset account connected with Accounts Receivable. Usually when a credit adjustment is entered into the Allowance account, a corresponding debit amount is entered into Bad Debts Expense (or Uncollectible Accounts Expense).

     

    The aging method takes place by sorting a company's accounts receivable according to the dates of these unpaid invoices. The invoice amounts that are not yet due are entered into the first of perhaps five columns. The invoice amounts that are 1-30 days past due are entered into the second column. Amounts that are 31-60 days past due are entered into the third column, and so on. (Accounting software will likely have a feature for generating an aging of accounts receivable.) The aging will be reviewed in order to determine the approximate amount of the receivables that may not be collected.

     

    The goal of the aging method is to have the company's balance sheet report the true amount of the receivables that will be turning to cash. For example, if the company's Accounts Receivable has a debit balance of AED 89,400 but the company estimates (based on its aging) that only AED 82,000 will be collected, the Allowance account must report a credit balance of AED 7,400.

     

    If a company fails to report a needed credit balance in its Allowance account, it will be overstating its assets, working capital, current ratio, retained earnings, and stockholders' equity. Its current period's earnings may also be overstated.

  • 43. What is the difference between periodic and perpetual inventory systems?
     

    The difference between the periodic and perpetual inventory systems involves the general ledger account Inventory.

     

    In a periodic system the account Inventory will:

    • have a constant balance (the ending balance from the previous period)
    • not include the cost of purchases (they are recorded in a Purchases account)
    • be adjusted at the end of the accounting period (so the balance reports the costs actually in inventory)
    • require a physical inventory at least once per year (and estimates within the year)
    • require a cost flow assumption (FIFO, LIFO, average)
    • require a calculation of the cost of goods sold (to be used on the income statement)

     

    In a perpetual system the account Inventory will:

    • be debited when there is a purchase of goods (there is no Purchases account)
    • be credited for the cost of the items sold (and the account Cost of Goods Sold will be debited)
    • have its balance continuously or perpetually changing because of the above entries
    • require a physical inventory to correct any errors in the Inventory account
    • require a cost flow assumption (FIFO, LIFO, average)

    It is possible that a company will use the periodic system in its general ledger and use a different computer system outside of its general ledger to track the flow of goods in and out of inventory.

  • 44. What is a memorandum entry?
     

    A memorandum entry is a short message entered into the general journal and also entered into a general ledger account. It is not a complete journal entry because it does not contain debit and credit amounts.

     

    An example of a memorandum entry might be the following:

    "On May 1, 2013 a 2-for-1 stock split was declared for the common stockholders of record as of the end of the day May 22, 2013. The stock split will result in the number of issued and outstanding shares of common shares increasing from 200,000 shares to 400,000 shares."

     

    Since a stock split does not change the balance in the Common Stock account, a complete journal entry was not required. The memorandum entry merely notes for future reference that the number of shares of stock has changed.

  • 45. With regard to depreciation, what does the term mid-month convention mean?
     

    In depreciation, the mid-month convention means that an asset placed into service during a given month is assumed to have been placed into service in the middle of that month. For example, if you place a warehouse into service on October 6, you will assume it was placed into service in the middle of October and will record depreciation for half of the month of October. If a building is placed into service on October 23, you will assume it was placed into service in the middle of October and will record depreciation for half of the month of October.

     

    The mid-month convention also applies to the disposal of an asset. This means that an asset that is disposed of on October 25 will be assumed to have been disposed of in the middle of October. If an asset is disposed of on October 3, it is also assumed that the asset was disposed of in the middle of October. In either situation, depreciation will be recorded for half of the month of October.

     

    The mid-month convention is pertinent for the income tax depreciation for certain property.  You can find more on this in the Internal Revenue Service Publication 946.

  • 46. What is the difference between prime costs and conversion costs?
     

    The difference between prime costs and conversion costs involves the three cost categories associated with manufacturing a product:

    • direct materials
    • direct labor
    • and manufacturing overhead (also known as factory overhead, production overhead, burden, indirect product costs, etc.)

    Prime costs are the two direct product costs. (The indirect product cost manufacturing overhead is excluded.). Hence, the prime costs are:

    • direct materials costs
    • direct labor costs

    Conversion costs are the manufacturing costs needed to convert the direct materials into products. Hence, conversion costs exclude the cost of direct materials and consist of the following:

    • direct labor costs
    • manufacturing overhead costs

    As you can see, the direct labor costs are both a prime cost and a conversion cost.

     

     

  • 47. What does stepped cost mean?
     

    Stepped cost refers to the behavior of the total cost of an activity at various levels of the activity. When a stepped cost is plotted on a graph (with the total cost represented by the y-axis and the quantity of the activity represented by the x-axis) the lines will appear as steps or stairs rising from left to right.

     

    To illustrate a stepped cost, let's assume that you are developing a website and find that the monthly cost of hosting the site is based on the number of visits. For 0 to 999 visits per month, the cost is AED 20 per month. When the visits are in the range of 1,000 to 2,999 the monthly cost jumps to AED 50. If the visits are 3,000 to 9,999 the cost will be AED 200 per month. For monthly visits of 10,000 to 24,999 the cost is AED 300, and so on. As the data indicates, the total monthly cost is constant or fixed only for a given range of activity (number of visits). When the number of visits exceeds the upper limit of a range, the monthly cost jumps to a higher level and remains fixed until the visits exceed the new upper limit.

     

    A stepped cost is also referred to as a step cost, a step-variable cost, or a step-fixed cost. The difference between a step-variable cost and a step-fixed cost has to do with the width of the range of activity. If the total cost increases with small increases in activity, it may be referred to as a step-variable cost. If the total cost will change only with large increases in the quantity of activity, the term step-fixed cost is more likely to be used.

     

    Knowing how costs behave is important for decision making. For example, a manufacturer will want to know how its costs will increase if a new product line is added (or how costs could decrease if an existing product line is eliminated).

  • 48. What is the difference between par and no par value stock?
     

    Some states' laws require or may have required common stock issued by corporations residing in their states to have a par value. The par value on common stock has generally been a very small amount per share. Other states might not require corporations to issue stock with a par value. So the par value on common stock is a legal consideration.

     

    From an accounting standpoint, the par value of an issued share of common stock must be recorded in an account separate from the amount received over and above the amount of par value. For example, if a corporation issues 100 new shares of its common stock for a total of AED 2,000 and the stock's par value is AED 1 per share, the accounting entry is a debit to Cash for AED 2,000 and a credit to Common Stock—Par AED 100, and a credit to Paid-in Capital in Excess of Par for AED 1,900. In total the Cash account increased by AED 2,000 and the paid-in capital reported under stockholders' equity increased by a total of AED 2,000 (AED 100 + AED 1,900).

     

    If a corporation is not required to have a par value or a stated value and the corporation issues 100 shares for AED 2,000, then the accounting entry will be a debit to Cash for AED 2,000 and a credit to Common Stock for AED 2,000.

     

    In other words, when the issued stock has a par value, the proceeds from the issuance gets divided between two of the paid-in capital accounts within stockholders' equity. If the issued stock does not have a par value, the proceeds from the issuance goes into just one paid-in capital account within stockholders' equity.

  • 49. What is a variable expense?
     

    An expense is a variable expense when its total amount changes in proportion to the change in sales, production, or some other activity.

     

    To illustrate a variable expense, let's assume that a website business sells a product and requires that the customer use a credit card. The credit card processor charges the business a fee of 3% of the amount charged. Therefore, in a month when sales are AED 10,000 the business will have a credit card expense of AED 300. If sales are AED 30,000 there will be a credit card expense of AED 900. The total credit card expense varies with sales because the fee has a fixed rate of 3% of sales.

     

    Another example of a variable expense is a retailer's cost of goods sold. For instance, if a company purchases a product for AED 30 and then sells it for AED 50, its cost of goods sold will be a constant rate of 60%. Hence when its sales are AED 10,000 the cost of goods will be AED 6,000. When the sales are AED 30,000 the cost of goods sold will be AED 18,000.

     

    Knowing how costs behave when sales or other activities change will allow you to better understand how a company's net income will change. It also allows you to quickly calculate a product's contribution margin and to estimate the company's break-even point.

  • 50. Why will some asset accounts have a credit balance?
     

    A few asset accounts intentionally have credit balances. For instance, the account Accumulated Depreciation(which is a plant asset account) will have a credit balance since it is credited for the amounts that are debited to Depreciation Expense. The account Allowance for Bad Debts will have a credit balance for the amounts in Accounts Receivable that are not likely to be collected. The accounts Accumulated Depreciation and Allowance for Bad Debts are referred to as contra asset accounts because their credit balances are contrary to the expected debit balances found in most asset accounts.

     

    There are also unexpected situations that result in asset accounts having credit balances. Here are five examples:

    1. An error caused by posting an amount to an incorrect account.
    2. Continuing to depreciate or amortize an asset after its balance has reached zero.
    3. Receiving and posting an amount that was greater than the recorded receivable.
    4. Expenses occurred faster than the agreed upon prepayments.
    5. The amount of checks written exceeded the positive amount in the Cash account.

    Before issuing the balance sheet, any errors (such as items 1 and 2) need to be corrected. The accounts with credit balances in items 3, 4, and 5 need to be reclassified to the liability section of the balance sheet.

  • 51. What is a fixed expense?
     

    A fixed expense is an expense that will be the same total amount regardless of changes in the amount of sales, production, or some other activity. For example, a retailer's monthly rent expense of AED 2,000 is a fixed expense because it will be a total of AED 2,000 whether the monthly sales are AED 15,000 or AED 30,000. We usually qualify the definition of a fixed expense by adding: within a relevant or reasonable range of activity. In other words, if the retailer needs to have monthly sales of AED 80,000 it is likely that the retailer will need to rent additional space, thereby increasing rent expense to be more than AED 2,000 per month.

     

    The following are some examples of expenses that are likely to be fixed within a reasonable range of sales:

    • the compensation of the store manager who receives the same salary and fringe benefits every month
    • the depreciation expense for a store's buildings, fixtures, and equipment
    • the constant monthly amounts for security, maintenance fees, phones, internet service, insurance, lighting, advertising, etc.

    Knowing the amount of a company's fixed expenses assists in understanding how its net income will change as volume changes. The total amount of fixed expenses can also be used to quickly estimate a company's break-even point.

  • 52. re direct costs fixed and indirect costs variable?
     

    Direct product costs such as raw materials are variable costs. Variable product costs increase in total as more units of products are manufactured.

     

    Costs that are direct to a department could be variable or fixed. For example, a supervisor in the painting department would be a direct cost to the painting department. Since the supervisor's salary is likely to be the same amount each month regardless of the quantity of products manufactured, it is a fixed cost to the department. The supplies furnished to the painting department will be a direct cost to the department, but will be a variable cost to the department if the total amount of supplies used in the department increases as the volume or activity in the department increases.

     

    An indirect product cost is the electricity used to operate a production machine. The cost of the electricity isvariable because the total electricity used is greater when more products are manufactured on the machine. Depreciation on the production machine is also an indirect product cost, except it is usually a fixed cost. That is, the machine's total depreciation expense is the same each year regardless of volume produced on the machine.

     

    As you can see, costs can be direct and indirect depending on the cost object: product, department, and others such as division, customer, geographic market. The cost is fixed if the total amount of the cost does not change as volume changes. If the total cost does change in proportion to the change in the activity or volume, it is a variable cost.

     

  • 53. What happens when the high-low method ends up with a negative amount?
     

    The high-low method of determining the fixed and variable portions of a mixed cost relies on only two sets of data: 1) the costs at the highest level of activity, and 2) the costs at the lowest level of activity. If either set of data is flawed, the calculation can result in an unreasonable, negative amount of fixed cost.

     

    To illustrate the problem, let's assume that the total cost is AED 1,200 when there are 100 units of product manufactured, and AED 6,000 when there are 400 units of product are manufactured. The high-low method computes the variable cost rate by dividing the change in the total costs by the change in the number of units of manufactured. In other words, the AED 4,800 change in total costs is divided by the change in units of 300 to yield the variable cost rate of AED 16 per unit of product. Since the fixed costs are the total costs minus the variable costs, the fixed costs will be calculated to a negative AED 400. This unacceptable answer results from total costs of AED 1,200 at the low point minus the variable costs of AED 1,600 (100 units times AED 16), or total costs of AED 6,000 at the high point minus the variable costs of AED 6,400 (400 units times AED 16).

     

    The negative amount of fixed costs is not realistic and leads me to believe that either the total costs at either the high point or at the low point are not representative. This brings to light the importance of plotting or graphing all of the points of activity and their related costs before using the high-low method. (The number of units uses the scale on the x-axis and the related total cost at each level of activity uses the scale on the y-axis.) It is possible that at the highest point of activity the costs were out of line from the normal relationship—referred to as an outlier. You may decide to use the second highest level of activity, if the related costs are more representative.

     

  • 54. What is the difference between break-even point and payback period?
     

    Break-even point is the volume of sales or services that will result in no net income or net loss on a company's income statement. In other words, the break-even point focuses on the revenues needed to equal exactly all of the expenses on a single income statement prepared under the accrual method of accounting.

     

    The break-even point in dollars of revenues can be calculated by dividing a company's total fixed expenses by its contribution margin ratio. The break-even calculation assumes that the selling prices, contribution margin ratio, and fixed expenses will not change.

     

    Payback period is the number of years needed for a company to receive net cash inflows that aggregate to the amount of an initial cash investment. Hence the payback period focuses on the pertinent cash flows of multiple accounting years instead of the net income of a single accounting period. The payback period is often computed when evaluating potential capital expenditures. However, the payback period is considered to be flawed because it ignores 1) the cash flows occurring after the payback period, and 2) the time value of money.

     

  • 55. Are payroll withholding taxes an expense or a liability?
     

    Payroll taxes withheld from employees' wages and salaries are liabilities of the employer. The payroll taxes withheld from employees include the employees' portion of the FICA or Social Security and Medicare taxes, federal income taxes, and state income taxes. The amounts withheld are really the employees' money that the employer is required by law to withhold and remit to the government. In other words, the employer is acting as an agent by withholding and remitting the employees' money. These taxes are not expenses of the company withholding them. They are a liability until the money is remitted to the government.

     

    Payroll taxes which are not withheld from employees are expenses of the employer. Two examples of payroll taxes that are not withheld from employees but which must be remitted to the government by the employer are the employer's portion of the FICA or Social Security and Medicare taxes and the state and federal unemployment taxes. Since these are to be paid by the employer, these are expenses. They are also liabilities until the employer remits the required amounts to the government.

     

  • 56. What is the difference between FIFO and LIFO?
     

    The difference between FIFO and LIFO results from the order in which changing unit costs are removed from inventory and become the cost of goods sold. When the unit costs have increased, LIFO will result in a larger cost of goods sold and a smaller ending inventory compared with FIFO. If the unit costs are stable, there will be little or no difference between FIFO and LIFO. Also note that the order in which the costs are removed from inventory is independent of the order in which the physical units are removed from inventory.

     

    To illustrate the difference between FIFO and LIFO, let's assume that a retail store carried only one product during its first year of business. It purchased 30 units in January at a cost of AED 40 each, 30 units in June at AED 43 each, and 30 units in November at AED 46 each. Thus, for the year the retailer purchased 90 units with a total actual cost of AED 3,870 [30XAED 40 + 30XAED 43 + 30XAED 46]. Let's also assume that 70 units were sold and that 20 units remain in inventory at the end of the year.

     

    FIFO assumes that the first costs (the oldest costs) for 70 of the units will be removed from inventory and will be expensed on the income statement as the cost of goods sold. Hence, the FIFO cost flow assumption is that the 70 units sold had a cost of AED 2,950 [30XAED 40 + 30XAED 43 + 10XAED 46]. FIFO also assumes that the 20 units remaining in inventory had the most recent cost of AED 46 each for a total of AED 920.

     

    LIFO assumes that the last costs (the most recent actual costs) for 70 units will be removed from inventory and will be expensed on the income statement as the cost of goods sold regardless of which units were actually shipped to customers. Therefore, the LIFO cost flow assumption is that the 70 units sold had a cost of AED 3,070 [30XAED 46 + 30XAED 43 + 10XAED 40]. LIFO also assumes that the 20 units remaining in inventory had the oldest cost of AED 40 each for a total of AED 800.

     

    In our example, LIFO results in AED 120 less of ending inventory and AED 120 less of gross profit (because the cost of goods sold was larger). The lower gross profit and the associated lower taxable income for a U.S. company can mean less income tax payments if the company is profitable and has significant and increasing levels of inventory.

  • 57. Why is the Cash Flow Statement identified as one of the financial statements?
     

    The Cash Flow Statement or Statement of Cash Flows is required as part of a full set of financial statementsbecause of the Financial Accounting Standards Board's Statement of Financial Accounting Standards No. 95,Statement of Cash Flows.

     

     

  • 58. What is the difference between inventory and the cost of goods sold?
     

    Inventory for a retailer or distributor is the merchandise that was purchased and has not yet been sold to customers. For a manufacturer, inventory consists of raw materials, packaging materials, work-in-process, and the finished goods that are owned and on hand. Inventory is generally valued at its cost. If a business has inventory it is often a major component of its current assets.

     

    The cost of goods sold is the cost of the merchandise or products that have been sold to customers during the period of the income statement. For a company that sells goods, the cost of goods sold is usually the largest expense on its income statement. As a result, care must be taken when computing and matching the cost of goods sold with the sales revenues.

     

    To illustrate how inventory and the cost of goods sold are connected, let's assume that a retailer carries only one product. It has 100 units of the product in inventory at the beginning of the year and purchases an additional 1,500 units during the year. Accountants refer to the combination of the beginning inventory plus the purchases for the period as the goods available for sale, which in this example is 1,600 units. If there are 125 units on hand at the end of the year, the ending inventory will report the cost of 125 units. The cost of goods sold for the year will be the costof the 1,475 units that are no longer available.

     

    If the per unit costs of the products (or inputs) change during the year, the company must follow a cost flow assumption [FIFO, LIFO, or average] in order to divide the cost of g

  • 59. What does per annum mean?
     

    Per annum means yearly or annually. For example, if a business charges its customers 1.5% per month on any unpaid balance, the per annum rate is 18%. The per annum rate was the result of 1.5% X 12 months in a year.

     

    When a supplier offers a credit customer an early-payment discount of 2% for paying an invoice in 10 days instead of paying the full amount in 30 days, the supplier is giving up 2% of the invoice amount in order to be paid 20 days early. To compute the rate per annum we multiply both the "2%" and the "20 days" by 18 (in order to get close to the 365 days in a year). Hence, the per annum rate is approximately 36%. To test this, let's assume that the invoice amount was AED 1,000 and the supplier states that the customer may deduct 36% per annum if the invoice is paid 20 days before the due date. The calculation will be AED 1,000 X 36% per annum X 20 days/360 days per year = AED 20. This amount agrees with the early-payment discount expressed as 2% of the AED 1,000 invoice amount.

  • 60. If a mortgage payment is due by December 31, but the payment is not made until the following month, should the loan payment be accrued at December 31?
     

    The interest portion of the mortgage payment should be accrued as of December 31 under the accrual method of accounting. In other words, there needs to be an adjusting entry dated December 31 to debit Interest Expense and to credit Interest payable for the amount of interest owed as of December 31.

     

    The principal balance on the mortgage loan already appears in the general ledger and on the balance sheet as the liability Mortgage Loan Payable. Therefore, there is no accrual needed for the principal portion of the loan payment due at December 31.

  • 61. Is the direct method still used in the statement of cash flows?
     

    The direct method of preparing the statement of cash flows is recommended by the Financial Accounting Standards Board (FASB). However, the direct method is rarely used.

     

    Recent editions of Accounting Trends & Techniques published by the American Institute of Certified Public Accountants surveyed 500 annual reports and found that less than 10 used the direct method, while more than 490 used the indirect method.

  • 62. What is the difference between adjusting entries and correcting entries?
     

    Generally, adjusting entries are required every accounting period so that a company's financial statements reflect the accrual method of accounting. It is typical for the adjusting entries to be dated as of the last day of the accounting period and to include an income statement account and a balance sheet account.

     

    Adjusting entries are necessary to:

    • accrue expenses and losses and the related liabilities
    • accrue revenues and gains and the related assets
    • defer expenses and the related assets
    • defer revenues and the related liabilities
    • record depreciation expense or bad debts expense and the change in the related contra asset account

    A correcting entry is needed only if an error is discovered in an account. Correcting entries can involve any combination of income statement and balance sheet accounts.

     

    Correcting entries are recorded if:

    • an erroneous amount was used in a previously posted entry
    • an entry was recorded in the wrong account

    oods available for sale between the ending inventory and the cost of goods sold.

    What is the difference between the current ratio and the quick ratio?

    The current ratio is the proportion (or quotient or fraction) of the amount of current assets divided by the amount of current liabilities.

     

    The quick ratio (or the acid test ratio) is the proportion of 1) only the most liquid current assets to 2) the amount of current liabilities. In other words, the quick ratio assumes that only the following current assets will turn to cashquickly: cash, cash equivalents, short-term marketable securities, and accounts receivable. Hence, the quick ratio does not include inventories, supplies, and prepaid expenses.

     

    To illustrate the difference between the current ratio and the quick ratio, let's assume that a company's balance sheet reports current assets of AED 60,000 and current liabilities of AED 40,000. Its current assets include AED 35,000 of inventory and AED 1,000 of supplies and prepaid expenses. The company's current ratio is 1.5 to 1 [AED 60,000 divided by AED 40,000]. Its quick ratio is 0.6 to 1 [(AED 60,000 minus AED 36,000) divided by AED 40,000].

     

    AccountingCoach PRO has 24 blank forms to guide you in calculating and understanding financial ratios. Also included are 24 filled-in forms based on two financial statements.

    What is the difference between the current ratio and working capital?

    The current ratio is the proportion (or quotient or fraction) of the amount of current assets divided by the amount of current liabilities.

     

    Working capital is not a ratio, proportion or quotient, but rather it is an amount. Working capital is the amount remaining after current liabilities are subtracted from current assets.

     

    To illustrate the difference between the current ratio and working capital, let's assume that a company's balance sheet reports current assets of AED 60,000 and current liabilities of AED 40,000. The company's current ratio is 1.5 to 1 (or 1.5:1, or simply 1.5) resulting from dividing AED 60,000 by AED 40,000. The company's working capital is AED 20,000 which is the remainder after subtracting AED 40,000 from AED 60,000.

     

  • 63. How do you record an asset that was partially financed?
     

    Let's assume that your company purchased a car for AED 10,000 and paid cash of AED 4,000 and signed a promissory note for AED 6,000. The accounting entry is a debit to the asset account Automobiles for the cost of AED 10,000; a credit to the asset account Cash for the AED 4,000 paid; and a credit to the liability account Notes Payable for AED 6,000.

     

    The liability account Notes Payable reports the principal amount owed at the time. Interest that will occur in the future is not recorded at the time of the purchase. The reason is that the interest is not owed as of that date. Each month, one month's interest on the note or loan will be recorded with a debit to Interest Expense and a credit to Cash or Interest Payable (if not paid). Any cash payments that exceed the amount of interest owed at that time will be debited to Notes Payable. The balance in the liability account Notes Payable should agree with the principal balance owed to lender. The balance in the liability account Interest Payable should agree with the interest due as of that date.

  • 64. What is a recurring journal entry?
     

     

    A recurring journal entry is a journal entry that is recorded in every accounting period. For example, a company issuing monthly financial statements might record depreciation by debiting Depreciation Expense for AED 3,000 and crediting Accumulated Depreciation for AED 3,000 each and every month. If the accounts and the amounts are identical each month, the recurring journal entry might be referred to as a memorized entry if the accounting software produces and records the entry. Some accountants refer to this type of recurring journal entry as a standard journal entry.

     

    The term recurring journal entry can also refer to monthly journal entries where the accounts are identical but the amounts vary by month. For example, the journal entry to record property insurance expense might involve Insurance Expense and Prepaid Insurance every month, but the amounts will change when the amount of the prepaid insurance premiums change. Other recurring entries will involve the identical accounts, but the amounts will be different in each accounting period. An example is the payroll entry. Each payroll entry will have the same accounts but different amounts due to the number of hours worked. Other examples of recurring entries with amounts that differ each period include sales, interest earned, interest expense, bank service charges, and so on.

     

    One company's recurring entry with differing amounts is generated by its software. Each month its computer system debits Freight Expense and credits a liability Accrued Freight  for the pounds shipped multiplied by a freight cost per pound. When the freight bills are received and paid, the liability and its cash are reduced. As long as its cost per pound is accurate, the company's computer system is routinely achieving the matching principle and the accrual method of accounting with little professional effort.

  • 65. What is the monthly close?
     

    In accounting the monthly close is the processing of transactions, journal entries and financial statements at the end of each month. Under the accrual method of accounting, it is imperative that the financial statements reflect only the transactions and journal entries having relevance to the current month's revenues and expenses, and end-of-the-month assets and liabilities. Expressed another way, the monthly close must achieve a proper cutoffof each month's financial activities.

     

    To ensure that the monthly financial statements are accurate and timely, companies will use standard journal entries, recurring journal entries, and checklists for the tasks that must be completed.

     

    If a company has inventories, its monthly close will be more challenging as it will have to be certain that the costs are recorded in the same month as the goods are added to the inventories. In short, the accrual of expenses becomes immensely important when goods are received and are sold.

     

    Another important step in the monthly close is to compare the amounts and percentages on the current financial statements to those of earlier months. For example, if the current income statement shows the cost of goods sold as 88% instead of the typical 81%, the current month's amounts need to be reviewed before releasing the financial statements. Often the comparison of the balance sheet amounts to those of earlier months will provide insight as to unusual amounts shown on the income statement.

  • 66. Why is the P&L profit entered on the credit side of the balance sheet?
     

    The profit or net income belongs to the owner of a sole proprietorship or to the stockholders of a corporation. The owner's or stockholders' equity is reported on the credit side of the balance sheet. Recall that the balance sheet reflects the accounting equation, Assets = Liabilities + Owner's Equity.

     

    Let's illustrate this with an example. Assume that you own a sole proprietorship and you provided a service to a customer. One of your business assets (cash or accounts receivable) increased and your liabilities were not involved. Therefore, your business liabilities will remain the same and your equity in the business will increase.

     

    Accountants prepare an income statement or P&L to report the revenues and expenses, but the ultimate effect is that the business assets and owner's equity will increase when there is a profit or net income.

  • 67. What is a standard cost?
     

    A standard cost has been described as a predetermined cost, an estimated future cost, an expected cost, abudgeted unit cost, a forecast cost, or a "should be" cost. Standard costs are often a part of a manufacturer's annual profit plan and operating budgets. Standard costs will be established for the following year's direct materials,direct labor, and manufacturing overhead. If standard costs are used, there will be:

    • a standard cost for each unit of input (e.g., AED 20 per hour of direct labor)
    • a standard quantity of each input for each unit of output (e.g., 2 hours of labor for each product)
    • a standard cost for each unit of output (e.g., AED 20 X 2 hours = AED 40 of direct labor per product)

    Under a standard cost system, the standard costs of the manufacturing activities will be recorded in the inventories and the cost of goods sold accounts. Since the company must pay its vendors and production workers the actual costs incurred, there are likely to be some differences. The difference between the standard costs and the actual manufacturing costs is referred to as a cost variance and will be recorded in separate variance accounts. Any balance in a variance account indicates that the company is deviating from the amounts in its profit plan.

     

    While standard costs can be a useful management tool for a manufacturer, its external financial statements must comply with the cost principle and the matching principle. Therefore, significant variances must be reviewed and properly reported as part of the cost of goods sold and/or inventories.

  • 68. What do negative variances indicate?
     

    Accountants often use negative amounts to indicate an unfavorable variance. For instance, if actual revenues are less than the budgeted revenues, the variance (or difference) will be shown as a negative amount. The reason is that having less revenues than planned is not good. On the other hand, if actual expenses are less than the budgeted amount of expenses, the variance will be shown as a positive amount. The reason is that fewer actual expenses than budgeted is favorable (or good, positive).

     

    Let's illustrate this further with an example. Assume that a company had the following actual amounts in a recent week: revenues AED 750, expenses AED 525, net income AED 225. For the same week, the company had budgeted the following amounts: revenues AED 900, expenses AED 700, net income AED 200. The comparison of actual to budget resulted in the following variances:

     

    • Revenues variance: unfavorable AED 150.   Presented as (150).
    • Expenses variance: favorable AED 175.   Presented as 175.
    • Net income variance: favorable AED 25.   Presented as 25.

    The net income variance is favorable because the favorable expense variance was AED 25 greater than theunfavorable revenues variance. The favorable AED 175 variance exceeded the unfavorable AED 150 variance resulting in the net variance of AED 25 favorable.

     

    Our example shows that the positive and negative signs for the variances are logical if you focus is on the company's net income. In other words, ask yourself one of the following questions:

    • "Is the difference between the actual and the budgeted amounts good or bad as far as the company's net income?"
    • "Is the variance favorable or unfavorable as far as the company's net income?"
    • "Does the difference have a positive or negative effect on the company's net income?"

    To assist others, it may be helpful to indicate on your report "( ) = an unfavorable effect on net income."

  • 69. What is the difference between assets and fixed assets?
     

    Assets are resources owned by a company as the result of transactions. Examples of assets are cash, accounts receivable, inventory, prepaid insurance, land, buildings, equipment, trademarks and customer lists purchased from another company, and certain deferred charges.

     

    The term fixed assets generally refers to the long-term assets, tangible assets used in a business that are classified as property, plant and equipment. Examples of fixed assets are land, buildings, manufacturing equipment, office equipment, furniture, fixtures, and vehicles. Except for land, the fixed assets are depreciatedover their useful lives.

     

  • 70. What is the difference between revenues and earnings?
     

    A U.S. corporation's revenues are reported on the top line of its income statement, while its earnings are reported on the bottom line (or near the bottom) of the income statement.

     

    Revenues is the gross amount earned from selling goods or providing services during the period shown in the heading of the income statement. In other words, revenues is the amount earned before deducting the cost of goods sold, expenses, and losses.

     

    Earnings is the net amount earned after deducting the cost of goods sold, expenses and losses. It is often presented as net earnings or net income. When a corporation's stock is publicly-traded, the earnings must also be reported on the income statement as earnings per share (EPS) of common stock.

  • 71. What is the difference between stockholder and shareholder?
     

    There is no difference between stockholder and shareholder. The terms are used interchangeably. Both terms mean the owner of shares of stock in a corporation and a part owner of a corporation.

     

  • 72. How do I compute the product cost per unit?
     

     

    In accounting, we define the product cost as the direct material, direct labor, and manufacturing overhead. Costs such as advertising, preparing invoices, delivery expense, office salaries, office rent and utilities, and interest on loans are examples of expenses that are not considered to be product costs. Rather, these costs are expensed immediately to the period instead of being assigned to a product.

     

    To be profitable, a company must have its selling prices large enough to cover both the product costs of the units sold and the period expenses.

     

    The product cost is used for valuing the inventory and for determining the cost of goods sold. Since some of the manufacturing overhead costs are fixed in total (factory rent, factory depreciation, factory managers' salaries), the per unit cost of a product will depend upon the number of units manufactured during a given year. In other words, the cost of a product is not know with precision, even though accountants will compute the per unit cost to the nearest penny.

  • 73. What is the difference between expenses and payments?
     

    Some current period payments will result in expenses in future periods: Under the accrual method of accounting, expenses are costs that have been used up or have been incurred in the process of earning revenues and/or operating a business. For example, a retailer will report its cost of the goods sold as an expense of the period in which the related sales occurred (even if the retailer has not yet paid for the goods, or had paid for the goods in an earlier period). Some expenses are allocations of a cost that was paid in an earlier period (e.g. depreciation of an asset purchased in a previous year, the allocation of a 6-month insurance premium). Expenses also include costs incurred in the current period that will be paid in a later period (e.g. current advertising that will be paid for in the next accounting period). Interest on a loan is a daily expense even though all of the interest will be paid when the loan comes due in the next accounting period.

     

    A payment is a disbursement of money (usually in the form of a check or currency). Some payments are current period expenses (e.g. current month's rent payment) but many payments are not expenses of the current period. Here are a few examples of payments that are not expenses:

    • a payment of AED 100,000 to purchase the land adjacent to a company will never become an expense
    • payments that are cash dividends to stockholders will never be a corporation's expense
    • principal payments to reduce a loan payable will never be an expense
    • payments to remit payroll tax withholdings will never be an expense
    • payments to reduce liabilities resulting from expenses reported in earlier accounting periods (e.g. payments to reduce interest payable, accounts payable, taxes payable)

     

    • payments for construction of a building that will be put into service next year
    • payments for an exhibit at next year's trade show

    •          payments for services to be received in a future accounting period

  • 74. What is meant by non operating expenses and losses?
     

    Nonoperating expenses are the expenses incurred by a business which are outside of its main or central operations. Nonoperating expenses are also described as incidental or peripheral. A common example is a retailer's interest expense. The retailer's main operations are purchasing and selling merchandise. Borrowing money is outside of its main or central operations.

     

    Losses often involve the disposal of property, plant and equipment for a cash amount that is less than the carrying amount (or book value) of the asset sold. An example of a loss is the retailer's disposal of a delivery truck for a cash amount that is less than the truck's carrying amount. Another example is a loss from a settlement of a lawsuit.

     

    Nonoperating expenses and losses are often reported on the income statement after the subtotal Income from operations and will often appear with the caption Other income and (expenses).

  • 75. What are pro forma financial statements?
     

    A pro forma financial statement is one based on certain assumptions and projections.

     

    For example, a corporation might want to see the effects of three different financing options. Therefore, it prepares projected balance sheets, income statements, and statements of cash flows. These projected financial statements are referred to as pro forma financial statements.

     

     

  • 76. What is meant by nonoperating revenues and gains?
     

    Nonoperating revenues are the amounts earned by a business which are outside of its main or central operations. Nonoperating revenues are also described as incidental or peripheral. A common example is a retailer's investment income or interest income. The retailer's main operations are purchasing and selling merchandise. Investing its idle cash in interest-bearing investments is outside of its main or central operations.

     

    Gains often involve the disposal of property, plant and equipment for a cash amount that is greater than the carrying amount (or the book value) of the asset sold. An example would be a retailer's disposal of a delivery truck for a cash amount that is greater than the truck's carrying amount. Another example is a gain from a settlement of a lawsuit.

     

    Nonoperating revenues and gains are often reported on the income statement after the subtotal Income from operations and will often appear with the caption Other income.

  • 77. What is an example of an unrealized gain?
     

    A common example of an unrealized gain is the gain in the market value of an investment in the stock of another corporation that is held as an available-for-sale security.

     

    The unrealized holding gain is reported on the balance sheet by 1) increasing the asset available-for-sale securities, and 2) increasing the stockholders' equity component accumulated other comprehensive income.  Note that the holding gains on available-for-sale securities are not reported on the income statement.

  • 78. What is the difference between revenues and receipts?
     

    A company's revenues are amounts it has earned as the result of business activities such as selling merchandise or performing services. Under the accrual method of accounting, revenues are reported on the income statement in the period in which they are earned even when a dependable customer is allowed to pay 60 days later. In this example, when the revenues are earned the company will credit a revenues account and will debit the asset account Accounts Receivable.

     

    A company's receipts usually refers to the cash that it receives. The following are examples of receipts which are not revenues:

     

    • borrowing AED 1,000 in cash from the bank
    • collecting an account receivable from a customer who had purchased goods on credit 30 days earlier
    • disposing of a company vehicle and receiving cash that is equal to the vehicle's book value
    • receiving AED 1,000 from an employee who had borrowed AED 1,000 from the company several weeks earlier
    • receiving cash from an investor for new shares of the company's common stock

    When a company makes a AED 200 cash sale (or performs services for AED 200 of cash) the company will have both AED 200 of revenues and AED 200 of cash receipts.

  • 79. What is the advantage of issuing bonds instead of stock?
     

    There are several advantages of issuing bonds or other debt instead of stock when acquiring assets. One advantage is that the interest on bonds and other debt is deductible on the corporation's income tax return. Dividends on stock are not deductible on the income tax return.

     

    A second advantage of financing assets with bonds instead of stock is that the ownership interest in the corporation will not be diluted by adding more owners. Bondholders and other lenders are not owners of the assets or of the corporation. Therefore, all of the gain in the value of the assets belongs to the stockholders. The bondholders will receive only the agreed upon interest. This is related to the concept of leverage or trading on equity. By issuing debt, the corporation gets to control a large asset by using other people's money instead of its own. If the asset ends up being very profitable, all of its earnings minus the interest, will enhance the owners' financial position.

  • 80. What is an ordinary annuity?
     

    In accounting, an ordinary annuity refers to a series of identical cash amounts with each amount occurring at the end of equal time intervals.

     

    An example of an ordinary annuity is the series of semiannual interest payments that are part of a bond payable. For instance, a 10-year bond with a maturity amount of AED 10 million and a stated interest rate of 6% will require interest payments of AED 300,000 at the end of each of the 20 six-month time intervals.

     

    Another example of an ordinary annuity is a mortgage loan having a fixed interest rate and a series of equal monthly payments that will begin 30 days after the loan is granted. Thus a 15-year mortgage loan will result in an ordinary annuity of 180 equal monthly payments with the first payment due approximately 30 days after the loan is made.

  • 81. Why are average balance sheet amounts used in calculating the turnover ratios?
     

    In the calculation of a turnover ratio, the numerator is an amount from an annual income statement, while the denominator is a balance sheet amount. Since a balance sheet amount is a snapshot and reflects only an instant or moment, there is an inconsistency between the numerator and the denominator

  • 82. Are the goods purchased by a retailer an expense or an asset?
     

    Some retailers view the goods purchased as part of the expense known as the cost of goods sold. Other retailers view the goods purchased as part of the asset inventory.

     

    To appreciate both views, let's assume that a retailer begins the year with inventory having a cost of AED 800. It ends the year with inventory having a cost of AED 900. During the year the retailer purchased goods having a cost of AED 7,000. Let's also assume that the cost per unit did not change during the year.

     

    Retailer X may view the AED 7,000 of purchases as an expense (cost of goods sold) except for AED 100, which was the cost of the goods added to its inventory (AED 900 vs. AED 800). Retailer X's income statement reports its cost of goods sold as: purchases of AED 7,000 minus the AED 100 increase in inventory = AED 6,900.

     

    Retailer Y may view the AED 7,000 of purchases as an increase to its asset inventory and will report its cost of goods sold as: beginning inventory of AED 800 + purchases of AED 7,000 = cost of goods available of AED 7,800 minus the ending inventory of AED 900 = AED 6,900.

     

    Regardless of whether the goods purchased are initially recorded in an inventory account or in a cost of goods sold account, the amounts reported on the financial statements must be the same: the expense (reported as the cost of goods sold on the income statement for the year) is AED 6,900 and the asset inventory (reported on the balance sheet as of the end of the year) is AED 900.

  • 83. How do you write off a bad account?
     

    There are two ways to write off a bad account receivable. One is the direct write-off method and the other occurs under the allowance method.

     

    Under the direct write-off method a company writes off a bad account receivable after the specific account is found to be uncollectible. This write off usually occurs many months after the account receivable and the credit sale were recorded. The entry to write off the bad account will consist of 1) a credit to Accounts Receivable in order to remove the amount that will not be collected, and 2) a debit to Bad Debts Expense to report the amount of the loss on the company's income statement.

     

    Under the allowance method a company anticipates that some of its credit sales and accounts receivable will not be collected. In other words, without knowing the specific accounts that will become uncollectible, the company debits Bad Debts Expense and credits Allowance for Doubtful Accounts. This Allowance account is a contra receivable account and it allows the company to report the net amount of the receivables that it expects will be turning to cash prior to identifying and removing a specific account receivable. When a specific customer's account does present itself as uncollectible, the customer's account will be written off by crediting Accounts Receivable and debiting Allowance for Doubtful Accounts.

     

    In the U.S. the direct write-off method is required for income tax purposes. However, for financial reportingpurposes the allowance method means recognizing the loss (the bad debts expense) closer to the time of the credit sales. As a result, the allowance method is more in line with the accountants' concept of conservatism and may result in a better matching of the bad debt expense with the credit sales.

  • 84. Why are some expenses deferred?
     

    Generally, expenses are deferred in order to comply with the accounting guideline known as the matching principle.

     

    To illustrate the concept, let's assume that a company pays AED 3,000 on December 30 to rent a warehouse for the upcoming three-month period of January 1 through March 31. Since none of the AED 3,000 expires or is used up in December, none of the amount should be reported as rent expense on the income statement for the month of December. Hence the AED 3,000 is deferred to a balance sheet account such as Prepaid Rent (or Prepaid Expenses), which is a current asset account.

     

    During the three months of January 1 through March 31 (when the prepaid rent is expiring) the AED 3,000 prepayment must be moved from the balance sheet asset account to an income statement expense account. The usual allocation will involve an adjusting entry to debit Rent Expense for AED 1,000 and credit Prepaid Rent for AED 1,000 on January 31, February 28 and March 31.

  • 85. What are operating expenses?
     

    Operating expenses are the costs associated with a company's main operating activities and which are reported on its income statement.

     

    For example, a retailer's main operating activities are the buying and selling of merchandise or goods. Therefore, its operating expenses will include:

    • Cost of goods sold. These costs are reported as operating expenses on the income statement because of the matching principle. The revenues from the sale of merchandise must be matched with the cost of the merchandise that is sold.
    • Selling, general and administrative expenses (SG&A). These costs are reported as operating expenses on the income statement because they pertain to operating the main business during that accounting period. These costs may have expired, may have been used up, or may not have a future value that can be measured.

    Some authors define operating expenses as only SG&A. In other words, they do not include the cost of goods sold as an operating expense. Such a definition will be deficient for calculating a company's operating income. Clearly, the calculation of operating income cannot omit the cost of goods sold.

  • 86. When do you adjust the amount of prepaid expenses?
     

    The balance in the current asset account Prepaid Expenses should be adjusted prior to issuing a company's financial statements. If the company issues financial statements for each calendar month, you will need to adjust the balance in Prepaid Expenses as of the end of each month. If your company issues only quarterly financial statements, you will need to adjust the balance at the end of each quarter.

     

    The goal is to have the balance in Prepaid Expenses be equal to the amount of the unexpired costs as of the end of the accounting period (which is also the date appearing in the heading of the balance sheet).

     

    Usually the adjusting entry for prepaid expenses will be a credit to Prepaid Expenses and a debit to the appropriate expense account(s). For instance, if Prepaid Expenses involve the prepayment of insurance premiums the adjusting entry will include a debit to Insurance Expense.

  • 87. What are prepaid expenses?
     

    Prepaid expenses are future expenses that have been paid in advance. You can think of prepaid expenses as costs that have been paid but have not yet been used up or have not yet expired.

     

    The amount of prepaid expenses that have not yet expired are reported on a company's balance sheet as an asset. As the amount expires, the asset is reduced and an expense is recorded for the amount of the reduction. Hence, the balance sheet reports the unexpired costs and the income statement reports the expired costs. The amount reported on the income statement should be the amount that pertains to the time interval shown in the statement's heading.

     

    A common prepaid expense is the six-month premium for insurance on a company's vehicles. Since the insurance company requires payment in advance, the amount paid is often recorded in the current asset account Prepaid Insurance. If the company issues monthly financial statements, its income statement will report Insurance Expense that is one-sixth of the amount paid. The balance in the account Prepaid Insurance will be reduced by the amount that was debited to Insurance Expense.

  • 88. What are interim financial statements?
     

    Interim financial statements for a corporation are the financial statements covering a period of less than one year. Often interim financial statements are issued for the quarters between the annual financial statements. The purpose is to give investors and other users updated information on the corporation's operations. Unlike the annual financial statements, the interim financial statements are usually unaudited and condensed. Therefore, it is wise to also read the previously issued and complete annual financial statements and reports.

     

    In order for the interim income statement amounts to add up to the amounts reported in the official income statement for the year, it is necessary that the accounting practices in the interim financial statements be consistent with the accounting practices that will be followed in the annual financial statements.

  • 89. What is work-in-process inventory?
     

    You can think of work-in-process (WIP) inventory as the goods that are on the factory floor. The manufacturing of these goods has begun but has not yet been completed.

     

    You can also think of work-in-process inventory as the general ledger current asset account that reports the cost of the goods that are on the factory floor. In the U.S. the cost reported as WIP should be the cost of the direct materials, direct labor and the allocation of manufacturing overhead for the goods on the factory floor.

     

    As the WIP goods become completely manufactured, their cost will be credited to the WIP account and will be debited to the Finished Goods Inventory account.

  • 90. What is the accrual method?
     

    The accrual method of accounting reports revenues on the income statement when they are earned even if the customer will pay 30 days later. At the time that the revenues are earned the company will credit a revenue account and will debit the asset account Accounts Receivable. (When the customer pays 30 days after the revenues were earned, the company will debit Cash and will credit Accounts Receivable.)

     

    The accrual method of accounting also requires that expenses and losses be reported on the income statement when they occur even if payment will take place 30 days later. For example, if a company has a AED 15,000 repair done on December 15 and the vendor allows for payment on January 15, the company will report a repair expense and a liability of AED 15,000 as of December 15. (On January 15 the company will credit Cash and will debit the liability account.)

     

    The accrual method of accounting, which is also known as the accrual basis of accounting, is required for large companies. (The cash method of accounting may be used by individuals and some small companies.) The accrual method and the associated adjusting entries will result in a more complete and accurate reporting of a company's assets, liabilities, equity, and earnings during each accounting period.

  • 91. What is public accounting?
     

    Public accounting can be viewed as firms of accountants that serve clients such as businesses (retailers, manufacturers, service companies, etc.), individuals, nonprofits and governments. The services provided by public accounting firms will vary by the size and the expertise of the firm. Here are some of the public accounting services:

    • preparation, review, and auditing of the clients' financial statements
    • tax work including the preparation of income tax returns, and estate and tax planning
    • consulting and advice involving accounting systems, mergers and acquisitions, and much more

    The people employed in public accounting are often certified public accountants or CPAs. Many accountants leave the larger public accounting firms after several years of experience and become an employee of a single business. In their new position they will be referred to as a private accountant, corporate accountant or internal accountant.

    Public accounting firms range in size from tens of thousands of small local firms to a few huge international firms employing hundreds of thousands of CPAs throughout the world.

     

    The positions in public accounting often consist of staff, senior, manager and partner.

  • 92. What is the coefficient of correlation?
     

    In simple linear regression analysis, the coefficient of correlation (or correlation coefficient) is a statistic which indicates the relationship between the independent variable and the dependent variable. The coefficient of correlation is represented by r and it has a range of -1.00 to +1.00.

    When the coefficient of correlation is a positive amount, such as +0.80, it means an increase in the independent variable will result in an increase in the dependent variable. (Also, a decrease in the independent variable will mean a decrease in the dependent variable.) When the coefficient of correlation is negative, such as -0.80, there is an inverse relationship. (An increase in the independent variable will mean a decrease in the dependent variable. A decrease in the independent variable will mean an increase in the dependent variable.)

    A coefficient of correlation of +0.8 or -0.8 indicates a strong correlation between the independent variable and the dependent variable. An r of +0.20 or -0.20 indicates a weak correlation between the variables. When the coefficient of correlation is 0.00 there is no correlation.

    When the coefficient of correlation is squared, it becomes the coefficient of determination. This means that an r of +0.80 or -0.80 will result in a coefficient of determination of 0.64 or 64%. (This tells you that 64% of the change in the total of the dependent variable is associated with the change in the independent variable.) An r of +0.20 or -0.20 indicates that only 4% (0.20 x 0.20) of the change in the dependent variable is explained by the change in the independent variable.

    It is important to realize that correlation does not guarantee that a cause-and-effect relationship exists between the independent variable and the dependent variable. However, a

  • 93. What is the full disclosure principle?
     

    For a business, the full disclosure principle requires a company to provide the necessary information so that people who are accustomed to reading financial information can make informed decisions concerning the company.

     

    The required disclosures can be found in a number of places including the following:

    • the company's financial statements including any supplementary schedules and notes (or footnotes).
    • Management's Discussion and Analysis that is included in a publicly-traded corporation's annual report to the U.S. Securities and Exchange Commission.
    • Quarterly earnings reports, press releases and other communications.

    The first note or footnote in a company's financial statements will disclose the significant accounting policies such as how and when revenues are recognized, how property is depreciated, how inventory and income taxes are accounted for, and more.

     

    Other disclosures in the notes to the financial statements include the effects of foreign currencies, contingent liabilities, leases, related-party transactions, stock options, and much more.

     

    Judgement is used in deciding the amount of information that is disclosed. For example, in 1980 large U.S. corporations were required to report as supplementary information the effects of inflation and changing prices on its inventory and property (and cost of goods sold and depreciation expense). After several years, the disclosure became optional since the cost of providing the information exceeded the benefits.

  • 94. What is an outstanding check?
     

    An outstanding check is a check that has been written by a company (and deducted from the appropriate general ledger cash account) but it has not yet cleared the bank account on which it is drawn. Hence, outstanding checks will mean that the balance in the bank account will be greater than the balance in the general ledger account (or in an individual's check register).

     

    In the bank reconciliation process, the total amount of outstanding checks is subtracted from the ending balance on the bank statement when computing the adjusted balance per bank.

     

    Checks that are outstanding for a long period of time are known as stale checks. In the U.S. outstanding checks are considered to be unclaimed property and the amounts must be turned over to a company's respective state after several years. Rather than allowing checks to become stale and then remitting the money to a state government, companies should contact the payee of any check that has been outstanding for several months.

     

    The amount of outstanding checks is sometimes referred to as float.

  • 95. What is a sunk cost?
     

    A sunk cost is a cost that was incurred in the past and cannot be undone. Since most transactions cannot be undone, most amounts spent in the past can be described as sunk. In other words, a past or sunk cost will be there regardless of what you decide to do today or in the future.

     

    To illustrate a sunk cost, let's assume that a company spent AED 100,000 last year to purchase and install a machine. Today, a better machine is available for AED 80,000 and it will reduce expenses by AED 50,000 in each of the next 10 years. Now the old machine can be sold for just AED 10,000. When deciding whether to purchase the new machine,the AED 100,000 that was spent on the old machine is a sunk cost.

     

    Basically the decision is whether to spend an additional AED 70,000 today (AED 80,000 minus AED 10,000) in order to save AED 50,000 each year for 10 years. (Current and future income taxes will also be relevant.) It may be difficult, but we need to exclude sunk costs from our decisions.

  • 96. What is a contra account?
     

    A contra account is a general ledger account which is intended to have its balance be the opposite of the normal balance for that account classification. For instance, a contra asset account is intended to have a credit balanceinstead of the debit balance normally found in an asset account. A contra revenue account is intended to have a debit balance instead of the credit balance normally found in a revenue account. The use of a contra account allows a company to continue to report the original amount (or the gross amount) and to also report the carrying amount (or net amount).

     

    To illustrate, let's use the contra asset account Allowance for Doubtful Accounts, which is associated with the asset account Accounts Receivable. If the balance in the Allowance account is a credit of AED 2,000 and the Accounts Receivable account has a normal debit balance of AED 40,000, the net realizable value of the receivables is AED 38,000. The use of this contra account allows 1) the original amount of uncollected sales invoices to continue to be reported in Accounts Receivable, and 2) the net amount of AED 38,000 to be reported on the balance sheet as the amount that will be turning to cash.

     

    Accumulated Depreciation of Equipment is a contra asset account that is associated with the plant asset Equipment. If the balance in the account Accumulated Depreciation is a credit of AED 50,000 and the Equipment account has a normal debit balance of AED 92,000, the carrying amount (or book value) of the equipment is AED 42,000.

     

    Sales Returns and Allowances is a contra revenue account that is associated with the revenue account Sales. If the balance in this contra account is a debit of AED 3,000 and the Sales account has a normal credit balance of AED 400,000, the net sales are AED 397,000. The contra account enables the company's management to see that its customers found AED 3,000 of the AED 400,000 of sales to be unacceptable.

  • 97. What is income smoothing?
     

    Income smoothing refers to reducing the fluctuations in a corporation's earnings. Income smoothing can range from good business methods to fraudulent reporting.

     

    Some business practices are ethical and will result in income smoothing. For example, a corporation might have an employee bonus plan, a deferred profit sharing plan, and a charitable giving plan that will result in expenses that total 25% of its pretax profits. In addition, a U.S. corporation might have a combined federal and state income tax rate of 40% on its incremental pretax profits. These examples will smooth income by causing huge expenses when profits are huge, and will result in little expense when profits are little. (Losses could actually result in a negative income tax expense.) In a year of low profits a corporation might eliminate jobs and postpone maintenance expenses. When profits are higher the corporation will add jobs and perform the maintenance that it had avoided.

     

    The term income smoothing is more likely associated with the manipulation of earnings, creative accounting and the aggressive interpretation and application of generally accepted accounting principles. Perhaps a company will increase its allowance for doubtful accounts with a significant charge to bad debts expense in the years with high profits. Then in years of low profits, the company will reduce the allowance for doubtful accounts. Perhaps a U.S. manufacturer using LIFO will deliberately reduce its inventory quantities in low profit years in order to liquidate the old LIFO layers containing low unit costs. Other manufacturers might increase production when sales and profits are low in order to have lower unit costs.

     

    Smoothing income by abusing the leeway in accounting principles is unethical and does a disservice to the users of the financial statements. Accountants should follow their general guidelines such as consistency, comparability, neutrality, full disclosure and conservatism.

  • 98. What is an asset's useful life?
     

    An asset's useful life is the period of time (or total amount of activity) for which the asset will be economically feasible for use in a business. In other words, it is the period of time that the business asset will be in service and used to earn revenues.

     

    Because of the advances in technology, an asset's useful life is often less than its physical life. For example, a computer may be useful for only three years even though it could physically be operated for decades.

     

    The useful life (as well as the salvage value at the end of the useful life) are estimated amounts needed in the calculation of the asset's depreciation. Depreciation is required so that the company's financial statements comply with the matching principle.

     

    In the U.S., income tax regulations specify the useful life that must be used for income tax reporting. This is one reason that in a given year the depreciation on a company's income tax return will not agree with the depreciation reported on its financial statements.

  • 99. What is periodicity in accounting?
     

    In accounting, periodicity means that accountants will assume that a company's complex and ongoing activities can be divided up and reported in annual, quarterly and monthly financial statements. For example, some earth-moving equipment may require two years to manufacture but the activities will be divided up and reported in quarterly financial statements. A similar situation occurs at a company that develops complex digital systems.

     

    Even a company that manufactures small consumer products will have ongoing activities and costs that overlap two years or more. Again, the accountants will assume that the revenues and costs can be assigned or allocated to the appropriate accounting periods. Hence, the accountants will report the company's net income and cash flows for each accounting period (year, quarter, month, etc.) and the company's financial position at the end of each accounting period.

     

    Periodicity is also known as the time period assumption.

  • 100. What is the cost principle?
     

    The cost principle is one of the basic underlying guidelines in accounting. It is also known as the historical cost principle.

     

    The cost principle requires that assets be recorded at the cash amount (or its equivalent) at the time that an asset is acquired. For example, if equipment is acquired for the cash amount of AED 50,000, the equipment will be recorded at AED 50,000. If the equipment will be useful for 10 years with no salvage value, the straight-line depreciation expense will be AED 5,000 per year (cost of AED 50,000 divided by 10 years). The equipment's market value, replacement cost or inflation-adjusted cost will not affect the annual depreciation expense of AED 5,000. The company's balance sheets will report the equipment's historical cost minus the accumulated depreciation.

     

    The cost principle also means that valuable brand names and logos that were developed through effective advertising will not be reported as assets on the balance sheet. This could result in a company's most valuable assets not being included in the company's asset amounts. (On the other hand, a brand name that is acquired through a transaction with another company will be reported on the balance sheet at its cost.)

     

    If a company has an asset that has a ready market with quoted prices, the historical cost may be replaced with the current market value on each balance sheet. An example is an investment consisting of shares of common stock that are actively traded on a major stock exchange.

  • 101. What is accelerated depreciation?
     

    Accelerated depreciation is the allocation of a plant asset's cost in a faster manner than the straight line depreciation. Compared to straight line depreciation, accelerated depreciation will mean 1) more depreciation in the earlier years of an asset's life and 2) less depreciation in the later years of the asset's life. [Note that the total amount of depreciation over the asset's life will be the same regardless of the depreciation method used.] Hence, the difference between accelerated depreciation and straight line depreciation is the timing of the depreciation.

     

    Three examples of accelerated depreciation methods include double-declining (200% declining) balance, 150% declining balance, and sum-of-the-years' digits (SYD).

     

    The U.S. income tax regulations allow a business to use accelerated depreciation on its income tax return while using straight line depreciation on its financial statements. For profitable corporations this will likely result in deferred income tax payments being reported on its financial statements

  • 102. What is the matching principle?
     

    The matching principle is one of the basic underlying guidelines in accounting. The matching principle directs a company to report an expense on its income statement in the same period as the related revenues.

     

    To illustrate the matching principle, let's assume that all of a company's sales are made through sales representatives (reps) who earn a 10% commission. The commissions for each calendar month's sales are paid to the reps on the 15th day of the following month. For example, if the company has AED 60,000 of sales in December, the company will pay commissions of AED 6,000 on January 15. The matching principle requires that AED 6,000 of commission expense be reported on the December income statement along with the related December sales of AED 60,000. This is likely to be carried out through an adjusting entry on December 31 that debits Commission Expense and credits Commissions Payable for AED 6,000.

     

    The matching principle is associated with the accrual method of accounting and adjusting entries. Without the matching principle, the company might report the AED 6,000 of commission expense in January (when it is paid) instead of December (when the expense and the liability are incurred).

     

    A retailer's or a manufacturer's cost of goods sold is another example of an expense that is matched with sales through a cause and effect relationship. However, not all costs and expenses have a cause and effect relationship with sales or revenues. Hence, the matching principle may require a systematic allocation of a cost to the accounting periods in which the cost is used up. For example, if a company purchases an elaborate office system for AED 252,000 that will be useful for 84 months, the company will match AED 3,000 of expense each month to its monthly income statement.

  • 103. What is straight line depreciation?
     

    Straight line depreciation is likely to be the most common method of matching a plant asset's cost to the accounting periods in which it is in service. Under the straight line method of depreciation, each full accounting year will be allocated the same amount or percentage of an asset's cost. (The total amount of depreciation over the years of the asset's useful life will be the asset's cost minus any expected or assumed salvage value.)

     

    To illustrate straight line depreciation let's assume that a company purchases equipment at a cost of AED 430,000 and it is expected to be used in the business for 10 years. At the end of the 10 years, the company expects to receive a salvage value of AED 30,000. Under the straight line method each full accounting year will be allocated AED 40,000 of depreciation, which is one-tenth (1/10) or 10% of the AED 400,000 that needs to be depreciated over the useful life of the equipment. If the asset is purchased in the middle of the accounting year there will be AED 20,000 of depreciation in the first and the eleventh accounting year and AED 40,000 in each of the years 2 through 10.

     

    In the U.S. a company may use the straight line method for its financial statements while at the same time be using the Internal Revenue Service's faster depreciation on its federal income tax return.

  • 104. What is a noncash expense?
     

    A noncash expense is an expense that is reported on the income statement of the current accounting period, but there was no related cash payment during the period.

     

    A common example of a noncash expense is depreciation. For instance, if a company purchased equipment on December 31, 2012 for AED 200,000 cash, it could have Depreciation Expense of AED 20,000 in each of the next 10 years. As a result its income statement will report Depreciation Expense of AED 20,000 in each of the years 2013 through 2022. Since there is no cash payment in any of those years, each year's AED 20,000 of depreciation expense is referred to as a noncash expense.

     

    Another example of a noncash expense is the amortization of bond issue costs. Perhaps a corporation costs incurred of AED 300,000 for professional fees and registration fees in order to issue AED 20 million in bonds. If the bonds will mature in 10 years, the corporation will defer the AED 300,000 of bond issue costs to the balance sheetand will then amortize the cost (send the cost to expense) at a rate of AED 30,000 per year. In each of the years of the bonds' life the corporation's income statement will report AED 30,000 of bond issue costs expense which will be a noncash expense.

  • 105. Which financial ratios are considered to be efficiency ratios?
     

    I consider the efficiency ratios to be the ratios also known as asset turnover ratios, activity ratios, or asset management ratios.

     

    These efficiency ratios include 1) accounts receivable turnover ratio, and the related ratio days' credit sales in accounts receivable; 2) inventory turnover, and the related ratio days' cost of sales in inventory; 3) total asset turnover; and 4) fixed asset turnover.

     

    The accounts receivable turnover ratio and the inventory turnover ratio are also used in the context of a firm's liquidity.

  • 106. Why is Accumulated Depreciation an asset account?
     

    Having an asset account such as Accumulated Depreciation allows a company's balance sheet to easily report both 1) the amount of an asset's cost that has been depreciated as of the date of the balance sheet, and 2) the asset's cost. This is possible because Accumulated Depreciation is credited each time that Depreciation Expenseis debited. Since Accumulated Depreciation will have a continually increasing credit balance it is referred to as a contra asset account .

     

    To illustrate, let's assume that at the beginning of the current year a company's asset account Equipment reports a cost of AED 70,000. From the time of purchase until the beginning of the year the related Accumulated Depreciation account has accumulated a credit balance of AED 45,000. During the current year the company debits Depreciation Expense for AED 10,000 and credits Accumulated Depreciation for AED 10,000. At the end of the current year the credit balance in Accumulated Depreciation will be AED 55,000.

     

    By crediting the account Accumulated Depreciation instead of crediting the Equipment account, the balance sheet at the end of the year can easily report both the equipment's cost of AED 70,000 and its accumulated depreciation of AED 55,000. This is more informative than reporting only the net amount of AED 15,000 (which would likely be the case if the contra asset account Accumulated Depreciation was not used).

  • 107. How does one prepare a company's first bank statement reconciliation?
     

    To prepare a bank reconciliation for a company that never prepared one previously, I would first make a list of outstanding checks. For example, if your recent bank statement is dated August 31, I would look at the bank statements from June through August and make a list of the check numbers that had been written after June 1, but had not appeared on any of the bank statements from June through August. Next to each check number write the dollar amount of each check. Subtract the total of the outstanding checks as of August 31 from the bank statement balance as of August 31. The resulting amount is the adjusted balance per bank.

     

    Next, look at the general ledger account that is associated with the bank statement. Let's assume it is the Cash account. Be certain that the Cash account shows items that appear on the recent bank statements. For example, Have the bank service charges been entered in the Cash account? Have the electronic transfers been entered? If not, you will need to make those entries. You may have to go back to earlier bank statements and enter those amounts as well.

     

    Eventually, you need to get the August 31 balance in the Cash account to be equal to the adjusted balance per bank. If the difference is not a significant amount, you can debit or credit the Cash account for the amount necessary for it to agree to the adjusted balance per bank. I would put the same amount into an income statement account such as Difference per Bank Rec. Keep a copy of your documentation and begin a file entitled Bank Reconciliations.

     

    When the September 30 bank statement arrives, prepare another bank reconciliation. Using a copy of the August 31 listing of outstanding checks, cross off the checks that cleared on the September bank statement. Prepare a September 30 listing of outstanding checks beginning with the checks not crossed off on the August 31 copy, and then add the checks written in September that did not clear on the September bank statement. The total of the outstanding checks as of September 30 should be deducted from the bank statement balance of September 30 to arrive at the adjusted balance per bank as of September 30. Be sure to enter into the Cash account the September bank service charge and other items appearing on the bank statement that have not yet been entered in the Cash account. This adjusted balance in the Cash account as of September 30 should be the same as the adjusted balance per bank as of September 30. If there is a difference, you must identify it and make any necessary adjustments.

  • 108. What is the units of activity depreciation?
     

    The units of activity depreciation is one of several methods of depreciation. The units of activity method of depreciation is unique in that a plant asset's useful life is expressed in the total units that are expected to be produced or the asset's total activity during its life. The asset's cost is then allocated to the accounting periods based on the plant asset's usage, units produced, activity, etc. Years and partial years are not relevant when using this depreciation method. (The other methods of depreciation express the plant asset's useful life in years and will allocate the plant asset's cost based on the mere passage of those years. Under these methods partial years are relevant.)

     

    To illustrate the units of activity method of depreciation, let's assume that a company acquires a finishing machine that is expected to perform the finishing operation on a total of 100,000 units of product. The machine has a cost of AED 225,000 and is expected to have a salvage value of AED 25,000. Under the units of activity method, the company will record AED 2 of depreciation whenever it finishes a product. The AED 2 is computed as follows: (AED 225,000 - AED 25,000) divided by the expected 100,000 units of product. In an accounting year when 8,000 units are finished, the depreciation will be AED 16,000. In a year when 23,000 units are finished, the depreciation will be AED 46,000. The depreciation will continue until a total of AED 200,000 of depreciation has been taken (and the book value will be AED 25,000).

     

    The units of activity method of depreciation is also referred to as the units of production method.

  • 109. Is depreciation a temporary account?
     

    Depreciation Expense is a temporary account since it is an income statement account. As a temporary account, Depreciation Expense will begin each accounting year with a zero balance and will have its balance at the end of the year closed to an equity account such as retained earnings or a proprietor's capital account.

     

    On the other hand, the balance sheet account Accumulated Depreciation is not a temporary account. Accumulated Depreciation is a contra asset account and its balance is not closed at the end of each accounting period. As a result, Accumulated Depreciation is a viewed as a permanent account.

  • 110. What is a temporary account?
     

    A temporary account is a general ledger account that begins each accounting year with a zero balance. At the end of the accounting year any balance in the account will be transferred to another account. This is referred to as closing the account. An example of a temporary account is the Sales account. The Sales account is used to keep a log of the sales occurring only in the current accounting year. After the sales for the year have been reported, the balance in the Sales account will be transferred or closed to another account thereby returning the account balance to zero.

     

    Temporary accounts include all of the income statement accounts: revenues, expenses, gains, losses. After the amounts for the year have been reported on the income statement, the balances in the temporary accounts will end up in a permanent account such as a corporation's retained earnings account or in a sole proprietor's capital account. (In manual systems, the balances in the temporary accounts will be transferred to an income summary account. Next the income summary account will be transferred to retained earnings or to the owner's capital account. Hence, the income summary account is also a temporary account.)

     

    A temporary account that is not an income statement account is the proprietor's drawing account. The balance in the drawing account is transferred directly to the owner's capital account and will not be reported on the income statement or in an income summary account.

  • 111. What is the units of activity depreciation?
     

    The units of activity depreciation is one of several methods of depreciation. The units of activity method of depreciation is unique in that a plant asset's useful life is expressed in the total units that are expected to be produced or the asset's total activity during its life. The asset's cost is then allocated to the accounting periods based on the plant asset's usage, units produced, activity, etc. Years and partial years are not relevant when using this depreciation method. (The other methods of depreciation express the plant asset's useful life in years and will allocate the plant asset's cost based on the mere passage of those years. Under these methods partial years are relevant.)

     

    To illustrate the units of activity method of depreciation, let's assume that a company acquires a finishing machine that is expected to perform the finishing operation on a total of 100,000 units of product. The machine has a cost of AED 225,000 and is expected to have a salvage value of AED 25,000. Under the units of activity method, the company will record AED 2 of depreciation whenever it finishes a product. The AED 2 is computed as follows: (AED 225,000 - AED 25,000) divided by the expected 100,000 units of product. In an accounting year when 8,000 units are finished, the depreciation will be AED 16,000. In a year when 23,000 units are finished, the depreciation will be AED 46,000. The depreciation will continue until a total of AED 200,000 of depreciation has been taken (and the book value will be AED 25,000).

     

    The units of activity method of depreciation is also referred to as the units of production method.

  • 112. What is preferred stock?
     

    Preferred stock is a type of capital stock issued by some corporations. Preferred stock is also known as preference stock.

     

    The word "preferred" refers to the dividends paid by the corporation. Each year, the holders of the preferred stock are to receive their dividends before the common stockholders are to receive any dividend. In exchange for this preferential treatment for dividends, the preferred stockholders (or shareholders) generally will never receive more than the stated dividend. For example, the holder of 100 shares of a corporation's 8% AED 100 par preferred stock will receive annual dividends of AED 800 (8% X AED 100 = AED 8 per share X 100 shares) before the common stockholders are allowed to receive any cash dividends for the year. Unless the preferred stock has a participating feature, this preferred stockholder will never receive more than AED 8 per share no matter how successful the corporation becomes.

     

    The features of preferred stocks can vary. Examples include cumulative, convertible, callable, participating, and more.

     

    Since the dividend on preferred stock is usually a fixed amount forever, once the preferred stock is issued its market value is likely to move in the opposite direction of inflation. The higher the rate of inflation, the less valuable is the fixed dividend amount. If the inflation rate declines, the value of the preferred stock is likely to increase, but no higher than the stock's call price.

     

    Most corporations do not issue preferred stock. Typically, corporations will issue only common stock and use debt.

  • 113. What is a rubber check?
     

    A rubber check is a check that is not paid (or honored) by the bank on which it is drawn. The reason the check is not paid is the maker's account had insufficient funds or not sufficient funds (NSF). Instead of the check being paid, it will be returned (or bounced back) through the banking system. Because the check was bounced back by the bank, the check is described as a rubber check.

     

    A rubber check also causes bank fees for the maker of the check and for the depositor of the check. These fees need to be recorded in the general ledger accounts. If the fees are overlooked initially, they will be adjusting items to the balance per books in the bank reconciliation.

     

    If a rubber check is not redeposit by the payee, the payee must also reduce its general ledger cash account for the amount of the check (and also debit another general ledger account).

  • 114. What is value billing?
     

    Value billing is a way of billing a client for services provided. Basically, the amount billed is based on the value of the service (or information) instead of the number of hours spent.

     

    The following illustrates value billing. The owner of a successful company contacts an accounting firm for tax advice. Two tax experts have lunch with the owner and inform her how to process transactions so that she will enjoy tax savings of AED 40,000. The owner was grateful for the enjoyable lunch and the valuable information. Several days later, she receives a bill for AED 2,500 and is surprised at the amount. She concludes that the tax experts billed her based on the amount of money they had saved her. In other words, the tax experts had utilized the concept of value billing.

  • 115. What is a plant asset?
     

    A plant asset is an asset with a useful life of more than one year that is used in producing revenues in a business's operations. Examples of plant assets include land, land improvements, buildings, machinery and equipment, office equipment, furniture, fixtures, vehicles, leasehold improvements, and construction work-in-progress. Plant assets are also referred to as fixed assets and/or property, plant and equipment.

     

    Plant assets are recorded at cost and depreciation is reported during their useful lives. (However, there is no depreciation of land, and the depreciation for construction work-in-progress begins when the asset is placed into service.) The cumulative amount of depreciation is reported in the contra plant asset account Accumulated Depreciation.

     

    Plant assets and the related accumulated depreciation are reported on a company's balance sheet in the noncurrent asset section entitled property, plant and equipment. Accounting rules also require that the plant assets be reviewed for possible impairment losses.

  • 116. What is window dressing?
     

    Window dressing refers to actions taken or not taken prior to issuing financial statements in order to improve the appearance of the financial statements.

     

    Here is an example of window dressing. A company operates throughout the year with a negative balance in its general ledger Cash account. (Its balance at the bank is positive due to the time it takes for its checks to clear its bank account.)  Since the financial statements report the Cash amount appearing in its general ledger account, the financial statements would report a negative amount of Cash. However, the company does not want its December 31 balance sheet to report a negative cash balance, since it will be reviewed by many outsiders. To avoid reporting a negative cash balance the company does not make the payments for amounts that should be paid between December 26 and December 31. This postponement of payments allows its book amount of Cash to temporarily be a positive amount. Then on January 2, the company issues checks for all of the amounts that normally would have been paid at the end of December.

  • 117. What is salvage value?
     

    In accounting, salvage value is an estimated amount that is expected to be received at the end of a plant asset's useful life. Salvage value is sometimes referred to as disposal value, residual value, terminal value, or scrap value.

     

    The estimated salvage value is deducted from the cost of the asset in order to determine the total amount of depreciation expense that will be reported during the asset's useful life.

     

    Accountants and income tax regulations often assume that plant assets will have no salvage value. This will result in an asset's entire cost being depreciated during the years that the asset is used in the business

  • 118. What is a condensed income statement?
     

    A condensed income statement is one that summarizes much of the income statement detail into a few captions and amounts.

     

    For example, a retailer's condensed income statement will summarize hundreds of categories of sales into one amount with the description Net Sales. Its detailed purchases and changes in inventory will be presented as one amount with the description Cost of Goods Sold. Perhaps thousands of operating expenses will be presented as one amount with the description Selling, General and Administrative, or SG&A.

     

    The readers of a condensed income statement will be able to easily and quickly focus on the company's net income and its key components.

  • 119. What is trading on equity?
     

     

    Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on common stock. For example, a corporation might use long term debt to purchase assets that are expected to earn more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the earnings of the corporation's common stockholders. The increase in earnings indicates that the corporation was successful in trading on equity.

  • 120. What is trading on equity?
     

    Trading on equity is sometimes referred to as financial leverage or the leverage factor.

     

    Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on common stock. For example, a corporation might use long term debt to purchase assets that are expected to earn more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the earnings of the corporation's common stockholders. The increase in earnings indicates that the corporation was successful in trading on equity.

  • 121. What is the statement of cash flows?
     

    The statement of cash flows is one of the main financial statements. It is to accompany the income statement, balance sheet, and statement of stockholders' equity. The statement of cash flows (also known as the cash flow statement) reports

    • the major sources and uses of cash during the period of the income statement
    • a reconciliation of the change in an organization's cash and cash equivalents (which are reported on the beginning and ending balance sheets)
    • supplementary information including the amount of income taxes paid, the amount of interest paid, and significant noncash investing and financing activities (such as issuing common stock in exchange for land)

    The statement of cash flow is important because investors, lenders, financial analysts, and others are interested in an organization's major cash inflows and outflows. (This information is not available from the income statement because the accrual basis of accounting requires that revenues be reported when earned and expenses be reported when incurred.)

     

    The statement of cash flows reports cash inflows as positive amounts and the cash outflows as negative amounts. They are reported in one of the three sections of the statement of cash flows: operating activities, investing activities, and financing activities.

  • 122. What is a compilation?
     

    A compilation refers to financial statements that were prepared or compiled by an organization's outside accountant. A compilation is often the result of an accounting service known as write-up work. With compilations, or compiled financial statements, the outside accountant converts the data provided by the client into financial statements without providing any assurances or auditing services.

     

    A compilation report should accompany the compiled financial statements and it should state that the financial statements 1) are the representation of the management of the organization, and 2) have not been reviewed or audited and that the accountant offers no opinion or assurances on them.

     

    Compilations allow companies without an accountant to have financial statements prepared at a lower cost than reviewed or audited financial statements.

  • 123. What is the difference between a deferred expense and a prepaid expense?
     

    Often the term deferred expense indicates that a payment was made more than one year before the cost is expensed. This deferred expense will be reported on the balance sheet as a noncurrent or long-term asset.

     

    Often the term prepaid expense indicates that a payment was made less than one year before the cost is expensed.  This prepaid expense is reported as a current asset.

     

    Sometimes an accountant does not intend for there to be a difference.  For example, an accountant might say that part of a company's six-month insurance premium should be deferred to the current asset account Prepaid Insurance. Accountants also state that any prepayment of a future expense will result in an adjusting entry known as a deferral.

  • 124. Should a manufacturer's selling prices be based on costs?
     

    A manufacturer's selling prices should not be based on costs alone. One reason is that the actual cost of each product is not known with precision. At best, each product's cost is an average that resulted from allocations of the indirect manufacturing costs. In addition, there are selling, general and administrative expenses that are even more difficult to associate with individual products.

     

    A more compelling reason that selling prices should not be based solely on costs is the market for a product. If a product is unique, protected by a patent and trademark, and the demand for the product is high, customers may accept a selling price that is unusually high. In other words, the value of the product is much greater than the costs identified with the product plus a normal profit or markup.

     

    At other times the market will include competitors offering a similar product at lower selling prices because of efficiencies, lower costs, or inaccurate cost calculations. Perhaps another competitor will sell a similar product at a lower selling price in hopes of attracting customers who will buy additional, more profitable products. These situations will likely prevent the manufacturer from achieving significant sales at selling prices that are based on costs plus a desired profit.

  • 125. What is an impairment?
     

    The term impairment is usually associated with a long-lived asset that has a market which has decreased significantly. For example, a meat packing plant may have recently spent large amounts for capital expenditures and then experienced a dramatic drop in the plant's value due to business and community conditions.

     

    If the undiscounted future cash flows from the asset (including the sale amount) are less than the asset's carrying amount, an impairment loss must be reported.

     

    If the impairment loss must be reported, the amount of the impairment loss is measured by subtracting the asset's fair value from its carrying value.

  • 126. If a customer pays for the same invoice twice, should the customer be informed?
     

    I say yes. If you become aware of the double payment when posting the customer's second remittance, I would double check your records to be certain you are not owed money from the customer and would then inform the customer.  If the check was sent in error, I would photocopy the check, document on the photocopy what had occurred, and then return it to the customer.

     

    If you did not notice the double payment when processing the customer's remittance, the customer's accounts receivable record will show a negative amount due for the sales invoice and might even show a negative amount due from the customer. If your company mails statements to its customers, the customer should be able to see its double payment when reviewing the statement.

  • 127. What does it mean to report expenses by function?
     

    To report expenses by function means to report them according to the activity for which the expenses were incurred.

     

    For a business, the reporting of expenses by function means the income statement will report expenses according to the following functional classifications: manufacturing, selling, general administrative, and financing.

     

    For a not-for-profit organization, the reporting of expenses by function means the statement of activities will report expenses according to the following functional classifications: 1) each of its major programs, and 2) the supporting services which are a) management and general, b) fund-raising, and c) membership development.

     

    (Classifying expenses according to salaries, electricity, repairs, etc. is referred to as natural classifications, or classifying expenses by their nature.)

  • 128. What is a controller's cushion?
     

    A controller's cushion or controller's reserve involves temporarily recording too much expensefor an item that the controller calculates. For example, the controller might budget AED 48,000 per year for depreciation and then record AED 4,000 of actual depreciation expense for each month. However, the controller expects the actual depreciation to be only AED 44,000 for the year.

     

    For the first eleven months, the financial statements will report AED 44,000 of depreciation expense. Then in the 12th and final month of the year no depreciation expense is recorded. This means that depreciation expense will beat its budget by AED 4,000 (AED 44,000 of actual depreciation versus the annual budget of AED 48,000). This favorable AED 4,000 is the controller's cushion. The idea is that this will cushion the effects of some unexpected expenses or losses that come to light at the end of the accounting year.

     

    The controller's reserve or controller's cushion is related to a concept known as budgetary slack.

  • 129. What is trend analysis?
     

     

    In the analysis of financial information, trend analysis is the presentation of amounts as a percentage of a base year.

     

    If I want to see the trend of a company's revenues, net income, and number of clients during the years 2006 through 2012, trend analysis will present 2006 as the base year and the 2006 amounts will be restated to be 100. The amounts for the years 2007 through 2012 will be presented as the percentages of the 2006 amounts. In other words, each year's amounts will be divided by the 2006 amounts and the resulting percentage will be presented. For example, revenues for the years 2006 through 2012 might have been AED 31,691,000; AED 40,930,000; AED 50,704,00; AED 63,891,000; AED 79,341,000; AED 101,154,000; AED 120,200,000. These revenue amounts will be restated to be 100, 129, 160, 202, 250, 319, and 379.

     

    Let's assume that the net income amounts divided by the 2006 amount ended up as 100, 147, 206, 253, 343, 467, and 423. The number of clients when divided by the base year amount are 100, 122, 149, 184, 229, 277, and 317.

     

    From this trend analysis we can see that revenues in 2012 were 379% of the 2006 revenues, net income in 2012 was 467% of the 2006 net income, and the number of clients in 2012 was 317% of the number in 2006. Using the restated amounts from trend analysis makes it much easier to see how effective and efficient the company has been during the recent years.

  • 130. What is elastic demand?
     

    Elastic demand means that demand for a product is sensitive to price changes. For example, if the selling price of a product is increased, there will be fewer units sold. If the selling price of a product decreases, there will be an increase in the number of units sold. Elastic demand is also referred to as the price elasticity of demand.

     

    The term inelastic demand means that the demand for a product is not sensitive to price changes.

     

    Elastic demand is a major concern for a manufacturer that attempts to set product prices based on costs. For instance, if the manufacturer's production and sales have declined and it fails to cut fixed costs, the manufacturer could be worse off by increasing selling prices.

  • 131. How can a manufacturer determine the precise cost of its products?
     

    A manufacturer may never be able to determine the precise cost of its individual products. The reason is that most of the manufacturing costs (other than materials and some labor) are indirect costs. This means that most of the manufacturing costs are not directly traceable to individual products and will need to be allocated to them. Examples of indirect manufacturing costs include the rent, property taxes, depreciation, heat, lighting, indirect production workers pay and benefits, repairs, maintenance, and others that occur in the factory.

     

    In addition to the manufacturing costs, there are selling, general and administrative (SG&A) expenses and perhaps interest expense. Generally, accountants do not consider these expenses to be product costs. As a result these expenses are reported on the income statement when they occur and without any allocation to the products. However, these expenses are associated with some or all of the products.

     

    The manufacturer can attempt to calculate the costs and expenses of each of its products, but I don't think the result will be the true, precise cost. In addition to the allocations (which are viewed as arbitrary), consider that changes in volume will affect a product's cost. For example, if a company's total fixed costs remain constant but its volume of products decreases by 20%, the cost of each product will increase. If volume increases, the cost of each product will decrease.

     

    Activity-based costing (ABC) is an attempt to improve the allocation of costs by identifying more of the root causes of the costs (rather than merely spreading costs to products based on machine hours). Even with ABC there will be arbitrary allocations which will prevent knowing each product's precise cost.

  • 132. What is treasury stock?
     

    Treasury stock is a corporation's previously issued shares of stock which have been repurchased from the stockholders and the corporation has not retired the repurchased shares. The number of shares of treasury stock (or treasury shares) is the difference between the number of shares issued and the number of shares outstanding. Since the treasury shares result in fewer shares outstanding, there may be a slight increase in the corporation's earnings per share.

     

    Treasury Stock is also the title of a general ledger account that will typically have a debit balance equal to the cost of the repurchased shares being held by the corporation. (Some corporations use the par value method instead.) The cost of the treasury stock purchased with cash will reduce the corporation's cash and the amount of its total stockholders' equity.

     

    The shares of treasury stock will not receive dividends, will not have voting rights, and cannot result in an income statement gain or loss. The shares of treasury stock can be sold, retired, or could continue to be held as treasury stock.

  • 133. Why does commitment and contingencies appear on the balance sheet without an amount?
     

    The term or caption commitment and contingencies appears near the end of a balance sheetwithout an amount in order to direct a reader's attention to the disclosures included in the notes to the financial statements.

     

    An amount is not shown for a variety of reasons. For example, a chain of retail stores may have signed five-year, noncancelable leases to rent retail space for AED 1 million per year. Thiscommitment needs to be disclosed to the readers of the balance sheet. However, if none of the AED 5 million is actually due as of the balance sheet date, there is no liability amount to be recorded in a liability account.

     

    Another example of a commitment is an electric utility which has signed a noncancelable contract to purchase 100 million tons of coal during the following 10 years. This commitment also needs to be disclosed to the readers of the balance sheet. However, if none of the coal has been delivered as of the balance sheet date, the utility company will not report a liability since nothing is due as of the balance sheet date.

     

    There are also some loss contingencies which are not recorded with amounts in the general ledger, but must be disclosed in the notes to the financial statements.

  • 134. What is sales mix?
     

    Sales mix is the relative proportion or ratio of a business's products that are sold. Sales mix is important because a company's products are likely to vary in their profitability.

     

    To illustrate sales mix, let's assume that an automobile company plans to sell 100,000 units in the current year. The planned sales mix is 20,000 units of the low-profit models + 50,000 units of the medium-profit models + 30,000 units of the high-profit models. In other words, the planned sales mix is 20%, 50%, 30%.

     

    Next, lets assume that the total units actually sold amounted to 95,000 units (which is 5,000 fewer units than planned). This could be a problem for the company attaining its planned earnings. However, it depends on the actual sales mix. What if the actual sales mix is 15%, 45%, 40%? This actual sales mix shows a smaller proportion of low-profit and medium-profit units being sold and a larger proportion of high-profit units being sold. In other words, this improved sales mix could mean greater earnings even though 5,000 fewer units were sold.

     

    Sales mix also applies to service businesses since the services provided are likely to vary in their profitability.

  • 135. What is the cost of capital?
     

    The cost of capital is the weighted-average, after-tax cost of a corporation's long-term debt, preferred stock, and the stockholders' equity associated with common stock. The cost of capital is a percentage and it is often used to compute the net present value of the cash flows in a proposed investment. It is also considered to be the minimum after-tax internal rate of return to be earned on new investments.

     

    For a profitable corporation, the costs of bonds and other long-term loans are usually the least expensive components of the cost of capital. One reason is that the interest will be deductible for U.S. income taxes. For example, a corporation paying 6% on its loans may have an after-tax cost of 4% when its combined federal and state income tax rate is 33%. On the other hand, the dividends paid on the corporation's preferred and common stock are not tax deductible.

     

    The cost of common stock (paid-in capital and retained earnings) is considered to be the most expensive component of the cost of capital because of the risks involved.

     

    Let's compute the cost of capital by assuming that a corporation has AED 40 million of long-term debt with an after-tax cost of 4%, AED 10 million of 7% preferred stock, and AED 50 million of common stock and retained earnings with an estimated cost of 15%. Its weighted-average, after-tax cost of capital is: (AED 40 million X 4% = AED 1.6 million) + (AED 10 million X 7% = AED 0.7 million) + (AED 50 million X 15% = AED 7.5 million) = AED 9.8 million divided by AED 100 million = 9.8%

  • 136. What is the chart of accounts?
     

    The chart of accounts is a listing of the general ledger accounts to which amounts can be posted. The chart of accounts is a helpful tool for identifying the best account for recording a transaction.

     

    In some accounting software the chart of accounts may be the means to open new general ledger accounts and to control their position in the financial statements.

     

    Usually the chart of accounts begins with the balance sheet accounts followed by the income statement accounts. The accounts will usually be in the same order as they are presented on the two financial statements.

  • 137. What is relevant range?
     

    In accounting, relevant range refers to a limited span of volume or activity. To illustrate, let's assume that a manufacturer's monthly production volume is consistently between 10,000 and 13,000 units and between 20,000 and 25,000 machine hours. Within this range of activity it operates smoothly with the same amount of monthly fixed costs (say AED 200,000) for supervisors, rent, depreciation, etc. If the volume were to drop below this range, the company would reduce the number of supervisors, the space rented, etc. so that its total monthly fixed costs would be smaller. If the volume exceeds the range, the company would incur additional fixed costs for more supervisors, space, etc. Hence, this company's relevant range of activity is 10,000 to 13,000 units of product or 20,000 to 25,000 machine hours. It is only in this relevant range that the monthly fixed costs are AED 200,000.

     

    There are also relevant ranges for variable costs and selling prices. Volume that is lower and/or higher than the respective relevant range can mean different variable costs per unit and different selling prices per unit.

     

    In short, cost behaviour and pricing is complicated. In order to simplify the analysis accountants will often assume that costs and selling prices are linear within the narrow band of activity known as the relevant range.

  • 138. What is the difference between liability and debt?
     

     

    Sometimes liability and debt mean the same thing. For instance in the debt-to-equity ratio, debt means the total amount of liabilities. In this case, debt not only includes short-term and long-term loans and bonds payable, debt also includes accrued wages and utilities, income taxes payable, and other liabilities. In other words, sometimesdebt is intended to mean all obligations...all amounts owed...all liabilities.

     

    At other times, the word debt is used more narrowly to mean only the formal, written financing agreements such as short-term loans payable, long-term loans payable, and bonds payable.

     

    Your question is a good reminder that people have different perspectives and therefore have different understandings and definitions of terminology.

    Where is a manufacturer's inventory reported in the balance sheet?

    A manufacturer's inventory will be reported in the current assets section of the balance sheet and in the notes to the financial statements. In the current assets section the amount of the manufacturer's inventory will be positioned after cash and cash equivalents, short-term investments, and receivables.

     

    If only the sum of the manufacturer's inventory categories is listed in the current assets section, then the notes to the financial statements will report the detailed amounts for raw materials and supplies, work-in-process and finished goods.

     

    The notes to the financial statements will also described how the manufacturer's inventory is valued. For example, the notes will disclose whether FIFO lower of cost or market, LIFO, weighted average, or other cost flow methods were used. If LIFO is used, then the excess of current cost over LIFO cost is also disclosed.

  • 139. Where can I find financial ratios for my industry?
     

    One source for financial ratios by industry is the RMA Annual Statement Studies Financial Ratio Benchmarks. RMA is the acronym for Risk Management Association and formerly for Robert Morris Associates. Your banker and many larger libraries subscribe to this publication. It contains the financial ratios for 740 industries based on the financial statements of more than 265,000 small and mid-sized companies.

     

    Another source for your industry's financial ratios is your industry's trade association, if it collects financial information from its members.

     

    In addition to comparing your company's financial ratios to its industry, you will want to compare your company's financial ratios to its own past and future financial ratios. Spotting a trend early can be very beneficial.

  • 140. How can I determine the difference in earnings from using LIFO instead of FIFO?
     

     

    The difference in a corporation's earnings from using LIFO instead of FIFO can be determined by the amounts reported in the balance sheet account LIFO Reserve. Generally, the LIFO Reserve information is found in the notes to the financial statements.

  • 141. What is the difference between assessed value and appraised value?
     

    Assessed value pertains to the amount that a local or state government has designated for specific property. This assessed value will be used when a property tax is levied by the government. For example, a city tax assessor is responsible for determining the assessed value for every parcel of land and every building within the city. The city government then establishes a real estate tax rate (or rates) that will be applied to the assessed values. Some local and state governments will also determine assessed values for personal property. The assessed value of real or personal property is not necessarily equal to the property's market value.

     

    Appraised value pertains to the amounts contained in an appraisal report for specific property. The appraisal report is generally prepared by a professional appraiser who looks at the property's features including size, type of construction, location, condition, and recent sales of comparable property in the vicinity. The appraised value is an attempt to determine the property's market value. The appraisal report for real estate is likely to report the appraised value of the land separate from the appraised value of the buildings. Hence, accountants might use the relationship of these values in order to allocate the cost of real estate into the cost of the land and the cost of the buildings.

     

    Appraised values have relevance because a company's balance sheet will report land and buildings at the costwhen they were acquired. (The balance sheet will also report the accumulated depreciation of the buildings.)

  • 142. What is the meaning of net assets?
     

    Net assets is defined as total assets minus total liabilities. In a sole proprietorship the amount of net assets is reported as owner's equity. In a corporation the amount of net assets is reported as stockholders' equity.

     

    In a not-for-profit (NFP) organization the amount of total assets minus total liabilities is actually reported as net assets in its statement of financial position. The net asset section for the NFP organization is divided into three classifications:

    1. unrestricted net assets
    2. temporarily restricted net assets
    3. permanently restricted net assets.
    4. The changes in these net asset classifications are reported in the organization's statement of activities.
  • 143. What is the effect on financial ratios when using LIFO instead of FIFO?
     

     

    During periods of significantly increasing costs, LIFO when compared to FIFO will cause lower inventory costs on the balance sheet and a higher cost of goods sold on the income statement.

     

    This will mean that the profitability ratios will be smaller under LIFO than FIFO. The profitability ratios include profit margin, return on assets, and return on stockholders' equity.

     

    The inventory turnover ratio will be higher when LIFO is used during periods of increasing costs. The reason is that the cost of goods sold will be higher and the inventory costs will be lower under LIFO than under FIFO.

  • 144. What is discount on bonds payable?
     

    Discount on bonds payable (or bond discount) occurs when bonds are issued for less than their face or maturity amount. This is caused by the bonds having a stated interest rate which is lower than the market interest rate for similar bonds.

     

    To illustrate the discount on bonds payable let's assume that a corporation will be issuing bonds with a maturity amount of AED 5,000,000 and a stated interest rate of 6% per year. However, the bonds are actually issued when the market demanded 6.1%. Since the investors will insist on earning the market interest rate of 6.1% the investors will not pay the full AED 5,000,000. If we assume that investors pay AED 4,900,000 for the bonds, the difference of AED 100,000 will be recorded by the issuer as a debit to the contra liability account Discount on Bonds Payable.

     

    Over the life of the bonds the debit balance in Discount on Bonds Payable will decrease as it is amortized to Interest Expense. The combination of the unamortized debit balance in Discount on Bonds Payable and the AED 5,000,000 credit balance in Bonds Payable is the book value or carrying value of the bonds payable.

  • 145. What is meant by owner's draws?
     

    Owner's draws are withdrawals of a sole proprietorship's cash or other assets for the personal use of the owner. Each of the owner's draws of cash will be recorded with a credit to Cash and a debit to the owner's draws account (two examples of account titles include R. Smith, Drawing; N. Ott, Withdrawals). The owner's draws account is a contra owner's capital account or contra owner's equity account because it will likely have a debit balance. The owner's draws account is also a temporary account because its balance will be closed at the end of each year. However, the debit balance is closed directly to the owner's capital account.

     

    The owner's draws are not reported as expenses on the income statement of the sole proprietorship. Rather, the owner's draws are considered to be a direct reduction of the owner's capital and owner's equity.

  • 146. What is the accounts receivable collection period?
     

    The accounts receivable collection period is similar to the days sales outstanding or the days sales in accounts receivable.

     

    To illustrate the accounts receivable collection period, let's assume a corporation had net credit sales of AED 360,000 during the past year and its accounts receivable balance was on average AED 40,000. The average credit sales per day were approximately AED 1,000 per day (AED 360,000 of annual credit sales divided by 360 or 365 days per year). The average accounts receivable balance of AED 40,000 divided by AED 1,000 of credit sales per day equals 40 days.

     

    An alternative calculation is to use the accounts receivable turnover ratio. In our example, the accounts receivable ratio is 9 times per year (AED 360,000 of net credit sales divided by AED 40,000—the average accounts receivable balance). 360 days per year divided by the accounts receivable turnover of 9 equals 40 days

     

  • 147. Do corporations issue both common stock and preferred stock?
     

    On the other hand, the holders of preferred stock usually receive only a fixed dividend, which must be paid before the common stock is paid a dividend. Because of that fixed dividend, the preferred stock will not increase in value as the corporation becomes increasingly successful.

  • 148. What does M and MM stand for?
     

    The Roman numeral M is often used to indicate one thousand, and MM is used to indicate one million. For example, an expense of AED 60,000 might appear as AED 60M. Sales of AED 3,000,000 might be written as AED 3MM. Internet advertisers are familiar with CPM which is the cost per thousand impressions.

     

    In recent years some people began using k to represent one thousand. For example, an annual salary of AED 60,000 might appear as AED 60k instead of AED 60M.

     

    In a recent business publication I saw million represented by mn and also by m (both lower case). This means it is possible for you to see AED 1,400,000 expressed as AED 1.4 million or AED 1.4mn or AED 1.4m or AED 1.4MM or AED 1,400k or AED 1,400M.

  • 149. What is the contribution margin ratio?
     

    The contribution margin ratio is the percentage of sales, service revenues or selling price that remains after all variable costs and variable expenses have been covered. In other words, the contribution margin ratio is the percentage of revenues that is available to cover a company's fixed costs, fixed expenses, and profit. (The contribution margin ratio is different from the gross margin ratio or gross profit percentage and cannot be computed directly from the reported amounts on the company's external income statement.)

     

    To illustrate the contribution margin ratio, we will assume that a company manufactures and sells a single product and has the following facts:

    • selling price per unit of AED 20
    • fixed manufacturing costs per month of AED 18,000
    • variable manufacturing costs per unit of AED 4
    • fixed SG&A expenses per month of AED 12,000
    • variable SG&A expenses per unit of AED 2
    • fixed interest expense per month of AED 1,000

    In this example the contribution margin per unit is AED 14 (the selling price of AED 20 minus the variable manufacturing costs of AED 4 and variable SG&A expenses of AED 2). Hence, the contribution margin ratio is 70% (the contribution margin per unit of AED 14 divided by the selling price of AED 20). This contribution margin ratio tells us that 70% of the sales, revenues, or selling price is available to cover the AED 31,000 of monthly fixed costs and fixed expenses. Once the AED 31,000 has been covered, 70% of the revenues will flow to the company's net income.

  • 150. What is the fixed asset turnover ratio?
     

     

    The fixed asset turnover ratio shows the relationship between the annual net sales and the net amount of fixed assets.

     

    The net amount of fixed assets is the amount of property, plant and equipment reported on the balance sheetafter deducting the accumulated depreciation. Ideally, you should use the average amount of net fixed assets during the year of the net sales.

     

    A corporation having property, plant and equipment with an average gross amount of AED 10 million and an average accumulated depreciation of AED 4 million would have average net fixed assets of AED 6 million. If its net sales were AED 18 million, its fixed asset turnover would be 3 (AED 18 million of net sales divided by AED 6 million of average net fixed assets).

  • 151. What is the difference between interest expense and interest payable?
     

    Interest expense is an income statement account which is used to report the amount of interest incurred on debt during a period of time.

     

    Interest payable is a current liability account that is used to report the amount of interest that has been incurred but has not yet been paid as of the date of the balance sheet.

     

    To illustrate the difference between interest expense and interest payable, let's assume that a company has AED 300,000 of debt with interest at 8% per year. The company pays the monthly interest as required, which is 15 days after each month ends. The loan began on January 2 of the current year. If the company's accounting year ends on December 31, the amount of interest expense for the year will be AED 24,000 (AED 300,000 x 8%). The amount of interest payable at December 31 will be December's interest of AED 2,000 (AED 30,000 x 8% x 1/12). The interest payable of AED 2,000 will be reported as a current liability since it is due within 15 days of the balance sheet date.

  • 152. What is the death spiral?
     

    In cost accounting and managerial accounting, the term death spiral refers to the repeated elimination of products resulting from spreading costs on the basis of volume instead of their root causes. The death spiral is also known as the downward demand spiral.

     

    To illustrate the death spiral let's assume that Product X is a simple, high-volume product that requires little manufacturing attention. If the accountant spreads the company's manufacturing overhead costs based on volume, Product X will appear to have high overhead costs. (In reality, Product X causes very little overhead cost especially when compared to the company's many complex, low-volume products.) If management responds to Product X's allocated high overhead costs and 1) seeks a price increase which causes the customer to move the production to a competitor with a lower price, 2) outsources the production, or 3) drops the product, then the company's manufacturing volume will decrease.

     

    If the company does not reduce its fixed overhead to correspond to the decreased manufacturing volume and the accountant continues to spread the overhead costs—including the cost of excess capacity—on the basis of volume, the remaining products will have to be assigned more of the overhead costs. If management again reacts to the new, higher, allocated costs by seeking price increases which cause a loss of sales, outsources production, or drops the products, the company's manufacturing volume will again decrease. If fixed costs are not decreased accordingly and the accountant again spreads the overhead on the basis of a new, even smaller volume, the entire company could die from the high fixed costs and a small volume of products being produced and sold.

     

    To avoid the death spiral, some companies attempt to allocate overhead costs based on activities and product complexities rather than simply spreading them on volume. Also, some companies do not allocate the costs of excess capacity to products in order to minimize the death spiral.

  • 153. What is the dividend yield?
     

     

    The dividend yield is the annual cash dividend per share of common stock divided by the market price of a share of the common stock.

     

    Usually, fast growing corporations have a low dividend yield. Public utilities generally have high dividend yields

  • 154. What is present value?
     

    In accounting, present value likely refers to the amount that remains after future cash amounts have been discounted to an earlier time. (The earlier time is depicted on a timeline as the point 0, which is the beginning of period 1.) The discounting process involves removing the time value of money, future interest, etc. which is contained within the future cash amounts.

     

    Accountants will record the present value when neither the cash amount, the cash equivalent amount, nor the fair market value of an item in a transaction is known.

     

    Accountants will also calculate a present value to determine an implicit interest rate or the effective interest rate. For example, if a bond payable with a face value of AED 100,000 and a stated interest rate of 8% is issued for AED 99,000 the accountant will seek the interest rate which will discount the future semiannual interest amounts of AED 40,000 and the maturity value of AED 100,000 to be exactly AED 99,000 at the time that the bonds were issued. That rate is the effective interest rate and it will be used to determine each period's interest expense and the amount of the discount on bonds payable to be amortized in each period.

  • 155. What is illusory profit?
     

    Illusory profit, also called phantom profit, is the difference between 1) the profit reported using historical costs required by US GAAP, and 2) the profit computed using replacement costs. Illusory profit is greatest during periods of rising costs at companies with significant amounts of inventory and plant assets.

     

    For example, when inventory is measured by using the first-in, first-out cost flow assumption under US GAAP, the actual historical cost of inventory that is charged to the cost of goods sold during periods of rising costs is smallerthan the amount computed using replacement costs. This smaller amount of costs charged to the income statement means reporting greater profit. The difference in the profit is said to be illusory.

     

    In the case of plant assets used during periods of rising costs, the depreciation expense reported on the income statement based on historical costs (required by US GAAP) will be less than the depreciation computed by using the higher replacement cost of the plant assets. The additional profit from this difference in depreciation is considered to be illusory profit.

  • 156. What is the debt ratio?
     

    The debt ratio is also known as the debt to asset ratio or the total debt to total assets ratio.

     

    The calculation of the debt ratio is: Total Liabilities divided by Total Assets.

     

    The debt ratio indicates the percentage of the total asset amounts stated on the balance sheet that is owed to creditors.

     

    A high debt ratio indicates that a corporation has a high level of financial leverage

  • 157. What is the death spiral?
     

    In cost accounting and managerial accounting, the term death spiral refers to the repeated elimination of products resulting from spreading costs on the basis of volume instead of their root causes. The death spiral is also known as the downward demand spiral.

     

    To illustrate the death spiral let's assume that Product X is a simple, high-volume product that requires little manufacturing attention. If the accountant spreads the company's manufacturing overhead costs based on volume, Product X will appear to have high overhead costs. (In reality, Product X causes very little overhead cost especially when compared to the company's many complex, low-volume products.) If management responds to Product X's allocated high overhead costs and 1) seeks a price increase which causes the customer to move the production to a competitor with a lower price, 2) outsources the production, or 3) drops the product, then the company's manufacturing volume will decrease.

     

    If the company does not reduce its fixed overhead to correspond to the decreased manufacturing volume and the accountant continues to spread the overhead costs—including the cost of excess capacity—on the basis of volume, the remaining products will have to be assigned more of the overhead costs. If management again reacts to the new, higher, allocated costs by seeking price increases which cause a loss of sales, outsources production, or drops the products, the company's manufacturing volume will again decrease. If fixed costs are not decreased accordingly and the accountant again spreads the overhead on the basis of a new, even smaller volume, the entire company could die from the high fixed costs and a small volume of products being produced and sold.

     

    To avoid the death spiral, some companies attempt to allocate overhead costs based on activities and product complexities rather than simply spreading them on volume. Also, some companies do not allocate the costs of excess capacity to products in order to minimize the death spiral.

  • 158. What are direct materials?
     

    Direct materials are the traceable matter used in manufacturing a product. The direct materials for a manufacturer of dessert products will include flour, sugar, eggs, milk, vegetable oil, spices, and other ingredients in the recipes. In manufacturing, the direct materials are listed in each product's bill of materials. (Indirect materials such as oil for greasing the baking pans, etc. will likely be viewed as part of the manufacturing supplies and will be allocated to products along with other manufacturing overhead.)

     

    The direct materials contained in manufactured products are also defined as:

    • a product cost (along with the costs of the direct labor and manufacturing overhead)
    • an inventoriable cost (along with the costs of direct labor and manufacturing overhead)
    • a prime cost (along with the cost of direct labor)

    The costs of direct materials should be reported in the financial statements according to their location or position:

    • if not yet put into production, report as raw materials inventory on the balance sheet
    • if put into production but the goods are not completed, report as part of the cost of work-in-process inventory on the balance sheet
    • if put into production and the goods are completed but not yet sold, report as part of the cost of the finished goods inventory on the balance sheet
    • if put into production and the goods have been completed and sold, report as part of the cost of goods sold on the income statement
  • 159. How can a business increase its cash flow from operations?
     

    A business can increase its cash flow from operations (or operating activities) by looking closely at each of its current assets and current liabilities. For instance, a manufacturer should examine its inventories of materials, work-in-process, finished goods, and supplies to identify the inventory items which have not turned over in a long time. Those items may need to be scrapped so that a loss can be reported and cash will not flow for income taxes. It may also mean less cash flowing out for new materials. Reviewing the turnover of each and every item may allow the company to reduce the inventory quantities thereby freeing up cash that would have been sitting ininventory.

     

    Accounts receivable needs to be monitored to be certain that every customer is adhering to the agreed upon credit terms and that the terms are consistent with your industry. You need to get those receivables turning to cash. Accounts payable should be reviewed to be sure that your company's cash is not being paid to suppliers prior to the required payment dates.

     

    In addition to the in-depth review of each of the current assets and current liabilities, companies need to review its staffing in light of current levels of business and the recent advances in software and technology. Perhaps the company can function just fine with a few less salaried employees.

     

    Lastly, the selling prices of some of a company's products, especially those that require lots of complex activities and result in many inefficiencies and headaches, may need to be increased.

  • 160. What is the dividend payout ratio?
     

    The dividend payout ratio, or simply the payout ratio, is the percentage of a corporation's earnings that is paid out in the form of cash dividends.

     

    The calculation of the dividend payout ratio is the cash dividends per share of common stock divided by the earnings per share of common stock.

     

    A fast growing corporation often has a low dividend payout ratio in order to retain and reinvest its earnings in additional income producing assets.

  • 161. What does it mean to amortize a loan?
     

    To amortize a loan usually means establishing a series of equal monthly payments that will provide the lender with 1) interest based on each month's unpaid principal balance, and 2) principal repayments that will cause the unpaid principal balance to be zero at the end of the loan. While the amount of each monthly payment is identical, the interest component of each payment will be decreasing and the principal component of each payment will be increasing during the life of the loan.

     

    To illustrate, let's assume a lender proposes to amortize a AED 60,000 loan at 4% annual interest over a 3-year period. This will require 36 monthly payments of AED 1,771.44 each. The first payment will consist of an interest payment of AED 200.00 (AED 60,000 X 4% X 1/12) plus a principal payment of AED 1,571.44 (AED 1,771.44 - AED 200.00). After the first payment is made, the principal balance will be AED 58,428.56 (AED 60,000.00 - AED 1,571.44). The second monthly payment of AED 1,771.44 will consist of interest of AED 194.76 (AED 58,428.56 X 4% X 1/12) plus a principal payment of AED 1,576.68 (AED 1,771.44 - AED 194.76). After the second payment is made, the remaining (or unpaid) principal balance will be AED 56,851.88.

     

    The 36th and final monthly payment of AED 1,771.44 will consist of interest of AED 5.89 (the principal balance after the 35th payment, which will be AED 1,765.55, times 4% X 1/12) plus a principal payment of AED 1,765.55. After the 36th payment the loan balance will be zero. In other words, the loan will have been amortized over its 3-year term.

     

    A listing of each month's interest and principal payments (and the remaining, unpaid principal balance after each payment) is referred to as an amortization schedule.

  • 162. What is the price earnings ratio?
     

    divided by the earnings per share of common stock.

     

    A corporation with a high price earnings ratio is expected to have above average increases in its future earnings per share.

  • 163. Why do people start their businesses as sole proprietorships?
     

    I believe that people start their businesses as a sole proprietorship because a sole proprietorship can be formed easily, quickly, and with little cost.

     

    Further, it is likely that the sole proprietor can also register the company as a limited liability company, or LLC. This process is often done online with the proprietor's state of residence. The fee to originate the LLC status and the annual renewal fee vary from state to state.

     

    If you are planning to form a company, you should seek professional advice as to which structure will best serve your needs.

  • 164. If I want a gross margin of 25%, what percent should I mark up my product?
     

     

    To achieve a gross margin or gross profit percentage of 25%, you will need to mark up your product's cost by 33.333%. The following illustrates how this is calculated.

     

    Assume a product has a cost of AED 75 and a selling price of AED 100. Since the gross profit is defined as selling price minus the cost of goods sold, this product will have a gross profit of AED 25 (AED 100 minus AED 75). The gross margin or gross profit percentage is 25% (gross profit of AED 25 divided by selling price of AED 100). The mark up of AED 25 on the cost of AED 75 equals 33.333% (AED 25 divided by AED 75).

     

    Let's prove this with one more example. Assume you have a product that you purchased for AED 9. If you mark it up by 33.333%, you will have a markup of AED 3 and the product will sell for AED 12. The income statement will show a sale of AED 12 minus its cost of AED 9 for a gross profit of AED 3. The gross profit of AED 3 divided by the selling price of AED 12 equals a 25% gross margin or gross profit percentage or gross profit ratio.

  • 165. Are salaried employees entitled to overtime pay?
     

    Some corporations issue both common stock and preferred stock. However, most corporations issue only common stock. In other words, it is necessary that a business corporation issue common stock, but it is optional whether the corporation will decide to also issue preferred stock.

     

    Usually the holders or owners of a corporation's common stock elect the corporation's directors, vote on significant matters, and enjoy increases in the value of their shares of common stock when the corporation becomes successful.

     

    Some salaried employees are entitled to overtime pay. The salaried employees entitled to overtime pay are referred to as nonexempt employees. The salaried employees that are not entitled to overtime pay are referred to as exempt employees.

     

    In the U.S. the employer and employees are required to comply with the federal Fair Labor Standards Act and with their state's rules for overtime pay. (The rules which are more advantageous for the employees must be followed.)

     

    In short, an employer cannot avoid paying overtime or an overtime premium merely by classifying an employee as salaried.

     

    One of the criteria for determining whether a salaried employee is exempt is the employee's salary. Unless exempted due to other criteria, an employee with a gross salary of less than AED 23,600 per year (AED 455 per week) is nonexempt and must be paid for his or her overtime hours.

     

    For additional criteria for exempt or nonexempt salaried employees contact your state and also the U.S. Department of Labor's Wage and Hour Division.

  • 166. What are indirect manufacturing costs?
     

    Indirect manufacturing costs are a manufacturer's product costs other than direct materials and direct labor. Indirect manufacturing costs are also referred to as manufacturing overhead, factory overhead, factory burden, or burden.

     

    Under traditional cost accounting, the indirect manufacturing costs are allocated (or spread) to the products manufactured based on direct labor hours, direct labor costs, or production machine hours. However, in recent decades the indirect manufacturing costs have increased significantly and are less likely to be caused by the quantity of direct labor or production machine hours. (This may not be a problem for financial reporting if the amount of inventory is consistently small, but it can be a problem for pricing and other decisions.)

     

    Examples of indirect manufacturing costs include:

    • depreciation, repairs and maintenance, electricity, etc. for the production facilities and equipment
    • salaries, wages and fringe benefits of the indirect manufacturing personnel such as production supervisors, material handlers, quality assurance, and other factory support personnel
    • factory supplies, outside services pertaining to manufacturing, and other manufacturing related costs.

     

  • 167. What is a deferred asset?
     

    I assume that the term deferred asset refers to a deferred charge or a deferred debit. A deferred charge is reported on the balance sheet in the long-term asset section other assets.

     

    An example of a deferred charge is bond issue costs. These costs include all of the fees that a corporation incurs in order to register and issue bonds. The fees are paid near the time that thebonds are issued but they will not be expensed at that time. Rather, the bond issue costs are initially deferred to the long-term asset section of the balance sheet. Then in each year of the life of the bonds, a portion of the bond issue costs will be systematically moved from the balance sheet and will appear as an expense on the income statement. The process of systematically reducing this deferred charge is known as amortizing the bond issue costs.

  • 168. What is the difference between paid-in capital and retained earnings?
     

    First, paid-in capital and retained earnings are the major categories of stockholders' equity.

     

    Paid-in capital, also referred to as contributed capital, is the amount that the corporation received from stockholders when the corporation issued its stock. Paid-in capital is also referred to as permanent capital.

     

    Retained earnings is the cumulative amount of after tax net income earned by the corporation since its inception minus the dividends that have been distributed to the stockholders since the corporation began.

  • 169. What does it mean to rotate stock?
     

    To rotate stock means to arrange the oldest units in inventory so they are sold before the newer units. For example, a grocery store will restock its shelves by putting the oldest units in the front part of the shelves. The newest units will be placed in the back of the shelves. The hope is that the customer will select the most convenient (older) units from the front of the shelf.

     

    It is important to rotate stock in all areas: retail display area, warehouse, factory, etc. The reason to rotate stock is to reduce the losses from deterioration and obsolescence.

     

    Ideally, when a company rotates its stock the units are physically flowing first-in, first-out (FIFO). However, in the accounting for the cost of inventory and the cost of the goods sold, the company may use a cost flow assumptionwhich is different from the flow of the physical units. For example, a U.S. company may use the last-in, first-out (LIFO) cost flow assumption even though it diligently rotates its stock of goods.

  • 170. What are byproducts?
     

    Byproducts, or by-products, are products with relatively little value that emerge from a common process along with the main products. The main products have significant value and are referred to as joint products. The point at which the byproducts and joint products emerge from the common process is known as the split-off point. The costs prior to the split-off point are known as the common costs.

     

    Since the value of the byproducts is usually insignificant, the accounting for the byproducts can vary. Here are two of several methods of accounting for byproducts:

    1. The byproducts could be valued at the split-off point at their net realizable value. This amount reduces the common costs which will be allocated to the joint products at the split-off point.
    2. None of the common costs is assigned to the byproducts. As a result the full amount of the common costs are allocated to the joint products at the split-off point. When the byproducts are sold, the amount received is reported as revenues.
  • 171. What is the coefficient of determination?
     

    The coefficient of determination is a statistic which indicates the percentage change in the amount of the dependent variable that is "explained by" the changes in the independent variables.

     

    For example, a manufacturer may have found through simple linear regression analysis involving 15 monthly observations that 64% of the change in the total cost of electricity (the dependent variable) was associated with the change in the monthly production machine hours (the independent variable). In this example the coefficient of determination is 0.64 or 64%.

     

    The coefficient of determination is symbolized by r-squared, where r is the coefficient of correlation. Hence, a coefficient of determination of 0.64 or 64% means that the coefficient of correlation was 0.8 or 80%. (The range for the coefficient of correlation is -1 to +1, and therefore the range for the coefficient of determination is 0 to +1.)

     

    It is important to note that a high coefficient of determination does not guarantee that a cause-and-effect relationship exists. However, a cause-and-effect relationship between the independent variable and the dependent variable will result in a high coefficient of determination.

    cause-and-effect relationship will mean there is correlation. It is also important to plot the data/observations used in the regression analysis in order to detect and review any outlier.

  • 172. What does the term organic growth mean?
     

     

    Organic growth often refers to the growth in a company's sales that did not occur because of an acquisition of another company. Expressed another way, organic growth is the internal growth or the growth from its existing businesses—not from the businesses it acquired during the period.

  • 173. What is the difference between an invoice and a voucher?
     

    An invoice from a vendor is the bill that is received by the purchaser of goods or services from an outside supplier. The vendor invoice lists the quantities of items, brief descriptions, prices, total amount due, credit terms, where to remit payment, etc.

     

    A voucher is an internal document used in a company's accounts payable department in order to collect and organize the necessary documentation and approvals before paying a vendor invoice. The voucher acts as a cover page to which the following will be attached: vendor invoice, company's purchase order, company's receiving report, and other information needed to process the vendor invoice for payment.

  • 174. How do I calculate IRR and NPV?
     

    The internal rate of return (IRR) and the net present value (NPV) are both discounted cash flow techniques or models. This means that each of these techniques looks at two things: 1) the current and future cash inflows and outflows (rather than the accrual accounting income amounts), and 2) the time at which the cash inflows and outflows occur. In other words, these models consider the time value of money: a dollar today is more valuable than a dollar in one year, a dollar received in three years is more valuable than a dollar received in five years, and so on.

     

    The internal rate of return or IRR is the rate that will discount all cash inflows and outflows to a net present value of AED 0. In other words, the IRR model provides you with the true, effective interest rate being earned on a project after taking into consideration the time periods when the various cash amounts are flowing in or out. If you use present value tables to calculate the internal rate of return, it will require some trial and error or iterations to determine the exact rate the project is earning. Software or some financial calculators will provide a quicker and more accurate answer.

     

    The net present value (NPV) discounts all of the cash inflows and outflows by a specified interest rate. The net amount of all of the discounted amounts is the net present value. If the net present value is AED 0, the project is expected to earn exactly the specified rate. If the net present value is a positive amount, the project will be earning more than the specified interest rate. A negative net present value means the project is expected to earn less than the specified interest rate

  • 175. What is notes receivable?
     

    Notes receivable is an asset of a company, bank or other organization that holds a written promissory note from another party. For example, if a company lends one of its suppliers AED 10,000 and the supplier signs a written promise to repay the amount, the company will enter the amount in its asset account Notes Receivable. The supplier will also enter the amount in its liability account Notes Payable.

     

    The portion of the notes receivable which is to be received within one year of the balance sheet date is reported in the current asset section of the lender's balance sheet. The remaining portion of the notes receivable will be reported in the noncurrent asset section Investments.

  • 176. What is the difference between gross profit margin and gross margin?
     

    The use of the terms such as gross margin and gross profit margin often varies by the person using the terms. Some people prefer to use gross margin instead of gross profit when referring to the dollars of gross profit. Often they want to avoid the use of the word profit because the selling and administrative expenses must also be covered. Recall that gross profit is defined as Net Sales minus Cost of Goods Sold.

     

    Others use the term gross margin to mean the gross profit as a percentage of net sales. Perhaps the term gross profit margin means the gross profit percentage or the gross margin ratio.

     

  • 177. What is an independent variable?
     

    In accounting, an independent variable is ideally a factor that causes a change in the total amount of the dependent variable. In other words, an independent variable should be something that drives a mixed cost to increase or decrease.

     

    To illustrate, let's assume that a manufacturer's production equipment uses a significant amount of electricity. Hence, the monthly electricity cost (the dependent variable) will increase when there is an increase in the number of production machine hours (the independent variable).

     

    In reality there are likely to be many independent variables that cause a change in the amount of the dependent variable. In the case of the monthly electricity cost, the independent variables could also include the non-production machines using electricity, the physical size of the products, the skill level of the operators, the outside temperature and humidity, etc.

     

    Multiple regression analysis is a statistical tool that can assist in determining the significant independent variables

  • 178. What is a bill payable?
     

    A bill payable is a document which shows the amount owed for goods or services received on credit. Examples of a bill payable include a monthly telephone bill, electricity bill, a bill for repairs or maintenance, the bill for merchandise purchased by a retailer on credit, etc. The provider of the goods or services is referred to as the supplier or vendor. Hence, the bill payable is also known as an unpaid vendor invoice.

     

    Under the accrual method of accounting or bookkeeping, a bill payable or unpaid vendor invoice is recorded in Accounts Payable with a credit entry. When the bill is paid, Accounts Payable will be reduced with a debit entry. The credit balance in Accounts Payable is reported on the company's balance sheet as a current liability.

  • 179. What is the book value per share of stock?
     

    If a corporation does not have preferred stock outstanding, the book value per share of stock is a corporation's total amount of stockholders' equity divided by the number of common shares of stock outstanding on that date.

     

    For example, if a corporation without preferred stock has stockholders' equity on December 31 of AED 12,421,000 and it has 1,000,000 shares of common stock outstanding on that date, its book value per share is AED 12.42.

     

    Keep in mind that the book value per share will not be the same as the market value per share. One reason is that a corporation's stockholders' equity is simply the difference between the total amount of assets reported on the balance sheet and the total amount of liabilities reported. Noncurrent assets are generally reported at original cost less accumulated depreciation and some valuable assets such as trade names might not be listed on the balance sheet.

  • 180. What is a financial statement?
     

    We use the term financial statement to mean one of the general-purpose, external financial statements such as the income statement, balance sheet, statement of cash flows, and the statement of stockholders' equity.

     

    These financial statements for a U.S. company must be prepared in accordance with U.S. generally accepted accounting principles—also referred to as US GAAP.

    What are the accounting entries for a fully depreciated car?

    If the car continues to be used after it is fully depreciated, there will be no further depreciationentries.

     

    If you sell the car after it is fully depreciated, you 1) debit Cash for the amount received, 2) debitAccumulated Depreciation for the car's accumulated depreciation, 3) credit the asset account containing the car—such as Vehicles, Automobiles, or Cars, 4) credit the account Gain on Sale of Vehicles for the amount necessary to have the entry's debit dollars equal to credit dollars. If the earlier depreciation amounts assumed a salvage value of zero, the gain will equal the cash received.

  • 181. Why is manufacturing overhead allocated to products?
     

    Manufacturing overhead, which is also known as factory overhead, burden, and indirect manufacturing costs, needs to be allocated to products for the following reasons:

    1. Some of the goods manufactured are not sold in the same period in which they were produced.
    2. The goods not sold must be reported at their cost in the company's asset entitled Inventory.
    3. Accounting principles require that each product's inventory cost include both direct and indirect manufacturing costs.
    4. Indirect costs by definition mean they are not directly traceable to a product and will require an allocation.
    5. Some companies set their products' selling prices based on their costs. In the long run, the products' selling prices must be large enough to cover all of a company's manufacturing costs (including the indirect manufacturing costs) plus the company's selling, general and administrative expenses and a profit for the company's owners.

    If a company never has inventory (because each period it sells all of its production) the allocation of manufacturing overhead could be avoided. The reason is that all of the manufacturing costs will be reported as the cost of goods sold. However, the company may still choose to allocate the manufacturing overhead for internal pricing decisions or to comply with a government contract.

  • 182. What is a dependent variable?
     

    In accounting, a dependent variable is likely to be the total of a mixed cost that will change as the result of several factors. A factor that causes the change in the total cost is referred to as the independent variable.

     

    To illustrate, assume that a manufacturer wants to estimate its total electricity cost for each month. The total electricity cost will be the dependent variable. Since the manufacturer's machines use large amounts of electricity, the total cost of electricity is dependent on the number of machine hours. In this example, the machine hours will be an independent variable. (It is likely that there will be many independent variables that cause the change in the amount of the dependent variable.)

     

    The dependent variable is usually expressed as y or y' (the estimated amount of y) and the amount is referenced on a graph's y-axis. (An independent variable is expressed as x and is referenced on a graph's x-axis.) Hence the equation for the monthly electricity cost will be y = a + bx, which signifies that the total electricity cost (y) for a specific month is equal to a fixed cost (a) plus a variable cost rate (b) multiplied times the number of machine hours (x) occurring during the month.

  • 183. What is the total asset turnover ratio?
     

    The total asset turnover ratio indicates the relationship of net sales for a specified year to the average amount of total assets during the same 12 months.

     

    Let's assume that during a recent year a corporation had net sales of AED 2,100,000 and its total assets during the same 12 month period averaged AED 1,400,000. The company's total asset turnover for the year was 1.5 (net sales of AED 2,100,000 divided by AED 1,400,000 of average total assets).

     

    This ratio will vary by industry, as some industries are more capital intensive than others. Always compare your company's financial ratios to the ratios of other companies in the same industry.

  • 184. What is inventory valuation?
     

    Inventory valuation is the dollar amount associated with the items contained in a company's inventory. Initially the amount is the cost of those items. However, under certain situations the cost could be replaced with a lower dollar amount.

     

    The inventory valuation includes all of the costs to get the inventory items in place and ready for sale. The inventory valuation excludes the costs of selling and administration.

     

    Since the inventory items are constantly being sold and restocked and since the costs of the items are constantly changing, a company must select a cost flow assumption. Cost flow assumptions include first-in, first-out; weighted average; and last-in, first out. The company must consistently follow its stated cost flow assumption.

     

    A manufacturer's inventory valuation will include the costs of production, namely direct materials, direct labor, and manufacturing overhead. Manufacturers are also required to consistently follow their cost flow assumptions.

     

    Inventory valuation is important in that it affects the cost of goods sold reported on the company's income statement. Inventory is also an important component of a company's current assets, working capital, and current ratio.

  • 185. Where should a business report cash which is restricted to purchase a long-term asset?
     

    The cash which a business has restricted to purchase a long-term asset should be reported on the balance sheetunder the asset heading Investments. Investments is the first of the long-term asset headings and it is positioned immediately after current assets.

     

    The cash restricted for a long-term asset is not reported as part of the company's current assets because the cash is not available to pay current liabilities. Expressed another way, when the business restricts its cash for the purchase of a long-term asset, the business must reduce the amount it reports as working capital (which is current assets minus current liabilities).

  • 186. What is the return on assets ratio?
     

    The return on assets ratio, or return on total assets ratio, relates a company's after tax net income during a specific year, to the company's average total assets during the same year.

     

    Let's assume that a company had AED 60,000 of net income after tax during a recent year. During the same 12 month period its total assets averaged AED 1,000,000. Its return on assets ratio for the year was 6% (AED 60,000 divided by AED 1,000,000).

     

    You would compare this company's return on assets to other companies in the same industry

  • 187. What is Notes Payable?
     

    In accounting, Notes Payable is a general ledger account in which a company records the face amounts of the promissory notes that it has issued. The amounts for the promissory notes (or simply notes) that have not been repaid are reported as part of the company's liabilities. The amounts are often reported on the balance sheet as long-term debt and/or short-term debt.

     

    Generally, the balance in the Notes Payable account will be reported on the balance sheet as follows:

    • the amount due within one year of the balance sheet date will be a current liability, and
    • the amount not due within one year of the balance sheet date will be a noncurrent liability.

    The company should also disclose pertinent information for the amounts owed on the notes. This will include the interest rates, maturity dates, collateral pledged, limitations imposed by the creditor, etc.

  • 188. What is financial reporting?
     

    Financial reporting includes the following:

    • the external financial statements (balance sheet, income statement, statement of cash flows, and statement of stockholders' equity)
    • the notes to the financial statements
    • press releases and conference calls regarding quarterly earnings and related information
    • quarterly and annual reports to stockholders
    • financial information posted on a corporation's website
    • financial reports to governmental agencies including quarterly and annual reports to the Securities and Exchange Commission (SEC)
    • prospectuses pertaining to the issuance of common stock and other securities
  • 189. What is a/c?
     

    In accounting, a/c is often used as an abbreviation for the word account. For example, an accountant might write the following message "Review the balance in the Interest Payable a/c."

  • 190. What is the working capital turnover ratio?
     

     

    The working capital turnover ratio is also referred to as net sales to working capital. It indicates a company's effectiveness in using its working capital.

     

    The working capital turnover ratio is calculated as follows: net annual sales divided by the average amount of working capital during the same 12 month period.

     

    For example, if a company's net sales for a recent year were AED 2,400,000 and its average amount of working capital during the year was AED 400,000, its working capital turnover ratio was 6 (AED 2,400,000 divided by AED 400,000).

     

    Working capital is defined as the total amount of current assets minus the total amount of current liabilities. As indicated above, you should use the average amount of working capital for the year of the net sales.

     

    As with most financial ratios, you should compare the working capital turnover ratio to other companies in the same industry and to the same company's past and planned working capital turnover ratio.

  • 191. In accounting, what is the meaning of cr.?
     

    In accounting, cr. is the abbreviation for credit.

     

    In accounting and in bookkeeping, credit or cr. indicates an entry on the right side of a general ledger account.

     

    Credit entries will increase the credit balances that are typical for liability, revenues, and stockholders' equity accounts. Credit entries will also decrease the debit balances usually found in asset and expense accounts.

  • 192. What is the difference between gross margin and contribution margin?
     

    Gross Margin is the Gross Profit as a percentage of Net Sales. The calculation of the Gross Profit is: Sales minusCost of Goods Sold. The Cost of Goods Sold consists of the fixed and variable product costs, but it excludes all of the selling and administrative expenses.

     

    Contribution Margin is Net Sales minus the variable product costs and the variable period expenses. TheContribution Margin Ratio is the Contribution Margin as a percentage of Net Sales.

     

    Let's illustrate the difference between gross margin and contribution margin with the following information: company had Net Sales of AED 600,000 during the past year. Its inventory of goods was the same quantity at the beginning and at the end of year. Its Cost of Goods Sold consisted of AED 120,000 of variable costs and AED 200,000 of fixed costs. Its selling and administrative expenses were AED 40,000 of variable and AED 150,000 of fixed expenses.

     

    The company's Gross Margin is: Net Sales of AED 600,000 minus its Cost of Goods Sold of AED 320,000 (AED 120,000 + AED 200,000) for a Gross Profit of AED 280,000 (AED 600,000 - AED 320,000). The Gross Margin or Gross Profit Percentage is the Gross Profit of AED 280,000 divided by AED 600,000, or 46.7%.

     

    The company's Contribution Margin is: Net Sales of AED 600,000 minus the variable product costs of AED 120,000 and the variable expenses of AED 40,000 for a Contribution Margin of AED 440,000. The Contribution Margin Ratio is 73.3% (AED 440,000 divided by AED 600,000).

  • 193. In accounting, what is the meaning of dr.?
     

    In accounting, dr. is the abbreviation for the word debit. (Today, accountants and bookkeepers use the termdebit, but five centuries ago in Italy, the term included the letter "r".)

     

    In accounting and bookkeeping, debit or dr. indicates an entry on the left side of a general ledger account. Typically, the accounts for assets and expenses will have debit balances. Debit entries will also reduce the credit balances typically found in the liability and stockholders' equity accounts.

  • 194. When calculating inventory turnover, do you use sales or the cost of goods sold?
     

    I calculate the inventory turnover by using the cost of goods sold. I use the cost of goods sold because inventory is in the general ledger at its cost and it is reported on the balance sheet at cost. Since inventory is the cost of goods on hand, it makes sense to relate it to the cost of goods sold.

     

    Assume that during the past year a company's inventory had an average cost of AED 10,000. (This was the average of the amounts in the asset account Inventory and the average of the amounts reported on the balance sheetduring the past year.) Also assume that during the year the company has sales of AED 60,000 and its cost of goods sold was AED 40,000. On average, the inventory turned over 4 times (AED 40,000 of cost of goods sold during the year divided by AED 10,000 the average cost of goods on hand during the year.)

  • 195. What is direct labor?
     

    Direct labour refers to the employees and temporary help who work directly on a manufacturer's products. (People working in the production area, but not directly on the products, are referred to as indirect labour.)

     

    The direct labour cost is 1) the cost of the wages and fringe benefits of the direct labor employees and 2) the cost of the temporary help who work directly on the manufacturer's products.

     

    The direct labour cost is also defined as:

    • a product cost (along with the costs of the direct materials and manufacturing overhead)
    • an inventoriable cost (along with the costs of the direct materials and manufacturing overhead)
    • a prime cost (along with direct materials)
    • a conversion cost (along with manufacturing overhead)

     

  • 196. Why doesn't the balance sheet equal the post-closing trial balance?
     

    The totals on the balance sheet will not equal the totals on the post-closing trial balance due to contra accounts. We will use  the contra account Accumulated Depreciation to illustrate why this occurs.

     

    The account Accumulated Depreciation will have a credit balance and it will be listed in the credit column of the trial balance. Its credit balance will be included with the other credit balances, most of which are liability accounts and owner or stockholder equity accounts.

     

    On the balance sheet, the credit balance in Accumulated Depreciation will not be reported with the other credit balances. Rather, the credit balance in Accumulated Depreciation will be a deduction from the debit balances reported in the asset section entitled property, plant and equipment.

  • 197. What is the free cash flow ratio?
     

     

    The free cash flow ratio is an amount, rather than a ratio.

     

    The free cash flow calculation often begins with the cash flow from operating activities shown on the statement of cash flows (SCF). Next the amount of capital expenditures, taken from the investing activities section of the SCF for the same period, is deducted to arrive at the amount of free cash flow.

     

    There are variations of the above calculation. For example, the dividends to stockholders might be viewed as a requirement and will be deducted along with the capital expenditure amoun

  • 198. Is an automobile loan payment an expense?
     

    Only the interest portion of an automobile loan payment is an expense. The principal portion of the loan payment is a reduction of the loan balance, which is reported as a Note Payable or Loan Payable in the liability section of the balance sheet.

     

    Expressed another way, an automobile loan payment consists of two components: an interest payment and a principal payment. While the loan payment is a cash outflow or an expenditure, only the interest portion is an expense that will be reported on a company's income statement.

  • 199. What is the return on stockholders' equity (after tax) ratio?
     

    The return on stockholders' equity, or return on equity, is a corporation's net income after income taxes divided by average amount of stockholders' equity during the period of the net income.

     

    To illustrate, let’s assume that a corporation's net income after tax was AED 100,000 for the most recent year. Let’s also assume that it did not have any preferred stock outstanding and that its stockholders’ equity was AED 950,000 at the beginning of the year and was AED 1,050,000 at the end of the year. The increase was at a uniform rate throughout the year. The return on stockholders’ equity will be 10% (AED 100,000 divided by the average stockholders’ equity of AED 1,000,000).

  • 200. What is inventory change and how is it measured?
     

    Inventory change is the difference between last period's ending inventory and the current period's ending inventory. If last period's ending inventory was AED 100,000 and the current period's ending inventory is AED 115,000, the inventory change is an increase of AED 15,000.

     

    The inventory change is often presented as an adjustment to purchases in the calculation of the cost of goods sold. If purchases were AED 300,000 during the current period and the inventory amounts are those listed above, the cost of goods sold is AED 285,000. (Purchases of AED 300,000 minus the AED 15,000 increase in inventory. The logic is that not all AED 300,000 of purchases should be matched against sales, because AED 15,000 of the purchases went into inventory.) This is an alternative to the method used in introductory accounting: beginning inventory of AED 100,000 + purchases of AED 300,000 = AED 400,000 of cost of goods available – ending inventory of AED 115,000 = cost of goods sold of AED 285,000.

     

    If last period's ending inventory was AED 100,000 and the current period's ending inventory is AED 93,000, the inventory change is a decrease of AED 7,000. Assuming purchases of AED 300,000 in the current period, the cost of goods sold is AED 307,000 (AED 300,000 of purchases plus the AED 7,000 decrease in inventory).

  • 201. What are marketable securities?
     

    Marketable securities are unrestricted financial instruments which can be readily sold on a stock exchange or bond exchange. Marketable securities are often classified into two groups: marketable equity securities and marketable debt securities.

     

    Marketable equity securities include shares of common stock and most preferred stock which are traded on a stock exchange and for which there are quoted market prices.

     

    Marketable debt securities include government bonds and corporate bonds which are traded on a bond exchange and for which there are quoted market prices.

  • 202. Why doesn't the balance sheet equal the post-closing trial balance?
     

    The totals on the balance sheet will not equal the totals on the post-closing trial balance due to contra accounts. We will use  the contra account Accumulated Depreciation to illustrate why this occurs.

     

    The account Accumulated Depreciation will have a credit balance and it will be listed in the credit column of the trial balance. Its credit balance will be included with the other credit balances, most of which are liability accounts and owner or stockholder equity accounts.

     

    On the balance sheet, the credit balance in Accumulated Depreciation will not be reported with the other credit balances. Rather, the credit balance in Accumulated Depreciation will be a deduction from the debit balances reported in the asset section entitled property, plant and equipment.

  • 203. What is a checking account?
     

    A checking account is a bank account in which a company deposits money and can subsequently withdraw the money by writing a check, by using a debit card, arranging for electronic transfers, etc. Except for the uncollected funds associated with recently deposited checks, the money in a checking account is available on demand. (Hence, a bank will refer to the amounts in its customers' checking accounts as demand deposits.)

     

    The balances in checking accounts are considered to be money and will be reported as part of a company's current asset cash. (The bank will report its customers' checking account balances as a current liability.)

     

    As part of its internal controls, a company should reconcile its checking account balance with the balance in the bank's records. This process is known as the bank reconciliation.

  • 204. What is the effect on the income statement when the allowance for uncollectible accounts is not established?
     

    Without the balance sheet account, Allowance for Uncollectible Accounts, all of the accounts receivable are assumed to be collectible and there is no bad debt expense reported on the income statement until an account receivable is written off. This approach is known as the direct write-off method. (When an account is written off, the entry will be a debit to Bad Debt Expense and a credit to Accounts Receivable.)

     

    When the account Allowance for Uncollectible Accounts is reported on the balance sheet, the companyanticipates that some of its accounts receivable will not be collected. In other words, without knowing specifically which account will not be collected, the company debits Bad Debt Expense and credits Allowance for Uncollectible Accounts. This results in an expense on the income statement (sooner than would occur under the direct write-off method) and a reduction of the current assets on the balance sheet. (When an account is written off under the "allowance" method, the entry will be a debit to Allowance for Uncollectible Accounts and a credit to Accounts Receivable.)

  • 205. What is the earnings per share (EPS) ratio?
     

     

    The earnings per share ratio, or simply earnings per share, or EPS, is a corporation's net income after tax that is available to its common stockholders divided by the weighted average number of shares of common stock that are outstanding during the period of the earnings.

     

    Net income available for common stock is the corporation's net income after income taxes minus the required dividend for the corporation's preferred stock, if it has preferred stock outstanding.

  • 206. What is a lien?
     

    A lien is a legal document filed by a creditor (lender) in order to record its claim on the debtor's (borrower's) property. The lien is recorded at a government's office. The lien provides a creditor with some protection or collateral until the debtor pays the creditor the amount owed.

     

    Here are three examples of liens:

    1. A bank may lend a retailer AED 50,000 but one of the conditions is that the bank will file a lien on the retailer's inventory. In this situation the bank's lien results in its loan becoming secured.
    2. A mortgage is a lien filed by a lender in order to secure the lender's long-term real estate loan. The lien will require that the lender be paid the amount owed on the loan before the real estate can be transferred to another party.
    3. The U.S. government may file a lien on a company's assets until a tax obligation has been paid.

    A lien on a company's assets is to be disclosed in the company's financial statements.

  • 207. What is the reorder point?
     

    The reorder point is the quantity of units in inventory that will trigger an order to purchase additional units. Let's assume that a company's reorder point for its Product X is 80 units. When the inventory of Product X drops to 80 units, the company places an order for additional units of Product X.

     

    The reorder point is calculated by 1) estimating the sales in the near future, 2) estimating the number of days between ordering and receiving the additional units, and 3) the number of units of safety stock.

     

    The reorder point indicates when to place an order. The economic order quantity indicates the optimum number of units to be ordered.

  • 208. What is the working capital ratio?
     

    Some use the term working capital ratio to mean working capital or net working capital. Working capital is defined as current assets minus current liabilities. When used in this manner, working capital ratio is not really a ratio. Rather, it is simply a dollar amount.

     

    For example, if a company has AED 900,000 of current assets and has AED 400,000 of current liabilities, its working capital is AED 500,000. If a company has AED 900,000 of current assets and has AED 900,000 of current liabilities, it has no working capital.

     

    Other people use the term working capital ratio to mean the current ratio, which is defined as the amount of current assets divided by the amount of current liabilities.

  • 209. What is a defined contribution pension plan?
     

    A defined contribution pension plan is one in which the employer contributes an amount into each eligible employee's account within an established plan. The employee decides on the investment strategy for the account and the resulting investment earnings, gains, or losses are recorded in his or her account. When the employee retires, the pension or retirement benefit is based upon his or her account balance. A 401(k) is an example of a defined contribution pension plan.

     

    The defined contribution pension plan eliminates the employer's uncertainty about its future pension expense and liabilities. It also means simpler accounting. As a result, more companies are choosing defined contributionpension plans over defined benefit pension plans.

  • 210. What is the time value of money?
     

    The time value of money tells us that receiving cash today is more valuable than receiving cash in the future. The reason is that the cash received today can be invested immediately and will begin growing in value. For instance, if a company receives AED 1,000 today and it is invested at 8% per year, the company will have AED 1,080 after 365 days.

     

    A time value of money of 8% per year also tells us that receiving AED 1,080 one year from now is comparable to receiving AED 1,000 today. With a time value of money of 8% per year, accountants will state that receiving AED 1,080 in one year has a present value of AED 1,000.

     

    In accounting, a time value of money of 8% means that a company performing services today in exchange for cash of AED 1,080 in one year has earned AED 1,000 of service revenues today. The AED 80 difference will become interest income as the company waits 365 days for the money.

     

    The time value of money is important in accounting because of the cost principle and the revenue recognition principle. However, materiality and cost/benefit allow the accountants to ignore the time value of money for its routine accounts receivable and accounts payable having credit terms of 30 or 60 days.

  • 211. What are the accounting principles, assumptions, and concepts?
     

    The basic or fundamental principles in accounting are the cost principle, full disclosure principle, matching principle, revenue recognition principle, economic entity assumption, monetary unit assumption, time period assumption, going concern assumption, materiality, and conservatism. The last two are sometimes referred to as constraints. Rather than distinguishing between a principle or an assumption, I prefer to simply say that these ten items are the basic principles or the underlying guidelines of accounting. (My reason is that accounting principles also include the statements of financial accounting standards and the interpretations issued by the Financial Accounting Standards Board and its predecessors, as well as industry practices.)

     

    There are also "qualities" of accounting information such as reliability, relevance, consistency, comparability, and cost/benefit.

  • 212. What is the gross margin ratio?
     

    The gross margin ratio is also known as the gross profit margin or the gross profit percentage.

     

    The gross margin ratio is computed by dividing the company's gross profit dollars by its net sales dollars.

     

    To illustrate the gross margin ratio, let's assume that a company has net sales of AED 800,000 and its cost of goods sold is AED 600,000. This means its gross profit is AED 200,000 (net sales of AED 800,000 minus its cost of goods sold of AED 600,000) and its gross margin ratio is 25% (gross profit of AED 200,000 divided by net sales of AED 800,000).

     

    A company should be continuously monitoring its gross margin ratio to be certain it will result in a gross profit that will be sufficient to cover its selling and administrative expenses.

     

    Since gross margin ratios vary between industries, you should compare your company's gross margin ratio to companies within your industry. However, you should keep in mind that there can also be differences within your industry. For example, your company may use LIFO while most companies in your industry use FIFO. Perhaps your company focuses its sales efforts on smaller customers who also require special administrative services. In that case, your company's gross margin ratio should be larger than your industry's in order to cover the higher selling and administrative expenses

  • 213. What is the consistency principle?
     

    The consistency principle requires accountants to be consistent from one accounting period to another in applying accounting principles, methods, practices, and procedures. In other words, the readers of a company's financial statements can presume that the same rules and measurements were followed in all of the years being reported. If a change is made to a more preferred accounting method, the effects of the change must be clearly disclosed.

     

    The Financial Accounting Standards Board refers to consistency as one of the characteristics or qualities that makes accounting information useful.

  • 214. What are conversion costs?
     

    Conversion costs are the combination of direct labor costs plus manufacturing overhead costs.

     

    You can think of conversion costs as the manufacturing or production costs necessary to convert raw materials into products. Expressed another way, conversion costs are a manufacturer's product or production costs other than the costs of raw materials.

     

    The term conversion costs often appears in the calculation of the cost of an equivalent unit in a process costing system.

  • 215. What is a long-term liability?
     

    A long-term liability is a non current liability. That is, a long-term liability is an obligation that is not due within one year of the date of the balance sheet (or not due within the company's operating cycle if it is longer than one year).

     

    Some examples of long-term liabilities are the noncurrent portions of the following:

    • bonds payable
    • long-term loans
    • capital leases
    • pension liabilities
    • postretirement healthcare liabilities
    • deferred compensation
    • deferred revenues
    • deferred income taxes
    • derivative liabilities

    Some long-term debt that is due within one year of the balance sheet date could continue to be reported as a long-term liability if there is:

    • a long-term investment that is sufficient and restricted for the payment of the debt, or
    • intent and a financing arrangement that replaces the debt with new long-term debt or with capital stock.
  • 216. What is meant by reconciling an account?
     

    Reconciling an account often means proving or documenting that an account balance is correct. For example, we reconcile the balance in the general ledger account Cash in Checking to the balance shown on the bank statement. The objective is to report the correct amount in the general ledger account Cash in Checking. You will often need to adjust the general ledger account balance for items appearing on the bank statement that were not entered in the general ledger account.

     

    I recall being asked to reconcile the general ledger account Freight Payable. What I needed to do was provide documentation that the balance in Freight Payable was proper. I proceeded to look at the shipments of recent sales and then determined how much we would be obligated to pay for the freight on those sales. We then adjusted the balance in Freight Payable to my documented amount. This reconciliation was done to have the correct account balance and to provide the outside auditors with documentation which could easily be reviewed.

     

    I also reconciled the balance in Utilities Payable by computing the daily cost of each utility that the company used. The cost per day was then multiplied by the number of days since the last meter reading date shown on the utility bills already entered in our accounting system. We then adjusted the Utilities Payable account balance to be equal to the documented amount.

  • 217. What is accrued interest?
     

    Accrued interest is the amount of loan interest that has already occurred, but has not yet been paid to the lender by the borrower.

    The accrued interest will be reported by the borrower as both

    1. an expense on its income statement, and
    2. a current liability on its balance sheet.

    The accrued interest will be reported by the lender as both

    1. revenue on its income statement, and
    2. a current asset on its balance sheet.

    Accrued interest is likely to require adjusting entries by both the borrower and the lender prior to issuing their financial statements.

  • 218. What is the difference between information and data?
     

    I was taught that information is useful data. The point is there are lots of data (plural of datum) everywhere, and most of the data will not be useful to a decision maker. Only after the data have been sorted and the relevant portions presented to a decision maker will the data become information.

     

    While that is the distinction that I learned many years ago, I believe that most people use the terms information and data interchangeably. In other words, one person might say data processing and another might say information processing, and both could be referring to the same thing.

    What is the entry to remove equipment that is sold before it is fully depreciated?

    When equipment that is used in a business is sold for cash before it is fully depreciated, there will be two journal entries:

     

    The first entry will be a debit to Depreciation Expense and a credit to Accumulated Depreciationto record the depreciation right up to the date of the sale (disposal).

     

    The second entry will consist of the following:

    1. Credit the account Equipment to remove the equipment's cost.
    2. Debit Accumulated Depreciation to remove the equipment's up-to-date accumulated depreciation.
  • 219. What is the days' sales in accounts receivable ratio?
     

    The days' sales in accounts receivable ratio, also known as the number of days of receivables, tells you the average number of days it takes to collect an account receivable. Since the days' sales in accounts receivable is an average, you need to be careful when using it.

     

    The calculation for determining the days' sales in accounts receivable is the number of days in the year (usually 360 or 365 days is used) divided by the accounts receivable turnover ratio for a specific year. If a company's accounts receivable turnover ratio was 10, then the days' sales in accounts receivable is 36 days (360 days divided by the turnover ratio of 10).

     

    Since the accounts receivable turnover ratio used in the days' sales in accounts receivable was based on 1) thecredit sales during a one-year time period, and 2) the average accounts receivable balances during that one-year period, the 36 days calculated above is an average. It is possible that within the accounts receivable there are some accounts which are 120 days or more past due. This information might be hidden by the average, because the average included some accounts that paid early. Therefore, it is best to review an aging of accounts receivable by customer to understand the detail behind the days' sales in accounts receivable ratio.

  • 220. What is a capital expenditure versus a revenue expenditure?
     

    A capital expenditure is an amount spent to acquire or improve a long-term asset such as equipment or buildings. Usually the cost is recorded in an account classified as Property, Plant and Equipment. The cost (except for the cost of land) will then be charged to depreciation expense over the useful life of the asset.

    A revenue expenditure is an amount that is expensed immediately—thereby being matched with revenues of the current accounting period. Routine repairs are revenue expenditures because they are charged directly to an account such as Repairs and Maintenance Expense. Even significant repairs that do not extend the life of the asset or do not improve the asset (the repairs merely return the asset back to its previous condition) are revenue expenditures.

  • 221. What is the profit margin (after tax) ratio?
     

    The after tax profit margin ratio tells you the profit per sales dollar after all expenses are deducted from sales. In other words, the after tax profit margin ratio shows you the percentage of net sales that remains after deducting the cost of goods sold and all other expenses including income tax expense. The calculation is: Net Income after Tax divided by Net Sales.

     

    The before tax profit margin ratio expresses the corporation's income before income tax expense as a percentage of net sales.

     

    The profit margin ratio is most useful when it is compared to 1) the same company's profit margin ratios from earlier accounting periods, 2) the same company's targeted or planned profit margin ratio for the current accounting period, and 3) the profit margin ratios of other companies in the same industry during the same accounting period.

  • 222. Why does a company debit Purchases instead of Inventory?
     

    Under the periodic inventory system a company determines its inventory value based on an estimated or actual physical count of goods multiplied by the unit costs of the items. As a result, the costs of the goods purchased by the company will be debited to the temporary accountPurchases. Under the periodic inventory system, there will also be temporary accounts that will be credited for Purchase Returns and Allowances and for Purchase Discounts.

     

    If a company wants its Inventory account to have a running dollar amount, it will use theperpetual inventory system. Under the perpetual inventory system, the costs of the goods purchased are debited to Inventory. The perpetual system also requires that the Inventory account be credited for the cost of the goods sold, for purchase returns and allowances, and forpurchase discounts.

    1. Debit Cash for the amount received.
    2. Get this journal entry to balance. If a debit amount is needed, it is a loss on the disposal. If a credit amount is needed, it is a gain on the disposal.

    If the equipment is traded-in or exchanged for another asset, the second journal entry will be different from the one we presented.

  • 223. How does petty cash affect expenses?
     

     

    Petty Cash is a current asset account; it is part of a company's cash. A petty cash fund is established by cashing a check drawn on the company's regular checking account and giving the currency and coins to the petty cash custodian. No expense is involved in this transaction since the company is simply creating the asset account Petty Cash by reducing another asset account.

    An expense occurs when the company pays the postal carrier for the postage that is due on the incoming mail. Another expense occurs when the company sends an employee to pick up some needed supplies. If these expenses are paid with money in the petty cash fund, the currency and coins held by the petty cash custodian will decrease and in place of that money the custodian will have petty cash receipts or petty cash vouchers. The expenses will be recorded in the general ledger when the petty cash fund is replenished.

    In order to get the expenses entered in the proper accounting period, it is necessary to replenish the petty cash fund at the end of each accounting period. (This is done in addition to replenishing the fund whenever the currency and coins are low.)

  • 224. What is a liquidity ratio?
     

    A liquidity ratio is an indicator of whether a company's current assets will be sufficient to meet the company's obligations when they become due.

     

    The liquidity ratios include the current ratio and the acid test or quick ratio. The current ratio and quick ratio are also referred to as solvency ratios. Working capital is an important indicator of liquidity or solvency, even though it is not technically a ratio.

     

    Liquidity ratios sometimes include the accounts receivable turnover ratio and the inventory turnover ratio. These two ratios are also classified as activity ratios.

  • 225. What is depreciation expense?
     

    Depreciation expense is the allocated portion of the cost of a company's fixed assets that is appropriate for the accounting period indicated on the company's income statement. For instance, if a company had paid AED 2,400,000 for its office building (excluding land) and the building has an estimated useful life of 40 years, each monthly income statement will report straight-line depreciation expense of AED 5,000 for 480 months. [However, the allocated cost of the fixed assets used in manufacturing will be part of the manufacturing overhead which will become part of the cost of the products manufactured.]

     

    Depreciation expense is referred to as a noncash expense because the recurring, monthly depreciation entry (a debit to Depreciation Expense and a credit to Accumulated Depreciation) does not involve a cash payment. As a result, the statement of cash flows prepared under the indirect method will add depreciation expense to the amount of net income.

     

    The common methods for computing depreciation expense include straight-line, double-declining balance, sum-of-the-years digits, and units of production or activity

  • 226. What is the weakness of traditional cost allocations?
     

    Traditional cost allocations are often based on volume such as number of products manufactured, number of direct labor hours, number of production machine hours, number of square feet, etc. Unfortunately, it is becoming more frequent that the common costs or indirect costs that require allocation are not caused by volume. In other words, traditional cost allocations are often based on something other than the root causes of the costs.

     

    It is possible that a significant amount of manufacturing overhead might not be caused by production machine hours, yet the overhead is allocated using those hours. For example, a few of a manufacturer's low volume products may require significant amounts of engineering changes, additional inspections, frequent machine setups with unusually short production runs, special handling, additional storage, and so on. To allocate these special costs to all products on the basis of the number of production machine hours (instead of allocating those costs based on their root causes) will result in individual product costs that are inaccurate and misleading.

  • 227. What is a defined benefit pension plan?
     

    A defined benefit pension plan is a retirement plan in which the employer commits to paying a specified monthly payment to each eligible employee when he or she retires at a stated age. The monthly benefit is often based on a formula such as a percentage for each year of employment times the employee's average monthly salary or wages during a three-year period prior to retirement. A hypothetical calculation for an employee retiring at age 65 might be 1% X 30 years of service X AED 4,000 per month average salary = AED 1,200 per month pension check.

     

    Under the defined benefit pension plan, the employer commits to depositing enough money into a pension fund in order to cover the future benefits. Since there is uncertainty in the investment returns, the life expectancy of retirees, and other factors, the employer's ongoing contributions, pensions expense, and net income are uncertain. This risk has resulted in the decline of defined benefit pension plans and has increased the popularity of defined contribution pension plans.

  • 228. What is a deferred cost?
     

    A deferred cost is a cost that occurred in a transaction, but will not be expensed until a future accounting period.

     

    An example of a deferred cost is the fees necessary to register a new bond issue. A company will likely have to pay attorneys and accountants to prepare and audit the many statements required by government agencies. When these fees are significant, they are recorded as deferred costs in the long-term asset account, Bond Issue Costs or Unamortized Bond Issue Costs. The amount of the deferred costs will then be amortized (systematically charged) to Bond Issue Cost Expense over the life of the bonds.

     

    A second example is the amount paid in advance for the next six months of insurance. This prepayment is a deferred cost that is recorded in the current asset Prepaid Insurance. In each of the future months, one-sixth of the deferred amount of the insurance premium should be charged to Insurance Expense.

     

    The capitalization of interest involved when a company constructs its own building is also a deferred cost. The reason is that the interest will be added to the cost of the building and depreciated over the life of the building—instead of being expensed immediately as interest expense.

     

  • 229. What is the days' sales in inventory ratio?
     

     

    The days' sales in inventory tells you the average number of days that it took to sell the average inventory held during the specified one-year period. You can also think of it as the number of days of sales that was held in inventory during the specified year. The calculation of the days' sales in inventory is: the number of days in a year (365 or 360 days) divided by the inventory turnover ratio.

     

    For example, if a company had an inventory turnover ratio of 9, the company's inventory turned over 9 times during the year. If we use 360 as the number of days in the year, the company had (on average) 40 days of inventory on hand during the year (360 days divided by the inventory turnover ratio of 9).

     

    Since the inventory turnover ratio reflects the average amount of inventory during the year, and since sales usually fluctuate during the year, the days' sales in inventory is an approximation.

  • 230. Is the cost of goods sold an expense?
     

    While we often think of expenses as salaries, advertising, rent, interest, and so on, the cost of goods sold is also an expense. The cost of goods that were sold needs to be matched with the pertinent sales on the income statement, just as commission expense must be matched with sales or other revenues.

  • 231. What is practical capacity?
     

    Practical capacity is a manufacturer's level of output (often expressed in machine hours, barrels, pounds, etc.) that is less than its theoretical or ideal capacity. For example, if a manufacturer has theoretical capacity of 2,080 hours based on 8 hours per day for 5 days per week for 52 weeks, its practical capacity might be only 1,860 hours. The 220 hour difference could be associated with repairs, maintenance, setups, plant shutdowns for holidays, and other downtime. Hence, a manufacturer's practical capacity is more realistic than its theoretical capacity.

     

    However, the manufacturer's annual output to meet its sales orders and production schedules could be considerably less than its practical capacity. As a result, cost accountants will also review 1) the annual machine hours that normally occurs over a span of several years, and 2) the number of machine hours expected in the upcoming year.

     

    In the long run, it is important that manufacturers plan and control their theoretical, practical, normal and next year's budgeted capacity levels.

  • 232. What are the methods for separating mixed costs into fixed and variable?
     

    I know of three methods for separating mixed costs into their fixed and variable costcomponents:

    1. Prepare a scattergraph by plotting points onto a graph.
    2. High-low method.
    3. Regression analysis.

    It is wise to prepare the scattergraph even if you use the high-low method or regression analysis. The benefit of the scattergraph is that it allows you to see if some of the plotted points are simply out of line. These points are referred to as outliers and will need to be reviewed and possibly adjusted or eliminated. In other words, you don't want incorrect data to distort your calculations under any of the three methods.

     

    Let's assume that a company uses only one type of equipment and it wants to know how much of the monthly electricity bill is a constant amount and how much the electricity bill will increase when its equipment runs for an additional hour. The scattergraph's vertical or y-axis will indicate the dollars of total monthly electricity cost. Its horizontal or x-axis will indicate the number of equipment hours. For each monthly electricity bill, a point will be entered on the graph at the intersection of the dollar amount of the total electricity bill and the equipment hours occurring between the meter reading dates shown on the electricity bill. If you plot this information for the most recent 12 months, you may see some type of pattern, such as a line that rises as the number of equipment hours increase.

     

    If you draw a line through the plotted points and extend the line through the y-axis, the amount where the line crosses the y-axis is the approximate amount of fixed costs for each month. The slope of the line indicates the variable cost per equipment hour. The slope or variable rate is the increase in the total monthly electricity cost divided by the change in the total number of equipment hours.

     

    The high-low calculation is similar but it uses only two of the plotted points: the highest point and the lowest point.

     

    Regression analysis uses all of the monthly electricity bill amounts along with their related number of equipment hours in order to calculate the monthly fixed cost of electricity and the variable rate for each equipment hour. Software can be used for regression analysis and it will also provide statistical insights.

     

    If  a scattergraph of data shows no clear pattern, you should not place much confidence in the calculated amount of  the fixed cost and variable rate regardless of the method used.

    What is a post-closing trial balance?

    A post-closing trial balance is a trial balance which is prepared after all of the temporary accounts in the general ledger have been closed. The temporary accounts include 1) the income statement accounts consisting of revenue, expense, gain, and loss accounts, 2) the summary accounts, and 3) the few temporary balance sheet accounts such as the sole proprietor's drawing account or the corporation's dividend account.

     

    All trial balances should have a heading that includes the company name, the words Trial Balance, and the date of the account balances. After the heading you will likely see the following four columns: account number, account title, debit balance amount, and credit balance amount. Most trial balances will not list any account having a AED 0.00 balance. As a result, the post-closing trial balance will list only the balance sheet accounts with a balance other than zero. The debit and credit amount columns will be summed and the totals should be identical.

     

    Today's accounting software will likely generate a post-closing trial balance or any other trial balance with the click of a mouse. Thanks to accounting software, trial balances are likely to be in balance since the manual calculations have been eliminated.

  • 233. What is a credit balance?
     

    In accounting, a credit balance is the ending amount found on the right side of a general ledger account or subsidiary ledger account.

     

    A credit balance is normal and expected for the following general ledger and subsidiary ledger accounts:

    • Liability accounts. These include Accounts Payable, Notes Payable, Wages Payable, Interest Payable, Income Taxes Payable, Customer Deposits, Deferred Income Taxes, and so on. For instance, a credit balance in Accounts Payable indicates the amount owed to vendors. (Therefore, a debit balance in a liability account indicates that the company has paid more than the amount owed, has made an incorrect entry, etc.) Since liability accounts are permanent accounts, their balances are not closed at the end of the accounting year.
    • Equity accounts. Four examples of equity accounts are Common Stock, Paid-in Capital in Excess of Par Value, Retained Earnings, and M. Smith, Capital. These are also permanent accounts and their balances arenot closed at the end of the accounting year.
    • Revenue accounts and gain accounts. Examples include Sales Revenues, Service Revenues, Interest Revenues, Gain on Disposal of Equipment, Gain from Lawsuit, etc. Since these accounts are temporary accounts, their balances will be transferred to Retained Earnings or to the proprietor's capital account at the end of each accounting year.
    • Contra-asset accounts. Two examples are Allowance for Doubtful Accounts and Accumulated Depreciation. The credit balances in these accounts will allow for the reporting of both the gross and net amounts for accounts receivable and for property, plant and equipment. These are permanent accounts and therefore their balances will not be closed at the end of the accounting year.
    • Contra-expense accounts. These include Purchases Discounts, Purchases Returns and Allowances, and Expenses Reimbursed by Employees, etc. The credit balances in these accounts allow the company to report both the gross and net amounts. The credit balances in these temporary accounts will be transferred to Retained Earnings or to the proprietor's capital account at the end of the accounting year.
  • 234. What is the inventory turnover ratio?
     

     

    The calculation for the inventory turnover ratio is: Cost of Goods Sold for a Year divided by Average Inventory during the same 12 months.

     

    To illustrate the inventory turnover ratio, let’s assume 1) that during the most recent year a company’s Cost of Goods Sold was AED 3,600,000, and 2) the company’s average cost in its Inventory account during the same 12 months was calculated to be AED 400,000. The company’s inventory turnover ratio is 9 (AED 3,600,000 divided by AED 400,000) or 9 times.

     

    The higher the inventory turnover ratio, the better, provided you are able to fill customers' orders on time. It would be foolish to lose customers because you didn't carry sufficient inventory quantities.

     

    A company's inventory turnover ratio should be compared to 1) its previous ratios, 2) its planned ratio, and 3) the industry average.

     

    Even with a favorable inventory turnover ratio, a company may have some excess and obsolete inventory items. Therefore, it is wise to compare the quantity of each item in inventory with the recent sales of each item.

  • 235. How do you calculate the actual or real interest rate on a bond investment?
     

    The actual or real interest rate on a bond can be calculated by using present value software or a financial calculator. The actual, real, or effective interest rate is the rate that will discount all of the future cash receipts back to the amount of cash paid to buy the bond. This interest rate is also known as the yield to maturity, yield, and market interest rate.

     

    The future cash receipts for a typical bond are the semiannual interest payments (interest rate stated on the bond X face amount of bond X 1/2 year) and the maturity amount of the bond. The interest payments form an ordinary annuity and the maturity amount is a single payment.

     

    If the bond's stated interest rate is less than the current market interest rate, the bond's market value is less than the maturity or face amount of the bond. In financial jargon, the bond will sell at a discount.

     

    If the bond's interest rate is more than the current market interest rate, the bond will have a market value that is more than the maturity or face amount of the bond. In other words, the bond will sell at a premium.

  • 236. What is theoretical capacity?
     

    Theoretical capacity is the level of a manufacturer's production that would be attained if all of its equipment and operations performed continuously at their optimum efficiency. Theoretical capacity is also referred to as ideal capacity.

     

    As the names imply, the theoretical capacity or ideal capacity is not realistic due to repairs, maintenance, setups, and other factors that will result in down time.

  • 237. What is a contra liability account?
     

    A contra liability account is a liability account where the balance will be either a debit balance or a zero balance. Since a debit balance in a liability account is contrary to the normal or expectedcredit balance, the account is referred to as a contra liability account.

     

    The most common contra liability accounts are Discount on Bonds Payable and Discount on Notes Payable. The debit balances in these accounts are amortized or allocated to Interest Expense over the life of the bonds or notes.

     

    The credit balance in the liability account Bonds Payable minus the debit balance in the contra liability account Discount on Bonds Payable is the carrying value or book value of the bonds. The credit balance in Notes Payable minus the debit balance in Discount on Notes Payable is the carrying value or book value of the notes payable.

  • 238. What is the difference between revenue, income, and gain?
     

     

    Revenue is the amount earned from a company's main activities such as selling merchandise or providing services.

     

    A gain results from a peripheral activity, such as selling the old delivery truck. A gain is the amount received that is in excess of the asset's carrying amount (book value). For example, if the company receives AED 3,000 for the truck, and its carry amount was AED 600, the company will report a gain of AED 2,400.

     

    Income is sometimes used instead of the word revenue: some people refer to the rent they receive as rent income. Generally, accountants use the word income to mean "net of revenues and expenses." For example, a retailer's income from operations is sales minus the cost of goods sold minus operating expenses.

  • 239. What is the debt to equity ratio?
     

    The debt to equity ratio or debt-equity ratio is calculated by dividing a corporation's total liabilities by the total amount of stockholders' equity: (Liabilities/Stockholders' Equity):1.

     

    A corporation with AED 1,200,000 of liabilities and AED 2,000,000 of stockholders' equity will have a debt to equity ratio of 0.6:1. A corporation with total liabilities of AED 1,200,000 and stockholders' equity of AED 400,000 will have a debt to equity ratio of 3:1.

     

    Generally, the higher the ratio of debt to equity, the greater is the risk for the corporation's creditors and its prospective creditors.

  • 240. What is the payback reciprocal?
     

    The payback reciprocal is a crude estimate of the rate of return for a project or investment. The payback reciprocal is computed by dividing the digit "1" by a project's payback period expressed in years. For example, if a project's payback period is 4 years, the payback reciprocal is 1 divided by 4 = 0.25 = 25%.

     

    The payback reciprocal overstates the true rate of return because it assumes that the annual cash flows will continue forever. It also assumes that the annual cash flows are identical in amount. Since these two conditions are unrealistic you should avoid the use of the payback reciprocal. Instead, you should compute the internal rate of return or the net present value because they will discount each of the actual cash amounts to reflect the time value of money.

  • 241. What is insurance expense?
     

    Under the accrual basis of accounting, insurance expense is the cost of insurance that has been incurred, has expired, or has been used up during the current accounting period for the nonmanufacturing functions of a business. (The insurance costs incurred for manufacturing operations are allocated to the goods produced.)

     

    To illustrate insurance expense, let's assume that a service company has insurance policies for its property, general liability, vehicles, and employees' worker compensation, medical, dental, life, and disability. The company pays the premiums on the various insurance policies in advance. Any insurance premium costs that have not expired as of the balance sheet date should be reported as a current asset such as Prepaid Insurance. The costs that have expired should be reported in income statement accounts such as Insurance Expense, Fringe Benefits Expense, etc. Here's a recap for the cost of insurance at a nonmanufacturing business:

    • Expired insurance premiums are reported as Insurance Expense.
    • Unexpired insurance premiums are reported as Prepaid Insurance (an asset account).

    A manufacturer will report on its income statement the insurance expense incurred for its selling, general and administrative functions. However, the insurance costs associated with the manufacturing function will be included in the cost of the current period's output. Any prepaid insurance costs will be reported as a current asset

  • 242. What is principles of accounting?
     

    Three meanings come to mind when you ask about principles of accounting...

    1. Principles of Accounting was often the title of the introductory course in accounting. It was also common for the textbook used in the course to be entitled Principles of Accounting.
    2. Principles of accounting can also refer to the basic or fundamental accounting principles: cost principles, matching principles, full disclosure principles, materiality principles, going concern principles, economic entity principles, and so on. In this context, principles of accounting refers to the broad underlying concepts which guide accountants when preparing financial statements.
    3. Principles of accounting can also mean generally accepted accounting principles (GAAP). When used in this context, principles of accounting will include both the underlying basic accounting principles and the official accounting pronouncements issued by the Financial Accounting Standards Board (FASB) and its predecessor organizations. The official pronouncements are detailed rules or standards for specific topics.

     

  • 243. How should the cost of a yearly subscription for a newspaper be recorded?
     

    In theory, the payment in advance for a one-year subscription should initially be recorded as a debit to Prepaid Expenses and a credit to Cash. During the subscription period, you would debit Subscription Expense and would credit Prepaid Expenses.

     

    For example, if the annual subscription cost is AED 240 and it is paid in advance, you would initially debit Prepaid Expenses for AED 240 and credit Cash for AED 240. If your company issues monthly financial statements, then each month during the subscription period you would debit Subscription Expense for AED 20 and credit Prepaid Expenses for AED 20. This results in 1) the matching of AED 20 to expense on each of the monthly income statements, and 2) the balance sheet reporting the amount that is prepaid or not yet expired.

     

    At a large company, the annual cost of AED 240 will usually be an immaterial amount. The materiality concept will allow you to violate the matching principle, and to avoid the monthly adjusting entry, by simply debiting Subscription Expense for the entire AED 240 at the beginning of the one-year subscription period.

  • 244. What is a contra asset account?
     

    A contra asset account is an asset account where the balance will be either a credit balance or a zero balance. (A debit balance in a contra asset account will violate the cost principle.) Since a credit balance in an asset account is contrary to the normal or expected debit balance the account is referred to as a contra asset account.

     

    The most common contra asset account is Accumulated Depreciation. Accumulated Depreciation is associated with property, plant and equipment and it is credited when Depreciation Expense is recorded. Recording the credits in the Accumulated Depreciation means that the cost of the property, plant and equipment will continue to be reported. Reporting the accumulated depreciation separately allows the readers of the balance sheet to see how much of the cost has been depreciated and how much has not yet been depreciated.

     

    Another contra asset account is Allowance for Doubtful Accounts. This account appears next to the current asset Accounts Receivable.  The account Allowance for Doubtful Account is credited when a company enters estimated amounts as debits to Bad Debts Expense under the allowance method.  The use of Allowance for Doubtful Accounts permits a reader to see the documented amounts in Accounts Receivable that the company has a right to collect from its credit customers. The separate credit balance in the account Allowance for Doubtful Accounts tells the reader how much of the debit balance in Accounts Receivable is unlikely to be collected.

     

    A less common example of a contra asset account is Discount on Notes Receivable. The credit balance in this account is amortized or allocated to Interest Income or Interest Revenue over the life of a note receivable.

  • 245. What is the accounts receivable turnover ratio?
     

    The financial ratio accounts receivable turnover is a company's annual sales divided by the company's average balance in its Accounts Receivable account during the same period of time.

     

    For example, if a company’s sales for the most recent year were AED 6,000,000 and its average balance in Accounts Receivable for the same twelve months was AED 600,000, its accounts receivable turnover ratio is 10. This indicates that on average the company’s accounts receivables turned over 10 times during the year, or approximately every 36 days (360 or 365 days per year divided by the turnover of 10).

     

    Whether the accounts receivable turnover ratio of 10 is good or bad depends on the company's past ratios, the average for other companies in the same industry, and by the specific credit terms given to this company's customers.

     

    It is important to note that the accounts receivable turnover ratio is an average, and averages can hide important details. For example, some past due receivables could be "hidden" or offset by receivables that have paid faster than the average. If you have access to the company's details, you should review a detailed aging of accounts receivable to detect slow paying accounts.

  • 246. Kindly illustrate various depreciation methods.
     

    I will illustrate the following methods of depreciation: straight-line, units of production, double-declining balance, and sum of the years' digits. These methods can be used for financial reporting. (The depreciation methods for income tax purposes are not illustrated.)

     

    Let's assume that a plant asset has a cost of AED 100,000 with an estimated salvage value of AED 10,000. This makes the depreciable cost AED 90,000. The asset has a useful life of 5 years or the production of 100,000 parts. The asset is placed into service on January 1, 2012 and the company's accounting year is January 1 through December 31.

     

    Straight-line: Depreciable cost of AED 90,000 divided by 5 years = AED 18,000 of depreciation each year for 5 years. Download our Straight-line Form and Template.

     

    Units of production: Depreciable cost of AED 90,000 divided by 100,000 parts = AED 0.90 per part. In 2012 the company produces 12,000 parts X AED 0.90 = AED 10,800 of depreciation. In 2013 the company produces 30,000 parts X AED 0.90 = AED 27,000 of depreciation. Continue until accumulated depreciation reaches AED 90,000. Download our Units of Activity (Production) Form and Template.

     

    Double-declining balance: Straight-line depreciation rate is 20% (100% divided by 5 years). Double the straight-line rate is 40% (20% X 2). This rate is applied to the book value of the asset at the beginning of each year. (Book value is cost minus accumulated depreciation.) For the year 2012 the double-declining balance depreciation is: beginning book value of AED 100,000 X 40% = AED 40,000. In 2013 the calculation is: beginning book value of AED 60,000 X 40% = AED 24,000. Continue until the accumulated depreciation reaches AED 90,000. Download our Double Declining Balance Form and Template.

     

    Sum of the years' digits: Add the digits in the years of useful life: 5+4+3+2+1 = 15. In the first year (2012) multiply 5/15 times the depreciable cost of AED 90,000 = AED 30,000 of depreciation. In 2013 multiply 4/15 times AED 90,000 = AED 24,000. In 2014 multiply 3/15 times AED 90,000, and so on.

  • 247. How do you calculate an asset's salvage value?
     

    In the calculation of depreciation expense, the salvage value of an asset is an estimated amount, and the estimated amount is often zero. With the common assumption of no salvage value, the entire cost of an asset used in a business will be depreciated over the asset's useful life.

  • 248. What is cash from operating activities?
     

    Cash from operating activities usually refers to the net cash inflow reported in the first section of the statement of cash flows. Cash from operating activities focuses on the cash inflows and outflows from a company's main business activities of buying and selling merchandise, providing services, etc.

     

    Cash from operating activities excludes the amount spent on capital expenditures such as new equipment and new facilities, the cash used for other long-term investments, and the cash received from the sale of long-term assets. Cash from operating activities also excludes the amount paid to stockholders in dividends or to acquire treasury stock, the amounts received from issuing stock and bonds, and the amounts spent to retire bonds.

  • 249. What is the break-even point?
     

    In accounting, the break-even point refers to the revenues needed to cover a company's total amount of fixed and variable expenses during a specified period of time. The revenues could be stated in dollars (or other currencies), in units, hours of services provided, etc.

     

    The break-even calculations are based on the assumption that the change in a company's expenses is related to the change in revenues. This assumption may not hold true for the following reasons:

    • A company is likely to have many diverse products with varying degrees of profitability.
    • A company may have many diverse customers with varying demands for special attention. Hence some expenses will increase for reasons other than the sale of additional units of product.
    • A company may be selling in a variety of markets. This could result in the selling prices in one market or country being lower than the selling prices in another market or country.
    • The company may see frequent fluctuations in its sales mix.

    The basic calculation of the break-even point in sales dollars for a year is: fixed expenses (fixed manufacturing, fixed SG&A, fixed interest) for the year divided by the contribution margin ratio or percentage.

     

    The basic calculation of the break-even point in units sold for a year is: fixed expenses for the year divided by the contribution margin per unit of product.

     

    If we assume that a company's fixed expenses are AED 480,000 for a year, the variable expenses (variable manufacturing, variable SG&A, variable interest) average AED 8 per unit of product, and the selling prices average AED 20 per unit (resulting in a contribution margin of AED 12 or 60% of the selling price)...

    • the break-even point in sales dollars is AED 800,000 [AED 480,000 divided by 60%]
    • the break-even point in units of product is 40,000 [AED 480,000 divided by AED 12 per unit]
  • 250. Why does the fixed cost per unit change?
     

     

    Fixed costs such as rent or a supervisor's salary will not change in total within a reasonable range of volume or activity. For example, the rent might be AED 2,500 per month and the supervisor's salary might be AED 3,500 per month. This total fixed cost of AED 6,000 per month will be the same whether the volume is 3,000 units or 4,000 units.

     

    On the other hand, the fixed cost per unit will change as the level of volume or activity changes. Using the amounts above, the fixed cost per unit is AED 2 when the volume is 3,000 units (AED 6,000 divided by 3,000 units). When the volume is 4,000 units, the fixed cost per unit is AED 1.50 (AED 6,000 divided by 4,000 units).

  • 251. Which financial statement shows a corporation's worth?
     

    Not one of the financial statements will show a corporation's worth. The balance sheet, income statement, statement of cash flows, and stockholders' equity statement merely provide information to assist financial experts in forming an opinion of a corporation's worth.

     

    In the past, some people mistakenly thought that a corporation's stockholders' equity was the corporation's worth. However, stockholders' equity (or the owner's equity of a proprietorship) is merely the result of subtracting the reported amount of liabilities from the reported amount of assets. Since the reported amounts reflect the cost principle and other accounting principles, the net result cannot be assumed to be the company's worth.

  • 252. When should a product warranty liability be recorded?
     

    A product warranty liability and warranty expense should be recorded at the time the product is sold, if it isprobable that customers will be making claims under the warranty and the amount can be estimated. These two conditions are part of the FASB's Statement of Financial Accounting Standards No. 5, Accounting for Contingencies. You can read this pronouncement (which includes a discussion of product warranties) at www.FASB.org/st.

    When the warranty liability is both probable and can be estimated, the accountant will accrue in the period of the sale a liability and an expense for the future warranty work. (This matching of warranty expense with the related sales revenue is reasonable, since the warranty could be as important in getting the sale as the product's advertising expense.)

    When work is done under the warranty coverage, the warranty liability will be reduced. To illustrate, assume that an automobile manufacturer debits Warranty Expense for AED 1,000 and credits Warranty Liability for AED 1,000 in the period that a car is sold. When the car needs a AED 400 repair under the warranty, the manufacturer will reduce Warranty Liability by debiting the account for AED 400. (Another account, such as Cash, will be credited for the AED 400 it remits to the dealer that performed the repair work.) This will leave a liability of AED 600 for additional repairs during the remainder of the warranty period.

  • 253. In least squares regression, what do y and a represent?
     

    Here are the meanings of the components or symbols used in the least squares equation of y = a + bx:

     

    y is the dependent variable, such as the estimated or expected total cost of electricity during a month. The amount of y is dependent upon the amounts of a and bx.

     

    a is the estimated total amount of fixed electricity costs during the month. It is the value of y, when x is zero. If the total cost line intersects the y-axis at AED 1,000 then it is assumed that thetotal fixed costs for a month are AED 1,000.

     

    b is the estimated variable cost per unit of x. It determines the slope of the total cost line. If b is AED 5, this means that the variable cost portion of electricity is estimated to be AED 5 for every unit ofx.

     

    x is the independent variable. For example, x could represent the known number of machine hours used in the month.

     

    bx is the total variable cost of electricity. If the company's electricity cost is estimated to be AED 5 per unit of x, and x is 4,000 machine hours, then the total variable cost of electricity for the month is estimated to be AED 20,000.

     

    In our example the total estimated cost of electricity (y) in a month when x is 4,000 machine hours will be AED 21,000.

  • 254. What is the difference between entries in a general journal versus a general ledger?
     

     

    In short, transactions are first recorded in journals. From the journals the amounts are posted to the specified accounts in the general ledger.

     

    Let's illustrate the difference between entries to the general journal versus general ledger with the depreciation associated with a company's equipment.

     

    The depreciation on equipment is first recorded in the general journal.  A journal lists transactions in order by date and is defined as the book of original entry. To record depreciation on equipment in the amount of AED 10,000, the general journal will show a date, such as December 31, a debit to Depreciation Expense for AED 10,000 and a credit to Accumulated Depreciation for AED 10,000.

     

    The amounts in the general journal are then posted to the specified accounts, which are contained in the general ledger. In our example, the account Depreciation Expense will be debited as of December 31 for AED 10,000 and the account Accumulated Depreciation will be credited as of December 31 for AED 10,000.

  • 255. What is a contra inventory account?
     

    A contra inventory account is a general ledger account with a credit balance. The credit balance of the contra inventory account is combined with the debit balance in the inventory account when a balance sheet is prepared.

     

    If a company reports its inventory at the lower of cost or market, it often records the costs of the items in its Inventory account and uses the contra inventory account Allowance to Reduce Inventory to the Lower of Cost or Market to report a lower amount of inventory on its balance sheet. For example, if the Inventory account has a debit balance of AED 40,000 for the cost of the goods on hand at a balance sheet date, but the market (replacement cost constrained by a floor and a ceiling) is AED 37,000, the Allowance account will be adjusted to show a credit balance of AED 3,000.

  • 256. What is a contingent liability?
     

    A contingent liability is a potential liability...it depends on a future event occurring or not occurring. For example, if a parent guarantees a daughter's first car loan, the parent has a contingent liability. If the daughter makes her car payments and pays off the loan, the parent will have no liability. If the daughter fails to make the payments, the parent will have a liability.

    If a company is sued by a former employee for AED 500,000 for age discrimination, the company has a contingent liability. If the company is found guilty, it will have a liability. However, if the company is not found guilty, the company will not have an actual liability.

    In accounting, a contingent liability and the related contingent loss are recorded with a journal entry only if the contingency is both probable and the amount can be estimated.

    If a contingent liability is only possible (not probable), or if the amount cannot be estimated, a journal entry is not required. However, a disclosure is required.

    When a contingent liability is remote (such as a nuisance suit), then neither a journal nor a disclosure is required.

    A product warranty is often cited as a contingent liability that is both probable and can be estimated.

  • 257. Where are accruals reflected on the balance sheet?
     

    Accrued expenses are reported in the current liabilities section of the balance sheet. Accrued expenses reported as current liabilities are the expenses that a company has incurred as of the balance sheet date, but have not yet been recorded or paid. Typical accrued expenses include wages, interest, utilities, repairs, bonuses, and taxes.

     

    Accrued revenues are reported in the current assets section of the balance sheet. The accrued revenues reported on the balance sheet are the amounts earned by the company as of the balance sheet date that have not yet been recorded and the customers have not yet paid the company.

     

    Accrued expenses and accrued revenues are also reflected in the income statement and in the statement of cash flows prepared under the indirect method. However, these financial statements reflect a time period instead of a point in time.

  • 258. What is the acid test ratio?
     

    The acid test ratio is similar to the current ratio except that Inventory, Supplies, and Prepaid Expenses areexcluded. In other words, the acid test ratio compares the total of the cash, temporary marketable securities, andaccounts receivable to the amount of current liabilities.

     

    Let's illustrate the acid test ratio by assuming that a company has cash of AED 7,000 + temporary marketable securities of AED 20,000 + accounts receivables of AED 93,000. This adds up to AED 120,000 of quick assets. If its current liabilities amount to AED 100,000 its acid test ratio is 1.2:1.

     

    The larger the acid test ratio, the more easily will the company be able to meet its current obligations.

  • 259. What is a debit balance?
     

    In accounting, a debit balance is the ending amount found on the left side of a general ledger account or subsidiary ledger account.

     

    A debit balance is normal and expected for the following accounts:

    • Asset accounts such as Cash, Accounts Receivable, Inventory, Prepaid Expenses, Buildings, Equipment, etc. For example, a debit balance in the Cash account indicates a positive amount of cash. (Therefore, a credit balance in Cash indicates a negative amount likely caused by writing checks for more than the amount of money currently on hand.)
    • Expense accounts and loss accounts including Cost of Goods Sold, Wages Expense, Rent Expense, Interest Expense, Loss on Disposal of Equipment, Loss from Lawsuit, etc. (The debit balances in these accounts will be transferred to Retained Earnings or to the proprietor's capital account at the end of each accounting year.)
    • Contra-revenue accounts including Sales Discounts, Sales Returns, etc. (The debit balances in these accounts allow for the reporting of both the gross and net amounts of sales. These balances will also be transferred to an equity account at the end of each accounting year.)
    • Contra-liability accounts such as Discount on Bonds Payable. (This debit balance allows for the presentation of both the maturity value and the book or carrying value of the bonds.)
    • Contra-equity accounts such as the owner's drawing account and Treasury Stock. (The debit balance in the drawing account will be closed to the owner's capital account thereby reducing its balance at the end of each year. The debit balance in Treasury Stock serves as a reduction to the total amount of Stockholders' Equity.)
  • 260. What are the effects of overstating inventory?
     

    If a corporation overstates its inventory, it will also be overstating its gross profit and net income as well as its current assets, total assets, retained earnings, stockholders' equity, and all of the related financial ratios.

     

    The gross profit and net income are overstated as a result of overstating inventory because not enough of the cost of goods available is being charged to the cost of goods sold. The higher amount of net income means that the reported amount of retained earnings and stockholders' equity is also too high.

     

    Since the overstated amount of inventory at the end of one accounting period becomes the beginning inventory of the following period, the following period's cost of goods sold will be too high and will result in the period's gross profit and net income being too low. (The retained earnings and other balance sheet amounts will be correct at the end of the second period.)

  • 261. Would you please explain unearned income?
     

     

    Unearned income or unearned revenue occurs when a company receives money before the money is earned. This is also referred to as deferred revenues or customer deposits. The unearned amount is recorded in a liability account such as Unearned Revenues, Deferred Revenues, or Customer Deposits. After the amount has been earned, the liability account is reduced and a revenue account is increased.

    Example 1. A lawn service company offers customers a special package of five applications of fertilizers and weed treatments for AED 200 if the customer prepays in March. The service will be provided in April, May, June, July, and September. When the company receives AED 200 in March, it will debit the asset Cash for AED 200 and will credit the liability account Unearned Revenues. Since these are balance sheet accounts (and since no work has yet been performed), no revenue is reported in March. In April when the first service is provided, the company will debit the liability account Unearned Revenues for AED 40 and will credit the income statement account Service Revenues for AED 40. At the end of April, the balance sheet will report the company's remaining liability of AED 160. Theincome statement for April will report that AED 40 was earned. The AED 40 entry is referred to as an adjusting entry and the same entry will be recorded in May, June, July, and September.

    Example 2. A company informs a customer that a AED 5,000 deposit is required before it will begin work on the customer's special order. The customer gives the company AED 5,000 on December 28 and the company will begin work on the special order on January 3. On December 28 the company will debit Cash for AED 5,000 and will credit a liability account, such as Customer Deposits (or Unearned Revenues or Deferred Revenues) for AED 5,000. No revenue is reported in December for this special order since the company did not perform any work. When the special order is completed in January the company will debit the liability account for AED 5,000 and will credit a revenue account.

     

  • 262. What is reported as property, plant and equipment?
     

    Property, plant and equipment is the long term or noncurrent asset section of the balance sheet. Included in this classification are land, buildings, machinery, office equipment, vehicles, furniture and fixtures used in a business. Also included in property, plant and equipment is the accumulated depreciation for these assets (except for land, which is not depreciated).

     

    The assets reported as property, plant and equipment are described as long-lived, tangible assets. They are also described as fixed assets or as plant assets.

     

    Generally, the property, plant and equipment assets are reported at their cost followed by a deduction for the accumulated depreciation that applies to all of these assets.

  • 263. In standard costing, how is the purchase price variance reclassified to arrive at actual cost?
     

    I assume that the purchase price variance was recorded at the time that the raw materials were purchased. If that price variance is significant, it should be reclassified to the following: raw materials inventory, work-in-process inventory, finished goods inventory, and cost of goods sold. The reclassification is also known as prorating the variance or allocating the variance.

     

    The reclassification of the purchase price variance should be based on the location of the raw materials which had created the price variance. If those raw materials were recently purchased and are entirely in the raw materials inventory, then all of the price variance should be assigned to the raw materials inventory. If the price variance occurred throughout the year, the variance should be assigned to the raw materials inventory, work-in-process inventory, finished goods inventory, and cost of goods sold based on the quantity of the raw materials in each of these categories.

     

    If the amount of the purchase price variance is very small and/or the inventory turnover rates are very high, the entire amount of the price variance might be reclassified entirely to the cost of goods sold.

  • 264. What is the difference between notes payable and notes receivable?
     

    A written promissory note is a note payable for the borrower and it is a note receivable for the lender. Hence, the promissory note is a liability for the borrower and it is an asset for the lender.

     

    To illustrate, let's assume that Local Retailer borrows AED 20,000 from its bank and signs a promissory note. Local Retailer records AED 20,000 in its liability account Notes Payable and also records the AED 20,000 in its Cash account. The bank records the AED 20,000 promissory note in its asset account Notes Receivable and it records the AED 20,000 increase in its customer's checking account (which is a liability account on the bank's balance sheet).

     

    Since the promissory note is a contract to pay interest at a specified date, it requires Local Retailer to report interest expense in each accounting period and to report interest payable for any interest owed at the end of an accounting period. The bank is required to report interest revenue in each accounting period and to reportinterest receivable for any interest it has earned but has not received as of the end of each accounting period.

  • 265. What is the current ratio?
     

     

    The current ratio is a financial ratio that shows the proportion of current assets to current liabilities. The current ratio is used as an indicator of a company's liquidity. In other words, a large amount of current assets in relationship to a small amount of current liabilities provides some assurance that the obligations coming due will be paid.

     

    If a company's current assets amount to AED 600,000 and its current liabilities are AED 200,000 the current ratio is 3:1. If the current assets are AED 600,000 and the current liabilities are AED 500,000 the current ratio is 1.2:1. Obviously a larger current ratio is better than a smaller ratio. Some people feel that a current ratio that is less than 1:1 indicates insolvency.

     

    It is wise to compare a company's current ratio to that of other companies in the same industry. You are also wise to look at the trend of the current ratio for a given company over time. Is the current ratio improving over time, or is it deteriorating?

     

    The composition of the current assets is also an important factor. If the current assets are predominantly in cash,marketable securities, and collectible accounts receivable, that is more comforting than having the majority of the current assets in slow-moving inventory.

  • 266. What is capitalized interest?
     

    Capitalized interest is the interest added to the cost of a self-constructed, long-term asset. It involves the interest on debt used to finance the asset's construction.

     

    The details of capitalized interest are explained in the Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standards No. 34, Capitalization of Interest Cost. You can find this accounting pronouncement at www.FASB.org/st.

     

    In short, there must be debt involved (cash and common stock are not considered). The interest specified by the pronouncement is added to the cost of the project, instead of being expensed on the current period's income statement. This capitalized interest will be part of the asset's cost reported on the balance sheet, and will be part of the asset's depreciation expense that will be reported in future income statements.

  • 267. What is interest payable?
     

    Interest payable is the interest expense that has been incurred (has already occurred) but has not been paid as of the date of the balance sheet. (The interest payable amount does not include the interest for the periods of time which follow the date of the balance sheet.)

     

    To illustrate interest payable, let's assume that on December 1 a company borrowed AED 100,000 at an annual interest rate of 12%. The company agrees to pay the principal and 9 months of interest when the note comes due on August 31.

     

    On December 31 the amount of interest payable is AED 1,000 (AED 100,000 X 12% X 1/12) and the company's balance sheet should report the following current liabilities:

    • Notes payable of AED 100,000
    • Interest payable of AED 1,000

    The future interest of AED 8,000 (for January through August) is not reported as a liability as of December 31.

     

     

    The company's January 31 balance sheet should report the following current liabilities:

    • Notes payable of AED 100,000
    • Interest payable of AED 2,000

    The future interest of AED 7,000 (for February through August) is not reported as a liability as of January 31.

  • 268. What is a fixed budget?
     

    A fixed budget is a budget that does not change or flex when sales or some other activity increases or decreases. A fixed budget is also referred to as a static budget.

     

    To illustrate a fixed budget, let's assume that a company pays commission on its sales at a rate of 5%. If the company prepares a fixed budget and it is projecting sales of AED 1 million, its budget for sales commissions will be fixed at AED 50,000. If the actual sales end up being only AED 900,000 the budget for commissions will remain unchanged at the fixed amount of AED 50,000.

     

    If instead the company used a flexible budget, its budget for sales commissions would be expressed as 5% of sales. This means that the budget for sales commissions will be AED 50,000 only when sales are AED 1 million. If sales are actually AED 900,000, the budget for sales commissions will flex and will be AED 45,000 (5% of AED 900,000).

  • 269. How do I calculate the cost of goods sold for a manufacturing company?
     

    The calculation of the cost of goods sold for a manufacturing company is: Beginning Finished Goods Inventory + Cost of Goods Manufactured = Finished Goods Available for Sale – Ending Finished Goods Inventory = Cost of Goods Sold.

     

    The formula can be rearranged to read: Cost of Goods Manufactured +/- the change in Finished Goods Inventory = Cost of Goods Sold. If the Finished Goods Inventory decreased, then the amount of this decrease is added to the Cost of Goods Manufactured. If the Finished Goods Inventory increased, then the amount of this increase is deducted from the Cost of Goods Manufactured.

  • 270. How are period costs reported in the financial statements?
     

    Under the accrual method of accounting, period costs such as selling, general and administrative expenses are reported on the income statement in the accounting period in which they are used up or expire. They are referred to as period costs because they are not assigned to products, and therefore cannot be included in the cost of items held in inventory.

     

    If a selling, general and administrative (SG&A) expense is prepaid, the prepaid portion will be reported as a current asset. When the prepaid expense expires, it will move to the income statement and become part of that period's SG&A expenses.

     

    Interest expense is also a period cost unless it is determined to be a necessary cost of a self-constructed, long-lived asset.

  • 271. Where do credit card payments get recorded?
     

    .

    The payment to the credit card company will result in a decrease in the Cash account. This is achieved by crediting Cash. The debit amount or amounts will depend on whether the credit card transactions were previously entered in the accounting records.

     

    For example, if the credit card purchases had not been previously entered, then there will be debits to the accounts that are appropriate for the charges. Let's assume that one credit card transaction was for an enrollment fee for a seminar. That amount might be debited to Seminars & Conventions Expense. If the other credit card transactions were for airline tickets and hotels, you might debit the account Travel Expenses for those amounts.

     

    However, it is possible that the credit card bill was recorded in the accounts prior to paying the credit card bill. Using the example above, the accountant may have debited Seminars & Convention Expenses and Travel Expense, and credited Credit Card Payable at the time the bill or statement was received. If the credit card bill is paid two weeks later, the payment will be recorded with a debit to Credit Card Payable and a credit to Cash.

  • 272. Is there a relationship between direct materials variances and direct labor variances?
     

    There can be a connection between the direct materials variances and the direct labor variances. In fact, there can be a relationship between many of the variances.

     

    Let's assume that a lower costing material is purchased in order to achieve a favorable materials price variance. If the materials have some negative attributes, it is possible that an unfavorable materials usage variance could result. If the materials' attributes cause additional labor hours, then an unfavorable direct labor efficiency variance will result. If the materials required more experienced labor, it is possible that a labor rate variance will also occur.

     

    The above example can also extend to the overhead variances. If more electricity and supplies had to be used because of the materials' attributes, there will be an unfavorable variable overhead efficiency variance. If the volume of output is curtailed by the materials' attributes, there could possibly be a fixed overhead volume variance.

     

    Companies should have specifications for its materials in order to prevent the above situation from occurring.

  • 273. Is a loan's principal payment included on the income statement?
     

    A loan's principal payment will not be included on the income statement. The principal payment is a reduction of a liability, such as Notes Payable or Loans Payable, which is reported on the balance sheet. The principal payment will also be reported as a cash outflow on the Statement of Cash Flows.

     

    Only the interest portion of a loan payment is reported on the income statement, and it is reported as Interest Expense.

  • 274. What is meant by events after the balance sheet date?
     

    Events after the balance sheet date are significant financial events that occur after the date of the balance sheet, but prior to the date that the financial statements are issued. For example, a company's balance sheet that has the heading of December 31, 2012 might not be finalized and distributed until February 1, 2013. During January new information may arise that has financial significance. Perhaps there is an event that provides more information about the conditions actually existing on December 31. The second type of event would be a new January event that does not change the December 31 amounts, but needs to be disclosed to the readers of the December 31 financial statements.

     

    An example of the first situation might be that a customer owes Jay Company AED 200,000 on December 31 and Jay Company assumed that the customer was financially sound. As a result Jay Company did not provide any allowance for the customer's account being uncollectible. Then on January 28, the customer filed for bankruptcy and Jay Company learns that none of the AED 200,000 receivable will be collected. If the customer's financial condition on December 31 was already in bankruptcy condition, Jay Company will need to adjust its December 31 balance sheet and its income statement for the year 2012 for this AED 200,000 of bad debts expense.

     

    An example of the second situation might be a loss arising from a catastrophe occurring on January 16, 2013. The amounts reported as of December 31, 2012 will not be adjusted since those amounts were correct as of December 31. However, the readers of the December 31 balance sheet and the 2012 income statement should be informed through a disclosure that something significant has occurred to the company's financial position since December 31.

     

    The events after the balance sheet date are often referred to as subsequent events or post balance sheet events.

  • 275. Are dividend payments shown as an expense on the income statement?
     

    A corporation's dividends are not an expense and therefore will not appear on its income statement. Cash dividends are a distribution of part of a corporation's earnings that are being paid to its stockholders.

    When a corporation has preferred stock, the dividends on preferred stock are deducted from a corporation's net income in order to arrive at earnings available for common stock. Earnings available for common stock is reported on the income statement. It is also used to calculate the common stock's earnings per share. The earnings per share figure is reported on the income statement when the corporation's stock is publicly traded.

  • 276. What is a credit memo?
     

    One type of credit memo is issued by a seller in order to reduce the amount that a customer owes from a previously issued sales invoice. For instance, assume that SellerCorp had issued a sales invoice for AED 800 for 100 units of product that it shipped to BuyerCo at a price of AED 8 each. BuyerCo informs SellerCorp that one of the units is defective and SellerCorp issues a credit memo for AED 8. The credit memo will cause the following in SellerCorp's accounting records: 1)  a debit of AED 8 to Sales Returns and Allowances, and 2) a credit of AED 8 to Accounts Receivable. In other words, the credit memo reduced SellerCorp's net sales and its accounts receivable. When BuyerCo records the credit memo, the following will occur in its accounting records: 1) a debit of AED 8 to Accounts Payable, and 2) a credit of AED 8 to Purchases Returns and Allowances (or Inventory).

     

    Another type of credit memo, also referred to as a credit memorandum, is issued by a bank when it increases a depositor's checking account for a certain transaction.

  • 277. What are goods in transit?
     

    Goods in transit refers to merchandise and other inventory items that have been shipped by the seller, but have not yet been received by the purchaser.

     

    To illustrate goods in transit, let's use the following example. Company J ships a truckload of merchandise on December 30 to Customer K, which is located 2,000 miles away. The truckload of merchandise arrives at Customer K on January 2. Between December 30 and January 2, the truckload of merchandise is goods in transit. The goods in transit requires special attention if the companies issue financial statements as of December 31. The reason is that the merchandise is the inventory of one of the two companies, but the merchandise is not physically present at either company. One of the two companies must add the cost of the goods in transit to the cost of the inventory that it has in its possession.

     

    The terms of the sale will indicate which company should report the goods in transit as its inventory as of December 31. If the terms are FOB shipping point, the seller (Company J) will record a December sale and receivable, and will not include the goods in transit as its inventory. On December 31, Customer K is the owner of the goods in transit and will need to report a purchase, a payable, and must add the cost of the goods in transit to the cost of the inventory which is in its possession.

     

    If the terms of the sale are FOB destination, Company J will not have a sale and receivable until January 2. This means Company J must report the cost of the goods in transit in its inventory on December 31. (Customer K will not have a purchase, payable, or inventory of these goods until January 2.)

  • 278. In what order are liabilities listed in the chart of accounts?
     

    The order of liabilities is not as structured as that of assets. Current liabilities will be listed first, but the order within current liabilities will vary from company to company.

     

    Some companies will list the current liabilities in this order: 1) short-term notes or loans payable, 2) current portions of long-term debt, 3) accounts payable, 4) payroll related liabilities, 5) other accrued expenses, and 6) income taxes payable. Other companies will list its accounts payable ahead of its short-term debt.

     

    After the current liabilities are listed, the long-term or noncurrent liabilities will be listed. This might include long-term debt, bonds payable, and deferred income taxes.

     

    In short, I would arrange the chart of accounts in the order that the accounts will appear on the balance sheet and income statement.

  • 279. What is meant by accounts written off?
     

    Accounts written off often refers to the accounts receivable that were deemed to be uncollectible and were removed from a receivable account in the general ledger. For example, a manufacturer may have written off an accounts receivable because a customer filed for bankruptcy and has insufficient assets. In this situation the account balance is written off with 1) a credit to Accounts Receivable, and 2) a debit to Allowance for Doubtful Accounts or Bad Debts Expense.

     

    Banks, credit card companies, hospitals, and other organizations will also remove uncollectible accounts from their receivables and will refer to them as accounts written off.

  • 280. Are LIFO inventory amounts ever written-up to their market value?
     

    LIFO inventory amounts will not be written-up, even when the current market value of the inventory is far greater than the amount reported on the balance sheet.

     

    The reason inventory is not increased to its current value is the cost principle, the cost flow assumption, consistency, and other accounting concepts and principles. When a company elects the LIFO cost flow assumption, it chooses to put its most recent costs in the cost of goods sold, and to leave its earlier costs in inventory. The company cannot violate the cost principle by later increasing the inventory to an amount that is greater than those earlier actual costs.

     

    One place that you might find part of the difference between the LIFO cost reported on the balance sheet and its current market value is the "Inventories" footnote to the financial statements. For example, in General Electric's 2011 Annual Report to the SEC (Form 10-K), it indicates that if General Electric had not been using LIFO (for many years), its balance sheet inventory amount would have been greater by AED 450 million. That does not mean that the difference between its inventory cost and its market value is AED 450 million, but I suspect that it is part of the difference.

  • 281. What is the difference between a trial balance and a balance sheet?
     

    A trial balance is an internal report that will remain in the accounting department. It is a listing of all of the accounts in the general ledger and their balances. However, the debit balances are entered in one column and the credit balances are entered in another column. Each column is then summed to prove that the total of the debit balances is equal to the total of the credit balances.

     

    A balance sheet is one of the financial statements that will be distributed outside of the accounting department and is often distributed outside of the company. The balance sheet is organized into sections or classifications such as current assets, long-term investments, property, plant and equipment, other assets, current liabilities, long-term liabilities, and stockholders' equity. Only the asset, liability, and stockholders' equity account balances from the general ledger or from the trial balance are then presented in the appropriate section of the balance sheet. Totals are also provided for each section to assist the reader of the balance sheet. The balance sheet is also referred to as the statement of financial position or the statement of financial condition.

  • 282. What is safety stock?
     

    Safety stock is an additional quantity of an item held in inventory in order to reduce the risk that the item will be out of stock. Safety stock acts as a buffer in case the sales of an item are greater than planned and/or the supplier is unable to deliver additional units at the expected time.

     

    There are additional holding costs associated with safety stock. However, the holding costs could be less than the cost of losing a customer if the customer's order cannot be filled.

  • 283. What is a journal entry?
     

    In manual accounting or bookkeeping systems, business transactions are first recorded in a journal...hence the term journal entry.

     

    A manual journal entry that is recorded in a company's general journal will consist of the following:

    • the appropriate date
    • the amount(s) and account(s) that will be debited
    • the amount(s) and account(s) that will be credited
    • a short description/memo
    • a reference such as a check number

    These journalized amounts (which will appear in the journal in order by date) are then posted to the accounts in the general ledger.

     

    Today, computerized accounting systems will automatically record most of the business transactions into the general ledger accounts immediately after the software prepares the sales invoices, issues checks to creditors, processes receipts from customers, etc. The result is we will not see journal entries for most of the business transactions.

     

    However, we will need to process some journal entries in order to record transfers between bank accounts and to record adjusting entries. For example, it is likely that at the end of each month there will be a journal entry to record depreciation. (This will include a debit to Depreciation Expense and a credit to Accumulated Depreciation.) In addition, there will likely be a need for journal entry to accrue interest on a bank loan. (This will include a debit to Interest Expense and a credit to Interest Payable.)

  • 284. What is the meaning of arrears?
     

    In accounting we use the word arrears in at least two ways. One use involves the omitted dividends on cumulative preferred stock. For example, if a corporation has cumulative preferred stock and due to a shortage of cash decides to omit the dividend on those preferred shares, the preferred dividend is in arrears. The result of having these dividends in arrears is that the owners of the common stock cannot receive a dividend until the preferred stock's dividends in arrears are paid and the preferred stock's current year dividend is also paid. Having dividends in arrears also requires a disclosure in the notes to the financial statements.

     

    Arrears is also used in the context of annuities. When an annuity's equal payments occur at the end of each period, the annuity is said to be an annuity in arrears or an ordinary annuity.

     

    Arrears is also used to simply mean past due, or behind in payments.

  • 285. How do I record exterior cement work? Is it an asset or an expense?
     

    If the cement work was done to repair or maintain existing cement work, then the expenditure should be recorded as an expense. Even if the cost is very large, repairs and maintenance must be expensed. The cost of repairs or maintenance cannot be recorded as an asset.

     

    If the cement work is an addition or an improvement (more than repairing or maintaining existing cement work), the cost of the cement work is viewed as a new asset. If the amount is significant, you should record the expenditure as an asset and then depreciate the cost over the useful life. However, if the amount of the addition or the improvement is relatively small, the accounting concept of materiality allows you to expense the entire amount immediately.

  • 286. Is a loan payment an expense?
     

    Often a loan payment consists of both an interest payment and a payment to reduce the loan's principal balance. The interest portion is an expense whereas the principal portion is a reduction of a liability such as Loans Payable or Notes Payable.

     

    If a company uses the accrual method of accounting, it is logical to record the interest expense and the interest liability at the end of each accounting period (instead of recording the interest expense when the payment is made). This is done with an adjusting entry in order to match the interest expense to the appropriate accounting period. It also results in the reporting of a liability for the amount of interest that the company owes as of the date of the balance sheet.

  • 287. What is the times interest earned ratio?
     

    The times interest earned ratio is an indicator of a company's ability to meet the interest payments on its debt. The times interest earned calculation is a corporation's income before interest and income tax expense, divided by interest expense.

     

    To illustrate the times interest earned ratio, let's assume that a corporation's net income after tax was AED 500,000; its interest expense was AED 200,000; and its income tax expense was AED 300,000. Given these assumptions, the corporation's income before interest and income tax expense is AED 1,000,000 (net income of AED 500,000 + interest expense of AED 200,000 + income tax expense of AED 300,000). Since the interest expense was AED 200,000, the corporation's times interest earned is 5 (AED 1,000,000 divided by AED 200,000).

     

    The higher the times interest earned ratio, the more likely it is that the corporation will be able to meet its interest payments.

  • 288. What would be a brief description of activity based costing?
     

    Activity based costing (ABC) is a more sophisticated and logical way to allocate a company's costs to its products (or other objects) than traditional costing. (Traditional costing might allocate all of the overhead costs solely on the basis of machine hours.) Activity based costing identifies the many activities that actually cause the company to consume resources. Next, it calculates the cost of each of the activities. Then it assigns each activity's cost only to the products that actually use the activities. Obviously this is important when some products require few activities, and other products require many activities.

     

    In the case of a manufacturer, some products may require special engineering, sophisticated testing, unique storage arrangements, and are low-volume items. Other products might be high-volume items that run continuously and require no special attention. In other words, some products require lots of activities(engineering, testing, storing, many machine setups, and running the production machine), while some products require just one activity–running the production machine. Under activity based costing, the products that require the activities mentioned above will be assigned the costs of engineering, testing, storing, setups, and producing activities. The products that run continuously will not be assigned costs for engineering, etc. These products will only be assigned the cost of the production activity. (If activities were not considered, and all costs were allocated solely on machine hours, the high-volume, easy-to-manufacture products would be assigned an enormous amount of overhead, and the low-volume, activity-intensive products would be assigned too little overhead cost.)

     

    Activity based costing is useful for service businesses as well as manufacturers. The process of identifying and determining the cost of activities can lead to improvements in a company's operations.

  • 289. What is a classified balance sheet?
     

    A classified balance sheet is one that arranges the balance sheet accounts into a format that is useful for the readers. For example, most balance sheets use the following asset classifications:

    • current
    • long-term investments
    • property, plant and equipment
    • intangible assets
    • other assets

    Liabilities are usually classified as:

    • current, or
    • long-term or noncurrent asset.
  • 290. What is lead time in purchasing?
     

    In purchasing, lead time is the estimated time between ordering goods and receiving the goods. For instance, if 100 units of Product X are ordered on April 11 and are expected to be received on April 25, the lead time is 14 days.

     

    The estimated lead time is one of the factors used in calculating the reorder point of items carried in inventory.

  • 291. How do you calculate the cost of carrying inventory?
     

    The cost of carrying or holding inventory is the sum of the following costs:

    1. Money tied up in inventory, such as the cost of capital or the opportunity cost of the money.
    2. Physical space occupied by the inventory including rent, depreciation, utility costs, insurance, taxes, etc.
    3. Cost of handling the items.
    4. Cost of deterioration and obsolescence.

    Often the costs are computed for a year and then expressed as a percentage of the cost of the inventory items. For example, a company might express the holding costs as 20%. If the company has AED 300,000 of inventory cost, its cost of carrying or holding the inventory is estimated to be AED 60,000 per year.

     

    The cost of carrying inventory will vary from company to company. For instance, if a company has a large cash balance with no attractive investment options, has excess space for storage, and its products have a low probability for deterioration or obsolescence, the company's holding or carrying costs are very low. A company with enormous debt, little space, and products subject to deterioration will have very high holding costs.

     

    For decision making, such as determining the economic order or production quantity, it is important to determine the incremental holding costs for a year. In other words, what will be theadditional holding costs expressed as an annual cost for the items being purchased or produced.

  • 292. What is a liability account?
     

    A liability account is a general ledger account in which a company records its debt, obligations, customer deposits and customer prepayments, certain deferred income taxes, etc. that are the result of a past transaction. Common liability accounts under the accrual method of accounting include Accounts Payable, Accrued Liabilities (amounts owed but not yet recorded in Accounts Payable), Notes Payable, Unearned Revenues, Deferred Income Taxes (certain temporary timing differences), etc.

     

    The balances in liability accounts are nearly always credit balances and will be reported on the balance sheet as either current liabilities or noncurrent (or long-term) liabilities.

     

    The company with the liability account for the debt or payables is known as the debtor. The lenders, vendors, suppliers, employees, tax agencies, etc. who are owed the money are known as the company's creditors.

  • 293. What is an imprest system of petty cash?
     

    An imprest system of petty cash means that the general ledger account Petty Cash will remain dormant at a set amount. For example, if the petty cash custodian is entrusted with a locking bag containing AED 100 of currency and coins, then the Petty Cash account will always report a debit balance of AED 100. This AED 100 is the imprest balance. As long as AED 100 is adequate for the organization's small disbursements, then the general ledger account Petty Cash will never have an entry again.

     

    When the coins and currency in the locking bag get low, the petty cash custodian will request a check to replenish the coins and currency that were disbursed. Since the requested check is drawn on the organization's checking account, the Cash account (not the Petty Cash account) will be credited. The debits will go to the expense accounts indicated by the petty cash receipts, e.g. postage expense, supplies expense. In other words, the general ledger account Petty Cash is not involved in the replenishment. (Replenishment means getting the total of the coins and currency in the locking bag back to AED 100.)

     

    Under the imprest system, the petty cash custodian should at all times have a combination of coins, currency, and petty cash receipts equal to AED 100, the imprest amount.

     

    Control occurs through the review of the petty cash receipts attached to each check request for replenishment. It also occurs by occasionally confirming that the items in the locking bag do indeed add up to the imprest amount.

  • 294. What is the journal entry to record a one-year subscription for a magazine?
     

    Let's assume that the cost of the one-year subscription for a monthly magazine is AED 24. Let's also assume the payment is made at the start of the subscription period, and that  your company prepares monthly financial statements.

     

    One way to enter the transaction is to debit the current asset Prepaid Subscriptions for AED 24 and to credit Cash for AED 24. At the end of each month you would make an adjusting entry to debit Subscriptions Expense for AED 2 and to credit Prepaid Subscriptions for AED 2. This approach would obviously match the annual cost to each of the 12 periods benefiting from the subscription. However, this is not practical given the small amount involved.

     

    Thanks to the accounting concept of materiality, accountants can ignore the matching principle when the amount is insignificant in relationship to the company's size. Since no investor or lender would be misled if the entire AED 24 appeared as an expense in one month and AED 0 appeared in the other 11 months, the following entry would be more practical: debit Subscriptions Expense for AED 24 and credit Cash for AED 24 at the time of entering the invoice into the accounting records.

     

    If the annual subscription was AED 8,400 for a trade journal and other membership services, a small company will likely find that amount to be significant and should not expense the entire amount in one month.

  • 295. What is capital stock?
     

    Capital stock is the combination of a corporation's common stock and preferred stock (if any).

     

    Common stock is usually the first and only capital stock issued by corporations. However, some corporations will also issue preferred stock.

     

    The amount received by the corporation when it issued shares of its capital stock is reported in the stockholders' equity section of the balance sheet.

  • 296. What causes a reduction in Accumulated Depreciation?
     

    The balance in the account Accumulated Depreciation will be reduced when an asset that has been depreciatedis removed.

     

    When an asset is sold, the depreciation expense is first recorded up to the date of the sale. Then the asset and its accumulated depreciation is removed and the proceeds are recorded.

     

    Here's an example. A company has Equipment of AED 600,000 and Accumulated Depreciation of AED 380,000 before an item of equipment is sold. The original cost of the equipment being sold was AED 50,000. The first step is to record the current period's depreciation on that one item. Let's assume the depreciation will be AED 500. Let's also assume that after it is recorded, the item's accumulated depreciation will be AED 40,500. The company receives AED 5,000 for the equipment. The journal entry to record the disposal will consist of a debit to Cash for AED 5,000; a debit to Accumulated Depreciation for AED 40,500; a debit to Loss of Disposal of Asset for AED 4,500; a credit to Equipment for AED 50,000.

     

    Prior to this transaction, the balance in the Accumulated Depreciation account was a credit balance of AED 380,000. The asset's current period depreciation of AED 500 increased the account's credit balance to AED 380,500. The disposal of the asset will reduce the balance in Accumulated Depreciation by AED 40,500 to a new balance of AED 340,000.

     

  • 297. What is petty cash?
     

    Petty cash is a small amount of cash on hand that is used for paying small amounts owed, rather than writing a check. Petty cash is also referred to as a petty cash fund. The person responsible for the petty cash is known as the petty cash custodian.

     

    Some examples for using petty cash include the following: paying the postal carrier the 17 cents due on a letter being delivered, reimbursing an employee AED 9 for supplies purchased, or paying AED 14 for bakery goods delivered for a company's early morning meeting.

     

    The amount in a petty cash fund will vary by organization. For some, AED 50 is adequate. For others, the amount in the petty cash fund will need to be AED 200.

     

    When the cash in the petty cash fund is low, the petty cash custodian requests a check to be cashed in order to replenish the cash that has been paid out.

  • 298. What is capital surplus?
     

    In the past, capital surplus was used to describe what is now referred to as paid-in capital in excess of par.

     

    For example, when a corporation issues shares of its common stock and receives more than the par value of the stock, two accounts are involved: 1) the account Common Stock is used to record the par value of the shares being issued, and 2) the amount that is greater than the par value is recorded in an account entitled Paid-in Capital in Excess of Par—Common Stock, or Premium on Common Stock.

     

    Many years ago, the account Paid-in Capital in Excess of Par—Common Stock and the account Premium on Common Stock were referred to as capital surplus.

  • 299. What is a nominal account in accounting?
     

    Nominal accounts in accounting are the temporary accounts, such as the income statement accounts. In other words, nominal accounts are the accounts that report revenues, expenses, gains, and losses. (The owner's drawing account is also a temporary account, even though it is not an income statement account.)

     

    Nominal or temporary accounts are closed at the end of each accounting year. This means that their account balances are transferred to a permanent account. This closing process allows the nominal accounts to start the next accounting year with zero balances.

     

    The balances from the income statement accounts will end up in the owner's equity account, if the enterprise is asole proprietorship. If the business is a corporation, the balances will end up in the retained earnings account.

     

  • 300. How can a company have a profit but not have cash?
     

    A company can have a profit but not have cash because profit is computed using revenues and expenses, which are different from the company's cash receipts and cash disbursements. In other words, there is a difference between revenues and receipts. There is also a difference between expenses and expenditures.

     

    To illustrate, let's assume that a new company uses the accrual method of accounting. It provides AED 10,000 of services to its clients in its first month and the clients are allowed to pay in 30 days. The company will have AED 10,000 of revenues in its first month, but the cash will not be received until the second month. If the company's expenses are AED 7,000 in the first month, the company will report a profit of AED 3,000 but will not have received any cash from its clients.

     

    Another company might have a profit of AED 60,000 in its first year, but during its first year it uses AED 65,000 of cash to acquire equipment that will be put into service at the beginning of the second year. This company will have a profit, but will not have the cash.

     

    Other examples where cash is paid out, but the profits are not reduced at the time of the payment, include prepayments of insurance, payments to increase the inventory of merchandise on hand, and payments to reduce liabilities.

  • 301. What is net income?
     

    In business, net income is the positive result of 1) revenues and gains minus 2) expenses and losses. A negative result is referred to as net loss. (Please note that some gains and losses are not included in the calculation of net income, but will be included in comprehensive income).

     

    Net income is also known as net earnings. The details of the net income calculation is reported in the business's income statement. The income statement is also known as the statement of income, statement of earnings, and statement of operations.

     

    The net income of a regular U.S. corporation includes the income tax expense which pertains to the items reported in its income statement. The net income of a sole proprietorship, partnership, and Subchapter S corporation will not include income tax expense since the owners (and not the entity) are responsible for the business income tax.

     

    A corporation's net income will cause an increase in the Retained Earnings account, which will also result in an increase in stockholders' equity. A net loss will cause a decrease.

     

    A sole proprietorship's net income will cause an increase in the owner's capital account, which will also mean an increase in owner's equity. A net loss will cause a decrease.

  • 302. What is a petty cash voucher?
     

    A petty cash voucher is usually a small form that is used to document a disbursement (payment) from a petty cash fund. Petty cash vouchers are also referred to as petty cash receipts and can be purchased from office supply stores.

     

    The petty cash voucher should provide space for the date, amount disbursed, name of person receiving the money, reason for the disbursement, general ledger account to be charged, and the initials of the person disbursing the money from the petty cash fund. Some petty cash vouchers are prenumbered and sometimes a number is assigned for reference and control. Receipts or other documentation justifying the disbursement should be attached to the petty cash voucher.

     

    When the petty cash fund is replenished, the completed petty cash vouchers provide the documentation for the replenishment check.

  • 303. Are insurance premiums a fixed cost?
     

    The cost of the insurance premiums for a company's property insurance is likely to be a fixed cost. The cost of worker compensation insurance is likely to be a variable cost. Whether a cost is a fixed cost, a variable cost, or a mixed cost depends on the independent variable.

     

    Let's illustrate this by looking at the cost of property insurance. The cost of insuring the factory building is a fixed cost when the independent variable is the number of units produced within the factory. In other words, the factory's property insurance might be AED 6,000 per year whether its output is 2 million units, 3 million units, or 5 million units. On the other hand, if the independent variable is the replacement cost of the factory buildings, the insurance cost will be a variable cost. The reason is the insurance cost on AED 12 million of factory buildings will be more than the insurance cost on AED 9 million of factory buildings, and less than the insurance premiums on AED 18 million of factory buildings.

     

    In the case of worker compensation insurance, the cost will vary with the amount of payroll dollars (excluding overtime premium) in each class of workers. For example, if the worker comp premiums are AED 5 per AED 100 of factory labor cost, then the worker comp premiums will be variable with respect to the dollars of factory labor cost. If the units of output in the factory correlate with the direct labor costs, then the worker compensation cost will also be variable with respect to the number of units produced. On the other hand, the worker compensation cost for the office staff is usually a much smaller rate and that worker compensation cost will not be variable with respect to the number of units of output in the factory. However, the worker compensation cost of the office staff will be variable with respect to the amount of office staff salaries and wages.

     

    As you have seen, determining which costs are fixed and which are variable can be a bit tricky.

  • 304. How should a mortgage loan payable be reported on a classified balance sheet?
     

    First, let's make it clear that the amount in the account Mortgage Loan Payable should be the principal amount owed to the lender. Any interest that has accrued since the last payment should be reported as Interest Payable, a current liability. (Future interest is not reported on the balance sheet.)

     

    Let's assume that a company has a mortgage loan payable of AED 238,000 and is required to make monthly payments of approximately AED 4,500 per month. Each of the monthly payments includes a AED 3,000 principal payment plus approximately AED 1,500 of interest. This means that during the next 12 months, the company will be required to repay AED 36,000 (AED 3,000 x 12 months) of principal. The required principal payments due within one year of the balance sheet date must be reported as a current liability. The remaining principal of AED 202,000 (AED 238,000 minus AED 36,000) will be reported as a long-term liability, since it is not due within one year of the balance sheet date.

     

    You can find the amount of principal due within the next year by reviewing the loan amortization schedule for each loan or by asking your lender.

  • 305. Why is it necessary to allocate a lump sum payment to individual items?
     

     

    It is necessary to allocate a lump sum payment to individual items in order to record a fair portion of the lump sum in each of the proper general ledger accounts.

     

    For instance, let's assume that a corporation made a lump sum payment of AED 450,000 in order to acquire a building, the land on which the building sits, and also some equipment. The lump sum payment means that the total cost of AED 450,000 has to be allocated among three general ledger accounts: Land, Buildings, and Equipment. The allocation must be done in a logical manner for the following reasons:

    1. the portion of the lump sum cost that is recorded in the Land account will not be depreciated
    2. the portion of the lump sum cost that is recorded in the Buildings account might be depreciated over a 25-year period, and
    3. the portion of the lump sum cost that is recorded in the Equipment account might be depreciated over 7 years.
  • 306. What is a burden rate in inventory?
     

    I assume that the burden rate in inventory refers to a manufacturer's indirect manufacturing costs, which are also referred to as factory overhead, indirect production costs, and burden. In the U.S., a manufactured product's costconsists of direct materials, direct labor, and manufacturing overhead. Since manufacturing overhead is an indirect cost, it is usually assigned or allocated through an overhead rate or burden rate. Two examples of an overhead or burden rate are 1) a percentage of direct labor, and 2) an hourly cost rate assigned on the basis of machine hours.

     

    A product's manufacturing cost, consisting of direct materials, direct labor and manufacturing overhead, is used to report the cost of goods sold and also the cost of units in inventory. Therefore, if you look at the detail of a product's inventory cost, you may see the manufacturing overhead being assigned or applied to the unit through a burden rate.

  • 307. What causes an increase in break-even point?
     

    There are several reasons why a company's break-even point will increase. One reason is an increase in the company's fixed costs, such as rent, depreciation, salaries of managers and executives, etc.

     

    A second reason for an increase in a company's break-even point is a reduction in the contribution margin. Contribution margin is sales minus the variable costs and variable expenses. An increase in the variable costs and expenses without a corresponding increase in selling prices will cause the contribution margin to shrink. With less contribution margin, it will take more sales in order to cover the fixed costs and fixed expenses. Of course, a decrease in selling price will also increase the break-even point.

     

    Another reason for a change in the break-even point is a change in the mix of products or services delivered. In other words, some products have higher contribution margins, and some products have lower contribution margins. If a company continues to sell the same total number of units of product, but a greater proportion of the units sold have a lower contribution margin, the company's break-even point will increase.

  • 308. What is inventory shrinkage?
     

    Inventory shrinkage is the term used to describe the loss of inventory. For example, if the inventory records of a retailer report that 3,261 units of Product X are on hand, but a physical count indicates that there are only 3,248 units on hand, there is an inventory shrinkage of 13 units. The retailer's inventory shrinkage might be due to shoplifting, employee theft, damage, obsolescence, etc.

     

    The term shrinkage is also used by manufacturers when referring to the loss of raw materials during a production process. For example, a manufacturer of baked food items will experience shrinkage throughout its processes due to ingredients adhering to the beaters and bowls, and also due to evaporation. This shrinkage is also known as spoilage or waste and it can be either normal or abnormal.

    Where is interest on a note payable reported on the cash flow statement?

    The interest paid on a note payable is included in the first section of the cash flow statemententitled cash flows from operating activities.

     

    If a company reports its cash flows from operating activities by using the indirect method, the interest expense for the period is included in the company's net income or net earnings. The interest expense will be adjusted to a cash amount through the changes to the working capital amounts, which are also reported as part of the operating activities. In addition, the actual amount of interest paid must be disclosed.

     

    If the cash flow statement, or statement of cash flows, is prepared using the direct method, the amount of interest paid should appear as a separate line within the cash flows from operating activities.

     

    The cash payments and cash receipts of principal on a note payable are reported in the financing activities section of the cash flow statement.

  • 309. What is working capital?
     

    Working capital is the amount of a company's current assets minus the amount of its current liabilities. For example, if a company's balance sheet dated June 30 reports total current assets of AED 323,000 and total current liabilities of AED 310,000 the company's working capital on June 30 was AED 13,000. If another company has total current assets of AED 210,000 and total current liabilities of AED 60,000 its working capital is AED 150,000.

     

    The adequacy of a company's working capital depends on the industry in which it competes, its relationship with its customers and suppliers, and more. Here are some additional factors to consider:

    • The types of current assets and how quickly they can be converted to cash. If the majority of the company's current assets are cash and cash equivalents and marketable investments, a smaller amount of working capital may be sufficient. However, if the current assets include slow-moving inventory items, a greater amount of working capital will be needed.
    • The nature of the company's sales and how customers pay. If a company has very consistent sales via the Internet and its customers pay with credit cards at the time they place the order, a small amount of working capital may be sufficient. On the other hand, a company in an industry where the credit terms are net 60 days and its suppliers must be paid in 30 days, the company will need a greater amount of working capital.
    • The existence of an approved credit line and no borrowing. An approved credit line and no borrowing allows a company to operate comfortably with a small amount of working capital.
    • How accounting principles are applied. Some companies are conservative in their accounting policies. For instance, they might have a significant credit balance in their allowance for doubtful accounts and will dispose of slow-moving inventory items. Other companies might not provide for doubtful accounts and will keep slow-moving items in inventory at their full cost.

    In short, analyzing working capital should involve more than simply subtracting current liabilities from current assets.

  • 310. What is a flexible budget?
     

    A flexible budget is a budget that adjusts or flexes for changes in the volume of activity. The flexible budget is more sophisticated and useful than a static budget, which remains at one amount regardless of the volume of activity.

     

    Assume that a manufacturer determines that its cost of electricity and supplies for the factory are approximately AED 10 per machine hour (MH). It also knows that the factory supervision, depreciation, and other fixed costs are approximately AED 40,000 per month. Typically, the production equipment operates between 4,000 and 7,000 hours per month. Based on this information, the flexible budget for each month would be AED 40,000 + AED 10 per MH.

     

    Now let's illustrate the flexible budget by using some data. If the production equipment is required to operate for 5,000 hours during January, the flexible budget for January will be AED 90,000 (AED 40,000 fixed + AED 10 x 5,000 MH). If the equipment is required to operate in February for 6,300 hours, then the flexible budget for February will be AED 103,000 (AED 40,000 fixed + AED 10 x 6,300 MH). If March requires only 4,100 machine hours, the flexible budget for March will be AED 81,000 (AED 40,000 fixed + AED 10 x 4,100 MH).

     

    If the plant manager is required to use more machine hours, it is logical to increase the plant manager's budget for the additional cost of electricity and supplies. The manager's budget should also decrease when the need to operate the equipment is reduced. In short, the flexible budget provides a better opportunity for planning and controlling than does a static budget.

     

  • 311. Why can a retailer record its purchase of merchandise as a debit to purchases within the cost of goods sold, instead of the asset inventory?
     

    Before we explain why companies will record the purchases of merchandise in the Purchases account instead of the Inventory account, let's agree that the objective of the accounting process is to have accurate financial statements. In this case we want an income statement which reports an accurate amount of cost of goods sold, and the resulting gross profit and net income. We need the balance sheet to report an accurate cost of inventory, and the resulting amount of current assets, working capital, total assets, and stockholders' equity. I believe this objective will require some type of an adjustment to the the Inventory account balance and to the cost of goods sold regardless of how the purchases of merchandise were initially recorded.

     

    Now for the reason companies often record purchases in a purchases account. Generally, companies will have a relatively stable amount of inventory and the cost of its annual purchases will be many times the cost of its inventory. This means that most of the cost of its purchases will appear as the cost of goods sold on its income statement. For the minor change in the cost of inventory from the beginning to the end of the accounting period, an adjustment can be made. For example, let's assume that the cost of purchases during the year amounted to AED 560,000. Let's also assume that the inventory at the end of the year has a cost of AED 70,000 compared to the inventory cost of AED 67,000 at the end of the previous accounting year. An adjustment will be entered to debit the Inventory account for AED 3,000 which will increase the Inventory account balance from AED 67,000 to AED 70,000. The credit portion of the entry of AED 3,000 will cause the cost of goods sold to be reported as AED 557,000 (AED 560,000 of debits in the Purchases account during the year minus the amount that increased the cost of inventory: AED 3,000). After this adjustment, the balance sheet will report the true cost of the ending inventory of AED 70,000 and the income statement will report the true cost of goods sold of AED 557,000.

  • 312. What is a lump sum payment?
     

    A lump sum payment is often associated with a single amount paid to acquire a group of items. For instance, a corporation might pay AED 50,000 for the inventory and equipment of a small manufacturer that is going out of business. The transaction did not specify any further details. The AED 50,000 is a lump sum payment.

     

    Sometimes the term lump sum payment merely indicates a single payment. For example, the maturity value of a bond might be referred to as a lump sum payment in order to distinguish it from the series of semiannual interest payments.

  • 313. How do you calculate the ceiling and floor in accounting?
     

    The ceiling and floor are involved in the lower of cost or market rule for valuing inventory. The ceiling is the upper limit for the market amount. The floor is the lowest amount allowed for the market amount. This means that the market amount will be the replacement cost, but within the limitations of the ceiling and the floor.

     

    The ceiling for the market value is the net realizable value. The net realizable value is calculated as the selling price in the ordinary course of business minus the cost of completion and disposal.

     

    The floor for the market value is the net realizable value minus the normal profit. The floor is calculated as the selling price in the ordinary course of business minus the cost of completion and disposal and minus the normal profit.

     

    The following is one illustration of the calculations. A company has an item with a cost of AED 10. Its replacement cost is AED 9, its net realizable value is AED 8, and its normal profit is AED 2. This means that the market amount for the lower of cost or market cannot be greater than the ceiling of AED 8 (the net realizable value). We also know that the market amount cannot be lower than the floor of AED 6 (the net realizable value of AED 8 minus the normal profit of AED 2). Since the replacement cost of AED 9 is greater than the ceiling, it cannot be used. As a result, the accountant will value the inventory item at the lower of (1) the cost of AED 10, or (2) the constrained replacement cost of AED 8. This makes the lower of cost or market amount AED 8.

     

  • 314. How do you record a check that clears the bank months after it was voided?
     

    Since you had voided the check months earlier, your general ledger no longer reflects 1) the original credit to the cash account, and 2) the original debit to another account. Now that the voided check has cleared the bank account, you will need to record the check in your general ledger. The entry will be a credit to the general ledger cash account and a debit (or debits) to the appropriate account.

     

    It might be helpful to recall the bank reconciliation rule: Put it where it isn't. The old check, which you had voided, is now on the bank statement, but it is not in the cash account. Therefore, you need to put the check amount into the general ledger.

  • 315. What is ERP?
     

    In accounting, ERP is the acronym for enterprise resource planning. ERP could be described as a database software package that supports all of a business's processes and operations including manufacturing, marketing, financial, human resources, and so on. In other words, the goal of ERP is to have one integrated system for the entire company.

     

    The integration of all of a company's information from all departments, processes, operations, etc. requires that an ERP system be very sophisticated. This in turn requires a company to commit considerable resources for planning, training, and implementing an ERP system.

     

    Two of the suppliers or vendors of major ERP systems are SAP and Oracle.

  • 316. Is the sale of a plant asset recorded in the sales account?
     

    The sale of a plant asset should not be recorded in the sales account. The sales account is used to report a retailer's sale of merchandise or a manufacturer's sale of products. In other words, sales result from a company's main revenue producing activities.

     

    The sale of a plant asset is a "peripheral" activity and does not qualify as sales revenues. Rather, the gain or loss on a sale of a plant asset is reported on the income statement as a separate item. Often this item is included in a section labeled as "other" or "nonoperating." (The gain or loss is the difference between the proceeds from the sale of the plant asset and the plant asset's carrying value at the time of the sale.)

     

    The proceeds from the sale of the plant asset is reported as a positive amount in the investing activities section of the statement of cash flows.

  • 317. What is a fixed cost?
     

    A fixed cost is one that does not change in total within a reasonable range of activity. For example, the rent for a production facility is a fixed cost if the rent will not change when there are reasonable changes in the amount of output or input. (Of course, if there is a need to double the output the rent will change when the company occupies additional work space.)

     

    While a fixed cost remains constant in total, the fixed cost per unit of output or input will change inversely with the change in the quantity of output or input. For instance, if the rent of the production facility is fixed at AED 120,000 per year and there are 30,000 machine hours of good output during the year, the rent will be AED 4 (AED 120,000/30,000) per machine hour. If there are 40,000 machine hours during the year, the rent will be AED 3 (AED 120,000/40,000) per machine hour.

     

    Many manufacturing overhead costs are fixed and the amounts occur in large increments. Some examples include depreciation on a company-owned factory, depreciation on machinery and equipment, salaries and benefits of manufacturing supervisors, factory administration costs, etc. One challenge for accountants is the allocation or assigning of the large fixed costs to the individual units of product (which likely vary in size and complexity). This allocation (or assigning or absorbing) is required by the accounting and income tax rules for valuing inventories and the cost of goods sold. If the fixed overhead is assigned using machine hours, one must keep in mind that the cost rate per machine hour is not how the fixed costs behave or occur. In our example, the cost of the rent might be assigned to the products at the rate of AED 3 or AED 4 per machine hour but the rent actually occurs at the rate of AED 10,000 per month.

  • 318. What is a BOM?
     

    BOM is the acronym for bill of materials. A BOM is a listing of the quantities of each of the materials used in manufacturing a product.

     

    Industrial manufacturers are likely to have an enormous number of BOMs. Each of the BOMs will be a very detailed list of all of the quantities of every material used in the various steps of manufacturing each part or product.

     

    To visualize a BOM, think of a bakery that produces only pies. Each pie's BOM will list the ingredients in the pie's recipe. Each BOM will list the number of pounds (or other unit of measure) of the specific fruit, the quantity of a specific sugar (or other sweetener), the quantity and type of cinnamon, the quantity of nutmeg, the type of crust. There will also be a BOM for the pie crust. The pie crust BOM will specify the quantity and type of flour, the quantity and type of butter (or oil), the quantity of salt, etc.

  • 319. What is the difference between reserve and allowance?
     

     

    More than 60 years ago, accountants in the U.S. used Reserve for Bad Debts as the title of the contra account associated with Accounts Receivable or Loans Receivable. They also used Reserve for Depreciation as the title of the contra account associated with plant assets. The use of the word reserve led some readers of the financial statements to conclude that money was set aside for replacing plant assets or the uncollectible accounts or loans. To avoid this misunderstanding, the accounting profession recommended that the word reserve have a very limited use. Accountants now use Allowance for Doubtful Accounts or Allowance for Bad Debts instead of Reserve for Bad Debts. In the case of plant assets, Accumulated Depreciation is used in place of Reserve for Depreciation.

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    To learn more, see the Related Explanations listed below:

  • 320. What is a contingent liability?
     

    A contingent liability is a potential liability. This means that the contingent liability might become an actual liability and a loss, or it might not. It depends on something in the future.

     

    If your parent guarantees your loan, your parent will have a contingent liability. Your parent will have an actual liability and a loss only if you do not make the payments on the loan. On the other hand, if you make the loan payments, your parent will not have a liability and loss.

     

    A AED 100,000 lawsuit filed against your company is a contingent liability (or loss contingency). Your company will have a liability and a loss only if your company is found guilty. If your company proves that it is not guilty, the contingent liability will not become an actual liability and loss.

     

    Another example of a contingent liability is a product warranty. If a company promised to replace a defective unit at no cost to the customer within one year of purchase, the company will have an actual liability only if units are defective. If the company is certain that no units will be returned as defective, the company will have no liability and no warranty expense.

     

    Accountants will record a journal entry to report a liability on the balance sheet and a loss or expense on the income statement only if the loss contingency is both probable and the amount can be estimated.

     

    If a contingent liability is possible (but not probable), no journal entry is needed. However, the accountant must disclose the contingent liability and loss in the notes to the financial statements.

     

    If a contingent liability is remote, then the accountant will not report the liability and loss and will not disclose it.

  • 321. What is an unpresented check?
     

    An unpresented check is a check written by a company and entered in its records, but the check has not yet cleared the company's checking account. In other words, the check has not yet been paid by the bank on which the check is drawn. An unpresented check is also known as an outstanding check.

     

    An unpresented check is listed on a bank reconciliation as a subtraction from the bank balance.

  • 322. What is meant by the term relevance in accounting?
     

    In accounting, the term relevance means it will make a difference to a decision maker.

     

    For example, in the decision to replace equipment that has been used for the past six years, the original cost of the equipment does not have relevance. In other words, the original cost is irrelevant or is not relevant in the decision to replace the equipment. What will have relevance are the future amounts, such as the cost of the new equipment, and the savings that will occur when the old equipment is replaced.

     

    Here's another expression of relevance: Costs that will differ among alternatives. Costs that will not differ among alternatives do not have relevance.

     

    In order to have relevance, accounting information must be timely. Financial statements issued three weeks after the accounting period ends will have more relevance than financial statements issued several months after the period ends. Having timeliness and relevance may mean sacrificing some precision or reliability.

     

    Read more about relevance in paragraphs 46-57 of the Statement of Financial Accounting Concepts No. 2,Qualitative Characteristics of Accounting Information, issued by the Financial Accounting Standards Board. You may read it at no cost at www.FASB.org.

  • 323. What is a real account?
     

    A real account is a general ledger account that does not close at the end of the accounting year. In other words, the balances in the real accounts are carried over to become the beginning balances of the next accounting period.

     

    Generally, the real accounts are the balance sheet accounts. Balance sheet accounts are the asset accounts (cash, accounts receivable, buildings, etc.), liability accounts (notes payable, accounts payable, wages payable, etc.), and stockholders' equity accounts (common stock, retained earnings, etc.).

     

    Real accounts are also referred to as permanent accounts.

     

    On the other hand, the income statement accounts (revenues, expenses, gains, losses) are known as temporary accounts because their balances are not carried over to the next accounting period. The income statement accounts begin each new accounting year with zero balances.

  • 324. How do you determine whether a person is an independent contractor or an employee?
     

    To assist you in determining whether someone is an independent contractor or an employee, you should refer to the Internal Revenue Service Publication 15-A, Employer's Supplemental Tax Guide. (It is a supplement to Circular E.)

     

    Part 1 of the guide is entitled Who Are Employees? and it provides this general rule: "...an individual is an independent contractor if you, the person for whom the services are performed, have the right to control or direct only the result of the work and not the means and methods of accomplishing the result."

     

    Part 2 of the guide is entitled Employee or Independent Contractor? It addresses your question in detail. In Part 2 you will find a thorough discussion of the rules and many examples to help you distinguish between independent contractors and employees.

  • 325. What is a long-term asset?
     

    A long-term asset is an asset that will not turn into cash or be consumed within one year of the date shown in the heading of the balance sheet. (If a company has an operating cycle that is longer than one year, a long-term asset will not turn to cash within the longer operating cycle.) Expressed another way, a long-term asset is an asset that does not meet the criteria of being reported as a current asset.

     

    Long-term assets are also known as noncurrent assets and include the following:

    • long-term investments These include certain investments in stocks and bonds of other corporations, a company's bond sinking fund, the cash surrender value of life insurance policies owned by the company, real estate awaiting to be sold, etc.
    • property, plant and equipment This classification includes land, buildings, machinery, equipment, vehicles, fixtures, etc. that are used in the business.
    • intangible assets These include trademarks, patents, customer lists, goodwill, etc. that were acquired in a transaction.
    • deferred charges This category includes bond issue costs that are being amortized over the life of the bonds and deferred income taxes that pertain to certain assets.

     

  • 326. What is the difference between an unadjusted trial balance and an adjusted trial balance?
     

    The differences between an unadjusted trial balance and an adjusted trial balance are the amounts recorded as part of the adjusting entries.

     

    Adjusting entries include the accrual of revenues that were earned but were not yet recorded, and the accrual of expenses that were incurred but were not yet recorded. Accrued expenses and the related liabilities often involve wages, utilities, repairs and maintenance, commissions, interest, and more.

     

    Adjusting entries also include depreciation and the deferral of or an adjustment of prepayments including prepaid insurance, unearned revenues, customer deposits, and more.

  • 327. What is the entry when a company lends money to an employee?
     

    When a company lends cash to one of its employees, the entry will include a credit to Cash and a debit to an asset account such as Notes Receivable from Employees (if a promissory note is involved) or Other Receivables-Advances to Employees (if a note is not involved).

     

    When the company earns interest on the loan, the interest should be credited to Interest Revenue or Interest Income and should be debited to Interest Receivable or Cash.

  • 328. What is the cost of sales?
     

    Cost of sales is the caption commonly used on a manufacturer's or retailer's income statement instead of the caption cost of goods sold or cost of products sold.

     

    The cost of sales for a manufacturer is the cost of finished goods in its beginning inventory plusthe cost of goods manufactured minus the cost of finished goods in ending inventory.

     

    The cost of sales for a retailer is the cost of merchandise in its beginning inventory plus the net cost of merchandise purchased minus the cost of merchandise in its ending inventory.

     

    The cost of sales does not include selling expenses or general and administrative expenses, which are commonly referred to as SG&A.

  • 329. How do cash dividends affect the financial statements?
     

    When a corporation declares a cash dividend on its stock, its retained earnings are decreased and its current liabilities (Dividends Payable) are increased. When the cash dividend is paid, the Dividends Payable account is decreased and the corporation's Cash account is decreased.

     

    The net result of the declaration and payment of the dividend is that the corporation's assets and stockholders' equity have decreased. Specifically, the balance sheet accounts Cash and Retained Earnings were decreased.

     

    The income statement is not affected by the declaration and payment of cash dividends on common stock. (The cash dividends on preferred stock are deducted from net income to arrive at net income available for common stock.)

     

    The cash dividends will be reported as a use of cash in the financing activities section of the statement of cash flows.

  • 330. What is the purpose of assigning accounts receivable?
     

     

    The purpose of assigning accounts receivable is to provide collateral in order to obtain a loan.

     

    To illustrate, let's assume that a corporation receives a special order from a new customer whose credit rating is superb. However, the customer pays for its purchases 90 days after it receives the goods. The corporation does not have sufficient money to purchase the raw materials, pay for the labor, and then wait 90 days to collect the receivable. The corporation's bank or a finance company may lend 80% of the receivable but insists that the receivable be assigned to them as collateral for the loan.

     

    Assigning a specific account receivable usually results in recording the receivable in a separate general ledger account such as Accounts Receivable Assigned. Some lenders require that the corporation's customer be notified of the assignment and that the customer must remit the receivable amount directly to the bank.

     

    Instead of assigning a specific receivable, the lender may require the corporation to assign all of its receivable as collateral for a loan.

  • 331. FIFO and LIFO is best with which type of products?
     

    Since FIFO and LIFO pertain to the flow of products' costs, I believe the answer involves the rate of change in the costs of products. In other words, if the costs of a company's products are steady, it won't matter whether a company uses FIFO or LIFO. The reason is that the first or older costs will be similar to the latest or recent costs. On the other hand, if the costs of its products are increasing significantly, there will be significant difference in profits and inventory values between FIFO and LIFO.

     

    In the U.S., accountants often cite LIFO as the preferred method when products' costs are changing. The reason is the matching of the latest costs of products with the sales revenues of the current period. U.S. tax  rules also allow for either FIFO or LIFO, but require that the same cost flow assumption be used on both the company's tax return and on the company's financial statements.

     

    By using LIFO when the costs of products are increasing, the company will be matching the recent higher costs with the current period sales. This will provide not only the improved matching of costs with revenues, it will also result in lower taxable income.

  • 332. What does an unfavorable volume variance indicate?
     

    An unfavorable volume variance indicates that the amount of fixed manufacturing overhead costs applied (or assigned) to the manufacturer's output was less than the budgeted or planned amount of fixed manufacturing overhead costs for the same time period. The unfavorable volume variance indicates that the period's output was less than the planned output.

     

    The volume variance is also referred to as the production volume variance, the capacity variance, or the idle capacity variance.

     

    In November 2004, the Financial Accounting Standards Board issued its Statement No. 151, which discusses the reporting of the fixed production overhead when less than normal capacity is utilized.

  • 333. What are the disclosures for a manufacturer's inventory?
     

    A manufacturer should disclose the following categories of inventory: raw materials, work-in-process, finished goods, manufacturing supplies, and packaging supplies. When some of these amounts are not significant, some categories may be combined, such as raw materials and supplies, or raw materials and work-in-process.

     

    In addition, a manufacturer (and others with inventory) should disclose the method for valuing the inventory. This includes whether it is cost or the lower of cost or market, and also the cost flow assumption such as 1) first-in, first-out or FIFO, 2) last-in, first-out or LIFO, 3) weighted average, etc. If LIFO is used, the company must disclose what the dollar amount of inventory would have been if FIFO had been used.

  • 334. What is bad debts expense?
     

    Bad debts expense often refers to the loss that a company experiences because it sold goods or provided services and did not require immediate payment. The loss occurs when the customer does not pay the amount owed. In other words, bad debts expense is related to a company's current asset accounts receivable.

     

    It is common to see two methods for computing the amount of bad debts expense:

    1. direct write-off method
    2. allowance method

    The direct write-off method requires that a customer's uncollectible account be first identified and then removed from the account Accounts Receivable. This method is required for U.S. income taxes and results in a debit to Bad Debts Expense and a credit to Accounts Receivable for the amount that is written off.

     

    The allowance method anticipates that some of the accounts receivable will not be collected. In other words, prior to knowing exactly which customers or clients will not be paying, the company will debit Bad Debts Expense and will credit Allowance for Doubtful Accounts for an estimated, anticipated amount. (The Allowance for Doubtful Accounts is a contra asset account that when combined with Accounts Receivable indicates a more realistic amount that will be turning to cash.)

     

    Many believe that the allowance method is the better method since 1) the balance sheet will be reporting a more realistic amount that will be collected from the company's accounts receivable, and 2) the bad debts expense will be reported on the income statement closer to the time of the related credit sales.

  • 335. What does a bookkeeper do?
     

    A bookkeeper is responsible for processing the paperwork for a company's business transactions. Ultimately the transactions will be recorded in accounts within the company's general ledger. Today this often involves the use of cost effective software such as QuickBooks from Intuit.

     

    Bookkeepers are expected to be accurate, efficient, and knowledgeable about debits and credits, the chart of accounts, accounts payable procedures, sales and accounts receivable, payroll, and more. Each bookkeeper's specific responsibilities will vary by type and size of the business.

     

    The bookkeeper's role may be expanded to include adjusting entries in order for the bookkeeper to generate income statements and balance sheets from the accounting software.

     

    The bookkeeper's work is usually overseen by an accountant and/or the small business owner.

  • 336. What causes an unfavorable fixed overhead budget variance?
     

    An unfavorable fixed overhead budget variance results when the actual amount spent on fixed manufacturing overhead costs exceeds the budgeted amount. The fixed overhead budget variance is also known as the fixed overhead spending variance.

     

    Fixed overhead costs are the indirect manufacturing costs that are not expected to change when the volume of activity changes. Some examples of fixed manufacturing overhead include the depreciation, property tax and insurance of the factory buildings and equipment, and the salaries of the manufacturing supervisors and managers.

     

    Since the fixed manufacturing overhead costs should remain the same within reasonable ranges of activity, the amount of the fixed overhead budget variance should be relatively small.

  • 337. What is the advantage of using historical cost on the balance sheet for property, plant and equipment?
     

    The main advantage of using historical cost on the balance sheet for property, plant and equipment is that historical cost can be verified. Generally, the cost at the time of purchase is documented with contracts, invoices, payments, transfer taxes, and so on.

     

    The historical cost of plant and equipment (not land) is also used to determine the amount of depreciation expense reported on the income statement. The accumulated amount of depreciation is also reported as a deduction from the assets' historical costs reported on the balance sheet. (In the case of impairment, some assets might be reported at less than the amounts based on historical cost.)

     

    The use of historical cost is also a disadvantage to those users of the financial statements who want to know the current values.

  • 338. How do we deal with a negative contribution margin ratio when calculating our break-even point?
     

    The negative contribution margin ratio indicates that your variable costs and expenses exceed your sales. In other words, if you increase your sales in the same proportion as the past, you will experience larger losses.

     

    My recommendation is to calculate the contribution margin and contribution margin ratio for each product (or service) that you offer. I suspect that some of your items have positive contribution margins, but the products with negative contribution margins are greater. You must get into the details.

     

    You also need to look at each of your customers. Perhaps some customers are buying in huge quantities, but those sales are not profitable. See which customers have positive contribution margins.

     

    By definition, the ways to eliminate the negative contribution margin are to 1) raise selling prices, 2) reduce variable costs, or 3) do some combination of the first two. If customers will not accept price increases in order for you to cover your variable costs, you are probably better off not having the sales. Remember that after covering the variable costs, those selling prices must then cover the fixed costs and expenses. A total negative contribution margin means your loss will be larger than the amount of the fixed costs and expenses.

     

    When setting prices or bidding for new work, you must think of the bottom line—profits. Many people focus too much on the top line—sales.

  • 339. How do you calculate the break-even point in terms of sales?
     

    The break-even point in sales dollars can be calculated by dividing a company's fixed expenses by the company's contribution margin ratio.

     

    The contribution margin is sales minus variable expenses. When the contribution margin is expressed as a percentage of sales it is referred to as the contribution margin ratio. (When we use the term "fixed expenses" we mean the company's total amount of fixed costs plus its fixed expenses. When we say "variable expenses" we mean the total of the company's variable costs plus its variable expenses.)

     

    Let's illustrate the break-even point in sales dollars with the following information. A company has fixed expenses of AED 100,000 per year. Its variable expenses are approximately 80% of sales. This means that the contribution margin ratio is 20%. (Sales minus the variable expenses of 80% of sales leaves a remainder of 20% of sales. In other words, after deducting the variable expenses there remains only 20% of every sales dollar to go towards the fixed expenses and profits. ) The fixed expenses of AED 100,000 divided by the contribution margin ratio of 20% equals AED 500,000. This tells you that if the company has sales of approximately AED 500,000 it will be at the break-even point—the point where sales will be equal to all of the company's expenses.

     

    It is wise to test your calculated break-even point. In our example the sales needed to be AED 500,000. If the variable expenses are 80% of sales, the variable expenses will be AED 400,000 (80% of AED 500,000). This leaves AED 100,000 as the contribution margin in dollars. After subtracting the fixed expenses of AED 100,000, the net income will be zero.

  • 340. Why is an increase in inventory shown as a negative amount in the statement of cash flows?
     

    An increase in inventory indicates that a company has purchased more goods than it has sold. Increasing inventory requires a cash outflow. Cash outflows have a negative effect on the company's cash balance.

     

    Negative amounts on the statement of cash flows can be interpreted to mean 1) a cash outflow, 2) that cash was used, or 3) that it was unfavorable for the company's cash balance. In other words, you can think of negative amounts as having a negative effect on the company's cash balance.

     

    Hence, the amount of the increase in inventory is shown as a negative amount on the statement of cash flows. Had inventory decreased, the amount of the decrease in inventory would be shown as a positive amount on the statement of cash flows.

  • 341. What is accrued income?
     

    Accrued income is an amount that has been 1) earned, 2) there is a right to receive the amount, and 3) it has not yet been recorded in the general ledger accounts. One example of accrued income is the interest earned on a bond investment.

     

    To illustrate, let's assume that a company invested AED 100,000 on December 1 in a 6% AED 100,000 bond that pays AED 3,000 of interest on each June 1 and December 1. On December 31, the company will have earned one month's interest amounting to AED 500 (AED 100,000 x 6% per year x 1/12 of a year, or 1/6 of the semiannual AED 3,000). No interest will be received in December since it will be part of the AED 3,000 to be received on June 1. The AED 500 of interest earned during December, but not yet received or recorded as of December 31 is known as accrued income.

     

    Under the accrual basis of accounting, accrued income is recorded with an adjusting entry prior to issuing the financial statements. In our example, there will need to be an adjusting entrydated December 31 that debits Interest Receivable (a balance sheet account) for AED 500, and credits Interest Income (an income statement account) for AED 500.

  • 342. What are balance sheet accounts?
     

    Balance sheet accounts are one of two types of general ledger accounts. (Income statement accounts make up the other type.) Balance sheet accounts are used to sort and store transactions involving assets, liabilities, and owner's or stockholders' equity. Examples of a corporation's balance sheet accounts include Cash, Accounts Receivable, Investments, Buildings, Equipment, Accumulated Depreciation, Notes Payable, Accounts Payable, Payroll Taxes Payable, Paid-in Capital, Retained Earnings, etc.

     

    Balance sheet accounts are described as permanent or real accounts because at the end of the accounting year the balances in these accounts are not closed. Instead, the end-of-the-accounting-year balances will be carried forward to become the beginning balances in the next accounting year. (This is different from the income statement accounts, which begin each accounting year with zero balances.)

     

    The balances in the balance sheet accounts are presented in a company's balance sheet, which is one of the main financial statements.

     

    It will be helpful to keep in mind that every adjusting entry will require at least one balance sheet account and one income statement account.

  • 343. Why is a product that sells for AED 50 reported in inventory at its cost of AED 40?
     

    Generally, items in inventory are valued at their cost—not their selling prices—because of the cost principle.

     

    Another reason for not valuing items in inventory at their selling prices is that inventory items cannot be sold without a sales effort. Until that effort is made and an item is actually sold, the company cannot report the AED 10 increase from AED 40 to AED 50. This is referred to as the revenue recognition principle. In other words, only after an item is actually sold can the company report the revenue of AED 50 minus the cost of AED 40 for a gross profit of AED 10.

     

    There are some exceptions to cost. One exception is industries where no sales effort is required and the extensive effort of production has been completed. In these industries the inventory can be reported at its net realizable value, which is the sales value minus the costs to dispose of the items. The gold mining industry and certain other commodities are examples of this exception to cost.

     

    Another exception can occur in any industry when a product will have to be sold for less than its cost. In that situation the item might be reported in inventory close to its net realizable value, provided it is less than the item's cost. (U.S. income tax rules require conformity between tax and financial reporting. As a result, there are complexities involved.)

  • 344. What is an irrevocable letter of credit?
     

    An irrevocable letter of credit is a financial instrument used by banks to guarantee a buyer's obligations to a seller. It is irrevocable because the letter of credit cannot be modified unless all parties agree to the modifications.

     

    Irrevocable letters of credit are often used to facilitate international trade because of the additional risks involved. The irrevocable letter of credit removes the seller's credit risk by assuring the seller that payment will be made by the buyer's bank if the buyer does not pay the seller.

     

    In an irrevocable letter of credit, the buyer is known as the applicant, the seller is the beneficiary, the buyer's bank is the issuing bank, and the seller's bank is the advising bank.

  • 345. What is a non-discount method in capital budgeting?
     

    A non-discount method of capital budgeting does not explicitly consider the time value of money. In other words, each dollar earned in the future is assumed to have the same value as each dollar that was invested many years earlier. The payback method is one of the techniques used in capital budgeting that does not consider the time value of money.

     

    The payback method simply computes the number of years it will take for an investment to return cash equal to the amount invested. For example, if an investment of AED 100,000 is made and it generates cash of AED 50,000 for two years followed by AED 10,000 per year for four additional years, its payback is two years (AED 50,000 + AED 50,000). If another investment of AED 100,000 generates cash of AED 20,000 per year for two years and then provides cash of AED 40,000 per year for six additional years, its payback is approximately 3.5 years (AED 20,000 + AED 20,000 + AED 40,000 + 0.5 times AED 40,000).

     

    As you can see in the examples, payback only answers one question: How long before the cash invested is returned? Payback does not address which investment is more profitable. Payback not only ignored the time value of money, it ignored all of the cash received after the payback period.

     

    The accounting rate of return or return on investment (ROI) are two more examples of methods used in capital budgeting that does not involve discounting future cash amounts.

     

    To overcome the shortcomings of payback, accounting rate of return, and return on investment, capital budgeting should include techniques that consider the time value of money. Two of these methods include (1) the net present value method, and (2) the internal rate of return calculation. Under these techniques, the future cash flows are discounted. This means that each dollar in the distant future will be less valuable than each dollar in the near future, and both of these will have less value than each dollar invested in the present.

  • 346. What is included in cash and cash equivalents?
     

    The term cash and cash equivalents includes: currency, coins, checks received but not yet deposited, checking accounts, petty cash, savings accounts, money market accounts, and short-term, highly liquid investments with a maturity of three months or less at the time of purchase such as U.S. treasury bills and commercial paper. The items included as cash and cash equivalents must also be unrestricted.

     

    The amount of cash and cash equivalents will be reported on the balance sheet as the first item in the listing of current assets. The change in the amount of cash and cash equivalents during an accounting period is explained by the statement of cash flows.

  • 347. What is a journal?
     

    In accounting and bookkeeping, a journal is a record of financial transactions in order by date. A journal is often defined as the book of original entry. The definition was more appropriate when transactions were written in a journal prior to manually posting them to the accounts in the general ledger or subsidiary ledger. Manual systems usually had a variety of journals such as a sales journal, purchases journal, cash receipts journal, cash disbursements journal, and a general journal.

     

    With today's computerized bookkeeping and accounting, it is likely to find only a general journal in which adjusting entries and unique financial transactions are entered. The recording and posting of most transactions will occur automatically when sales and vendor invoice information is entered, checks are written, etc. In other words, accounting software has eliminated the need to first record routine transactions into a journal.

  • 348. Why does the internal rate of return equate to a net present value of zero?
     

    Internal rate of return and net present value are discounted cash flow techniques. To discountmeans to remove the interest contained within the future cash amounts.

     

    If the net present value of an investment or project is more than AED 0, the project is earning more than the interest rate used to discount the future cash amounts. If the net present value of a project is less than AED 0, the project is earning less than the interest rate used to discount the future cash amounts.

     

    If the present value of a project is exactly AED 0, the project is earning exactly the interest rate used to discount the future cash amounts. In other words, if a project has an internal rate of return of 15%, and you discount the project's future cash amounts by 15%, the project's net present value will be exactly AED 0.

  • 349. Should a retailer's delivery surcharges be reported as revenues or as other income?
     

    I believe that a retailer's delivery surcharges are a price adjustment and should be reported as operating revenues. The surcharges are operating revenues that will be matched with the higher operating expenses such as gasoline. The delivery surcharges should not be reported as nonoperating revenues or other income. Nonoperating revenues or other income items would be outside the main activities of the retailer and would include items such as interest earned or the gain on the sale of a plant asset.

     

    The retailer can record the delivery surcharges in a separate operating revenue account. In other words the sales revenues account could be used to record the revenues excluding the surcharges and then another sales revenue account could be designated as the delivery surcharge revenues account. Those two accounts would then be added together to report total operating revenues.

  • 350. What is the difference between dividends and interest expense?
     

     

    Dividends are a distribution of a corporation's earnings to its stockholders. Dividends are not an expense of the corporation and, therefore, dividends do not reduce the corporation's net income or its taxable income. When a dividend of AED 100,000 is declared and paid, the corporation's cash is reduced by AED 100,000 and its retained earnings (part of stockholders' equity) is reduced by AED 100,000.

     

    Interest on bonds and other debt is an expense of the corporation. The interest expense will reduce the corporation's net income and its taxable income. When interest expense occurs and is paid, the corporation's cash is reduced by the interest payment, but some cash will be saved by the reduction in income taxes. The corporation's retained earnings will also be reduced by less than the amount of interest expense. For example, if a corporation has an incremental tax rate of 40%, interest expense of AED 100,000 will result in AED 40,000 less in income tax expense and income tax payments. This means that an interest payment of AED 100,000 will reduce the corporation's cash and retained earnings by the net amount of AED 60,000 (AED 100,000 of interest minus AED 40,000 of tax savings).

     

    Since interest is formally promised to the lenders, accountants must accrue interest expense and the related liability Interest Payable. If the payment for interest is not made, the corporation will face legal consequences.

     

    Dividends on common stock are not legally required. Therefore, if the corporation does not declare a dividend there is no liability for the omitted dividends.

  • 351. How do you calculate the payback period?
     

     

    The payback period is calculated by counting the number of years it will take to recover thecash invested in a project.

     

    Let's assume that a company invests AED 400,000 in more efficient equipment. The cash savings from the new equipment is expected to be AED 100,000 per year for 10 years. The payback period is 4 years (AED 400,000 divided by AED 100,000 per year).

     

    A second project requires an investment of AED 200,000 and it generates cash as follows: AED 20,000 in Year 1; AED 60,000 in Year 2; AED 80,000 in Year 3; AED 100,000 in Year 4; AED 70,000 in Year 5. The payback period is 3.4 years (AED 20,000 + AED 60,000 + AED 80,000 = AED 160,000 in the first three years + AED 40,000 of the AED 100,000 occurring in Year 4).

     

    Note that the payback calculation uses cash flows, not net income. Also, the payback calculation does not address a project's total profitability. Rather, the payback period simply computes how fast a company will recover its cash investment.

  • 352. How do you report a write-down in inventory?
     

    A write-down in a company's inventory is recorded by reducing the amount reported as inventory. In other words, the asset account Inventory is reduced by a credit. The debit in the entry to write down inventory is reported in an account such as Loss on Write-Down of Inventory, an income statement account.

     

    If the amount of the Loss on Write-Down of Inventory is relatively small, it can be reported as part of the cost of goods sold. If the amount of the Loss on Write-Down of Inventory is significant, it should be reported as a separate line on the income statement.

     

    Since the amount of the write-down of inventory reduces net income, it will also reduce the amount reported as owner's equity or stockholders' equity. Hence for the balance sheet and in the accounting equation, the asset inventory is reduced and the owner's or stockholders' equity is reduced.

  • 353. What are income statement accounts?
     

    Income statement accounts are one of two types of general ledger accounts. (Balance sheet accounts make up the other type.) Income statement accounts are used to sort and store transactions involving revenues, expenses, gains, and losses. The income summary account is also an income statement account. The number of income statement accounts used at a large company could be in the thousands. A few examples of income statement accounts include Sales, Service Revenues, Salaries Expense, Rent Expense, Advertising Expense, Interest Expense, Gain on Disposal of Truck, etc.

     

    Income statement accounts are described as temporary accounts because at the end of each accounting year the balances in the income statement accounts will be closed. This means that the balances will be combined and the net amount will be transferred to a balance sheet equity account. In the case of a corporation, the equity account is Retained Earnings. In the case of a sole proprietorship it is the owner's capital account.

     

    The closing of the income statement accounts at the end of an accounting year means that the income statement accounts will begin the subsequent year with zero balances. As a result, the balances in the income statement accounts will be the year-to-date amounts.

     

    It will be helpful to remember that every adjusting entry will require at least one income statement account and at lease one balance sheet account.

  • 354. What is a vendor?
     

    A vendor is a person or business that supplies goods or services to a company. Another term for vendor is supplier.

     

    In many situations a company presents the vendor with a purchase order stating the goods or services needed, the price, delivery date, and other terms. Generally, when the vendor delivers the goods or services it will also send an invoice to the company. The company should then match the vendor's invoice with its purchase order and receiving report. If the three documents are in agreement, the company can than arrange for payment to the vendor.

  • 355. What is the procedure for preparing a trial balance?
     

    To prepare a trial balance, you or the accounting software will simply list the titles of all of the accounts in the general ledger that have balances. To the right of the account titles you will have two columns for entering each account's balance. One column is headed "Debit" and the other column is headed "Credit." You then list each account's balance in the appropriate column. After all of the account balances are entered, each column is summed. The total of the debit column should be equal to the total of the credit column.

     

    Prior to accounting software, there were many opportunities for errors. For example, an amount might be written incorrectly when posted from a journal to the account, a math error might occur when calculating an account's balance, an amount might be written incorrectly in one of the columns on the trial balance, and so on. The trial balance alerted you that an amount or amounts were wrong. If the trial balance did not balance, it meant rechecking all of the amounts.

     

    Today, the accounting software has eliminated the math and clerical errors. As a result, the trial balance does not play the critical role that it did many years ago.

  • 356. What is the role of a company's controller?
     

     

    A company's controller is the chief accounting officer and heads the accounting department. The controller is responsible for the company's financial statements, general ledger, cost accounting, payroll, accounts payable, accounts receivable, budgeting, tax compliance, and various special analyses.

     

    At larger companies the controller will supervise accountants and other professionals who assist the controller. The titles of the subordinates could include accounting manager, cost accounting manager, tax manager, accounts payable manager, credit manager, payroll manager, and so on. These managers might be supervising accountants who are supervising accounting clerks.

     

    At smaller companies it is possible that the controller will be the only accountant and will be assisted by an accounting clerk and an accounts payable clerk.

     

    Often the controller reports to the chief financial officer (CFO). However, at small companies the controller might report directly to the president or owner.

  • 357. How do I determine my payroll tax liabilities?
     

    Your payroll tax liabilities will include the following:

    1. Social Security and Medicare taxes that were to be withheld plus your company's matching of those taxes.
    2. State and federal unemployment taxes. Your state can tell you the rate for your company and the wages to which the rate applies. For example, it might be 5% on the first AED 9,000 of annual wages and salaries. The federal rate (after credit) is 0.6% on the first AED 7,000 of annual wages and salaries.
    3. Check with your city, county, and state for any other payroll taxes.

    In addition to the payroll taxes, you may have payroll related liabilities for worker compensation insurance, health insurance, 401-k contributions, pensions, vacations, and so on. Your liabilities will also include other payroll withholdings taxes that were to be remitted for the employee, but have not yet been remitted.

  • 358. What causes a corporation's market value to be greater than its book value
     

    One cause of a corporation's market value being greater than its book value is the accountant's cost principle. In order for an item to be listed as an asset on a corporation's balance sheet, the item must have been purchased (or donated). If an item is not listed on the balance sheet as an asset, it will not be included in a corporation's book value. (A corporation's book value is the amount of stockholders' equity reported on the balance sheet, which is the amount of assets reported minus the amount of liabilities reported.)

     

    Often a corporation's most valuable assets were not purchased and, therefore, will not be reported as assets and will not be included in the corporation's book value. Think of the late Steve Jobs and the culture he developed at Apple. He and his team, the innovative culture, the wildly successful brand names, etc. could never be listed on the balance sheet as assets nor directly included in the corporation's book value.

     

    On the other hand, the market does recognize those attributes as being immensely valuable. Hence the corporation's market value was and is greater than its book value.

  • 359. What is net?
     

    In accounting, net usually refers to the combination of positive and negative amounts. For example, the amount of net sales is the combination of the amount of gross sales (a positive amount) and some negative amounts such as sales returns, sales allowances, and sales discounts. Hence, if gross sales are 990 and sales returns are 10, sales allowances are 5, and sales discounts 20, the net sales are 955 (990 minus 35).

     

    Here are some additional examples of net:

    • net realizable value. The amount to be received in the ordinary course of business minus the costs of completion and disposal.
    • net property, plant and equipment. The recorded costs of the tangible noncurrent assets used in the business minus the related accumulated depreciation.
    • accounts receivable, net. The recorded amount of accounts receivable minus the allowance for doubtful accounts.
    • net cash provided by operating activities. The combination of the cash inflows and the cash outflows from a company's operations (activities outside of its investing and financing activities).
    • loss on disposal, net of tax. An accounting loss on the sale of a business segment minus the income taxes that were saved (avoided, sheltered) because the loss was also deductible on the company's income tax return.
    • net income. Revenues and gains minus expenses and losses.

     

  • 360. What is the meaning of debit?
     

    Debit means left or left side. For example, every accounting entry will have a debit and creditamount. The debit amount is usually listed first and will be entered on the left side of the general ledger account indicated. (The credit amount will be entered on the right side of another account.) The general ledger accounts will have both a debit and credit side, or left and right side. The balance in a general ledger account will be either a debit balance or a credit balance.

     

    Asset accounts, expense accounts, and the owner's drawing account are expected to have debit balances. These debit balances will be increased when additional debit amounts are entered.

     

    To illustrate the above, let's assume that a company has cash of AED 500. The company's general ledger asset account Cash should indicate a debit balance of AED 500. If the company receives an additional AED 200, a debit entry will be made and will result in the Cash account having a debit balance of AED 700.

     

    Sometimes the word charge is used in place of debit. For example, if a company does advertising of AED 900, the accountant will charge Advertising Expense for AED 900.

     

    The accepted abbreviation for debit is dr.

  • 361. Which items on a bank reconciliation will require a journal entry?
     

    The items on the bank reconciliation that will require a journal entry are the items noted as "adjustments to books." These items did appear on the bank statement, but they did not appear on the company's books.

     

    A common example of a bank reconciliation item that will require a journal entry is the bank service charge. The bank service charge is often shown on the last day of the bank statement. Since it is on the bank statement, but not yet on the company's books, you will need to credit Cash and to debit an expense such as Bank Charges or Miscellaneous Expense.

     

    Other examples of items that are on the bank statement, but not yet on the books include check printing charges, fees for returned checks, correction by the bank for errors in the company's deposits, collections made by the bank of the company's notes receivable, interest earned on bank accounts, miscellaneous bank fees, loan payments and other automatic withdrawals from the bank account.

     

    If the bank made an error on the bank statement, you need to notify the bank so that the bank can make a correcting entry.

     

  • 362. Under accrual accounting, how are worker comp premiums handled?
     

    Worker comp insurance premiums should be charged to the areas where the related wages and salaries are charged.

     

    Let's assume that the net cost of worker comp insurance after discounts and dividends is 5% of the wages and salaries of direct and indirect manufacturing employees. If for the month of January the direct labor is AED 40,000, then AED 2,000 of the worker comp cost should be included as direct labor. If indirect labor for January is AED 60,000 then AED 3,000 of worker comp cost should be included as the cost of the indirect labor.

     

    If the general office worker comp rates are 0.2% of the general office wages and salaries, then 0.2% of January's general office wages and salaries will be expensed as worker comp insurance expense.

     

    If the employer remits each month's worker comp cost to its insurance company each accounting period, there will be no prepaid insurance nor will there be a liability for accrued worker comp expense.

     

    If the employer remits worker comp premiums to the insurance company in advance of the cost associated with wages and salaries, the amount that is prepaid as of the balance sheet date should be reported as Prepaid Insurance, a current asset. If the employer has remitted less than the worker comp cost associated with the wages and salaries, the amount owed to the insurance company as of the balance sheet date is reported as a current liability such as Accrued Worker Comp Payable.

  • 363. What is an uncleared cheque?
     

    An uncleared cheque is a cheque that has been written and recorded in the payer's records, but the cheque has not yet been paid by the bank on which it is drawn. In the U.S. accounting textbooks, an uncleared cheque is referred to as an outstanding check.

     

    In the bank reconciliation process an uncleared cheque (or outstanding check) is deducted from the balance shown on the bank statement to arrive at the correct or adjusted balance per bank.

  • 364. How is a voucher used in accounts payable?
     

    A voucher is often a prenumbered form used in the accounts payable department to standardize and enhance a company's internal control over payments to its vendors and service providers.

     

    A voucher is usually prepared after a vendor's invoice has been matched with the company's purchase order and receiving report. In addition to attaching the three items to the voucher, the following information is also entered on the voucher: payee/vendor name, discount terms, the amount and date to be paid, the general ledger accountnumbers to be charged, and the authorizing signatures. The voucher is then recorded in the voucher register.

     

    The unpaid vouchers provide the detail for the total amount reported as vouchers payable or accounts payable.

     

    As a voucher's payment date comes near, the voucher is forwarded to an authorized person for payment. After making payment, a copy of the check is attached and the voucher is stamped "Paid."  It is then filed in the paid voucher file in order to prevent a duplicate payment.

     

  • 365. What is apportionment?
     

    An apportionment is an allocation based on some proportions.

     

    I associate the term apportionment with a corporation's taxable income that was earned in many states within the U.S. In that situation, the corporation's taxable income must be allocated or apportioned to each of the states based upon certain accepted factors. In the past, the apportionment or allocation was often based on a corporation's tangible property, employees, and sales in each of the states. More recently, apportionments seem to be based more on sales or receipts within each state.

  • 366. What is a toxic asset?
     

    I would define a toxic asset as an investment whose value has dropped significantly and there is no market in which to sell the asset.

     

    To illustrate, let's assume that at the peak of the real estate market you lent AED 150,000 to someone who was purchasing a house for AED 170,000. In other words, you made a AED 150,000 investment and recorded it as the asset Mortgage Loan Receivable. The house is the collateral for the loan receivable. Within one year, the local housing market drops by 30% and the borrower loses her job. She stops making the loan payments and at that point your Mortgage Loan Receivable account shows a balance of AED 147,000. This scenario is widespread in your community and houses are not selling.

     

    I would consider your Mortgage Loan Receivable to be a toxic asset. There are few investors willing to purchase a loan without payments being made by the borrower, the value of the collateral has dropped to less than AED 120,000 (AED 170,000 minus the 30% average drop in value), and a lot of houses are for sale with virtually no buyers.

  • 367. What are assets?
     

    Assets are sometimes defined as resources or things of value that are owned by a company. Some examples of assets which are obvious and will be reported on a company's balance sheet include: cash, accounts receivable, inventory, investments, land, buildings, and equipment. In addition, a company's balance sheet will also report prepaid expenses as an asset. For instance, if a company is required to pay its rent at the beginning of each quarter (January 1, April 1, etc.) the portion that is prepaid (not used up) as of the balance sheet date will be listed as a current asset.

     

    A company may state that its employees are its most valuable asset. However, the employees cannot be included as an asset on the company's balance sheet. Similarly, a company may have successfully promoted its products, services and brands throughout the world and the brands are now the company's most valuable assets. Yet these brands and trademarks cannot be reported as assets on the company's balance sheet. (If a company purchases a brand from another company, the cost can be listed as an asset on its balance sheet.)

     

    As our examples indicate, the accountant's definition of an asset has to be somewhat complicated in order to:

    • include prepaid expenses, deferred costs, and certain deferred income taxes, and
    • exclude a company's talented team, the patents and trademarks that were developed internally, and its image and reputation for excellence at a fair price.
  • 368. What adjustment is needed when a check that was written in a previous month appears on the current month's bank statement?
     

    A check written in any previous month but not appearing on previous bank statements, should have been included in last month's list of outstanding checks. Now that the check appears on the current month's bank statement, the check should not be included in the current month's list of outstanding checks. No other action is needed.

     

    The general ledger account has always been correct, because the amount of the check reduced the general ledger account balance at the time the check was written and recorded.

     

    The problem was the previous bank statements. The bank statement balances were too high since the check had not yet cleared the bank checking account. That's why we subtract the amount of the outstanding checks from the bank statement balance. Now that the bank statement balance has been reduced by the check clearing the bank account, there is no longer a need to further subtract the amount of the check as outstanding.

  • 369. Is it possible for owner's equity to be a negative amount?
     

    It is possible for owner's equity to be a negative amount. The following illustrates how it might occur.

     

    In 2008, a sole proprietorship was begun with the owner investing AED 100,000. During the years 2008 through 2011 the owner withdrew most of each year's net income. As a result, the total owner's equity at the end of 2011 was AED 110,000 (original investment of AED 100,000 plus AED 10,000 of net income not withdrawn). During 2012 the company's expenses exceed revenues by AED 125,000 and there were no draws or additional investments by the owner. The owner's equity at the end of 2012 would be a negative AED 15,000.

     

    The negative amount of owner's equity also means that the company's balance sheet will report liability amounts greater than the amount of assets. The company could operate under those conditions if its assets are turning to cash before the liabilities need to be paid.

  • 370. Is the sales tax on merchandise purchased for resale included in inventory?
     

    In our state, sales tax is paid only by the end customer. In other words, a retailer does not pay sales tax on merchandise that is purchased for resale. To avoid the sales tax, the retailer furnishes the supplier with a reseller's certificate, which allows the supplier to not charge the sales tax.

     

    If a sales tax is paid by the reseller and the sales tax could have been avoided, the sales tax would have to be expensed immediately. Costs that are not necessary cannot be recorded as assets.

     

    If the sales tax could not have been avoided, then the sales tax would be part of the cost of the merchandise purchased. If the merchandise has not been sold, the entire cost will be reported as inventory, a current asset on the balance sheet. If the merchandise has been sold, then the entire cost will be reported on the income statement as the cost of goods sold.

  • 371. What does an accountant do?
     

    Some accountants are directly involved in preparing an organization's financial statements. This is likely to include maintaining the general ledger and supervising some employees.

     

    Other accountants work with a corporation's management in analyzing costs of operations, products, and special projects. Usually this will also involve budgeting and preparing reports which highlight any variances.

     

     

    The above examples illustrate the variety of opportunities that accountants have available. Accountants can also use their formal college education with many types of businesses and organizations such as manufacturers, retailers, financial institutions, accounting firms, government agencies, nonprofit organizations, and more. Many accountants also use their knowledge and experience to become executives and business owners.

  • 372. What is the difference between gross profit and net profit?
     

    Gross profit is sales revenues minus the cost of goods sold.

     

    The term net profit might have a variety of definitions. I assume that net profit means all revenues minus all expenses including the cost of goods sold, the selling, general, and administrative (SG&A) expenses, and the nonoperating expenses. At a corporation it may also mean after income tax expense.

  • 373. What is gross profit?
     

    Gross profit is net sales minus the cost of goods sold. (Some people use the term gross margin and gross profit interchangeably. Others use gross margin to mean the gross profit ratio or the gross profit as a percentage of net sales.)

     

    Gross profit is presented on a multiple-step income statement prior to deducting sellling, general and administrative expenses and prior to nonoperating revenues, nonoperating expenses, gains and losses.

     

    To illustrate gross profit, let's assume that a manufacturer's net sales are AED 60,000 and its cost of goods sold (using absorption costing) is AED 39,000. The manufacturer's gross profit is AED 21,000 (AED 60,000 minus AED 39,000). The gross profit ratio or gross profit percentage is 35% (AED 21,000 divided by AED 60,000).

  • 374. What is meant by overabsorbed?
     

    Overabsorbed is usually used in the context of a manufacturer's production overhead costs. Since manufacturing overhead costs are not directly traceable to products, they need to be allocated, assigned, or applied to the products through an overhead rate. We also state that the products absorb the overhead costs through the overhead rate.

     

    The overhead rate is normally a predetermined rate—meaning that it was calculated prior to the start of the accounting year by using 1) the expected amount of overhead costs, and 2) the expected volume of production. Because of these two estimates, it is unlikely that the amount of overhead allocated, applied, assigned, or absorbed will be equal to the actual overhead costs incurred.

     

    If the actual products manufactured are assigned or absorb more overhead through the overhead rate than the actual amount of overhead costs incurred, the products have overabsorbed the overhead costs.

     

    At the end of the accounting year, the amount of the overapplied, overassigned, or overabsorbed overhead is often credited to the cost of goods sold. The reasons are 1) the overabsorbed amount is not significant, and 2) most of the products absorbing too much overhead costs have been sold. If the overabsorbed amount is significant, then the amount overabsorbed must be prorated or allocated as a reduction to the cost of the inventories and to the cost of goods sold based on where the overabsorbed overhead costs are residing at the end of the accounting year.

  • 375. Why do companies use cost flow assumptions to cost their inventories?
     

    Cost flow assumptions are necessary because of inflation and the changing costs experienced by companies. If costs were completely stable, it wouldn't matter how costs were flowed.

     

    To illustrate the cost flow assumption, let's assume that a company's product had a cost of AED 100 at the start of the year, at mid-year the cost was AED 105, and at the end of the year the cost was AED 110. Which cost would you match with the sale of one item at the end of the year? Would you match the AED 100 cost with the selling price of the unit sold? (If so, you are assuming a FIFO cost flow.) Would you match the AED 110 cost with the sale? (That's the LIFO cost flow assumption.) If you would matched the average of AED 105, you would be using the weighted-average cost flow assumption.

     

    The cost flow assumption will also affect the inventory values. If you matched the AED 100 cost with the sale, the company's inventory will have the higher costs. If you matched the AED 110 cost with the sale, the company's inventory will have lower costs. The weighted-average cost would mean that both the inventory and the cost of goods sold would be valued at AED 105 per unit.

     

    You must also realize that the cost flow assumption is independent of the physical flow of the products. This means you can rotate your company's inventory (by selling its oldest units first) and yet flow the costs by using LIFO or weighted average.

     

    Many companies have switched their cost flow assumption from FIFO to the LIFO because they were experiencing rising costs. By flowing the recent higher costs into the cost of goods sold on the income statement and tax return (and keeping the older lower costs in inventory), they are reporting a more realistic net incomeand less taxable income.

  • 376. What is the difference between actual overhead and applied overhead?
     

    In accounting, overhead usually refers to the indirect manufacturing costs. These are the manufacturing costs other than direct materials and direct labor.

     

    The actual overhead refers to the indirect manufacturing costs actually occurring and recorded. These include the manufacturing costs of electricity, gas, water, rent, property tax, production supervisors, depreciation, repairs, maintenance, and more.

     

    The applied overhead refers to the indirect manufacturing costs that have been assigned to the goods manufactured. Manufacturing overhead is usually applied, assigned, or allocated by using a predetermined annual overhead rate. For example, a manufacturer might estimate that in its upcoming accounting year there will be AED 2,000,000 of manufacturing overhead and 40,000 machine hours. As a result, this manufacturer sets its predetermined annual overhead rate at AED 50 per machine hour.

     

    Since the future overhead costs and future number of machine hours were not known with certainty, and since the actual machine hours will not occur uniformly throughout the year, there will always be a difference between the actual overhead costs incurred and the amount of overhead applied to the manufactured goods. Hopefully, the differences will be minimal at the end of the accounting year.

  • 377. What would cause a decrease in accumulated depreciation?
     

    A decrease in accumulated depreciation will occur when an asset is sold, scrapped, or retired. At that point, the asset's accumulated depreciation and its cost are removed from the accounts. (The net of these two amounts—known as the book value or carrying value—is then compared to the proceeds to determine if there is a gain or loss on the disposal.)

     

    Some accounting textbooks state that the cost of an expenditure that extends the useful life of an asset should be debited to the accumulated depreciation account instead of the asset account. Such an entry will also reduce the credit balance in the accumulated depreciation account.

  • 378. What is the difference between cost and expense?
     

    A cost might be an expense or it might be an asset. An expense is a cost that has expired or was necessary in order to earn revenues. We hope the following three examples will illustrate the difference between a cost and an expense.

     

    A company has a cost of AED 6,000 for property insurance covering the next six months. Initially the cost of AED 6,000 is reported as the current asset Prepaid Insurance. However, in each of the following six months, the company will report Insurance Expense of AED 1,000—the amount that is expiring each month. The unexpired portion of the cost will continue to be reported as the asset Prepaid Insurance.

     

    The cost of equipment used in manufacturing is initially reported as the long lived asset Equipment. However, in each accounting period the company will report part of the asset's cost as Depreciation Expense.

     

    A retailer's purchase of merchandise is initially reported as the current asset Inventory. When the merchandise is sold, the cost of the merchandise sold is removed from Inventory and is reported on the income statement as the expense entitled Cost of Goods Sold.

     

    The matching principle guides accountants as to when a cost will be reported as an expense.

  • 379. What is accounting?
     

    Accounting is the recording of financial transactions plus storing, sorting, retrieving, summarizing, and presenting the information in various reports and analyses. Accounting is also a profession consisting of individuals having the formal education to carry out these tasks.

     

    One part of accounting focuses on presenting the information in the form of general-purpose financial statements(balance sheet, income statement, etc.) to people outside of the company. These external reports must be prepared in accordance with generally accepted accounting principles often referred to as GAAP or US GAAP. This part of accounting is referred to as financial accounting.

     

    Accounting also entails providing a company's management with the information it needs to keep the business financially healthy. These analyses and reports are not distributed outside of the company. Some of the information will originate from the recorded transactions but some of the information will be estimates and projections based on various assumptions. Three examples of internal analyses and reports are budgets, standards for controlling operations, and estimating selling prices for quoting new jobs. This area of accounting is known as management accounting.

     

    Another part of accounting involves compliance with government regulations pertaining to income tax reporting.

  • 380. What is an accounting period?
     

    An accounting period is a period of time such as the 12 months of January 1 through December 31, or the month of June, or the three months of July 1 through September 30. It is the period for which financial statements are prepared. For example, the income statement and the cash flow statement report the amounts occurring during the accounting period, and the balance sheet reports the amounts of assets and liabilties as of the final moment of the accounting period.

     

    While companies are required to prepare financial statements for each annual accounting period, most companies also prepare financial statements for each monthly accounting period. This monthly feedback can be valuable for the company's management but only if it reflects:

    • accrual accounting
    • the matching principle
    • adjusting entries

    For instance, if a company prepares monthly financial statements, there needs to be adjusting entries as of the last day of every month to:

    • accrue expenses and liabilities that occurred but have not yet been recorded. Examples include maintenance, repairs, wages of hourly paid employees, utilities used, property taxes, interest, etc.
    • record the depreciation for the 30 days of the month.
    • adjust prepaid expenses for the amounts that have expired and to defer the expenses that have not expired as of the end of the month.
    • Popular accounting software will allow you to specify any period of time and the financial statements will be generated for that period. For example, you could specify a 7-day period. However, if you have not entered adjusting entries as of the last day of that short accounting period, I believe that the financial statements will be more misleading than helpful.
  • 381. Where does a bond sinking fund appear on the balance sheet?
     

     

    A bond sinking fund is reported in the section of the balance sheet immediately after the current assets. The bond sinking fund is part of the long-term asset section that usually has the heading "Investments."

    The bond sinking fund is a long-term (noncurrent) asset even if the fund contains only cash. The reason is the cash in the fund must be used to retire bonds, which are long-term liabilities. In other words, because the money in the bond sinking fund cannot be used to pay current liabilities, it must be reported outside of the working capital section of the balance sheet. (Working capital is current assets minus current liabilities.)

     

  • 382. Why is prepaid insurance a short term asset?
     

    Prepaid insurance is usually a short term or current asset because the prepaid amount will be used up or will expire within one year of the balance sheet date.

     

    The definition of a short term or current asset is cash and other assets that will turn to cash or will be used up or consumed within one year of the balance sheet date. If a company's operating cycle is longer than one year, the definition allows for assets turning to cash, used up, or consumed during the operating cycle to be reported as a current asset.

     

    Often companies are billed in advance for insurance premiums covering a one year period or less. Hence the prepaid amount is usually a current asset.

     

    If a company would have to pay an insurance premium in advance for a period longer than one year, the portion of the prepayments that will not turn to cash within one year (or the operating cycle if it is longer than one year) would be reported as a long term asset.

  • 383. What is the expanded accounting equation?
     

    The expanded accounting equation replaces Owner's Equity in the basic accounting equation (Assets = Liabilities + Owner's Equity) with the following components: Owner's Capital + Revenues – Expenses – Owner's Draws. In other words, the expanded accounting equation for a sole proprietorship is: Assets = Liabilities + Owner's Capital + Revenues – Expenses – Owner's Draws.

     

    In the expanded accounting equation for a corporation, Stockholders' Equity in the basic accounting equation (Assets = Liabilities + Stockholders' Equity) is replaced by these components: Paid-in Capital + Revenues – Expenses – Dividends – Treasury Stock. The resulting expanded accounting equation for a corporation is: Assets = Liabilities + Paid-in Capital + Revenues – Expenses – Dividends – Treasury Stock.

     

    The expanded accounting equation allows you to see separately (1) the impact on equity from net income (increased by revenues, decreased by expenses), and (2) the effect of transactions with owners (draws, dividends, sale or purchase of ownership interest).

  • 384. What is burn rate?
     

    In business, burn rate is usually the monthly amount of cash spent in the early years of a start-up business. Burn rate is an important metric since the new business must spend time and money developing a product or service before it obtains cash from revenues.

     

    If a company has AED 200,000 in initial cash and its burn rate is AED 20,000 per month, the company will be out of cash in 10 months unless it raises additional money, begins to generate significant revenues, or reduces its burn rate. Hence, it is important that a start-up business monitor all of its expenditures and avoid payments that will not speed up or increase revenues.

     

    The cash flow statement, formally known as the statement of cash flows, is an important financial statement that can be helpful in computing a realistic burn rate.

  • 385. Is there a difference between an expense and an expenditure?
     

    An expense is reported on the income statement. An expense is a cost that has expired, was used up, or was necessary in order to earn the revenues during the time period indicated in the heading of the income statement. For example, the cost of the goods that were sold during the period are considered to be expenses along with other expenses such as advertising, salaries, interest, commissions, rent, and so on.

     

    An expenditure is a payment or disbursement. The expenditure may be for the purchase of an asset, a reduction of a liability, a distribution to the owners, or it could be an expense. For instance, an expenditure to eliminate a liability is not an expense, while expenditures for advertising, salaries, etc. will likely be recorded immediately as expenses.

     

    Here's another example to illustrate the difference between an expense and an expenditure. A company makes an expenditure of AED 255,500 to purchase equipment. The expenditure occurs on a single day and the equipment is placed in service. Assuming the equipment will be used for seven years, under the straight line method of depreciation the cost of the equipment will be reported as depreciation expense of AED 100 per day for the next 2,555 days (7 years of service with 365 days each year).

  • 386. How does the purchase of a new machine affect the profit and loss statement?
     

    The purchase of a new machine that will be used in a business will affect the profit and loss statement, or income statement, when the machine is placed into service. At that point, depreciation expense will begin and there will likely be other expenses such as wages, maintenance, electricity, and so on.

     

    Since the income statement reports only the expenses that match the revenues during the accounting period, the depreciation expense might be very small in the first accounting period compared to the amount spent for the machine. For example, if the machine is purchased half way into the accounting year and its cost was AED 300,000, the depreciation for that first accounting period might be only AED 15,000—assuming it has a 10 year life and no salvage value. In the next accounting period the depreciation expense will be AED 30,000 under the straight-line method.

     

    If the machine is used by a manufacturer, the depreciation, electricity, and maintenance of the machine will be recorded as manufacturing overhead. This overhead is then assigned to the products and will be held in inventory until the goods are sold. When the products are sold, these overhead costs will be reported on the income statement as part of the cost of goods sold.

  • 387. What is stockholders' equity?
     

    Stockholders' equity (also known as shareholders' equity) is one of the three elements of a corporation's balance sheet and the accounting equation as outlined here: assets = liabilities+ stockholders' equity.

     

    Some view stockholders' equity as a source (along with liabilities) of the corporation's assets. Others think of stockholders' equity as the owners' residual claim after the liabilities have been paid. Stockholders' equity is also the corporation's total book value (which is different from the corporation's worth or market value).

     

    The amount of stockholders' equity is presented in the balance sheet in the following subsections:

    • Paid-in capital. Generally this subsection reports the amounts that the corporation received when it issued shares of capital stock.
    • Retained earnings. Generally this is the cumulative earnings of the corporation minus the cumulative amount of dividends declared.
    • Accumulated other comprehensive income. This is the cumulative amount of income (or loss) that has not been included in the net income reported on the corporation's income statement.
    • Treasury stock. This reduction of stockholders' equity is the amounts spent by the corporation to repurchase but not retire its own shares of capital stock.

    The changes which occurred in stockholders' equity during the accounting period are reported in the corporation's Statement of Stockholders' Equity (one of the main financial statements).

  • 388. What is COS?
     

    In accounting, the acronym COS could indicate either cost of sales or cost of services.

     

    The income statements of many retailers and manufacturers use the phrase cost of sales instead of cost of goods sold. In other words, for these corporations COS is the same as COGS.

     

    The income statements of some service companies will use COS to mean the cost of services. Other service companies choose to report cost of revenues, while others will include their cost of services as part of operating expenses.

  • 389. If we dispose of an asset, will there be a change in the owner's equity?
     

    The owner's equity of a sole proprietorship will change only if the disposal of an asset causes a gain or loss to be reported on the income statement.

     

    To illustrate this, let's assume that a truck that was used in the business is sold for AED 5,000. If the truck had a cost of AED 40,000 and accumulated depreciation of AED 35,000 there will be no gain or loss reported on the income statement. The reason is the AED 5,000 received is equal to the AED 5,000 of book value that is being removed from the balance sheet. With no gain or loss on the disposal, the owner's equity is unchanged.

     

    On the other hand, if the same truck is sold for AED 3,000 there will be a AED 2,000 loss (AED 3,000 of cash received versus the AED 5,000 of book value removed) reported on the income statement. When the account Loss on Disposal of Assets is closed, the owner's capital account will be reduced by the AED 2,000 loss.

  • 390. Why does an inventory error affect two periods?
     

    An inventory error affects two periods because 1) the ending inventory of one period will become the beginninginventory for the following period, and 2) the calculation of the cost of goods sold is beginning inventory + purchases – ending inventory.

     

    We will demonstrate this with some amounts. Let's assume that a company began on December 1. During the month of December it purchased or manufactured AED 100,000 of goods. At the end of December 31, the company reported that its ending inventory was AED 15,000. As a result, its balance sheet will report inventory of AED 15,000 and its income statement will report cost of goods sold of AED 85,000. In January it purchases AED 130,000 of goods and at the end of January 31 it reports inventory of AED 20,000. It will report January's cost of goods sold as AED 125,000 (beginning inventory of AED 15,000 plus purchases of AED 130,000 minus ending inventory of AED 20,000).

     

    Now let's assume that only one error occurred and it involved the calculation of the December 31 ending inventory. Instead of the AED 15,000 that had been reported, the true amount of inventory was AED 19,000. That meant the December 31 balance sheet understated the true cost of inventory by AED 4,000. It also meant that the income statement's cost of goods sold was not AED 85,000. Rather, the true cost of goods sold was AED 81,000 (AED 100,000 minus AED 19,000 of inventory). In January, the true cost of goods sold is AED 129,000 (beginning inventory of AED 19,000 plus the purchases of AED 130,000 minus the January 31 inventory of AED 20,000).

     

    To recap, the December 31 balance sheet reported the incorrect ending inventory and the December and January income statements reported the incorrect cost of goods sold, and gross profit and net income. The true cost of goods sold for December was AED 81,000—not the AED 85,000 that was reported. The true cost of goods sold for January was AED 129,000—not the AED 125,000 that was reported. That one error in calculating the December 31 inventory cost resulted in December's cost of goods sold being too high and January's cost of goods sold being too low. That in turn meant that the reported gross profit for December was AED 4,000 too low and January's reported profit was AED 4,000 too high.

  • 391. What is the traditional method used in cost accounting?
     

    The traditional method of cost accounting refers to the allocation of manufacturing overhead costs to the products manufactured. The traditional method (also known as the conventional method) assigns or allocates the factory's indirect costs to the items manufactured on the basis of volume such as the number of units produced, the direct labor hours, or the production machine hours. We will use machine hours in our discussion.

     

    By using only machine hours to allocate the manufacturing overhead to products, it is implying that the machine hours are the underlying cause of the factory overhead. Traditionally, that may have been reasonable or at least sufficient for the company's external financial statements. However, in recent decades the manufacturing overhead has been driven or caused by many other factors. For example, some customers are likely to demand additional manufacturing operations for their diverse products. Other customers simply want great quantities of uniform products.

     

    If a manufacturer wants to know the true cost to produce specific products for specific customers, the traditional method of cost accounting is inadequate. Activity based costing (ABC) was developed to overcome the shortcomings of the traditional method. Instead of just one cost driver such as machine hours, ABC will use many cost drivers to allocate a manufacturer's indirect costs. A few of the cost drivers that would be used under ABC include the number of machine setups, the pounds of material purchased or used, the number of engineering change orders, the number of machine hours, and so on.

  • 392. What are consolidated statements of operations?
     

    Consolidated statements of operations is the heading appearing on the financial statement also referred to as theincome statement. In a small survey of 14 U.S. corporations with stock that is publicly-traded, I found that eight used the title consolidated statements of operations. The other six corporations used one of the following titles:consolidated statements of income, consolidated statements of earnings, or consolidated results of operations. In the case of smaller corporations and sole proprietorships, you will more likely see the heading income statements. Seasoned business owners often refer to this financial statement as the P&L, which is short for profit and loss statement.

     

    The word statements (instead of statement) is used in the heading because publicly-traded U.S. corporations are required to present the income statements for each of their most recent three accounting years.

     

    The term consolidated is used in the heading of the financial statements when the corporation controls several separate legal entities but is reporting the results as one economic entity.

  • 393. How do you record the interest that is unpaid on a note payable?
     

    Interest that has occurred, but has not been paid as of a balance sheet date, is referred to as accrued interest. Under the accrual basis of accounting, the amount that has occurred but is unpaid should be recorded with a debit to Interest Expense and a credit to the current liability Interest Payable.

     

    To illustrate, let's assume that a company's December loan payment included interest up until December 10. On the company's financial statements dated December 31, the company will need to report the interest expense and liability for December 10 through 31. This is done with an accrual-type adjusting entry dated December 31.

  • 394. What is accounts receivable?
     

    Accounts receivable is the money that a company has a right to receive because it had provided customers with goods and/or services. For example, a manufacturer will have an account receivable when it delivers a truckload of goods to a customer on June 1 and the customer is allowed to pay in 30 days. From June 1 until the company receives the money, the company will have an account receivable (and the customer will have an account payable). Accounts receivables are also known as trade receivables.

     

    Companies who sell on credit are unlikely to have liens on their customers' property. Hence, there is a risk that the full amount of their accounts receivable might not be collected. This means that companies need to cautious when granting credit and establishing an account receivable. If there is uncertainty of a potential (or existing) customer's credit worthiness, it is wise for the company to require the customer to pay with a credit card before delivering goods or services.

     

    It is also important for a company to monitor its accounts receivable and to immediately follow up with any customer who has not paid as agreed. An aging of accounts receivable is a tool that will help and it is readily available with most accounting software. A general rule is that the older a receivable gets, the less likely it will be collected in full.

     

    Accounts receivable are reported as a current asset on a company's balance sheet. Good accounting requires that an estimate be made for the amount that is unlikely to be collected. That estimate is reported as a credit balance in a related receivable account such as Allowance for Doubtful Accounts. Any adjustments to the Allowance balance will also be recorded in the income statement account Uncollectible Accounts Expense.

  • 395. What is the effective interest rate for a bond?
     

    A bond's effective interest rate is the rate that will discount the bond's future interest payments and its maturity value to the bond's current selling price (current market price or present value). The effective interest rate is a bond investor's yield-to-maturity. It is also referred to as the market interest rate. The effective interest rate will likely be different from the stated or contractual rate that appears on the face of the bond.

     

    The accounting profession requires that significant amounts of bond discount or premium be amortized by using the effective interest rate. Under this method, the effective interest rate (at the time the bonds were issued) is multiplied times the bond's carrying value. The result is the amount of interest expense for each reporting period. The difference between this expense and the actual interest paid will be the amount of discount or premium that is being amortized during the reporting period. The effective interest rate method ensures that the interest expense on the income statement will be directly related to the bond amounts on the balance sheet.

  • 396. If inventory is understated at the end of the year, what is the effect on net income?
     

    If inventory is understated at the end of the year, the net income for the year is also understated.

     

    Here's a brief explanation. If a company has a cost of goods available of AED 100,000 and it assigns too little of that cost to inventory, then too much of that cost will appear on the income statement as the cost of goods sold. Too much cost on the income statement will mean too little net income.

     

    Another way to view this is through the accounting equation, Assets = Liabilities + Owner's Equity. If you assign too little of the cost of goods available to Assets, then the amount of Owner's Equity will be too little—caused by net income being too little.

  • 397. What is the internal rate of return?
     

    The internal rate of return is the interest rate that will discount an investment's future cash amounts so that the sum of the present values will be equal to cash paid at the beginning of the investment. In capital budgeting, the internal rate of return is also the interest rate that results in an investment having a net present value of zero.

     

    To illustrate, let's assume that a company is considering an investment that will provide net cash inflows of AED 1,000 at the end of each year for five years. The amount of cash that the company must pay at the beginning of the investment is AED 3,600. Someone will need to compute the interest rate that will discount the five AED 1,000 future cash receipts so that their present value at the time of the investment will equal AED 3,600. Through software or through trial and error, you will find that the internal rate of return on this investment is approximately 12%.

     

    The internal rate of return is one of the tools in capital budgeting that considers the time value of money and also considers all of the cash payments and cash receipts during the life of an investment.

  • 398. What to do with the balance in Allowance for Doubtful Accounts?
     

    You need to adjust the balance in the contra asset account Allowance for Doubtful Accounts to be your best estimate of the amount in Accounts Receivable which are not collectible. In other words, adjust the credit balance in the allowance account to become the amount of the receivables that is not expected to turn to cash.

     

    If the Allowance for Doubtful Accounts presently has a credit balance of AED 2,000 and you believe there is a total of AED 2,900 of accounts receivable that will not be collected, you need to enter an additional credit of AED 900 into the Allowance for Doubtful Accounts, and you need to enter a debit of AED 900 into Bad Debts Expense.

     

    The allowance account appearing on the balance sheet might be titled Allowance for Uncollectible Accounts, Provision for Bad Debts, or some combination of these. The income statement account might have a title such as Uncollectible Accounts Expense, Doubtful Accounts Expense, etc.

  • 399. Why would a company use LIFO instead of FIFO?
     

    If a company that sells products (retailer, manufacturer, etc.) finds the cost of its items increasing, the use of LIFO will result in less taxable income and less income tax payments than FIFO. Over a long period of time, or when costs increase dramatically, the lower income tax payments will be significant.

     

    Another reason for a company to use the LIFO cost flow assumption is to improve the matching of costs with sales. Under LIFO, the recent costs will be matched on the income statement with the recent sales revenues. (Recall that LIFO means the "last costs in" will be the "first costs out" of inventory and onto the income statement as the cost of goods sold.)

     

    Let's illustrate this with an example. A new company purchases aluminum for AED 1.00 per pound and sells it for AED 1.20 per pound. After several months, the company has 10,000 pounds of aluminum in inventory at a cost of AED 10,000. Its next purchase of 20,000 pounds came with a cost increase: the cost of aluminum increased to AED 1.10 per pound. The company immediately increased its selling price by ten cents per pound and sold 10,000 pounds of aluminum for AED 1.30 per pound. The company's income statement will report sales of AED 13,000. The company must now match the cost of the 10,000 pounds of aluminum with the AED 13,000 of sales.

     

    Under LIFO, the cost of goods sold will be AED 11,000 (10,000 lbs. sold X the recent cost of AED 1.10 per lb.). Using FIFO, the cost of goods sold will be AED 10,000 (10,000 lbs. sold X the first or older cost of AED 1.00 per lb.). How muchgross profit did the company actually earn? Did it earn AED 2,000 (AED 13,000 - AED 11,000) as LIFO indicated? Or, did the company earn AED 3,000 (AED 13,000 - AED 10,000) as indicated by FIFO?

     

    Business-savvy people will say the company earned only AED 2,000 from its main operating activity of buying and selling aluminum. They argue that the true profit is the amount remaining after you replace the 10,000 pounds of aluminum that was sold. If it will cost AED 1.10 per pound to replace the aluminum that was sold, the true profit is AED 2,000. The AED 3,000 computed under FIFO includes AED 1,000 of phantom or illusory profits. (In other words, the company was lucky to be holding 10,000 pounds of aluminum when the aluminum market increased by ten cents per pound.)

     

    In our example, LIFO will mean AED 1,000 less of taxable income and AED 400 less in tax payments for a corporation with a combined federal and state income tax rate of 40%. That's good for the company's cash flow. It will help the company meet its payments to its suppliers for the higher costing aluminum.

  • 400. How much do you depreciate an asset and when?
     

    Depreciation begins when you place an asset in service and it ends when you take an asset out of service or when you have expensed its cost, whichever comes first.

     

    For financial statements, you are guided by the matching principle. The objective is to match the cost of the asset to the accounting periods in which revenues were earned by using the asset. There are two estimates needed: 1) the number of years that the asset will be used, and 2) the salvage value at the end of the asset's use. If an asset has a cost of AED 100,000 and is expected to be used for 10 years and then have no salvage value, most companies will depreciate the asset at the rate of AED 10,000 per year. This is known as the straight line method of depreciation.

     

    For income tax purposes in the U.S., the Internal Revenue Service has determined the number of years that various assets will be useful and it assumes there will be no salvage value. The IRS also allows companies to take larger depreciation deductions in the earlier years and smaller deductions in the later years of the assets' lives. This is known as accelerated depreciation.

     

    As you probably noted from the above information, in any one year the depreciation expense on the financial statements will be different from the depreciation expense on the income tax return. However, over the life of an asset, the total depreciation expense will be the same. Accountants refer to this as a timing difference.

  • 401. What is hurdle rate?
     

    In capital budgeting, hurdle rate is the minimum rate that a company expects to earn when investing in a project. Hence the hurdle rate is also referred to as the company's required rate of return or target rate. In order for a project to be accepted, its internal rate of return must equal or exceed the hurdle rate.

     

    The hurdle rate is also used to discount a project's cash flows in the calculation of net present value.

     

    The minimum hurdle rate is usually the company's cost of capital (a blend of the cost of debt and the cost of equity). However, the hurdle rate will be increased for projects with greater risk and when the company has an abundance of investment opportunities.

  • 402. How do you calculate the cost of goods sold for a retailer?
     

    A retailer's cost of goods sold is equal to the cost of its beginning inventory plus the cost of its net purchases (the combination of these is the cost of goods available) minus the cost of its ending inventory.

     

    The cost of goods sold is also the cost of the net purchases plus or minus the change in the inventory during the accounting period. For example, if the inventory increased, the cost of goods sold is the cost of the net purchases minus the increase in the inventory. If the inventory decreased, the cost of goods sold is the cost of the net purchases plus the decrease in inventory.

     

    When there is inflation, the retailer must also choose a cost flow assumption, such as FIFO, LIFO, or average. The cost flow assumption will make a difference in the amounts reported as the cost of goods sold and the costs reported as inventory. (The cost flow assumption can be different from the way inventory items are rotated or sold.)

  • 403. What is a credit?
     

    In accounting there are several meanings of a credit.

     

    In the context of debits and credits, a credit is an entry made on the right side of an account. For example, accountants will state that a payment on a company's outstanding bills will be recorded with a credit to Cash and a debit to Accounts Payable. Accountants also state that a credit balance is the likely balance for liability and revenue accounts.

     

    A credit is also used when a customer returns some recently purchased goods. For example, the seller might tell the customer that a credit will be given for the returned goods. The seller then processes a credit memo which will be recorded as a credit in the Accounts Receivablerecords.

     

    The word credit, as opposed to a credit, could refer to the terms of a sale in which the customer is allowed to pay at a later date. Credit could also refer to a company's ability to borrow money.

  • 404. What is the income statement?
     

    The income statement is a key financial statement which reports on a company's profitability during a relatively short period of time such as the past year, month, 13 weeks, etc. The heading of the income statement informs the reader of the period covered.

     

    The main components of the income statement are:

    • Revenues.These are the amounts earned through the sale of goods and the providing of services.
    • Expenses. These include the cost of goods sold, SG&A expenses, and interest expense.
    • Certain gains and losses. One example is the disposal of a noncurrent asset for an amount that is different from its book value.

    The income statement best measures a company's profitability when the accrual basis of accounting is used. Under this method the revenues are the amounts earned (not the cash received in the period). The expenses are the amounts that best match the revenues and the time period (not the cash that was paid during the period). The income statement's bottom line (revenues and gains minus expenses and losses) is reported as net income or earnings. The income statement of a corporation with stock that is publicly traded will also report theearnings per share of common stock. The income statement is also known as the statement of operations, results of operations, statement of earnings, and P&L (for profit and loss statement).

  • 405. Where is the premium or discount on bonds payable presented on the balance sheet?
     

    The unamortized premium on bonds payable and the unamortized discount on bonds payable will be presented with the related bonds as liabilities on the balance sheet. For example, if there is a premium on the bonds that will come due in 13 years, both the bonds payable and the premium on bonds payable will be reported together as a long-term liability. If the premium on bonds is associated with bonds that will be due in 11 months (and the corporation will be using its working capital to pay the bondholders), the premium and the bonds will be reported together as a current liability.

     

    The discount on bonds payable will also cling to the bonds. If the bonds mature more than one year from the date of the balance sheet, both the bonds and the unamortized discount will be reported as a long-term liability. If the bonds are due in less than one year (and will require the use of the corporation's working capital), the discount and the bonds are reported as a current liability.

     

    The premium and discount accounts are viewed as valuation accounts. The unamortized premium on bonds payable will have a credit balance that increases the carrying amount (or the book value) of the bonds payable. The unamortized discount on bonds payable will have a debit balance and that decreases the carrying amount (or book value) of the bonds payable.

  • 406. What is the difference between the accounts rent receivable and rent revenue?
     

    Rent Receivable is a balance sheet asset account which indicates the amount of rent that has been reported as having been earned, but the money has not yet been collected.

     

    Rent Revenue is an income statement account that reports the amount of rent that has been earned during a period of time. Under the accrual method of accounting, rent revenue is reported on the income statement in the period in which it is earned (rather than in the period when the money is received). The account Rent Revenue is also known as Rental Income.

  • 407. Why would the cost behavior change outside of the relevant range of activity?
     

    Cost behavior often changes outside of the relevant range of activity due to a change in the fixed costs. When volume increases to a certain point, more fixed costs will have to be added. When volume shrinks significantly, some fixed costs could be eliminated.

     

    Here's an illustration. A company manufactures products in its 100,000 square foot plant. The company's depreciation on the plant is AED 1,000,000 per year. The capacity of the plant is 500,000 units of output and its normal output is 400,000 units per year. When the company is manufacturing between 300,000 and 500,000 units, it needs salaried managers earning AED 400,000 per year. Below 300,000 units of output, some of the salaried manager positions would be eliminated. Above 500,000 units, the company will need to add plant space and managers.

     

    For this example, the relevant range is between 300,000 units and 500,000 units of output per year. In that range the total of the two fixed costs is AED 1,400,000 per year. Below 300,000 units, the fixed costs will drop to less than AED 1,400,000 because some salaries will be eliminated and some of the space might be rented. When the volume exceeds 500,000 units per year, the company will need to add fixed costs because of the additional space and the additional managers. Perhaps the total fixed costs will be AED 2,000,000 for output between 500,000 units and 700,000 units.

  • 408. Is the deposit for a booth at a future trade show an asset?
     

    The deposit for a booth at a future trade show is an asset until the trade show occurs.

     

    Once the trade show occurs the deposit amount should be moved from the balance sheet asset account to an income statement expense account.

  • 409. What is the difference between accounts payable and accounts receivable?
     

    Accounts payable are amounts a company owes because it purchased goods or services on credit from a supplier or vendor. Accounts receivable are amounts a company has a right to collect because it sold goods or services on credit to a customer. Accounts payable are liabilities. Accounts receivable are assets.

     

    Let's assume that Company A sells merchandise to Company B on credit. (Perhaps the invoice states that the amount is due in 30 days.) Company A will record a sale and will also record an account receivable. Company B will record the purchase (perhaps as inventory) and will also record an account payable.

     

    Our example reminds me of an old saying, "There are two sides to every transaction." In accounting we also expect symmetry: Company A has a sale and a receivable, Company B has a purchase and a payable.

  • 410. What is contribution margin?
     

    In accounting contribution margin is defined as revenues minus variable expenses. In other words, the contribution margin reveals how much of a company's revenues will be contributing (after covering the variable expenses) to the company's fixed expenses and net income. The contribution margin can be presented as 1) the total amount for the company, 2) the amount for each product line, 3) the amount for a single unit of product, and 4) as a ratio or percentage of net sales.

     

    The contribution margin of a manufacturer is the amount of net sales that is in excess of the variable manufacturing costs and the variable SG&A expenses. To illustrate, let's assume that a manufacturer has a single product and 80,000 units were produced and sold during a recent year. The selling price was AED 10 per unit, variable manufacturing costs were AED 3 per unit, and variable SG&A expenses were AED 1 per unit. The company's fixed manufacturing costs were AED 300,000 and its fixed SG&A expenses were AED 90,000. The company's contribution margin was AED 480,000 (AED 800,000 - AED 240,000 - AED 80,000). The contribution margin per unit was AED 6 (AED 10 - AED 3 - AED 1). The contribution margin ratio was 60% (AED 6/AED 10 or AED 480,000/AED 800,000).

     

    The contribution margin is also a key component in computing a company's break-even point.

  • 411. What is premium on common stock?
     

    The premium on common stock involves the amount the issuing corporation receives when it issues common stock having a par value. The premium on common stock is the dollar amount that is in excess of the common stock's par value.

     

    To illustrate the premium on common stock, let's assume that a corporation issues one share of its common stock having a par value of AED 0.10 per share. If the corporation receives AED 20 in exchange for the share, AED 19.90 will be recorded as the premium on common stock.

     

    Accounting textbooks often refer to the premium on common stock as paid-in capital in excess of par value–common stock or as contributed capital in excess of par value–common stock.

     

  • 412. Where does the purchase of equipment show up on a profit and loss statement?
     

    The purchase of equipment that will be used in a business is not reported on the profit and loss statement. However, the depreciation of the equipment will be reported as depreciation expense on the profit and loss statements during the years that the equipment is used.

     

    For example, if a company buys equipment for AED 100,000 and it is expected to be used for 10 years, the company's profit and loss statements will report depreciation expense of AED 10,000 in each of the 10 years (assuming the straight-line method of depreciation is used).

     

    The purchase of equipment is shown on the statement of cash flows for the period in which the purchase took place. The equipment will also be reported on the company's balance sheets at its cost minus its accumulated depreciation.

     

    The profit and loss statements are also known as income statements, statements of operations, and statements of earnings.

  • 413. What does a balance sheet tell us?
     

    A balance sheet reports the dollar amounts of a company's assets, liabilities, and  owner's equity (or stockholders' equity) as of a previous date.

     

    Assets include cash, accounts receivable, inventory, investments, land, buildings, equipment, some intangible assets, and others. Generally assets are reported at their cost or a lower amount due to depreciation, the cost principle, and conservatism. The cost principle also means that some very valuable aspects of the company are not listed as assets. For example, a company's outstanding reputation, its effective management team, and its amazing brand recognition are not reported as assets if they were not acquired in a transaction involving another party or entity.

     

    Liabilities are obligations of a company as of the balance sheet date. These include loans payable, accounts payable, warranty obligations, taxes payable, and more.

     

    The stockholders' equity or owner's equity reports the amount of  the assets that came from the owners and not from its creditors.

     

    The balance sheet allows you to easily determine the amount of a company's working capitaland whether the company is highly leveraged.

     

    With every balance sheet distributed by a company there should be notes or footnotes. These notes provide important additional information about the company's financial position including potential liabilities not yet appearing as amounts on the balance sheet.

  • 414. What is a LIFO Reserve?
     

     

    Let's assume that a company's accounting system uses FIFO (first-in, first-out), but the company wants its financial and income tax reporting to use a LIFO (last-in, first-out) cost flow assumption due to persistent inflation of its costs. The LIFO reserve is a contra inventory account that will reflect the difference between the FIFO cost and LIFO cost of its inventory.

     

    With consistently increasing costs, the balance in the LIFO reserve account will have a credit balance—resulting in less costs reported in inventory. Recall that under LIFO the latest (higher) costs are expensed to the cost of goods sold, while the older (lower) costs remain in inventory.

     

    The credit balance in the LIFO reserve reports the difference in the inventory costs under LIFO versus FIFOsince the time that LIFO was adopted. The change in the balance during the current year represents the current year's inflation in costs.

     

    The change in the balance in the LIFO reserve will also increase the current year's cost of goods sold. That in turn reduces the company's profits and taxable income. The change in the balance of the LIFO reserve during the current year multiplied by the income tax rate reveals the difference in the income tax for the year. (Thebalance in the LIFO reserve times the income tax rate reveals the difference in income tax since LIFO was adopted.)

     

    The disclosure of the LIFO reserve allows you to better compare the profits and ratios of a company using LIFO with the profits and ratios of a company using FIFO.

     

    Since the accounting profession has discouraged the use of the word "reserve" in financial reporting, the inventory notes in annual reports have descriptions such as Revaluation to LIFO, Excess of FIFO over LIFO cost, and LIFO allowance instead of LIFO reserve.

     

  • 415. Why is the distinction between product costs and period costs important?
     

    The distinction between product costs and period costs is important for 1) properly measuring net income during a period of time and 2) reporting the proper cost of inventory on the balance sheet.

     

    Product costs cling to the units of products purchased or manufactured. If a unit is unsold, the product costs will be reported as inventory, a current asset on the balance sheet. The product costs for a retailer will be the amount paid to the supplier plus any freight-in. Product costs for a manufacturer will be the direct materials, direct labor, and manufacturing overhead. Product costs will be reported on the income statement as the cost of goods sold expense in the period that the units of product are sold.

     

    Period costs do not cling or attach to the units of product and will not be included in the cost of inventory. For example, the interest incurred by a retailer to finance its operations will be expensed in the period in which the interest occurs. Interest is not deferred by adding it to the cost of the units in inventory. Similarly, selling expenses and general administrative salaries are expensed in the period that the employees earn those salaries, the same period in which the company incurs the salaries expense. The insurance premiums that a company pays for nonmanufacturing protection will be expensed in the period in which the insurance premiums expire.  (Insurance premiums for the factory building will be included in the manufacturing overhead which will be part of the products' cost.)

  • 416. What is goodwill?
     

    In accounting, goodwill is an intangible asset associated with a business combination. Goodwill is recorded when a company acquires (purchases) another company and the purchase price is greater than the combination or net of 1) the fair value of the identifiable tangible and intangible assets acquired, and 2) the liabilities that were assumed.

     

    Goodwill is reported on the balance sheet as a noncurrent asset. Since 2001, U.S. companies are no longer required to amortize the recorded amount of goodwill. However, the amount of goodwill is subject to a goodwill impairment test at least once per year.

     

    Outside of accounting, goodwill could refer to some value that has been developed within a company as a result of delivering amazing customer service, unique management, teamwork, etc. This goodwill, which is unrelated to a business combination, is not recorded or reported on the company's balance sheet.

  • 417. What is the abbreviation for debit and credit?
     

    The abbreviation for debit is dr. and the abbreviation for credit is cr.

    Having dr. as the abbreviation for debit appears unusual, since there is no "r" in the spelling of the word debit. Apparently the abbreviation dr. is associated with the Latin or Italian word used more than 500 years ago when double entry accounting was first documented.

     

    How do I learn of new accounting rules?

    The U.S. accounting rules issued by the Financial Accounting Standards Board (FASB) can be found on its free website www.fasb.org/st/. There you will find:

    • FASB Statements (Statements of Financial Accounting Standards)
    • FASB Interpretations
    • FASB Technical Bulletins
    • FASB Emerging Issues Task Force (EITF) Abstracts
    • FASB Concepts (Statements of Financial Accounting Concepts)

    Each of the "FASB Statements" has three options: Text, Summary, and Status. The Status option provides the issue date, the effective date, and a listing of the other pronouncements that are affected by the Statement.

  • 418. What is the net book value of a noncurrent asset?
     

    The net book value of a noncurrent asset is the net amount reported on the balance sheet for a long-term asset.

     

    To illustrate net book value, let's assume that several years ago a company purchased equipment to be used in its business. The equipment's cost was AED 100,000 and its accumulated depreciation as of its recent balance sheet date was AED 40,000. This means that up to the balance sheet date AED 40,000 of the asset's cost had been reported as Depreciation Expense. It also means that the equipment's net book value is AED 60,000 (AED 100,000 of cost minus AED 40,000 of accumulated depreciation). Net book value or simply book value indicates that AED 60,000 of the noncurrent asset's cost has not yet been charged to depreciation expense.

     

    Net book value or book value can also be associated with noncurrent assets other than fixed assets. Two examples include long-term investments and unamortized bond issue costs.

  • 419. Is the reversal of a previous year's accrued expense permanent?
     

    Yes, a reversing entry is permanent.

     

    To illustrate, let's assume that a company had accrued interest expense of AED 10,000 as of December 31, the end of its accounting year. The accrual adjusting entry will record an additional AED 10,000 of expense to be reported on the December income statement and an additional AED 10,000 liability on the December 31 balance sheet.

     

    On January 1 the account Interest Expense will begin with a zero balance, since expenses are temporary accounts that are closed at the end of each accounting year. On January 2, a reversing entry is recoded which removes the AED 10,000 liability and causes a AED 10,000 credit balance in Interest Expense. The negative amount in Interest Expense will disappear as soon as the interest portion of the January loan payment is recorded.

     

    The accrual entry on December 31 was needed only for the December financial statements. Early in January the December 31 accrued interest must be permanently removed or reversed because the actual interest will soon be recorded. The reversing entry will assure that the interest expense amount is reported only once.

  • 420. Why isn't the direct write off method of uncollectible accounts receivable the preferred method?
     

    Under the direct write off method, a company does not anticipate bad debt expense. Rather, it waits until an account is actually written off as uncollectible before recording bad debt expense. This means its accounts receivable will be reported on the balance sheet at their full amounts—implying that all of the accounts receivable will be turning to cash. If there is some doubt concerning the collectibility of some of the receivables, the assets are potentially overstated and the company's profit is potentially overstated. Since there is usually a significant amount of time between a credit sale and the write off of a bad account, the bad debt expense will occur in a much later period than the revenue from the sale. This is a problem under the matching principle.

     

    The accounting profession prefers the allowance method over the direct write off method because the accounts receivable will be presented on the balance sheet with a reduction called the allowance for doubtful accounts. This means the net amount of the accounts receivable will be lower and closer to the amount that will actually be collected. Bad debt expense is reported at the time that the allowance for doubtful accounts is created and adjusted. Hence, the bad debt expense is reported closer to the time of the credit sale.

     

    It should be noted that the Internal Revenue Service requires the direct write off method. They prefer to see the tax deduction for bad debt expense only when an account receivable is actually written off—as opposed to allowing a deduction for an anticipated potential loss.

  • 421. What is par value?
     

    Par value is a per share amount appearing on stock certificates. It is also an amount that appears on bondcertificates.

     

    In the case of common stock the par value per share is usually a very small amount such as AED 0.10 or AED 0.01 or AED 0.001 and it has no connection to the market value of the share of stock. The par value is usually described as the common stock's legal capital and it is part of the corporation's paid-in (or contributed) capital.

     

    When a share of common stock having a par value of AED 0.01 is issued for AED 25, the account Common Stock will be credited for AED 0.01 and an additional paid-in capital account will be credited for AED 24.99 (and Cash will be debited for AED 25.00).

     

    If a state no longer requires a corporation's common stock to have a par value, a corporation might issue no-par stock (which may or may not have a stated value).

     

    In the case of bonds, the par value is also the face amount or maturity value of the bonds.

  • 422. Why does LIFO usually produce a lower gross profit than FIFO?
     

    LIFO usually produces a lower gross profit than FIFO only because the costs of the goods purchased or produced have been increasing over the past decades. Since LIFO assigns the latest costs of the goods purchased or produced to the cost of goods sold, the rising costs mean a higher amount of cost of goods sold on the income statement. That in turn means a lower gross profit than assigning the first or oldest costs to the cost of goods sold under FIFO.

     

    If costs were to steadily decrease over several years, LIFO would result in a higher gross profit than FIFO. The reason is that LIFO would be assigning the latest costs (which will be lower costs than the first or oldest costs) to the cost of goods sold on the income statement. That in turn means a higher gross profit than under the FIFO cost flow assumption.

  • 423. What items are added to the balance per bank on the bank reconciliation?
     

    The items that are added to the balance per bank when doing a bank reconciliation include (1) deposits in transit, and (2) bank errors that when corrected by the bank will increase the balance on the bank statement.

     

    (1) A deposit in transit on the bank reconciliation refers to the cash and checks that have been received by a company as of the ending date of the bank statement, but the cash and checks were not deposited in time for them to appear on the bank statement.

     

    To illustrate deposits in transit, let's assume that your company's accounting period ends on the last day of each month and that your bank statement also ends (or "cuts off") on the last day of each month. When you receive the bank statement ending on January 31, it is likely that its balance will not agree with the January 31 balance in your company's general ledger. One reason for the difference could be that the cash and checks received from customers on January 31 were deposited at the bank too late in the day. (After a specified time on January 31, the bank will record the deposits as of the next business day causing them to appear on the February bank statement.) Another example of a deposit in transit involves a retailer that is open until 9 p.m. on January 31 and deposits the receipts on the morning of February 1. The transactions right up to closing time on January 31 are properly recorded in the company's general ledger as of January 31. However, the deposit will appear on the February bank statement. Since the money from January 31 is indeed part of the company's cash and sales on January 31, the company's general ledger is correct, but the bank statement balance will need to be increased as part of the bank reconciliation process.

     

    (Items that are subtracted from the balance per bank include outstanding checks, and bank errors that when corrected will reduce the bank balance.)

     

    (2) Bank errors involve amounts that were recorded incorrectly by the bank. For example, if a company wrote a check for AED 89 but the bank coded the check as AED 98, the bank statement balance will be too low. (The bankdeducted AED 9 too much from the account, and therefore, the bank owes the customer AED 9.) When the bank makes the correction, the bank balance will increase by AED 9.00. This adjustment should appear on the bank reconciliation as an addition to the balance per bank.

     

    If a company deposits AED 97 and the bank records the deposit as AED 79, the bank added AED 18 too little into the account...the bank owes the company AED 18. When the bank makes the correction, the bank statement balance will increase by AED 18. The company's general ledger has the correct amount recorded, but the bank has the incorrect balance on the bank statement. Hence the balance per bank needs to be increased by AED 18.

     

    Tip: For determining whether a bank error will be an addition or a deduction on the bank reconciliation, be sure to think in terms of the change in the balance of the bank account. Both of the bank errors described above caused the bank balance to be too low. The correction of each of these errors will result in an increase to thebalance per bank.

     

  • 424. What will cause a change in net working capital?
     

    Net working capital or working capital is defined as current assets minus current liabilities. Therefore, a change in the total amount of current assets without a change of the same amount in current liabilities will result in a change in the amount of working capital. Similarly, a change in the total amount of current liabilities without an identical change in the total amount of current assets will cause a change in working capital.

     

    For instance, if the owner makes an additional investment of AED 20,000 in her company, the company's total current assets will increase by AED 20,000 but there is no increase in its current liabilities. As a result, the company's working capital increases by AED 20,000. (The other change is an increase in the owner's capital account.)

     

    If a company borrows AED 50,000 and agrees to repay the loan in 90 days, the company's working capital has not increased. The reason is that the current asset Cash increased by AED 50,000 and the current liability Loans Payable also increased by AED 50,000.

     

    The use of AED 30,000 to buy merchandise for inventory will not change the amount of working capital. The reason is that the total amount of current assets will not change. The current asset Cash decreases by AED 30,000 and the current asset Inventory increases by AED 30,000.

     

    If a company sells a product for AED 3,400 which is in its inventory at a cost of AED 2,500 the company's working capital will increase by AED 900. Working capital increased because 1) the current asset accounts  Cash or Accounts Receivable will increase by AED 3,400 and Inventory will decrease by AED 2,500; 2) current liabilities will not change. Owner's equity will increase by AED 900.

     

    The use of AED 100,000 for the construction of a storage building will reduce working capital because the current asset Cash decreased and a long-term asset Storage Building has increased.

  • 425. Are earnings different from profits?
     

    Earnings and profits are often used interchangeably. Others might make a distinction between the two words.

     

    In the case of earnings per share, earnings means a corporation's net income after income tax expense. However, in another context the word earnings could mean an amount that is prior to income tax expense. Some people might use the word earnings to mean an amount before all expenses are considered.

     

    Some people use the word profits to mean net income before income tax expense, while others use the wordprofits to mean net income after income tax expense. The term gross profit means sales minus the cost of goods sold.

     

    Knowing that people might use terms differently, you may need to ask the person a question to clarify their intended meaning.

  • 426. In accounting, are debit balances good?
     

    It is best if you accept the meaning that the word debit has had for 500 years: a debit is an amount entered on the left-side of an account. Don't add "good" or "bad" or "add" or "subtract" or other meanings.

     

    If you associate the word "good" with debits, you will have a problem when it comes to expenses. After all, expenses have debit balances. Since expenses will reduce a company's profits, they are not good.

     

    Lots of people have tried to make debit mean something more than left side. It never works. That's why after 500 years we are still using the unusual word debit.

     

  • 427. What is net present value?
     

    Net present value is the combination of the present value of an investment's cash inflows and the present value of the investment's cash outflows. To compute those present value amounts, the future cash flows are discounted by a specified rate. The specified rate could be the investor's cost of capital or it could be some other minimum rate that must be earned.

     

    The advantages of using the net present value to evaluate investments are 1) all of the investment's cash flows are used in the calculation, and 2) the time value of money is considered because the future cash amounts are discounted to the present.

     

    A project or investment that results in a net present value of AED 0 means that the project is expected to earn exactly the specified rate that was used in discounting the future cash flows. A slightly negative net present value indicates that the project will earn slightly less than the specified rate. For instance, if the specified rate of 16% was used for discounting the cash flows, a slightly negative net present value could mean that the project is expected to earn 15.7%. (Hence, a project could earn a very respectable profit but have a negative net present value because it just missed achieving the specified rate.)

     

    To find the exact rate that a project is expected to earn, the project's cash flows can be used to compute the internal rate of return, which is another discounted cash flow technique for evaluating investments.

  • 428. What is the difference between the direct method and the indirect method for the statement of cash flows?
     

    The main difference between the direct method and the indirect method involves the cash flows from operating activities, the first section of the statement of cash flows. (There is no difference in the cash flows reported in the investing and financing activities sections.)

     

    Under the direct method, the cash flows from operating activities will include the amounts for lines such as cash from customers and cash paid to suppliers. In contrast, the indirect method will show net income followed by the adjustments needed to convert the total net income to the cash amount from operating activities.

     

    The direct method must also provide a reconciliation of net income to the cash provided by operating activities. (This is done automatically under the indirect method.)

     

    Nearly all corporations prepare the statement of cash flows using the indirect method.

  • 429. What are the advantages of departmentalizing manufacturing overhead costs?
     

    The departmentalizing of manufacturing overhead costs allows for better planning and control if the head of each department is held responsible for the costs and productivity of his or her department.

     

    The departmentalizing of manufacturing overhead costs also allows for the computation and application of several departmental overhead cost rates instead of having a single, plant-wide overhead rate. This is important when there are a variety of products and some require many operations in a department with high overhead rates, while other products require very few operations in the high cost department. There may also be products which require many hours of processing, but they occur in low cost departments.  For instance, the assembly and packing departments of a manufacturer are likely to have very low overhead cost rates. On the other hand, the fabricating and milling departments will likely have much higher overhead cost rates.

  • 430. Is a favorable variance always an indicator of efficiency in operation?
     

    In a standard costing system, some favorable variances are not indicators of efficiency in operations. For example, the materials price variance, the labor rate variance, the manufacturing overhead spending and budget variances, and the production volume variance are generally not related to the efficiency of the operations.

     

    On the other hand, the materials usage variance, the labor efficiency variance, and the variable manufacturing efficiency variance are indicators of operating efficiency. However, it is possible that some of these variancescould result from standards that were not realistic. For example, if it realistically takes 2.4 hours to produce a unit of output, but the standard is set for 2.5 hours, there should be a favorable variance of 0.1 hour. This 0.1 hour variance results from the unrealistic standard, rather than operational efficiency.

  • 431. How does inflation affect the cost of goods sold?
     

    Generally speaking, inflation will increase the cost of goods sold. When and by how much depends on which cost flow assumption (FIFO, LIFO) is used.

     

    Under LIFO (last-in, first out), the latest/higher costs will flow quickly to the cost of goods sold, and the older/lower costs will remain in inventory. If a company can increase its selling prices by the amount of the cost increases, the gross profit (sales minus the cost of goods sold), net income, taxable income, income taxes, and inventory will remain nearly the same.

     

    FIFO (first-in, first out) results in the older/lower costs flowing from inventory to the cost of goods sold. The recent/higher costs are added to inventory. Compared to LIFO, inventory will be larger and the cost of goods sold will be smaller. If selling prices are increased by the full amount of the cost increases, FIFO will report more gross profit, net income, taxable income, income tax payments, and inventory than LIFO. The additional profits are referred to as illusory or as phantom profits. To avoid paying income taxes on these phantom profits, many companies have switched from FIFO to LIFO.

     

    As mentioned in the beginning, these are general comments. You should always determine the specific facts for your situation and should consult with a professional accountant and tax adviser.

  • 432. Is it acceptable for companies to use two methods of depreciation?
     

    Yes, many companies use two or more methods of depreciation.

     

    It is acceptable and common for companies to depreciate its plant assets by using the straight line method on its financial statements, while using an accelerated method on its income tax return.

     

    A company could also be depreciating its equipment over ten years for its financial statements, while using sevenyears for its income tax return.

     

    Even the depreciation for financial statements could consist of some assets being depreciated using the units of production or units of activity method, while other assets are depreciated using the straight line method.

  • 433. What is the difference between a bookkeeper and an accountant?
     

    Before I provide a distinction, you should be aware that some people use the words interchangeably. Even though I was the accountant, treasurer, and CFO of a company, the owner introduced me to a group of business leaders as the bookkeeper. He knew I kept the company's books, so "bookkeeper" made sense to him.

    Generally, a bookkeeper is a person without a college degree in accounting who performs much of the data entry tasks. This includes entering the bills from vendors, paying bills, processing payroll data, preparing sales invoices, mailing statements to customers, etc.

     

    The accountant is likely to have a college degree with a major in accounting and takes over where the bookkeeper leaves off. The accountant will prepare adjusting entries to record expenses that occurred but are not yet entered by the bookkeeper. (Examples include interest on bank loans since the last loan payment, wages earned by employees that will be processed next week, etc.) Other adjustments to accounts include the calculation and recording of depreciation, establishing allowances for uncollectible accounts, etc.). After making the adjusting entries, the accountant prepares the company's financial statements (income statement, balance sheet, statement of cash flows.) The accountant also assists the company's management to understand the financial impact of its past and future decisions.

     

    The distinction between accountant and bookkeeper keeps changing as accounting software and other software evolves. For many years, companies used the title of accounting clerks for employees doing the tasks formerly performed by bookkeepers. The accounting clerks are usually supervised by an accountant.

  • 434. What is a sole proprietorship?
     

    A sole proprietorship is a form of business organization that is owned by one person. The owner is referred to as a sole proprietor.

     

    In accounting, the balance sheet of the sole proprietorship reflects the accounting equation: Assets = Liabilities + Owner's Equity. Owner's Equity consists of the owner's capital account and also a drawing account. The drawing account is a temporary account in which the owner's current year draws or withdrawals are recorded. (The sole proprietor has draws because he or she does not receive a salary or wages. Hence, the income statement will not report an expense for the owner's work. This means that the net income reflects the total return for the owner's work and investment.)

     

    A sole proprietorship is not legally separate from its owner (as would be the case with a corporation). However, a sole proprietor may be able to register as a limited liability company in order to limit his or her personal liability. Be sure to seek professional advice as to the appropriate form of business for your situation and location.

  • 435. At what point are revenues considered to be earned?
     

    Revenues, which are derived from an entity's main activities such as the sale of merchandise or the performance of service, are considered to be earned when the earning process has been substantially completed.

     

    For example, a merchandiser's sales revenues are considered earned when the goods have been shipped or delivered to the customers and the merchandiser has a right to a collectible accounts receivable. (Under accrual accounting it is not necessary to have received the cash in order to have earned the revenues.) The reason is that the substantial and difficult parts of the selling process (having the merchandise, finding customers, getting customers to place orders, and delivering the merchandise to customers) have been completed. Collecting the accounts receivable is usually an automatic process which requires little or no effort.

     

    General guidance for determining when revenues are earned can be found in paragraphs 83 and 84 of the FASB's Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises and in an Intermediate Accounting textbook.

  • 436. What is common stock?
     

    Common stock is the type of ownership interest (expressed in "shares") that exists at every U.S. corporation. (A relatively few corporations will have preferred stock in addition to the common stock.) The owners of common stock are known as common stockholders, common shareholders, or simply as stockholders or shareholders.

     

    Common Stock is also the title of the general ledger account that is credited when a corporation issues new shares of common stock. (The amount of the credit will depend on the state's regulations.) The balance in Common Stock will be reported in the corporation's balance sheet as a component of paid-in capital, a section within stockholders' equity.

     

    Generally, the holders of common stock elect the corporation's board of directors and will participate in a corporation's success through increases in the market value of their shares of common stock and perhaps through cash dividends.

     

    A drawback of common stock is that the common stockholders are last in line if the corporation is dissolved.

  • 437. Is a prepaid expense recorded initially as an expense?
     

    A prepaid expense might be recorded initially as 1) an expense, or 2) as an asset.

    1. If a prepaid expense is recorded initially as an expense, then at the end of an accounting period, only the true expense amount for the period should remain in the expense account. The future expense (the portion that has not yet expired; the unexpired part) must be credited to the expense account and debited to the prepaid asset account.
    2. If a prepaid expense is recorded initially in a prepaid asset account, the true expense of the period (the expired portion) needs to be removed and debited to the related expense account. The remaining amount in the prepaid asset account should be the unexpired portion.

    Let's illustrate these two possibilities by assuming that an insurance premium of AED 6,000 is paid on December 1. This cost covers the six month period of December 1 through May 31. As a result the monthly expense will be AED 1,000. Let's also assume that the company did not have any insurance prior to December 1.

    1. On December 1, the account Insurance Expense was initially debited for AED 6,000 and Cash was credited for AED 6,000. On December 31, an adjusting entry will be needed to debit Prepaid Insurance for AED 5,000 and to credit Insurance Expense for AED 5,000. After this adjusting entry is recorded, the balance in Insurance Expense will be December's true expense of AED 1,000 (original debit of AED 6,000 minus the adjusting entry credit of AED 5,000) and the balance in Prepaid Insurance will be the debit of AED 5,000. This represents five months of cost that has not yet expired (5 months x AED 1,000 per month).
    2. On December 1, the account Prepaid Insurance was initially debited for AED 6,000 and Cash was credited for AED 6,000. On December 31, an adjusting entry will be needed to debit Insurance Expense for AED 1,000 (the amount that expired during December) and to credit Prepaid Insurance for AED 1,000. After this adjusting entry is recorded, the balance in the asset Prepaid Insurance will be AED 5,000 (the initial debit of AED 6,000 minus the credit of AED 1,000; and the unexpired amount consisting of 5 months x AED 1,000 per month). The account Insurance Expense will report the debit of AED 1,000.

    Usually there would be insurance coverage prior to December 1. In that case the year-to-date balance in the expense account should be equal to the expired insurance cost during the year-to-date period. If there is a conflict between getting the prepaid asset balance to be correct and the expense balance to be correct, make certain that the prepaid asset balance is correct.

  • 438. Are utility bills an expense or a liability?
     

    Because of double-entry accounting and the accrual-basis of accounting, the cost of utilities (electricity, natural gas, sewer, water, etc.) will involve both an expense and a liability. For example, a retailer who is responsible for her store's heat and light will incur an expense for the amount of utilities used during the accounting period. The retailer will also have a liability for the utilities that were used but have not yet been paid. Since the utility company provides the electric and gas service before it bills the user, the retailer will be incurring an expense every day and will be incurring a liability every day. The amount of the liability increases each day and is reduced by the amount paid by the retailer. (When the retailer pays the amount billed by the utility for the previous month's usage, the retailer will still have a liability for the utilities used since last month.)

     

    For a manufacturer, the cost of the utilities used in the factory will be assigned or allocated to the products as manufacturing overhead. If all of the products manufactured remain in inventory, the cost of the utilities used in the factory are embedded in the inventory's cost. When products are sold, the cost of utilities allocated to those products will automatically be expensed as part of the cost of goods sold. Under accrual accounting, the cost of the utilities that were used are included in the products' cost—whether or not the utilities have been paid. Because of double-entry accounting, the amount owed for the utilities that were used is also reported on the balance sheet as a liability.

     

    Since natural gas, electricity, and other utilities are used before the meters are read and billed by the utility company, the company using the utilities will have to estimate (1) the amounts used during an accounting period, and (2) the amounts owed at the end of each accounting period. The amounts are entered into the accounting records through an accrual-type adjusting entry.

  • 439. What is an escrow payment?
     

    An escrow payment is an amount deposited with another party and it is to be released only for its specified purpose.  The following is one example of an escrow payment.

     

    A borrower and lender arrange for the borrower's monthly mortgage payment to include an amount equal to one-twelfth of the property's annual real estate tax. Assuming the annual tax is AED 6,000 the monthly mortgage payment will include an escrow payment of AED 500. When the lender receives these monthly escrow payments of AED 500 each, the lender must hold them in escrow, or hold the funds in an escrow account. When the annual real estate taxes come due, the lender pays the real estate taxes by using the money in the borrower's escrow account.

  • 440. Where does the interest paid on bank loans get reported on the statement of cash flows.
     

    The interest paid on bank loans is included in the operating activities section of the statement of cash flows. This is the case for both short-term and long-term bank loans. However, the principal amounts that were borrowed and the amounts that were repaid are reported separately under financing activities.

     

    Under the indirect method, the interest expense is part of the corporation's net income which then gets adjusted to the cash amount. The amount of interest paid is required to be disclosed separately and is usually shown at the bottom of the statement of cash flows or in the notes to the financial statements.

  • 441. Does a company have to use the IRS years of useful life for depreciation?
     

    For the company's financial statements, the economic life of the asset should be used—not the years of useful life required for income tax purposes. In other words, the Internal Revenue Service (IRS) might stipulate that certain equipment is to be depreciated on the income tax return over 7 years. However, the company knows that the equipment will be useful in producing revenues for 10 years. Accounting's matching principle requires that the company's financial statements match the equipment's costs to its revenues over a 10-year period. (This will result in the most accurate measurement of the company's accounting net income.) However, on the tax return the company must follow the IRS rules and will depreciate the asset over 7 years. Obviously, this will result in two sets of depreciation amounts. (Further, the company's financial statements can use straight-line depreciation over the 10 years while the income tax return is using an accelerated method of depreciation over the 7 years.)

     

    The difference in each year's depreciation is referred to as a timing difference. The reason is that over the life of the equipment, the total amount of depreciation expense is likely to be the same. It is just a matter of timing as to when that total amount is reported on the financial statements versus the income tax returns.

     

  • 442. Can a fully depreciated asset be revalued?
     

    No. A fully depreciated asset cannot be revalued because of accounting's cost principle, matching principle, and going concern assumption.

     

    For instance, let's assume that a company purchased a building 30 years ago at a cost of AED 600,000. The company then depreciated the building at a rate of AED 20,000 per year for 30 years. Today the building continues to be used by the company and it plans to continue using it for many more years. The company's current balance sheet will report the building at its cost of AED 600,000 minus its accumulated depreciation of AED 600,000. In other words, the building will be reported at its book value of AED 0.

     

    The cost principle prevents the company from recording and reporting more than its actual cost of AED 600,000. The matching principle requires that only the actual cost of AED 600,000 can be allocated or matched to the years in which the company benefits from the use of the building. Lastly, the company is assumed to be a going concern and therefore it is not liquidating. Hence the amount that the company would receive if it sold the building is not appropriate for its financial statements.

     

    Even if the building's current value is estimated to be AED 2 million, the financial statements must report the actual cost and the depreciation based on that cost—even if this means reporting a book value of AED 0. It also means there will be no additional depreciation expense reported after the AED 600,000 of actual cost has been reported as depreciation expense.

  • 443. Does paying an account payable affect net income?
     

    Paying accounts payable that are already included in a company's accounting records will not affect the company's net income. (Generally speaking, net income is revenues minus expenses.)

     

    Under the accrual basis of accounting, if an expense is associated with an accounts payable, the expense will be recorded at the time the accounts payable is recorded—not at the time of the payment. For example, on January 2 a company has its office copier repaired. The cost of the repair is AED 300 and is to be paid by January 31. On January 2, the invoice for the repair is recorded with a AED 300 debit to Repairs and Maintenance Expense–Office Equipment and a AED 300 credit to Accounts Payable. On January 31 when the invoice is paid, the company will debit Accounts Payable and will credit Cash for AED 300. As you see, the January 31 transaction affects two balance sheet accounts; no expense account or other income statement account is involved.

     

    The January 31 transaction also illustrates that an expenditure is not necessarily an expense. Here are two additional examples: (1) A company pays cash to purchase an asset that will be used in the business. At the time of the purchase, an expenditure takes place, but not an expense. The expense will occur later when the asset is depreciated. (2) A company repays AED 50,000 of principal owed on its bank loan. The AED 50,000 is an expenditure, but it is not an expense.

     

    Expenses are costs that are used up in order for the company to earn revenues. Expenses are also costs that expired during an accounting period. Under accrual accounting, expenses can occur before or after a cash expenditure is made.

     

  • 444. What is going concern?
     

     

    Going concern is a basic underlying assumption in accounting. The assumption is that a company or other entity will be able to continue operating for a period of time that is sufficient to carry out its commitments, obligations, objectives, and so on. In other words, the company will not have to liquidate or be forced out of business in the foreseeable future.

     

    The going concern provides some logic for the cost principle: If a company is a going concern, it is not planning to liquidate, so why report the current value of its long term assets? However, if an asset's value has been impaired, the asset's carrying amount might be reduced to an amount lower than its carrying value.

  • 445. What is depreciation?
     

    Depreciation is the assigning or allocating of a plant asset's cost to expense over the accounting periods that the asset is likely to be used. For example, if a business purchases a delivery truck with a cost of AED 100,000 and it is expected to be used for 5 years, the business might have depreciation expense of AED 20,000 in each of the five years. (The amounts can vary depending on the method and assumptions.)

     

    In our example, each year there will be an adjusting entry with a debit to Depreciation Expense for AED 20,000 and acredit to Accumulated Depreciation for AED 20,000. Since the adjusting entries do not involve cash, depreciation expense is referred to as a noncash expense.

  • 446. What is IRS mileage rate for use of a car for business?
     

    The standard rate allowed by the Internal Revenue Service for the business use of an automobile in the year 2010 is 50 cents per mile. (This is lower than the rate allowed in the year 2009.) In addition to the standard rate of 50 cents per mile, you are also allowed to claim an expense for parking fees and tolls associated with the business use of your car.

     

    An alternative to the standard rate per mile is to compute the business portion of the actual expenses for gasoline, repairs, insurance, depreciation, licenses, etc.

     

    You can learn more about income tax issues at www.irs.gov.

  • 447. Does collecting a customer's accounts receivable affect net income?
     

    Collecting accounts receivable that are in a company's accounting records will not affect the company's net income. (Generally speaking, net income is revenues minus expenses.)

     

    Under the accrual basis of accounting, revenues and accounts receivable are recorded when a company sells products or earns fees by providing services on credit. At the point of delivering the goods or services, the company debits Accounts Receivable and credits Sales Revenues or Service Revenues. When an account receivable is collected 30 days later, the asset account Accounts Receivable is reduced and the asset account Cash is increased. No revenue account is involved at the time of collection.

     

    Your question brings to light the difference between a receipt and a revenue. Cash receipts from collecting accounts receivable or from the proceeds of a bank loan are not revenues. Revenues are amounts that companies earn through their operations by selling products or providing services (whether or not cash is received at the time of the sale or service).

  • 448. What if an employee's actual vacation payment is greater than the amount that has been accrued?
     

    It is common for companies to accrue its vacation pay expense and liability by using the pay rates at the time of the adjusting entries. If an employee is entitled to a greater amount because of a pay rate increase, the difference is expensed in the accounting period when the actual vacation payment is recorded.

     

    Let's illustrate this with a company that has an accounting year ending on December 31, 2012 and only one employee. The company's handbook specifies that the employee's vacation accrues monthly and that the vacation check will be paid on each July 1. Let's assume that on July 1, 2013 the employee will be entitled to 80 hours of vacation pay at the employee's pay rate on that date. On December 31, 2012 the employee's pay rate is AED 15 per hour and the company's liabilities include AED 600 for accrued vacations (80 hours X 6/12 year X AED 15). On June 30, 2013 the company will report an accrued liability of AED 1,200 (80 hours X AED 15). However, on June 10, 2013 the employee received a 3% pay rate increase. This means the employee's vacation check on July 1, 2013 will be AED 1,236 (AED 15.45 X 80 hours). The difference of AED 36 (AED 1,236 v. AED 1,200) is simply charged to Vacation Expense in the period of the vacation pay entry. In other words, the vacation pay entry will include a debit to Vacations Payable or Accrued Vacations Liability for AED 1,200 (the amount that has been accrued in earlier periods) and a debit to Vacation Expense for AED 36. The credits will include the payroll withholdings and the liability for the net payroll amount or Cash.

     

    As shown above, the additional AED 36 was simply debited to Vacation Expense in the period of the vacation pay entry. The past monthly accruals were not changed or restated as the estimates and the amount of difference is immaterial.

  • 449. What is the accounting journal entry for depreciation?
     

    The journal entry for depreciation contains a debit to the income statement account Depreciation Expense and a credit to the balance sheet account Accumulated Depreciation.

     

    The purpose of the journal entry for depreciation is to achieve the matching principle. In each accounting period, part of the cost of certain assets (equipment, building, vehicle) gets moved from the balance sheet to depreciation expense on the income statement so it can be matched with the revenues obtained by using these assets.

     

    The account Accumulated Depreciation is reported under the asset heading of Property, Plant and Equipment. It is also known as a contra asset account because it is an asset account with a credit balance. Because Accumulated Depreciation is a balance sheet (or real or permanent) account, its balance will carry over to the next accounting period. This means that its credit balance could get as large as the cost of the assets being depreciated.

     

    The income statement account Depreciation Expense is a temporary account. At the end of each year, its balance is transferred out of the account and Depreciation Expense will begin the new year with a zero balance.

     

    It is important to realize that when the depreciation expense entry is recorded, a company's net income is reduced by the expense, but its cash is not reduced. (Cash would have been reduced when the asset was acquired.) You should also realize that depreciation is an estimate based on the asset's historical cost (not its replacement cost), its estimated useful life, and its estimated salvage value. The focus of depreciation is to allocate and match the cost to expense and it is not to provide an estimate of the current value of the asset. As a result, the market value of a one year old computer will likely be less than the remaining amount reported on the balance sheet. On the other hand, a rental property in a growing area might have a market value that is greater than the remaining amount reported on the balance sheet.

  • 450. Why are accruals needed every month?
     

    Accrual adjusting entries are needed monthly only if a company issues monthly financial statements. Two reasons for the monthly accrual adjusting entries are:

    1. To report the revenues and receivables which were earned during the month, but the transactions had not been recorded in the accounts as of the end of the month, and
    2. To record the expenses and liabilities which were incurred during the month, but the transactions had not been recorded in the accounts as of the end of the month.

    Monthly accrual, deferral, and other adjusting entries must be recorded prior to issuing monthly financial statements in order to comply with the accrual basis of accounting.

  • 451. Where are short-term bank loans reported on the statement of cash flows?
     

    The cash inflows from new short-term bank loans and the cash outflows to repay the principal amount of short-term bank loans are reported in the financing activities section of the statement of cash flows. This is also true for long-term bank loans.

     

    The interest payments for short-term and long-term bank loans are reported in the operating activities section of the statement of cash flows.

  • 452. What is the 13 point average for inventory?
     

     

    The 13 point average for inventory for the calendar year 2012 would be the sum of the inventory amount at December 31, 2011 plus the 12 end-of-the-month amounts in 2012 divided by 13.

     

    The reason for using these 13 dates is to develop an average for the year that considers every month's average inventory. This is much preferred over an annual average that is based on just two points: the amount of inventory at December 31, 2011 plus the inventory amount at December 31, 2012 divided by 2. By using 13 points throughout the year, seasonal variations will be included. Using only the end of year point for two years is generally not indicative of the inventory levels in the months throughout the year.

     

    The 13 point average is also useful for determining other annual averages, such as accounts receivable, assets, and so on. With the use of computers, we can easily improve upon the 13 point average by using 365 points during the year.

     

  • 453. What is a valuation account?
     

    In accounting, a valuation account is usually a balance sheet account that is used in combination with another balance sheet account in order to report the carrying amount of an asset or liability.

     

    An example of a valuation account that is associated with an asset is the Allowance for Doubtful Accounts. This account's credit balance will be combined with the debit balance in Accounts Receivable in order to report the carrying amount of the company's accounts receivable. Other valuation accounts include Discount on Notes Receivable, Accumulated Depreciation, and allowance accounts used with inventory and investments.

     

    An example of a valuation account associated with a liability is Discount on Bonds Payable. The debit balance in this valuation account will be combined with the credit balance in Bonds Payable in order to report the carrying amount of the bonds. Premium on Bonds Payable is a valuation account with a credit balance.

  • 454. Are income taxes affected by accelerated depreciation?
     

    Using accelerated depreciation on the income tax return will mean greater depreciation expense and smaller taxable income in the earlier years of an asset's life. However, it will be followed by smaller depreciation expense and greater taxable income in the later years of the asset's life.

     

    For a corporation with consistent taxable income, the use of accelerated depreciation on the income tax return instead of the straight-line method, will defer some income tax until the later years of an asset's life. Over the entire life of the asset, the total depreciation expense is the same. The methods merely affect the timing of the depreciation.

     

    It is also important to note that a corporation may use the straight-line method on its financial statements and at the same time use accelerated depreciation on its income tax returns. The differences in income taxes resulting from using different methods are referred to as timing differences or temporary differences.

  • 455. In accounting, what is meant by relevant costs?
     

    Relevant costs are those costs that will make a difference in a decision. Relevant costs are future costs that will differ among alternatives.

     

    We can demonstrate relevant costs with the following situation. A company is deciding whether or not to eliminate a product line. The product line accounts for approximately 4% of the company's activities. If the product line is eliminated, the officers of the corporation will continue to receive the same salaries and the central office expenses will not change. The product line managers and other employees working directly on the product line will be terminated. Hence, their salaries will be eliminated.

     

    The salaries of the product line managers and other employees whose salaries will be eliminated are relevant to the decision. If these salaries are AED 700,000 with the product line and AED 0 without the product line, the AED 700,000 of savings is relevant. Those cost savings and other possible cost savings will be considered along with the loss of sales revenues.

     

    On the other hand, the officers' salaries are not relevant in the decision. In other words, it doesn't matter if the officers' salaries are AED 500,000 or AED 5,000,000. The officers' salaries will be the same with or without the product line. Similarly, the decision maker does not need to know the amount of its central office expenses, since they will be the same with or without the product line. Expenses from previous years are also irrelevant.

     

    To recap, relevant costs are the future costs that will differ among alternatives. You might use the past costs to help you predict those future costs, but the past costs are otherwise irrelevant to the decision. Accountants refer to the past costs as sunk costs.

  • 456. How are dividends paid when there are dividends in arrears?
     

    When a corporation has dividends in arrears on its cumulative preferred stock, it must first pay the past omitted preferred dividends and then the current year's preferred dividends before it can pay its common stockholders any dividends.

     

    For example, if a corporation has cumulative preferred stock with an annual dividend of AED 10,000 and it has omitted the dividends for the past three years, there is AED 30,000 of dividends in arrears. In order to pay any dividend to its common stockholders, the corporation will have to first pay its preferred stockholders AED 40,000. That is the amount of the past omitted dividends of AED 30,000 and the current year preferred dividend of AED 10,000.

     

    Using the information above, but assuming that the corporation pays a total of only AED 5,000 in dividends in the current year, the preferred stockholders must receive the entire AED 5,000 and the dividends in arrears will be AED 35,000 at the end of the current year.

  • 457. Are commissions considered to be revenues or expenses?
     

    The company or person earning and receiving commissions will have commissions revenue. The company or party that pays the commissions will have commissions expense.

     

    Under accrual accounting, the commissions do not have to be received in order to be reported as revenues. If a company has earned the commissions but has not yet received the money, it will report Commissions Revenues on its income statement and Commissions Receivable as an asset on its balance sheet.

     

    Under accrual accounting, the commissions do not have to be paid in order to be reported as expense. If a company has incurred the commissions expense, but has not yet paid the commissions, it will report Commissions Expense on its income statement and Commissions Payable (or include the commissions as part ofAccounts Payable) as a liability on its balance sheet.

  • 458. When are expenses credited?
     

    While general ledger expense accounts are typically debited and have debit balances, there are times when the expense accounts are credited.

     

    Some instances when general ledger expense accounts are credited include:

     

    • the end-of-year closing entries
    • the reversing entry for a previous accrual adjusting entry involving an expense
    • an adjusting entry to defer part of a prepayment that was debited to an expense account
    • a correcting entry to reclassify an amount from the incorrect expense account to the correct account
  • 459. What is a mortgage loan?
     

    A mortgage loan is a loan with a lien on real estate so that the lender has collateral until the loan is repaid. On any given date, the borrower is liable for the unpaid principal balance plus any accrued interest expense up to that point. It is common for mortgage loans to require monthly interest and principal payments that will repay the principal balance over a number of years.

     

    In accounting, the borrower's balance sheet will report a current liability for 1) the principal payments that will be coming due within one year after the balance sheet date, and 2) any accrued interest that is owed as of the balance sheet date. (Interest for future accounting periods is not reported as a liability.)

     

    The borrower's balance sheet will also report a noncurrent liability for the difference between 1) the total unpaid principal balance owed as of the date of the balance sheet, minus 2) the principal payments that are reported as a current liability.

     

    The lender's balance sheet will report a current asset and a noncurrent asset for the principal balance receivable and any accrued interest receivable. These amounts will be symmetrical to the amounts reported as liabilities on the borrower's balance sheet for the same date.

  • 460. Could a company's statement of cash flows show a positive net cash flow from operating activities even though it reported a net loss on its income statement?
     

    Yes, a company with a net loss on its income statement could report a positive net cash flow from operating activities on its statement of cash flows.

     

    Let's use the following amounts to illustrate this situation. A company's income statement for a recent year reported revenues of AED 2,000,000 and expenses of AED 2,075,000 for a net loss of AED 75,000. The expenses included depreciation expense of AED 100,000. A comparison of the company's balance sheets reveals that its accounts receivable decreased by AED 10,000 and its accounts payable increased by AED 7,000 during the same year. To keep our illustration simple, let's assume that except for cash, the reported amounts for the other current assets and current liabilities remained the same.

     

    Now let's follow the indirect method of preparing the operating activities section of the statement of cash flows. We begin with the net income for the year, which was a negative AED 75,000. Next we add the depreciation expense of AED 100,000 because the depreciation expense reduced net income but did not use cash. Then we add the decrease in accounts receivable. A decrease in accounts receivable indicates that the company collected more cash than the amount of its current year's sales. Lastly, the increase in accounts payable is added. The increase in accounts payable indicates that the company paid out less cash than the amount of expenses shown on the income statement.

     

    The total of the above amounts, (75,000) + 100,000 + 10,000 + 7,000 is a positive net cash flow from operating activities of AED 42,000.

  • 461. Is the current portion of long term debt adjusted monthly?
     

    A monthly adjustment to the current portion of long term debt is necessary when:

     

    1. the company issues monthly balance sheets, and

     

    1. the amount to be paid on a loan's principal balance during the next 12 months is different from the amount presently shown as a current liability.

     

    The amount reported as a current liability plus the amount reported as a long term liability must be equal to the total amount owed on the debt.

    What is the meaning of sundry and sundry debtors?

    Sundry can mean various, miscellaneous, or diverse. Sundry debtors might refer to a company's customers who rarely make purchases on credit and the amounts they purchase are not significant.

     

    I suspect that the term sundry was more common when bookkeeping was a manual task. In other words, prior to the low cost of computers and accounting software, a bookkeeper had to add a page to the company's ledger book for every new customer. If a new page was added for every occasional customer, the ledger book would become unwieldly. It was more practical to have one page entitled sundry on which those occasional customers' small transactions were entered.

     

    With the efficiency and low cost of today's accounting systems, I believe the need for classifying customers and accounts as sundry has been greatly reduced.

  • 462. Why is interest expense a nonoperating expense?
     

    Interest expense is a nonoperating expense when it is not part of a company's main operations. For example, a retailer's main operations are the purchasing and sale of merchandise, and a manufacturer's main operations are the production and sale of goods.  Neither the retailer nor the manufacturer has as its main operations the borrowing and lending of money. (On the other hand, a bank's main operations involves interest expense on its depositors' savings accounts and interest revenues on its loans and bond investments.)

     

    By reporting interest expense as a nonoperating expense, it also allows for a better comparison between the operating income of a retailer that has little debt with a retailer that has a significant amount of debt.

  • 463. How does revenue affect the balance sheet?
     

    Generally, revenues (sales, fees earned) will increase a corporation's stockholders' equity and its assets.

     

    More specifically, revenues will increase the retained earnings section of stockholders' equity. The assets that usually increase are cash or accounts receivable. However, it is possible that another asset would increase or that a liability would decrease.

     

    Revenues are also reported as the top line on the income statement.

  • 464. What accounts for the difference in inventory values between periodic LIFO and perpetual LIFO?
     

     

    The difference between periodic LIFO and perpetual LIFO involves the time at which costs are removed from inventory. Under periodic LIFO, the latest costs are assumed to be removed from inventory at the end of the year. Under, perpetual LIFO the latest costs are assumed to be removed from inventory at the time of each sale.

     

    We will illustrate the difference by using the following information. A company's accounting year is January 1 through December 31 and the company sells only one type of product. In its beginning inventory are 2 units with a cost of AED 10 each. The company sells 1 unit on March 1. On April 1, the company purchases 5 units at a cost of AED 11 each. On September 1, the company sells 3 units. In summary, the company had 2 units on January 1, purchased 5 units on April 1, sold 4 units during the year, and has 3 units on hand at December 31.

     

    Under periodic LIFO, the costs of the latest purchases starting with the end of the year are removed first. Since 4 units were sold during the year, the costs removed from inventory and charged to the cost of goods sold will be the latest cost of 4 units, which is AED 11 each. This means the cost of its December 31 inventory under periodic LIFO will be AED 31 (1 unit at AED 11 plus 2 units at AED 10).

     

    Under perpetual LIFO, the costs of the latest purchases as of the date of each sale are removed first. On March 1, the latest cost at that time for the 1 unit sold was AED 10. At the time of the sales on September 1, the latest costs of the 3 units sold was AED 11 each. Under perpetual LIFO its cost of goods sold will be AED 43 (1 at AED 10 and 3 at AED 11), and its inventory will be reported at a cost of AED 32 (2 units at AED 11 and 1 unit at AED 10).

  • 465. What is prime cost?
     

    Prime cost is the combination of a manufactured product's costs of direct materials and direct labor. In other words, prime cost refers to the direct production costs.  Indirect manufacturing costs are not part of prime cost.

  • 466. What is the difference between biweekly and semi monthly payroll?
     

    Biweekly payroll involves paydays that occur 26 times per year, such as every other Friday.

     

    Semimonthly payroll refers to paydays that occur 24 times per year, such as paydays that occur on the 15th day and the last day of every month.

     

  • 467. If an accrual adjusting entry increases an expense and a liability, how does the balance sheet remain in balance?
     

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

  • 468. What is SG&A?
     

    SG&A is the acronym for selling, general and administrative. SG&A are the expenses incurred to 1) promote, sell, and deliver a company's products and services, and 2) manage the overall company.

     

    SG&A will appear as operating expenses on the income statement for the period in which the expenses occurred. Hence, SG&A expenses are said to period costs as opposed to product costs. This means that SG&A expenses are not assigned to the cost of goods sold or to the goods in inventory.

     

    Examples of SG&A include sales commissions, advertising, promotional materials, compensation of the company's officers as well as the marketing, sales, finance and office staffs, the rent, utilities, supplies, computers, etc. that are outside of the manufacturing function. (SG&A will not include interest expense since interest expense is reported as a nonoperating expense.)

  • 469. What are the journal entries for a stock split?
     

    The only journal entry needed for a stock split is a memo entry to note that the number of shares has changed and that the par value per share has changed (if the stock has a par value). However, a typical journal entry with debits and credits is not needed since the total dollar amounts for the par value and other components of paid-in capital and stockholders' equity do not change.

     

    For example, if a corporation has 100,000 shares of AED 1.00 par value stock and it declares a 2-for-1 stock split, the corporation will have 200,000 shares with a par value of AED 0.50 per share. Before and after the stock split, the total par value is AED 100,000. Other account balances within stockholders' equity also remain the same.

     

  • 470. Why is an amount in the cash flows from investing activities shown in parenthesis?
     

    An amount shown in parenthesis within the investing activities section of the cash flow statement indicates that cash was used to purchase a long-term asset. For example, if a company spent AED 350,000 to purchase property, plant and equipment, it will be reported in the cash flows from investing activities as Capital expenditures....(350,000).

     

    The amounts appearing in parenthesis can be thought of as indicating the following:

     

    • cash flowed out
    • cash was reduced
    • cash was used
    • it was not good for the cash balance

    Positive amounts, which are the amounts not in parenthesis, indicate:

     

    • cash flowed in
    • cash was increased
    • cash was provided
    • it was good for the cash balance

    The amounts received from the sale of long-term assets will be shown without parenthesis. For example, if the company sells some of the equipment it had used in the business, the amount received will appear as a positive amount.

  • 471. What is an unpresented cheque or check and does it require an adjustment to the balance sheet?
     

    I define an unpresented cheque as a check that was written but has not yet been paid by the bank on which it is drawn. An unpresented check is also referred to as an outstanding check or a check that has not yet cleared the bank. Outstanding checks are deducted from the balance per the bank in order to arrive at the adjusted or corrected balance per bank.

     

    When a check is written, it will be recorded as a credit to the Cash account in the company's general ledger. Whether the check clears the bank or not, the company's Cash account balance is proper. The Cash account balance will be presented on the balance sheet without any adjustment for unpresented or outstanding checks

  • 472. What is the difference between liquidity and liquidation?
     

    Liquidity usually refers to a company's ability to pay its bills when they become due. Liquidity is often evaluated by comparing a company's current assets to its current liabilities. Working capital, the current ratio, and the quick ratio are referred to as liquidity ratios or short-term solvency ratios , since their calculations use some or all of the current assets and the current liabilities. Sometimes a company's accounts receivable turnover ratio, inventory turnover ratio, and free cash flow are also used to assess a company's liquidity.

     

    Liquidation is a term commonly used when a company sells parts of its business for cash, or when it sells assets in order to pay debts. Liquidation may also involve the winding down or the closing of a business.

  • 473. What are some examples of investing activities?
     

    Investing activities are identified with changes in a corporation's long-term assets. Investing activities are reported in a separate section of the financial statement Statement of Cash Flows(SCF)—also referred to as the cash flow statement

     

    Examples of investing activities include the acquisition (purchase) of long-term investments, equipment used in the business, a building used in the business, and so on. The purchase of these long-term assets is shown as a negative amount in the investing activities section of the SCF, because the acquisition will use (will reduce) cash.

     

    Investing activities also include the sale of long-term investments and the sale of long-term assets that had been used in the business. The proceeds (money received) from the sale of long-term assets will also be reported in the investing activities section of the cash flow statement. The money received will appear as a positive amount, since the effect on cash is positive. The sale is providing or increasing the company's cash.

  • 474. Are repairs to office equipment an expense?
     

    .

    Repairing and maintaining office equipment is an immediate expense. This is true even if the repair cost is a very large amount.

     

    If a large expenditure is made to improve office equipment, that cost would be recorded as an asset and then depreciated over the remaining life of the equipment.

     

    Small expenditures to improve office equipment are usually expensed immediately because of the materialityconcept. This means the amount is so small that no one will be misled by having the entire amount appear immediately as an expense rather than appearing as depreciation expense over several years. Often improvements of less than AED 500 or AED 1,000 are considered immaterial and are expensed immediately.

  • 475. What is OEM and EOM?
     

    OEM is the acronym for original equipment manufacturer.

     

    EOM is the acronym for end of month.

     

  • 476. What is LIFO?
     

    LIFO is the acronym for last-in, first-out. It is a cost flow assumption that can be used by U.S. companies in moving the costs of products from inventory to the cost of goods sold.

     

    Under LIFO the latest or more recent costs of products purchased (or produced) are the first costs expensed as the cost of goods sold. This means that the costs of the oldest products will be reported as inventory.

     

    It is important to understand that while LIFO is matching the latest or most recent costs with sales on the income statement, the company can be shipping the oldest physical units of product. In other words, the flow of costs does not have to match the flow of the physical units. This is why LIFO is a cost flow assumption or anassumed flow of costs. (If the costs flowing matched the physical units flowing, it would be the specific identification method and there would be no need to assume a cost flow.)

  • 477. What is the meaning of pro rata?
     

    Pro rata is a Latin term that means in proportion. Pro rata is related to prorate, a term used in cost accounting.

     

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

  • 478. Is an entry made for outstanding checks when preparing a bank reconciliation?
     

    No entry is made to a company's general ledger for outstanding checks when preparing a bank reconciliation. The reason is outstanding checks are an adjustment to the bank balance. Outstanding checks are not an adjustment to the company's Cash account in its general ledger.

     

    However, if a company voids one of its outstanding checks, the company will need to make an entry to its general ledger. The entry will debit Cash in order to increase the account balance. The credit portion of the entry will likely be to the account that was originally debited when the check was issued.

  • 479. How can a company with a net loss show a positive cash flow?
     

    A common explanation for a company with a net loss to report a positive cash flow is depreciation expense. Depreciation expense reduces a company's net income (or increases its net loss) but it does not involve a payment of cash in the current period. For example, if a company purchased equipment last year for AED 2,100,000 and depreciates the equipment over seven years, its depreciation expense this year might be AED 300,000. This year's AED 300,000 entry involves a debit to Depreciation Expense and a credit to Accumulated Depreciation. Not a penny left the checking account this year. (All AED 2,100,000 of cash left the checking account last year.) If the company's income statement reports a loss of AED 50,000 after the AED 300,000 "non-cash" depreciation expense, its cash may have actually increased by AED 250,000.

     

    Another explanation involves accrual accounting. A corporation must report its expenses as they are incurred and that is often before the corporation pays the invoice. For example, a corporation with an accounting year ending December 31 might have a huge expense at the end of 2012, but the invoice is not due until January 2013. The 2012 net income was reduced, but the corporation's cash is not reduced until 2013.

     

    Here's one more example. A corporation might receive a deposit from one of its customers in December 2012, but will not earn the revenues until 2013. In that case, the corporation's cash increased in 2012, but the corporation's revenues and net income will not increase until 2013.

     

    It is a good idea to get comfortable reading the statement of cash flows. It should be included with a corporation's income statement and balance sheet.

     

  • 480. What are the limitations of the payback period?
     

    The payback period (which tells the number of years needed to recover the amount of cash that was initially invested) has two limitations or drawbacks:

    1. The net incremental cash flows are usually not adjusted for the time value of money. This means that a net incremental cash inflow of AED 50,000 in the fourth year of an investment is deemed to have the same value or purchasing power as a AED 50,000 cash outflow that was part of the initial investment made four years earlier.
    2. The incremental cash flows received after the payback period are ignored. Let's illustrate what this means by using two hypothetical projects which are being considered as an investment:
    • Project #187 has a payback period of 4 years. However, the amounts of the net incremental cash inflows are expected to decline beginning in Year 4 and are expected to end in Year 7.
    • Project #188 has a payback period of 6 years. However, the amounts of its net incremental cash inflows are positive and are expected to grow exponentially from Year 4 through Year 15.

    While Project #187's payback period is faster, Project #188 is a significantly better investment. Hence, the limitation of using the payback period for ranking potential investments.

  • 481. What are cost flow assumptions?
     

    The phrase cost flow assumptions often refers to the methods available for moving the costs of a company's products from its inventory to its cost of goods sold. In the U.S. the cost flow assumptions include FIFO, LIFO, and average. (If specific identification is used, there is no need to make an assumption.)

     

    FIFO, LIFO, and average are cost flow assumptions because the costs flowing out of inventory do not have to match the specific physical units being shipped. Let's illustrate this important point with a company that has four units of the same product in its inventory. The units were purchased at increasing costs and in the following sequence: AED 40, AED 41, AED 43, and AED 44. If the company ships the oldest unit (the unit with a cost of AED 40), it will expense via the cost of goods sold: AED 40 under FIFO, AED 44 under LIFO, or AED 42 under the average method. If the company ships the most recently purchased unit (the physical unit having a cost of AED 44), the  inventory will be reduced and the cost of goods sold will be increased by: AED 40 under FIFO, AED 44 under LIFO, or the average of AED 42. In other words, the cost used to reduce the inventory and to increase the cost of goods sold was based on an assumed cost flow without regard to which physical unit was actually shipped.

     

    Other than a one-time change to a better cost flow assumption, the company must consistently use the same cost flow assumption.

  • 482. What is the difference between financial accounting and management accounting?
     

    Financial accounting has its focus on the financial statements which are distributed to stockholders, lenders, financial analysts, and others outside of the company. Courses in financial accounting cover the generally accepted accounting principles which must be followed when reporting the results of a corporation's past transactions on its balance sheet, income statement, statement of cash flows, and statement of changes in stockholders' equity.

     

    Managerial accounting has its focus on providing information within the company so that its management can operate the company more effectively.  Managerial accounting and cost accounting also provide instructions on computing the cost of products at a manufacturing enterprise. These costs will then be used in the external financial statements. In addition to cost systems for manufacturers, courses in managerial accounting will include topics such as cost behavior, break-even point, profit planning, operational budgeting, capital budgeting, relevant costs for decision making, activity based costing, and standard costing.

  • 483. Where should I enter unpaid wages?
     

    Under the accrual basis of accounting, unpaid wages that have been earned by employees should be entered as 1) Wages Expense and 2) Wages Payable or Accrued Wages Payable. Wages Expense is an income statement account. Wages Payable is a current liability account that is reported on the balance sheet.

     

    The recording of wages that have been earned but not yet paid or processed through the routine payroll entries is referred to as accruing wages. This is done through an accrual-type adjusting entry.

  • 484. What are direct costs?
     

    Direct costs can be traced directly to a cost object such as a product or a department. In other words, direct costs do not have to be allocated to a product, department, or other cost object.

     

    For example, if a company produces artisan furniture, the cost of the wood and the cost of the craftsperson are direct costs—they are clearly traceable to the production department and to each item produced—no allocationwas needed. On the other hand, the rent of the building that houses the production area, warehouse, and office is not a direct cost of either the production department or the items produced. The rent is an indirect cost—an indirect cost of operating the production department and an indirect cost of crafting the product.

     

    To calculate the total cost of the production department or to calculate each product's total cost, it is necessary to allocate some of the rent (and other indirect costs) to the department and to the product.

     

  • 485. What is owner's equity?
     

    Owner's equity is one of the three main components of a sole proprietorship's balance sheet and accounting equation. Owner's equity represents the owner's investment in the business minus the owner's draws or withdrawals from the business plus the net income (or minus the net loss) since the business began.

     

    Mathematically, the amount of owner's equity is the amount of assets minus the amount of liabilities. Since the amounts must follow the cost principle (and others) the amount of owner's equity does not represent the current fair market value of the business.

     

    Owner's equity is viewed as a residual claim on the business assets because liabilities have a higher claim. Owner's equity can also be viewed (along with liabilities) as a source of the business assets.

  • 486. Can absorption costing cause an increase in net income?
     

    Absorption costing could result in an increase in net income if a company increases its production and its inventory. This occurs because fixed manufacturing overhead is allocated to more production units—some of which will be reported as inventory.

     

    To illustrate, let's assume that a company has no beginning inventory and it has production plans for 100,000 units. Let's also assume that its annual fixed manufacturing overhead is AED 600,000. If 100,000 units are produced, the fixed manufacturing cost per unit will be AED 6 (AED 600,000 divided by 100,000 units). If the 100,000 units are sold for AED 20 each, the income statement will report sales revenues of AED 2,000,000 and its cost of goods sold will include AED 600,000 of fixed manufacturing overhead.

     

    Now let's assume that the company decides to produce 120,000 units even though sales are expected to remain at 100,000 units. Because the fixed manufacturing overhead remains at AED 600,000 the cost per unit for fixed manufacturing overhead will be AED 5 (AED 600,000 divided by 120,000 units produced). In this case the company will report the same sales revenues of AED 2,000,000 (100,000 units sold times AED 20) but its cost of goods sold will include only AED 500,000 of fixed manufacturing overhead (100,000 units sold times AED 5). The company's balance sheet account Inventory will include AED 100,000 (20,000 units times AED 5) of the company's fixed manufacturing overhead.

     

    As was illustrated above, the income statement will report a lower cost of goods sold when production and inventory increased. A smaller cost of goods sold will mean more gross profit and more net income.

  • 487. What are some examples of financing activities?
     

    Financing activities involve long-term liabilities, stockholders' equity (or owner's equity) , and changes to short-term borrowings. Financing activities are reported in its own section of the financial statement known as the statement of cash flows (SCF) or cash flow statement.

     

    Examples of financing activities that involve long-term liabilities include the issuance or redemption of bonds. An increase in bonds payable is reported as a positive amount in the financing activities section of the SCF. The positive amount signifies a source of cash, or that cash was provided by issuing additional bonds. A decrease in bonds payable will be reported as a negative amount in the financing activities section of the cash flow statement. A negative amount connotes that cash was used to repurchase or redeem the corporation's bonds.

     

    Examples of financing activities involving stockholders' equity include the issuance of common stock or preferred stock. Increases in these stock accounts will be reported as positive amounts in the financing activities section of the SCF. Positive amounts communicate that cash was provided by issuing more shares of stock—a source of cash. Examples of uses of cash (which are reported as negative amounts) in the financing activities section of the cash flow statement include a corporation's purchase of its own stock, and dividends declared and paid on its stock. (The increase in retained earnings resulting from the corporation's net income is reported in the operating activities section of the SCF.)

     

  • 488. What is the difference between accounts payable and accounts receivable?
     

    When a company purchases goods or services on credit, it will increase its accounts payable (acurrent liability). When a company sells goods or services on credit, it will increase its accounts receivable (a current asset).

     

    Just as one company's purchase is another company's sale, the accounts payable of one company will be the accounts receivable of another company. Some accountants refer to this as symmetry.

     

    To illustrate this, let's assume that Max Corporation receives AED 5,000 of goods it ordered from Super Supply Company on credit. This transaction will result in Max recording a AED 5,000 accounts payable (and a purchase), and Super Supply recording a AED 5,000 accounts receivable (and a sale).

  • 489. What are the two methods for recording prepaid expenses?
     

    The two methods for recording prepaid expenses have to do with the general ledger account that is initially debited at the time of the cash payment. The two methods or approaches are:

    1. debit an asset account (such as Prepaid Insurance) which is the balance sheet method, or
    2. debit an expense account (such as Insurance Expense) which is the income statement method.

    The use of either method will almost always require an adjusting entry prior to issuing the company's financial statements. However, the amount, the account that will be debited, and the account that will be credited in the adjusting entry will depend on the method used.

     

    In short, either the balance sheet method or the income statement method for recording prepaid expenses may be used as long as the asset account balance is equal to the unexpired or unused cost as of the balance sheet date.

  • 490. Why is there a difference in the amounts for Bad Debts Expense and Allowance for Doubtful Accounts?
     

    The amount reported in Bad Debts Expense is the loss that occurred from extending credit during the period of time indicated in the heading of the income statement. Bad Debts Expense is usually an estimated amount based on a company's credit sales during the period or the change in the collectibility of its accounts receivable.

     

    The amount reported in the Allowance for Doubtful Accounts is the estimated amount of the accounts receivable that will not be collected. The Allowance for Doubtful Accounts is a contra asset account or valuation account associated with the balance in Accounts Receivable. Since these two accounts are balance sheet accounts, their account balances must report the amounts that are relevant at a specific moment in time, namely the date of the balance sheet.

     

    To illustrate, let's assume that on December 31 a company had AED 100,000 in Accounts Receivable and its balance in Allowance for Doubtful Accounts was a credit balance of AED 3,000. For the first 30 days of January the company does not have any other information on bad accounts. Then on January 31 the company learns that an additional AED 1,000 of its accounts receivable will not be collectible. On January 31 the company will make an adjusting entryto debit Bad Debts Expense for AED 1,000 and to credit Allowance for Doubtful Accounts for AED 1,000. After this entry is recorded, the company's income statement for the month of January will report Bad Debts Expense of AED 1,000 and its January 31 balance sheet will report a credit balance in Allowance for Doubtful Accounts in the amount of AED 4,000.

  • 491. What are the limitations of the payback period?
     

    The payback period (which tells the number of years needed to recover the amount of cash that was initially invested) has two limitations or drawbacks:

    1. The net incremental cash flows are usually not adjusted for the time value of money. This means that a net incremental cash inflow of AED 50,000 in the fourth year of an investment is deemed to have the same value or purchasing power as a AED 50,000 cash outflow that was part of the initial investment made four years earlier.
    2. The incremental cash flows received after the payback period are ignored. Let's illustrate what this means by using two hypothetical projects which are being considered as an investment:
    • Project #187 has a payback period of 4 years. However, the amounts of the net incremental cash inflows are expected to decline beginning in Year 4 and are expected to end in Year 7.
    • Project #188 has a payback period of 6 years. However, the amounts of its net incremental cash inflows are positive and are expected to grow exponentially from Year 4 through Year 15.

    While Project #187's payback period is faster, Project #188 is a significantly better investment. Hence, the limitation of using the payback period for ranking potential investments.

  • 492. Where is treasury stock reported on the balance sheet?
     

    Under the cost method of recording treasury stock, the cost of treasury stock is reported at the end of the Stockholders' Equity section of the balance sheet. Treasury stock will be a deduction from the amounts in Stockholders' Equity.

     

    Treasury stock is the result of a corporation repurchasing its own stock and holding those shares instead of retiring them.

     

    In the general ledger there will be an account Treasury Stock with a debit balance. (At the time of the purchase of treasury stock, the corporation will debit the account Treasury Stock and will credit the account Cash.)

  • 493. In a bank reconciliation, what happens to the outstanding checks of the previous month?
     

    The outstanding checks of the previous month will have either cleared the bank in the current month or will remain on the list of outstanding checks.

     

    If an outstanding check of the previous month clears the bank (is paid by the bank) in the current month, you simply remove that check from the list of outstanding checks.

     

    If an outstanding check of the previous month does not clear the bank in the current month, the check will remain on the list of outstanding checks until the month that it does clear the bank. In the bank reconciliation process, the total amount of the outstanding checks is deducted from the balance appearing on the bank statement.

  • 494. Why do you separate current liabilities from long-term liabilities?
     

    Current liabilities are separated from long-term liabilities on classified balance sheets. (You don't have to prepare a classified balance sheet, but it is the norm. Classified balance sheets also separate the current assets from the long-term assets.)

     

    Current liabilities are the obligations that are due within one year of the balance sheet's date and will require a cash payment or will need to be renewed. Knowing which liabilities will have to be paid within one year is important to lenders, financial analysts, owners, and executives of the company. (Current assets include cash and other assets that will turn to cash within one year.) Knowing the liabilities that are due within one year and the amount of assets turning to cash within one year are so important that it makes sense to prepare a classified balance sheet.

     

    The amount of current liabilities is used in two of the most common financial ratios. Working capital is the amount of current assets minus the amount of current liabilities. The current ratio is computed by dividing the amount of current assets by the amount of current liabilities.

     

  • 495. In bookkeeping, why are revenues credits?
     

    In bookkeeping, revenues are credits because revenues cause owner's equity or stockholders' equity to increase.

     

    Recall that the accounting equation, Assets = Liabilities + Owner's Equity, must always be in balance. The asset accounts are expected to have debit balances, while the liability and owner's equity accounts are expected to have credit balances. Therefore, when a company earns revenues, it will debit an asset account (such as Accounts Receivable) and will need to credit another account such as Service Revenues. The credit balance in Service Revenues will eventually be moved to the sole proprietor's capital account or to a corporation's Retained Earnings account (thereby increasing the credit balance in one of those owner's or stockholders' equity accounts).

  • 496. What is the cost of goods sold?
     

    The cost of goods sold is the cost of the merchandise that a retailer, distributor, or manufacturer has sold.

     

    The cost of goods sold is reported on the income statement and can be considered as an expense of the accounting period. By matching the cost of the goods sold with the revenues from the goods sold, the matching principle of accounting is achieved.

     

    The sales revenues minus the cost of goods sold is gross profit.

     

    Cost of goods sold is calculated in one of two ways. One way is to adjust the cost of the goods purchased or manufactured by the change in inventory of finished goods. For example, if 1,000 units were purchased or manufactured but inventory increased by 100 units then the cost of 900 units will be the cost of goods sold. If 1,000 units were purchased but the inventory decreased by 100 units then the cost of 1,100 units will be the cost of goods sold.

     

    The second way to calculate the cost of goods sold is to use the following costs: beginning inventory + the cost of goods purchased or manufactured = cost of goods available – ending inventory.

     

    When costs change during the accounting period, a cost flow will have to be assumed. Cost flow assumptions include FIFO, LIFO, and average.

  • 497. What are net incremental cash flows?
     

    Net incremental cash flows are the combination of the cash inflows and the cash outflows occurring in the same time period, and between two alternatives. For example, a company could use the net incremental cash flows to decide whether to invest in new, more efficient equipment or to retain its existing equipment.

     

    Net incremental cash flows are necessary for calculating an investment's:

    • net present value
    • internal rate of return
    • payback period

    To illustrate net incremental cash flows let's assume that Your Corporation has the opportunity to purchase a product line from Divesting Company for a single cash payment of AED 800,000. Your Corporation expects that the product line will result in the following cash flows occurring in each year for 10 years:

    • additional cash receipts or cash inflows of AED 900,000 (from the collection of accounts receivable related to product sales)
    • additional cash payments or cash outflows of AED 750,000 (for payments related to the product line's costs and expenses)

    These cash flows indicate that the net incremental cash flows are expected to be a positive AED 150,000 per year for 10 years, or that there will be net incremental cash inflows of AED 150,000 per year for 10 years.

  • 498. What is a purchase allowance?
     

    A purchase allowance is a reduction in the buyer's cost of merchandise that it had purchased. The purchase allowance is granted by the supplier because of a problem such as shipping the wrong items, the incorrect quantity, flaws in the goods, etc. In the case of a purchase allowance, the buyer does not return the merchandise to the supplier.

     

    Under a periodic inventory system, the buyer will record the purchase allowance with 1) a credit to the account Purchase Allowances or to the account Purchase Returns and Allowances, and 2) a debit to Accounts Payable. (The supplier will record the allowance with a debit to Sales Allowances and a credit to Accounts Receivable.)

     

    The buyer will offset the debit balance in its Purchases account with the credit balance in Purchase Allowances as part of its computation of net purchases.

  • 499. Can you help me to understand credit memo and debit memo in the bank reconciliation?
     

    A bank credit memo is an item on a company's bank statement that increases a company's checking account balance. A bank debit memo is an item on the bank statement that reduces the company's checking account balance. Since these items are already on the bank statement, the only adjustment that could be required is in the company's accounting records. The old rule for the bank reconciliation "Put it where it isn't" means that the bank's credit memo amount must be added to the company's accounting records, if it is not yet in the company's accounts. Since the bank credit memo increased the checking account balance, the company's Cash account will have to be debited and another account will need to be credited. For example, if the bank statement shows a credit memo for AED 100 for interest earned, the company will need to have a debit of AED 100 in its Cash account and will need a credit of AED 100 in Interest Revenue or Interest Income.

     

    If the bank statement shows a debit memo of AED 25 for a service fee, the bank statement balance was decreased by AED 25. As part of the bank reconciliation process the following entry must be made if the item has not yet been recorded in the company's records: debit Bank Fee Expense or Miscellaneous Expense AED 25 and credit CashAED 25. The company's Cash account needs to be credited because this company's asset account decreased.

     

    The reason the bank used "debit" to decrease the company's checking account is that its customers' checking account balances are liabilities for the bank. (The bank's cash was debited when customers deposited money and the bank's liability account Demand Deposits or Checking Account Deposits was credited.) When the bank pays a customer's check, the bank's cash is reduced and the bank's liabilities are reduced. The bank records this with a credit to Cash and a debit to Demand Deposits.

  • 500. What causes a variation in profit margin and turnover ratios between industries?
     

    Mega grocery stores, discount stores, and warehouse clubs often have small profit margins but have high turnover ratios. The small profit margins as a percent of sales exist because of intense competition. The inventory turnover ratios are high because the stores feature the fast selling brands at low prices. Their strategy is that huge sales volumes with small profit margins will still result in adequate net income dollars.

     

    In contrast to the stores with low profit margins and high turnover ratios, is a heavy equipment manufacturer with a high demand product that takes six months to manufacture. If this manufacturer has few or no competitors, a great product, and an excellent reputation for service, its profit margin can be very large. Unlike the discount stores, its inventory turnover will be very very low.

     

    There can also be differences within the same industry. For example, one computer company might assemble and ship computers within hours of receiving the order via its website. Its inventory turnover will be off the charts, perhaps 90 times per year. If most of its customers pay with credit cards at the time the computer is shipped, the company will have very little in accounts receivable and will enjoy great cash flow. Another computer company might sell only through retailers. This company will have to assemble the computers in advance, store them, and then extend 60 days credit to the retailers. Obviously its turnover ratios will be less impressive than the ratios of the first company.

     

    A company's management is another variable that explains differences in the profit margin and turnover ratios. Some managements are more focused, aggressive and disciplined in processing orders, controlling inventory. and improving processes. Companies with less proficient managers could end up having less impressive turnover ratios and profits.

  • 501. What is a purchase return?
     

    A purchase return occurs when a buyer returns merchandise that it has purchased from a supplier.

     

    Under the periodic inventory system, the cost of the merchandise that was returned is recorded as 1) a credit to the general ledger account Purchase Returns or the account Purchase Returns and Allowances, and 2) a debit toAccounts Payable. (The supplier/seller will record the return with a debit to Sales Returns and a credit to Accounts Receivable.)

     

    The credit balance in the Purchase Returns account will partially offset the debit balance in the account Purchases.

     

    Since the return of purchased merchandise is time consuming (and therefore costly), having the separate general ledger account Purchase Returns allows managers to quickly see the magnitude of the returns.

  • 502. What journal entries are prepared in a bank reconciliation?
     

    Journal entries are required for the items listed as adjustments to the balance per books on the bank reconciliation. These adjustments involve items that appear on the bank statement that were not recorded in the company's general ledger accounts. Typical adjustments include the bank service charge for maintaining the account, check printing charges, fees for returned checks, and interest earned.

     

    The journal entries for the bank fees would debit Bank Service Charges (or Miscellaneous Expense if the amounts are insignificant) and a credit to Cash. The journal entry for a customer's check that was returned due to insufficient funds will debit Accounts Receivable and will credit Cash.

  • 503. What is the entry for a loan to an employee?
     

    When a company lends money to one of its employees, the company will debit the asset account Loans to Employees and will credit the asset account Cash.

     

    The portion of the balance in Loans to Employees that will be due within one year of the balance sheet date is reported as a current asset. The portion of the balance in that account that is not due within one year of the balance sheet date will be reported as a long term asset.

     

    Interest on the loan should be accrued by the company and reported as other revenue. The company's entry to accrue interest is a debit to the current asset Interest Receivable and a credit to Interest Revenue.

  • 504. What is yield to maturity?
     

    Yield to maturity is the total return that will be earned by someone who purchases a bond and holds it until its maturity date. The yield to maturity might also be referred to as yield, internal rate of return, or the market interest rate at the time that the bond was purchased by the investor. The yield to maturity is expressed as an annual percentage rate.

     

    To illustrate, let's assume that a 5% AED 100,000 bond will mature in 5 years and will pay interest each June 1 and December 1. Hence the bond will pay interest of AED 2,500 every six months until it matures. If the current market interest rate for this type of bond is 6%, the bond's current market value will be less than AED 100,000. The market value of a 5% bond in a 6% bond market will be approximately AED 95,735. This is the present value of the AED 2,500 of interest that will be received every six months for 5 years plus the present value of the AED 100,000 that will be received at the end of 5 years. (All of the cash amounts are discounted by the market interest rate. However, the 6% annual market rate will be restated to be 3% per semiannual period and the 5 years will be restated to be 10 semiannnual periods.)

     

    The investor's yield to maturity will be the market rate of 6% (even though the bond's stated rate is 5%) consisting of the following two components:

    • the current yield of more than 5.2% because the investor is receiving cash of AED 2,500 every six months (AED 5,000 per year) on an investment of only AED 95,735.
    • a gain of AED 4,265 because the investor bought the bond for AED 95,735 but will receive cash of AED 100,000 at maturity.
  • 505. Why does a cost system developed for inventory valuation distort product cost information?
     

    The cost system for inventory valuation may have been developed to provide a reasonable total cost of inventory and a reasonable total cost of goods sold in order to have reasonably accurate financial statements. If a company has small inventory amounts and significant sales, a simple cost system that spreads manufacturing overhead costs solely on the basis of machine hours can result in a reasonably accurate balance sheet and income statement.

     

    While a simple cost system using just one cost driver (machine hours) may result in accurate financial statements, it often fails to provide the true cost of individual products that vary in complexity. For example, one product might require very few machine hours but will require many hours of special handling. The costs assigned on the basis of machine hours alone will be too low in relationship to the true cost of manufacturing this product. Another product might require many machine hours but no other activities. This product's cost will be overstated because the rate assigned via the machine hours will include an amount for other activities that generally occur for the other products manufactured.

     

    A cost system developed for inventory valuation is limited to the cost of direct materials, direct labor, and manufacturing overhead. The total cost of providing products to a customer will also include nonmanufacturing expenses. One customer might require a company to incur additional selling, delivering, storing, and administrative expenses. Another customer might not require any of those activities and their related expenses.

     

    Activity based costing attempts to calculate the true cost of a product and customer by assigning costs and expenses based on their root causes. Because there are many root causes, the company will assign costs based on many cost drivers. This results in more accuracy for the cost and expense of a specific product for a specific customer than simply spreading the manufacturing costs on the basis of one cost driver such as machine hours.

  • 506. What is a purchase discount?
     

    A purchase discount is a deduction that may be available to a buyer if the buyer pays an invoice within a prescribed time. For example, a supplier's invoice for AED 10,000 with the credit terms 2/10 net 30 indicates that the buyer will be allowed a purchase discount of AED 200 (2% of AED 10,000) if the buyer pays within 10 days. If the buyer pays in 30 days, there is no purchase discount.

     

    Under a periodic inventory system, the purchase discount on merchandise purchased is credited to the general ledger account Purchase Discounts. The credit balance in this account (along with the credit balance in the Purchase Returns and Allowances account) will be deducted from the debit balance in the Purchases account in calculating the amount of net purchases.

     

    A purchase discount of 2% for paying 20 days early (paying in 10 days instead of 30 days) equates to an annual rate of 36%. A purchase discount of 1% for paying 20 days early means an annual rate of 18%.

     

    While the buyer refers to this as a purchase discount, the seller will refer to it as a sales discount. The discount is also known as an early-payment discount or a cash discount.

  • 507. How do I start a petty cash fund?
     

    To start a petty cash fund you need to open a general ledger account entitled Petty Cash. This will be an additional cash account that you could report either separately or have its balance included with other cash accounts when preparing a balance sheet.

     

    Next you need to write a check for the amount that you believe is the amount needed for making small payments in your office. Let's assume that the amount will be AED 100. When processing the check you would indicate the account code for Petty Cash, so that the new account will be debited for AED 100.

     

    You also need to designate one person to be the petty cash custodian. This person's name will be the payee of the AED 100 check. This person will then be accountable for the AED 100. At all times the custodian must have a combination of cash and petty cash receipts which add up to AED 100.

     

    Just prior to issuing financial statements, the petty cash custodian should request cash for the petty cash receipts. This is known as replenishing the petty cash fund. This allows for the expenses to be included in the income statement and will result in the custodian having the AED 100 of cash that will be reported in the balance sheet. The custodian can also replenish the petty cash fund when there is little cash on hand due to a large amount of petty cash payments.

  • 508. Is the rental cost of a building considered overhead?
     

    The rental cost of a building used in manufacturing is part of manufacturing overhead. Manufacturing overhead is an indirect product cost. Indirect product costs are allocated or assigned to products on some reasonable basis. As a result, the rental cost of a manufacturing building will cling to the products manufactured. If the goods manufactured are in inventory, some of the rent of the manufacturing facility is in inventory. When a product is sold, the manufacturing rent that is included in the product cost will be part of the cost of goods sold.

     

    The rental cost of a building that is not used for manufacturing (e.g. rent for a sales office, rent for the general administrative office) is not part of the manufacturing overhead. This rent does not cling to the products and will not be part of the cost of an item in inventory. The rent for nonmanufacturing facilities is immediately expensed in the accounting period when the building is rented.

     

    If a rented building is used for both manufacturing and nonmanufacturing activities, the rent should be allocated to each (perhaps on the basis of square footage).

  • 509. What is a bank reconciliation?
     

    A bank reconciliation is a process performed by a company to ensure that the company's records (check register,general ledger account, balance sheet, etc.) are correct and that the bank's records are also correct.

     

    The bank reconciliation for a company's checking account begins with the company noting the balance per the bank statement and then making some notations about that balance. For example, the balance on the bank statement is probably not the amount that appears in the company's records. In all likelihood the checks written by the company in the days immediately before the date of the bank statement will not have cleared (been deducted from) the checking account. These are called outstanding checks. Another possibility is that the company received money on the closing date of the bank statement and properly recorded the amount in its records. However, the money was deposited into the bank too late in the day and will appear on the next bank statement. This is known as a deposit in transit. Let's begin the bank reconciliation by assigning some amounts to the items just mentioned:

     

    Balance per bank statement at October 31 AED 6,442.56; outstanding checks as of October 31 AED 3,400.00; deposits in transit at October 31 AED 1,000.00. The adjusted balance per the bank statement on October 31 is AED 4,042.56 (AED 6,442.56 + AED 1,000.00 - AED 3,400.00).

     

    Next, the bank reconciliation requires that the amount in the company's records (for this bank statement account) be noted. In all likelihood the amount in the company's records will not agree with the adjusted bank amount. One explanation could be the bank fees that the bank took out of the checking account, but the fees were not yet recorded in the company's records. A common example is the bank service charge for maintaining the checking account, handling returned checks, and check printing fees. The bank might also deduct loan payments or process other transactions that the company has not yet entered into its records. Let's illustrate the company's adjusted balance with some amounts:

     

    Balance per the company's records (account register, general ledger account) AED 4,340.56; bank service charge AED 63.00; check printing charge AED 120.00. The adjusted balance per the company's records, or per books, is AED 4,157.56 (AED 4,340.56 - AED 63.00 - AED 120.00).

     

    If the adjusted balance per the bank agrees with the adjusted balance per the books, the bank reconciliation is completed. In our example, the adjusted balance per the bank is AED 4,042.56 and the adjusted balance per the company's books is AED 4,157.56. The difference of AED 115.00 means that the bank reconciliation is not completed. The AED 115.00 difference must be identified. Finding the difference is likely to be tedious, but it must be done. After all differences have been identified, any adjustments to the company's balance must be entered into the company's records with a journal entry. It is the reconciled, adjusted balance that is to be reported on the company's balance sheet.

  • 510. Which date is used to record a credit card transaction?
     

    When a business uses its credit card, the transaction date is the date the credit card is used, not the date that the credit card statement is paid.

     

    For example, if a business uses its credit card to purchase an asset on December 30, both the asset and the liability to the credit card company should be recorded as of December 30.

     

    When the business pays the credit card company (perhaps 30 days later), the business will be reducing its cash and its liability to the credit card company.

  • 511. How is the account Cash Short and Over used?
     

    Cash Short and Over is an income statement account in which shortages or overages in cash are recorded. The Cash Short and Over account might be used by bank tellers to record any differences between their actual cash at the end of the day versus the expected amount of cash based on checks cashed, deposits received, etc. The account Cash Short and Over is also used to record differences discovered when replenishing a company's petty cash fund.

     

    Let's illustrate the Cash Short and Over account with the petty cash fund. Assume that the company has a petty cash fund of AED 100 and its general ledger account Petty Cash reports an imprest balance of AED 100. Let's now assume that when the petty cash fund is replenished, there is AED 6.00 on hand and there are petty cash receipts indicating that AED 93.00 were disbursed. These two amounts indicate there is a shortage of AED 1.00. (The custodian started with cash of AED 100 and has documents showing that AED 93 was disbursed. Therefore, the custodian should have AED 7 on hand—not AED 6.)

     

    Using the above information, the journal entry to replenish the petty cash fund will include a credit to Cash-Checking Acct for AED 94. (This is the amount needed to get the petty cash on hand back to the imprest general ledger amount of AED 100.) The debits will be the accounts and amounts shown on the petty cash receipts, which total AED 93. To get the journal entry to balance, there needs to be another debit for AED 1 and it will be recorded in Cash Short and Over.

     

    A debit in Cash Short and Over represents an expense. In our example, the company will have an expense of AED 1, since there was a cash shortage of AED 1. A credit to Cash Short and Over indicates that there was more cash on hand than was expected. In other words, a credit to Cash Short and Over represents a revenue.

     

    If petty cash custodians and bank tellers were perfect money handlers, there would never be an entry to the account Cash Short and Over. The Cash Short and Over account provides an organization with a mechanism for monitoring its cash handling proficiency.

     

    The balance in Cash Short and Over is reported on the income statement. If the balance is insignificant, the account balance will likely be reported as part of miscellaneous expense.

  • 512. What does capitalize mean?
     

    The word capitalize means to record the amount of an item in a balance sheet account as opposed to the income statement. (The accounts in the general ledger and in the chart of accounts consist of two types of accounts: balance sheet accounts and income statement accounts.)

     

    To illustrate, let's assume that your company purchases a new computer printer for your office. Its cost is AED 700. If your company is a small company, it might capitalize the cost of the printer. That means the printer will be included in an equipment account and will be reported in the property, plant and equipment section of the balance sheet. Its cost will be depreciated over the printer's useful life.

     

    A larger company might decide that AED 700 is an immaterial amount and will not capitalize the printer as an asset. Rather, the large company will expense the printer immediately. (This larger company might have a policy of not capitalizing any asset with a cost of less than AED 1,000 because of the materiality convention. This is allowed because no reader of the financial statement is going to be misled because the AED 700 will appear as an expense in the year the printer is purchased instead of AED 140 in that year and AED 140 in each of the subsequent four years.)

     

  • 513. What is meant by the full cost of a product?
     

    Many (perhaps most) accountants use the term full cost to mean the full manufacturing or production cost of a product. To these accountants this means a product's cost of materials, labor, and both variable and fixed manufacturing overhead. These accountants do not include selling, administrative, or interest costs in their definition of the full cost of a product. Their view is consistent with the way that inventory and the cost of goods sold are reported on a company's financial statements.

     

    Some accountants use the term full cost to mean more than a product's manufacturing or production costs (including fixed manufacturing overhead). These accountants use full cost to mean the manufacturing cost plusan allocated portion of the company's selling, administrative, and interest costs. These accountants are concerned that some products require a larger portion of selling and administrative costs while other products require a small portion. Only when a product's selling and administrative costs are combined with the product's manufacturing costs will they be able to determine whether each product's selling price is sufficient or is aligned with its "full cost".

     

    It is important to realize that the term full cost can have different meanings to different business professionals

  • 514. What is the difference between the current ratio and the acid test ratio?
     

    The difference between the current ratio and the acid test ratio (or quick ratio) generally involves the current assets-inventory, prepaid expenses, and some deferred income taxes.

     

    The current ratio uses the total amount of all of the current assets.

     

    The acid test ratio uses only the following current assets, which are considered to be quick assets: cash and cash equivalents, short-term marketable securities, and accounts receivable (net of the allowance for uncollectible accounts). In other words, the acid test ratio excludes inventory (which is a significant current asset for retailers and manufacturers) and some other amounts such as prepaid expenses and deferred income taxes (that are classified as current assets).

     

    To illustrate the difference between the current ratio and the acid test ratio, let's assume that a company has current liabilities of AED 50,000 and has the following current assets:

    • Cash and cash equivalents AED 5,000
    • Short-term marketable securities AED 10,000
    • Accounts receivable, net AED 25,000
    • Inventory AED 56,000
    • Prepaid expenses AED 4,000

    The current ratio is 2 to 1 (or 2:1) calculated as: total current assets of AED 100,000 divided by the total current liabilities of AED 50,000.

     

    The acid test ratio or quick ratio is 0.8 to 1 (or 0.8:1) calculated as: quick assets of AED 40,000 (AED 5,000 + AED 10,000 + AED 25,000) divided by the total current liabilities of AED 50,000.

  • 515. What type of account is the Dividends account?
     

    When a corporation declares a dividend on its common stock, it will credit a current liability account Dividends Payable and will debit either 1) Retained Earnings, or 2) Cash Dividends Declared. Cash Dividends Declared is a balance sheet account, but it is a temporary account. The reason it is a temporary account is that its debit balance will be closed to the Retained Earnings account before the end of the accounting year.

  • 516. What does a debit signify in bookkeeping?
     

    In bookkeeping, a debit can signify an increase in an asset, an expense, and the owner's draws. A debit can also signify a decrease in a liability, revenues, and owner's equity.

     

    A debit is one-half of bookkeeping's double-entry system. The other half is a credit.

     

    A debit is also the amount entered on the left-side of a T-account.

     

  • 517. What is a service department?
     

    A service department is usually associated with a manufacturer. A service department is part of the factory operations, but does not produce the factory's output. Rather, it provides services to the factory's production departments. Some examples of service departments include the factory maintenance department, quality control, factory information technology departments, and the purchasing department.

     

    The head of each service department is held responsible for the costs incurred in his or her service department. In traditional cost accounting each service department's costs are then allocated to the production departments. The service departments' costs become a production department's indirect factory overhead which is then allocated to the output of each production department.

  • 518. Why is depreciation on the income statement different from the depreciation on the balance sheet?
     

    Depreciation on the income statement is the amount of depreciation expense that is appropriate for the period of time indicated in the heading of the income statement. The depreciation reported on the balance sheet is the accumulated or the cumulative total amount of depreciation that has been reported as expense on the income statement from the time the assets were acquired until the date of the balance sheet.

     

    Let's illustrate the difference with an example. A company has only one depreciable asset that was acquired three years ago at a cost of AED 120,000. The asset is expected to have a useful life of 10 years and no salvage value. The company uses straight-line depreciation on its monthly financial statements. In the asset's 36th month of service, the monthly income statement will report depreciation expense of AED 1,000. On the balance sheet dated as of the last day of the 36th month, accumulated depreciation will be reported as AED 36,000. In the 37th month, the income statement will report AED 1,000 of depreciation expense. At the end of the 37th month, the balance sheet will report accumulated depreciation of AED 37,000.

  • 519. What does amortization mean?
     

    In accounting we use the word amortization to mean the systematic allocation of a balance sheet item to expense (or revenue) on the income statement. Conceptually, amortization is similar to depreciation and depletion. An example of amortization is the systematic allocation of the balance in the contra-liability account Discount of Bonds Payable to Interest Expense over the life of the bonds. (The accountant credits Discount on Bonds Payable and debits Bond Interest Expense with a portion of the balance each accounting period.) In the case of a premium on bonds payable, the accountant systematically moves a portion of the balance in Premium on Bonds Payable by debiting the account and crediting Interest Expense.

     

    Amortization also applies to asset balances, such as discount on notes receivable, deferred charges, and some intangible assets.

     

    Amortization is a term used with mortgage loans. For example, a mortgage lender often provides the borrower with a loan amortization schedule. This schedule lists each loan payment during the life of the loan, the amount of each payment that is for interest, the amount of each payment that is for principal, and the principal balance after each loan payment.

  • 520. What is the difference between an adjunct account and a contra account?
     

    Let's illustrate adjunct and contra accounts with bonds payable. If a corporation issues AED 100,000 of its bonds payable for a price of 97, it will be issuing the bonds at a discount of 3%. Its journal entry will include a debit to Cash for AED 97,000; a credit to Bonds Payable for AED 100,000; and a debit to Discount on Bonds Payable for AED 3,000. Discount on Bonds Payable is a contra account because it is a liability account with a debit amount. The carrying value of the bonds will begin at AED 97,000 since the AED 100,000 in Bonds Payable is offset by the AED 3,000 debit in Discount on Bonds Payable.

     

    If a corporation issues AED 300,000 of bonds at a price of 102, it will be issuing the bonds at a premium of 2%. The journal entry will include a debit to Cash for AED 306,000; a credit to Bonds Payable for AED 300,000; and a credit to Premium on Bonds Payable for AED 6,000. Since a credit balance is the normal balance for a liability account, the account Premium on Bonds Payable cannot be referred to as a contra account. Here is where the term adjunct account is used. Immediately after the bonds are issued, the bonds will have a carrying value of AED 306,000 (AED 300,000 PLUS AED 6,000).

     

    Some people might use the term adjunct accounts for both the Discount on Bonds Payable and for the Premium on Bonds Payable. Others might use the term valuation accounts.

     

    Other examples of contra accounts include Allowance for Doubtful Accounts, Accumulated Depreciation, Discount on Notes Payable, Discount on Notes Receivable, LIFO Reserve, and certain investment accounts.

  • 521. Why isn't a corporation's dividend shown on its income statement?
     

    A dividend paid by a corporation is a distribution of previously earned net income (profits). A dividend is not an expense or a loss. Therefore, dividends declared and/or paid are not part of the computation of net income that is presented on the income statement.

     

  • 522. Isn't objectivity violated when estimates are used in bookkeeping and accounting?
     

    The use of estimates does not necessarily violate objectivity. If it is not possible to determine the exact amount of an expense and/or liability within a reasonable time, estimates may be necessary. In that situation, objectivity is met when the estimated amounts are similar to the amounts that another professionally-trained person would also compute with the same available information.

     

    The accounting principles, guidelines and characteristics often involve some degree of trade-offs. For example, a company's financial statements are expected to be both timely and precise. Unfortunately, achieving timeliness and relevance may require sacrificing some precision and reliability.

  • 523. What is a limitation of the inventory turnover ratio?
     

    One limitation of the inventory turnover ratio is that it tells you the average number of times per year that a company's inventory has been sold. For example, if during the past year a company had sales of AED 7 million, cost of goods sold of AED 5 million, and its inventory cost averaged AED 1 million, the company's inventory turnover was on average 5 (AED 5 million of cost of goods sold divided by AED 1 million of inventory cost). A turnover ratio of 5 indicates that on average the inventory had turned over every 72 or 73 days (360 or 365 days per year divided by the turnover of 5).

     

    However, the average turnover ratio of 5 might be hiding some important details. What if four items make up 40% of the company's sales and account for only 10% of the inventory cost? These fast selling items will have a turnover ratio of 20 (cost of goods sold of AED 2,000,000 divided by their average inventory cost of AED 100,000) meaning these items turn every 18 days (360 days divided by the turnover of 20). This means that the remaining items in inventory will have a cost of goods sold of AED 3,000,000 and their average inventory cost will be AED 900,000. As a result, the majority of the items in inventory will have an average turnover ratio of 3.3 (AED 3,000,000 divided by AED 900,000). In other words, the majority of items are turning on average every 109 days (360 days divided by the turnover ratio of 3.3). That's a significant difference from the 72 days that we first computed on the totals.

     

    People within the company can overcome the shortcomings described above, since they have access to all of the sales and inventory detail. A computer generated report can compute the inventory turnover ratio and the days' sales in inventory for each and every item sold and/or held in inventory. By reviewing each item, the slow moving items will not be hidden behind an average.

  • 524. What is accumulated depreciation?
     

    Accumulated depreciation is the total amount of a plant asset's cost that has been allocated to depreciation expense since the asset was put into service. Accumulated depreciation is associated with constructed assets such as buildings, machinery, office equipment, furniture, fixtures, vehicles, etc.

     

    Accumulated Depreciation is also the title of the contra asset account which is credited when Depreciation Expense is recorded each accounting period.

     

    The amount of accumulated depreciation is used to determine a plant asset's book value (or carrying value). For example, a delivery truck having a cost of AED 50,000 and accumulated depreciation of AED 31,000 will have a book value of AED 19,000. (It is important to note that an asset's book value does not indicate the asset's market value since depreciation is merely an allocation technique.)

     

    The accumulated depreciation of each plant asset cannot exceed the asset's cost. If an asset remains in use after its cost has been fully depreciated, the asset's cost and its accumulated depreciation will remain in the general ledger accounts and the depreciation expense stops. When the asset is disposed (sold, retired, etc.) the asset's cost and accumulated depreciation are removed from the accounts.

  • 525. How do you compute the selling price of a bond?
     

    The selling price or the market value of a bond is the present value of the future cash derived from the bond. In other words, the semiannual interest payments and the payment of the face value of the bond at its maturity date will be discounted by the market interest rate. The resulting present value of those two amounts is the market value.

     

    The semiannual interest payments are considered an annuity, since the bond's stated interest rate and the resulting interest payments do not change even though the market rates are changing each hour. The annuity consisting of the semiannual interest payments will be discounted by the current market interest rate (the rate an investor desires). The lump sum at maturity is a single payment and that too will be discounted by the same market rate used to discount the interest payments. The resulting present value of the lump sum plus the present value of the interest annuity will be the present value and the market value of the bond.

     

    When market interest rates increase, the locked-in or fixed interest payments promised in the bond will become less attractive. Hence the present/market value of the bond will decline as the market demands higher interest payments. If market interest rates decrease, the locked-in or fixed interest payments promised in the bond will become more attractive and will result in a higher present/market value.

     

    One caution for potential investors in bonds: Bonds will likely have a call feature. This means the issuer of the bond has the option to call in the bonds at a specified amount, such as 106% of its face value. This could mean a limit to the upside gain for an investor if interest rates decline. You should discuss this further with your financial adviser.Earnings and Stockholders' What are phantom profits?

    The terms phantom profits or illusory profits are often used in the context of inventory (but can also pertain to depreciation) during periods of rising costs. The amount of phantom or illusory profit is the difference between the profit reported using historical cost—as required by generally accepted accounting principles (GAAP)—and the profit that would have been reported if replacement cost had been used.

     

    For example, Company X sells products that are petroleum based. The historical cost using the first-in, first-out (FIFO) cost flow might have resulted in AED 100 per unit appearing as the cost of goods sold on the recent income statement. Had the replacement cost of the product been used, the cost of goods sold might have been AED 145. Assuming the product was sold for AED 165, the financial statements will report a gross profit of AED 65 (AED 165 minus AED 100). If replacement cost would have been allowed and used, the gross profit would be AED 20 (selling price of AED 165 minus the replacement cost of AED 145). The amount of phantom or illusory profit was AED 45 (AED 65 reported minus AED 20 measured using replacement cost). An economist would argue that you must first replace the item before you can measure the profit. GAAP doesn't allow the use of replacement cost since that violates the (historical) cost principle.

     

    During periods of inflation the amount of phantom or illusory profits will be reduced if the last-in, first-out (LIFO)cost flow assumption is used. The reason is that the last or more recent cost is closer to the replacement cost.

     

    A similar situation occurs with depreciation. Under GAAP the amount of depreciation expense reported in the financial statements is based on the historical cost of the asset and is not based on the asset's replacement cost. For example, an electric utility is depreciating (and usually charging its customers) the original cost of a power plant until the plant is fully depreciated. However, the utility is using up the economic capacity of that plant and the economic capacity might have a replacement cost that is three times as much as the plant's original cost. The utility (or any manufacturer depreciating productive assets) will be reporting higher profits using depreciation expense based on old low cost instead of current replacement cost. The resulting higher profits (the difference between the depreciation under GAAp versus the depreciation based on replacement cost) are phantom or illusory profits.Equity.loan.textbooks.administrative expense.)

  • 526. Are estimates allowed in bookkeeping?
     

    While bookkeeping involves mostly precise amounts from sales and purchase invoices, cash receipts and checks written, etc. there are situations when estimates need to be entered. This is especially true when monthly financial statements are prepared under the accrual method of accounting. For instance, the monthly bookkeeping entries for depreciation, property taxes, utilities, fringe benefits and more will need to be estimates.

     

    Even the end-of-year financial statements will require some estimated amounts. For example, a company's liability for warranties on its products and its allowance for uncollectible accounts receivable will need to be estimates. Providing an estimated amount is better than ignoring reality and reporting a zero amount.

     

    I recommend that the company's accountant review the estimated amounts that will be entered in the bookkeeping or accounting system.

  • 527. Is Accounts Payable a debit or a credit or both?
     

    Since Accounts Payable is a liability account, it should have a credit balance. The credit balance indicates the amount that company or organization owes to its suppliers or vendors.

     

    The Accounts Payable account is credited when goods or services are purchased on credit terms (as opposed to being purchased for cash). Accounts Payable is debited when a payment is made to a supplier or vendor.

     

    Stated another way, a credit to Accounts Payable will increase the balance in Accounts Payable, and a debit to Accounts Payable will decrease the balance.

  • 528. What entry is made when selling a fixed asset?
     

    When a fixed asset or plant asset is sold, the asset's depreciation expense must be recorded up to the date of the sale. Next, 1) the asset's cost and accumulated depreciation is removed, 2) the amount received is recorded, and 3) any difference is reported as a gain or loss.

     

    Here's an example. A company sells one of its machines on January 31 for AED 5,000. The last time depreciationwas recorded was on December 31. Depreciation expense is AED 400 per month. The general ledger shows the machine's cost was AED 50,000 and its accumulated depreciation at December 31 was AED 40,000.

     

    On January 31 the company will debit Depreciation Expense for AED 400 and will credit Accumulated Depreciation for AED 400 in order to record the depreciation during January. In its next entry on January 31, the company will debit Cash for AED 5,000 (the amount received); debit Accumulated Depreciation for AED 40,400 (the balance at January 31); debit Loss of Disposal of Asset AED 4,600; and credit Machines for AED 50,000.

     

    Let's step back and review the disposal of the machine. As of January 31, the machine's book value is AED 9,600 (cost of AED 50,000 minus its accumulated depreciation of AED 40,400). Because the asset is sold, the AED 9,600 of book value or carrying value is removed from the accounts. In its place, the company received and records the cash of AED 5,000. Since the company received AED 4,600 less than the amount it removed, it will report a loss of AED 4,600.

     

    If the company had received more cash than the asset's book value, it would report the difference as a credit to Gain on Disposal of Asset.

  • 529. What is the difference between a bookkeeper and an accounting clerk?
     

    I envision a bookkeeper as a person employed by a smaller company and being responsible for recording nearly all of its transactions. Hence, the bookkeeper would likely process sales invoices, customers' remittances, purchases, payments to vendors, payroll, monitoring receivables, preparing journal entries, and more.

     

    I view an accounting clerk as a person employed by a larger company and having a more specialized role. For example, a large company may employ one or more accounts payable clerks to process a large volume of purchases and payments. The company may also employ a payroll clerk to process its many employees' pay and fringe benefits. Perhaps an accounts receivable clerk will be employed to focus solely on the company's credit customers. A manufacturer may employ a cost accounting clerk to prepare price quotes and to monitor production information.

  • 530. What is "deficit" appearing in stockholders' equity?
     

    The term deficit is used instead of retained earnings when the retained earnings is a negative amount.

  • 531. Why are loan costs amortized?
     

    When loan costs are significant, they must be amortized because of the matching principle. In other words, all of the costs of a loan must be matched to the accounting periods when the loan is outstanding.

     

    To clarify this, let's assume that a company incurs legal, accounting, and registration fees of AED 120,000 during February in order to obtain a AED 4 million loan at an annual interest rate of 9%. The loan will begin on March 1 and the entire AED 4 million of principal will be due five years later. The company's cost of the borrowed money will be AED 360,000 (AED 4 million X 9%) of interest each year for five years plus the one-time loan costs of AED 120,000.

     

    It would be misleading to report the entire AED 120,000 of loan costs as an expense of one month. Hence, the matching principle requires that each month during the life of the loan the company should report AED 2,000 (AED 120,000 divided by 60 months) of expense for the loan costs in addition to the interest expense of AED 30,000 per month (AED 4 million X 9% per year = AED 360,000 per year divided by 12 months per year). The combination of the amortization of the loan cost plus the interest expense will mean a total monthly expense of AED 32,000 for 60 months beginning on March 1.

  • 532. Is the cost of land, buildings, and machinery a fixed cost?
     

    Some people refer to land, buildings, and machinery as fixed assets. They are also referred to as plant assets, or as property, plant, and equipment.

     

    The depreciation expense on the buildings and machinery is often viewed as a fixed cost or fixed expense. Hence, in the calculation of the break-even point, the annual depreciation expense on the fixed assets other than land is part of the fixed costs or fixed expenses. There is no depreciation of land.

  • 533. What are some of the methods for evaluating capital expenditures?
     

    Some capital expenditures are selected out of necessity, such as a government requirement to change the system for discharging environmentally harmful vapors or to comply with an OSHA requirement. After budgetingfor the required capital expenditures, companies might use the following techniques for evaluating other capital expenditures.

     

    Payback. This calculates the number of years it will take to recoup the cash spent on a project. A criticism of payback is that the time value of money is not considered and the cash flows over the entire life of the project are not considered.

     

    Accounting Rate of Return or Return on Investment. This approach looks at the increase in accounting profit compared to the increased investment. This approach also ignores the time value of money.

     

    Internal rate of return. This method does consider the time value of money and looks at the cash flows over the entire life of the project. The technique computes the rate that will discount the future cash flows to be equal to the cash outlay for the project.

     

    Net present value. This method discounts the project's future cash flows by a predetermined rate, such as the targeted or needed rate. If the cash flows discounted by the targeted rate exceed the cash investment, the project is accepted. That is, the project provides the targeted return or more.

  • 534. What are sales?
     

    In accounting, sales refers to the revenues earned when a company sells its goods, products, merchandise, etc. (If a company sells one of its noncurrent assets that was used in its business, the amount received is not recorded in its Sales account.)

     

    The amounts recorded at the time of the sales transaction is also known as gross sales since there may be subsequent subtractions for sales returns, sales allowances, and early payment discounts. (Gross sales minus these subtractions results in the amount of net sales.)

     

    Under the accrual basis or accrual method of accounting, goods sold on credit are reported as sales (revenue) when the goods have been transferred to the buyer. Usually this occurs before the seller receives payment from the buyer. The sales on credit are recorded with a debit to Accounts Receivable and a credit to Sales.

  • 535. What is double-entry bookkeeping?
     

    Double-entry bookkeeping refers to the 500-year-old system in which each financial transaction of a company is recorded with an entry into at least two of its general ledger accounts.

     

    For example, if a company borrows AED 10,000 from its bank, the company's asset account Cash is increased with a debit entry of AED 10,000 and the company's liability account Loans Payable is increased with a credit entry of AED 10,000. If the company repays AED 3,000 the company will decrease the amount in its Cash account with a credit entry of AED 3,000 and will reduce the balance in its Loan Payable account with a debit entry of AED 3,000.

     

    When the company pays its monthly rent of AED 2,000, a credit entry of AED 2,000 will be made in its Cash account anda AED 2,000 debit entry will be made in its Rent Expense account. If a company collects AED 500 from a customer who had previously purchased goods on credit, the company will make a debit entry of AED 500 in its Cash account andwill make a credit entry of AED 500 in its asset account Accounts Receivable.

     

    Double-entry bookkeeping requires that the debit amounts must always equal the credit amounts. Today's sophisticated bookkeeping software will have the double-entry requirements written into its code. This will prevent many of the errors that occurred in the past when bookkeeping was done manually.

  • 536. If a company issues stocks or bonds to pay outstanding debt, should this noncash transaction be included in the cash flow statement?
     

    If a company issues stocks or bonds for cash and then pays off the debt, the transaction is reported in the financing section of the statement of cash flows.

     

    If the transaction is a direct conversion of debt to equity (shares of stock) or debt to bonds and no cash receipts or cash payments occur, the transaction is to be disclosed as supplementary information.

     

    This situation and other noncash financing and investing activities are described in Paragraph 32 of the Statement of Financial Accounting Standards No. 95, Statement of Cash Flows, available at www.FASB.org/st.

  • 537. Are repairs to office equipment and factory equipment period costs?
     

    Repairs to office equipment are period costs. That is, the cost of the repairs to office equipment will be reported as a selling, general and administrative (SG&A) expense in the period in which the repairs take place.

     

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

  • 538. How do you reduce a company's break-even point?
     

    The formula for a product's break-even point expressed in units is: Total Fixed Costs divided by Contribution Margin per Unit. The contribution margin per unit is the product's selling price minus its variable costs and expenses. Fixed costs and fixed expenses are those which do not change as volume changes. Variable costs and expenses increase as volume increases and they will decrease when volume decreases.

     

    To reduce a company's break-even point you could reduce the amount of fixed costs. When an automobile manufacturer cuts thousands of salaried positions and closes assembly plants that are not fully utilized, the company is reducing its fixed costs by hundreds of millions of dollars each year. Having fewer fixed costs means fewer car sales will be required to cover them.

     

    You can also reduce the break-even point by increasing the contribution margin per unit. The contribution margin will increase if there is a reduction in variable costs and expenses per unit. For example, if a car company can obtain components at a reduced cost, the variable costs decrease. The reduced variable costs means that the contribution margin increased.

     

    The contribution margin will also increase if the company is able to increase its selling prices. (Of course the company must be careful that the increased selling price does not cause fewer unit sales.)

     

    Perhaps a combination of reduced fixed costs, reduced variable costs, and slight increases in prices is possible. Some products might be redesigned to provide unique features that customers will pay for and the additional revenue is greater than the variable costs required to add those features.

     

    Reality is more complicated than a simple formula because companies have more than one product, competition may not allow for increasing selling prices, contracts may not allow certain actions, etc.

  • 539. How many days after a month ends should the bank reconciliation be done?
     

    The bank reconciliation should be done within a few days after the month ends. The reasons include 1) making certain that the company's Cash account has the correct balance, and 2) making sure that the financial statements for the month include all of the company's transactions. At the latest, the bank reconciliation should be done prior to closing the books for the month.

     

    The bank reconciliation might reveal that some revenues and/or receipts were electronically deposited into the bank account but were not yet recorded in the accounting records. Likewise, there might be some expensesand/or payments that were deducted electronically from the bank account, but were not yet entered into the company's accounts. Further, the bank reconciliation might reveal some errors in the transactions already recorded in the company's general ledger.

     

    To save time and to improve internal control, have the bank reconciliation be performed by someone other than the person writing the checks and/or recording amounts in the general ledger.

  • 540. What is the profit and loss statement?
     

    The profit and loss statement, or P&L, is a name that is often used for what today is the income statement, statement of income, statement of operations, or statement of earnings. In other words, the profit and loss statement reports a company's revenues, expenses, and most of the gains and losses which occurred during the period of time specified in its heading.

     

    The profit and loss statement's period of time could be a year, a year-to-date period such as nine months, a quarter of a year, one month, four weeks, 52 weeks, etc. (A few gains and losses will not be reported on the profit and loss statement and will instead be reported on the company's statement of comprehensive income.)

     

    Under the accrual basis (or method) of accounting the revenues and expenses reported on the profit and loss statement should be:

    • the revenues (sales, service fees) that were earned during the accounting period, and
    • the expenses (cost of goods sold, salaries, rent, advertising, etc.) that match the revenues being reported orhave expired during the accounting period

    Today, the bottom line of this financial statement will appear as net income, which is the net amount of the revenues, expenses, gains, and losses being reported.

  • 541. What is a deposit in transit?
     

    A deposit in transit is cash (currency, coins, checks, electronic transfers) that a company has received and is rightfully reported as Cash on its balance sheet, but does not appear on the bank statement until a later date.

     

    For example, a retailer might receive AED 5,000 on Saturday (June 29) and AED 3,000 on Sunday (June 30). The money is deposited each evening in the bank's night depository. The store's Cash should be debited on each of those days for the respective amounts. However, the bank statement will report the AED 8,000 as a deposit on Monday, July 1, when the bank processes the items from the night depository.

     

    When reconciling the bank statement dated June 30, the store will have to increase the balance on the bank statement by AED 8,000 for the deposits in transit. (Recall that the AED 8,000 is rightfully reported on the company's books as of June 30, but the AED 8,000 is not recorded on the bank statement as of June 30.)

  • 542. What is bookkeeping?
     

    Bookkeeping involves the recording, storing and retrieving of financial transactions for a company, nonprofit organization, individual, etc.

     

    Common financial transactions and tasks that are involved in bookkeeping include:

     

    • Billing for goods sold or services provided to clients.
    • Recording receipts from customers.
    • Verifying and recording invoices from suppliers.
    • Paying suppliers.
    • Processing employees' pay and the related governmental reports.
    • Monitoring individual accounts receivable.
    • Recording depreciation and other adjusting entries.
    • Providing financial reports.

    Today bookkeeping is done with the use of computer software. For example, QuickBooks (from Intuit) is a low-cost bookkeeping and accounting software package that is widely used by small businesses in the U.S.

     

    Bookkeeping requires knowledge of debits and credits and a basic understanding of financial accounting, which includes the balance sheet and income statement.

  • 543. Why would a company use double-declining depreciation on its financial statements?
     

    Most companies will not use the double-declining balance method of depreciation on their financial statements. The reason is that it causes the company's net income in the early years of an asset's life to be lower than it would be under the straight-line method.

     

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

  • 544. What does it mean to replenish the petty cash fund?
     

    Replenishing the petty cash fund means the petty cash custodian requests and receives cash from the company's regular checking account in order to have the cash on hand equal to the amount reported in the general ledger account, Petty Cash.

     

    Let's assume that Company X has a petty cash fund of AED 100 and Mary is the company's employee responsible for handling the petty cash transactions. At all times Mary should have AED 100 in some combination of cash and petty cash vouchers (receipts). Let's assume that Mary has AED 20.00 in cash and she has petty cash vouchers of AED 79.70. She knows that AED 20.00 is too little cash to have on hand. As a result she will request that a check be written from the company's regular checking account in the amount of AED 80 (AED 100.00 that is reported in the Petty Cash account minus the AED 20.00 that is actually on hand.) The replenishment means the cash in the custodian's possession will be returned to AED 100, even if the vouchers do not equal the amount needed (AED 80 in this example). The small difference will be expensed along with the amounts shown in the vouchers.

     

    It is important to point out that the AED 80 check will be credited to Cash (the company's checking account). No entry will be made to the Petty Cash account.

  • 545. How do I calculate depreciation using the sum of the years' digits?
     

    The sum of the years' digits, often referred to as SYD, is a form of accelerated depreciation. (A more common form of accelerated depreciation is the declining balance method used in tax depreciation.) The sum of the years' digits method will result in greater depreciation in the earlier years of an asset's useful life and less in the later years. However, the total amount of depreciation over an asset's useful life should be the same regardless of the depreciation method used. The difference is in the timing of the total depreciation.

     

    To illustrate the sum of the years' digits method of depreciation, let's assume that a plant asset is purchased at a cost of AED 160,000. The asset is expected to have a useful life of 5 years and then be sold for AED 10,000. This means that the asset's depreciable amount will be AED 150,000 to be expensed over its useful life of 5 years.

     

    Next the digits in the years of the asset's useful life are summed: 1 + 2 + 3 + 4 + 5 = 15. In the first year of the asset's life, 5/15 of the depreciable amount (5/15 of AED 150,000) or AED 50,000 will be debited to Depreciation Expense and AED 50,000 will be credited to Accumulated Depreciation. In the second year of the asset's life, AED 40,000 (4/15 of AED 150,000) will be the depreciation amount. In the third year, AED 30,000 (3/15 of AED 150,000) will be the depreciation. The fourth year will be AED 20,000 (2/15 of AED 150,000) and the fifth year will be AED 10,000 (1/15 of AED 150,000). As indicated earlier, the total depreciation during the asset's useful life needs to sum to the depreciable cost (in this case AED 150,000) regardless of the depreciation method used.

     

    Instead of adding the individual digits in the years of the asset's useful life, the following formula can be used: n(n+1) divided by 2. In this formula, n = the useful life in years. Let's use the formula to check our calculation above. When the useful life is 5 years, the formula will be 5(5+1)/2 = 5(6)/2 = 30/2 = 15. If the useful life is 10 years, the formula will show 10(10+1)/2 = 10(11)/2 = 110/2 = 55. In the first year of the asset having a 10 year useful life, the depreciation will be 10/55 of the asset's depreciable cost. The second year will be 9/55 of the asset's depreciable cost. In the tenth year, the depreciation will be 1/55 of the asset's depreciable cost.

  • 546. Are depreciation, depletion and amortization similar?
     

    In accounting the terms depreciation, depletion and amortization often involve the movement of costs from the balance sheet to the income statement in a systematic and logical manner.

     

    For example, the systematic expensing of the cost of assets such as buildings, equipment, furnishings and vehicles is known as depreciation. The systematic expensing of the cost of natural resources is referred to asdepletion. The systematic expensing of other long-term costs such as bond issue costs and organization costs is referred to as amortization.

     

    Depreciation, depletion and amortization are also described as noncash expenses, since there is no cash outlay in the years that the expense is reported on the income statement. As a result, these expenses are added back to the net income reported in the operating activities section of the statement of cash flows when it is prepared under the indirect method.

     

    The term amortization is also used to indicate the systematic reduction in a loan balance resulting from a predetermined schedule of interest and principal payments.

  • 547. How do you record the sale of land?
     

    If a company sells land that it was holding for future use, the company will 1) debit Cash for the amount it receives, 2) credit Land for the amount in the general ledger account that applies to the land being sold, and 3) record the difference as a gain or loss on sale of land.

     

    Since land does not get depreciated, there is no depreciation expense to be recorded up to the date of the sale, nor is there any accumulated depreciation to be removed from the books of the company.

    What causes a recovery of the loss associated with inventory at the lower of cost or market?

    When inventory is valued at the lower of cost or market, and the market is less than cost, a loss is recorded. (Market is the replacement cost constrained by the net realizable value and the net realizable value minus the normal profit.) For example, let's assume that on December 31 the market is greater than the cost of inventory; therefore, the cost is reported on the balance sheet. Then on January 31 the market is AED 1,000 less than cost. On January 31, the company records a loss by debiting the income statement account Loss from Reducing Inventory to LCM for AED 1,000 and crediting the balance sheet account Allowance to Reduce Inventory to LCM for AED 1,000. On February 28 the inventory has a market amount that is only AED 200 less than cost. The question is "What causes this AED 800 recovery?"

     

    I see two reasons why the January loss might be reduced/recovered in February. The first possibility is that the market (constrained replacement cost) has increased for the items that were on hand on January 31 and remain on hand at February 28. The second possibility is that some of the items on hand on January 31 that had a market value less than their cost were sold during February–thereby eliminating the need for most of the balance that had been in the Allowance account.

  • 548. What is a natural business year?
     

    A natural business year is the period of 12 consecutive months (or 52-53 consecutive weeks) ending at a low point of an organization's activities. For example, a school district will have a natural business year of July 1 through June 30, since classes for the school year end in early June.

     

    A retailer's natural business year might be the 52-53 consecutive weeks ending on the Saturday closest to each February 1. This is a low point of activity as it follows the retailer's holiday season and its January clearance sales. The 52-53 week periods (instead of 12 month periods) will result in an equal number of Saturdays in most of the natural business years (as well as in the 13-week quarters and in the 4-5 week months).

     

    Many companies have a natural business year of January 1 through December 31. On the other hand, some companies are required by government regulations to end their accounting years on December 31, even though it is not the end of their natural business year.

     

    The term fiscal year is associated with companies having financial reporting years that do not end on December 31.

  • 549. Why are sales a credit?
     

    The account Sales is credited because a corporation's sales of products will cause its stockholders' equity to increase. A sole proprietorship's sales will cause the owner's equity to increase.

     

    The Sales account is used in order to keep a tally of the sales made during an accounting year. However, when the accounting year is completed, the credit balance will be moved via closing entries to the corporation's Retained Earnings account or to the sole proprietorship's Owner's Capital account.

     

    Recall that asset accounts will likely have debit balances and the liability and stockholders' equity accounts will likely have credit balances. To confirm that crediting the Sales account is logical, think of a cash sale. The asset account Cash is debited and therefore the Sales account will have to be credited. Also the accounting equationwill remain in balance because the asset Cash is increased with a debit, and through the closing entries an owner's or stockholders' equity account will be increased with a credit.

  • 550. What does arms length transaction mean?
     

    An arms length transaction involves two independent parties and each is attempting to get the best deal possible.

     

    For example, if your mother is selling her two-year old car to you for AED 7,000 and the blue book wholesale value is AED 14,000, that is NOT an arms length transaction. Your mother is giving you a very good deal instead of attempting to get the fair market value of the car.

     

    In an arms length transaction, the seller of a car attempts to get as much as possible for the car from an independent person who is striving to get the car for the lowest possible price. Both parties probably know the retail value and the wholesale value of the car and both want the best price: the seller is attempting to sell the car at a price that is close to the retail value and the buyer is attempting to buy the car for the wholesale value or less.

  • 551. What is a fiscal year?
     

    A fiscal year usually refers to an accounting year that does not end on December 31. (The accounting year of January 1 through December 31 is usually referred to as a calendar year.) Some examples of the fiscal years used by U.S. corporations include:

    • the 12 months of February 1 through January 31
    • the 12 months of October 1 through September 30
    • the 12 months of June 1 through May 31
    • the 52 weeks (four 13-week quarters) ending on the Saturday closest to January 31 (This will require an occasional fiscal year of 53 weeks since 52 weeks X 7 days = 364 days vs. 365 days per year.)

    One reason a business or other organization will have its accounting year end on a date other than December 31 is to fit its natural business year. For example, school districts will use fiscal years of July 1 through June 30. Retailers often end their fiscal years near the end of January.

     

    A corporation or other organization needing audited financial statements will likely save auditing fees by having its accounting year different from the calendar year end of December 31.

  • 552. Is depreciation a source of funds?
     

    Some people state that depreciation is a source of funds or a source of cash. I disagree.

     

    Depreciation expense is reported as a positive amount on the statement of cash flows prepared under the popular indirect method. However, the reason it is listed is to adjust the net income amount that had been reduced by depreciation expense on the income statement. (Recall that the depreciation entry debits Depreciation Expense and credits Accumulated Depreciation—the cash account is not involved.) In other words, the positive depreciation amount reported on the statement of cash flows is merely one of the adjustments needed to convert the accrual net income to the cash provided from operating activities. Depreciation is not a source of cash.

     

    Let's illustrate this with some amounts. A sidewalk florist operates a cash only business. During the most recent year, this florist had cash revenues of AED 100,000. Its expenses included AED 70,000 of cash expenses and AED 8,000 of depreciation expense on its truck that was purchased in an earlier year. During the year there were no other revenues or expenses, and the florist's cash balance increased by AED 30,000. The florist's income statement will report net income of AED 22,000 (revenues of AED 100,000 minus expenses of AED 78,000).

     

    The florist's statement of cash flows prepared under the indirect method will begin with net income of AED 22,000. It will then add the AED 8,000 of depreciation expense. The result is cash provided by operating activities of AED 30,000—which agrees to the business's change in its cash balance.

     

    The AED 8,000 of depreciation expense was not a source of cash, even though it appears as a positive amount on the statement of cash flows.

     

    Editor's note: A reader's comment points out that the depreciation on the income tax return will reduce taxable income and that in turn will likely reduce the amount of cash paid for income taxes. This reduction in income taxes is a source of cash.

  • 553. Is rent expense a period cost or a product cost?
     

    When a company incurs rent for its manufacturing operations, the rent is a product cost. It is common for the rent to be included in the manufacturing overhead that will be allocated or assigned to the products. That rent as part of the manufacturing overhead cost will cling to the products. If the products remain in inventory, the rent is included in the manufacturing overhead portion of the product's cost. When products are sold, the rent allocated to those products will be expensed as part of the cost of goods sold.

     

    If the rent is for items involved in the selling function (rent for office space, equipment, autos, etc.) or if the rent is for items in the administrative function of the company, the rent is a period cost and will be expensed in the period when the expense is incurred. These rents will not be allocated to the products for external financial statements.

  • 554. What is the effective interest rate?
     

    The effective interest rate is the true rate of interest earned. It could also be referred to as the market interest rate, the yield to maturity, the discount rate, the internal rate of return, the annual percentage rate (APR), and the targeted or required interest rate.

     

    For example, a AED 1,000 bond that promises to pay 5% interest is said to have a stated, contractual, face, or nominal interest rate of 5%. This means that the corporation will pay exactly AED 50 per year during the life of the bond and the principal amount at maturity. If the market interest rates increase by one percentage point, the 5% bond becomes less attractive and will drop in value because the bond contract states that the corporation will pay AED 50 per year for the life of the bond–even in a 6% market. New investors will purchase the 5% bond in a 6% market only if they will earn 6% interest over the life of the bond. To arrive at the price they will pay for a bond paying only AED 50 per year in interest, the investors and the market will discount the future cash flows by 6% to arrive at the present value. (In other words, the AED 50 per year annuity will be discounted by 6% and the AED 1,000 at maturity will be discounted by 6%. The combination of the present value of the annuity and the present value of the maturity amount is the amount that will provide an investor with exactly a 6% return over the remaining life of the bond.) This is why the effective rate is also referred to as the discount rate, the market interest rate, the yield to maturity, the internal rate of return on the investment, the targeted rate, or required rate of return.

     

    The preferred way to amortize the premium or discount on bonds payable is through the use of the effective interest rate. The effective interest rate will be multiplied times the carrying value of the bonds in order to determine the bond interest expense. The difference between this expense and the cash interest payment is the amount amortized.

  • 555. How do you divide the cost of real estate into land and building?
     

    We will use the following example to illustrate how to divide the cost of real estate into the cost of the land and the cost of the building. Assume that the entire cost of a real estate purchase is AED 220,000. The appraisal made at the time of the purchase indicates that the land has a market value of AED 50,000 and the building has a market value of AED 200,000...for a total market value of AED 250,000.

     

    We can use the appraisal amounts for dividing the actual cost of AED 220,000 into the cost of the land and the cost of the building. There are two related techniques which will have the same results.

    1. Since the appraisal report indicated that the land's value is AED 50,000 out of the AED 250,000 of total appraised value, we can assign 20% (50/250) of the total cost of AED 220,000 to the land, or AED 44,000. The building's appraised value is AED 200,000 out of the AED 250,000 total appraised value. Therefore we can assign 80% (200/250) of the total cost of AED 220,000 to the building, or AED 176,000.
    2. The real estate's total cost of AED 220,000 is 88% of the total appraised value of AED 250,000. We can multiply the land's appraised value of AED 50,000 times 88% in order to get the cost of the land at AED 44,000. The building's appraised value of AED 200,000 times the 88% cost ratio equals the cost of land at AED 176,000.

    A self-check of both calculations indicates the same costs: land at AED 44,000 plus the building at AED 176,000 equals the total actual cost of AED 220,000.

     

    We did not deviate from the cost principle. We merely used the appraised market values as a logical way to divide up the actual cost between the land and building. This assignment or allocation is necessary because the cost of the building used in a business will be depreciated, while the cost of the land is not depreciated.

  • 556. What are the required financial statements?
     

    The required financial statements for U.S. business corporations are:

     

    1. Statement of income. This financial statement is also known as the statement of operations, statement of earnings, or income statement. It reports the corporation's revenues, expenses, gains and losses (except for items stipulated as other comprehensive income) for a period of time such as a year, quarter, 13 months, etc.
    2. Statement of comprehensive income. This financial statement begins with the bottom line of the income statement and then lists the items considered to be other comprehensive income. Some of these items involve currency translation, hedging, available-for-sale securities, and pensions.
    3. Balance sheet. This statement of financial position reports a corporation's assets, liabilities and stockholders' equity as of the final instant of the date shown in its heading (December 31, January 31, June 30, etc.)
    4. Statement of cash flows. This statement reports the major causes for the change in cash and cash equivalentsduring the accounting period. The cash flows are presented as operating, investing, or financing activities.
    5. Statement of stockholders' equity. This financial statement is often presented as the statement ofshareholders' equity, statement of equity, statement of changes in stockholders' equity, etc. It reports all of the changes in stockholders' equity which occurred during the accounting period.

    The five annual financial statements must be accompanied with notes to the financial statements. These notes are needed in order to disclose additional information about items that are reported or are not reported in the financial statements.

     

    You can see examples of the required financial statements (and the required notes) for a publicly traded U.S. corporation by searching the Internet for the corporation's name plus the words investor relations. Select Annual Reports (or select SEC filings and annual reports or 10-K).

  • 557. What is the meaning of debtor?
     

    A debtor is a person or entity that owes money. In other words, the debtor has a debt or legal obligation to pay an amount to another person or entity.

     

    For example, if you borrow AED 10,000 from a bank, you are the debtor and the bank is the creditor.

  • 558. Is there a difference between work-in-process and work-in-progress?
     

    It depends on the user of the terms. I use the term "work-in-process" to mean a manufacturer's inventory that is not yet completed. I think of work-in-process as the goods that are on the factory floor of a manufacturer. The amount of Work-in-Process Inventory would be reported along with Raw Materials Inventory and Finished Goods Inventory on the manufacturer's balance sheet as a current asset.

     

    I use the term "work-in-progress" to mean construction of long term assets (that will be used in the company's business) that are not yet completed. For example, if a company is constructing an addition to its building and the work is only partially completed, the amount spent so far would be recorded as Work-in-Progress, Construction in Progress, or Construction Work-in-Progress (CWIP) and the account would be on the balance sheet as a long-term asset in the section entitled Property, Plant and Equipment. When the project is completed and put into service, the amount would be transferred out of CWIP and would be reported in the account Buildings within Property, Plant and Equipment. At that point, the depreciation of the addition will begin. (If a company is constructing an assembly line or a huge machine that will take time to build, the amounts would also be accumulated in CWIP. When the project is completed and is placed into service, the amount will be transferred from CWIP to Equipment and depreciation will begin.)

     

    To make matters even more complicated, companies producing items under a long-term contract would use an account entitled Construction-in-Process.

     

    Your question points out the need for caution and complete understanding of what the communicator intends. Remember that the sender of a message might not realize that there are important differences between slightly different terms.

  • 559. What is the difference between a contingent liability and an estimated liability?
     

    A contingent liability is a potential liability (and a potential loss). It is dependent upon a future event occurring or not occurring. For instance, if someone files a lawsuit against Jay Corp, Jay Corp will have a contingent liability. The lawsuit liability is dependent upon Jay Corp losing the lawsuit. (Some lawsuits are nuisance suits and will not cause a loss and liability.) When a contingent liability and loss are probable and the amount can be estimated, an estimated amount will be recorded as a liability.

     

    Some liabilities are not contingent liabilities but are estimated liabilities. For example, the electricity consumed, property taxes, worker compensation insurance premiums, repairs, etc. are absolutely owed because the services or goods were delivered. There is nothing contingent about these. However, the precise amounts may not be known at the time that the financial statements are prepared. Therefore, these liabilities had to be recorded by using estimated amounts. I suspect that many of the accrual-type adjusting entries involve estimated liabilities.

  • 560. What is a contingent asset?
     

    A contingent asset is a potential asset associated with a contingent gain. Unlike contingent liabilities and contingent losses, contingent assets and contingent gains are not recorded in accounts, even when they are probable and the amount can be estimated.

     

    An example of a contingent gain and contingent asset might be a lawsuit filed by Company A against Company B for infringement of Company A's patent. If it is probable that Company A will win the lawsuit and receive an estimated amount of money, it has a contingent asset and a contingent gain.

     

    However, it will not report the asset and gain until the lawsuit is settled. (At most Company A will prepare a very carefully worded disclosure stating that it possibly could win the case.) On the other hand, Company B will need to make an entry in its accounts if the loss contingency is probable and the amount can be estimated. If one of those are missing, Company B will have to disclose the loss contingency in the notes to its financial statements.

  • 561. Why Does Inventory Get Reported on Some Income Statements?
     

    Inventory is an asset and its ending balance should be reported as a current asset on a company's balance sheet. Inventory is not an income statement account. However, the change in Inventory is a component in the calculation of the Cost of Goods Sold. (Cost of Goods Sold is considered to be an expense and is subtracted from Sales on a merchandising company's income statement.) Some income statements will show the calculation of Cost of Goods Sold as Beginning Inventory + Net Purchases = Goods Available - Ending Inventory. In that situation the beginning and ending inventory does appear on the income statement.

     

    The introductory course in accounting will often use the formula mentioned in calculating the Cost of Goods Sold: Beginning inventory + Net Purchases = Cost of Goods Available - Ending Inventory = Cost of Goods Sold. However, it is my experience that financial statements prepared with accounting software often find that calculation to be awkward, and instead show the following: Net Purchases + or - the change in Inventory = Cost of Goods Sold. The concept is that if ending inventory has increased, some of the cost of the Net Purchases should be added to Inventory and should not be charged against the current period Sales. The result is that the Net Purchases amount on the income statement is reduced and the amount of the reduction is added to the Inventory cost reported on the balance sheet. If the ending Inventory is smaller than the beginning Inventory amount, then the cost in Inventory should be reduced and added to the cost of the Net Purchases to report the correct amount as Cost of Goods Sold on the income statement.

     

    I suspect that the authors of beginning accounting texts believe it is instructional to list the beginning inventory and ending inventory amounts in the Cost of Goods Sold section of the income statement. Perhaps they believe that the Cost of Goods Available is an important concept. As a result, they show the beginning amount of Inventory and the ending amount of Inventory on the Income Statement. I believe that this is awkward for accounting software. (Here are some reasons: The ending balance of last year's Inventory will have to appear in the year-to-date column of the income statement, while the Inventory's ending balance from the previous month must be reported in the current month column. The current month's ending balance in Inventory must appear in both columns.)

     

    To recap, Inventory is a current asset and should be reported on the balance sheet. The change in Inventory has an effect on the Cost of Goods Sold appearing on the income statement. It's probably easiest to report only the change in Inventory in the Cost of Goods Sold section of the income statement.

  • 562. Does sales commission get reported in the income statement?
     

    Sales commissions earned by a company would be reported as revenue in the company's income statement. Sales commissions that a company must pay to others are reported as an expense.

     

    Under the accrual basis of accounting (as opposed to the cash basis) commission revenues should be reported when the company earns the commissions. The commission expense should be reported when the company has incurred the expense and liability. (This would also be the time when the other party has earned the commissions and the right to receive them.)

     

    The commission revenues would be reported as operating revenue (in the section where sales are reported), if the commissions are earned as a main activity of the company. If the commissions are incidental or involve a peripheral activity, these commission revenues would be reported as other income.

     

    Commission expense would be reported as a selling expense along with other operating expenses when they are related to the company's main activities. If a commission expense pertains to a peripheral activity, it would be reported as other expense.

     

  • 563. Why not use Sales in the Inventory Turnover Ratio?
     

    The short answer is: Because Inventory is at cost. Inventory is not on the company's books at selling prices.

     

    The Inventory Turnover Ratio is Cost of Goods Sold divided by average Inventory. Let's illustrate the ratio with the following amounts: Sales for the year AED 800,000; Cost of Goods Sold for the year AED 600,000; Inventory (average amount at cost during the year) AED 200,000. Inventory Turnover Ratio = AED 600,000 divided by AED 200,000 = 3 times. On average the inventory turned over approximately 3 times during the year.

     

    Had we used Sales in the ratio, it would indicate that the inventory had turned over 4 times (Sales of AED 800,000 divided by AED 200,000 of Inventory), which is not the case. While some organizations do use Sales in the calculation, it is not logical to divide selling prices by cost. The resulting ratio is not reality. (Perhaps some use Sales because the Cost of Goods Sold number is not readily available for every company. In order to have comparability with all companies, they may have opted to use Sales.)

  • 564. What is a T-account?
     

    A T-account is a visual aid used to depict an account in a general ledger. Above the top portion of the T would be the account title. On the left-side of the base of the T would be any debit amounts; on the right-side would be the credit amounts.

     

    The T-account can be helpful in determining the proper balance for an account or to determine the amount to be entered in order to arrive at a desired balance. I always use two (or more) T-accounts when determining how to adjust an account balance. Drawing two T-accounts reminds us that every transaction or adjustment will have to involve at least two accounts because of double-entry accounting.

     

    A common use of T-accounts is in preparing adjusting entries (accruals and deferrals). I begin by drawing two T-accounts. Next, I note that one of the T-accounts will affect a balance sheet account. The other T-account is noted as affecting an income statement account.

     

    As a young accountant I had to determine the effect of a new FASB standard on my employer's financial statements. I reported on the impact on the company's expenses in great detail. I thought I was done until the controller drew two T-accounts on a piece of paper and said, "What about the other account? You told me about the expense account, but what other account or accounts are affected. You know we have double-entry accounting!"

     

    You might get in the habit of using two T-accounts each time you attempt to determine the proper accounting entry. It will help you see the proper amounts and the proper accounts.

  • 565. What are the effects of depreciation?
     

    The depreciation of assets such as equipment, buildings, furnishing, trucks, etc. causes a corporation's asset amounts, net income, and stockholders' equity to decrease. This occurs through an accounting adjusting entry in which the account Depreciation Expense is debited and the contra asset account Accumulated Depreciation is credited.

     

    The amount of the annual depreciation that is reported on the financial statements is an estimate based on the asset's 1) cost, 2) estimated salvage value, and 3) useful life. Depreciation should be thought of as an allocation of the asset's cost to expense (and not as a valuation technique). In other words, the accountant is matching the cost of the asset to the periods in which revenues are generated from the asset.

     

    The amount of the annual depreciation reported on the U.S. income tax return is based on the tax regulations. Since depreciation is a deductible expense for income tax purposes, the corporation's taxable income (and associated tax payments) will be reduced by its tax depreciation expense. (In any one year, the depreciation expense for taxes will likely be different from the amount reported on the financial statements.)

     

    It should be noted that depreciation is viewed as a noncash expense. That is, the corporation's cash balance is not changed by the annual depreciation entry. (Often the corporation's cash is reduced for the asset's entire cost at the time the asset is acquired.)

  • 566. What is a nonprofit organization?
     

    A nonprofit organization is an organization without commercial owners and which addresses the needs of society. Nonprofit organizations are also known as not-for-profits or simply as nonprofits. Nonprofit organizations are likely to be involved in areas such as religious, education, health, social services, arts, etc.

     

    Nonprofit organizations may apply to be exempt from federal income taxes. Donors' contributions to nonprofit organizations may or may not be charitable deductions. For more information regarding these issues see Publication 557 at IRS.gov.

     

    A nonprofit organization's financial reporting includes a statement of financial position, a statement of activities, and a statement of cash flows. Some nonprofits are required to file IRS Form 990 or Form 990-EZ. Since nonprofits do not have commercial owners, the difference between the amounts of assets and liabilities is reported as net assets (instead of owner's or stockholders' equity). The amount of net assets is presented as: unrestricted, temporarily restricted, or permanently restricted. The classification is dependent upon the donors' stipulations.

     

    The typical sources of a nonprofit's revenues are donor contributions, program fees, dues, fundraising events, grants, and investment income. Expenses are presented in the following classifications: program expenses, management and general, and fundraising.

  • 567. What are payroll withholding taxes?
     

     

    In the U.S. payroll withholding taxes are the taxes that an employer is required to deduct from its employees' gross wages, salaries, bonuses, and other compensation.

     

    The typical payroll withholding taxes include each employee's portion of the Social Security and Medicare taxes (also referred to as FICA), federal income tax, and often state income tax. (A few cities and states may also require additional payroll taxes.)

     

    After deducting the payroll withholding taxes from its employees, the employer is required to remit the amounts in a timely manner to the appropriate government.

     

    In addition to payroll withholding taxes, most employers also withhold nontax amounts for insurances, savings plans, union dues, court-ordered garnishments, and so on.

  • 568. Are undeposited checks reported as cash?
     

    Undeposited checks that are not postdated (not dated with a future date) are reported as cash. Accountantsdefine cash as more than just currency and coins. For example, unrestricted checking accounts are also reported as cash.

  • 569. What is a balance sheet and why is it prepared?
     

    The balance sheet is prepared in order to report an organization's financial position as of a specified moment, such as midnight on December 31.

     

    A corporation's balance sheet reports its assets (resources that were acquired in past transactions), its liabilities(obligations and customer deposits), and its stockholders' equity (the difference between the amount of assets and liabilities). Some people state that the balance sheet reports the amounts of the assets and the claims against those assets (liabilities and stockholders' equity). Others state that the balance sheet reports a corporation's assets and the amount that was provided by creditors (the liabilities) and the amounts provided by the owners (stockholders' equity).

     

    A classified balance sheet reports the current assets in a section that is separate from the long-term asset. Similarly, current liabilities are reported in a section that is separate from long-term liabilities. This allows bankers, owners, and others to easily compute the amount of an organization's working capital. (Working capital is defined as current assets minus current liabilities.)

     

    The balance sheet has some limitations. For example, land and buildings are usually reported at cost minus the accumulated depreciation of the buildings. If these assets have increased in value, the fair value is not reported due to the cost principle. Also, brand names and trademarks may have significant value, but are not reported on the balance sheet, if they were not acquired in a transaction.

     

    The balance sheet should be read with the other financial statements (income statement, statement of cash flows, and the statement of changes in stockholders' equity) and with the notes to the financial statements.

  • 570. What is the purpose of depreciation?
     

    The purpose of depreciation is to match the cost of a productive asset (that has a useful life of more than a year) to the revenues earned from using the asset. Since it is hard to see a direct link to revenues, the asset's cost is usually allocated to (assigned to, spread over) the years in which the asset is used. Depreciation systematically allocates or moves the asset's cost from the balance sheet to expense on the income statement over the asset's useful life. In other words, depreciation is an allocation process in order to achieve the matching principle; it is nota technique for determining the fair market value of the asset.

     

    The accounting entry for depreciation is a debit to Depreciation Expense and a credit to Accumulated Depreciation (a contra-asset account that is reported in the same section of the balance sheet as the asset that is being depreciated).

  • 571. What is the segregation of duties?
     

    The segregation of duties is associated with the safeguarding of an organization's assets and the topic known as internal control.

     

    An example of the segregation of duties would be a company's requirement that the bank statement for its checking account must be reconciled by someone other than a person writing checks and someone other than a person recording amounts in the company's general ledger.

     

    Another example of the segregation of duties is that the person handling cash cannot be the same person that records cash amounts in the company's ledgers.

     

    By segregating or separating the duties, it becomes harder for dishonest actions to go undetected.

  • 572. What is the difference between bad debt and doubtful debt?
     

    Some people will use these terms or account titles interchangeably: Bad Debt Expense, Doubtful Account Expense, Uncollectible Account Expense. The same for these terms or account titles: Allowance for Bad Debts, Allowance for Doubtful Accounts, Allowance for Uncollectible Accounts.

     

    The "Allowance for ..." is a balance sheet account. However, it is a contra account to the asset Accounts Receivable. (Generally, the Allowance account will have a credit balance—whereas Accounts Receivable and other asset accounts normally have debit balances.) The Allowance account communicates to the reader of the balance sheet the amount of Accounts Receivable that will likely not be collected.

     

    The three Expense account titles listed above are income statement accounts and will have the usual debit balance. These expense accounts report how much bad debt expense was incurred during the period shown in the heading of the income statement.

  • 573. Is a utility bill an expense?
     

    The utility bill for a retailer or for a service company is an expense. Under the accrual basis of accounting, the utility bill is an expense for the period indicated by the meter reading dates.

     

    A manufacturer's utility bill is more complicated. The utility bill for its selling and general administration will be an expense for the period indicated by the meter reading dates. However, the utility bill for the direct and indirect manufacturing operations is part of its manufacturing overhead. As such, the utility bill will be assigned or allocated to the units produced. In other words, the utility bill will be clinging to the units produced. Some of the utility cost will be clinging to the units in inventory and therefore will be part of the cost of the asset inventory. Some of the utility cost will be clinging to the units that have been sold and will be part of the expense known as the cost of goods sold.

  • 574. What is the difference between a ledger and a trial balance?
     

    A ledger is often defined as a book of accounts. Today a ledger is most likely an electronic record or file containing a group of accounts. For example, a company's general ledger is the record containing all of its asset, liability, owner equity, revenue, expense, gain, and loss accounts. Each of these accounts will contain the amounts that are pertinent to the account.

     

    A trial balance is a listing of the name and the balance of each of the accounts in the general ledger. The trial balance is not a financial statement. Rather, it is an internal report that documents which accounts have debit balances and which accounts have credit balances and proves that the total of the debit balances is equal to the total of the credit balances.

  • 575. What is the high-low method?
     

    The high-low method is a simple technique for computing the variable cost rate and the total amount of fixed costs that are part of mixed costs. Mixed costs are costs that are partially variable and partially fixed. The cost of electricity used in a factory is likely to be a mixed cost since some of the electricity will vary with the number of machine hours, while some of the cost will not vary with machine hours. Perhaps this second part of the electricity cost is associated with circulating and chilling the air in the factory and from the public utility billing its large customers with a significant fixed monthly charge not directly tied to the kilowatt hours of electricity used.

     

    The high-low method uses two sets of numbers: 1) the total dollars of the mixed costs occurring at the highest volume of activity, and 2) the total dollars of the mixed costs occurring at the lowest volume of activity. It is assumed that at both points of activity the total amount of fixed costs is the same. Therefore, the change in the total costs is assumed to be the variable cost rate times the change in the number of units of activity. Prior to using the high-low method, it is important to plot or graph all of the data available to be certain that the two sets of numbers being used are indeed representative.

     

    To illustrate the high-low method, let's assume that a company had total costs of electricity of AED 18,000 in the month when its highest activity was 120,000 machine hours. (Be sure to match the dates of the machine hours to the electric meter reading dates.) During the month of its lowest activity there were 100,000 machine hours and the total cost of electricity was AED 16,000. This means that the total monthly cost of electricity changed by AED 2,000 when the number of machine hours changed by 20,000. This indicates that the variable cost rate was AED 0.10 per machine hour.

  • 576. Which companies would benefit most from Activity-Based Costing?
     

    Activity-based costing (ABC) emphasizes that activities consume companies' resources and driver costs (rather than volume alone driving costs). As a result, the companies benefiting the most from ABC would be companies with a significant amount of overhead pertaining to a diversity of activities in providing goods (or services) to customers whose demands also vary. In other words, if your company has little overhead cost and manufactures almost identical products requiring similar attention for each product, the need for ABC probably isn't there.

     

    The overhead that we are referring to is not limited to manufacturing overhead. Some customers also demand activities that drive up the administrative overhead and the selling expenses. The idea behind ABC is that the customers and products that are causing the manufacturing and administrative overheads to occur should be assigned those costs. If there is the diversity of products and customers (some require costly activities and some don't), it isn't fair to simply spread all of the cost of all of the activities to all of the products and customers on the basis of just one activity, such as machining hours. The non-machining overhead costs should not be assigned to products and customers that don't require the other activities. The products and customers that demand the other activities should be assigned the cost of the other activities.

     

    Again, if your company has little variation among products and customers, and most of its overheads are related to just one activity, such as machining hours, using machine hours to allocate the overhead costs is probably satisfactory. However, if you manufacture products that are not uniform in the attention and activities necessary to serve the customer, you should learn more about activity-based costing.

  • 577. What is ROI?
     

    ROI is the acronym for return on investment. Originally the objective of ROI was to relate a return (the income statement benefit) to the amount invested (such as the asset information from the balance sheet).

     

    During the first half of the 20th century, ROI was helpful in monitoring the decentralized divisions of large diverse corporations. The ROI calculation may have divided a division's operating income by the average amount of operating assets being utilized by the division. For instance, a division with an operating income of AED 1 million that used AED 10 million of operating assets had an ROI of 10%.

     

    A drawback of ROI is that the accounting amounts (revenues, expenses, asset book values, etc.) ignore the time value of money. As a result, companies began using discounted cash flows to better assess the profitability of its investments. Calculations such as net present value and internal rate of return became common and ROI was referred to as the accounting rate of return.

     

    In the 21st century we see ROI used in the context of internet marketing and the adoption of wellness programs at large companies. In these examples the income statement benefits (more sales, lower health insurance expense) are related to the amounts being spent. Here, too, the ROI calculations do not consider the time value of money.

  • 578. How do you account for a project under construction?
     

    I will assume that the project under construction is a major rebuilding of equipment or an addition to a building. The amounts spent on these projects would be debited to a long term asset account such as Construction Work in Progress. This account is often reported as the last line within the balance sheetclassification Property, Plant and Equipment.

     

    There will be no depreciation until the project is completed and the asset is placed into service. When the completed asset is placed into service, the project's cost will be removed from the account Construction Work in Progress and will be debited to the appropriate plant asset account.

  • 579. How is the material usage variance account reported on the financial statements?
     

    The material usage variance in a standard costing system results from using more or less than the standard quantity of direct materials specified for the actual goods produced. If the actual quantity of the input direct materials is more than the standard quantity allowed for the good output, the variance is unfavorable and theMaterial Usage Variance account will have a debit balance . If the actual quantity of the input direct materials isless than the standard quantity allowed for the good output, the variance is favorable and a credit will be entered in the Materials Usage Variance account.

     

    When preparing the financial statements, a debit balance in the Materials Usage Variance account (which means an unfavorable variance) will have to be added to the standard cost of the products. If the standard costs associated with the variance are in the goods that have been sold, the debit balance in the variance account will be added to the Cost of Goods Sold, an income statement expense. (This is reasonable, because the standard cost is too low compared to the actual cost of the materials.) If the output associated with the variances is entirely in finished goods inventory, then the debit balance in the variance account will be added to the finished goods inventory amount reported on the balance sheet. Again, this is necessary because the standard cost of the finished goods inventory is too low. If the products are in work in process, finished goods inventory, and cost of goods sold, you would assign the variance to all three categories based on the proportions associated with the variance amounts. Accountants refer to this as prorating the variances. If the variance amount is insignificant, accountants will simply assign these small variances to the cost of goods sold. This is reasonable if most of the goods that were produced have been sold. Generally, inventories are small in relation to the quantities produced.

     

    Credit balances in the variance accounts represent favorable variances and will reduce the standard costs that are reported as debit balances in inventory on the balance sheet or as cost of goods sold expense on the income statement. The favorable variances will be prorated as discussed above or simply credited to cost of goods sold when the variances are not significant or material in amount.

  • 580. What is bank balance and book balance?
     

    The terms bank balance and book balance are used in the accounting and bookkeeping procedure known as reconciling the bank statement.

     

    The bank balance is also known as the balance per bank or balance per bank statement and it refers to the ending balance appearing on a bank statement. For example, when a company receives its June checking account statement from its bank, the June 30 balance will be the bank balance. Usually this bank balance will not agree with the amount in the company's records since some checks written by the company will not have cleared the checking account by June 30. Similarly, some money received by the company on June 30 may not have been deposited in time for the amount to appear on the June bank statement.

     

    In the bank reconciliation the term book balance may be referred to as the balance pe