Adjusting Entries

Adjusting entries are journal entries made at the end of the accounting period to allocate revenue and expenses to the period in which they actually are applicable. Adjusting entries are required because normal journal entries are based on actual transactions, and the date on which these transactions occur may not be the date required to fulfill the matching principle of accrual accounting. The two major types of adjusting entries are:

Accruals: for revenues and expenses that are matched to dates before the transaction has been recorded. Deferrals: for revenues and expenses that are matched to dates after the transaction has been recorded.

Accruals Accrued items are those for which the firm has been realizing revenue or expense without yet observing an actual transaction that would result in a journal entry. For example, consider the case of salaried employees who are paid on the first of the month for the salary they earned over the previous month. Each day of the month, the firm accrues an additional liability in the form of salaries to be paid on the first day of the next month, but the transaction does not actually occur until the paychecks are issued on the first of the month. In order to report the expense in the period in which it was incurred, an adjusting entry is made at the end of the month. For example, in the case of a small company accruing $80,000 in monthly salaries, the journal entry might look like the following: Date Account Titles & Explanation Debit Credit 9/30 Salary expense 80,000

Salaries payable 80,000

Salaries accrued in September, to be paid on Oct 1.

In theory, the accrued salary could be recorded each day, but daily updates of such accruals on a large scale would be costly and would serve little purpose - the adjustment only is needed at the end of the period for which the financial statements are being prepared. Some accrued items for which adjusting entries may be made include:

Salaries Past-due expenses Income tax expense Interest income Unbilled revenue

Deferrals Deferred items are those for which the firm has recorded the transaction as a journal entry, but has not yet realized the revenue or expense associated with that journal entry. In other words, the recognition of deferred items is postponed until a later accounting period. An example of a deferred item would be prepaid insurance. Suppose the firm prepays a 12-month insurance policy on Sep 1. Because the insurance is a prepaid expense, the journal entry on Sep 1 would look like the following: Date Account Titles & Explanation Debit Credit 9/1 Prepaid Expenses 12,000

Cash

12-month prepaid insurance policy.

12,000

The result of this entry is that the insurance policy becomes an asset in the Prepaid Expenses account. At the end of September, this asset will be adjusted to reflect the amount "consumed" during the month. The adjusting entry would be: Date Account Titles & Explanation Debit Credit 9/30 Insurance Expense 1,000

Prepaid Expenses

Insurance expense for Sep.

1,000

This adjusting entry transfers $1000 from the Prepaid Expenses asset account to the Insurance Expense expense account to properly record the insurance expense for the month of September. In this example, a similar adjusting entry would be made for each subsequent month until the insurance policy expires 11 months later. Some deferred items for which adjusting entries would be made include:

Prepaid insurance Prepaid rent Office supplies Depreciation Unearned revenue

In the case of unearned revenue, a liability account is credited when the cash is received. An adjusting entry is made once the service has been rendered or the product has been shipped, thus realizing the revenue. Completing the Adjusting Entries To prevent inadvertent omission of some adjusting entries, it is helpful to review the ones from the previous accounting period since such transactions

often recur. It also helps to talk to various people in the company who might know about unbilled revenue or other items that might require adjustments

Closing Entries At the end of the accounting period, the balances in temporary accounts are transferred to an income summary account and a retained earnings account, thereby resetting the balance of the temporary accounts to zero to begin the next accounting period. First, the revenue accounts are closed by transferring their balances to the income summary account. Consider the following example for which September 30 is the end of the accounting period. If the revenue account balance is $1100, then the closing journal entry would be: Date Accounts Debit Credit 9/30 Revenue 1100

Income Summary 1100 Next, the expense accounts are closed by transferring their balances to the income summary account. If the expense account balance is $1275, then the closing entry would be: Date Accounts Debit Credit 9/30 Income Summary 1275

Expenses 1275 At this point, the net balance of the income summary account is a $175 debit (loss). The income summary account then is closed to retained earnings: Date Accounts Debit Credit 9/30 Retained Earnings 175

Income Summary 175 Finally, the dividends account is closed to retained earnings. For example, if $50 in dividends were paid during the period, the closing journal entry would be as follows: Date Accounts Debit Credit 9/30 Retained Earnings 50

Dividends 50 Once posted to the ledger, these journal entries serve the purpose of setting the temporary revenue, expense, and dividend accounts back to zero in preparation for the start of the next accounting period.

Note that the income summary account is not absolutely necessary - the revenue and expense accounts could be closed directly to retained earnings. The income summary account offers the benefit of indicating the net balance between revenue and expenses (i.e. net income) during the closing process.

he Accounting Process & Cycle MBA Accounting Notes Full - Free Notes

The Accounting Process (The Accounting Cycle) The accounting process is a series of activities that begins with a transaction and ends with the closing of the books. Because this process is repeated each reporting period, it is referred to as the accounting cycle and includes these major steps: Identify the transaction or other recognizable event. Prepare the transaction's source document such as a purchase order or invoice. Analyze and classify the transaction. This step involves quantifying the transaction in monetary terms (e.g. dollars and cents), identifying the accounts that are affected and whether those accounts are to be debited or credited. Record the transaction by making entries in the appropriate journal, such as the sales journal, purchase journal, cash receipt or disbursement journal, or the general journal. Such entries are made in chronological order. Post general journal entries to the ledger accounts. Note: The above steps are performed throughout the accounting period as transactions occur or in periodic batch processes. The following steps are performed at the end of the accounting period: Prepare the trial balance to make sure that debits equal credits. The trial balance is a listing of all of the ledger accounts, with debits in the left column and credits in the right column. At this point no adjusting entries have been made. The actual sum of each column is not meaningful; what is important is that the sums be equal. Note that while out-of-balance columns indicate a recording error, balanced columns do not guarantee that there are no errors. For example, not recording a transaction or recording it in the wrong account would not cause an imbalance.

Correct any discrepancies in the trial balance. If the columns are not in balance, look for math errors, posting errors, and recording errors. Posting errors include: posting of the wrong amount, omitting a posting, posting in the wrong column, or posting more than once.

repare adjusting entries to record accrued, deferred, and estimated amounts. ost adjusting entries to the ledger accounts. repare the adjusted trial balance. This step is similar to the preparation of the unadjusted trial balance, but this time the adjusting entries are included. Correct any errors that may be found. repare the financial statements. Income statement: prepared from the revenue, expenses, gains, and losses. Balance sheet: prepared from the assets, liabilities, and equity accounts. Statement of retained earnings: prepared from net income and dividend information. Cash flow statement: derived from the other financial statements using either the direct or indirect method. repare closing journal entries that close temporary accounts such as revenues, expenses, gains, and losses. These accounts are closed to a temporary income summary account, from which the balance is transferred to the retained earnings account (capital). Any dividend or withdrawal accounts also are closed to capital. ost closing entries to the ledger accounts. repare the after-closing trial balance to make sure that debits equal credits. At this point, only the permanent accounts appear since the temporary ones have been closed. Correct any errors. repare reversing journal entries (optional). Reversing journal entries often are used when there has been an accrual or deferral that was recorded as an adjusting entry on the last day of the accounting period. By reversing the adjusting entry, one avoids double counting the amount when the transaction occurs in the next period. A reversing journal entry is recorded on the first day of the new period. Instead of preparing the financial statements before the closing journal

entries, it is possible to prepare them afterwards, using a temporary income summary account to collect the balances of the temporary ledger accounts (revenues, expenses, gains, losses, etc.) when they are closed. The temporary income summary account then would be closed when preparing the financial statements.

Adjusting Entries Adjusting entries are journal entries made at the end of the accounting period to allocate revenue and expenses to the period in which they actually are applicable. Adjusting entries are required because normal journal entries are based on actual transactions, and the date on which these transactions occur may not be the date required to fulfill the matching principle of accrual accounting. The two major types of adjusting entries are: Accruals: for revenues and expenses that are matched to dates before the transaction has been recorded. Deferrals: for revenues and expenses that are matched to dates after the transaction has been recorded. Accruals Accrued items are those for which the firm has been realizing revenue or expense without yet observing an actual transaction that would result in a journal entry. For example, consider the case of salaried employees who are paid on the first of the month for the salary they earned over the previous month. Each day of the month, the firm accrues an additional liability in the form of salaries to be paid on the first day of the next month, but the transaction does not actually occur until the paychecks are issued on the first of the month. In order to report the expense in the period in which it was incurred, an adjusting entry is made at the end of the month. For example, in the case of a small company accruing $80,000 in monthly salaries, the journal entry might look like the following: Date Account Titles & Explanation Debit Credit 9/30

Salary expense 80,000

Salaries payable 80,000 Salaries accrued in September, to be paid on Oct 1. In theory, the accrued salary could be recorded each day, but daily updates of such accruals on a large scale would be costly and would serve little purpose - the adjustment only is needed at the end of the period for which the financial statements are being prepared. Some accrued items for which adjusting entries may be made include: Salaries Past-due expenses Income tax expense Interest income Unbilled revenue Deferrals Deferred items are those for which the firm has recorded the transaction as a journal entry, but has not yet realized the revenue or expense associated with that journal entry. In other words, the recognition of deferred items is postponed until a later accounting period. An example of a deferred item would be prepaid insurance. Suppose the firm prepays a 12-month insurance policy on Sep 1. Because the insurance is a prepaid expense, the journal entry on Sep 1 would look like the following: Date Account Titles & Explanation Debit Credit 9/1 Prepaid Expenses 12,000

Cash 12,000 12-month prepaid insurance policy. The result of this entry is that the insurance policy becomes an asset in the Prepaid Expenses account. At the end of September, this asset will be adjusted to reflect the amount "consumed" during the month. The adjusting entry would be: Date Account Titles & Explanation Debit Credit 9/30 Insurance Expense 1,000

Prepaid Expenses 1,000 Insurance expense for Sep. This adjusting entry transfers $1000 from the Prepaid Expenses asset account to the Insurance Expense expense account to properly record the insurance expense for the month of September. In this example, a similar adjusting entry would be made for each subsequent month until the insurance policy expires 11 months later. Some deferred items for which adjusting entries would be made include: Prepaid insurance Prepaid rent Office supplies Depreciation Unearned revenue In the case of unearned revenue, a liability account is credited when the cash is received. An adjusting entry is made once the service has been rendered or

the product has been shipped, thus realizing the revenue. Completing the Adjusting Entries To prevent inadvertent omission of some adjusting entries, it is helpful to review the ones from the previous accounting period since such transactions often recur. It also helps to talk to various people in the company who might know about unbilled revenue or other items that might require adjustments

The Balanced Scorecard Traditional financial performance metrics provide information about a firm's past results, but are not well-suited for predicting future performance or for implementing and controlling the firm's strategic plan. By analyzing perspectives other than the financial one, managers can better translate the organization's strategy into actionable objectives and better measure how well the strategic plan is executing. The Balanced Scorecard is a management system that maps an organization's strategic objectives into performance metrics in four perspectives: financial, internal processes, customers, and learning and growth. These perspectives provide relevant feedback as to how well the strategic plan is executing so that adjustments can be made as necessary. The Balance Scorecard framework can be depicted as follows: The Balanced Scorecard Framework

Financial Performance Objectives Measures Targets Initiatives Customers Objectives Measures Targets

Initiatives Strategy Internal Processes Objectives Measures Targets Initiatives Learning & Growth Objectives Measures Targets Initiatives

The Balanced Scorecard (BSC) was published in 1992 by Robert Kaplan and David Norton. In addition to measuring current performance in financial terms, the Balanced Scorecard evaluates the firm's efforts for future improvement using process, customer, and learning and growth metrics. The term "scorecard" signifies quantified performance measures and "balanced" signifies that the system is balanced between: short-term objectives and long-term objectives financial measures and non-financial measures lagging indicators and leading indicators internal performance and external performance perspectives Financial Measures Are Insufficient While financial accounting is suited to the tracking of physical assets such as manufacturing equipment and inventory, it is less capable of providing useful reports in environments with a large intangible asset base. As intangible assets constitute an ever-increasing proportion of a company's market value, there is an increase in the need for measures that better report such assets as loyal

customers, proprietary processes, and highly-skilled staff. Consider the case of a company that is not profitable but that has a very large customer base. Such a firm could be an attractive takeover target simply because the acquiring firm wants access to those customers. It is not uncommon for a company to take over a competitor with the plan to discontinue the competing product line and convert the customer base to its own products and services. The balance sheets of such takeover targets do not reflect the value of the customers who nonetheless are worth something to the acquiring firm. Clearly, additional measures are needed for such intangibles. Scorecard Measures are Limited in Number The Balanced Scorecard is more than a collection of measures used to identify problems. It is a system that integrates a firm's strategy with a purposely limited number of key metrics. Simply adding new metrics to the financial ones could result in hundreds of measures and would create information overload. To avoid this problem, the Balanced Scorecard focuses on four major areas of performance and a limited number of metrics within those areas. The objectives within the four perspectives are carefully selected and are firm specific. To avoid information overload, the total number of measures should be limited to somewhere between 15 and 20, or three to four measures for each of the four perspectives. These measures are selected as the ones deemed to be critical in achieving breakthrough competitive performance; they essentially define what is meant by "performance". A Chain of Cause-and-Effect Relationships Before the Balanced Scorecard, some companies already used a collection of both financial and non-financial measures of critical performance indicators. However, a well-designed Balanced Scorecard is different from such a system in that the four BSC perspectives form a chain of cause-and-effect relationships. For example, learning and growth lead to better business processes that result in higher customer loyalty and thus a higher return on capital employed (ROCE). Effectively, the cause-and-effect relationships illustrate the hypothesis behind the organization's strategy. The measures reflect a chain of performance drivers that determine the effectiveness of the strategy implementation. Objectives, Measures, Targets, and Initiatives

Within each of the Balanced Scorecard financial, customer, internal process, and learning perspectives, the firm must define the following: Strategic objectives - what the strategy is to achieve in that perspective. Measures - how progress for that particular objective will be measured. Targets - the target value sought for each measure. Initiatives - what will be done to facilitate the reaching of the target. The following sections provide examples of some objectives and measures for the four perspectives. Financial Perspective The financial perspective addresses the question of how shareholders view the firm and which financial goals are desired from the shareholder's perspective. The specific goals depend on the company's stage in the business life cycle. For example: Growth stage - goal is growth, such as revenue growth rate Sustain stage - goal is profitability, such ROE, ROCE, and EVA Harvest stage - goal is cash flow and reduction in capital requirements The following table outlines some examples of financial metrics: Objective Specific Measure Growth Revenue growth Profitability Return on equity Cost leadership Unit cost

Customer Perspective The customer perspective addresses the question of how the firm is viewed by its customers and how well the firm is serving its targeted customers in order to meet the financial objectives. Generally, customers view the firm in terms of time, quality, performance, and cost. Most customer objectives fall into one of those four categories. The following table outlines some examples of specific customer objectives and measures:

Objective Specific Measure New products % of sales from new products Responsive supply Ontime delivery To be preferred supplier Share of key accounts Customer partnerships Number of cooperative efforts

Internal Process Perspective Internal business process objectives address the question of which processes are most critical for satisfying customers and shareholders. These are the processes in which the firm must concentrate its efforts to excel. The following table outlines some examples of process objectives and measures: Objective Specific Measure Manufacturing excellence Cycle time, yield Increase design productivity Engineering efficiency Reduce product launch delays Actual launch date vs. plan

Learning and Growth Perspective Learning and growth metrics address the question of how the firm must learn, improve, and innovate in order to meet its objectives. Much of this perspective is employee-centered. The following table outlines some examples of learning and growth measures: Objective Specific Measure Manufacturing learning Time to new process maturity Product focus % of products representing 80% of sales Time to market Time compared to that of competitors

Achieving Strategic Alignment throughout the Organization Whereas strategy is articulated in terms meaningful to top management, to be implemented it must be translated into objectives and measures that are actionable at lower levels in the organization. The Balanced Scorecard can be cascaded to make the translation of strategy possible. While top level objectives may be expressed in terms of growth and profitability, these goals get translated into more concrete terms as they progress down the organization and each manager at the next lower level develops objectives and measures that support the next higher level. For example, increased profitability might get translated into lower unit cost, which then gets translated into better calibration of the equipment by the workers on the shop floor. Ultimately, achievement of scorecard objectives would be rewarded by the employee compensation system. The Balanced Scorecard can be cascaded in this manner to align the strategy thoughout the organization. The Process of Building a Balanced Scorecard While there are many ways to develop a Balanced Scorecard, Kaplan and Norton defined a four-step process that has been used across a wide range of organizationsL: Define the measurement architecture - When a company initially introduces the Balanced Scorecard, it is more manageable to apply it on the strategic business unit level rather than the corporate level. However, interactions must be considered in order to avoid optimizing the results of one business unit at the expense of others. Specify strategic objectives - The top three or four objectives for each perspective are agreed upon. Potential measures are identified for each objective. Choose strategic measures - Measures that are closely related to the actual performance drivers are selected for evaluating the progress made toward achieving the objectives. Develop the implementation plan - Target values are assigned to the measures. An information system is developed to link the top level metrics to lower-level operational measures. The scorecard is integrated into the management system.

Balanced Scorecard Benefits Some of the benefits of the Balanced Scorecard system include: Translation of strategy into measurable parameters. Communication of the strategy to everybody in the firm. Alignment of individual goals with the firm's strategic objectives - the BSC recognizes that the selected measures influence the behavior of employees. Feedback of implementation results to the strategic planning process. Since its beginnings as a peformance measurement system, the Balanced Scorecard has evolved into a strategy implementation system that not only measures performance but also describes, communicates, and aligns the strategy throughout the organization. Potential Pitfalls The following are potential pitfalls that should be avoided when implementing the Balanced Scorecard: Lack of a well-defined strategy: The Balanced Scorecard relies on a welldefined strategy and an understanding of the linkages between strategic objectives and the metrics. Without this foundation, the implementation of the Balanced Scorecard is unlikely to be successful. Using only lagging measures: Many managers believe that they will reap the benefits of the Balanced Scorecard by using a wide range of non-financial measures. However, care should be taken to identify not only lagging measures that describe past performance, but also leading measures that can be used to plan for future performance. Use of generic metrics: It usually is not sufficient simply to adopt the metrics used by other successful firms. Each firm should put forth the effort to identify the measures that are appropriate for its own strategy and competitive position.

Chart of Accounts The chart of accounts is a listing of all the accounts in the general ledger, each account accompanied by a reference number. To set up a chart of accounts, one first needs to define the various accounts to be used by the business. Each account should have a number to identify it. For very small

businesses, three digits may suffice for the account number, though more digits are highly desirable in order to allow for new accounts to be added as the business grows. With more digits, new accounts can be added while maintaining the logical order. Complex businesses may have thousands of accounts and require longer account reference numbers. It is worthwhile to put thought into assigning the account numbers in a logical way, and to follow any specific industry standards. An example of how the digits might be coded is shown in this list: Account Numbering 1000 - 1999: asset accounts 2000 - 2999: liability accounts 3000 - 3999: equity accounts 4000 - 4999: revenue accounts 5000 - 5999: cost of goods sold 6000 - 6999: expense accounts 7000 - 7999: other revenue (for example, interest income) 8000 - 8999: other expense (for example, income taxes) By separating each account by several numbers, many new accounts can be added between any two while maintaining the logical order. Defining Accounts Different types of businesses will have different accounts. For example, to report the cost of goods sold a manufacturing business will have accounts for its various manufacturing costs whereas a retailer will have accounts for the purchase of its stock merchandise. Many industry associations publish recommended charts of accounts for their respective industries in order to establish a consistent standard of comparison among firms in their industry. Accounting software packages often come with a selection of predefined account charts for various types of businesses. There is a trade-off between simplicity and the ability to make historical comparisons. Initially keeping the number of accounts to a minimum has the advantage of making the accounting system simple. Starting with a small number of accounts, as certain accounts acquired significant balances they would be split into smaller, more specific accounts. However, following this strategy makes it more difficult to generate consistent historical comparisons. For example, if the accounting system is set up with a miscellaneous expense account that later is broken into more detailed accounts, it then would be

difficult to compare those detailed expenses with past expenses of the same type. In this respect, there is an advantage in organizing the chart of accounts with a higher initial level of detail. Some accounts must be included due to tax reporting requirements. For example, in the U.S. the IRS requires that travel, entertainment, advertising, and several other expenses be tracked in individual accounts. One should check the appropriate tax regulations and generate a complete list of such required accounts. Other accounts should be set up according to vendor. If the business has more than one checking account, for example, the chart of accounts might include an account for each of them. Account Order Balance sheet accounts tend to follow a standard that lists the most liquid assets first. Revenue and expense accounts tend to follow the standard of first listing the items most closely related to the operations of the business. For example, sales would be listed before non-operating income. In some cases, part or all of the expense accounts simply are listed in alphabetical order. Sample Chart of Accounts The following is an example of some of the accounts that might be included in a chart of accounts. Sample Chart of Accounts Asset Accounts Current Assets 1000 Petty Cash 1010 Cash on Hand (e.g. in cash registers) 1020 Regular Checking Account 1030 Payroll Checking Account 1040 Savings Account 1050 Special Account 1060 Investments - Money Market 1070 Investments - Certificates of Deposit 1100 Accounts Receivable 1140 Other Receivables 1150 Allowance for Doubtful Accounts 1200 Raw Materials Inventory 1205 Supplies Inventory 1210 Work in Progress Inventory 1215 Finished Goods Inventory - Product #1 1220 Finished Goods Inventory - Product #2 1230 Finished Goods Inventory Product #3 1400 Prepaid Expenses 1410 Employee Advances 1420 Notes

Receivable - Current 1430 Prepaid Interest 1470 Other Current Assets Fixed Assets 1500 Furniture and Fixtures 1510 Equipment 1520 Vehicles 1530 Other Depreciable Property 1540 Leasehold Improvements 1550 Buildings 1560 Building Improvements 1690 Land 1700 Accumulated Depreciation, Furniture and Fixtures 1710 Accumulated Depreciation, Equipment 1720 Accumulated Depreciation, Vehicles 1730 Accumulated Depreciation, Other 1740 Accumulated Depreciation, Leasehold 1750 Accumulated Depreciation, Buildings 1760 Accumulated Depreciation, Building Improvements Other Assets 1900 Deposits 1910 Organization Costs 1915 Accumulated Amortization, Organization Costs 1920 Notes Receivable, Non-current 1990 Other Noncurrent Assets Liability Accounts Current Liabilities 2000 Accounts Payable 2300 Accrued Expenses 2310 Sales Tax Payable 2320 Wages Payable 2330 401-K Deductions Payable 2335 Health Insurance Payable 2340 Federal Payroll Taxes Payable 2350 FUTA Tax Payable 2360 State Payroll Taxes Payable 2370 SUTA Payable 2380 Local Payroll Taxes Payable 2390 Income Taxes Payable 2400 Other Taxes Payable 2410 Employee Benefits Payable 2420 Current Portion of Long-term Debt 2440 Deposits from Customers 2480 Other Current Liabilities Long-term Liabilities 2700 Notes Payable 2702 Land Payable 2704 Equipment Payable 2706 Vehicles Payable 2708 Bank Loans Payable 2710 Deferred Revenue 2740 Other Longterm Liabilities Equity Accounts

3010 Stated Capital 3020 Capital Surplus 3030 Retained Earnings Revenue Accounts

4000 Product #1 Sales 4020 Product #2 Sales 4040 Product #3 Sales 4060 Interest Income 4080 Other Income 4540 Finance Charge Income 4550 Shipping Charges Reimbursed 4800 Sales Returns and Allowances 4900 Sales Discounts Cost of Goods Sold

5000 Product #1 Cost 5010 Product #2 Cost 5020 Product #3 Cost 5050 Raw Material Purchases 5100 Direct Labor Costs 5150 Indirect Labor Costs 5200 Heat and Power 5250 Commissions 5300 Miscellaneous Factory Costs 5700 Cost of Goods Sold, Salaries and Wages 5730 Cost of Goods Sold, Contract Labor 5750 Cost of Goods Sold, Freight 5800 Cost of Goods Sold, Other 5850 Inventory Adjustments 5900 Purchase Returns and Allowances 5950 Purchase Discounts Expenses

6000 Default Purchase Expense 6010 Advertising Expense 6050 Amortization Expense 6100 Auto Expenses 6150 Bad Debt Expense 6200 Bank Fees 6250 Cash Over and Short 6300 Charitable Contributions Expense 6350 Commissions and Fees Expense 6400 Depreciation Expense 6450 Dues and Subscriptions Expense 6500 Employee Benefit Expense, Health Insurance 6510 Employee Benefit Expense, Pension Plans 6520 Employee Benefit Expense, Profit Sharing Plan 6530 Employee Benefit Expense, Other 6550 Freight Expense 6600 Gifts Expense 6650 Income Tax Expense, Federal 6660 Income Tax Expense, State 6670 Income Tax Expense, Local 6700 Insurance Expense, Product Liability 6710 Insurance Expense, Vehicle 6750 Interest Expense 6800 Laundry and Dry Cleaning Expense 6850 Legal and Professional Expense 6900 Licenses Expense 6950 Loss on NSF Checks 7000 Maintenance Expense 7050 Meals and Entertainment Expense 7100 Office Expense 7200 Payroll Tax Expense 7250

Penalties and Fines Expense 7300 Other Taxes 7350 Postage Expense 7400 Rent or Lease Expense 7450 Repair and Maintenance Expense, Office 7460 Repair and Maintenance Expense, Vehicle 7550 Supplies Expense, Office 7600 Telephone Expense 7620 Training Expense 7650 Travel Expense 7700 Salaries Expense, Officers 7750 Wages Expense 7800 Utilities Expense 8900 Other Expense 9000 Gain/Loss on Sale of Assets

General Journal Entries The journal is the point of entry of business transactions into the accounting system. It is a chronological record of the transactions, showing an explanation of each transaction, the accounts affected, whether those accounts are increased or decreased, and by what amount. A general journal entry takes the following form: Date Name of account being debited Amount

Name of account being credited Amount Optional: short description of transaction Consider the following example that illustrates the basic concept of general journal entries. Mike Peddler opens a bicycle repair shop. He leases shop space, purchases an initial inventory of bike parts, and begins operations. Here are the general journal entries for the first month: Date Account Names & Explanation Debit Credit 9/1

Cash 7500

Capital 7500 Owner contributes $7500 in cash to capitalize the business. 9/8 Bike Parts 2500

Accounts Payable 2500 Purchased $2500 in bike parts on account, payable in 30 days. 9/15 Expenses 1000

Cash 1000 Paid first month's shop rent of $1000. 9/17 Cash 400

Accounts Receivable 700

Revenue

1100 Repaired bikes for $1100; collected $400 cash; billed customers for the balance. 9/18 Expenses 275

Bike Parts 275 $275 in bike parts were used. 9/25 Cash 425

Accounts Receivable 425 Collected $425 from customer accounts. 9/28 Accounts Payable 500

Cash 500 Paid $500 to suppliers for parts purchased earlier in the month. Most of the above transactions are entered as simple journal entries each debiting one account and crediting another. The entry for 9/17 is a compound journal entry, composed of two lines for the debit and one line for the credit. The transaction could have been entered as two separate simple journal entries, but the compound form is more efficient.

In this example, there are no account numbers. In practice, account numbers or codes may be included in the journal entries to allow each account to be positively identified with no confusion between similar accounts. The journal entry is the first entry of a transaction in the accounting system. Before the entry is made, the following decisions must be made: which accounts are affected by the transaction, and which account will be debited and which will be credited. Once entered in the journal, the transactions may be posted to the appropriate T-accounts of the general ledger. Unlike the journal entry, the posting to the general ledger is a purely mechanical process - the account and debit/credit decisions already have been made.

Trial Balance If the journal entries are error-free and were posted properly to the general ledger, the total of all of the debit balances should equal the total of all of the credit balances. If the debits do not equal the credits, then an error has occurred somewhere in the process. The total of the accounts on the debit and credit side is referred to as the trial balance. To calculate the trial balance, first determine the balance of each general ledger account as shown in the following example: General Ledger Cash Sep 1 7500 17 400 25 425 Sep

15 1000 28 500 Bal. 6825 Accounts Receivable Sep 17 700 Sep 25 425 Bal. 275 Parts Inventory Sep 8 2500 Sep 18 275 Bal. 2225 Accounts Payable Sep 28 500 Sep 8 2500 Bal. 2000 Capital Sep 1

7500 Bal. 7500 Revenue Sep 17 1100 Bal. 1100 Expenses Sep 15 1000 Sep 18 275

Bal. 1275 Once the account balances are known, the trial balance can be calculated as shown: Trial Balance Account Title Debits Credits Cash 6825 Accounts Receivable 275 Parts Inventory 2225 Accounts Payable 2000 Capital 7500

Revenue 1100 Expenses 1275

10600

10600

In this example, the debits and credits balance. This result does not guarantee that there are no errors. For example, the trial balance would not catch the following types of errors: Transactions that were not recorded in the journal Transactions recorded in the wrong accounts Transactions for which the debit and credit were transposed Neglecting to post a journal entry to the ledger If the trial balance is not in balance, then an error has been made somewhere in the accounting process. The following is listing of common errors that would result in an unbalanced trial balance; this listing can be used to assist in isolating the cause of the imbalance. Summation error for the debits and credits of the trial balance Error transferring the ledger account balances to the trial balance columns Error in numeric value Error in transferring a debit or credit to the proper column Omission of an account Error in the calculation of a ledger account balance Error in posting a journal entry to the ledger Error in numeric value Error in posting a debit or credit to the proper column Error in the journal entry

Error in a numeric value Omission of part of a compound journal entry The more often that the trial balance is calculated during the accounting cycle, the easier it is to isolate any errors; more frequent trial balance calculations narrow the time frame in which an error might have occurred, resulting in fewer transactions through which to search.

Source Documents The source document is the original record of a transaction. During an audit, source documents are used as evidence that a particular business transaction occurred. Examples of source documents include: Cash receipts Credit card receipts Cash register tapes Cancelled checks Customer invoices Supplier invoices Purchase orders Time cards Deposit slips Notes for loans Payment stubs for interest At a minimum, each source document should include the date, the amount, and a description of the transaction. When practical, beyond these minimum requirements source documents should contain the name and address of the other party of the transaction. When a source document does not exist, for example, when a cash receipt is not provided by a vendor or is misplaced, a document should be generated as soon as possible after the transaction, using other documents such as bank statements to support the information on the generated source document. Once a transaction has been journalized, the source document should be filed and made retrievable so that transactions can be verified should the need arise at a later date.

Preparing the Financial Statements Once the adjusting entries have been made or entered into a worksheet, the financial statements can be prepared using information from the ledger accounts. Because some of the financial statements use data from the other statements, the following is a logical order for their preparation: Income statement Statement of retained earnings Balance sheet Cash flow statement Income Statement The income statement reports revenues, expenses, and the resulting net income. It is prepared by transferring the following ledger account balances, taking into account any adjusting entries that have been or will be made: Revenue Expenses Capital gains or losses Statement of Retained Earnings The retained earnings statement shows the retained earnings at the beginning and end of the accounting period. It is prepared using the following information: Beginning retained earnings, obtained from the previous statement of retained earnings. Net income, obtained from the income statement Dividends paid during the accounting period Balance Sheet The balance sheet reports the assets, liabilities, and shareholder equity of the company. It is constructed using the following information: Balances of all asset accounts such cash, accounts receivable, etc. Balances of all liability accounts such as accounts payable, notes, etc. Capital stock balance Retained earnings, obtained from the statement of retained earnings

Cash Flow Statement The cash flow statement explains the reasons for changes in the cash balance, showing sources and uses of cash in the operating, financing, and investing activities of the firm. Because the cash flow statement is a cash-basis report, it cannot be derived directly from the ledger account balances of an accrual accounting system. Rather, it is derived by converting the accrual information to a cash-basis using one of the following two methods: Direct method: cash flow information is derived by directly subtracting cash disbursements from cash receipts. Indirect method: cash flow information is derived by adding or subtracting non-cash items from net income.

When an adjusting entry is made for an expense at the end of the accounting period, it is necessary to keep track of this expense so that the transaction will be allocated properly between the two periods. Reversing entries are a way to handle such transactions. Consider the case in which a note is issued on the 16th of September, with interest payable on the 15th of October. If the total interest to be paid at the end of the 30 day period is $100, then half of the amount would be allocated to the month of September using the following adjusting journal entry: Period-End Adjusting Entry Date Account Title Debit Credit 9/30 Interest Expense 50

Interest Payable

50 15 days of accrued interest. On October 15, the 30 days of interest will be paid as a $100 lump sum. If the bookkeeper remembers that half of that interest already was recorded as an expense in September, then he or she can record only $50 as the interest expense for October. Alternatively, a reversing entry can be made at the beginning of October as follows: Reversing Entry Date Account Title Debit Credit 10/1 Interest Payable 50

Interest Expense 50 Reversing entry for 15 days of interest accrued in Sep. Note that the above journal entry is exactly the reverse of the adjusting entry made on September 30. Once this reversing entry is posted, the affected ledger accounts will appear as follows: Ledger Accounts After Reversing Entry Interest Payable Oct 1 50 Sep 30 50

Bal. 0 Interest Expense Oct 1 50 Bal. 50 The interest payable account carried a credit balance of $50 over to the new period, and this balance became zero when the October 1 reversing entry was posted. Because the interest expense ledger account was closed at the end of the reporting period on September 30 (as were all expense accounts), its balance was reset to zero at that time. After the posting of the reversing entry on October 1, the interest expense ledger account had a credit balance (i.e. a negative expense balance) of $50. On Oct 15, the note matures and the $100 interest is due. Because the reversing entry was made on Oct 1, the Oct 15 entry is for the full $100 that is due on the note, and is recorded as follows: October 15 Journal Entry Date Account Title Debit Credit 10/15 Interest Expense 100

Interest Payable 100 Interest for Sep 16 through Oct 15. The ledger accounts will appear as follows once the journal entries through October 15 are posted:

Interest Payable Oct 1 50 Sep 30 50 Oct 15 100 Bal. 100 Interest Expense Oct 15 100 Oct 1 50 Bal. 50 The net interest expense for October then is $50, as it should be since the other $50 already was reported in September. As can be seen in the ledger accounts, the net effect is that a $50 interest expense will be realized in October, and the full $100 of interest will be paid to the holder of the note. Reversing entries are a useful tool for dealing with certain accruals and deferrals. Their use is optional and depends on the accounting practices of the particular firm and the specific responsibilities of the bookkeeping staff.

Reversing Entries When an adjusting entry is made for an expense at the end of the accounting period, it is necessary to keep track of this expense so that the transaction will be allocated properly between the two periods. Reversing entries are a way to handle such transactions.

Consider the case in which a note is issued on the 16th of September, with interest payable on the 15th of October. If the total interest to be paid at the end of the 30 day period is $100, then half of the amount would be allocated to the month of September using the following adjusting journal entry: Period-End Adjusting Entry Date Account Title Debit Credit 9/30 Interest Expense 50

Interest Payable

15 days of accrued interest.

50

On October 15, the 30 days of interest will be paid as a $100 lump sum. If the bookkeeper remembers that half of that interest already was recorded as an expense in September, then he or she can record only $50 as the interest expense for October. Alternatively, a reversing entry can be made at the beginning of October as follows: Reversing Entry Date Account Title Debit Credit 10/1 Interest Payable 50

Interest Expense

Reversing entry for 15 days of interest accrued in Sep.

Note that the above journal entry is exactly the reverse of the adjusting entry made on September 30. Once this reversing entry is posted, the affected ledger accounts will appear as follows: Ledger Accounts After Reversing Entry Interest Payable Oct

50

1 50 Sep 30 50

Bal. 0 Interest Expense

Oct 1 50

Bal. 50 The interest payable account carried a credit balance of $50 over to the new period, and this balance became zero when the October 1 reversing entry was posted. Because the interest expense ledger account was closed at the end of the reporting period on September 30 (as were all expense accounts), its balance was reset to zero at that time. After the posting of the reversing entry on October 1, the interest expense ledger account had a credit balance (i.e. a negative expense balance) of $50. On Oct 15, the note matures and the $100 interest is due. Because the

reversing entry was made on Oct 1, the Oct 15 entry is for the full $100 that is due on the note, and is recorded as follows: October 15 Journal Entry Date Account Title Debit Credit 10/15 Interest Expense 100

Interest Payable

Interest for Sep 16 through Oct 15.

The ledger accounts will appear as follows once the journal entries through October 15 are posted: Interest Payable Oct

100

1 50 Sep 30 50 Oct 15 100

Bal. 100 Interest Expense Oct 15 100

Oct 1 50

Bal. 50 The net interest expense for October then is $50, as it should be since the other $50 already was reported in September. As can be seen in the ledger accounts, the net effect is that a $50 interest expense will be realized in October, and the full $100 of interest will be paid to the holder of the note. Reversing entries are a useful tool for dealing with certain accruals and deferrals. Their use is optional and depends on the accounting practices of the particular firm and the specific responsibilities of the bookkeeping staff.

Preparing the Financial Statements Once the adjusting entries have been made or entered into a worksheet, the financial statements can be prepared using information from the ledger accounts. Because some of the financial statements use data from the other statements, the following is a logical order for their preparation:

Income statement Statement of retained earnings Balance sheet Cash flow statement

Income Statement The income statement reports revenues, expenses, and the resulting net income. It is prepared by transferring the following ledger account balances, taking into account any adjusting entries that have been or will be made:

Revenue

Expenses Capital gains or losses

Statement of Retained Earnings The retained earnings statement shows the retained earnings at the beginning and end of the accounting period. It is prepared using the following information:

Beginning retained earnings, obtained from the previous statement of retained earnings. Net income, obtained from the income statement Dividends paid during the accounting period

Balance Sheet The balance sheet reports the assets, liabilities, and shareholder equity of the company. It is constructed using the following information:

Balances of all asset accounts such cash, accounts receivable, etc. Balances of all liability accounts such as accounts payable, notes, etc. Capital stock balance Retained earnings, obtained from the statement of retained earnings

Cash Flow Statement The cash flow statement explains the reasons for changes in the cash balance, showing sources and uses of cash in the operating, financing, and investing activities of the firm. Because the cash flow statement is a cash-basis report, it cannot be derived directly from the ledger account balances of an accrual accounting system. Rather, it is derived by converting the accrual information to a cash-basis using one of the following two methods:

Direct method: cash flow information is derived by directly subtracting

cash disbursements from cash receipts.

Indirect method: cash flow information is derived by adding or

subtracting non-cash items from net income.

Source Documents The source document is the original record of a transaction. During an audit, source documents are used as evidence that a particular business transaction occurred. Examples of source documents include:

Cash receipts Credit card receipts Cash register tapes Cancelled checks Customer invoices Supplier invoices Purchase orders Time cards Deposit slips Notes for loans Payment stubs for interest

At a minimum, each source document should include the date, the amount, and a description of the transaction. When practical, beyond these minimum requirements source documents should contain the name and address of the other party of the transaction. When a source document does not exist, for example, when a cash receipt is not provided by a vendor or is misplaced, a document should be generated as soon as possible after the transaction, using other documents such as bank statements to support the information on the generated source document. Once a transaction has been journalized, the source document should be filed and made retrievable so that transactions can be verified should the need arise at a later date. Trial Balance If the journal entries are error-free and were posted properly to the general ledger, the total of all of the debit balances should equal the total of all of the credit balances. If the debits do not equal the credits, then an error has

occurred somewhere in the process. The total of the accounts on the debit and credit side is referred to as the trial balance. To calculate the trial balance, first determine the balance of each general ledger account as shown in the following example: General Ledger Cash Sep 1 7500 17 400 25 425 Sep 15 1000 28 500

Bal. 6825 Accounts Receivable Sep 17 700 Sep 25 425

Bal. 275 Parts Inventory Sep 8 2500 Sep 18 275

Bal. 2225 Accounts Payable Sep 28 500 Sep 8 2500

Bal. 2000 Capital

Sep 1 7500

Bal. 7500

Revenue

Sep 17 1100

Bal. 1100 Expenses Sep 15 1000 Sep 18 275

Bal. 1275 Once the account balances are known, the trial balance can be calculated as shown: Trial Balance Account Title Debits Credits Cash 6825 Accounts Receivable 275 Parts Inventory 2225 Accounts Payable 2000

Capital 7500 Revenue 1100 Expenses 1275

10600

10600

In this example, the debits and credits balance. This result does not guarantee that there are no errors. For example, the trial balance would not catch the following types of errors:

Transactions that were not recorded in the journal Transactions recorded in the wrong accounts Transactions for which the debit and credit were transposed Neglecting to post a journal entry to the ledger

If the trial balance is not in balance, then an error has been made somewhere in the accounting process. The following is listing of common errors that would result in an unbalanced trial balance; this listing can be used to assist in isolating the cause of the imbalance.

Summation error for the debits and credits of the trial balance

Error transferring the ledger account balances to the trial balance columns o Error in numeric value o Error in transferring a debit or credit to the proper column o Omission of an account Error in the calculation of a ledger account balance Error in posting a journal entry to the ledger o Error in numeric value o Error in posting a debit or credit to the proper column Error in the journal entry o Error in a numeric value o Omission of part of a compound journal entry

The more often that the trial balance is calculated during the accounting cycle, the easier it is to isolate any errors; more frequent trial balance calculations narrow the time frame in which an error might have occurred, resulting in fewer transactions through which to search.

General Journal Entries The journal is the point of entry of business transactions into the accounting system. It is a chronological record of the transactions, showing an explanation of each transaction, the accounts affected, whether those accounts are increased or decreased, and by what amount. A general journal entry takes the following form:

Date Name of account being debited Amount

Name of account being credited Amount

Optional: short description of transaction

Consider the following example that illustrates the basic concept of general journal entries. Mike Peddler opens a bicycle repair shop. He leases shop space, purchases an initial inventory of bike parts, and begins operations. Here are the general journal entries for the first month: Date Account Names & Explanation Debit Credit 9/1 Cash 7500

Capital

Owner contributes $7500 in cash to capitalize the business.

9/8 Bike Parts

7500

2500

Accounts Payable

Purchased $2500 in bike parts on account, payable in 30 days.

9/15 Expenses

2500

1000

Cash 1000

Paid first month's shop rent of $1000.

9/17 Cash

400

Accounts Receivable 700

Revenue

Repaired bikes for $1100; collected $400 cash; billed customers for the balance.
9/18 Expenses

1100

275

Bike Parts

$275 in bike parts were used.

9/25 Cash

275

425

Accounts Receivable

Collected $425 from customer accounts.

9/28 Accounts Payable

425

500

Cash

Paid $500 to suppliers for parts purchased earlier in the month.

500

Most of the above transactions are entered as simple journal entries each debiting one account and crediting another. The entry for 9/17 is a compound journal entry, composed of two lines for the debit and one line for the credit. The transaction could have been entered as two separate simple journal entries, but the compound form is more efficient. In this example, there are no account numbers. In practice, account numbers or codes may be included in the journal entries to allow each account to be positively identified with no confusion between similar accounts. The journal entry is the first entry of a transaction in the accounting system. Before the entry is made, the following decisions must be made:

which accounts are affected by the transaction, and which account will be debited and which will be credited.

Once entered in the journal, the transactions may be posted to the appropriate T-accounts of the general ledger. Unlike the journal entry, the posting to the general ledger is a purely mechanical process - the account and debit/credit decisions already have been made.

Closing Entries At the end of the accounting period, the balances in temporary accounts are transferred to an income summary account and a retained earnings account, thereby resetting the balance of the temporary accounts to zero to begin the

next accounting period. First, the revenue accounts are closed by transferring their balances to the income summary account. Consider the following example for which September 30 is the end of the accounting period. If the revenue account balance is $1100, then the closing journal entry would be: Date Accounts Debit Credit 9/30 Revenue 1100

Income Summary 1100 Next, the expense accounts are closed by transferring their balances to the income summary account. If the expense account balance is $1275, then the closing entry would be: Date Accounts Debit Credit 9/30 Income Summary 1275

Expenses 1275 At this point, the net balance of the income summary account is a $175 debit (loss). The income summary account then is closed to retained earnings: Date Accounts Debit

Credit 9/30 Retained Earnings 175

Income Summary 175 Finally, the dividends account is closed to retained earnings. For example, if $50 in dividends were paid during the period, the closing journal entry would be as follows: Date Accounts Debit Credit 9/30 Retained Earnings 50

Dividends 50 Once posted to the ledger, these journal entries serve the purpose of setting the temporary revenue, expense, and dividend accounts back to zero in preparation for the start of the next accounting period. Note that the income summary account is not absolutely necessary - the revenue and expense accounts could be closed directly to retained earnings. The income summary account offers the benefit of indicating the net balance between revenue and expenses (i.e. net income) during the closing process.

Chart of Accounts The chart of accounts is a listing of all the accounts in the general ledger,

each account accompanied by a reference number. To set up a chart of accounts, one first needs to define the various accounts to be used by the business. Each account should have a number to identify it. For very small businesses, three digits may suffice for the account number, though more digits are highly desirable in order to allow for new accounts to be added as the business grows. With more digits, new accounts can be added while maintaining the logical order. Complex businesses may have thousands of accounts and require longer account reference numbers. It is worthwhile to put thought into assigning the account numbers in a logical way, and to follow any specific industry standards. An example of how the digits might be coded is shown in this list: Account Numbering 1000 - 1999: asset accounts 2000 - 2999: liability accounts 3000 - 3999: equity accounts 4000 - 4999: revenue accounts 5000 - 5999: cost of goods sold 6000 - 6999: expense accounts 7000 - 7999: other revenue (for example, interest income) 8000 - 8999: other expense (for example, income taxes) By separating each account by several numbers, many new accounts can be added between any two while maintaining the logical order. Defining Accounts Different types of businesses will have different accounts. For example, to report the cost of goods sold a manufacturing business will have accounts for its various manufacturing costs whereas a retailer will have accounts for the purchase of its stock merchandise. Many industry associations publish recommended charts of accounts for their respective industries in order to establish a consistent standard of comparison among firms in their industry. Accounting software packages often come with a selection of predefined account charts for various types of businesses. There is a trade-off between simplicity and the ability to make historical comparisons. Initially keeping the number of accounts to a minimum has the advantage of making the accounting system simple. Starting with a small number of accounts, as certain accounts acquired significant balances they would be split into smaller, more specific accounts. However, following this

strategy makes it more difficult to generate consistent historical comparisons. For example, if the accounting system is set up with a miscellaneous expense account that later is broken into more detailed accounts, it then would be difficult to compare those detailed expenses with past expenses of the same type. In this respect, there is an advantage in organizing the chart of accounts with a higher initial level of detail. Some accounts must be included due to tax reporting requirements. For example, in the U.S. the IRS requires that travel, entertainment, advertising, and several other expenses be tracked in individual accounts. One should check the appropriate tax regulations and generate a complete list of such required accounts. Other accounts should be set up according to vendor. If the business has more than one checking account, for example, the chart of accounts might include an account for each of them. Account Order Balance sheet accounts tend to follow a standard that lists the most liquid assets first. Revenue and expense accounts tend to follow the standard of first listing the items most closely related to the operations of the business. For example, sales would be listed before non-operating income. In some cases, part or all of the expense accounts simply are listed in alphabetical order. Sample Chart of Accounts The following is an example of some of the accounts that might be included in a chart of accounts. Sample Chart of Accounts Asset Accounts

Current Assets

1000 Petty Cash 1010 Cash on Hand (e.g. in cash registers) 1020 Regular Checking Account 1030 Payroll Checking Account 1040 Savings Account 1050 Special Account 1060 Investments - Money Market 1070 Investments - Certificates of Deposit 1100 Accounts Receivable 1140 Other Receivables 1150 Allowance

for Doubtful Accounts 1200 Raw Materials Inventory 1205 Supplies Inventory 1210 Work in Progress Inventory 1215 Finished Goods Inventory - Product #1 1220 Finished Goods Inventory - Product #2 1230 Finished Goods Inventory Product #3 1400 Prepaid Expenses 1410 Employee Advances 1420 Notes Receivable - Current 1430 Prepaid Interest 1470 Other Current Assets

Fixed Assets

1500 Furniture and Fixtures 1510 Equipment 1520 Vehicles 1530 Other Depreciable Property 1540 Leasehold Improvements 1550 Buildings 1560 Building Improvements 1690 Land 1700 Accumulated Depreciation, Furniture and Fixtures 1710 Accumulated Depreciation, Equipment 1720 Accumulated Depreciation, Vehicles 1730 Accumulated Depreciation, Other 1740 Accumulated Depreciation, Leasehold 1750 Accumulated Depreciation, Buildings 1760 Accumulated Depreciation, Building Improvements

Other Assets

1900 Deposits 1910 Organization Costs 1915 Accumulated Amortization, Organization Costs 1920 Notes Receivable, Non-current 1990 Other Noncurrent Assets Liability Accounts

Current Liabilities

2000 Accounts Payable 2300 Accrued Expenses 2310 Sales Tax Payable 2320 Wages Payable 2330 401-K Deductions Payable 2335 Health Insurance Payable 2340 Federal Payroll Taxes Payable 2350 FUTA Tax Payable 2360 State Payroll Taxes Payable 2370 SUTA Payable 2380 Local Payroll Taxes Payable 2390 Income Taxes Payable 2400 Other Taxes Payable 2410 Employee Benefits Payable 2420 Current Portion of Long-term Debt 2440 Deposits from Customers 2480 Other Current Liabilities

Long-term Liabilities

2700 Notes Payable 2702 Land Payable 2704 Equipment Payable 2706 Vehicles Payable 2708 Bank Loans Payable 2710 Deferred Revenue 2740 Other Longterm Liabilities Equity Accounts

3010 Stated Capital 3020 Capital Surplus 3030 Retained Earnings Revenue Accounts

4000 Product #1 Sales 4020 Product #2 Sales 4040 Product #3 Sales 4060 Interest Income 4080 Other Income 4540 Finance Charge Income 4550 Shipping Charges Reimbursed 4800 Sales Returns and Allowances 4900 Sales Discounts Cost of Goods Sold

5000 Product #1 Cost 5010 Product #2 Cost 5020 Product #3 Cost 5050 Raw Material Purchases 5100 Direct Labor Costs 5150 Indirect Labor Costs 5200 Heat and Power 5250 Commissions 5300 Miscellaneous Factory Costs 5700 Cost of Goods Sold, Salaries and Wages 5730 Cost of Goods Sold, Contract Labor 5750 Cost of Goods Sold, Freight 5800 Cost of Goods Sold, Other 5850 Inventory Adjustments 5900 Purchase Returns and Allowances 5950 Purchase Discounts Expenses

6000 Default Purchase Expense 6010 Advertising Expense 6050 Amortization

Expense 6100 Auto Expenses 6150 Bad Debt Expense 6200 Bank Fees 6250 Cash Over and Short 6300 Charitable Contributions Expense 6350 Commissions and Fees Expense 6400 Depreciation Expense 6450 Dues and Subscriptions Expense 6500 Employee Benefit Expense, Health Insurance 6510 Employee Benefit Expense, Pension Plans 6520 Employee Benefit Expense, Profit Sharing Plan 6530 Employee Benefit Expense, Other 6550 Freight Expense 6600 Gifts Expense 6650 Income Tax Expense, Federal 6660 Income Tax Expense, State 6670 Income Tax Expense, Local 6700 Insurance Expense, Product Liability 6710 Insurance Expense, Vehicle 6750 Interest Expense 6800 Laundry and Dry Cleaning Expense 6850 Legal and Professional Expense 6900 Licenses Expense 6950 Loss on NSF Checks 7000 Maintenance Expense 7050 Meals and Entertainment Expense 7100 Office Expense 7200 Payroll Tax Expense 7250 Penalties and Fines Expense 7300 Other Taxes 7350 Postage Expense 7400 Rent or Lease Expense 7450 Repair and Maintenance Expense, Office 7460 Repair and Maintenance Expense, Vehicle 7550 Supplies Expense, Office 7600 Telephone Expense 7620 Training Expense 7650 Travel Expense 7700 Salaries Expense, Officers 7750 Wages Expense 7800 Utilities Expense 8900 Other Expense 9000 Gain/Loss on Sale of Assets

The Balanced Scorecard Traditional financial performance metrics provide information about a firm's past results, but are not well-suited for predicting future performance or for implementing and controlling the firm's strategic plan. By analyzing perspectives other than the financial one, managers can better translate the organization's strategy into actionable objectives and better measure how well the strategic plan is executing. The Balanced Scorecard is a management system that maps an organization's strategic objectives into performance metrics in four perspectives: financial, internal processes, customers, and learning and growth. These perspectives provide relevant feedback as to how well the strategic plan is executing so that adjustments can be made as necessary. The Balance Scorecard framework can be depicted as follows:

The Balanced Scorecard Framework

Financial Performance

Objectives Measures Targets Initiatives

Customers

Objectives Measures Targets Initiatives Strategy Internal Processes

Objectives Measures Targets Initiatives

Learning & Growth

Objectives Measures Targets Initiatives

The Balanced Scorecard (BSC) was published in 1992 by Robert Kaplan and David Norton. In addition to measuring current performance in financial terms, the Balanced Scorecard evaluates the firm's efforts for future improvement using process, customer, and learning and growth metrics. The term "scorecard" signifies quantified performance measures and "balanced" signifies that the system is balanced between: short-term objectives and long-term objectives financial measures and non-financial measures lagging indicators and leading indicators internal performance and external performance perspectives

Financial Measures Are Insufficient While financial accounting is suited to the tracking of physical assets such as manufacturing equipment and inventory, it is less capable of providing useful reports in environments with a large intangible asset base. As intangible assets constitute an ever-increasing proportion of a company's market value, there is an increase in the need for measures that better report such assets as loyal customers, proprietary processes, and highly-skilled staff. Consider the case of a company that is not profitable but that has a very large customer base. Such a firm could be an attractive takeover target simply because the acquiring firm wants access to those customers. It is not uncommon for a company to take over a competitor with the plan to discontinue the competing product line and convert the customer base to its own products and services. The balance sheets of such takeover targets do not reflect the value of the customers who nonetheless are worth something to the acquiring firm. Clearly, additional measures are needed for such intangibles. Scorecard Measures are Limited in Number The Balanced Scorecard is more than a collection of measures used to identify problems. It is a system that integrates a firm's strategy with a purposely limited number of key metrics. Simply adding new metrics to the financial ones

could result in hundreds of measures and would create information overload. To avoid this problem, the Balanced Scorecard focuses on four major areas of performance and a limited number of metrics within those areas. The objectives within the four perspectives are carefully selected and are firm specific. To avoid information overload, the total number of measures should be limited to somewhere between 15 and 20, or three to four measures for each of the four perspectives. These measures are selected as the ones deemed to be critical in achieving breakthrough competitive performance; they essentially define what is meant by "performance". A Chain of Cause-and-Effect Relationships Before the Balanced Scorecard, some companies already used a collection of both financial and non-financial measures of critical performance indicators. However, a well-designed Balanced Scorecard is different from such a system in that the four BSC perspectives form a chain of cause-and-effect relationships. For example, learning and growth lead to better business processes that result in higher customer loyalty and thus a higher return on capital employed (ROCE). Effectively, the cause-and-effect relationships illustrate the hypothesis behind the organization's strategy. The measures reflect a chain of performance drivers that determine the effectiveness of the strategy implementation. Objectives, Measures, Targets, and Initiatives Within each of the Balanced Scorecard financial, customer, internal process, and learning perspectives, the firm must define the following: Strategic objectives - what the strategy is to achieve in that perspective. Measures - how progress for that particular objective will be measured. Targets - the target value sought for each measure. Initiatives - what will be done to facilitate the reaching of the target.

The following sections provide examples of some objectives and measures for the four perspectives. Financial Perspective The financial perspective addresses the question of how shareholders view the

firm and which financial goals are desired from the shareholder's perspective. The specific goals depend on the company's stage in the business life cycle. For example: Growth stage - goal is growth, such as revenue growth rate Sustain stage - goal is profitability, such ROE, ROCE, and EVA Harvest stage - goal is cash flow and reduction in capital requirements

The following table outlines some examples of financial metrics:

Objective Specific Measure Growth Revenue growth Profitability Return on equity Cost leadership Unit cost

Customer Perspective The customer perspective addresses the question of how the firm is viewed by its customers and how well the firm is serving its targeted customers in order to meet the financial objectives. Generally, customers view the firm in terms of time, quality, performance, and cost. Most customer objectives fall into one of those four categories. The following table outlines some examples of specific customer objectives and measures: Objective Specific Measure New products % of sales from new products Responsive supply Ontime delivery To be preferred supplier Share of key accounts Customer partnerships Number of cooperative efforts Internal Process Perspective

Internal business process objectives address the question of which processes are most critical for satisfying customers and shareholders. These are the processes in which the firm must concentrate its efforts to excel. The following table outlines some examples of process objectives and measures: Objective Specific Measure Manufacturing excellence Cycle time, yield Increase design productivity Engineering efficiency Reduce product launch delays Actual launch date vs. plan

Learning and Growth Perspective Learning and growth metrics address the question of how the firm must learn, improve, and innovate in order to meet its objectives. Much of this perspective is employee-centered. The following table outlines some examples of learning and growth measures: Objective Specific Measure Manufacturing learning Time to new process maturity Product focus % of products representing 80% of sales Time to market Time compared to that of competitors

Achieving Strategic Alignment throughout the Organization Whereas strategy is articulated in terms meaningful to top management, to be implemented it must be translated into objectives and measures that are actionable at lower levels in the organization. The Balanced Scorecard can be cascaded to make the translation of strategy possible. While top level objectives may be expressed in terms of growth and profitability, these goals get translated into more concrete terms as they progress down the organization and each manager at the next lower level develops objectives and measures that support the next higher level. For

example, increased profitability might get translated into lower unit cost, which then gets translated into better calibration of the equipment by the workers on the shop floor. Ultimately, achievement of scorecard objectives would be rewarded by the employee compensation system. The Balanced Scorecard can be cascaded in this manner to align the strategy thoughout the organization. The Process of Building a Balanced Scorecard While there are many ways to develop a Balanced Scorecard, Kaplan and Norton defined a four-step process that has been used across a wide range of organizationsL: 1. Define the measurement architecture - When a company initially introduces the Balanced Scorecard, it is more manageable to apply it on the strategic business unit level rather than the corporate level. However, interactions must be considered in order to avoid optimizing the results of one business unit at the expense of others. 2. Specify strategic objectives - The top three or four objectives for each perspective are agreed upon. Potential measures are identified for each objective. 3. Choose strategic measures - Measures that are closely related to the actual performance drivers are selected for evaluating the progress made toward achieving the objectives. 4. Develop the implementation plan - Target values are assigned to the measures. An information system is developed to link the top level metrics to lower-level operational measures. The scorecard is integrated into the management system. Balanced Scorecard Benefits Some of the benefits of the Balanced Scorecard system include: Translation of strategy into measurable parameters. Communication of the strategy to everybody in the firm. Alignment of individual goals with the firm's strategic objectives - the BSC recognizes that the selected measures influence the behavior of employees. Feedback of implementation results to the strategic planning process.

Since its beginnings as a peformance measurement system, the Balanced Scorecard has evolved into a strategy implementation system that not only measures performance but also describes, communicates, and aligns the strategy throughout the organization. Potential Pitfalls The following are potential pitfalls that should be avoided when implementing the Balanced Scorecard: Lack of a well-defined strategy: The Balanced Scorecard relies on a well-defined strategy and an understanding of the linkages between strategic objectives and the metrics. Without this foundation, the implementation of the Balanced Scorecard is unlikely to be successful. Using only lagging measures: Many managers believe that they will reap the benefits of the Balanced Scorecard by using a wide range of nonfinancial measures. However, care should be taken to identify not only lagging measures that describe past performance, but also leading measures that can be used to plan for future performance. Use of generic metrics: It usually is not sufficient simply to adopt the metrics used by other successful firms. Each firm should put forth the effort to identify the measures that are appropriate for its own strategy and competitive position.

The Accounting Process (The Accounting Cycle) The accounting process is a series of activities that begins with a transaction and ends with the closing of the books. Because this process is repeated each reporting period, it is referred to as the accounting cycle and includes these major steps: 1. Identify the transaction or other recognizable event. 2. Prepare the transaction's source document such as a purchase order or invoice. 3. Analyze and classify the transaction. This step involves quantifying the transaction in monetary terms (e.g. dollars and cents), identifying the

accounts that are affected and whether those accounts are to be debited or credited. 4. Record the transaction by making entries in the appropriate journal, such as the sales journal, purchase journal, cash receipt or disbursement journal, or the general journal. Such entries are made in chronological order. 5. Post general journal entries to the ledger accounts. Note: The above steps are performed throughout the accounting period

as transactions occur or in periodic batch processes. The following steps are performed at the end of the accounting period:

6. Prepare the trial balance to make sure that debits equal credits. The trial balance is a listing of all of the ledger accounts, with debits in the left column and credits in the right column. At this point no adjusting entries have been made. The actual sum of each column is not meaningful; what is important is that the sums be equal. Note that while out-of-balance columns indicate a recording error, balanced columns do not guarantee that there are no errors. For example, not recording a transaction or recording it in the wrong account would not cause an imbalance. 7. Correct any discrepancies in the trial balance. If the columns are not in balance, look for math errors, posting errors, and recording errors. Posting errors include: o posting of the wrong amount, o omitting a posting, o posting in the wrong column, or o posting more than once.

8. repare adjusting entries to record accrued, deferred, and estimated amounts. 9. ost adjusting entries to the ledger accounts. 10. repare the adjusted trial balance. This step is similar to the preparation of the unadjusted trial balance, but this time the adjusting entries are included. Correct any errors that may be found. 11. repare the financial statements. o Income statement: prepared from the revenue, expenses, gains, and losses.

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Balance sheet: prepared from the assets, liabilities, and equity accounts. Statement of retained earnings: prepared from net income and dividend information. Cash flow statement: derived from the other financial statements using either the direct or indirect method.

12. repare closing journal entries that close temporary accounts such as revenues, expenses, gains, and losses. These accounts are closed to a temporary income summary account, from which the balance is transferred to the retained earnings account (capital). Any dividend or withdrawal accounts also are closed to capital. 13. ost closing entries to the ledger accounts. 14. repare the after-closing trial balance to make sure that debits equal credits. At this point, only the permanent accounts appear since the temporary ones have been closed. Correct any errors. 15. repare reversing journal entries (optional). Reversing journal entries often are used when there has been an accrual or deferral that was recorded as an adjusting entry on the last day of the accounting period. By reversing the adjusting entry, one avoids double counting the amount when the transaction occurs in the next period. A reversing journal entry is recorded on the first day of the new period. Instead of preparing the financial statements before the closing journal entries, it is possible to prepare them afterwards, using a temporary income summary account to collect the balances of the temporary ledger accounts (revenues, expenses, gains, losses, etc.) when they are closed. The temporary income summary account then would be closed when preparing the financial statements.