Accounting, Financial, Taxation

Assets are financed both by debt and equity. “Equity“ represents the “net assets“ of a corporation. This concept can be compared to owning a house (asset) with an outstanding mortgage note (liability). If the house is valued at $200,000 and the payoff on the mortgage note is $140,000, then the equity in the house is $60,000. A company’s balance sheet is viewed in much the same way. It is composed of many assets, a variety of liabilities, and a residual interest (equity) in those assets. The relationship between the three defines the balance sheet equation.

Furthermore, there continues to exist an inverse relationship between a company’s debt and its equity. If equity increases relative to total assets, then debt decreases proportionally. The greater the equity component in a balance sheet, the less pressure on the organization to cover related interest costs and generate a profit. Stockholders’ equity is generally divided into two categories: “contributed capital” and “earned capital“.

Let’s go to a bit details…………

Contributed Capital

Contributed capital is recognized when a company acquires assets through the sale or exchange of common stock. When this occurs, companies recognize additional contributed capital in the balance sheet as well as an asset or reduction in an existing liability. Most often the asset received is cash, but occasionally a building and/or equipment can be received as well. Companies also have the flexibility to settle existing debt obligations with the issuance of common shares. In all of these cases, the net assets of the companies change because of management’s decision.

A company balance sheet may show that contributed capital consists of common stock and additional paid-in capital. Alongside these elements is the company’s disclosure of: authorized common shares, issued common shares, and outstanding common shares. Authorization establishes the ceiling on the total number of shares that may be issued by the company. The Articles of Incorporation identify this number, which can be exceeded only if the corporate charter is amended. The issued number of shares is the shares sold over time, while the number of shares outstanding can be less than or equal to the number of shares issued. If the number of shares outstanding is less than the number of shares issued, the company has reacquired some of its own common stock. Companies do this to enhance future earnings per share, reduce total future dividends paid, support executive compensation programs, or help fend off hostile takeovers. Reacquired shares are called “treasury shares“.

Understand that par value and fair market value are unrelated measures. Multiplying the number of shares outstanding by a par value, a value of $116 million is recorded in the company’s balance sheet, for instance, the $116 million also constitutes the legal capital of the firm. Legal capital is used as a protective means to prevent companies from distributing dividends in excess of earnings and additional paid-in capital. It provides some measure of value to creditors in case of liquidation.

The paid-in capital account represents the excess of selling price per common share over par value per share. Because company stock is sold periodically, the selling price will often vary depending on market conditions. Thus, paid-in capital can accumulate in different amounts with each public offering of the firm.

Earned Capital

The other component of shareholders’ equity is called “earned capital” or “retained earnings“. Earned capital represents the accumulated earnings of that company since its inception, less any dividends paid to the company’s shareholders. Many newly established companies pay limited dividends and instead concentrate on growth. Rather than acquire capital externally at an additional cost, they can use these internally generated funds in a more efficient way. Established companies, on the other hand, attract a different type of investor who looks to dividends as a source of periodic revenue. When a company first begins operations, accumulated or retained earnings are zero. With the passage of time however, earnings are reported and dividends are distributed. As a result, retained earnings may be positive or negative. A positive measure indicates that the company has attained some level of profitability (net income) and has distributed less than those earnings to shareholders. Negative retained earnings suggest that the company has sustained net losses over time or paid out dividends in excess of profits achieved. There is no relationship between retained earnings and a company’s cash position. Remember that retained earnings are a subset of equity, and equity supports all assets.

Accumulated Other Comprehensive Income

An additional component of stockholders’ equity is “accumulated other comprehensive income“. Accumulated other comprehensive income includes gains and losses related to certain events that have historically bypassed the income statement for income smoothing reasons. Therefore, for many years, the only reported measure of a company’s performance was net income.

A recent change in financial reporting now requires companies to report a more complete measure of income called “comprehensive income“. In essence, comprehensive income includes not just net income but other comprehensive income. As increases and decreases in other comprehensive income occur during the reporting period, these are reported in the statement of change in stockholders’ equity or in a separate statement of comprehensive income. But any accumulated balance of these unrealized gains and losses is reported under stockholders’ equity in the balance sheet.

These items normally include unrealized gains and losses on available for sale securities, translation gains and losses on foreign currency, and excess of additional pension liability over unrecognized prior service cost.

Shares Purchased For Compensation Plans

The last element that appears on the balance sheet is the “cost of shares reacquired” for compensation plans, also known as a “company’s treasury stock“. Treasury stock represents stock that has been repurchased by the issuer for some intended purpose. For example, companies that buy back their shares do the following:

1. Take advantage of current market conditions and lower stock prices - Reacquisition of shares at low prices eliminates future dividend payments to existing shareholders, therefore enhancing future cash flow.
2. Support ongoing executive compensation programs - If key executives exercise stock options, the company must have existing shares to issue to these individuals. A stock option gives the holder the right to buy company stock at a predetermined price, often at a great discount. Essentially, stock options represent a form of deferred compensation.
3. Enhance future earnings per share - If shares of stock are no longer outstanding, they are removed from the computation of earnings per share. Fewer outstanding shares increase earnings per share in subsequent accounting periods. Companies often seek opportunities to enhance this measure.

For example: if Royal Bali Cemerlang reacquires 100,000 shares to be held in treasury and pays $30 per share, treasury stock is reported at $3 million. On the balance sheet, treasury stock is a contra-equity account and is therefore deducted from stockholders’ equity. Some users of financial information believe treasury stock should be considered an asset but fail to recognize that a company cannot own itself.

Read also part of this “Classification and Element Of Balance Sheet” post series are:

Accounting records are kept on the accrual basis, except in the case of very small businesses. To accrue means to collect or accumulate. This means that revenue is recognized when earned, regardless of when cash is actually collected and expense is matched to the revenue, regardless of when cash is paid out. Most revenue is earned when goods or services are delivered. At this time, title to the goods or services is transferred and a legal obligation to pay for such goods or services is created. Some revenue, such as rental income, is recognized on a time basis, and is earned when the specified period of time has passed. The accrual concept demands that expenses be kept in step with revenue, so that each month sees only that month’s expenses applied against the revenue for that month. The necessary matching is brought about through a type of journal entry. In this post, we shall discuss these adjusting entries, and also the closing entries through which the adjusted balances are ultimately transferred to balance sheet accounts at the end of the fiscal year.

Adjusting Entries Covering Recorded Data

To adjust expense or income items that have already been recorded, a reclassification is required; that is, amounts have to be transferred from an asset, one of the prepaid expenses accounts (e.g., Prepaid Insurance), to an expense account (Insurance Expense). The following examples will show how adjusting entries are made for the principal types of recorded expenses.

Prepaid Insurance

Assume that on April 1, a business paid a $1,200 premium for one year’s insurance in advance. This represents an increase in one asset (prepaid expense) and a decrease in another asset (cash). Thus the entry would be:

[Debit]. Prepaid Insurance = $1,200
[Credit]. Cash = $1,200

At the end of April, one-twelfth of the $1,200, or $100, has expired. Therefore, an adjustment has to be made, decreasing or crediting Prepaid Insurance and increasing or debiting Insurance Expense. The entry would be:

[Debit]. Insurance Expense = $100
[Credit]. Prepaid Insurance = $100

Thus, $100 would be shown as Insurance Expense in the income statement for April and the balance of $1,100 would be shown as part of Prepaid Insurance in the balance sheet.

Another example: An insurance policy covering a two-year period was purchased on November 1 for $600. The amount was debited to Prepaid Insurance. The adjusting entry for the two-month period ending December 31 would be:

[Debit]. Insurance Expense = $50*
[Credit]. Prepaid Insurance = $50

* ($600/ 2 years) multiplied by (2/12) years equals $50

Prepaid Rent

Assume that on April 1 a business paid $1,800 to cover the rent for the next three months. The full amount would have been recorded as a prepaid expense in April. Since there is a three-month period involved, the rent expense each month is $600. The balance of Prepaid Rent would be $1,200 at the beginning of May. The adjusting entry for April would be:

[Debit]. Rent Expense = $600
[Credit]. Prepaid Rent = $600

Supplies

A type of prepayment that is somewhat different from those previously described is the payment for office supplies or factory supplies. Assume that on April 1, $400 worth of supplies were purchased. There were none on hand before. This would increase the asset Supplies and decrease the asset Cash. At the end of April, when expense and revenue were to be matched and statements prepared, a count of the supplies on hand will be made. Assume that the inventory count shows that $250 of supplies are still on hand. Then the amount consumed during April was $150. The two entries are as follows:

April 1:

[Debit]. Supplies = $400
[Credit]. Cash = $400

April 30:

[Debit]. Supplies Expense = $150
[Debit]. Supplies = $150

Supplies Expense of $150 will be included in the April income statement; Supplies of $250 will be included as an asset on the balance sheet of April 30.

Accumulated Depreciation

In the previous three adjusting entries, the balances of the assets mentioned were all reduced. These assets usually lose their value in a relatively short period of time. However, assets that have a longer life expectancy (such as a building) are treated differently because the accounting profession wants to keep a balance sheet record of the equipment’s original, or historical, cost. Thus the adjusting entry needed to reflect the true value of the long-term asset each year must allocate its original cost, known as depreciation. In order to accomplish the objectives of keeping original cost of the equipment and also maintaining a running total of the depreciation allocated, we must create a new account entitled “Accumulated Depreciation“. This account, known as a contra asset (an asset that has the opposite balance to its asset), summarizes and accumulates the amount of depreciation over the equipment’s total useful life.

Example: Assume that machinery costing $15,000 was purchased on February 1 of the current year and was expected to last ten years. With the straight-line method of depreciation (equal charges each period), the depreciation would be $1,500 a year, or $125 a month. The adjusting entry would be as follows:

[Debit]. Depreciation Expense = $125
[Credit]. Accumulated Depreciation = $125

At the end of April, Accumulated Depreciation would have a balance of $375, representing three months’ accumulated depreciation. The account would be shown in the balance sheet as follows:

Machinery $15,000
Less: Accumulated Depreciation $ 375
____________________________________

Machinery Book Value = $14,625

Another example: a machinery costing $12,000, purchased on November 30, is being depreciated at the rate of 10 percent per year. The adjusting entry for December 31 would be:

[Debit]. Depreciation Expense—Machinery = $100*
[Credit]. Accumulated Depreciation—Machinery = $100

*$12,000 times 10% per year times (1/12) year equals $100

Adjusting Entries Covering Unrecorded Data

In the previous section we discussed various kinds of adjustments to accounts to which entries had already been made. Now we consider those instances in which an expense has been incurred or an income earned but the applicable amount has not been recorded during the month.

Example: if salaries are paid on a weekly basis, the last week of the month may run into the next month. If April ends on a Tuesday, then the first two days of the week will apply to April and will be an April expense, whereas the last three days will be a May expense. To arrive at the proper total for salaries for the month of April, we must include, along with the April payrolls that were paid in April, the two days’ salary that was not paid until May. Thus, we make an entry to accrue the two days’ salary.

Accrued Salaries

Assume that April 30 falls on Tuesday. Then, two days of that week will apply to April and three days to May. The payroll is $500 per day, $2,500 per week. For this example, $1,000 would thus apply to April and $1,500 to May. The entry would be as follows:

April 30:

[Debit]. Salaries Expense = $1,000
[Credit]. Salaries Payable = $1,000

When the payment of the payroll is made—on May 8—the entry would be as follows:

May 8:

[Debit]. Salaries Expense = $1,500
[Debit]. Salaries Payable = $1,000
[Credit]. Cash = $2,500

As can be seen above, $1,000 was charged to expense in April and $1,500 in May. The debit to Accrued Salaries Payable of $1,000 in May merely canceled the credit entry made in April, when the liability was set up for the April salaries expense.

Closing Entries

After the income statement and balance sheet have been prepared, a summary account—known as “Income Summary“—is set up. Then, by means of closing entries, each expense account is credited so as to produce a zero balance, and the total amount for the closed-out accounts is debited to Income Summary. Similarly, the individual revenue accounts are closed out by debiting them and their total amount is credited to the summary account. Thus, the new fiscal year starts with zero balances in the income and expense accounts, whereas the Income Summary balance gives the net income or the net loss for the old year.

Let’s do one example for easier understanding. Below is Royal Bali Cemerlang’s trial balance:

The closing procedure and its steps are as follows:

Close out revenue accounts. Debit the individual income accounts and credit their total to Income Summary.

Jan. 31:

[Debit]. Fees Income = $2,500
[Credit]. Income Summary = $2,500

Close out expense accounts. Credit the individual expense accounts and debit their total to Income Summary.

Jan. 31:

[Debit]. Income Summary = $900
[Credit]. Rent Expense = $500
[Credit]. Salaries Expense = $200
[Credit]. Supplies Expense = $200

Close out the Income Summary account. If there is a profit, the credit made for total income in the first entry above will exceed the debit made for total expense in the second entry above. Therefore to close out the balance to zero, a debit entry will be made to Income Summary. A credit will be made to the capital account to transfer the net income for the period. If expenses exceed income, then a loss has been sustained and a credit will be made to Income Summary and a debit to the capital account. Based on the information given, the entry is:

Jan. 31:

[Debit]. Income Summary = $1,600
[Credit]. Capital Account or Retained Earning = $1,600

Close out the drawing account. The drawing account is credited for the total amount of the drawings for the period, and the capital account is debited for that amount. The difference between net income and drawing for the period represents the net change in the capital account for the period.

The net income of $1,600 less drawings of $400 results in a net increase of $1,200 in the capital account. The closing entry is as follows:
Jan. 31:

[Debit]. Capital Account = $300
[Credit]. Drawing Account = $300

Ruling Accounts

After the posting of the closing entries, all revenue and expense accounts and the summary accounts are closed. When ruling an account where only one debit and one credit exist, a double rule is drawn below the entry across the debit and credit money columns. The date and reference columns also have a double rule, in order to separate the transactions from the period just ended and the entry to be made in the subsequent period.

Post-Closing Trial Balance

After the closing entries have been made and the accounts ruled, only balance sheet accounts—assets, liabilities, and capital—remain open. It is desirable to produce another trial balance to ensure that the accounts are in balance. This is known as a post-closing trial balance.

Closing entries are used to close out (or bring the balance to $0) temporary accounts (nominal accounts) to Retained Earnings. Basically, closing entries are journal entries to transfer the nominal accounts to the real accounts. For the accounting period being closed, temporary accounts are: revenue, expense, income summary and dividends paid/declared accounts.

For easier understanding and more clearly figure, here is an “Income Statement” example:

Closing Revenues

Revenues reported on the income statement are closed to the income summary account. Since Revenues are posted to the General Ledger as a credit, debiting the Revenue accounts for the total balance will zero them out. The entry to close Revenues to the Income Summary account is as follows:

[Debit]. Revenues = $4,960
[Credit]. Income Summary = 4,960

Closing Expenses

Expenses reported on the income statement are closed to the income summary account. Since Expenses are posted to the General Ledger as a debit, crediting the Expense accounts for the total balance will zero them out. The entry to close Expenses to the Income Summary account is as follows:

[Debit]. Income Summary = $4,423
[Credit]. Expenses = 4,423

Closing Income Summary

The income summary account is used as a check figure because the balance in the account, after Revenues and Expenses are closed out, should be equal to Net Income or Net Loss for the period being closed. A Net Income for an accounting period creates a credit balance in the income summary account, and a Net Loss creates a debit balance. Now close the Income Summary account to Retained Earnings (debiting or crediting the account depending on the ending balance):

[Debit]. Income Summary = $537
[Credit]. Retained Earnings = 537

Closing Dividends

If Dividends were paid or declared during the accounting period in questions, the account will need to be closed out to Retained Earnings. Since Dividends have a debit balance, and reduce Retained Earnings, the account will be credited in order to close it out:

[Debit]. Retained Earnings XXXo
[Credit]. Dividends XXX

Finally, the balance in the Retained Earnings account will be the ending retained earnings for the accounting period in question and go on the balance sheet in its proper place.

Note: As with other journal entries, closing entries are posted to the right general ledger.