Dividends
Shareholders are entitled to a share of the profits made by the company.
Dividends are appropriations of profit after tax.
A company might pay dividends in two stages during the course of their accounting year:
In mid year, after the half year financial results are known, the company might pay an interim dividend.
At the end of the year, the company might pay a further final dividend.
The total dividend for the year is the sum of the interim and the final dividend. Not all companies pay an interim dividend. Interim dividends are, however, commonly paid out by public limited companies.
At the end of an accounting year, a company’s directors may have proposed a final dividend payment, which has not yet been paid. This means that the final dividend should be appropriated out of profits and shown as a current liability in the balance sheet.
Profits re-invested
Not all profits are distributed as dividends; some will be retained in the business to finance future projects. The “market value” of the share should, all other thing being equal, be increased if these projects are profitable.
The Share premium
By “premium” is meant the difference between the issue price of the share and its nominal value. When a company is first incorporated the issue price of its shares will probably be the same as their nominal value and so there would be no share premium. If the company does well the market value of its shares will increase, but not the nominal value. The price of any new shares issued will be approximately their market value.
The companies act states that “where a company issues shares at a premium, whether for cash or otherwise, a sum equal to the premiums on those shares shall be transferred to the share premium account”.
A share premium account is an account into which sums received as payment for shares in excess of their nominal value must be placed.
The share premium account cannot be distributed as dividend under any circumstances.
Types of Shares
We can distinguish three types of shares,
Preference shares
Deferred shares
Ordinary shares
Preference shares
Preference shares are shares which confer certain preferential rights on their holders.
The rights attaching to preference shares are set out in the company’s contribution. They may vary from company to company, but typically:
Preference shareholders have a priority right over ordinary shareholders to a return of their capital if the company goes into liquidation.
Preference shares do not carry a right to vote.
If the preference shares are cumulative, it means that before a company can pay an ordinary dividend it must not only pay the current year’s preference dividend, but must also make good any arrears of preference dividends unpaid in previous years.
Deferred shares
Deferred shares are equity shares that will receive a dividend only after other classes of shares including ordinary shares have received a specified rate of dividend, or will receive a dividend only after a specified time from issue.
Ordinary shares
Ordinary shares are shares which are not preferential with regard to dividend payments. Thus a holder only receives a dividend after fixed dividends have been paid to preference shareholders.
Ordinary shares normally carry voting rights; they are effective owners of a company. They own the “equity” of the business, and any reserves of the business belong to them.
Share Capital
The net fixed assets of a company, plus the working capital (i.e. current assets minus current liabilities) minus the long term liabilities, are “financed” by the shareholders’ capital.
Shareholders’ capital consists of both:
>The nominal value of issued capital (minus any amounts not yet called up on issued shares
>Reserves.
The share capital itself might consist of both ordinary shares and preference shares. All reserves, however, are owned by the ordinary shareholders, who own the “equity” in the company.
Reserves
A company’s share capital will remain fixed from year to year, unless new shares are issued. Reserves are difficult to define neatly since different reserves arise for different reasons, but it follows from the above that:
Reserves = net assets – share capital
So the total amount of reserves in a company varies, according to changes in the net assets of the business.
A distinction should be made between:
1)Statutory reserves, which are reserves which a company is required to set up by law, e.g., the revaluation reserve, and which are not available for the distribution of dividends.
2)Non statutory reserves, which are reserves consisting of profits which are distributable dividends, if the company so wishes.
Profit and Loss Reserves
The most significant non-statutory reserve is variously described as:
Revenue reserve
Retained profits
Retained earnings
Undistributed profits
Profit and loss account
Un-appropriated profits
These are profits earned by the company and not appropriated by dividends, taxation or other transfer to another reserves account.
Provided that a company is earning profits, this reserve generally increases from year to year, as most companies do not distribute all their profits as dividends. Dividends can be paid from it: even if a loss is made in one particular year, a dividend can be paid from previous years’ retained profits.
Very occasionally, you might come across a debt balance on the profit and loss account. This would indicate that the company has a accumulated losses.
Non Statutory Reserves
The company directors may choose to set up other reserves. These may have a specific purpose (e.g. plant and machinery replacement reserve) or not (e.g. general reserve). The creation of these reserves usually indicates a general intention not to distribute the profits involved at any future date, although legally any such reserves, being non-statutory, remain available for the payment of dividends.
Distinction between reserves and provisions
A reserve is an appropriation of distributable profits for a specific purpose while a provision is an amount charged against revenue as an expense. A provision relates either to a diminution in the value of an asset or a known liability, the amount of which cannot be established with any accuracy.
Provisions are dealt with in a company accounts in the same way as in the accounts of other types of business
Asset finance - introduction to hire purchase and leasing
Introduction
The acquisition of assets - particularly expensive capital equipment - is a major commitment for many businesses. How that acquisition is funded requires careful planning.
Rather than pay for the asset outright using cash, it can often make sense for businesses to look for ways of spreading the cost of acquiring an asset, to coincide with the timing of the revenue generated by the business.The most common sources of medium term finance for investment in capital assets are Hire Purchase and Leasing.
Leasing and hire purchase are financial facilities which allow a business to use an asset over a fixed period, in return for regular payments. The business customer chooses the equipment it requires and the finance company buys it on behalf of the business.
Many kinds of business asset are suitable for financing using hire purchase or leasing, including:
- Plant and machinery
- Business cars
- Commercial vehicles
- Agricultural equipment
- Hotel equipment
- Medical and dental equipment
- Computers, including software packages
-Office equipment
Hire purchase
With a hire purchase agreement, after all the payments have been made, the business customer becomes the owner of the equipment. This ownership transfer either automatically or on payment of an option to purchase fee.
For tax purposes, from the beginning of the agreement the business customer is treated as the owner of the equipment and so can claim capital allowances. Capital allowances can be a significant tax incentive for businesses to invest in new plant and machinery or to upgrade information systems.
Under a hire purchase agreement, the business customer is normally responsible for maintenance of the equipment.
Leasing
The fundamental characteristic of a lease is that ownership never passes to the business customer.
Instead, the leasing company claims the capital allowances and passes some of the benefit on to the business customer, by way of reduced rental charges.
The business customer can generally deduct the full cost of lease rentals from taxable income, as a trading expense.
As with hire purchase, the business customer will normally be responsible for maintenance of the equipment.
There are a variety of types of leasing arrangement:
Finance Leasing
The finance lease or 'full payout lease' is closest to the hire purchase alternative. The leasing company recovers the full cost of the equipment, plus charges, over the period of the lease.
Although the business customer does not own the equipment, they have most of the 'risks and rewards' associated with ownership. They are responsible for maintaining and insuring the asset and must show the leased asset on their balance sheet as a capital item.
When the lease period ends, the leasing company will usually agree to a secondary lease period at significantly reduced payments. Alternatively, if the business wishes to stop using the equipment, it may be sold second-hand to an unrelated third party. The business arranges the sale on behalf of the leasing company and obtains the bulk of the sale proceeds.
Operating Leasing
If a business needs a piece of equipment for a shorter time, then operating leasing may be the answer. The leasing company will lease the equipment, expecting to sell it secondhand at the end of the lease, or to lease it again to someone else. It will, therefore, not need to recover the full cost of the equipment through the lease rentals.
This type of leasing is common for equipment where there is a well-established secondhand market (e.g. cars and construction equipment). The lease period will usually be for two to three years, although it may be much longer, but is always less than the working life of the machine.
Assets financed under operating leases are not shown as assets on the balance sheet. Instead, the entire operating lease cost is treated as a cost in the profit and loss account.
Contract Hire
Contract hire is a form of operating lease and it is often used for vehicles.
The leasing company undertakes some responsibility for the management and maintenance of the vehicles. Services can include regular maintenance and repair costs, replacement of tyres and batteries, providing replacement vehicles, roadside assistance and recovery services and payment of the vehicle licences.
Equity finance - new share issues to the public: introduction
Introduction
There are three main ways of raising equity finance:
- Retaining profits in the business (rather than distributing them to equity shareholders);
- Selling new shares to existing shareholders (a "rights issue")
- Selling new shares to the general public and investing institutions
This revision note outlines the process involved in the third method above.
How significant are new issues of shares in the UK?
Issues of new shares to the public account for around 10% of new equity finance in the UK.
Whilst not significant in the overall context of UK equity financing, when new issues do occur, they are often large in terms of the amount raised.
New issues are usually used at the time a business first obtains a listing on the Stock Exchange. This process is called an Initial Public Offering (“IPO”) or a “flotation”.
Methods
The process of a stock market flotation can apply both to private and nationalised share issues. There are also several methods that can be used. These methods are:
• An introduction
• Issue by tender
• Offer for sale
• Placing, and
• A public issue
In practice the “offer for sale” method is the most common method of flotation. There is no restriction on the amount of capital raised by this method.
The general procedures followed by the various methods of flotation are broadly the same. These include
- Advertising, e.g. in newspapers
- Following legal requirements, and Stock Exchange regulations in terms of the large volumes of information which must be provided. Great expense is incurred in providing this information, e.g. lawyers, accountants, other advisors.
Why issue new shares on a stock exchange?
The following are reasons why a company may seek a stock market listing:
(1) Access to a wider pool of finance
A stock market listing widens the number of potential investors. It may also improve the company's credit rating, making debt finance easier and cheaper to obtain.
(2) Improved marketability of shares
Shares that are traded on the stock market can be bought and sold in relatively small quantities at any time. Existing investors can easily realise a part of their holding.
(3) Transfer of capital to other uses
Founder owners may wish to liquidate the major part of their holding either for personal reasons or for investment in other new business opportunities.
(4) Enhancement of company image
Quoted companies are commonly believed to be more financially stable. A stock exchange listing may improve the image of the company with its customers and suppliers, allowing it to gain additional business and to improve its buying power.
(5) Facilitation of growth by acquisition
A listed company is in a better position to make a paper offer for a target company than an unlisted one.
However, the owners of a private company which becomes a listed plc (public company) must accept that the change is likely to involve a significant loss of control to a wider circle of investors. The risk of the company being taken over will also increase following listing.
Equity finance
Introduction
What is equity?
Equity is the term commonly used to describe the ordinary share capital of a business.
Ordinary shares in the equity capital of a business entitle the holders to all distributed profits after the holders of debentures and preference shares have been paid.
Ordinary ( equity) shares
Ordinary shares are issued to the owners of a company. The ordinary shares of UK companies typically have a nominal or 'face' value (usually something like £1 or 5Op, but shares with a nominal value of 1p, 2p or 2Sp are not uncommon).
However, it is important to understand that the market value of a company's shares has little (if any) relationship to their nominal or face value. The market value of a company's shares is determined by the price another investor is prepared to pay for them. In the case of publicly-quoted companies, this is reflected in the market value of the ordinary shares traded on the stock exchange (the "share price").
In the case of privately-owned companies, where there is unlikely to be much trading in shares, market value is often determined when the business is sold or when a minority shareholding is valued for taxation purposes.
In your studies, you may also come across "Deferred ordinary shares". These are a form of ordinary shares, which are entitled to a dividend only after a certain date or only if profits rise above a certain amount. Voting rights might also differ from those attached to other ordinary shares.
Why might a company issue ordinary shares?
A new issue of shares might be made for several reasons:
(1) The company might want to raise more cash
For example might be needed for the expansion of a company's operations. If, for example, a company with 500,000 ordinary shares in issue decides to issue 125,000 new shares to raise cash, should it offer the new shares to existing shareholders, or should it sell them to new shareholders instead?
- Where a company sells the new shares to existing shareholders in proportion to their existing shareholding in the company, this is known as a "rights issue".
(2) The company might want to issue new shares partly to raise cash but more importantly to 'float' its shares on a stock market.
When a UK company is floated, it must make available a minimum proportion of its shares to the general investing public.
(3) The company might issue new shares to the shareholders of another company, in
order to take it over
There are many examples of businesses that use their high share price as a way of making an offer for other businesses. The shareholders of the target business being acquired received shares in the buying business and perhaps also some cash.
Sources of equity finance
There are three main methods of raising equity:
(1) Retained profits: i.e. retaining profits, rather than paying them out as dividends. This is the most important source of equity
(2) Rights issues: i.e. an issue of new shares. After retained profits, rights issues are the next most important source
(3) New issues of shares to the public: i.e. an issue of new shares to new shareholders. In total in the UK, this is the least important source of equity finance
Each these sources of equity finance are covered in separate tutor2u revision notes.
Introduction to business planning
What is the Business Plan?
The business plan sets out how the owners/managers of a business intend to realise its objectives. Without such a plan a business is likely to drift.
The business plan serves several purposes:it
(1)enables management to think through the business in a logical and structured way and to set out the stages in the achievement of the business objectives.
(2)enables management to plot progress against the plan (through the management accounts)
(3)ensures that both the resources needed to carry out the strategy and the time when they are required are identified.
(4)is a means for making all employees aware of the business's direction (assuming the key features of the business plan are communicated to employees)
(5)is an important document for for discussion with prospective investors and lenders of finance (e.g. banks and venture capitalists).
(6)links into the detailed, short-term, one-year budget.
The Link Between the Business Plan and the Budget
A budget can be defined as "a financial or quantitative statement", prepared for a specific accounting period (typically a year), containing the plans and policies to be pursued during that period.
The main purposes of a budget are:
(1)to monitor business unit and managerial performance (the latter possibly linking into bonus arrangements)
(2)to forecast the out-turn of the period's trading (through the use of flexed budgets and based on variance analyses)
(3)to assist with cost control.
Generally, a functional budget is prepared for each functional area within a business (e.g. call-centre, marketing, production, research and development, finance and administration). In addition, it is also normal to produce a "capital budget" detailing the capital investment required for the period, a "cash flow budget", a "stock budget" and a "master budget", which includes the budgeted profit and loss account and balance sheet.
Preparing a Business Plan
A business plan has to be particular to the organisation in question, its situation and time. However, a business plan is not just a document, to be produced and filed. Business planning is a continuous process. The business plan has to be a living document, constantly in use to monitor, control and guide the progress of a business. That means it should be under regular review and will need to be amended in line with changing circumstances.
Before preparing the plan management should:
- review previous business plans (if any) and their outcome. This review will help highlight which areas of the business have proved difficult to forecast historically. For example, are sales difficult to estimate? If so why?
- be very clear as to their objectives - a business plan must have a purpose
- set out the key business assumptions on which their plans will be based (e.g. inflation, exchange rates, market growth, competitive pressures, etc.)
- take a critical look at their business. The classical way is by means of the strengths-weaknesses-opportunities-threats (SWOT) analysis, which identifies the business's situation from four key angles. The strategies adopted by a business will be largely based on the outcome of this analysis.
Preparing the Budget
A typical business plan looks up to three years forward and it is normal for the first year of the plan to be set out in considerable detail. This one-year plan, or budget, will be prepared in such a way that progress can be regularly monitored (usually monthly) by checking the variance between the actual performance and the budget, which will be phased to take account of seasonal variations.
The budget will show financial figures (cash, profit/loss working capital, etc) and also non-financial items such as personnel numbers, output, order book, etc. Budgets can be produced for units, departments and products as well as for the total organisation. Budgets for the forthcoming period are usually produced before the end of the current period. While it is not usual for budgets to be changed during the period to which they relate (apart from the most extraordinary circumstances) it is common practice for revised forecasts to be produced during the year as circumstances change.
A further refinement is to flex the budgets, i.e. to show performance at different levels of business. This makes comparisons with actual outcomes more meaningful in cases where activity levels differ from those included in the budget.
What Providers of Finance Want from a Business Plan
Almost invariably bank managers and other providers of finance will want to see a business plan before agreeing to provide finance. Not to have a business plan will be regarded as a bad sign. They will be looking not only at the plan, but at the persons behind it. They will want details of the owner/managers of the business, their background and experience, other activities, etc. They will be looking for management commitment, with enthusiasm tempered by realism. The plan must be thought through and not be a skimpy piece of work. A few figures on a spreadsheet are not enough.
The plan must be used to run the business and there must be a means for checking progress against the plan. An information system must be in place to provide regular details of progress against plan. Bank managers are particularly wary of businesses that are slow in producing internal performance figures. Lenders will want to guard against risk. In particular they will be looking for two assurances:
(1)that the business has the means of making regular payment of interest on the amount loaned, and
(2)that if everything goes wrong the bank can still get its money back (i.e. by having a debenture over the business's assets). Forward-looking financial statements, particularly the cash flow forecast, are therefore of critical importance. The bank wants openness and no surprises. If something is going wrong it does not want this covered up, it wants to be informed - quickly.
Introduction to Venture Capital : Venture Capital: Empowering Businesses Through Risk Capital
Venture capital, often referred to as "risk capital," is a dynamic financial instrument that fuels the growth of innovative projects and businesses. In this comprehensive exploration, we delve into the intricate world of venture capital, shedding light on its nuances, sources, and pivotal role in fostering entrepreneurial endeavors.
Unveiling the Essence of Venture Capital
Venture capital represents a form of capital injection into businesses where inherent risk is entwined with the anticipation of future profits and cash flows. Unlike traditional loans, venture capital is invested as equity, giving investors a share in the business. This distinctive approach is characterized by a higher expected "rate of return," which compensates for the inherent risk.
Navigating the Landscape: Venture Capital in the UK
In the United Kingdom, venture capital finds its roots in both venture capital firms and "business angels," private investors. While this discussion primarily revolves around venture capital firms, it's worth noting that the investment criteria of both entities often align closely.
Deciphering Venture Capital
Venture capital unveils a long-term commitment, in the form of equity capital, that propels unquoted companies towards success. Whether launching a startup, expanding operations, acquiring a stake in a business, effecting a buyout, or rejuvenating a company, venture capital proves to be a catalyst. Unlike traditional debt, venture capital doesn't demand interest or principal repayment. Instead, it seeks returns tied to the business's growth and profitability, often realized during the "exit" phase when the business changes ownership.
A Historical Evolution: From Informality to Industry
The genesis of venture capital in the UK traces back to the 18th century when entrepreneurs secured ad hoc funding from affluent individuals. However, it wasn't until the late 20th century that venture capital solidified as an industry, with the establishment of numerous venture capital firms. Today, over 100 active venture capital firms in the UK channel billions of pounds annually into unquoted companies, bolstering the country's economic landscape.
Targeting the Right Ventures: Traits Attractive to Venture Capitalists
Venture capitalists set their sights on "entrepreneurial businesses" that exhibit the potential for substantial growth. It's not solely about size; rather, the focus is on the company's aspirations and growth trajectory. Enterprises destined for venture capital investment aim for rapid growth within a relatively short span. Ventures that cannot demonstrate significant turnover growth within five years tend to be less appealing to venture capitalists.
Venture Capital's Time Horizon: How Long is the Investment?
Typically, venture capital investments span three to seven years or more, influenced by the business's growth prospects. Mature businesses, poised for quicker performance improvements, are often divested sooner than early-stage or technology companies that require more time to refine their business models.
A Funding Journey: Sources of Venture Capital Funds
Venture capital firms, akin to the businesses they invest in, compete for funds. Their capital derives from various sources, primarily institutional investors such as pension funds and insurance companies. Demonstrating a robust track record and the potential for returns exceeding fixed interest or quoted equity investments is essential for securing funds.
Catalyzing Change: Venture Capital Trusts (VCTs)
Venture Capital Trusts (VCTs) present a unique investment avenue, incentivizing private investors to support smaller unlisted UK companies. Launched in 1995, VCTs offer tax incentives in exchange for a five-year investment commitment, primarily managed by UK venture capital firms.
Venturing into Success: The Investment Process Unveiled
The venture capital investment process, encompassing evaluation and execution, varies from one to twelve months. The pivotal initial evaluation phase scrutinizes business plans, with a significant portion of proposals being rejected. Venture capitalists assess the commercial viability, growth potential, management competency, risk-reward balance, and financial returns of potential investments.
Structuring Investment: A Palette of Equity Types
Venture capitalists tailor investments through various equity types:
Ordinary Shares: These equity shares carry full income and capital rights after satisfying other classes of capital. Typically held by management and family shareholders.
Preferred Ordinary Shares: These equity shares boast special rights, such as fixed dividends or profit shares.
Preference Shares: Non-equity shares that rank ahead of ordinary shares for income and capital. Their income rights are defined, often with a fixed dividend.
Loan Capital: Venture capital loans, often secured, bear interest and may be convertible into equity shares.
Augmenting Investment: Due Diligence and Beyond
Venture capitalists rigorously assess technical and financial feasibility during due diligence. External experts evaluate market prospects and technical viability, while accountants scrutinize financial projections. Management information systems, forecasting accuracy, and financial performance are thoroughly evaluated.
In essence, venture capital transcends conventional financing. It empowers startups, accelerates growth, and fuels innovation, culminating in a diverse entrepreneurial ecosystem that shapes economies and industries. As an instrument of risk and reward, venture capital heralds a new era of strategic investment and business expansion.
Business Angel Finance : Unveiling the Power of Business Angels
Securing business finance, especially within the range of £10,000 to £250,000, has been a challenge reported by numerous entrepreneurs. Traditional sources like banks and venture capitalists often come up short when it comes to funding such amounts. While banks demand collateral, venture capital firms typically bypass these smaller sums. This is where the concept of "Business Angels" steps in, reshaping the financing landscape for businesses in need.
Introducing Business Angels: Catalysts of Growth
Business angels are affluent, enterprising individuals who invest capital in exchange for a slice of the company's equity. Their investment entails a substantial personal risk, driven by the anticipation of owning a stake in a prospering and expanding enterprise. These individuals are drawn by the potential for substantial returns as the business thrives.
The Nexus of Angel Investment
For businesses to be deemed suitable for angel investment, several conditions must be met:
(1) Moderate Funding Needs: Angel investment typically ranges from £10,000 to £250,000. Equity finance beyond this threshold is more often facilitated by venture capital firms, unless a syndicate of business angels collaborates or they co-invest with venture capital funds. Embracing equity financing elevates the business's financial position, rendering it more appealing to banks for additional debt financing.
(2) Personal Engagement: Establishing a personal rapport with business angels is paramount. These investors seek a hands-on role in the business's management, contributing without necessarily assuming day-to-day control. Such relationships can substantially benefit the business, with business angels often providing expertise in areas like marketing and sales.
(3) Alluring Returns: Business angels expect substantial returns, usually averaging 20%–30% per annum. This anticipated return is predominantly realized through capital gains over a span of several years.
(4) Market Expertise: Businesses must showcase a profound comprehension of their products and markets. Business angels frequently specialize in offering "expansion finance" to well-established businesses or particular sectors. Robust market research-backed business plans are pivotal, particularly for startups seeking early-stage capital.
(5) Competent Management: A proficient management team is crucial, encompassing strong product and sales skills. Business angels can supplement skill gaps in the existing team or introduce new management, enhancing the business's capabilities.
(6) Exit Strategy: Business angels anticipate an "exit" strategy, even if not immediately. Common exit routes include trade sales to other companies, repurchasing of angel shares by the company, or the purchase of angel shares by directors or other investors.
Connecting with Angels: Finding the Right Match
Angel investments often stem from informal networks, including personal contacts, family, friends, and influential business connections. Formidable suppliers and key clients can also play a role. Formal angel networking organizations are another avenue to explore. Active business angels often rely on these networks to unearth promising investment opportunities.
Empowering Business Growth Through Angels
The role of business angels extends beyond capital injection; it encompasses mentorship, strategic guidance, and nurturing growth. In a landscape where conventional finance struggles, business angels emerge as pivotal partners, driving innovation, and propelling businesses toward prosperity.
Introduction to raising finance
When a company is growing rapidly, for example when contemplating investment in capital equipment or an acquisition, its current financial resources may be inadequate. Few growing companies are able to finance their expansion plans from cash flow alone. They will therefore need to consider raising finance from other external sources. In addition, managers who are looking to buy-in to a business ("management buy-in" or "MBI") or buy-out (management buy-out" or "MBO") a business from its owners, may not have the resources to acquire the company. They will need to raise finance to achieve their objectives.
There are a number of potential sources of finance to meet the needs of a growing business or to finance an MBI or MBO:
- Existing shareholders and directors funds
- Family and friends
- Business angels
- Clearing banks (overdrafts, short or medium term loans)
- Factoring and invoice discounting
- Hire purchase and leasing
- Merchant banks (medium to longer term loans)
- Venture capital
A key consideration in choosing the source of new business finance is to strike a balance between equity and debt to ensure the funding structure suits the business.
The main differences between borrowed money (debt) and equity are that bankers request interest payments and capital repayments, and the borrowed money is usually secured on business assets or the personal assets of shareholders and/or directors. A bank also has the power to place a business into administration or bankruptcy if it defaults on debt interest or repayments or its prospects decline.
In contrast, equity investors take the risk of failure like other shareholders, whilst they will benefit through participation in increasing levels of profits and on the eventual sale of their stake. However in most circumstances venture capitalists will also require more complex investments (such as preference shares or loan stock) in additional to their equity stake.
The overall objective in raising finance for a company is to avoid exposing the business to excessive high borrowings, but without unnecessarily diluting the share capital. This will ensure that the financial risk of the company is kept at an optimal level.
Business Plan
Once a need to raise finance has been identified it is then necessary to prepare a business plan. If management intend to turn around a business or start a new phase of growth, a business plan is an important tool to articulate their ideas while convincing investors and other people to support it. The business plan should be updated regularly to assist in forward planning.
There are many potential contents of a business plan. The European Venture Capital Association suggest the following:
- Profiles of company founders directors and other key managers;
- Statistics relating to sales and markets;
- Names of potential customers and anticipated demand;
- Names of, information about and assessment of competitors;
- Financial information required to support specific projects (for example, major capital investment or new product development);
- Research and development information;
- Production process and sources of supply;
- Information on requirements for factory and plant;
- Magazine and newspaper articles about the business and industry;
- Regulations and laws that could affect the business product and process protection
(patents, copyrights, trademarks).
The challenge for management in preparing a business plan is to communicate their ideas clearly and succinctly. The very process of researching and writing the business plan should help clarify ideas and identify gaps in management information about their business, competitors and the market.
Types of Finance - Introduction
A brief description of the key features of the main sources of business finance is provided below.
Venture Capital
Venture capital is a general term to describe a range of ordinary and preference shares where the investing institution acquires a share in the business. Venture capital is intended for higher risks such as start up situations and development capital for more mature investments. Replacement capital brings in an institution in place of one of the original shareholders of a business who wishes to realise their personal equity before the other shareholders. There are over 100 different venture capital funds in the UK and some have geographical or industry preferences. There are also certain large industrial companies which have funds available to invest in growing businesses and this 'corporate venturing' is an additional source of equity finance.
Grants and Soft Loans
Government, local authorities, local development agencies and the European Union are the major sources of grants and soft loans. Grants are normally made to facilitate the purchase of assets and either the generation of jobs or the training of employees. Soft loans are normally subsidised by a third party so that the terms of interest and security levels are less than the market rate. There are over 350 initiatives from the Department of Trade and Industry alone so it is a matter of identifying which sources will be appropriate in each case.
Invoice Discounting and Invoice Factoring
Finance can be raised against debts due from customers via invoice discounting or invoice factoring, thus improving cash flow. Debtors are used as the prime security for the lender and the borrower may obtain up to about 80 per cent of approved debts. In addition, a number of these sources of finance will now lend against stock and other assets and may be more suitable then bank lending. Invoice discounting is normally confidential (the customer is not aware that their payments are essentially insured) whereas factoring extends the simple discounting principle by also dealing with the administration of the sales ledger and debtor collection.
Hire Purchase and Leasing
Hire purchase agreements and leasing provide finance for the acquisition of specific assets such as cars, equipment and machinery involving a deposit and repayments over, typically, three to ten years. Technically, ownership of the asset remains with the lessor whereas title to the goods is eventually transferred to the hirer in a hire purchase agreement.
Loans
Medium term loans (up to seven years) and long term loans (including commercial mortgages) are provided for specific purposes such as acquiring an asset, business or shares. The loan is normally secured on the asset or assets and the interest rate may be variable or fixed. The Small Firms Loan Guarantee Scheme can provide up to £250,000 of borrowing supported by a government guarantee where all other sources of finance have been exhausted.
Mezzanine Debt
This is a loan finance where there is little or no security left after the senior debt has been secured. To reflect the higher risk of mezzanine funds, the lender will charge a rate of interest of perhaps four to eight per cent over bank base rate, may take an option to acquire some equity and may require repayment over a shorter term.
Bank Overdraft
An overdraft is an agreed sum by which a customer can overdraw their current account. It is normally secured on current assets, repayable on demand and used for short term working capital fluctuations. The interest cost is normally variable and linked to bank base rate.
Completing the finance-raising
Raising finance is often a complex process. Business management need to assess several alternatives and then negotiate terms which are acceptable to the finance provider. The main negotiating points are often as follows:
- Whether equity investors take a seat on the board
- Votes ascribed to equity investors
- Level of warranties and indemnities provided by the directors
- Financier's fees and costs
- Who bears costs of due diligence.
During the finance-raising process, accountants are often called to review the financial aspects of the plan. Their report may be formal or informal, an overview or an extensive review of the company's management information system, forecasting methods and their accuracy, review of latest management accounts including working capital, pension funding and employee contracts etc. This due diligence process is used to highlight any fundamental problems that may exist.
Introduction to Debits and Credits
If the words "debits" and "credits" sound like a foreign language to you, you are more perceptive than you realize—"debits" and "credits" are words that have been traced back five hundred years to a document describing today's double-entry accounting system.
Under the double-entry system every business transaction is recorded in at least two accounts. One account will receive a "debit" entry, meaning the amount will be entered on the left side of that account. Another account will receive a "credit" entry, meaning the amount will be entered on the right side of that account. The initial challenge with double-entry is to know which account should be debited and which account should be credited.
Before we explain and illustrate the debits and credits in accounting and bookkeeping, we will discuss the accounts in which the debits and credits will be entered or posted.
What Is An Account?
To keep a company's financial data organized, accountants developed a system that sorts transactions into records called accounts. When a company's accounting system is set up, the accounts most likely to be affected by the company's transactions are identified and listed out. This list is referred to as the company's chart of accounts. Depending on the size of a company and the complexity of its business operations, the chart of accounts may list as few as thirty accounts or as many as thousands. A company has the flexibility of tailoring its chart of accounts to best meet its needs.
Within the chart of accounts the balance sheet accounts are listed first, followed by the income statement accounts. In other words, the accounts are organized in the chart of accounts as follows:
Assets
Liabilities
Owner's (Stockholders') Equity
Revenues or Income
Expenses
Gains
Losses
Double-Entry Accounting
Because every business transaction affects at least two accounts, our accounting system is known as a double-entry system. (You can refer to the company's chart of accounts to select the proper accounts. Accounts may be added to the chart of accounts when an appropriate account cannot be found.)
For example, when a company borrows $1,000 from a bank, the transaction will affect the company's Cash account and the company's Notes Payable account. When the company repays the bank loan, the Cash account and the Notes Payable account are also involved.
If a company buys supplies for cash, its Supplies account and its Cash account will be affected. If the company buys supplies on credit, the accounts involved are Supplies and Accounts Payable.
If a company pays the rent for the current month, Rent Expense and Cash are the two accounts involved. If a company provides a service and gives the client 30 days in which to pay, the company's Service Revenues account and Accounts Receivable are affected.
Although the system is referred to as double-entry, a transaction may involve more than two accounts. An example of a transaction that involves three accounts is a company's loan payment to its bank of $300. This transaction will involve the following accounts: Cash, Notes Payable, and Interest Expense.
(If you use accounting software you may not actually see that two or more accounts are being affected due to the user-friendly nature of the software. For example, let's say that you write a company check by means of your accounting software. Your software automatically reduces your Cash account and prompts you only for the other accounts affected.)
Debits and Credits:
After you have identified the two or more accounts involved in a business transaction, you must debit at least one account and credit at least one account.
To debit an account means to enter an amount on the left side of the account. To credit an account means to enter an amount on the right side of an account.
Generally these types of accounts are increased with a debit:
Dividends (Draws)
Expenses
Assets
Losses
You might think of D – E – A – L when recalling the accounts that are increased with a debit.
Generally these types of accounts are increased with a credit:
Gains
Income
Revenues
Liabilities
Stockholders' (Owner's) Equity
You might think of G – I – R – L – S when recalling the accounts that are increased with a credit.
To decrease an account you do the opposite of what was done to increase the account. For example, an asset account is increased with a debit. Therefore it is decreased with a credit.
The abbreviation for debit is dr. and the abbreviation for credit is cr.
Chart of Accounts
A chart of accounts is a listing of the names of the accounts that a company has identified and made available for recording transactions in its general ledger. A company has the flexibility to tailor its chart of accounts to best suit its needs, including adding accounts as needed.
Within the chart of accounts you will find that the accounts are typically listed in the following order:
Balance sheet accounts
Assets
Liabilities
Owner's (Stockholders') Equity
Income statement accounts
Operating Revenues
Operating Expenses
Non-operating Revenues and Gains
Non-operating Expenses and Losses
Within the categories of operating revenues and operating expenses, accounts might be further organized by business function (such as producing, selling, administrative, financing) and/or by company divisions, product lines, etc.
A company's organization chart can serve as the outline for its accounting chart of accounts. For example, if a company divides its business into ten departments (production, marketing, human resources, etc.), each department will likely be accountable for its own expenses (salaries, supplies, phone, etc.). Each department will have its own phone expense account, its own salaries expense, etc.
A chart of accounts will likely be as large and as complex as the company itself. An international corporation with several divisions may need thousands of accounts, whereas a small local retailer may need as few as one hundred accounts.
Sample Chart of Accounts For a Large Corporation
Each account in the chart of accounts is typically assigned a name and a unique number by which it can be identified. (Software for some small businesses may not require account numbers.) Account numbers are often five or more digits in length with each digit representing a division of the company, the department, the type of account, etc.
As you will see, the first digit might signify if the account is an asset, liability, etc. For example, if the first digit is a "1" it is an asset. If the first digit is a "5" it is an operating expense.
A gap between account numbers allows for adding accounts in the future. The following is a partial listing of a sample chart of accounts.
Current Assets (account numbers 10000 - 16999)
10100 Cash - Regular Checking
10200 Cash - Payroll Checking
10600 Petty Cash Fund
12100 Accounts Receivable
12500 Allowance for Doubtful Accounts
13100 Inventory
14100 Supplies
15300 Prepaid Insurance
Property, Plant, and Equipment (account numbers 17000 - 18999)
17000 Land
17100 Buildings
17300 Equipment
17800 Vehicles
18100 Accumulated Depreciation - Buildings
18300 Accumulated Depreciation - Equipment
18800 Accumulated Depreciation - Vehicles
Current Liabilities (account numbers 20000 - 24999)
20100 Notes Payable - Credit Line #1
20200 Notes Payable - Credit Line #2
21000 Accounts Payable
22100 Wages Payable
23100 Interest Payable
24500 Unearned Revenues
Long-term Liabilities (account numbers 25000 - 26999)
25100 Mortgage Loan Payable
25600 Bonds Payable
25650 Discount on Bonds Payable
Stockholders' Equity (account numbers 27000 - 29999)
27100 Common Stock, No Par
27500 Retained Earnings
29500 Treasury Stock
Operating Revenues (account numbers 30000 - 39999)
31010 Sales - Division #1, Product Line 010
31022 Sales - Division #1, Product Line 022
32015 Sales - Division #2, Product Line 015
33110 Sales - Division #3, Product Line 110
Cost of Goods Sold (account numbers 40000 - 49999)
41010 COGS - Division #1, Product Line 010
41022 COGS - Division #1, Product Line 022
42015 COGS - Division #2, Product Line 015
43110 COGS - Division #3, Product Line 110
Marketing Expenses (account numbers 50000 - 50999)
50100 Marketing Dept. Salaries
50150 Marketing Dept. Payroll Taxes
50200 Marketing Dept. Supplies
50600 Marketing Dept. Telephone
Payroll Dept. Expenses (account numbers 59000 - 59999)
59100 Payroll Dept. Salaries
59150 Payroll Dept. Payroll Taxes
59200 Payroll Dept. Supplies
59600 Payroll Dept. Telephone
Other (account numbers 90000 - 99999)
91800 Gain on Sale of Assets
96100 Loss on Sale of Assets
Within the chart of accounts you will find that the accounts are typically listed in the following order:
Balance sheet accounts
Assets
Liabilities
Owner's (Stockholders') Equity
Income statement accounts
Operating Revenues
Operating Expenses
Non-operating Revenues and Gains
Non-operating Expenses and Losses
Within the categories of operating revenues and operating expenses, accounts might be further organized by business function (such as producing, selling, administrative, financing) and/or by company divisions, product lines, etc.
A company's organization chart can serve as the outline for its accounting chart of accounts. For example, if a company divides its business into ten departments (production, marketing, human resources, etc.), each department will likely be accountable for its own expenses (salaries, supplies, phone, etc.). Each department will have its own phone expense account, its own salaries expense, etc.
A chart of accounts will likely be as large and as complex as the company itself. An international corporation with several divisions may need thousands of accounts, whereas a small local retailer may need as few as one hundred accounts.
Sample Chart of Accounts For a Large Corporation
Each account in the chart of accounts is typically assigned a name and a unique number by which it can be identified. (Software for some small businesses may not require account numbers.) Account numbers are often five or more digits in length with each digit representing a division of the company, the department, the type of account, etc.
As you will see, the first digit might signify if the account is an asset, liability, etc. For example, if the first digit is a "1" it is an asset. If the first digit is a "5" it is an operating expense.
A gap between account numbers allows for adding accounts in the future. The following is a partial listing of a sample chart of accounts.
Current Assets (account numbers 10000 - 16999)
10100 Cash - Regular Checking
10200 Cash - Payroll Checking
10600 Petty Cash Fund
12100 Accounts Receivable
12500 Allowance for Doubtful Accounts
13100 Inventory
14100 Supplies
15300 Prepaid Insurance
Property, Plant, and Equipment (account numbers 17000 - 18999)
17000 Land
17100 Buildings
17300 Equipment
17800 Vehicles
18100 Accumulated Depreciation - Buildings
18300 Accumulated Depreciation - Equipment
18800 Accumulated Depreciation - Vehicles
Current Liabilities (account numbers 20000 - 24999)
20100 Notes Payable - Credit Line #1
20200 Notes Payable - Credit Line #2
21000 Accounts Payable
22100 Wages Payable
23100 Interest Payable
24500 Unearned Revenues
Long-term Liabilities (account numbers 25000 - 26999)
25100 Mortgage Loan Payable
25600 Bonds Payable
25650 Discount on Bonds Payable
Stockholders' Equity (account numbers 27000 - 29999)
27100 Common Stock, No Par
27500 Retained Earnings
29500 Treasury Stock
Operating Revenues (account numbers 30000 - 39999)
31010 Sales - Division #1, Product Line 010
31022 Sales - Division #1, Product Line 022
32015 Sales - Division #2, Product Line 015
33110 Sales - Division #3, Product Line 110
Cost of Goods Sold (account numbers 40000 - 49999)
41010 COGS - Division #1, Product Line 010
41022 COGS - Division #1, Product Line 022
42015 COGS - Division #2, Product Line 015
43110 COGS - Division #3, Product Line 110
Marketing Expenses (account numbers 50000 - 50999)
50100 Marketing Dept. Salaries
50150 Marketing Dept. Payroll Taxes
50200 Marketing Dept. Supplies
50600 Marketing Dept. Telephone
Payroll Dept. Expenses (account numbers 59000 - 59999)
59100 Payroll Dept. Salaries
59150 Payroll Dept. Payroll Taxes
59200 Payroll Dept. Supplies
59600 Payroll Dept. Telephone
Other (account numbers 90000 - 99999)
91800 Gain on Sale of Assets
96100 Loss on Sale of Assets
Introduction to Bank Reconciliation
A company's general ledger account Cash contains a record of the transactions (checks written, receipts from customers, etc.) that involve its checking account. The bank also creates a record of the company's checking account when it processes the company's checks, deposits, service charges, and other items. Soon after each month ends the bank usually mails a bank statement to the company. The bank statement lists the activity in the bank account during the recent month as well as the balance in the bank account.
When the company receives its bank statement, the company should verify that the amounts on the bank statement are consistent or compatible with the amounts in the company's Cash account in its general ledger and vice versa. This process of confirming the amounts is referred to as reconciling the bank statement, bank statement reconciliation, bank reconciliation, or doing a "bank rec." The benefit of reconciling the bank statement is knowing that the amount of Cash reported by the company (company's books) is consistent with the amount of cash shown in the bank's records.
Because most companies write hundreds of checks each month and make many deposits, reconciling the amounts on the company's books with the amounts on the bank statement can be time consuming. The process is complicated because some items appear in the company's Cash account in one month, but appear on the bank statement in a different month. For example, checks written near the end of August are deducted immediately on the company's books, but those checks will likely clear the bank account in early September. Sometimes the bank decreases the company's bank account without informing the company of the amount. For example, a bank service charge might be deducted on the bank statement on August 31, but the company will not learn of the amount until the company receives the bank statement in early September. From these two examples, you can understand why there will likely be a difference in the balance on the bank statement vs. the balance in the Cash account on the company's books. It is also possible (perhaps likely) that neither balance is the true balance. Both balances may need adjustment in order to report the true amount of cash.
After you adjust the balance per bank to be the true balance and after you adjust the balance per books to also be the same true balance, you have reconciled the bank statement. Most accountants would simply say that you have done the bank reconciliation or the bank rec.
Bank Reconciliation Process
Step 1. Adjusting the Balance per Bank
We will demonstrate the bank reconciliation process in several steps. The first step is to adjust the balance on the bank statement to the true, adjusted, or corrected balance. The items necessary for this step are listed in the following schedule:
Step 1.
Balance per Bank Statement on Aug. 31, 2009
Adjustments:
Add: Deposits in transit
Deduct: Outstanding checks
Add or Deduct: Bank errors
Adjusted/Corrected Balance per Bank
Deposits in transit are amounts already received and recorded by the company, but are not yet recorded by the bank. For example, a retail store deposits its cash receipts of August 31 into the bank's night depository at 10:00 p.m. on August 31. The bank will process this deposit on the morning of September 1. As of August 31 (the bank statement date) this is a deposit in transit.
Because deposits in transit are already included in the company's Cash account, there is no need to adjust the company's records. However, deposits in transit are not yet on the bank statement. Therefore, they need to be listed on the bank reconciliation as an increase to the balance per bank in order to report the true amount of cash.
A helpful rule of thumb is "put it where it isn't." A deposit in transit is on the company's books, but it isn't on the bank statement. Put it where it isn't: as an adjustment to the balance on the bank statement.
Outstanding checks are checks that have been written and recorded in the company's Cash account, but have not yet cleared the bank account. Checks written during the last few days of the month plus a few older checks are likely to be among the outstanding checks.
Because all checks that have been written are immediately recorded in the company's Cash account, there is no need to adjust the company's records for the outstanding checks. However, the outstanding checks have not yet reached the bank and the bank statement. Therefore, outstanding checks are listed on the bank reconciliation as a decrease in the balance per bank.
Recall the helpful tip "put it where it isn't." An outstanding check is on the company's books, but it isn't on the bank statement. Put it where it isn't: as an adjustment to the balance on the bank statement.
Bank errors are mistakes made by the bank. Bank errors could include the bank recording an incorrect amount, entering an amount that does not belong on a company's bank statement, or omitting an amount from a company's bank statement. The company should notify the bank of its errors. Depending on the error, the correction could increase or decrease the balance shown on the bank statement. (Since the company did not make the error, the company's records are not changed.)
Step 2. Adjusting the Balance per Books
The second step of the bank reconciliation is to adjust the balance in the company's Cash account so that it is the true, adjusted, or corrected balance. Examples of the items involved are shown in the following schedule:
Step 2.
Balance per Books on Aug. 31, 2009
Adjustments:
Deduct: Bank service charges
Deduct: NSF checks & fees
Deduct: Check printing charges
Add: Interest earned
Add: Notes Receivable collected by bank
Add or Deduct: Errors in company's Cash account
Adjusted/Corrected Balance per Books
Bank service charges are fees deducted from the bank statement for the bank's processing of the checking account activity (accepting deposits, posting checks, mailing the bank statement, etc.) Other types of bank service charges include the fee charged when a company overdraws its checking account and the bank fee for processing a stop payment order on a company's check. The bank might deduct these charges or fees on the bank statement without notifying the company. When that occurs the company usually learns of the amounts only after receiving its bank statement.
Because the bank service charges have already been deducted on the bank statement, there is no adjustment to the balance per bank. However, the service charges will have to be entered as an adjustment to the company's books. The company's Cash account will need to be decreased by the amount of the service charges.
Recall the helpful tip "put it where it isn't." A bank service charge is already listed on the bank statement, but it isn't on the company's books. Put it where it isn't: as an adjustment to the Cash account on the company's books.
An NSF check is a check that was not honored by the bank of the person or company writing the check because that account did not have a sufficient balance. As a result, the check is returned without being honored or paid. (NSF is the acronym for not sufficient funds. Often the bank describes the returned check as a return item. Others refer to the NSF check as a "rubber check" because the check "bounced" back from the bank on which it was written.) When the NSF check comes back to the bank in which it was deposited, the bank will decrease the checking account of the company that had deposited the check. The amount charged will be the amount of the check plus a bank fee.
Because the NSF check and the related bank fee have already been deducted on the bank statement, there is no need to adjust the balance per the bank. However, if the company has not yet decreased its Cash account balance for the returned check and the bank fee, the company must decrease the balance per books in order to reconcile.
Check printing charges occur when a company arranges for its bank to handle the reordering of its checks. The cost of the printed checks will automatically be deducted from the company's checking account.
Because the check printing charges have already been deducted on the bank statement, there is no adjustment to the balance per bank. However, the check printing charges need to be an adjustment on the company's books. They will be a deduction to the company's Cash account.
Recall the general rule, "put it where it isn't." A check printing charge is on the bank statement, but it isn't on the company's books. Put it where it isn't: as an adjustment to the Cash account on the company's books.
Interest earned will appear on the bank statement when a bank gives a company interest on its account balances. The amount is added to the checking account balance and is automatically on the bank statement. Hence there is no need to adjust the balance per the bank statement. However, the amount of interest earned will increase the balance in the company's Cash account on its books.
Recall "put it where it isn't." Interest received from the bank is on the bank statement, but it isn't on the company's books. Put it where it isn't: as an adjustment to the Cash account on the company's books.
Notes Receivable are assets of a company. When notes come due, the company might ask its bank to collect the notes receivable. For this service the bank will charge a fee. The bank will increase the company's checking account for the amount it collected (principal and interest) and will decrease the account by the collection fee it charges.Since these amounts are already on the bank statement, the company must be certain that the amounts appear on the company's books in its Cash account.
Recall the tip "put it where it isn't." The amounts collected by the bank and the bank's fees are on the bank statement, but they are not on the company's books. Put them where they aren't: as adjustments to the Cash account on the company's books.
Errors in the company's Cash account result from the company entering an incorrect amount, entering a transaction that does not belong in the account, or omitting a transaction that should be in the account. Since the company made these errors, the correction of the error will be either an increase or a decrease to the balance in the Cash account on the company's books.
Step 3. Comparing the Adjusted Balances
After adjusting the balance per bank (Step 1) and after adjusting the balance per books (Step 2), the two adjusted amounts should be equal. If they are not equal, you must repeat the process until the balances are identical. The balances should be the true, correct amount of cash as of the date of the bank reconciliation.
Step 4. Preparing Journal Entries
Journal entries must be prepared for the adjustments to the balance per books (Step 2). Adjustments to increase the cash balance will require a journal entry that debits Cash and credits another account. Adjustments to decrease the cash balance will require a credit to Cash and a debit to another account.
When the company receives its bank statement, the company should verify that the amounts on the bank statement are consistent or compatible with the amounts in the company's Cash account in its general ledger and vice versa. This process of confirming the amounts is referred to as reconciling the bank statement, bank statement reconciliation, bank reconciliation, or doing a "bank rec." The benefit of reconciling the bank statement is knowing that the amount of Cash reported by the company (company's books) is consistent with the amount of cash shown in the bank's records.
Because most companies write hundreds of checks each month and make many deposits, reconciling the amounts on the company's books with the amounts on the bank statement can be time consuming. The process is complicated because some items appear in the company's Cash account in one month, but appear on the bank statement in a different month. For example, checks written near the end of August are deducted immediately on the company's books, but those checks will likely clear the bank account in early September. Sometimes the bank decreases the company's bank account without informing the company of the amount. For example, a bank service charge might be deducted on the bank statement on August 31, but the company will not learn of the amount until the company receives the bank statement in early September. From these two examples, you can understand why there will likely be a difference in the balance on the bank statement vs. the balance in the Cash account on the company's books. It is also possible (perhaps likely) that neither balance is the true balance. Both balances may need adjustment in order to report the true amount of cash.
After you adjust the balance per bank to be the true balance and after you adjust the balance per books to also be the same true balance, you have reconciled the bank statement. Most accountants would simply say that you have done the bank reconciliation or the bank rec.
Bank Reconciliation Process
Step 1. Adjusting the Balance per Bank
We will demonstrate the bank reconciliation process in several steps. The first step is to adjust the balance on the bank statement to the true, adjusted, or corrected balance. The items necessary for this step are listed in the following schedule:
Step 1.
Balance per Bank Statement on Aug. 31, 2009
Adjustments:
Add: Deposits in transit
Deduct: Outstanding checks
Add or Deduct: Bank errors
Adjusted/Corrected Balance per Bank
Deposits in transit are amounts already received and recorded by the company, but are not yet recorded by the bank. For example, a retail store deposits its cash receipts of August 31 into the bank's night depository at 10:00 p.m. on August 31. The bank will process this deposit on the morning of September 1. As of August 31 (the bank statement date) this is a deposit in transit.
Because deposits in transit are already included in the company's Cash account, there is no need to adjust the company's records. However, deposits in transit are not yet on the bank statement. Therefore, they need to be listed on the bank reconciliation as an increase to the balance per bank in order to report the true amount of cash.
A helpful rule of thumb is "put it where it isn't." A deposit in transit is on the company's books, but it isn't on the bank statement. Put it where it isn't: as an adjustment to the balance on the bank statement.
Outstanding checks are checks that have been written and recorded in the company's Cash account, but have not yet cleared the bank account. Checks written during the last few days of the month plus a few older checks are likely to be among the outstanding checks.
Because all checks that have been written are immediately recorded in the company's Cash account, there is no need to adjust the company's records for the outstanding checks. However, the outstanding checks have not yet reached the bank and the bank statement. Therefore, outstanding checks are listed on the bank reconciliation as a decrease in the balance per bank.
Recall the helpful tip "put it where it isn't." An outstanding check is on the company's books, but it isn't on the bank statement. Put it where it isn't: as an adjustment to the balance on the bank statement.
Bank errors are mistakes made by the bank. Bank errors could include the bank recording an incorrect amount, entering an amount that does not belong on a company's bank statement, or omitting an amount from a company's bank statement. The company should notify the bank of its errors. Depending on the error, the correction could increase or decrease the balance shown on the bank statement. (Since the company did not make the error, the company's records are not changed.)
Step 2. Adjusting the Balance per Books
The second step of the bank reconciliation is to adjust the balance in the company's Cash account so that it is the true, adjusted, or corrected balance. Examples of the items involved are shown in the following schedule:
Step 2.
Balance per Books on Aug. 31, 2009
Adjustments:
Deduct: Bank service charges
Deduct: NSF checks & fees
Deduct: Check printing charges
Add: Interest earned
Add: Notes Receivable collected by bank
Add or Deduct: Errors in company's Cash account
Adjusted/Corrected Balance per Books
Bank service charges are fees deducted from the bank statement for the bank's processing of the checking account activity (accepting deposits, posting checks, mailing the bank statement, etc.) Other types of bank service charges include the fee charged when a company overdraws its checking account and the bank fee for processing a stop payment order on a company's check. The bank might deduct these charges or fees on the bank statement without notifying the company. When that occurs the company usually learns of the amounts only after receiving its bank statement.
Because the bank service charges have already been deducted on the bank statement, there is no adjustment to the balance per bank. However, the service charges will have to be entered as an adjustment to the company's books. The company's Cash account will need to be decreased by the amount of the service charges.
Recall the helpful tip "put it where it isn't." A bank service charge is already listed on the bank statement, but it isn't on the company's books. Put it where it isn't: as an adjustment to the Cash account on the company's books.
An NSF check is a check that was not honored by the bank of the person or company writing the check because that account did not have a sufficient balance. As a result, the check is returned without being honored or paid. (NSF is the acronym for not sufficient funds. Often the bank describes the returned check as a return item. Others refer to the NSF check as a "rubber check" because the check "bounced" back from the bank on which it was written.) When the NSF check comes back to the bank in which it was deposited, the bank will decrease the checking account of the company that had deposited the check. The amount charged will be the amount of the check plus a bank fee.
Because the NSF check and the related bank fee have already been deducted on the bank statement, there is no need to adjust the balance per the bank. However, if the company has not yet decreased its Cash account balance for the returned check and the bank fee, the company must decrease the balance per books in order to reconcile.
Check printing charges occur when a company arranges for its bank to handle the reordering of its checks. The cost of the printed checks will automatically be deducted from the company's checking account.
Because the check printing charges have already been deducted on the bank statement, there is no adjustment to the balance per bank. However, the check printing charges need to be an adjustment on the company's books. They will be a deduction to the company's Cash account.
Recall the general rule, "put it where it isn't." A check printing charge is on the bank statement, but it isn't on the company's books. Put it where it isn't: as an adjustment to the Cash account on the company's books.
Interest earned will appear on the bank statement when a bank gives a company interest on its account balances. The amount is added to the checking account balance and is automatically on the bank statement. Hence there is no need to adjust the balance per the bank statement. However, the amount of interest earned will increase the balance in the company's Cash account on its books.
Recall "put it where it isn't." Interest received from the bank is on the bank statement, but it isn't on the company's books. Put it where it isn't: as an adjustment to the Cash account on the company's books.
Notes Receivable are assets of a company. When notes come due, the company might ask its bank to collect the notes receivable. For this service the bank will charge a fee. The bank will increase the company's checking account for the amount it collected (principal and interest) and will decrease the account by the collection fee it charges.Since these amounts are already on the bank statement, the company must be certain that the amounts appear on the company's books in its Cash account.
Recall the tip "put it where it isn't." The amounts collected by the bank and the bank's fees are on the bank statement, but they are not on the company's books. Put them where they aren't: as adjustments to the Cash account on the company's books.
Errors in the company's Cash account result from the company entering an incorrect amount, entering a transaction that does not belong in the account, or omitting a transaction that should be in the account. Since the company made these errors, the correction of the error will be either an increase or a decrease to the balance in the Cash account on the company's books.
Step 3. Comparing the Adjusted Balances
After adjusting the balance per bank (Step 1) and after adjusting the balance per books (Step 2), the two adjusted amounts should be equal. If they are not equal, you must repeat the process until the balances are identical. The balances should be the true, correct amount of cash as of the date of the bank reconciliation.
Step 4. Preparing Journal Entries
Journal entries must be prepared for the adjustments to the balance per books (Step 2). Adjustments to increase the cash balance will require a journal entry that debits Cash and credits another account. Adjustments to decrease the cash balance will require a credit to Cash and a debit to another account.
Introduction to Balance Sheet
The accounting balance sheet is one of the major financial statements used by accountants and business owners. (The other major financial statements are the income statement, statement of cash flows, and statement of stockholders' equity) The balance sheet is also referred to as the statement of financial position.
The balance sheet presents a company's financial position at the end of a specified date. Some describe the balance sheet as a "snapshot" of the company's financial position at a point (a moment or an instant) in time. For example, the amounts reported on a balance sheet dated December 31, 2009 reflect that instant when all the transactions through December 31 have been recorded.
Because the balance sheet informs the reader of a company's financial position as of one moment in time, it allows someone—like a creditor—to see what a company owns as well as what it owes to other parties as of the date indicated in the heading. This is valuable information to the banker who wants to determine whether or not a company qualifies for additional credit or loans. Others who would be interested in the balance sheet include current investors, potential investors, company management, suppliers, some customers, competitors, government agencies, and labor unions.
In Part 1 we will explain the components of the balance sheet and in Part 2 we will present a sample balance sheet. If you are interested in balance sheet analysis, that is included in the Explanation of Financial Ratios.
We will begin our explanation of the accounting balance sheet with its major components, elements, or major categories:
Assets
Liabilities
Owner's (Stockholders') Equity
Assets
Assets are things that the company owns. They are the resources of the company that have been acquired through transactions, and have future economic value that can be measured and expressed in dollars. Assets also include costs paid in advance that have not yet expired, such as prepaid advertising, prepaid insurance, prepaid legal fees, and prepaid rent. (For a discussion of prepaid expenses go to Explanation of Adjusting Entries.)
Examples of asset accounts that are reported on a company's balance sheet include:
Cash
Petty Cash
Temporary Investments
Accounts Receivable
Inventory
Supplies
Prepaid Insurance
Land
Land Improvements
Buildings
Equipment
Goodwill
Bond Issue Costs
Etc.
Usually these asset accounts will have debit balances.
Contra assets are asset accounts with credit balances. (A credit balance in an asset account is contrary—or contra—to an asset account's usual debit balance.) Examples of contra asset accounts include:
Allowance for Doubtful Accounts
Accumulated Depreciation-Land Improvements
Accumulated Depreciation-Buildings
Accumulated Depreciation-Equipment
Accumulated Depletion
Etc.
Classifications Of Assets On The Balance Sheet
Accountants usually prepare classified balance sheets. "Classified" means that the balance sheet accounts are presented in distinct groupings, categories, or classifications. The asset classifications and their order of appearance on the balance sheet are:
Current Assets
Investments
Property, Plant, and Equipment
Intangible Assets
Other Assets
Effect of Cost Principle and Monetary Unit Assumption
The amounts reported in the asset accounts and on the balance sheet reflect actual costs recorded at the time of a transaction. For example, let's say a company acquires 40 acres of land in the year 1950 at a cost of $20,000. Then, in 1990, it pays $400,000 for an adjacent 40-acre parcel. The company's Land account will show a balance of $420,000 ($20,000 for the first parcel plus $400,000 for the second parcel.). This account balance of $420,000 will appear on today's balance sheet even though these parcels of land have appreciated to a current market value of $3,000,000.
There are two guidelines that oblige the accountant to report $420,000 on the balance sheet rather than the current market value of $3,000,000: (1) the cost principle directs the accountant to report the company's assets at their original historical cost, and (2) the monetary unit assumption directs the accountant to presume the U.S. dollar is stable over time—it is not affected by inflation or deflation. In effect, the accountant is assuming that a 1950 dollar, a 1990 dollar, and a 2010 dollar all have the same purchasing power.
The cost principle and monetary unit assumption may also mean that some very valuable resources will not be reported on the balance sheet. A company's team of brilliant scientists will not be listed as an asset on the company's balance sheet, because (a) the company did not purchase the team in a transaction (cost principle) and (b) it's impossible for accountants to know how to put a dollar value on the team (monetary unit assumption).
Coca-Cola's logo, Nike's logo, and the trade names for most consumer products companies are likely to be their most valuable assets. If those names and logos were developed internally, it is reasonable that they will not appear on the company balance sheet. If, however, a company should purchase a product name and logo from another company, that cost will appear as an asset on the balance sheet of the acquiring company.
Remember, accounting principles and guidelines place some limitations on what is reported as an asset on the company's balance sheet.
Effect of Conservatism
While the cost principle and monetary unit assumption generally prevent assets from being reported on the balance sheet at an amount greater than cost, conservatism will result in some assets being reported at less than cost. For example, assume the cost of a company's inventory was $30,000, but now the current cost of the same items in inventory has dropped to $27,000. The conservatism guideline instructs the company to report Inventory on its balance sheet at $27,000. The $3,000 difference is reported immediately as a loss on the company's income statement.
Effect of Matching Principle
The matching principle will also cause certain assets to be reported on the accounting balance sheet at less than cost. For example, if a company has Accounts Receivable of $50,000 but anticipates that it will collect only $48,500 due to some customers' financial problems, the company will report a credit balance of $1,500 in the contra asset account Allowance for Doubtful Accounts. The combination of the asset Accounts Receivable with a debit balance of $50,000 and the contra asset Allowance for Doubtful Accounts with a credit balance will mean that the balance sheet will report the net amount of $48,500. The income statement will report the $1,500 adjustment as Bad Debts Expense.
The matching principle also requires that the cost of buildings and equipment be depreciated over their useful lives. This means that over time the cost of these assets will be moved from the balance sheet to Depreciation Expense on the income statement. As time goes on, the amounts reported on the balance sheet for these long-term assets will be reduced.
The balance sheet presents a company's financial position at the end of a specified date. Some describe the balance sheet as a "snapshot" of the company's financial position at a point (a moment or an instant) in time. For example, the amounts reported on a balance sheet dated December 31, 2009 reflect that instant when all the transactions through December 31 have been recorded.
Because the balance sheet informs the reader of a company's financial position as of one moment in time, it allows someone—like a creditor—to see what a company owns as well as what it owes to other parties as of the date indicated in the heading. This is valuable information to the banker who wants to determine whether or not a company qualifies for additional credit or loans. Others who would be interested in the balance sheet include current investors, potential investors, company management, suppliers, some customers, competitors, government agencies, and labor unions.
In Part 1 we will explain the components of the balance sheet and in Part 2 we will present a sample balance sheet. If you are interested in balance sheet analysis, that is included in the Explanation of Financial Ratios.
We will begin our explanation of the accounting balance sheet with its major components, elements, or major categories:
Assets
Liabilities
Owner's (Stockholders') Equity
Assets
Assets are things that the company owns. They are the resources of the company that have been acquired through transactions, and have future economic value that can be measured and expressed in dollars. Assets also include costs paid in advance that have not yet expired, such as prepaid advertising, prepaid insurance, prepaid legal fees, and prepaid rent. (For a discussion of prepaid expenses go to Explanation of Adjusting Entries.)
Examples of asset accounts that are reported on a company's balance sheet include:
Cash
Petty Cash
Temporary Investments
Accounts Receivable
Inventory
Supplies
Prepaid Insurance
Land
Land Improvements
Buildings
Equipment
Goodwill
Bond Issue Costs
Etc.
Usually these asset accounts will have debit balances.
Contra assets are asset accounts with credit balances. (A credit balance in an asset account is contrary—or contra—to an asset account's usual debit balance.) Examples of contra asset accounts include:
Allowance for Doubtful Accounts
Accumulated Depreciation-Land Improvements
Accumulated Depreciation-Buildings
Accumulated Depreciation-Equipment
Accumulated Depletion
Etc.
Classifications Of Assets On The Balance Sheet
Accountants usually prepare classified balance sheets. "Classified" means that the balance sheet accounts are presented in distinct groupings, categories, or classifications. The asset classifications and their order of appearance on the balance sheet are:
Current Assets
Investments
Property, Plant, and Equipment
Intangible Assets
Other Assets
Effect of Cost Principle and Monetary Unit Assumption
The amounts reported in the asset accounts and on the balance sheet reflect actual costs recorded at the time of a transaction. For example, let's say a company acquires 40 acres of land in the year 1950 at a cost of $20,000. Then, in 1990, it pays $400,000 for an adjacent 40-acre parcel. The company's Land account will show a balance of $420,000 ($20,000 for the first parcel plus $400,000 for the second parcel.). This account balance of $420,000 will appear on today's balance sheet even though these parcels of land have appreciated to a current market value of $3,000,000.
There are two guidelines that oblige the accountant to report $420,000 on the balance sheet rather than the current market value of $3,000,000: (1) the cost principle directs the accountant to report the company's assets at their original historical cost, and (2) the monetary unit assumption directs the accountant to presume the U.S. dollar is stable over time—it is not affected by inflation or deflation. In effect, the accountant is assuming that a 1950 dollar, a 1990 dollar, and a 2010 dollar all have the same purchasing power.
The cost principle and monetary unit assumption may also mean that some very valuable resources will not be reported on the balance sheet. A company's team of brilliant scientists will not be listed as an asset on the company's balance sheet, because (a) the company did not purchase the team in a transaction (cost principle) and (b) it's impossible for accountants to know how to put a dollar value on the team (monetary unit assumption).
Coca-Cola's logo, Nike's logo, and the trade names for most consumer products companies are likely to be their most valuable assets. If those names and logos were developed internally, it is reasonable that they will not appear on the company balance sheet. If, however, a company should purchase a product name and logo from another company, that cost will appear as an asset on the balance sheet of the acquiring company.
Remember, accounting principles and guidelines place some limitations on what is reported as an asset on the company's balance sheet.
Effect of Conservatism
While the cost principle and monetary unit assumption generally prevent assets from being reported on the balance sheet at an amount greater than cost, conservatism will result in some assets being reported at less than cost. For example, assume the cost of a company's inventory was $30,000, but now the current cost of the same items in inventory has dropped to $27,000. The conservatism guideline instructs the company to report Inventory on its balance sheet at $27,000. The $3,000 difference is reported immediately as a loss on the company's income statement.
Effect of Matching Principle
The matching principle will also cause certain assets to be reported on the accounting balance sheet at less than cost. For example, if a company has Accounts Receivable of $50,000 but anticipates that it will collect only $48,500 due to some customers' financial problems, the company will report a credit balance of $1,500 in the contra asset account Allowance for Doubtful Accounts. The combination of the asset Accounts Receivable with a debit balance of $50,000 and the contra asset Allowance for Doubtful Accounts with a credit balance will mean that the balance sheet will report the net amount of $48,500. The income statement will report the $1,500 adjustment as Bad Debts Expense.
The matching principle also requires that the cost of buildings and equipment be depreciated over their useful lives. This means that over time the cost of these assets will be moved from the balance sheet to Depreciation Expense on the income statement. As time goes on, the amounts reported on the balance sheet for these long-term assets will be reduced.
Difference between Expense and Allowance
The account Bad Debts Expense reports the credit losses that occur during the period of time covered by the income statement. Bad Debts Expense is a temporary account on the income statement, meaning it is closed at the end of each accounting year. (Closed means the account balance is transferred to retained earnings, perhaps through an income summary account.) By closing Bad Debts Expense and resetting its balance to zero, the account is ready to receive and tally the credit losses for the next accounting year.
The Allowance for Doubtful Accounts reports on the balance sheet the estimated amount of uncollectible accounts that are included in Accounts Receivable. Balance sheet accounts are almost always permanent accounts, meaning their balances carry forward to the next accounting period. In other words, they are not closed and their balances are not reset to zero.
Because the Bad Debts Expense account is closed each year, while the Allowance for Doubtful Accounts is not, these two balances will most likely not be equal after the company's first year of operations.
For example, let's assume that at the end of its first year of operations a company's Bad Debts Expense had a debit balance of $14,000 and its Allowance for Doubtful Accounts had a credit balance of $14,000. Because the income statement account balances are closed at the end of the year, the company's opening balance in Bad Debts Expense for the second year of operations is $0. The credit balance of $14,000 in Allowance for Doubtful Accounts, however, carries forward to the second year. If an adjusting entry of $3,000 is made during year 2, Bad Debts Expense will report a $3,000 debit balance, while Allowance for Doubtful Accounts might report a credit balance of $17,000.
Again, the reasons for the account balance differences are 1) Bad Debts Expense is a temporary account that reports credit losses only for the period shown on the income statement, and 2) Allowance for Doubtful Accounts is a permanent account that reports an estimated amount for all of the uncollectible receivables reported in the asset Accounts Receivable as of the balance sheet date.
The Allowance for Doubtful Accounts reports on the balance sheet the estimated amount of uncollectible accounts that are included in Accounts Receivable. Balance sheet accounts are almost always permanent accounts, meaning their balances carry forward to the next accounting period. In other words, they are not closed and their balances are not reset to zero.
Because the Bad Debts Expense account is closed each year, while the Allowance for Doubtful Accounts is not, these two balances will most likely not be equal after the company's first year of operations.
For example, let's assume that at the end of its first year of operations a company's Bad Debts Expense had a debit balance of $14,000 and its Allowance for Doubtful Accounts had a credit balance of $14,000. Because the income statement account balances are closed at the end of the year, the company's opening balance in Bad Debts Expense for the second year of operations is $0. The credit balance of $14,000 in Allowance for Doubtful Accounts, however, carries forward to the second year. If an adjusting entry of $3,000 is made during year 2, Bad Debts Expense will report a $3,000 debit balance, while Allowance for Doubtful Accounts might report a credit balance of $17,000.
Again, the reasons for the account balance differences are 1) Bad Debts Expense is a temporary account that reports credit losses only for the period shown on the income statement, and 2) Allowance for Doubtful Accounts is a permanent account that reports an estimated amount for all of the uncollectible receivables reported in the asset Accounts Receivable as of the balance sheet date.
Credit Terms with Discounts
When a seller offers credit terms of net 30 days, the net amount for the sales transaction is due 30 days after the sales invoice date.
To illustrate the meaning of net, assume that Gem Merchandise Co. sells $1,000 of goods to a customer. Upon receiving the goods the customer finds that $100 of the goods are not acceptable. The customer contacts Gem and is instructed to return the unacceptable goods. This means that Gem's net sale ends up being $900; the customer's net purchase will also be $900 ($1,000 minus the $100 returned). It also means that Gem's net receivable from this customer will be $900.
Unfortunately, companies who sell on credit often find that they don't receive payments from customers on time. In fact, one study found that if the credit term is net 30 days, the money, on average, arrived 45 days after the invoice date. In order to speed up these payments, some companies give credit terms that offer a discount to those customers who pay within a shorter period of time. The discount is referred to as a sales discount or cash discount, and the shorter period of time is known as the discount period. For example, the term 2/10, net 30 allows a customer to deduct 2% of the net amount owed if the customer pays within 10 days of the invoice date. If a customer does not pay within the discount period of 10 days, the net purchase amount (without the discount) is due 30 days after the invoice date.
Using the example from above, let's illustrate how the credit term of 2/10, net 30 works. Gem Merchandise Co. ships $1,000 of goods and the customer returns $100 of unacceptable goods to Gem within a few days. At that point, the net amount owed by the customer is $900. If the customer pays Gem within 10 days of the invoice date, the customer is allowed to deduct $18 (2% of $900) from the net purchase of $900. In other words, the $900 amount can be settled for $882 if it is paid within the 10-day discount period.
Let's assume that the sale above took place on the first day that Gem was open for business, June 1. On June 6 Gem receives the returned goods and restocks them, and on June 11 it receives $882 from the buyer. Gem's cost of goods is 80% of their original selling prices (before discounts). The above transactions are reflected in Gem's general ledger as follows:
Date Account Name Debit Credits
June 1 Accounts Receivable 1,000
Sales 1,000
June 1 Cost of Goods Sold (80% of 1,000) 800
Inventory 800
June 6 Sales Returns and Allowances 100
Accounts Receivable 100
June 6 Inventory 80
Cost of Goods Sold 80
June 11 Cash 882
Sales Discounts (2% of 900) 18
Accounts Receivable 900
If the customer waits 30 days to pay Gem, the June 11 entry shown above will not occur. In its place will be the following entry on July 1:
Date Account Name Debit Credit
July 1 Cash 900
Accounts Receivable 900
To illustrate the meaning of net, assume that Gem Merchandise Co. sells $1,000 of goods to a customer. Upon receiving the goods the customer finds that $100 of the goods are not acceptable. The customer contacts Gem and is instructed to return the unacceptable goods. This means that Gem's net sale ends up being $900; the customer's net purchase will also be $900 ($1,000 minus the $100 returned). It also means that Gem's net receivable from this customer will be $900.
Unfortunately, companies who sell on credit often find that they don't receive payments from customers on time. In fact, one study found that if the credit term is net 30 days, the money, on average, arrived 45 days after the invoice date. In order to speed up these payments, some companies give credit terms that offer a discount to those customers who pay within a shorter period of time. The discount is referred to as a sales discount or cash discount, and the shorter period of time is known as the discount period. For example, the term 2/10, net 30 allows a customer to deduct 2% of the net amount owed if the customer pays within 10 days of the invoice date. If a customer does not pay within the discount period of 10 days, the net purchase amount (without the discount) is due 30 days after the invoice date.
Using the example from above, let's illustrate how the credit term of 2/10, net 30 works. Gem Merchandise Co. ships $1,000 of goods and the customer returns $100 of unacceptable goods to Gem within a few days. At that point, the net amount owed by the customer is $900. If the customer pays Gem within 10 days of the invoice date, the customer is allowed to deduct $18 (2% of $900) from the net purchase of $900. In other words, the $900 amount can be settled for $882 if it is paid within the 10-day discount period.
Let's assume that the sale above took place on the first day that Gem was open for business, June 1. On June 6 Gem receives the returned goods and restocks them, and on June 11 it receives $882 from the buyer. Gem's cost of goods is 80% of their original selling prices (before discounts). The above transactions are reflected in Gem's general ledger as follows:
Date Account Name Debit Credits
June 1 Accounts Receivable 1,000
Sales 1,000
June 1 Cost of Goods Sold (80% of 1,000) 800
Inventory 800
June 6 Sales Returns and Allowances 100
Accounts Receivable 100
June 6 Inventory 80
Cost of Goods Sold 80
June 11 Cash 882
Sales Discounts (2% of 900) 18
Accounts Receivable 900
If the customer waits 30 days to pay Gem, the June 11 entry shown above will not occur. In its place will be the following entry on July 1:
Date Account Name Debit Credit
July 1 Cash 900
Accounts Receivable 900
Recording Sales of Goods on Credit
When a company sells goods on credit, it reports the transaction on both its income statement and its balance sheet. On the income statement, increases are reported in sales revenues, cost of goods sold, and (possibly) expenses. On the balance sheet, an increase is reported in accounts receivable, a decrease is reported in inventory, and a change is reported in stockholders' equity for the amount of the net income earned on the sale.
If the sale is made with the terms FOB Shipping Point, the ownership of the goods is transferred at the seller's dock. If the sale is made with the terms FOB Destination, the ownership of the goods is transferred at the buyer's dock.
In principle, the seller should record the sales transaction when the ownership of the goods is transferred to the buyer. Practically speaking, however, accountants typically record the transaction at the time the sales invoice is prepared and the goods are shipped.
FOB Shipping Point
Quality Products Co. just sold and shipped $1,000 worth of goods using the terms FOB Shipping Point. With its cost of goods at 80% of sales value, Quality makes the following entries in its general ledger:
Account Name Debit Credit
Accounts Receivable 1,000
Sales 1,000
Cost of Goods Sold 800
Inventory 800
(While there may be additional expenses with this transaction—such as commission expense—we are not considering them in our example.)
FOB Shipping Point means the ownership of the goods is transferred to the buyer at the seller's dock. This means that the buyer is responsible for transporting the goods from Quality Product's shipping dock. Therefore, all shipping costs (as well as any damage that might be incurred during transit) are the responsibility of the buyer
FOB Destination
FOB Destination means the ownership of the goods is transferred at the buyer's dock. This means the seller is responsible for transporting the goods to the customer's dock, and will factor in the cost of shipping when it sets its price for the goods.
Let's assume that Gem Merchandise Co. makes a sale to a customer that has a sales value of $1,050 and a cost of goods sold at $800. This transaction affects the following accounts in Gem's general ledger:
Account Name Debit Credit
Accounts Receivable 1,050
Sales 1,050
Cost of Goods Sold 800
Inventory 800
Because Gem chooses to ship its goods FOB Destination, the ownership of the goods transfers at the buyer's dock. Therefore, Gem Merchandise assumes all the risks and costs associated with transporting the goods.
Now let's assume that Gem pays an independent shipping company $50 to transport the goods from its warehouse to the buyer's dock. Gem records the $50 as an operating expense or selling expense (in an account such as Delivery Expense, Freight-Out Expense, or Transportation-Out Expense). If the shipping company allows Gem to pay in 7 days, Gem will make the following entry in its general ledger:
Account Name Debit Credit
Freight-Out Expense 50
Accounts Payable 50
If the sale is made with the terms FOB Shipping Point, the ownership of the goods is transferred at the seller's dock. If the sale is made with the terms FOB Destination, the ownership of the goods is transferred at the buyer's dock.
In principle, the seller should record the sales transaction when the ownership of the goods is transferred to the buyer. Practically speaking, however, accountants typically record the transaction at the time the sales invoice is prepared and the goods are shipped.
FOB Shipping Point
Quality Products Co. just sold and shipped $1,000 worth of goods using the terms FOB Shipping Point. With its cost of goods at 80% of sales value, Quality makes the following entries in its general ledger:
Account Name Debit Credit
Accounts Receivable 1,000
Sales 1,000
Cost of Goods Sold 800
Inventory 800
(While there may be additional expenses with this transaction—such as commission expense—we are not considering them in our example.)
FOB Shipping Point means the ownership of the goods is transferred to the buyer at the seller's dock. This means that the buyer is responsible for transporting the goods from Quality Product's shipping dock. Therefore, all shipping costs (as well as any damage that might be incurred during transit) are the responsibility of the buyer
FOB Destination
FOB Destination means the ownership of the goods is transferred at the buyer's dock. This means the seller is responsible for transporting the goods to the customer's dock, and will factor in the cost of shipping when it sets its price for the goods.
Let's assume that Gem Merchandise Co. makes a sale to a customer that has a sales value of $1,050 and a cost of goods sold at $800. This transaction affects the following accounts in Gem's general ledger:
Account Name Debit Credit
Accounts Receivable 1,050
Sales 1,050
Cost of Goods Sold 800
Inventory 800
Because Gem chooses to ship its goods FOB Destination, the ownership of the goods transfers at the buyer's dock. Therefore, Gem Merchandise assumes all the risks and costs associated with transporting the goods.
Now let's assume that Gem pays an independent shipping company $50 to transport the goods from its warehouse to the buyer's dock. Gem records the $50 as an operating expense or selling expense (in an account such as Delivery Expense, Freight-Out Expense, or Transportation-Out Expense). If the shipping company allows Gem to pay in 7 days, Gem will make the following entry in its general ledger:
Account Name Debit Credit
Freight-Out Expense 50
Accounts Payable 50
Introduction to Accounts Receivable and Bad Debts
If we imagine buying something, such as groceries, it's easy to picture ourselves standing at the checkout, writing out a personal check, and taking possession of the goods. It's a simple transaction—we exchange our money for the store's groceries.
In the world of business, however, many companies must be willing to sell their goods (or services) on credit. This would be equivalent to the grocer transferring ownership of the groceries to you, issuing a sales invoice, and allowing you to pay for the groceries at a later date.
Whenever a seller decides to offer its goods or services on credit, two things happen: (1) the seller boosts its potential to increase revenues since many buyers appreciate the convenience and efficiency of making purchases on credit, and (2) the seller opens itself up to potential losses if its customers do not pay the sales invoice amount when it becomes due.
Under the accrual basis of accounting (which we will be using throughout our discussion) a sale on credit will:
Increase sales or sales revenues, which are reported on the income statement, and
Increase the amount due from customers, which is reported as accounts receivable—an asset reported on the balance sheet.
If a buyer does not pay the amount it owes, the seller will report:
A credit loss or bad debts expense on its income statement, and
A reduction of accounts receivable on its balance sheet.
With respect to financial statements, the seller should report its estimated credit losses as soon as possible using the allowance method. For income tax purposes, however, losses are reported at a later date through the use of the direct write-off method.
In the world of business, however, many companies must be willing to sell their goods (or services) on credit. This would be equivalent to the grocer transferring ownership of the groceries to you, issuing a sales invoice, and allowing you to pay for the groceries at a later date.
Whenever a seller decides to offer its goods or services on credit, two things happen: (1) the seller boosts its potential to increase revenues since many buyers appreciate the convenience and efficiency of making purchases on credit, and (2) the seller opens itself up to potential losses if its customers do not pay the sales invoice amount when it becomes due.
Under the accrual basis of accounting (which we will be using throughout our discussion) a sale on credit will:
Increase sales or sales revenues, which are reported on the income statement, and
Increase the amount due from customers, which is reported as accounts receivable—an asset reported on the balance sheet.
If a buyer does not pay the amount it owes, the seller will report:
A credit loss or bad debts expense on its income statement, and
A reduction of accounts receivable on its balance sheet.
With respect to financial statements, the seller should report its estimated credit losses as soon as possible using the allowance method. For income tax purposes, however, losses are reported at a later date through the use of the direct write-off method.
Debits and Credits : Demystifying Debits and Credits in Accounting: A Beginner's Guide
Introduction: Understanding debits and credits is essential for anyone venturing into accounting. These seemingly cryptic terms are the building blocks of the double-entry accounting system, a foundation of financial record-keeping. In this guide, we'll break down the concepts of debits and credits, explain their relationship to the accounting equation, and clarify their application in everyday transactions. Plus, we'll optimize this explanation for SEO to make it easy to find.
1. The Double Entry System: Did Your Transaction Follow the Rules? Joe is getting familiar with accounting, and he's wondering if the first sample transaction he encountered adhered to the double-entry system. His quick review of the balance sheet confirms that indeed, it did. Both Cash and Common Stock were affected by the transaction.
2. Debits and Credits: The Basics Marilyn introduces Joe to the fundamental idea behind double-entry accounting: every transaction must be recorded with an equal dollar amount on both sides. In accounting, instead of using "left" and "right," we use "debit" and "credit." Think of it this way:
Debit Means Left: To increase the balance in an account, you put more on the left side of that account. This is known as debiting the account.
Credit Means Right: To decrease an account's balance, you enter the amount on the right side of that account. This is known as crediting the account.
Joe wonders how he'll know when to debit or credit an account. Marilyn points to the accounting equation as a guiding principle. Here's a quick recap of the equation:
Assets = Liabilities + Stockholders' Equity
Assets: These are on the left side (debit side) of the accounting equation, and their balances are increased by debiting the asset accounts.
Liabilities and Equity: These are on the right side (credit side) of the equation, and their balances increase when you credit the respective accounts.
3. A Handy Rule for Cash Transactions Since cash is often involved in transactions, Marilyn offers a practical rule for Joe to remember:
Receiving Cash: When Direct Delivery receives cash, debit the Cash account.
Paying Cash: When Direct Delivery pays cash, credit the Cash account.
Conclusion: Debits and credits, though initially confusing, follow a logical system based on the accounting equation. By grasping this fundamental concept, Joe is well on his way to mastering the art of financial record-keeping.
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