The Accounting Process, Part One - Module 2 of 6

The Accounting Process, Part One

Before we address the accounting process, some definitions will help.  A fiscal year is the year that reflects the financial reporting cycle for a business and may or may not coincide with the standard calendar year that runs from January to December.  For example, the fiscal year for the U.S. government runs from October through the following September.  Throughout this presentation, we will refer to the rules of accounting.  The Financial Accounting Standards Board drafts and updates the rules that govern the practice of financial accounting, and these rules are collectively called the Generally Accepted Accounting Principles, or “GAAP.”  In certain situations, GAAP must be followed, such as tax liability computations, audits, contracts and Securities and Exchange filings.[1]   

Recognition

The twin principles of revenue recognition and matching address how and when revenue and expenses should be recorded.  Revenue could be recognized when an item is ordered, produced, shipped or received by the purchaser.  The rules of accounting require that the revenue’s associated expenses be matched with the recording of revenue.  A business can thus determine its profit for a given accounting period.   

Two factors determine revenue recognition.  One is the “realization event” and the other is the completion of the “earnings process.”[2]  Realization of income occurs when a company receives cash and has earned that cash, such as by substantially performing its services or delivering its goods. Once both points are satisfied (earning and receipt), a business may “realize” the income by recording the recognition in its accounting ledgers. 

For example, assume Acme Corporation manufactures mobile phones.  Acme ships 1,000 phones to The Phone Store, bills at a unit cost of $30 each and receives a check for $30,000.  Acme has delivered its goods and received its associated revenue in the form of a check.  Acme would record a $30,000 gain in its cash and sales accounts. If Acme received the $30,000 payment, but had not yet delivered the phones, it would not yet have realized the income.

If a sale includes a warranty, then the company could conceivably record the gain when the warranty expires and there is no further possibility of a claim.  However, the prevailing approach is to simply record warranty costs, which reflect the estimated costs of honoring the outstanding warranties for the accounting period (which may calculated by multiplying the expected reimbursement by the probability of having to pay the reimbursement).[3]

When a company receives revenue from services, it can record the revenue in different ways, depending on how it is received.  Under the “specific performance method,”[4] a company records the revenue earned when it completes the service rendered, such as when it repairs equipment.  Another method, called the “proportional performance method,”[5] allocates revenue proportionate to an external factor such as time or cost. 

For example, Acme Corporation enters into a contract to build a football stadium for $60,000,000 over five years.  It recognizes revenue from the project at $12,000,000 annually.   

The “completed performance method”[6] allocates revenue on the basis of a final critical event that must occur before revenue may be recorded, such as a settlement payment to a law firm to conclude a lawsuit. 

Matching 

While the recognition rules determine when a company is to record revenues, the matching principle indicates when the company is to record expenses.  Note that “costs” are the amount a company pays to obtain goods and services while “expenses” are charges that a company incurs or expects to incur. The distinction is important because certain expenses are recognized before the company incurs any costs.[7]

For example, Acme Corporation has an annual property insurance policy with Baker Property and Casualty Company that costs $4,800 in annual premiums.  In December, it prepays its insurance premiums for the first six months of the following year by increasing its expense account called “prepaid insurance” in the amount of $2,400 and reducing its cash account by the same amount.

One approach to matching revenue with expenses is called “direct matching.”[8]  When a retailer buys inventory, it does not record an inventory expense but, rather, it records the acquired inventory as a “cost of goods sold” expense, called “COGS,” in the calculation of revenue, when its inventory is calculated or actually sold.[9] The cost of goods sold may include things like raw materials, machinery maintenance and other expenses necessary to produce a product.

For example, Crenshaw Markets operates a chain of retail stores that sells inexpensive art items and gifts.  At the end of its fiscal year, Crenshaw counts all of its items in inventory and compares the amount to its inventory it started with at the beginning of the year.  It assigns a monetary value to the result, which is the cost of the inventory sold, called “cost of goods sold” to get its gross profit, from which it then deducts its other expenses to get its final net profit.    

Crenshaw reported sales at $300,000 at the end of its most recent fiscal year.  The company started the year with $150,000 in inventory and ended the year with $50,000 in inventory. It also incurred $90,000 in salaries, administration, interest, taxes and other expenses.  Its COGS figure is therefore $100,000, which is its starting inventory of $150,000 minus its ending inventory of $50,000.  The COGS amount of $100,000 is then subtracted from its sales amount of $300,000 to yield a gross profit of $200,000.  Crenshaw then deducts its $90,000 in expenses to arrive at a figure of $110,000 in net profit. 

Another matching approach is the “immediate write-off,”[10] which occurs when expenses cannot be traced to any specific revenue and are consequently recorded as they occur. These include salaries and administrative expenses.  Note that in our example, Crenshaw recorded its salaries, interest, and other expenses as they were incurred, but its cost of goods sold amount is calculated at the end of the year. 

A third approach is to formulate a “systematic and rational allocation”[11] in assigning costs incurred, such as incrementally deducting the value of a hotel building every year as an expense.  The building produces periodic revenue, but, every year, also loses a portion of its value as it normally ages.  This is called “depreciation.”  Depreciation is not matched with any expense, nor is it an immediate write-off.  Rather, it is structured in a systematic and rational way.[12]

Accrual and Deferral of Revenue and Expenses

Accruals and deferrals denote situations when revenue and expenses do not concur in time.[13]  There are four possible scenarios involving accruals and deferrals as they pertain to revenue and expenses.[14]  Revenue can accrue before the company delivers its goods or performs its service or, alternatively, revenue may be deferred until after a company tenders its obligations.  Similarly, a company may accrue an expense and thus pay for something before using it or, alternatively, a company may defer an expense, effectively benefitting from something before paying for it. 

For example, Duke Accounting Service prepares financial statements for Acme Corporation and bills Acme for $1,000.  Duke records the accrued revenue after the statements are prepared, but before it has received any payment.  It also records the amount owed by Acme in an accounts receivable account.  Acme’s later payment increases Duke’s cash account and reduces its accounts receivable,     but it will not affect Duke’s income that was recorded earlier.

Acme liked the work Duke did so much that it paid Duke a retainer fee of $3,000 in anticipation of having Duke perform future work for several upcoming financial transactions.  Duke records receipt of $3,000 in its cash account and also records the fee as deferred revenue.  The firm then recognizes the fee as the work is performed by reducing its deferred revenue account and increasing its fee revenue account.      

Duke hires the law firm of Everett and Fry, which provides certain opinion letters attesting to the legality of its operations for $4,000 annually. The law firm bills Duke at the end of each quarter for $1,000.  Duke records the expense of $1,000 and also records $1,000 as a payable amount. The expense account shows that the expense was incurred during the current quarter and the fee payable account shows it is owed for payment later on. When Duke pays the bill, both its cash account and payable account will be reduced.  This is an example of an accrued expense.

Duke maintains a property insurance policy on its building and every six months it prepays its insurance premiums.  It increases its prepaid insurance account and decreases its cash account.  As time progresses, Duke will periodically reduce its prepaid insurance account and increase its insurance expense account. This is an example of a deferred expense.    

Although this accounting process is called “accrual accounting,” it includes deferral of income and expenses as well.  An alternative approach, called “cash accounting,” would be to record income and expenses as they occur. Cash accounting is used by individuals in preparing their personal taxes.  In cash accounting, everything is tracked on a cash basis, and it is the way most people handle their personal finances.[15]

Current Assets

Now we turn our attention to accounts that businesses maintain.  Current assets are those assets that a business expects to convert into cash within one year while current liabilities are those liabilities a business expects to pay within one year.[16]  Subtracting current liabilities from current assets theoretically indicates what a business would have left over if it used all its current assets to pay its current liabilities. This number is called “working capital.”[17]  It is another measure that accountants use to gauge the financial health of a business.

Assets are listed on the balance sheet in order of their liquidity.  Liquidity refers to the ability of a business to convert an asset into cash.  The most liquid of current assets is the cash account.  Cash includes currency, account balances and cash equivalents, which are typically short-term money market instruments with maturities of three months or less, such as commercial paper and treasury bills.[18] 

Another classification is restricted cash, which are funds that are committed to prior obligations and therefore not generally available to satisfy short-term expenses with cash.  Restricted cash is omitted from the current cash account.  These funds include minimum amounts banks require depositors to maintain, called “compensating balances.”[19]

Companies may also maintain a petty cash account, where immediate obligations of small amounts are recorded through a system of vouchers that are later reconciled with the preparation of the balance sheet. Since cash is easily subject to theft and embezzlement, businesses often employ strict internal controls involving audits and bank reconciliation statements to verify all cash balances and transactions.[20]  Marketable securities that a company expects to convert into cash within one year are recorded at market value as current assets.  Securities are recorded as noncurrent assets if they are to be held for more than one year.[21]   

Receivables are next in order of liquidity and they represent a business’s right to receive future cash payments.  Sometimes, businesses deliver goods or perform services in exchange for an expectation of future payment.  These are called “trade receivables” and often include a cash discount incentive for early payment.  The format for the cash discount is the discount percentage followed by the time period in days during which the discount is available, followed by the final payment period.[22]

For example, Acme Corporation extends a “3/10 net 30” cash discount for a $100,000 sale to Baker Company, one of the buyers of Acme’s products.  If Baker pays within ten days, then it may deduct three percent of the total amount due, which would be $3,000, and Baker would therefore only have to pay Acme $97,000.  If Baker misses the initial ten-day discount period, then it must pay the entire bill of $100,000 within 30 days of billing.

Besides trade receivables, businesses may also record interest on notes and loans as it accrues, along with cash advances and credit sales.  Receivables are typically reported at their “net realizable value,” which is the net amount the business expects to receive.[23]  If the date at which a buyer’s eligibility to take a cash discount passes, then the seller would make an adjustment to its ledgers in an account called “Cash Discounts Not Taken.”[24]

In a perfect world, a company would collect all of its receivables, but invariably there are buyers who default on payment obligations.  Businesses record these anticipated losses as “bad debt expense,” and aggregate the bad debts in an account called “Allowance for Doubtful Accounts.”[25]  A business should periodically estimate the amount of its uncollectible accounts.  One such method, called the “percentage of sales” method, involves assuming, based on prior experience, what percentage of credit sales will go uncollected for a given period and then making the appropriate entry in the company’s books.[26]

For example, every year Acme assumes that is will not be able to collect 7% of its debts and it anticipates sales of $2,000,000.  It would therefore make an allowance for bad debts in the amount of $140,000.

A second method is called “aged receivables analysis,” which is an approach wherein a company assigns its outstanding receivables into categories that reflect different likelihoods of collection.[27]  The company then periodically compares the total amount that is expected to be uncollectible to the allowance for bad debts and makes an adjustment to reflect the new amount.

For example, Acme Corporation has $295,000 in its allowance for bad debts account. After conducting its periodic analysis, it concludes that $310,000 will be uncollectible, so it increases it allowance for bad debts by $15,000.

Sometimes a business will need to borrow funds to continue its operations and it will therefore pledge its accounts receivable as collateral for a loan.  The company may record these funds in a separate account called “Assigned Accounts Receivable.”  If the secured party, which is the creditor who claims a security interest in the accounts receivable, has a right to sell or pledge the receivables, the accounts that are subject to the security interest must be listed separately on the balance sheet.  Even if the creditor does not have the right to sell or pledge the receivables, the existence of the security may need to be disclosed in the balance sheet’s footnotes.[28]   

Businesses may also sell receivables to other entities and the accounting for these sales transactions has many steps.  A business may elect to establish accounts receivable and notes receivable with its owners, managers and other businesses under its control.  The particulars of these arrangements must be disclosed in the footnotes to the financial statements.[29]

Liabilities

Another current asset is a prepaid expense.  For example, a business may prepay its insurance or rent for the upcoming quarter or year.  It will record the expense and the outstanding amount to be paid as a payable and then it will gradually reduce the outstanding payable amount as time progresses.[30]

For example, Acme Corporation prepays Carson Property and Casualty Insurance Company its insurance bill on January 1^st for the January to March quarter in the amount of $360.  It reduces its cash account by $360 and increases its prepaid insurance account by the same amount.  At the end of each of the months of January, February and March, Acme records an insurance expense of $120 and simultaneously reduces its prepaid insurance account by $120.

Accounts payable, another current liability, are the mirror images of accounts receivable.  As current liabilities, they are monies a business owes and expects to pay within one year, and typically include supplies.  Accounts payable are recorded when goods are acquired or services performed, and payment is to occur in the future.  Cash discounts apply to accounts payable in the same way as they do for accounts receivable.[31] 

For example, Acme Corporation purchases a shipment of supplies for $10,000 from Baker Company with terms of “3/10 net 30.”  If Acme pays for the supplies within ten days, it will receive a 3% discount of $300 and will only be obligated to pay Baker $9,700; otherwise payment in the full amount is due 30 days from the date of sale.

Notes payable are current assets, consisting of short-term business loans payable with interest reportable as a periodic expense or accrual.  Alternatively, a business may borrow funds and receive only a discounted amount which represents the amount of interest.[32]

For example, Acme Corporation borrows $120,000 from First Bank with a three-month term and a 12 percent annual rate.  Therefore, for the term of the note, Acme will pay three percent in interest.  Acme receives $96,400 from First Bank and records interest expense of $3,600.  The company must repay $100,000 to First Bank at the end of three months.           

            Our next module will continue our discussion and explanation of the accounting process.