Tag Archives | accounting

Debit vs Credit

Debit vs Credit

Since the late 13th century, people have discussed debit vs credit. It was numerous centuries ago that double entry accounting was conceived. Now, it is an international standard to record all business transactions with a debit and a credit. This double entry keeps the accounting equation balanced and ensures that one account is not left out of a transaction. If a mistake is made, it often results in an unbalanced ledger.

Should You Learn It?

Even though accounting software guides you along the double entry process, it is still important to understand the debit and credit rules. This gives you the ability to correct mistakes and edit your company’s books. Without knowing the fundamentals of double entry accounting, you run the risk of keeping inaccurate records that may be beyond repair.

Entrepreneurs are often guilty of not truly understanding accounting and their company’s financial statements. Understanding these begins with grasping the debit and credit rules. These rules are part of a bigger concept: keeping the assets equal to the liabilities plus shareholders’ equity.

What are the rules?

The basic rules state whether an account increase or decreases with a debit or credit. Asset accounts and expense accounts increase with debits and decrease with credits. This means you debit cash to increase the cash account. It also means you debit your COGS to increase your cost of goods account. On the other hand, liabilities, revenues, and shareholders’ equity increase with credits and decrease with debits.

While these rules are not instinctual, they have helped businesses keep accurate records for centuries. The extra work to record a debit and credit for each transaction helps prevent errors as well as making mistakes easier to identify.

 

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Cash Accounting vs. Accrual Accounting

See Also:

Accrual Based Accounting

Generally Accepted Accounting Principles (GAAP)

 

Cash Accounting vs. Accrual Accounting

There are two different types of accounting that businesses use: cash accounting and accrual accounting. Most businesses use accrual accounting, but it varies by the type of business. These two methods are both legal and accepted by the Internal Revenue Service. The primary difference between the two is when income and expenses are recorded in the books. When thinking about cash basis accounting, picture a lemonade stand. When thinking about accrual basis accounting, imagine a grocery store.

Define Cash Basis Accounting

Cash accounting is simply recording transactions in the books when money changes hands. This excludes accounts payable, accounts receivable, and anything that has not caused a monetary transaction. A lemonade stand would use cash accounting because of its simplicity. The books of a small juice stand would not reflect payables on credit from suppliers. It would not show an anticipated receivable from customers. Another example of a cash accounting business might be a consultant. By deciding the most tax-friendly times for payments and expenses during the year, a consultant can minimize taxes due. This is not tax invasion; it is just deciding when he or she will collect payments for his or her services.

Some argue that this method fails to adhere to the matching principle. In cash accounting, revenues and expenses from the same period are not recorded as accurately. For example, if you sell 100,000 widgets in December but receive payment in January, cash basis accounting will recognize that revenue in January—the next accounting year. This can have unwanted effects on how much taxes are due.

Define Accrual Basis Accounting

Accrual accounting is the widely-accepted method for most businesses. In fact, some businesses are required to use accrual basis, depending on the amount of sales. Accrual basis accounting records transactions when they are made. This means sales are recorded before the money enters the company even if the product or service was sold on credit. It also means that expenses are recorded as they are accrued.

Here’s another example to exemplify the difference: a company decides to purchase all new inventory. The entire purchase is realized even if it is not paid for yet. Think of the implications of this at the end of a year. A company could make a large purchase at the end of the year to minimize the taxes due for that period. This will increase revenue, and therefore taxes, for the following year. This example shows it is possible to distort the matching of income and expenses using accrual basis as well as cash basis accounting.

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Operating Cycle Definition

See Also:
Operating Cycle Analysis

Operating Cycle Definition

The Operating cycle definition, also known as cash operating cycle or cash conversion cycle or asset conversion cycle, establishes how many days it takes for a company to turn purchases of inventory into cash receipts from its eventual sale. Operating cycle has three components of payable turnover days, Inventory Turnover days and Accounts Receivable Turnover days. These come together to form the complete measurement of operating cycle days. The operating cycle formula and operating cycle analysis stems logically from these. To be more specific, the payable turnover days are the period of time in which a company keeps track of how quickly they can pay off their financial obligations to suppliers. The next step, inventory turnover, is the ratio that indicates how many times a company sells and replaces their inventory over time. Usually, this ratio is calculated by taking the overall sales and dividing it by the overall inventory. However, the ratio can also be calculated by taking the cost of goods sold and dividing it by the average inventory. The final step, the accounts receivable turnover days, encase the period of time in which the company is evaluated on how fast they can receive payments for their sales. As said before, when all of these steps are put together the operating cycle is complete

Operating Cycle Applications

The operating cycle concept indicates a company’s true liquidity. By tracking the historical record of the operating cycle of a company and comparing it to its peer groups in the same industry, it gives investors investment quality of a company. A short company operating cycle is preferable since a company realizes its profits quickly and allows a company to quickly acquire cash that can be used for reinvestment. A long business operating cycle means it takes longer time for a company to turn purchases into cash through sales. In general, the shorter the cycle, the better a company is since less time capital is tied up in the business process. In other words, it is in a business’ best interest to shorten the business cycle over time. The easiest way to do this is to try to shorten each of the three cycle sections by, at least, a small amount. The aggregate change that comes from the shortening of these sections can create a significant change in the overall business cycle which can consequently lead to a more successful business.

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Variable vs Fixed Costs

See Also:
Absorption vs Variable Costing
Semi Variable Costs
Sunk Costs
Marginal Costs
Average Cost

Variable vs Fixed Cost

Define Fixed and Variable Costs

In accounting, a distinction is often made between variable costs and fixed costs. Variable costs change with activity or production volume. Fixed costs remain constant regardless of activity or production volume.

In accounting, all costs can be described as either fixed costs or variable costs. Variable costs are inventoriable costs – they are allocated to units of production and recorded in inventory accounts, such as cost of goods sold. Fixed costs, on the other hand, are all costs that are not inventoriable costs. All costs that do not fluctuate directly with production volume are fixed costs. Fixed costs include indirect costs and manufacturing overhead costs.

When comparing fixed costs to variable costs, or when trying to determine whether a cost is fixed or variable, simply ask whether or not the particular cost would change if the company stopped its production or primary business activities. If the company would continue to incur the cost, it is a fixed cost. If the company would no longer incur the cost, then it is most likely a variable cost.

Variable Cost, Fixed Cost – Examples

For example, if a telephone company charges a per-minute rate, then that would be a variable cost. A twenty minute phone call would cost more than a ten minute phone call. A good example of a fixed cost is rent. If a company rents a warehouse, it must pay rent for the warehouse whether it is full of inventory or completely vacant.

Other examples of fixed costs include executives’ salaries, interest expenses, depreciation, and insurance expenses. Examples of variable costs include direct labor and direct materials costs.

Fixed and Variable Costs and Decision-Making

When making production-related decisions, should managers consider fixed costs or only variable costs? Generally speaking, variable costs are more relevant to production decisions than fixed costs.

For example, if a manager is deciding between keeping production levels constant or increasing production, the primary factors in this decision will be the variable or incremental costs of the production of additional units of output, and not the fixed costs related to the operations that cannot be altered and will not change with the level of production. Therefore, in most straightforward instances, fixed costs are not relevant for production decision, and incremental costs, or variable costs, are relevant for these decisions.

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Translation Exposure

See Also:
Transaction Exposure
Currency Swap
Exchange Traded Funds
Hedge Funds
Fixed Income Securities

Translation Exposure

Translation exposure is a type of foreign exchange risk faced by multinational corporations that have subsidiaries operating in another country. It is the risk that foreign exchange rate fluctuations will adversely affect the translation of the subsidiary’s assets and liabilities – denominated in foreign currency – into the home currency of the parent company when consolidating financial statements. Translation exposure is also called accounting exposure, or translation risk.

Translation exposure can affect any company that has assets or liabilities that are denominated in a foreign currency or any company that operates in a foreign marketplace that uses a currency other than the parent company’s home currency. The more assets or liabilities the company has that are denominated in a foreign currency, the greater the translation risk.

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Ultimately, for financial reporting, the parent company will report its assets and liabilities in its home currency. So when the parent company is preparing its financial statements, it must include the assets and liabilities it has in other currencies. When valuing the foreign assets and liabilities for the purpose of financial reporting, all of the values will be translated into the home currency. Therefore foreign exchange rate fluctuations actually change the value of the parent company’s assets and liabilities. This is essentially the definition of accounting exposure.

Accounting Exposure Example

Here is a simplified example of accounting exposure. Assume the domestic division of a multinational company incurs a net operating loss of $3,000. But at the same time, a foreign subsidiary of the company made of profit of 3,000 units of foreign currency. At the time, the exchange rate between the dollar and the foreign currency is 1 to 1. So the foreign subsidiary’s profit exactly cancels out the domestic division’s loss.

Before the parent company consolidates its financial reports, the exchange rate between the dollar and the foreign currency changes. Now 1 unit of foreign currency is only worth $.50. Suddenly the profit of the foreign subsidiary is only worth $1,500 and it no longer cancels out the domestic division’s loss. Now the company as a whole must report a loss. This is a simplified example of translation exposure.

Hedging Translation Risk

A company with foreign operations can protect against translation exposure by hedging. The company can protect against the translation risk by purchasing foreign currency, by using currency swaps, by using currency futures, or by using a combination of these hedging techniques. Any one of these techniques can be used to fix the value of the foreign subsidiary’s assets and liabilities to protect against potential exchange rate fluctuations.

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Translation Exposure

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Translation Exposure

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Standard Chart of Accounts

See Also:
Chart of Accounts (COA)
Problems in Chart of Accounts Design
Complex Number for SGA Expenses

Standard Chart of Accounts

In accounting, a standard chart of accounts is a numbered list of the accounts that comprise a company’s general ledger. The company chart of accounts is basically a filing system for categorizing all of a company’s accounts and classifying all transactions according to the accounts they affect. The chart of accounts list of categories may include assets, liabilities, owners’ equity, revenues, cost of goods sold, operating expenses, and other relevant accounts. (See chart of accounts example below). The standard chart of accounts is sometimes also called the uniform chart of accounts. A chart of accounts template is used to prepare the basic chart of accounts for any subsidiary companies or related entities in order to make consolidation easier.

A standard chart of accounts is organized according to a numerical system. Each major category will begin with a certain number, and then the sub-categories within that major category will all begin with the same number. For example, if assets are classified by numbers starting with the digit 1, then cash accounts might be labeled 101, accounts receivable might be labeled 102, inventory might be labeled 103, and so on. And if liabilities accounts are classified by numbers starting with the digit 2, then accounts payable might be labeled 201, short-term debt might be labeled 202, and so on.

Depending on the size of the company, the chart of accounts may include a few dozen accounts or it may include a few thousand accounts. Depending on the sophistication of the company, the chart of accounts can be paper-based or computer-based. The chart of account is useful for analyzing past transactions and using historic data to forecast future trends.

Below is an example of chart of accounts that may be used to set up the general ledger of most companies. You may customize your COA to your industry by adding to the Inventory, Revenue and Cost of Goods Sold sections to the sample chart of accounts.

SAMPLE CHART OF ACCOUNTS

1000 ASSETS

1010 CASH Operating Account
1020 CASH Debitors
1030 CASH Petty Cash

1200 RECEIVABLES

1210 A/REC Trade
1220 A/REC Trade Notes Receivable
1230 A/REC Installment Receivables
1240 A/REC Retainage Withheld
1290 A/REC Allowance for Uncollectible Accounts

1300 INVENTORIES

1310 INV – Reserved
1320 INV – Work-in-Progress
1330 INV – Finished Goods
1340 INV – Reserved
1350 INV – Unbilled Cost & Fees
1390 INV – Reserve for Obsolescence

1400 PREPAID EXPENSES & OTHER CURRENT ASSETS

1410 PREPAID – Insurance
1420 PREPAID – Real Estate Taxes
1430 PREPAID – Repairs & Maintenance
1440 PREPAID – Rent
1450 PREPAID – Deposits

1500 PROPERTY PLANT & EQUIPMENT

1510 PPE – Buildings
1520 PPE – Machinery & Equipment
1530 PPE – Vehicles
1540 PPE – Computer Equipment
1550 PPE – Furniture & Fixtures
1560 PPE – Leasehold Improvements

1600 ACCUMULATED DEPRECIATION & AMORTIZATION

1610 ACCUM DEPR Buildings
1620 ACCUM DEPR Machinery & Equipment
1630 ACCUM DEPR Vehicles
1640 ACCUM DEPR Computer Equipment
1650 ACCUM DEPR Furniture & Fixtures
1660 ACCUM DEPR Leasehold Improvements

1700 NON – CURRENT RECEIVABLES

1710 NCA – Notes Receivable
1720 NCA – Installment Receivables
1730 NCA – Retainage Withheld

1800 INTERCOMPANY RECEIVABLES

 

1900 OTHER NON-CURRENT ASSETS

1910 Organization Costs
1920 Patents & Licenses
1930 Intangible Assets – Capitalized Software Costs

2000 LIABILITIES

 

2100 PAYABLES

2110 A/P Trade
2120 A/P Accrued Accounts Payable
2130 A/P Retainage Withheld
2150 Current Maturities of Long-Term Debt
2160 Bank Notes Payable
2170 Construction Loans Payable

2200 ACCRUED COMPENSATION & RELATED ITEMS

2210 Accrued – Payroll
2220 Accrued – Commissions
2230 Accrued – FICA
2240 Accrued – Unemployment Taxes
2250 Accrued – Workmen’s Comp
2260 Accrued – Medical Benefits
2270 Accrued – 401 K Company Match
2275 W/H – FICA
2280 W/H – Medical Benefits
2285 W/H – 401 K Employee Contribution

2300 OTHER ACCRUED EXPENSES

2310 Accrued – Rent
2320 Accrued – Interest
2330 Accrued – Property Taxes
2340 Accrued – Warranty Expense

2500 ACCRUED TAXES

2510 Accrued – Federal Income Taxes
2520 Accrued – State Income Taxes
2530 Accrued – Franchise Taxes
2540 Deferred – FIT Current
2550 Deferred – State Income Taxes

2600 DEFERRED TAXES

2610 D/T – FIT – NON CURRENT
2620 D/T – SIT – NON CURRENT

2700 LONG-TERM DEBT

2710 LTD – Notes Payable
2720 LTD – Mortgages Payable
2730 LTD – Installment Notes Payable

2800 INTERCOMPANY PAYABLES

 

2900 OTHER NON CURRENT LIABILITIES

3000 OWNERS EQUITIES

3100 Common Stock
3200 Preferred Stock
3300 Paid in Capital
3400 Partners Capital
3500 Member Contributions
3900 Retained Earnings

4000 REVENUE

4010 REVENUE – PRODUCT 1
4020 REVENUE – PRODUCT 2
4030 REVENUE – PRODUCT 3
4040 REVENUE – PRODUCT 4
4600 Interest Income
4700 Other Income
4800 Finance Charge Income
4900 Sales Returns and Allowances
4950 Sales Discounts

5000 COST OF GOODS SOLD

5010 COGS – PRODUCT 1
5020 COGS – PRODUCT 2
5030 COGS – PRODUCT 3
5040 COGS – PRODUCT 4
5700 Freight
5800 Inventory Adjustments
5900 Purchase Returns and Allowances
5950 Reserved

6000 – 7000 OPERATING EXPENSES

6010 Advertising Expense
6050 Amortization Expense
6100 Auto Expense
6150 Bad Debt Expense
6200 Bank Charges
6250 Cash Over and Short
6300 Commission Expense
6350 Depreciation Expense
6400 Employee Benefit Program
6550 Freight Expense
6600 Gifts Expense
6650 Insurance – General
6700 Interest Expense
6750 Professional Fees
6800 License Expense
6850 Maintenance Expense
6900 Meals and Entertainment
6950 Office Expense
7000 Payroll Taxes
7050 Printing
7150 Postage
7200 Rent
7250 Repairs Expense
7300 Salaries Expense
7350 Supplies Expense
7400 Taxes – FIT Expense
7500 Utilities Expense
7900 Gain/Loss on Sale of Assets

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Realized and Unrealized Gains and Losses

See Also:
Accounting Income vs Economic Income
Capital Gains
Proforma Earnings
Operating Income
Net Income
Asset Market Value vs Asset Book Value

Realized and Unrealized Gains and Losses

In accounting, there is a difference between realized and unrealized gains and losses. Realized income or losses refer to profits or losses from completed transactions. Unrealized profit or losses refer to profits or losses that have occurred on paper, but the relevant transactions have not been completed. An unrealized gain or loss is also called a paper profit or paper loss, because it is recorded on paper but has not actually been realized.

Realized income or losses are recorded on the income statement. These represent gains and losses from transactions that have been completed and recognized. Unrealized income or losses are recorded in an account called accumulated other comprehensive income, which is found in the owners equity section of the balance sheet. These represent gains and losses from changes in the value of assets or liabilities that have not yet been settled and recognized.

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Realized – Unrealized Examples

If a company owns an asset, and that asset increases in value, then it may intuitively seem like the company earned a profit on that asset. For example, say a company owns $10,000 worth of stock. Then the value of that stock rises to $15,000. On paper, the company made a paper profit of $5,000. However, the company cannot record the $5,000 as income.

This unrealized gain will not be realized until the company actually sells the stock and collects the cash. Until the stock is sold, the paper profit of $5,000 can only be recorded as an unrealized profit in the accumulated other comprehensive income account in the owners’ equity section of the balance sheet.

Once the company actually sells the stock, the unrealized gain is realized. Only after the stock is sold, the transaction is completed, and the cash is collected, can the company report the income as realized income on the profit and loss statement.

Similarly, if a company owns an asset, and that asset decreases in value, then it may intuitively seem like the company incurred a loss on that asset. For example, say a company owns $10,000 worth of stock. Then the value of that stock plunges to $5,000. On paper, the company suffered a paper loss of $5,000. However, the company cannot record the $5,000 as a loss on the income statement.

This paper loss will not be realized until the company actually sells the stock and takes the actual loss. Until the stock is sold, the paper loss of $5,000 can only be recorded as an unrealized loss in the accumulated other comprehensive income account in the owners’ equity section of the balance sheet.

Once the company actually sells the stock, the unrealized loss becomes realized. Only after the stock is sold, the transaction is completed, and the cash changes hands, can the company report the loss as a realized loss on the income statement.

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realized and unrealized gains and losses

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