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Posted in 6. Operations by Erin Lawlor on the December 1st, 2008

<< How to Use Financials and Ratios

Businesses live or die on the value of their products and services.   Similarly, individuals and departments within businesses survive on the value of their internal products.  Accounting is no different.  Accounting provides both services and products that add value to an organization.

The most important thing in accounting is to understand accounting and your own accounting systems.  But, if you want to truly succeed, think beyond debits, credits and reconciliations and become an expert in your company’s industry.   Financial accounting knowledge transfers fairly seamlessly from one business to another but specific industry and management accounting knowledge may not and it is through that kind of knowledge that you can add value to your organization.

Research your industry, spend time with operations people, become familiar with what their processes are and the order in which they occur.   Learn how they use their information systems, understand the logic behind both the information they track and the order in which that information is organized.  Become familiar with the way your systems interact, how they are dependent on each other and how they are independent of each other.   Find out from them what information they have and what information they wish they could have.  Ask them if they use reports from accounting, if so, do they find them to be reliable, timely and useful.  (Always make sure to have the appropriate permissions for internal research).

As an accountant you perform the financial functions that keep a business going but you are also the custodian of a wide variety of business information.  In addition to standard accounting data, you have access to information about lenders, suppliers, customers and operations.  As you increase your understanding of your company and industry you will increase your understanding of the information available to you.   Find ways to increase and improve the information you can make available to your company and you will have a real impact on its success and on the value you add to it.

© 2008-2010 Erin Lawlor

<< How to Use Financials and Ratios

**disclaimer: All information posted on this blog is from my own experience and training. The guidelines I present are general and in my experience, standard practice. I do not write with authority from any Accounting Standards Boards.

How to Use Financial Statements and Ratios

Posted in 2. Double Entry Transactions,5. Financial Statements,6. Operations by Erin Lawlor on the September 24th, 2008

<< Accounting System Structure – Quick Reference

This post talks about how to make use of the information in Financial Statements.  Those statements are really the results of past operations.  It is important to use this information to be proactive and look to the future to predict results and to set goals, expectations and budgets based on the evidence provided from the past.

Time analysis is the most important tool you will use in analyzing your Financial Statements.  It is essential in managing and securing resources because it can quickly pinpoint changes that indicate errors or fraud as well as the unexpected changes that might require adjustments to cash planning and/or operations.

The first Statement to look at is the Comparison Trial Balance.  This Statement is very important, it shows the amounts posted to each account month by month complete with totals at the end.  The month to month analysis is extremely important for verifying your numbers before you start with ratio analysis.

You can either show all accounts on this Statement or you can limit it to Income Statement Accounts. I choose to include both types of Accounts so I can track the changes in Financial Position provided by the Balance Sheet Accounts.

I’ve added a few entries to the Comparison Trial Balance Report from posts # 7 and 9.   You can see that the monthly changes in Rent Expense for Oct and Nov will catch your attention.

Account Description Jun Jul Aug Sept Oct Nov Dec Total
1000 Checking -$3,000 $-3,000 $-3,000 -$3,000 -$3,000 -$3,000 -$3,000 $-21,000
2000 Accounts Payable $0 $0 $0 $0 -$3,000 $3,000 $0.
7000 Rent $3,000 $3,000 $3,000 $3,000 $6,000 $0 $3000 $21,000
Totals $0 $0 $0 $0 $0 $0 $0 $0

**This example starts with June because of space limitations here.  The additional entries for all months except September are not included in the Income Statement or Balance Sheet, I’ve only added them here for illustration.

Let’s start with Financial Ratios by looking at the Income Statement and its ratios.

Income Statement:

The Income Statement gives you a good overview of your Expenses in relation to your Revenue.  It can also help to pinpoint potential problems.

As the dollar value of Sales changes, the dollar values of Costs of Goods and Expenses should also change.   By tracking the changes in dollar values in terms of percentages of sales, you can more easily evaluate whether changes in dollar amounts are reasonable.

The percentages are based on a Percentage of Sales.  So, Gross Profit Margin = Gross Margin/Sales, Net Profit Margin = Net Income(Profit)/Sales etc.

Know your percentages. Watch your trends over time, both as they accumulate throughout the fiscal year, and as they compare month to month and year to year. Percentages can also be compared to industry ratio standards to measure your results against others in your industry.

Some expenses like wages and payroll taxes, or general office expenses are more meaningful when grouped together to find a percentage of the group rather than as a single line item.

This is the Income Statement that developed through the progressive post entries.

Income Statement % of Sales
Sales $50,000
Cost of Goods Sold $0 0%
————
Gross Margin $50,000 100% Gross Profit Margin %
Rent $3,000 6%
Office Supplies $150
Subscriptions $300
Utilities $125
Fuel $275
Repairs & Maintenance $500
Credit Card Interest $50
———–
Operating Expenses $4,400 9%
———–
Operating Income $45,600 91% Operating Profit Margin %
Other Revenues and Expenses $0
Net Income $45,600 91% Net Profit Margin %

This is a very limited Income Statement Example built from very few entries, but even with the information available, it gives useful information.  There is also obviously a problem with this Income Statement, it has no Cost of Goods Sold to relate to Sales.  In this case, we’re either missing information or we’re violating the Revenue Principle and recording Sales before they’ve been earned.  (Pinpointed Problem)

Gross Margin is also called Gross Profit or even Gross Profit Margin and the terms Income and Profit are also often used interchangeably.  Just be consistent in your terminology so that users will not be wondering if there is a difference in meaning if you use a different term.

**Comparing your business against other businesses in your industry is called Benchmarking.  There are a number of free or fee based benchmarking services online.

Remember that the Income Statement is a Yearly Statement, all its accounts are reset to zero at the end of each year and the difference (Net Income) is transferred to the Equity section of the Balance Sheet as either Retained Earnings (for Corporations) or as Owners Capital (for all other types of entities).

Balance Sheet Ratios:

The Balance Sheet gives you a good overview of your financial position at any point in time.  The Balance Sheet is not a Yearly Statement, it is a cumulative statement whose accounts retain their balances from the beginning to the end of the entity.

All Assets and Liabilities on the Balance Sheet should contribute to increasing the value of the entity.  If they are not contributing, they might need to be liquidated.

The “Current” sections of the Balance Sheet are important to keep track of because it will be Current Assets which will pay off Current Liabilities, you want to make sure you have at least as many Current Assets as Current Liabilities.  The items in the Current Sections are considered to be the most liquid, that is, they are the most likely to be able to convert to cash at (or close to) their stated value.

Two Assets to pay particular attention to are Accounts Receivable and Inventory.  Receivables are an essential tool in doing business, they finance purchases for your customers but it is important to watch their aging and balances to make sure you are not extending credit to customers who are unable to pay.  Watch Inventory turnover to make sure you that your inventory is selling and that you are not carrying obsolete or otherwise unsellable items.

Purchases that your Vendors finance for you are liabilities called Payables.  Payables and other Liabilities are essential for financing current operations and growth but keep close track of their related interest and fees to make sure their costs do not exceed their benefits.

Balance Sheet
Assets
Current Assets
1000 Checking Account $44,350
Fixed Assets
1500 Office Equipment $1,300
1520 Office Furniture $1,650
————
Total Fixed Assets $2,950
————
Total Assets $47,300
Liabilities and Equity
Current Liabilities
2000 Accounts Payable $1,700
————
Total Liabilities $1,700
Equity
Net Income $45,600
————
Total Liabilities and Equity $47,300

Some important financial ratios to keep track of are:

Current Ratio which is Current Assets/Current Liabilities this ratio should always be at least 1

Quick Ratio = Current Assets – Inventory/Current Liabilities this ratio removes Inventory from Current Assets because Inventory is usually the least liquid of the Current Assets.

The next ratios are approximations, they give you a good idea about what they are measuring.  They are general enough to give you an idea about where to look for trouble items but they are not specific enough to be fool proof.

Inventory Turnover = Sales/Inventories this ratio gives you a rough idea of how many times your inventory is sold and restocked.  Of course, it does not specifically identify inventory items so there may be items that are not selling but it does tell you how well your sales are covering your costs.

Days Sales Outstanding = Receivables/(Sales/360) this ratio gives you a number that represents aging of your receivables.  If your terms are net 30 days and this ratio gives you a number of 45 or more, then it is a good indicator that you should watch your collections carefully.

Fixed Asset Turnover = Sales/Net Fixed Assets (Fixed Assets – Accumulated Depreciation) this ratio provides an idea of how effectively your Fixed assets are contributing to operations.   This ratio can be slightly misleading because Assets are carried at book value rather than market value which might scew this ratio depending on the age of the Assets.

Total Assets Turnover = Sales/Total Assets this ratio provides an idea of how effectively your total assets contribute to operations and increases in entity value.  Although this ratio will have the same problems as the Fixed Asset Turnover ratio both of these ratios are still important to recognize and watch for trends.

As I said at the beginning of this post, know your percentages (ratios) watch them carefully.  You should use them to your advantage for predictions, corrections and budgets for your current and future operations and policies.

© 2008 – 2010 Erin Lawlor

<< Accounting System Structure – Quick Reference

**disclaimer: All information posted on this blog is from my own experience and training. The guidelines I present are general and in my experience, standard practice. I do not write with authority from any Accounting Standards Boards.

Comments Off on How to Use Financial Statements and Ratios

Percentage of Completion and Work in Progress

Posted in 6. Operations by Erin Lawlor on the September 11th, 2008

<< Cost of Goods Sold and Inventory Accounting Journals and Ledgers

The Revenue Principle of GAAP requires Revenue to be recorded in the period it is Earned regardless of when it is billed or when cash is received.

In some cases, it is simple to determine the timing for Revenues Earned, once ownership of a product is transferred or a service is complete, revenue is considered to have been earned.  But if revenue recognition were delayed until the end of a long term contract, the Matching Principle of tying revenues and their direct costs to each other would be violated.  The solution to this problem is the Percentage of Completion method of Revenue Recognition.

Contract Revenues are tied to Costs, but Billings on Contracts are not always tied to Costs. Sometimes elements of a contract are billed in advance or sometimes they are delayed by mutual agreement (or disagreement). This mismatch between actual billed revenue and earned revenue will require an adjusting entry but since the Percentage of Completion method adjusts billed revenue to reflect earned revenue, billings are posted to revenues and adjusted later to reflect the correct earned revenue amount. (Debit Accounts Receivable, Credit Sales).

Long Term Contracts will have estimates for both sides of a contract, Costs and Revenues.  Calculating Percentage of Completion requires both total actual and total estimated numbers to calculate a percentage so it uses the side where both the actual and estimated numbers can be known, Costs.

  • Percent Complete = Actual Costs to Date / Total Estimated Costs

The Percent Complete is then applied to the Total Estimated Revenue to determine Earned Revenue to Date.

  • Earned Revenue to Date = Percent Complete * Total Estimated Revenue

Finally, the Earned Revenue to Date is compared to the Billings on Contract to Date.  The difference is either added to or subtracted from the Revenue.

  • Total Billings on Contract – Earned Revenue to Date = Over/Under Billed Revenue


**The Over/Under Billed Revenue accounts are Balance Sheet Accounts and they are often called either Billings in Excess of Costs (liability account that reflects over-billings) or Costs in Excess of Billings (asset account that reflects under-billings).

Work In Progress Statement:

A Work in Progress Statement is used to compile the information necessary for the percentage of completion calculations but also to provide crucial information about the total value and progress of work on hand inventory.

Description Contract Value Actual Billings to Date Actual Costs to Date Total Est. Costs Est. Costs to Complete Estimated Gross Profit % Complete Earned Revenue to Date Over Billings Under Billings
Contract A 50,000 35,000 30,000 40,000 10,000 10,000 75% 37,500 2,500
Contract B 52,500 27,500 22,500 45,000 22,500 7,500 50% 26,250 1,250
Totals 102,500 62,500 52,500 85,000 32,500 17,500 62% 63,750 1,250 2,500
1,250

So, for Contract A

  • Percentage Complete = 30,000 / 40,000 = .75
  • Earned Revenue = 50,000 * .75 = 37,500
  • Over/Under Billings = 37,500 – 35,000 = 2,500 (Under-Billed)

Entries to record Over/Under Billings:

Account Description Debits Credits
1250 Costs in Excess of Billings $2,500
2050 Billings in Excess of Costs $1,250
4000 Sales $1,250
$2,500 $2,500

What if there were prior balances in the Costs and Billings in Excess Accounts?

The amounts from Work in Progress Statement are either Total Estimates or Total Amounts to Date. This means that the over/under amounts are also total to date amounts. Over/Under adjustment entries are made to adjust total numbers to their “To Date” amounts. If there were previous entries, there would also be previous balances in the Costs/Billings in excess accounts. New entries should bring their balances to the new “To Date” amounts.

Assume that the Costs in Excess of Billings account had a previous balance of 1,000 and the Billings in Excess of Costs account had a previous balance of 500. The net prior amount is Costs in Excess of 500 meaning that earned revenue has already been adjusted for that 500 and only requires an additional adjustment of 1,250 – 500 = 750.  Instead of the entries listed above, the entries to adjust Earned Revenue in this case would be.

Account Description Debits Credits
2050 Billings in Excess of Costs $500
1250 Costs in Excess of Billings $2,500
1250 Costs in Excess of Billings $1,000
2050 Billings in Excess of Costs $1,250
4000 Sales $750
$3,000 $3,000

Notice that I completely removed the previous balances from both the Costs and Billings in Excess Accounts instead of just making net entries to bring them up to the current balance. This creates a good audit trail for future account analysis.

© 2008 – 2010 Erin Lawlor

Next: >> Accounting Journals and Ledgers

<< Cost of Goods Sold and Inventory

**disclaimer: All information posted on this blog is from my own experience and training. The guidelines I present are general and in my experience, standard practice. I do not write with authority from any Accounting Standards Boards.

Cost of Goods Sold and Inventory

Posted in 6. Operations by Erin Lawlor on the September 7th, 2008

<< Financials – Statement of Cash Flows >>WIP Statement and Percent of Completion

The purpose of an Inventory System in Financial Accounting is to account for resources and to match costs to their related sales as closely as possible. Management Accounting is more concerned with the details of inventory management but for Financial Accounting, when inventory is purchased or sold, the objective is to satisfy the Matching Principle and to accurately represent the financial position of the entity.

The Matching Principle requires that revenues and their related costs be matched up and posted into the same accounting period. When Inventory is purchased and before it is sold, there are no revenues to match it to so it cannot be considered a cost until it is sold.

The inventory examples assume that the entity has ownership of products purchased and that they are purchased and manufactured for sale as finished goods. There are cases where the entity purchasing materials for and accounting for a project are not the owners of the product even as it is in the process of construction or manufacturing. In these cases, purchases are debited directly to Income Statement Cost accounts. The key concept is ownership.

There are two systems used to account for Inventory, the Periodic System and the Perpetual System. Each has its own accounting methods and I’ll demonstrate those methods here. I will not be explaining Inventory Valuation methods (FIFO, LIFO, Specific Identification etc.)

Periodic Inventory System – Assumes Entity Owns Inventory until Sale:

The first system I’ll demonstrate is the Periodic System. The Periodic System may work well for companies where changes in sales can be tied closely to changes in inventory purchases. Under this system, as inventory is purchased, it is debited to the Income Statement Account “Purchases” and the Balance Sheet Account “Inventory” is adjusted at the end of the year when the available inventory is counted and valued. At this time, the balances of the Inventory and Purchase Accounts are transferred to Cost of Goods Sold Account and the value of the Ending Inventory is transferred back from Cost of Goods Sold to Ending Inventory.

Entry for purchases throughout the year.

Account Description Debits Credits
5050 Purchases $10,000
2000 Accounts Payable $10,000

*In the entry above, the credit entry could be cash, I chose Accounts Payable because it will be the most common account used in this situation.

At the end of the year, inventory is counted and valued and adjusting entries are made to the Balance Sheet and Income Statement Accounts.

This entry assumes prior entries and the following account balances at the end of the year: Beginning Inventory of $5,000, Purchases of $60,000 and Ending Inventory of $6,000.

Entry to transfer balances to Cost of Goods Sold and adjust the Inventory Account to equal the ending balance valuation.

Account Description Debits Credits
5000 Cost of Goods Sold $65,000
1375 Inventory $5,000
5050 Purchases $60,000
1375 Inventory $6,000
5000 Cost of Goods Sold $6,000

When working with accounts like Inventory under the Periodic Inventory system, I prefer to remove the entire account balance and make the adjusting entry equal to the new ending balance. This strategy makes future auditing of the account more clear.

Freight-In is considered a direct cost of inventory because all costs that are directly related to the acquisition and preparation for sale of inventory are considered part of its direct cost. Freight-In is not included in the adjusting entries, it is maintained in a separate account. Freight-In is an Income Statement Cost Account.

Companies using the Periodic Inventory System provide more detail for Cost of Goods Sold on the Income Statement and expand the entry to include the Cost of Goods Sold calculation/statement.

The format for the Cost of Goods Sold Statement is:

  • + Beginning Inventory
  • + Net Purchases (Inventory Purchases – Returns)
  • + Freight “In” Charges
  • – Ending Inventory
  • ————————–
  • Cost of Goods Sold

Perpetual Inventory System – Assumes Entity Owns Inventory until Sale:

The next system is the Perpetual Inventory System. Using this system, inventory purchases are debited to a Balance Sheet Inventory account rather than an Income Statement Purchase account and they are transferred to the Cost of Goods Sold account at the time of sale.

Under the perpetual system, products that are purchased as finished goods are accounted for in one inventory account but products that will be manufactured use three inventory accounts, raw materials, work in progress and finished goods.

For the purposes of this entry, I will use one Cost of Goods Accounts (5000), three Inventory Accounts (in the 1300 range) and one Revenue Account (4000 – Sales). The Account Numbers are not important to the concept, they are used here to provide easy identification. The important concept is the difference between Cost of Goods which is an Income Statement Item and Inventory which is a Balance Sheet Item.

In the case of retail, where products are purchased as finished goods and then resold, products are owned by the seller until sold. An example of the initial cost entry is:

Account Description Debits Credits
1375 Inventory $1,500
2000 Accounts Payable $1,500

There are two entries to make when Products (Inventory) are sold:

Record the Sale:

Account Description Debits Credits
1200 Accounts Receivable $3,000
4000 Sales $3,000

And then transfer the Cost of the products that were sold from Inventory to Cost of Goods:

Account Description Debits Credits
5000 Cost of Goods Sold $1,500
1375 Inventory $1,500

In the case of Value Added or Manufacturing, all costs related to purchasing materials and preparing them for sale are included in their value. When a company purchases Raw Materials well in advance a Raw Materials Inventory Account is used. In cases where the company is manufacturing or constructing a product for sale but only purchases inventory as it is required, the Raw Materials Inventory Account is skipped and the Purchases are debited directly into the Work in Progress Inventory Account.

Purchase of Raw Materials In Advance:

Account Description Debits Credits
1300 Inventory – Raw Materials $500
2000 Accounts Payable $500

To Record the purchase of Raw Materials that will be put to immediate use:

Account Description Debits Credits
1325 Inventory – Work in Progress (Materials) $500
2000 Accounts Payable $500

Or, to transfer the cost of the Raw Materials that are in the process of Manufacturing to Work in Progress.

Account Description Debits Credits
1325 Inventory – Work in Progress (Materials) $500
1300 Inventory – Raw Materials $500

To Record Direct Labor:

Account Description Debits Credits
1325 Inventory – Work in Progress (Labor) $500
2000 Operating Account $500

To Transfer the Cost of the Value Added or Manufactured Goods that are completed to Finished Goods:

Account Description Debits Credits
1375 Inventory – Finished Goods $1,500
1325 Inventory – Work in Progress $1,500

* Credit entries are “Source of Funds/Value” entries and for these examples they are either cash – Operating (Bank) Account, a delay in cash – Accounts Payable OR they are Transfers of Values. For cash or cash delays, I selected the accounts that would be the most commonly used for each. Payroll is usually posted when it is paid and Purchases are often made on account.

Sales/Revenue Entries

There are two entries to make when Products (Inventory) are sold:

Record the Sale:

Account Description Debits Credits
1200 Accounts Receivable $3,000
4000 Sales $3,000

And then transfer the Cost of the products that were sold from Inventory to Cost of Goods:

Account Description Debits Credits
5000 Cost of Goods Sold $1,500
1375 Inventory $1,500

Cost of Goods Sold, Services – No Inventory:

In the case of Services, there is no product for ownership transfer so, an example of the the initial cost entry is simple:

Account Description Debits Credits
5000 Cost of Goods (Labor) $1,000
1000 Operating Account $1,000

The entry for the sale of services is as simple as the entry for its cost:

Account Description Debits Credits
1200 Accounts Receivable $2,000
4000 Sales $2,000

Cost of Goods Sold: No Inventory Accounting, Assumes Entity does not Own Inventory:

The Cost entries are simply made directly to the Income Statement Cost Accounts.

Account Description Debits Credits
5000 Labor Costs $5,000
5100 Equipment Costs $5,000
5200 Materials Costs $20,000
5300 Subcontract Costs $60,000
1000 Operating Account $5,000
2000 Accounts Payable $85,000

The Revenue entries for this Cost of Goods Sold case will be the same as the Revenue Entry above for Services. However, if the manufacturing or construction of the product extends over several accounting periods, there are additional entries that may have to be made to adjust a portion of the Revenue Entry into a either an “Under-Billings” Asset account or an “Over-Billings” Liability account in order to satisfy the Revenue Principle. I will address those adjustments in the next post.

© 2008 – 2010 Erin Lawlor

Next Up:>> >>Work in Progress Statement and Percent Complete Revenue Adjustments

<< Financial Statements – Statement of Cash Flows

**disclaimer: All information posted on this blog is from my own experience and training. The guidelines I present are general and in my experience, standard practice. I do not write with authority from any Accounting Standards Boards.