Adjusting Entries

Adjusting entries are entries that are required to be made before financial statements are created and published.

Adjusting entries are often categorized as Accruals or Deferrals.

It may help if you are clear on the reason why accrual and deferral entries are needed.   The goal is  to ensure that all the expenses and revenues that properly belong (were incurred) in a period get recorded in that period - MATCHING principle......


IMPORTANT POINT - Accruals and Deferrals never include CASH.

So - for ACCRUALS - An accrual means that we incurred something that related to this period - but the cash/money has not changed hands yet (i.e. we have not paid for a service/item we have received (accrued expense).....or...the customer has not paid us for work we have done (accrued revenue).   HOWEVER - the transaction affected the current period - so we need to record it as an expense or revenue for the current period to ensure proper matching.
Now, since no cash has changed hands, the transaction will affect either Accounts Payable (for an expense) or Accounts Receivable (for revenue).

Example
DEBIT: Utilities Expense

           CREDIT: Accounts Payable

Electric bill for May (not going to be paid until June).

Now  - for DEFERRALS - A deferral means that we paid/got paid for something in the current period that will actually affect a FUTURE period.  So since cash has changed hands (and so the Cash account is affected), it is being recorded in the current period - but we have to be sure that we do not (incorrectly) include the amount as Revenue or Expense for the current period; because it does not belong to the current period.

For example, Deferred/Prepaid Revenue - is an amount a customer pays us today for work we will (promise to) do in a FUTURE time-period.  When we receive the cash it is not revenue until we complete the work (even though we have the cash). So we will show the increase in cash (with a DEBIT) - but show the amount received as as a liability, Prepaid/Deferred Revenue (with a CREDIT).


Why is Deferred Revenue a liability?
Because by taking the customer's cash we now have an 'obligation' to perform - and the definition of a Liability is a debt/obligation......


Now - here's the key next step.   
When we actually DO the work (maybe next month....) we will need to create another transaction.  In that future period when the work is complete, the transaction that is needed is to now record the revenue we have earned by doing the work, and we do this by transferring it out of Deferred Revenue (with a Debit, to decrease) and recording it in a Revenue account (with a credit). 

So - to recap the Journal Entries.....
May:
DEBIT: Cash

             CREDIT: Prepaid Revenue  (liability)
Customer deposit for work to be completed in June


June:
DEBIT: Prepaid Revenue

              CREDIT: Revenue
Record revenue for work completed


Hope this helps! 

Valuing Inventory

Inventory is often one of the most significant current assets that a company reports on its balance sheet. The inventory dollars shown on a balance sheet represents the value of the asset on- hand (yet to be sold). During the fiscal year, as sales of product are made, the cost of the product sold must be taken out of inventory (the asset) and reclassified as cost of goods sold (an expense). Like all other journal entries, this entry reflects what is actually happening - product has left the company as a result of the sale - so inventory must be reduced. The cost of the inventory is then matched (as an expense) with the revenue (sale) that it generated.

In companies that have a high volume of sales transactions it is unrealistic to attempt to determine the exact cost of the specific item sold. For example, suppose you are Wal-Mart....with the thousands of product shipments that come into and go out of their regional warehouses, how realistic is it going to be to determine the exact cost of the specific pack of athletic socks that was sold at 2:45 today at the store in Des Moines? Pretty unrealistic, right?

In recognition of the impossibility, the Accounting profession allows companies (such as Wal-Mart) to make an assumption about how product is sold, in order to determine the cost of the product - as long as the assumption is based on an approved methodology. There are three approved costing methodologies for determining cost of goods sold and the remaining inventory asset - First in First Out (FIFO), Last In First Out (LIFO) and Weighted Average cost. A company chooses one of these approved methods and must stick with it - no changing methods every year! However, a different method can be used for different divisions within a company or for different categories of inventory.

When using FIFO, LIFO or Average cost - the goal is to determine the dollar amount to be used to create the journal entry to move cost of product sold out of inventory and into cost of goods sold;

DR: Cost of Goods Sold
CR: Inventory

Additionally, the timing of when this journal entry is made will affect the amount of the calculation. If the company is using a perpetual inventory accounting system, the calculation and associated journal entry will be made every time a sale occurs. However, if the company is using a periodic inventory system, the calculation and associated journal entry to affect inventory will be made, once per period at the end of the period.

The combination of the cost assumption (FIFO, LIFO, Average) used in the accounting for inventory combined with the timing (Perpetual, Periodic) gives rise to the statement that there are in fact SIX ways to account for inventory - FIFO Periodic, FIO Perpetual, LIFO Perpetual, LIFO Periodic, Weighted Average Perpetual and Weighted Average Periodic. What is facinating is that depending on the combination chosen (LIFO Periodic vs LIFO Perpetual), a company can have FIVE different calculated amounts that could be used for cost of goods sold. Notice I said FIVE different amounts (but SIX methods, right? So what's up with that?). That's because FIFO Periodic will give the same calculated amount for cost of goods sold as FIFO Perpetual will. However, LIFO Periodic will give a different calculated amount than LIFO Perpetual and so will Weighted Average Periodic vs. Weighted Average Perpetual.

As long as a company is consistently using one of the approved methods it can report the resulting calculated amount as cost of good sold on its income statement and as a reduction to the inventory(asset) balance. Yet, another company, with the exact same data, will report a different amount, simply because a different method was chosen. The choice made will depend on several factors, including the tax benefits of using one method over another. For example, in periods when inventory/product costs are rising, LIFO Periodic will yield the highest cost of goods sold amount and therefore the lower net income - and thus, the lower tax charge. However, using a perpetual inventory system yields operational benefits that may outweigh the tax benefit. Each company has to make its own determination.

Budgets

All companies should create annual budgets. Large corporations certainly do. It is often a time-cosuming process, lasting several months. The budgeting process for a large corporation with a fiscal year-end of December 31, could start as early as July in order to have a completed budget ready for the beginning of the new fiscal year.

The purpose of a budget is to provide an outline of the financial plan for the fiscal year. The plan is broken down into departmental budgets so that each area of the company has their section of the plan as their guide for the upcoming year.

The 'budget' for any company is not just a single budget, it is actually a series of several budgets that all inter-connect to create the Master budget for the coming year.

The budgeting process starts with a forecast. This forecast is created by the sales team and establishes a projection of the sales that they expect to be able to make in the coming year. Their estimate forms the basis of the budgets - the company must do what needs to be done in order to supply the product needed to meet the sales projections.

JOB ORDER COSTING

In any company, understanding the cost of the product being sold is critical to the company's continued success. If you do not undertand how much your product costs, you could potentially set a price that is too low which could result in you not making any profit or you could set a price that is too high, resulting in your company pricing its product out of the market. Either one of these scenarios would be devastating to the company. In a manufacturing environment the determination of cost is more challenging(see previous posting) than in a merchandising company, but it must still be done.

Job Order Costing is one of the two methods that are used to account for costs in a manufacturing environment (the other is Process costing which I will cover in another post).
In a job cost environment as costs are incurred for ongoing production, the costs are charged to Work-in-process (WIP) where they are accumulated and aggregated for each 'job' that is worked on. When that job is complete, then the total cost of the job is moved out of WIP and transferred to Finished Goods inventory. Then, when the job is sold (i.e. the customer comes to pick it up), the cost is moved from Finished Goods inventory to Cost of Goods Sold (COGS). [COGS is an expense, subtracted from Sales on the income statement to determine Gross Profit.]

The WIP account in the general ledger becomes a control account (similar to Accounts Receivable). There is a corresponding sub-ledger comprised of job accounts - one account for each job in process. As costs (Labor, Materials, Overhead) are incurred they need to be identified as to which job they belong, so that they can be posted to the appropriate job account in the sub-ledger, allowing the total cost of the job to be accumulated. It should go without saying that total of the balances in each job account in the sub-ledger MUST equal the balance in the WIP control account in the general ledger.

A job cost system is appropriate in the following circumstances;

• There is a definable start and stop to the production process for a unit of production ( i.e. a 'job')
• Each 'job' has identifiable charactersitics that distinguish it from other jobs

These characteristics make it possible to effectively identify the costs that belong specifically to each job - making it easier to accumulate those costs by job.

Reviewing costs after a job is completd can provide valuable insights into the company's production process. Once the job is complete and the accumulated cost of a job has been transferred to Finished Goods inventory, the data about the job's cost can be used in a variety of ways;

• Allow the company to set a price that covers the cost of the job and ensures a fair profit.
• Allow the company to review the costs charged to the job to see if they were correct and to see if there are ways to reduce costs in the future.
• If the price was 'fixed' prior to starting the job, then understanding the cost of the job will allow management to see if the price charged was adequate and to review their pricing for future jobs, if necessary.

A job cost system is not only able to be used in a manufacturing environment. In the motion picture industry each movie is different with a definite start and stop; the costs associated with a movie are easy to identify and accumulate. Similarly, technicians for a company like Geek Squad will maintain time and materials separately for each computer that they work on, so that customer can be billed appropriately. Each of these is an example where a job cost system is being used in a non-manufacturing situation.

Cost of Goods Manufactured : Cost of Goods Sold

Cost of Goods Sold

Like any other company, a manufacturing company has to create an income statement. On that income statement they will report Sales less Cost of Goods Sold to determine their Gross Profit.

For a manufacturing company the calculation of Cost of Goods Sold will differ from a merchandising company because a manufacturing company makes its inventory (the product it plans to sell), while a merchandiser purchases it.

If you remember - the calculation for Cost of Goods Sold (for a merchandiser) is;

Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold

When a manufacturer does this calculation, the cost of purchases is replaced by the cost to produce/make product - this is cost of goods manufactured - so the calculation looks like this;

Beginning Inventory + Cost of Goods Manufactured - Ending Inventory = Cost of Goods Sold

Cost of Goods Manufactured

Cost of Goods Manufactured is comprised of the total costs incurred to make the product - these include all Direct Labor, Direct Materials and Overhead incurred - in other words total manufacturing costs.

So, to calculate Cost of Goods Manufactured for a period, a manufacturing company has to identify Direct Labor, Direct Materials and Overhead costs (i.e. manufacturing costs) incurred to make product during that period of time.

The calculation of cost of goods manufactured is;

Beginning Work In Process $

+ Manufacturing Costs ($) Incurred

(Direct Labor + Direct Materials used + Overhead costs)

- Ending Work in Process $

= Cost of Goods Manufactured.

In order to do this calculation the company will create a Cost of Goods Manufactured Statement. (see above)

On the Cost of Goods Manufactured statement;

Direct Materials used is derived from the following calculation;

Beginning Raw Materials Inventory + Purchases - Ending Raw Materials Inventory = Direct Materials Used

Direct Labor is based on time charged by workers in the manufacturing process.

Overhead costs are an accumulation of costs, such as production-related indirect materials and indirect labor as well as depreciation, property taxes, insurance for production related facilities.

Inventories

All companies have to report the value of their inventory on their financial statements. For merchandising companies this is based on the cost to acquire the inventory (Purchase price, Freight, etc.) However, manufacturing companies MAKE the product that they plan to sell.

So, at the end of their fiscal year, or at any time that they need to report on inventory - it is very unlikely that everything that they are making (in order to sell) is in a completed state. There will be product that is partially complete. However, we cannot ignore these items - we have incurred costs to make them, so far - and as we have learned, all costs incurred to create the product (i.e. manufacturing costs) are considered part of inventory.

This leads manufacturing companies to categorize their inventory as follows;

Finished Goods: Product fully complete and ready for sale.
Work In Process: Product that is partially complete and still needs more work to be done for it to be ready for sale.
Raw Materials: Items which are the components needed to create the product. Not sold individually, used collectively in the manufacturing process to create the finished product to be sold.

Manufacturing Costs

Manufacturing Costs

Like any other kind of company, a manufacturing company is in business to make money. It wants to generate revenues and in order to do that it will incur costs. What makes a MANUFACTURING company different from a MERCHANDISING company is HOW it views and records the costs that it incurs.
A MERCHANDISING company buys inventory for the purpose of re-selling it at a profit - A MANUFACTURING company on the other hand, MAKES the product it intends to sell. This distinction is at the root of the challenge a manufacturing company has as it records the costs it incurs. Costs incurred to make the product are considered maufacturing costs.


So - what is important to take away from a discussion of manufacturing costs......

The SIMILARITIES to a MERCHANDISING company

• Costs incurred are for the most part very similar to the costs a merchandising company incurs - salaries, wages, utilities, rent, depreciation, insurance, etc.
• Costs are recorded in the journal and posted to the ledger.
• Costs are recorded with DEBITs and CREDITs.
• If payment is with cash - Credit is to CASH
• If purchase is on account - Credit is to Accounts Payable

The DIFFERENCES......

• Inventory for a manufacturing company is not purchased - it is MADE
• Costs incurred for wages, salaries, depreciation etc. which are incurred as part of the production process (i.e. manufacturing costs) are NOT recorded as EXPENSES
• So, before recording a cost, a determination has to be made regarding the REASON the cost was incurred. If the cost was incurred as part of the process to manufacture the product then the cost is not an expense - instead it is included in account treated as part of INVENTORY cost (an asset).
• This means that the Chart of Accounts for a Manufacturing company is quite a bit expanded when compared to a merchandising company- for example, there may be multiple accounts for 'depreciation' - one depreciation account in the Chart of Accounts may be classified as expense, another may be part of inventory. Either account is subject to be DEBIT-ed when a depreciation charge is incurred - which account gets Debit-ed depends on why the cost was incurred.
• If the depreciation is related to the Factory where the product is made - then the charge is related to the manufacturing process and is debit-ed to the depreciation account in Inventory.
• If, however, the charge is related to the headquarters office building then the charge is not part of the manufacturing process - it is therefore treated as an expense and is debit-ed to depreciation expense.

Manufacturing Cost Categories

Manufacturing Costs can be categorized as Labor, Materials or Overhead costs. All manufacturing costs incurred can be slotted into one of these three categories.

Direct Labor - Costs incurred for the employees directly involved with creating the product

Direct Materials - Costs of materials used directly in each unit created in the production process

Overhead - Costs incurred in the manufacturing process which cannot be directly assocuated with or attributed to specific units of production. Overhead costs include costs such as depreciation, insurance, utilities - as long as these costs were incurred for a production-related facility.

Also included in Overhead are Indirect Labor and Indirect Materials

• Indirect Labor - Costs incurred for the employees who are part of the manufacturing process but who are not directly making the product (e.g. Factory supervisor)
• Indirect Materials - Materials used out of inventory which were were used in the production process, but cannot be associated with a specific unit of production.