La Tasha Roberts
Material Type:
Community College / Lower Division
Creative Commons Attribution

Accounting For Business and Entrepreneurs, Concepts and Technology

Accounting For Business and Entrepreneurs, Concepts and Technology


The content will cover basic Accounting and Managerial concepts for Non-Accounting Majors. This textbook approaches Financial and Managerial Accounting from a business perspective. The topics covered are relevant for business owners and entrepreneurs; helping them to understand what information is needed to run a business, make decisions, and grow the business. 

Table of Contents

Chapter 1: Introduction to Accounting

Chapter 2: Analyzing, Posting, and Adjusting Transactions

Chapter 3: Receivables

Chapter 4: Accounting for a Merchandising Company

Chapter 5: Financial Statements

Chapter 6: Internal Control and Cash

Chapter 7: Long-term Assets

Chapter 8: Liabilities

Chapter 9: Other business entities: Partnerships and Corporations

Chapter 10: The Role of Accounting in the Basic Management Process

Chapter 11: Job Order Costing

Chapter 12: Cost Behavior and CVP Analysis

Chapter 13: Budgeting

Chapter 14: Differential Analysis: Relevant Costs

Chapter 1 Learning Objectives

By the end of this lesson, you will be able to:

  • LO1: Define the purpose of accounting
  • LO2: Describe the accounting process.
  • LO3: Describe the forms of businesses.
  • LO4: Define the different types of business entities.
  • LO5: Classify the different types of business activities.
  • LO6: Identify the four basic financial statements and their purposes
  • LO7: Define assets, liabilities, and Owner’s equity.

What Is the Purpose of Accounting?

The Purpose of Accounting

The purpose of accounting is to provide financial information to users in order for those users to make decisions.  Accounting is often called the “language of business.”  Accounting is the means by which financial information is communicated to users.  The focus of this text is on the role of accounting in business.

Financial Accounting deals with preparing financial information for external users.  Managerial accounting deals with preparing financial information for external users.


Users of accounting information are separated into two groups, internal and external. Internal users are the people within a business organization who use accounting information.  External users are people outside the business entity that use accounting information.  Accounting information is valuable because decision makers, internal and external, can use it to evaluate the financial decisions of various alternatives. Accountants reduce uncertainty by using professional judgment to quantify the future financial impact of taking action or delaying action.  Accounting information plays a significant role in reducing uncertainty within an organization.

Nature and Objective of Business and Accounting

A business is an organization that provides goods or services to customers.  The objective of most business is to earn a profit.  Profit is the difference between the amount received for selling your goods and services and the cost of providing those goods and services.

Types of Businesses

Three types of businesses operated for profit include service, merchandising (retailers), and manufacturing businesses.  Examples of each type of business are below:

Service businesses:

  • Federal Express (Delivery services)
  • American Airlines (Transportation services)
  • Marriott Hotels (Hotel services)
  • Universal Studios (Entertainment services)

Merchandising businesses (Retailers):

  • Target (general merchandise)
  • Amazon (books)
  • Walmart (general merchandise)
  • Safeway Stores (groceries)

Manufacturing businesses:

  • Ford Motor Company (vehicles)
  • Dell Inc. (Computers)



Forms of Businesses

A business is normally organized in one of the following four forms:

  • proprietorship
  • partnership
  • limit liability company
  • corporation

A proprietorship is an unincorporated business owned and run by one individual with no distinction between the business and  the owner. The owner is entitled to all profits and are responsible for ALL business's debts, losses, and liabilities. The primary disadvantage of proprietorships is that the owner has unlimited liability to creditors for the debts of the company.  In the United States, more than 70% of all businesses are proprietorships.

partnership is a legal form of business operation between two or more individuals who share management and profits. The In the United States, about 10% of all business are partnerships.  The partners of a partnership also have unlimited liability to creditors for the debts of the company.

A corporation is a legal entity that is separate and distinct from its owners. Corporations enjoy most of the rights and responsibilities that an individual possesses; that is, a corporation has the right to enter into contracts, loan and borrow money, sue and be sued, hire employees, own assets and pay taxes. The ownership of a corporation is represented by shares of stock. A corporation issues the stock to individuals or other entities, who then become owners or stockholders of the corporation. A major advantage of a corporation is that stockholders' have limited liability to creditors for the debts of the company.  It is limited to their investment.

 limited liability company (LLC) combines attributes of a partnership and a corporation. The primary advantage of the limited liability company form is that it operates similar to a partnership, but its owners' (or members') liability for the debts of the company is limited to their investment. Many professional practices such as, lawyers, doctors, and accountants are organized as limited liability companies. A Limited Liability company is governed by the State you register the company; this means, it can still function like any of the other businesses entities.

Use the attached resource to see what business structure will best suit your business.

Business Activities

All companies are engaged in the following three business activities:

Operating activities involve the current assets, current liabilities, revenues, and expenses.  Revenues are the assets received from selling the company’s goods or services. Revenues are normally identified according to their source.

Investing activities involve buying and selling of company noncurrent assets to start and operate a business. These assets would include land, buildings, computers, office and store machines, office furnishings, trucks, and automobiles.

Financing activities involve obtaining funds to begin and operate a business. Companies obtain funds by:

  • issuing shares of stock (Ownership in the business)
  • borrowing from the bank
  • Issuing bonds (borrowing from the public)

Accounting Process

Accounting is the systemic gathering of financial information about a business and reporting this information to users. The report can be in the form of financial statements, such as the Profit and Loss (Income Statement), or the Balance Sheet. Also, if the company is publicly traded, they must submit an annual report on the financial state of the company.

There are six major steps in this process:


  • Recording: entering financial information about economic events into the accounting system. This system can be a program, such as QuickBooks, that can either be cloud based or downloaded to your desktop.
  • Classifying: we must ask ourselves what type of information is this? Is this an invoice or a bill? This will help to sort the financial information.
  • Summarizing: providing the information in an easy to understand method.
  • Reporting: this would be in the form of the financial statements.
  • Interpreting: users will use this information to make decisions.

The Accounting Equation

There is a delicate balancing of the financial information; we will use the Accounting Equation to stay in balance. The Accounting Equation is:

Accounting Equation

The left side shows the assets or economic resourLeft side equals right sideces of the company, the right side of the equal shows the claims on the company assets. These claims can be from a creditor or the owner(s).






Accounting Equation


Classifying Accounts Examples

The table shown below lists some of the main account names we will use. As we move forward, the list of accounts will increase.



  • Current assets are cash and other assets that are expected to be converted to cash or sold or used up within one accounting period which is normally one year or less.   This would normally include cash, accounts receivable, notes receivable, supplies, and prepaid expenses.
  • Long-term assets: Property, Plant, and Equipment are physical assets of a long-term nature. The fixed assets may also be reported on the balance sheet as property, plant, and equipment or plant assets. Fixed assets include equipment, machinery, buildings, and land. Except for land, these assets depreciate over a period of time. The cost less accumulated depreciation is called the book value and is normally reported on the classified balance sheet.
  • Intangible assets represent rights of a long-term nature, such as patent rights, copyrights, and goodwill.  This will be discussed in different chapter.


  • Current liabilities are liabilities that are due within one accounting period, which is normally one year or less, and are to be paid out of current assets. Normally current liabilities include accounts payable, notes payable, wages payable, interest payable, taxes payable, and unearned revenue.
  • Long-term Liabilities are liabilities that are due after the first accounting period.

Owner's Equity:

Owner's equity will be the difference between your assets minus your liabilities (debt) that the owner of the business can claim. This can be derived from the investments, net income less the dividends, that is retained in the business. The owner can decide to withdraw some of the equity in the company.



Taking It Further with Technology

We have learned the basics of Accounting using the pen to paper method but, we know technology affects every aspect of your life. Even in the world of business, we have different devices or programs that help us to run our business. Let's explore them.

Social Media

Social Media Icons

Social media is a way for a business owner to connect with customers and find new customers. The benefits of using social media can save a company advertising cost by creating their own media. One of the other benefits of social media is you can gain loyal customers; all of the these options are advatanges to social media. One of the disadvantages is the time it takes to learn all the different platforms. Thankfully, there are tech companies that you can purchase already created content and post it own your social media page.

Customer Relationship Management

CRM icon

CRM's will help a company to streamline communication with customers as well as staff.  These programs help to orgainize and automate your customer interactions. The scale of the program you select can depend on cost and needs of the company.

Collecting Payments

Online Payments icon

Paying for services or purchases has become easier with the use of these payment apps. As a customer, you can send money or pay for services from a business. As a business owner, you can use these apps to collect fees and increase your sales because you take different forms of payment.

Virtual Office Assistants and Virtual Offices

Virtual AssistantVirtual meeting icon

When the Pandemic hit, every company had to find a way for work to continue; those that could, started to work remote. This caused companies to address what "working from home" means and how to sufficiently get the work done; companies scrammbled to get equipment and laptops to employees. Businesses saw a huge benefit for some employees to work from home because employees were more productive and it was saving some operational costs. Some companies laid off employees.

Even now that some employees are back at the physical office, this created a new administrative position called a Virtual Assistants; the employee can work from home, using their own equipment, and work for more than just one company at any location. This also caused a huge wave with virtual offices; now, you can complete work from a remote location, using technology to keep appointments and conduct virtual meetings. Keeping information in one place is easy with cloud storage.

There are so many apps or programs you can use to run your business efficiently, it just takes some research to see what apps or programs works best for your business.




Comprehensive Problem

This Comprehensive Problem will span the entire textbook starting as a service company, then, a merchandising company, and lastly, a manufacturing company. This will also serve an an example of the graded comprehensive problem you will compelete as an exam grade.


Theia Ellis worked in the field as a Physical Therapist until the Pandemic; she found herself out of a job, even though she loved her patients and her work. Her patients loved her as well, stating they would follow her to another facility. After going on serveral job interviews, she decided to open her own business. With the money from her servant's package and her savings, she invested $15,000, acquired some used equipment from Facebook Marketplace for $4,500, and went in search of an office location. She wanted some place her clients would feel safe and private to conduct sessions. She found a place with private suites and an open space for sessions; the rent and utilities would be $3,500 a month. The other monthly expenses were:

  • Business insurance $900 a year
  • Supplies - $375
  • Uniforms - $175
  • New laptop and printer - $2,500
  • Advertising and signage - $425
  • Internet - $100/month
  • A lawyer to complete the formation papers for the LLC - $550
  • LLC fee - $300
  • EMR system - $120/month

After consulting with a lawyer, Proficient Therapy LLC was formed; the doors will open on Jan. 1. Theia signed the lease for the unit, paying the first month's rent and purchased all the necessary items for the business to start. Using the Accounting equation, it will look like this:


As you can see, Theia has a starting net loss because no revenue has been earned. We will use this information when we check back in with Proficient Therapy.

Chapter 1 Summary

We have discused the basic foundation of Accounting using the Accounting Equation, Assets = Liabilities + Owner's Equity. We will start off by viewing the information from a the sole proprietorship's perspective. We will slowly add new concepts and materials each week. After each chapter, please return to Blackboard to complete your chapter assignments in OHM.

Chapter 2: Analyzing Transactions using the Accounting Equation

LO1: Describe the chart of accounts.

LO2: Describe and illistrate the journalizing transactions using the expanded equation grid.

LO3: Describe and illistrate the journalizing transactions using T accounts.

LO4: Prepare an Unadjusted Trial Balance.

The Chart of Accounts

As we seen in chapter 1, the Chart of Accounts can be extensive depending on the industry or the company. Even so, the Chart of Accounts will have a basic format that most companies will use.

A group of accounts for a business entity is called a ledger; the list of accounts in the ledger is called a Chart of Accounts. The accounts are listed in the order they appear in the Balance Sheet.

Income Statement:

Revenues. Some may ask, what does revenue mean? This means the way the business makes money. For example, if you sell product, you would have a Sales account in your chart of accounts or you can also have an inventory account because you purchase product.

Expenses. You will use, consume, or expire the prepaid assets of the company to generate revenue, such as, Prepaid Rent or Prepaid Insurance. This means you have paid for this upfront and will use, consume, or expire a flat amount each month and it will be listed on your Income Statement in the "Expenses" area. Also, to generate revenue, you will use  expenses; for example, you paid for some advertising to generate customers; this will be classified as Advertising expense. The expenses are listed in order from greatest to least and Miscellaneous Expense will always be last.




Accrual Accounting and Cash Basis Accounting

What Is Accrual Accounting?

Accrual accounting is an accounting method that records revenue when earned and records expenses when incurred regardless of when cash is received or paid to the Income Statement.  Companies often earn revenue before or after cash is received and incur expenses before or after cash is paid. Accrual basis accounting is designed to avoid misleading information arising from the timing of cash receipts and payments.

What is Cash Accounting?

Cash accounting is an accounting method that reports revenue when it is received and when expenses are paid to the Income Statement; this may not happen in the same period the services or expenses were made.

Quickbooks offers a detailed breakdown of Accrual Basis Vs. Cash Basis.


For this class, we will focus on Accrual Accounting.


The four corporate financial statements described and illustrated in chapter 1 were prepared using accounting “rules,” called generally accepted accounting principles (GAAP). Generally accepted accounting principles (GAAP) are necessary so that stakeholders can compare companies across time. If the management of a company could prepare financial statements as they saw fit, the comparability between companies and across time would be impossible.

Accounting principles and concepts develop from research, accepted accounting practices, and pronouncements of regulators. Within the United States, the Financial Accounting Standards Board (FASB) has the primary responsibility for developing accounting principles. The FASB publishes Statements of Financial Accounting Standards as well as interpretations of these Standards.

The Securities and Exchange Commission (SEC), an agency of the U.S. government, also has authority over the accounting and financial disclosures for corporations whose stock is traded and sold to the public. The SEC normally accepts the accounting principles set forth by the FASB. However, the SEC may issue Staff Accounting Bulletins on accounting matters that may not have been addressed by the FASB.

Many countries outside the United States use generally accepted accounting principles adopted by the International Accounting Standards Board (IASB).

Accounting Principles and Concepts

Business Entity Concept: The business entity concept limits the economic data recorded in an accounting system to data related to the activities of that company. In other words, the company is viewed as an entity separate from its owners, creditors, or other companies. For example, a company with one owner records the activities of only that company and does not record the personal activities, property, or debts of the owner. A business entity may take the form of a proprietorship, partnership, corporation, or limited liability company (LLC).

Cost Concept: The cost concept initially records assets in the accounting records at their cost or purchase price.

Going Concern Concept: The going concern concept assumes that a company will continue in business indefinitely. This assumption is made because the amount of time that a company will continue in business is not known.

Matching Concept: The matching concept reports the revenues earned by a company for a period with the expenses incurred in generating the revenues. That is, expenses are matched against the revenues they generated.

Revenue Recognition Principle: Revenues are normally recorded at the time a product is sold or a service is rendered, which is referred to as the revenue recognition principle. At the point of sale, the sale price has been agreed upon, the buyer acquires ownership of the product or acquires the service, and the seller has a legal claim against the buyer for payment.

Unit of Measure Concept: In the United States, the unit of measure concept requires that all economic data be recorded in dollars. Other relevant, non-financial information may also be recorded, such as terms of contracts. However, it is only through using dollar amounts that the various transactions and activities of a business can be measured, summarized, reported, and compared. Money is common to all business transactions and thus is the unit of measurement for financial reporting.

Adequate Disclosure Concept: The adequate disclosure concept requires that the financial statements, including related notes, contain all relevant data a stakeholder needs to understand the financial condition and performance of the company. Nonessential data are excluded to avoid clutter.

Accounting Period Concept: The accounting period concept requires that accounting data be recorded and summarized in financial statements for periods of time. For example, transactions are recorded for a period of time such as a month or a year.

Transaction Analysis

We will use the extended version of the Accounting Equation to evaluate transactions using T accounts. As you can see, we implemented the Equation with an "Increase" or "Decrease"; once you go to the other side of the equal, the "Increase" and Decrease flip.





Examples of Transactions

To illustrate accrual accounting, the following transactions are used for Landry Medical Group:

  1. Received $1,800 from ILS Company as rent for the parking lot.
  2. Paid a premium of $2,400 for a two-year general business insurance policy that covers risks from fire and theft.
  3. Purchased a new piece of equipment for $6,000 on account.
  4. Dr. Landry invested an additional $5,000 in the business.
  5. Purchased supplies for $240 on account.
  6. Purchased $8,500 of office equipment. Paid $1,700 cash as a down payment, with the remaining $6,800 ($8,500 − $1,700) due in five monthly installments of $1,360 ($6,800 ÷ 5).
  7. Provided services of $6,100 to patients on account.
  8. Received $5,500 for services provided to patients who paid cash.
  9. Received $4,200 from insurance companies on patients' accounts for services that were provided in transaction 7.
  10. Paid $100 on account for supplies that were purchased in transaction 5.
  11. Expenses paid during November were as follows: wages, $2,790; rent, $800; utilities, $580; interest, $100; and miscellaneous, $420.
  12. Personally withdrew $1,200.



Breaking It Down - Assets

Here's the Assets listed in the T accounts:


Breaking It Down - Liabilities and Equity





The Adjustment Process

Accrual accounting requires the updating of the accounting records prior to preparing financial statements. This updating is called the adjustments.  Adjustments are necessary because, at any point in time, some accounts of the accounting equation are not up to date. The income statement of a business reports all revenues earned and all expenses incurred to generate those revenues during a given period. An income statement that does not report all revenues and expenses is incomplete, inaccurate, and possibly misleading. Similarly, a balance sheet that does not report all of an entity’s assets, liabilities, and stockholders’ equity at a specific time may be misleading. Each adjustment has a dual purpose: (1) to make the income statement report the proper revenue or expense and (2) to make the balance sheet report the proper asset or liability. Thus, every adjustment affects at least one income statement account and one balance sheet account.

The accounts that need adjusting are:

  • Deferrals are the result of cash being received or paid before the revenue is earned or the expense is incurred.
  • Accruals are normally the result of cash being received or paid after revenue has been earned or an expense has been incurred.
  • Prepaid or deferred expenses: Initially recorded assets but become expenses over time or through normal operations of business. Examples include prepaid insurance and prepaid advertising.
  • Unearned or deferred revenues: Initially recorded as liabilities but become revenues over time or through normal operations of the business. Examples include unearned rent and insurance premiums received in advance.
  • Accrued expenses or liabilities: Expenses that have been incurred but are not recorded in the accounts. Examples include unpaid wages and utility expenses.
  • Accrued revenues or assets: Revenues that have been earned but are not recorded in the accounts. Examples include revenue for patient services that have been earned but are not recorded in the accounts and accrued interest on notes receivable.

Adjustment Example

Let's make the end of the period adjustments for Landry Medical Group.

  1. Service revenue accrued but unbilled - $19,750.
  2. Used up all the supplies in the Supplies account.
  3. Wages accrued but not paid - $4,900
  4. Paid $1,500 to creditors; this will pay the remaining balance in supplies and make the first installment payment.
  5. Depreciation of equipment - $575
  6. Insurance expired - $100

Accounting Cycle

The accounting cycle is the process that goes through the following steps:

  1. Analyze the source documents (checks, contracts, invoices, etc.)
  2. Determine what accounts are affected (Assets, Liabilities, and Owner’s Equity).
  3. Determine if the accounts are increasing or decreasing and how each transaction affects the financial statements (Income Statement, Statement of Owner's Equity, Balance Sheet, and Statement of Cash Flows). Record the economic transactions.
  4. Assemble adjustment data and record those adjustment to the accounts.
  5. Prepare the financial statements.

Comprehensive Problem

Let's check in with Theia Ellis, owner of Proficient Therapy LLC.

Here is the information for Proficient Therapy LLC:

Here are the transactions for the Month of January:


4. Provided services for clients on account, $9,400; we will use Gross Patient Service Revenue.

5. Purchased additional equipment for $7,000, paying a down payment of $1,000 and making monthly installments of $500 for one year.

7. Received $ 3,760 from the insurance companies for Jan. 4.

10. Created a Groupon advertisement giving patients 20% off services; this will be cash paying clients.

14. Paid wages to part-time workers, $ 1,825.

15. The Groupon was a success! Received $11,700 in advance payment for services; we will record this as unearned revenue.

16. Paid $375 to the Office Depot credit card.

18. Recorded services provided to clients on account, $ 3,625.

20. Purchases more supplies on account from Office Depot, $1,265.

24. Met with the manager of a nursing home to come by twice a week to provide services to the patients. The contract was for a flat rate of $2,000 per month for 3 months; received $6,000.

26. Paid for my professional membership dues of $380.

27. Paid wages to part-time workers, $1,825.

29. Paid utilities of $760.

30. Withdrew $1,750 for personal use.

Using the information, enter the economic transactions into GNU cash program. Use the Accounts below:


Adjusting entries for the month of January:

      1. Insurance expired during January is $75.
      2. Supplies on hand on January 31 are $759.
      3. Made the first installment payment of $500.
      4. Depreciation of equipment is $ 250.
      5. Some Groupon clients came in for services, $3,510.
      6. Groupon collected their fee from adjustment (e): $1,755
      7. Accrued wages of $1,095.
      8. Earned $1,000 from transaction 24.


Chapter 3: Receivables

In this lesson you will be able to account for receivables and short term investments and you will be able to:

  • Distinguish between the direct write off and allowance methods.
  • Determine the financial statement effects accounting for uncollectible accounts using the direct write off and allowance methods.
  • Analyze the notes receivable transactions and effects on the financial statements

Accounts Receivable

Accounts Receivable

All receivables expected to be realized in cash within a year are presented in the Current Assets section of the balance sheet. These assets are normally listed in the order of their liquidity, that is, the order in which they are expected to be converted to cash during normal operations.

The usual transaction creating a receivable is selling merchandise or services on account (on credit). This is recorded as an increase to Accounts Receivable. These accounts are normally collected within 30 or 60 days. They are classified on the balance sheet as a current asset.

Uncollectible Receivables

Uncollectible Receivables

A major concern about accounts receivable is that some customers will not pay their accounts and may become uncollectible.

  • Companies may shift the risk of uncollectible receivables to by accepting major credit cards like American Express, Discover, MasterCard or VISA.  This shifts the risk to the credit card companies.
  • Companies may also sell their receivables to a buyer of receivables called a factor.  The risk may shift to the factor.

Many companies will grant credit to their customers. Regardless how well you check for customers, some credit sales will be uncollectible. When an account is uncollectible it is recorded as a bad debt expense.

There are two methods of accounting for uncollectible receivables are as follows:


Direct Write-off Method:

General accepted accounting principles (GAAP) do not recognized the direct write-off method.  Under the direct write-off method, bad debt expense is recorded when the customer's account is determine to be uncollectible. At that time, the customer's account receivable is written off.

Uncollectible Receivables: the Allowance Method

The two allowance methods used to estimate uncollectible accounts are as follow:



Percentage of the Accounts Receivable Method

The allowance method estimates the uncollectible accounts receivable at the end of the accounting period. Based on this estimate, Bad Debt Expense is recorded by an adjustment.

Percentage of the Sales Method

The percent of sales method assume that a percent of the credit sales is uncollectible. This percent can come from industry standards or historical trends from the company.

The Importance

The importance of keeping up with how much Accounts receivable is uncollected because there is cash on the line. The longer you wait to collect payment, the more you lose to collect. Please read the following article on Aging of Receivables.

Notes Recievable

Notes receivable are amounts that customers owe for which a legal, written document is issued. If notes receivable are expected to be collected within a year, they are classified on the balance sheet as a current asset.


Parts of a promissory note are as follows:

  1. The maker is the party making the promise to pay.
  2. The payee is the party to whom the note is payable.
  3. The face amount is the amount the note is written for on its face.
  4. The issuance date is the date a note is issued.
  5. The due date or maturity date is the date the note is to be paid.
  6. The term of a note is the amount of time between the issuance and due dates.
  7. The interest rate is that rate of interest that must be paid on the face amount for the term of the note.

The interest rate is stated on an annual (yearly) basis, while the term is expressed in days. Thus, the interest and maturity value on the note in computed as follows: Principle X Rate X Time.

To simplify, 360 days per year are used in this chapter. In practice, companies such as banks and mortgage lenders use the exact number of days in a year, 365.

The maturity value is the amount that must be paid at the due date of the note, which is the sum of the face amount and the interest. You will hear the word for face to also mean principle.

The maturity date will be counting the days left in the month it is issued and counting the days for each month until you have accumulated the total days.

January- 31July - 31
Feb- 28August - 31
March - 31September - 30
April - 30October - 31
May - 31November - 30
June - 30December - 31

For example, Roberts Company issued a $40,000, 6%, 45 day note on Feb.1 to Peoples Inc.

We will use the formula Principle X Rate X Time to calculate the amount of interest: $40,000 X 0.06 X (45/360) = 300

Now, to calculate the due date we will look at the table to count the 45 days; let's determin the due date of the note:

Number of days in the Note45
Days remaining in February28
Days remaining in March17
Due date of the Note March 17th

Therefore, on March 17, Peoples Inc will pay the maturity value, face + interest, to Roberts Company. 

Notes may be used to settle a customer's account receivable. Notes and accounts receivable that result from sales transactions are sometimes called trade receivables. All notes and accounts receivable in this chapter are assumed to be from sales transactions.


Chapter 4: Merchandise Inventory

You will be able to describe the basis for inventory valuation and you will be able to:

  • Define merchandise inventory.
  • Calculate ending inventory and cost of goods sold under the periodic inventory system using FIFO, LIFO, Weighted Average methods.
  • Describe factors considered when selecting and inventory method and the effects of such a selection on the financial statements.

Merchandising Business

The revenue activities of a merchandising business involve the buying and selling of inventory (merchandise for resale).   When the merchandise is purchased, it is shown on the balance sheet as a current asset. A retail business first purchases merchandise to sell to its customers. When this inventory is sold, the revenue is reported as sales revenue. The cost of the inventory sold is reported as cost of goods sold. The cost of goods sold is subtracted from sales revenue to arrive at gross profit.  The operating expenses are subtracted from gross profit to arrive at operating income.

Sales Transactions

Cash Sales Transactions: Sales transactions may be a cash sale or credit sale. Cash sales are recorded in the accounts by increasing cash and sales. Under the perpetual inventory system, Cost of goods sold should be increased and merchandise inventory should be decrease in the same transaction. Credit card sales using VISA, MasterCard, or American Express are recorded as cash sales with a reduction of the credit card fees.

Credit Sales: Credit sales are recorded in the accounts by increasing accounts receivable and sales.  Increasing the cost of goods sold and decreasing inventory should also be made in the same transaction.

Sales Discounts: A merchandiser may grant customers sales discounts as incentives to encourage them to pay their bills early.  For example, a seller may offer credit terms of 2/10, n/30, which provides a 2% sales discount if the invoice is paid within 10 days. If not paid within 10 days, the total invoice amount is due within 30 days.  A buyer refers to a sales discount as a purchases discount.

The revenue recognition principle requires that revenue be recorded in the amount expected to be received from the sale.  Therefore, sales revenue should be recorded net of the sales discount.

Sales Returns and Allowances:  Merchandising companies usually allow customers to return goods that are defective or unsatisfactory for a variety of reasons, such as wrong color, wrong size, wrong style, wrong amounts, or inferior quality. In fact, when their policy is satisfaction guaranteed, some companies allow customers to return goods simply because they do not like the merchandise. A sales return is merchandise returned by a buyer. Sellers and buyers regard a sales return as a cancellation of a sale. Alternatively, some customers keep unsatisfactory goods, and the seller gives   them an allowance off the original price. A sales allowance is a deduction from the original invoiced sales price granted when the customer keeps the merchandise but is dissatisfied for any of a number of reasons, including inferior quality, damage, or deterioration in transit. When a seller agrees to the sales return or sales allowance, the seller sends the buyer a credit memorandum indicating a reduction (crediting) of the buyer's account receivable.

Sales Tax

Sales Taxes Almost all states levy a sales tax on sales of merchandise inventory.  A sales tax is levied on the final user of a product.  Buyers who purchase product to resale do not have to pay a sales tax. That is referred to as buying it wholesale.  When a sale is made on account or for cash, the seller charges the buyer by increasing Accounts Receivable or cash to the total sales plus sales tax, increasing the sales revenue for the amount of the sales, and increasing sales tax payable for the sales taxes.

Purchasing Inventory

There are two systems for recording and accounting for merchandise inventory: perpetual and periodic.


In either case, perpetual or period, an inventory physical count must be taken and compared to the records.   This physical inventory is used to determine the cost of inventory on hand at the end of the period, which is the amount reported as Inventory on the balance sheet.


Purchase Discounts

Purchases Discounts: Normally, the purchaser of inventory will take the discounts taken with the discount period.  Purchases discounts are given for early payment of a purchase invoice.  The credit terms 2/10, n30 mean that the buyer is entitled to a 2% discount if paid within 10 days (2/10) from the invoice date.  If the discount period is missed, the buyer must pay the full invoice within 30 days (n30). In a perpetual inventory system, the merchandise inventory is reduced for the purchase discount.

Purchase Returns and Allowances: Purchases returns and allowances result when merchandise inventory received by a buyer is defective, damaged, or not what was ordered. In these cases, the buyer may return the merchandise for full credit or request a price adjustment (allowance).  In a perpetual inventory system, the inventory is reduced for the return or allowance.

Shipping Terms

Freight Cost: Freight cost (shipping cost) must be paid by either the buyer or the seller.  Who pays the freight cost is determined when title (ownership) of merchandise inventory passes.  Title may pass to the buyer the seller either delivers to the inventory to the freight carrier or when the buyer received the inventory.

Shipping Terms

We have all purchased goods online, as a consumer, when the rights to the goods can happen in two ways:

  • The term FOB (free on board) shipping point means that the title for the goods pass to the buyer when the seller delivers the merchandise inventory to the transportation company.   Such costs are part of the buyer's total cost of purchasing inventory and should be added to the cost of the inventory.  
  • The term FOB destination means that the seller pays the freight costs from the shipping point (seller’s dock) to the final destination.  Such cost would be included in the operating expenses as a shipping expense or freight out expense.


Here's an example of how to calculate the different shipping terms.

Below are two invoices received by Theia Ellis; she purchsed some merchandise for her company:

The terms are expressed in 1/10, n/30; this means they get a 1% discount if they pay in 10 days and pay the remainder in 30 days. The shipping terms gives two benefits, first, to the seller because there will be some form of payment either in 10 days or 30 and second, the buyer gets a discount for paying early. 

Now, we will calculate how much Theia will pay each invoice:

Invoice #8905654: $2,678.75 ( 2,500 - 375 - 21.25 + 575)

Invoice #4599125: $4,189.50 ( 4,500 - 225 - 85.50)

Inventory Shrinkage

Inventory Shrinkage: Although under the perpetual inventory system, the inventory account is continually updated for purchase and sales transactions, a physical inventory count is necessary.  The difference in the physical count and the records is normally caused by loss of inventory due to shoplifting, employee theft, or errors.  Thus, the physical inventory on hand at the end of the accounting period is usually less than the balance of Inventory. This difference is called inventory shrinkage or inventory shortage.

Under the perpetual inventory system, the inventory account is continually updated for purchase and sales transactions. As a result, the balance of the inventory account is the amount of merchandise available for sale at that point in time.

Periodic Inventory Method

As mentioned earlier, most company uses the perpetual inventory system; but, for merchandising companies with enormous variety of inventory and cost of a perpetual system is not cost benefit, they may use a periodic inventory system.  In a periodic system, cost of goods sold is calculated as follows:


In order to calculate Cost of merchandise purchase, you must replace the entries to Inventory with four (4) new accounts and they are:

  • Purchases
  • Purchase returns and allowances
  • Purchase Discount
  • Freight In

To calculate Cost of merchandise purchased is as follows:


Cost Flow Methods: When identical units of inventory are acquired at various unit costs, it is necessary to determine the cost of the unit sold using various cost flow methods.  We will discuss three common cost flow methods using the periodic method in this chapter:



Mama T's Treats purchased some custom mixers to sell online with the company's brand and logo. The information is show below:

After conducting a physical count of the units, only 75 were left; each unit sold for $350.

Determine the Cost of Goods Sold, Ending Inventory, and Gross Profit for each of the three methods.

Remember, we're only asking one question, what happened to the inventory? Is it sitting in the warehouse or did we sell it?

Here are the final calculations:


Lower Cost of Market

Generally, companies should use historical cost to value inventories and cost of goods sold. However, “Rule of Conservatism” states the for financial statement purposes, companies should us value inventory items at less than their cost when the market is lower.  A decline in the selling price of the goods or their replacement cost may indicate such a loss of utility. This section explains how accountants handle some of these departures from the cost basis of inventory measurement.

The lower-of-cost-or-market (LCM) method is an inventory costing method that values inventory at the lower of its historical cost or its current market (replacement) cost. The term cost refers to historical cost of inventory as determined under the specific identification, FIFO, LIFO, or weighted-average inventory method. Market generally refers to a merchandise item’s replacement cost in the quantity usually purchased. The basic assumption of the LCM method is that if the purchase price of an item has fallen, its selling price also has fallen or will fall. The LCM method has long been accepted in accounting.

Chapter 5: Financial Statements

By the end of this section, you will be able to:

  • Prepare a simple: Income Statement, Statement of Retained Earnings, Balance Sheet, and Statement of Cash Flows
  • Prepare a Classified Balance Sheet

Delivery of Information

The accounting reports providing this information are called financial statements. The order of the financial statements and the explanation of each statement are listed below:

Financial StatementsDescriptionOrder of Preparation
Income Statement or Profit and LossShows a detail of the revenues and expenses for a specific period of time.1
Retained Earnings StatementShows a detail of the changes that occurred in the Retained Earnings during a specific period of time.2
Balance SheetShows the Accounting Equation ( Assets = Liabilities + Stockholders' Equity) on a specific date in time.3
Statement of Cash FlowsShows the inflows and outflows of the Cash account for a specific period of time.4

These reports are prepared at the end of an accounting period.

Income Statement

Financial statements present the results of operations and the financial position of the company. Four main statements are commonly prepared by publicly-traded companies and are prepared in the following order:

Income Statement

The income statement reports the results of the operation of the company. The time period covered by the income statement may vary; it can be monthly, quarterly, or yearly. The income statement formula is: revenues minus expenses. Expenses should be listed in the order of the greatest amount first, except for Miscellaneous and Income Tax Expenses should be last.


The Multi-step Income

This Income statement will breakdown the expenses to Selling and Administrative; we will use this type of statement to analyze any increases or decreases.

First, we will take Sales and deduct the Sales Discounts and Sales Returns and Allowances to get Net Sales. Next, we deduct the Cost of Goods Sold from it to get the Gross Profit. The Gross Profit represents what we sold the product for minus what we purchased the product for; this will show us the gross amount before we deduct any expenses. 

We will break the expenses down as shown in the illistration:

Selling expenses are expenses incurred in the process of selling the goods or product. As you see, this would be any department, such as the sales team, or any process of the product or goods, such as delivery, shipping, or the depreciation of the equipment that makes the good or product. 

Administrative expenses are general expenses incurred in a normal process of the business such as rent expense, office salaries, depreciation on the office equipment, etc. 

Other Revenue and Expenses are items not related to the primary function of the business. For example, If I sold a product but I owned a building and leased out offices, I would put my Rent Revenue in this field. 

Retained Earnings (Statement of Owner's Equity)

Statement of Retained Earnings

The statement of retained earnings reports the changes in retained earnings. A corporation may retain all of its net income for expanding operations, or it may pay a portion or all of its net income as dividends.

Statement of Retained Earnings Example

Here's another way to complete the Equity Statement:

Owner's Equity Example


Balance Sheet

Balance Sheet

The balance sheet reports the financial position of the company at a point in time.  The financial condition of a business can be expressed as the accounting equation. The balance sheet, sometimes called the statement of financial condition. Assets on the Balance Sheet are listed in the order of liquidity or how quickly consumed.

 Balance Sheet example

Classified Balance Sheet

The classified balance sheet is prepared to assist the user in decision making through analysis.  Let’s first address the classified balance sheet.  The classified balance sheet is prepared with various sections and subsections as follows:


  • Current assets are cash and other assets that are expected to be converted to cash or sold or used up within one accounting period which is normally one year or less.   This would normally include cash, accounts receivable, notes receivable, supplies, and prepaid expenses.
  • Long-term assets: Property, Plant, and Equipment are physical assets of a long-term nature. The fixed assets may also be reported on the balance sheet as property, plant, and equipment or plant assets. Fixed assets include equipment, machinery, buildings, and land. Except for land, these assets depreciate over a period of time. The cost less accumulated depreciation is called the book value and is normally reported on the classified balance sheet.
  • Intangible assets represent rights of a long-term nature, such as patent rights, copyrights, and goodwill.  This will be discussed in chapter 6.


  • Current liabilities are liabilities that are due within one accounting period, which is normally one year or less, and are to be paid out of current assets. Normally current liabilities include accounts payable, notes payable, wages payable, interest payable, taxes payable, and unearned revenue.
  • Long-term Liabilities are liabilities that are due after the first accounting period.

Analysis: At this time we will discuss a few liquidity measures.  The ability to pay current debt is important.  The Quick Ratio, Current Ratio, and Working Capital calculation let the users know if they have enough current assets to pay current liabilities.

Working Capital

The Working Capital is the excess of the current assets minus the current liabilities; it will show if a company has pay it's current obligations or liabilities. The Working Capital can be express in dollars; the formula to express Working Capital in dollars is: Current Assets - Current Liabilities. To express the Working Capital in a ratio is called Current Ratio; the formula to express Current ratio is: Current Assets/Current Liabilities.

Quick Ratio

The Quick Ratio looks at the "quick" assets, Cash, termorary investments, and receivables, and divide it by current liabilities. This can also be referred to as the acid-test ratio.

Statement of Cash Flow

Statement of Cash Flows

The statement of cash flows reports the change in the balance sheet due to the changes in cash during a period. The statement of cash flows looks at the three business activities of operating, investing, and financing.   Any changes in cash must be related to one or more of these activities.

Operating Activities: The most important cash flow is from the operating activities.  The net cash flows from operating activities is reported first. Operating activities are associated with cash flow from the company’s income statement.  Bankers and creditors look at the cash flow from operating activities to see if the operating activities are generating enough cash In the short term, creditors use cash flows from operating activities to assess whether the company's operating activities are generating enough cash to repay them. In the long term, a company cannot survive unless it generates positive cash flows from operating activities. Thus, cash flows from operating activities is also a focus of employees, managers, suppliers, customers, and other stakeholders who are interested in the long-term success of the company.

Investing Activities: The net cash flows from investing activities is reported second. This is because investing activities directly impact the operations of the company. Cash receipts from selling property, plant, and equipment are reported in this section. Likewise, any purchases of property, plant, and equipment are reported as cash payments. Companies that are expanding rapidly, such as start-up companies, normally report negative net cash flows from investing activities. In contrast, companies that are downsizing or selling segments of the business may report positive net cash flows from investing activities.

Financing Activities: The net cash flows from financing activities is reported third. Any cash receipts from issuing debt or stock are reported in this section as cash receipts. Likewise, cash payments of debt and dividends are reported in this section.

The statement of cash flows is completed by adding the net cash flows from operating, investing, and financing activities to determine the net increase or decrease in cash for the period. This net increase or decrease in cash is then added to the cash at the beginning of the period to arrive at the cash at the end of the period.

 Statement of Cash Flow example

Financial Statement Analysis

Management’s analysis of financial statements primarily relates to parts of the company. Using this approach, management can plan, evaluate, and control operations within the company. Management obtains any information it wants about the company’s operations by requesting special-purpose reports. It uses this information to make difficult decisions, such as which employees to lay off and when to expand operations. Our primary focus in this chapter, however, is not on the special reports accountants prepare for management. Rather, it is on the information needs of persons outside the firm.

Investors, creditors, and regulatory agencies generally focus their analysis of financial statements on the company as a whole. Since they cannot request special-purpose reports, external users must rely on the general-purpose financial statements that companies publish. These statements include a balance sheet, an income statement, a statement of stockholders’ equity, a statement of cash flows, and the explanatory notes that accompany the financial statements.


Financial Statement Analysis: Horizontal Analysis

Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information. This information reveals significant relationships between data and trends in those data that assess the company’s past performance and current financial position. The information shows the results or consequences of prior management decisions. In addition, analysts use the information to make predictions that may have a direct effect on decisions made by users of financial statements.

Comparative financial statements present the same company’s financial statements for one or two successive periods in side-by-side columns. The calculation of dollar changes or percentage changes in the statement items or totals is horizontal analysis. This analysis detects changes in a company’s performance and highlights trends.

The good news is you have already been performing the first part of horizontal analysis without realizing it when you were preparing the statement of cash flows.  Horizontal analysis consists of 2 things:

  • Dollar amount of change  (calculated as Current Year amount – Previous Year amount)
  • Percentage of change  (calculated as Dollar amount of change / previous year amount)

Horizontal analysis is called horizontal because we look at one account at a time across time.  We can perform this type of analysis on the balance sheet or the income statement. 

This example from Safeway Stores shows a horizontal analysis balance sheet. Image source: Author


Financial Statement Analysis: Vertical Analysis

Vertical analysis is a method that expresses each item on the financial statements as a percentage of a base.  The base on the income statement is sales and the base on the balance sheet is total assets or total liabilities and stockholders’ equity.


Other Financial Analyses

Other analyses of the company's financial condition and performance are normally analyzed and interpreted by focusing upon the following characteristics:

  • Liquidity is the ability to convert assets to cash. Short-term creditors such as banks and suppliers focus on a company's liquidity as a means of evaluating the ability of the company to pay short-term debt.
  • Solvency  is the ability of a company to pay its long-term debts.  Investors in bonds and banks, focus on a company's solvency as a means to evaluate the ability of the company to pay both the interest and the principle on long-term debt.
  • Profitability is the ability of a company to generate net income.

Chapter 6: Internal Control and Cash

At the end of the chapter, you will be able to:

  • Understand Fraud
  • Sarbanes-Oxley Act and its impact on controls and financial reporting.
  • Internal controls procedures that provide a reasonable assurance that the financial statements can be relied on.
  • Bank reconciliation that determines if the general ledger balance for cash is correct.


Fraud occurs when an employee gains something of value, usually money or property, at a cost to the employer by knowingly making a misrepresentation of a matter of fact. Fraud commonly occurs from the following examples:


Federal Regulation

Federal Regulation

Sarbanes-Oxley Act (SOX): After the increase of corporate fraud in the early 2000's, the U.S. Congress passed the Sarbanes-Oxley Act in 2002 to protect investors from the possibility of fraudulent accounting practices by corporations.

Sarbanes-Oxley applies only publicly held companies; although all companies have been impacted by Sarbanes-Oxley. The law emphasizes the importance of effective internal control.  Internal control is defined as the procedures and processes used by a company to:

  1. Safeguard its assets.
  2. Process information accurately.
  3. Ensure compliance with laws and regulations.

The Sarbanes Oxley Act requires all financial reports to include an Internal Controls Report. This shows that a company's financial data accurate and adequate controls are in place to safeguard financial data. Year-end financial disclosure reports are also a requirement. A SOX auditor is required to review controls, policies, and procedures during a Section 404 audit.


Internal Regulations

Internal Control

 Objectives of Internal Control

The objectives of internal control are to provide reasonable assurance that:

  1. Assets are safeguarded and used for business purposes.
  2. Business information is accurate.
  3. Employees and managers comply with laws and regulations.

Internal control can safeguard assets by preventing theft, fraud, misuse, or misplacement of funds and inventory. A serious concern of internal control is preventing employee fraud. Employee fraud is the intentional act of deceiving an employer for personal gain. Such fraud may range from minor overstating of a travel expense report to stealing millions of dollars. Employees stealing from a business often adjust the accounting records in order to hide their fraud. Thus, employee fraud usually affects the accuracy of business information.  Accurate information is necessary to successfully operate a business. Businesses must also comply with laws, regulations, and financial reporting standards. Examples of such standards include environmental regulations, safety regulations, and generally accepted accounting principles (GAAP).


Control Environment

Control Environment

The control environment is the overall attitude of management and employees about the importance of controls. Three factors influencing a company's control environment are as follows:

  1. Management's philosophy and operating style
  2. The company's organizational structure
  3. The company's personnel policies

Management's philosophy and operating style relates to whether management emphasizes the importance of internal controls. An emphasis on controls and adherence to control policies creates an effective control environment. In contrast, overemphasizing operating goals and tolerating deviations from control policies creates an ineffective control environment.

All businesses face risks such as changes in customer requirements, competitive threats, regulatory changes, and changes in economic factors. Management should identify such risks, analyze their significance, assess their likelihood of occurring, and take any necessary actions to minimize them.

Control Activities

Control activities provide reasonable assurance that business goals will be achieved, including the prevention of fraud. Control procedures, which constitute one of the most important elements of internal control, include the following:

  1. Competent personnel, rotating duties, and mandatory vacations
  2. Separating responsibilities for related operations
  3. Separating operations, custody of assets, and accounting

 Competent Personnel, Rotating Duties, and Mandatory Vacations

A successful company needs competent employees who are able to perform the duties that they are assigned. Procedures should be established for properly training and supervising employees. It is also advisable to rotate duties of accounting personnel and mandate vacations for all employees. In this way, employees are encouraged to adhere to procedures. Cases of employee fraud are often discovered when a long-term employee, who never took vacations, missed work because of an illness or another unavoidable reason.

Separating Responsibilities for Related Operations

The responsibility for related operations should be divided among two or more persons. This decreases the possibility of errors and fraud.

Separating Operations, Custody of Assets, and Accounting

The responsibilities for operations, custody of assets, and accounting should be separated. In this way, the accounting records serve as an independent check on the operating managers and the employees who have custody of assets. For example, the person that handles cash should not be the same person that record cash transactions into the journals.

Proofs and Security Measures

Proofs and security measures are used to safeguard assets and ensure reliable accounting data. Proofs involve procedures such as authorization, approval, and reconciliation. For example, an employee planning to travel on company business may be required to complete a “travel request” form for a manager's authorization and approval.

  • Documents used for authorization and approval should be prenumbered, accounted for, and safeguarded. Prenumbering of documents helps prevent transactions from being recorded more than once or not at all. In addition, accounting for and safeguarding prenumbered documents helps prevent fraudulent transactions from being recorded. For example, blank checks are prenumbered and safeguarded. Once a payment has been properly authorized and approved, the checks are filled out and issued.
  • Reconciliations are also an important control. Later in this chapter, the use of bank reconciliations as an aid in controlling cash is described and illustrated.
  • Security measures involve measures to safeguard assets. For example, cash on hand should be kept in a cash register or safe. Inventory not on display should be stored in a locked storeroom or warehouse. Accounting records such as the accounts receivable subsidiary ledger should also be safeguarded to prevent their loss. For example, electronically maintained accounting records should be safeguarded with access codes and backed up so that any lost or damaged files could be recovered if necessary.


Monitoring the internal control system is used to locate weaknesses and improve controls. Monitoring often includes observing employees' behavior and the accounting system for indicators of control problems. Some such indicators are Warning Signs of Internal Control Problems.  Other potential warning signs are:


Fraud Tips

Tips on Preventing Employee Fraud in Small Companies

  • Do not have the same employee write company checks and keep the books. Look for payments to vendors you don't know or payments to vendors whose names appear to be misspelled.
  • If your business has a computer system, restrict access to accounting files as much as possible. Also, keep a backup copy of your accounting files and store it at an off-site location.
  • Be wary of any employee working in finance that declines to take vacations. They may be afraid that a replacement will uncover fraud.
  • Require and monitor supporting documentation (such as vendor invoices) before signing checks.
  • Track the number of credit card bills you sign monthly.
  • Limit and monitor access to important documents and supplies, such as blank checks and signature stamps.
  • Check W-2 forms against your payroll annually to make sure you're not carrying any fictitious employees.
  • Rely on yourself, not on your accountant, to spot fraud.

Source: Steve Kaufman, “Embezzlement Common at Small Companies,” Knight-Ridder Newspapers, reported in Athens Daily News/Athens Banner-Herald, March 10, 1996, p. 4D.

Cash and Cash Equivalents


Most companies use checking accounts to handle their cash transactions. The company deposits its cash receipts in a bank checking account and writes checks to pay its bills. Keep in mind, a bank account is an asset to the company BUT to the bank your account is a liability because the bank owes the money in your bank account to you.  For this reason, in your bank account, deposits are credits (remember, liabilities increase with a credit) and checks and other reductions are debits (liabilities decrease with a debit).

The bank sends the company a statement each month. The company checks this statement against its records to determine if it must make any corrections or adjustments in either the company’s balance or the bank’s balance.   A bank reconciliation is a schedule the company (depositor) prepares to reconcile, or explain, the difference between the cash balance on the bank statement and the cash balance on the company’s books. The company prepares a bank reconciliation to determine its actual cash balance and prepare any entries to correct the cash balance in the ledger.

Certificates of Deposit

A certificate of deposit (CD) is an interest-bearing deposit that can be withdrawn from a bank at will (demand CD) or at a fixed maturity date (time CD). Only demand CDs that may be withdrawn at any time without prior notice or penalty are included in cash. Cash does not include postage stamps, IOUs, time CDs, or notes receivable.

Bank Statment

Bank Statement

A bank statement is a record of your bank account transactions, typically for one month, prepared by the bank.  In the Deposit and credits section, you see the deposits made into the account and a CM which is a collection of a note (see note at bottom of statement) and interest the bank has paid to your account.  In the Checks and debits section, you see the individual checks that have been processed by the bank and you also see SC for a bank service charge on your account as well as a NSF (stands for Non Sufficient Funds) and means we made a deposit from a customer but the customer did not have enough money to pay the check (bounced check). A bank statement looks like this:




Company's Records

Company’s Records

The company’s records (or books) refers to the general ledger posting and can be in the form of cash disbursement journal, cash receipt journal, cash general ledger postings or lists of cash transactions.  An example of a cash listing is:



The bank balance on September 30 is $27,395 but according to our records, the ending cash balance is $24,457.  We need to do a bank reconciliation to find out why there is a difference.

Bank Reconciliation

Bank Reconciliation

A bank reconciliation compares the bank statement and our company’s records and reconciles or balances to two account balances.  How does it do this?  There are several items of information we can get by comparing the bank statement to our records — anything that doesn’t match or doesn’t exist on both places is called a reconciling item.  A reconciling item will be added or subtracted to the bank or book side of the reconciliation.  The following table will give you some examples of how these reconciling items apply in a bank reconciliation:


Bank Reconciliation Information


Compare the deposits listed on the bank statement with the deposits on the company’s books. To make this comparison, place check marks in the bank statement and in the company’s books by the deposits that agree. Then determine the deposits in transit. A deposit in transit is typically a day’s cash receipts recorded in the depositor’s books in one period but recorded as a deposit by the bank in the succeeding period. The most common deposit in transit is the cash receipts deposited on the last business day of the month. Normally, deposits in transit occur only near the end of the period covered by the bank statement. For example, a deposit made in a bank’s night depository on May 31 would be recorded by the company on May 31 and by the bank on June 1. Thus, the deposit does not appear on a bank statement for the month ended May 31. Also check the deposits in transit listed in last month’s bank reconciliation against the bank statement. Immediately investigate any deposit made during the month but missing from the bank statement (unless it involves a deposit made at the end of the period).

Paid checks

If canceled checks (a company’s checks processed and paid by the bank) are returned with the bank statement, compare them to the statement to be sure both amounts agree. Then, sort the checks in numerical order. Next, determine which checks are outstanding. Outstanding checks are those issued by a depositor but not paid by the bank on which they are drawn. The party receiving the check may not have deposited it immediately. Once deposited, checks may take several days to clear the banking system. Determine the outstanding checks by comparing the check numbers that have cleared the bank with the check numbers issued by the company. Use check marks in the company’s record of checks issued to identify those checks returned by the bank. Checks issued that have not yet been returned by the bank are the outstanding checks. If the bank does not return checks but only lists the cleared checks on the bank statement, determine the outstanding checks by comparing this list with the company’s record of checks issued. Sometimes checks written long ago are still outstanding. Checks outstanding as of the beginning of the month appear on the prior month’s bank reconciliation. Most of these have cleared during the current month; list those that have not cleared as still outstanding on the current month’s reconciliation.

Bank debit and credit memos

Verify all debit and credit memos on the bank statement. Debit memos reflect deductions for such items as service charges, NSF checks, safe-deposit box rent, and notes paid by the bank for the depositor. Credit memos reflect additions for such items as notes collected for the depositor by the bank and wire transfers of funds from another bank in which the company sends funds to the home office bank. Check the bank debit and credit memos with the depositor’s books to see if they have already been recorded. Make journal entries for any items not already recorded in the company’s books.

Bank Errors

Sometimes banks make errors by depositing or taking money out of your account in error.  You will need to contact the bank to correct these errors but will not record any entries in your records because the bank error is unrelated to your records.

Book Errors

List any Book errors. A common error by depositors is recording a check in the accounting records at an amount that differs from the actual amount. For example, a $47 check may be recorded as $74. Although the check clears the bank at the amount written on the check ($47), the depositor frequently does not catch the error until reviewing the bank statement or canceled checks.

Deposits in transit, outstanding checks, and bank service charges usually account for the difference between the company’s Cash account balance and the bank balance.

Bank Reconciliation Expample

After comparing the bank statement and records of My Company, you should have identified the following reconciling items:

  1. Deposit in transit dated 9/30 for $6,700.
  2. Outstanding checks #2004, 2008, 2009, 2012.
  3. Interest paid by the bank $3.
  4. Note collected by bank $3500 less $500 fee
  5. Bank service charge $5
  6. Customer NSF $350
  7. Error in Check #2005 correctly processed by bank as $5,843 but recorded in our records as $5,483.  This is a difference of $360 (5,843 – 5,483) and since we did not take enough cash we need to reduce cash by $360.

Using the chart provided above and the reconciling items, the bank reconciliation would appear as follows:

When the bank and book are in agreement, you are almost finished.  On the bank side of the reconciliation, you do not need to do anything else except contact the bank if you notice any bank errors.  On the book side, you will need to do journal entries for each of the reconciling items.

Adjusting Entries for Book side Reconciling Items

The ending cash balance on the general ledger is reconciled to the adjusted bank statement balance.  When a company maintains more than one checking account, it must reconcile each account separately with the balance on the bank statement for that account. The depositor should also check carefully to see that the bank did not combine the transactions of the two accounts.

Within the internal control structure, segregation of duties is an important way to prevent fraud. One place to segregate duties is between the cash disbursement cycle and bank reconciliations. To prevent collusion among employees, the person who reconciles the bank account should not be involved in the cash disbursement cycle. Also, the bank should mail the statement directly to the person who reconciles the bank account each month. Sending the statement directly limits the number of employees who would have an opportunity to tamper with the statement.


Chapter 7: Long-term Assets

In this section, we will look at the accounting treatment for plant assets, natural resources and intangible assets.  Investments will be covered in other chapters. Property, plant, and equipment (fixed assets or operating assets) compose more than one-half of total assets in many corporations. These resources are necessary for the companies to operate and ultimately make a profit. It is the efficient use of these resources that in many cases determines the amount of profit corporations will earn.

  • Define, classify, and account for the cost of fixed assets.
  • Compute depreciation using the straight-line and double-declining-balance methods.
  • Describe the accounting for the disposal of fixed assets.
  • Describe the accounting for natural resources.
  • Describe the accounting for intangible assets.
  • Describe the reporting of fixed assets, natural resources, and intangible assets on the income statement and balance sheet.

Long-term Assets Section of the Balance Sheet

On a classified balance sheet, the asset section contains: (1) current assets; (2) property, plant, and equipment; and (3) other categories such as intangible assets and long-term investments. Previous chapters discussed current assets.  Property, plant, and equipment are often called plant and equipment or simply plant assets. Plant assets are long-lived assets because they are expected to last for more than one year. Long-lived assets consist of tangible assets and intangible assets. Tangible assets have physical characteristics that we can see and touch; they include plant assets such as buildings and furniture, and natural resources such as gas and oil. Intangible assets have no physical characteristics that we can see and touch but represent exclusive privileges and rights to their owners.

Plant Assets

Plant Assets

To be classified as a plant asset, an asset must:

  • (1) be tangible, that is, capable of being seen and touched;
  • (2) have a useful service life of more than one year;
  • and (3) be used in business operations rather than held for resale.

Common plant assets are buildings, machines, tools, and office equipment. On the balance sheet, these assets appear under the heading “Property, plant, and equipment”.

Property, plant, and equipment (fixed assets or operating assets) compose more than one-half of total assets in many corporations. These resources are necessary for the companies to operate and ultimately make a profit. It is the efficient use of these resources that in many cases determines the amount of profit corporations will earn.

Initial recording of plant assets

When a company acquires a plant asset, accountants record the asset at the cost of acquisition (historical cost).   When a plant asset is purchased for cash, its acquisition cost is simply the agreed on cash price.  This cost is objective, verifiable, and the best measure of an asset’s fair market value at the time of purchase. Fair market value is the price received for an item sold in the normal course of business (not at a forced liquidation sale). Even if the market value of the asset changes over time, accountants continue to report the acquisition cost in the asset account in subsequent periods.

The acquisition cost of a plant asset is the amount of cost incurred to acquire and place the asset in operating condition at its proper location. Cost includes all normal, reasonable, and necessary expenditures to obtain the asset and get it ready for use. Acquisition cost also includes the repair and reconditioning costs for used or damaged assets as longs as the item was not damaged after purchase. Unnecessary costs (such as traffic tickets or fines or repairs that occurred after purchase) that must be paid as a result of hauling machinery to a new plant are not part of the acquisition cost of the asset.


Purchasing Land


The cost of land includes its purchase price and other many other costs including:

  • real estate commissions,
  • title search and title transfer fees,
  • title insurance premiums,
  • existing mortgage note or unpaid taxes (back taxes) assumed by the purchaser,
  • costs of surveying, clearing, and grading;
  • and local assessments for sidewalks, streets, sewers, and water mains.
  • Sometimes land purchased as a building site contains an unusable building that must be removed.

The accountant the entire costs to Land, including the cost of removing the building less any cash received from the sale of salvaged items while the land is being readied for use. Land is considered to have an unlimited life and is therefore not depreciable. However, land improvements, including driveways, temporary landscaping, parking lots, fences, lighting systems, and sprinkler systems, are attachments to the land. They have limited lives and therefore are depreciable. Owners record depreciable land improvements in a separate account called Land Improvements. They record the cost of permanent landscaping, including leveling and grading, in the Land account.


Recording a purchase of a Building

When a business buys a building, its cost includes:

  • the purchase price,
  • repair and remodeling costs,
  • unpaid taxes assumed by the purchaser,
  • legal costs,
  • and real estate commissions paid.

Determining the cost of constructing a new building is often more difficult. Usually this cost includes architect’s fees; building permits; payments to contractors; and the cost of digging the foundation. Also included are labor and materials to build the building; salaries of officers supervising the construction; and insurance, taxes, and interest during the construction period. Any miscellaneous amounts earned from the building during construction reduce the cost of the building. For example, an owner who could rent out a small completed portion during construction of the remainder of the building, would credit the rental proceeds to the Buildings account rather than to a revenue account.

Recording Equipment or Machinery

Often companies purchase machinery or other equipment such as delivery or office equipment. Its cost includes:

  • the seller’s net invoice price (whether the discount is taken or not),
  • transportation charges incurred,
  • insurance in transit,
  • cost of installation,
  • costs of accessories,
  • and testing costs.
  • Also included are other costs needed to put the machine or equipment in operating condition in its intended location.

The cost of machinery does not include removing and disposing of a replaced, old machine that has been used in operations. Such costs are part of the gain or loss on disposal of the old machine.

Lum Sum Purchases

Lump Sum Purchases

Sometimes a company buys land and other assets for a lump sum. When land and buildings purchased together are to be used, the firm divides the total cost and establishes separate ledger accounts for land and for buildings. This division of cost establishes the proper balances in the appropriate accounts. This is especially important later because the depreciation recorded on the buildings affects reported income, while no depreciation is taken on the land.

Disposal of Assets

The definition of depreciation is the rational and systematic allocation of the cost of an asset over its useful life. Depreciation is the amount of plant asset cost allocated to each accounting period benefiting from the plant asset’s use. Depreciation is a process of allocation, not valuation. Eventually, all assets except land wear out or become so inadequate or outmoded that they are sold or discarded; therefore, firms must record depreciation on every plant asset except land. They record depreciation even when the market value of a plant asset temporarily rises above its original cost because eventually the asset is no longer useful to its current owner.

To compute the amount of depreciation expense, accountants consider four major factors:

  1. Cost of the asset.
  2. Estimated salvage value of the asset. Salvage value (or residual value) is the amount of money the company expects to recover, less disposal costs, on the date a plant asset is scrapped, sold, or traded in.
  3. Estimated useful life of the asset. Useful life refers to the time the business owning the asset intends to use it; useful life is not necessarily the same as either economic life or physical life. The economic life of a car may be 7 years and its physical life may be 10 years, but if a business has a policy of trading cars every 3 years, the useful life for depreciation purposes is 3 years. Useful life can be expressed in years, months, working hours, or units of production. Obsolescence also affects useful life. For example, a machine capable of producing units for 20 years, may be expected to be obsolete in 6 years. Thus, its estimated useful life is 6 years—not 20. Another example, you may have seen a demolition crew setting off explosives in a huge building and wonder why the owners decided to destroy what looked like a perfectly good building. The building was destroyed because it had reached the end of its economic life. The land on which the building stood could be put to better use, possibly by constructing a new building.
  4. Depreciation method used in depreciating the asset. We describe the three common depreciation methods next.

Methods of Depreciation

Straight-line method: Straight-line depreciation has been the most widely used depreciation method in the United States for many years because, as you saw in Chapter 3, it is easily applied. To apply the straight-line method, a business expenses an equal amount of plant asset cost to each accounting period.

  • The formula for calculating depreciation under the straight-line method is:

Depreciation Expense =   ( Cost – Salvage value ) / Useful Life

Using the straight-line method for assets is appropriate where (1) time rather than obsolescence is the major factor limiting the asset’s life and (2) the asset produces relatively constant amounts of periodic services. Assets that possess these features include items such as pipelines, fencing, and storage tanks.

Units-of-production (output) Method: The units-of-production or units of activity depreciation method assigns an equal amount of depreciation to each unit of product manufactured or service rendered by an asset. Since this method of depreciation is based on physical output, it is applied in situations where usage rather than obsolescence leads to decreasing of the asset. Under this method, you would compute the depreciation rate per unit of output. Then, multiply this figure by the number of units of goods or services produced during the accounting period to find the period’s depreciation expense.

      The units of production method requires a 2-step process:

  • Step 1: Calculate Depreciation Rate per Unit:

Depreciation Rate per unit =   ( Cost –  Salvage) / expected number of units

  • Step 2: Calculate Depreciation Expense:

Depreciation Expense = Number of units produced for the period x Depreciation Rate per unit.

Double-declining-balance method: to apply the double-declining-balance (DDB) method of computing periodic depreciation charges you begin by calculating the straight-line depreciation rate. To do this, divide 100 per cent by the number of years of useful life of the asset. Then, multiply this rate by 2. Next, apply the resulting double-declining rate to the declining book value of the asset. Ignore salvage value in making the calculations. At the point where book value is equal to the salvage value, no more depreciation is taken.

The double declining balance method requires a 3-step process:

  • Step 1: Calculate the Straight line (S/L) rate

                         S/L rate = 1 / useful life in years

  • Step 2: Calculate the double declining (DD) rate

                    DD rate = 2 x S/L rate calculated in Step 1

  • Step 3: Calculate Depreciation Expense

                      Depreciation Expense = Beginning Book Value x DD rate

Remember, book value is calculated as Asset Cost – Accumulated Depreciation.

Sale of Assets

Companies frequently dispose of plant assets by selling them. By comparing an asset’s book value (cost less accumulated depreciation) with its selling price (or net amount realized if there are selling expenses), the company may show either a gain or loss. If the sales price is greater than the asset’s book value, the company shows a gain. If the sales price is less than the asset’s book value, the company shows a loss. Of course, when the sales price equals the asset’s book value, no gain or loss occurs.

Accounting for depreciation to date of disposal: When selling or otherwise disposing of a plant asset, a firm must record the depreciation up to the date of sale or disposal. For example, if it sold an asset on April 1 and last recorded depreciation on December 31, the company should record depreciation for three months (January 1-April 1). When depreciation is not recorded for the three months, operating expenses for that period are understated, and the gain on the sale of the asset is understated or the loss overstated.

When retiring a plant asset from service, a company removes the asset’s cost and accumulated depreciation from its plant asset accounts.

Occasionally, a company continues to use a plant asset after it has been fully depreciated. In such a case, the firm should not remove the asset’s cost and accumulated depreciation from the accounts until the asset is sold, traded, or retired from service. Of course, the company cannot record more depreciation on a fully depreciated asset because total depreciation expense taken on an asset may not exceed its cost.

Sometimes a business retires or discards a plant asset before fully depreciating it. When selling the asset as scrap (even if not immediately), the firm removes its cost and accumulated depreciation from the asset and accumulated depreciation accounts. In addition, the accountant records its estimated salvage value in a Salvaged Materials account and recognizes a gain or loss on disposal.

Other Losses

Sometimes accidents, fires, floods, and storms wreck or destroy plant assets, causing companies to incur losses. We call these types of losses we call them "unusual" because we are estimating they will only occur once.


Disposal of Assets

All plant assets except land eventually wear out or become inadequate or obsolete and must be sold, retired, or traded for new assets. When disposing of a plant asset, a company must remove both the asset’s cost and accumulated depreciation from the accounts. Overall, then, all plant asset disposals have the following steps in common:

  • Bring the asset’s depreciation up to date.
  • Record the disposal by:
  • Writing off the asset’s cost.
  • Writing off the accumulated depreciation.
  • Recording any consideration (usually cash) received or paid or to be received or paid.
  • Recording the gain or loss, if any.

As you study this section, remember these common procedures accountants use to record the disposal of plant assets. In the paragraphs that follow, we discuss accounting for the (1) sale of plant assets, (2) retirement of plant assets without sale (write it off) , and (3) trading plant assets.

Natural Rescources

Resources supplied by nature, such as ore deposits, mineral deposits, oil reserves, gas deposits, and timber stands, are natural resources or wasting assets. Natural resources represent inventories of raw materials that can be consumed (exhausted) through extraction or removal from their natural setting (e.g. removing oil from the ground).

Intangible assets

Although they have no physical characteristics, intangible assets have value because of the advantages or exclusive privileges and rights they provide to a business. Intangible assets generally arise from two sources: (1) exclusive privileges granted by governmental authority or by legal contract, such as patents, copyrights, franchises, trademarks and trade names, and leases; and (2) superior entrepreneurial capacity or management know-how and customer loyalty, which is called goodwill.

All intangible assets are nonphysical, but not all nonphysical assets are intangibles. For example, accounts receivable and prepaid expenses are nonphysical, yet classified as current assets rather than intangible assets. Intangible assets are generally both nonphysical and noncurrent; they appear in a separate long-term section of the balance sheet entitled “Intangible assets”.

Examples of intangible assets include:

  • Research and development (R&D)
  • Amortization
  • A patent
  • A copyright
  • A franchise
  • A trademark
  • A lease
  • A leasehold improvement
  • Goodwill

Initially, firms record intangible assets at cost like most other assets. However, computing an intangible asset’s acquisition cost differs from computing a plant asset’s acquisition cost. Firms may include only outright purchase costs in the acquisition cost of an intangible asset; the acquisition cost does not include cost of internal development or self-creation of the asset. If an intangible asset is internally generated in its entirety, none of its costs are capitalized. Therefore, some companies have extremely valuable assets that may not even be recorded in their asset accounts.

Amortization is the systematic write-off of the cost of an intangible asset to expense. A portion of an intangible asset’s cost is allocated to each accounting period in the economic (useful) life of the asset. All intangible assets are not subject to amortization. Only recognized intangible assets with finite useful lives are amortized. The finite useful life of such an asset is considered to be the length of time it is expected to contribute to the cash flows of the reporting entity. (Pertinent factors that should be considered in estimating useful life include legal, regulatory, or contractual provisions that may limit the useful life). The method of amortization should be based upon the pattern in which the economic benefits are used up or consumed. If no pattern is apparent, the straight-line method of amortization should be used by the reporting entity.

Recognized intangible assets deemed to have indefinite useful lives are not to be amortized. Amortization will however begin when it is determined that the useful life is no longer indefinite. The method of amortization would follow the same rules as intangible assets with finite useful lives.

Straight-line amortization is calculated the same was as straight-line depreciation for plant assets. Generally, we record amortization by debiting Amortization Expense and crediting the intangible asset account. An accumulated amortization account could be used to record amortization. However, the information gained from such accounting would not be significant because normally intangibles do not account for as many total asset dollars as do plant assets.

A copyright is an exclusive right granted by the federal government giving protection against the illegal reproduction by others of the creator’s written works, designs, and literary productions. The finite useful life for a copyright extends to the life of the creator plus 50 years.  Most publications have a limited (finite) life; a creator may amortize the cost of the copyright to expense on a straight-line basis or based upon the pattern in which the economic benefits are used up or consumed.

A franchise is a contract between two parties granting the franchisee (the purchaser of the franchise) certain rights and privileges ranging from name identification to complete monopoly of service. In many instances, both parties are private businesses. For example, an individual who wishes to open a hamburger restaurant may purchase a McDonald’s franchise; the two parties involved are the individual business owner and McDonald’s Corporation. This franchise would allow the business owner to use the McDonald’s name and golden arch, and would provide the owner with advertising and many other benefits. The legal life of a franchise may be limited by contract.

The parties involved in a franchise arrangement are not always private businesses. A government agency may grant a franchise to a private company. A city may give a franchise to a utility company, giving the utility company the exclusive right to provide service to a particular area.

In addition to providing benefits, a franchise usually places certain restrictions on the franchisee. These restrictions generally are related to rates or prices charged; also they may be in regard to product quality or to the particular supplier from whom supplies and inventory items must be purchased.

If periodic payments to the grantor of the franchise are required, the franchisee charges them to a Franchise Expense account. If a lump-sum payment is made to obtain the franchise, the franchisee records the cost in an asset account entitled Franchise and amortizes it over the finite useful life of the asset. The legal life (if limited by contract) and the economic life of the franchise may limit the finite useful life

A trademark is a symbol, design, or logo used in conjunction with a particular product or company. A trade name is a brand name under which a product is sold or a company does business. Often trademarks and trade names are extremely valuable to a company, but if they have been internally developed, they have no recorded asset cost. However, when a business purchases such items from an external source, it records them at cost and amortizes them over their finite useful life.

A lease is a contract to rent property. The property owner is the grantor of the lease and is the lessor. The person or company obtaining rights to possess and use the property is the lessee. The rights granted under the lease are a leasehold. The accounting for a lease depends on whether it is a capital lease or an operating lease.  The proper accounting for capital leases for both lessees and lessors has been an extremely difficult problem. We leave further discussion of capital leases for an intermediate accounting text.

In accounting, goodwill is an intangible value attached to a company resulting mainly from the company’s management skill or know-how and a favorable reputation with customers. A company’s value may be greater than the total of the fair market value of its tangible and identifiable intangible assets. This greater value means that the company generates an above-average income on each dollar invested in the business. Thus, proof of a company’s goodwill is its ability to generate superior earnings or income.

A goodwill account appears in the accounting records only if goodwill has been purchased. A company cannot purchase goodwill by itself; it must buy an entire business or a part of a business to obtain the accompanying intangible asset, goodwill.  Specific reasons for a company’s goodwill include a good reputation, customer loyalty, superior product design, unrecorded intangible assets (because they were developed internally), and superior human resources. Since these positive factors are not individually quantifiable, when grouped together they constitute goodwill. The intangible asset goodwill is not amortized. Goodwill is to be tested periodically for impairment. The amount of any goodwill impairment loss is to be recognized in the income statement as a separate line before the subtotal income from continuing operations (or similar caption). The goodwill account would be reduced by the same amount.




Chapter 8: Liabilities

By the end of this section, you will be able to:

  • Describe the accounting for payrolls, short-term financing devices, and other current liabilities.
  • Describe the occurrence and accounting for typical current liabilities.
  • Record the effects on financial statements related to notes payable.
  • Define contingent liabilities and discern when these should be recorded in the accounts, and when footnote disclosure is appropriate.
  • Record transactions related to product warranties.
  • Record the effects on financial statement related to accrue salaries.

Current Liabilites

Liabilities result from some past transaction and are obligations to pay cash, provide services, or deliver goods at some future time. This definition includes each of the liabilities discussed in previous chapters and the new liabilities presented in this chapter. The balance sheet divides liabilities into current liabilities and long-term liabilities. Current liabilities are obligations that (1) are payable within one year or one operating cycle, whichever is longer, or (2) will be paid out of current assets or create other current liabilities. Long-term liabilities are obligations that do not qualify as current liabilities.

In this section, we describe liabilities not previously discussed that are clearly determinable—sales tax payable, federal excise tax payable, and current portions of long-term debt.  Warranties, notes payable and payroll liabilities will be examined later.

Sales Tax Payable

Many states have a state sales tax on items purchased by consumers. The company selling the product is responsible for collecting the sales tax from customers. When the company collects the taxes,   Cash, Sales and Sales Tax Payable are all increased.  Periodically, the company pays the sales taxes collected to the state. At that time, Sales Tax Payable and Cash is decreased.

Current portions of long-term debt Accountants move any portion of long-term debt that becomes due within the next year to the current liability section of the balance sheet.

Notes Payable

Notes Payable Transactions

Remember, with Notes Receivable we learned we need to know 3 things about a note:

  1. Principal (the amount of money we borrowed)
  2. Interest Rate (typically an annual interest rate)
  3. Maturity term (or frequency of the year — how many days or months for the note)

In Notes Receivable, we were the ones providing funds that we would receive at maturity.  Now, we are going to borrow money that we must pay back later so we will have Notes Payable.  Interest is still calculated as Principal x Interest x Time of the year  (use 360 days as the base if note term is days or 12 months as the base if note term is in months).

Interest-bearing notes: To receive short-term financing, a company may issue an interest-bearing note to a bank. An interest-bearing note specifies the interest rate charged on the principal borrowed. The company receives from the bank the principal borrowed; when the note matures, the company pays the bank the principal plus the interest which is called the maturity value.

Payroll Accounting: Employee Deductions

Payroll Accounting Defined

If you haven’t already, at some point you will most likely receive a paycheck.  The first time you do, you will be disappointed.  You will want to know who took all your money!  But not to worry, this section and the next will explain where it all goes.

What is included in an employee’s paycheck?

  • Gross Pay:  This is the amount of money you are promised either hourly, weekly or annually.
  • Federal Income Tax Withheld (also referred to as FIT):  You will fill out a document called a W-4 when you are hired.  This document allows you to claim allowances and a federal filing status for tax purposes.  These options along with your gross pay are used to calculate your federal tax withheld.  This will reduce your gross pay.
  • State Income Tax Withheld (also referred to as SIT):  A different form than the W-4 but the same concept except it applies to the state.  Not all states have a state income tax.  This will reduce your gross pay.
  • FICA Social Security Tax (also referred to as OASDI):  This tax helps fund social security and is calculated as gross pay x 6.2% unless you make OVER $118,500 in 2015 then you are only responsible to pay 6.2% of $118,500 and nothing more.  This will reduce your gross pay.
  • FICA Medicare Tax (also referred to as HI): This tax helps fund medicare and is calculated as gross pay x 1.45%.  Everyone must pay the 1.45% of gross pay without limit.  This will reduce your gross pay.
  • Voluntary Deductions: Any deductions you authorize will also reduce your gross pay.  This includes things like medical premiums, 401K and savings accounts, charity donations, etc.
  • Net Pay:  Finally!  This is the amount you will receive after all taxes and voluntary deductions have been taken out.

Wait — this section is on current liabilities so how do they fit in?  Your employer will take money out of your paycheck for the items listed above and combine them with other employee amounts to send one big check to the government or business (for voluntary deductions).  When you are paid, the company records liabilities for the amounts taken out of your paycheck.

Payroll Accounting: Employer Deductions

Don’t think employers are getting off easy!  There is a cost (more than gross pay) for having employees.  The employer must pay the following on every dollar an employee earns:

  • FICA Social Security Tax:  This tax helps fund social security and is calculated as gross pay x 6.2% unless an employee makes OVER $118,500 in 2015 then you are only responsible to pay 6.2% of $118,500 and nothing more for that employee.
  • FICA Medicare Tax: This tax helps fund medicare and is calculated as gross pay x 1.45%.  Everyone must pay the 1.45% of gross pay without limit.
  • Federal Unemployment Tax (FUTA):  This tax is for unemployment claims and is typically calculated as 0.8% of the first $7,000 of an employee’s earnings.  Once the employee has earned more than $7,000 in gross pay for the year, the company no longer has to pay FUTA tax.
  • State Unemployment Tax (SUTA):  This tax is for the state unemployment and does not have a consistent rate.  The rate is provided by the state annually and can change each year by business.
  • Voluntary Deductions Matching: Any matching funds the company provides for insurance or retirement plans.

Contingent Liabilities


Some liabilities may arise from past transactions if certain events occur in the future. These potential liabilities are called contingent liabilities.

The accounting for contingent liabilities depends on the following two factors:

  1. Likelihood of occurring
  • The likelihood of occurring is classified as probable, reasonably possible, or remote. The ability to measure the potential liability is classified as estimable or not  estimable.
  1. Measurement—It is reasonable estimable or not.
  • Probable means that the future even is likely to occur.  Reasonable possible means the chances of the future event occurring is more than remote but less than likely.  Remote means the chance of the future event occurring is slight.

Examples of Contingent Liabilities:

  1. Income Tax Disputes
  2. Pending or threats from litigation
  3. Warranties



Probable and Estimable

If a contingent liability is probable and the amount of the liability can be reasonably estimated, it is recorded and disclosed. The liability is recorded by increasing an expense and a liability.

Product Warranties

Estimated product warranty payable:  When companies sell products such as computers, often they must guarantee against defects by placing a warranty on their products. When defects occur, the company is obligated to reimburse the customer or repair the product. For many products, companies can predict the number of defects based on experience. To provide for a proper matching of revenues and expenses, the accountant estimates the warranty expense resulting from an accounting period’s sales which will be used as a reserve to pull actual warranty expenses from at a later date. The increase is to Warranty Expense and the increase to Estimated Warranty Payable (or Liability).

Bonds Payable

Bonds payable

Corporations finance that operation by using the following sources:

  • Getting a loan from the bank with either short-term or long-term debt.
  • Selling common or preferred stock
  • Selling Bonds

In this portion of the chapter we will discuss the topic of selling bonds.  A bond is a long-term debt, or liability, owed by its issuer. Physical evidence of the debt lies in a negotiable bond certificate. In contrast to long-term notes, which usually mature in 10 years or less, bond maturities often run for 20 years or more.  A bond is an interest bearing document and requires periodic interest payment with the face amount paid at the maturity date.  The goal is to calculate the interest to be paid; the maturity date; and the maturity value.

Generally, a bond issue consists of a large number of $1,000 bonds rather than one large bond. For example, a company seeking to borrow $100,000 would issue one hundred $1,000 bonds rather than one $100,000 bond. This practice enables investors with less cash to invest to purchase some of the bonds.

Bonds derive their value primarily from two promises made by the borrower to the lender or bondholder. The borrower promises to pay (1) the face value or principal amount of the bond on a specific maturity date in the future and (2) periodic interest at a specified rate on face value at stated dates, usually semiannually, until the maturity date.

Selling (issuing) bonds

A company seeking to borrow millions of dollars generally is not able to borrow from a single lender. By selling (issuing) bonds to the public, the company secures the necessary funds.

Usually companies sell their bond issues through an investment company or a banker called an underwriter. The underwriter performs many tasks for the bond issuer, such as advertising, selling, and delivering the bonds to the purchasers. Often the underwriter guarantees the issuer a fixed price for the bonds, expecting to earn a profit by selling the bonds for more than the fixed price.

When a company sells bonds to the public, many purchasers buy the bonds. Rather than deal with each purchaser individually, the issuing company appoints a trustee to represent the bondholders. The trustee usually is a bank or trust company. The main duty of the trustee is to see that the borrower fulfills the provisions of the bond indenture. A bond indenture is the contract or loan agreement under which the bonds are issued. The indenture deals with matters such as the interest rate, maturity date and maturity amount, possible restrictions on dividends, repayment plans, and other provisions relating to the debt. An issuing company that does not adhere to the bond indenture provisions is in default. Then, the trustee takes action to force the issuer to comply with the indenture.

Bonds may differ in some respects; they may be secured or unsecured bonds, registered or unregistered (bearer) bonds, and term or serial bonds. Next, we will discuss these different type of bonds.

Certain bond features are matters of legal necessity, such as how a company pays interest and transfers ownership. Such features usually do not affect the issue price of the bonds. Other features, such as convertibility into common stock, are sweeteners designed to make the bonds more attractive to potential purchasers. These sweeteners may increase the issue price of a bond.

  • Secured bonds: A secured bond is a bond for which a company has pledged specific property to ensure its payment. Mortgage bonds are the most common secured bonds. A mortgage is a legal claim (lien) on specific property that gives the bondholder the right to possess the pledged property if the company fails to make required payments.
  • Unsecured bonds: An unsecured bond is a debenture bond, or simply a debenture. A debenture is an unsecured bond backed only by the general creditworthiness of the issuer, not by a lien on any specific property. A financially sound company can issue debentures more easily than a company experiencing financial difficulty.
  • Registered bonds: A registered bond is a bond with the owner’s name on the bond certificate and in the register of bond owners kept by the bond issuer or its agent, the registrar. Bonds may be registered as to principal (or face value of the bond) or as to both principal and interest. Most bonds in our economy are registered as to principal only. For a bond registered as to both principal and interest, the issuer pays the bond interest by check. To transfer ownership of registered bonds, the owner endorses the bond and registers it in the new owner’s name. Therefore, owners can easily replace lost or stolen registered bonds.
  • Unregistered (bearer) bonds: An unregistered (bearer) bond is the property of its holder or bearer because the owner’s name does not appear on the bond certificate or in a separate record. Physical delivery of the bond transfers ownership.
  • Coupon bonds: A coupon bond is a bond not registered as to interest. Coupon bonds carry detachable coupons for the interest they pay. At the end of each interest period, the owner clips the coupon for the period and presents it to a stated party, usually a bank, for collection.
  • Term bonds and serial bonds: A term bond matures on the same date as all other bonds in a given bond issue. Serial bonds in a given bond issue have maturities spread over several dates. For instance, one-fourth of the bonds may mature on 2011 December 31, another one-fourth on 2012 December 31, and so on.
  • Callable bonds: A callable bond contains a provision that gives the issuer the right to call (buy back) the bond before its maturity date. The provision is similar to the call provision of some preferred stocks. A company is likely to exercise this call right when its outstanding bonds bear interest at a much higher rate than the company would have to pay if it issued new but similar bonds. The exercise of the call provision normally requires the company to pay the bondholder a call premium of about $30 to $70 per $1,000 bond. A call premium is the price paid in excess of face value that the issuer of bonds must pay to redeem (call) bonds before their maturity date.
  • Convertible bonds: A convertible bond is a bond that may be exchanged for shares of stock of the issuing corporation at the bondholder’s option. A convertible bond has a stipulated conversion rate of some number of shares for each $1,000 bond. Although any type of bond may be convertible, issuers add this feature to make risky debenture bonds more attractive to investors.
  • Bonds with stock warrants: A stock warrant allows the bondholder to purchase shares of common stock at a fixed price for a stated period. Warrants issued with long-term debt may be nondetachable or detachable. A bond with nondetachable warrants is virtually the same as a convertible bond; the holder must surrender the bond to acquire the common stock. Detachable warrants allow bondholders to keep their bonds and still purchase shares of stock through exercise of the warrants.
  • Junk bonds Junk bonds are high-interest rate, high-risk bonds. Many junk bonds issued in the 1980s financed corporate restructurings. These restructurings took the form of management buyouts (called leveraged buyouts or LBOs), hostile takeovers of companies by outside parties, or friendly takeovers of companies by outside parties. In the early 1990s, junk bonds lost favor because many issuers defaulted on their interest payments. Some issuers declared bankruptcy or sought relief from the bondholders by negotiating new debt terms.

Several advantages come from raising cash by issuing bonds rather than stock. First, the current stockholders do not have to dilute or surrender their control of the company when funds are obtained by borrowing rather than issuing more shares of stock. Second, it may be less expensive to issue debt rather than additional stock because the interest payments made to bondholders are tax deductible while dividends are not. Finally, probably the most important reason to issue bonds is that the use of debt may increase the earnings of stockholders through favorable financial leverage.

Bond Price and Interest Rates

The price of a bond issue often differs from its face value. The amount a bond sells for above face value is a premium. The amount a bond sells for below face value is a discount. A difference between face value and issue price exists whenever the market rate of interest for similar bonds differs from the contract rate of interest on the bonds. The effective interest rate (also called the yield) is the minimum rate of interest that investors accept on bonds of a particular risk category. The higher the risk category, the higher the minimum rate of interest that investors accept. The contract rate of interest is also called the stated, coupon, or nominal rate is the rate used to pay interest. Firms state this rate in the bond indenture, print it on the face of each bond, and use it to determine the amount of cash paid each interest period. The market rate fluctuates from day to day, responding to factors such as the interest rate the Federal Reserve Board charges banks to borrow from it; government actions to finance the national debt; and the supply of, and demand for, money.

Market and contract rates of interest are likely to differ. Issuers must set the contract rate before the bonds are actually sold to allow time for such activities as printing the bonds. Assume, for instance, that the contract rate for a bond issue is set at 12%. If the market rate is equal to the contract rate, the bonds will sell at their face value. However, by the time the bonds are sold, the market rate could be higher or lower than the contract rate.

As shown above, if the market rate is lower than the contract rate, the bonds will sell for more than their face value. Thus, if the market rate is 10% and the contract rate is 12%, the bonds will sell at a premium as the result of investors bidding up their price. However, if the market rate is higher than the contract rate, the bonds will sell for less than their face value. Thus, if the market rate is 14% and the contract rate is 12%, the bonds will sell at a discount. Investors are not interested in bonds bearing a contract rate less than the market rate unless the price is reduced. Selling bonds at a premium or a discount allows the purchasers of the bonds to earn the market rate of interest on their investment.

Computing long-term bond prices involves finding present values using compound interest. Buyers and sellers negotiate a price that yields the going rate of interest for bonds of a particular risk class. The price investors pay for a given bond issue is equal to the present value of the bonds.

Issuers usually quote bond prices as percentages of face value—100 means 100% of face value, 97 means a discounted price of 97% of face value, and 103 means a premium price of 103% of face value. For example, one hundred $1,000 face value bonds issued at 103 have a price of $103,000 (100 bonds x $1,000 each x 103%). Regardless of the issue price, at maturity the issuer of the bonds must pay the investor(s) the face value (or principal amount) of the bonds.

Financial Statement Effects on Issuance of Bonds

When a company issues bonds, it incurs a long-term liability on which periodic interest payments must be made, usually twice a year. If an interest date fall on other than balance sheet dates, the company must accrue interest in the proper periods. It would be nice if bonds were always issued at the par or face value of the bonds.  But, certain circumstances prevent the bond from being issued at the face amount.  We may be forced to issue the bond at a discount or premium.

Chapter 9: Corporations, Partnerships, and LLCs

By the end of this section, you will be able to:

  • The students should be able to develop the accounting for stockholders’ equity, earnings, and dividends.
  • Explain “retained earnings.”
  • Financial Statements effect from Cash and Stock Dividends.
  • Define dividends between preferred and common stockholders.
  • Explain the effect of stock dividends and stock splits on the stockholders’ equity section of the balance sheet.


Partnerships are another form of a business entity; it is an association of two or more

  Characteristics are:

  • Moderately complex to form. If you're wanting to form a Partnership, it is best to consult with a lawyer and a CPA.
  • ALL partners are personally responsible for any debt created by any of the partners.
  • Limited life; if a partner dies or retires, the relationship will cease to exist. This will be true is a new partner is added the the relaionship.
  • All invested property becomes joint property to all the partners.
  • Net profits and losses will be split up between the owners based on the partnership agreement.

Limited Liability Company

One of the most popular small business formations is a Limited Liability Company; the benefits are the limited liability to its owners.


A corporation is an entity recognized by law as possessing an existence separate and distinct from its owners; that is, it is a separate legal entity. Endowed with many of the rights and obligations possessed by a person, a corporation can enter into contracts in its own name; buy, sell, or hold property; borrow money; hire and fire employees; and sue and be sued.  Let’s look at a video to learn about the difference in partnerships and corporations.

Corporations have a remarkable ability to obtain the huge amounts of capital necessary for large-scale business operations. Corporations acquire their capital by issuing shares of stock; these are the units into which corporations divide their ownership. Investors buy shares of stock in a corporation for two basic reasons. First, investors expect the value of their shares to increase over time so that the stock may be sold in the future at a profit. Second, while investors hold stock, they expect the corporation to pay them dividends (usually in cash) in return for using their money.

Advantages and Disadvantages of a Corporation

Corporations have many advantages over sole proprietorships and partnerships. The major advantages a corporation has over a sole proprietorship are the same advantages a partnership has over a sole proprietorship. Although corporations may have more owners than partnerships, both have a broader base for investment, risk, responsibilities, and talent than do sole proprietorships. Since corporations are more comparable to partnerships than to sole proprietorships, the following discussion of advantages contrasts the partnership with the corporation.


  • Easy transfer of ownership. In a partnership, a partner cannot transfer ownership in the business to another person if the other partners do not want the new person involved in the partnership. In a publicly held (owned by many stockholders) corporation, shares of stock are traded on a stock exchange between unknown parties; one owner usually cannot dictate to whom another owner can or cannot sell shares.
  • Limited liability. Each partner in a partnership is personally responsible for all the debts of the business. In a corporation, the stockholders are not personally responsible for its debts; the maximum amount a stockholder can lose is the amount of his or her investment.
  • Continuous existence of the entity. In a partnership, many circumstances, such as the death of a partner, can terminate the business entity. These same circumstances have no effect on a corporation because it is a legal entity, separate and distinct from its owners.
  • Easy capital generation. The easy transfer of ownership and the limited liability of stockholders are attractive features to potential investors. Thus, it is relatively easy for a corporation to raise capital by issuing shares of stock to many investors. Corporations with thousands of stockholders are not uncommon.
  • Professional management. Generally, the partners in a partnership are also the managers of that business, regardless of whether they have the necessary expertise to manage a business. In a publicly held corporation, most of the owners (stockholders) do not participate in the day-to-day operations and management of the entity. They hire professionals to run the business on a daily basis.
  • Separation of owners and entity (no mutual agency). Since the corporation is a separate legal entity, the owners do not have the power to bind the corporation to business contracts. This feature eliminates the potential problem of mutual agency that exists between partners in a partnership. In a corporation, one stockholder cannot jeopardize other stockholders through poor decision making.


The corporate form of business has the following disadvantages:

  • Double taxation. Because a corporation is a separate legal entity, its net income is subject to double taxation. The corporation pays a tax on its income, and stockholders pay a tax on corporate income received as dividends.
  • Government regulation. Because corporations are created by law, they are subject to greater regulation and control than single proprietorships and partnerships.

Forming a Corporation

Corporations are chartered by the state. Each state has a corporation act that permits the formation of corporations by qualified persons. Incorporators are persons seeking to bring a corporation into existence. Most state corporation laws require a minimum of three incorporators, each of whom must be of legal age, and a majority of whom must be citizens of the United States.

The laws of each state view a corporation organized in that state as a domestic corporation and a corporation organized in any other state as a foreign corporation. If a corporation intends to conduct business solely within one state, it normally seeks incorporation in that state because most state laws are not as severe for domestic corporations as for foreign corporations. Corporations conducting interstate business usually incorporate in the state that has laws most advantageous to the corporation being formed. Important considerations in choosing a state are the powers granted to the corporation, the taxes levied, the defenses permitted against hostile takeover attempts by others, and the reports required by the state.

Once incorporators agree on the state in which to incorporate, they apply for a corporate charter. A corporate charter is a contract between the state and the incorporators, and their successors, granting the corporation its legal existence. The application for the corporation’s charter is called the articles of incorporation.

After supplying the information requested in the incorporation application form, incorporators file the articles with the proper office in the state of incorporation. Each state requires different information in the articles of incorporation, but most states ask for the following:

  • Name of corporation.
  • Location of principal offices.
  • Purposes of business.
  • Number of shares of stock authorized, class or classes of shares, and voting and dividend rights of each class of shares.
  • Value of assets paid in by the incorporators (the stockholders who organize the corporation).
  • Limitations on authority of the management and owners of the corporation.

On approving the articles, the state office (frequently the secretary of state’s office) grants the charter and creates the corporation.

As soon as the corporation obtains the charter, it is authorized to operate its business.

Stockholders:  Stockholders are the owners of the corporation.  You become an owner by receiving shares of stock in the company.  Stockholders do not have the right to participate actively in the management of the business unless they serve as directors and/or officers. However, stockholders do have certain basic rights, including the right to (1) dispose of their shares, (2) buy additional newly issued shares in a proportion equal to the percentage of shares they already own (called the preemptive right), (3) share in dividends when declared, (4) share in assets in case of liquidation, and (5) participate in management indirectly by voting at the stockholders’ meeting (one vote for every share of stock).

Normally, companies hold stockholders’ meetings annually. At the annual stockholders’ meeting, stockholders vote on such issues as changing the charter, increasing the number of authorized shares of stock to be issued, approving pension plans, selecting the independent auditor, and other related matters. Stockholders who do not personally attend the stockholders’ meeting may vote by proxy. A proxy is a legal document signed by a stockholder, giving a designated person the authority to vote the stockholder’s shares at a stockholders’ meeting.

Board of directors Elected by the stockholders, the board of directors is primarily responsible for formulating policies for the corporation. The board appoints administrative officers and delegates to them the execution of the policies established by the board. The board’s more specific duties include: (1) authorizing contracts, (2) declaring dividends, (3) establishing executive salaries, and (4) granting authorization to borrow money. The decisions of the board are recorded in the minutes of its meetings. The minutes are an important source of information to an independent auditor, since they may serve as notice to record transactions (such as a dividend declaration) or to identify certain future transactions (such as a large loan).

Corporate officers A corporation’s bylaws usually specify the titles and duties of the officers of a corporation. The number of officers and their exact titles vary from corporation to corporation, but most have a president, several vice presidents, a secretary, a treasurer, and a controller.

The president is the chief executive officer (CEO) of the corporation. He or she is empowered by the bylaws to hire all necessary employees except those appointed by the board of directors.

Most corporations have more than one vice president. Each vice president is responsible for one particular corporate operation, such as sales, engineering, or production. The corporate secretary maintains the official records of the company and records the proceedings of meetings of stockholders and directors. The treasurer is accountable for corporate funds and may supervise the accounting function within the company. A controller carries out the accounting function. The controller usually reports to the treasurer of the corporation.

Stockholders' Equity Section

The Stockholders' Equity section consist of:

  • Paid in Capital: includes common stock, preferred stock, and any Paid in Capital accounts including Paid in Capital for treasury stock.
  • Retained Earnings: comes from the Statement of Retained Earnings financial statement
  • Treasury Stock: reports the cost we paid for Treasury Stock and this reduces total equity


Common Stock

Common Stock

All corporations have common stock.  Common stock provides the following rights to shareholders:

  • sell or transfer any of their shares
  • buy additional newly issued shares in a proportion equal to the percentage of shares they already own (called the preemptive right),
  • receive a dividend when declared,
  • receive a portion of any money left over after paying all debts in a liquidation, and
  • one vote for every share of stock.

It is important to note that shareholders cannot take money out of the business whenever they want like owners could in a sole proprietorship or partnership.  Shareholders receive earnings of the company in the form of dividends which must be declared by the board of directors.

There is some terminology we need to get familiar with for stock.  These include:

  • Authorized shares:  Authorized share are the total number of shares we are allowed to sell as specified in the corporate charter.
  • Issued shares: Issued shares are the total number of share we have given out to shareholders.
  • Outstanding shares:  Outstanding shares are the total number of shares currently held by shareholders.  Issues and outstanding shares will be different if the company has treasury stock, which we will discuss later.
  • Par value:  Random value assigned to each share of stock in the corporate charter.
  • No par value: A par value was not assigned to each share of stock in the corporate charter.
  • Stated value: No par value stock (meaning no value was assigned to stock in the charter) but the board of directors voted and determined a value for each share of stock.
  • Market value:  Current value of a share of stock as determined by the stock exchange.

Preferred Stock

Preferred Stock

All corporations have common stock.  Another type of stock some corporations may have is preferred stock.  Preferred stock has the same rights and terminology associated with common stock with a few differences.  Preferred stock is guaranteed a specific amount or rate of dividends each year when dividends are declared.  Preferred stockholders may give up their right to vote.

Types of preferred stock

When a corporation issues both preferred and common stock, the preferred stock may be:

  • Noncumulative preferred stock is preferred stock on which the right to receive a dividend expires whenever the dividend is not declared.  This means that if the company does not declare dividends this year they do not have to pay preferred shareholders the guaranteed dividend amount.
  • Cumulative preferred stock is preferred stock for which the right to receive a basic dividend accumulates if the dividend is not paid. Companies must pay unpaid cumulative preferred dividends before paying any dividends on the common stock.  This means if the company does not declare dividends this year, the amount owed from this year will rollover to next year.  Preferred shareholders must receive all dividends owed before common shareholders can get a dividend.
  • Convertible preferred stock is preferred stock that is convertible into common stock of the issuing corporation. Many preferred stocks do not carry this special feature; they are nonconvertible. Holders of convertible preferred stock shares may exchange them, at their option, for a certain number of shares of common stock of the same corporation.
  • Callable preferred stock means that the corporation can inform nonconvertible preferred stockholders that they must surrender their stock to the company. Also, convertible preferred stockholders must either surrender their stock or convert it to common shares.  Most preferred stocks are callable at the option of the issuing corporation.  Preferred shares are usually callable at par value plus a small premium of 3 or 4 % of the par value of the stock. This call premium is the difference between the amount at which a corporation calls its preferred stock for redemption and the par value of the preferred stock.

Why would a corporation call in its preferred stock? Corporations call in preferred stock for many reasons: (1) the outstanding preferred stock may require a 12 per cent annual dividend at a time when the company can secure capital to retire the stock by issuing a new 8 per cent preferred stock; (2) the issuing company may have been sufficiently profitable to retire the preferred stock out of earnings; or (3) the company may wish to force conversion of its convertible preferred stock because the cash dividend on the equivalent common shares is less than the dividend on the preferred shares.

Treasury Stock

Treasury stock is the corporation’s own capital stock that it has issued and then reacquired; this stock has not been canceled and is legally available for reissuance. Because it has been issued, we cannot classify treasury stock as unissued stock.  Instead, treasury stock reduces shares outstanding but does not change shares issued.

A corporation may reacquire its own capital stock as treasury stock to: (1) cancel and retire the stock; (2) reissue the stock later at a higher price; (3) reduce the shares outstanding and thereby increase earnings per share; or (4) issue the stock to employees. If the intent of reacquisition is cancellation and retirement, the treasury shares exist only until they are retired and canceled by a formal reduction of corporate capital.

For dividend or voting purposes, most state laws consider treasury stock as issued but not outstanding, since the shares are no longer in the possession of stockholders. Also, accountants do not consider treasury shares outstanding in calculating earnings per share.

When firms reacquire treasury stock, they record the stock at cost as a decrease in a stockholders’ equity account called Treasury Stock. Any excess of the reissue price over cost represents additional paid-in capital and is credited to Paid-In Capital—Common (Preferred) Treasury Stock.

Retained Earnings

The retained earnings portion of stockholders’ equity typically results from accumulated earnings, reduced by net losses and dividends. Like paid-in capital, retained earnings is a source of assets received by a corporation. Paid-in capital is the actual investment by the stockholders; retained earnings is the investment by the stockholders through earnings not yet withdrawn.

The balance in the corporation’s Retained Earnings account is the corporation’s net income, less net losses, from the date the corporation began to the present, less the sum of dividends paid during this period. Net income increases Retained Earnings, while net losses and dividends decrease Retained Earnings in any given year. Thus, the balance in Retained Earnings represents the corporation’s accumulated net income not distributed to stockholders.

When the Retained Earnings account has a negative balance, a deficit exists. A company indicates a deficit by listing retained earnings with a negative amount in the stockholders’ equity section of the balance sheet. The firm need not change the title of the general ledger account even though it contains a negative balance. The most common increases and decreases made to Retained Earnings are for income (or losses) and dividends. Occasionally, accountants make other entries to the Retained Earnings account.


Cash Dividends

Dividends are distributions of earnings by a corporation to its stockholders. Usually the corporation pays dividends in cash, but it may distribute additional shares of the corporation’s own capital stock as dividends. Occasionally, a company pays dividends in merchandise or other assets. Since dividends are the means whereby the owners of a corporation share in its earnings, accountants charge them against retained earnings.  Dividends are always based on shares outstanding!

Before dividends can be paid, the board of directors must declare them so they can be recorded in the corporation’s minutes book. Three dividend dates are significant:

  • Date of declaration. The date of declaration indicates when the board of directors approved a motion declaring that dividends should be paid. The board action creates the liability for dividends payable (or stock dividends distributable for stock dividends).
  • Date of record. The board of directors establishes the date of record; it determines which stockholders receive dividends. The corporation’s records (the stockholders’ ledger) determine its stockholders as of the date of record.
  • Date of payment. The date of payment indicates when the corporation will pay dividends to the stockholders.

Preferred Stock Dividends

Preferred Stock Dividends

Stock preferred as to dividends means that the preferred stockholders receive a specified dividend per share before common stockholders receive any dividends. A dividend on preferred stock is the amount paid to preferred stockholders as a return for the use of their money.

Noncumulative preferred stock is preferred stock on which the right to receive a dividend expires whenever the dividend is not declared. When noncumulative preferred stock is outstanding, a dividend omitted or not paid in any one year need not be paid in any future year. Because omitted dividends are lost forever, noncumulative preferred stocks are not attractive to investors and are rarely issued.

Cumulative preferred stock is preferred stock for which the right to receive a basic dividend accumulates if the dividend is not paid. Companies must pay unpaid cumulative preferred dividends before paying any dividends on the common stock.

Dividends in arrears are cumulative unpaid dividends, including the dividends not declared for the current year. Dividends in arrears never appear as a liability of the corporation because they are not a legal liability until declared by the board of directors. However, since the amount of dividends in arrears may influence the decisions of users of a corporation’s financial statements, firms disclose such dividends in a footnote.

The board of directors of a corporation possesses sole power to declare dividends. The legality of a dividend generally depends on the amount of retained earnings available for dividends—not on the net income of any one period. Firms can pay dividends in periods in which they incurred losses, provided retained earnings and the cash position justify the dividend. And in some states, companies can declare dividends from current earnings despite an accumulated deficit. The financial advisability of declaring a dividend depends on the cash position of the corporation.

Stock Dividends

A company that lacks sufficient cash for a cash dividend may declare a stock dividend to satisfy its shareholders. Note that in the long run it may be more beneficial to the company and the shareholders to reinvest the capital in the business rather than paying a cash dividend. If so, the company would be more profitable and the shareholders would be rewarded with a higher stock price in the future.

Stock dividends are payable in additional shares of the declaring corporation’s capital stock. When declaring stock dividends, companies issue additional shares of the same class of stock as that held by the stockholders.

Stock dividends have no effect on the total amount of stockholders’ equity or on net assets. They merely decrease retained earnings and increase paid-in capital by an equal amount. Immediately after the distribution of a stock dividend, each share of similar stock has a lower book value per share. This decrease occurs because more shares are outstanding with no increase in total stockholders’ equity.

A corporation might declare a stock dividend for several reasons:

  • Retained earnings may have become large relative to total stockholders’ equity, so the corporation may desire a larger permanent capitalization.
  • The market price of the stock may have risen above a desirable trading range. A stock dividend generally reduces the per share market value of the company’s stock.
  • The board of directors of a corporation may wish to have more stockholders (who might then buy its products) and eventually increase their number by increasing the number of shares outstanding. Some of the stockholders receiving the stock dividend are likely to sell the shares to other persons.
  • Stock dividends may silence stockholders’ demands for cash dividends from a corporation that does not have sufficient cash to pay cash dividends.

The percentage of shares issued determines whether a stock dividend is a small stock dividend or a large stock dividend. Firms use different accounting treatments for each category.

Stock Split

Stock Split

A company can control their market price in some cases.  When the market price is too high, people will not invest in the company.  What can we do?  We can split our stock!  A stock splits does not cause an accounting entry as it does not change any monetary amounts listed on the financial statements.  What does it do?

  • Shares increase by number of the stock split
  • Par value decreases by the number of the stock split

Technology: Creating a Chatbot

We will create a chatbot for your business. Please refer to Blackboard.

Chapter 10: Accounting in the Management Process

Managerial accounting helps managers make good decisions. Managerial accounting provides information about the cost of goods and services, whether a product is profitable, whether to invest in a new business venture, and how to budget. It compares actual performance to planned performance and facilitates many other important decisions critical to the success of organizations.

The remaining chapters in this book focus on managerial accounting. This chapter provides an overview of managerial accounting and shows how to determine the cost of a particular type of product known as a job.


After you complete the required assignments you will be able to:

  • Compare/Contrast Financial vs. Managerial Accounting.
  • Define product and period costs
  • Compute cost of goods sold for a manufacturer
  • Prepare a manufacturing statement

Managerial Accounting VS Financial Accounting

Compare Managerial Accounting with Financial Accounting

Whereas financial accounting provides financial information primarily for external use, managerial accounting information is for internal use. By reporting on the financial activities of the organization, financial accounting provides information needed by investors and creditors.

Most managerial decisions require more detailed information than that provided by external financial reports. For instance, in their external financial statements, large corporations such as General Electric Company show single amounts on their balance sheets for inventory. However, managers need more detailed information about the cost of each of several hundred products.


Managerial Accounting Reports

Financial reporting by manufacturing companies

Many of you will work in manufacturing companies or provide services for them. Others will work in retail or service organizations that do business with manufacturers. This section will help you understand how manufacturing companies work and how to read both their internal and external financial statements.

Assume you own a bicycle store and purchase bicycles and accessories to sell to customers. To determine your profitability, you would subtract the cost of bicycles and accessories from your gross sales as cost of goods sold. However, if you owned the manufacturing company that made the bicycles, you would base your cost of goods sold on the cost of manufacturing those bicycles. Accounting for manufacturing costs is more complex than accounting for costs of merchandise purchased that is ready for sale.

Perhaps the most important accounting difference between merchandisers and manufacturers relates to the differences in the nature of their activities. A merchandiser purchases finished goods ready to be sold. On the other hand, a manufacturer must purchase raw materials and use production equipment and employee labor to transform the raw materials into finished products.

Thus, while a merchandiser has only one type of inventory—merchandise available for sale—a manufacturer has three types—unprocessed materials, partially complete work in process, and ready-for-sale finished goods. Instead of one inventory account, three different inventory accounts are necessary to show the cost of inventory in various stages of production.

We compare a manufacturer’s cost of goods sold section of the income statement to that same section of the merchandiser’s income statement in the chart below. There are two major differences in these cost of goods sold sections: (1) goods ready to be sold are referred to as merchandise inventory by a merchandiser and finished goods inventory by a manufacturer, and (2) the net cost of purchases for a merchandiser is equivalent to the cost of goods manufactured by a manufacturer.

Product Cost Vs Period Expenses

Product Costs vs Period Expenses

Companies also classify costs as product costs and period costs. Product costs are the costs incurred in making products. These costs include the costs of direct materials, direct labor, and manufacturing overhead.

Period expenses are closely related to periods of time rather than units of products. For this reason, firms expense (deduct from revenues) period costs in the period in which they are incurred. Accountants treat all selling and administrative expenses (operating expenses) as period costs for external financial reporting. 

 In manufacturing companies, a product’s cost is made up of three cost elements: direct material costs, direct labor costs, and manufacturing overhead costs.

Period Cost

Period costs are recorded as expenses of the current period as either selling or administrative expenses.

Selling expenses are costs incurred to obtain customer orders and get the finished product in the customers’ possession. Advertising, market research, sales salaries and commissions, and delivery and storage of finished goods are selling costs. The costs of delivery and storage of finished goods are selling costs because they are incurred after production has been completed. Therefore, the costs of storing materials are part of manufacturing overhead, whereas the costs of storing finished goods are a part of selling costs. Remember that retailers, wholesalers, manufacturers, and service organizations all have selling costs.

Administrative expenses are nonmanufacturing costs that include the costs of top administrative functions and various staff departments such as accounting, data processing, and personnel. Executive salaries, clerical salaries, office expenses, office rent, donations, research and development costs, and legal costs are administrative costs. As with selling costs, all organizations have administrative costs.

To illustrate, assume a company pays its sales manager a fixed salary. Even though the manager may be working on projects to benefit the company in future accounting periods, it expenses the sales manager’s salary in the period incurred because the expense cannot be traced to the production of a specific product.

In summary, product costs (direct materials, direct labor and overhead) are not expensed until the item is sold when the product costs are recorded as cost of goods sold.  Period costs are selling and administrative expenses, not related to creating a product, that are shown in the income statement along with cost of goods sold.

Cost Classification

We will cover many cost classifications useful for planning and control.  We will introduce the basic concepts behind these classifications but you will use them (and get in greater depth) in other chapters.

  1. Fixed vs Variable Costs.

A fixed cost remains the same in total but changes per unit.  Fixed costs examples include your monthly rent, salaried employees, straight-line depreciation as these amounts do not change based on volume.  A variable cost remains the same per unit but changes in total.  Variable cost examples include sales commissions, hourly workers, units-of-production method depreciation as these amounts will change based on total volume but the amount charged per unit does not change.

  1. Direct vs Indirect Costs.

A direct cost is an amount that can be traced to a specific department, process or job.  Direct costs can be product costs like direct materials or direct labor or they can be period costs like an accountant’s salary would be traced to the accounting department.  Indirect costs is an amount that cannot be traced to a specific department, process or job.  These costs are typically allocated (or estimated) to the departments, processes or jobs using those items.  Indirect costs can be product costs like overhead or period costs like an IT employee’s salary to the sales department.  The sales department needs the services provided by IT and the IT employee’s time would be an indirect expense to the sales department.

  1. Controllable vs Non-controllable Costs.

When evaluating the performance of an executive or manager under managerial accounting, it is helpful to recognize that some costs and expenses may be out of the control of that manager or executive.  One example is the manager’s salary.  The manager has no control over his own salary and has no power to change or stay within the budget for the salary.  Controllable costs are things the executive, manager, or department even can control or change.  If the executive, manager or department cannot change or control the cost, it is an uncontrollable cost.  An example of an uncontrollable cost would be an allocation of administrative expenses to each job or department.

  1. Differential Costs including Sunk and Opportunity Costs.

Differential Costs represent the difference between two alternatives.  We will analyze what is relevant to our decision making including any opportunity costs.  Opportunity costs are what you give up by choosing one alternative over another (think about what you are giving up by taking this course — what else could you be doing?).  Sunk costs are not relevant for decision making as the cost cannot be recovered at a later date.

Statement of Cost of Goods Manufactured

The statement of cost of goods manufactured supports the cost of goods sold figure on the income statement.  The two most important numbers on this statement are the total manufacturing cost and the cost of goods manufactured. Be careful not to confuse the terms total manufacturing cost and cost of goods manufactured with each other or with the cost of goods sold.

Total Manufacturing Cost includes the costs of all resources put into production during the period (meaning, the direct materials, direct labor and overhead applied). Cost of goods manufactured consists of the cost of all goods completed during the period. It includes total manufacturing costs plus the beginning work in process inventory minus the ending work in process inventory. Cost of goods sold are the costs of all goods SOLD during the period and includes the cost of goods manufactured plus the beginning finished goods inventory minus the ending finished goods inventory.  Cost of goods sold is reported as an expense on the income statements and is the only time product costs are expensed.  This chart will summarize the formulas you will need:


Chapter 11: Job Order Costing

After you complete the required assignments you will be able to:

  • Understand the difference between direct materials, direct labor, and overhead.
  • Calculate the cost of a job.
  • Apply overhead to jobs using a predetermined overhead rate.
  • Determine and record adjustments for over- or under-applied factory overhead

Process Costing Vs Job Order Costing

The two main types of cost accounting systems for manufacturing operations are process cost and job order cost systems.

Many businesses produce large quantities of a single product or similar products. Pepsi-Cola makes soft drinks, Exxon Mobil produces oil, and Kellogg Company produces breakfast cereals on a continuous basis over long periods. For these kinds of products, companies do not have separate jobs. Instead, production is an ongoing process.

Job costing and process costing have important similarities:

  • Both job and process cost systems have the same goal: to determine the cost of products.
  • Both job and process cost systems have the same cost flows. Accountants record production in separate accounts for materials inventory, labor, and overhead. Then, they transfer the costs to a Work in Process Inventory account.
  • Both job and process cost systems use predetermined overhead rates to apply overhead.

Job costing and process costing systems also have their significant differences:

  • Types of products produced. Companies that use job costing work on many different jobs with different production requirements during each period. Companies that use process costing produce a single product, either on a continuous basis or for long periods. All the products that the company produces under process costing are the same.
  • Cost accumulation procedures. Job costing accumulates costs by individual jobs. Process costing accumulates costs by process or department.
  • Work in Process Inventory accounts. Job cost systems have one Work in Process Inventory account for each job. Process cost systems have a Work in Process Inventory account for each department or process.

What kinds of companies would use job costing?  The chart below shows how various companies choose different accounting systems, depending on their products. First, companies producing individual, unique products known as jobs use job costing (also called job order costing). Companies such as construction companies and consulting firms, produce jobs and use job costing.



Characteristics of Job Order Costing

The general cost accumulation model

In general, companies match the flow of costs to the physical flow of products through the production process. They place materials received from suppliers in the materials storeroom and record the cost of those materials when purchasing them to raw materials inventory. As they are needed for production, the materials move from the materials storeroom (raw materials inventory) to the production departments with their cost.

During production, the materials processed by workers and machines become partially manufactured products. At any time during production, these partially manufactured products are collectively known as work in process (or goods in process).

Completed products are finished goods. When the products are completed and transferred to the finished goods storeroom, the company removes their costs from Work in Process Inventory and assigns them to Finished Goods Inventory. As the goods are sold, the company transfers related costs from Finished Goods Inventory to Cost of Goods Sold.

 Some companies, like furniture manufacturers, produce batches of products. They produce all of the components of a single product (e.g. coffee tables) in one batch. They would then produce the components of another product (e.g. dining room sets) in a new batch. (Some university food service companies prepare meals this way.) Companies such as these use job costing methods to accumulate the cost of each batch.

Applied Factory Overhead Vs Actual Factory Overhead

By definition, overhead cannot be traced directly to jobs.  Most company use a predetermined overhead rate (or estimated rate) instead of actual overhead for the following reasons:

  • A company usually does not incur overhead costs uniformly throughout the year. For example, heating costs are greater during winter months. However, allocating more overhead costs to a job produced in the winter compared to one produced in the summer may serve no useful purpose.
  • Some overhead costs, like factory building depreciation, are fixed costs. If the volume of goods produced varies from month to month, the actual rate varies from month to month, even though the total cost is constant from month to month. The predetermined rate, on the other hand, is constant from month to month.
  • Predetermined rates make it possible for companies to estimate job costs sooner. Using a predetermined rate, companies can assign overhead costs to production when they assign direct materials and direct labor costs. Without a predetermined rate, companies do not know the costs of production until the end of the month or even later when bills arrive. For example, the electric bill for July will probably not arrive until August. If Creative Printers had used actual overhead, the company would not have determined the costs of its July work until August. It is better to have a good estimate of costs when doing the work instead of waiting a long time for only a slightly more accurate number.

Predetermined overhead rates

Predetermined overhead rates are used to apply overhead to jobs until we have all the actual costs available.  To create the rate, we use cost drivers to assign overhead to jobs. A cost driver is a measure of activities, such as machine-hours, that is the cause of costs. To assign overhead to jobs, the cost driver should be the cause of the overhead costs, or at least be reasonably associated with the overhead costs. Just as automobile mileage is a good cost driver for measuring the cause of gasoline consumption, machine-hours is a measure of what causes energy costs. By assigning energy costs to jobs based on the number of machine-minutes or hours the job uses, we have a pretty good idea of the energy costs required to produce the job.

Most manufacturing and service organizations use predetermined rates.

To calculate a predetermined overhead rate, a company divides the estimated total overhead costs for a period by an estimated base (or expected level of activity). This activity could be total expected machine-hours, total expected direct labor-hours, or total expected direct labor cost for the period. Companies set predetermined overhead rates at the beginning of the year in which they will use them.  This formula computes a predetermined rate:

Predetermined Overhead Rate (POHR) = Estimated Overhead/Estimated Base (DLC, DLH, MH, Etc.)

Notice how the predetermined rate is based on ESTIMATED overhead and the ESTIMATED base or level of activity.  To apply overhead, we will use the actual amount of the base or level of activity x the predetermined overhead rate.  Again, to apply overhead use this formula:

Applied Overhead = Actual amount of base x POHR

Actual Overhead

Actual Overhead costs are the true costs incurred and typically include things like indirect materials, indirect labor, factory supplies used, factory insurance, factory depreciation, factory maintenance and repairs, factory taxes, etc.  Actual overhead costs are any indirect costs related to completing the job or making a product.  Next, we look at how we correct our records when the actual and our applied (or estimated) overhead do not match (which they almost never match!).

We know overhead is applied using estimated or budgeted overhead and a base.  Actual overhead costs may be different and we will not have all of those costs until late in the year.  Estimated may be close but is rarely accurate with what really happens, so the result is Over-applied or Under-applied Overhead.  At the end of the year, we will compare the applied overhead to the actual overhead and if applied overhead is GREATER than actual overhead, overhead is over-applied. Any adjustments to will be made to Cost of Goods Sold.

Job Costing Process

job cost system (job costing) accumulates costs incurred according to the individual jobs. Companies generally use job cost systems when they can identify separate products or when they produce goods to meet a customer’s particular needs.

Who uses job costing? Examples include home builders who design specific houses for each customer and accumulate the costs separately for each job, and caterers who accumulate the costs of each banquet separately. Consulting, law, and public accounting firms use job costing to measure the costs of serving each client. Motion pictures, printing, and other industries where unique jobs are produced use job costing. Hospitals also use job costing to determine the cost of each patient’s care.

Chapter 12: Cost Behavior and CVP

Hello, you should be able to understand these concepts:

  • Classify cost as fixed, variable, or mixed
  • Compute contribution margin, ratio, and unit
  • Determine Break Even Analysis

Cost Behavior

Cost Behavior Vs. Cost Estimation

Cost behavior patterns

There are four basic cost behavior patterns: fixed, variable, mixed (semi-variable), and step which graphically would appear as below.

Fixed Costs

Fixed costs remain in TOTAL but change per unit based on the actual amount of production.  Here is a video to discuss these concepts. Examples of fixed costs include monthly rent, mortgage or car payments, employee salary, depreciation calculated under straight-line method, and insurance.

Variable Costs

Variable Costs remain the same PER UNIT but CHANGE in total. Variable costs for a manufacturer would include things like direct labor of hourly workers, other wage employees, direct materials, applied overhead, sales commissions, and depreciation under units of production method.

 Mixed Costs

Mixed costs are costs that contain a portion of both fixed and variable costs.  Common examples include utilities and even your cell phone!  You may be charged a fixed amount each month for data usage or text messages allowed but when you exceed your limit, you are charged a set amount (variable cost) based on each text message or gigabyte of data you use over your limit.

Cost Classification: Fixed, Mixed, Variable, and Step

Fixed costs remain constant (in total) over some relevant range of output. Depreciation, insurance, property taxes, and administrative salaries are examples of fixed costs. Recall that so-called fixed costs are fixed in the short run but not necessarily in the long run.

In contrast to fixed costs, variable costs vary (in total) directly with changes in volume of production or sales. In particular, total variable costs change as total volume changes. If pizza production increases from 100 10-inch pizzas to 200 10-inch pizzas per day, the amount of dough required per day to make 10-inch pizzas would double. The dough is a variable cost of pizza production. Direct materials and sales commissions are variable costs.

Direct labor is a variable cost in many cases. If the total direct labor cost increases as the volume of output increases and decreases as volume decreases, direct labor is a variable cost. Piecework pay is an excellent example of direct labor as a variable cost. In addition, direct labor is frequently a variable cost for workers paid on an hourly basis, as the volume of output increases, more workers are hired. However, sometimes the nature of the work or management policy does not allow direct labor to change as volume changes and direct labor can be a fixed cost.

Mixed costs have both fixed and variable characteristics. A mixed cost contains a fixed portion of cost incurred even when the facility is idle, and a variable portion that increases directly with volume. Electricity is an example of a mixed cost. A company must incur a certain cost for basic electrical service. As the company increases its volume of activity, it runs more machines and runs them longer. The firm also may extend its hours of operation. As activity increases, so does the cost of electricity.

Managers usually separate mixed costs into their fixed and variable components for decision-making purposes. They include the fixed portion of mixed costs with other fixed costs, while assuming the variable part changes with volume.  We will look at ways to separate fixed and variable components of a mixed cost later in the chapter.  A step cost is a mixed cost.  A step cost remains constant at a certain fixed amount over a range of output (or sales). Then, at certain points, the step costs increase to higher amounts. Visually, step costs appear like stair steps.

Supervisors’ salaries are an example of a step cost when companies hire additional supervisors as production increases. For instance, the local McDonald’s restaurant has one supervisor until sales exceed 100 meals during the lunch hour. If sales regularly exceed 100 meals during that hour, the company adds a second supervisor. The supervisor costs will remain the same for between 0 – 100 meals served that hour.  When meals served are between 101 – 200, the supervisor cost goes up to reflect 2 supervisors. Step costs will increase by the same amount for each new cost or step.  Step costs are sometimes labeled as step variable costs (many small steps) or step fixed costs (only a few large steps).

Although we have described four different cost patterns (fixed, variable, mixed, and step), we simplify our discussions in this chapter by assuming managers can separate mixed and step costs into fixed and variable components using cost estimation techniques.

Cost Volume Profit Analysis

Companies use cost-volume-profit (CVP) analysis (also called break-even analysis) to determine what affects changes in their selling prices, costs, and/or volume will have on profits in the short run. A careful and accurate cost-volume-profit (CVP) analysis requires knowledge of costs and their fixed or variable behavior as volume changes.

cost-volume-profit chart is a graph that shows the relationships among sales, costs, volume, and profit. Look at illustration below.  The illustration shows a cost-volume-profit chart for Video Productions, a company that produces DVDs. Each DVD sells for $20. The variable cost per DVD is $12, and the fixed costs per month are $ 40,000.

The total cost line represents the fixed costs of $40,000 plus $12 per unit. Thus, if Video Productions produces and sells 6,000 DVDs, the company’s total costs are $112,000, made up of $40,000 fixed costs and $ 72,000 total variable costs ($ 72,000 = $ 12 per unit X 6,000 units produced and sold).

The total revenue line shows how revenue increases as volume increases. Total revenue is $ 120,000 for sales of 6,000 tapes ($ 20 per unit X 6,000 units sold). In the chart, we demonstrate the effect of volume on revenue, costs, and net income, for a particular price, variable cost per unit, and fixed cost per period.

At each volume, one can estimate the company’s profit or loss. For example, at a volume of 6,000 units, the profit is $8,000. We can find the net income either by constructing an income statement or using the profit equation. The contribution margin income statement gives the following results for a volume of 6,000 units:

We have introduced a new term in this income statement—the contribution margin. The contribution margin is the amount by which revenue exceeds the variable costs of producing that revenue. We can calculate it on a per unit or total sales volume basis. On a per unit basis, the contribution margin for Video Productions is $8 (the selling price of $20 minus the variable cost per unit of $ 12).

The contribution margin indicates the amount of money remaining after the company covers its variable costs. This remainder contributes to the coverage of fixed costs and to net income. In Video Production’s income statement, the $ 48,000 contribution margin covers the $ 40,000 fixed costs and leaves $ 8,000 in operating income.

You can also calculate a contribution margin ratio by using the following formula:

Contribution Margin RATIO  = Contribution Margin/Sales

 The CVP chart above shows cost data for Video Productions in a relevant range of output from 500 to 10,000 units. The relevant range is the range of production or sales volume over which the basic cost behavior assumptions hold true. For volumes outside these ranges, costs behave differently and alter the assumed relationships. For example, if Video Productions produced and sold more than 10,000 units per month, it might be necessary to increase plant capacity (thus incurring additional fixed costs) or to work extra shifts (thus incurring overtime charges and other inefficiencies). In either case, the assumed cost relationships would no longer be valid.

The contribution margin income statement is used quite frequently since it separates fixed and variable costs to allow a company to see what it can directly change and what it cannot change.   Below we will show how to use this new contribution margin income statement to do the following analyses:

  1. Breakeven in units—the number of units needed to be sold to breakeven
  2. Breakeven in dollars—the number of sales dollars needed to breakeven
  3. Target profit in units—the number of units needed to be sold to reach a target profit
  4. Target profit in dollars—the number of sales dollars needed to reach a target profit
  5. Margin of Safety—the difference between current sales dollars (or budget) and breakeven in sales
  6. Margin of Safety Ratio—the margin of safety (5 above)/ current sales
  7. Operating leverage

Break Even Analysis

 A company breaks even for a given period when sales revenue and costs charged to that period are equal. Thus, the break-even point is that level of operations at which a company realizes no operating income or loss. A company may express a break-even point in dollars of sales revenue or number of units produced or sold. No matter how a company expresses its break-even point, it is still the point of zero operating income or loss. To illustrate the calculation of a break-even point work with the previous company, Video Productions.

Recall that Video Productions produces DVDs selling for $20 per unit. Fixed costs per period total $40,000, while variable cost is $12 per unit making the contribution margin per unit $8 or 40% (8/12) of sales.  We compute the break-even point in units and sales dollars as:

  • Break Even in Units = Fixed Cost / Unit Contribution Margin
  • Break Even in Dollars = Fixed cost / Contribution Margin Ratio

The result tells us that Video Productions breaks even at a volume of 5,000 units per month. We can prove that to be true by computing the revenue and total costs at a volume of 5,000 units as follows:

Look at the cost-volume-profit chart and note that the revenue and total cost lines cross at 5,000 units—the break-even point. Video Productions has Operating income at volumes greater than 5,000, but it has losses at volumes less than 5,000 units.

Target Profit

The unit sales or dollar sales can also can be calculated by using the formula above.  Let’s say that Video Productions wants to achieve a target profit of $50,000.  The following calculations would be completed to calculate the unit and dollars sales to achieve target profit:

  • Target Profit in Units = Fixed Cost + Target / Unit Contribution Margin
  • Target Profit in Dollars = Fixed Cost + Taget / Unit Contribution Margin Ratio

Margin of Safety

If a company’s current sales are more than its break-even point, it has a margin of safety equal to current sales minus break-even sales. The margin of safety is the amount by which sales can decrease before the company incurs a loss. For example, assume Video Productions currently has sales of $120,000 and its break-even sales are $ 100,000. The margin of safety is $ 20,000, computed as follows:

Margin of safety = Current sales – Break even sales

Margin of safety = $ 120,000 – $ 100,000 = $ 20,000

Sometimes people express the margin of safety as a percentage, called the margin of safety rate or just margin of safety percentage. The margin of safety ratio is equal to

Using the data just presented, we compute the margin of safety rate is $20,000 / 120,000 = 16.67 %

This means that sales volume could drop by 16.67 percent before the company would incur a loss.

In the contribution approach that we used for breakeven analysis did not take inventories into consideration.  We will not review the difference in the generally accepted accounting principles approach which is referred to as absorption costing and the contribution approach which is referred to as variable costing.

Absorption Costing

Absorption costing, also called full costing, is what you are used to under Generally Accepted Accounting Principles.  Under absorption costing, companies treat all manufacturing costs, including both fixed and variable manufacturing costs, as product costs. Remember, total variable costs change proportionately with changes in total activity, while fixed costs do not change as activity levels change. These variable manufacturing costs are usually made up of direct materials, variable manufacturing overhead, and direct labor.   The product costs (or cost of goods sold) would include direct materials, direct labor and overhead.  The period costs would include selling, general and administrative costs.

Remember the following under absorption costing:

  • Typically used for financial reporting (GAAP)
  • ALL manufacturing costs are included in the cost (direct materials, direct labor, fixed and variable overhead)
  • Can be misleading as some costs are not affected by products
  • Fixed manufacturing overhead costs are applied to units PRODUCED and not just unit sold
  • Income statement shows Sales – Cost of Goods sold = Gross Margin (or Gross Profit) – Operating Expenses = Net Income and is based on the number of units SOLD.

Variable Costing

Variable costing (also known as direct costing) treats all fixed manufacturing costs as period costs to be charged to expense in the period received. Under variable costing, companies treat only variable manufacturing costs as product costs. The logic behind this expensing of fixed manufacturing costs is that the company would incur such costs whether a plant was in production or idle. Therefore, these fixed costs do not specifically relate to the manufacture of products.

In variable costing, it is important to remember:

  • ONLY includes variable costs meaning costs that increase with volume
  • Does not include FIXED costs as volume levels do not change these costs (fixed costs treated as period costs not product costs)
  • Can provide more accurate information for decision makers as costs are better tied to production levels
  • Can be applied to ALL costs and not just product costs.
  • Uses Contribution Margin Income Statement showing Sales – VARIABLE expenses = Contribution Margin – Fixed Expenses = Net Income and is based on the number of units SOLD.

Chapter 13: Budgeting

By the end of this section, you will be able to:

  • Describe budgeting, its objectives, its impact on human behavior, and types of budget systems.
  • Describe and prepare a master budget for a manufacturing company.

Introduction to Budgeting and Budgeting Processes

The Budget—For Planning and Control

Time and money are scarce resources to all individuals and organizations; the efficient and effective use of these resources requires planning. Planning alone, however, is insufficient. Control is also necessary to ensure that plans actually are carried out. A budget is a tool that managers use to plan and control the use of scarce resources. A budget is a plan showing the company’s objectives and how management intends to acquire and use resources to attain those objectives.

Companies, nonprofit organizations, and governmental units use many different types of budgets. Responsibility budgets are designed to judge the performance of an individual segment or manager. Capital budgets evaluate long-term capital projects such as the addition of equipment or the relocation of a plant. This chapter examines the master budget, which consists of a planned operating budget and a financial budget. The planned operating budget helps to plan future earnings and results in a projected income statement. The financial budget helps management plan the financing of assets and results in a projected balance sheet.

The budgeting process involves planning for future profitability because earning a reasonable return on resources used is a primary company objective. A company must devise some method to deal with the uncertainty of the future. A company that does no planning whatsoever chooses to deal with the future by default and can react to events only as they occur. Most businesses, however, devise a blueprint for the actions they will take given the foreseeable events that may occur.

A budget: (1) shows management’s operating plans for the coming periods; (2) formalizes management’s plans in quantitative terms; (3) forces all levels of management to think ahead, anticipate results, and take action to remedy possible poor results; and (4) may motivate individuals to strive to achieve stated goals.

Companies can use budget-to-actual comparisons to evaluate individual performance. For instance, the standard variable cost of producing a personal computer at IBM is a budget figure. This figure can be compared with the actual cost of producing personal computers to help evaluate the performance of the personal computer production managers and employees who produce personal computers. We will do this type of comparison in a later chapter.

Many other benefits result from the preparation and use of budgets. For example: (1) businesses can better coordinate their activities; (2) managers become aware of other managers’ plans; (3) employees become more cost conscious and try to conserve resources; (4) the company reviews its organization plan and changes it when necessary; and (5) managers foster a vision that otherwise might not be developed.

The planning process that results in a formal budget provides an opportunity for various levels of management to think through and commit future plans to writing. In addition, a properly prepared budget allows management to follow the management-by-exception principle by devoting attention to results that deviate significantly from planned levels. For all these reasons, a budget must clearly reflect the expected results.

Failing to budget because of the uncertainty of the future is a poor excuse for not budgeting. In fact, the less stable the conditions, the more necessary and desirable is budgeting, although the process becomes more difficult. Obviously, stable operating conditions permit greater reliance on past experience as a basis for budgeting. Remember, however, that budgets involve more than a company’s past results. Budgets also consider a company’s future plans and express expected activities. As a result, budgeted performance is more useful than past performance as a basis for judging actual results.

A budget should describe management’s assumptions relating to: (1) the state of the economy over the planning horizon; (2) plans for adding, deleting, or changing product lines; (3) the nature of the industry’s competition; and (4) the effects of existing or possible government regulations. If these assumptions change during the budget period, management should analyze the effects of the changes and include this in an evaluation of performance based on actual results.

Budgets are quantitative plans for the future. However, they are based mainly on past experience adjusted for future expectations. Thus, accounting data related to the past play an important part in budget preparation. The accounting system and the budget are closely related. The details of the budget must agree with the company’s ledger accounts. In turn, the accounts must be designed to provide the appropriate information for preparing the budget, financial statements, and interim financial reports to facilitate operational control.

Management should frequently compare accounting data with budgeted projections during the budget period and investigate any differences. Budgeting, however, is not a substitute for good management. Instead, the budget is an important tool of managerial control. Managers make decisions in budget preparation that serve as a plan of action.

The period covered by a budget varies according to the nature of the specific activity involved. Cash budgets may cover a week or a month; sales and production budgets may cover a month, a quarter, or a year; and the general operating budget may cover a quarter or a year.

Budgeting involves the coordination of financial and non-financial planning to satisfy organizational goals and objectives. No foolproof method exists for preparing an effective budget. However, budget makers should carefully consider the conditions that follow:

  • Top management support: All management levels must be aware of the budget’s importance to the company and must know that the budget has top management’s support. Top management, then, must clearly state long-range goals and broad objectives. These goals and objectives must be communicated throughout the organization. Long-range goals include the expected quality of products or services, growth rates in sales and earnings, and percentage-of-market targets. Overemphasis on the mechanics of the budgeting process should be avoided.
  • Participation in goal setting Management uses budgets to show how it intends to acquire and use resources to achieve the company’s long-range goals. Employees are more likely to strive toward organizational goals if they participate in setting them and in preparing budgets. Often, employees have significant information that could help in preparing a meaningful budget. Also, employees may be motivated to perform their own functions within budget constraints if they are committed to achieving organizational goals.
  • Communicating results People should be promptly and clearly informed of their progress. Effective communication implies (1) timeliness, (2) reasonable accuracy, and (3) improved understanding. Managers should effectively communicate results so employees can make any necessary adjustments in their performance.
  • Flexibility If significant basic assumptions underlying the budget change during the year, the planned operating budget should be restated. For control purposes, after the actual level of operations is known, the actual revenues and expenses can be compared to expected performance at that level of operations.
  • Follow-up Budget follow-up and data feedback are part of the control aspect of budgetary control. Since the budgets are dealing with projections and estimates for future operating results and financial positions, managers must continuously check their budgets and correct them if necessary. Often management uses performance reports as a follow-up tool to compare actual results with budgeted results.

The term budget has negative connotations for many employees. Often in the past, management has imposed a budget from the top without considering the opinions and feelings of the personnel affected. Such a dictatorial process may result in resistance to the budget. A number of reasons may underlie such resistance, including lack of understanding of the process, concern for status, and an expectation of increased pressure to perform. Employees may believe that the performance evaluation method is unfair or that the goals are unrealistic and unattainable. They may lack confidence in the way accounting figures are generated or may prefer a less formal communication and evaluation system. Often these fears are completely unfounded, but if employees believe these problems exist, it is difficult to accomplish the objectives of budgeting.

Problems encountered with such imposed budgets have led accountants and management to adopt participatory budgeting. Participatory budgeting means that all levels of management responsible for actual performance actively participate in setting operating goals for the coming period. Managers and other employees are more likely to understand, accept, and pursue goals when they are involved in formulating them.

Within a participatory budgeting process, accountants should be compilers or coordinators of the budget, not preparers. They should be on hand during the preparation process to present and explain significant financial data. Accountants must identify the relevant cost data that enables management’s objectives to be quantified in dollars. Accountants are responsible for designing meaningful budget reports. Also, accountants must continually strive to make the accounting system more responsive to managerial needs. That responsiveness, in turn, increases confidence in the accounting system.

Although many companies have used participatory budgeting successfully, it does not always work. Studies have shown that in many organizations, participation in the budget formulation failed to make employees more motivated to achieve budgeted goals. Whether or not participation works depends on management’s leadership style, the attitudes of employees, and the organization’s size and structure. Participation is not the answer to all the problems of budget preparation. However, it is one way to achieve better results in organizations that are receptive to the philosophy of participation.

Master Budget

A master budget consists of a projected income statement (planned operating budget) and a projected balance sheet (financial budget) showing the organization’s objectives and proposed ways of attaining them. In diagram below, we depict a flowchart of the financial planning process that you can use as an overview of the elements in a master budget. The remainder of this chapter describes how a company prepares a master budget. We emphasize the master budget because of its prime importance to financial planning and control in a business entity.

The budgeting process starts with management’s plans and objectives for the next period. These plans take into consideration various policy decisions concerning selling price, distribution network, advertising expenditures, and environmental influences from which the company forecasts its sales for the period (in units by product or product line). Managers arrive at the sales budget in dollars by multiplying sales units times sales price per unit. They use expected production, sales volume, and inventory policy to project cost of goods sold. Next, managers project operating expenses such as selling and administrative expenses.

This chapter cannot cover all areas of budgeting in detail—entire books have been written on budgeting. However, the following video provides an overview of a budgeting procedure that many successful companies have used.

We begin the budget process by discussing the planned operating budget or projected income statement.

The projected balance sheet, or financial budget, depends on many items in the projected income statement. Thus, the logical starting point in preparing a master budget is the projected income statement, or planned operating budget. However, since the planned operating budget shows the net effect of many interrelated activities, management must prepare several supporting budgets (sales, production, and purchases, to name a few) before preparing the planned operating budget. The process begins with the sales budget.

Operating Budgets

In this Operating Budget section, we will discuss the following budgets:

  1. Sales Budget
  2. Production Budget
  3. Cost of Goods Sold Budget
  4. Selling and Administrative Expense Budget
  5. Income Statement

Sales Budget

he cornerstone of the budgeting process is the sales budget because the usefulness of the entire operating budget depends on it. The sales budget involves estimating or forecasting how much demand exists for a company’s goods and then determining if a realistic, attainable profit can be achieved based on this demand. Sales forecasting can involve either formal or informal techniques, or both.

Formal sales forecasting techniques often involve the use of statistical tools. For example, to predict sales for the coming period, management may use economic indicators (or variables) such as the gross national product or gross national personal income, and other variables such as population growth, per capita income, new construction, and population migration.

To use economic indicators to forecast sales, a relationship must exist between the indicators (called independent variables) and the sales that are being forecast (called the dependent variable). Then management can use statistical techniques to predict sales based on the economic indicators.

Management often supplements formal techniques with informal sales forecasting techniques such as intuition or judgment. In some instances, management modifies sales projections using formal techniques based on other changes in the environment. Examples include the effect on sales of any changes in the expected level of advertising expenditures, the entry of new competitors, and/or the addition or elimination of products or sales territories. In other instances, companies do not use any formal techniques. Instead, sales managers and salespersons estimate how much they can sell. Managers then add up the estimates to arrive at total estimated sales for the period.

Usually, the sales manager is responsible for the sales budget and prepares it in units and then in dollars by multiplying the units by their selling price. The sales budget in units is the basis of the remaining budgets that support the operating budget.

Production Budget

The production budget considers the units in the sales budget and the company’s inventory policy. Managers develop the production budget in units and then in dollars. Determining production volume is an important task. Companies should schedule production carefully to maintain certain minimum quantities of inventory while avoiding excessive inventory accumulation. The principal objective of the production budget is to coordinate the production and sale of goods in terms of time and quantity.

Companies using a just-in-time inventory system need to closely coordinate purchasing, sales, and production. In general, maintaining high inventory levels allows for more flexibility in coordinating purchases, sales, and production. However, businesses must compare the convenience of carrying inventory with the cost of carrying inventory; for example, they must consider storage costs and the opportunity cost of funds tied up in inventory.

Firms often subdivide the production budget into budgets for materials, labor, and manufacturing overhead, which we will discuss in the manufacturing budgets. Usually materials, labor, and some elements of manufacturing overhead vary directly with production within a given relevant range of production. Fixed manufacturing overhead costs do not vary directly with production but are constant in total within a relevant range of production. To determine fixed manufacturing overhead costs accurately, management must determine the relevant range for the expected level of operations.

Cost of Goods Sold Budget

The cost of goods sold budget establishes the forecast for the inventory expense and is usually on of the largest expenses on an income statement.  A cost of goods sold budget would not be necessary for a service company since they do not sell a product.  Management must now prepare a schedule to forecast cost of goods sold, the next major amount in the planned operating budget. We need to understand the costs for making the product.

Selling and Administrative Budget

The costs of selling a product are closely related to the sales forecast. Generally, the higher the forecast, the higher the selling expenses. Administrative expenses are likely to be less dependent on the sales forecast because many of the items are fixed costs (e.g. salaries of administrative personnel and depreciation of administrative buildings and office equipment). Managers must also estimate other expenses such as interest expense, income tax expense, and research and development expenses.

Budgeted Income Statement

We will use a standard multi-step income statement showing sales minus gross profit is gross profit (or gross margin).  Gross profit minus operating expenses is the income from operations.  We will need the Sales budget, Cost of goods sold budget, and the Selling and Administrative expense budgets.

Manufacturing Budgets

In a manufacturing company, you will have a budget for all of your manufacturing costs including Direct Materials, Direct Labor and Overhead.  Each cost will have their own budget.  You will need the information from the Sales and Production budgets to complete these 3 budgets:

  • Material Budget
  • Direct Labor Budget
  • Manufacturing Overhead Budget

Materials Budget

The materials budget (or materials purchases budget) is used to plan how much raw materials we need to have available to meet budgeted production.  This budget is prepare similarly to the production budget as the company must decide how much raw materials inventory they want to have on hand at the end of each quarter.  This is typically determined as a percent of next quarter’s material needs.  In a materials budget, we will deal with units first and then add the budgeted cost near the end.  We also need to know how many direct materials are needed for each unit.

Direct Labor Budget

The direct labor budget is a very easy one.  We need to know the units required from the production budget.  Next, we need to know how many direct labor hours it takes to complete one unit and the cost per labor hour.  Using this information, we can determine how many direct labor hours are required to meet the budgeted level of production.  We will take the production units x direct labor per unit to get the number of direct labor hours.  Finally, we will take the direct labor hours x the rate per hour.

Manufacturing Overhead Budget

The final budget for manufacturing is the manufacturing overhead budget.  The manufacturing overhead budget is prepare depending on how the company allocates overhead.  The company can choose to allocate overhead using one predetermined overhead rate, departmental rates or using activity-based costing.  Further, the company can choose to separate the fixed and variable overhead costs and assign costs to overhead using only the variable overhead.

Cash Budget

Cash budget: After the preceding analyses have been prepared, sufficient information is available to prepare the cash budget and compute the balance in the Cash account for each quarter. Preparing a cash budget requires information about cash receipts and cash disbursements from all the other operating budget schedules.

Cash receipts We can prepare the cash receipts schedule based on how the company expects to collect on sales.  We know, from past experience, how much of our sales are cash sales and how much are credit sales.  We also can analyze past accounts receivable to determine when credit sales are typically paid.

Flexible Budget

Early in the chapter, you learned that a budget should be adjusted for changes in assumptions or variations in the level of operations. Managers use a technique known as flexible budgeting to deal with budgetary adjustments. A flexible operating budget is a special kind of budget that provides detailed information about budgeted expenses (and revenues) at various levels of output.

A flexible budget can be prepared for any level of activity.  The advantage to a flexible budget is we can create a budget based on the ACTUAL level of production to give us a clearer picture of our results by comparing the flexible budget to actual results. 

Flexible Budget A flexible budget is a budget prepared using the ACTUAL level of production instead of the budgeted activity. The difference between actual costs incurred and the flexible budget amount for that same level of operations is called a budget variance. Budget variances can indicate a department’s or company’s degree of efficiency, since they emerge from a comparison of what was with what should have been.  The performance report shows the budget variance for each line item.

A flexible budget allows volume differences to be removed from the analysis since we are using the same actual level of activity for both budget and actual.  How can we do this?  We will need to determine the budgeted variable cost per unit for each variable cost.  Budgeted fixed costs would remain the same because they do not change based on volume.

Flexible budgets often show budgeted amounts for every 10 per cent change in the level of operations, such as at the 70 per cent, 80 per cent, 90 per cent, and 100 per cent levels of capacity. However, actual production may fall between the levels shown in the flexible budget. If so, the company can find the budgeted amounts at that level of operations using the following formula:

Budgeted amount = Budgeted fixed portion of costs + [Budgeted variable portion of cost per unit X Actual units of output]

Standard Costs

Uses of standard costs

Whenever you have set goals that you have sought to achieve, these goals could have been called standards. Periodically, you might measure your actual performance against these standards and analyze the differences to see how close you are to your goal. Similarly, management sets goals, such as standard costs, and compares actual costs with these goals to identify possible problems.

This section begins with a discussion of the nature of standard costs. Next, we explain how managers use standard costs to establish budgets. Then we describe how management uses the concept of management by exception to investigate variances from standards. We also explain setting standards and how management decides whether to use ideal or practical standards. The section closes with a discussion of the other uses of standard costs.

Nature of standard costs

standard cost is a carefully predetermined measure of what a cost should be under stated conditions. Standard costs are not only estimates of what costs will be but also goals to be achieved. When standards are properly set, their achievement represents a reasonably efficient level of performance.

Usually, effective standards are the result of engineering studies and of time and motion studies undertaken to determine the amounts of materials, labor, and other services required to produce a product. Also considered in setting standards are general economic conditions because these conditions affect the cost of materials and other services that must be purchased by a manufacturing company.

Manufacturing companies determine the standard cost of each unit of product by establishing the standard cost of direct materials, direct labor, and manufacturing overhead necessary to produce that unit. Determining the standard cost of direct materials and direct labor is less complicated than determining the standard cost of manufacturing overhead.

The standard direct materials cost per unit of a product consists of the standard amount of material required to produce the unit multiplied by the standard price of the material. You must distinguish between the terms standard price and standard cost. Standard price usually refers to the price per unit of inputs into the production process, such as the price per pound of raw materials.


Flexible operating budget and budget variances illustrated:  As stated earlier, a flexible operating budget provides detailed information about budgeted expenses at various levels of activity. The main advantage of using a flexible operating budget along with a planned operating budget is that management can appraise performance on two levels. First, management can compare the actual results with the planned operating budget, which enables management to analyze the deviation of actual output from expected output. Second, given the actual level of operations, management can compare actual costs at actual volume with budgeted costs at actual volume. The use of flexible operating budgets gives a valid basis for comparison when actual production or sales volume differs from expectations.

A company makes a valid analysis of expense controls by comparing actual results with a flexible operating budget based on the levels of sales and production that actually occurred.

Calculating Material Variances

As stated earlier, standard costs represent goals. Standard cost is the amount a cost should be under a given set of circumstances. The accounting records also contain information about actual costs.

The amount by which actual cost differs from standard cost is called a variance. When actual costs are less than the standard cost, a cost variance is favorable. When actual costs exceed the standard costs, a cost variance is unfavorable. Do not automatically equate favorable and unfavorable variances with good and bad. You must base such an appraisal on the causes of the variance.

Materials Variances

The standard materials cost of any product is simply the standard quantity of materials that should be used multiplied by the standard price that should be paid for those materials. Actual costs may differ from standard costs for materials because the price paid for the materials and/or the quantity of materials used varied from the standard amounts management had set. These two factors are accounted for by isolating two variances for materials—a price variance and a usage variance.

Accountants isolate these two materials variances for three reasons. First, different individuals may be responsible for each variance—a purchasing agent for the price variance and a production manager for the usage variance. Second, materials might not be purchased and used in the same period. The variance associated with the purchase should be isolated in the period of purchase, and the variance associated with usage should be isolated in the period of use. As a general rule, the sooner a variance can be isolated, the greater its value in cost control. Third, it is unlikely that a single materials variance—the difference between the standard cost and the actual cost of the materials used—would be of any real value to management for effective cost control. A single variance would not show management what caused the difference, or one variance might simply offset another and make the total difference appear to be immaterial.

Materials price variance:  In a manufacturing company, the purchasing and accounting departments usually set a standard price for materials meeting certain engineering specifications. They consider factors such as market conditions, vendors’ quoted prices, and the optimum size of a purchase order when setting a standard price. A materials price variance (MPV) occurs when a company pays a higher or lower price than the standard price set for materials. Materials price variance is the difference between actual price paid (AP) and standard price allowed (SP) multiplied by the actual quantity of materials purchased (AQ). In equation form, the materials price variance can be done in two ways:

Materials price variance = (SP-AP) x AQ purchased

Materials usage variance Because the standard quantity of materials used in making a product is largely a matter of physical requirements or product specifications, usually the engineering department sets it. But if the quality of materials used varies with price, the accounting and purchasing departments may perform special studies to find the right quality.

The materials usage variance occurs when more or less than the standard amount of materials is used to produce a product or complete a process. The variance shows only differences from the standard quantity caused by the quantity of materials used; it does not include any effect of variances in price. Thus, the materials usage variance is:

Materials usage variance = (SQ-AQ) x SP

Calculating Labor Variances

Labor Variances

Labor rate variance: The labor rate variance occurs when the average rate of pay is higher or lower than the standard cost to produce a product or complete a process. The labor rate variance is similar to the materials price variance.

To compute the labor rate variance, we use the actual direct labor-hour rate paid (AR), the standard direct labor-hour rate allowed (SR) and the actual hours of direct labor services worked (AH).  It can also be calculated in either of the following ways:

Labor rate variance= (SR – AR) x AH


Labor efficiency variance Usually, the company’s engineering department sets the standard amount of direct labor-hours needed to complete a product. Engineers may base the direct labor-hours standard on time and motion studies or on bargaining with the employees’ union. The labor efficiency variance occurs when employees use more or less than the standard amount of direct labor-hours to produce a product or complete a process. The labor efficiency variance is similar to the materials usage variance.

To compute the labor efficiency variance, we will use the actual direct labor-hours worked (AH), the standard direct labor-hours allowed (SH), and the standard direct labor-hour rate per hour (SR) in either of the following ways:

Labor efficiency variance= (SH – AH) x SR

Chapter 14: Differential Analysis

By the end of this section, you will be able to:

  • Analyze product costs for planning and decision making.
  • Identify relevant costs and apply them to managerial decisions.
  • List the necessary criteria that make information relevant to a decision involving two or more alternative courses of action.
  • Describe the nature of differential analysis and illustrate its application to decisions involving:
    1. Accepting business at a special price
    2. Discontinuing an unprofitable segment
    3. Making or buying
    4. Replacing a long term asset

Differential Analsysis Examples

Differential analysis involves analyzing the different costs and benefits that would arise from alternative solutions to a particular problem. Relevant revenues or costs in a given situation are future revenues or costs that differ depending on the alternative course of action selected. Differential revenue is the difference in revenues between two alternatives. Differential cost or expense is the difference between the amounts of relevant costs for two alternatives.

Future costs that do not differ between alternatives are irrelevant and may be ignored since they affect both alternatives similarly. Past costs, also known as sunk costs, are not relevant in decision making because they have already been incurred; therefore, these costs cannot be changed no matter which alternative is selected.

For certain decisions, revenues do not differ between alternatives. Under those circumstances, management should select the alternative with the least cost. In other situations, costs do not differ between alternatives. Accordingly, management should select the alternative that results in the largest revenue. Many times both future costs and revenues differ between alternatives. In these situations, the management should select the alternative that results in the greatest positive difference between future revenues and expenses (costs).

To illustrate relevant, differential, and sunk costs, assume that Joanna Bennett invested $400 in a tiller so she could till gardens to earn $1,500 during the summer. Not long afterward, Bennett was offered a job at a horse stable feeding horses and cleaning stalls for $1,200 for the summer. The costs that she would incur in tilling are $100 for transportation and $150 for supplies. The costs she would incur at the horse stable are $100 for transportation and $50 for supplies. If Bennett works at the stable, she would still have the tiller, which she could loan to her parents and friends at no charge.

The tiller cost of $400 is not relevant to the decision because it is a sunk cost. The transportation cost of $100 is also not relevant because it is the same for both alternatives. These costs and revenues are relevant (note: differential means difference):

Based on this differential analysis, Joanna Bennett should perform her tilling service rather than work at the stable. Of course, this analysis considers only cash flows; nonmonetary considerations, such as her love for horses, could sway the decision.

In many situations, total variable costs differ between alternatives while total fixed costs do not. For example, suppose you are deciding between taking the bus to work or driving your car on a particular day. The differential costs of driving a car to work or taking the bus would involve only the variable costs of driving the car versus the variable costs of taking the bus.

Suppose the decision is whether to drive your car to work every day for a year versus taking the bus for a year. If you bought a second car for commuting, certain costs such as insurance and an auto license that are fixed costs of owning a car would be differential costs for this particular decision.

Before studying the applications of differential analysis, you must realize that opportunity costs are also relevant in choosing between alternatives.  An opportunity cost is the potential benefit that is forgone by not following the next best alternative course of action. For example, assume that the two best uses of a plot of land are as a mobile home park (annual income of $100,000) and as a golf driving range (annual income of $60,000). The opportunity cost of using the land as a mobile home park is $60,000, while the opportunity cost of using the land as a driving range is $100,000.

Companies do not record opportunity costs in the accounting records because they are the costs of not following a certain alternative. Thus, opportunity costs are not transactions that occurred but that did not occur. However, opportunity cost is a relevant cost in many decisions because it represents a real sacrifice when one alternative is chosen instead of another.

Applying Differential Analysis

Applications of differential analysis

To illustrate the application of differential analysis to specific decision problems, we consider five decisions:

  1. setting prices of products;
  2. accepting or rejecting special orders;
  3. adding or eliminating products, segments, or customers;
  4. processing or selling joint products; and
  5. deciding whether to make products or buy them.

Although these five decisions are not the only applications of differential analysis, they represent typical short-term business decisions using differential analysis. Our discussion ignores income taxes.

Pricing Decisions

When applying differential analysis to pricing decisions, each possible price for a given product represents an alternative course of action. The sales revenues for each alternative and the costs that differ between alternatives are the relevant amounts in these decisions. Total fixed costs often remain the same between pricing alternatives and, if so, may be ignored. In selecting a price for a product, the goal is to select the price at which total future revenues exceed total future costs by the greatest amount, thus maximizing income.

A high price is not necessarily the price that maximizes income. The product may have many substitutes. If a company sets a high price, the number of units sold may decline substantially as customers switch to lower-priced competitive products. Thus, in the maximization of income, the expected volume of sales at each price is as important as the contribution margin per unit of product sold. In making any pricing decision, management should seek the combination of price and volume that produces the largest total contribution margin. This combination is often difficult to identify in an actual situation because management may have to estimate the number of units that can be sold at each price.

Make or Buy Decisions

Managers also apply differential analysis to make-or-buy decisions. A make-or-buy decision occurs when management must decide whether to make or purchase a part or material used in manufacturing another product. Management must compare the price paid for a part with the additional costs incurred to manufacture the part. When most of the manufacturing costs are fixed and would exist in any case, it is likely to be more economical to make the part rather than buy it.

Make or Buy Example

To illustrate the application of differential analysis to make-or-buy decisions, assume that Small Motor Company manufactures a part costing $6 for use in its toy automobile engines. Cost components are: materials, $3.00; labor, $1.50; fixed overhead costs, $1.05; and variable overhead costs, $0.45. Small could purchase the part for $5.25. Fixed overhead would presumably continue even if the part were purchased. The added costs (variable costs only) of manufacturing amount to $4.95 ($3.00 DM + $1.50 DL + $0.45 Variable OH). This amount is 30 cents per unit less than the purchase price of the part. Therefore, manufacturing the part should be continued as shown in the following analysis:

In make-or-buy decisions, management also should consider the opportunity cost of not utilizing the space for some other purpose. In the previous example, if the opportunity costs of not using this space in its best alternative use is more than 30 cents per unit times the number of units produced, the part should be purchased.

In some manufacturing situations, firms avoid a portion of fixed costs by buying from an outside source. For example, suppose eliminating a part would reduce production so that a supervisor’s salary could be saved. In such a situation, firms should treat these fixed costs the same as variable costs in the analysis because they would be relevant costs.

Sometimes the cost to manufacture may be only slightly less than the cost of purchasing the part or material. Then management should place considerable weight on other factors such as the competency of existing personnel to undertake manufacturing the part or material, the availability of working capital, and the cost of any loans that may be necessary.

Accepting or Rejecting Special Orders

Sometimes management has an opportunity to sell its product in two or more markets at two or more different prices. Movie theaters, for example, sell tickets at discount prices to particular groups of people—children, students, and senior citizens. Differential analysis can determine whether companies should sell their products at prices below regular levels.

Good business management requires keeping the cost of idleness at a minimum. When operating at less than full capacity, management should seek additional business. Management may decide to accept such additional business at prices lower than average unit costs if the differential revenues from the additional business exceed the differential costs. By accepting special orders at a discount, businesses can keep people employed that they would otherwise lay off.

Adding or Eliminating

Periodically, management has to decide whether to add or eliminate certain products, segments, or customers. If you have watched a store or a plant open or close in your area, you have seen the results of these decisions. Differential analysis is useful in this decision making because a company’s income statement does not automatically associate costs with certain products, segments, or customers. Thus, companies must reclassify costs as those that the action would change and those that it would not change.

If companies add or eliminate products, they usually increase or decrease variable costs. The fixed costs may change, but not in many cases. Management bases decisions to add or eliminate products only on the differential items; that is, the costs and revenues that change.

Capital Budgeting

Capital budgeting is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds, within the framework of company goals and objectives. A capital project is any available alternative to purchase, build, lease, or renovate buildings, equipment, or other long-range major items of property. The alternative selected usually involves large sums of money and brings about a large increase in fixed costs for a number of years in the future. Once a company builds a plant or undertakes some other capital expenditure, its future plans are less flexible.

Typical capital budgeting decisions are:

  1. Decision to purchase equipment to reduce cost
  2. Decision to expand by purchasing a new facilities.
  3. Decision to make a purchasing decision on which equipment to buy.
  4. Decision to replace equipment

Poor capital-budgeting decisions can be costly because of the large sums of money and relatively long periods involved. If a poor capital budgeting decision is implemented, the company can lose all or part of the funds originally invested in the project and not realize the expected benefits. In addition, other actions taken within the company regarding the project, such as finding suppliers of raw materials, are wasted if the capital-budgeting decision must be revoked. Poor capital-budgeting decisions may also harm the company’s competitive position because the company does not have the most efficient productive assets needed to compete in world markets.

Making capital-budgeting decisions involves analyzing cash inflows and outflows. This section shows you how to calculate the benefits and costs used in capital-budgeting decisions. Because money has a time value, these benefits and costs are adjusted for time.

The Time Value of Money

Money received today is worth more than the same amount of money received at a future date, such as a year from now. This principle is known as the time value of money. Money has time value because of investment opportunities, not because of inflation. For example, $100 today is worth more than $100 to be received one year from today because the $100 received today, once invested, grows to some amount greater than $100 in one year. Future value and present value concepts are extremely important in assessing the desirability of long-term investments (capital budgeting).

The net cash inflow (as used in capital budgeting) is the net cash benefit expected from a project in a period. The net cash inflow is the difference between the periodic cash inflows and the periodic cash outflows for a proposed project.

Asset Replacement

Asset replacement:  Sometimes a company must decide whether or not it should replace existing plant assets. Such replacement decisions often occur when faster and more efficient machinery and equipment appear on the market.

The computation of the net cash inflow is more complex for a replacement decision than for an acquisition decision because cash inflows and outflows for two items (the asset being replaced and the new asset) must be considered. To illustrate, assume that a company operates two machines purchased four years ago at a cost of $18,000 each. The estimated useful life of each machine is 12 years (with no salvage value). Each machine will produce 40,000 units of product per year. The annual cash operating expenses (labor, repairs, etc.) for the two machines together total $14,000. After the old machines have been used for four years, a new machine becomes available. The new machine can be acquired for $28,000 and has an estimated useful life of eight years (with no salvage value). The new machine produces 60,000 units annually and entails annual cash operating expenses of $10,000. The $4,000 reduction in operating expenses ($14,000 for old machines – $10,000 for the new machine) is a $4,000 increase in net cash inflow (savings) before taxes.

The firm would pay $28,000 in the first year to acquire the new machine. In addition to this initial outlay, the annual net cash inflow from replacement is computed as follows:

Notice that these figures concentrated only on the differences in costs for each of the two alternatives. Two other items also are relevant to the decision. First, the purchase of the new machine creates a $28,000 cash outflow immediately after acquisition. Second, the two old machines can probably be sold, and the selling price or salvage value of the old machines creates a cash inflow in the period of disposal. Also, the previous example used straight-line depreciation.
Out-of-pocket and sunk costs A distinction between out-of-pocket costs and sunk costs needs to be made for capital budgeting decisions. An out-of-pocket cost is a cost requiring a future outlay of resources, usually cash. Out-of-pocket costs can be avoided or changed in amount. Future labor and repair costs are examples of out-of-pocket costs.

Sunk Cost

Sunk costs are costs already incurred. Nothing can be done about sunk costs at the present time; they cannot be avoided or changed in amount. The price paid for a machine becomes a sunk cost the minute the purchase has been made (before that moment it was an out-of-pocket cost). The amount of that past outlay cannot be changed, regardless of whether the machine is scrapped or used. Thus, depreciation is a sunk cost because it represents a past cash outlay. Depletion and amortization of assets, such as ore deposits and patents, are also sunk costs.

A sunk cost is a past cost, while an out-of-pocket cost is a future cost. Only the out-of-pocket costs (the future cash outlays) are relevant to capital budgeting decisions. Sunk costs are not relevant, except for any effect they have on the cash outflow for taxes.

Initial cost and salvage value: Any cash outflows necessary to acquire an asset and place it in a position and condition for its intended use are part of the initial cost of the asset. If an investment has a salvage value, that value is a cash inflow in the year of the asset’s disposal.

Cost of Capital

The cost of capital: The cost of capital is important in project selection. Certainly, any acceptable proposal should offer a return that exceeds the cost of the funds used to finance it. Cost of capital, usually expressed as a rate, is the cost of all sources of capital (debt and equity) employed by a company. For convenience, most current liabilities, such as accounts payable and federal income taxes payable, are treated as being without cost. Every other item on the right (equity) side of the balance sheet has a cost. The subject of determining the cost of capital is a controversial topic in the literature of accounting and finance and is not discussed here. We give the assumed rates for the cost of capital in this book. Next, we describe several techniques for deciding whether to invest in capital projects.

Short Term Business Decisions

Payback period

The payback period is the time it takes for the cumulative sum of the annual net cash inflows from a project to equal the initial net cash outlay. In effect, the payback period answers the question: How long will it take the capital project to recover, or pay back, the initial investment?

If the net cash inflows each year are a constant amount, the formula for the payback period is:

Payback Period=Initial Cash Outlay/Annual net cash inflow

Payback Period = $120,000/$18,200 = 6.6 years.

For the two assets discussed in the previous section, you can compute the payback period as follows. The purchase of the $120,000 equipment creates an annual net cash

Remember that the payback period indicates how long it will take the machine to pay for itself. The replacement machine being considered has a payback period of 10.8 years but a useful life of only 8 years. Therefore, because the investment cannot pay for itself within its useful life, the company should not purchase a new machine to replace the two old machines.

When using payback period analysis to evaluate investment proposals, management may choose one of these rules to decide on project selection:

  • Select the investments with the shortest payback periods.
  • Select only those investments that have a payback period of less than a specified number of years.