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The categories of assets, liabilities, and owners' equity that might appear on a typical balance sheet of a merchandising or manufacturing company, Some of these categories could be combined, or, alternatively, further divided, as the corporation deems that more or less detail would be useful to various audiences for its ï¬nancial statements. For example, the corporation may decide it is unnecessary to separate its Fixed Assets into factory equipment, ofï¬ce equipment, and land and buildings; these could all be combined into a single category. Or, alternatively, it might further categorize its cash into cash in the bank and cash-equivalent securities.
These categories are not listed in random order, but rather in order of decreasing liquidity. The more liquid the asset, the closer it is to becoming cash. Of course, no asset is more liquid than cash itself, so cash is the ï¬rst asset listed. Accounts receivable appear second because presumably the company expects to collect these amounts from customers within the next few months, although of course a small percentage of these accounts receivable may prove to be simply uncollectible. Inventory is next, as it has to be sold-that is, turned into accounts receivable-before it becomes cash.
Now we encounter a subtotal: Current Assets, the sum of the ï¬rst ï¬ve categories. The temporal deï¬nition of "current" is 1 year, and included in current assets are those assets that either are now cash or will be turned into cash within the next 12 months. For example, if such extended payment terms have been provided to some customers that a portion of the accounts receivable are not due within the next year, that portion should be listed as a long-term asset (i.e., below the current asset subtotal).
The meaning of ï¬xed assets is well explained by a phrase that is often used in its stead: Property, Plant, and Equipment. These assets, used in the operation of the business, typically have reasonably long useful lives, but not inï¬nite lives.
You might be inclined to argue that certain of the ï¬xed assets are readily saleable (for example, forklift trucks or salespersons' automobiles), could surely be turned into cash within the next 12 months, and therefore should be considered current assets. Yes, they "could" be sold, but that presumably is not the corporation's intent; the corporation bought these assets to use, not to resell. They are properly classiï¬ed as long-term assets. On the other hand, suppose the company has made the decision to sell its ï¬‚eet of salespersons' vehicles (and insist that the salespersons purchase their own vehicles and be reimbursed for mileage) and is now actively soliciting bids from prospective purchasers, with the expectation that the ï¬‚eet sale will be consummated within the next few months. Then, indeed, the ï¬‚eet should appropriately be considered a current asset.
Intangibles are "rights," not physical things. For example, a corporation might acquire a patent or a trademark, which it would then value as an intangible. Intangibles are often the key to the corporation's future proï¬tability. Valuing these intangibles is perplexing, particularly when, as in the case of trademarks, the value has built up over many years of use. Think, for example, of the trademarks Pepsi, Google, HP, Apple, Nabisco, and Pampers. Several of these trademarks could be sold for very large amounts, and yet are valued by their current owners at or near zero. We will see in Chapter 3 that intangibles are just one category on a very long list of assets and liabilities that we are severely challenged to value appropriately.
Goodwill is rather an oddball asset; it surely is not a tangible asset and, unlike some intangible assets, it cannot be sold or traded. It arises when one company buys another company, say, Federated Department Stores buys Macy's or Marshall Field's for a price that exceeds the value of the assets it obtains from the acquired company. If Federated pays out cash (reduces its asset Cash) by more than the values by which it increases its other assets (such as inventory and property, plant, and equipment), how do we make the balance sheet balance? Why would Federated pay more than the value of the assets it acquires? Because it believes that the future prospects for the operations being acquired-call it goodwill-are sufï¬ciently bright so as to justify the premium price paid. An interesting question that we will return to later is whether this goodwill is a permanent asset or one that will diminish in value over time.
You may at this point quite reasonably view this list of assets as somewhat incomplete. Are these really the key assets owned by the company? What about, say, customer loyalty, or the aggregate scientiï¬c expertise in the development department, or the "culture" of the corporation, the set of beliefs and processes that differentiate it from its competitors? Indeed they are not physical assets, but they are almost surely the corporate strengths that the CEO trumpets in her annual report to shareholders. They must be important-and they are-but they are devilishly difï¬cult to value, as we will explore they are bound up in and with the employees of the corporation. These employees go home every night and do not have to come back to work the next day; in no sense, therefore, does the corporation "own" these vital assets. Their value to the corporation lies in their future productivity but the ï¬nancial statements record only history.
You might jump to the conclusion that an increase in total assets is a good sign, suggesting strong performance. Not so. Performance is best judged by analysis of the income statement. An increase in total assets may result simply from inefï¬cient use of assets or it may accompany corporate growth in revenues.
Now turn to the other side of the balance sheet. The deï¬nition of Current Liabilities parallels that of current assets: liabilities that must be discharged within the next 12 months. I use the term "discharged" rather than "paid," because indeed some of the liabilities require certain performance by the corporation rather than the payment of cash. For example, down payments (advance payments) provided by customers remain a liability-typically a current liability-until the company provides to the customer the goods or services for which the down payment was made.
Note that amounts due more than a year into the future are classiï¬ed as long-term liabilities. An example would be instalments on a 5-year term loan; those instalments due within the next 12 months are classiï¬ed as current and the remainder as long term. As with the asset side of the balance sheet you might wonder if this enumeration of the corporation's obligations is complete. For example, the corporation has issued purchase orders for goods and services to be received in future accounting periods; in due course the goods or services will arrive and the accounts payable will be recognized. In the meantime, we might (but do not) record the obligation on the liability side and balance it with an asset labeled something like "right to receive" goods or services. Why bother? Accounting is complicated enough without making extra work for the accountants. Let us just wait until the goods or services-say, inventory-show up and then the value of both the asset Inventory and the liability Accounts Payable will be increased by the same dollar amount. Similarly, employment contracts might be valued equally as a liability and a "right to future services," an asset, but why bother-and moreover no employee is an indentured servant! Assume that within the account Accrued Liabilities are some wages and salaries owed to employees when in the future they actually take vacation leave that they have earned. How is this obligation different from obligations associated with issued and outstanding purchase orders? The difference is that the corporation has already received the "value" for those future vacation wages in the form of work done by the employees; employees "earn" (we generally say "accrue") vacation when they work, not when they actually take the vacation time off. The same is true of the corporation's obligation to pay pensions to current and former employees. How about lawsuits that the company will have to defend (lawsuits are frequent but unpredictable in our litigious society)? If we do not know who the plaintiffs will be or what wrongdoing they will allege, we do not have much basis for valuing this lingering liability.
But suppose the corporation manufactures champagne corks; it knows from experience that champagne drinkers have a predilection to injure their eyes by exploding corks into them, and then to sue the manufacturer; the corporation may decide that these lawsuits are so frequent and predictable that valuing this liability on the balance sheet makes sense. Warranty obligations also fall into this category.
A BALANCE SHEET REFLECTS THE NATURE OF THE BUSINESS
Would a balance sheet of another kind of business look similar to Federated's? Yes, the structure is the same. But, no, the relative importance of various assets and liabilities on the balance sheet may be quite different, driven by the different nature of the business the company conducts. Compare in your mind a department store group such as Federated with an electric power utility such as Commonwealth Edison (CE) that generates and distributes electricity.
Compared to Federated, CE has huge investments in ï¬xed assets: generating plants and distribution facilities. Its inventory is relatively small: just fuel for its generating plants. Its long-term debt is high both because it needs the funds to invest in ï¬xed assets and because the steady and predictable nature of its business (a regulated public utility) permits it to service this high debt with relatively little risk of default. CE's investment in accounts receivable (that is, the total owed to it by its customers) is modest because its customers pay their bills in a timely manner; you can imagine that CE has an effective way to assure prompt payment by its customers!
Think for a moment about commercial banks. What are their primary liabilities? Bank deposits that its customers (you, me, companies, and so forth) entrust to the bank; these deposits are our assets, but they are liabilities to the bank, and, its primary assets are loans: promises to pay executed by its borrowers. When an individual or company borrows from the bank, the borrower's liabilities increase while the bank's assets increase correspondingly.
Now compare a supermarket with a department store like Federated. At ï¬rst glance, they may look much alike, but the supermarket's investment in assets, as a proportion of its sales, will be lower than the department store. Its inventory of food moves (turns over) more quickly- it had better, to assure freshness-and it owns essentially no customer accounts receivables (though its customers may well use Visa or other major credit cards). The supermarket need not hold a high cash balance (i.e., safety stock of cash) because its business is not seasonal (as the department store's is) and cash purchases by its customers are both steady and highly predictable.
Think about a manufacturer of commercial aircraft like Boeing. The in-process manufacturing time for large aircraft is necessarily long, and thus Boeing has high inventory values (but minimum ï¬nished goods inventories, as completed aircraft are immediately delivered to the customer). Given the sorry ï¬nancial position of most large airlines, at least in this country in the early years of the twenty-ï¬rst century, the aircraft manufacturers may have to provide generous ï¬nancing terms to its airline purchasers, with resulting high values of accounts and notes receivable.
Some of these struggling airlines have negative retained earnings. In fact, in the entire 80-plus year history of the airline industry, cumulative losses have exceeded cumulative proï¬ts! (It is a wonder that new airlines continue to be formed!) Of course, many of these large U.S. airlines have declared bankruptcy in recent years. As interesting as the question is, this is not the time or place to speculate on whether or how these bankrupt airlines can rearrange both their ï¬nances and their operations to exit bankruptcy and remain solvent.
STRUCTURE OF THE INCOME STATEMENT
The corporation may have received other orders during the period, orders for goods or services to be delivered or provided in future accounting periods; those orders will not appear as sales/revenue until those future periods.
Cost of Goods Sold for the period includes the cost only of those goods or services for which revenue is recorded in this period. Thus, cost of goods sold does not include the cost of all merchandise received in this period (in a merchandising enterprise) or the cost of all goods produced (in a manufacturing enterprise). Rather, cost of goods sold is matched to the revenue in order that the Gross Proï¬t (or Gross Margin, equivalent terms) will have useful meaning to the readers of ï¬nancial statements. Gross proï¬t (margin) indicates the aggregate amount by which sales values exceeded acquisition costs (of merchandise in a retail environment) or production costs (in a manufacturing company)-clearly useful data! But, of course, any corporation-merchandising, service, or manufacturing-incurs other expenses in addition to those reï¬‚ected in cost of goods sold. These are referred to as Operating Expenses and they too are "matched"-but matched to the accounting period rather than to sales/revenue. That is, accountants must include all operating expenses relevant to the accounting period, but exclude those that pertain to earlier or later periods. For example, the company's facilities rental agreement may call for quarterly payments, but if the relevant accounting period is a month rather than a quarter, the accountant needs to include only the equivalent of one month's rent. Chapter 4 discusses further the techniques used to assure proper matching of revenues and expenses. Obviously, a retail enterprise that incurs few or no engineering/development expenses will omit that category. Such a company might want to show a separate line item for advertising and promotion distinct from other sales and marketing expenses. In short, deï¬ning relevant categories of operating expenses are generally left to the company and are a function of the nature of its business.
The primary non-operating expense at most companies is interest expense, i.e., interest on its borrowings. The amount of interest expense is a function of how the corporation chooses to ï¬nance its activities, not how it operates its business.
AN INCOME STATEMENT REFLECTS THE NATURE OF THE BUSINESS
As with a company's balance sheet, much about the nature of the company's business is reï¬‚ected in its income statement.
A supermarket chain can expect only a very modest gross margin percentage. The supermarket can still be adequately or even handsomely proï¬table, despite a low gross margin, both because it typically generates very high sales volumes in relation to total investments (total assets) and because its operating expenses (clerks' salaries, store rental, utilities, and so forth) are quite modest.
In contrast, a high-tech instrument manufacturer had better be able to generate a very signiï¬cant gross margin. The high-tech manufacturer typically must incur high engineering, development, and selling expenses to maintain its technology edge and to convince customers to purchase complicated state-of-the-art instruments; it must generate a high gross margin so that it is still left with reasonable net income after these high operating expenses.
An electric public utility also must generate a high gross margin in order that it can meet the high expenses associated with extensive and expensive ï¬xed assets and pay the interest charges on its large borrowings and still have a reasonable net income.
Some service companies report a low gross margin because most of its expenditures involve salaries to professionals and these salaries are included in its cost of goods sold (more logically referred to as cost of services rendered). Banks must earn sufï¬cient spread between the interest revenue they receive on loans and interest expenses they incur in attracting deposits (which provide the funds that are loaned) to cover their operating expenses.
COST ACCOUNTING IN MANUFACTURING
The typical manufacturing conversion process involves employees bringing together various materials, altering some of those materials, and assembling them into a ï¬nal product that is shipped to the customer. Think of manufacturers of automobiles, consumer electronics instruments, furniture, pots and pans, microwaves, and the list is endless. The focus of some manufacturers is the processing of materials from one state to another: reï¬ning petroleum, producing paper or glass, making wine or beer, and again the list are endless.
To track the costs for these manufacturing activities, the cost accounting system must be able to identify and value the materials-direct materials-used as well as the hours of employee time-direct labour-devoted to the activities. Conceptually, this tracking is straightforward:
The workers keep track of the time they spend on various tasks or jobs, and the material is counted, weighed, or otherwise measured. The execution of this simple concept can, however, is quite challenging: a great deal of data must be "captured" accurately and in a timely manner.
Acquiring and processing the data on direct material and direct labour are necessary but not sufï¬cient. Much more must be included:
the cost of power to run the machines and heat and light the manufacturing facility,
the salaries of supervisors who oversee not a single job but many simultaneously,
the depreciation of the manufacturing equipment and facilities,
the salaries of the maintenance and janitorial crews,
IT expenses-equipment, staff, and materials that are ubiquitous on modern manufacturing ï¬‚oors,
the salaries of the production and inventory control personnel,
The cost of comprehensive insurance coverage.
How does the cost accounting system determine how much of these seven costs (a complete list would, of course, be much longer) should be assigned to a particular job or process? Well, if the supervisors are overseeing only one complex process, that is easy; but if the supervisors are overseeing tens or hundreds of jobs simultaneously, the record-keeping could be hopelessly complex. Similarly, in most manufacturing operations it is impractical or impossible to meter the amount of power, IT, or production control salaries utilized by each job.
You undoubtedly recognize these seven costs as examples of overhead. The direct costs discussed above can be identiï¬ed directly with individual jobs or tasks. Overhead costs are, in contrast, often called indirect costs. Bear in mind that not all labour costs-i.e., wages, salaries, and related fringe beneï¬ts paid to employees-are direct costs; compensation paid to supervisors, janitors, production schedulers, IT troubles hooters, and so forth are included in indirect costs.
ACCOUNTING FOR OVERHEAD
If we cannot (or ï¬nd it impractical or too expensive to) track these overhead costs to individual jobs or tasks, how do we deal with them? One possibility would be simply to give up the idea of tracking them in such detail: instead of matching them to the activity and thus including them in cost of goods sold, match them to the accounting period-just as are nonmanufacturing expenses such as selling and administrative expenses. That is, treat them as period costs rather than product costs.
This approach has the great appeal of simplicity! Its drawbacks are several:
The aggregate of these costs is large-and getting larger. One hundred or more years ago during the early part of the industrial revolution when cost accounting techniques were ï¬rst developed, overhead costs were minor: simple machinery, limited supervision, no IT to speak of. Today, however, overhead costs typically overshadow direct costs; indeed generally indirect labour costs are higher than direct labour costs. And, this trend toward higher indirect costs and lower direct costs continues as more manufacturing activities are automated.
The indirect costs (overhead costs) must be allocated to jobs in some rational-but necessarily arbitrary-manner. This allocation is accomplished by the use of an overhead rate applied to an overhead vehicle. We combine all of the indirect costs (elements of overhead) in a single bucket and spread them-like peanut butter-across all the activities (jobs). But this process is complicated by the fact that inventory valuations and cost of goods sold valuations must be determined in "real time"-as the manufacturing occurs-and not simply at the end of the period when all overhead costs can be totalled up.