The double entry system of bookkeeping owes its origin to an Italian merchant named Lucas Pacioli who wrote the first book on double entry bookkeeping entitled "Decomputis et Scripturis". It was published in Venice in 1544. All modern methods of accounting are simply adaptation of the system invented by that ancient pioneer.
Definition and Explanation:
The double entry theory of bookkeeping can be defined as the system of recording transactions having two fundamental aspects - one involving the receiving of a benefit and the other to giving the benefit - in the same set of books.
In this theory, as the two fold aspects of each transaction are recorded, the name "double entry" has been given to this system.
Every transaction involves two fold aspects e.g., an aspect of receiving and an aspect of giving. One who receives is a debtor (Dr) and one who gives is a creditor (Cr). Under the double entry system, both the aspects of giving and receiving are recorded in terms of accounts. The account which receives the benefit is debited and the account which gives the benefit is credited. It is the ultimate result of this system that every debit must have corresponding credit and vice versa and on any particular day the total of the debit entries and the credit entries on the various accounts must be equal.
Advantages of Double Entry System:
The main advantages of double entry theory of book keeping are as follows:
Trial balance can be drawn up on any day to prove the arithmetical accuracy of record.
The nominal sides of transactions being recorded: it is possible to prepare Trading and Profit and Loss Account from which the Gross Profit and Net Profit made by the business during a particular period can be easily ascertained.
As all personal accounts of debtors and creditors as well as real accounts are kept, it is possible to prepare Balance Sheet.
The transactions being recorded in the most scientific and systematic way gives the most reliable information of business.
It prevents fraud by rendering any alteration in any account more difficult.
It enables the trader to compare the different items, such as sales, purchases, opening stock and closing stock of one period with similar items of preceding period and the trader may thus know whether his business is progressing or not.
Disadvantages of Double Entry System:
The following are the main disadvantages of this system:
This system requires the maintenance of a number of books of accounts which is not practical in small concerns.
The system is costly because a number of records are to be maintained.
There is no guarantee of absolute accuracy of the books of accounts inspite of agreement of the trial balance.
Showing posts with label ACCOUNTING. Show all posts
Showing posts with label ACCOUNTING. Show all posts
Thursday, July 7, 2011
Tuesday, June 28, 2011
Definition and Explanation of Bookkeeping & Important Bookkeeping Terms:
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
CONTACT:
0322-3385752
R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN
The work book or books mean books of accounts and keeping implies maintaining in proper form and order. Thus bookkeeping may be defined as the art of recording business transactions in books in a regular and systematic manner. It has been defined by different experts as:
"The science and art of correctly recording in books of accounts all those business transactions that result in the transfer of money's worth."
"The art and science of recording business transactions in such a systematic way as a trader may know the result of his trade at the end of a certain period and may also prove the accuracy of such record."
"The science and art of correctly recording business dealings in a set of books with a view to having a permanent record of transactions and the financial result thereof."
It should be noted from the above definitions that bookkeeping primarily deals in the art of recording transactions in books.
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
CONTACT:
0322-3385752
R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN
Important Bookkeeping Terms:
Before attempting to learn the art or science of bookkeeping it will be better to clarify some of the terms that will have to be used again and again.
Transaction:
Any dealing between two persons or things in a transaction. It may relate to purchase and sale of goods, receipt and payment of cash and rendering of services by one party to another. Transaction is of two kinds - cash transaction and credit transaction. When cash is paid or received as a result of an exchange, the transaction is said to be a cash transaction. When the payment or receipt of cash is postponed for future date, this transaction is said to be credit transaction.
Business:
It includes any activity undertaken for the purpose of earning profit e.g., banking business, and insurance business, a merchant business etc., etc.
Proprietor:
He is the owner of a business. He invests capital in it, gives his time and attention to it. He is entitled to receive the profit or bear loss arising out of it.
Drawings:
The cash or goods taken away by the proprietor from the business for his personal use are called has drawings.
Purchases:
Goods purchased are called purchases. When the goods purchased for cash they are called cash purchases but if they are purchased for which payment will have to be made at some future date it is known as credit purchases.
Purchases Returns:
If goods purchased are found defective or unsatisfactory, they are sometimes returned to the persons from whom they were purchased or to suppliers are called purchases returns or returns outwards.
Sales:
Goods sold are called sales. When goods are sold for cash they are called cash sales, but when they are sold without having received payment, they are credit sales.
Sales Returns:
If a person to whom goods have been sold finds that they are defective or unsatisfactory and returns them, are called sales returns or returns inwards.
Trade Discount:
It is rebate or allowance from the scheduled price granted by the seller to the buyer. Trade discount is usually granted in the following circumstances:
(a) When selling to a fellow trader.
(b) When the buyer is an old customer.
(c) When sales are made in bulk.
(d) As a custom of trade.
Cash Discount:
It is deduction or allowance allowed by creditor to a debtor. If a person pays his debit before the due date of payment the recipient may grant him an allowance for doing so. This allowance is known as cash discount
Commission:
It is a form of remuneration for services rendered by one person to another.
Expenditure:
An expenditure takes place when assets or service is acquired.
Expense:
It means an expenditure whose benefit is finished or enjoyed immediately such as salaries, rent etc. Difference between expense and expenditure is that the benefit of the former is consumed by the business in present whereas in latter case benefit will be available for future activities of the business.
Account:
A summarized record of transactions relating to person or thing is called an account.
Debtor (Account Receivable):
A person who owes money to another is a debtor. When we say that we owe Mr. Rahim $200, we mean that we have received from Mr. Rahim $200 which we have to repay. We stand as debtor to Mr. Rahim for $200. It is also termed as accounts receivable.
Creditor (Accounts Payable):
A person who pays out something or to whom money is owing is a creditor. It is also termed as accounts payable.
Assets:
These are the things of value possessed by a trader such as building, land, machinery, furniture, etc.
Liabilities:
They are the debt due by a business to its proprietor and others.
Voucher:
Any written evidence in support of a business transaction is called a voucher. When a ream of paper is bought from a stationer, he gives a cash memo. The cash memo is a voucher for the payment. When wages for the month are paid to the peon, receipt is taken from him. The receipt serves as a voucher for the payment.
Goods (Merchandise):
It includes all merchandise commodities which are purchased by the business for selling.
Stock (Inventory):
Goods or merchandise on hand, that is goods remaining unsold, is called stock, stock in trade, or inventory.
Equity:
A claim which can be enforced against the assets of the firm is called equity. In other words, the rights to properties are called equities. Equities are of two types: the right of creditors and the right of owners. The equities of creditors represent debts of the business and are called liabilities. The equities of the owner is called capital, proprietorship or owner's equity.
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
CONTACT:
0322-3385752
R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
CONTACT:
0322-3385752
R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN
The work book or books mean books of accounts and keeping implies maintaining in proper form and order. Thus bookkeeping may be defined as the art of recording business transactions in books in a regular and systematic manner. It has been defined by different experts as:
"The science and art of correctly recording in books of accounts all those business transactions that result in the transfer of money's worth."
"The art and science of recording business transactions in such a systematic way as a trader may know the result of his trade at the end of a certain period and may also prove the accuracy of such record."
"The science and art of correctly recording business dealings in a set of books with a view to having a permanent record of transactions and the financial result thereof."
It should be noted from the above definitions that bookkeeping primarily deals in the art of recording transactions in books.
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
CONTACT:
0322-3385752
R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN
Important Bookkeeping Terms:
Before attempting to learn the art or science of bookkeeping it will be better to clarify some of the terms that will have to be used again and again.
Transaction:
Any dealing between two persons or things in a transaction. It may relate to purchase and sale of goods, receipt and payment of cash and rendering of services by one party to another. Transaction is of two kinds - cash transaction and credit transaction. When cash is paid or received as a result of an exchange, the transaction is said to be a cash transaction. When the payment or receipt of cash is postponed for future date, this transaction is said to be credit transaction.
Business:
It includes any activity undertaken for the purpose of earning profit e.g., banking business, and insurance business, a merchant business etc., etc.
Proprietor:
He is the owner of a business. He invests capital in it, gives his time and attention to it. He is entitled to receive the profit or bear loss arising out of it.
Drawings:
The cash or goods taken away by the proprietor from the business for his personal use are called has drawings.
Purchases:
Goods purchased are called purchases. When the goods purchased for cash they are called cash purchases but if they are purchased for which payment will have to be made at some future date it is known as credit purchases.
Purchases Returns:
If goods purchased are found defective or unsatisfactory, they are sometimes returned to the persons from whom they were purchased or to suppliers are called purchases returns or returns outwards.
Sales:
Goods sold are called sales. When goods are sold for cash they are called cash sales, but when they are sold without having received payment, they are credit sales.
Sales Returns:
If a person to whom goods have been sold finds that they are defective or unsatisfactory and returns them, are called sales returns or returns inwards.
Trade Discount:
It is rebate or allowance from the scheduled price granted by the seller to the buyer. Trade discount is usually granted in the following circumstances:
(a) When selling to a fellow trader.
(b) When the buyer is an old customer.
(c) When sales are made in bulk.
(d) As a custom of trade.
Cash Discount:
It is deduction or allowance allowed by creditor to a debtor. If a person pays his debit before the due date of payment the recipient may grant him an allowance for doing so. This allowance is known as cash discount
Commission:
It is a form of remuneration for services rendered by one person to another.
Expenditure:
An expenditure takes place when assets or service is acquired.
Expense:
It means an expenditure whose benefit is finished or enjoyed immediately such as salaries, rent etc. Difference between expense and expenditure is that the benefit of the former is consumed by the business in present whereas in latter case benefit will be available for future activities of the business.
Account:
A summarized record of transactions relating to person or thing is called an account.
Debtor (Account Receivable):
A person who owes money to another is a debtor. When we say that we owe Mr. Rahim $200, we mean that we have received from Mr. Rahim $200 which we have to repay. We stand as debtor to Mr. Rahim for $200. It is also termed as accounts receivable.
Creditor (Accounts Payable):
A person who pays out something or to whom money is owing is a creditor. It is also termed as accounts payable.
Assets:
These are the things of value possessed by a trader such as building, land, machinery, furniture, etc.
Liabilities:
They are the debt due by a business to its proprietor and others.
Voucher:
Any written evidence in support of a business transaction is called a voucher. When a ream of paper is bought from a stationer, he gives a cash memo. The cash memo is a voucher for the payment. When wages for the month are paid to the peon, receipt is taken from him. The receipt serves as a voucher for the payment.
Goods (Merchandise):
It includes all merchandise commodities which are purchased by the business for selling.
Stock (Inventory):
Goods or merchandise on hand, that is goods remaining unsold, is called stock, stock in trade, or inventory.
Equity:
A claim which can be enforced against the assets of the firm is called equity. In other words, the rights to properties are called equities. Equities are of two types: the right of creditors and the right of owners. The equities of creditors represent debts of the business and are called liabilities. The equities of the owner is called capital, proprietorship or owner's equity.
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
CONTACT:
0322-3385752
R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN
Thursday, May 12, 2011
Rewards That The Accountant Can Provide A Company Operator
MA ECONOMICS EXTERNAL COACHING CLASSES.
MICRO ECONOMICS, STATISTICS & MACRO ECONOMICS.
GUESS PAPERS AND NOTES ARE AVAILABLE, PAST PAPERS FROM 1996 ALSO AVAILABLE.
0322-3385752
According to some scientific studies the quantity of single professionals carries on growing. Unlike the past, whenever poor organizing along with a insufficient management techniques caused the disappointment associated with businesses, business people nowadays are located being assembling clubs that improve effectiveness and supply help with regard to growth of their particular company. There are several important participants, including an accountant that need to become area of the overall staff.
Here are 5 ways an accountant can make a difference inside the performance of the enterprise.
Trustworthy Expert. Working a company entails coping with issues relating to financial situation and also producing decisions which may be challenging. Entrepreneurs have to have a expert which will listen to concerns within self-assurance. Anyone needs to offer dependable expert opinions in addition to comments that's impartial. Regarding have confidence in, reliability and integrity, business people use an accountant.
Smart Lawyer. Each day business people encounter intricate choices. It is necessary that proprietors have a individual that has the capacity to information these by means of these kinds of rocky routes. To prevent the dog owner coming from building a severe mistake in the monetary globe, the actual accountant offers advice upon concerns including lucrative prices designs, expense decisions, as well as tax concerns in addition to assets planning and economic forecasting.
Team Member. The skills of an accountant are usually diverse and their particular encounters broad. They can aid businesses with a route of much better efficiency. Most of the specialists could have each general company knowledge in addition to specialize in specific kinds of organizations and also industries. As a member of the c's, the actual accountant can offer expertise and also knowledge towards the organization so as bottom reinforce the particular supervision, marketing and also authorized goals. As the accountant helps owners regarding starting businesses, the accountant may supply assistance with regard to planning, investigation as well as progression of the business.
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
CONTACT:
0322-3385752
R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.
Connection. Using the large numbers of jobs required of economic owners they often times have a problem remaining abreast of regulations regarding finances. Any time changes happen which get a new company, the particular accountant will be the person that will serve both because interpreter and also sharer regarding regulatory info. The particular accountant works together with the owner so that you can develop a policy for finances that will both fulfill the existing challenges as well as result in the company to grow within profitability.
Link. The actual accountant maintains his / her finger around the heartbeat with the organization to monitor health. Certainly one of their main tasks is to make sure that funds runs are sufficient. The an accounting firm perform to construct interactions and rehearse equipment to evaluate the time from the proprietors to be able to start to see the business increase.
MA ECONOMICS EXTERNAL COACHING CLASSES.
MICRO ECONOMICS, STATISTICS & MACRO ECONOMICS.
GUESS PAPERS AND NOTES ARE AVAILABLE. PAST PAPERS FROM 1996 ALSO AVAILABLE.
0322-3385752
MICRO ECONOMICS, STATISTICS & MACRO ECONOMICS.
GUESS PAPERS AND NOTES ARE AVAILABLE, PAST PAPERS FROM 1996 ALSO AVAILABLE.
0322-3385752
According to some scientific studies the quantity of single professionals carries on growing. Unlike the past, whenever poor organizing along with a insufficient management techniques caused the disappointment associated with businesses, business people nowadays are located being assembling clubs that improve effectiveness and supply help with regard to growth of their particular company. There are several important participants, including an accountant that need to become area of the overall staff.
Here are 5 ways an accountant can make a difference inside the performance of the enterprise.
Trustworthy Expert. Working a company entails coping with issues relating to financial situation and also producing decisions which may be challenging. Entrepreneurs have to have a expert which will listen to concerns within self-assurance. Anyone needs to offer dependable expert opinions in addition to comments that's impartial. Regarding have confidence in, reliability and integrity, business people use an accountant.
Smart Lawyer. Each day business people encounter intricate choices. It is necessary that proprietors have a individual that has the capacity to information these by means of these kinds of rocky routes. To prevent the dog owner coming from building a severe mistake in the monetary globe, the actual accountant offers advice upon concerns including lucrative prices designs, expense decisions, as well as tax concerns in addition to assets planning and economic forecasting.
Team Member. The skills of an accountant are usually diverse and their particular encounters broad. They can aid businesses with a route of much better efficiency. Most of the specialists could have each general company knowledge in addition to specialize in specific kinds of organizations and also industries. As a member of the c's, the actual accountant can offer expertise and also knowledge towards the organization so as bottom reinforce the particular supervision, marketing and also authorized goals. As the accountant helps owners regarding starting businesses, the accountant may supply assistance with regard to planning, investigation as well as progression of the business.
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
CONTACT:
0322-3385752
R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.
Connection. Using the large numbers of jobs required of economic owners they often times have a problem remaining abreast of regulations regarding finances. Any time changes happen which get a new company, the particular accountant will be the person that will serve both because interpreter and also sharer regarding regulatory info. The particular accountant works together with the owner so that you can develop a policy for finances that will both fulfill the existing challenges as well as result in the company to grow within profitability.
Link. The actual accountant maintains his / her finger around the heartbeat with the organization to monitor health. Certainly one of their main tasks is to make sure that funds runs are sufficient. The an accounting firm perform to construct interactions and rehearse equipment to evaluate the time from the proprietors to be able to start to see the business increase.
MA ECONOMICS EXTERNAL COACHING CLASSES.
MICRO ECONOMICS, STATISTICS & MACRO ECONOMICS.
GUESS PAPERS AND NOTES ARE AVAILABLE. PAST PAPERS FROM 1996 ALSO AVAILABLE.
0322-3385752
Saturday, December 18, 2010
IAS 31-INTERESTS IN JOINT VENTURES
Scope
IAS 31 applies to accounting for all interests in joint ventures and the reporting of joint venture assets, liabilities, income, and expenses in the financial statements of venturers and investors, regardless of the structures or forms under which the joint venture activities take place, except for investments held by a venture capital organisation, mutual fund, unit trust, and similar entity that (by election or requirement) are accounted for as under IAS 39 at fair value with fair value changes recognised in profit or loss. [IAS 31.1]
Key Definitions [IAS 31.3]
Joint venture: a contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control.
Venturer: a party to a joint venture and has joint control over that joint venture.
Investor in a joint venture: a party to a joint venture and does not have joint control over that joint venture.
Control: the power to govern the financial and operating policies of an activity so as to obtain benefits from it.
Joint control: the contractually agreed sharing of control over an economic activity. Joint control exists only when the strategic financial and operating decisions relating to the activity require the unanimous consent of the venturers.
Jointly Controlled Operations
Jointly controlled operations involve the use of assets and other resources of the venturers rather than the establishment of a separate entity. Each venturer uses its own assets, incurs its own expenses and liabilities, and raises its own finance. [IAS 31.13]
IAS 31 requires that the venturer should recognise in its financial statements the assets that it controls, the liabilities that it incurs, the expenses that it incurs, and its share of the income from the sale of goods or services by the joint venture. [IAS 31.15]
Jointly Controlled Assets
Jointly controlled assets involve the joint control, and often the joint ownership, of assets dedicated to the joint venture. Each venturer may take a share of the output from the assets and each bears a share of the expenses incurred. [IAS 31.18]
IAS 31 requires that the venturer should recognise in its financial statements its share of the joint assets, any liabilities that it has incurred directly and its share of any liabilities incurred jointly with the other venturers, income from the sale or use of its share of the output of the joint venture, its share of expenses incurred by the joint venture and expenses incurred directly in respect of its interest in the joint venture. [IAS 31.21]
Jointly Controlled Entities
A jointly controlled entity is a corporation, partnership, or other entity in which two or more venturers have an interest, under a contractual arrangement that establishes joint control over the entity. [IAS 31.24]
Each venturer usually contributes cash or other resources to the jointly controlled entity. Those contributions are included in the accounting records of the venturer and recognised in the venturer's financial statements as an investment in the jointly controlled entity. [IAS 31.29]
IAS 31 allows two treatments of accounting for an investment in jointly controlled entities – except as noted below:
proportionate consolidation [IAS 31.30]
equity method of accounting [IAS 31.38]
Proportionate consolidation or equity method are not required in the following exceptional circumstances: [IAS 31.1-2]
An investment in a jointly controlled entity that is held by a venture capital organisation or mutual fund (or similar entity) and that upon initial recognition is designated as held for trading under IAS 39. Under IAS 39, those investments are measured at fair value with fair value changes recognised in profit or loss.
The interest is classified as held for sale in accordance with IFRS 5.
A parent that is exempted from preparing consolidated financial statements by paragraph 10 of IAS 27 may prepare separate financial statements as its primary financial statements. In those separate statements, the investment in the jointly controlled entity may be accounted for by the cost method or under IAS 39.
An investor in a jointly controlled entity need not use proportionate consolidation or the equity method if all of the following four conditions are met:
1. the venturer is itself a wholly-owned subsidiary, or is a partially-owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the venturer not applying proportionate consolidation or the equity method;
2. the venturer's debt or equity instruments are not traded in a public market;
3. the venturer did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; and
4. the ultimate or any intermediate parent of the venturer produces consolidated financial statements available for public use that comply with International Financial Reporting Standards.
Proportionate Consolidation
Under proportionate consolidation, the balance sheet of the venturer includes its share of the assets that it controls jointly and its share of the liabilities for which it is jointly responsible. The income statement of the venturer includes its share of the income and expenses of the jointly controlled entity. [IAS 31.33]
IAS 31 allows for the use of two different reporting formats for presenting proportionate consolidation: [IAS 31.34]
The venturer may combine its share of each of the assets, liabilities, income and expenses of the jointly controlled entity with the similar items, line by line, in its financial statements; or
The venturer may include separate line items for its share of the assets, liabilities, income and expenses of the jointly controlled entity in its financial statements.
Equity Method
Procedures for applying the equity method are the same as those described in IAS 28 Investments in Associates.
Separate Financial Statements of the Venturer
In the separate financial statements of the venturer, its interests in the joint venture should be: [IAS 31.46]
accounted for at cost; or
accounted for under IAS 39 Financial Instruments: Recognition and Measurement.
Transactions Between a Venturer and a Joint Venture
If a venturer contributes or sells an asset to a jointly controlled entity, while the assets are retained by the joint venture, provided that the venturer has transferred the risks and rewards of ownership, it should recognise only the proportion of the gain attributable to the other venturers. The venturer should recognise the full amount of any loss incurred when the contribution or sale provides evidence of a reduction in the net realisable value of current assets or an impairment loss. [IAS 31.48]
The requirements for recognition of gains and losses apply equally to non-monetary contributions unless the gain or loss cannot be measured, or the other venturers contribute similar assets. Unrealised gains or losses should be eliminated against the underlying assets (proportionate consolidation) or against the investment (equity method). [SIC 13]
When a venturer purchases assets from a jointly controlled entity, it should not recognise its share of the gain until it resells the asset to an independent party. Losses should be recognised when they represent a reduction in the net realisable value of current assets or an impairment loss. [IAS 31.49]
Financial Statements of an Investor
An investor in a joint venture who does not have joint control should report its interest in a joint venture in its consolidated financial statements either: [IAS 31.51]
in accordance with IAS 28 Investments in Associates – only if the investor has significant influence in the joint venture; or
in accordance with IAS 39 Financial Instruments: Recognition and Measurement.
Partial Disposals of Joint Ventures
If an investor loses joint control of a jointly controlled entity, it derecognises that invesgtment and recognises in profit or loss the difference between the sum of the proceeds received and any retained interest, and the carrying amount of the investment in the jointly controlled entity at the date when joint control is lost. [IAS 31.45]
Disclosure
A venturer is required to disclose:
Information about contingent liabilities relating to its interest in a joint venture. [IAS 31.54]
Information about commitments relating to its interests in joint ventures. [IAS 31.55]
A listing and description of interests in significant joint ventures and the proportion of ownership interest held in jointly controlled entities. A venturer that recognises its interests in jointly controlled entities using the line-by-line reporting format for proportionate consolidation or the equity method shall disclose the aggregate amounts of each of current assets, long-term assets, current liabilities, long-term liabilities, income, and expenses related to its interests in joint ventures. [IAS 31.56]
The method it uses to recognise its interests in jointly controlled entities. [IAS 31.57]
Venture capital organisations or mutual funds that account for their interests in jointly controlled entities in accordance with IAS 39 must make the disclosures required by IAS 31.55-56. [IAS 31.1]
IAS 31 applies to accounting for all interests in joint ventures and the reporting of joint venture assets, liabilities, income, and expenses in the financial statements of venturers and investors, regardless of the structures or forms under which the joint venture activities take place, except for investments held by a venture capital organisation, mutual fund, unit trust, and similar entity that (by election or requirement) are accounted for as under IAS 39 at fair value with fair value changes recognised in profit or loss. [IAS 31.1]
Key Definitions [IAS 31.3]
Joint venture: a contractual arrangement whereby two or more parties undertake an economic activity that is subject to joint control.
Venturer: a party to a joint venture and has joint control over that joint venture.
Investor in a joint venture: a party to a joint venture and does not have joint control over that joint venture.
Control: the power to govern the financial and operating policies of an activity so as to obtain benefits from it.
Joint control: the contractually agreed sharing of control over an economic activity. Joint control exists only when the strategic financial and operating decisions relating to the activity require the unanimous consent of the venturers.
Jointly Controlled Operations
Jointly controlled operations involve the use of assets and other resources of the venturers rather than the establishment of a separate entity. Each venturer uses its own assets, incurs its own expenses and liabilities, and raises its own finance. [IAS 31.13]
IAS 31 requires that the venturer should recognise in its financial statements the assets that it controls, the liabilities that it incurs, the expenses that it incurs, and its share of the income from the sale of goods or services by the joint venture. [IAS 31.15]
Jointly Controlled Assets
Jointly controlled assets involve the joint control, and often the joint ownership, of assets dedicated to the joint venture. Each venturer may take a share of the output from the assets and each bears a share of the expenses incurred. [IAS 31.18]
IAS 31 requires that the venturer should recognise in its financial statements its share of the joint assets, any liabilities that it has incurred directly and its share of any liabilities incurred jointly with the other venturers, income from the sale or use of its share of the output of the joint venture, its share of expenses incurred by the joint venture and expenses incurred directly in respect of its interest in the joint venture. [IAS 31.21]
Jointly Controlled Entities
A jointly controlled entity is a corporation, partnership, or other entity in which two or more venturers have an interest, under a contractual arrangement that establishes joint control over the entity. [IAS 31.24]
Each venturer usually contributes cash or other resources to the jointly controlled entity. Those contributions are included in the accounting records of the venturer and recognised in the venturer's financial statements as an investment in the jointly controlled entity. [IAS 31.29]
IAS 31 allows two treatments of accounting for an investment in jointly controlled entities – except as noted below:
proportionate consolidation [IAS 31.30]
equity method of accounting [IAS 31.38]
Proportionate consolidation or equity method are not required in the following exceptional circumstances: [IAS 31.1-2]
An investment in a jointly controlled entity that is held by a venture capital organisation or mutual fund (or similar entity) and that upon initial recognition is designated as held for trading under IAS 39. Under IAS 39, those investments are measured at fair value with fair value changes recognised in profit or loss.
The interest is classified as held for sale in accordance with IFRS 5.
A parent that is exempted from preparing consolidated financial statements by paragraph 10 of IAS 27 may prepare separate financial statements as its primary financial statements. In those separate statements, the investment in the jointly controlled entity may be accounted for by the cost method or under IAS 39.
An investor in a jointly controlled entity need not use proportionate consolidation or the equity method if all of the following four conditions are met:
1. the venturer is itself a wholly-owned subsidiary, or is a partially-owned subsidiary of another entity and its other owners, including those not otherwise entitled to vote, have been informed about, and do not object to, the venturer not applying proportionate consolidation or the equity method;
2. the venturer's debt or equity instruments are not traded in a public market;
3. the venturer did not file, nor is it in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing any class of instruments in a public market; and
4. the ultimate or any intermediate parent of the venturer produces consolidated financial statements available for public use that comply with International Financial Reporting Standards.
Proportionate Consolidation
Under proportionate consolidation, the balance sheet of the venturer includes its share of the assets that it controls jointly and its share of the liabilities for which it is jointly responsible. The income statement of the venturer includes its share of the income and expenses of the jointly controlled entity. [IAS 31.33]
IAS 31 allows for the use of two different reporting formats for presenting proportionate consolidation: [IAS 31.34]
The venturer may combine its share of each of the assets, liabilities, income and expenses of the jointly controlled entity with the similar items, line by line, in its financial statements; or
The venturer may include separate line items for its share of the assets, liabilities, income and expenses of the jointly controlled entity in its financial statements.
Equity Method
Procedures for applying the equity method are the same as those described in IAS 28 Investments in Associates.
Separate Financial Statements of the Venturer
In the separate financial statements of the venturer, its interests in the joint venture should be: [IAS 31.46]
accounted for at cost; or
accounted for under IAS 39 Financial Instruments: Recognition and Measurement.
Transactions Between a Venturer and a Joint Venture
If a venturer contributes or sells an asset to a jointly controlled entity, while the assets are retained by the joint venture, provided that the venturer has transferred the risks and rewards of ownership, it should recognise only the proportion of the gain attributable to the other venturers. The venturer should recognise the full amount of any loss incurred when the contribution or sale provides evidence of a reduction in the net realisable value of current assets or an impairment loss. [IAS 31.48]
The requirements for recognition of gains and losses apply equally to non-monetary contributions unless the gain or loss cannot be measured, or the other venturers contribute similar assets. Unrealised gains or losses should be eliminated against the underlying assets (proportionate consolidation) or against the investment (equity method). [SIC 13]
When a venturer purchases assets from a jointly controlled entity, it should not recognise its share of the gain until it resells the asset to an independent party. Losses should be recognised when they represent a reduction in the net realisable value of current assets or an impairment loss. [IAS 31.49]
Financial Statements of an Investor
An investor in a joint venture who does not have joint control should report its interest in a joint venture in its consolidated financial statements either: [IAS 31.51]
in accordance with IAS 28 Investments in Associates – only if the investor has significant influence in the joint venture; or
in accordance with IAS 39 Financial Instruments: Recognition and Measurement.
Partial Disposals of Joint Ventures
If an investor loses joint control of a jointly controlled entity, it derecognises that invesgtment and recognises in profit or loss the difference between the sum of the proceeds received and any retained interest, and the carrying amount of the investment in the jointly controlled entity at the date when joint control is lost. [IAS 31.45]
Disclosure
A venturer is required to disclose:
Information about contingent liabilities relating to its interest in a joint venture. [IAS 31.54]
Information about commitments relating to its interests in joint ventures. [IAS 31.55]
A listing and description of interests in significant joint ventures and the proportion of ownership interest held in jointly controlled entities. A venturer that recognises its interests in jointly controlled entities using the line-by-line reporting format for proportionate consolidation or the equity method shall disclose the aggregate amounts of each of current assets, long-term assets, current liabilities, long-term liabilities, income, and expenses related to its interests in joint ventures. [IAS 31.56]
The method it uses to recognise its interests in jointly controlled entities. [IAS 31.57]
Venture capital organisations or mutual funds that account for their interests in jointly controlled entities in accordance with IAS 39 must make the disclosures required by IAS 31.55-56. [IAS 31.1]
Saturday, December 11, 2010
Difference between capital and revenue expenditures
Difference between capital and revenue expenditures affects the fundamental principle of correct accounting. Proper adjustments are necessary before preparation of the final accounts. All items of capital and expenditure will find place in the balance sheet whereas all items of revenue expenditure will be included in the profit and loss account. If any incorrect adjustment or allocation is made between these expenditures, this will falsify the final results as disclosed by the revenue account or the balance sheet.
Capital Expenditures:
Expenditure means the amount spent. Any expenditure incurred for the following purposes is capital expenditure:
For acquiring fixed assets such as land, building, plant and machinery, furniture and fitting and motor vehicles. These assets should not be acquired with a view to resell them at a profit but to retain in the business. The cost of fixed asset would include all expenditure up to the asset becomes ready for use.
For making improvement and extensions to the fixed asset e.g., additions to buildings.
For increasing the earning capacity of a business or for reducing the cost of manufacture, administration or distribution in a business e.g., expenditure incurred in removing the business to a central locality or compensation paid to retrenched employee.
For raising capital monies for the business such as brokerage paid for arranging loans, discount on issue of shares and debentures, underwriting commission etc.
All capital expenditures represent either an asset or liability and are shown in the balance sheet.
List of Capital Expenditures - (Examples of Capital Expenditures):
The following is a list of the usual items of capital expenditures:
Cost of goodwill.
Cost of freehold land and building and the legal charges incurred in this connection.
Cost of lease.
Cost of machineries, plants, tools, fixtures, etc.
Cost of trade marks, patents, copy rights, designs, etc.
Cost of car, lorry etc.
Cost of installation of lights and fans.
Cost of any other assets acquired by way of equipment.
Erection cost of plant and machinery.
Cost of addition to existing assets.
Structural improvements and alteration in the existing assets.
Expenses for developments in case of mines and plantations.
Expenses for administration incurred during construction and equipment of any industrial enterprise.
Expenses incurred in experimenting which finally result in the acquisition of a patent or other rights.
Revenue Expenditures:
Expenditures will be treated as revenue expenditures if it is incurred for the following purposes:
Expenditure for purchasing floating assets i.e., assets meant for resale at a profit or for being converted into saleable goods, such as the cost of goods, raw materials and stores.
Expenditures incurred by maintaining assets in proper working order e.g., repairs to plant and machinery, building furniture and fittings etc.
Expenditures incurred for meeting day to day expenses of carrying on a business e.g., salaries, rent, rates, taxes, stationery, postage etc.
All revenue expenditures have to be deducted from the income earned by the firm. That is to say, all revenue items will be taken to the profit and loss account.
List of Revenue Expenditures - (Examples of Revenue Expenditures):
The following is a list of the usual items of revenue expenditures:
Expenses incurred for the ordinary administration and carrying on the business.
Expenses for repairs, renewals and replacement of permanent assets.
Cost of goods for resale.
Cost of raw materials and stores acquired for consumption in course of manufacturing.
Wages paid for manufacture of products for sales.
Expenses for the manufacture and distribution of the finished goods.
Loss from wear and tear and obsolescence of assets.
Depreciation of lease.
Interest on loans borrowed for business.
Loss from sale of fixed assets.
Fees for renewal of patent rights, etc.
Up-keep and maintenance of motor car and van.
Maintenance of fan and lights.
Book value of assets discarded or totally damaged or destroyed by fire or other reasons.
Difference Between Capital and Revenue Expenditures:
Following is the difference between capital and revenue expenditures.
Capital Expenditures Revenue Expenditures
1 Its effect is long term i.e., it is not exhausted within the current account year. Its benefit is enjoyed in future year or years also. In a word, its effect is reduces gradually. 1 Its effect is temporary, i.e., it is exhausted within the current accounting year.
2 An asset is acquired or the value of an asset is increased as a result result of this expenditure. 2 Neither an asset is acquired nor the value of an asset is increased.
3 It does not occur again and again - it is non-recurring and irregular. 3 It occurs repeatedly - It is recurring and regular.
4 Generally, it has physical existence i.e., it can be seen with eyes. 4 It has no physical existence, i.e., it cannot be seen with eyes.
5 This expenditure improves the position of the concern 5 This expenditure helps to maintain the concern
6 A portion of this expenditure is shown in the trading and profit and loss account or income and expenditure account as depreciation. 6 The whole amount of this expenditure is shown in trading and profit and loss account or income and expense account. But deferred revenue expenditures and prepaid expenses are not shown.
7 It appears in balance sheet until its benefit is fully exhausted. 7 It does not appear in balance sheet. Deferred revenue expenditure, outstanding expenditure, outstanding expenses and prepaid expenses, however, temporarily shown in the balance sheet.
8 It does not reduce the revenue of the concern. Purchase of fixed assets does not effect revenue. 8 It reduces revenue. Payment of salaries to employees decreases revenue.
Capital and Revenue Receipts, Payments, Profits and Losses:
Capitalized and Revenue Receipts:
Receipts refer to the actual amounts of cash received. They can be either of capital nature or revenue nature.
Capital receipts include the following:
Capital brought in by the proprietor at the commencement and any additions made subsequently.
Money borrowed from partners, bankers, private individuals etc.
Money received by the sale of fixed assets.
Money received on account of capital profit.
Revenue receipts include the following:
Money received by the sale of floating assets - by sale of goods.
Money received on account of some revenue profit.
Capital and Revenue Payments:
Definition and Explanation:
Capital payment is an amount paid on account of some capital expenditure and a revenue payment is an amount actually paid on account of some revenue expenditure. Expenditure is the full amount incurred whether paid or not, whilst payments refer to the amount actually paid.
Example:
If a building is purchased for $20,000 from X and $10,000 is paid in cash and the remaining sum to be paid after six months; $20,000 is capital expenditure, but $10,000 is only capital payment. Similarly if goods are purchased from X for 30,000 and $15,000 is paid in cash; $30,000 is revenue expenditure but only $15,000 is revenue payment.
Capital and Revenue Profits:
Definition and Explanation:
Capital profit means a profit made on the sale of a fixed asset or profit earned on raising monies for the business. For example a building purchased for $20,000 is sold for $25,000 the profit $5,000 thus made is a capital profit.
Revenue profit on the other hand is a profit made by the business e.g., profit on the sale of goods, income from investments, commission earned etc.
Whenever, capital profit is made it should either be transferred to the capital account of the proprietor or credited to capital reserve account which would appear as a liability on the balance sheet. But capital profits should in no case be transferred to profit and loss account because it is non-trading profit. Revenue profits on the other hand should be transferred to profit and loss account because they arise out of regular trading operation.
Capital and Revenue Losses:
Definition and Explanation:
Capital loss means a loss made on the sale of a fixed asset or a loss incurred in connection with the raising of money for business. Capital loss may be shown as an asset in the balance sheet. But as this asset is a fictitious nature, it would would advisable to write off it.
Revenue loss, on the other hand, is the loss incurred in trading operations such as loss on the sale of goods. Revenue losses are charged to profit and loss account of the year in which they occur.
More About Capital and Revenue Expenditures:
Capitalized or Deferred Revenue Expenditures:
Where a certain revenue expenditure incurred is of such a nature that its benefit is likely to be spread over a certain number of years, or where it is of non-recurring and special nature and large in amount, in such circumstances, instead of debiting the entire amount to the profit and loss account of the year in which it has been incurred, it may be spread over a number of years, a proportionate amount being charged to each year's profit and loss account. The remaining portion of the expenditure is carried forward and is known as capital expenditure or or deferred revenue expenditure and is shown as an asset in the balance sheet. Item such as preliminary expenses, cost of issue of debentures are examples that may be classified under this head.
Exceptions to General rules:
There are certain expenses which are usually of a revenue in nature but under certain circumstances they become capital expenditures. The following are the examples of expenses which are usually revenue but under certain circumstances become capital.
Legal Charges:
These are, as a rule, revenue charges, but legal charges incurred in connection with the purchase of a fixed asset are capital expenditures as they form an additional cost of the asset acquired.
Wages:
Wages are ordinary a revenue expenditure. But in a manufacturing business where the firm's own men are employed in making of fixed asset, the wages paid for such purpose would be capitalized. For example if the firm's own men are employed in making extension to the factory building or in erection of plant or manufacturing tools for own requirements. the wages and salaries paid to the persons are not revenue but capital expenditures.
Brokerage and Stamp Duty:
Normally these are revenue expenditures, but brokerage paid on acquisition of a property and stamp duty involved thereon can be capitalized.
Freight and Carriage:
This is revenue charge, but freight and carriage paid on newly acquired plant or fixed assets are capital expenditures.
Advertising:
Ordinarily amount expended on advertising is revenue charge but the cost of special advertising undertaken for the purpose of introducing a new line of goods may be capitalized.
Development Expense:
In concern like collieries, mines, tea, rubber etc., all expenses incurred during the period of development are treated as capital.
Preliminary Expenses:
These are the expenses incurred in connection with the formation of a public company. These expenses although are revenue in nature but are allowed to be capitalized and can be shown as an asset in the balance sheet.
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KARACHI, PAKISTAN.
Capital Expenditures:
Expenditure means the amount spent. Any expenditure incurred for the following purposes is capital expenditure:
For acquiring fixed assets such as land, building, plant and machinery, furniture and fitting and motor vehicles. These assets should not be acquired with a view to resell them at a profit but to retain in the business. The cost of fixed asset would include all expenditure up to the asset becomes ready for use.
For making improvement and extensions to the fixed asset e.g., additions to buildings.
For increasing the earning capacity of a business or for reducing the cost of manufacture, administration or distribution in a business e.g., expenditure incurred in removing the business to a central locality or compensation paid to retrenched employee.
For raising capital monies for the business such as brokerage paid for arranging loans, discount on issue of shares and debentures, underwriting commission etc.
All capital expenditures represent either an asset or liability and are shown in the balance sheet.
List of Capital Expenditures - (Examples of Capital Expenditures):
The following is a list of the usual items of capital expenditures:
Cost of goodwill.
Cost of freehold land and building and the legal charges incurred in this connection.
Cost of lease.
Cost of machineries, plants, tools, fixtures, etc.
Cost of trade marks, patents, copy rights, designs, etc.
Cost of car, lorry etc.
Cost of installation of lights and fans.
Cost of any other assets acquired by way of equipment.
Erection cost of plant and machinery.
Cost of addition to existing assets.
Structural improvements and alteration in the existing assets.
Expenses for developments in case of mines and plantations.
Expenses for administration incurred during construction and equipment of any industrial enterprise.
Expenses incurred in experimenting which finally result in the acquisition of a patent or other rights.
Revenue Expenditures:
Expenditures will be treated as revenue expenditures if it is incurred for the following purposes:
Expenditure for purchasing floating assets i.e., assets meant for resale at a profit or for being converted into saleable goods, such as the cost of goods, raw materials and stores.
Expenditures incurred by maintaining assets in proper working order e.g., repairs to plant and machinery, building furniture and fittings etc.
Expenditures incurred for meeting day to day expenses of carrying on a business e.g., salaries, rent, rates, taxes, stationery, postage etc.
All revenue expenditures have to be deducted from the income earned by the firm. That is to say, all revenue items will be taken to the profit and loss account.
List of Revenue Expenditures - (Examples of Revenue Expenditures):
The following is a list of the usual items of revenue expenditures:
Expenses incurred for the ordinary administration and carrying on the business.
Expenses for repairs, renewals and replacement of permanent assets.
Cost of goods for resale.
Cost of raw materials and stores acquired for consumption in course of manufacturing.
Wages paid for manufacture of products for sales.
Expenses for the manufacture and distribution of the finished goods.
Loss from wear and tear and obsolescence of assets.
Depreciation of lease.
Interest on loans borrowed for business.
Loss from sale of fixed assets.
Fees for renewal of patent rights, etc.
Up-keep and maintenance of motor car and van.
Maintenance of fan and lights.
Book value of assets discarded or totally damaged or destroyed by fire or other reasons.
Difference Between Capital and Revenue Expenditures:
Following is the difference between capital and revenue expenditures.
Capital Expenditures Revenue Expenditures
1 Its effect is long term i.e., it is not exhausted within the current account year. Its benefit is enjoyed in future year or years also. In a word, its effect is reduces gradually. 1 Its effect is temporary, i.e., it is exhausted within the current accounting year.
2 An asset is acquired or the value of an asset is increased as a result result of this expenditure. 2 Neither an asset is acquired nor the value of an asset is increased.
3 It does not occur again and again - it is non-recurring and irregular. 3 It occurs repeatedly - It is recurring and regular.
4 Generally, it has physical existence i.e., it can be seen with eyes. 4 It has no physical existence, i.e., it cannot be seen with eyes.
5 This expenditure improves the position of the concern 5 This expenditure helps to maintain the concern
6 A portion of this expenditure is shown in the trading and profit and loss account or income and expenditure account as depreciation. 6 The whole amount of this expenditure is shown in trading and profit and loss account or income and expense account. But deferred revenue expenditures and prepaid expenses are not shown.
7 It appears in balance sheet until its benefit is fully exhausted. 7 It does not appear in balance sheet. Deferred revenue expenditure, outstanding expenditure, outstanding expenses and prepaid expenses, however, temporarily shown in the balance sheet.
8 It does not reduce the revenue of the concern. Purchase of fixed assets does not effect revenue. 8 It reduces revenue. Payment of salaries to employees decreases revenue.
Capital and Revenue Receipts, Payments, Profits and Losses:
Capitalized and Revenue Receipts:
Receipts refer to the actual amounts of cash received. They can be either of capital nature or revenue nature.
Capital receipts include the following:
Capital brought in by the proprietor at the commencement and any additions made subsequently.
Money borrowed from partners, bankers, private individuals etc.
Money received by the sale of fixed assets.
Money received on account of capital profit.
Revenue receipts include the following:
Money received by the sale of floating assets - by sale of goods.
Money received on account of some revenue profit.
Capital and Revenue Payments:
Definition and Explanation:
Capital payment is an amount paid on account of some capital expenditure and a revenue payment is an amount actually paid on account of some revenue expenditure. Expenditure is the full amount incurred whether paid or not, whilst payments refer to the amount actually paid.
Example:
If a building is purchased for $20,000 from X and $10,000 is paid in cash and the remaining sum to be paid after six months; $20,000 is capital expenditure, but $10,000 is only capital payment. Similarly if goods are purchased from X for 30,000 and $15,000 is paid in cash; $30,000 is revenue expenditure but only $15,000 is revenue payment.
Capital and Revenue Profits:
Definition and Explanation:
Capital profit means a profit made on the sale of a fixed asset or profit earned on raising monies for the business. For example a building purchased for $20,000 is sold for $25,000 the profit $5,000 thus made is a capital profit.
Revenue profit on the other hand is a profit made by the business e.g., profit on the sale of goods, income from investments, commission earned etc.
Whenever, capital profit is made it should either be transferred to the capital account of the proprietor or credited to capital reserve account which would appear as a liability on the balance sheet. But capital profits should in no case be transferred to profit and loss account because it is non-trading profit. Revenue profits on the other hand should be transferred to profit and loss account because they arise out of regular trading operation.
Capital and Revenue Losses:
Definition and Explanation:
Capital loss means a loss made on the sale of a fixed asset or a loss incurred in connection with the raising of money for business. Capital loss may be shown as an asset in the balance sheet. But as this asset is a fictitious nature, it would would advisable to write off it.
Revenue loss, on the other hand, is the loss incurred in trading operations such as loss on the sale of goods. Revenue losses are charged to profit and loss account of the year in which they occur.
More About Capital and Revenue Expenditures:
Capitalized or Deferred Revenue Expenditures:
Where a certain revenue expenditure incurred is of such a nature that its benefit is likely to be spread over a certain number of years, or where it is of non-recurring and special nature and large in amount, in such circumstances, instead of debiting the entire amount to the profit and loss account of the year in which it has been incurred, it may be spread over a number of years, a proportionate amount being charged to each year's profit and loss account. The remaining portion of the expenditure is carried forward and is known as capital expenditure or or deferred revenue expenditure and is shown as an asset in the balance sheet. Item such as preliminary expenses, cost of issue of debentures are examples that may be classified under this head.
Exceptions to General rules:
There are certain expenses which are usually of a revenue in nature but under certain circumstances they become capital expenditures. The following are the examples of expenses which are usually revenue but under certain circumstances become capital.
Legal Charges:
These are, as a rule, revenue charges, but legal charges incurred in connection with the purchase of a fixed asset are capital expenditures as they form an additional cost of the asset acquired.
Wages:
Wages are ordinary a revenue expenditure. But in a manufacturing business where the firm's own men are employed in making of fixed asset, the wages paid for such purpose would be capitalized. For example if the firm's own men are employed in making extension to the factory building or in erection of plant or manufacturing tools for own requirements. the wages and salaries paid to the persons are not revenue but capital expenditures.
Brokerage and Stamp Duty:
Normally these are revenue expenditures, but brokerage paid on acquisition of a property and stamp duty involved thereon can be capitalized.
Freight and Carriage:
This is revenue charge, but freight and carriage paid on newly acquired plant or fixed assets are capital expenditures.
Advertising:
Ordinarily amount expended on advertising is revenue charge but the cost of special advertising undertaken for the purpose of introducing a new line of goods may be capitalized.
Development Expense:
In concern like collieries, mines, tea, rubber etc., all expenses incurred during the period of development are treated as capital.
Preliminary Expenses:
These are the expenses incurred in connection with the formation of a public company. These expenses although are revenue in nature but are allowed to be capitalized and can be shown as an asset in the balance sheet.
B.COM CRASH CLASSES IN JUST 20 DAYS
ACCOUNTING, STATISTICS, ECONOMICS & ADVANCED ACCOUNTING.
CONTACT:
KHALID AZIZ
0322-3385752
KARACHI, PAKISTAN.
Friday, December 3, 2010
INCOMPLETE RECORDS
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Incomplete records are intended to signify any accounting records which fall short of complete double entry. There are varying degrees of incompleteness and the procedure to be adopted in order to prepare final accounts must depend upon the nature of the records and data available.
Approach to be adopted
In order to prepare a profit and loss account and a balance sheet, the following procedure is recorded:
Step 1
Construct a statement of the financial position at the beginning of the year. This requires assets and liabilities to be determined. The values of any fixed assets can be obtained from such details as the trader is able to supply of their cost and the dates upon which they were acquired, provision for depreciation from the date of acquisition to the commencement of the current period being deducted. The trader must provide an estimate of the value of his stock and estimated asset values posted to the debit side. The total of the book debts should be debited to a total debtors account, and the total of the liabilities credited to a total creditors account. The excess of the aggregate of the assets over the liabilities may be taken to represent the amount of traders' capital at the commencement of the period and should be credited to his capital account.
Step 2
A carefully analysis should be made of the bank statement, and a cash summary prepared. For this purpose, analysis columns should be prepared for each of the principle headings of receipts and payments.
Step 3
Ascertain the amounts of any cash taking which have not been paid into the bank, but have been used by the trader for the payment of business expenses, goods purchased for cash and personal expenses. An estimate should also be obtained of the value of any stock which may have been withdrawn by the trader for his own personal use or for that of his family.
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Step 4
On completion of the above analysis, posting will be made as follows:
1. Cash takings to the credit of total debtors account
2. Income from investments to the credit of income from investment account
3. Proceeds of sale assets to the credit of the appropriate asset accounts
4. Other items to the credit of the relevant accounts
If a profit or loss on the sale assets is disclosed, this should be transferred either to profit and loss account or to the proprietors' capital account.
Step 5
The amount of any cash taking used for business or private purposes should be noted, the appropriate account debited and total debtors account credited.
Step 6
This involves calculating year end adjustments and balances. A schedule should be compiled of the book debts outstanding, the total of which should be carried down in the total debtors account. The balance of this account will now represent the total sales for the period and should be transferred to the trading account. Similarly, a schedule should be made of liabilities outstanding to trade and other creditors. The total should be carried down in the total creditors account. The balance of this account will now represent the total purchases for the period and should be transferred to the debit of trading account. Accruals and prepayments will be carried down as closing balances in the relevant expenses accounts.
Step 7
The whole of the transactions will now be recorded in total in double entry form and it will be possible to extract a trading and profit and loss account and balance sheet in the usual way.
JOIN KHALID AZIZ
ICMAP STAGE 1, 2, 3, 4
ICAP MODULE B, C, D
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ICMAP STAGE 1, 2, 3, 4
ICAP MODULE B, C, D
PIPFA
MA-ECONOMICS
B.COM
I.COM
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Incomplete records are intended to signify any accounting records which fall short of complete double entry. There are varying degrees of incompleteness and the procedure to be adopted in order to prepare final accounts must depend upon the nature of the records and data available.
Approach to be adopted
In order to prepare a profit and loss account and a balance sheet, the following procedure is recorded:
Step 1
Construct a statement of the financial position at the beginning of the year. This requires assets and liabilities to be determined. The values of any fixed assets can be obtained from such details as the trader is able to supply of their cost and the dates upon which they were acquired, provision for depreciation from the date of acquisition to the commencement of the current period being deducted. The trader must provide an estimate of the value of his stock and estimated asset values posted to the debit side. The total of the book debts should be debited to a total debtors account, and the total of the liabilities credited to a total creditors account. The excess of the aggregate of the assets over the liabilities may be taken to represent the amount of traders' capital at the commencement of the period and should be credited to his capital account.
Step 2
A carefully analysis should be made of the bank statement, and a cash summary prepared. For this purpose, analysis columns should be prepared for each of the principle headings of receipts and payments.
Step 3
Ascertain the amounts of any cash taking which have not been paid into the bank, but have been used by the trader for the payment of business expenses, goods purchased for cash and personal expenses. An estimate should also be obtained of the value of any stock which may have been withdrawn by the trader for his own personal use or for that of his family.
JOIN KHALID AZIZ
ICMAP STAGE 1, 2, 3, 4
ICAP MODULE B, C, D
PIPFA
MA-ECONOMICS
B.COM
I.COM
O/A LEVEL ACCOUNTS, ECONOMICS, URDU & PAK STUDIES
0322-3385752
Step 4
On completion of the above analysis, posting will be made as follows:
1. Cash takings to the credit of total debtors account
2. Income from investments to the credit of income from investment account
3. Proceeds of sale assets to the credit of the appropriate asset accounts
4. Other items to the credit of the relevant accounts
If a profit or loss on the sale assets is disclosed, this should be transferred either to profit and loss account or to the proprietors' capital account.
Step 5
The amount of any cash taking used for business or private purposes should be noted, the appropriate account debited and total debtors account credited.
Step 6
This involves calculating year end adjustments and balances. A schedule should be compiled of the book debts outstanding, the total of which should be carried down in the total debtors account. The balance of this account will now represent the total sales for the period and should be transferred to the trading account. Similarly, a schedule should be made of liabilities outstanding to trade and other creditors. The total should be carried down in the total creditors account. The balance of this account will now represent the total purchases for the period and should be transferred to the debit of trading account. Accruals and prepayments will be carried down as closing balances in the relevant expenses accounts.
Step 7
The whole of the transactions will now be recorded in total in double entry form and it will be possible to extract a trading and profit and loss account and balance sheet in the usual way.
JOIN KHALID AZIZ
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ICAP MODULE B, C, D
PIPFA
MA-ECONOMICS
B.COM
I.COM
O/A LEVEL ACCOUNTS, ECONOMICS, URDU & PAK STUDIES
0322-3385752
Wednesday, December 1, 2010
Important Points About Cash Flow Calculation:
The estimation of this, through difficult, is the most crucial step in investment analysis. Here are some important points about that calculation.
• Profits vs. cash flows
That flows are different from profits. Profit is not necessarily that flow; it is the difference between revenue earned and expenses incurred rather than cash received and paid. Also, in the calculation of profits, an arbitrary distinction between revenue expenditure is made.
• Incremental flows
That flows should be estimated on Incremental basis. Incremental flows are found out by comparing alternative investment projects. The comparison may simply be between cash flows with and without the investment proposal under consideration when real alternatives do not exist.
• Components of cash flows
Three components of these flows can be identified: one- initial investment two- annual flows, and three- terminal flows.
• Initial investment
Initial investment will comprise the original cost (including freight and installation charges) of the project, plus any increase in working capital. In the case of replacement decision, the after-tax salvage value of the old asset should also be adjusted to compute the initial investment.
• Net cash flow
Annual net flow is the difference between cash inflows including taxes. Tax computations are based on accounting profits. Care should be taken in properly adjusting deprecation while computing net flows.
• Depreciation
Depreciation is a not-flow through tax shield. The following formula can be used to calculate change in net flows from operations
• Working capital and capital expenditure
In practice, changes in Working capital items - debtors (receivable), creditors (payable) and stock (inventory) - affect cash flows. Also, the firm may be required to incur capital expenditure, during the operation of the investment project.
• Free flows and the discount rate
Free flows are available to service both the shareholders and the debt holders. Therefore, debt flows (interest charges and repayment of principle) are not considered in the computation of free flows. The financing effect is captured by the firms weighted cost of debt and equity, which is used to discount the projects cash flows. This approach is based on two assumptions:
1. The projects risk is the same as the firms risk
2. The firms debt ratio is consistent and the projects debt capacity is the same as the firms.
• Terminal flows
Terminal cash are those, which occur in the projects last year in addition to annual cash flows. They would consist of the after tax salvage value of the project and working capital released (if any). In case of replacement decision, the foregone salvage value of old asset should also be taken into account.
• Terminal value of new product
Terminal value of new product may depend on that, which could be generated much beyond the assumed analysis or horizon period. The firm may make reasonable assumption regarding the cash flow growth rate after the horizon period.
• Incremental flows
The term incremental flows should be interpreted carefully. The concept should be extended to include the opportunity cost of the existing facilities used by the proposal. Sunk cost and the allocated overheads are irrelevant in computing cash flows. Similarly, a new project may cannibalize sales of the existing products. The projects cash flows should adjust for the reduction in flows on account of the cannibalization.
• Inflation
The net present value rule gives correct answer to choose an investment under inflation if it is treated consistently in cash flows and discount rate. The discount rate is a market determined rate and therefore, includes the expected inflation rate. It is thus generally stated in nominal terms. It should also be stated in nominal terms to obtain an unbiased net present value. Alternatively, the real cash flows can be discounted at the real discount rate to calculate unbiased net present value.
• Profits vs. cash flows
That flows are different from profits. Profit is not necessarily that flow; it is the difference between revenue earned and expenses incurred rather than cash received and paid. Also, in the calculation of profits, an arbitrary distinction between revenue expenditure is made.
• Incremental flows
That flows should be estimated on Incremental basis. Incremental flows are found out by comparing alternative investment projects. The comparison may simply be between cash flows with and without the investment proposal under consideration when real alternatives do not exist.
• Components of cash flows
Three components of these flows can be identified: one- initial investment two- annual flows, and three- terminal flows.
• Initial investment
Initial investment will comprise the original cost (including freight and installation charges) of the project, plus any increase in working capital. In the case of replacement decision, the after-tax salvage value of the old asset should also be adjusted to compute the initial investment.
• Net cash flow
Annual net flow is the difference between cash inflows including taxes. Tax computations are based on accounting profits. Care should be taken in properly adjusting deprecation while computing net flows.
• Depreciation
Depreciation is a not-flow through tax shield. The following formula can be used to calculate change in net flows from operations
• Working capital and capital expenditure
In practice, changes in Working capital items - debtors (receivable), creditors (payable) and stock (inventory) - affect cash flows. Also, the firm may be required to incur capital expenditure, during the operation of the investment project.
• Free flows and the discount rate
Free flows are available to service both the shareholders and the debt holders. Therefore, debt flows (interest charges and repayment of principle) are not considered in the computation of free flows. The financing effect is captured by the firms weighted cost of debt and equity, which is used to discount the projects cash flows. This approach is based on two assumptions:
1. The projects risk is the same as the firms risk
2. The firms debt ratio is consistent and the projects debt capacity is the same as the firms.
• Terminal flows
Terminal cash are those, which occur in the projects last year in addition to annual cash flows. They would consist of the after tax salvage value of the project and working capital released (if any). In case of replacement decision, the foregone salvage value of old asset should also be taken into account.
• Terminal value of new product
Terminal value of new product may depend on that, which could be generated much beyond the assumed analysis or horizon period. The firm may make reasonable assumption regarding the cash flow growth rate after the horizon period.
• Incremental flows
The term incremental flows should be interpreted carefully. The concept should be extended to include the opportunity cost of the existing facilities used by the proposal. Sunk cost and the allocated overheads are irrelevant in computing cash flows. Similarly, a new project may cannibalize sales of the existing products. The projects cash flows should adjust for the reduction in flows on account of the cannibalization.
• Inflation
The net present value rule gives correct answer to choose an investment under inflation if it is treated consistently in cash flows and discount rate. The discount rate is a market determined rate and therefore, includes the expected inflation rate. It is thus generally stated in nominal terms. It should also be stated in nominal terms to obtain an unbiased net present value. Alternatively, the real cash flows can be discounted at the real discount rate to calculate unbiased net present value.
CONSIGNMENT ACCOUNTING
JOIN KHALID AZIZ
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
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CONTACT:
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Definition and Explanation of Consignment:
The word consignment can be generally defined as the act of sending a quantity of goods by the manufacturers and producers of one country or place to their agents in another at the risk of the principals for the purpose of sale.
Goods so sent are known as "consignment". The sender of the goods is called the consignor. Generally the manufacturers or producers are consignors. The person to whom goods are forwarded for the purpose of sale is known as the consignee. The consignment can be classified as:
Outward consignment.
Inward consignment.
It is called "outward" when the dispatch of a quantity of goods from one country to another is made for the purpose of sale and is called "inward" when the receipt of the quantity of goods is made for the purpose of sale.
Goods sent on consignment do not become the property of the consignee. He has not bought them. The ownership remains with the sender or the consigner. If the goods are destroyed, the receiver (consignee) is not responsible. The loss will fall on the consignor. The consignee tries to sell the goods according to the instructions of the consignor. When the goods have been sold, he will deduct his expenses, commission, etc., from the sale proceeds and the balance is remitted to the consignor. The relationship between the consignor and the consignee is that of principle and agent. The consignee is the agent. The consignee acts entirely on behalf of the consignor. The consignee is entitled to his remuneration which is generally fixed on the basis of a commission of sales. The expenses incurred by the consignee must also be reimbursed by the principal. It is important to remember that the consignee does not buy the goods; he merely receives the possession of the goods.
Distinction/Difference Between Consignment and Sale:
The following are the main points of the difference between consignment and sale.
Transfer of Legal Ownership of the Goods:
In case of sale, the legal ownership of the goods sold is transferred to the purchaser of goods. Whereas in case of a consignment of goods , the legal ownership of the goods is not transferred to the consignment but the ownership of the goods remains vested in the consignor till the goods consigned are sold by the consignee.
Relationship Between Consignor and Consignee:
In case of a sale of goods, the relationship between the seller and the purchaser of the goods is that of a creditor and a debtor whereas in case of a consignment the relationship between the consignor and the consignee is that of a principal and agent. because the consignee is to sell goods on behalf of the consignor.
Expenses Incurred:
In consignment, expenses incurred by the consignee in connection with the goods consigned to him are usually borne by the consignor whereas in case of a sale, expenses incurred after sale of goods are born by the purchaser.
Risk Attached to the Goods:
In case of consignment, risk attached to the goods sold lies with the consignor till the goods consigned are sold by the consignee. But in case of a sale, risk attached to the goods sold is transferred to the buyer of goods.
Return of Goods:
In case of consignment, return of goods is possible if the goods are not sold by the consignee. But in case of sale, return of goods is not possible as goods once sold are not returnable.
Requirement of Account Sale:
In case of consignment, account sale is required to be submitted periodically by the consignee to the consignor. But in case of sales no account sale is required to be submitted by the purchaser to the seller.
Definitions of Important Terms Used in Consignment Accounting:
Commission:
The term commission as used in connection with consignment denotes the remuneration of the consignee for selling the goods of the consignor. This commission is generally calculated at a rate percentage on the gross proceeds of the sales.
Del Credere Commission:
The del credere commission is an extra commission allowed to the consignee on his guaranteeing the realization of the debts in full, in connection with the credit sale of goods on consignment. Goods may be sold by the consignee either for cash or on credit. When they are sold on credit, the consignee may guarantee that they will be duly paid for and that he will be liable to indemnify the consignor for all bad debts. In such cases; the consignor pays the consignee an extra commission for this guarantee. The extra commission is called del credere commission.
Advance Against Consignment:
Usually the consignee is asked to accept a bill of exchange to cover part of the value of goods. This is a guarantee by the consignee that when sales are effected, he will make the necessary payment. Of course, instead of a bill of exchange, the agent may remit a sum of money to the principle as an advance. This advance or the amount of the bill of exchange will be adjusted when the goods are sold.
Consignment Account:
The consignment account is one which shows what profit or loss is made out of the dealing of the goods sent on consignment. It is the combination of the trading and profit and loss account of any particular consignment.
Proforma Invoice:
When the consignor sends the goods to the consignee, he forwards a statement showing the particulars such as quantity, quality, price of goods etc. This statement is called the Proforma invoice. But in case of regular sale, an invoice is prepared and sent along with the goods. It implies that a sale has taken place.
Account Sale:
An account sale is a statement prepared and sent by the consignee to the consignor at periodical intervals, dealing there in the goods sold, price realized, expenses incurred, commission payable to and the net amount due from the consignee.
Consignment Accounting Journal Entries:
As the goods sent on consignment by the consigner are not his sales, he must not record consignment as sales and the consignee must must not record them as purchases. The consigner should not take up any profit on the transaction until the goods have been actually sold by the consignee. Since the goods still belong to the consignor, any unsold goods in the hands of the consignee at the end of the trading period should be included in the consignor's stock. The recording of the consignment transactions in the books of the consignor and consignee will be made in the following manner:
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
CONTACT:
KHALID AZIZ
0322-3385752
0312-2302870
R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.
Accounting Entries in the Books of Consignor:
(1) On dispatch of goods:-
Consignment account (With the cost of goods)
To Goods sent on consignment account
--------------------------------------------------------------------------------
(2) On payment of expenses on dispatch:-
Consignment account (With the amount spent as expenses)
To Bank account
--------------------------------------------------------------------------------
(3) On receiving advance:
Cash or bills receivable account (With the amount cash or bill)
To Consignee's personal account
--------------------------------------------------------------------------------
(4) On the consignee reporting sale (as per A/S):-
Consignee's personal account (With gross proceeds of sales)
To Consignment account
--------------------------------------------------------------------------------
(5) For expenses incurred by the consignee (as per A/S):-
Consignment account (With the amount of expenses)
To Consignee's personal account
--------------------------------------------------------------------------------
(6) For commission payable to the consignee:-
Consignment account (With the amount of expenses)
To Consignee's personal account
--------------------------------------------------------------------------------
Assuming that all the goods sent have been sold, the consignment account will show at this stage the actual profit or loss made on it. The same is transferred to profit and loss account.
The entry in case of profit is:
Consignment account
To profit and loss account
--------------------------------------------------------------------------------
In case of loss the entry is:
Profit and loss account
To Consignment account
--------------------------------------------------------------------------------
Note: The goods sent on consignment account may be closed by a transfer to trading account.
When Consignment is Partly Sold:
When all the goods sent on consignment have not been sold., the value of unsold goods in the hands of the consignee must be ascertained and the profit or loss should be found out by taking this stock into account. The entry is:
Stock on consignment account
To Consignment account
--------------------------------------------------------------------------------
Stock on consignment account is an asset and will be shown in the balance sheet of the consignor. Valuation of stock is discussed on valuation of stock page.
Accounting Entries in the Books of Consignee:
(1) When consignment goods are received:-
No entry is made in the books of account. The consignee is not the owner of the goods and therefore he makes no entry when he receives the goods.
--------------------------------------------------------------------------------
(2) For expenses incurred by the consignee:-
Consignor's personal account
To Cash account
(3) When advance is given:-
Consignor's personal account
To Cash or bills payable account
--------------------------------------------------------------------------------
(4) When goods are sold:-
Cash or bank account
To Consignor's personal account
--------------------------------------------------------------------------------
(5) For commission due:-
Consignor's personal account
To commission account
--------------------------------------------------------------------------------
The consignor's account will be closed by debiting it with cash or final bill or draft in settlement.
Valuation of Unsold Stock Or Closing Stock in Consignment Accounting:
The valuation of stock laying with the consignee at the time of final closing of the account of the consignor is generally made at cost or market price whichever is less. The meaning of cost, however, should be properly understood. Cost should not mean merely the cost at which the consignor invoices the goods. If such expenses as normally increase the value of goods have been incurred, a proportionate of such expenses should be included in the cost. In other words, all the expenses incurred to move the goods from the consignor's premises to the premises of consignee should be included. Expenses which are incurred up to the moment the goods are received into the godown of the consignee are treated as part of the cost. But expenses incurred after the goods have been put into the godown should not be included into the cost because such expenses do not increase the value of goods. Examples of such expenses are godown rent, insurance godown, advertisement, salaries of salesmen, etc. It does not matter who pays the expenses (consignor or consignee).
Example:
Suppose, 1000 units are dispatched at a cost of $20 each. The consignor pay $100 for insurance in transit and $200 for packing. The consignee pays 700 for freight, $100 as octroi duty and $100 as cartage. He also pays $200 as godown rent and $150 as insurance premium. The last two items will be excluded while calculating the cost. The total cost will be $20,000 + $100 + 200 + 700 + $100 + $100 = $21,200. The cost per unit, therefore, comes to $21.20. If 100 units remain unsold, the value of stock will be: 100 × 21.20, i.e., $2,300. If the market price is less than this figure, then the value of stock will be on the basis of market price.
Valuation and Treatment of Normal and Abnormal Loss in Consignment Accounting:
Normal Loss:
Normal loss of goods should also be considered while valuing the closing stock or unsold stock. Normal loss means inherent and unavoidable loss. For example if a certain quantity of coal is consigned, some of it is bound to be lost because of loading and unloading and because of some of it turning into dust. In the nature of coal shortage is unavoidable.
Example:
Suppose 100 tons of coal are despatched. The cost of one ton of coal is $20 and the freight incurred is $470. To the consignor the total cost is $2,470. Suppose, the consignee receives only 95 tones. In that case the consignor can say that the cost of one ton of coal is $2,470/95 or $26. If 20 tons of coal are left unsold with the consignee, the value of stock will be $20 × $26 = $520.
Abnormal Loss:
Some losses are accidental or may arise out of carelessness. For example, theft of goods or destruction of goods by fire. Such losses are more or less abnormal and in any case, do not occur often. Suppose part of the goods stolen. This will reduce the value of stock and, therefore, the profit on consignment. In order to see the effect of theft clearly, it is better to find out the value of the goods thus lost. After finding out the value, the consignment account is credited and profit and loss account is debited. The effect of this will be that the consignment account will show its proper profit and in the profit and loss account this profit will be reduced to show actual profit. If part of the loss is recoverable from an insurance company, the amount which can be recovered should be deducted from the loss for the purpose of debiting the profit and loss account. The amount of the loss should be calculated like stock on consignment.
Example/Problem of Abnormal Loss:
1,000 Motors were consigned by A & Co., of Lahore to Bashir of Karachi at an invoice cost of $150 each. A & Co., paid freight $10,000 and insurance $1,500. During transit 100 motors were completely destroyed. Bashir took delivery of the remaining motors and paid $14,400 as duty.
Bashir sent a bank draft to A & Co., for $50,000 as an advance payment and later sent an account sale showing that 800 motors were sold at $220 each. Expenses incurred by Bashir on godown rent and advertisement etc., amounted to $2,000. Bashir is entitled to commission of 5 per cent.
Required: Prepare consignment account and Bashir's account in the books of A & Co., assuming that nothing has been recovered from the insurance company due to defect in the policy.
Consignment to Karachi Account
$ $
To Goods sent on consignment 1,50,000 By sales (800 × 220) 1,76,000
To Bank - freight and insurance 11,500 By Profit and loss account - Ab. Loss* 16,150
To Bashir - duty 14,400 By Stock on consignment** 17,750
To Bashir - expenses 2,000
To Bashir - commission 8,800
To Profit and loss account 23,200
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
2,09,900 2,09,900
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
Bashir
$ $
To Consignment account 1,76,000 By Bank 50,000
By Consignment account
Duty 14,400
Expenses 2,000
--------------------------------------------------------------------------------
16,400
By Consignment account-commission 8,800
By Balance c/d 1,00,800
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
1,76,000 1,76,000
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
Working Note:
(1)
*Calculation of abnormal loss:
100 motors at $150 each $15,000
Add 100/1000 of freight and insurance (11,500 × 100/1000) 1,150
--------------------------------------------------------------------------------
Abnormal loss 16,150
--------------------------------------------------------------------------------
(2)
**Calculation of Closing Stock:
100 motors at $150 each $15,000
Add 100/1000 of freight and insurance (11,500 × 100/1000) 1,150
100/900 of duty 1,600
--------------------------------------------------------------------------------
Closing stock or unsold stock 17,750
--------------------------------------------------------------------------------
JOIN KHALID AZIZ
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
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Invoicing Goods Higher Than Cost in Consignment:
Sometimes in place of sending the goods to the consignee at cost price the consignor invoices them at higher price, the object being not to disclose to the consignee the amount of consignor's profit. The pro-forma invoice is sent to the consignee. The real cost of the goods is not disclosed. Therefore the entries made in this case are a little different from those if the goods are sent at actual cost. The difference in entries is only in respect of goods sent on consignment and stock. When goods are invoiced at selling price, the following entries are made:
On sending goods at invoice price i.e., higher than cost:-
Consignment Account Dr.
To Goods Sent on Consignment Account Cr.
At the end of the year difference between the invoice price and the cost will be credited to the consignment account by debiting goods sent on consignment account. For example, if the goods costing $10,000 are invoiced at $12,000 an entry will have to be made at the end of the year for $2,000.
Goods Sent on Consignment Account Dr.
To Consignment Account Cr.
The purpose of this entry is to show the cost of goods sent out and calculate the profit on consignment.
The stock in hand at the end of the year (unsold stock) with the consignee will be valued according to the invoice price plus the share of expenses. The usual entry is:-
Stock on Consignment Account Dr.
To Consignment Account Cr.
As the stock should not be shown at more than cost, therefore, the difference in entry No. 3 above will be calculated and the following entry will be passed:
Consignment Account Dr.
To Stock Reserve Account Cr.
In the balance sheet, the stock reserve account will appear on the asset side as reduced from the stock on the consignment account.
Example:
Rashid of city A sends 100 sewing machines on consignment to Malik of city B. The cost of each machine is $130 but the invoice price is at the rate of $160 each. Rashid spends $400 on packing and despatch. Malik receives the consignment and immediately accepts Rashid's draft for $8000. Subsequently, Malik informs Rashid that 80 machines have been sold at $175 each. Expenses paid by Malik are; freight $600, godown rent $50, and insurance $100. Malik is entitled to a commission of 6 per cent on sales and 1-1/2 percent as del credere commission.
Give journal entries in the books of Rashid . Also prepare necessary ledger accounts:
Solution:
Journal
Consignment to city B 16,000
To Goods sent on consignment account 16,000
(100 machines at $160 each sent on consignment)
--------------------------------------------------------------------------------
Consignment to city B 400
To Cash account 400
(Expenses incurred on consignment)
--------------------------------------------------------------------------------
Bills receivable account 8,000
To Malik 8,000
(Malik's acceptance received)
--------------------------------------------------------------------------------
Malik 14,000
To Consignment to city B account 14,000
(80 machine's sold Malik at $175 each)
--------------------------------------------------------------------------------
Consignment to city B account 750
To Malik 750
(Expenses incurred)
--------------------------------------------------------------------------------
Consignment to city B account 1,050
To Malik 1,050
(Commission at 6% plus 1-1/2 on sales)
--------------------------------------------------------------------------------
Consignment to city B account 600
To Stock reserve account 600
(Difference in closing stock adjusted)
--------------------------------------------------------------------------------
Stock on consignment account 3,400
To Consignment to city B account 3,400
(Value of 20 machines in the hands of Malik)
--------------------------------------------------------------------------------
Goods sent on consignment account 3,000
To Consignment to city B account 3,000
(The difference in the invoice value and cost, $30 per machine adjusted)
--------------------------------------------------------------------------------
Goods sent on consignment account 13,000
To Trading account 13,000
(Transfer of goods sent on consignment to trading account)
--------------------------------------------------------------------------------
Consignment to city B account 1,600
To Profit and loss account 1,600
(Transfer of profit on consignment)
JOIN KHALID AZIZ
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
CONTACT:
0322-3385752
0312-2302870
R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.
ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM.
FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA.
COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA.
CONTACT:
0322-3385752
0312-2302870
R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN.
Definition and Explanation of Consignment:
The word consignment can be generally defined as the act of sending a quantity of goods by the manufacturers and producers of one country or place to their agents in another at the risk of the principals for the purpose of sale.
Goods so sent are known as "consignment". The sender of the goods is called the consignor. Generally the manufacturers or producers are consignors. The person to whom goods are forwarded for the purpose of sale is known as the consignee. The consignment can be classified as:
Outward consignment.
Inward consignment.
It is called "outward" when the dispatch of a quantity of goods from one country to another is made for the purpose of sale and is called "inward" when the receipt of the quantity of goods is made for the purpose of sale.
Goods sent on consignment do not become the property of the consignee. He has not bought them. The ownership remains with the sender or the consigner. If the goods are destroyed, the receiver (consignee) is not responsible. The loss will fall on the consignor. The consignee tries to sell the goods according to the instructions of the consignor. When the goods have been sold, he will deduct his expenses, commission, etc., from the sale proceeds and the balance is remitted to the consignor. The relationship between the consignor and the consignee is that of principle and agent. The consignee is the agent. The consignee acts entirely on behalf of the consignor. The consignee is entitled to his remuneration which is generally fixed on the basis of a commission of sales. The expenses incurred by the consignee must also be reimbursed by the principal. It is important to remember that the consignee does not buy the goods; he merely receives the possession of the goods.
Distinction/Difference Between Consignment and Sale:
The following are the main points of the difference between consignment and sale.
Transfer of Legal Ownership of the Goods:
In case of sale, the legal ownership of the goods sold is transferred to the purchaser of goods. Whereas in case of a consignment of goods , the legal ownership of the goods is not transferred to the consignment but the ownership of the goods remains vested in the consignor till the goods consigned are sold by the consignee.
Relationship Between Consignor and Consignee:
In case of a sale of goods, the relationship between the seller and the purchaser of the goods is that of a creditor and a debtor whereas in case of a consignment the relationship between the consignor and the consignee is that of a principal and agent. because the consignee is to sell goods on behalf of the consignor.
Expenses Incurred:
In consignment, expenses incurred by the consignee in connection with the goods consigned to him are usually borne by the consignor whereas in case of a sale, expenses incurred after sale of goods are born by the purchaser.
Risk Attached to the Goods:
In case of consignment, risk attached to the goods sold lies with the consignor till the goods consigned are sold by the consignee. But in case of a sale, risk attached to the goods sold is transferred to the buyer of goods.
Return of Goods:
In case of consignment, return of goods is possible if the goods are not sold by the consignee. But in case of sale, return of goods is not possible as goods once sold are not returnable.
Requirement of Account Sale:
In case of consignment, account sale is required to be submitted periodically by the consignee to the consignor. But in case of sales no account sale is required to be submitted by the purchaser to the seller.
Definitions of Important Terms Used in Consignment Accounting:
Commission:
The term commission as used in connection with consignment denotes the remuneration of the consignee for selling the goods of the consignor. This commission is generally calculated at a rate percentage on the gross proceeds of the sales.
Del Credere Commission:
The del credere commission is an extra commission allowed to the consignee on his guaranteeing the realization of the debts in full, in connection with the credit sale of goods on consignment. Goods may be sold by the consignee either for cash or on credit. When they are sold on credit, the consignee may guarantee that they will be duly paid for and that he will be liable to indemnify the consignor for all bad debts. In such cases; the consignor pays the consignee an extra commission for this guarantee. The extra commission is called del credere commission.
Advance Against Consignment:
Usually the consignee is asked to accept a bill of exchange to cover part of the value of goods. This is a guarantee by the consignee that when sales are effected, he will make the necessary payment. Of course, instead of a bill of exchange, the agent may remit a sum of money to the principle as an advance. This advance or the amount of the bill of exchange will be adjusted when the goods are sold.
Consignment Account:
The consignment account is one which shows what profit or loss is made out of the dealing of the goods sent on consignment. It is the combination of the trading and profit and loss account of any particular consignment.
Proforma Invoice:
When the consignor sends the goods to the consignee, he forwards a statement showing the particulars such as quantity, quality, price of goods etc. This statement is called the Proforma invoice. But in case of regular sale, an invoice is prepared and sent along with the goods. It implies that a sale has taken place.
Account Sale:
An account sale is a statement prepared and sent by the consignee to the consignor at periodical intervals, dealing there in the goods sold, price realized, expenses incurred, commission payable to and the net amount due from the consignee.
Consignment Accounting Journal Entries:
As the goods sent on consignment by the consigner are not his sales, he must not record consignment as sales and the consignee must must not record them as purchases. The consigner should not take up any profit on the transaction until the goods have been actually sold by the consignee. Since the goods still belong to the consignor, any unsold goods in the hands of the consignee at the end of the trading period should be included in the consignor's stock. The recording of the consignment transactions in the books of the consignor and consignee will be made in the following manner:
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Accounting Entries in the Books of Consignor:
(1) On dispatch of goods:-
Consignment account (With the cost of goods)
To Goods sent on consignment account
--------------------------------------------------------------------------------
(2) On payment of expenses on dispatch:-
Consignment account (With the amount spent as expenses)
To Bank account
--------------------------------------------------------------------------------
(3) On receiving advance:
Cash or bills receivable account (With the amount cash or bill)
To Consignee's personal account
--------------------------------------------------------------------------------
(4) On the consignee reporting sale (as per A/S):-
Consignee's personal account (With gross proceeds of sales)
To Consignment account
--------------------------------------------------------------------------------
(5) For expenses incurred by the consignee (as per A/S):-
Consignment account (With the amount of expenses)
To Consignee's personal account
--------------------------------------------------------------------------------
(6) For commission payable to the consignee:-
Consignment account (With the amount of expenses)
To Consignee's personal account
--------------------------------------------------------------------------------
Assuming that all the goods sent have been sold, the consignment account will show at this stage the actual profit or loss made on it. The same is transferred to profit and loss account.
The entry in case of profit is:
Consignment account
To profit and loss account
--------------------------------------------------------------------------------
In case of loss the entry is:
Profit and loss account
To Consignment account
--------------------------------------------------------------------------------
Note: The goods sent on consignment account may be closed by a transfer to trading account.
When Consignment is Partly Sold:
When all the goods sent on consignment have not been sold., the value of unsold goods in the hands of the consignee must be ascertained and the profit or loss should be found out by taking this stock into account. The entry is:
Stock on consignment account
To Consignment account
--------------------------------------------------------------------------------
Stock on consignment account is an asset and will be shown in the balance sheet of the consignor. Valuation of stock is discussed on valuation of stock page.
Accounting Entries in the Books of Consignee:
(1) When consignment goods are received:-
No entry is made in the books of account. The consignee is not the owner of the goods and therefore he makes no entry when he receives the goods.
--------------------------------------------------------------------------------
(2) For expenses incurred by the consignee:-
Consignor's personal account
To Cash account
(3) When advance is given:-
Consignor's personal account
To Cash or bills payable account
--------------------------------------------------------------------------------
(4) When goods are sold:-
Cash or bank account
To Consignor's personal account
--------------------------------------------------------------------------------
(5) For commission due:-
Consignor's personal account
To commission account
--------------------------------------------------------------------------------
The consignor's account will be closed by debiting it with cash or final bill or draft in settlement.
Valuation of Unsold Stock Or Closing Stock in Consignment Accounting:
The valuation of stock laying with the consignee at the time of final closing of the account of the consignor is generally made at cost or market price whichever is less. The meaning of cost, however, should be properly understood. Cost should not mean merely the cost at which the consignor invoices the goods. If such expenses as normally increase the value of goods have been incurred, a proportionate of such expenses should be included in the cost. In other words, all the expenses incurred to move the goods from the consignor's premises to the premises of consignee should be included. Expenses which are incurred up to the moment the goods are received into the godown of the consignee are treated as part of the cost. But expenses incurred after the goods have been put into the godown should not be included into the cost because such expenses do not increase the value of goods. Examples of such expenses are godown rent, insurance godown, advertisement, salaries of salesmen, etc. It does not matter who pays the expenses (consignor or consignee).
Example:
Suppose, 1000 units are dispatched at a cost of $20 each. The consignor pay $100 for insurance in transit and $200 for packing. The consignee pays 700 for freight, $100 as octroi duty and $100 as cartage. He also pays $200 as godown rent and $150 as insurance premium. The last two items will be excluded while calculating the cost. The total cost will be $20,000 + $100 + 200 + 700 + $100 + $100 = $21,200. The cost per unit, therefore, comes to $21.20. If 100 units remain unsold, the value of stock will be: 100 × 21.20, i.e., $2,300. If the market price is less than this figure, then the value of stock will be on the basis of market price.
Valuation and Treatment of Normal and Abnormal Loss in Consignment Accounting:
Normal Loss:
Normal loss of goods should also be considered while valuing the closing stock or unsold stock. Normal loss means inherent and unavoidable loss. For example if a certain quantity of coal is consigned, some of it is bound to be lost because of loading and unloading and because of some of it turning into dust. In the nature of coal shortage is unavoidable.
Example:
Suppose 100 tons of coal are despatched. The cost of one ton of coal is $20 and the freight incurred is $470. To the consignor the total cost is $2,470. Suppose, the consignee receives only 95 tones. In that case the consignor can say that the cost of one ton of coal is $2,470/95 or $26. If 20 tons of coal are left unsold with the consignee, the value of stock will be $20 × $26 = $520.
Abnormal Loss:
Some losses are accidental or may arise out of carelessness. For example, theft of goods or destruction of goods by fire. Such losses are more or less abnormal and in any case, do not occur often. Suppose part of the goods stolen. This will reduce the value of stock and, therefore, the profit on consignment. In order to see the effect of theft clearly, it is better to find out the value of the goods thus lost. After finding out the value, the consignment account is credited and profit and loss account is debited. The effect of this will be that the consignment account will show its proper profit and in the profit and loss account this profit will be reduced to show actual profit. If part of the loss is recoverable from an insurance company, the amount which can be recovered should be deducted from the loss for the purpose of debiting the profit and loss account. The amount of the loss should be calculated like stock on consignment.
Example/Problem of Abnormal Loss:
1,000 Motors were consigned by A & Co., of Lahore to Bashir of Karachi at an invoice cost of $150 each. A & Co., paid freight $10,000 and insurance $1,500. During transit 100 motors were completely destroyed. Bashir took delivery of the remaining motors and paid $14,400 as duty.
Bashir sent a bank draft to A & Co., for $50,000 as an advance payment and later sent an account sale showing that 800 motors were sold at $220 each. Expenses incurred by Bashir on godown rent and advertisement etc., amounted to $2,000. Bashir is entitled to commission of 5 per cent.
Required: Prepare consignment account and Bashir's account in the books of A & Co., assuming that nothing has been recovered from the insurance company due to defect in the policy.
Consignment to Karachi Account
$ $
To Goods sent on consignment 1,50,000 By sales (800 × 220) 1,76,000
To Bank - freight and insurance 11,500 By Profit and loss account - Ab. Loss* 16,150
To Bashir - duty 14,400 By Stock on consignment** 17,750
To Bashir - expenses 2,000
To Bashir - commission 8,800
To Profit and loss account 23,200
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
2,09,900 2,09,900
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
Bashir
$ $
To Consignment account 1,76,000 By Bank 50,000
By Consignment account
Duty 14,400
Expenses 2,000
--------------------------------------------------------------------------------
16,400
By Consignment account-commission 8,800
By Balance c/d 1,00,800
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
1,76,000 1,76,000
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
Working Note:
(1)
*Calculation of abnormal loss:
100 motors at $150 each $15,000
Add 100/1000 of freight and insurance (11,500 × 100/1000) 1,150
--------------------------------------------------------------------------------
Abnormal loss 16,150
--------------------------------------------------------------------------------
(2)
**Calculation of Closing Stock:
100 motors at $150 each $15,000
Add 100/1000 of freight and insurance (11,500 × 100/1000) 1,150
100/900 of duty 1,600
--------------------------------------------------------------------------------
Closing stock or unsold stock 17,750
--------------------------------------------------------------------------------
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Invoicing Goods Higher Than Cost in Consignment:
Sometimes in place of sending the goods to the consignee at cost price the consignor invoices them at higher price, the object being not to disclose to the consignee the amount of consignor's profit. The pro-forma invoice is sent to the consignee. The real cost of the goods is not disclosed. Therefore the entries made in this case are a little different from those if the goods are sent at actual cost. The difference in entries is only in respect of goods sent on consignment and stock. When goods are invoiced at selling price, the following entries are made:
On sending goods at invoice price i.e., higher than cost:-
Consignment Account Dr.
To Goods Sent on Consignment Account Cr.
At the end of the year difference between the invoice price and the cost will be credited to the consignment account by debiting goods sent on consignment account. For example, if the goods costing $10,000 are invoiced at $12,000 an entry will have to be made at the end of the year for $2,000.
Goods Sent on Consignment Account Dr.
To Consignment Account Cr.
The purpose of this entry is to show the cost of goods sent out and calculate the profit on consignment.
The stock in hand at the end of the year (unsold stock) with the consignee will be valued according to the invoice price plus the share of expenses. The usual entry is:-
Stock on Consignment Account Dr.
To Consignment Account Cr.
As the stock should not be shown at more than cost, therefore, the difference in entry No. 3 above will be calculated and the following entry will be passed:
Consignment Account Dr.
To Stock Reserve Account Cr.
In the balance sheet, the stock reserve account will appear on the asset side as reduced from the stock on the consignment account.
Example:
Rashid of city A sends 100 sewing machines on consignment to Malik of city B. The cost of each machine is $130 but the invoice price is at the rate of $160 each. Rashid spends $400 on packing and despatch. Malik receives the consignment and immediately accepts Rashid's draft for $8000. Subsequently, Malik informs Rashid that 80 machines have been sold at $175 each. Expenses paid by Malik are; freight $600, godown rent $50, and insurance $100. Malik is entitled to a commission of 6 per cent on sales and 1-1/2 percent as del credere commission.
Give journal entries in the books of Rashid . Also prepare necessary ledger accounts:
Solution:
Journal
Consignment to city B 16,000
To Goods sent on consignment account 16,000
(100 machines at $160 each sent on consignment)
--------------------------------------------------------------------------------
Consignment to city B 400
To Cash account 400
(Expenses incurred on consignment)
--------------------------------------------------------------------------------
Bills receivable account 8,000
To Malik 8,000
(Malik's acceptance received)
--------------------------------------------------------------------------------
Malik 14,000
To Consignment to city B account 14,000
(80 machine's sold Malik at $175 each)
--------------------------------------------------------------------------------
Consignment to city B account 750
To Malik 750
(Expenses incurred)
--------------------------------------------------------------------------------
Consignment to city B account 1,050
To Malik 1,050
(Commission at 6% plus 1-1/2 on sales)
--------------------------------------------------------------------------------
Consignment to city B account 600
To Stock reserve account 600
(Difference in closing stock adjusted)
--------------------------------------------------------------------------------
Stock on consignment account 3,400
To Consignment to city B account 3,400
(Value of 20 machines in the hands of Malik)
--------------------------------------------------------------------------------
Goods sent on consignment account 3,000
To Consignment to city B account 3,000
(The difference in the invoice value and cost, $30 per machine adjusted)
--------------------------------------------------------------------------------
Goods sent on consignment account 13,000
To Trading account 13,000
(Transfer of goods sent on consignment to trading account)
--------------------------------------------------------------------------------
Consignment to city B account 1,600
To Profit and loss account 1,600
(Transfer of profit on consignment)
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Monday, November 15, 2010
ACCOUNTING:CONCEPTS AND PRINCIPLES
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The historical development of accounting practice has been closely related to the economic development of the country. In the earlier stages of the American economy, a business enterprise was very often managed by its owner, and the accounting records and reports were used mainly by the owner manager in conducting the business. Bankers and other lenders often relied on their personal relationship with the owner rather than on financial statements as the basis for making loans for business purposes. If a large amount was owed to a bank or supplier, the creditor often participated in management decisions,
As business organizations grew in size and complexity, "management" and "outsiders" became more-clearly differentiated. From the latter group, which includes owners (stockholders), creditors, government, labor unions, customers, and the general public, came the demand for accurate financial information for use in judging the performance of management. In addition, as the size and complexity of the business unit increased, the accounting problems involved in the issuance of financial statements became more and more complex, With these developments came an awareness of the need for a framework of concepts and generally accepted accounting principles to serve as guidelines for the preparation of the basic financial statements.
DEVELOPMENT OF CONCEPTS AND PRINCIPLES
The word "principle" as used in the context of generally accepted accounting principles does not have the same authoritativeness as universal principles or natural laws relating to the study of astronomy, physics, or other physical sciences. Accounting principles have been developed by individuals to help make accounting data more useful in an ever changing society. They represent the best possible guides, based on reason, observation, and experimentation, to the achievement of the desired results. The selection of the best method from among many alternatives has come about gradually, and in some subject matter areas a clear consensus is still lacking. These principles continually are reexamined and revised to keep pace with the increasing complexity of business operations. General acceptance among the members of the accounting profession is the criterion for determining an accounting principle.
Responsibility for the development of accounting principles has rested primarily on practicing accountants and accounting educators, working both independently and under the sponsorship of various accounting organizations. These principles also are influenced by business practices and customs, ideas and beliefs of the users of the financial statements, governmental agencies, stock exchanges, and other business groups.
Financial Accounting Standards Board
In 1973, the Financial Accounting standards Board (FASB) was appointed by the Financial Accounting Foundation (FAF). The FAF is an independent, nonprofit organization that was created in 1972 to oversee the standard setting process, to appoint members of standard setting boards (the FASB and the Governmental Accounting Standards Board) and advisory councils, and to raise funds for the operation of the standard setting process.
The FASB replaced the Accounting Principles Board (APB), which provided much of the leadership in the development of generally accepted accounting principles from 1959 to 1973. The APB was composed of eighteen accountants who were members of the American Institute of Certified Public Accountants and who served without pay and continued their affiliations with their firms or institutions. The FASB, which is presently the dominant body in the development of generally accepted accounting principles, is composed of seven members, four of whom must be CPAs drawn from public practice. These seven members serve full time, receive a salary, and must resign from the firm or institution with which they have been affiliated. The FASB is assisted by an advisory council of approximately forty members, whose major responsibilities include the recommendation of priorities and agenda and the review of FASB plans, activities, and statements proposed for issuance, The FASB employs a full time research staff and administrative staff as well as task forces to study specific matters from time to time.
As problems in financial reporting are identified, the FASB conducts extensive research to identify the principal issues involved and the possible solutions. Generally, after issuing discussion memoranda and preliminary proposals and evaluating comments from interested parties, the Board issues Statements of Financial Accounting Standards, which become part of generally accepted accounting principles. To explain, clarify, or elaborate on existing pronouncements, the Board also issues Interpretations, which have the same authority as the standards.
Presently, the Board is in the process of developing a broad conceptual framework for financial accounting. This project, which is expected to take many years to complete, is an attempt to develop a 1~ constitution" that can be used to evaluate current standards and can serve as the basis for future standards. The results of the completed portion of this project have been published as six Statements of Financial Accounting Concepts, which are briefly described as follows
Objectives of Financial Reporting by Business Enterprises (No. 1) Sets forth three broad objectives of
Financial reporting:
I To provide financial information that is useful in making rational investment, credit, and similar decisions;
2. To provide financial information to enable users to predict cash flows to the business and subsequently
to themselves,.
3. To provide financial information about business resources (assets), claims to these resources (liabilities
and owner's equity), and changes in these resources and claims.
Qualitative Characteristics of Accounting Information (No. 2) Identifies the essential qualities of the accounting information included in financial reports as follows: usefulness, understandability, relevance, reliability verifiability, timeliness, neutrality, completeness, and comparability.
Elements of Financial Statements of Business Enterprises (No. 3) Replaced by Statement No. 6.
Objectives of Financial Reporting by Nonbusiness Organizations (No. 4) Sets forth the objectives that guide the preparation of the financial statements for nonbusiness organizations.
Recognition and Measurement in Financial Statements of Business Enterprises (No. 5) Identifies the financial statements that should be prepared to meet the objectives of financial reporting for business enterprises.
Elements of Financial Statements (No. 6)
Replaces Statement No. 3 and defines the interrelated elements of financial statements that are directly related
to measuring the performance and status of businesses and nonprofit organizations,
Governmental Accounting Standards Board
The Governmental Accounting Standards Board was formed in 1984 as an arm of the Financial Accounting Foundation. The GASB has a full time chairperson and four part time members who have responsibility for establishing the accounting standards to be followed by state and municipal governments. The GASB employs a full time research staff and administrative staff. An advisory council of approximately 20 members assists the GASB and also has fund raising responsibilities.
Accounting Organizations
Among the oldest and most influential organizations of accountants are the American Institute of Certified Public Accountants (AICPA) and the American Accounting Association (AAA). Each organization publishes monthly or quarterly periodicals and, from time to time, issues other publications in the form of research studies, technical opinions, and monographs. There are also other national accounting organizations as well as many state societies and local chapters of the national and state organizations. These groups provide forums for the interchange of ideas and discussion of accounting principles.
Government Organizations
Of the various governmental agencies with an interest in the development of accounting principles, the Securities and Exchange Commission has been the most influential. Established by an act of Congress in 1934, the SEC issues regulations that must be observed in the preparation of financial statements and other reports filed with the Commission.
The Internal Revenue Service (IRS) issues regulations that govern the determination of income for purposes of federal income taxation. Because these regulations sometimes conflict with financial accounting principles, many enterprises maintain two sets of accounts to satisfy both reporting requirements, To avoid this increased record keeping, there have been times when firms have adopted practices that are acceptable for tax purposes as generally accepted accounting principles.'
Other regulatory agencies exercise a dominant influence on the accounting principles of the industries under their jurisdiction. In rare situations, Congress may also enact legislation that dictates accounting principles. These situations usually involve controversial issues on which no clear consensus has been reached within the profession.
Other Influential Organizations
The Financial Executives Institute (FEI) has influenced the development of accounting principles by encouraging and sponsoring accounting research. The FEI also comments on proposed pronouncement s of the FASB, the SEC, and other organizations.
The Institute of Management Accountants (IMA) is one of the largest organizations of accountants. It is primarily concerned with management's use of accounting information in directing business operations. Since management is responsible for the preparation of the basic financial statements, however, the IMA communicates its recommendations on generally accepted accounting principles to appropriate organizations.
Although the organizations mentioned above traditionally have had the most influence upon the establishment of accounting principles, other organizations representing users of accounting reports are increasingly making their views known. Prominent in this group are the Financial Analysts Federation (investors and investment advisors) and the Securities Industry Associates (investment bankers). Many accounting principles have been introduced and integrated with discussions in earlier chapters. The remainder of this chapter is devoted to the underlying assumptions, concepts, and principles of the greatest importance and widest applicability. Attention also will be directed to applications of principles to specific situations in order to facilitate better understanding of accounting practices.
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BUSINESS ENTITY
The business entity concept assumes that a business enterprise is separate and distinct from the persons who supply its assets, This distinction exists regardless of the legal form of the business organization. The accounting equation, Assets = Equities, or Assets = Liabilities + Owner's Equity, is an expression of the entity concept; i.e., the business owns the assets and owes the various claimants. Thus, the accounting process primarily is concerned with the enterprise as a productive economic unit and only secondarily is concerned with the investor as a claimant to the assets of the business.
The business entity concept used in accounting for a sole proprietorship is distinct from the legal concept of a sole proprietorship. The nonbusiness assets, liabilities, revenues, and expenses of a sole proprietor are excluded from the business accounts. If a sole proprietor owns two or more dissimilar enterprises, each one is treated as a separate business entity for accounting purposes. Legally, however, a sole proprietor is personally, liable for all business debts and may be required to use nonbusiness assets to satisfy the business creditors. Conversely, business assets are not immune from the claims of the sole proprietor's personal creditors.
Differences between the business entity concept and the legal nature of other forms of business organization will be considered in later chapters. For accounting purposes, however, revenues and expenses of any enterprise are viewed as affecting the business assets and liabilities, not the investors' assets and liabilities.
GOING CONCERN
Only in rare cases is a business organized with the expectation of operating for only a certain period of time. In most cases, it is not possible to determine in advance the length of life of an enterprise, and so an assumption must be made. The nature of the assumption will affect the manner of recording some of the business transactions, which in turn will affect the data reported in the financial statements.
It is customary to assume that a business entity has a reasonable expectation of continuing in business at a profit for an indefinite period of time. This provides much of the justification for recording plant assets at acquisition cost and depreciating them in an orderly manner without reference to their current realizable values. If there is no immediate expectation of selling them, plant assets should not be reported on the balance sheet at their estimated realizable values regardless of whether their current market value is less than their book value or greater than their book value. If the firm continues to use the assets,, the change in market value causes no gain or loss, nor does it increase or decrease the usefulness of the assets. Thus, if the going concern assumption is a valid concept, the investment in plant assets will serve the purpose for which it was made the investment in the assets will be recovered even though they may be individually marketable only at a loss.
The going concern assumption similarly supports the treatment of prepaid expenses as assets, even though they may not be salable. To illustrate, assume that On the last day of its fiscal year, a wholesale firm receives from a printer a $20,000 order of sales catalogs. If there were no assumption that the firm is to continue in business, the catalogs would be merely scrap paper and the value reported for them on the balance sheet would be small.
When there is conclusive evidence that a business entity has a limited life, the accounting procedures should be appropriate to the expected terminal date of the entity. Changes in the application of normal accounting procedures may be needed for business organizations in receivership or bankruptcy, for example. In such cases, the financial statements should clearly disclose the limited life of the enterprise and should be prepared from the "quitting concern" or liquidation point of view, rather than from a "going concern" point of view.
OBJECTIVE EVIDENCE
Entries in the accounting records and data reported on financial statements must be based on objectively determined evidence. If this principle is not followed, the confidence of the many users of the financial statements could not be maintained. For example, objective evidence such as invoices and vouchers for purchases, bank statements for the amount of cash in bank, and physical counts for merchandise on hand supports much of accounting. Such evidence is completely objective and can be verified.
Evidence is not always conclusively objective, for there are many cases in accounting in which judgments, estimates, and other subjective factors must be taken into account. In such situations, the most objective evidence available should be used. For example, the provision for doubtful accounts is an estimate of the losses expected from failure to collect sales made on account. The estimation of this amount should be based on such objective factors as past experience in collecting accounts receivable and reliable forecasts of future business activities. To provide accounting reports that can be accepted with confidence, evidence should be developed that will minimize the possibility of error, intentional bias, or fraud.
UNIT OF MEASUREMENT
All business transactions are recorded in terms of money. Other pertinent information of a nonfinancial nature may also be recorded, such as the description of assets acquired, the terms of purchase and sale contracts, and the purpose, amount, and term of insurance policies. But it is only through the record of dollar amounts that the diverse transactions and activities of a business may be measured, reported, and periodically compared. Money is both the common factor of all business transactions and the only feasible unit of measurement that can be used to achieve uniform financial data.
The generally accepted use of the monetary unit for accounting for and reporting the activities of an enterprise has two major limitations: (1) it limits the scope of accounting reports and (2) it assumes a stability of the measurement unit.
Scope of Accounting Reports
Many factors affecting the activities and the future prospects of an enterprise cannot be expressed in monetary terms. In general, accounting does not attempt to report such factors. For example, information regarding the capabilities of the management, the state of repair of the plant assets, the effectiveness of the employee welfare program, the attitude of the labor union, the effectiveness of antipollution measures, and the relative strengths and weaknesses of the firm's competitors cannot be expressed in monetary terms. Although such matters are important to those concerned with enterprise operations, at the present time, accountancy does not assume responsibility for reporting information of this kind.
Changes in Price Levels
As a unit of measurement, the dollar differs from such quantitative standards as the kilogram, liter, or meter, which have not changed for centuries. The instability of the purchasing power of the dollar is well known, and the disruptive effect of the declining value of the dollar is acknowledged by accountants. In the past, however, this declining value generally has not been given recognition in the accounts or in conventional financial statements.
To indicate the nature of the problem, assume that the plant assets acquired by an enterprise for $ 100,000 twenty years ago are now to be replaced with similar assets which will cost $200,000 at present price levels. Assume further that during the twenty year period the plant assets had been fully depreciated and the net income of the enterprise had amounted to $300,000. Although the initial outlay of $100,000 for the plant assets was recovered through depreciation charges, the amount represents only half of the cost of replacing the assets. Instead of considering the current value of the new assets to have increased to double the value of two decades earlier, the dollars recovered can be said to have declined to one half of their earlier value. From either point of view, the firm has suffered a loss in purchasing power, which is the same as a loss of capital. In addition, $100,000 of the net income reported during the period might be said to be illusory, since it must be used to replace the assets.
The use of a monetary unit that is assumed to be stable insures objectivity. In spite of the inflationary trend
in the United States, historical dollar financial statements are considered to be better than statements based on
movements of the general price level. There are, however, two widely discussed recommendations for
supplementing conventional statements and thus resolving financial reporting problems created by increasing
price levels: (1) supplemental financial data based on current costs and (2) supplemental financial data based
on constant dollars. The discussion in the following sections is confined to the basic concepts and problems of
these recommendations.
Current Cost Data. Current cost is the amount of cash that would have to be paid currently to acquire assets
of the same age and in the same condition as existing assets. When current costs are used as the basis for
financial reporting, assets, liabilities, and owner's equity are stated at current values, and expenses are stated at
the current cost of doing business. The use of current costs permits the identification of gains and losses that
result from holding assets during periods of changes in price levels. To illustrate, assume that a firm acquired
land at the beginning of the fiscal year for $50,000 and that at the end of the year its current cost (value) is
$60,000. The land could be reported at its current cost of $60,000, and the $ 10,000 increase in value could be
reported as an unrealized gain from holding the land.
The major disadvantage in the use of current costs is the absence of established standards and procedures for determining such costs. However, many accountants believe that adequate standards and procedures will evolve through experimentation with actual applications.
Constant Dollar Data. Constant dollar data, also known as general price level data, are historical costs that have been converted to constant dollars through the use of a price level index. In this manner, financial statement elements are reported in dollars, each of which has the same (that is, constant) general purchasing power.
A price level index is the ratio of the total cost of a group of commodities prevailing at a particular time to the total cost of the same group of commodities at an earlier base time. The total cost of the commodities at the base time is assigned a value of 100 and the price level indexes for all later times are expressed as a ratio to 100. For example, assume that the cost of a selected group of commodities amounted to S12,000 at a particular time and $13,200 today. The price index for the earlier, or base, time becomes 100 and the current price index is 110 [(13,200 + 12,000) x 1001.
Current Annual Reporting Requirements for Price Level Changes. In 1979, the Financial Accounting Standards Board undertook an experimental program for reporting the effects of changing prices by requiring approximately 1,300 large, publicly held enterprises to disclose certain current cost information and constant dollar information annually as supplemental data. In 1984, after reviewing the experiences with these 1979 disclosure requirements, the FASB concluded that current cost information was more useful than constant dollar information as a supplement to the basic financial statements. In 1986, the FASB eliminated the requirement to disclose the effects of changing prices, but encouraged it companies to disclose such information voluntarily. The information that is now being disclosed includes elements of both current cost and constant dollar data, as shown in the following footnote from the annual report of The Pillsbury Company:
Information on effects (?f changing prices and inflation
Financial statements, prepared using historical costs as required by generally accepted accounting principles. may not reflect the full impact of current costs and general inflation.
The following supplementary disclosures attempt to remeasure certain historical financial information to recognize the effects of changes in current costs using specific price indices. 7 he current cost information is then expressed in average Fiscal 1986 dollars to reflect the effects of general inflation based on the U. S. Consumer Price Index....
ACCOUNTING PERIOD
A complete and accurate picture of an enterprise's success or failure cannot be obtained until it discontinues operations, converts its assets into cash, and pays off its debts. Then, and only then, is it possible to determine its true net income, But many decisions regarding the business must be made by management and interested outsiders during its existence. It is therefore necessary to prepare periodic reports on operations, financial position, and cash flows.
Reports may be prepared when a certain job or project is completed, but more often they are prepared at specified time intervals. For a number of reasons, including custom and various legal requirements, the longest interval between reports is one year.
This element of periodicity creates many of the problems of accountancy. The basic problem is the determination of periodic net income. For example, the need for adjusting entries discussed in earlier chapters is directly attributable to the division of the life of an enterprise into arbitrary time periods. Problems of inventory costing, of recognizing the uncollectibility of receivables, and of selecting depreciation methods are also directly related to the periodic measurement process. Furthermore, the amounts of the assets and the equities reported on the balance sheet also will be affected by the methods used in determining net income. For example, the cost flow assumption used in determining the cost of merchandise sold during the accounting period will have a direct effect on the amount of cost assigned to the remaining inventory,
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MATCHING REVENUE AND EXPIRED COSTS
During the early stages of accounting development, accountants viewed the balance sheet as the principal financial statement. Over the years, the emphasis has shifted to the income statement as the users of financial statements have become more concerned with the results of business operations than with financial position. The determination of periodic net income is a two fold problem involving (1) the revenue recognized during the period and (2) the expired costs to be allocated to the period. It is thus a problem of matching revenue and expired costs, the residual amount being the net income or net loss for the period.
Recognition of Revenue
Revenue is measured by the amount charged to customers for merchandise delivered or services rendered to them. The problem created by periodicity is one of timing; that is, at what point is the revenue realized? For any particular accounting period, the question is whether revenue items should be recognized and reported as such in the current period or whether their recognition should be delayed to a future period.
Various criteria are acceptable for determining when revenue is realized. In any case, the criteria used should reasonably agree with the terms of the contractual arrangements with the customer and be based, insofar as possible, on objective evidence. The criteria most often used are described in the remaining paragraphs of this section.
Point of Sale. Revenue from the sale of merchandise usually is determined by the point of sale method under which revenue is realized at the time title passes to the buyer. At point of sale, the sale price has been agreed upon, the buyer acquires the right of ownership in the merchandise, and the seller has a legal claim against the buyer. The realization of revenue from the sale of services may be determined in a like manner, although there is often a time lag between the time of the initial agreement and the completion of the service. For example, assume that a contract provides that certain repair services be performed, either for a specified price or on a time and materials basis. The price or terms agreed upon in the initial contract do not become revenue until the work has been performed.
Theoretically, revenue from the production and sale of merchandise and services emerges continuously as effort is expended. As a practical matter, however, it is usually not possible to make an objective determination until both (1) the contract price has been agreed upon and (2) the seller's portion of the contract has been completed.
Receipt of Payment. The recognition of revenue may be delayed until payment is received. When this criterion is used, revenue is considered to be realized at the time the cash is collected, regardless of when the sale was made. The cash basis is widely used by physicians, attorneys, and other enterprises in which professional services are the source of revenue. It has little theoretical justification but has the practical advantage of simplicity of operation and avoidance of the problem of estimating losses from uncollectible accounts. Its acceptability as a fair method of timing the recognition of revenue from personal services is influenced somewhat by the fact that it may be used in determining income subject to the federal income tax. It is not an appropriate method of measuring revenue from the sale of merchandise.
Installment Method. In some businesses, especially in the retail field, it is common to make sales on the installment plan. In the typical installment sale, the buyer makes a down payment and agrees to pay the remainder in specified amounts at stated intervals over a period of time. The seller may retain technical title to the goods or may take other means to make repossession easier in the event that the buyer defaults on the payments. Despite such provisions, installment sales ordinarily should be treated in the same manner as any other sale on account, in which case the revenue is considered to be realized at the point of sale.
In some exceptional cases, the circumstances are such that the collection of receivables is not reasonably assured. In these cases, the installment method of deter mining revenue may be used. Under this method, each receipt of cash is considered to be revenue and to be composed of partial amounts of (1) the cost of merchandise sold and (2) gross profit on the sale.
As a basis for illustration, assume that in the first year of operations, a dealer in household appliances had total installment sales of $300,000, and the cost of the merchandise sold amounted to $180,000. Assume also that collections of the installment accounts receivable were spread over three years as follows: 1st year, $140,000; 2nd year, $100,000; 3rd year, $60,000. According to the point of sale method, all of the revenue would be recognized in the first year, and the gross profit realized in that year would be determined as follows:
Installment sales $300,000
Cost of merchandise sold 180,000
Gross profit $120,000
Percentage of Completion. Enterprises engaged in large construction projects may devote several years to the completion of a particular contract, To illustrate, assume that a contractor engages in a project that will require three years to complete, for a contract price of $50,000,000. Further assume that the total cost to be incurred, which will also be spread over the three year period, is estimated at $44,000,000. According to the point of sale criterion, neither the revenue nor the related costs would be recognized until the project is completed. Therefore, using the completed contract method of determining revenue, the entire net income from the contract would be reported in the third year.
Whenever the total cost of a long term contract and the extent of the project's progress reasonably can be estimated, it is preferable to consider the revenue as being realized over the entire life of the contract. The amount of revenue to be recognized in any particular period is then determined on the basis of the estimated percentage of the contract that has been completed during the period. The estimated percentage of completion can be developed by comparing the incurred costs with the most recent estimates of total costs or by estimates by engineers, architects, or other qualified personnel of the progress of the work performed. To continue with the illustration, assume that by the end of the first fiscal year the contract is estimated to be one fourth completed and the costs incurred during the year were $11,200,000. According to the percentage of -completion method, the revenue to be recognized and the income for the year would be determined as follows:
Revenue ($50,000,000 x 25%) $12,500,000
Costs incurred 11,200,000
Income (Year 1) $ 1,300,000
The costs actually incurred during the year (rather than one fourth of the original cost estimate of $44,000,000 or $11,000,000) are deducted from the revenue recognized.
The 1988 edition of Accounting Trends & Techniques indicated that 94% of the surveyed companies with long term contracts used the percentage of completion method. Although the use of this method involves some subjectivity, and hence possible error, in the determination of the amount of reported revenue, the financial statements may be more informative and more useful than they would be if none of the revenue was recognized until completion of the contract.
The method used to recognize revenue on a long term contract should be noted in the financial statements, as indicated in the following excerpt taken from a note to the financial statements of Martin Marietta Corporation:
Revenue Recognition. Sales under long term contracts generally are recognized under the percentage of completion method, and include a proportion of the earnings expected to he realized on the contract... Other sales are recorded upon shipment of products or performance of services.
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Allocation of Costs
Properties and services acquired by an enterprise generally are recorded at cost. "Cost" is the amount of cash or equivalent given to acquire the property or the service. If property other than cash is given to acquire properties or services, the cost is the cash equivalent of the property given. When the properties or the services acquired are sold or used, the costs are deducted from the related revenue to determine the amount of net income or net loss. The costs of properties or services acquired and on hand at any particular time represent assets. Such costs may also be called "unexpired costs." As the assets are sold or used, they became "expired costs" or "expenses."
The techniques of determining and recording cost expirations have been described and illustrated in earlier chapters. In general, there are two approaches to cost allocations: (1) compute the amount of the expired cost or (2) compute the amount of the unexpired cost. For example, it is customary to determine the portion of plant assets that have expired. After the depreciation for the period has been recorded, the balances of the plant asset accounts minus the balances of the related accumulated depreciation accounts represent the unexpired cost of the assets. The alternative approach must be used for merchandise and supplies, unless perpetual inventory records are maintained. If the cost of the merchandise or supplies on hand at the end of the period is determined by taking a physical inventory, the remaining costs in the related accounts are assumed to have expired. It might appear that the first approach emphasizes expired costs and the second emphasizes unexpired costs. This is not the case, however, since the selection of the method is based merely on convenience or practicality.
Many of the costs allocable to a period are treated as an expense at the time of incurrence because they will be wholly expired at the end of the period. For example, when a monthly rent is paid at the beginning of a month, the cost incurred is unexpired and hence it is an asset; but, since the cost incurred will be wholly expired at the end of the month, the rental is usually charged directly to the appropriate expense account. This process makes subsequent adjusting entry unnecessary. The proper allocation of costs among periods is the most important consideration. Any one of many accounting techniques may be used in achieving this objective.
ADEQUATE DISCLOSURE
Financial statements and their accompanying footnotes or other explanatory materials should contain all of the pertinent data believed essential to the reader's understanding of the enterprise's financial status. Criteria for adequate disclosure, or full disclosure, often must be based on value judgments rather than on objective facts.
Financial statements are made more useful by the use of headings and subheadings and by merging items in significant categories. Although all essential data should be disclosed within these categories, judgment must be exercised by excluding nonessential information to avoid clutter, For example, detailed information as to the amount of cash in various special and general funds, the amount on deposit in each of several banks, and the amount invested in various marketable government securities is not needed by the reader of financial statements, Such information displayed on the balance sheet would hinder rather than aid understanding.
In most cases, all of the pertinent data needed by the reader cannot be presented in the financial statements themselves. The statements therefore normally include essential or explanatory information in accompanying notes.
Accounting Methods Employed
When there are several acceptable alternative methods that could have a significant effect on amounts reported on the statements, the particular method used should be disclosed. Examples include inventory cost flow and pricing methods, depreciation methods, and various criteria of revenue recognition. There is considerable variation in the format used to disclose accounting methods employed. One form of disclosure is to present "Significant Accounting Policies" as the initial note.
Changes in Accounting Estimates
There are many cases in accounting in which the use of estimates is necessary, These estimates should be revised when additional information or subsequent developments permit better insight or improved judgment upon which to base the estimates. If the effect of such a change on net income is material, it should be disclosed in the financial statements for the year in which the change is adopted.
Contingent Liabilities
As discussed previously, contingent liabilities are potential obligations that will materialize only if certain events occur in the future. If the liability is probable and the amount of the liability can be reasonably estimated, it should be recorded in the accounts. Such liabilities discussed in preceding chapters include vacation pay payable and product warranty payable. Although the vacation pay liability is dependent on employees taking vacations, the liability is probable and is reasonably estimated. Likewise, although the product warranty liability is dependent upon customers presenting products for repair, the product warranty liability is probable and is reasonably estimated. If the amount of the potential obligation cannot be reasonably estimated, the details of the contingency should be disclosed., The most common contingent liabilities disclosed in notes to the financial statements stem from litigation, guarantees, and discounting receivables.
Segment of a Business
Many companies diversify their operations; that is, they are involved in more than one type of business activity. These companies may also operate in foreign markets. The individual segments of such diversified
companies ordinarily experience differing rates of profitability, degrees of risk, and opportunities for growth. To help financial statement users in assessing past performance and future potential of diversified companies, financial statements should disclose such information as the enterprise's operations in different industries, its foreign markets, and its major customers. The required information for each significant reporting segment includes the following: revenue, income from operations, and identifiable assets associated with the segment.
Events Subsequent to Date of Statements
Events occurring or becoming known after the close of the period may have a significant effect on the financial statements and should be disclosed. For example, if an enterprise should suffer a crippling loss from a fire or other catastrophe between the end of the year and the issuance of the statements, the facts should be disclosed. Similarly, such occurrences as the issuance of long term debt or capital stock, or the purchase of another business enterprise after the close of the period should be made known.
CONSISTENCY
A number of accepted alternative principles affecting the determination of income statement and balance sheet amounts have been presented in various sections of the text. Recognizing that different methods may be used under varying circumstances and that the comparison of an enterprise's current financial statements with those of the preceding year is common practice, some guide or standard is needed to assure that the enterprise's periodic financial statements can be compared.
The amount and the direction of change in net income and financial position from period to period is very important to readers and may greatly influence their decisions. Therefore, interested persons should be able to assume that successive financial statements of an enterprise are based consistently on the same generally accepted accounting principles. If the principles are not applied consistently, the trends indicated could be the result of changes in the principles used rather than the result of changes in business conditions or managerial effectiveness.
The concept of consistency does not completely prohibit changes in the accounting principles used. Changes are permissible when it is believed that the use of a different principle will more fairly state net income and financial position. Examples of changes in accounting principles include a change in the method of inventory pricing, a change in depreciation method for previously recorded assets, and a change in the method of accounting for long term construction contracts. Consideration of changes in accounting principles must be accompanied by consideration of the general rule for disclosure of such changes, which is as follows:
The nature of and justification for a change in accounting principle and its effect on income should be disclosed in the financial statements of the period in which the change is made. The justification for the change should explain clearly why the newly adopted accounting principle is preferable.
There are various methods of reporting the effect of a change in accounting principle on net income. The cumulative effect of the change on net income may be reported on the income statement of the period in which the change is adopted. In some cases, the effect of the change could be applied retroactively to past periods by presenting revised income statements for the earlier years affected. The application of the consistency concept does not require that a specific accounting method be used uniformly throughout an enterprise.
MATERIALITY
In following generally accepted accounting principles, the accountant must consider the relative importance of any event, accounting procedure, or change in procedure that affects items on the financial statements. Absolute accuracy in accounting and full disclosure in reporting are not ends in themselves, and there is no need to exceed the limits of practicality. The determination of what is significant and what is not requires the exercise of judgment, Precise criteria cannot be formulated.
To determine materiality, the size of an item and its nature must be considered in relationship to the size and the nature of other items. The erroneous classification of a $10,000 asset on a balance sheet exhibiting total assets of $10,000,000 would probably be immaterial. If the assets totaled only $100,000, however, it certainly would be material, If the $10,000 represented a note receivable from an officer of the enterprise, it might well be material even in the first assumption. If the loan was increased to $ 100,000 between the close of the period and the issuance of the statements, both the nature of the item at the balance sheet date and the subsequent increase in amount would require disclosure.
The concept of materiality may be applied to procedures used in recording transactions. As was stated in an earlier chapter, small expenditures for plant assets may be treated as an expense of the period rather than as an asset. The saving in clerical costs is justified if the practice does not materially affect the financial statements. In establishing a dollar amount as the dividing line between a revenue expenditure and a capital expenditure, consideration would need to be given to such factors as (1) amount of total plant assets, (2) amount of plant assets in relationship to other assets, (3) frequency of occurrence of expenditures for plant assets, (4) nature and expected life of plant assets, and (5) probable effect on the amount of periodic net income reported.
Custom and practicality also influence criteria of materiality. Corporate financial statements seldom report the cents amounts or even the hundreds of dollars. A common practice is to round to the nearest thousand.
For large corporations, there is an increasing tendency to report the financial data in terms of millions, carrying figures to one decimal.
A technique known as "whole dollar" accounting, which is used by some businesses, eliminates the cents amounts from accounting entries at the earliest possible point in the accounting sequence. There are some accounts, such as those with customers and creditors, in which it is not feasible to round to the nearest dollar. Nevertheless, the technique yields savings in office costs and improved productivity. The errors introduced into other accounts by rounding the amounts of individual entries at the time of recording tend to be compensating in nature, and the amount of the final error is not material. It should not be inferred from the foregoing that whole dollar accounting encourages or condones errors. The unrecorded cents are not lost; they are merely reported in a manner that reduces recording costs without materially affecting the accuracy of accounting data.
CONSERVATISM
Periodic statements are affected to a great degree by the selection of accounting procedures and other value judgments. Historically, accountants have tended to be conservative, and in selecting among alternatives they have often favored the method or the procedure that yielded the lesser amount of net income or of asset value. This attitude of conservatism often was expressed in the statement to "anticipate no profits and provide for all losses," For example, it is acceptable to price merchandise inventory at lower of cost or market. If market price is higher than cost, the higher amount is ignored in the accounts and, if presented in the financial statements, is presented parenthetically. Such an attitude of pessimism has been due in part to the need for an offset to the optimism of business management. It could also be argued that potential future losses to an enterprise from poor management decisions would be lessened if net income and assets were understated.
Current accounting thought has shifted somewhat from this philosophy of conservatism. Conservatism is no longer considered to be a dominant factor in selecting among alternatives. Revenue should be recognized when realized, and expired costs should be matched against revenue according to the principles based on reason and logic. The element of conservatism may be considered only when other factors affecting a choice or alternatives are neutral. The concepts of objectivity, consistency, disclosure, and materiality are more important than conservatism, and the latter should be a factor only when the others do not play a significant role.
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The historical development of accounting practice has been closely related to the economic development of the country. In the earlier stages of the American economy, a business enterprise was very often managed by its owner, and the accounting records and reports were used mainly by the owner manager in conducting the business. Bankers and other lenders often relied on their personal relationship with the owner rather than on financial statements as the basis for making loans for business purposes. If a large amount was owed to a bank or supplier, the creditor often participated in management decisions,
As business organizations grew in size and complexity, "management" and "outsiders" became more-clearly differentiated. From the latter group, which includes owners (stockholders), creditors, government, labor unions, customers, and the general public, came the demand for accurate financial information for use in judging the performance of management. In addition, as the size and complexity of the business unit increased, the accounting problems involved in the issuance of financial statements became more and more complex, With these developments came an awareness of the need for a framework of concepts and generally accepted accounting principles to serve as guidelines for the preparation of the basic financial statements.
DEVELOPMENT OF CONCEPTS AND PRINCIPLES
The word "principle" as used in the context of generally accepted accounting principles does not have the same authoritativeness as universal principles or natural laws relating to the study of astronomy, physics, or other physical sciences. Accounting principles have been developed by individuals to help make accounting data more useful in an ever changing society. They represent the best possible guides, based on reason, observation, and experimentation, to the achievement of the desired results. The selection of the best method from among many alternatives has come about gradually, and in some subject matter areas a clear consensus is still lacking. These principles continually are reexamined and revised to keep pace with the increasing complexity of business operations. General acceptance among the members of the accounting profession is the criterion for determining an accounting principle.
Responsibility for the development of accounting principles has rested primarily on practicing accountants and accounting educators, working both independently and under the sponsorship of various accounting organizations. These principles also are influenced by business practices and customs, ideas and beliefs of the users of the financial statements, governmental agencies, stock exchanges, and other business groups.
Financial Accounting Standards Board
In 1973, the Financial Accounting standards Board (FASB) was appointed by the Financial Accounting Foundation (FAF). The FAF is an independent, nonprofit organization that was created in 1972 to oversee the standard setting process, to appoint members of standard setting boards (the FASB and the Governmental Accounting Standards Board) and advisory councils, and to raise funds for the operation of the standard setting process.
The FASB replaced the Accounting Principles Board (APB), which provided much of the leadership in the development of generally accepted accounting principles from 1959 to 1973. The APB was composed of eighteen accountants who were members of the American Institute of Certified Public Accountants and who served without pay and continued their affiliations with their firms or institutions. The FASB, which is presently the dominant body in the development of generally accepted accounting principles, is composed of seven members, four of whom must be CPAs drawn from public practice. These seven members serve full time, receive a salary, and must resign from the firm or institution with which they have been affiliated. The FASB is assisted by an advisory council of approximately forty members, whose major responsibilities include the recommendation of priorities and agenda and the review of FASB plans, activities, and statements proposed for issuance, The FASB employs a full time research staff and administrative staff as well as task forces to study specific matters from time to time.
As problems in financial reporting are identified, the FASB conducts extensive research to identify the principal issues involved and the possible solutions. Generally, after issuing discussion memoranda and preliminary proposals and evaluating comments from interested parties, the Board issues Statements of Financial Accounting Standards, which become part of generally accepted accounting principles. To explain, clarify, or elaborate on existing pronouncements, the Board also issues Interpretations, which have the same authority as the standards.
Presently, the Board is in the process of developing a broad conceptual framework for financial accounting. This project, which is expected to take many years to complete, is an attempt to develop a 1~ constitution" that can be used to evaluate current standards and can serve as the basis for future standards. The results of the completed portion of this project have been published as six Statements of Financial Accounting Concepts, which are briefly described as follows
Objectives of Financial Reporting by Business Enterprises (No. 1) Sets forth three broad objectives of
Financial reporting:
I To provide financial information that is useful in making rational investment, credit, and similar decisions;
2. To provide financial information to enable users to predict cash flows to the business and subsequently
to themselves,.
3. To provide financial information about business resources (assets), claims to these resources (liabilities
and owner's equity), and changes in these resources and claims.
Qualitative Characteristics of Accounting Information (No. 2) Identifies the essential qualities of the accounting information included in financial reports as follows: usefulness, understandability, relevance, reliability verifiability, timeliness, neutrality, completeness, and comparability.
Elements of Financial Statements of Business Enterprises (No. 3) Replaced by Statement No. 6.
Objectives of Financial Reporting by Nonbusiness Organizations (No. 4) Sets forth the objectives that guide the preparation of the financial statements for nonbusiness organizations.
Recognition and Measurement in Financial Statements of Business Enterprises (No. 5) Identifies the financial statements that should be prepared to meet the objectives of financial reporting for business enterprises.
Elements of Financial Statements (No. 6)
Replaces Statement No. 3 and defines the interrelated elements of financial statements that are directly related
to measuring the performance and status of businesses and nonprofit organizations,
Governmental Accounting Standards Board
The Governmental Accounting Standards Board was formed in 1984 as an arm of the Financial Accounting Foundation. The GASB has a full time chairperson and four part time members who have responsibility for establishing the accounting standards to be followed by state and municipal governments. The GASB employs a full time research staff and administrative staff. An advisory council of approximately 20 members assists the GASB and also has fund raising responsibilities.
Accounting Organizations
Among the oldest and most influential organizations of accountants are the American Institute of Certified Public Accountants (AICPA) and the American Accounting Association (AAA). Each organization publishes monthly or quarterly periodicals and, from time to time, issues other publications in the form of research studies, technical opinions, and monographs. There are also other national accounting organizations as well as many state societies and local chapters of the national and state organizations. These groups provide forums for the interchange of ideas and discussion of accounting principles.
Government Organizations
Of the various governmental agencies with an interest in the development of accounting principles, the Securities and Exchange Commission has been the most influential. Established by an act of Congress in 1934, the SEC issues regulations that must be observed in the preparation of financial statements and other reports filed with the Commission.
The Internal Revenue Service (IRS) issues regulations that govern the determination of income for purposes of federal income taxation. Because these regulations sometimes conflict with financial accounting principles, many enterprises maintain two sets of accounts to satisfy both reporting requirements, To avoid this increased record keeping, there have been times when firms have adopted practices that are acceptable for tax purposes as generally accepted accounting principles.'
Other regulatory agencies exercise a dominant influence on the accounting principles of the industries under their jurisdiction. In rare situations, Congress may also enact legislation that dictates accounting principles. These situations usually involve controversial issues on which no clear consensus has been reached within the profession.
Other Influential Organizations
The Financial Executives Institute (FEI) has influenced the development of accounting principles by encouraging and sponsoring accounting research. The FEI also comments on proposed pronouncement s of the FASB, the SEC, and other organizations.
The Institute of Management Accountants (IMA) is one of the largest organizations of accountants. It is primarily concerned with management's use of accounting information in directing business operations. Since management is responsible for the preparation of the basic financial statements, however, the IMA communicates its recommendations on generally accepted accounting principles to appropriate organizations.
Although the organizations mentioned above traditionally have had the most influence upon the establishment of accounting principles, other organizations representing users of accounting reports are increasingly making their views known. Prominent in this group are the Financial Analysts Federation (investors and investment advisors) and the Securities Industry Associates (investment bankers). Many accounting principles have been introduced and integrated with discussions in earlier chapters. The remainder of this chapter is devoted to the underlying assumptions, concepts, and principles of the greatest importance and widest applicability. Attention also will be directed to applications of principles to specific situations in order to facilitate better understanding of accounting practices.
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BUSINESS ENTITY
The business entity concept assumes that a business enterprise is separate and distinct from the persons who supply its assets, This distinction exists regardless of the legal form of the business organization. The accounting equation, Assets = Equities, or Assets = Liabilities + Owner's Equity, is an expression of the entity concept; i.e., the business owns the assets and owes the various claimants. Thus, the accounting process primarily is concerned with the enterprise as a productive economic unit and only secondarily is concerned with the investor as a claimant to the assets of the business.
The business entity concept used in accounting for a sole proprietorship is distinct from the legal concept of a sole proprietorship. The nonbusiness assets, liabilities, revenues, and expenses of a sole proprietor are excluded from the business accounts. If a sole proprietor owns two or more dissimilar enterprises, each one is treated as a separate business entity for accounting purposes. Legally, however, a sole proprietor is personally, liable for all business debts and may be required to use nonbusiness assets to satisfy the business creditors. Conversely, business assets are not immune from the claims of the sole proprietor's personal creditors.
Differences between the business entity concept and the legal nature of other forms of business organization will be considered in later chapters. For accounting purposes, however, revenues and expenses of any enterprise are viewed as affecting the business assets and liabilities, not the investors' assets and liabilities.
GOING CONCERN
Only in rare cases is a business organized with the expectation of operating for only a certain period of time. In most cases, it is not possible to determine in advance the length of life of an enterprise, and so an assumption must be made. The nature of the assumption will affect the manner of recording some of the business transactions, which in turn will affect the data reported in the financial statements.
It is customary to assume that a business entity has a reasonable expectation of continuing in business at a profit for an indefinite period of time. This provides much of the justification for recording plant assets at acquisition cost and depreciating them in an orderly manner without reference to their current realizable values. If there is no immediate expectation of selling them, plant assets should not be reported on the balance sheet at their estimated realizable values regardless of whether their current market value is less than their book value or greater than their book value. If the firm continues to use the assets,, the change in market value causes no gain or loss, nor does it increase or decrease the usefulness of the assets. Thus, if the going concern assumption is a valid concept, the investment in plant assets will serve the purpose for which it was made the investment in the assets will be recovered even though they may be individually marketable only at a loss.
The going concern assumption similarly supports the treatment of prepaid expenses as assets, even though they may not be salable. To illustrate, assume that On the last day of its fiscal year, a wholesale firm receives from a printer a $20,000 order of sales catalogs. If there were no assumption that the firm is to continue in business, the catalogs would be merely scrap paper and the value reported for them on the balance sheet would be small.
When there is conclusive evidence that a business entity has a limited life, the accounting procedures should be appropriate to the expected terminal date of the entity. Changes in the application of normal accounting procedures may be needed for business organizations in receivership or bankruptcy, for example. In such cases, the financial statements should clearly disclose the limited life of the enterprise and should be prepared from the "quitting concern" or liquidation point of view, rather than from a "going concern" point of view.
OBJECTIVE EVIDENCE
Entries in the accounting records and data reported on financial statements must be based on objectively determined evidence. If this principle is not followed, the confidence of the many users of the financial statements could not be maintained. For example, objective evidence such as invoices and vouchers for purchases, bank statements for the amount of cash in bank, and physical counts for merchandise on hand supports much of accounting. Such evidence is completely objective and can be verified.
Evidence is not always conclusively objective, for there are many cases in accounting in which judgments, estimates, and other subjective factors must be taken into account. In such situations, the most objective evidence available should be used. For example, the provision for doubtful accounts is an estimate of the losses expected from failure to collect sales made on account. The estimation of this amount should be based on such objective factors as past experience in collecting accounts receivable and reliable forecasts of future business activities. To provide accounting reports that can be accepted with confidence, evidence should be developed that will minimize the possibility of error, intentional bias, or fraud.
UNIT OF MEASUREMENT
All business transactions are recorded in terms of money. Other pertinent information of a nonfinancial nature may also be recorded, such as the description of assets acquired, the terms of purchase and sale contracts, and the purpose, amount, and term of insurance policies. But it is only through the record of dollar amounts that the diverse transactions and activities of a business may be measured, reported, and periodically compared. Money is both the common factor of all business transactions and the only feasible unit of measurement that can be used to achieve uniform financial data.
The generally accepted use of the monetary unit for accounting for and reporting the activities of an enterprise has two major limitations: (1) it limits the scope of accounting reports and (2) it assumes a stability of the measurement unit.
Scope of Accounting Reports
Many factors affecting the activities and the future prospects of an enterprise cannot be expressed in monetary terms. In general, accounting does not attempt to report such factors. For example, information regarding the capabilities of the management, the state of repair of the plant assets, the effectiveness of the employee welfare program, the attitude of the labor union, the effectiveness of antipollution measures, and the relative strengths and weaknesses of the firm's competitors cannot be expressed in monetary terms. Although such matters are important to those concerned with enterprise operations, at the present time, accountancy does not assume responsibility for reporting information of this kind.
Changes in Price Levels
As a unit of measurement, the dollar differs from such quantitative standards as the kilogram, liter, or meter, which have not changed for centuries. The instability of the purchasing power of the dollar is well known, and the disruptive effect of the declining value of the dollar is acknowledged by accountants. In the past, however, this declining value generally has not been given recognition in the accounts or in conventional financial statements.
To indicate the nature of the problem, assume that the plant assets acquired by an enterprise for $ 100,000 twenty years ago are now to be replaced with similar assets which will cost $200,000 at present price levels. Assume further that during the twenty year period the plant assets had been fully depreciated and the net income of the enterprise had amounted to $300,000. Although the initial outlay of $100,000 for the plant assets was recovered through depreciation charges, the amount represents only half of the cost of replacing the assets. Instead of considering the current value of the new assets to have increased to double the value of two decades earlier, the dollars recovered can be said to have declined to one half of their earlier value. From either point of view, the firm has suffered a loss in purchasing power, which is the same as a loss of capital. In addition, $100,000 of the net income reported during the period might be said to be illusory, since it must be used to replace the assets.
The use of a monetary unit that is assumed to be stable insures objectivity. In spite of the inflationary trend
in the United States, historical dollar financial statements are considered to be better than statements based on
movements of the general price level. There are, however, two widely discussed recommendations for
supplementing conventional statements and thus resolving financial reporting problems created by increasing
price levels: (1) supplemental financial data based on current costs and (2) supplemental financial data based
on constant dollars. The discussion in the following sections is confined to the basic concepts and problems of
these recommendations.
Current Cost Data. Current cost is the amount of cash that would have to be paid currently to acquire assets
of the same age and in the same condition as existing assets. When current costs are used as the basis for
financial reporting, assets, liabilities, and owner's equity are stated at current values, and expenses are stated at
the current cost of doing business. The use of current costs permits the identification of gains and losses that
result from holding assets during periods of changes in price levels. To illustrate, assume that a firm acquired
land at the beginning of the fiscal year for $50,000 and that at the end of the year its current cost (value) is
$60,000. The land could be reported at its current cost of $60,000, and the $ 10,000 increase in value could be
reported as an unrealized gain from holding the land.
The major disadvantage in the use of current costs is the absence of established standards and procedures for determining such costs. However, many accountants believe that adequate standards and procedures will evolve through experimentation with actual applications.
Constant Dollar Data. Constant dollar data, also known as general price level data, are historical costs that have been converted to constant dollars through the use of a price level index. In this manner, financial statement elements are reported in dollars, each of which has the same (that is, constant) general purchasing power.
A price level index is the ratio of the total cost of a group of commodities prevailing at a particular time to the total cost of the same group of commodities at an earlier base time. The total cost of the commodities at the base time is assigned a value of 100 and the price level indexes for all later times are expressed as a ratio to 100. For example, assume that the cost of a selected group of commodities amounted to S12,000 at a particular time and $13,200 today. The price index for the earlier, or base, time becomes 100 and the current price index is 110 [(13,200 + 12,000) x 1001.
Current Annual Reporting Requirements for Price Level Changes. In 1979, the Financial Accounting Standards Board undertook an experimental program for reporting the effects of changing prices by requiring approximately 1,300 large, publicly held enterprises to disclose certain current cost information and constant dollar information annually as supplemental data. In 1984, after reviewing the experiences with these 1979 disclosure requirements, the FASB concluded that current cost information was more useful than constant dollar information as a supplement to the basic financial statements. In 1986, the FASB eliminated the requirement to disclose the effects of changing prices, but encouraged it companies to disclose such information voluntarily. The information that is now being disclosed includes elements of both current cost and constant dollar data, as shown in the following footnote from the annual report of The Pillsbury Company:
Information on effects (?f changing prices and inflation
Financial statements, prepared using historical costs as required by generally accepted accounting principles. may not reflect the full impact of current costs and general inflation.
The following supplementary disclosures attempt to remeasure certain historical financial information to recognize the effects of changes in current costs using specific price indices. 7 he current cost information is then expressed in average Fiscal 1986 dollars to reflect the effects of general inflation based on the U. S. Consumer Price Index....
ACCOUNTING PERIOD
A complete and accurate picture of an enterprise's success or failure cannot be obtained until it discontinues operations, converts its assets into cash, and pays off its debts. Then, and only then, is it possible to determine its true net income, But many decisions regarding the business must be made by management and interested outsiders during its existence. It is therefore necessary to prepare periodic reports on operations, financial position, and cash flows.
Reports may be prepared when a certain job or project is completed, but more often they are prepared at specified time intervals. For a number of reasons, including custom and various legal requirements, the longest interval between reports is one year.
This element of periodicity creates many of the problems of accountancy. The basic problem is the determination of periodic net income. For example, the need for adjusting entries discussed in earlier chapters is directly attributable to the division of the life of an enterprise into arbitrary time periods. Problems of inventory costing, of recognizing the uncollectibility of receivables, and of selecting depreciation methods are also directly related to the periodic measurement process. Furthermore, the amounts of the assets and the equities reported on the balance sheet also will be affected by the methods used in determining net income. For example, the cost flow assumption used in determining the cost of merchandise sold during the accounting period will have a direct effect on the amount of cost assigned to the remaining inventory,
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MATCHING REVENUE AND EXPIRED COSTS
During the early stages of accounting development, accountants viewed the balance sheet as the principal financial statement. Over the years, the emphasis has shifted to the income statement as the users of financial statements have become more concerned with the results of business operations than with financial position. The determination of periodic net income is a two fold problem involving (1) the revenue recognized during the period and (2) the expired costs to be allocated to the period. It is thus a problem of matching revenue and expired costs, the residual amount being the net income or net loss for the period.
Recognition of Revenue
Revenue is measured by the amount charged to customers for merchandise delivered or services rendered to them. The problem created by periodicity is one of timing; that is, at what point is the revenue realized? For any particular accounting period, the question is whether revenue items should be recognized and reported as such in the current period or whether their recognition should be delayed to a future period.
Various criteria are acceptable for determining when revenue is realized. In any case, the criteria used should reasonably agree with the terms of the contractual arrangements with the customer and be based, insofar as possible, on objective evidence. The criteria most often used are described in the remaining paragraphs of this section.
Point of Sale. Revenue from the sale of merchandise usually is determined by the point of sale method under which revenue is realized at the time title passes to the buyer. At point of sale, the sale price has been agreed upon, the buyer acquires the right of ownership in the merchandise, and the seller has a legal claim against the buyer. The realization of revenue from the sale of services may be determined in a like manner, although there is often a time lag between the time of the initial agreement and the completion of the service. For example, assume that a contract provides that certain repair services be performed, either for a specified price or on a time and materials basis. The price or terms agreed upon in the initial contract do not become revenue until the work has been performed.
Theoretically, revenue from the production and sale of merchandise and services emerges continuously as effort is expended. As a practical matter, however, it is usually not possible to make an objective determination until both (1) the contract price has been agreed upon and (2) the seller's portion of the contract has been completed.
Receipt of Payment. The recognition of revenue may be delayed until payment is received. When this criterion is used, revenue is considered to be realized at the time the cash is collected, regardless of when the sale was made. The cash basis is widely used by physicians, attorneys, and other enterprises in which professional services are the source of revenue. It has little theoretical justification but has the practical advantage of simplicity of operation and avoidance of the problem of estimating losses from uncollectible accounts. Its acceptability as a fair method of timing the recognition of revenue from personal services is influenced somewhat by the fact that it may be used in determining income subject to the federal income tax. It is not an appropriate method of measuring revenue from the sale of merchandise.
Installment Method. In some businesses, especially in the retail field, it is common to make sales on the installment plan. In the typical installment sale, the buyer makes a down payment and agrees to pay the remainder in specified amounts at stated intervals over a period of time. The seller may retain technical title to the goods or may take other means to make repossession easier in the event that the buyer defaults on the payments. Despite such provisions, installment sales ordinarily should be treated in the same manner as any other sale on account, in which case the revenue is considered to be realized at the point of sale.
In some exceptional cases, the circumstances are such that the collection of receivables is not reasonably assured. In these cases, the installment method of deter mining revenue may be used. Under this method, each receipt of cash is considered to be revenue and to be composed of partial amounts of (1) the cost of merchandise sold and (2) gross profit on the sale.
As a basis for illustration, assume that in the first year of operations, a dealer in household appliances had total installment sales of $300,000, and the cost of the merchandise sold amounted to $180,000. Assume also that collections of the installment accounts receivable were spread over three years as follows: 1st year, $140,000; 2nd year, $100,000; 3rd year, $60,000. According to the point of sale method, all of the revenue would be recognized in the first year, and the gross profit realized in that year would be determined as follows:
Installment sales $300,000
Cost of merchandise sold 180,000
Gross profit $120,000
Percentage of Completion. Enterprises engaged in large construction projects may devote several years to the completion of a particular contract, To illustrate, assume that a contractor engages in a project that will require three years to complete, for a contract price of $50,000,000. Further assume that the total cost to be incurred, which will also be spread over the three year period, is estimated at $44,000,000. According to the point of sale criterion, neither the revenue nor the related costs would be recognized until the project is completed. Therefore, using the completed contract method of determining revenue, the entire net income from the contract would be reported in the third year.
Whenever the total cost of a long term contract and the extent of the project's progress reasonably can be estimated, it is preferable to consider the revenue as being realized over the entire life of the contract. The amount of revenue to be recognized in any particular period is then determined on the basis of the estimated percentage of the contract that has been completed during the period. The estimated percentage of completion can be developed by comparing the incurred costs with the most recent estimates of total costs or by estimates by engineers, architects, or other qualified personnel of the progress of the work performed. To continue with the illustration, assume that by the end of the first fiscal year the contract is estimated to be one fourth completed and the costs incurred during the year were $11,200,000. According to the percentage of -completion method, the revenue to be recognized and the income for the year would be determined as follows:
Revenue ($50,000,000 x 25%) $12,500,000
Costs incurred 11,200,000
Income (Year 1) $ 1,300,000
The costs actually incurred during the year (rather than one fourth of the original cost estimate of $44,000,000 or $11,000,000) are deducted from the revenue recognized.
The 1988 edition of Accounting Trends & Techniques indicated that 94% of the surveyed companies with long term contracts used the percentage of completion method. Although the use of this method involves some subjectivity, and hence possible error, in the determination of the amount of reported revenue, the financial statements may be more informative and more useful than they would be if none of the revenue was recognized until completion of the contract.
The method used to recognize revenue on a long term contract should be noted in the financial statements, as indicated in the following excerpt taken from a note to the financial statements of Martin Marietta Corporation:
Revenue Recognition. Sales under long term contracts generally are recognized under the percentage of completion method, and include a proportion of the earnings expected to he realized on the contract... Other sales are recorded upon shipment of products or performance of services.
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Allocation of Costs
Properties and services acquired by an enterprise generally are recorded at cost. "Cost" is the amount of cash or equivalent given to acquire the property or the service. If property other than cash is given to acquire properties or services, the cost is the cash equivalent of the property given. When the properties or the services acquired are sold or used, the costs are deducted from the related revenue to determine the amount of net income or net loss. The costs of properties or services acquired and on hand at any particular time represent assets. Such costs may also be called "unexpired costs." As the assets are sold or used, they became "expired costs" or "expenses."
The techniques of determining and recording cost expirations have been described and illustrated in earlier chapters. In general, there are two approaches to cost allocations: (1) compute the amount of the expired cost or (2) compute the amount of the unexpired cost. For example, it is customary to determine the portion of plant assets that have expired. After the depreciation for the period has been recorded, the balances of the plant asset accounts minus the balances of the related accumulated depreciation accounts represent the unexpired cost of the assets. The alternative approach must be used for merchandise and supplies, unless perpetual inventory records are maintained. If the cost of the merchandise or supplies on hand at the end of the period is determined by taking a physical inventory, the remaining costs in the related accounts are assumed to have expired. It might appear that the first approach emphasizes expired costs and the second emphasizes unexpired costs. This is not the case, however, since the selection of the method is based merely on convenience or practicality.
Many of the costs allocable to a period are treated as an expense at the time of incurrence because they will be wholly expired at the end of the period. For example, when a monthly rent is paid at the beginning of a month, the cost incurred is unexpired and hence it is an asset; but, since the cost incurred will be wholly expired at the end of the month, the rental is usually charged directly to the appropriate expense account. This process makes subsequent adjusting entry unnecessary. The proper allocation of costs among periods is the most important consideration. Any one of many accounting techniques may be used in achieving this objective.
ADEQUATE DISCLOSURE
Financial statements and their accompanying footnotes or other explanatory materials should contain all of the pertinent data believed essential to the reader's understanding of the enterprise's financial status. Criteria for adequate disclosure, or full disclosure, often must be based on value judgments rather than on objective facts.
Financial statements are made more useful by the use of headings and subheadings and by merging items in significant categories. Although all essential data should be disclosed within these categories, judgment must be exercised by excluding nonessential information to avoid clutter, For example, detailed information as to the amount of cash in various special and general funds, the amount on deposit in each of several banks, and the amount invested in various marketable government securities is not needed by the reader of financial statements, Such information displayed on the balance sheet would hinder rather than aid understanding.
In most cases, all of the pertinent data needed by the reader cannot be presented in the financial statements themselves. The statements therefore normally include essential or explanatory information in accompanying notes.
Accounting Methods Employed
When there are several acceptable alternative methods that could have a significant effect on amounts reported on the statements, the particular method used should be disclosed. Examples include inventory cost flow and pricing methods, depreciation methods, and various criteria of revenue recognition. There is considerable variation in the format used to disclose accounting methods employed. One form of disclosure is to present "Significant Accounting Policies" as the initial note.
Changes in Accounting Estimates
There are many cases in accounting in which the use of estimates is necessary, These estimates should be revised when additional information or subsequent developments permit better insight or improved judgment upon which to base the estimates. If the effect of such a change on net income is material, it should be disclosed in the financial statements for the year in which the change is adopted.
Contingent Liabilities
As discussed previously, contingent liabilities are potential obligations that will materialize only if certain events occur in the future. If the liability is probable and the amount of the liability can be reasonably estimated, it should be recorded in the accounts. Such liabilities discussed in preceding chapters include vacation pay payable and product warranty payable. Although the vacation pay liability is dependent on employees taking vacations, the liability is probable and is reasonably estimated. Likewise, although the product warranty liability is dependent upon customers presenting products for repair, the product warranty liability is probable and is reasonably estimated. If the amount of the potential obligation cannot be reasonably estimated, the details of the contingency should be disclosed., The most common contingent liabilities disclosed in notes to the financial statements stem from litigation, guarantees, and discounting receivables.
Segment of a Business
Many companies diversify their operations; that is, they are involved in more than one type of business activity. These companies may also operate in foreign markets. The individual segments of such diversified
companies ordinarily experience differing rates of profitability, degrees of risk, and opportunities for growth. To help financial statement users in assessing past performance and future potential of diversified companies, financial statements should disclose such information as the enterprise's operations in different industries, its foreign markets, and its major customers. The required information for each significant reporting segment includes the following: revenue, income from operations, and identifiable assets associated with the segment.
Events Subsequent to Date of Statements
Events occurring or becoming known after the close of the period may have a significant effect on the financial statements and should be disclosed. For example, if an enterprise should suffer a crippling loss from a fire or other catastrophe between the end of the year and the issuance of the statements, the facts should be disclosed. Similarly, such occurrences as the issuance of long term debt or capital stock, or the purchase of another business enterprise after the close of the period should be made known.
CONSISTENCY
A number of accepted alternative principles affecting the determination of income statement and balance sheet amounts have been presented in various sections of the text. Recognizing that different methods may be used under varying circumstances and that the comparison of an enterprise's current financial statements with those of the preceding year is common practice, some guide or standard is needed to assure that the enterprise's periodic financial statements can be compared.
The amount and the direction of change in net income and financial position from period to period is very important to readers and may greatly influence their decisions. Therefore, interested persons should be able to assume that successive financial statements of an enterprise are based consistently on the same generally accepted accounting principles. If the principles are not applied consistently, the trends indicated could be the result of changes in the principles used rather than the result of changes in business conditions or managerial effectiveness.
The concept of consistency does not completely prohibit changes in the accounting principles used. Changes are permissible when it is believed that the use of a different principle will more fairly state net income and financial position. Examples of changes in accounting principles include a change in the method of inventory pricing, a change in depreciation method for previously recorded assets, and a change in the method of accounting for long term construction contracts. Consideration of changes in accounting principles must be accompanied by consideration of the general rule for disclosure of such changes, which is as follows:
The nature of and justification for a change in accounting principle and its effect on income should be disclosed in the financial statements of the period in which the change is made. The justification for the change should explain clearly why the newly adopted accounting principle is preferable.
There are various methods of reporting the effect of a change in accounting principle on net income. The cumulative effect of the change on net income may be reported on the income statement of the period in which the change is adopted. In some cases, the effect of the change could be applied retroactively to past periods by presenting revised income statements for the earlier years affected. The application of the consistency concept does not require that a specific accounting method be used uniformly throughout an enterprise.
MATERIALITY
In following generally accepted accounting principles, the accountant must consider the relative importance of any event, accounting procedure, or change in procedure that affects items on the financial statements. Absolute accuracy in accounting and full disclosure in reporting are not ends in themselves, and there is no need to exceed the limits of practicality. The determination of what is significant and what is not requires the exercise of judgment, Precise criteria cannot be formulated.
To determine materiality, the size of an item and its nature must be considered in relationship to the size and the nature of other items. The erroneous classification of a $10,000 asset on a balance sheet exhibiting total assets of $10,000,000 would probably be immaterial. If the assets totaled only $100,000, however, it certainly would be material, If the $10,000 represented a note receivable from an officer of the enterprise, it might well be material even in the first assumption. If the loan was increased to $ 100,000 between the close of the period and the issuance of the statements, both the nature of the item at the balance sheet date and the subsequent increase in amount would require disclosure.
The concept of materiality may be applied to procedures used in recording transactions. As was stated in an earlier chapter, small expenditures for plant assets may be treated as an expense of the period rather than as an asset. The saving in clerical costs is justified if the practice does not materially affect the financial statements. In establishing a dollar amount as the dividing line between a revenue expenditure and a capital expenditure, consideration would need to be given to such factors as (1) amount of total plant assets, (2) amount of plant assets in relationship to other assets, (3) frequency of occurrence of expenditures for plant assets, (4) nature and expected life of plant assets, and (5) probable effect on the amount of periodic net income reported.
Custom and practicality also influence criteria of materiality. Corporate financial statements seldom report the cents amounts or even the hundreds of dollars. A common practice is to round to the nearest thousand.
For large corporations, there is an increasing tendency to report the financial data in terms of millions, carrying figures to one decimal.
A technique known as "whole dollar" accounting, which is used by some businesses, eliminates the cents amounts from accounting entries at the earliest possible point in the accounting sequence. There are some accounts, such as those with customers and creditors, in which it is not feasible to round to the nearest dollar. Nevertheless, the technique yields savings in office costs and improved productivity. The errors introduced into other accounts by rounding the amounts of individual entries at the time of recording tend to be compensating in nature, and the amount of the final error is not material. It should not be inferred from the foregoing that whole dollar accounting encourages or condones errors. The unrecorded cents are not lost; they are merely reported in a manner that reduces recording costs without materially affecting the accuracy of accounting data.
CONSERVATISM
Periodic statements are affected to a great degree by the selection of accounting procedures and other value judgments. Historically, accountants have tended to be conservative, and in selecting among alternatives they have often favored the method or the procedure that yielded the lesser amount of net income or of asset value. This attitude of conservatism often was expressed in the statement to "anticipate no profits and provide for all losses," For example, it is acceptable to price merchandise inventory at lower of cost or market. If market price is higher than cost, the higher amount is ignored in the accounts and, if presented in the financial statements, is presented parenthetically. Such an attitude of pessimism has been due in part to the need for an offset to the optimism of business management. It could also be argued that potential future losses to an enterprise from poor management decisions would be lessened if net income and assets were understated.
Current accounting thought has shifted somewhat from this philosophy of conservatism. Conservatism is no longer considered to be a dominant factor in selecting among alternatives. Revenue should be recognized when realized, and expired costs should be matched against revenue according to the principles based on reason and logic. The element of conservatism may be considered only when other factors affecting a choice or alternatives are neutral. The concepts of objectivity, consistency, disclosure, and materiality are more important than conservatism, and the latter should be a factor only when the others do not play a significant role.
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