Financial Statements

As a newly hired Staff I there will be a responsibility to analyze the work papers for the organization’s clients. In this situation a client is not clear about why a Staff I is asking for information on adjusting lower of cost or market inventory valuation, capitalizing interest on building construction, recording gain or loss on asset disposal, and adjusting goodwill for impairment and requires explanations on these topics. An explanation of each is provided to include sources from accounting websites, Generally Accepted Accounting Principles (GAAP), and accounting pronouncements.

In addition to the explanation for each accounting practice there is also an explanation of the impact it will have on the financial statements and examples of calculations to aid with real-world application. Client Understanding Paper When beginning a job in the accounting field it is likely that the newly hired staff will be responsible for analyzing the documentation of clients within the organization. If a client becomes confused why certain documents are required to be analyzed explanations will need to be provided to the client for his or her understanding.

Within this paper is an explanation of some of the topics a newly hired accountant may encounter when working with clients. These topics cover adjusting lower of cost or market inventory on valuation, capitalizing interest on building construction, recording gain or loss on asset disposal, and adjusting goodwill for impairment. Adjusting Lower of Cost or Market Inventory on Valuation A requirement of Generally Accepted Accounting Principles (GAAP) is that inventory is recorded at the lower of cost or the market value and is known as Lower of Cost and Market (LCM).

This pronouncement is covered under Accounting Research Bulletin No. 43 (ARB). The need for LCM typically occurs because the inventory has become obsolete, it has deteriorated, or the market prices have declined for the inventory. When using LCM inventory cannot be reported higher than the net realizable value less expenses known as ceiling and cannot be reported lower than the net realizable value plus normally attainable profit known as the floor (Investopedia, 2013).

Net realizable value (NRV) is defined by AccountingCoach (2013) as “the expected selling price in the ordinary course of business minus the cost necessary for completion and disposal” (para. 08). NRV is considered to be a main component when determining market value. The definition of market found in the term “lower of cost or market” is considered to be the cost upon replacement. However, as mentioned above the market amount must fall between the market ceiling and floor. For example, if the replacement cost is in the middle of the ceiling and floor that figure will be the market cost.

If the cost is above ceiling, the ceiling will be the market value, and if the replacement cost is below the floor, the floor amount will become the market value. Once LCM is determined GAAP permits it to be applied in three ways: inventory total basis, item by item basis, or inventory categories basis. Inventory total basis will yield the smallest loss on the income statement and smallest reduction of cost to inventory, and the loss is reported in the accounting period when the loss took place.

Item by item basis is the opposite of inventory total basis because it results in the largest loss reported on the income statement and largest reduction of cost to the inventory. Item by item basis is also reported in the accounting period when the loss took place. Inventory category basis settles in the middle of inventory total basis and item by item basis, and reports loss on the income statement when the market value drops below cost (AccountingCoach, LLC. , 2013).

There is an inquiry for capitalizing interesting on building construction because the interest created from the debt for the assets construction is added to the cost of the construction instead of expensing on the income statement of the current period. According to, the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 34, Capitalization of Interest Cost the interest will be added to the construction cost and reported on the balance sheet. It eventually will be reported on the income statement but will show as part of the assets depreciation expense.

The ability to capitalize on the interest ends upon completion of the assets creation and does not include minor modifications. For example, if multiple pieces of equipment are in construction and after each is completed it is prior to the completion of others then the interest may be capitalized on each individual unit upon completion. Recording Gain or Loss on Asset Disposal Under GAAP when a company disposes of a long-term asset at a cost different from the book value of the asset the difference will require an adjustment to net income on the cash flow statement.

The difference between the disposal price and book value is considered either a gain or loss. For example, if a vehicle has a cost of $20,000 less accumulated depreciation of $17,000 the book value will be the difference equating to $3,000. If the vehicle is disposed of for $3,500 the difference between the book value and disposal amount equates to $500. This $500 is recognized as a gain on the sale of the asset and increases net income. Using the same example if the asset sold for $2,000 a loss of $1,000 would be recognized on the asset resulting in a reduction of net income.

In the operating section of the cash flow statement any gain recognized will need to be deducted and any loss will need to be added. These additions and deductions must occur to avoid double counting because a requirement of asset disposal is that the proceeds recognized from the sale must be reported in the investing activities section of the cash flow statement that directly follows the operating activities section. If no loss or gain occurs because there are no proceeds and the asset has been fully depreciated a debit will be made to accumulated depreciation, and a credit will be made to fixed assets.

Adjusting Goodwill for Impairment When a company purchases an intangible asset for more than the assets book value then goodwill impairment occurs. The difference between the purchase price of the asset and the book value is the goodwill and will require an adjustment. For example, if ABC Insurance is sold for $10 million to Progressive Insurance but only has a book value of $8 million then the difference of $2 million is considered goodwill and is reported as an asset on Progressive’s balance sheet.

If after the sale occurs Progressive decides to remove all of ABC Insurance’s local offices and designates them as an online company only resulting in a loss in sales of 50% this may result in a drop in fair market value to $5 million. The drop in fair market value will require Progressive to make a goodwill impairment. Progressive will combine the current market value of $5 million to the goodwill of $2 million comparing the total of $7 million to the purchase price of $10 million.

The difference created of $3 million must be reflected in the books by reducing goodwill by $3 million. Recording goodwill impairments is important because it can represent a large portion of a company’s net worth. If these changes are not reported the net worth can seem overinflated and mislead investors. This very reason is why companies are required to have their goodwill tested annually, comparing the actual value of the assets in question to their recorded value and adjusting for the difference every year (InvestingAnswers Inc. 2013). In summary, clients may have limited accounting background and may require explanations of accounting terms and documentation, accounting authority, accounting procedures, and the purpose and impact of certain accounting practices. Explained within this paper is a brief overview regarding common accounting practices, such as LCM to include NRV, how to apply LCM, and the impact it will have on the financial statements.

Also included is when and what interest can be capitalised on building construction, how to record gain or loss on the disposal of an asset, a definition of goodwill, and how and why it must be adjusted if there is an impairment.

Working with Financial Statements Accounting is the heart and soul of executing a successful business. Accounting is used to provide record for all items that are paid and received for a business over any period of time. Within the purpose of accounting lies the need to provide continuity and sustainability within a business, without it a business will not thrive. The information obtained is kept on record, in order to give insight to upper management on data concerning the daily revenue and expenses of that business. This data is needed to not only inform the employees of the business, but also the investing parties of that business as well.

Success in business is equated to being accountable of all aspects of revenue and expenses. To help aid in the understanding of the practice of accounting, Team A will discuss the subjects of revenue and expense recognition principles. We will also discuss the importance of journal adjustments that are prepaid, unearned, and accrued for both revenues and expenses over time. Each item discussed helps provided and maintains a balance for the completion of a financial statement. If entered correctly, the all entries used will provide a clear picture of the account efforts of any business.

The Revenue Recognition and Expense Recognition Principle Being able to account for a business’s revenues and expenses in a certain accounting period is difficult to determine. To do it correctly, one would need to understand two principles that set the standard; the revenue recognition principle and the expense recognition principle. In chapter 4 of our textbook Financial Accounting Tools for Business Decision Making, it states “the revenue recognition principle requires that companies recognize revenue in the accounting period in which it is earned.

In a service company, revenue is considered to be earned at the time the service is performed. ” Therefore, the definition is that it is only to be recorded when the items sold where the profit can be estimated reliability and when the amount is recoverable. What tells the revenue to be recognized and to ignore when the cash inflows occur is when the account will use the accrual basis of accounting. An example to illustrate revenue recognition principle is when a phone company sells talk time through scratch cars. There is no revenue to recognize when a customer purchased the scratch card.

The revenue is recognized when the customer has made the call and actually consumed the talk time. The expense recognition principle is defined in the same chapter as, “The principle that dictates that companies match efforts (expenses) with results (revenues). ” They provide a simple rule to remember as “Let the expenses follow the revenues. ” which would indicate how the expense recognition goes hand and hand with the revenue recognition. To illustrate that, we could say it is sales commission owed to an employee because it is based on the total of a sale.

In the same accounting period as the sale, the commission expense is when it should be recorded. At the same time, the sale is recognized and expensed when the cost of inventory is delivered to the customer. That is when the commission expense should be recorded in the same accounting period as the sale. That would be the example of the matching principle is associated with the cause and effect of accounting. Situations That Require Adjusting Journal Entries Adjusting entries are grouped as deferrals and accruals and each has two subgroups. The two categories of deferrals are prepaid expenses and unearned revenue.

Prepaid expenses are recorded as assets until they are used or consumed. For example prepaid monthly insurance is recorded as an asset until the coverage has been consumed. Because prepaid expenses expire with time does not require daily adjustments, which would be unrealistic. When preparing financial statements adjusting entries are made to record the expense consumed of the prepaid assets and show the remaining amounts in the asset account. Unearned revenue is when cash is received before service is provided, which increases the liability account. For that reason unearned revenue are opposite of prepaid expenses.

When a company receives a payment for a future service, it credits liability the unearned revenue account increases. The recognition process occurs during the accounting period where the service was provided. Then the company makes the adjusting entry for the unearned revenue by debiting the liability account and crediting the revenue account. Before the adjustment is made liabilities are overstated and revenue is understated. The second category for adjusting entries is for accruals. Preceding the entry adjustments the revenue account or the expense account are understated.

Consequently the entry adjustment for accruals increases the balance sheet and income statement account. Accrued revenue is accumulated revenue that is not recorded at the statement date because revenue is accrued with passing time, which is impractical to record daily. The adjusting entry records the amount owed to a business at the balance sheet date and the revenue earned in that time. The adjusting entry increases both the revenue account and the asset account. If services provided to client that were not billed will not be recorded.

The accrual of unrecorded service account increases accounts receivable, which also increases stockholder equity by increasing revenue account. It would be unethical for a company to backdate sales or accounts receivable to increase revenue and asset accounts to meet a quarter’s target sales. Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Adjustments are made to recognize expenses incurred at the current accounting period and record debt that is present at the balance sheet date. Consequently adjusting entry increase expense account and increase liability account.

Why Adjusting Entries are Important Every business or organization makes adjusting entries in the end of a set accounting period. Adjusting entries are entries made at the end of an accounting period to make certain that the profits and expenditures recognition principles are followed (Kimmel, Weygandt, & Kieso, 2011). Accrual transactions and the purposes of these transactions should be reported when these financial actions occur. These actions should be recorded not only when cash is paid or received but also anytime a financial action takes place.

These important concepts in accounting are imperative because they recognize net gains or losses and a business’ financial position can be identified within the accounting period. The preparations of general entries and postings are important and the information added to these journals should be precise and reliable. The truth in numbers is critical, and the information should be calculated exactly. There are numerous reasons regarding why adjusting entries are important. To establish if the accurate value of cost of goods sold and gross profit, adjusting entry of closing stock is needed.

To determine the correct value of net profit, adjusting entry of depreciation is needed. Making adjusting entries of advance expenses are essential because after this step is completed an accountant can take away advance expense from expenses collected, and this will be charged in next accounting period when these expenses will be payable. To show the correct amounts due to a third party and to show correct expenses for the accounting period making adjusting entries of outstanding expenses are important. In this entry the accountant must have debit expense and credit outstanding expense for a third party accounted for. Conclusion

As one can see, revenue recognition and expense recognition are important parts of the accounting process of any business. It is also important to understand what situations require a company to adjust their journal entries and why it is so important to do so. With the appropriate accounting techniques and accurate journaling, a company’s financial statements become more accurate and easier for both internal and external users to understand. Not only do accurate financial statements keep a company above suspicion and consequence, but it helps users make informed decisions about that company based on its financial health.

Without good decision making based on accurate information, a company will not be able to succeed. References Kimmel, P. D. , Weygandt, J. J. , & Kieso, D. E. ( 2010). Financial accounting: Tools for business decision making (6th ed. ). Hoboken, NJ: John Wiley & Sons. 2011 Financial Principles Explained. Retrieved from http://accountingexplained. com/financial/principles/revenue-recognition Walther, L. (2012) Financial Accounting 2012 Edition. Retrieved from http://www. principlesofaccounting. com/chapter3/chapter3. html sofaccounting. com/chapter3/chapter3. html

Financial statements are an important source of information to multiple groups of people. These people may belong within the organization or they may be outsiders. The internal users of financial statement include managers, financial analysts, CFOs and accountants. Whereas external users may include government agencies, such as tax agencies and the securities and exchange commission, financial consultants, investors, creditors, etc.

Now there are certain limitations that financial statements have, and this may cause problems in making intra and inter-company comparisons.

In order to minimize or overcome the short-comings of financial statements investors, accountants, CFOs have all developed different analytical tools and techniques. For internal users, especially managers, performance measures have played a significant role in minimizing the effects of these limitations. Analysts now use tools that aid in valuing company’s performance beyond financial results, bringing factors like leadership, patents, specialized workforce, brands and human resources into the picture. Technology has removed a lot of barriers, especially with respect to finance, as companies today are also implementing financial data warehouses the use of which makes it a lot easier for organizations and individuals to make decisions that are logical and in most cases correct.

Moreover, some companies are also voluntarily disclosing information about their strategy, key success factors and their management objectives in supplements to their financial statements. This gives the investors, creditors, and other external users of financial statements more of an idea of what the firm is about and where it may be standing in a couple of years from now.

REFERENCE

Helfert, Erich A. (2001). Financial Analysis Tools and Techniques: A Guide For Managers. McGraw-Hill.

Financial Statements Accounting is a function by which users can understand the internal financial workings of a company. Use of public accounting dates as far back as the late nineteenth century (Hendrickson, 2007) and continues today under the set guidelines that accounting professionals refer to as generally accepted accounting principles. These principles are set in the United States by the Financial Accounting Standards Board and the Securities and Exchange Commission (Weygandt, p. 9, 2008). The International Financial Standards Board collaborates on ways to standardize these principles globally.

Through accounting, an entity methodically identifies financial transactions, chronologically records and analyzes the transactions, and communicates this information to interested users (Weygandt, p. 4, 2008). In this paper, the subject is to identify the four basic financial statements, how they interrelate, and how both internal and external users make use of these statements. Companies prepare the four basic financial statements in the following sequence; income statement, retained earnings statement, balance sheet, and statement of cash flows (Weygandt, p. 1, 2008). The reason for the order is each statement supplies an important piece of financial information the next statement needs. Further examination of each of the financial statements clarifies the flow of information from statement to statement. Preparation of the income statement comes first. The income statement examines only the revenues and expenses of the entity over a certain period. If the revenues exceed the expenses within the period, the result is a net income (Weygandt, p. 21, 2008).

If expenses exceed the revenues, a net loss results for the period. The next financial statement, the retained earnings statement, needs the net loss or net income figure. The second basic financial statement is the retained earnings statement. This statement reflects why there is an increase or decrease in the retained earnings of an entity over a period (Weygandt, p. 21, 2008). The period is the same as the income statement. The retained earnings statement carries over the ending balance of the prior period retained earnings statement.

If it is the first statement of this kind for the entity, it begins with a retained earnings amount of zero. At this point, the net income or net loss carries from the income statement. A net income balance increases retained earnings; a net loss decreases retained earnings. The last item a retained earnings statement takes into consideration is dividends. If the entity decides to pay out a dividend, the retained earnings statement shows the dividend, which decreases the ending balance of retained earnings. The balance sheet comes third in the sequence of financial statements.

The balance sheet reports the assets, liabilities, and stockholder’s equity of an entity on a specific date (Weygandt, p. 23, 2008). This date correlates with the ending date of the periods for the prior statements. The total of assets must equal the total of liabilities and stockholder’s equity on the balance sheet. Stockholder’s equity consists of the total of common stock, revenue, retained earnings, dividends, and expenses. The retained earnings balance above carries to the balance sheet. The last of the four basic financial statements is the statement of cash flows.

This statement summarizes the inflow and outflow of cash over the same period as the income statement and retained earnings statement. The cash flow statement shows the cash effects on company operations, investing transactions, financing transactions, net increase or decrease of cash, and the ending cash balance (Weygandt, p. 24, 2008). The cash balance (under assets) from the balance sheet flows into the statement of cash flows. Internal and external users both make use of the four basic financial statements.

Managers, employees, directors, and owners are examples of internal users; people within a company that use the information for daily operations. An income statement can help determine where expenses need to be cut or where expansion would be wise because of revenue generation. The retained earnings statement helps with decisions to make dividend distributions or invest excess earnings back into the business. A director could use the balance sheet quickly to review if liabilities are too far exceeding the equity of the company. Employees could use cash flow statements as proof of performance for compensation requests.

Investors and creditors are examples of external users because they are persons outside of a company using the financial statements. Investors review these statements when making investment decisions. They need to see profitability and dividend distributions. The information is also used in making calculations such as return on assets or debt to total assets. Creditors also use the information on these statements to calculate ratios for determining whether or not to lend money, interest rates at which to lend, or even the length of the term for which they are lending. In ummary, one can see how accounting and the four basic financial statements it produces (income statement, retained earnings statement, balance sheet and statement of cash flows) are an integral part of any business entity. Businesses use these statements both internally and externally to function. The fact that public accounting has been part of the business structure for over a century shows its true value. References Hendrickson, H. S. (2007). Encyclopedia of business and finance (2nd ed. ). Detroit, MI: Macmillan. Weygandt, J. J. (2008). Financial accounting (6th ed. ). Retrieved from The University of Phoenix eBook Collection database.

Financial Statements for Internal Reporting Purposes vs. Financial Statements for External Reporting Purposes It is common in most companies to maintain two set of financial statements; one being used/presented for internal reporting purposes and another for reporting externally. Internal reports are used primarily to aid management in the decision making process throughout the course of the business. These are subject to internal audit to make sure that all information reported are fair and correct, safeguard the assets of the company, assure compliance to laws and regulations, etc.

The company employs the internal accountants and therefore, unregulated, although there are international standards for internal auditing. External Reports on the other hand, are to provide information on the financial position, performance and changes in the financial position of the company for a variety of users such as the government, shareholders, financial institutions, employees, vendors, and the public itself. These reports should be very understandable, and are assumed to be read by users who have reasonable knowledge on financials and business, and for those who are willing to study the information diligently.

Most of the external users depend completely on these reports for their decision making. The reports are expected to be reliable so the companies should employ external auditors that are independent from the company. This is to avoid conflict of interests and bias towards the information presented by the company. Ideally, the financial statements that are audited by the internal auditors should be the same as the statements that would be subject to external audit.

The problem arises when the company decided to report financial statements that are entirely different from the internally used and that of externally used. But still the intention of the company why it reported two different reports should be considered as well because that is where the ethical issue starts. If the company’s primary intention is to conceal the truth to avoid tax penalties, attract more investors, or lure a vendor to give a high credit limit, then the ethical standard of utilitarianism, rights and duties as well as the fairness and equity are violated.

For utilitarianism approach, the external users will surely not benefit from the concealment. Their investments, assets, as well as the benefits from taxes are at risk. Only the company will benefit from it. In terms of the rights and duties approach, the shareholders has all the rights to know the true standing of the company and the duty of the company is to provide them the truth. The issue on fairness and equity is that other users may be able benefit from some concealment while others may not.

Maintaining two sets of Financial Records/Statement has been a long practice for almost all if not all major companies worldwide. An example of which is the manner of reporting sunk costs. Companies do recognize sinking cost in the Financial Statement. While this could be creditable as expense for tax accounting purposes, the said cost is no longer relevant for management decision thus no longer required in the books for Internal Purposes. Keeping two books would allow company executives to better examine items that matter to them especially those which affect the company in the future.

There is nothing wrong in maintain two sets of books specially if the reports are in accordance the accounting guidelines such as the GAAP or other statutory requirements required by the government where the company operates and are prepared in accordance with the Bureau of Internal Revenue regulations. As explained above, the books for internal management are for their use only and need not be shown to the public or used in taxation purposes.

16th January 2012 34 Mansion road Granchestor meadows Oxford Ox1 6ds Dear Mr Han , I am writing this letter to explain to you the component of your financial statement, this includes the Balance sheet at 31st of March 2011 and the profit and loss account for the year ended in 31st of March 2011 , hope you have a b etter understanding after reading my letter. The Profit and Loss account shows whether your business has made profit or loss , over your financial year.

This also shows how much sales you’ve made and how much loss, it helps you make decisions in the future and improve on your business. You may also view whether you made Profit or loss weekly, monthly but usually it is shows yearly. Revenue Expenditure is the money you spend on items on a day to day basis. This may vary depending on the Business type. Some examples of what may be included is, Premises costs, staff costs, purchase stock. These are the Revenue expenditure from your account.

Rents and Rates – ? 6,000 Wages and salaries – ? 3,920 Advertising – ? 1,500 Telephone and postage – ? 190 Revenue income is the money coming into the business from performing its daily tasks; these also vary on the type of business owned. Some of the examples of revenue income within a business are sales, commission received and also rent received. The revenue incomes from your account are Sales at a cost of ? 63,850. Balance sheet this is a businesses’ net worth at a particular point.

Balance sheet also shows the value of a business as it states what the business owns also known as assets and also known as liabilities. Capital Income is the money that is invested into the business by its owners and all other investors. The money is usually to set up the business, have equipment. It is usually equipment that will stay and be used in the business for a longer period of time an example may be Premises. The capital income of your account is a capital of ? 16,000.

Capital expenditure – These are used to buy capital assets that stay in the business for a long period of time some examples may be , Buildings, Machinery ,Office , Furniture and fittings. Here is the capital expenditure from your Accounts . Equipment ? 13,175 Motor Vehicles ? 2,400 The profit and loss account calculates the amount of profit that is left after the cost of producing goods and service it is then deducted from the amount of sales revenue, this is calculated by sales revenue take away costs of goods that have been sold.

Cost of sales is the value of stock that is used to generate the sales, the calculation for costs of goods sold is Opening stock plus purchases take away closing stock. Net profit is the money left after all the other expenses have been deducted from the gross profit and also any other income that has been added on, this is calculated by adding the Gross Profit to expenses. Fixed assets are the items that a business owns and that will stay for a long period of time , you may see this on a business balance sheet that will include Buildings, Machinery ,Office , Furniture and fittings.

These assets lose their value over a period of time, meaning that after every year the value in the balance sheet is reduced to give affair value of the asset. The fixed assets from your account are Equipment and also Motor Vehicles. Current assets ,are the items of value that are owned by a business whose value is likely to rise and fall irregularly in number or amount on a regular basis ,this also occurs every time the business makes a transaction. Current assets include Stock – ? 7,400 Debtors – ? 150 Cash in the bank – ? 560 Cash in hand – ? 250

Current liabilities –Is what is owned by a business and it should be paid back in less than one year of time the examples are creditors and also overdrafts. The current liabilities from your account are Creditors at ? -1610. Net assets – This shows the total value of the entire assets take away the value of the liabilities. Net assets are calculated by Current assets plus fixed assets take away (current liabilities long term liabilities) the total of your net assets are ? 12,325. Capital employed –This represents the capital investment necessary for a business to function.

Consequently, it is not a measure of assets, but of capital investment: stock or shares and long-term liabilities. It’s the initial capital invested in the business calculated by profit and opening capital being added minus drawings. Capital employed and net assets always have the same /equal answers. After the explanation of showing the purpose of Profit and loss account, explaining and giving calculations and examples I hope it helped you understand, if any questions please contact Yours sincerely.