If the amount received for the bonds (excludes any accrued interest received and any bond issue costs) is more than the face amount of the bonds, there will be a credit to Premium on Bonds Payable. If the amount received for the bonds is less than the bonds’ face amount, there will be a debit to Discount on Bonds Payable. The Premium or Discount accounts are reported next to the account Bonds Payable.  The amount of the Premium or Discount is then amortized to Bond Interest Expense over the life of the bonds.

The issuer of bonds makes formal promises to pay interest usually every six months (semiannually) and to pay the principal or maturity amount at a specified date many years in the future. The agreement covering the details of the bonds payable is known as the bond’s indenture.

U. S. corporations issue bonds and other long term debt instead of common stock because 1) it is less costly than issuing common stock, 2) the interest it pays to the bondholders is deductible for income tax purposes, and 3) the bondholders are not owners and therefore the present ownership interest is not diluted.

Some liabilities have low interest rates and some have no interest associated with them. For example, some of a company’s accounts payable may allow payment in 30 days. With those payables it is better to have the liability and to keep your cash in the bank until they become due.

In our personal lives, our first house was probably purchased with a downpayment and mortgage loan. That mortgage loan was a big liability, but it allowed us to upgrade our living space. I viewed my mortgage loan liability as a good thing because it allowed me to own a nice home in a beautiful neighborhood.

So some liabilities are good—especially the ones that have a very low interest rate. Too many liabilities could cause financial hardships.

Learn more about the Balance Sheet.

A depositor will earn more interest on a certificate of deposit than the amount earned on a savings account or money market account. The length of a certificate of deposit could be one month, three months, six months, one year, 17 months, three years, etc. Generally the longer the time until maturity, the higher the interest rate.

A CD that matures in less than one year will be reported by the bank as a current liability, and will be reported as a short-term investment by the depositor (provided the amount is not restricted by the depositor).

The amount of the accrued income will also increase the corporation’s retained earnings. This occurs because the accrual adjusting entry included a credit to a revenue account—thereby increasing the corporation’s net income.

Learn more about Adjusting Entries.

If the cumulative earnings minus the cumulative dividends declared result in a negative amount, there will be a negative amount of retained earnings. This negative amount of retained earnings will be reported as a separate line within stockholders’ equity.

If the amount of negative retained earnings is greater than the amount of paid-in capital, the total of the stockholders’ equity section will also be a negative amount.

To recap, negative amounts can occur and the negative amounts must be reported.

Learn more about Stockholders’ Equity.

By having the details of the accounts receivable activity in a subsidiary ledger, a company can better control its financial information. For example, the credit manager and others in the credit department of a company will have access to any and all of the credit sales information through the subsidiary ledger without having access to any other account in the company’s general ledger.

In job order costing systems, the job cost sheets or records serve as the subsidiary ledger containing the detail for the general ledger account Work in Process. The Work in Process account is now a control account containing aggregate amounts for direct materials, direct labor, factory overhead applied, transfers to finished goods, etc. Manufacturing personnel will have full access to the job cost sheets without gaining access to other accounts in the general ledger.

Since companies are integrating accounting records with their other information into one database, I assume there will be less use of the term subsidiary ledgers in the future. There will likely be a report generated to provide the information formerly contained in the subsidiary ledger.

Since an employee is not purchased, there is no past transaction and cost that the accountant can record in order to report this person as an asset owned by the entity. The salary and bonuses paid to a key employee are reported as expenses in the period in which the employee performed services.

Not being able to record a valuable employee as an asset is similar to a valuable brand name developed internally by a company over time. Since the brand name was not purchased from another entity, there is no past transaction and purchase cost to be recorded.

I assume that an entity’s payment made to another professional sports team for a professional athlete’s services for the next three years will result in recording the payment as an asset—a prepaid expense or deferred charge—that will then be amortized to expense over the three year contract.

Learn more about Accounting Principles.

If you purchase an asset and the sales tax is required, the sales tax should be recorded as part of the cost of the goods or services received. For example, if you were required to pay sales tax on the new company car, the cost of the car will include the sales tax. If you purchased supplies and the cost of the supplies was subject to sales tax, the sales tax is part of the cost of the supplies. If you received services that were subject to the sales tax, the sales tax is a necessary part of the cost of the services.

If your state does not allow an exemption from sales tax for the asset you purchased, the sales tax should be recorded as part of the cost of the asset.

Prior to 1988, accountants prepared a funds flow statement. Generally, the funds flow statement reported on the change in working capital from one balance sheet date to another.

Read AccountingCoach.com’s explanation of the cash flow statement.

The liability account Notes Payable reports the principal amount owed at the time. Interest that will occur in the future is not recorded at the time of the purchase. The reason is that the interest is not owed as of that date. Each month, one month’s interest on the note or loan will be recorded with a debit to Interest Expense and a credit to Cash or Interest Payable (if not paid). Any cash payments that exceed the amount of interest owed at that time will be debited to Notes Payable. The balance in the liability account Notes Payable should agree with the principal balance owed to lender. The balance in the liability account Interest Payable should agree with the interest due as of that date.

You can call your lender to verify the amount of principal and interest owed at a specific date and then compare the amounts to the balances in your general ledger accounts.

Land improvements are recorded in a general ledger asset account entitled Land Improvments. The depreciation of land improvements will result in depreciation expense on the company’s income tax return. This will reduce its taxable income and will reduce a profitable company’s income tax payments.

An example of a leasehold improvement is the permanent improvement to a building that is being rented under a 10 year lease. For instance, the tenant might construct permanent walls and offices inside of the warehouse that it leases from the owner. The lease will likely state that all improvements to the building will belong to the owner of the building. The amount spent by the tenant to improve the building will be recorded by the tenant in its asset account Leasehold Improvements. Generally, the amount of these leasehold improvements will be depreciated by the tenant over the useful life of the improvements or over the life of the lease, whichever is shorter. The depreciation expense associated with the leasehold improvements will reduce the tenant’s taxable income and its income tax payments if the company is profitable.

Learn more about Depreciation.

The principal balance on the mortgage loan already appears in the general ledger and on the balance sheet as the liability Mortgage Loan Payable. Therefore, there is no accrual needed for the principal portion of the loan payment due at December 31.

Let’s illustrate this with an example. Assume that you own a sole proprietorship and you provided a service to a customer. One of your business assets (cash or accounts receivable) increased and your liabilities were not involved. Therefore, your business liabilities will remain the same and your equity in the business will increase.

Accountants prepare an income statement or P&L to report the revenues and expenses, but the ultimate effect is that the business assets and owner’s equity will increase when there is a profit or net income.

Learn more about Accounting Equation.

The term fixed assets generally refers to the long-term, tangible assets used in a business that are classified as property, plant and equipment. Examples of fixed assets are land, buildings, manufacturing equipment, office equipment, furniture, fixtures, and vehicles. Except for land, the fixed assets are depreciated over their useful lives.

Learn more about fixed asset Depreciation.

Other comprehensive income includes unrealized gains and losses on certain investments in securites, foreign currency items, and certain pension liability adjustments.

Net income is reported on the income statement and is included in the retained earnings section of stockholders’ equity.  Other comprehensive income items are not reported on the income statement, and are included in the accumulated other comprehensive income section of stockholders’ equity.

The accounting for comprehensive income is provided in the Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income, available for reading at www.FASB.org/st.

The unrealized holding gain is reported on the balance sheet by 1) increasing the asset available-for-sale securities, and 2) increasing the stockholders’ equity component accumulated other comprehensive income.  Note that the holding gains on available-for-sale securities are not reported on the income statement.

Learn more about unrealized gains and other comprehensive income at www.FASB.org/st.

A second advantage of financing asset with bonds instead of stock is that the ownership interest in the corporation will not be diluted by adding more owners. Bondholders and other lenders are not owners of the assets or of the corporation. Therefore, all of the gain in the value of the assets belongs to the stockholders. The bondholders will receive only the agreed upon interest.  This is related to the concept of leverage or trading on equity. By issuing debt, the corporation gets to control a large asset by using other people’s money instead of its own. If the asset ends up being very profitable, all of its earnings minus the interest, will enhance the owners’ financial position.

These efficiency ratios include 1) accounts receivable turnover ratio, and the related ratio days’ credit sales in accounts receivable; 2) inventory turnover, and the related ratio days’ cost of sales in inventory; 3) total asset tunover; and 4) fixed asset turnover.

The accounts receivable turnover ratio and the inventory turnover ratio are also used in the context of a firm’s liquidity.

The total asset turnover and fixed asset turnover are indicators of a company’s effectiveness in utilizing its assets.

Learn more about Financial Ratios.

Here is an example of window dressing. A company operates throughout the year with a negative balance in its general ledger Cash account. (Its balance at the bank is positive due to the time it takes for its checks to clear its bank account.)  Since the financial statements report the Cash amount appearing in its general ledger account, the financial statements would report a negative amount of Cash. However, the company does not want its December 31 balance sheet to report a negative cash balance, since it will be reviewed by many outsiders. To avoid reporting a negative cash balance the company does not make the payments for amounts that should be paid between December 26 and December 31. This postponement of payments allows its book amount of Cash to temporarily be a positive amount. Then on January 2, the company issues checks for all of the amounts that normally would have been paid at the end of December.

To illustrate the accounts receivable collection period, let’s assume a corporation had net credit sales of $360,000 during the past year and its accounts receivable balance was on average $40,000. The average credit sales per day were approximately $1,000 per day ($360,000 of annual credit sales divided by 360 or 365 days per year). The average accounts receivable balance of $40,000 divided by $1,000 of credit sales per day equals 40 days.

An alternative calculation is to use the accounts receivable turnover ratio. In our example, the accounts receivable ratio is 9 times per year ($360,000 of net credit sales divided by $40,000—the average accounts receivable balance). 360 days per year divided by the accounts receivable turnover of 9 equals 40 days.

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The net amount of fixed assets is the amount of property, plant and equipment reported on the balance sheet after deducting the accumulated depreciation. Ideally, you should use the average amount of net fixed assets during the year of the net sales.

A corporation having property, plant and equipment with an average gross amount of $10 million and an average accumulated depreciation of $4 million would have average net fixed assets of $6 million. If its net sales were $18 million, its fixed asset turnover would be 3 ($18 million of net sales divided by $6 million of average net fixed assets).

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The calculation of the debt ratio is: Total Liabilities divided by Total Assets.

The debt ratio indicates the percentage of the total asset amounts stated on the balance sheet that is owed to creditors.

A high debt ratio indicates that a corporation has a high level of financial leverage.

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Paid in capital, also referred to as contributed capital, is the amount that the corporation received from stockholders when the corporation issued its stock. Paid in capital is also referred to as permanent capital.

Retained earnings is the cumulative amount of after tax net income earned by the corporation since its inception minus the dividends that have been distributed to the stockholders since the corporation began.

Learn more about Stockholders’ Equity.

For example, if a corporation without preferred stock has stockholders’ equity on December 31, 2007 of $12,421,000 and it has 1,000,000 shares of common stock outstanding on that date, its book value per share is $12.42.

Keep in mind that the book value per share will not be the same as the market value per share. One reason is that a corporation’s stockholders’ equity is simply the difference between the total amount of assets reported on the balance sheet and the total amount of liabilities reported. Long term assets are generally reported at original cost less accumulated depreciation and some valuable assets such as trade names might not be listed on the balance sheet.

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Let’s assume that during the year 2007 a corporation had net sales of $2,100,000 and its total assets during the same 12 month period averaged $1,400,000. The company’s total asset turnover for 2007 was 1.5 (net sales of $2,100,000 divided by $1,400,000 of average total assets).

This ratio will vary by industry, as some industries are more capital intensive than others. Always compare your company’s financial ratios to the ratios of other companies in the same industry.

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Let’s assume that a company had $60,000 of net income after tax during the year 2007. During the same 12 month period its total assets averaged $1,000,000. Its return on assets ratio for 2007 was 6% ($60,000 divided by $1,000,000).

You would compare this company’s return on assets to other companies in the same industry.

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The working capital turnover ratio is calculated as follows: net annual sales divided by the average amount of working capital during the same 12 month period.

For example, if a company’s net sales for the year 2007 were $2,400,000 and its average amount of working capital during the year 2007 was $400,000, its working capital turnover ratio was 6 ($2,400,000 divided by $400,000).

Working capital is defined as the total amount of current assets minus the total amount of current liabilities. As indicated above, you should use the average amount of working capital for the year of the net sales.

As with most financial ratios, you should compare the working capital turnover ratio to other companies in the same industry and to the same company’s past and planned working capital turnover ratio.

Learn more about Financial Ratios.

For example, if a company has $900,000 of current assets and has $400,000 of current liabilities, its working capital is $500,000. If a company has $900,000 of current assets and has $900,000 of current liabilities, it has no working capital.

Other people use the term working capital ratio to mean the current ratio, which is defined as the amount of current assets divided by the amount of current liabilities.

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I recall being asked to reconcile the general ledger account Freight Payable. What I needed to do was provide documentation that the balance in Freight Payable was proper. I proceeded to look at the shipments of recent sales and then determined how much we would be obligated to pay for the freight on those sales. We then adjusted the balance in Freight Payable to my documented amount. This reconciliation was done to have the correct account balance and to provide the outside auditors with documentation which could easily be reviewed.

I also reconciled the balance in Utilities Payable by computing the daily cost of each utility that the company used. The cost per day was then multiplied by the number of days since the last meter reading date shown on the utility bills already entered in our accounting system. We then adjusted the Utilities Payable account balance to be equal to the documented amount.

Learn more about Adjusting Entries and Bank Reconciliation.

The calculation for determining the days’ sales in accounts receivable is the number of days in the year (usually 360 or 365 days is used) divided by the accounts receivable turnover ratio for a specific year. If a company’s accounts receivable turnover ratio was 10, then the days’ sales in accounts receivable is 36 days (360 days divided by the turnover ratio of 10).

Since the accounts receivable turnover ratio used in the days’ sales in accounts receivable was based on 1) credit sales during a one-year time period, and 2) the average accounts receivable balances during that one-year period, the 36 days calculated above is an average. It is possible that within the accounts receivable there are some accounts which are 120 days or more past due. This information might be hidden by the average, because the average included some accounts that paid early. Therefore, it is best to review an aging of accounts receivable by customer to understand the detail behind the days’ sales in accounts receivable ratio.

Learn more about Financial Ratios.

The liquidity ratios include the current ratio and the acid test or quick ratio. The current ratio and quick ratio are also referred to as solvency ratios. Working capital is an important indicator of liquidity or solvency, even though it is not technically a ratio.

Liquidity ratios sometimes include the accounts receivable turnover ratio and the inventory turnover ratio. These two ratios are also classified as activity ratios.

Learn more about Financial Ratios including the liquidity ratios.

For example, if a company had an inventory turnover ratio of 9, the company’s inventory turned over 9 times during the year. If we use 360 as the number of days in the year, the company had (on average) 40 days of inventory on hand during the year (360 days divided by the inventory turnover ratio of 9).

Since the inventory turnover ratio reflects the average amount of inventory during the year, and since sales usually fluctuate during the year, the days’ sales in inventory is an approximation.

Learn more about Financial Ratios including the inventory turnover ratio.

To illustrate the inventory turnover ratio, let’s assume 1) that during the year 2007 a company’s Cost of Goods Sold was $3,600,000, and 2) the company’s average cost in its Inventory account during same 12 months of 2007 was calculated to be $400,000. The company’s inventory turnover ratio is 9 ($3,600,000 divided by $400,000) or 9 times.

The higher the inventory turnover ratio, the better, provided you are able to fill customers’ orders on time. It would be foolish to lose customers because you didn’t carry sufficient inventory quantities.

A company’s inventory turnover ratio should be compared to 1) its previous ratios, 2) its planned ratio, and 3) the industry average.

Even with a favorable inventory turnover ratio, a company may have some excess and obsolete inventory items. Therefore, it is wise to compare the quantity of each item in inventory with the recent sales of each item.

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A corporation with $1,200,000 of liabilities and $2,000,000 of stockholders’ equity will have a debt to equity ratio of 0.6:1. A corporation with total liabilities of $1,200,000 and stockholders’ equity of $400,000 will have a debt to equity ratio of 3:1.

Generally, the higher the ratio of debt to equity, the greater is the risk for the corporation’s creditors and its prospective creditors.

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For example, if the annual subscription cost is $240 and it is paid in advance, you would initially debit Prepaid Expenses for $240 and credit Cash for $240. If your company issues monthly financial statements, then each month during the subscription period you would debit Subscription Expense for $20 and credit Prepaid Expenses for $20. This results in 1) the matching of $20 to expense on each of the monthly income statements, and 2) the balance sheet reporting the amount that is prepaid or not yet expired.

At a large company, the annual cost of $240 will usually be an immaterial amount. The materiality concept will allow you to violate the matching principle, and to avoid the monthly adjusting entry, by simply debiting Subscription Expense for the entire $240 at the beginning of the one-year subscription period.

Learn more about Adjusting Entries.

For example, if a company’s sales for the year 2007 were $6,000,000 and its average balance in Accounts Receivable for the same twelve months of 2007 was $600,000, its accounts receivable turnover ratio is 10. This indicates that on average the company’s accounts receivables turned over 10 times during the year 2007—or approximately every 36 days (360 or 365 days per year divided by the turnover of 10).

Whether the accounts receivable turnover ratio of 10 is good or bad depends on the company’s past ratios, the average for other companies in the same industry, and by the specific credit terms given to this company’s customers.

It is important to note that the accounts receivable turnover ratio is an average, and averages can hide important details. For example, some past due receivables could be “hidden” or offset by receivables that have paid faster than the average. If you have access to the company’s details, you should review a detailed aging of accounts receivable to detect slow paying accounts.

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Let’s illustrate the acid test ratio by assuming that a company has cash of $7,000 + temporary marketable securities of $20,000 + accounts receivables of $93,000. This adds up to $120,000 of quick assets. If its current liabilities amount to $100,000 its acid test ratio is 1.2:1.

The larger the acid test ratio, the more easily will the company be able to meet its current obligations.

The acid test ratio is also known as the quick ratio.

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