会计英文

ENGLISH LANGUAGE IN ACCOUNTING
Unit One Accounting Profession

INTRODUCTION OF ACCOUNTING. Accounting is a process of recorded, classifying, summarizing, and interpreting of those business activities that can be in expressed in monetary terms. A person who specializes in this field is known as an accountant.

Accounting frequently offers the qualified person an opportunity to move ahead quickly in todays business world. Indeed, many of the heads of large corporations throughout the world have advanced to their position from the accounting department. Accounting is a basic and vital element in every modern business. It records the past growth or decline of the business. Careful analysis of these results and trends may suggest the ways in which the business may grow in future. Expansion or reorganization should not be planned without proper analysis of the accounting information; and new products and the campaign to advertise and sell them should not be launched without the help of accounting expertise.

Accounting is one of the fastest growing professions in the modern business world. Every new store, school, restaurant, or filling stationindeed, any new enterprise of any kindincreases the demand for accountants. Consequently, the demand for competent accountants is generally much greater than the supply. Government officials often have a legal background; similarly, the men or women in management often have a background on accounting. They are usually familiar with the methodology of finance and the fundamentals of fiscal and business administration.

DISTINCTION BETWEEN BOOKKEEPING AND ACCOUNTING Earlier accounting procedures were simple in comparison with modern methods. The simple bookkeeping procedures of a hundred years ago have placed in many cases by the data-processing computer. The control of the fiscal affairs of an organization must be as scientific as possible in order to be effective.

In the past, a bookkeeper kept the books of accounts for an organization; the present-day accountants job developed from the bookkeepers job. Today, a sharp distinction is made between the relatively unchanged works performed by a bookkeeper and the more sophisticated duties of
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the accountants. The bookkeeper simply enters data in financial records books; the accountant must understand entire system of records so that he or she can analyze and interpret business transaction. To explain the difference briefly, the accountant sets up a bookkeeping system and interprets the data in it, whereas the bookkeeper performs the routine work of recording figures in books. Because interpretation of the figures is such an important part of the accountants function, accounting has often been described as an art.

DIVISIONS OF ACCOUNTING The field of accounting is divided into three broad divisions: public, private, and governmental. A certified accountant or a CPA, as the term is usually abbreviated, must pass a series of examinations, after which he or she receives a certificate. In the United States, the certification examinations are prepared and administered by the American Institute of Certified Public Accountants. The various states or other major governmental jurisdictions set additional qualifications for residence, experience, and so on. The British equivalent for a CPA is called a charted accountant.
CPA CPA
CPAs can offer their services to the public on an individual consultant basis for which they receive a fee. In this respect or many others, they are similar to doctors or lawyers. Like them, CPAs may be self-employed or partners in a firm; or they may be employed by an accounting firm.

Many accountants worked in government offices or for nonprofit organizations. These two areas are often joined under the term government and institutional accounting. The two are similar because of legal restrictions in the way in which they receive and spend funds. Therefore, a legal background is sometimes necessary for this type of accounting practice.

All branches of governments employ accountants. In addition, government-owned corporation have accountants on their staffs. All of these accountants, like those in private industry, work on a salary basis. They tend to become specialists in limited fields like transportation or public utilities.
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Nonprofit organizations are, of course, in business for some purpose other than making money. They include cultural organizations like symphony orchestras or opera societies, charitable organizations, religious groups, or corporate-owned research organizations. Although they are limited in the manner in which they can raise and spend their funds, they usually benefit from special provisions in the tax laws.

Private accountants, also called executive or administrative accountants, handle the financial records of a business. Like those who work for government or nonprofit organizations, they are salaried rather than paid a fee. Those who work for manufacturing concerns are sometimes called industrial accountants. Some large corporations employ hundreds of employees in their accounting offices.

The chief accounting officer of a company is the controller, or comptroller, as he or she is sometimes called. Controllers are responsible for maintaining the records of the companys operations. On the basis of the data that have been recorded, they measure the companys performance; they interpret the results of the operations; and they plan and recommend future actions. This position is very close to the top of management. Indeed, a controller is often just a step away from being the executive officer of a corporation.

Many people have chosen accounting as a professional because of its many advantages. Many jobs are available, primarily because the education and training for accounting careers have not kept pact with the demand for accounting services. Once on the job, private or governmental accountants have security, and they are usually given the chance to move upward in the company sometimes, as we have noted, to the top. Salaries for people with accounting training are usually good, even on the lower levels, and for those who rise to the top of the profession, they are correspondingly high. Certified public accountants now enjoy professional status similar to that of doctors or lawyers.

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Unit Two The Conventions of Contemporary Accounting (1)

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Accounting conventions are concepts and rules which have been accepted in performing bookkeeping and accounting. It came from a careful observation of accounting practice which revealed patterns of consistent behavior. The existence of conventions was not generally recognized by accountants until the 20th century. They were developed to aid accountants in exercising judgment and estimation in order to limit likely differences in recording similar events by different accountants. The principal convention of contemporary accounting will be discussed.

THE ENTITY CONVENTION Contemporary accounting divides the community into separate units called accounting entities. For each accounting entity a self-contained, double-entry accounting system is employed. Transactions between accounting entities are recorded in the accounts of both entities. Each accounting entity interprets transactions from its own viewpoint. For example, the same transaction may be recorded as a sale by one accounting entity and as a purchase by another. Similarly, one accounting entity may record a transaction as an investment, while the other accounting entity may record it as a capital contribution.

In any particular case the identification of the accounting entity may be difficult. Consider, for example, the case of a large chain of retail stores. Is the accounting entity the whole business, a regional operation, a single store or a single department in that store? The answer can be found only by looking at the organization of the business. If a department has its own accounting system and records transactions with other departments, then it is an entity for accounting purpose. If it has no records, then it is not an accounting entity. The accounting entity is, therefore, identified as the smallest unit of activity with a self-contained accounting system.

THE GOING CONCERN CONVENTION Contemporary accounting assumes the entity will remain in operation for the foreseeable future. This assumption is known as the going concern or the continuity convention. This assumption does not refer simply to its continued existence. It also assumes that it will continue in the same line of business as those in which it is cur 4 122
rently involved.

The assumption of continuity is made in the absence of evidence to the contrary. In other words, when it is clear that an assumption of continued existence would result in misleading financial reports, then the assumption is not made. A major problem facing the accounting profession is in identifying the circumstances under which the continuity assumption should be abandoned. Sometimes company failures occur with the accounting reports continuing to be based upon the going concern convention. These accounting reports are subsequently as misleading. And premature abandonment of the continuity assumption by accountants may cause liquidation if it results in demands by creditors for repayment of accounts outstanding. Authoritative guidelines are needed in this area if continuity is to remain a basic assumption of contemporary accounting.

THE MONETARY CONVENTION In contemporary accounting, an entitys transactions are recorded in the accounts in the monetary unit of the country in which it is operating. However, in general, financial statements are presented in the currency of the country where the reports are published.

The use of money as the unit of account is accepted today without question, but that has not always been the case. For example, such commodities as cattle, salt, shells, and tobacco are said to be employed as a unit of account.

The use of money as a unit of account does create some difficulties. In the first place, transactions must be expressed in money before they can be recorded in the accounts. In some cases transactions or events may not have an obvious money amount. Transactions and events of this type are either ignored or assigned a subjective or arbitrary money amount.

The second difficulty associated with the monetary convention is that the value of money is not constant over time. Its purchasing power changes as a result of either inflation or deflation. Accountants conventionally choose to ignore the changes in the purchasing power of money in the accounts. And this will cause some deficiencies in accounting reports.

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THE CONSISTENCY CONVENTION Contemporary accounting assumes that accountants consistently apply accounting procedures from one period to the next. As a corollary, if accounting procedures are changed, the fact of the change and its effect on reported results are supposed to be disclosed in the financial statements. The purpose of this convention is to allow meaningful inter-period comparisons of results of an entity. Without consistency in accounting procedures, management could manipulate a firms reported results merely by changes in accounting procedures. Under these circumstances inter-period comparisons would have to be treated with skepticism.

This convention differs from the others in an important respect. The others describe conventional practices actually used by accountants. The consistency convention, however, involves prescription. This convention is one that accountants ought to follow rather than that is necessary followed.

The consistency convention does not mean that accounting methods cannot be changed. A change should be made if a new procedure would result in financial statements with improved truth and fairness. If a justifiable change is made, the fact and the effect of the changes should be disclosed. The convention only requires that capricious changes in procedure which can be justified by reference to a true and fair view should not be made.

The convention does not require an inter-firm consistency in accounting procedures. Two similar firms in the same industry may record a similar transaction in different ways and still comply with the consistency convention. The convention applies only to the accounting practices of a particular entity from period to period. The lack of inter-firm consistency means that analyst needs to exercise a great deal of care in making inter-firm comparisons.

Even, the convention does not mean that there must be an internal consistency in the use of accounting procedures. For example, the convention does not imply that a business depreciates all its assets on same basis or that all discounts allowed are treated as expense. Consistency would allow, for example, that plant and equipment be depreciated on a straight-line basis and that motor vehicles be depreciated on an accelerated basis. All that consistency implies is that the accounting procedures for a particular type of transactions are the same from period to the next.
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Unit Three The Conventions of Contemporary Accounting (2)

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THE CONVENTION OF CONSERVATISM It is a characteristic of contemporary accounting that accountants act conservatism or prudently in the measurement of profit. In general, this means that accountants use reasonable pessimism in measuring revenues and expenses. Revenues are not recorded until they are reasonably certain, but expenses are recorded as soon as they are become probable. Similarly, when accountants have a choice of measurements of cost for assets and liabilities, they will, other things being equal, choose the lowest for assets and the highest for liabilities. The effect of this convention is that reported profits and net assets will be lower than under most alternative assumptions.

There are several possible explanations for the convention of conservatism. One is that it is the traditional role of accountants to curb the optimism of management. Accountants are seen as a sobering influence, forcing management to assess proposals and expectations in a realistic way to minimize errors arising from over-optimism.

A second explanation is that all conservatism is a natural reaction to uncertainly. As students will behave conservatively and publicly choose a modest expectation of an exam result even through they may think that they have a good chance for a high grade, accountants faced with uncertainty about futures events also behave conservatively.

A third explanation is that statements users may prefer conservatism to any alternative policy. Given that profit measurement depends upon estimates, conservatism ensures that the actual profit must be at least as high as the reported profit. Conservatism allows confidence in published reports. Whatever profits and net assets may be, they will not be less than those disclosed in the published accounts.

THE OBJECTIVITY CONVENTION Where an accountant has a choice of measurements the most objective will be preferred, other things equal. As far as possible, an accountant will avoid incorporating guesses or estimates in the accounting records and reports. In practical terms, objectivity means that an accountant requires evidence of the existence and the amount of a trans 8 122
action before recording in the books. For many transactions the evidence is documentary, for example, invoices, receipts, cash register type and credit notes. The documentary evidence is the stimulus for recording transactions.

Accountants prefer objectivity for two reasons. First, it makes the accountants job easier. Routine rule-following is easier than a careful examination of each transaction to determine a reasonable amount for recording purpose. Second, reliance upon documentary evidence and generally accepted accounting procedures provides accountants with some support if their professional competence is questioned. It is a more convincing defense to produce evidence to support accounting records or to argue that generally accepted procedures were used than to assert that the entries seemed reasonable at the time.

THE MATERIALITY CONVENTION It is contemporary accounting practice to record and report separately only those transactions which are material. An item is judged to be material if it is important enough to influence the decisions of statement users. Some items are material because they are large. For example, a large bad-debt write-off would usually be regarded as a material event. Some items are material because they are small. For example, a very low inventory figure may be judged to be material if it reflects unfavorably on a firms liquidity. Some items may be material if they differ significantly in amount from the same item in earlier periods. For example, a small bad-debt write-off may be judged material if it is twice as large as normal. Some items may be judged to be material solely because of their nature and regardless of their relative size. For example, the sales figure would probably be material no matter how large, how small or how variable it was.

Materiality has two principal applications. One is in the processing and the other is in disclosure.
In recording process, accountant must decide how much detail is necessary. Are separate ledger accounts needed for every asset or could some assets be grouped under a general heading, for example, plant and equipment? In general, ledger accounts would be maintained only if they contained material data. All not-material items would be aggregated in sundry accounts. In other
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words, the decision of accounting system should be strongly influenced by considerations of materiality.

The second aspect of materiality relates to disclosure. Accountants use the notion of materiality as a criterion to decide how much detail to include in financial reports. If a piece of information is not material, then it should not be disclosed separately. For example, nowadays nearly all published financial statements omit cents and most show dollar amounts rounded to the nearest thousand. Any greater detail is judged to be not material.

THE ACCOUNTING PERIOD CONVENTION It is contemporary accounting practice to measure the result of an entitys operation over a relatively short period and to present a balance sheet at frequent intervals.

The economic activity of a business is continuous. All transaction are recorded in the accounts and change the picture of the firm, as revealed in financial statements. The firm changes continuously as it carries out its operations. Changes cease only when the firm cease operations. In this world of continuity of operations and change, accountants are required by law to report on financial position and results at least annually. This requirement for annual reporting is a relatively modern development. Even as late as the 19th century major businesses presented financial statements at irregular and lengthy intervals. Annual reporting probably arose from the demands of investors, owners, creditors and taxation authorities who were not prepared to wait until the end of a firms life before the success of its operation was measured.

The accounting period convention does, however, lead to difficulties. First, it should be realized that the shorter the reporting period the greater the need for estimates and judgment. Over a short period, few transactions will be completed and there will be more accruals and deferrals than for longer period. Incorporating accruals and deferrals into the accounts increase the subjectivity of financial statements. In addition, financial reports for short periods may provide misleading impressions of the long-run prospects for the firm. A balance sheet represents a snapshot of the entitys financial position at an instant of time. Immediately before and after the date of the balance sheet, the financial position is different. Bye the time the balance sheet is published the financial position of the firm may have changed dramatically. As a result, the balance sheet is out of date the day after the end of the accounting period, and by the time it is published; it is of histori 10 122
cal interest only.

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Unit Four Accounting Equation and Double Entry

The financial condition or position of a business enterprise is represented by the relationship of assets to liabilities and capital.
Assets are properties that are owned and have monetary value; for instance, cash, inventory, buildings, equipments.
Liabilities are amounts owned to outsiders, such as notes payable, accounts payable, bonds payable. Liabilities may also include certain deferred items, such as income taxes to be allocated.

Capital is the interest of the owner in an enterprise. Also known as owners equity.
These three basic elements are connected by fundamental relationship called balance-sheet equation, sometimes called simply the accounting equation. This equation expresses the equality of the assets on one side with the claims of the creditors and owners on the other side: Assets = Liability + Capital.
=+
According to the accounting equation, a firm is assumed to possess its assets subject to the rights of the creditors and owners.
The equilibrium which the bookkeeping record achieves through the accounting equation is an essential feature of double entry. The creation of assets within an enterprise is always accompanied by the incurring of identical financial obligations, either to the properties of the enterprise (owners equity) or to outside creditors (liabilities). The derivation of profit is always accompanied by an identical increase in the net assets (i.e. assets minus liabilities) of the enterprise. It is now possible to see how double-entry bookkeeping produces this equilibrium of results by ensuring that the equation holds well at all times.

Examplev1: Assume that a business owned assets $100 000, owed the creditors $80 000, and owed the owner $20 000. The accounting equation would be: Assets = Liabilities + Capital $100 000 $80 000 $20 000
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1 10 8 2 100 000 = = + 80 000 + 20 000
If over a certain period of time, the firm had a net income of $10 000, representing an increase of net assets; the change may be reflected as increased cash, increased inventory or other assets, or decreased liabilities. Suppose that $6 000 was used to reduce liabilities and the balance remained in assets. The equation would then be: Assets = Liabilities + Capital $104 000 $74 000 $30 000
6 000 104 000 = = + 74 000 + 30 000
Example 2: The selected events of January of Water Dentists are as following: (1) Invest $4 000 to practice. (2) Bought supplies for cash $300. (3) Bought office furniture from Brown Furniture company on account $2 000. The accounting equation after each transaction will appear as follows: (1) Assets = Liabilities + Capital Cash Water Capital + $4 000 +$4 000 (2) Assets = Liabilities + Capital Cash Supplies Water Capital $4 000 $4 000 - $300 + $300 $3 700 $300 $4 000 (3) Assets = Liabilities + Capital Cash Supplies Furniture Accounts Payable Water Capital $3 700 $300 $4 000 +$2 000 +$2 000 $3 700 $300 $2000 $2000 $4000
2 1. 4 000 2. 3 00 3. 2 000 1. +4 000 = + +4 000
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4 000 - 300 3 700 3. 3700 300 +2 000 3 700 300 2 000 +2 000 2 000 4 000 + 300 300 = 4 000 + 4 000 + 4 000
2.
We shall call any business event which alters the amount of assets, liabilities, or capital a transaction. In example 1, the net changes in asset groups were discussed; in example 2, we show how the accountant makes a meaningful record of a series of transactions, reconciling them step by step with the accounting equation.
1 2
However, preparing a new equation A=L+C after each transaction would be cumbersome and costly; especially there are a great many transactions in an accounting period. Also, information for a specific item such as cash would be lost as successive transactions were recorded. This information could be obtained by going back and summarizing the transactions, but that would be very time-consuming.
A=L+C
A much more efficient way is to classify the transaction according to items on the balances sheet and income statement. The increases and decreases are then recorded according to type of item by means of a summary called account.

An account may be defined as a record of the increases, decreases, and balances in an individual item of asset, liability, capital, revenue, or expense.
The simplest form of the account is known as the T account because it resembles the letter T. The account has three parts: (1) the name of the account and the account number, (2) the debit side (left side), and (3) the credit side (right side). The increases are entered on one side, and the decreases on the other. The balance (the excess of the total of one side over the total of the other) is inserted near the last figure on the side with the larger amount. Account Title Left side or debit side Right side or credit side
T T 1 2 3 14 122
When an amount is entered on the left side of an account, it is a debit, and the account is said to be debited. When an amount is entered on the right side, it is a credit, and the account is said to be credited. The abbreviations for debit and credit are Dr. and Cr., respectively.
Dr. Cr.
Whether an increase in a given item is credited or debited depends on the category of the item. By convention, asset and expense increases are recorded as debits while liability, capital and income increases are recorded as credits. Assets and expense decreases are recorded as credits, while liability, capital, income decreases are recorded as debits. The following tables summarize the rule. Liabilities, Capital and Income Assets and Expenses Dr. + (Increases) Cr. (Decreases) Dr. (Decreases) Cr. + (Increases)
Dr + () Cr. () Dr. () Cr. + ()
Example 3: T&T Co. LTD bought furniture from ABC Co. on account, $2 000. In this event, the company is receiving an asset (furniture) and therefore, debits Furniture to show the increases. They are not paying cash but creating a new liability, thereby increasing the liability account (Accounts Payable). Furniture Dr. $2 000
3 ABC Dr 2,000 Cr. Dr. Cr. 2,000
Accounts Payable Cr. Dr. Cr. $2 000
An account has a debit balance when the sum of its debits exceeds the sum of its credits; it
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has a credit balance when the sum of creditors is the greater. In double-entry accounting, which is in almost universal use, there are equal debit and credit entries for every transaction. Where there are only two accounts affected, the debit and credit amounts are equal. If more than two accounts are affected, the total of the debit entries must equal the total of the credit entries.

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Unit Five Ledgers

As was mentioned earlier, an account is a record of the changes and balances in the value of an individual item of an organization. It is understandable that an enterprise may use a member of accounts. The complete set of accounts for a business entity is called a ledger. It is the reference book of the accounting system and is used to classify and summarize transactions and to prepare data for financial statements. It is also a valuable source of information for managerial purposes, giving, for example, amount of sales for the period or the cash balance at the end of the period.

GENERAL LEDGER The general ledger is the book used to list all the accounts established by an organization. It is desirable to establish a systematic method of identifying and locating each account in the ledger. The chart of accounts, sometimes called the code of accounts, is a listing of the accounts by title and numerical designation. In some companies, the chart of accounts may run to hundreds of items. It serves both as an index to the ledger and a description of the accounting system and also a link between financial statements and the ledger.

Generally, blocks of numbers are assigned to various groups of accounts. A simple chart structure is to have the first digit represent the major group in which the account is located. Thus, account which have numbers beginning with 1 are assets; 2, liabilities; 3, capital; 4, income; and 5, expenses. The second or the third digit designates the position of the account in the group.
1 2 3 4 5
In the two-digit system, assets are assigned the block of numbers 10-19, and the liabilities 20-29. In larger firms, a three digit (or higher) system may be used, with assets assigned 100-199, and liabilities 200-299. Example 1: Numerical designations for the account groups under two-digit and three-digit methods: Account Group Two-digit Three-digit 1. Assets 10-19 100-199 2. Liabilities 20-29 200-299 3. Capital 30-39 300-399 4. Income 40-49 400-499 5. Expenses 50-59 500-599
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2 3 1. 2. 3. 4. 5. 2 10-19 20-29 30-39 40-49 50-59 3 100-199 200-299 300-399 400-499 500-599
Thus, cash may be account 11 under the first system and 101 under the second system. The cash may be further broken down as 101, Cash-First National Bank; 102, Cash-Second National Bank; and so on.
11 101 101102
In designing a numbering structure for the accounts, it is important to provide adequate flexibility to permit expansion without having to revise the basic system. There are various systems of coding, depending on the needs and desires of the company.

SUBSIDARY LEDGER Further simplification of the general ledger is brought about by the use of subsidiary ledger. In particular, for those businesses which sell goods on credit and which find it necessary to maintain a separate account with each customer and eliminates the need to make multiple entries in the general ledger.

The advantages of subsidiary ledgers are as following:
(1) Reduces ledger detail. Most of information will be in the subsidiary ledger, and the general ledger will be reserved chiefly for summary or total figures. Therefore, it will be easier to prepare the financial statements.
1.
(2) Permits better division of labor. Here, each special or subsidiary will be handed by a different person. Therefore, one person may work on the general ledger accounts while another person may work simultaneously on the subsidiary ledger.
2.
(3) Permits a different sequence of accounts. In the general ledger, it is desirable to have the accounts in the same sequence as in the balance sheet and income statement. As a further said, it is desirable to use numbers to locate and refer to the accounts. However, in connection with accounts receivable, which involves names of customers or companies, it is preferable to have the accounts alphabetical sequence.
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3.
(4) Permits better internal control. Better control is maintained if a person other than the person responsible for the general ledger is responsible for the subsidiary ledger. For example, the subsidiary accounts receivable ledger trial balance should agree with the balance of the accounts receivable accounts in the general ledger. The general ledger account acts as a controlling account, and the subsidiary ledger must agree with the control.
4.
The idea of control accounts introduced above is an important one in accounting. Any group of similar accounts may be removed from the general ledger and a controlling account substituted for it. Not only is another level of error-protection thereby provided, but the time needed to prepare the general ledger trial balance and the financial statements becomes further reduced.

In order to be capable of supplying information concerning the businesses accounts receivable, a firm needs a separate account for each customer. These customers accounts are grouped together in a subsidiary ledger known as the accounts receivable ledger. Each time the accounts receivable (control account) is increased or decreased, a customers account in the accounts receivable ledger must also be increased or decreased by the same amount.

The subsidiary ledger and control account technique may be applied similarly to transactions with creditors and other groups of related accounts, detailed information which in not required in the general ledger. It is particularly useful, for example, in accounting for inventories, fixed assets or expenses and it has general application to the accounts of manufacturing enterprises and organizations consisting of a head office and one or more branches. It enables the general ledger to be confined to the basic information necessary for a broad understanding of operating results and financial position of a business.

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Unit Six Journals

In a western accounting system, the information about each business transaction is initially recorded in an accounting recorded called a Journal. Afterward, the data is transferred or posted to the ledger, the book of subsequent or secondary entry. The various transactions are evidenced by sales tickets, purchase invoices, check stubs, and so on. Since the journal is the accounting recorded which transactions are first recorded, it is sometimes called the book of original entry. It is also called the day book because the journal is a chronological (day-by-day) record of all business transactions.

The information about each transaction that should be recorded includes the date of transaction, the debit and credit figures in specific ledger accounts, and a brief explanation of the transaction. At convenient intervals, the debit and credit amounts recorded in the journals are transferred to the accounts in the ledger. The process of recording a transaction in a journal is called journalizing the transaction and the one of transferring information from the journal to the ledger is called posting and usually done monthly. The updated ledger accounts, in turn, serve as the basis for preparing the balance sheet and other financial statements.

ADVANTAGES OF USING JOURNALS. Technically speaking, it is possible to record transactions indirectly in the ledgers, then why bother to maintain a journal? The answer is that the unit of organization for the journal is the transaction, whereas the unit of organization for ledger is the account. By having both a journal and a ledger, we achieve several advantages which would not be possible if transactions were recorded indirectly in ledger accounts.

(1) The journal shows all information about a transaction in one place and also provides an explanation of the transaction. In a journal entry, the debits and credits for a given transaction are recorded together, but when the transaction is recorded in the ledger, the debits and credits are entered in different accounts. Since a ledger may contain hundreds of accounts, it would be very difficult to locate all the facts about a particular transaction by looking in the ledger. The journal is the record which shows the complete story of a transaction in one entry.
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(2) The journal provides a chronological record of all the events in the life of a business. If we want to look up the facts about a transaction of some months or years back, all we need is in the date of the transaction in order to locate it in the journal.
2.
(3) The use of a journal helps to prevent errors. If the transactions were recorded directly in the ledger, it would be very easy to make errors such as omitting the debit or the credit, or entering the debit twice or the credit twice. Such errors are not likely to be made in the journal, since the offsetting debits and credits appear together for each transaction.
3.
TYPES OF JOURNALS. Many businesses maintain several types of journal. The nature of operation and the volume of transactions in the particular business determine the number and types of journals needed. Journals are designed to recorded information about different transactions, including sales, purchases, cash receipts and cash disbursements, and many others. Journal have two or more columns to record increases or decreases in the accounts affected by the transaction, and they often have space for the a date and an explanation of the transaction. They may be grouped into (1) general journals and (2) specialized journals.
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The simplest type of journal is called a general journal. It has only two money columns, one for debits and the other for credits; it may be used for all the types of transaction. To illustrate journalizing, we present the standard form of general journal as below:
General Journal
Date (1) 19 Sept. 1 Account Titles and Description (2) Cash Accounts Receivable Collected receivable from ABC CO. Land Cash Purchased land for office site P.R (3) 11 13 Debit (4) 5 500 5 500 Credit (5)
17 11
150 000 150 000
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(1) 19 9 . 1 ABC . (2) (3) 11 13 (4) 5 500 5 500 (5)
17 11
150 000 150 000
We describe the entries in the general journal according to the numbering in the table above.
(1) Date. The year, month, and day of the first entry are written in the date column. The year and month do not have to be repeated for the additional entries until a new month occurs or a new page is needed.
1.
(2) Description. The account title to be debited is entered on the first line, next to the date column. The name of the account to be credited is entered on the line below and indented. A brief explanation of the transaction is usually made on the ling below the credit. Generally, a blank line is left between the explanation and the next entry.
2.
(3) P.R. (Posting Reference). Nothing is entered in the column until the particular entry is posted; that is, until the amounts are transferred to the related ledger accounts.
3.
(4) Debit. The debit amount for each account is entered in this column. Generally, there is only one item, but there could be two or more separate item.
4.
(5) Credit. The amount of each account is entered in this column. Here again, there is generally only one account, but there could be two or more accounts involved with different amounts.
5.
SPECIAL JOURNALS. In the modern world, a business of any size enters into so many transactions that the use of a single journal would impose intolerable restrictions on its ability to maintain adequate records. It is, therefore, usual to break down or subdivide the journal into a number of specialized journals, each being used to record transactions of certain kind. It is much simpler and more efficient to group together those transactions which are repetitive such as sales, purchases, cash receipts and cash payments and place each of them in a special journal. In par 22 122
ticular, it is likely that all the transactions involving credit sales will be recorded in a separate journal known as the sales journal; all transactions involving credit purchases of goods in a purchase journal; receipts of cash in a cash receipts journal; and cash payments in a cash payments journal. Special journal may also be maintained for other groups of transactions which occur frequently, such as returns or allowances in respect of goods bought or sold, bills of exchange receivable or payable journal, leaving the general journal to record only those transactions not included elsewhere.

Example 1: Sales on account are made during the months as follows: On February 1 to A. Anderson for $200, on February 2 to B. Butler for $350, on February 12 to C. Chase for $125. These can be journalized in the sales journal.
Sales
Date 19 Feb. 1 2 12 A. Anderson B. Butler C. Chase
Journal
P.R Amount $ 200 350 125
Account Debited
1 2 1 A. 200 2 2 B. 350 2 12 C. 125 19 2 . 1 2 12 A. B. C. $ 200 350 125
Special journal have several advantages:
(1) Reduce detail recording. Each sales transaction is recorded on a single line with all details included on that line: date, customers name, and amount.
1.
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(2) Reduce posting. There is only one posting made to Accounts Receivable and one posting to Sales, regardless of the number of transactions.
2.
(3) Permit better division of labor. If there are several journals, it makes it possible for more than one bookkeeper to work on the books at the same time.
3.
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Unit Seven The Trial Balance

Since equal dollar amounts of debits and credits are entered in the accounts for every transaction recorded, the sum of all the debits in the ledger must be equal to the sum of all the credits. If the computation of account balances has been accurate, it follows that the total of the accounts with debit balances must be equal to the total of the accounts with credit balances.

PREPAIRING A TRIAL BALANCE. Before using the account balances to prepare financial statements, it is desirable to prove that the total of accounts with debit balances is in fact equal to the total of accounts with credit balances. This proof of equality of debit and credit balances is called a trial balance. A trial balance is a two-column schedule listing the name and balances of all the accounts in the order in which they appear in the ledger. The debit balances are listed in the left-hand column and the credit balances in the right-hand column. The totals of the columns should agree. The procedure is as follows:
(1) List account titles in numerical order. (2) Record balances of each account, entering the debit balances in the left column and the
credit balances in the right column. (3) Add the columns and record the totals. (4) Compare the totals.
1. 2. 3. 4.
Asset and expenses accounts are debited for increases and would normally have debit balances. Liabilities, capital, and income accounts are credited for increases and would normally have credit balances.

If the totals of debits and credits agree, the trial balance is in balance, indicating that debits and credits are equal for the hundreds or thousands of transactions entered in the ledger.

Example 1: The summary of the transactions for ABC Co. LTD and their effect on the accounts is shown
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below. The trial balance is then taken. (Omitted)
ABC Co. LTD. Trial Balance September 30, 19

Dr. Cash Furniture Accounts Payable Capital Income Rent Expense Salaries Expense
1: ABC () ABC . 19 9 30 500 200 $ 8500 $ 8 500 $ 5 800 2 000 $ 2 000 4 000 2 500
Cr.
$ 5 800 2 000 $ 2 000 4 000 2 500 500 200 $ 8500 $ 8 500
USES AND LITMITATIONS OF THE TRIAL BALANCE. The trial balance provide proof that the ledger is in balance. The agreement of the debit and credit totals of the trial balance gives assurance that:

(1) Equal debits and credits have been recorded for all transaction. (2) The debit and credit of each account has been correctly computed. (3) The additional of the account balances in the trial balance has been correctly performed.
1. 2. 3.
Suppose that the debit and credit totals of the trial balance do not agree. This situation indi 26 122
cates that one or more errors have been made. Typical of such errors are:

(1) (2) (3) (4) (5)
The entering of a debit as a credit or vice versa; Arithmetical mistakes in balancing account; Clerical errors in copying account balances into the trial balance; Listing a debit balance in the credit column of the trial balance, or vice versa; and Errors in addition of the trial balance.
1. 2. 3. 4. 5.
The preparation of a trial balance does not prove that transactions have been correctly analyzed and recorded in the proper accounts. If, for example, the purchase of a machine was incorrectly charged to expense, the trial balance would still balance, but theoretically the accounts would be wrong, as Expense would overstated and Machinery understated. Also, if a transaction were complete omitted from the ledger, the error would not be disclosed by the trial balance. In brief, the trial balance proves only one aspect of the ledger, and that is the equality of debits and credits.

Despite the limitations, the trial balance is a useful device. It not only provides assurance that the ledger is in balance, but it also serves as a convenient stepping-stone for the preparation of financial statements showing the financial position of the business, intended for distribution to managers, owners, banker, and various outsiders. The trial balance, on the other hand, is merely a working paper, useful to the accountant but not intended for distribution to others. The balance sheet and other financial statements can be prepared more conveniently from the trial balance than directly from the ledger, especially if there are a great many ledger accounts.

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Unit Eight Cash Basis and Accrual Basis of Accounting

Because an income statement pertains to a definite period of time, it becomes necessary to determine just when an item of revenue or expenses is to be accounted for. Two systems can be used in dealing with this problem: cash basis and accrual basis.

DISTINCTIONS BETWEEN CASH BASIS AND ACCRUAL BASIS. Under the cash basis, revenue is recorded when received in cash and expenses are recorded in the period in which cash payment is made. The cash basis of accounting does not give a good picture of profitability because it fails to match revenue and related expenses and therefore does not lead to a logical measurement of income. For example, it ignores uncollected revenue which has been earned and expenses which have been incurred but not paid. The use of it is limited mostly to individual income tax returns and to accounting records of physicians and other professional people.

Most business firms use the accrual basis of accounting and it will be discussed in more details. The accrual basis differs significantly from cash basis of accounting. Under the accrual basis it needs to record revenue in the period in which it is earned and to record expenses in the period in which they are incurred. The effect of events on the business is recognized as service are rendered or consumed rather than when cash is received or paid.

Essential to the accrual basis is the matching of expenses with the revenue that they helped produce. Most revenue is earned when goods or services are delivered. At this time, title to goods or services is transferred, and there is legal obligation created to pay for such goods and services. Some revenue is recognized on a time basis, such as rental income, and is earned when the specified period of time has passed. The accrual concept demands that expenses be kept in step with revenue, so that each month sees only that months expense applied against the revenue for that month. Therefore, under the accrual system, the accounts are adjusted at the end of the accounting period to properly reflect the revenue earned and the cost and expenses applicable to period. The entries to be made on the balance day are called adjusting entries.
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ADJUSTMENTS UNDER ACCRUAL BASIS. Balance-day adjustments are of four main kinds:

(1) Transactions which have been recorded in the books of account during the current period, but which relate wholly or partly to subsequent accounting periods; (2) Transactions which have occurred during the current period, but which for some reason have not been recorded in the books of account prior to balance day; (3) Allocations to the current period of its share of the original cost of fixed capital assetsdepreciation; (4) Provision for anticipated revenue, costs or losses arising out of the current periods operations, the exact amounts of which can not be determined at balance-day.
1. 2. 3. 4.
The following examples will show how the adjusting entries are made for the four types of adjustments.
Example 1: Prepaid Expenses Assume that a business paid a $1 200 premium on April 1 for one years assurance in advance. This represents an increase in one asset (prepaid expense) and a decrease in another asset (cash). Thus, the entry would be: Dr. Prepaid Insurance Cr. Cash
1 4 1 1 200 1 200 1 200
$ 1 200 $ 1 200
At the end of April, 1/12 of the $1 200 or $100 had expired or been used up. Therefore, an adjustment has to be made, decreasing or crediting Prepaid Insurance and Increasing or debiting Insurance Expense. The entry would be: Dr. Insurance Expense Cr. Prepaid Insurance $ 100 $100
4 1 200 1/12 100
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100 100
Example 2: Accrued Salaries Assume that April 30 falls on the Tuesday for the last weekly payroll period. Then, two days of that week will apply to April, three days to May. The payroll for the week amounted to $2 500, of which $1 000 applied to April and $1 500 to May. The entries would be as follows: April 30 Dr. Salaries Expense Cr. Salaries Payable $ 1 000 $ 1 000
2 4 30 4 4 3 5 2 500 1 000 4 1 500 5 4 30 1 000 1 000
When the payment of the payroll is made, say, on May 3, the entry would be as follows: May 3. Dr. Salaries Expense Salaries Payable Cr. Cash $ 1 500 $ 1 000 $ 2 500
5 3 53 1 000 1 500 2 500
As can be seen above, $1 000 was charged to expense in April and $1 500 in May. The debit to Salaries Payable of $1 000 in May is merely canceled the credit entry made in April, when the liability was set up for the April salaries expense.
1 000 4 1 500 5 5 1 000 4 4
Example 3: Accumulated Depreciation This is a valuation of offset account, which means that the balance is offset against the related asset account. In the case of property, plant and equipment, it is desirable to know the original cost as well as the value after depreciation. Assume the machinery costing $15 000 was purchased on February 1 of the current year and was expected to 10 years. With the straight-line method of accounting, the depreciation would be $1 500 a year, or $125 a month. The adjusting entry would be as follows:
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Dr. Depreciation Expense Cr. Accumulated Depreciation

3
$ 125 $ 125
15 000 2 1 10 1 500 125 1 200 1 200
At the end of April, Accumulated Depreciation would have a balance of $375, representing three months accumulated depreciation. The account would be shown in the balance sheet as follows: Machinery Less: Accumulated Depreciation $ 15 000 375
$ 14 625
375 3 15 000 375 14 625
Example 4: Allowance for Uncollected Accounts A business with many accounts receivables will reasonably expect to have losses from uncollectible accounts. It will be not known which specific accounts will not be collect, but past experience furnishes an estimate of the total uncollectible amount.
4
Assume that a business estimates that 1 percent of sales on account will be uncollectible. Then, if such sales $10 000 for April, it is estimated that $100 will be uncollectible. The actual loss may not definitely be determined for a year or more, but the loss attributed to April sales would call for an adjusting entry. Dr. Uncollectible Accounts expense Cr. Allowance for Uncollectible Accounts $ 100 $ 100
1% 4 10 000 100 4 1 200 1 200
If the balance in Accounts Receivable at April 30 was $9 500 and the previous months balance in Allowance for Uncollectible Accounts was $300, the balance sheet at April 30 would show
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the following: Accounts Receivable Less: Allowance for Uncollectible Accounts $ 9 500 400
$ 9 100
4 30 9 500 300 4 30 9 500 400 9 100
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Unit Nine Balance Sheet

NATURE AND PURPOSE OF BALANCE SHEET. The balance sheet is one of the basic financial statements. Financial statements are the main source of financial information for persons outside the business organization and also useful to management. These statements are very concise, summarizing in three or four pages the activities of a business for a specified period of time, such as a month or a year. They show the financial position of the business at the end of the time period and also the operating result by which the business arrived at this financial position.

The basic purpose of financial statements is to assist decision maker in evaluating the financial strength, profitability, and future prospects of a business. Thus, managers, investors, major customers, and labor all have a direct interest in these reports. Every large corporation prepares annual financial statements which are distributed to all owners of the business. In addition, these statements are filed with various government agencies and become a matter public record.

The balance sheet is a financial statement which shows the financial position of a business entity by summarizing the assets, liabilities, and owners equity at a specific date. This statement is also called a Statement of Financial Position or Statement of Financial Condition.

Every business prepares a balance sheet at the end of year, and most companies prepare one at the end of each month. A balance sheet consists of a listing of the assets and liabilities of a business and of the owners equity. In preparing the balance sheet, it is not necessary to make any further analyze of the data. The needed datathat is, the balances of the assets, liabilities, and capital accountsare already available.

FORMAT OF BALANCE SHEET. The balance sheet may be arranged in either account form or report form. In the account form, the assets are listed on the left side of the page and liabilities and owners equity on the right side. And in the report form, the liabilities and owners equity sections are listed below rather than to the right of the assets section. Both the account form and the report form are widely used. The following balance sheets illustrate the difference.
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ABC Co. LTD. Balance Sheet December 31, 19

Assets Cash$20 500 Accounts Receivable65 000 Supplies 1 500 Land 68 000 Buildings 133 500 Cleaning Equipment 39 000 Delivery Equipment22 500 Total assets $350 000 Liabilities $ Owners Equity Liabilities: Notes Payable $26 000 Accounts Payable 36 000 Income Taxes Payable 18 000 Owners Equity: Capital Stock $225 000 Retained Earnings 45 000 Total Liabilities & Owners Equity
$80 000
270 000 $350 000
ABC Co. LTD. Balance Sheet December 31, 19

Assets Cash Accounts Receivable Supplies Land Buildings Cleaning Equipment Delivery Equipment Total $20 500 65 000 1 500 68 000 133 500 39 000 22 500 $350 000 Liabilities & Owners Equity Liabilities: Notes Payable $26 000 Accounts Payable 36 000 Income Taxes Payable 18 000 Owners Equity Capital Stock $225 000 Retained Earnings 45 000 Total
$80 000
270 000 $350 000
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ABC 19_ _ 12 31 $20 500 65 000 1 500 68 000 133 500 39 000 22 500 : $26 000 36 000 18 000 : $225 000 45 000 270 000 $350 000 $80 000 $350 000
ABC 19_ _ 12 31 $20 500 65 000 1 500 68 000 133 500 39 000 22 500 $350 000 : $225 000 45 000 270 000 $350 000 $26 000 36 000 18 000 $80 000
Note that the balance sheet sets forth in its heading three items: (1) the name of the business, (2) the name of the financial statement Balance Sheet, and (3) the date of the balance sheet. Below the heading is the body of the balance sheet, which consists of three distinct sections: assets, liabilities, and owners equity.
1. 2.
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3.
Another point to note about the form of a balance sheet is that cash is always the first asset listed; it is followed by receivables, supplies and any other assets that will soon be converted into cash or consumed in operations. Following these items are the more permanent assets, such as land, buildings, and equipment. The liabilities of a business are always listed before the owners equity.

CLASSIFIED BALANCE SHEET. The balance sheet becomes a more useful statement for comparison and financial analysis if the assets and liabilities groups are classified. For example, an important index of the financial state of business, derivable from the classified balance sheet, is the ratio of current assets to current liabilities. This current ratio ought, generally, to be at least 2 to 1; that is, current assets should be twice current liabilities. For our purpose, we will designate the following classifications: ASSETS LIABILITIES Current Current Fixed Long-term Other
21
Current Assets. Assets reasonably expected to be converted into cash or used in the current operation of the business. (The current period is generally as one year.) Example are cash, notes receivable, accounts receivable, inventory, and prepaid expenses (prepaid insurance, prepaid rent, and so on).

Fixed Assets. Long-lived assets used in the production of goods or services. These assets, sometimes called non-current assets or plant assets, are used in the operation of the business rather than being held for sale.

Other Assets. Various assets other than current assets, fixed assets, or assets to which specific captions are given. For instance, the caption Investments would be used if significant sums were invested. Often, companies show a caption for intangible assets such as patents or goodwill. In other cases, there may be a caption for deferred charges. If, however, the amounts are not large in
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relation to total assets, the various items may be grouped under one caption, Other Assets.

Current Liabilities. Debts which must be satisfied from current assets within next operation period, usually one year. Examples are accounts payable, notes payable, the current portion of long-term debt, and various accrued items as salaries payable and taxes payable.

Long-term Liabilities. Liabilities which are payable beyond the next year. The most common examples are bonds payable and mortgages payable. The example on next page shows a classified balance sheet of typical form.
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ABC Co. LTD. Classified Balance Sheet December 31, 19

Assets Current Assets Cash Accounts Receivable Supplies Total Current Assets Fixed Assets Land Buildings Cleaning Equipment Delivery Equipment Total Fixed Assets Total assets Liabilities $ Owners Equity Current Liabilities Notes Payable Accounts Payable Income Taxes Payable Total Current Liabilities Long-term Liabilities Total Liabilities Owners Equity Capital Stock Retained Earnings Total Owners Equity Total Liabilities & Owners Equity
$20 500 65 000 1 500 $87 000 $68 000 133 500 39 000 22 500 263 000 $350 000
$26 000 36 000 18 000 $80 000 0 $80 000 $225 000 45 000 270 000 $350 000
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ABC 19_ _ 12 31 $225 000 45 000 270 000 $350 000 $26 000 36 000 18 000 $80 000 0 $80 000 $68 000 133 500 39 000 22 500 263 000 $350 000 $20 500 65 000 1 500 $87 000
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Unit Ten Income Statement

NATURE AND PURPOSE OF INCOME STATEMENT. An income statement is a financial statement showing the results of operations for a business by matching revenue and related expenses for a particular accounting period. It shows the net income or net loss.

When we measure the net income earned by a business we are measuring its economic performanceits success or failure as a business enterprise. Stockholders, prospective investors, managers, bankers, and other creditors are anxious to see the latest available income statement and thereby to judge how well the company is doing.

Alternative titles for the Income Statement include Earnings Statement, Statement of Operations, and Profit and Loss Statement. However, income statement is by far the most popular term for this important financial statement. In brief, we can say that an income statement is used to summarize the operating results of a business by matching the revenue earned during a given time period with the expenses incurred in obtaining that revenue.

Every business prepares an annual income statement, and most businesses prepare quarterly and monthly income statements as well. The period of time covered by an income statement is termed the companys accounting period. This period may be a month, a quarter of a year, a year, or any other specified period of time. A 12-month accounting period used by an entity is called its fiscal year. The fiscal year used by most companies coincides with the calendar year and ends on December 31. However, some businesses select to use a fiscal year which ends on some other date. It may be convenient for the business to end its fiscal year during a slack season rather than during a time of peak business activity. The fiscal year of some governments, for example, begins on October 1 and ends 12 months later on September 30.
12 12 31 10 1 12 9 30
There are town common forms of income statement: the multiple-step income statement and the single-step income statement.
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MULTIPLE-STEP INCOME STATEMENT. The multiple-step income statement is so named because of the series of steps in which costs and expenses are deducted from revenue. As a first step, the cost of goods sold is subtracted from net sales to produce an amount for gross profit on sales. As a second step, operating expenses are deducted to obtain a subtotal term income from operations (or operating income). As a final step, income tax expenses are subtracted to determine net income. The multiple-step income statement is noted for its numerous sections and significant subtotals. It is widely used by small businesses, and the official format of income statement in china is a multiple-step one. The following is a multiple-step income statement. It is also a classified income statement because the various items of expense are classified into significant groups.
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XYZ TRADERS Income Statement For the year ended December 31, 19
Revenue: Sales $ 506 000 Less: Sales returns and allowances $ 4 000 Sales discounts 2 000 6 000 Net sales $ 500 000 Cost of goods sold: Inventory, Jan. 1 $ 60 000 Purchases$ 300 000 Less: Purchases returns & allowances $2 000 Purchases discounts 1 000 3 000 Net purchases$ 297 000 Add: Transportation-in13 000 Cost of goods purchased 310 000 Cost of goods available for sale $370 000 Less: Inventory, Dec. 31 70 000 Cost of goods sold300 000 Gross profit on sales: $200 000 Operating expenses: Selling expense: Sales salaries$76 000 Delivery service 4 000 Adverting16 000 Depreciation9 000 Total selling expense $105 000 General & administrative expenses: Office salaries $60 000 Telephone2 000 Depreciation8 000 Total general & administrative expenses 70 000 Total operating expenses175 000 Income from operations$25 000 Income tax expenses5 000 Net income $20 000

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XYZ 19_ _ 12 31 : $ 506 000 : $ 4 000 2 000 : 1 1 $ 60 000 $ 300 000 : $2 000 1 000 : 3 000 6 000
$ 500 000
$ 297 000 13 000 310 000 $370 000 : 12 31 70 000 300 000 : $200 000 : : $76 000 4 000 16 000 9 000 $105 000 : $60 000 2 000 8 000 70 000 175 000 $25 000 5 000 $20 000
The classified income statement enables management, stockholders, analysts, ant others to study the changes in the expenses over successive periods. The items of an income statement may be classified as the following four groups.

(1) Revenue. This includes gross income from the sales of products or services. It may be
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designated a Sales, Incomes from Fees, and so on, to indicate gross income. The gross amount is reduced by sales returns and allowances and sales discounts to arrive at net sales. (2) Cost of goods sold. This includes the costs related to the products or services sold. It would be relatively simple to compute for a firm that retails goods; it would be more complex for a manufacturing firm that changes raw materials into finished products. (3) Operating expenses. This includes all expenses or resources consumed in obtaining revenue. Operating expenses are further divided into two groups. Selling expenses are those related to the promotion and sales of the companys product or service. General and administrative expenses are those related to overall activities of the business, such as the salaries of the president and other officers. (4) Other expenses. This includes non-operating and incidental expenses. Income taxes is shown an non-operating expense because they dont help to produce operating revenue (sales). Those expenses appear in the final section of the income statement after the figure of showing income from operations.
1. 2. 3. 4.
SINGLE-STEP INCOME STATEMENT. The income statements prepared by large corporations for distribution to thousands of stockholders often are greatly condensed because public presumably is more interested in a concise report than in the details of operations. The single-step form of income statement takes its name from the fact that the total of all expenses (including the cost of goods sold) is deducted from total revenue in a single step. All types of revenue, such as sales, interest earned, and rent revenue, are added together to show the total revenue. Then all expenses are grouped together and deducted in one step without the use of subtotals. A condensed income statement in single-step from is shown below.
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B&B CORPORATION Income Statement For the year ended December 31, 19
Revenue: Net sales $90 000 000 Interest earned 1 800 000 Total revenue $91 800 000 Expenses: Cost of goods sold $60 000 000 Selling expenses 14 400 000 General administrative expenses 9 750 000 Income taxes expense 3 150 000 Total expenses87 300 000 Net income $4 500 000
B&B : $90 000 000 1 800 000 $91 800 000 : $60 000 000 14 400 000 9 750 000 3 150 000 87 300 000 $4 500 000 19_ _ 12 31
Use of the single-step income statement has increased in recent years, perhaps because it is relatively simple and easy to read. A disadvantage of this format is that useful concepts such as the gross profit on sales are not readily apparent.

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Unit Eleven Statement of Changes in Financial Position and Cash Flow Statement

STATEMENT OF CHANGES IN FINANCIAL POSITION. Statement of changes in financial position is a financial statement showing the sources and uses of working capital during the accounting period. In addition, this statement shows financing and investing activities, such as exchange transactions, which do not directly affect working capital.

A statement of changes in financial position helps us to understand how and why the financial position of a business has changed during the period. This statement summarizes the long-term financing and investing activities of the business; it shows where the financial resources (funds) have come from and where they have gone. With the understanding of how the funds have flowed into the business and how these funds have been used, we can begin to answer such important questions as: Do the normal operations of the business generate sufficient funds to enable the company to pay regular dividends? Has the company been forced to borrow to pay for new plant assets, or has it been able to generate the funds from the current operation? Is the business becoming more solvent or less solvent? Perhaps the most puzzling question is: How can a profitable business be running low on cash and working capital? Even though a business operates profitably, its working capital may be decline and the business may even become insolvent.

The statement of changes in financial position gives us answer to these questions, because it shows in detail the amount of funds received from each source and the amount of funds used for each purpose throughout the year. In fact, this financial statement used to be called a statement of sources and applications of funds. Many people still call it simply a funds statement.

Funds here are defined as working capitalthe excess of current assets over current liabilities. If the amount of working capital increased during a given fiscal period, this means that more working capital was generated than was used for various business purposes; if a decrease in working capital occurred, the reverse is true. One of the key purposes of the statement of changes in financial position is to explain fully the increase or decrease in working capital during a fiscal period. This is done by showing where working capital originated and how it is used.
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Any transaction that increases the amount of working capital is a source of working capital. The principal sources of working capital include:
(1) Net sources of funds provided by current operationsthe inflow of funds from sales exceeds the outflow of funds to cover the cost of merchandise purchases and expenses of doing business. (2) Sales of noncurrent assets. A business may obtain working capital by selling noncurrent assets, such as plant and equipment or long-term investments, in exchange for current assets. (3) Long-term borrowing. Long-term borrowing such as issuing bonds payable, results in an increase in current assets, thereby increasing working capital. (4) Sales of additional shares of stock. The sale of capital stock results in an inflow of current assets, thereby increasing working capital.
1. 2. 3. 4.
The uses of working capital mainly include:
(1) Declaration of cash dividends. The declaration of a cash dividend results in a current liability (dividend payable) and is therefore a use of funds. (2) Purchase of noncurrent assets. Purchases of noncurrent assets, such as plant and equipment, reduce the current assets or increase current liabilities, in either case, working capital is reduced. (3) Repayment of long-term debt. Working capital is decreased when current assets are used to repay long-term debts. (4) Repurchase of outstanding stock. When cash is paid out to repurchase outstanding shares of stock, working capital is reduced.
1. 2. 3. 4.
The example below shows a simple statement of changes in financial position, saving the process of preparation.
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AAA COMPANY Statement of Changes in Financial Position For Month of May

Sources of working capital: Operations (net income)$7 500 Additional investment by owner 20 000 Total sources of working capital $27 500 Uses of working capital: Purchase of land $47 000 Withdrawal by owner 2 000 Total uses of working capital 49 000 Decrease in working capital$21 500
AAA 5 : () $7 500 20 000 $27 500 : $47 000 2 000 49 000 $21 500
CASH FLOW STATEMENT. A statement of changes in financial position is designed to provide stockholders and other outsiders with an overview of the companys liquid resources. Managers, however, are often more concerned with have enough cash available to meet the companys maturing liabilities. To help managers plan and control cash balances, most companies prepare cash flow statements. These statements explain the changes in the companys cash balance by summarizing the cash receipts and cash disbursements occurring over the accounting period.

Cash flow statements often are prepared monthly as well as annually. In addition, many companies prepare projected cash flow statements (called cash budgets or cash forecasts) which forecast the cash receipts and cash disbursements of future accounting periods. These forecasts enable managers to plan the companys borrowing and investment activities so as to avoid cash shortages or excessively high cash balances.
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Cash flow statements did not appear in the annual report to stockholders and other outsiders until recently; they are prepared only for internal use by management. However, banks often insist that a company applying for a loan include both a cash flow statement and a cash forecast with the loan application.

We will get a general idea of the forecast of the cash flow statement by looking at the following example.
AAA COMPANY Cash Flow Statement For the year ended December 31, 19
Cash receipts: Cash generated from operations$50 000 Sales of land 70 000 Sales of capital stock65 000 Total cash receipts$185 000 Cash payments: Purchase of equipment $90 000 Retirement of bonds payable 75 000 Withdrawal by owner 40 000 Total cash payments205 000 Decrease in cash during the year$20 000
AAA 19_ _ 12 31 : $50 000 70 000 65 000 $185 000 : $90 000 75 000 40 000 205 000 $20 000
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Unit Twelve The System of Internal Control

BASIC IDEAS OF INTERNAL CONTROL. The topic of internal control goes hand-in-hand with the study of accounting and auditing. Business decisions of all types are based at least in part upon accounting information. And auditors nowadays study and evaluate the clients internal control system before the performing of other audit procedures, which is known as the system-based audit. How do the decision makers and auditors know that the accounting information they receive is accurate and reliable? This assurance comes, in large part, from the companys system of internal control.

A system of internal control consists of all the measures taken by an organization for the purpose of (1) protecting its resources against waste, fraud, and inefficiency; (2) ensuring accuracy and reliability in accounting and operating data; (3) securing compliance with company policies; and (4) evaluating the level of performance in all divisions of the company. In short, a system of internal control includes all of the measures designed to assure managements that the entire business operates according to plan.
1 2 3 4
A basic principle of internal control is that no one person should handle all phases of a transaction from the beginning to end. When business operations are so organized that two or more employees are required to participate in every transaction, the possibility of fraud is reduced and the work of one employee gives assurance of the work of another.

Many people think of internal control as a means of safeguarding cash and preventing fraud. Although internal control is an important factor in protecting assets and preventing fraud, this is only a part of its roles. Remember that business decisions are based on accounting data; and the system of internal control provides assurance of the dependability of the accounting data used in making decisions.

The decisions made by management are communicated throughout the organization and become company policy. The result of the policiesthe consequences of the managerial decisionsmust be reported back to management so that the soundness of the company policies can
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be evaluated. Among the means of communication included in the system of internal control are organization charts, manuals of accounting policies and procedures, flow charts, financial forecasts, purchase orders, receiving reports, invoices, and many other documents. The term documentation refers to all the charts, forms, reports, and other business papers that guide and describe the working of a companys system of accounting and internal control.

INTERNAL ACCOUNTING CONTROL. Internal control falls into major classes: administrative controls and accounting controls. Administration controls are measures that increase operation efficiency and compliance with policies in all parts of the organization. For example, an administrative control may be a requirement that traveling salespersons submit reports showing the number of calls made on customers each day. Another example is a directive requiring airline pilots to have regular medicine examinations. These internal administrative controls have no direct bearing on the reliability of the financial statements. Consequently, administrative controls are not of direct interests to accountants and independent auditors.

Internal accounting controls are measures that protection of assets and to the reliability of accounting and financial reports. Since it has a direct effect on the reliability at accounting information and is the main concern of accountants and auditors, we will examine it in more details.

Accounting system. Accounting system is a very important part of a internal control system, it consists of the methods of records established to identify, assemble, analyze, classify, record, and report on entitys transactions and to maintain accountability for the related assets and liabilities. An effective accounting system should

(1) Identify and record all valid transactions. (2) Describe on a timely basis the transactions in sufficient detail to permit proper classification of transactions for financial reporting. (3) Measure the value of transactions in a manner that permits recording their proper monetary value in the financial statements. (4) Determine the time period in which the transactions occurred to permit recording of the transactions in the proper accounting period. (5) Present properly the transactions and related disclosures in the financial statements.
1
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2 3 4 5
Accounting control procedures. The control procedures consist of policies and procedures that are established to provide reasonable assurance that entity objectives will be achieved. The accounting control procedures may be classified into the following categories: (1) proper authorization; (2) segregation of duties; (3) documents and records; (4) access control; and (5) independent checks, which will be discussed one by one.
1 2 3 4 5
1. Proper Authorization. A major purpose of proper authorization procedures is to assure that transactions are authorized by management personnel acting within the scope of their authority. Authorizations may be general or specific. The former relates to the general conditions under which transactions are authorized such as standard price lists for products and credit policies for charge sales. The latter relates to the granting of the authorization on a case-by-case basis. This may occur, for example, in nonroutine transactions, such as major capital expenditures and capital stock issues. Specific authorization may apply to routine transactions that exceed the limit prescribed in the general authorization such as granting credit to a customer who does not meet specific credit conditions because of extenuating circumstances.
1.
2. Segregation of Duties. The category of control procedures involves the assignment of responsibility for a transaction so that the duties of one employee automatically provide a cross-check on the work of one or more other employees. The primary purpose of segregation of duties is the prevention and prompt the detection of the error or irregularities in the performance of assigned responsibilities. Duties are considered incompatible from a control standpoint when it is possible for an individual to commit errors or irregularities in the normal course of his or her duties and prevent their detection by the internal control system. Generally, the following four types of situation certainly need the segregation of duties.
2.
(1) Responsibility for executing a transaction, recording the transaction, and maintaining custody of the assets resulting from the transaction should be assigned to different individuals or departments. (2) The various steps involved in executing a transaction should be assigned to different indi 52 122
viduals or departments. (3) Responsibility for certain accounting operations should be segregated. (4) There should be proper segregation of duties within the EDP department and between EDP and user department.
1 2 3 4
3. Documents. Documents provide evidence of the occurrence of transactions and the price, nature, and the terms of the transactions. Invoices, checks, contracts, and time tickets are illustrative of common types of documents. When duly signed or stamped, documents also provide a basis for establishing responsibility for the executing and recording of transactions. Prenumbered are useful in maintaining control and accountability. Prenumbering helps to assure (1) all transaction are recorded and (2) no transactions are recorded more than once. When prenumbering exists, all voided documents should be retained.
3. 1 2
4. Access Controls. Access controls are concerned with limiting the following two types of access to assets and important records: (1) direct physical access and (2) indirect access through the preparation or processing of documents such as sales orders and disbursement vouches that authorize the use or disposition of the assets. Thus, these controls pertain primarily to security devices and measures for the safekeeping of assets, documents, records, and computer programs and files. Security devices include on-site safeguards such as bank deposit vaults and certified public warehouses. Security measures include limiting access to storage areas to authorized personnel.
4. 1 2
5. Independent Checks. Independent checks involve verification of (1) work performed by another individual or department, or (2) the proper valuation of recorded amounts. Independent checks may be made with varying degrees of frequency. Manual clerical checks may be made daily on all or selected transactions. In contrast, comparisons of assets with recorded accountability and management review of reports may occur periodically, such as weekly or monthly. Some independent checks, such as petty cash counts, may be made on a surprise basis.
5. 12
All internal control systems are subject to inherent limitations. One limitation is the human factor that exists in control procedures. The effectiveness of specific controls can be nullified by an employee through misunderstanding of introductions, carelessness, fatigue, and absenteeism. It
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is also possible for the effectiveness of a control to be minimized through deliberate circumvention by one employee or jointly by persons both within and outside the entity. The latter situation is referred to as collusion. Management may also override specific controls.

A second limitation is that controls may not encompass all transactions. For example, controls may not apply to nonroutine transactions such as officers bonuses and extraordinary events.

In addition, it should be recognized that internal controls exists in a dynamic rather than a static business environment. Changed conditions may necessitate major modifications in the control structure. Consequently, special care should be taken in evaluating the effectiveness of a internal control structure.

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Unit Thirteen Cash and Its Control

DEFINITION OF CASH. Accountants define cash a money on deposit in banks and any items that banks will accepts for immediate deposit. These items include not only coins and paper money, but also checks and money orders. On the other hand, notes receivable, IOUs, and postdated checks are not accepted for immediate deposit and are not included in the accountants definition of cash.

In the balance sheet, cash is listed first among the current assets, because it is the most current and liquid of all assets. The banker, credit manager, or investor who studies a balance sheet critically is always interested in the total amounts of cash as compared with other balance sheet items, such accounts payable. These outside users of a companys financial statements are not interested, however, in such details as the number of separate bank accounts, or in the distinction between cash on hand and cash in banks. A business that carries checking accounts with several banks will maintain a separate ledger account for each bank account. In the balance sheet, however, the entire amount of cash on hand and cash on deposit with several banks will be shown as a single amount. One objective in preparing financial statements is to keep them short, concise, and easy to read.

Efficient management of cash includes measures that will:
1. Provide accurate accounting for cash receipts, cash payments and cash balances; 2. Prevent losses from fraud or theft; 3. Maintain a sufficient amount of cash at all times to make necessary payments, plus a reasonable balance for emergencies. 4. Prevent unnecessary large amounts of cash from being held idle in bank accounts which produce no revenue.
1. 2. 3. 4.
INTERNAL CONTROLS OVER CASH. Cash is more susceptible to theft than any other
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assets. Furthermore, a large portion of the total transactions of a business involve the receipt or disbursement of cash. For both these reasons, internal control over cash is of great importance to management and also to the employees of a business. If a cash shortage arises in a business in which internal controls are weak or nonexistent, every employee is under suspicion. Perhaps no one employee can be proved guilty of the theft, but neither can any employee prove his or her innocence.

On the other hand, if internal controls over cash are adequate, theft without detection is virtually impossible except through the collusion of two or more employees. To achieve internal control over cash or any other group of assets requires first of all that the custody of assets be clearly separated from the recording of transactions. Secondly, the recording function should be subdivided among employees, so that the work of one person is verified by that of another. This subdivision of duties discouraged fraud, because collusion among employees would be necessary to conceal an irregularity. Internal control is more easily achieved in large companies than in small companies, because extensive subdivision of duties is more feasible in large business.

The major steps in establishing internal controls over cash include the following:
1. Separate the function of handling cash from the maintenance of accounting records. Employees who handle cash should not have access to the accounting records, and accounting personnel should not have access to cash.
1.
2. Prepare an immediate control listing of cash receipts at the time and place that the money is received. This initial listing may consist of a cash register tape or serially numbered sales tickets rather than formal entries in the accounting records. A list of incoming check should be prepared by the employees assigned to open the mail.
2.
3. Require that all the cash receipts be deposited daily in the bank.
3.
4. Make all payments by check. The only exception should be for small payments to be made in cash from a petty cash fund. Payments should never be made out of cash receipts. Checks should never be drawn payable to cash. A check drawn to a named payee requires endorsement by the payee on the back of the check before it can be cashed or deposited. This endorsement provides permanent evidence identifying the person who received the funds. On the other hand, a
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check payable to cash can be deposited or cashed by anyone.

4.
5. Require that the validity and amount of every expenditure be verified before a check is issued in payment.
5.
6. Separate the function of approving expenditure from the function of signing checks.
6.
BANK STATEMENT AND BANK RECONCILIATION. Since all cash receipts are to be deposited intact in the bank and all significant cash disbursements are to be made by check through the bank, each month the bank will provide the depositor with a statement of the depositors account, accompanied by the checks paid and charged to the account during the month. A bank statement shows the balance on deposit at the beginning of the month, the deposits, the checks paid, any other debits and credits during the month, and the new balance at the end of the month.

The balance shown on the monthly statement received from the bank will usually not agree with the balance of cash shown by the depositors accounting records. Certain transactions recorded by the depositor will not yet have been recorded by the bank. For instance, some checks may be written by the depositor and deducted from the cash account on the depositors records but not yet presented to the bank for payment, deposits in transit, and so on. In order to assure that the bank and depositor are in agreement on the amount of money on deposit, a bank reconciliation needs to be prepared, because the bank and the depositor maintain independent records of the deposits, the checks and the running balances of bank account. Once a month an employee prepares a bank reconciliation to verify that these two independent sets of records are in agreement. For strong internal control, the employee who prepares the bank reconciliation should not have access to cash or be responsible for recording cash transactions in the accounting records.

PETTY CASH FUND. As previously emphasized, adequate internal control over cash requires that all receipts be deposited in the bank and all disbursements be made by check. However, every business finds it convenient to have a small amount of cash on hand with which to make some minor expenditure. Examples include payments for small purchases of office supplies, post-
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age stamps and taxi fares. Internal control over these small cash payments can be best achieved through a petty cash fund.

When a disbursement is made from the petty cash fund, the custodian of the fund is required to fill out a petty cash voucher for expenditure, the date, and the signature of the person receiving the money. The petty cash box should, therefore, always contain cash and /or vouchers totaling the exact amount of the fund.

When the amount is nearly exhausted, the fund should be replenished. To replenish a petty cash fund means to replace the amount of money that has been spent. In practice, the petty cash fund is usually replenished at the end of an accounting period; even through the fund is not running low. And occasional surprise counts of the fund should be made to prevent careless handling, theft, and misuse of petty cash fund.

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Unit Fourteen Account Receivable

SIGNIFICANCE OF ACCOUNTS RECEIVABLE. Account receivable arise when a business sells goods and services on credit. Sales and profits can be increased by granting customers the privilege of making payment a month or more after the date of sale. However, no business concern wants to sell on credit to a customer who will prove unable or unwilling to pay his or her account. Consequently, most business organizations have a credit department which investigates the credit worthiness of each prospective customer.

Regardless of how thoroughly the credit department investigates prospective customers, some uncollectible accounts will arise as a result of errors in judgment or because of unexpected development. In fact, a limited amount of uncollectible accounts is evidence of a sound credit policy. If the credit department should become too cautious and conservative in rating customers, it might avoid all credit losses, but, in so doing, lose profitable business by rejecting many acceptable customers.

ALLOWANCE FOR DOUBTFUL ACCOUNTS. There is no way of telling in advance which accounts receivable will be collected and which one will prove to be worthless. It is therefore not possible to credit the account of any particular customer to reflect the overall estimate of the years credit losses. Neither is it possible to credit the Accounts Receivable controlling account in the general ledger. If the Accounts Receivable controlling account were to be credited with the estimated amount of doubtful accounts, this controlling account would no longer be in balance with the total of the numerous customers accounts in the subsidiary ledger. The only practicable alternative, therefore, is to credit a separate account called Allowance for Doubtful Accounts with the amount estimated to be uncollectible.

The Allowance of Doubtful Accounts often is described as a contra-asset account or a valuation account. Both of these terms indicate that the Allowance for Doubtful Accounts has a credit balance, which is offset against the asset Accounts Receivable to produce the proper balance sheet value for this asset.
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The provision for uncollectible accounts is an estimate based upon past experience. The larger the allowance established for doubtful accounts, the lower the net valuation of accounts receivable will be. The valuation of assets at conservative amounts is a long-standing tradition in accounting.

There are two methods of estimating uncollectible accounts expense, one is referred to as the balance sheet approach and rests on an aging of the accounts receivable, the other is regarded as the income statement approach and compute the uncollectible accounts as a percentage of the years net sales.

Aging the accounts receivable. A past-due account receivable is always viewed with some suspicion. The fact that a receivable is past due suggests that the customer is either unable or unwilling to pay. The analysis of accounts receivable by age is known as aging the accounts, as illustrated by the scheduled below. Analysis of Accounts Receivable by Age December, 31, 19-Not yet Customers Company A Company B Company C Company D Company E Others Totals percentage Total $ 500 150 800 900 400 32 250 $ 35 000 100 400 16 300 $ 18 000 51 10 000 $ 10 000 29 4 200 $ 4 350 12 200 $ 1 000 3 1 500 $ 1 650 5 800 $ 800 $ 100 due $ 500 $ 150 1-30 days past due 31-60 days past due 61-90 days past due over 90 days past due
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19_ _ 12 31 A B C D E 400 16 300 $ 18 000 51 10 000 $ 10 000 29 4 200 $ 4 350 12 200 $ 1 000 3 1 500 $ 1 650 5 800 $ 800 $ 100 $ 500 $ 150 1~30 31-60 61-90 90 $ 500 150 800 900 400 32 250 $ 35 000 100
The longer past due an account receivable becomes, the greater the likelihood that it will not be collected in full. In recognition of this fact, the analysis of receivables by age groups can be used as a stepping-stone in determining a reasonable amount to add to the Allowance for Doubtful Accounts. To determine this amount, we estimate the percentage of probable expense for each age group of accounts receivable. This percentage, when applied to the dollar amount in each age group, gives a probable expense for each group. By adding together the probable expense for all the age groups, the required balance in the Allowance for Doubtful Accounts is determined. The following schedule lists the group totals from the preceding illustration and shows how the total probable expense from uncollectible accounts is computed. Accounts Receivable by Age Groups
percentage considered Total Not yet due 1-30 days past due 31-60 days past due 61-90 days past due Over 90 days past due Totals $ 18 000 10 000 4 350 1 000 1 650 $ 35 000 Uncollectible 1 3 10 20 50 Probable Uncollectible Accounts $ 100 300 435 200 825 $ 1 940
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1~30 31~60 61~90 90 $ 18 000 10 000 4 350 1 000 1 650 $ 35 000 1 3 10 20 50 $ 100 300 435 200 825 $ 1 940
This summary indicates that an allowance for doubtful accounts of $ 1 940 is required.
1 940
Estimating uncollectible accounts as a percentage of net sales. An alternative approach preferred by some companies consists of computing the charge to uncollectible accounts expenses as a percentage of the net sales for the year. The question to be answered is not How large a valuation allowance is needed to reduce our receivables to realizable value? Instead, the question is stated as How much uncollectible accounts expense is associated with this years volume of sales?

As an example, assume that for several years the expense of uncollectible accounts has averaged 1% of net sales (sales minus returns and allowances and sales discounts). At the end of current year, the following account balances appear in the ledger. Dr. Cr. Sales $ 1 260 000 Sales returns and allowances $40 000 Sales discounts 20 000
1% $40 000 20 000 $ 1 260 000
The net sales of the current year amount to $ 1 200 000; 1% of this amount is $ 12 000.
1 200 000 1% 12 000
If a company makes both cash sales and credit sales, it is better to exclude the cash sales from consideration and to compute the percentage relationship of uncollectible accounts expense to credit sales only.

This approach of estimating uncollectible accounts receivable as a percentage of credit sales is easier to apply than the method of aging accounting receivable. The aging of receivables, however, tends to give a more reliable estimate of uncollectible accounts because of the consideration
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given to the age and collectibility of the specific accounts receivable at the balance sheet date. Some companies use the income statement approach for preparing monthly financial statements and internal reports, but use the balance sheet method for preparing annual financial statements.

Whenever an account receivable from a specific customer is determined to be uncollectible, it no longer qualifies as an asset and should be written off. To write off an account receivable is to reduce the balance of the customers account to zero. The journal entry to accomplish this consists of a credit to the Accounts Receivable controlling account in the general ledger (and to the customers account in the subsidiary ledger), and an offsetting debit to the Allowance for Doubtful Accounts.

INTERNAL CONTROL FOR ACCOUNTS RECEIVABLE. Proper segregation of duties is of significance to the management of accounts receivable. In a small business, it is not uncommon to find that one employee has responsibility for handling cash receipts from customers, maintaining the accounts receivable records, issuing credit memos for goods returned by customers, and writing off receivables judged to be uncollectible. Such as a combination of duties is a virtual invitation to fraud. The employee in this situation is able to remove the cash collected from a customer without making any record of the collection. The next step is to dispose of the balance in the customers account. This can be done by issuing a credit memo indicating that the customer had returned merchandise, or by writing off the customers account as uncollectible. Thus, the employee has the cash, the customers account shows a zero balance and the books are in balance.

To avoid fraud in the handling of receivables, some of the most important rules are that who maintain the accounts receivable subsidiary ledger must not have access to cash receipts, and employees who handle cash receipts must not have access to the records of receivable. Furthermore, employees who maintain records of receivable must not have authority to issue credit memos or to write off receivables as uncollectible. These are classic examples of incompatible duties. In addition, documents such as sales invoices and credit memos must be serially numbered and every number in the series accounted for.

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Unit Fifteen Inventories

GENERAL BACKGROUND OF INVENTORY. One of the largest assets in a retail store or in a wholesale business is the inventory of merchandise and the sale of this merchandise at prices in excess of costs is the major source of revenue. For a merchandising company, the inventory consists of all goods owned and held for sale in the regular course of business. Merchandise held for sale will normally converted into cash within less than a years time and is therefore regarded as a current asset. In the balance sheet, inventory is listed immediately after accounts receivable, because it is just one step further removed from conversion into cash than are the accounts receivable.

In manufacturing business there are three major types of inventories: raw materials, goods in process of manufacture, and finished goods. All three classes of inventories are included in the current asset section of the balance sheet.

To expand our definition of inventory to fit manufacturing companies as well as merchandising companies we can say that inventory means the aggregate of those items of tangible property which (1) are held for sale in the ordinary course of business, (2) are in process of production for such sale, or (3) are to be currently consumed in the production of goods or services to be available for sale.
1 2 3
The inventory figure appears in both the balance sheet and the income statement. In the balance sheet, the inventory is often the largest current asset. In the income statement, the ending inventory is subtracted from the cost of goods available for sale to determine the cost of goods sold during the period. How can a business determine, at the end of a year, a month, or other accounting period, the quantity and the cost of the goods remaining on hand?

How can management determine the cost of the goods sold during the period? These amounts must be determined before either a balance sheet or an income statement can be prepared. In fact, the determination of inventory value and of the cost of goods sold may be the most important single step in measuring the profitability of a business. The two alternative approaches to the determination of inventory and of cost of goods sold are called the perpetual inventory system and the
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periodic inventory system.

PERPETUAL INVENTORY SYSTEM. It is a system of accounting for merchandise that provides a continuous record showing the quantity and cost of all goods on hand. Companies that sell products of high unit value such as automobile and television sets usually maintain a perpetual inventory system that shows at all times the amount of inventory. As merchandise is acquired, it is added to an inventory account; as goods are sold, their cost is transferred out of inventory and into cost of goods sold account. This continuous updating of the inventory account explains the name perpetual inventory system.

PERODIC INVENTORY SYSTEM. It is a system of accounting for merchandise in which inventory at the balance sheet date is determined by counting and pricing the goods on hand. Cost of goods sold is computed by subtracting the ending inventory from the cost of goods available for sale.

The periodic inventory system is likely to be used by a business that sales variety of merchandise with low unit prices, such as a drugstore or hardware store. To maintain perpetual inventory records in such a business would ordinarily be too time-consuming and expensive.

TAKING A PHYSICAL INVENTORY. Physical inventory are useful under either perpetual inventory system or periodic inventory system. Under the periodic system, the balance of inventory in the ledger account represents the beginning inventory because no entry has been made in the Inventory account since the end of the preceding period. All purchases of goods during the present period have been recorded in the Purchases account. The ending inventory does not appear anywhere in the ledger accounts; it must be determined by a physical count of goods on hand at the end of the accounting period. Under the perpetual system, physical inventories are taken to make sure that the tangible assets are in agreement with their records, and physical inventory can be conducted at dates other than year-end or it can be taken for different products or different departments at various dates during the year, sine the perpetual records always show the amounts which should be on hand.

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A physical inventory should be carefully planned and supervised to prevent such errors as the double counting of items, the omission of goods from the count, and other quantitative errors. There are various methods of counting merchandise. One of the simplest procedures is carried out by the use of two-member teams. One member of the team counts and calls the description and quantity of each item. The other person lists the description and quantities on an inventory sheet. In taking a physical inventory, special considerations should be given to goods in transit and the passage of title to merchandise.

PRICING THE INVENTORY. The primary basis of accounting for inventory is cost, which has been defined generally as the price paid or consideration given to acquire an asset. The prices of many kinds of merchandise are subject to frequent changes. When identical lots of goods are purchased at various dates during the year, each lot may be acquired at different cost price.

In order to establish a dollar amount for cost of goods sold and for the ending inventory, we must make an assumption as to which units were sold and which units remain on hand at the end of the year. There are several acceptable assumptions on this point; four of the most common will be considered. Each assumption made as to the cost of the units in the ending inventory leads to different methods of pricing inventory and to different amounts in the financial statements. The four inventory valuation methods to be considered are known as (1) specific identification, (2) average cost, (3) first-in, first-out, and (4) last-in, first-out.
1 2 3 4
Specific Identification Method. A method of pricing inventory by identifying the units in the ending inventory as coming from specific purchases. If the units in the ending inventory can be identified as coming from specific purchases, they may be priced at the mounts listed on the purchased invoices. The specific identification method is best suited to inventories of high-priced, low-volume items.

Average-Cost Method. Average cost is computed by dividing the total cost of goods available for sale by the number of units available for sale. This computation gives a weighted-average unit cost, which is then applied to the units in the ending inventory. The average-cost method is logical if the items are identical. Its shortcoming is that changes in current replacement costs of inventory are concealed because these costs are averaged with older costs. As a result of this averaging, the reported gross profit may not reflect current market conditions.
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First-in, First-out Method. The first-in, first-out method, which is often referred to as FIFO, is based upon the assumption that first merchandise acquired is the first merchandise sold. In other words, each sale is made out of the older goods in stock; the ending inventory therefore consists of the most recently acquired goods. The FIFO method of determining inventory cost may be adopted by any business, regardless of whether or not the physical flow of merchandise actually corresponds to this assumption of selling the oldest units in stock.

During a period of rising price the first-in, first-out method will result in a larger amount being assigned as the cost of the ending inventory than would be assigned under the average-cost method. When a relatively large amount is allocated as cost of the ending inventory, a relatively small amount will remain as cost of goods sold. It may be argued in support of the first-in, first-out method that the inventory valuation reflects recent costs and is therefore a realistic value in the light of conditions prevailing at the balance sheet date.

Last-in, First-out Method. The last-in, first-out method, commonly known as LIFO, is one of the most interesting methods of pricing inventories. The title of this method suggests that the most recently acquired goods are sold first, and that the ending inventory consists of old goods acquired in the earliest purchases. Although this assumption is not in accord with physical movement of merchandise in most business, there is a strong logical argument to support LIFO method.

For the purpose of measuring income, the flow of costs may be more significant than the physical flow of merchandise. Supporters of the LIFO method contend that the measurement of income should be base upon current market conditions. Therefore, current sales revenue should be offset by the current cost of the goods sold. Under the LIFO method, the costs assigned to the cost of goods sold are relatively current, because they stem from the most recent purchases. Under the FIFO method, on the other hand, the cost of goods sold is based on older costs.

The search for the best method of inventory valuation is rendered difficult because the inventory figure is used in both the balance sheet and the income statement, and these two financial statements are intended for different purposes. In the income statement the function of the inventory figure is to permit a matching of costs
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and revenue. In the balance sheet the inventory and the other current assets are regarded as a measure of the companys ability to meet its current debts.

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Unit Sixteen Plant and Equipment

NATURE OF PLANT AND EQUIPMENT. The plant and equipment is used to describe long-lived assets acquired for use in the operation of the business and not intended for resale to customers. Among the more common examples are land, buildings, machinery, furniture and fixtures, office equipment, and automobiles. A delivery truck in the showroom of an automobile dealer is an inventory; when this same truck is sold to a drugstore for use in making deliveries to customers, it becomes a unit of plant and equipment.

The term fixed asset has long been used in accounting literature to describe all types of plant and equipment. This term, however, has virtually disappeared from the published financial statements of large corporations. Plant and equipment appears to be a more descriptive term. Another alternative title used on many corporation balance sheets is property, plant, and equipment.

It is convenient to think of a plant asset as a stream of services to be received by the owner over a period of years. Ownership of a delivery truck, for example, may provide about 100 000 miles of transportation. The cost of the delivery truck is customarily entered in a plant and equipment account entitled Delivery Truck, which in essence represents payment in advance for several years of transportation service. Similarly, a building may be regarded as payment in advance for several years supply of housing services. As the years go by, these services are utilized by business and the cost of the plant asset is gradually transferred into depreciation expense.
10
MAJOR CATEGORIES OF PLANT AND EQUIPMENT. Plant and equipment items are often classified into the following groups:

1. Tangible plant assets. The term tangible denotes physical substance, as exemplified by land, or a machine. This category may be subdivided into two distinct classifications: a. Plant property subject to depreciation. Included are plant assets of limited useful life such as buildings and office equipment. b. Land. The only plant asset not subject to depreciation is land, which has an unlimited term of existence.
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1. a. b.
2. Intangible assets. The term intangible assets is used to describe assets which are used in the operation of the business but no physical substance, and are noncurrent. Current assets such as accounts receivable or prepaid rent are not included in the intangible classification, even though they are lacking in physical substance. The intangible assets will be separately discussed in Unit Eighteen.
2.
DETERMINING THE COST OF PLANT AND EQUIPMENT. The cost of plant and equipment includes all expenditures reasonable and necessary in acquiring the asset and placing it in a position and condition for use in the operations of the business. Only reasonable and necessary expenditures should be included. For example, if the companys truck driver receives a traffic ticket while handling a new machine to the plant, the traffic fine is not part of the cost of the new machine. If the machine in dropped and damaged while being unloaded, the cost repairing the damage should be recognized as expense in the current period and should not be added to the cost of the machine.

Assets Purchased for Cash. Cost is most easily determined when an asset is purchased for cash. The cost of the asset is then equal to the cash outlay necessary in acquiring the asset plus any expenditure for freight, insurance while in transit, installation, trial runs and any other costs necessary to make the asset ready for use.

Assets Acquired by Exchange. Assets are frequently acquired by trading in an existing asset as partial or complete payment for a new asset. The cost amount of the new asset is the money amount of the resources given up to acquire it. The resources given up in this case include a non-monetary asset. Determination of the cost of the new asset depends upon the measurement of the money amount of the asset traded in.

The AICPA in Opinion No.29 recommended that: Accounting for nonmonetary transactions should be based upon the fair values of the assets (or services) involved, which is the same as that used in monetary transactions.
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29
This recommendation is based upon an assumption that where a nonmonetary asset is exchanged for another, two separate transactions occur. The traded asset is realized for cash at its fair market price and the proceeds are used to acquire the new asset. The Opinion thus interprets the money amount of the traded asset as the price for which it could be sold in a normal arms-length transaction. This amount is referred to as the assets fair market value.

Donated Assets. In some circumstances assets may be donated to a firm. For example, to stimulate investment in a depressed area, a local council may donate land to firms which commence operations in the area. Under these circumstances the donated assets are recorded at their fair market value at the date of donation.

Self-constructed Assets. Many assets are constructed by the owner rather than acquired by purchase or exchange. The cost of self-constructed assets is the money amounts of resources embodied in the asset. The amount of direct materials, direct labor, and variable overhead is clearly part of the cost of constructing assets and there is no dispute about their inclusion in the amount. Interest cost incurred during the construction period is viewed as part as of the cost of the asset. The treatment of fixed factory overhead is, however, an issue which remains in dispute.

CAPITAL EXPENDITURES AND REVENUE EXPENDITURES. Expenditures for the purchase or expansion of plant assets are called capital expenditures and recorded in asset accounts. Expenditures for ordinary repairs, maintenance, fuel, and other items necessary to the ownership and use of plant and equipment are called revenue expenditures and recorded by debits to expense accounts. The charge to an expense account is based on the assumption that the benefits from the expenditure will be used up in the current period, and the cost should therefore be deducted from the revenue of the current period in determining the net income.

A business may purchase many items which will benefit several accounting periods, but which have a relatively low cost. Examples of such items include wastebaskets, and pencil sharpeners. Such items are theoretically capital expenditures, but if they are recorded as assets in the
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accounting records, it will be necessary to compute and record the related depreciation expense in future periods. Extra work involved in developing more precise accounting information should be weighed against the benefits that result. Thus, for reasons of convenience and economy, expenditures which are not material in dollar amount are treated in the accounting records as expenses of the current period. In brief, any material expenditure that will benefit several accounting periods is considered a capital expenditure. Any expenditure that will benefit only the current period or that is not material in amount is treated as revenue expenditure. Many companies develop formal policy statements defining capital and revenue expenditures as guide towards consistent accounting practice from year to year. These policy statements often set a minimum dollar limit for a capital expenditure.

A careful distinction between capital and revenue expenditure is essential to attainment of one of the most fundamental objectives of accountingthe determination of net income for each year of operation of a business. A capital expenditure is recorded by debiting an asset account, the transaction has no immediate effect upon net income. However, the depreciation of the amount entered in the asset account will be reflected as an expense in future periods. A revenue expenditure, on the other hand, is recorded by debiting an expense account and therefore represents an immediate deduction from earnings in the current period.

Plant assets such as buildings and equipments depreciate because of physical deterioration or obsolescence. As units of plant and
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Unit Eighteen Intangible Assets

If a trademark or trade name is purchased, however, the cost may be substantial. Such cost should be capitalized and amortized to expense over a period of no more than 40 years. If the use of the trademark is discontinued or its contribution to earnings becomes doubtful, any unamortized cost should be written off immediately.
40
FRANCHISES. A franchise is a right granted by a company or a government unit to conduct a certain type of business in a specific geographical area. An example of a franchise is the right to operate a Mc Donalds restaurant in a specific neighborhood. The cost of franchises varies greatly and often may be quite substantial. When the cost of a franchise is small, it may be charged immediately to expense or amortized over a short period such as five years. When the cost is substantial, amortization should be based upon the life of the franchise (if limited); the amortization period, however, may not exceed 40 years.
5 40
COPYRIGHTS. A copyright is an exclusive right granted by a government to protect to production and sale of literary or artistic materials for the life of the creator plus 50 years. The cost of sustaining a copyright in some cases is minor and therefore is chargeable to expense when paid. Only when a copyright is purchased will the expenditure be material enough to warrant its being capitalized and spread over the useful life. The revenue from copyright is usually limited to only a few years, and the purchase cost should. Of course, be amortized over the years in which the revenue is expected.
50
OTHER INTANGIBES AND DEFERRED CHARGES. Many other types of intangible assets are found in the published balance sheets of large corporations. Some examples are formulas, processes, name lists, and film rights.

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Intangibles, particularly these with limited lives, are sometime classified as deferred charges in the balance sheet. A deferred charge is an expenditure that is expected to yield benefits for several accounting periods and should be amortized over its estimated useful life. Included in this category are such items as bond issuance costs, plant rearrangement and moving costs, start-up costs, and organization costs. The distinction between intangibles and deferred charges in not an important one; both represent a stream services in the form of long-term prepayments awaiting allocation to those accounting periods in which the services will be consumed.

RESEARCH AND DEVELOPMENT (R&D) COSTS. The spending of billions of dollars a year on research and development leading to all kinds of new products is a striking characteristic of modern industry. In the past, some companies treated all research and development costs as expense in the year incurred; other companies in the same industry recorded these costs as intangible assets to be amortized over future years. This diversity of practice prevented the financial statements of different companies from being comparable.

The lack of uniformity in accounting for R&D was ended when the Financial Accounting Standards Board ruled that all research and development expenditures should be charged to expense when incurred. This action by the FASB had beneficial effect of reducing the number of alternative accounting practice and helping to make financial statements of different companies more comparable.

However, the FASBs decision was very controversial. Critics argued that a policy of reducing current earnings for all R&D expenditures might discourage companies from undertaking large R&D programs.

The controversy over the FASBs position on R&D expenditures raises an interesting question about the formulation of accounting standards: Is it possible for accounting standards to describe an economic activity without also influencing that activity?

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Unit Nineteen Liabilities

INTRODUCTION. In contemporary accounting the term liabilities is used to describe a heterogeneous group of items. Some liabilities are therefore obligations, for instance, contingent liabilities; some are items which are not obligations at all, and these include deferred credits. The result is that there is no clear understanding of the nature of a liability. The AICPA conveys clearly the lack of understanding of the nature of liabilities when it defines liabilities as Economic obligations of an enterprise that are recognized and measured in conformity with generally accepted accounting principles. Liabilities also include certain deferred credits that are not obligations but that are recognized and measured in conformity with generally accepted accounting principles. This definition could be paraphrased as liabilities are those items which accountants treat as liabilities. In other words, accountants are not sure what liabilities are, but they know one when they see one.

The nature of liabilities in contemporary accounting would become much clearer if the term was used to describe only financial obligations. Deferred credits are not obligations but are simply credit left-overs and it would be much better if they were shown as a separate and distinct class of items on the balance sheet.

The separation of financial obligations from deferred credits would allow statement users to obtain a much clearer picture of the financial position of the entity. Currently, items which are not obligations in any sense are frequently mixed with items which are payable now or will become payable in the future. The statement users may believe that the entity is obligated to pay larger amount than are, in fact, due.

If deferred credits are excluded, a liability can be defined as follows:

A financial obligation which is currently enforceable against an entity or which is expected to become enforceable in the future provided that the amount of the obligation can be determined whit reasonable certainly and that it does not arise from an executory contract.

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CURRENT LIABILITIES. Current liabilities are obligations that must be paid within one year or the operating cycle (whichever is longer). A comparison of the amount of current liabilities with the amount of current assets available for paying these debts helps us in judging a companys short-run-debt-paying ability. Among the more common current liabilities is accounts payable, notes payable, and so on.

Account Payable. Accounts payable, or trade accounts payable, is the most commonly seen current liabilities. They represent balances owed to outsiders from goods, supplies, and services purchased on open account. Accounts payable arise because of the time lag between the receipt of services or acquisition of title to assets and the payment for them. A first essential of satisfactory internal control over accounts payable is the segregation of duties so that a cash disbursement to a creditor will be made only after approval of the purchasing, receiving, accounting, and finance departments. All purchase transactions should be evidenced by serially numbered purchase orders, copies of which are sent to the accounts payable department for comparison with receiving reports and vendors invoices.

Notes Payable. Obligations in the form of written promissory notes are known as notes payable. Notes payable are issued whenever bank loans are obtained. Other transactions which may give rise to notes payable include the purchase of real estate or costly equipment, the purchase of merchandise, and the substitution of a note for a past-due account payable.

NONCURRENT LIABILITIES AND OTHER LIABILITES. Non-current liabilities are obligations that do not need to be paid within one year or the operating cycle (whichever is longer). The most common examples are bonds payable and mortgages payable, and long-term notes payable. There are such types of liabilities that have special characteristics as pension obligation, estimated liabilities, contingent liabilities and deferred items.

Bonds Payable. When a corporation needs to raise a large amount of long-term capital, it generally sells additional shares of capital stock or issues bonds payable. The issuance of bonds payable is the equivalent of splitting a large loan into a great many units, called bonds. Each bond is, in essence, a long-term interest-bearing note payable.

There are different types of bonds. Bonds secured by the pledge of specific assets are called
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mortgage bonds. An unsecured bond is called a debenture bond; its value rests upon the general credit of the corporation. When the name of the owner is registered with the issuing corporation, the bond is a registered bond. Payment of interest is made by semiannual checks mailed to the registered owners. Coupon bonds have interest coupons attached; each sic months during the life of the bond one of these coupons becomes due. The bondholder detaches the coupon and deposits it with a bank for collection. The name of the holder is not registered with the corporation. A convertible bond is one which may be exchanged for common stock at the option of the bondholder.

Mortgage Notes Payable. Purchase of real estate and certain types of equipment often are financed by the issuance of mortgage notes payable. When a mortgage note is issued, the borrower pledges title to specific assets as collateral for the loan. If the borrower defaults on the notes, the lender may foreclose upon these assets. Mortgage notes usually payable in equal monthly installments. These monthly installments may continue until the loan is completely repaid, or the not may contain a due date at which the remaining unpaid balance of the loan must be repaid in a single, lump sum payment.

Pension Plans. A pension plan is a contract between a company and its employees under which the company agrees to pay retirement benefits to eligible employees. An employer company usually meets its obligations under a pension plan by making regular payments to an insurance company or other outside agency. As pension obligations accrue, the employer company records them by a debit to Pension Expense and a credit to Cash. If all required payments are made promptly to the pension fund trustee, no liability need appear on the employer companys financial statements.

Estimated Liabilities. An estimated liability is one known to exist, but for which the dollar amount is uncertain. A common example is the liability of a manufacturer to honor any warranty on products sold. For example, assume that a company manufactures and sells TV sets which carry a two-year warranty. To achieve the objective of offsetting current revenue with all related expenses, the liability for future warranty repairs on TV sets sold during the current period should be estimated and recorded at the balance sheet date. This estimate will be based upon the companys past experience.

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Contingent Liability. A contingent liability may be regarded as a possible liability, which may develop into a full-fledged liability or may be eliminated entirely by a future event. A common contingent liability is the possibility of loss relating to a lawsuit filed against a company. Until the lawsuit is resolved, uncertainty exists as to the amount, if any, of the companys liability. Central to the definition of a contingent liability is the element of uncertaintyuncertainty both as to the amount of loss and whether, in fact, a loss actually has occurred.

Deferred Credits. The term deferred credit describes items classified among liabilities on the balance sheet which are neither enforceable obligations (actual liabilities) nor possible liabilities. Common examples of deferred items are provisions for some expenditure, and deferred tax.

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Unit Twenty Owners Equity

The owners equity in a business represents the resources invested by the owners. It is called stockholders equity in a corporation. Owners equity is a broader term because the concepts being presented are equally applicable to the ownership equity in corporations, partnerships, and single proprietorships.

OWNERS EQUITY IN CORPORATION AND SINGLE PROPRIETORSHIPS. The owners equity of a corporation consists of two elements: capital stock and retained earnings, as shown in the following illustration: Stockholders equity: Capital stock $ 1 000 000 Retained earnings 278 000 Total stockholders equity $ 1 278 000
: $ 1 000 000 278 000 $ 1 278 000
The $ 1 000 000 shown under the caption capital stock represents the amount invested in the business by its owners. The $ 278 000 of retained earnings represents the portion of owners equity which has been accumulated through profitable operation of the business. The corporation has chosen to retain this $ 278 000 in the business rather than to distribute these earnings to stockholders as dividends. The total earnings of the corporation may have been considerably more than $ 278 000, because any earnings which were paid to stockholders ad dividends would not appear on the balance sheet. The term retained earnings describes only the earnings which were not paid out in the form of dividends. The amount of the retained earnings account at any balance sheet date represents the accumulated earnings of the company since the date of incorporation, minus any losses and minus all dividends distributed to stockholders.
1 000 000 278 000 278 000 278 000
A single proprietorship is not required to maintain to distinction between invested capital and earned capital. Consequently, the balance sheet of a single proprietorship will have only one item in the owners equity section, as illustrated below:
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Owners equity: Bill white Capital

:
$ 30 000
$ 30 000
CHANGES OF OWNERS EQUITY. The equity of the owners is a residual claim because the claim of the creditors legally comes first. If you are the owner of a business, you are entitled to whatever remains after the claims of the creditors are fully satisfied. Thus, owners equity is equal to the total assets minus the liabilities. For example, a company has total assets of $ 350 000, and its total liabilities amounting to $ 80 000, therefore, the owners equity must equal to $ 270 000($ 350 000-$ 80 000).
350 000 80 000 270 000 350 000-80 000
Suppose that the company borrows $ 20 000 from a bank. After recording the additional asset of $ 20 000 in cash and recording the new liability of $ 20 000 owed to the bank, now the company hast total assets of $ 370 000 and the total liabilities of $ 100 000, and therefore the owners equity still is equal to $ 270 000.
20 000 20 000 370 000 100 000 270 000
It is apparent that the total assets of the business were increased by the act of borrowing money from a bank, but the increase in total assets was exactly offset by an increase in liabilities, and the owners equity remained unchanged. The owners equity in a business is not increased by incurring of liabilities of any kind.

Increases In Owners Equity. The owners equity comes from two sources: (1) investment by the owners; (2) Earnings from profitable operation of the business.
1 2
For a proprietorship, the owners equity is represented by the term capital. The total capital comes from the owners initial investment and net income. The net income is the excess of revenue over expenses for the accounting period and it is the increase in capital resulting from profitable operation of a business.

For a corporation, the caption capital stock in the balance sheet represents the amount invested by the owners of the business, as previously mentioned. When the owners of a corporation invest cash or other assts in the business, the corporation issues in exchange shares of capital stock as evidence of the investors ownership equity. Thus, the owners of a corporation are termed stockholders.
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The basic unit of capital stock is called share, but a corporation may issue capital stock certificates in denominations of 1 share, 100 shares, or any other number. The total number of shares of capital stock outstanding at any given time represents 100% ownership of the corporation. Outstanding shares are those in the hands of stockholders. The number of shares owned by an individual investor determines the extent of his or her ownership of the corporation. Capital provided to a corporation by stockholders in exchange for shares of either preferred or common stock is called paid-in capital, or contributed capital.
1 100
The earning of net income, or profits, is a major goal of almost every business enterprise, large or small. Profits increase the owners equity in the business and the increase is usually accompanied by an increase in total assets. The resources generated by profitable operations may be retained in the business to finance expansion, or they may be distributed as dividends to the stockholders. Some of the largest corporations have become large by retaining their profits in the business and using these profits for growth. Retained profits may be used, for example, to acquire new plant and equipment, to carry on research leading to new territories. But remember, retained earnings is not an asset; it is an element of stockholders equity.

Decrease In Owners Equity. Decreases in owners equity also are caused in two ways: (1) Distribution of cash or other assets by the business to its owners; (2) Losses from unprofitable operation of the business.
1 2
The distribution of cash for a single proprietorship takes the form of personal withdrawals, and a drawing account is used to show the decrease in capital. A dividend is a distribution of assets (usually cash) by a corporation to its stockholders. In some respects, dividends are similar to expense in that they reduce both the assets and the owners equity in the business. However, dividends are not an expense, and they are not deducted from revenue in the income statement. The reason that dividends are not viewed as an expense is that these payments do not serve to generate revenue. Rather, they are a distribution of profits to the owners of the business. Since the declaration and payment of a dividend reduce the stockholders equity, the dividend could be recorded by debiting the Retained Earnings account. However, a clearer record is created if a separate Dividends account is debited for all amounts distributed as dividends to stockholders. At the end of a period the Dividends account is credited and the Retained Earnings account is debited to close the Dividends account.
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An expense always causes a decrease in owners equity. Expenses are the cost of the goods and service used up in the process of earning revenue. When the expenses exceeds the revenue generated, the business is said to be operating at a loss.

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Unit Twenty-One Revenue and Expenses

Income Statement is prepared to show the net income or net loss of a business for a specific period of time. Net income is the excess of the price of goods sold and services rendered over the cost of goods and services used up during a given time period. To determine net income, it is necessary to measure for a given time period (1) the price of goods sold and services rendered and (2) the cost of goods and services used up. The technical accounting terms for these items comprising net income are revenue and expenses.
1 2
REVENUE. When a business renders services to its customers or delivers merchandise to them, it either receives immediate payment in cash or acquires an account receivable which will be collected and thereby become cash within a short time. The revenue for any given period is equal to the inflow of cash and receivables from sales made in that period. For any single transaction, the amount of revenue is a measurement of the asset values received from customers.

Revenue causes an increase in owners equity. The inflow of cash and receivable from customers increase the total assets of the company; on the other side of the accounting equation, the liabilities do not change, but owners equity is increased to match the increase in total assets. Thus revenue is the gross increase in owners equity resulting from business activities.

Various terms are used to describe different types of revenue; for example, the revenue earned by a real estate broker might be called Sales Commissions Earned, or alternatively, Commission Revenue. In the professional practice of lawyers, physicians, dentists, and CPAs, the revenue is called Fees Earned. A business which sells merchandise rather than services will use the term Sales to describe the revenue earned. Another type of revenue is Interest Earned, which means the amount received as interest on notes receivable, bank deposits, government bonds, or other securities.

When is revenue recorded in the accounting records? For example, assume that on May 24, a real estate company signs a contract to represent a client in selling the clients personal residence.
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The contract entitles the real estate company to a commission equal to 5% of the selling price, due 30 days after the date of sale. On June 10, the real estate company sells the house at a price of $ 120 000, thereby earning a $ 6 000 commission ($ 120 000 5%), to be received on July 10. When should the company record this $ 6 000commission revenuein May, June, or July?
5 24 5% 30 6 10 120 000 6 000 5% 120 000 7 10 6 000 5 6 7
The company should record this revenue on June 10the day it rendered the service of selling the clients house. As the company will not collect this commission until July, it must also record an account receivable on June 10. In July, when this receivable is collected, the company must not record revenue a second time. Collecting an amount receivable increase one asset, cash, and decreases other assetAccounts Receivable. Thus, collecting an account receivable does not increase owners equity and does not represent revenue.
6 10 7
Our answer illustrates a generally accepted accounting principle called the realization principle. The realization principle states that a business should record revenue at the time services are rendered to customers or goods sold are delivered to customers. In short, revenue is recorded when it is earned, without regard as to when the cash is received.

EXPENSES. Expenses are the cost of the goods and services used up in the process of earning revenue. Example include the cost of employees salaries, advertising, rent, utilities, and the gradual wearing-out (depreciation) of such assets as buildings, automobiles, and office equipment. All these costs are necessary to attract and service customers and thereby earn revenue. Expenses are often called the costs of doing business, that is, the cost of the various activities necessary to carry on a business.

An expense always causes a decrease in owners equity. The related changes in the accounting equation can be either (1) a decrease in assets, or (2) an increase in liabilities. An expense reduces assets if payment occurs at the time that the expense is recorded or if payment has been made in advance. If the expense will not be paid until later, as, for example, the purchase of advertising services on account, the recording of the expense will be accompanied by an increase in liabilities.
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A significant relationship exists between revenue and expenses. Expenses are incurred for the purpose of producing revenue. In measuring net income for a period, revenue should be offset by all of the expenses incurred in producing that revenue on a basis of cause and effect, which is called the matching principle.

Timing is an important factor in matching (offsetting) revenue with the related expenses. For example, in preparing monthly income statements, it is important to offset this months expenses against this months revenue. We should not offset this months expenses against last months revenue, because there is no cause and effect relationship between the two.

We previously explained that revenue and cash receipts are not one and the same thing. Similarly, expense and cash payments are not identical. The cash payment for an expense may occur before, after or in the same period that an expense helps to produce revenue. In deciding when to record an expense, the critical question is In what period will this expenditure help to produce revenue? not When did the cash payment occur?

Much expenditure made by a business benefit tow or more accounting periods. Fire insurance policies, for example, usually cover a period of 12 months. If a company prepares monthly income statements, a portion of the cost of such a policy is in force. In this case, apportionment of the cost of the policy by months is an easy matter. If the 12-month policy cost $ 240, for example, the insurance expense for each month amounts to $ 20.
12 240 20
Not at all transaction can be so precisely divided by accounting periods. The purchase of a building, furniture and fixtures, machinery, a typewriter, or an automobile provides benefits to the business over all the years in which such an asset is used. No one can determine in advance exactly how many years of service will be received form such long-lived assets. Nevertheless, in measuring the net income of a business for a period of one year or less, the accountant must estimate what portion of the cost the building and other long-lived assets is applicable to the current year. Since the allocations of these costs are estimated rather than precise measurements, it follows that income statements should be regarded as useful approximations of net income rather than as absolutely accurate computations.

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For some expenditure, such as those for advertising or employee training programs, it is not possible to estimate objectively the number of accounting period over which revenue is likely to be produced. In such cases, generally accepted accounting principles require that the expenditure be charged immediately to expense. This treatment is based upon the accounting principles of objectivity and conservatism. Accounting requires objective evidence that expenditure will produce revenue in future periods before they will view the expenditure as creating an asset. When this objective evidence does not exist, they follow the conservative practice of recording the expenditure as an expense. Conservatism, in this context, means applying the accounting treatment which results in the lowest (most conservative) estimate of net income for the current period.

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Unit Twenty-Two Purchases

The term purchase not only refers to the purchase of merchandise for resale but also includes the buying of various types of property for use within a business. The procedures followed in purchasing activities depend upon the type and size of the business enterprise. The owner of a small retail store may do all the purchasing, or one employee may devote part of his or her time to purchasing. In larger firms, a purchasing department consisting of a manager and staff who devote full time to the purchasing operation may be required. In this lesson we will introduce some procedure and terms that may be found within the purchasing area.

PURCHASING REQUISITION. Any department within an enterprise may request the purchasing department to purchase merchandise or other items by submitting a form called a purchase requisition. Purchase requisitions are generally prenumbered consecutively to prevent their misuse or loss. The requisitions are prepared in duplicate with the original going to the purchasing department and the duplicate being retained by the department preparing the requisition. A purchase requisition must contain the name of the department who made the request and the quantity and description of the requested merchandise. The approved purchase requisition is the purchasing departments authorization to order the merchandise requisitioned.

PURCHASE ORDER. A purchase order is a written order by a buyer for merchandise or other items recorded on the buyers purchase requisition. Purchase orders are generally prepared on specially designed forms but may be prepared on a printed form or on forms provided by a vendor. Purchase orders are prepared in multiple copies and are numbered consecutively. Generally, but not always, the original copy goes to the vendor, the supplier from whom the goods are ordered. It is also common practice to send both the original and duplicate copy to the supplier. In such a case, the duplicate is an acknowledgement copy on which the supplier will sign to indicate an acceptance of the order, creating a formal contract. This signed copy is then returned to the ordering firm. Who gets the remaining copies of the purchase order is a matter of policy within each firm. The department originating the requisition may get a copy, the receiving department may get a copy, or the accounting department may get a copy. The practice followed with respect to requisitioning, purchasing, receiving, recording, and paying for merchandise by each individual firm will govern the distribution of copies.
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INVOICE. An voice, sometimes referred to as a purchase invoice, is a document prepared by a seller which states the items shipped, the cost of the merchandise, and the method of shipment. While this document is considered to be a purchase invoice by the buyer, it is a sales invoice from the sellers viewpoint.

Purchase invoices are normally received by the buyer before the shipment arrives but may be received after the shipment arrives. Upon receipt, the invoice is numbered (consecutively) and compared with a copy of the purchase order to insure that quantities, prices, descriptions, and the terms are correct and that the delivery date and method of shipment meet the specification.

RECEIVED REPORT. When merchandise is received, the receiving personnel may prepare a receiving report indicating the merchandise received, or the contents of the shipment may be compared with a copy of the purchase order. If a receiving report is prepared, it must be compared with the purchase order by personnel in either the accounting or purchasing department. When prices and extensions have been verified, the purchase can be entered in an invoice register and then posted to creditors account in the accounts payable ledger. The invoice is then filed in an unpaid invoice file until it is paid.

INVOICE REGISTER. An invoice register is a book of original entry in which all invoices dealing with purchasing on account, whether the purchase involve merchandise, supplies or other items, are recorded. The invoice register may be set up on a departmental basis to provide more information and perhaps better control.

Generally, property purchased consists of one of three things: (1) merchandise for resale; (2) supplies for use in the course of the business; or (3) equipment (plant assets) for use in operating the business. Therefore, an invoice register is set up to handle these types of transactions.
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1 2 3
Often, an incorrect invoice will be received, and at a later date another purchase invoice will be received to correct the initial invoice. If the corrected purchase invoice is received before the initial invoice has been entered in the invoice register, the initial invoice may be discarded and the corrected invoice may be entered in the invoice register. If the initial invoice has already been entered in the invoice register when the corrected invoice is received, only the difference between the two invoices is recorded.

At any point in time, the invoice register may be footed and the total debits compared with the total credits to prove the invoice register. The total debits must equal the total credits.
BACK ORDERS. Often the supplier is unable to fill the complete order at the time requested and must back order the items not shipped. In such a case the supplier may ship a partial order and send the invoice for the complete order, indicating what has been back ordered and when it will be shipped.

BILL OF LADING. A bill of lading is a receipt given to a shipper when merchandise is shipped by air freight, highway freight, or railroad. The bill of lading is prepared in triplicate (original, shipping order, and memorandum). All three copies are signed by the freight agent who returns the original and memorandum copies to shipper and retains the shipping copy for his or her records.

While a purchase invoice specifies a given quantity of merchandise, the corresponding bill of lading may differ from the invoice as to quantity and description. The reason for this is that merchandise is shipped in crates cartons, or other packages rather than the individual containers. The total number of packages and total weight are indicated on the bill of lading. Freight charges are based upon the total weight of the merchandise, the type of merchandise, and the distance it is being shipped.

DEBIT AND CREDIT MEMORANDA. Merchandise is not always received in satisfactory conditions or according to the terms agreed upon by the buyer. The shipment may be damaged,
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may be the wrong merchandise, or may be delivered too late. In such cases the buyer may return the shipment to the vendor, or may agree to keep the shipment if granted an allowance. A debit memorandum is a document that a buyer uses to inform a seller that the sellers Accounts Payable account on the buyers book is being debited due to an error or an allowance for damaged merchandise. A credit memorandum is a document that a seller uses to inform a buyer that the buyers Accounts Receivable account on the sellers books has been credited due to errors, returns, or allowances.

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Unit Twenty-Three Sales

The procedures used in accounting for sales depend on several factors. A great deal depends on the types of business, organization of the sales department, types of goods sold, volume of sales, method of selling, and the sales terms. There are a number of steps in the accounting cycle for sales transactions. When the orders are received they must be examined for acceptability, terms determined, credit approved, a sales invoice prepared, merchandise packed and shipped or delivered, any finally collection is made before the sales cycle is complete.

The determination of the appropriate method of selling and terms of sales is of great importance in the sales cycle. They will necessarily affect the procedures used in handling the sales transaction. And we will primarily examine the sales terms and methods of selling in this unit.

SALES FOR CASH. While some businesses sell for cash or on credit, others sell for cash only. Examples include snack shops, food stores, and some gas stations. Various procedures are used to handle cash sales and cash registers are usually employed. The cash register is a means of internal control since the total cash sales for the day should be reconciled to the cash in the register drawer. Sales tickets are normally prepared in duplicate form. One copy is given to the customer as a receipt, and the second copy is retained in the register and later removed by a person in the accounting department who will analyze and record the sale.

SALES ON CREDIT. Sales on credit are often referred to as sales on account or charge sales. In such a sales transaction, the seller exchanges merchandise for the buyers promise to pay at a later date. Most wholesale sales and a significant portion of retail sales are now made on credit. Since the business that sells on account assumes an additional risk, it is best to investigate the financial condition of the buyers. Larger businesses often have a credit department which establishes credit policies and approves or disapproves individual credit sales. Experienced credit manager have learned to establish credit policies that will neither be so tight as to reduce sales nor so loose as to create excessive bad debt losses.

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SALES ON APPROVAL. A sale made on approval means that the customer has the right to return the goods within a specified time period. Therefore, the sale is not final until the customers intentions are known. Mail-order businesses engaged in the sale of stamps, coins, or books are examples of businesses which sell on approval. Approval sales may be handled as charge sales and returns treated as ordinary sales returns. They may also be handled as cash sales. When treated as such, a record is kept until it is known that the customer will keep the goods. By a specified date, the customer must either pay for the goods or return them. The accountant may wait until payment is received, and then it may be recorded as a cash sale.

COD SALES. Merchandise may be sold for Cash on Delivery (COD). Such terms call for payment by the buyer when the goods are delivered. The delivery and collection agent may be an employee of the seller, the post office, an express company, a trucking company, a railroad, a steamship company, or any other common carrier.

Cash on delivery sales made by a retail business are usually recorded as cash sales. Upon approval, a sale ticket is prepared and listed on a COD list for control purposes. The merchandise is delivered and the sales price is collected. At the end of each day, the delivery agent returns the COD sales tickets and the money collected. These tickets are compared with the COD list and the sale is recorded. It should be remembered that title to the goods purchased does not pass to the buyer until payment has been received. Therefore, the inventory is considered to be the property of the seller until payment is received. Although delivery may be made through the post office or other common carrier, retail merchandise who sells on COD terms usually makes their own deliveries and collections.

SALES ON CONSIGNMENT. Sometimes a business will market goods on a consignment basis. When sold on a consignment basis, the merchandise is shipped to an agent dealer with the agreement that the agent dealer is not required to pay for the goods unless they are sold. Under such a method of selling, title to the goods consigned is retained by the shipper until the goods are
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sold by the agent dealer. The owner of the goods shipped on consignment is referred to as the consignor. The agent dealer is called the consignee.

The consignee may work on a commission basis, or may earn a profit by making additional markups on the merchandise. Periodically, the consignee will prepare a statement of consignment sales. This statement will show consigned goods on hand, consignment sales made, expense chargeable to consignor such as transportation, insurance, and storage expenses, and the amount due to the consignor.

INSTALLMENT SALES. Property such as appliances, stereo equipment, furniture, clothes, automobiles, real estate, and may other types of merchandise may be sold on an installment basis. Such a method refers to a plan whereby the seller agrees to give the buyer physical possession of the goods in exchange for a promise to make payments periodically over a specified time interval. The agreement between the buyer and seller is referred to in legal terms as a conditional sales contract. Quite often a down payment is required. The sales contract will contain wording to the effect that the seller will retain title to the property until payment is made in full. A high price is usually charged for goods sold on installment to offset the added risk imposed on the seller for waiting to collect payments and the additional record-keeping expenses involved.

TRADE AND CASH DISCOUNTS. Manufacturers and wholesales publish catalogs in order to describe their products and list their retail prices. Usually, they offer deductions from these list prices to dealers who buy in large quantities. These deductions are known as trade discounts. By offering these discounts, a business can adjust a price at which it is willing to bill its goods without changing the list price in the catalog. For example, XYZ Company wants to advertise its stereo radio at a list price of $ 150.00. However, the radio is offered to dealers at a trade discount of 30 percent, which amounts to $ 45.00. Therefore, the dealer pays only $ 105.00 for the set.
XYZ 150 30% 45 105
While trade discounts are used to make price differentials among different classes of customers and as a means of avoiding catalog revisions, can discounts are used primarily to induce prompt payment by customers. In other words, the seller may allow the buyer to deduct a certain
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percent of the bill if he or she makes the payment before the amount is due. The payment terms should be clearly stated on the face of the invoice. In the following are examples of some commonly used terms.

2/10, n/30. this is read as two ten, net thirty and means that a 2 percent discount of the invoice price is allowed if payment is made within 10 days following the invoice date, and the gross invoice price is due 30 days from the invoice date.
2/10n/30 10 2% 30
2/EOM, n/60. This is read as two EOM, net sixty and means a 2 percent discount may be deducted if the invoice is paid by the end of the month. The discount may not be taken after the end of the month, and payment is due 60 days from the invoice date.
2/OEM,n/60 2% 60
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Unit Twenty-four Information Systems

Traditionally, man, material, money and machines have been considered that main resources of an organization, but in recent years there has been a growing awareness that information is an additional important resource without which organization objectives can not be achieved. In general terms, information is produced by converting raw data into a more useful and refined form. The volume of data in modern organization has grown to such proportions that information production has become a specialized activity. Although accountants in the past have been involved in the production of information for management, their traditional role is changing with the emergence of a new technology of information production and information system design.

OBJECTIVES OF THE INFORMATION SYSTEM. Some specialized information systems are limited to the handling of a large volume of data, e.g. the preparation of monthly bills by an electricity corporation, while others are designed to assist in day-to-day operations, such as production scheduling in a manufacturing firm. Special information systems are limited and sectional in nature, reflecting only a segment of the organizations activities. Since the organization is an integrated entity with interdependent functions, the information system should also be an integrated whole encompassing the overall activities of the organization. The objectives of an information system will depend on the view management takes about its information requirements; these may include one of the following: record keeping, operations and control, and integrated planning and policy making.

Record Keeping. In many organizations, the volume of transactions is so great that handling of information with efficiency, accuracy and economy represents a difficult problem. In these organizations, the processing of routine information becomes the first priority in mechanization. The information system is designed either to assemble the evidence of transactions or simply to give a summarized historical report. The provision of information for decision making in these situations, while important, is not the objective of the system.

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Examples of the output of information systems oriented to record keeping are historical financial statements, customer billings, inventory status reports, income tax returns and social security payment listings.

Operations and Control. The information system may be designed to assist employees in their day-to-day operations, and to exercise control over the implementations of short-run plans. An airline passenger booking system and a production scheduling system are examples of information systems oriented to operations. An airline booking system is designed to give instantaneous reports on the status of seats available on particular flights, so that passenger bookings can be confirmed on the spot. A production scheduling system is used to determine the allocation of machine time to various jobs, so that delivery schedules can be met at the least cost.

Variance reports on financial, sales and production plans are examples of information systems oriented to control. These reports compare actual performance with planned performance, so that corrective measures may be taken on the basis of difference disclosed.

Integrated Planning and Policy Making. At the general management level, the problems of concern are the performance of the entire organization and formulation of long-term plans. These problems are relatively broad in scope, usually involving the overall activities of the organization. The information system designed for the needs of general management may comprise a mathematical model of the entire operation. By representing the entire operation in the form of a mathematical model and by manipulating the model, it is often possible to predict the likely outcome of alternative decisions. These mathematical models are usually called corporate models. They provide an example of an information system oriented to integrated planning and policy making.

DATA PROCESSING SYSTEM. Data processing system is a part of the total information system. All data processing systems go through a common data processing cycle which has tree steps: Input, processing or manipulation, and output. They differ in the extent to which they are mechanized and may be classified into manual, mechanical, punched card and computerized systems.
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Manual Data Processing Systems. Manual data processing systems are predominant in small organizations where all functions are performed manually. The traditional tools used in conjunction with manual systems are pencils, pens, printed forms, journals, ledgers, worksheets, files, etc. Manual systems are easy to set up and the initial establishment costs are low. The system is flexible and therefore changes cane introduced at any stage without encountering serious difficulty. On the other hand, variable costs per transaction are high and the system output is prone to errors.

Mechanical Systems. In mechanical systems, manual effort is assisted by mechanical devices such as typewriters, calculators, accounting machines and cash registers. The set-up cost of mechanical systems is higher than that for manual systems, but data processing is relatively error free. Another advantage is that control figures (such as total account receivable) are produced automatically. A disadvantage of mechanical system is that the capacity of each machine is limited by the speed of the operator, because the operation itself is performed manually. As a result, operator speed is critical and a bottleneck can occur in the system as the volume of transactions increases.

Punched Card Systems. A punched card system makes use of a combination of machines, most of which require only a minimum amount of manual effort and supervision in order to perform their tasks. The operations performed automatically in a punched card system are: recording, sorting, comparing, calculating, summarizing and reporting. However, the card punch and verifier must be operated manually.

Punched card systems are widely used because of their speed, accuracy of processing and low variable costs. However, the system has two undesirable features. First, the files of the system need to be converted to and maintained as punched cards. Second, the calculator has limited mathematical and logic capability, which makes the punched card system inadequate for more complex applications.

Electronic Computer Systems. The development of manual, mechanical and punched card systems reflects a general trend in data processing to eliminate the human element as far as possible. The electronic computer is a logical extension of the punched card system. In a punched card system several machines perform such tasks as recording, sorting, calculating, summarizing and reporting. Electronic computer systems are generally able to perform all
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these functions automatically with greater speed and accuracy. This is accomplished by a series of instructions called a program, which is stored in the electronic computer.

Electronic computer systems are superior in speed, computational and logic capabilities, accuracy and versatility. As a result computers are gaining wider acceptance in both large and small organizations.

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Unit Twenty-five Single Proprietorships

A business enterprise may be organized as a single proprietorship, a partnership, or a corporation. We will look at the single proprietorship in this unit and the other two forms of organization will be discussed in the next two units.

A business owned by one person is called a single proprietorship. Often the owner also acts as the manager. This form of business organization is common for small retail stores and service enterprise, for farms, and for professional practice in law, medicine, and public accounting. In fact, the single proprietorship is the most common form of business organization in western economy. Most of these businesses, however, tend to be relatively small.

CHARACTERISTICS OF SINGLE PROPRIETORSHIP. An important characteristic of the sole proprietorship is that, from a legal viewpoint, the business and its owner are not regarded as separate entities. Thus, the owner is personally liable for the debts of the business. If the business becomes insolvent, creditors can force the owner to sell his or her personal assets to pay the business debts. In other words, the proprietorships liability is unlimited; that is, it is not limited to his or her investment in the firm.

From an accounting viewpoint, however, a single proprietorship is regarded as an entity separate from the other affairs of its owner. For example, assume that Bill White owns two single proprietorshipa gas station and a shoe store. The assets, liabilities, revenues, and expense relating to the gas station would not appear in the financial statements of the shoe store. Also, Whites personal assets, such as his house, furniture, and savings account, would not appear in the financial statements of either business entity.

ADVANTAGES AND DISADVANTAGES OF THE PROPRIETORSHIP. The principal virtue of the proprietorship is its simplicity; in most cases, it is necessary only to set up a shop and begin operations. The principal disadvantages of the proprietorship are unlimited liability and limitations on size. Generally, a proprietorship can raise funds only to the extent that the individual
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proprietor can do so. Often, this keeps the firm from raising large amounts of money.

A proprietorship itself is not subject to taxation of income. Rather, the income or loss derived from the proprietorship is included and taxed in the personal tax return of the proprietor.
ACCOUNTING FOR THE OWNERS EQUIY IN A SINGLE PROPRIETORSHIP. Most accounting principles apply to all three forms of organization and the main area of difference lies in accounting for owners equity.

The accounting records for a single proprietorship do not include accounts for capital stock, retained earnings, or dividends. Instead of these accounts, a capital account and a drawing account are maintained for the owner. A corporation must maintain separate accounts for capital stock and remained earnings, because distributions to owners in the form of dividends cannot legally exceed the earnings of the corporations. In a solely owned business, however, the owner is free to withdraw assets from the business at any time and in any amount.

THE OWNERS CAPITAL ACCOUNT. In a single proprietorship, the title of the capital account includes the name of the owner, as , for example, Bill White, Capital. The Capital account is credit with the amount of the proprietors original investment in the business and also with any subsequent investments. When the accounts are closed at the end of each accounting period, the Income Summary account is closed into the owners capital account. Thus the Capital account is credited with the net income earned or debited with the net loss incurred. Withdrawals by the proprietor during the period are debited to a drawing account, which later is closed into the Capital account.

THE OWNERS DRAWING ACCOUNT. A withdrawal of cash or other assets by the owner reduces the owners equity in the business and could be recorded by debiting the owners capital account. However, a clearer record is created if a separate drawing accounting is maintained. This drawing account (entitled, for example, Bill White, Drawing) replaces the dividends account used by a corporation.
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The Drawing account is debited for any of the following transactions:
1. Withdrawals of cash or other assets. If the proprietorship of a clothing store, for example, withdraws merchandise for personal use, the Drawing account is debited for the cost of the goods withdrawn. The offsetting credit is to the Purchase account (or to Inventory if a perpetual inventory system is maintained.) 2. Payment of the proprietors personal bills out of the business bank account. 3. Collection of an account receivable of the business, with the cash collected being retained personally by the proprietor.
1. 2. 3.
Withdrawals by the proprietor (like dividends to stockholders) are not expense of business. Expenses are incurred for the purpose of generating revenue, and a withdrawal of cash or other assets by the proprietor does not have this purpose.

FINANCIAL STATEMENTS FOR A SINGLE PROPRIETORSHIP. The balance sheet of a single proprietorship differs from that of a corporation only in the owners equity section. The balance sheet for a single proprietorship shows the entire ownership equity as a single dollar amount without any effort to distinguish between the amount originally invested by the owner and the later increase or decrease in owners equity as a result of profitable or unprofitable operations. Whereas the ownership equity of a corporation consists of two elements: capital stock and retained earnings.

The income statement of a proprietorship differs from that of a corporation in two significant respects. First, the income statement for a single proprietorship does not include any salary expense representing managerial services rendered by the owner. One reason for not including a salary to the owner-manager is the fact that individuals in such a position are able to set their own salaries at any amount they choose. The use of an unrealistic salary to the proprietor would tend to destroy the significance of the income statement as a device for measuring the earning power of the business. It is more logical to regard the owner-manger as working to earn the entire net income of the business than as working for salary.

The second distinctive feature of the income statement of a single proprietorship is the absence of any income taxes expense. Since a proprietorship is not recognized as a legal entity sepa-
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rate from its owner, the business does not file its own income tax return or pay any income taxes. However, the proprietor must include the income of the business on his or her individual income tax return, along with any taxable income from other sources. In contrast, a corporation does pay income taxes on its earnings, and income taxes expense will appear in its income statement.

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Unit Twenty-six Partnerships

A partnership is an unincorporated business that is jointly owned by two or more people. Partnerships, like single proprietorships, are widely used for small businesses and professional practices. In the fields of manufacturing, wholesaling, and retail trade, partnerships are also popular, because they afford a means of combining the capital and abilities of two or more persons. As in the case of a single proprietorship, a partnership is not legally an entity separate from its owners; consequently, a partnership is personally responsible for the debts of the partnership is a business entity separate from the personal activities of the partners. A partnership is often referred to as a firm; the name of the firm often includes the word company as, for example Adams, Myers, and Company.

SIGNFICANT FEATURES OF PARTNERSHIP. Before taking up the accounting problems peculiar to partnerships, it will be helpful to consider briefly some of the distinctive characteristics of the partnership form of organization. These characteristics (such as limited life and unlimited liability) all stem from the basic point that a partnership is not a separate legal entity in itself but merely a voluntary association of individuals.

Ease of Formation. A partnership can be created without any legal formalities. When two or more persons agree to become partners, such agreement constitutes a contract and a partnership is automatically created. The contract should be in writing in order to lessen the chances for misunderstanding and future disagreement.

Limited Life. A partnership may be ended at any time by the death or withdraw of any member of the firm. Other factors which may bring an end to a partnership include the bankruptcy or incapacity of a partner, or the completion of the project for which the partnership was formed. The admission of a new partner or the retirement of an existing member means an end to the old partnership, although the business may be continued by the information of a new partnership.

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Mutual Agency. Each partner acts as an agent of the partnership, with authority to enter into contracts. The partnership is bound by the acts of any partner as long as these acts are within the scope of normal operations. The factor of mutual agency suggests the need for exercising great caution in the selection of a partner. To be in partnership with an irresponsible person or one lacking in integrity is an intolerable situation.

Unlimited Liabilities. Each partner is personally responsible for all the debts of the firm. The lack of any ceiling on the liability of a partner may deter a wealthy person from entering a partnership.

A new member joining an existing partnership may or may not assume liability for debts incurred by the firm prior to his or her admission. A partner withdrawing from membership must give adequate public notice of withdrawal; otherwise the former partner may be held liable for partnership debts incurred subsequently to his or her withdrawal. The retiring partner remains liable for partnership debts existing at the time of withdrawal unless the creditors agree to a release of this obligation.

Co-ownership of Partnership Property and Profits. When a partner invests a building, inventory, or other property in a partnership, he or she does not retain any personal right to the assets contributed. The property becomes jointly owned by all partners. Each member of a partnership also has an ownership right in the profits.

ADVANTAGES AND DISADVANTAGES OF A PARTNERSHIP. Perhaps the most important advantage of most partnerships is the opportunity to bring together sufficient capital to carry on a business. The opportunity to combine special skills, as, for example, the specialized talents of an engineer and an accountant, may also include individuals to join forces in a partnership. To form a partnership is much easier and less expensive than to organize a corporation. Members of a partnership enjoy more freedom form government regulation and more flexibility of action than do the owners of a corporation. The partners may withdraw funds and make business decisions of all type without the necessity of formal meeting or legalistic procedures.

Operating as a partnership may in some cases produce income tax advantages as compared
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with doing business as a corporation. The partnership itself is not a legal entity and does not have to pay income taxes as does a corporation, although the individual partners pay taxes on their respective shares of the firms income.

Offsetting these advantages of a partnership are such serious disadvantages as limited life, unlimited liability, and mutual agency. Furthermore, if a business is to require a large amount of capital, the partnership is a less effective device for raising funds than is a corporation. Many persons who invest freely in common stocks of corporations are unwilling to enter partnership because of the unlimited liability imposed on partners.

LIMITED PARTNERSHIPS. In recent years, a number of businesses have been organized as limited partnerships. This form of organization is widely used for businesses which provide tax sheltered income to investors, such as real estate syndications and oil drilling ventures. However, limited partnerships are not appropriate for businesses in which the owners intend to be active managers.

A limited partnership must have at least one general partner as well as one or more limited partners. The general partners are partners in the traditional sense, with unlimited liability for the debts of the business and right to make managerial decisions. The limited partners, however, are basically investors rather than traditional partners. They have the right to participate in profits of the business, but their liability for losses is limited to amount of their investments. Also, limited partners do not actively participate in management of the business. Thus, the concept of unlimited liability and mutual agency apply only to the general partners of a limited partnership.

THE PARTNERSHIP CONTRACT. Although a partnership can be formed by an oral agreement, it is highly desirable that a written partnership agreement be repaired, summarizing the partners mutual understanding on such points as:

1. Name of the partnership, and the duties and rights of each partner; 2. Amount to be invested by each partner including the procedure for valuing any noncash assets invested or withdrawn by partners; 3. Methods of sharing profits and losses; 4. Withdrawals to be allowed to each partner.
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1. 2. 3. 4.
PARTNERSHIP ACCOUNTING. Partnership accounting is similar to that in single proprietorship, except that separate capital and drawing accounts are maintained for each partner. A distinctive feature of partnership accounting is that the net income of the business must be divided among the partners in the manner specified by the partnership agreement. Partners may divide net income equally. They can, however, share net income in any way they wish. Factors that partners might consider in arriving at an equitable plan to divide net income include (1) the amount of time each partner devotes to the business, (2) the amount of capital invested by each partner, and (3) any other contribution by each partner to the success of the partnership. Net income, for example, may be shared in any agreed ratio such as in the ratio of beginning capital, or in a fixed ratio after any allowance is made to each partner for salary and interested on capital invested.
1 2 3
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Unit Twenty-seven Corporation

A corporation is a legal entity having an existence separate and distinct from that of its owners. In the eyes of the law, a corporation is an artificial person having many of the rights and responsibilities of a real person.

A corporation, as a separate legal entity, may own property in its own name. Thus, the assets of a corporation belong to the corporation itself, not to be stockholders. A corporation has legal status in court, that is, it may sue and be sued as if it were a person. As a legal entity, a corporation enters into contracts, is responsible for its own debts, and pay income taxes on its earnings.

Nearly all large businesses and many small ones are organized as corporations. There are still more single proprietorship and partnership than corporations, but in dollar volume of business activity, corporation holds an impressive lead. Why is the corporation the most common form of organization for large businesses? One reason is that corporations obtain their equity capital by issuing shares of capital stock. Since a corporation may issue a vast number of these shares, it may amass the combined savings of a great number of investors, thus, the corporation is an ideal means of obtaining the capital necessary to finance large-scale operations.

ADVANTAGES OF THE CORPORATION FORM OF ORGANIZATION. The corporation offers a number of advantages not available in other forms of organization. Among these advantages are the following:

No Personal Liability for Stockholders. Creditors of a corporation have a claim against the assets of the corporation, not against the personal property of the stockholders. Thus, the amount of money which stockholders risk by investing in a corporation is limited to amount of their investment. To many investors, this is the most important advantage of the corporate form.

Ease of Accumulating Capital. Ownership of a corporation is evidenced by transferable shares of stock. The sale of corporate ownership in units of one or more shares permits both large
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and small investors to participate in ownership of the business. Some corporations actually have more than a million individual stockholders. For this reason, large corporations are often said to be publicly owned. Of course not all corporations are large. Many small businesses are organized as corporations and are owned by a limited number of stockholders. Such corporations are said to be closely held.

Ownership Shares are readily transferable. Shares of stock may be sold by one investor to another without dissolving or disrupting the business organization. The shares of most large corporations may be bought or sold by investors in organized markets, such as the New York Stock Exchange.

Investments in these shares have the advantage of liquidly, because investor may easily convert their corporate ownership into cash by selling their stock.

Continuous Exercise. A corporation is a separate legal entity with a perpetual existence. The continues life of the corporation despite changes in ownership is made possible by the issuance of transferable shares of stock. By way of contrast, a partnership is a relatively unstable form of organization which is dissolved by the death or retirement of any of its members. The continuity of the corporate entity is essential to most large-scale business activities.

Professional Management. The stockholders own the corporation, but they do not manage it on a daily basis. To administer the affairs of the corporation, the stockholders elect a board of directors. The directors, in turn, hire a president and other corporate officers to manage the business. There is no mutual agency in a corporation; thus, an individual stockholder has no right to participate in the management of the business unless he or she has been hired as a corporate officer.

DISADVANTAGES OF THE CORPORATE FORM OF ORGANIZATION. Among the disadvantages of the corporations are:

Heavy Taxation. The income of a partnership or a single proprietorship is taxable only as personal income to the owners of the business. The income of a corporation, on the other hand, is
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subject to income taxes which must be paid by the corporation. If a corporation distributes its earnings to stockholders, the stockholders must pay personal income taxes on the amounts they receive. This practice of first taxing corporate income to the corporation and then taxing distributions of the income to the stockholders in sometimes called double taxation.

Greater Regulation. A corporation comes into existence under the terms of state laws and these same laws may provide for considerable regulation of the corporations activities. For example, the withdrawal of funds from a corporation is subject to certain limits set by law. Securities and exchange authorities require large corporations to make extensive public disclosure of their affairs.

Separation of Ownership and Control. The separation of the functions of ownership and management may be an advantage in some cases but a disadvantage in others. On the whole, the excellent record or growth and earning in most large corporations indicates that the separation of ownership and control has benefited rather than injured stockholders. In a few instances, however, a management group chosen to operate a corporation for the benefit of insiders. The stockholders may find it difficult in such cases to take the concerted action necessary to oust the officers.

RIGHTS TO STOCKHOLDERS OF A CORPORATION. The ownership of stock in a corporation usually carries the following basic rights:

1. To vote for directors, and thereby to be represented in the management of the business. 2. To share in profits by receiving dividends declared by the board of directions. 3. To share in the distribution of assets if the corporation is liquidated. 4. To subscribe for additional shares in the event that the corporation decides to increase the amount of stock outstanding.
1. 2. 3. 4.
Stockholders meetings are usually held once a year. Each share of stock is entitled to one vote.
FUNCTIONS OF THE BOARD OF DIRECTORS AND CORPORATE OFFICERS. The primary function of the board of directors are to manage the corporation and to protect the inter-
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ests of stockholders. At this level, management may consist principally of formulating policies and reviewing acts of the officers. Specific duties of the directors include declaring dividends, setting the salaries of officers, reviewing the system of internal control with the internal auditors and with the companys independent auditors, authorizing officers to arrange loans from banks, and authorizing important contracts of various kinds. The official actions of the board are recorded in the minute book.

Corporate officers usually include a president, one or more vice-presidents, a controller, a treasure, and a secretary. A vice-president is often made responsible for the sales function; other vice-presidents may be given responsibility for such important functions as personnel, finance, and production. The controller or chief accounting officer is responsible for the maintenance of adequate internal control and for the preparation of accounting records and financial statements. The treasurer has custody of the companys funds and is generally responsible for planning and controlling the companys cash position. The secretary represents the corporation in many contractual and legal matters and maintains minutes of meetings of directors and stockholders. Another responsibility of the secretary is to coordinate the preparation of the annual report, which includes the financial statements and other information relating to corporate activities.

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Unit Twenty-eight Cost Accountinga Concept Emphasis

There are may different concepts of cost in accounting, and the one which is relevant in any particular context depends very much on the purpose to be served by the cost accounting. In general, cost information is needed for three different purposes. The first is a financial accounting purpose, involving the measurement of cost as part of the process of income determination and asset valuation. The second is a cost accounting purpose, relating to planning and cost control. The third purpose in providing cost information is concerned with another managerial problem, that of formulating business policy and making operating decisions.

COST CLASSIFICATIONS FOR INCOME MEASUREMENT. Direct and Indirect Cost. A cost classification that relates to traceability of costs to cost units is a particularly useful for income measurement purposes. The Cost unit is the unit of activity the cost of which is being measured. There are several types of cost unit, such as particular job or product or batch of products, or a particular manufacturing process; or a department. The cost unit is largely determined by the nature of the manufacturing activity in which the enterprise is engaged.

Costs that are directly associated with a particular unit of activity are called direct costs. Those costs that are incurred by the factory for the benefit of production in general, and which can not be identified with individual units of activity, are known as indirect costs. The cost of labor applied to a particular product thus constitutes a direct cost, while the factory managers salary is an example of an indirect cost.

Product Costs and Period Costs. Accountants often distinguish between products costs and period costs. Product costs are those identified with goods purchased or produced for resale; they are also called inventoriable costs because they are initially identified as a part of the inventory on hand. In turn, these inventoriable costs become expenses in the form of cost of goods sold only when the inventory is sold. In contrast, period costs are noninventoriable costs; they are deducted as expenses during the current period without having been previously classified as costs of inventory.

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COST CLASSIFICATION FOR PLANNING AND CONTROL. Variable and Fixed Costs. Variable costs are defined as costs which vary directly and necessarily with changes in the level of output. They are also often assumed to vary more or less in proportion, so that average costs per unit of output remain relatively constant. Variable costs comprise prime costs and variable manufacturing overhead.

Fixed costs are those costs which are unaffected by changes in the level of production. Examples are factory rent and depreciation of machinery. A fixed cost may be said to be fixed only in relation to given period of time and a given range rate of activity. Costs which are fixed in the short run when capacity is given may become variable in the longer run when capacity can be increased.

Some costs and expenses are partly fixed and partly variable, for example, machine repairs. Also, costs may be variable for some purposes and fixed for others. Generally, direct costs are variable, while manufacturing overhead may be either fixed or variable.

Controllable and Non-controlled Costs. The concept of controllable costs is used to establish responsibility for costs and performance at different management levels, and thus to facilitate the delegation of authority. Some costs are controllable at the factory-floor level, while other costs are controlled only at an executive-management level, perhaps on a discretionary basis, e.g. in the case of research and development expenditures. In the evaluation of efficiency, the only costs which should be taken into account are those which can be controlled by the person responsible for the department or activity under review. The other coststhe non-controllable costsare irrelevant for purposes of fixing responsibility or assessing performance.

COST CLASSIFICATIONS FOR DECISION MAKING. Incremental and Sunk Costs. Incremental costs by definition relate to the additional costs of making a change, such as increasing the level of activity or adding a new product line. Incremental costs are sometimes regarded as synonymous with the economists marginal costs, but a distinction should be drawn between the two concepts. Marginal costs are costs at the margin, i.e. the costs of a single additional unit or
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production, whereas incremental costs can be the costs of additional batches of production, the additional costs resulting from changes in the pattern of production, or indeed the additional costs of any changes in policy. Marginal costs thus constitute a special case of incremental costs and their use in business decision making is restricted to areas where a single unit is of some significance. Incremental costs, like marginal costs, need to be considered in relation to a particular time interval, and for purposes of some decisions it is necessary to distinguish between long-run and short-run incremental costs.

Sunk costs comprise all those costs which remain the same irrespective of which alternative is chosen, and which are therefore not relevant to the decision in question.
In many situations, incremental costs may be the same as variable costs. But it is important not to confuse one concept with other (nor sunk costs with fixed costs). For example, suppose one has a choice of continuing to sell one million units of a product in Shanghai rather than in Beijing. The variable manufacturing costs are unlikely to be affected by decision; hence they are sunk costs and can be ignored. On the other hand, certain non-manufacturing costs, such as transport and advertising, may be incremental costs for purposes of this decision.
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Avoidable and Unavoidable Costs. Avoidable costs and unavoidable costs may be considered to be special types of incremental and sunk costs, respectively. While incremental costs are associated with an increase in activities, the concept of avoidable cost is relevant to a contraction of activities. Avoidable costs are costs that can be eliminated if activity is discontinued. Generally, it will be found that direct costs may often be avoided while allocated costs may not.

Opportunity Costs. Opportunity cost is the value of the sacrifice or opportunity forgone. For example, if a young man can earn $ 10 000 a year in a gainful employment, the opportunity cost to him of three years study at a tertiary institution would appear to be $30 000. In business, the opportunity cost of a scarce resource may be defined simply as the earnings which may be derived from the best alternative use of the resource. For example, the opportunity cost of using funds for a particular purpose may be measured by reference to the highest interest which could be earned on those funds or by the highest return which could be obtained on alternative investments of
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similar risk. Similarly, the opportunity cost of processing partly-finished may be measured by reference to the proceeds from an immediate sale, which must be sacrificed in order to continue processing.
1 3
Future Costs. For purpose of decision making, the most relevant costs are future costs, because decisions generally relate to the future. Current costs also have relevance for many decisions but, by and large, past costs are irrelevant for decisions.

Examples of managements use of future costs may be found in a large number of areas, including cost control, long-range planning, budgeting, evaluation of capital projects and business decisions in general.

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Unit Twenty-nine Tax Accounting

Tax accounting is a branch of accounting that involves determining the correct liabilitythat is, the amount owedfor taxes, and preparing the necessary tax-return forms.
Income taxes are major concern to businesses as well as to individuals. Unfortunately, businessmen themselves often do not understand the tax laws, and they must therefore depend on the advice of tax accountants and lawyers. A tax accountant must have a thorough knowledge of the tax code of his or her country and of any divisions within it that have the power to levy, or impose, taxes.

It is easy to appreciate the impact of income taxes on business. Careful planning designed to decrease the tax liability to the lowest level is thus a major concern of business. This planning is made possible by various provisions in the tax laws that offer alternative methods for handling particular transactions or accounting procedures. One alternative may thus have a significant tax advantage over another, resulting in either a tax saving, or postponement of tax liability. A business can pay substantially more taxes than necessary if the wrong financial decision is made. Among these potentially significant decisions might be included the form of business under which to organize, whether or not to set up multiple corporations, and which accounting methods should be used to deal with inventory and depreciation.

CHOOSING THE RIGHT FORM OF ORGANIZATION. There are three major forms of business ownership: the single proprietorship, the partnership, and the corporation. Tax laws vary considerably for each of these. In the case of both the individual proprietorship and partnership forms of business, income is taxed to the individual proprietor or partners. The owners of these businesses therefore pay the progressive income tax rate for individuals on their business income. A progressive income tax is one that charges a higher rate for higher earnings.

Corporations, on the other hand, are subject to a tax on their profits, while the stockholders of a corporation are also taxed at the individual rates on the dividends they receive from these profits.
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Dividends are paid out of the corporations earnings. The corporation is not allowed to deduction for the dividends it pays out when is taxable income is computed. This results in double taxation of the corporations income.

In certain cases, the double tax is eliminated or reduced under special provisions of the tax laws. Under one provision, the taxpayer receives a dividend exemption (income not subject to taxation) up to $ 100 for dividends received during the tax year. Another provision allows a corporation to be taxed as partnership if it meets the following requirements for a small business:
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1. It is domestic, rather than a foreign corporation. 2. It has no more than fifteen stockholders. 3. All the stockholders are different people. 4. No stockholder is a nonresident alien. 5. There is only one class of stock.
1. 2. 15 3. 4. 5.
While the small-business corporation can save a great deal in taxes by being taxed as partnership, it keeps the other nontax advantages, such as limited liability.

Other income tax advantages often encourage the corporate form of organization. One of these is the possibility of selling the business or liquidating it; that is, of going out of business and disposing of the assets. When this occurs, it is possible to obtain long-term capital-gains treatment. A long-term capital gain is a profit on the sale of a capital asset that has been owned for a specified period. Long-term capital gains get preferential tax treatmentthat is, half the rate applied to other kinds of income. A second possible tax advantage of the corporate structure is the deferral or postponement of double taxation by simply not paying dividends. A third is the flexibility that come form being able to time the distribution of earning so that they occur during the years in which the owners have the lowest tax liability. A fourth advantage is income splitting. This is a provision of the tax laws that allows the owner of a corporation to divide dividend payments from the corporation among members of his family by having each one own some of the stock. A fifth possible advantage is related to fringe benefits, such as group life insurance, medical payment plans, and wage continuation plans, that provide for full or partial payment of wages and salary to the employees during sickness. Many of these fringe benefits are encouraged in the tax laws by allowing deferred tax payments.
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CHOOSING THE RIGHT ACCOUNTING METHODS. The choice of one method or procedure over the possible alternatives can lead to a tax advantage.

Some methods of accounting for depreciation offer a tax advantage. For example, in the decliningbalance method, a greater percentage of the cost of a fixed asset is figured for the earlier years of the life of the asset. The result is that part of the tax liability is deferred until later years.

There is also a special tax credit for investment in most kinds of depreciable assets, with the exception of buildings that are acquired and placed in service. This credit was instituted as means of stimulating new investment in productive facilities.

There are also different accounting methods for the inventory, commonly known as FIFO and LIFO. The LIFO method may be better from a tax standpoint since this method results in a lower tax liability in a period of rising prices. Under LIFO, the higher-priced goods are depreciated in the accounting period.

A tax advantage also exists for businessesthat sell merchandise for personal use. These sales are often made on the installment basis, with payments spread over a period of weeks, months, or perhaps even years. For tax purpose, it is permissible to report the profit from sales during the years in which the actual payments are made rather than during the year of the original sale.

A tax advantage is also available to holders of most depletive assetsthose which are used up, or depleted, over a period of timelike oil, natural gas, uranium, or coal. The taxpayer who owns assets of this kind is allowed a deduction on the gross income derived from the asset. The deduction is known as a depletion allowance; because of the economic importance of many of the depletive assets, the percentages allowed to the taxpayer are of great political concern.

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ACCOUNTING FOR INCOME TAXES. The basic accounting procedure for computing income taxes is relatively simple. The final or estimated tax liability is charged to the Income Tax Expense account and is deducted on the income statement. The liability is credited to the Estimated Income Taxes Payable account and is then classified as a current liability on the statement of financial position. There are, however, accounting problems that arise in regard to income taxes. These problems result from difference in the amount of taxable income and the amount of income reported on the income statement. This may result form the use of different accounting methods for tax purposes.

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Unit Thirty Auditing

NATURE OF ADUITING. Auditing is the process by which a competent, independent person accumulates and evaluates evidence about quantifiable information related to a specific economic entity for the purpose of determining and reporting on the degree of correspondence between the quantifiable information and established criteria.

Quantifiable Information and Established Criteria. To do an audit, there must be information in a verifiable form and some standards by which the auditor can evaluate the information.

Quantifiable information can and does take many forms. It is possible to audit such things as a companys financial statements, the amount of time it takes an employee to complete an assigned task, the total cost of a government construction contract, and an individuals tax return.

The criteria for evaluating quantitative information also varies. For example, in the audit of historical financial statements by CPA firms, the criterion is usually generally accepted accounting principles. For the audit of tax returns by the Internal Revenue Service, the criterion is the Internal Revenue Code, not generally accepted accounting principles.

Economic Entity. Whenever an audit is conducted, the scope of the auditors responsibility must be made clear. The primary method involves defining the economic entity and the time period. In most instances the economic entity is also a legal entity, such as a corporation, unit of government, partnership, or proprietorship. In some cases, however, the entity is defined as a division, a department, or even a individual. The time period for conducting an audit is typically one year, but there are also audits for a month, a quarter, several years, and in come cases, the life time of an entity.

Accumulating and Evaluating Evidence. Evidence is defined as any information used by the auditor to determine whether the quantifiable information being audited is stated in accordance with the established criteria. Evidence takes many different forms, including oral testimony of the auditee (client), written communication with outsiders, and observations by the auditor. It is important to obtain a sufficient quality and volume of evidence to satisfy the audit objectives. The process of determining the amount of evidence necessary and evaluating whether the quantifiable
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information corresponds to the established criteria is a critical part of every audit.

Competent, Independent Person. The auditor must be qualified to understand the criteria used and competent to know the types and amount of evidence to accumulate to reach the proper conclusion after the evidence has been examined. The auditor also must have an independent mental attitude. It does little good to have a competent person who is biased performing the evidence accumulation when unbiased information and objective thinking are needed for the judgments and decisions to be made.

Independence can not be absolute by any means, but it must be a goal that is worked toward, and it can be achieved to a certain degree. For example, even though an auditor is paid a fee by a company, he or she may still be sufficiently independent to conduct audits that can be relied upon by users. Auditors may not be sufficiently independent if they are also company employees.

Reporting. The final stage in the audit process is the audit reportthe communication of the findings to users. Reports differ in nature, but in all cases they must inform readers of the degree of correspondence between quantifiable information and established criteria. Reports also differ in form and can vary from the highly technical type usually associated with financial statements to a simple oral report in the case of an audit conducted for a particular individual.

TYPES OF AUDITS. There are broadly three types of audits: operational audits, compliance audits, and audits of financial statements.

Operational Audits. An operational audit is a review of any part of an organizations operating procedures and methods for the purpose of evaluating efficiency and effectiveness. At the completion of an operational audit, recommendations to management for improving operations are normally expected.

Because of the many different areas in which operational effectiveness can be evaluated, it is impossible to characterize the conduct of a typical operational audit. In one organization, the
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auditor might evaluate the relevancy and sufficiency of the information used by management in making decisions to acquire new fixed assets, while in a different organization the auditor might evaluate the efficiency of the paper flow in processing sales. In operational auditing, the reviews are not limited to accounting. They can include the evaluation of organization structure, computer operations, production methods, marketing, and any other area in which the auditor is qualified.

The conduct of an operational audit and the reported results are less easily defined than either of other two types of audits. Efficiency and effectiveness of operations are far more difficult to evaluate objectively than compliance or the presentation of financial statements in accordance with generally accepted accounting principles; and establishing criteria for evaluating the quantifiable information in an operational audit is an extremely subjective matter. In this sense, operational auditing is more similar to management consulting than to what is generally regarded as auditing. Operational auditing has increased in importance in the past decade.

Compliance Audits. The purpose of a compliance audit is to determine whether the auditee is following specific procedures or rules set down by some higher authority. A compliance audit for a private business could include determining whether accounting personnel are following the procedures prescribed by the company controller, reviewing wage rates for compliance with minimum wage laws, or examining contractual agreements with bankers and other lenders to be sure the company is complying with legal requirements. In the audit of governmental units such as school districts, there is increased compliance auditing due to extensive regulation by higher government authorities. In virtually every private and not-for-profit organization, there are prescribed policies, contractual agreements, and legal requirements that may call for compliance auditing.

Results of compliance audits are generally reported to someone within the organizational unit being audited rather than to a broad spectrum of users. Management, as opposed to outside users, is the primary group concerned with the extent of compliance with certain prescribed procedures and regulations. Hence, a significant portion of work of this type is done by auditors employed by the organizational units themselves. There are exceptions. When an organization wants to determine whether individuals or organizations that are obligated to follow its requirements are actually complying, the auditor is employed by the organization issuing the requirements. An example is
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the auditing of taxpayers for compliance with the federal tax lawsthe auditor is employed by the government to audit the taxpayers tax returns.

Audit of Financial Statements. An audit of financial statements is conducted to determine whether the overall financial statementsthe quantifiable information being verifiedare state in accordance with specified criteria. Normally, the criteria are generally accepted accounting principles. Although it is also common to conduct audits of financial statements prepared using the cash basis or some other basis of accounting appropriate for the organization. The assumption underlying an audit of financial statements is that they will be used by different groups for different purposes. Therefore, it is more efficient to have one auditor perform an audit and draw conclusions that can be relied upon by all users than to have each user perform his or her own audit.

If a user believes that the general audit does not provide sufficient information for his or her purpose, the user has the option of obtaining more data. For example, a general audit of a business may provide sufficient financial information for a banker considering a loan to the company, but a corporation considering a merger with that business may also wish to know the replacement cost of fixed assets and other information relevant to the decision. The corporation may use its own auditors to get the additional information.

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ENGLISH LANGUAGE IN ACCOUNTING

Unit One Accounting Profession

ENGLISH LANGUAGE IN ACCOUNTING

Unit Two The Conventions of Contemporary Accounting (1)

ENGLISH LANGUAGE IN ACCOUNTING

ENGLISH LANGUAGE IN ACCOUNTING

Unit Three The Conventions of Contemporary Accounting (2)

ENGLISH LANGUAGE IN ACCOUNTING

ENGLISH LANGUAGE IN ACCOUNTING

cal interest only.

Unit Four Accounting Equation and Double Entry

ENGLISH LANGUAGE IN ACCOUNTING

1 10 8 2 100 000 = = + 80 000 + 20 000

ENGLISH LANGUAGE IN ACCOUNTING

Dr + () Cr. () Dr. () Cr. + ()

Accounts Payable Cr. Dr. Cr. $2 000

ENGLISH LANGUAGE IN ACCOUNTING

Unit Five Ledgers

The advantages of subsidiary ledgers are as following:

ENGLISH LANGUAGE IN ACCOUNTING

Unit Six Journals

ENGLISH LANGUAGE IN ACCOUNTING

150 000 150 000

(1) 19 9 . 1 ABC . (2) (3) 11 13 (4) 5 500 5 500 (5)

150 000 150 000

ENGLISH LANGUAGE IN ACCOUNTING

1 2 1 A. 200 2 2 B. 350 2 12 C. 125 19 2 . 1 2 12 A. B. C. $ 200 350 125

Special journal have several advantages:

ENGLISH LANGUAGE IN ACCOUNTING

Unit Seven The Trial Balance

below. The trial balance is then taken. (Omitted)

ABC Co. LTD. Trial Balance September 30, 19

$ 5 800 2 000 $ 2 000 4 000 2 500 500 200 $ 8500 $ 8 500

ENGLISH LANGUAGE IN ACCOUNTING

(1) (2) (3) (4) (5)

Unit Eight Cash Basis and Accrual Basis of Accounting

ENGLISH LANGUAGE IN ACCOUNTING

4 1 200 1/12 100

2 4 30 4 4 3 5 2 500 1 000 4 1 500 5 4 30 1 000 1 000

5 3 53 1 000 1 500 2 500

ENGLISH LANGUAGE IN ACCOUNTING

Dr. Depreciation Expense Cr. Accumulated Depreciation

15 000 2 1 10 1 500 125 1 200 1 200

375 3 15 000 375 14 625

1% 4 10 000 100 4 1 200 1 200

4 30 9 500 300 4 30 9 500 400 9 100

ENGLISH LANGUAGE IN ACCOUNTING

Unit Nine Balance Sheet

ABC Co. LTD. Balance Sheet December 31, 19

270 000 $350 000

ABC Co. LTD. Balance Sheet December 31, 19

270 000 $350 000

ENGLISH LANGUAGE IN ACCOUNTING

ENGLISH LANGUAGE IN ACCOUNTING

ABC Co. LTD. Classified Balance Sheet December 31, 19

ENGLISH LANGUAGE IN ACCOUNTING

Unit Ten Income Statement

ENGLISH LANGUAGE IN ACCOUNTING

ENGLISH LANGUAGE IN ACCOUNTING

ENGLISH LANGUAGE IN ACCOUNTING

ENGLISH LANGUAGE IN ACCOUNTING

The uses of working capital mainly include:

AAA COMPANY Statement of Changes in Financial Position For Month of May

ENGLISH LANGUAGE IN ACCOUNTING