I stumbled upon a blog called Joel on Software a couple of years ago and have been a fan and a reader ever since.  So, when the writer, Joel Spolsky, partnered up with Jeff Atwood (codinghorror.com) for this new site, I was curious and when I started listening to their weekly podcasts (they’ve done 32 as of this writing) I was hooked.

This week, their podcast included a topic that I wanted to talk about and relate to my experience in writing my “blog”.  I encourage you to follow the link above for stackoverflow and listen to the latest podcast (at least starting at about 34:45 and ending at about 55:15) the discussion is very insightful.

The topic I want to write about is how to stay positive after receiving negative feedback.  Actually, I have received both good and bad feedback for my site, I try to give them equal consideration.  I received one comment that told me my site was poo.  My initial reaction to that comment was that the person was just mean because clearly, my site is not poo to me.  But then I tried to be more open to what that person might be trying to tell me.  Perhaps that person was looking for a quick answer to a question and was frustrated because it is likely that there are no quick answers here.   In that sense, I failed the frustrated commenter.

The negative comment caused me to evaluate my writing more than any positive comment would.  I am still not a quick answer person but I do try to keep in mind that posts that are too wordy are boring and unhelpful.  My conclusion is that instead of allowing negative comments to hurt your feelings, step back and take another look and decide what there is to be learned from them.  Don’t dwell on the negative, instead, appreciate the opportunity to learn from it.  Applying this philosophy to the negative feedback you receive in life - including unsuccessful sales, job interviews or blogs can only help you to improve and become more successful.

To address the frustrated commenter, the only possible way I can give a quick answer is to have a clear question first.  I invite/encourage you to put your questions in the comment section.   It is likely that either I or other readers will be able to provide an answer that will be helpful for you.

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.

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. 

**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.

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.

<< 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.

This post is a quick overview of subjects covered in more detail in other posts. I usually like to see a quick version so I am trying to present that option to others as well.

The Double Entry Accounting System collects, organizes, summarizes and reports on Financial Transaction data.

Financial Transactions: Exchanges of things of value.

There are three basic questions that must be answered for each financial transaction, they are:

• Question 1. How much money changed hands? What is the value of this exchange?
• Question 2: How was the money used?  What was either gained or paid for by this exchange?
• Question 3: Where did the money come from? What is the source of funds in this exchange?

Example:

• Answer 1: 3,000.00
• Answer 2: Rent
• Answer 3: Checking Account

The answers for each of the financial transaction questions are recorded in Journals.   Journals have a grid format with a varying number of columns but to start, we’ll use three columns.

The descriptions that answer questions 2 and 3 are always entered on separate lines to the left of the two numeric columns.

The amount associated with question 2 is entered on the same line as its description and it is always answered in the left (debit) numeric column. The amount associated with question 3 is entered on the same line as its description and it is always answered in the right (credit) numeric column.

General Journal Example:

To ensure that both sides of the transactions are recorded, Total Debits must always equal Total Credits.

Chart of Accounts: The Chart of Accounts is basically a list of the descriptions used to answer Transaction Questions 2 and 3.   Each unique description is called an account.  One of the best features of the Chart of Accounts is that when you have a new type of transaction you can just add a new description (account).

To keep the Chart of Accounts manageable and meaningful, it is important to strike a balance between having a long specific list and a short general list.  To accomplish this objective, the Chart of Accounts should have descriptions for types of things, and not for specific things.  You want the Accounts to be specific enough to be useful but not too specific because the fewer accounts you have the better overall picture you can have.

Chart of Accounts Organization: The Chart of Accounts is organized using three different methods.

• First:  Accounting Types
• Second:  Order of Liquidity - the ease of converting to cash
• Third: Account Numbers

The listing below shows the Chart of Accounts organization along with sample Account Number Ranges.

• Assets: 1000’s
  • Current Assets 1000 - 1499
  • Fixed Assets 1500 -1999
• Liabilities: 2000’s
  • Current Liabilities 2000 - 2499
  • Long Term Liabilities 2500 - 2999
• Equity: 3000’s
• Revenue: 4000’s
• Costs of Goods Sold: 5000’s
• I leave the 6000’s open to allow for a Cost of Goods Sold Subtype
• Expenses: 7000’s
• Other Revenue: 8000’s
• Other Expenses: 9000’s

Journals and Ledgers:

There are two types of Ledgers and Journals in the system, General and Subsidiary.   If you recall from above, I said that Accounts should only be created in the Chart of Accounts/General Ledger to describe types of things not individual things themselves. Well, in some cases especially in the case of cash substitutes like Accounts Payable and Accounts Receivable more detail is required. So, to maintain the summary nature of the Chart of Accounts/General Ledger and to provide more detail, a Subsidiary System of Journals and Ledgers was developed.

General Ledger: The General Ledger is the combination of the Chart of Accounts, Account Balances and Accounting Periods.  The General Ledger maintains the summary balances of ALL financial transactions.

The General Ledger adds the essential organizational element of Time (Accounting Periods) to the Accounting System, so in addition to the original three organizational methods of the Chart of Accounts, the General Ledger is organized in four ways.

• 1. Accounting Type
• 2. Order of Liquidity
• 3. Account Number
• 4. Accounting Periods

Accounting Periods are generally date/time intervals of Months, Quarters and Years. The element of time is essential to accounting.  It provides the ability to report balances for any given accounting period as well as the ability to compare the results of different accounting periods against each other.

If the system is going to organize around accounting periods, then we need to add dates to the data we gather with transactions.  There can be a variety of dates that are relevant to a transaction, the transaction date, the invoice date, the due date, the expiration date etc. but for purposes of this post, the date we’ll focus on is the transaction date.

The Journal transaction grid introduced in the previous section needs to be expanded to 5 columns to accommodate the new data requirements of date and account number.

General Journal Example:

Subsidiary Journals and Ledgers: The two most common Subsidiary Systems are:

• Accounts Payable
• Accounts Receivable

All financial transactions that involve a general ledger account with an associated subsidiary ledger must be recorded in that subsidiary ledger first.

Subsidiary Journal:

Notice that the Subsidiary Journal uses more columns than the General Journal.  It uses the extra columns to track data that is specific to the Subsidiary Ledger as well as to the General Ledger.

General Journal:

The system requires that all financial transactions have an entry in the General Journal as well as in the General Ledger.  So, once the entries are posted to the Subledger Journals, they are then summarized and posted to the General Journal.

General Journal
Transaction Date	Jrnl	Ref	Account	Description	Debit	Credit
9/01/08	AP	55	1520	Furniture & Fixtures	$1,650
9/01/08	AP	55	7300	Credit Card Interest & Fees	$50
9/01/08	AP	55	2000	Accounts Payable		$1,700

Notice the new columns in this General Journal example, they are cross referencing entries to show where the transaction was originally recorded.  The Jrnl in this example says AP = Accounts Payable and the Ref (55) is the same as in the AP Journal example above.  The Ref is the transaction reference number and will increment for each transaction.

Ledger Examples:

Each financial transaction is recorded in the appropriate Journals and then summarized and posted to the Ledger Accounts.

Accounts Payable Subledger						Account: ACEC
Transaction Date	Jrnl	Ref	Description	Debit	Credit	Balance
			Beginning Balance			$0
8/01/08	AP	23	123_0808 (invoice)		$2,500	$2,500
8/31/08	CD	37	123_0808 (payment)	$2,500		$0
9/01/08	AP	55	123_0908 (invoice)		$1,700	$1,700

General Ledger						Account: 2000
Transaction Date	Jrnl	Ref	Description	Debit	Credit	Balance
			Beginning Balance			$0
8/01/08	AP	23	Accounts Payable Invoices		$2,500	$2,500
8/31/08	CD	37	Cash Disbursements	$2,500		$0
9/01/08	AP	55	Accounts Payable Invoices		$1,700	$1,700

The Subsidiary Ledger (Subledger) is like the General Ledger/Chart of Accounts in that it contains a list of Accounts specific to its purpose.  The Accounts Payable SubLedger contains a list of AP Accounts and their balances.

The Total Balance of each Subledger must equal the balance of its related General Ledger Account Balance.  All financial transactions are recorded in the General Journal and the General Ledger and only the transactions with a gl account that has a related Subledger are posted to a Subsidiary Journal and Ledger.

If the Subledger does not Balance with its related account on the General Ledger, it means that there may be entries in either the Subledger or the General Ledger that are not in the other.  They should each have matching entries and there should be no entries made to the General Ledger for an Account with a related Subledger that are not also made to the Subledger and vice verse.

Next: How to Use Financial Statements and Ratios >>

<< Accounting Journals and Ledgers

**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.

The process of gathering and storing Financial Transaction data in the Accounting System is accomplished through the use of both:

• Ledgers: which maintain Account Balances
• Journals: which maintain the line by line detail of each Transaction.

Ledgers:

I’m starting with Ledgers because we’ve gone through the basic organization of the Accounting System from Double Entry (debit/credit) Transaction Posting, to the Chart of Accounts and finally the General Ledger.  I’ll stay on the topic of the General Ledger first and then back up to the Journals where each transaction is originally posted.

In Accounting, there are two types of Ledgers, the General Ledger (Book of final entry) and Subsidiary (Sub) Ledgers. The Accounts for the General Ledger come from the Chart of Accounts. The Accounts for the Subledgers depend on the specific purpose of the Subledger.

If you remember in the “Chart of Accounts - Basics”, I said that Accounts should only be created to describe types of things not individual things themselves. Well, in some cases especially in the case of cash substitutes like Accounts Payable and Accounts Receivable more detail is required. So, to maintain the summary nature of the Chart of Accounts/General Ledger and to provide more detail, Subsidiary (Sub) Ledgers were developed.

Everything that is posted into Subledgers is also posted into the General Ledger and they act together to provide progressive levels of detail/summary.

The two most common Subledgers are:

• The Accounts Payable Subledger: which maintains a list of Vendors (or creditors) and their individual Account Balances.  Each individual Vendor represents a Subledger (Accounts Payable - Vendor) Account.
• The Accounts Receivable Subledger: which maintains a list of Customers and their individual Account Balances.   Each individual Customer represents a Subledger (Accounts Receivable - Customer) Account.

Each Subledger relates directly to a General Ledger Account that requires more detail than the General Ledger can offer.  These GL Accounts are often referred to as control accounts. The Balance of a Control Account should always be equal to the total of its related Subledger Account Balances. As you can see, the total of the Accounts Payable Subledger below equals the Balance of the related General Ledger Accounts Payable Account.

General Ledger Account Description Debits Credits 1000 Checking Account $44,350 1200 Accounts Receivable $0 1500 Office Equipment $1,300 1520 Office Furniture $1,650 2000 Accounts Payable $1,700 4000 Sales $50,000 7000 Rent $3,000 7020 Office Supplies $150 7040 Subscriptions $300 7060 Utilities $125 7100 Fuel $275 7200 Repairs and Maintenance $500 7300 Credit Card Interest and Fees $50 Totals $51,700 $51,700

Accounts Payable Subledger Account Description Balance ACEC Ace Credit Card Corp. $1,700 JOHN Johnson Management $0 SHEL Shelton Oil $0 Totals (see GL Account 2000) $1,700

The listings above are Ledger Account summaries. Both the General Ledger and the Subledgers actually have a more detailed section for each Account. Those sections include summarized entries and balances along with references indicating which journals those entries originated in.

The tables below show an example of a Subledger Account and an example of the corresponding General Ledger Account.

Accounts Payable Subledger						Account: ACEC
Transaction Date	Jrnl	Ref	Description	Debit	Credit	Balance
			Beginning Balance			$0
8/01/08	AP	23	123_0808 (invoice)		$2,500	$2,500
8/31/08	CD	37	123_0808 (payment)	$2,500		$0
9/01/08	AP	55	123_0908 (invoice)		$1,700	$1,700

General Ledger						Account: 2000
Transaction Date	Jrnl	Ref	Description	Debit	Credit	Balance
			Beginning Balance			$0
8/01/08	AP	23	Accounts Payable Invoices		$2,500	$2,500
8/31/08	CD	37	Cash Disbursements	$2,500		$0
9/01/08	AP	55	Accounts Payable Invoices		$1,700	$1,700

Because there can be multiple Subledgers, there are also multiple Journals. The Jrnl field indicates which journal the entry came from. The AP’s in the jrnl field mean that those entries came from the Accounts Payable Journal and the CD entry came from the Cash Disbursements Journal which is the journal that maintains detail for Cash Outflows. The Jrnl and Ref field together give a cross reference that enable the user to access more detail about each entry.

Journals:

All financial transactions are recorded in Journals. The Journal maintains each individual transaction line by line. Just as there are two types of Ledgers, there are also two types of Journals: The General Journal and the Subsidiary Journals. Most entries will originate in Subsidiary Journals, however, if none of the GL Accounts affected by an entry have a related subsidiary journal, the entry will originate in the General Journal.

Everything that is posted into Subsidiary Journals is also posted into the General Journal. Journals act together with Ledgers to provide progressive levels of detail/summary.

Subsidiary Journal:

The format for Transactions in the the Subledger Journals is similar to the format for the General Journal that I’ve used in previous posts except they require at least three more columns in the grid. One for the Subledger Account, one for an Invoice Number and one for a Reference Number. This entry in the Accounts Payable Journal shows the detail for the both of the Ledger entries above that indicate Jrnl = AP and Ref = 55.

This entry records A Credit Card Statement into Accounts Payable, which includes the purchase of a Chair and a Desk along with Credit Card charges.

Accounts Payable Journal
Subledger Account	Invoice #	Transaction Date	Ref	GL Account	Description	Debit	Credit
ACEC	123_908	9/01/08	55	2000	Ace Credit Card Corp.		$1,700
				1520	Chair	$750
				1520	Desk	$900
				7300	Credit Card Interest & Fees	$50

Note that the Vendor Account, the Invoice #, Transaction Date and Ref# are not re-entered for each line. It is assumed that those three items remain the same for each of their balancing entries.

** Important: Individual transactions for each Subledger Account must have a unique identifying number, in this case, its an Invoice Number. That number combined with the Subledger Account creates a unique pair that prevents duplicate payments and provide a way for each party to reference the transaction for payments or if disputes or questions arise.

General Journal:

Since the system requires that all financial transactions have an entry in the General Ledger, they must also have an entry in the General Journal. This requires some duplication of effort but it is necessary. So, once the entries are posted to the Subledger Journals, they are then summarized and posted to the General Journal after which the Balances in the General Ledger are updated.

General Journal
Transaction Date	Jrnl	Ref	Account	Description	Debit	Credit
9/01/08	AP	55	1520	Furniture & Fixtures	$1,650
9/01/08	AP	55	7300	Credit Card Interest & Fees	$50
9/01/08	AP	55	2000	Accounts Payable		$1,700

The Path of entries for Financial Entries:

Transactions containing a GL Account that is related to a subsidiary journal start with the Subsidiary Journal otherwise they start with the General Journal

Subsidiary Journal –> Post to Subsidiary Ledger by its Account –> Post to General Journal —-> Summarize and post to General Ledger by GL Account.

Next: Accounting Structure - Quick Reference>>

<< Percentage of Completion and Work in Progress

**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.

This Post is a listing of which General Ledger Accounts are used by which Financial Statement.

Trial Balance: All Accounts

Trial Balance: Income Statement Accounts Only

The Income Statement uses the Accounts for Accounting Types:

• Income
• Costs (of goods sold)
• Expenses
• Other Income and Expenses

Trial Balance: Balance Sheet Accounts Only

The Balance Sheet uses Accounts for Accounting Types:

• Assets
• Liabilities
• Owners (Stockholders) Equity

These example accounts do not have beginning balances and no equity contributions.  If there had been equity contributions the equity accounts would also be included in this section of the trial balance.

Statement of Cash Flows: This Statement documents both the change in Cash Position and the change in Financial Position.  The Statement of Cash Flows is essentially a Yearly Balance Sheet with an emphasis on Cash.

Notice that debits and credits are presented in the way that they contribute to cash.  This report might take some adjusting to as the +/- of all debit and credit accounts except Cash are reversed.

Next up: >> Financials - Trial Balance

<< General Ledger

**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.

The Cash Flow Statement (Statement of Cash Flows) provides an overview of the way Funds move through an Entity, how they impact Overall Value and eventually reconcile with Cash Balances and determine Net Cash Flow in any given year.

The Cash Flow Statement is essentially the same as a yearly Balance Sheet - it’s just organized a little bit differently and is more summarized. The Balance Sheet accumulates its amounts from the beginning, the Cash Flow Statement only accumulates its balances over one business year. Since the Balance Sheet Accounts carry their balances from year to year, the Cash Flow Statement presents its amounts as either Increases or Decreases to groups of Accounts throughout the year.

Balance Sheet:

The Balance Sheet uses the three categories: Assets, Liabilities and Equity.  Notice that Cash is listed first and Net Income is listed last.

• Assets
  • Current Assets (including Cash)
  • Fixed Assets (Net of Accumulated Depreciation)
• Liabilities
  • Current Liabilities
  • Long Term Liabilities
• Equity
  • Owners’ Capital (Contributions, Stock and Paid in Capital)
  • Retained Earnings
  • Net Income

Cash Flow Statement:

You’ve heard the term “Bottom Line”  well, that term refers to the end result - the numbers at the bottom of the page.  Since the end result of the Cash Flow Statement is Net Cash, it is at the bottom of the report and everything else on the report funnels down to the bottom to come to the final Net Cash number.

The Cash Flow Statement uses the three categories: Operating, Investing and Financing.  Notice that Net Income is listed first and Cash is listed last.  Opposite from the Balance Sheet.

• Operating Activities
  • Net Income
  • + Depreciation Expense (+ Increase and -Decrease in Accumulated Depreciation)
  • + Increases in Current Liabilities
  • + Decreases in Current Assets
  • - Increases in Current Assets
  • - Decreases in Current Liabilities
• Investing Activities
  • + Decreases in Long Term/Fixed Assets (Independent of Accumulated Depreciation)
  • - Increases in Long Term/Fixed Assets (Independent of Accumulated Depreciation)
• Financing Activities
  • + Increases in Long Term Liabilities/Debt
  • - Decreases in Long Term Liabilities/Debt
  • + Increases in Owners’ Capital
  • - Decreases in Owners’ Capital
  • - Increases in Dividends
• Cash (Beginning Cash Balance - Net Increase/Decrease = Ending Cash Balance)

The net contribution to cash is summarized for each section and then combined to equal Net Cash Flow. Net Cash Flow is then combined with the Beginning Cash Balance to reconcile to the Ending Cash Balance for the year. Net Cash Flow is the difference between the Beginning and Ending Cash Balances.

The Cash Flow Statement is an important indicator of available cash for operations but also of how an entity is generating cash, if it is able to sustain itself and its growth through its operations or if it generated cash through increased debt and equity and/or decreased capital assets.

Statement of Cash Flows (Including Depreciation Entries from Balance Sheet Post)

Statement of Cash Flows
Cash Flows From Operating Activities
Net Income	$45,104
Depreciation	$496
Increase in Payables	$1,700
	————
Net Cash Provided by Operating Activities	$47,300
	————
Cash Flows From Investing Activities
Increase in Fixed Assets	$2,950
	————
Net Cash Used by Investing Activities	-$2,950
	————
Cash Flows From Financing Activities
	$0
	————
Net Cash Provided by Financing Activities	$0
	————
Increase in Cash and Cash Equivalents (Net Cash Flow)	$44,350
Cash and Cash Equivalents at Beginning of Year	$0
	————
Cash and Cash Equivalents at End of Year	$44,350

Next up: >> Cost of Goods Sold and Inventory

<< Financial Statements - Balance Sheet

**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.

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	30,000	7,500	50%	26,250	1,250	…
Totals	102,500	62,500	52,500	85,000	40,000	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.

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.

The Balance Sheet is the financial statement that summarizes the value of an entity’s resources and the claims on those resources at any given time. Balance Sheet accounts start accumulating their balances from the beginning of the entity and continue until the end. This contrasts with the Income Statement whose accounts are reset to zero at the end of each fiscal (business) year.

The Accounting Types reported on the Balance Sheet are:

Assets - Assets are items of value that are owned by the business and their value is expected to last beyond the current fiscal (business) year.

Liabilities are essentially debts, they are agreements to delay payments and so, are sources of funds because they provide a way to acquire or pay for goods and services without a direct transfer of cash at the time of the exchange.

Equity (Owners Equity) is a source of funds through direct owner investment (stock or owners capital accounts or owner “re-investment” (retained earnings) when some or all of the income from the previous year is retained by the business rather than distributing it to the owners.

The Balance sheet Equity Section refers to Total Equity which is Owners Equity + Net Income. The Net Income portion is easily calculated because since the total debits and total credits of all financial accounts must be equal, and the Balance Sheet and Income Statement split the Accounts between them. The difference between the Balance Sheet Accounts will equal the difference between the Income Statement Accounts - which is Net Income.

Since Owners Equity is only part of Total Equity, Net Income can also be calculated using a rewrite of the Accounting Equation:

• From: Assets = Liabilities + Equity
• To: Assets - Liabilities = Total Equity (Owners Equity + Net Income)

Move Owners Equity to the other side of the equation as well and the equation becomes:

• Assets - Liabilities - Owners Equity = Net Income  - or -
• Net Income = Assets - Liabilities - Owners Equity

Balance Sheet Draft:

The Balance Sheet does not contain any of the same accounts as the Income Statement, but it does summarize the Income Statement on one line called “Net Income” that is inserted (without an account #) at the end of the Equity Section of each Balance Sheet. The Net Income entry completes the Accounting Equation for the Balance Sheet: Assets = Liabilities + (Total) Equity (Owners Equity + Net Income)

So, the listing of balance sheet accounts from the Income Statement post gives us a start in creating a Balance Sheet prior to year end closing entries.

The Balance Sheet has a section for each of the elements of the Accounting Equation, Assets, Liabilities and Equity. It also divides Assets and Liabilities into Current and Long Term (or Fixed Asset) sections. The “Current” sections contain accounts for Assets and Liabilities that are expected to convert to cash within one year.

Current Liabilities are the claims on Current Assets the information from these Sections provide the information for two important financial ratios that help to determine if the business is able to fulfill its short term obligations.

• Current Ratio = Current Assets/Current Liabilities
  • A Current Ratio of at least 1:1 (or >= 1) indicate that there is at least one dollar of current assets for each dollar of debt.
• Quick Ratio = Current Assets - Inventory/Current Liabilities
  • A Quick Ratio of at least 1:1 indicates that there is at least one dollar of cash or cash equivalent (including accounts receivable) for each dollar of debt.

Balance Sheet Format:

To convert the account listing above to a Balance Sheet format, I’ll add some section headings and a line for the Net Income from the previous Income Statement post.

Assets = Liabilities + Equity. The the first thing I check when I read a Balance Sheet is whether it is “in balance”/the accounting equation is true. Once I know it balances, I can focus on the substance of the report.

Notice that the Net Income entry doesn’t have an account number beside it. Net Income does not have an account, it is the difference between the Balance Sheet Accounts. It is also the difference between the Income Statement Accounts.

Book Values:

Each item on the Balance Sheet is stated at its original value or cost. Since the accounts accumulate their balances from “the beginning of time”, each balance sheet item also stays there at its original value until it is sold, written off or satisfied (debts paid off or equity repurchased).

Items that are listed on the Balance Sheet do lose their value over time so instead of reducing their original account values, contra accounts are used to write down, depreciate or amortize them. Contra Accounts are the same Accounting Type as their counterparts but if their counterpart is a debit account, the contra account is a credit account. The Net Value of the Original Account and the Contra Account together reflects the decrease in book value without losing the historical value. Contra Accounts like Accumulated Depreciation prevent items from “falling off” the Balance Sheet while they are still owned by the entity because when the item’s value eventually depreciates to zero, it is still part of the original account balance.

Depreciation is determined by type of fixed asset. Depreciation methods, classes of assets and examples are listed in IRS Publication 946. Sometimes entities use different depreciation methods for book/tax purposes. Always ask a tax professional for guidance in making decisions that have tax implications.

The purpose of this entry is to demonstrate basic depreciation entries rather than depreciation calculations. I will use straight-line depreciation and assume that the assets were put into service on January 1st. Publication 946 (pg 31) indicates that office equipment is depreciated over 5 years and office furniture is depreciated over 7 years. For the depreciation entry I will add a contra asset account and a depreciation expense account.

Balance Sheet After Closing Entries:

At the end of each year when the Income Statement accounts are reset to zero, the difference between their debit and credit balances (Net Income/(Loss)) is posted to a Balance Sheet Equity account called Retained Earnings (for corporations or Owners’ Capital for other types of organizations). An example of this entry can be found at the end of the