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Day 430 of Roadwork Training in a Wheelchair in the Fox Hill Neighborhoo...

Accounting: The Language of Business - Vol. 2 (Intermediate: Part 24)

It's really amazing that in the age of unbelief, as a smart man called it, there isn't even more fraud. After all, with no God, there's no one to ever call you to account, and no accounting at all if you can get away with it.

Ben Stein

Review of the Accounting Cycle (Part A)

by

Charles Lamson

Introduction

Companies sell merchandise, purchase inventory, and compensate employees everyday---and each individual event represents a transaction. Consider the retailer Target. In its 1,792 U.S. stores, it reported sales of over $73 billion and employed over 390,000 people in fiscal year 2015 (Gordon, Raedy, Sannella, 2019). These statistics indicate the magnitude of Target's transactions. For example, if Target paid each employee weekly, there would be over 20 million paychecks issued in a year.

A company's accounting system tracks all the transactions that occur every day and ultimately aggregates and summarizes them in publicly available financial statements. The accounting cycle describes the process by which a company records transactions in its books and summarizes their effects in the financial statements.

In the next several posts, we discuss the nine steps in the accounting cycle. The process starts with the transaction analysis to determine whether an economic event has occurred that changes assets, liabilities, or stockholders' equity [the assets remaining in a business once all liabilities have been settled (Investopedia)]. After making this determination, a company journalizes transactions and posts them to its ledger accounts. Next, the entity ensures numerical accuracy of the process by preparing a trial balance. Before preparing financial statements, a company determines whether adjustments are required to ensure that it has reported all economic events occurring in that period. Finally, it prepares the financial statements and closes all temporary accounts. Temporary accounts are short-term accounts that start each accounting period with zero balance and close at the end to maintain a record of accounting activity during that period. They include the income statements, expense accounts, and income summary accounts (thebalancemoney.com).

These steps ensure that every transaction flows to the financial statements, enabling investors, creditors, and other financial statement users to use the statements to analyze a company's financial position and economic performance. 

The Accounting Cycle

The accounting cycle describes the process by which a company records business transactions and ultimately aggregates and summarizes them in the financial statements. As a roadmap for the next several posts, Exhibit 4.1 presents the nine steps in the accounting cycle. The accounting cycle steps do not depend on the accounting standards being used: whether a company uses GAAP or IFRS, the accounting cycle begins with analyzing transactions and ends with a post-closing trial balance. 

EXHIBIT 4.1 The Accounting Cycle

Step 1: Analyze the Transaction

A transaction is an economic event that involves a change in an asset, a liability, or a stockholders' equity account that companies record in their accounting records. The accounting equation (also called the balance sheet equation) is initially used to analyze transactions. We begin this section by reviewing the accounting equation and then expand it to illustrate transaction analysis.

The Accounting Equation

The accounting equation illustrates the relationship among assets, liabilities, and stockholders' equity as follows:

(4.1a)

Assets = Liabilities + Stockholders' Equity

Or, using abbreviations, this equation is:

(4.1b)

A = L + E

The accounting equation demonstrates that creditors and owners have claims to a company's assets. We review the definition of each element of the accounting equation in Exhibit 4.2 along with examples of each element.

EXHIBIT 4.2 Accounting Equation Definitions (U.S. GAAP definitions from FASB Concepts Statement Number 6, Elements of Financial Statements. IFRS definitions are nearly identical.) 

The fact that all transactions affect at least two accounts and that the accounting equation will always balance is referred to as the double-entry system. For example, if an asset increases, then there must be either a decrease in another asset, an increase in liabilities, or an increase in stockholders' equity.

An expanded version of the accounting equation includes the various components of stockholders' equity. Stockholders' equity in equation form is:

(4.2)

Stockholders' Equity = Contributed Capital + Ending Retained Earnings + Accumulated Other Comprehensive Income

Contributed capital consists primarily of owners' investments in the business. Accumulated other comprehensive income increases or decreases with other comprehensive income. Other comprehensive income is an additional component of comprehensive income. We introduce other comprehensive income and accumulated other comprehensive income now, due to its complexity, and we explore in much more detail in future posts.

Revenue and gains increase retained earnings, whereas expenses, losses, and distributions to owners (dividends) decrease retained earnings. We represent retained earnings in equation form as follows:

(4.3)

Ending Retained Earnings = Beginning Retained Earnings + Revenues + Gains - Expenses - Losses - Dividends Declared

When revenues and gains exceed expenses, losses, and dividends over time, retained earnings is positive. Retained earnings is negative when expenses, losses, and dividends exceed revenues and gains over time. A negative balance in retained earnings is called a deficit. We review definitions of each of these terms in Exhibit 4.3. 

EXHIBIT 4.3 Expanded Accounting Equation Elements (U.S. GAAP definitions from FASB Concepts Statements No. 6. Elements of Financial Statements. IFRS definitions are somewhat different, but these differences do not affect the explanations of the steps in the accounting cycle.)

Exhibit 4.4 presents the components of stockholders' equity graphically. Consistent with Equation 4.2, stockholders' equity is comprised of contributed capital, ending retained earnings, and accumulated other comprehensive income. Also, ending retained earnings is equal to beginning retained earnings and is increased by net income and decreased by net losses and dividends. Net income (and net loss) is increased by revenues and gains and decreased by expenses and losses.

EXHIBIT 4.4 Components of Stockholders' Equity

Given Equations 4.2 and 4.3, we expand the basic accounting equation to represent the elements of stockholders' equity as follows:

This expanded equation allows companies to analyze complex transactions, which will be illustrated in an example in the next post. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ALGEBRA, 2ND ED., PP. 91-95*

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Accounting: The Language of Business - Vol. 2 (Intermediate: Part 23)

And just remember, every dollar we spend on outsourcing is spent on U.S. goods or invested back in the U.S. market. That's accounting.

Arthur Laffer

Judgment and Applied Financial Accounting Research (Part H)

by

Charles Lamson

Applying the Research Process

Building research skills is critical to success in the accounting profession. The significant volume of accounting standards makes it impossible to commit them to memory. In addition, the business environment is constantly changing, requiring revisions of accounting standards. Nonetheless, professionals must be able to find the answers to technical accounting questions in order to function effectively on a day-to-day basis. Acquiring research skills takes a great deal of practice. To illustrate, let's take the case of deciding whether to capitalize or expense certain costs incurred during the production process (Example 3.2).

EXAMPLE 3.2

The Financial Reporting Research Process

PROBLEM: Tough Guy Enterprises, a U.S. GAAP reporter, manufactures high quality jeans for little boys. The cost to produce one pair of jeans includes $10 of material and $5 for labor. Tough Guy produced the following number of genes over the last 5 years:

Additional data are available for the current year (Year 6):

Search the Codification to determine how to record each type of cost. Write a memo to the file to communicate your results.

SOLUTION: We will follow the steps in the financial accounting research process.

1. Establish and understand the facts.

The facts are straightforward, as captured in the problem statement. In real-world problems, the facts are typically more difficult to identify. 

Tough Guy Enterprises is a U.S. GAAP reporter that manufactures jeans. It produced the following number of jeans over the past five years:

 Additional facts for the current year or Year 6:

2. Identify the issue: What is the research question?

The accounting issue is whether Tough Guy should record expenditures as an expense (expensed) or as an asset (capitalized as part of the cost of inventory) and included in cost of goods sold when the inventory is sold. As a result, the research question is which of these expenditures should Tough Guy allocate to inventory and which should it expense immediately?

3. Search the authoritative literature.

We begin our search using Codification Topic 330 – Inventory (Appendix A from part 20). None of the industry subtopics is relevant (agriculture, airlines, contractors, entertainment, extractive activities, real estate, software). Next, we review the Overall subtopic, ASC 330–10. Because we are interested in the way Tough Guy will initially record inventory, we will use Section 30 – Initial Measurement of ASC 330–10.

4. Evaluate the results of the search.

A thorough review of Section 30 identifies the relevant parts of the Codification to use in developing a conclusion, as summarized next.

5. Develop conclusions.

The conclusions are clear in this case with one exception: fixed overhead allocation. The allocation of the fixed production overhead is more complex than the other costs. According to ASC 330-10-30–3, the allocation of fixed production overhead is based on the normal capacity of the production facility. Normal capacity is the production expected to be achieved over a number of periods and under normal circumstances. In this case, we estimate normal capacity at 5 million pairs of jeans per year, which is the average of the prior five years of production (5.0, 5.1, 4.9, 4.8, and 5.2 million). Thus, we would allocate $1 per pair of jeans to inventory (the fixed overhead of $5 million dollars divided by the normal capacity of 5 million pairs of jeans). The total amount of fixed overhead allocated to inventory is $4.2 million ($1 per pair * 4.2 million pairs produced during the current year).

The following table lists the expenditures and their proper accounting treatment (expense versus capitalize).

6. Communicate the results of the research.

     The following memo to the file documents the results of the research.   

MEMORANDUM TO THE FILE

FACTS

Tough Guy Enterprises manufactures jeans and is a U.S. GAAP reporter. The company produced 4.2 million pairs of jeans in the current year and the following number of jeans over the preceding five years:

Tough Guy has incurred the following expenditures related to its gene production during the current year: 

ISSUE

Which of these expenditures should Tough Guy allocate to inventory and which should it expense immediately?

ANALYSIS

ASC 330-10-30–1 indicates that inventory is typically stated at cost (i.e., the cost incurred to bring the inventory to its existing condition and location).

ASC 330–10-30-3 states that variable production overhead costs are allocated to each unit of production on the basis of the actual use of the production facilities. The allocation of fixed production overhead is based on the normal capacity of the production facility where normal capacity is defined as the production expected to be achieved over a number of periods and under normal circumstances. ASC 330–10-30–6 allows the actual level of production to be used if it approximates normal capacity.

ASC 330–10-30-6 explains that the amount of fixed overhead allocated to each unit of production should not be increased in periods of abnormally low production.

ASC 330–10-30–7 requires that unallocated overhead costs be recognized in the period they are incurred and that wasted materials (spoilage) be recognized in the period they are incurred.

ASC 330–10-30-8 stipulates that general and administrative expenses should typically be recognized as expenses if they are not clearly related to production. Also, selling costs should not be included in inventory.

CONCLUSION

The conclusions are clear in this case with no exception: fixed overhead allocation. The allocation of the fixed production overhead is more complex than the other costs. According to ASC 330-10-30–3, the allocation of fixed production overhead is based on the normal capacity of the production facility. Normal capacity is the production expected to be achieved over a number of periods and under normal circumstances. In this case, we estimate normal capacity at 5 million pairs of jeans per year, which is the average of the prior five years of production (5.0, 5.1, 4.9, 4.8, and 5.2 million). Thus, we would allocate $1 per pair of jeans in inventory (the fixed overhead of $5 million divided by the normal capacity of 5 million pairs of jeans).

In conclusion, Tough Guy should allocate $73.5 million to inventory and expense $6.25 million immediately. Specifics of this allocation are detailed in the following table.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 71-75*                          

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Crown Chakra Positive Energy, Frequency of God, 963Hz, Healing Frequency...

Accounting: The Language of Business - Vol. 2 (Intermediate: Part 22)

When I hear health professionals suggesting that you shouldn't worry about the balance of calories in versus calories out, but rather eat clean and follow your hunger instincts, well, I really just want to pinch their heads off. That's like a millionaire suggesting that instead of worrying about what's in your bank account, just listen to your shopping instincts and buy high-quality goods . . . weight loss is not magic. To a great extent, it's accounting.

Chalene Johnson

Judgement and applied Financial Accounting research (part G)

by

Charles Lamson

Steps in the Applied Financial Accounting Research Process

If you have been following along (parts 15-21), you should be familiar with the form and content of the authoritative literature. We will now outline the six steps used in the financial reporting research process. These steps are presented in Exhibit 3.9 and discussed more extensively below. Financial statement preparers as well as auditors can use this process.

EXHIBIT 3.9 Steps in the Financial Accounting Research Process

Step 1: Establish and Understand the Facts

The first step in the research process is to understand the facts involved in the business transaction. What exactly does the business transaction look like? What parties are involved and how? What are the stipulations specified in any relevant contract? What is the timing of the transaction(s)? 

The way the facts are presented to the accountant will vary in practice. The facts may be conveyed to you in a concise and thorough manner. For example, your manager may explain the transaction to you at an audit team meeting or a client may email the information. Alternatively, you may need to spend a significant amount of time establishing the facts by talking to the parties involved or reading through documents.

Regardless of the manner in which the facts are initially presented, it is critical that the researcher thoroughly understand the business transaction. Misunderstood facts will often lead to incorrect conclusions.

Step 2: Identify the Issue: What is the Research Question?

After establishing the fact pattern associated with the business transaction, the researcher needs to identify the issue. That is, the researcher needs to determine the exact research question. For example, a research question might be, "Should ABC company recognize the revenue associated with this business transaction in the current fiscal year or the next fiscal year?" Typically, the research question (or issue) can be articulated in just a few sentences.

Step 3: Search the Authoritative Literature

Searching the authoritative literature can take a considerable amount of time, depending on the specific research question, even for experienced accountants. Understanding the structure of the Codification (Due to the large volume of diverse and complex standards, the body of U.S. GAAP became difficult to use. In response to this problem, the Financial Accounting Standards Board (FASB) developed the Financial Accounting Standards Board Accounting Standards Codification (ASC), often referred to as the Codification, which groups and summarizes all current standards by topic.) is invaluable for completing this step. Because the Codification is organized by topic, the research typically begins by identifying the appropriate topic to examine. For example, when researching an issue related to inventory, begin with Topic 330 – Inventory. It is sometimes possible to refine the search further, depending on the nature of the research question. If your question related to inventory was an issue as to how to initially record an item of inventory, you would most likely begin at ASC 330–10-30-10 - Inventory – Overall – Initial Measurement.

When searching the authoritative literature, you will often see cross references to other Codification topics. For example, if you were researching an issue related to disclosure requirements for inventory, you would start in ASC 330–10-50 Inventory - Overall – Disclosure. However, Paragraph 6 relates to disclosures of significant estimates and provides a cross reference to ASC 270 5-10–50 Risks and Uncertainties – Overall – Disclosure. Always check the applicability of cross references to be certain that you have done a thorough search of the literature.

You should also be aware that the Codification includes a search engine. Thus, if you are unsure where to start your research or you are unsure whether you have found all of the appropriate literature, you may want to search for various terms within the Codification using the search engine.

Step 4: Evaluate the Results of the Search

After you have found all the relevant authoritative literature, take the time to read it thoroughly, keeping in mind that much of the language used is highly technical and complex.

You may find that after reading through the authoritative literature, you need to change or refine the research question. Thus, these steps can be an iterative process [relating to or involving iteration (repetition of a mathematical or computational procedure applied to the result of a previous application, typically as a means of obtaining successively closer approximations to the solution of a problem)]. In fact, sometimes you will discover that you need to obtain additional facts related to the business transaction and return to Step 1.

Step 5: Develop Conclusions

After assimilating the relevant literature, decide on the best financial reporting treatment. Sometimes, there is only one correct answer. In other cases, the answer may not exist in the literature, particularly in Level 1 of the hierarchy. Accountants use judgment to work down the levels of the hierarchy and sometimes have to utilize a similar transaction that is covered in the authoritative literature. Other times, there are multiple legitimate treatments found in the accounting standards. Accountants compare the various treatments and identify the alternative that will result in the most faithful representation of the economic event.

Step 6: Communicate the Results of the Research

After finishing the first five steps, the accountant documents and communicates the results of the research process. This documentation may be done in a variety of forms such as a memo to the file or a client letter. The information included depends upon the audience, but it will most likely include documentation from all of the preceding steps:

• The facts of the business transaction.

• The research question.

• The analysis of the issue (i.e., a summary of the authoritative literature).

• The recommendation.

When articulating your research and recommendation in written form, write clearly and concisely to address the research question and communicate all relevant information. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 69-70*

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