Managing Your Business With Accounting

The Purpose of this site is to educate people on accounting topics, cost and management accounting, nigeria tax law, audit principle and business managemnt

Chart of Accounts February 23, 2011

Filed under: Financial Accounting — Godwin @ 11:34 am

Introduction to 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

Sample Chart of Accounts for a Small Company

This is a partial listing of another sample chart of accounts. Note that each account is assigned a three-digit number followed by the account name. The first digit of the number signifies if it is an asset, liability, etc. For example, if the first digit is a “1″ it is an asset, if the first digit is a “3″ it is a revenue account, etc. The company decided to include a column to indicate whether a debit or credit will increase the amount in the account. This sample chart of accounts also includes a column containing a description of each account in order to assist in the selection of the most appropriate account.
 Asset Accounts

No. Account Title To
Increase
Description/Explanation of Account
101 Cash Debit Checking account balance (as shown in company records), currency, coins, checks received from customers but not yet deposited.
120 Accounts Receivable Debit Amounts owed to the company for services performed or products sold but not yet paid for.
140 Merchandise Inventory Debit Cost of merchandise purchased but has not yet been sold.
150 Supplies Debit Cost of supplies that have not yet been used. Supplies that have been used are recorded in Supplies Expense.
160 Prepaid Insurance Debit Cost of insurance that is paid in advance and includes a future accounting period.
170 Land Debit Cost to acquire and prepare land for use by the company.
175 Buildings Debit Cost to purchase or construct buildings for use by the company.
178 Accumulated
Depreciation – Buildings
Credit Amount of the buildings’ cost that has been allocated to Depreciation Expense since the time the building was acquired.
180 Equipment Debit Cost to acquire and prepare equipment for use by the company.
188 Accumulated
Depreciation – Equipment
Credit Amount of equipment’s cost that has been allocated to Depreciation Expense since the time the equipment was acquired.

 Liability Accounts

No. Account Title To
Increase
Description/Explanation of Account
210 Notes Payable Credit The amount of principal due on a formal written promise to pay. Loans from banks are included in this account.
215 Accounts Payable Credit Amount owed to suppliers who provided goods and services to the company but did not require immediate payment in cash.
220 Wages Payable Credit Amount owed to employees for hours worked but not yet paid.
230 Interest Payable Credit Amount owed for interest on Notes Payable up until the date of the balance sheet. This is computed by multiplying the amount of the note times the effective interest rate times the time period.
240 Unearned Revenues Credit Amounts received in advance of delivering goods or providing services. When the goods are delivered or services are provided, this liability amount decreases.
250 Mortgage Loan Payable Credit A formal loan that involves a lien on real estate until the loan is repaid.

 Owner’s Equity Accounts

No. Account Title To
Increase
Description/Explanation of Account
290 Mary Smith, Capital Credit Amount the owner invested in the company (through cash or other assets) plus earnings of the company not withdrawn by the owner.
295 Mary Smith, Drawing Debit Amount that the owner of the sole proprietorship has withdrawn for personal use during the current accounting year. At the end of the year, the amount in this account will be transferred into Mary Smith, Capital (account 290).

 Operating Revenue Accounts

No. Account Title To
Increase
Description/Explanation of Account
310 Service Revenues Credit Amounts earned from providing services to clients, either for cash or on credit. When a service is provided on credit, both this account and Accounts Receivable will increase. When a service is provided for immediate cash, both this account and Cash will increase.

 Operating Expense Accounts

No. Account Title To
Increase
Description/Explanation of Account
500 Salaries Expense Debit Expenses incurred for the work performed by salaried employees during the accounting period. These employees normally receive a fixed amount on a weekly, monthly, or annual basis.
510 Wages Expense Debit Expenses incurred for the work performed by non-salaried employees during the accounting period. These employees receive an hourly rate of pay.
540 Supplies Expense Debit Cost of supplies used up during the accounting period.
560 Rent Expense Debit Cost of occupying rented facilities during the accounting period.
570 Utilities Expense Debit Costs for electricity, heat, water, and sewer that were used during the accounting period.
576 Telephone Expense Debit Cost of telephone used during the current accounting period.
610 Advertising Expense Debit Costs incurred by the company during the accounting period for ads, promotions, and other selling and expenses (other than salaries).
750 Depreciation Expense Debit Cost of long-term assets allocated to expense during the current accounting period.

 Non-Operating Revenues and Expenses, Gains, and Losses

No. Account Title To
Increase
Description/Explanation of Account
810 Interest Revenues Credit Interest and dividends earned on bank accounts, investments or notes receivable. This account is increased when the interest is earned and either Cash or Interest Receivable is also increased.
910 Gain on Sale of Assets Credit Occurs when the company sells one of its assets (other than inventory) for more than the asset’s book value.
960 Loss on Sale of Assets Debit Occurs when the company sells one of its assets (other than inventory) for less than the asset’s book value.

Accounting software frequently includes sample charts of accounts for various types of businesses. It is expected that a company will expand and/or modify these sample charts of accounts so that the specific needs of the company are met. Once a business is up and running and transactions are routinely being recorded, the company may add more accounts or delete accounts that are never used.

At Least Two Accounts for Every Transaction

The chart of accounts lists the accounts that are available for recording transactions. In keeping with the double-entry system of accounting, a minimum of two accounts is needed for every transaction—at least one account is debited and at least one account is credited.

When a transaction is entered into a company’s accounting software, it is common for the software to prompt for only one account name—this is because the software is programmed to automatically assign one of the accounts. For example, when using accounting software to write a check, the software automatically reduces the asset account Cash and prompts you to designate the other account(s) such as Rent Expense, Advertising Expense, etc..

Some general rules about debiting and crediting the accounts are:

  Expense accounts are debited and have debit balances

  Revenue accounts are credited and have credit balances

  Asset accounts normally have debit balances

  To increase an asset account, debit the account

  To decrease an asset account, credit the account

  Liability accounts normally have credit balances

  To increase a liability account, credit the account

  To decrease a liability account, debit the account

The above is from Accounting Coach website.

 

Accounts Receivable and Bad Debts Expense

Filed under: Financial Accounting — Godwin @ 11:22 am

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:

  1. Increase sales or sales revenues, which are reported on the income statement, and
  2. 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:

  1. A credit loss or bad debts expense on its income statement, and
  2. 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.

Recording Services Provided on Credit

Assume that on June 3, Malloy Design Co. provides $4,000 of graphic design service to one of its clients with credit terms of net 30 days. (Providing services with credit terms is also referred to as providing services on account.)

Under the accrual basis of accounting, revenues are considered earned at the time when the services are provided. This means that on June 3 Malloy will record the revenues it earned, even though Malloy will not receive the $4,000 until July. Below are the accounts affected on June 3, the day the service transaction was completed:

Date Account Name Debit Credit

 

 

 

June 3 Accounts Receivable 4,000  

 

    Service Revenues   4,000

 

In this transaction, the debit to Accounts Receivable increases Malloy’s current assets, total assets, working capital, and stockholders’ (or owner’s) equity—all of which are reported on its balance sheet. The credit to Service Revenues will increase Malloy’s revenues and net income—both of which are reported on its income statement.

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

 

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 Credit

 

 

 

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

Examples of Amounts Due Under Varying Credit Terms

The following chart shows the amounts a seller would receive under various credit terms for a merchandise sale of $1,000 and an authorized return of $100 of goods.

Credit Terms Brief Description Amount To be Received
Net 10 days The net amount is due within 10 days of the invoice date. $900
Net 30 days The net amount is due within 30 days of the invoice date. $900
Net 60 days The net amount is due within 60 days of the invoice date. $900
2/10, n/30 If paid within 10 days of the invoice date, the buyer may deduct 2% from the net amount. ($900 minus $18) $882
2/10, n/30 If paid in 30 days of the invoice date, the net amount is due. $900
1/10, n/60 If paid within 10 days of the invoice date, the buyer may deduct 1% from the net amount. ($900 minus $9) $891
1/10, n/60 If paid in 60 days of the invoice date, the net amount is due. $900
Net EOM 10 The net amount is due within 10 days after the end of the month (EOM). In other words, payment for any sale made in June is due by July 10. $900

Costs of Discounts

Some business people believe that the credit term of 2/10, net 30 is far too generous. They argue that when a $900 receivable is settled for $882 (simply because the customer pays 20 days early) the seller is, in effect, giving the buyer the equivalent of a 36% annual interest rate (2% for 20 days equates to 36% for 360 days). Some sellers won’t offer terms such as 2/10, net 30 because of these high percentage equivalents. Other sellers are discouraged to find that some customers take the discount and ignore the obligation to pay within the stated discount period.

Credit Risk

When a seller provides goods or services on credit, the resultant account receivable is normally considered to be an unsecured claim against the buyer’s assets. This makes the seller (the supplier) an unsecured creditor, meaning it does not have a lien on any of the buyer’s assets—not even on the goods that it just sold to the buyer.

Sometimes a supplier’s customer gets into financial difficulty and is forced to liquidate its assets. In this situation the customer typically owes money to lending institutions as well as to its suppliers of goods and services. In such cases, it’s the secured creditors (the banks and other lenders that have a lien on specific assets such as cash, receivables, inventory, equipment, etc.) who are paid first from the sale of the assets. Often there is not enough money to pay what is owed to the secured lenders, much less the unsecured creditors. In other words, the suppliers will never be paid what they are owed.

To avoid this kind of risk, some suppliers may decide not to sell anything on credit, but require instead that all of its goods be paid for with cash or a credit card. Such a company, however, may lose out on sales to competitors who offer to sell on credit.

To minimize losses, sellers typically perform a thorough credit check on any new customer before selling to them on credit. They obtain credit reports and check furnished references. Even when a credit check is favorable, however, a credit loss can still occur. For example, a first-rate customer may experience an unexpected financial hardship caused by one of its customers, something that could not have been known when the credit check was done. The point is this: any company that sells on credit to a large number of customers should assume that, sooner or later, it will probably experience some credit losses along the way.

Allowance Method for Reporting Credit Losses

Accounts receivable are reported as a current asset on a company’s balance sheet. Since current assets by definition are expected to turn to cash within one year (or within the operating cycle, whichever is longer), a company’s balance sheet could overstate its accounts receivable (and therefore its working capital and stockholders’ equity) if any part of its accounts receivable is not collectible.

To guard against overstatement, a company will estimate how much of its accounts receivable will never be collected. This estimate is reported in a balance sheet contra asset account called Allowance for Doubtful Accounts. (Some companies call this account Provision for Doubtful Accounts or Allowance for Uncollectible Accounts.) Any increases to Allowance for Doubtful Accounts are also recorded in the income statement account Bad Debts Expense (or Uncollectible Accounts Expense).

This method of anticipating the uncollectible amount of receivables and recording it in the Allowance for Doubtful Accounts is known as the allowance method. (If a company does not use an allowance account, it is following the direct write-off method, which is discussed later.)

Allowance for Doubtful Accounts and Bad Debts Expense – June

As we stated above, the account Allowance for Doubtful Accounts is a contra asset account containing the estimated amount of the accounts receivable that will not be collected. For example, let’s assume that Gem Merchandise Co.’s Accounts Receivable has a debit balance of $100,000 at June 30. Gem anticipates that approximately $2,000 of this is not likely to turn to cash, and as a result, Gem reports a credit balance of $2,000 in Allowance for Doubtful Accounts. The accounting entry to adjust the balance in the allowance account will involve the income statement account Bad Debts Expense.

Since June was Gem’s first month in business, its Allowance for Doubtful Accounts began June with a zero balance. At June 30, when it issues its first balance sheet and income statement, its Allowance for Doubtful Accounts will have a credit balance of $2,000. This is done using the following adjusting journal entry:

Date Account Name Debit Credit

 

 

 

June 30 Bad Debts Expense 2,000  

 

    Allowance for Doubtful Accounts   2,000

Here are some of the accounts in a T-account format:

Accounts Receivable   Allowance for Doubtful Accounts
June 1 Balance           June 1 Balance
                 
June Sales 105,000 5,000 June Collections       2,000 June 30 Adjust
June 30 Balance 100,000           2,000 June 30 Balance
                 
     
     
    Bad Debts Expense
  June 1 Balance    
         
  June 30 Adjust 2,000    
  June 30 Balance 2,000    
         

With Allowance for Doubtful Accounts now reporting a credit balance of $2,000 and Accounts Receivable reporting a debit balance of $100,000, Gem’s balance sheet will report a net amount of $98,000. Since this net amount of $98,000 is the amount that is likely to turn to cash, it is referred to as the net realizable value of the accounts receivable.

Under the allowance method, the Gem Merchandise Co. does not need to know specifically which customer will not pay, nor does it need to know the exact amount. This is acceptable because accountants believe it is better to report an approximate amount that is uncollectible rather than imply that every penny of the accounts receivable will be collected.

Gem’s Bad Debts Expense will report credit losses of $2,000 on its June income statement. This expense is being reported even though none of the accounts receivables were due in June. (Recall the credit terms were net 30 days.) Gem is attempting to follow the matching principle by matching the bad debts expense as best it can to the accounting period in which the credit sales took place.

Since the net realizable value of a company’s accounts receivable cannot be more than the debit balance in Accounts Receivable, the balance in the Allowance for Doubtful Accounts must be a credit balance or a zero balance.

Allowance for Doubtful Accounts and Bad Debts Expense – July

Now let’s assume that at July 31 the Gem Merchandise Co. has a debit balance in Accounts Receivable of $230,000. (The balance increased during July by the amount of its credit sales and it decreased by the amount it collected from customers.) The Allowance for Uncollectible Accounts still has the credit balance of $2,000 from the adjustment on June 30. This means Gem’s general ledger accounts before the July 31 adjustment to Allowance for Uncollectible Accounts will be reporting a net realizable value of $228,000 ($230,000 minus $2,000).

Gem reviews the details of its accounts receivable and estimates that as of July 31 approximately $10,000 of the $230,000 will not be collectible. In other words, the net realizable value (or net cash value) of its accounts receivable as of July 31 is only $220,000 ($230,000 minus $10,000). Before the July 31 financial statements are released, Gem must adjust the Allowance for Doubtful Accounts so that its ending balance is a credit of $10,000 (instead of the present credit balance of $2,000). This requires the following adjusting entry:

Date Account Name Debit Credit

 

 

 

July 31 Bad Debts Expense 8,000  

 

    Allowance for Doubtful Accounts   8,000

 

After this journal entry is recorded, Gem’s July 31 balance sheet will report the net realizable value of its accounts receivables at $220,000 ($230,000 debit balance in Accounts Receivable minus the $10,000 credit balance in Allowance for Doubtful Accounts).

Here’s a recap in T-account form:

Accounts Receivable   Allowance for Doubtful Accounts
June 1 Balance           June 1 Balance
                 
June Sales 105,000   5,000 June Collections         2,000 June 30 Adjust
June 30 Balance 100,000             2,000 June 30 Balance
                 
July Sales 225,000 95,000 July Collections         8,000 July 31 Adjust
July 31 Balance 230,000           10,000 July 31 Balance
                 
     
     
    Bad Debts Expense
  June 1 Balance    
         
  June 30 Adjust   2,000    
  June 30 Balance   2,000    
         
  July 31 Adjust   8,000    
  July 31 Balance 10,000    
         

 

As seen in the T-accounts above, Gem estimated that the total bad debts expense for the first two months of operations (June and July) is $10,000. It is likely that as of July 31 Gem will not know the precise amount of actual bad debts, nor will Gem know which customers are the ones that won’t be paying their account balances. However, the matching principle is better met by Gem making these estimates and recording the credit loss as close as possible to the time the sales were made.

By reporting the $10,000 credit balance in Allowance for Doubtful Accounts, Gem is also adhering to the accounting principle of conservatism. In other words, if there is some doubt as to whether there are $10,000 of credit losses or no credit losses, Gem’s accountant “breaks the tie” by choosing the alternative that reports a smaller amount of profit and a smaller amount of assets. (It is reporting a net realizable value of $220,000 instead of the $230,000 of accounts receivable.) If a company knows with certainty that every penny of its accounts receivable will be collected, then the Allowance for Doubtful Accounts will report a zero balance. However, if it is likely that some of the accounts receivable will not be collected in full, the principle of conservatism requires that there be a credit balance in Allowance for Doubtful Accounts.

Writing Off an Account under the Allowance Method

Under the allowance method, if a specific customer’s accounts receivable is identified as uncollectible, it is written off by removing the amount from Accounts Receivable. The entry to write off a bad account affects only balance sheet accounts: a debit to Allowance for Doubtful Accounts and a credit to Accounts Receivable. No expense or loss is reported on the income statement because this write-off is “covered” under the earlier adjusting entries for estimated bad debts expense.

Let’s illustrate the write-off with the following example. On June 3, a customer purchases $1,400 of goods on credit from Gem Merchandise Co. On August 24, that same customer informs Gem Merchandise Co. that it has filed for bankruptcy. The customer states that its bank has a lien on all of its assets. It also states that the liquidation value of those assets is less than the amount it owes the bank, and as a result Gem will receive nothing toward its $1,400 accounts receivable. After confirming this information, Gem concludes that it should remove, or write off, the customer’s account balance of $1,400.

Under the allowance method of recording credit losses, Gem’s entry to write off the customer’s account balance is as follows:

Date Account Name Debit Credit

 

 

 

Aug 24 Allowance for Doubtful Accounts 1,400  

 

    Accounts Receivable   1,400

The two accounts affected by this entry contain this information:

Accounts Receivable   Allowance for Doubtful Accounts
June 1 Balance           June 1 Balance
                 
June Sales 105,000    5,000 June Collections         2,000 June 30 Adjust
June 30 Balance 100,000             2,000 June 30 Balance
                 
July Sales 225,000   95,000 July Collections         8,000 July 31 Adjust
July 31 Balance 230,000           10,000 July 31 Balance
                 
Aug Sales 204,000 194,000 Aug Collections          
Aug 23 Balance 240,000           10,000 Aug 23 Balance
                 
       1,400 Aug 24 W-Off   Aug 24 W-Off 1,400    
Aug 24 Balance 238,600             8,600 Aug 24 Balance
                 
     

 

Note that prior to the August 24 entry of $1,400 to write off the uncollectible amount, the net realizable value of the accounts receivables was $230,000 ($240,000 debit balance in Accounts Receivable and $10,000 credit balance in Allowance for Doubtful Accounts). After writing off the bad account on August 24, the net realizable value of the accounts receivable is still $230,000 ($238,600 debit balance in Accounts Receivable and $8,600 credit balance in Allowance for Doubtful Accounts).

The Bad Debts Expense remains at $10,000; it is not directly affected by the journal entry write-off. The bad debts expense recorded on June 30 and July 31 had anticipated a credit loss such as this. It would be double counting for Gem to record both an anticipated estimate of a credit loss and the actual credit loss.

Recovery of Account under Allowance Method

After a seller has written off an accounts receivable, it is possible that the seller is paid part or all of the account balance that was written off. Under the allowance method, if such a payment is received (whether directly from the customer or as a result of a court action) the seller will take the following two steps:

  1. Reinstate the account that was written off by reversing the write-off entry. If we assume that the $1,400 written off on Aug 24 is collected on October 10, the reinstatement of the account looks like this:

 

Date Account Name Debit Credit

 

 

 

Oct 10 Accounts Receivable 1,400  

 

    Allowance for Doubtful Accounts   1,400

 

  1. Process the $1,400 received on October 10:

 

Date Account Name Debit Credit

 

 

 

Oct 10 Cash 1,400  

 

    Accounts Receivable   1,400

 

The seller’s accounting records now show that the account receivable was paid, making it more likely that the seller might do future business with this customer.

Bad Debts Expense as a Percent of Sales

Another way sellers apply the allowance method of recording bad debts expense is by using the percentage of credit sales approach. This approach automatically expenses a percentage of its credit sales based on past history.

For example, let’s assume that a company prepares weekly financial statements. Past experience indicates that 0.3% of its sales on credit will never be collected. Using the percentage of credit sales approach, this company automatically debits Bad Debts Expense and credits Allowance for Doubtful Accounts for 0.3% of each week’s credit sales. Let’s assume that in the current week this company sells $500,000 of goods on credit. It estimates its bad debts expense to be $1,500 (0.003 x $500,000) and records the following journal entry:

Date Account Name Debit Credit

 

 

 

Oct 10 Bad Debts Expense 1,500  

 

    Allowance for Doubtful Accounts   1,500

 

The percentage of credit sales approach focuses on the income statement and the matching principle. Sales revenues of $500,000 are immediately matched with $1,500 of bad debts expense. The balance in the account Allowance for Doubtful Accounts is ignored at the time of the weekly entries. However, at some later date, the balance in the allowance account must be reviewed and perhaps further adjusted, so that the balance sheet will report the correct net realizable value. If the seller is a new company, it might calculate its bad debts expense by using an industry average until it develops its own experience rate.

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.

Aging of Accounts Receivable

The general ledger account Accounts Receivable usually contains only summary amounts and is referred to as a control account. The details for the control account—each credit sale for every customer—is found in the subsidiary ledger for Accounts Receivable. The total amount of all the details in the subsidiary ledger must be equal to the total amount reported in the control account.

The detailed information in the accounts receivable subsidiary ledger is used to prepare a report known as the aging of accounts receivable. This report directs management’s attention to accounts that are slow to pay. It is also useful in determining the balance amount needed in the account Allowance for Doubtful Accounts.

The aging of accounts receivable report is typically generated by sorting unpaid sales invoices in the subsidiary ledger—first by customer and then by the date of the sales invoices. If a company sells merchandise (or provides services) and allows customers to pay 30 days later, this report will indicate how much of its accounts receivable is past due. It also reports how far past due the accounts are.

With the click of a mouse, most accounting software will provide the aging of accounts receivable report. For example, Gem Merchandise Co.’s software looks at each of its customer’s accounts receivable activity and compares the date of each unpaid sales invoice to the date of the report. If we assume the report is dated August 31 and that Gem’s credit terms are net 30 days, any unpaid sales invoices with an August date will be classified as current. Any unpaid invoices with a date in July are classified as 1 – 30 days past due. Any unpaid invoices with a date of June are classified as 31 – 60 days past due, and so on. The sorted information is present in a report that looks similar to the following:

Gem Merchandise Co.
Aging of Accounts Receivable
As of August 31, 2010

Customer Name Total Receivable Current Past Due
1 – 30 Days
Past Due
31 – 60 Days
Past Due
61+ Days
ABC Co. $  62,456 $  59,121 $3,335 $       – $        –
Extreme Co. $  18,210 $          – $      – $       – $18,210
Main Corp. $  48,954 $  48,954 $      – $       – $        –
Trifect LLC $    1,200 $          – $      – $1,200 $        –
Totals $130,820 $108,075 $3,335 $1,200 $18,210

 

If a customer realizes that one of its suppliers is lax about collecting its account receivable on time, it may take advantage by further postponing payment in order to pay more demanding suppliers on time. This puts the seller at risk since an older, unpaid accounts receivable is more likely to end up as a credit loss. The aging of accounts receivable report helps management monitor and collect the accounts receivable in a more timely manner.

Aging Used in Calculating the Allowance

The aging of accounts receivable can also be used to estimate the credit balance needed in a company’s Allowance for Doubtful Accounts. For example, based on past experience, a company might make the assumption that accounts not past due have a 99% probability of being collected in full. Accounts that are 1-30 days past due have a 97% probability of being collected in full, and the accounts 31-60 days past due have a 90% probability. The company estimates that accounts more than 60 days past due have only a 60% chance of being collected. With these probabilities of collection, the probability of not collecting is 1%, 3%, 10%, and 40% respectively.

If we multiply the totals from the aging of accounts receivable report by the probabilities of not collecting, we arrive at the expected amount of uncollectible receivables. This is illustrated below:

Gem Merchandise Co.
Expected Amount of Accounts Receivable That is Uncollectible
As of August 31, 2010

Age of Accounts Receivables Accounts Receivable Amount Probability of Not Collecting Expected Uncollectible Amount
Current $108,075 1% $1,081
Past Due: 1 – 30 days $    3,335 3% $   100
Past Due: 31 – 60 days $    1,200 10% $   120
Past Due: 61+ days $  18,210 40% $7,284
   Totals $130,820   $8,585

 

This computation estimates the balance needed for Allowance for Doubtful Accounts at August 31 to be a credit balance of $8,585.

 Customers

To improve the probability of collection (and avoid bad debts expense) many sellers prepare and mail monthly statements to all customers that have accounts receivable balances. If worded skillfully, the seller can use the statement to say “thank you for your continued business” while at the same time “reminding” the customer that receivables are being monitored and payment is expected. To further prompt customers to pay in a timely manner, the statement may indicate that past due accounts are assessed interest at an annual rate of 18% (1.5% per month). Because transactions are usually itemized on the statement, some customers use the statement as a means to compare its records with those of the seller.

Pledging or Selling Accounts Receivable

A company’s accounts receivable are considered to be a type of asset, and as such can be pledged as collateral for a loan. Asset-based lenders will often lend a company an amount equal to 80% of the value of its accounts receivable.

Some companies sell their accounts receivable to a factor. A factor buys the accounts receivables at a discount and then goes about the business of collecting and keeping the money owed through the receivables. Sometimes the factor will purchase the accounts receivables with recourse. This means the company that sold the receivables remains financially responsible if a customer does not remit the full amount to the factor. When the factor purchases the receivables without recourse, the company selling the receivables is not responsible for unpaid amounts.

Accounts Receivable Ratios

There are two commonly used financial ratios that address the relationship between the amount of a company’s accounts receivable as reported on the balance sheet and the amount of credit sales as reported on the income statement. These ratios are:

  1. Accounts receivable turnover ratio, and
  2. Days sales in accounts receivable.

 

Use the following link to learn how to calculate these ratios: Financial Ratios.

Direct Write-off Method

Generally accepted accounting principles (GAAP) require that companies use the allowance method when preparing financial statements. The use of the allowance method is not permitted, however, for purposes of reporting income taxes in the United States because the Internal Revenue Service (IRS) does not allow companies to anticipate these credit losses. As a result, companies must use the direct write-off method for income tax reporting.

In the direct write-off method, a company will not use an allowance account to reduce its Accounts Receivable. Accounts Receivable is only reduced if and when a company knows with certainty that a specific amount will not be collected from a specific customer.

For example, let’s assume that on October 21, Gem Merchandise Co. is convinced that a specific customer’s account receivable originating on June 5 in the amount of $1,238 is definitely uncollectible. Using the direct write-off method, the following entry is made:

Date Account Name Debit Credit

 

 

 

Oct. 21 Bad Debts Expense 1,238  

 

    Accounts Receivable   1,238

 

Usually many months will pass between the time of the sale on credit and the time that the seller knows with certainty that a customer is not going to pay. It is difficult to adhere to the matching principle and the concept of conservatism when a significant amount of time elapses between the time of the sales revenues and the time that the bad debts expense is reported. This is why, for purposes of financial reporting (not tax reporting), companies should use the allowance method rather than the direct write-off method.

Additional Information and Resources

Because the material covered here is considered an introduction to this topic, many complexities have been omitted. You should always consult with an accounting professional for assistance with your own specific circumstances.

The above is from Accounting Coach website

 

Bank Reconciliation Made Easy. February 22, 2011

Filed under: Financial Accounting — Godwin @ 5:00 pm

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, 2010
   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, 2010
   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.

In this part we will provide you with a sample bank reconciliation including the required journal entries. We will assume that a company has the following items:

Item #1. The bank statement for August 2010 shows an ending balance of $3,490.
Item #2. On August 31 the bank statement shows charges of $35 for the service charge for maintaining the checking account.
Item #3. On August 28 the bank statement shows a return item of $100 plus a related bank fee of $10. The return item is a customer’s check that was returned because of insufficient funds. The check was also marked “do not redeposit.
Item #4. The bank statement shows a charge of $80 for check printing on August 20.
Item #5. The bank statement shows that $8 was added to the checking account on August 31 for interest earned by the company during the month of August.
Item #6. The bank statement shows that a note receivable of $1,000 was collected by the bank on August 29 and was deposited into the company’s account. On the same day, the bank withdrew $40 from the company’s account as a fee for collecting the note receivable.
Item #7. The company’s Cash account at the end of August shows a balance of $967.
Item #8. During the month of August the company wrote checks totaling more than $50,000. As of August 31 $3,021 of the checks written in August had not yet cleared the bank and $200 of checks written in June had not yet cleared the bank.
Item #9. The $1,450 of cash received by the company on August 31 was recorded on the company’s books as of August 31. However, the $1,450 of cash receipts was deposited at the bank on the morning of September 1.
Item #10. On August 29 the company’s Cash account shows cash sales of $145. The bank statement shows the amount deposited was actually $154. The company reviewed the transactions and found that $154 was the correct amount.

 

Before we begin our sample bank reconciliation, learn the following bank reconciliation tip.

Put it where it isn’t.

If an item appears on the bank statement but not on the company’s books, the item is probably going to be an adjustment to the Cash balance on (per) the company’s books.

If an item is already in the company’s Cash account, but has not yet appeared on the bank statement, the item is probably an adjustment to the balance per the bank statement.

Our approach to the bank reconciliation is to prepare two schedules. The first schedule begins with the ending balance on the bank statement. We refer to this schedule as Step 1. The second schedule begins with the ending Cash account balance in the general ledger. We call this schedule Step 2.

Items 1 through 10 above have been sorted into the following schedules labeled Step 1and Step 2. The item number is shown in the far right column of each schedule.

Step 1.  Balance per Bank Statement on Aug. 31, 2010 $  3,490 Item #1
   Adjustments: 0  
       Deposits in transit +  1,450 Item #9
       Outstanding checks –  3,221 Item #8
       Bank errors 0  
   Adjusted/Corrected Balance per Bank $  1,719  

 

Step 2.  Balance per Books on Aug. 31, 2010 $     967 Item #7
   Adjustments:    
       Bank service charges –       35 Item #2
       NSF checks & fees –     110 Item #3
       Check printing charges –       80 Item #4
       Interest earned +        8 Item #5
       Note Receivable collected by bank +     960 Item #6
       Errors in company’s Cash account +        9 Item #10
   Adjusted/Corrected Balance per Books 1,719  

 

Step 1 Amounts

Let’s review the schedule for Step 1. In all likelihood the balance shown on the bank statement is not the true balance to be reported on the company’s balance sheet. The bank reconciliation process is to list the items that will adjust the bank statement balance to become the true cash balance. As the schedule for Step 1 indicates, the amount of deposits in transit must be added to the bank statement’s balance. Also, the amount of checks that have been written, but not yet appearing on a bank statement, must be subtracted from the bank statement’s balance. Next any bank errors should be listed and should be reported to the bank for correction. (The company does not report deposits in transit and/or outstanding checks to the bank.)
Step 2 Amounts and Required Journal Entries

Step 2 begins with the balance in the company’s Cash account found in its general ledger. The bank reconciliation process includes listing the items that will adjust the Cash account balance to become the true cash balance. We will review each item appearing in Step 2 and the related journal entry that is required. Remember that any adjustment to the company’s Cash account requires a journal entry. Generally, the adjustments to the books are the result of items found on the bank statement but have not yet been entered in the company’s Cash account.

Item #2 Bank service charges. Since the bank deducted $35 from the company’s checking account, but the company has not yet deducted this from its Cash account, the following journal entry needs to be made.

Date Account Name Debit Credit
 
August 31, 2010 Bank Service Charge Expense 35  
    Cash   35
         

(If the annual amount of service charges is small, debit Miscellaneous Expense.)

Item #3 NSF checks and fees. Since the bank deducted these legitimate amounts from the company’s bank account, the company will need to deduct these amounts from its Cash account. As mentioned, the NSF check of $100 was from a customer. Therefore, the company will likely undo the reduction to Accounts Receivable that took place when the company originally processed the $100 check. If the company wishes to recover the bank fee of $10 from the customer, it should add the $10 fee to the amount that the customer owes the company. The journal entry might look like this:

Date Account Name Debit Credit
 
August 28, 2010 Accounts Receivable 110  
    Cash   110
         

(If the amount cannot be recovered from the customer, charge an expense.)

Item #4 Check printing charges. Because this expense is not yet entered on the company’s books, but the amount has been deducted from its bank account, the company will make the following journal entry.

Date Account Name Debit Credit
 
August 20, 2010 Supplies 80  
    Cash   80
         

Item #5 Interest earned. The bank increased the checking account balance by $8 on August 31. Since the bank did not notify the company previously, the company must now increase the balance in its Cash account.

Date Account Name Debit Credit
 
August 31, 2010 Cash 8  
    Interest Revenue   8
         

Item #6 Notes receivable collected. The bank increased the company’s checking account when it collected a note for the company on August 29. It was determined that the company had not yet made an entry to its Cash account for this transaction. As a result the following journal entry is needed.

Date Account Name Debit Credit
 
August 29, 2010 Cash 960  
  Bank Service Charge Expense 40  
    Notes Receivable   1,000
         

Item #10 Company error. The company had entered $145 in its Cash account on August 29, but the bank statement showed the correct amount: $154. The transaction involved the cash sales for the day. As a result the company’s Cash account will have to be increased by $9 as follows:

Date Account Name Debit Credit
 
August 29, 2010 Cash 9  
    Sales   9
         

Step 3 Comparing the Adjusted Balances

In the above schedules the adjusted balance for Step 1 is $1,719 and the adjusted balance for Step 2 is $1,719. The company believes that all items involving cash have been included in the schedules. As a result the company has successfully completed its bank reconciliation as of the August 31, 2010.

The above is from Accounting Coach website.

 

Understanding cash flow forecasts and cash flow management February 19, 2011

Filed under: Financial Accounting — Godwin @ 9:19 pm



You might not need an accounting qualification to be successful in business but understanding accounts will help you understand the basics of financial management accounts and be comfortable using standard financial tools and measures to monitor the performance of your business.

This article explains the importance of managing and forecasting cash flow and your cash flow balance.  The other main management accounting measures you need to keep a very close eye on are:

 

Why cash flow is so important 

Your business needs cash to survive.  Even if your business is profitable on paper, unless cash is flowing in to the business faster than it is flowing out of the business you will very quickly find yourself in a position where you are unable to pay your suppliers or your staff.  If this happens your business is insolvent and it is unlawful to continue to trade.  If your business becomes insolvent it will not survive unless you find some form of financial funding.

If you are a director of a limited company that is operating whilst insolvent you could be fined and will be barred from holding any directorships in the future.

What does a cash flow forecast tell you?

Cash flow planning:

  • enables you to analyse when you expect to get paid and when you need to pay your own bills so you can determine whether you have enough cash in the bank to pay your bills
  • shows when there is likely to be a negative cash flow, ie a shortfall.  If the cash flow plan indicates this will happen you should arrange suitable finance in advance – a far preferable (and probably cheaper) option than trying to find working capital quickly once you hit a cash flow crisis
  • shows when there may be a positive cash flow, ie a surplus.  If the cash flow plan indicates this will happen you can plan in advance how and where to use or invest it

 

Cash flow analysis

A typical cash flow forecast is divided into:

  • receipts – which is all the cash coming into your business, such as sales revenue and any loans
  • outgoings – which is all the cash going out of your business, such as sales costs, buying stock or raw materials, office overheads, wages and any loan repayments
  • balances – a monthly cash balance, along with a cumulative cash balance which should be equal to the amount of cash (or overdraft) in your bank account.

 

Working out, or forecasting, your cash flow

The more accurately you can calculate your cash flow forecast, the more useful it will be in helping you predict the future position of your business. Cash flow planning and forecasting is typically done on a weekly or monthly basis depending on when you need to take cash out of your business to pay your bills.  In order to calculate accurate cash flow forecasts you will need:

  • realistic forecasts for future expected sales (which probably does NOT mean taking the previous year’s sales figure and dividing it by 12 to show a monthly forecast for this year!)
  • a realistic view on when you expect to receive payment for the sales you have made (which is not usually in the same month it was earned, unless you are a cash business or customers pay in advance)
  • details of how much and when all your items of expenditure will need to be paid for. Look at the payment terms and conditions on all the items you have bought or agreements you have entered into.
  • include details of how much and when any loan repayments are due
  • if you have it, last year’s actual cash flow figures may help you to recall items you have forgotten about.
  • if you’re registered for VAT you will need to show input and output VAT as separate items in your cash flow forecast


Your cash flow as a business management tool

Update your cash flow forecast with actual numbers as soon as they are available so the forecast becomes your actual cash flow position as you go through the year.

Review the cash flow forecast using the most up to date figures at least monthly so you can take corrective action before the cashflow situation becomes critical.

Do some ‘what if’ scenarios to determine the impact of, say, sales running at 5% below forecast, or costs increasing by 10%. This will show you where you need to focus your attention to ensure you hit your targets.

If it looks like you have a cash problem looming always take advice from a qualified accountant or business adviser first, rather than from an organisation that is going to loan you some money.

 

 
Follow

Get every new post delivered to your Inbox.