Accounting Principles: Learn The Basics of Accounting and Bookkeeping

1. Course Intro: Hi, welcome to Accounting Principles course. Whether you are an accountant who want to expand current skills, or business owner who want to understand financial statements, and students who are seeking to learn accounting from scratch. This course is for you. My name is Martinez, and I will be your instructor in this course. Together. We will master the basics of accounting. I started my career in 2006, then become a qualified management accountant in 2012, currently working as a financial manager. So I have both the experience and knowledge to help you throughout the course. I built this course for anyone looking for comprehensive understanding of accounting process. After completing all lessons, you will be able to identify, record, and analyze measured financial transactions and report financial statements. You will become at the end, a confident accountant. This course covers the accounting for proprietorship Companies who are owned by one individual or one entity. I covered the major topics using multiple accounting resources. So no need to search anywhere else other than this course. After each section, I will practice with you a complete exercise. Together, we will learn the details step-by-step. We start at beginning with the basic concepts of accounting. Building a good understanding of what accounting is about. Then expand our information gradually by practicing different topics from debit and the credit until we prepare all financial statements. Feel free to watch the preview of my lessons down below. I will be always available in the Q and a section to answer any question you have. Thanks for joining me. Let's get started. 2. What is Accounting?: Welcome to lesson one. We will start our course by learning what is accounting? Accounting consists of three main activities. It identifies, records and communicates economic events of an organization to interested users. What we understand from this definition, there are three main activities. First one is identification, second one is recording, and third one is communicating. If I want to make it easier to understand, we will consider identification as inputs, recording as the process, and finally, communication as outputs. Let us start with identification. Identification referred to selecting relevant events. What do we mean by relevant events? They have economic significance to a particular company which any occurrence will impact the company financial condition. So relevant events are more company-specific, which differ from one business to another, such as sales of meals in a restaurant. Another example is purchasing of manufacturing machines in a factory. The second activity is recording. It includes recording economic events and systematic and chronological entries. What do chronological means? It means events are recorded in the order in which they are happened or incurred. To record these events, they must be measured in dollar value or any other currency. During the process of recording. These events are classified and accounting ledgers. We will talk about ledgers in deep later in this course. One of the mistakes that people thinking about accounting, they always referred to as bookkeeping. Actually, bookkeeping is the recording process only in accounting activities. Bookkeeping does not equal accounting. The final activity is communicating. There are two main roles and this stage, first one is accumulating similar transactions to report them in the aggregate in financial statements. We will see later in this course, once we explain the accounting cycle. The second roll to analyze and interpret reported information using different methods such as ratios, graphs, trends, and relationships. We will explain how to analyze financial statements later in this course as well. That's the end of our lesson. Thanks for watching and see you the next one. 3. Users of Financial Information: We learned in our previous lesson, what is accounting? Today we will talk about users of financial information. There are two main groups of users. The first one is internal users, and the second one is external users. Internal users are managers who run the business. While external users are individuals or organizations who want to know about the financial condition or the capability of the company. Let us start with some examples of internal users. The first department is finance, e.g. they want to know whether there is sufficient funds to pay bonuses to employees or dividends to stockholders. Another example is sales department. They want to know the best price to sell their products or services in the market. We have also production department. They may ask, what is the cost of production per unit and how to reduce it effectively without losing quality. There is also human resources department. They may ask, can we afford providing increments to our employees this year or not? Our last example is management. It is important to the management to know which product line is profitable and which one is losing. For external users, let us take another examples. The first user is investors. They need financial information to decide whether to buy, hold, or sell their ownership shares of the company. Another user is banks. They want to evaluate the risk of providing bank facilities or lending money to the company. Another example is suppliers to study whether to provide credit terms to the company or limit their sales to be on cash-basis. Only. One more example is customers. When there is long-term contract between the company and its customer, the customer uses accounting information related to the company to know about its financial capabilities to ensure smooth operation during contract period. This is more common and construction business, the customer wants to make sure only bidders with good financial capabilities can bid and earn such contracts. The last example is government, such as tax authority. They want to assure compliance with laws, regulations, and tax calculations. The end of our lesson, thanks for watching and see you the next one. 4. What is U.S. GAAP?: After we learned about users of financial information, in this lesson, we will talk about gab. Gab referred to generally accepted accounting principles. It is a common set of standards, rules, and procedures which indicate how to report economic events in the financial statements. There are two main groups support establishing gab in the United States. The first organization is fast. Fast preferred to Financial Accounting Standards Board, which is an independent private sector, not-for-profit organization that established standards for both public and private companies. The second group is sick. Sick refer to US Securities and Exchange Commission, which is a government agency that established reporting requirements for public companies who are required to follow GAAP. Sec depends on fast for setting the standards. They are not sitting these standards themselves. By applying GAP standards, financial statements will earn multiple benefits. We will focus here in three main benefits. The first one is comparable information, gap maintain consistency. As a result, users can compare financial statements over time for the same company or with other companies for the same period. The second benefit, reliable information gap reduce the chances of risk and fraud. Also presented information is unbiased and objective. Unbiased means a company cannot select information to favor one user over another user. Objective means transactions are recorded based on solid evidence. Accountants cannot record or represent any information based on their personal opinion. As a result, users can trust the reported information in the financial statements. Third benefit is providing relevant information by disclosing all related information which make a difference in the way users assess the company. This reported information affects users decision. These are three main benefits of adopting gab while preparing financial statements. Rather than gab, there are other set of standards established by International Accounting Standards Board, IASB. These standards are called International Financial Reporting Standards. Ifrs. As markets become more global, money countries outside the United States have adopted IFRS to be able to compare their financial statements with other countries. This subject become more crucial for multinational companies located in the United States, which has multiple branches around the world. The main branch and the US has to follow gab, while other branches may follow IFRS or any other national standards. Setting bodies for these two standards have made a huge efforts to reduce differences between US GAAP and IFRS. This is the end of our lesson. Thanks for watching and see you the next one. 5. Economic Entity, Monetary Unit, Going Concern and Periodicity: We learned in our previous lesson, what is gab? We will talk in this lesson about basic concepts of accounting. I will explain 12 main concepts which will be splitted into three parts. Each part will contain four concepts. This is part one. Let us get started. Our first concept is economic entity assumption. It means a company keeps its activities separated from owner's personal activities. As a result, only business-related transactions are recorded while owner's personal transactions outside the company are not recorded. Let us assume a company purchased land. It will be registered by the company name rather than owner name. This transaction will be recorded in the company books. In contrast, if the owner buys another land which is registered by his own name, it will not be recorded in the company books as bad economic entity assumption. We have also another type of transactions between the company and its owner. These transactions are considered business-related transactions. One example, owner invested capital in a company. Another example, when the owner withdraw cash from company bank account. These types of transactions are recorded in the books of the company. Let us move to the second concept, which is monetary unit assumption. Money provides appropriate basis for measurements and analysis. This assumption requires companies to include only transaction data that can be expressed in money terms, such as US dollar or any other currency. Some relevant information such as quality of service or moral. If employees are difficult to be quantified. As a result, it cannot be expressed in money value, cannot be recorded. Furthermore, accounting ignore price level changes for inflation or deflation. It assumes the monetary unit, such as US dollar and other currencies are reasonably stable. Our third concept is going concern assumption. It assumes companies to last long enough to fulfill their objectives and commitments, which means companies will have very long life. This assumption is used based on historical cost principle. When we assume liquidation of e-business, fair value principle is applied. Liquidation approach require companies to evaluate assets at fair value rather than acquisition cost. Fair value is the price to be received to sell an asset or paid to settle a liability when maturity date. Fair value is a market-based measurement. The going concern assumption applies and most business situations only where liquidation approach is inapplicable. Let us see our fourth concept, which is periodicity assumption. If we like to measure the exact result of accompany activities, we have to wait until liquidation to support decision-makers. We cannot wait such long time. Users need to know the company performance on timely basis to evaluate the business and to compare results. Periodicity assumption allow companies to report its economic activities using multiple time periods, such as monthly, quarterly, and yearly periods. The shorter period, the more difficult to measure net income accurately for the same period. Furthermore, the quicker to report results, the more likely information to include errors and it would be less reliable. This is the end of our lesson. Thanks for watching and see you the next one. 6. Accrual Basis, Historical Cost, Conservatism and Expense Recognition: We learned in our previous lesson, four basic concepts of accounting. In this lesson, we will learn additional four concepts which are accrual basis, historical cost, conservatism, and matching principle. Let us start with accrual basis of accounting. It means transactions are recorded in the period in which events are occurring. Expenses are recorded when they are incurred rather than paid, while revenues are recorded when they are earned rather than received in cash. Example of expense is payroll for the month of December 2019. It is recorded in December 2019, even though it will be paid on January 2020. Another example is sales of inventory in December 2019. Its revenue is recorded in December 2019, even though it is collected in January 2020. There is an alternative approach which is cash-basis. Under cash-basis, expenses are recognized once cash is paid, while revenues are recognized once cash is collected. If all business transactions are cash, both accrual and cash basis will have the same results. Cash-basis is not allowed in both GAAP and IFRS. Our next concept is historical cost principle. It means assets and liabilities are reported on basis of acquisition price. If we buy inventory in January 2019 by $100, it will be recorded by $100. After one year, the recorded value will be $100 as well. What if market value increased for these goods to become $150? According to historical cost principle, good's value will not be adjusted for a price increase. But what if market value for the same goods decreased to become $50? Company will follow conservatism approach. In inventory case, it will follow the rule of lower of cost or market. We call it LCM. We will talk about lower of cost or market later on this course. Our next concept is conservatism. Accountants will recognize losses once anticipated rather than incurred. In contrast, potential gains are not allowed to be recognized until they are earned. One example is when value of inventory is expected to be reduced. Company will follow conservatism approach by using lower of cost or market. Another example, when inventory prices are increased, no gains will be recognized until these goods are sold with higher prices. The final concept and this part is expense recognition. We can call it matching principle as well. What is expense? Expenses are assets consumed or liabilities incurred or both as a result of selling goods, rendering services. This concept is about expenses to follow revenues. Matching means linking a force which is expenses, with accomplishments, which is revenues. One example is salaries for December 2019. It is linked with the sales of services rendered for the same period. Even though salaries are paid on January 2020 and sales of surfaces are collected also in January 2020. These expenses will be recorded in the same period in which revenues are earned, which is December 2019, rather than at the time of collection. There are some cases it is difficult to match cost with its related revenue, such as administration cost. In this case, such transactions are expensed as incurred. This is the end of our lesson. Thanks for watching and see you the next one. 7. Revenue Recognition, Full Disclosure, Materiality and Objectivity: We learned up to now eight basic concepts of accounting. We will learn today additional four concepts which are revenue recognition, full disclosure principle, materiality principle, and finally, objectivity principle. Our ninth concept is revenue recognition. Revenue recognition is a combination of accrual accounting. Matching principle. Revenues are recognized in the period in which they are realized or realizable and earned, not in the period when cash is collected. Revenues are realized when cash payment is received. Realizable means a collection of revenues is reasonably assured, especially when the company enter into a contract with a customer to sell goods or services with a specific amount of cash. Means goods are delivered and services are rendered. Once these two rules are met together, company will recognize revenue in the books. But what if cash is received in advance before the sale? It will be recorded as a liability. This liability will be offsetted once revenue is earned. Before moving to the next concept, I would like to mention that both FASB and IASB have jointly issued a framework for recognizing revenue from contracts with customers. It improves the comparability of financial statements across all industries with effective year of 2018. Gab, the standard is ASC six O6, while under international standards it is IFRS 15. This framework is a five-step model that recognizes revenues in the period in which performance obligation is satisfied as follow. The first step to identify the contract with customer. The second step is to identify the separate performance obligation in the contract. There disturb to determine the transaction price. For the stub is allocating transaction price to the separate performance obligation. The final step is recognizing revenue once performance obligation is satisfied. This is just a brief idea about this framework. But for this course, we will focus on the main concept of recognizing revenues. Our next concept is full disclosure principle. To decide which information to report companies follow general practice of providing information which influence users decisions. Users fine financial information in three places in the body of financial statements, or in the notes to these statements or in the supplementary information. There are four financial statements and accounting. We have a statement of financial position, which we call it balance sheet. There is also income statement, statement of changes in equity. And finally, the statement of cash flow. The notes to financial statements generally explain represented information in the main body. These nodes will be presented in quantity or quality basis. Description of accounting policies and procedures used to prepare the financial statements. Another example is explanation of uncertainties and contingencies included in the financial statements. Supplementary information is any information presented in addition to the financial statements, which is not considered necessary to fairly present the financial statements. It could be presented with the financial statements itself or in a separate document. A common example is unexpanded schedule or table with full details for any line item in the financial statements, such as a full breakdown, cost of goods sold or operating expenses in the income statement. The next concept is materiality principle. Materiality is a company-specific principle. Information considered to be material if removing such data will impact users decisions on financial statements. And contrast information which has no influence on user's decision would be considered immaterial. Assisting materiality is a challenging aspect in accounting. It requires evaluating relative size and importance. To explain the subject, let us see the following table. We have two companies, a and B. Company a has a gross profit of $1 million. While Company B has a gross profit of $20,000. We notice there is unusual gain included in the sales figure for the value of $10,000 in both companies. We can consider it immaterial for company, since it is only 1% of gross profit. For company B, it is different scenario, while unusual gain is same for both companies. It is considered material for company B since it is 50 per cent of gross profit. Including such unusual gain and sales figure for B company, will mislead the users of its financial statements. Normally, companies and auditors have adopted five per cent cab of net income. And the total amounts below this percentage is considered immaterial. This threshold should not be used to hide important information from the users, such as hiding illegal transactions. Our last concept is objectivity principle. It means information is reported in financial statements based on solid evidence rather than personal opinion of accountants or the management. Their opinions could be optimistic or pessimistic rather than independent and unbiased. One example, The Management is too optimistic that believes a massive gain could be earned from a lawsuit. It may record the revenue accordingly, even though the evidence does not assure such outcome. Objectivity principle require the company to wait until solid evidence can be obtained to prove such gain. This is the end of our lesson. Thanks for watching and see you the next one. 8. Business Legal Forms: In previous lesson, we learned about 12 basic concepts of accounting. This lesson, we will talk about legal forms the business can take and how it affects owner's liabilities and tax return. When we explained economic entity assumption, we address that accounting require business-related transactions to be separated from owner's personal transactions? There are several legal forms we will discuss in this lesson for common forms. Our first legal form is proprietorship is a business owned by one person, which has a separate economic entity for accounting purpose only. In contrast, it is not a separate legal entity from its owner. It has unlimited liabilities, which means the owner is personally liable for all debts of the business. Owners. Personal assets, such as cars, buildings, cash, and banks, are all at risk to cover business liabilities. A proprietorship income is not subject to business income tax. Instead, it is reported and text and the owner personal tax return. The second legal form is partnership. It is a business owned by two or more persons. Like proprietorship. Partnership has separate economic entity which require business-related transactions to be separated from owner's personal transactions. In contrast, partnership is not legally separated from its owners. Each partner has unlimited personal liability for the debts of partnership. In contrast, each partner share of profit is reported and text and partners tax return. It is not subject to business income tax. Our third legal form is cooperation. It has separate economic entity and it is legally separated from its owners. The owners of corporations are called share holders, who are not personally liable for business debts. And corporation boards of directors are elected to oversee the company. And corporation officers are selected to run day-to-day operations. Ownership of corporation is divided into transferable shares of stock. Stockholders may transfer all or part of their ownership at anytime corporation suffer from double taxation effect. There is a business income tax and another tax on any distribution of income to shareholders through dividends. Corporation is more suitable for companies which require large amount of capital. Or four companies who want to go public in stock market. The last legal form as limited liability company, we call it LLC. It is a hybrid business form between a corporation and proprietorship or partnership. It takes the advantages of these forums and leave the disadvantages. It offers a limited liability corporation and tax treatments of proprietorship or partnership. Llc has protected liability to its owners, are not personally liable to all business debts, and it avoids double taxation issue in corporation. Business income tax is reported and text and the owner personal tax return. One more buoyant to add, that proprietorship and partnership can be established as LLC, but Corp cannot be a limited liability company. To recap, let us see the following table. We noticed that all business forms have economic entity for accounting purpose. For legal entity, it is available only for corporations and limited liability company. There is no legal entity for a proprietorship or partnership. Regarding limited liabilities. It is available for both corporation and LLC. For business tax, it is only available for corporation. Finally, for personal tax, it is available in all business forums. This is the end of lesson seven. Thanks for watching and see you the next one. 9. Accounting Equation: In previous lesson, we learned about business legal forms. And this lesson we will talk about accounting equation. Let us have a look at the following formula. Assets equal liabilities plus owner's equity. Assets are resources owned by a business. Why liabilities and owner's equity are claims against these resources. We can look at accounting equation in different direction. It can show the values of how assets were financed by liabilities and owner's equity. Accounting equation, liabilities usually appear before owner's equity because they are paid first before the claims of owners. If the business is liquidated. Regarding assets, they are resources owned by a business and expected to generate future economic benefits, such as cash, inventory, machines, equipment, and lands. Future economic benefits eventually result in future cash inflows. One example is inventory is purchased for the purpose of reselling to customers, which will result in cash collection. Another example is machines. It is used to produce products which will be sold to generate cash in the business. Regarding liabilities, it is creditor's claims against assets. It can be expressed as assets financed by creditors. It represent future outflows of resources, such as wages payable to employees, accounts payable to suppliers, loans payable to banks, and tax payable to government. Regarding owner's equity, it represent owners claims against assets. It can be expressed as assets financed by owners. If we change accounting equation to represent owner's equity, it will equal to assets minus liabilities. For this reason, owner's equity is called net assets or residual equity. It is the remaining assets after subtracting all liabilities. Proprietorship, owner investments and revenues increase equity, while owner withdrawals and expenses decrease equity. Investment by owners or assets the owner adds in the business. It is normally recorded in accounting ledger called owner's capital. For revenues. It is the gross increase in equity resulting from a business earning activities. Revenues result in increase of assets or reduce liabilities or both. E.g. revenue from rendering of programming surfaces, it will generate cash inflows and it will increase assets accordingly. Or when the company receive cash in advance from customers and recorded as liability. This liability will be reduced and settled once revenue is rendered. Regarding owner drawings, it is assets withdrawn by the owner for personal use, such as cash withdrawing from company bank account to be used personally by the owner. Regarding expenses, it is the cost of assets consumed or services used for the purpose of earning revenues, such as salaries of employees, uses of supplies and goods, cost of utilities, advertisement, brand, and bank interest. Expenses are usually result in reduction of assets or increase of liabilities or both. E.g. advertisement expense will result in cash payment and assets will decrease accordingly. Or if this advertisement was purchased on credit, accounts payable will increase and liabilities will increase accordingly. At the end, we can expand owners equity in accounting equation to be as follows. Assets equal liabilities plus owner's capital plus revenues minus owner's drawings minus expenses. This is the end of lesson eight. Thanks for watching and see you the next one. 10. Transaction Analysis Using Accounting Equation: In a previous lesson, we learned about accounting equation. In this lesson, we will talk about transaction analysis using accounting equation. At the beginning. Let us remember what is accounting equation. Assets equal to liabilities plus owner's equity. We can see the expanded version of accounting equation as follows. Assets equal liabilities plus owner's capital plus revenues minus owner's drawings minus expenses. This lesson, we will analyze multiple transactions and see how it affect the accounting equation. Our first transaction is investment by owner. The owner decided to open a company to provide advertisement surfaces. On 1st December 2018, He invested $10,000 cash and the business. This transaction will result in equal increase in assets and owners equity cash will increase by $10,000 and owner's capital will increase by $10,000. If we apply this analysis on accounting equation. And under Assets group, we see how cash increased by $10,000. For liabilities. There is no effect because investment was done by the owner, not by the creditors. And their owner's equity. This investment will increase owner's capital by $10,000. You can observe the equality of accounting equation has maintained $10,000 on the left side and $10,000 on the right side. The second transaction is purchase of equipment for cash. On second December 2018, the company purchased printing equipment by $4,000 cash. This transaction result in equal increase and decrease in total assets. Cash will decrease by $4,000 and equipment will increase by $4,000. If we apply this analysis on accounting equation, we will notice how cash balance is reduced from $10,000 to become $6,000. Equipment balance become $4,000 after this transaction. This transaction has no effect on liabilities or owner's equity. Observe the equality of accounting equation. The value of total assets is $10,000, while total value of liabilities and owner's equity is $10,000 as well. The next transaction is purchase of office supplies on credit. On third, December 2018, the company purchased office supplies for $2,000 on credit. It is expected to last several months. The vendor allowed to pay this bill in the future. This transaction will increase assets because these supplies expected to have future economic benefits. As indicated, it will last several months after the date of purchasing. Additionally, this transaction will increase liabilities because the purchase was on credit. As a result of a supplies will increase by $2,000 and accounts payable will increase by $2,000. If we apply this analysis on accounting equation, we will notice under Assets group how office supplies increased by $2,000 and their liabilities accounts payable balance become $2,000 after this transaction. Observe the equality of accounting equation. The value of total assets is $12,000, while total value of liabilities and owner's equity is $12,000 as well. Our next transaction is providing advertisement services for cash. On 15th, December, 2018, the company provided advertisement surfaces to one customer for $1,000 cash. This transaction will increase revenues by $1,000. Because advertisement surfaces represent earning activities of the company. Revenues will increase owner's equity accordingly. Additionally, cash will increase because the company received cash against the surfaces. If we apply this transaction on the accounting equation, we will notice under Assets group how cash balance increased by $1,000. Under owner's equity, revenues balance become $1,000 after this transaction. Observe the equality of accounting equation. The value of total assets is $13,000, while total value of liabilities and owner's equity is $13,000 as well. The next transaction is providing advertisement surfaces on credit. On 16 December 2018, the company provided advertisement surfaces to another customer for $2,000 on credit. This transaction will increase revenues by $2,000. Because advertisements surfaces represent earning activities of the company. Revenues will increase owner's equity accordingly. Additionally, accounts receivable will increase because the company allowed its customer to pay the bill in future. If we apply this transaction on the accounting equation, we will notice under Assets group how accounts receivable increased by $2,000 and their owners equity revenues balance increased from $1,000 to become $3,000. Observe the equality of accounting equation. The value of total assets is $15,000, while total value of liabilities and owner's equity is $15,000 as well. Our next transaction is payment to a vendor or 19th December 2018. The company paid It's been there $500 by cash, which is a partial settlement of their bill. This transaction will reduce both cash and accounts payable by $500. If we apply this transaction on the accounting equation, we notice under Assets group how cash balance will be reduced from $7,000 to become $6,500. And their liabilities accounts payable balance will be reduced from $2,000 to become $1,500. Observe the equality of accounting equation. The value of total assets is 14,500, while total value of liabilities and owner's equity is 14,500 as well. The next transaction is receipt of cash from customer. On 20 December 2018, the company received $1,500 cash from its customer against previous services performed on 16 December 2018. This transaction will increase cash by $1,500 and reduce accounts receivable by $1,500. If we apply this transaction on accounting equation, we will notice under Assets group how cash balance increased from 6,500 to become 1,000. Additionally, accounts receivable balance decreased from $2,000 to become $500. Observe the equality of accounting equation. The value of total assets is 14,500, while total value of liabilities and owner's equity is 14,500 as well. Our next transaction is cash withdrawals by the owner. On 25th December 2018, the owner withdraws 1,000 cash from the company for personal use. This transaction, we reduce cash by $1,000 and increase owner's drawings by $1,000. Owner's drawings will reduce owner's equity accordingly. If we apply this transaction on accounting equation, we will notice under Assets group how cash balance decreased from $8,000 to become $7,000. Under owner's equity, owner's withdrawals balanced become $1,000 after this transaction. Observe the equality of accounting equation. The value of total assets is 13,500, while total value of liabilities and owner's equity is 13,500 as well. Our final transaction is payment of salaries, expenses. On 31st December 2018, the company paid salaries to its employees for $2,500 by cash. This transaction will increase expenses by $2,500 Because salaries are utilized to perform earning activities in the company, it represent the cost of providing advertisement surfaces. Owners equity will be reduced accordingly. Additionally, cash will be reduced by the same amount, $2,500. If we apply this transaction on the accounting equation, we will notice under Assets group how cash balance reduced from $7,000 to become $4,500. And our owner's equity, salaries, expenses balanced become $2,500 after this transaction. Observe the equality of accounting equation. The value of total assets is 11,000, while total value of liabilities and owner's equity is 11,000 as well. This is the end of Lesson nine. Thanks for watching and see you the next one. 11. Debits and Credits: In a previous lesson, we learn transaction analysis using accounting equation. In this lesson, we will talk about debits and credits. To understand debits and credits, we have to learn first what is the meaning of account? It is an individual accounting record which is used to sort and store transactions of specific asset, liability or owners equity item. The symbol form account consists of three parts. Title of the account. The left side, which is called debit side, and the right side, which is called credit side. Because the shape of account represent the letter T. We call it T account. This form is useful for illustration purpose. However, there is another standard form which is called three column ledger account. We will see this form later in this course. Once we talk about posting to ledgers, the term debit means left, and the term credit means right. Debits and credits do not mean increase or decrease. But they describe where the transaction is booked. On the left side or on the right side of the account. E.g. the act of entering an amount on the left side is called debiting the account. While recording an entry. On the right side is called crediting the account. Debits and credits are commonly abbreviated as DR and CR for credit. These abbreviations come from old record keeping practice, where the term debater and the creditor were used instead of debit and credit. The abbreviations used the first and last letters of these terms. By comparing the total amounts of the two sides, the account shows a debit balance. If the total of debits amounts exceed the total of credit amounts. The position of debit balance is shown on the left side, which is the debit side. And contrast, the account shows a credit balance. If the total of credit amounts exceed the total of the debit amounts. That position of credit balance is shown on the right side, which is the credit side. To illustrate account balance. Let us see the following example of cash account. The transaction data is taking from our previous lesson. In the tabular summary. Each positive transaction represent a receipt of cash, and each negative amount represents a payment of cash. Notice that in T-account we record the increases of cash as debits and decreases of cash as accredits. The first value is $10,000, represent a cash receipt and it is recorded on the debit side of the account. Then X value is $4,000 represents a cash payment and it is recorded on the credit side of the account. Then x value is $1,000, represent a cash receipt and it is recorded on the debit side of the account. The next value is $500, represent a cash payment and it is recorded on the credit side of the account. Then x value is $1,500, represent a cash receipt and it is recorded on the debit side of the account. The next two values are $1,000 and $2,500 represent cash payments which are recorded on the credit side of the account. The balance of cash account is the difference value between total debits and total credits. In our case, it is $4,500 debit balance. And it is shown on the debit side. To understand in which side the account increase and decrease, we have to learn what is the normal balance of account? Let us first remember the accounting equation. Is assets equal liabilities plus owner's equity. Accounts related to the left side of the equation will increase on the left side, which is called the debit side. And these accounts normally show debit balances. All accounts related to the right side of the equation will increase on the right side, which is called the credit side. And these accounts normally show credit balances. Normal balance of an account is on the side where increases is recorded. Regarding assets accounts, they increase on the debit side and decrease on the credit side. Assets accounts normally show debit balances. Regarding liabilities accounts. They increase on the credit side and decrease on the debit side. Liabilities accounts normally show credit balances. Regarding owner's equity. Let us remember that investment by owner and revenues increase owner's equity. While owner's drawings and expenses reduce owner's equity. As a result, both owner's capital and revenue accounts increase on the credit side and decrease on the debit side. They normally show credit balances accordingly. In contrast, owner's drawings and expenses accounts increase on the debit side and decrease on the credit side. They normally show debit balances accordingly. To summarize debit and credit rules and effects for each type of account. Let us see the followings. We will start with the basic accounting equation and then expand the equation to indicate all owners equity accounts. We can see the effect on assets, owners drawings, and expenses accounts. They increase on the debit side and decrease on the credit side. These accounts normally show debit balances. In contrast, liabilities, owner's capital and revenue accounts increase on the credit side and decrease on the debit side. These accounts normally show credit balances. One last point to add, when we discussed transaction analysis using accounting equation in our previous lesson. Remember that each transaction must affect two or more accounts to keep accounting equation in balance. In other words, debits must equal credits for each transaction. The equality of debits and credits provide the basis for double entry system. The double-entry system. Each transaction is recorded and appropriate accounts with dual effect by debiting one account and crediting another account. As a result, the sum of all the bits to the accounts must equal the sum of all the credits. This system helps to ensure accuracy and reduce errors while recording transactions. This is the end of Lesson ten. Thanks for watching and see you the next one. 12. Introduction to Financial Statements: In a previous lesson, we learned debits and credits. In this lesson, we will take an introduction to financial statements. There are four financial statements which are used by both internal and external users. Are fair statement is income statement. It reports revenues, expenses, and the resulting net income or net loss for a specific period of time. We have also Statement of Changes in Equity, which reports changes of owner's capital account for a specific period of time. Our next statement is balanced sheet. It is also called statement of financial position. It reports assets, liabilities, and owners equity at a specific date. Our last report is statement of cash flows, which reports cash receipts and cash payments from operating, investing, and financing activities for a specific period of time. To illustrate these four statements, we will use our sample data from previous lessons. Remember our accounting equation example. Under Assets, group, cash balance is $4,500. Printing equipment balance is 4,000, supplies balance is 2000s, and account receivable balance is $500. Total assets balance is $11,000. Regarding liabilities, accounts payable balance is 1,500. For owner's equity group, owner's capital balance is $10,000. Owner's drawings balance is $1,000. Advertisement revenues balance is $3,000, and salaries expenses balance is $2,500. Total liabilities and owner's equity balance is $11,000. We will start with income statement. Revenues are reported first. In our example, they include $3,000. Advertisement revenues. Expenses are reported after revenues. In our example, they include $2,500. Salaries, expenses, net income or net loss is reported at the bottom of the statement. In our example, it is $500 net income. Our next report is Statement of Changes in Equity. Start with the beginning balance of owner's capital account, then it is increased by owners investment and net income. In contrast, it is decreased by owner's drawings and net loss. In our example, the beginning balance of owner's capital account is zero. It will increase by investment, by owner, which is $10,000, and increase by net income, which is $500. Observed the connection between income statement and the statement of changes in equity, where net income balance is represented accordingly. The total increase is 10,500 dollar. Furthermore, owner's drawings of $1,000 will be deducted and the ending balance of owner's capital account will become $9,500. Observed the connection between statement of changes in equity and the balance sheet, where the ending balance of owner's capital account will be transferred to balance sheet and it will be presented under equity group. Additionally, notice that equity structure in this example is used by proprietorship and partnership. For cooperation, we are using different equity structure and different accounts, such as share capital, share premium, dividends, and returned earning accounts. We will present in this course the Simbel equity structure of proprietorship. Our next statement is balanced sheet. Start with assets at the top, then followed by liabilities and owners equity. In our example, there are four assets. Accounts. Cash balance with 4,500, dollar, accounts receivable balance with $500 of supplies balance with $2,000, and printing equipment balance with $4,000. For liabilities, we have accounts payable balance with $1,500. For owner's equity, the ending balance of owner's capital, $9,500 is taken from Statement of Changes in Equity. Notice that total assets equal to total liabilities and owner's equity with the value of $11,000. This is exactly matching with our accounting equation example. Observed the connection between the balance sheet and statement of cash flows, where cash ending balance is matching in both statements. Our last report is statement of cash flows. It to start with cash flows from operating activities, then followed by cash flow from investing activities, then followed by cash flows from financing activities. The sum of these three values will result net increase or decrease of cash. Then we will add cash opening balance to reach at the bottom line, cash ending balance, which must match the same value of cash account and the balance sheet. In our example, under cash flows from operating activities, we have three values. Our first value is cash receipts from customers with a value of $2,500. Notice that this figure come from same nine transaction data, which is taken from our previous lessons. Our next value is $500 cash paid to vendors. Then we have $2,500 cash paid to employees as salaries. The net cash generated by operating activities is negative $500. Our next group is cash flows from investing activities, which include $4,000 purchase of printing equipment by cash. The next group is cash flows from financing activities, which include $10,000 investment by owner and $1,000 drawings by owner. The net cash generated by financing activities as $99,000. Then we will calculate the net increase in cash from all activities, which is $4,500. We will add to this figure the cash beginning balance in December 1st, which is zero. And our example to reach at the bottom line, cash ending balance as of December 31st. This is statement include a lot of complications. But for now, I would like you to understand the basic form of this statement and how it is linked with other statements. At the end. Notice how these four statements are interrelated. Net income of $500 on the income statement is added to the beginning balance of owner's capital in the statement of changes in equity. The next connection is owner's capital balance of $9,500 in the Statement of Changes in Equity is reported on the balance sheet under equity group. The last relationship is cash balance of $4,500 and the balance sheet is reported as cash ending balance on the statement of cash flows. This is the end of our lesson. Thanks for watching and see you the next one. 13. Chart of Accounts: In this lesson, we will learn the chart of account. It is a master list of all accounts a company uses to record the transactions in the accounting system. This list includes account code and the account name. And most countries, the number and type of accounts differ from one company to another. It is up to the accountants and management to decide the level of details required to report. A small business might use 20 to 30 accounts to report. It's the transactions. A larger business may require thousands of accounts. The numbering system usually start with balance sheet accounts and followed by income statement accounts, e.g. the following numbering system uses a three-digit code. In this case, the first digit is used for account type, such as number one for assets. Number two for liabilities. Number three for owner's equity. Number four for revenues, and number five for expenses. The next two digits are used for subcategories. Let us see the following example of three digits code. The ranging 100-199, assigned two asset accounts. The range 200-299 assigned to liability accounts, the range 300-399 assigned to equity accounts. They range 400-499, assigned to revenue accounts. The range 500-599 assigned to expense accounts. The following list shows an example of a chart of accounts. Account code 101 indicate cash. Account code 115 indicate accounts receivable. 120 indicate inventory, 150 indicate equipment to 101 indicate accounts payable. 205 indicate notes payable. 301 indicate owner's capital account. 305 indicate owner's drawings account for 101 indicate service revenue. 501 indicates salaries expense. 511 indicate rent expense, 525 indicate utilities expense, 590 indicate interest expense. Notice that there are gaps in the chart of accounts. Companies normally leave gaps to be able to insert new accounts as needed in the future. This is the end of our lesson. Thanks for watching and see you the next one. 14. What is Accounting Cycle?: In this section, we will study the recording process in the accounting system to record the transactions and to prepare financial statements. Companies follow multiple procedures as follows. The first step is selecting and analyzing transactions. The next step is journalizing transactions. The next step is posting journal entries to ledger accounts. After that, we will prepare a trial balance before adjustments. The next is the record adjusting entries for accruals and deferrals. Then we prepare a trial balance after adjustments. Next, we prepare financial statements. Then we pass closing entries to close the period. After that, we can prepare a post-closing trial balance, which is an optional process. Finally, we can use reversing entries in the accounting cycle, which is also an optional process. Notice that once these steps have been completed, the sequence starts over again in the next accounting period. The first process of analyzing transactions is already discussed in our previous section. We will learn the other steps in details in this section. This is the end of our lesson. Thanks for watching and see you the next one. 15. Journalizing: After we discuss what is accounting cycle, we will learn the journalizing process in this lesson. Journalizing is the process of recording transactions in chronological order. Chronological means the order in which transactions occur. Each transaction is recorded in a separate journal entry. Using the journal to record business transactions is useful for multiple reasons. It discloses the effect of all transactions in one place. It provides a chronological record. It helps to reduce errors by using debit and credit rules. Companies may use different kinds of journals, but all of them will use the basic form, which is called general journal. In some cases, a company may use special journals in addition to general journal, such as cash receipts journal, cash payments journal, sales journal, and purchases journal. We will focus on our course on general journal. Let us see what it consists of. First, it includes the date of transaction. It includes also the account title and explanation. Then we have reference number, which is used for account code. Then we have the debit amount and the credit amount. Finally, it includes the journal page number. To understand how to journalize transactions. Let us see the following example. An owner decided to open a company to provide programming surfaces. When first January 2019, he invested $15,000 cash in the business. Let us first analyze which accounts get affected by this transaction. Cash account will increase by $15,000. Since the owner invested cash, then owner's capital account will increase by $15,000 as well. Since owner investment will affect the capital account. After analyzing the transaction, we can start entering this transaction into the journal. At the beginning. We will enter the date in the first column, which is January 1st. Then we enter the debit account title and it's value, which is in our case, the cash account, with a value of $15,000. Why cash is debited? Because cash is an asset account which increase on the debit side. Notice that the dollar sign is not used in the journal entry. The next step to enter the credit account title and it's value, which is in our case, the owner's capital account with a value of $15,000. Why owner's capital is credited? Because owner's capital is an equity account, which increase on the credit side. Notice that the title of credit account is indented from the left margin. This practice is useful to differentiate credit accounts from debit accounts. Notice also, debit accounts are always presented before credit accounts. After recording the credit value, we enter a brief explanation. In our case, we can write owner investment by cash. The final step to keep reference number blank. Normally, accountants will fill reference number at the time of posting. Remember that reference number is used for account code. Account title and account code come from the chart of accounts. At the end. Notice how double-entry system is maintained. The debit value must equal the credit value, which is in our case $15,000. This journal entry is considered a symbol entry because it affects two accounts only. In other cases, the transaction may affect three or more accounts. In such cases, the entry is called compound entry. To explain compound interests. Let us see the following example. On fifth January 2019, the company purchased an equipment with a total value of $3,000. It's paid $2,000 by cash and the remaining value of $1,000 on account to be paid later. This case, there are three accounts affected. The first account is equipment, which increased by $3,000. The second account is cash, which decreased by $2,000. The third account is accounts payable, which increased by $1,000 since the remaining value was on account. In our journal, we enter the date, the date first, which is January 5th. Then we enter the debit account, which is equipment with the value of $3,000. We debited equipment because it is an asset account, which increase on the debit side. Next we enter both credit accounts. The first one is cash with the value of $2,000. We credited cash because it is an asset account which decrease on the credit side. The second credit account is accounts payable with a value of $1,000. We credited accounts payable because it is a liability account, which increase on the credit side. The explanation of our transaction is purchase of equipment by cash with a balanced on account. The reference number is kept a blank until we post this transaction. At the end, notice that total debit amount must equal total credit amount. This is the end of our lesson. Thanks for watching and see you the next one. 16. Posting to General Ledger: After we learned what is generalizing and accounting cycle, we will discuss posting to general ledger. Posting is the process of transferring journal entries to the ledger accounts. We studied before. The symbol form of ledger account, which is called the T account. We will see in this lesson the standard form, which is called three-column ledger account. It is called that because it has three money value columns, debit, credit, and balance. The balance amount is calculated after each transaction. This form includes the followings. The date, explanation, reference number, which is used to indicate journal page number where the source data was transferred. Then we have the debit value, credit value, balance value, and finally, account code number. Now, let us see the steps of posting transactions. We will use our symbol entry example from previous lesson. Notice that the debited account was cash and the credit that account was owner's capital account. At the beginning, we start with cash general ledger account. We enter all the data from journal entry, which are the deed first January 2019. Then we enter the journal page number J1 in the reference column. After that, we enter the debit value of $15,000. Since cash account was debited and the journal entry, the credit column is kept a blank because there is no credit effect on the cash account. At the end of the system. The balanced value is calculated after each transaction. In our case, it is $15,000. Notice that the explanation column is used infrequently because it is already available in the journal entry. Notice also, the dollar sign is not used in the general ledger. The second step in the journal entry, we record account code number in the reference column, which is related to the debit account. In our case, it is 101 for cash general ledger account. Our third step involve the general ledger of owner's capital account. We enter all the data from journal entry, which are the date, fair January 2019. Then we enter journal page number J1 in the reference column. After that, we keep the debit value blank because there is no direct effect on the owner's capital account. Then we enter the credit value of $15,000. Since owner's capital account was accredited in the journal entry. At the end of the system, the balanced value is calculated after each transaction. In our case, it is $15,000. The fourth step in the journal entry, we recorded account code number and the reference column, which is related to the credit account. In our case, it is 301 for owner's capital account. The last step in posting process, we review and make sure all reference numbers are filled in the journal, which means all transactions are posted. This process is useful to avoid errors before preparing the trial balance. If we want to apply posting process on the T account, we can follow the same procedures as follows. The first step to enter the date and the bit value of $15,000 in the cash account. Then we enter the account code and the journal entry reference column, which is 101. After that, we enter the date and the credit value of $15,000 in the owner's capital account. Then we enter the account code and the journal entry reference column, which is 301. The last system to verify all reference numbers are filled in the journal to make sure all transactions are posted. This the end of our lesson. Thanks for watching and see you the next one. 17. Using Subsidiary Ledgers: We learned in our previous lesson, posting to general ledger. This lesson, we will discuss using subsidiary ledgers. So what do you mean by subsidiary ledger? It is a group of accounts with a common characteristic. We can indicate it as an expansion to a general ledger account. So why subsidiary ledgers are used? Imagine we have hundreds or even thousands of customers and we need to know the details of sales and collections for each customer. Maintaining such large information in one general ledger account is considered impractical. On the other hand, creating a general ledger account for each customer is considered impractical as well. But why? Because our chart of accounts, the trial balance, will contain large list of accounts and it will be more difficult to prepare financial statements. The best practice to keep one general ledger account to control multiple subsidiary accounts. The sum of all subsidiary accounts balances must equal the balance of one general ledger account. Let us see the following example. We have a general ledger account which is accounts receivable with a balance of $6,000. This is a control account of three subsidiary accounts, which are customer aim with a balance of $1,000 and Customer B with a balance of $2,000, and customer C, with a balance of $3,000. Notice that the total balance of $6,000 for these three customers equal the balance of their general ledger account, which is accounts receivable. Up to this point, we learned what a subsidiary ledger and why we use it. But what about posting? If we choose to create subsidiary ledgers in our accounting system, there will be dual posting, first posting to the subsidiary ledgers and another posting to general ledgers. To clarify this subject, let us see the following example. We have four general ledger accounts, cash account, accounts receivable, accounts payable, and owner's capital. Cash account in this example, has no subsidiary account. The Boston is done directly to the cash general ledger account. For accounts receivable, there are three subsidiary accounts, customer, aim, customer B, and customers. In this case, there is dual posting. One posting to subsidiary accounts and another posting to general ledger account. For accounts payable. It is the same case. Dual posting is done to subsidiary accounts and to the general ledger account. Finally, for owner's capital, we are posting directly to the general ledger account. Regarding accounts receivable and payable. Usually we post their subsidiary ledgers on daily basis to keep customer and vendor accounts up to date. And we post their balances to general ledger accounts on monthly basis. In most recent accounting softwares, dual posting is done in real time. Once we post to subsidiary ledger, the general ledger will be updated automatically. We saw in this example, subsidiary ledgers are used for accounts receivable and payable. Actually, we are using subsidiary ledgers more often with other accounts as well, such as inventory, fixed assets, and even cash and bank accounts. To have better idea about dual posting, lets us see the following example. On tenth January 2019, the company sold customer a programming services on account for the amount of $5,000. Notice that there are two accounts get affected. Accounts receivable and sales revenue, which are both increased by the same value of $5,000. As a result, accounts receivable for customer a is debited by $5,000 since it is an asset account. Sales revenue is accredited by the same value of $5,000 since it is an equity account. Now, the first step to enter the date, explanation, journal page number, and the debit value of $5,000 in the subsidiary account for customer aim, and also the same value in the general ledger for accounts receivable. Then we enter the account code 102 and the check-mark in the journal entry reference column. What do we mean by this reference? Accounts receivable code number indicate posting is done to the general ledger while the check mark indicates the posting is done for the subsidiary account, which is in this case customer aim. You can notice the code number for customer a is totally different than accounts receivable code. Normally we generate separate sequence for each group of subsidiary ledgers. This example, we are using five digits code for customer ledgers, starting with digit number seven. For vendors, we can start with different number, e.g. digit number eight. Our third step to enter the date, explanation, journal page number, and the credit value of $5,000 in sales revenue account. Then we enter the account code in the journal entry reference column, which is 401. The last system to verify all reference numbers are filled in the journal to make sure all transactions are posted in both subsidiary account and general ledger accounts. We considered in this example that dual posting is done in real time. Let us see now what will happen if we post monthly to general ledger accounts. To explain this topic, we will have in this example, additional subsidiary account, which has customer B. This customer has two transactions, a credit sale of $10,000 on 15 January 2019, and the cash collection of $7,000 on 26th January 2019. The balance for customer B is $3,000. Now, the month end 31st, January 2019, we post the total value of all debit transactions to the general ledger account, which is $15,000. Then we post the total value of all credit transactions to the general ledger account, which is $7,000. Notice that the balance of general ledger for accounts receivable is $8,000, which equal the balance of both subsidiary accounts for Customer a and Customer B. At the end. Let us see the advantages of using subsidiary accounts. First, it provides up-to-date details on specific account rather than recording all similar transactions in one general ledger account. Second, trial balance will contain less general ledger accounts, which results and easier preparation of financial statements. Finally, it helps to locate errors by using control accounts and by splitting posting responsibilities to be done by two accountants. One accountant is posting daily to subsidiary ledgers, and another accountant will post monthly to general ledgers. The end of our lesson. Thanks for watching and see you the next one. 18. Trial Balance: After we learned journalizing and posting in previous lessons, we will discuss for this lesson the trial balance. It has a list of all general ledger accounts and their balances at a given time. Normally, accounts with zero balances are not listed in the trial balance. Trial balance can be prepared at any given time or date, but companies usually prepare it at the end of an accounting period, which will help to prepare financial statements. General ledger accounts are listed in the same order in which they appear in the chart of accounts. Debit and credit balances are separated and the trial balance debit balances appear on the left column, and the credit balances appear on the right column. Total debit balances must equal total credit balances. This equality in trial balance is mandatory under double entry system. Notice that the dollar sign is used in trial balance for the first figure in each column and also in the totals. Trial balance is considered a useful check point since it's equality would help to catch recording errors. E.g. the accountant posted only the debit portion of a journal entry without posting the credit portion. In this case, the trial balance can detect such errors. On the other hand, even though total debits equal total credits, there are some type of mistakes may still exist, such as a transaction is not journalized at all. As a result, there is no posting to general ledger. Another example, when a correct journal entry is not posted. In this case, the trial balance is still matching. One more example, when a journal entry is posted twice to general ledger. In this case also, total debit and the credit balances in trial balance is still matching. Our last example, when the accountant used incorrect account and journalizing or posting. This case, both debit and credit balances will match and trial balance. These are four types of mistakes that can be exist even though the sum of debit balances equal the sum of credit balances. That's the end of our lesson. Thanks for watching and see you the next one. 19. Accrual vs Cash Basis: Before learning adjusting entries, we have to understand the difference between accrual basis and cash basis. Accrual basis recognized revenue, once earned rather than received in cash. Expenses are recognized once incurred rather than paid. In contrast, cash-basis recognized revenue, once collected and recognize expenses once paid by cash. Cash basis seems to be a symbol approach, but it reports misleading financial statements. It fails to record revenues for a business which we are formed the surfaces but not collected cash against these surfaces. Cash-basis is not allowed under GAAP or IFRS. On the other hand, accrual basis reflects real business performance by recording events in the same period in which they occur. It increases also the comparability of financial statements from one period to another. Since cash-basis is still important for decision-makers, companies must report the statement of cash flows. To understand the difference between accrual and cash basis. Let us see the following example. On 1st December 2018, a company paid $1,200 for one year of a trend starting from December 2018 and ending November 2019. We will see in this example how the company will recognize office rent expense under both accrual basis and cash basis. Under accrual-basis, we will recognize rent expense among the 12 months, which means $100 every month. Notice in these two tables, we recognize $100 rent expense in 2018 while it is $1,100 for 2019. Let us see now how we recognize rent expense under cash-basis. In this case, the full value, $1,200, will be recognized in one month, which is December 2018. For 2019, there is no rent expense to be recognized. Why we book the whole expense in December 2018. Because cash-basis recognize the expense once paid by cash. We see in this example how cash-basis can mislead the users of financial statements. The cost was recognized in one month rather than distributing this cost among all related periods. As a result, net income in 2018 under cash basis will be lower than net income under accrual-basis for the same period. For 2019, it is the opposite. Net income under cash basis will be higher than accrual basis. These are the main differences between accrual basis and cash basis. That's the end of our lesson. Thanks for watching and see you the next one. 20. Why Adjusting Entries?: Before we talk about the structure of adjusting entries, we should understand why we need to record adjusting entries with every time we prepare financial statements. Companies need to record revenues in the same period in which surfaces are performed, and also to record expenses in the period in which they are incurred. So we use adjusting entries to achieve these requirements. What do we understand from the subject? There are three accounting principle affect the recording process of adjusting entries. The first principle is periodicity assumption, which we call it time period assumption. Under this assumption that economic life of a business can be divided into multiple time periods, such as one month, three months, or one year. Monthly and quarterly periods are called interim periods, while one-year period is called fiscal year. Fiscal year is a 12 month period, which we'll begin with the first day of a month and ends 12th month later. For most companies, their fiscal year match the calendar year from January until 31st December. Other companies may use different fiscal year, e.g. from July until Thursday, June. Another example, a fiscal year ending January 31st. But why? There are some companies with high seasonal variation in sales, it is better for them to choose a fiscal year end when sales activities are at the lowest level, especially after holiday season. This 12 month fiscal year will show more constant results from one period to another. The second principle is revenue recognition. Under this principle, revenues are recognized in the period in which services are performed and when materials are delivered. Or we can indicated as one's performance obligation is satisfied as per IFRS. Our third principle is expense recognition. We call it also matching principle. Under this principle, we match expenses with revenues and same period when expenses make its contribution to generate revenues. To explain it in a simple way, we can say, let the expenses follow the revenues. These are three principles which reads the needs to record adjusting entries. But what about trial balance before adjustment? It may not contain up-to-date and complete data. But why? Let us see the following reasons. Some transactions are not journalized daily, e.g. monthly salaries for employees. Another reason, some expenses are not journalized during the accounting period because these costs expire with the passage of time, such as rent and insurance contracts. Our final reason, some items may be recorded, e.g. a. Utility bill is not received until the next accounting period. The end of our lesson. Thanks for watching and see you the next one. 21. Structure of Adjusting Entries: After we learned why we need to record adjusting entries, we will talk today about the types of these adjustments. Adjusting entries are classified either as deferrals, accruals. To understand how to differ these two groups, let us say the following. We notice on the left side if cash is paid or received before recognizing expenses or revenues, there will be prepaid expenses or unearned revenues. We call them deferrals. But why? Because the recognition of expenses and revenues are both bond for future periods until expenses incurred and revenues earned. Now, for the right side, if cash is paid or received after the related expenses or revenues are recognized, there will be accrued expenses or accrued revenues. We call them accruals because cash was not paid or received at the time of recognition of expenses or revenues. We will see in our next lessons how to record deferrals and accruals with examples. And you will notice how each adjusting entry will affect one or more income statement account and one or more balance sheet account. But for sure not the cash account. The end of our lesson. Thanks for watching and see you the next one. 22. Prepaid Expenses: After we learned the structure of adjusting entries, we will discuss the details of both deferrals and accruals. For this lesson, we will study the first group of deferrals, which is prepaid expenses. So what do we mean by deferrals? Defer means to postpone or delay, difference our expenses or revenues that are recognized at a date later than when cash was paid or collected. When companies make payments of expenses which benefit more than one accounting period, they record an asset which is called prepaid expense, such as insurance, print, advertisement, and supplies. In addition, the purchase of building and equipment is considered a part of deferrals, but it is categorized under fixed assets. We will talk about fixed assets and depreciation in a future section later in this course. So prepaid expense is a cost which expire either with the passage of time, such as rent and insurance, or by consumption such as supplies. The exploration of these costs do not require daily entries, which would be impractical. And instead, companies postpone the recognition of these expenses until they prepare financial statements. Let us see now the effect of adjusting entries on prepaid expenses. Since assets are overstated and expenses are understated at the time of preparing financial statements. An adjusting entry for prepaid expenses result in increase or debit to expense account and a decrease or credit to the asset account. Let us have a look on specific types of prepaid expenses. We will start with insurance. Normally, insurance premium is paid in advance. As a result, it is recorded as an asset at the time of payment. So what will happen at the date of preparing financial statements? We will record the adjusting entry by debiting insurance expense and crediting prepaid insurance account. To understand the subject, let us see the following example. On first February 2019, the company paid insurance premium in advance for one year for the amount of $2,400. At the time of payment, the company record this advanced payment as an asset, which we call it prepaid insurance as follow. We see in this example how prepaid insurance increased by $2,400 and cash account decreased by the same amount, $2,400. In journal entry, we debit prepaid insurance by $2,400 and credit cash account by $2,400. We can write an explanation, insurance premium for one year. Now, at the date of preparing financial statements on 28th February 2019, there is one month passed out of 12, which means we have to recognize insurance expense for the amount of $200, which results from dividing $2,400 over 12 months. We see in this case, there are two accounts get affected. Insurance expense will increase by $200 and the prepaid insurance will decrease by $200. We can write an explanation insurance expense for February 2019. As a result of this entry. The balance of prepaid insurance will be $2,200, which represent the value of remaining period of 11 months. For insurance expense, the balance will be $200, which represent one month benefit utilized out of 12 months. We saw in this example how insurance expense was recognized with the passage of time. Let us see now another example for office supplies related costs will be recognized by their usage and consumption. On second February 2019, the company paid $500 cash for office supplies, which are expected to last several months. At the date of preparing financial statements, which is 28 February 2019, the company count the remaining quantities of office supplies and found a value of $400 is still on hand. In this case, the use of office supplies is calculated by the difference between $500 and the value of remaining quantities for $100, which result $100 supplies expenses. To record this adjusting entry, we debit supplies expenses by $100 and credit office supplies by the same value, $100. We can write an explanation, office supplies usage for February 2019. As a result of this entry, the balance of office supplies account will be $400, which represent the remaining quantities on hand as of 28 February 2019. While the balance of supplies expenses is $100, which represent the usage value of the supplies. This is the end of our lesson. Thanks for watching and see you the next one. 23. Unearned Revenues: We learned in our previous lesson, the first group of deferrals, which is called prepaid expenses. We will discuss in this lesson the second category, which is an earned revenues. When companies receive cash before surfaces are performed, they record a liability which is called an earned revenue, such as airline tickets. The customer bay cash in advance, and sales value is recorded as unearned revenue until flight services provided. Another examples are magazine subscription, rent, and advertisement. During the accounting period, it is unpractical to make daily entries as company performed surfaces. And instead, the company delays the recognition of revenue until they prepare financial statements. This is the treatment for surfaces. But what about materials? If we receive cash advance, again, sales of material, we will book it in the same way as liability, which we call it an earned revenues. This liability account will be offsetted to become sales revenues once these materials are delivered. Let us see now the effect of adjusting entries when unearned revenues. Since liabilities are overstated and revenues are understated at the time of preparing financial statements and adjusting entry for unearned revenues result a decrease or the bit to liability account, and an increase or credit to revenue account. After recording the adjusting entry liability balance represent the value of remaining revenues to be recognized and future periods. To understand the subject, let us have a look at specific type of unearned revenue, which is advertisements surfaces. Once the company receive cash in advance, it will be recorded as an increase of liabilities. So what will happen at the date of preparing financial statements? We will record an adjusting entry by debiting unearned revenue and credit thing advertisement revenue accounts. E.g. on first February 2019, the company received $10,000 cash in advance against advertisement services to be performed in the future. At the time of collection, the company will record this collection as liability, which we call it an earned revenue as follow. We see in this example how cash account increased by $10,000 and an earned advertisement revenue account increased by the same value of $10,000. In journal entry, we debit cash account and credit unearned advertisement revenue account by the value of $10,000. We can write an explanation, cash advance for advertisement surfaces. Now, at the date of preparing financial statements on 28th February 2019, the company performed partial advertisement services for the value of $6,000 during the month of February 2019. We see in this case, there are two accounts get affected. Advertisement revenue account will increase by $6,000 and an earned revenue account will decrease by the same value, $6,000. In journal entry, we debit unearned advertisement revenue and credit advertisement revenue accounts by $6,000. We can write an explanation, advertisement revenue for February 2019. As a result of this adjusting entry, the balance of unearned advertisement revenue account will be $4,000, which represent the remaining revenue value to be recognized and future periods once advertisement services are performed. For advertisement revenue account, the balance is $6,000, which represent the value of services rendered in February 2019. The end of our lesson. Thanks for watching and see you the next one. 24. Accrued Expenses: After we learn deferrals, we will study in this lesson the first group of accruals, which we call it accrued expenses. So what do we mean by accrued expenses? Are expenses incurred but not yet paid or recorded at the time of preparing financial statements, such as Bank and Trust and salaries to employees. So companies make these adjustments of accrued expenses to record its obligations which are exist at the balance sheet date but not yet recognized. Prior to recording adjusting entry, both liabilities and expenses are understated. Therefore, an adjusting entry for accrued expenses result in increase or the bit to expense account and an increase or a credit to the liability account. Let us have a look at specific types of accrued expenses. We will start with accrued interest. On first March 2019, the company signed a six month note payable for the amount of $10,000. The note requires to pay annual interest rate of 6%. The maturity date of both the face value and interest must be paid after six months. So how we close our accounting period for the month of March 2019, we should record an adjusting entry for accrued interests as follow. We will start by calculating interest value for one month. This value is determined by three factors. First one is the face value of notes payable. Second factor is the percentage of interest rate. Third factor is length of time in terms of one year, because we are using annual interest rate. So to calculate the interest for the month of March 2019, we multiply the face value, which is $10,000 by six per cent, which is the annual interest rate by the period which is one month over 12. The result for one month will be $50, while total value of interests is a $300, which is payable after six months. Let us see now how to record the adjusting entry for March 2019. We notice there are two accounts get affected. Interest expense will increase by $50 and accrued interest will increase by the same value, $50. In journal entry, we debit interest expense by $50 and the credit accrued interest by $50. We can write an explanation, accrued interest for March 2019. As a result of this entry, the balance of interests expense account will be $50, which represent one month cost for Mars 2019. While the balance of accrued interests account is $50, which represent the liabilities for one month to be paid at maturity date. So what would be the journal entry at maturity date on 31st, August 2019. At that date, there is one month and recorded expense for August 2019. Wildfires months expenses from March to July 2019 are already recognized in previous periods, which are included in the accrued interest account. To record the payment entry at maturity date, we debit interest expense account by $50 and debit accrued interest account by $250. Why the bit? Because to reduce a liability account, we record the transaction on the debit side. Then we debit notes payable account by $10,000. At the end, we credit cash account by the amount of $10,300, which represent the total amount payable for both interest and the face value of notes payable. We can write an explanation, payment of interest and face value of notes payable. After this entry, the balance for interest expense account will be $300, which represent expenses for six months. While the balance of accrued interest account will be zero after this payment. Let us take another example of accrued expenses, which is accrued salaries. We will assume the company is paying salaries to employees on fifth of each subsequent month. E.g. the seller is value is $2,000 for March 2019, which will be paid on fifth April 2019. In this case, we cannot close March period without recognizing the cost of salaries. We record our adjusting entry by increasing both salaries expense and accrued salaries accounts. In journal entry, we debit salaries expense by $2,000 and the credit accrued salaries by the same value, $2,000. We can write an explanation accrued salaries for March 2019. As a result of this entry, the balance of salaries expense account will be $2,000, which represent the cost of salaries for March 2019. While the balance of accrued salaries account will be $2,000, which represent the liabilities to be paid on fifth April 2019. So what would be the payment entry on fifth April 2019? We debit accrued salaries account by the amount of $2,000. But why debit? Because a reduction of liability account will be done on the debit side. Then we credit cash account by the same value, $2,000. We can write an explanation, salaries payment for March 2019. After this entry, the balance of accrued salaries account will become zero after this payment. This is the end of our lesson. Thanks for watching and see you the next one. 25. Accrued Revenues: We will study in this lesson the second category of accruals, which we call it accrued revenues. So what do we mean by accrued revenues? They are revenues earned by performing surfaces, but not yet recorded at the time of preparing financial statements. Accrued revenues may accumulate with the passage of time, such as interest revenue. Or it may result from surfaces that have been performed but not yet build. These surfaces are not built because only a portion of total services are performed and the client will not be built until all surfaces are completed. Prior to recording adjusting entry, both assets and revenue accounts are understated. Therefore, an adjusting entry for accrued revenues result in increase or debit to an asset account and an increase or credit to the revenue account. Let us take one example of advertisement surfaces. On 31st March, 2019, the company perform advertisement surfaces worth $1,000 during the month of March 2019. The total advertisement surfaces will be completed by April 2019 with the total value of $1,500. So how to close our accounting period for March 2019 without issuing the bill to our customer. We should record an adjusting entry for accrued revenues as follow. We notice in this example, there are two accounts get affected. Accrued advertisement revenue and advertisement revenue accounts will increase by the same value of $1,000. In journal entry, we debit accrued advertisement revenue by $1,000 and the credit advertisement revenue by the same value of $1,000. We can write an explanation accrued revenue for March 2019. As a result of this entry, the balance of accrued revenue account will be $1,000, which represent the receivable value which is related to March 2019 and it will be built in the future. While the balance for advertisement revenue account will be $1,000, which represents the partial value of services revenue for the month of March 2019. So what will happen once all services are performed on 15th, April 2019? The company is going to build the client the full value of advertisement surfaces for the amount of $1,500. In this case, a value of $1,000 was already recognized under accrued revenue account in March 2019. So what is the billing entry to be recorded on 15 April 2019? We will debit accounts receivable with the full value of $1,500. And then credit to accounts. The first account to be credited is accrued advertisement revenue by $1,000 because of this revenue was already recognized in March 2019. The second account is advertisement revenue to be credited by the value of $500, which represent services value for April 2019. We can write an explanation advertisement invoice for customer aim. After recording this entry, the balance of accrued revenue account will become zero. While the balance of advertisement revenue account will become $1,500, which represent the full value of advertisement services performed until 15 April 2019. At the end, let us consider the client paid this bill and 25th April 2019. In this case, we debit cash account by $1,500 and then credit accounts receivable by the same value of $1,500. After this entry, accounts receivable balance will become zero, which represent the bill was paid in full value. This is the end of our lesson. Thanks for watching and see you the next one. 26. Adjusted Trial Balance: After posting all adjusting entries, companies prepare another trial balance, which is called adjusted trial balance. It shows balances of all general ledger accounts after recording all adjustments at the end of the accounting period. The purposes of preparing adjusted trial balance are as follows. First, to prove the equality of total debit balances and total credit balances after adjustments. Second, it is a primary tool to prepare financial statements since it includes all the data needed. To understand the subject better. See the following example of unadjusted trial balance for the period ended 30 June 2019. We can see in this example, the trial balance starts with cash account with a balance of $10,000, then accounts receivable with a balance of $2,000, a balance of 500 for prepaid rent, 1,000 for equipment, 1,000 for accounts payable, 15,000 for owner's capital, 6,000 for service revenue, 1,500 for salaries expense. The total debit and credit balances are $22,000. At the end of the accounting period, the company recorded the following adjusting entries. The first entry to record accrued salaries for June 2019 by debiting salaries expense account, and then crediting accrued salaries account for the value of $500. The second adjusting entry to recognize rent expense for June 2019 by debiting rent expense account and then crediting prepaid rent account for the value of $100. After we bought these adjusting entries, we can prepare the adjusted trial balance. To make it easier to understand. We will add two more columns for adjustments and two more for the final balances after adjustments. Notice that affected amounts are highlighted in red color. We can see there are two extra accounts added. The first one is accrued salaries and the second one is rent expense. As a result of the first entry, salaries expense account is debited by $500 and accrued salaries account is accredited by the same value of $500. For the second adjusting entry, rent expense account is debited by $100 and prepaid rent account is credited by the same value of $100. Let us now calculate the balances. After these adjustments. We will start with prepaid rent account. The balance of $500 is reduced by a credit transaction, $100 to become $400 debit balance after adjustment. The second account get affected as salaries expense. The balance of $1,500 is increased by a debit transaction or $500 to become $2,000 debit balance after adjustment. There the count is accrued salaries, which is increased by a credit transaction or $500 to become also $500 credit balance after adjustment. Our last account is rent expense, which is increased by a debit transaction of $100 to become also $100 debit balance after adjustment. At the end, let us see how adjusted trial balance will looks like. You can notice the affected accounts are as follows. Prepaid rent with a balance of $400, a balance of $500 per accrued salaries, $2,000 for salaries expense, and $100 for rent expense. Notice the equality of total debit balances with total credit balances for the value of 22,500. The last point to observe how we use dollar sign in the first figure for each column and also in the totals. This is the end of our lesson. Thanks for watching and see you the next one. 27. Closing the Books: After our financial statements have been completed, the company start to make the accounts ready for next period. This process is called closing, and it is done at the end of current accounting period. Let us now identify the accounts foreclosing purpose. We have two groups of accounts, temporary accounts and permanent accounts. Temporary accounts accumulate data related to one accounting period only. They include all income statement accounts plus owners drawing account. So why we call them temporary? Because they are opened at the beginning of a period and then used to record transactions related to that particular period and then closed at the end of the same period. These accounts are summarized as follows. Revenues accounts, expenses, accounts, and owners drawing account. In contrast, permanent accounts are related to one or more future accounting periods. They include all balance sheet accounts, including owner's capital account. So why we call them permanent? Because these accounts are not closed from period to another. Instead, their balances are carried forward into the next accounting period. These accounts are summarized as follows. Asset accounts, liabilities accounts, and owner's capital account. Let us now see the steps of closing process. In general, companies use a control account to close revenues and expenses accounts. We call this account income summary. But why to use a control account? This step is important to avoid recording excessive details in the capital account. In closing process, temporary accounts are closed and permanent accounts and their balances of all temporary accounts becomes zero after closing. I illustrate this process. Let us see the following. The first system to debit each revenue account for its balance and credit income summary with a total value of revenues. Second step to debit income summary for the total value of expenses and credit, each expense account for its balance. There, the disturb to debit income summary and credit owner's capital for the amount of net income. If we have net loss, that entry will be the opposite by debiting owner's capital and credit income summary. For the stub to debit owner's capital and credit owner's drawings. It's balance. After recording these entries, the balances of all temporary accounts will become zero. And these accounts are then become ready to accumulate data in the next accounting period, which is totally separated from previous period. The closing process we saw right now is applicable for proprietorship and partnership companies. But what about corporation incorporation? We use different equity structure and the closing process will change accordingly. In this case, temporary accounts will not be closed in corporate capital account. Instead, they are closed and different equity account, which is called returned earning. Why we call it retained earnings. Because it's balanced, represent the value of net income left over after distributing dividends to stockholders. To illustrate this process, let us see the following. We notice here income summary and dividend accounts are closed and returned earning rather than corporate capital account. This process is specific for corporation, which is different from proprietorship and partnership. We will focus in this course on proprietorship Companies. This is the end of our lesson. In the next lesson, we will practice the closing entries with example. Thanks for watching. 28. Closing Entries: After we learn the closing process, we will study how to record closing entries in our books to understand the subject better, see the following example of adjusted trial balance for the period ended 30 June 2019. At the beginning, we will identify the accounts for closing purpose as temporary or permanent accounts. Remember that temporary accounts, our revenues, expenses, and owners drawing account. While permanent accounts are assets, liabilities, and owner's capital account. This example, we have the following temporary accounts. Service revenue, salaries, expense, insurance expense, supplies expense, and owners drawing accounts. Next, let us see the permanent accounts. We have cash account, accounts receivable, prepaid insurance, equipment, accounts payable, accrued salaries, and owner's capital accounts. To start the closing process, we will follow these steps. First, we close revenues to income summary. Second, we close expenses to income summary. Third step, we close income summary to owner's capital. For the step, we close owners drawing to owner's capital account. Let us start with the closing revenue accounts. We debit service revenue account by $5,000. But why debit? Because revenues normally have credit balances. And to make these balances zero, we have to record a debit transaction to close them. After that, we credit income summary account by the same value of $5,000. The second step is to close expenses accounts as follow. We debit income summary account for the total value of all expenses, which is $3,000. Then we credit salaries expense for the value of $2,000 and insurance expense for the value of $500 and then supplies expense for the value of $500. But why we credit all these expenses? Because expenses accounts normally have debit balances and to make these balance is zero, we have to record credit transaction to close them. Let us move now to our third step. We notice income summary account has one credit transaction or $5,000.01 debit transaction of $3,000. As a result, net income value is $2,000. To close this balance, we debit income summary account by $2,000 and then credit owner's capital account by the same value of $2,000. After this transaction, income summary balance will become zero. Remember that if we have net loss, the closing entry will be reversed. Owner's capital account will be debited and income summary account will be credited. Let us now move to our last step to close owners drawing account. We debit owner's capital account by the value of $1,500. And then credit owners drawing account by the same value of $1,500. But why credit? Because drawing accounts normally have debit balances and to make these balances zero, we have to record credit transaction to close them. After recording all closing entries, temporary accounts balances will become zero and the capital balance will represent total equity balance of the owner as follow. We noticed in our example, there are two closing entries affected capital balance. One credit transaction of $2,000, which come from closing income summary account, and another debit transaction of $1,500, which come from closing owners drawing account. As a result, the ending balance will become $15,500. This balance will be shown in both the balance sheet and the statement of changes in equity. The last point to observe income summary account. This account is used only in closing process. We are not using income summary account to post any transaction during the year. This is the end of our lesson. In the next lesson, we will prepare the trial balance after closing. Thanks for watching. 29. Post Closing Trial Balance: After posting all closing entries, we can prepare another trial balance called post-closing trial balance. This type of trial balance lists permanent accounts and their balances only. Since all temporary accounts balances becomes zero after closing. The purpose of post-closing trial balance to prove the equality of permanent accounts balances which are carried forward into the next accounting period. It provides evidence that the company journalized and posted closing entries properly. It shows also the accounting equation is in balance at the end of accounting period. Remember that this balance of total debits and credits does not mean that records are free of errors. Still, there are some type of mistakes may exist. E.g. a. Transaction is not journalized and posted at all. Another example, a transaction is posted twice. Let us have a look at our trial balance before closing. This example is taken from our previous lesson. Notice that the following temporary accounts will be closed and they will not be shown in post-closing trial balance. These accounts are owners drawing service, revenue, salaries, expense, insurance expense, and supplies expense accounts. Let us now prepare the post-closing trial balance, which will contain permanent accounts only. We will start with cash account for the balance of $10,000. Accounts receivable with a balance of $3,000, 1,000 for prepaid insurance, 6,000 for equipment, 3,500 for accounts payable, 1,000 for accrued salaries, and finally, 15,500 for owner's capital. Total debit and credit balances is $20,000. This equality means all permanent accounts are ready to be carried forward for the next accounting period. Remember that this is only applicable for proprietorship and partnership companies. For cooperation. There's different equity structure and the closing process will change accordingly. This is the end of our lesson. Thanks for watching and see you the next one. 30. Reversing Entries: After preparing financial statements and closing the books, some accountants prefer to reverse 13 adjusting entries at the beginning of the next accounting period. Each reversing entry is the exact opposite of the adjusting entry made in previous period. The use of reversing entries is an optional process in the accounting cycle. The purpose of using reversing entries to simplify recording a subsequent transaction related to an adjusting entry, e.g. a. Payment for interest expense related to current and previous periods resulted debiting two accounts interest expense for the current period and accrued interest for the previous period. With reversing entries, we can debit the whole payment to interest expense account. To understand the subject better, see the following two examples. We will start with an accrual account, which is accrued salaries. In our example, a company is being monthly salaries every two weeks. This payment is done based on five days per week. On 27 September 2019, the company paid $10,000 for salaries incurred between 16 September and the 27th September 2019. The payment entry is recorded by debiting salaries, expense, and crediting cash account for the value of $10,000. The second entry will be recorded on Thursday, September 2019. At this date, there is one day accrued salaries for the value of $1,000, which will be paid on 11 October 2019. The adjusting entry is recorded by debiting salaries expense, and crediting accrued salaries for the value of $1,000. Our third entry is done also at the end of September 2019 to close expenses accounts by debiting income summary and the crediting salaries expense account for the value of $11,000. Our last entry on 11 October 2019, the company pay $10,000 for salaries incurred between Thursday, September, and October 2019. Out of this value, there is $1,000 related to accrued salaries. As a result, the payment entry will debit to accounts salaries expense by $9,000 and accrued salaries by $1,000, then cash account will be credited by $10,000. Let us see now what will happen when we use reversing entries. Notice the first three entries in September 2019 are the same, whether we use reversing entries or not. On 1st October 2019, we will use a reversing entry which will be the exact opposite of the original adjusting entry. In this case, we will debit accrued salaries and credit salaries expense accounts for the value of $1,000. So what will happen at the time of payment? We will record the whole cash payment as expenses by debiting salaries, expense, and crediting cash account for the value of $10,000. This is where reversing entries become handy by debiting one account as expenses rather than the bidding multiple accounts. After recording payment entry, the balance of salaries expense account will become $9,000, which represent the value of salaries incurred between October and 11 October 2019. On the other hand, the balance of accrued salaries account will become zero because we have one credit transaction on Thursday, September, and another debit transaction on 1st October for the value of $1,000. Let us now move to another example for a different account which has office supplies. First October 2019, the company purchased office supplies for the value of $8,000 by cash. In this case, we debit office supplies and credit cash account for the value of $8,000. 31st October 2019. The company found there is still 3,000 dollar value of office supplies on hand. In this case, we record the adjusting entry by debiting supplies expense and crediting office supplies for the value of $5,000. At the end of October 2019, we will close expenses accounts by debiting income summary and the crediting supplies expense accounts for the value of $5,000. Let us see now what will happen when we use reversing entries. Remember that while using reversing entries will record the whole cash payment as expenses. In our example, on first October 2019, we debit supplies expense and credit cash account for the value of a $1,000 31st October 2019, when the company found there is still 3,000 dollar value of office supplies on hand. We debit office supplies and credit supplies expense accounts for the value of $3,000. After recording this adjusting entry, the balance of supplies expense account will become $5,000, which represent the cost of supplies used during the period. While the balance of office supplies account will become $3,000, which represent the quantities of supplies which are still on hand. At the end of October 2019, we will close expenses accounts by debiting income summary and crediting supplies expense accounts for the value of $5,000. So what will happen in the next accounting period? We will record the reversing entry in first November 2019, which will be the exact opposite of our adjusting entry. In this case, we debit supplies, expense, and credit office supplies accounts for the value of $3,000. After recording this entry, office supplies account will become zero. And the company continued to record the purchase of office supplies as expenses, while another adjusting entry will be recorded at the end of each subsequent period. At the end, remember that this process is totally optional in the accounting cycle. Since both ways will have the same ending result, the company may choose the more suitable process to follow. This is the end of our lesson. Thanks for watching and see you the next one. 31. Classified Balance Sheet: The balance sheet is a snapshot of a company financial position at a specific date. Up to this point, we learned unclassified balance sheet whose items are grouped into assets, liabilities, and owners equity. To improve users understanding of a company financial position, it is preferred to use a classified balance sheet which groups similar assets and similar liabilities using standard classifications. One of the more important classification is the separation between current and non-current items for both assets and liabilities as follow. Their assets, we group them into current assets and non-current assets. Each group listed specific type of accounts, e.g. non-current assets, list long-term investments, property, plant and equipment, and intangible assets, and liabilities and equity. We have three main groups. Current liabilities, non-current liabilities, and owner's equity. We will see in this lesson the accounts that are listed under each of these groups. But before that, we need to learn something called operating cycle. This is important to understand the rule behind separation between current and non-current assets or liabilities. So what do we mean by operating cycle? It is the timespan from the payment of cash to acquire goods and services until cash is received from sales of these goods and services. For a service company, it starts with paying salaries to employees who are performing these surfaces. And total cash is collected from customers. For our merchandise company, it starts from paying suppliers to acquire inventory until cash is received from customers. In general, operating cycle period is less than one year. This means most companies use a one-year period in deciding which assets and liabilities are current and non-current. And disregard a classified balance sheet lists current assets before non-current assets and current liabilities before non-current liabilities. Item in current assets are listed in the order of how quickly they will be converted into cash. While items and current liabilities are listed in the order of how quickly they will be paid by cash. Let us start with the first group, which is current assets, are assets that accompany expect to convert into cash or to be used within one year or operating cycle, whichever is longer. Such as accounts receivable are current assets because they are expected to be collected within one year. Another example is inventory, which is classified as current assets because the company expect to use them in operation or to sell them within one year. Let us now have a look at common types of current assets, such as cash, short-term investments, accounts receivable, inventory, and prepaid insurance. And the balance sheet. These assets are listed in the order in which they are expected to be converted into cash. Cash account is listed first because it is the most liquid item. While prepaid expense is listed last because it will not be converted into cash. Instead, it will be expensed during the period. Let us move to the second classification, which is long-term investments. They are usually the followings. First group is investment in stocks and bonds, which are expected to be held for more than the longer of one year or operating cycle. If these securities are expected to be sold within one year, they will be classified as short-term investments. We have also on our list long-term notes, receivable, and long-term assets, such as land and buildings, which are not used in operating activities. If they are used in operating the business, they will be classified under our next classification, which is property, plant and equipment. They are tangible assets that are both long-lived and used in operating the business, which are expected to generate future economic benefits, such as land, buildings, equipment, and furniture. These assets are reported in the balance sheet at cost minus accumulated depreciation. So what do we mean by depreciation? It is the practice of allocating the cost of the asset among its useful life. Not that depreciation is an expense account which will be reported in the income statement. So what about accumulated depreciation? It is an account that shows the total amount of depreciation that accompany has expense so far and the asset life. Notice that lands are not depreciated because they are assumed to have a limited useful life. Let us now move to our next classification, which is intangible assets. They are long lived assets that don't have physical substance. One famous example is goodwill. Other examples are patents, copyrights, trademarks, which gives the company exclusive right of use for a specific period of time. These intangible assets are amortized among the period of exclusive right of use. Our next classification is current liabilities are obligations due to be paid or settled within one year or operating cycle, whichever is longer. Common examples are accounts payable, notes, payable, income tax payable, accrued salaries, accrued interest, earned revenues, and short-term bank loans. It includes also any portion of long term debt. Current liabilities are reported in the order of those items to be settled first, let us now move to our next classification, which is non-current liabilities. They are obligations to be paid or settled after one year or operating cycle, whichever is longer. Such as bonds payable, long-term notes payable, long-term bank loans, and pension liabilities. If a company has both short and long-term items in each of these categories, they will be separated into two accounts in the ledger. Our last classification is owner's equity. The content of this section will vary depending on the legal form of the business. For proprietorship, there is one capital account. In partnership. There is a capital account for each partner. For corporation, the equity section is usually divided into two accounts, common stock and retained earnings. For returned earnings account, it is affected by two items, net income or loss and dividends. This is the end of our lesson. Thanks for watching and see you the next one. 32. Exercise One Introduction: After we learn the accounting cycle, we will solve in this section, a comprehensive exercise starting from preparing journal entries until completing financial statements and post-closing trial balance. Let us now have a look at our example. An owner established a new company on 1st December, 2019 to provide cleaning services. During the month of December 2019. The following transactions have been completed as follow. On December 1st, the owner invested $20,000 cash in the business. On Thursday, December, the company purchased a new vehicle for $9,000 by spending $5,000 cash and the balance on account on fifth December purchase cleaning supplies for $1,000 by cash on a December 2000 $400 for one year vehicle insurance effective 1st December 2019. On 11 December, build the customer $3,000 for cleaning surfaces. On 15 December paid $1,000 cash for amount owed on the vehicle. On 18th December paid 1,500 for employee salaries. On 22nd December collected $1,200 from its customer, which was built on 11 December 2019. On 25th December paid $500 for gasoline consumption. On Thursday December, the owner withdraws $800 for personal use. At the end of the period, the following information was collected for the purpose of preparing financial statements and built fees for services performed on 31st December 2019 was $2,500. Depreciation expense on the vehicle was $150. One month was expired out of 12 for insurance premium. A physical inventory count shows $250 of cleaning supplies was on hand as of 31st December 2019 and paid salaries for employees where $600. In order to start the recording process, the following chart of accounts was created, which contain the following accounts. 101 for cash, account, 112 for accounts receivable, 126 for cleaning supplies, one-thirty for prepaid insurance, 1354, accrued revenue, 157 for vehicles, 158 for accumulated depreciation, to 101 for accounts payable, 212 for accrued salaries, 301 for owner's capital, 306 for owner's drawings, 354 income summary for 101 for service revenue, 501 for salaries expense, 510 for supplies expense, 524 Gasoline Expense, 530 for insurance expense, and finally, 544 depreciation expense. Let us see now the requirements. First, journalize and post all December transactions using page number J1 for the journal. Second, repair the trial balance before adjustments as of 31st December 2019. Third, journalize and post the adjusting entries using page number J2 for the journal. Fourth requirement to prepare the adjusted trial balance as of 31st, December, 2019. Then prepare income statement statement of changes in equity and a classified balance sheet as of 31st, December, 2019. After that, journalize and post closing entries using page number J3 for the journal. Finally, prepare a post-closing trial balance as of 31st December, 2019. This is our exercise in the following lessons, we will go through all these requirements step-by-step. Thanks for watching. 33. Exercise One Journal Entries: We will start solving our exercise with journalizing process for the transactions incurred in December 2019. Let us see our first transaction. The owner invested $20,000 cash in the business. To analyze this transaction, we notice there are two accounts get affected. Cash account and owner's capital account, which both increased with a value of $20,000. To record this entry, we debit cash account by $20,000. Since it is an asset account which increase in the debit side. Then we credit owner's capital account by $20,000. Since cash investment increase equity, which increase on the credit side, we can write an explanation, owner investment by cash. Let us move to our next transaction on third December 2019, the company purchase a new vehicle for the value of $9,000 by spending $5,000 cash and the balanced on account. In this case, we have three accounts get affected. Our first account is vehicles, which will increase by $9,000. The second account is cash, which will decrease by $5,000. Our third account is accounts payable, which will increase by the difference value of $4,000. Because the Portuguese was partially on credit. To record this entry, we debit vehicle's account by $9,000. Since it is an asset account which increase in the debit side, then we credit cash by $5,000. Since it is an asset account which decrease in the credit side. After that, we credit accounts payable by $4,000. Since it is a liability account which increase in the credit side. We can write an explanation, purchase a vehicle by cash and credit. Our next transaction on fifth December 2019, the company purchase cleaning supplies for the value of $1,000 by cash. We notice in this transaction there are two accounts get affected. Cleaning supplies will increase by $1,000 and cash account will decrease by $1,000. To record this entry, we debit cleaning supplies account by $1,000. Since it is an asset account which increase in the debit side, then we credit cash account by $1,000. Since it is an asset account which decrease in the credit side. We can write an explanation, purchase of cleaning supplies by cash. The next transaction on aid, December 2019, the company paid $2,400 for one year vehicle insurance effective 1st December 2019. There are two accounts get affected in this transaction. Prepaid insurance will increase by $2,400 because the premium paid in advance, which will benefit future periods for 12 months. The second account get affected as cash, which will decrease by $2,400. To record this entry, we debit prepaid insurance by $2,400. Since it is an asset account which increase in the debit side. Then we credit cash account by $2,400. Since it is an asset account which decrease in the credit side, we can write an explanation, insurance payment for one year. Our next transaction on 11 December 2019, the company build its customer $3,000 against cleaning surfaces. In this case, we have two accounts get affected. Accounts receivable will increase by $3,000 because the transaction indicate billing rather than Collection, which means the service was on credit. The second account gets affected a service revenue which will increase by $3,000 because cleaning surfaces represent the earning activities of the company. To record this transaction, we debit accounts receivable by $3,000. Since it is an asset account which increase in the debit side, then we credit service revenue account by $3,000. Since the revenue accounts increase equity, which increase in the credit side. We can write an explanation cleaning service bill on account. The next transaction on 15 December 2019, the company paid $1,000 for amount owed on the vehicle. We notice here there are two accounts get affected, accounts payable and cash account, which both decreased by $1,000 because the transaction represent a payment to a vendor. To record this entry, we debit accounts payable by $1,000, since it is a liability account which decrease in the debit side. After that, we credit cash account by $1,000. Since it is an asset account which decrease in the credit side, we can write an explanation, vendor payment by cash. Our next transaction on 18th December 2019, the company paid $1,500 for employees salaries. In this case, there are two accounts get affected. Salaries expense will increase by $1,500 because it represents the cost of providing cleaning services for December 2019. The second account gets affected is cash, which will decrease by $1,500. To record this entry, we debit salaries expense account by $1,500. Since expenses accounts reduce equity and as a result, expenses increase in the debit side. Then we credit cash account by $1,500. Since cash account is an asset account which decrease in the credit side, we can write an explanation, salaries payment for December 2019. Let us move to the next transaction on 22nd, December 2019. The company collected $1,200 from its customer, which was built on 11 December 2019. We notice in this transaction there are two accounts get affected. Cash account will increase by $1,200 and accounts receivable will decrease by $1,200 because the transaction was a conviction from customer. To record this transaction, we debit cash account by $1,200. Since it is an asset account which increase in the debit side. After that, we credit accounts receivable by $1,200. Since it is an asset account which decrease in the credit side. We can write an explanation, cash collection from customer. Our next transaction on 25th December 2019, the company paid $500 gasoline consumption for its vehicle. In this case, there are two accounts get affected. Gasoline expense will increase by $500 because it represents the cost of utilizing the vehicle to provide cleaning services in December 2019. The second account gets affected is cash, which will decrease by $500. To record this transaction, we debit gasoline expense by $500. Since expenses accounts reduce equity and as a result, expenses increase in the debit side. Then we credit cash account by $500. Since it is an asset account which decrease in the credit side. We can write an explanation, payment of gasoline for December 2019. Our last transaction on Thursday, December 2019, the owner withdraws $800 cash for personal use. And this transaction, there are two accounts get affected. Owners drawing account will increase by $800 because this amount used for owner's personal use. The second account gets affected is cash, which will decrease by $800. To record this entry, we debit owners drawing account by $800. Since drawing account will reduce equity. And as a result, drawing account increase in the debit side. After that, we credit cash account by $800. Since it is an asset account which decrease in the credit side, we can write an explanation, owners drawing by cash. At the end, we have completed journal entries for transactions. In the next lesson, we will post all these transactions to general ledger. Thanks for watching. 34. Exercise One Posting to General Ledger: After completing journal entries in our exercise, we will post these entries to the general ledger. Let us start with our first entry on 1st December 2019. In this entry, we debited cash account and credited owner's capital account by the value of $20,000. To post this entry, we open our cash ledger account and start posting process by entering the date which is 1st December 2019. Then we enter the explanation which is owner investment by cash. After that, we entered journal page number as a specified in our question, it was J1. Then we enter the debit value of $20,000. But why debit? Because cash account was debited in the journal entry. Notice that we should keep the credit value blank because there is no credit effect for this transaction on the cash account. After that, we calculate the balance value after this transaction, which will be $20,000. The second disturb and posting process to record the account number in the reference column in The Journal, which is 101. Our third step to open owner's capital account. Then we enter the date which is 1st December 2019. Then we enter the explanation which is owner investment by cash. Then we enter journal page number in the reference column, which is J1. After that, we should keep the debit value blank because there is no debit effect on the owner's capital account. Then we enter the credit value of $20,000. But why credit? Because capital account was accredited and the journal entry after that, we calculate the balance value after this transaction, which will be $20,000. Our fourth step to record the account number and the reference column in the journal, which is 301. Let us move to our next transaction on Thursday, December 2019. In this entry, we debited vehicle's account by $9,000 and credit to accounts, cash account by $5,000 and accounts payable by $4,000. To post this entry, we open vehicles ledger account and start posting process by entering the date which is their December 2019. Then we enter the explanation which is purchase a vehicle by cash and credit. Then we enter journal page number and the reference column, which is J1. After that, we enter the debit value of $9,000. Then we calculate the balance after this transaction, which will be $9,000. The second step and posting process to record the account number and the reference column in the journal, which is 157. Our third step to open cash account. Then we enter the date which is third December 2019. Then we enter the explanation which is porches of vehicle by cash and credit. Then we enter journal page number and the reference column, which is J1. After that, we enter the credit value of $5,000. Then we calculate the balance after this transaction, which will be $15,000. The fourth step and posting process to record the account number and the reference column and the Journal, which is 101. The next system to open accounts payable ledger account. Then we enter the date which is third December 2019. Then we enter the explanation which has bought shares of vehicle by cash and credit. Then we enter journal page number and the reference column, which is J1. After that, we enter the credit value of $4,000. Then we calculate the balance after this transaction, which will be $4,000. The losses in this transaction, to record the account number and the reference column in the journal which is 201. Let us see our next transaction on fifth December 2019. And this entry, we debited cleaning supplies account by $1,000 and credited cash account by $1,000. To post this entry, we opened cleaning supplies ledger account, and start posting process by entering the date which is December 2019. Then we enter the explanation which is purchase cleaning supplies by cash. Then we enter journal page number in the reference column, which is J1. After that, we enter the debit value of $1,000. Then we calculate the balance after this transaction, which will be $1,000. The second step in posting process to record the account number and the reference column in The Journal, which is 126. Our third step to open cash account. Then we enter the date which is fifth December 2019. Then we enter the explanation which is porches cleaning supplies by cash. Then we enter journal page number and the reference column, which is J1. After that, we enter the credit value of $1,000. Then we calculate the balance after this transaction, which will be $14,000. The fourth step and posting process to record the account number and the reference column and the Journal which is 101. Let us move to our next transaction on a December 2019. And this entry, we debited prepaid insurance account by $2,400 and credited cash account by $2,400. To post this entry, we open prepaid insurance ledger account and start posting process by entering the date which is a December 2019. Then we enter the explanation which is insurance payment for one year. Then we enter journal page number and the reference column, which is J1. After that, we enter the debit value of $2,400. Then we calculate the balance after this transaction, which will be $2,400. The second step and posting process to record the account number and the reference column and the Journal, which is 130. Our third step to open cash account. Then we enter the date which is a December 2019. Then we enter the explanation, which is insurance payment for one year. Then we enter journal page number in the reference column, which is J1. After that, we enter the credit value of $2,400. Then we calculate the balance after this transaction, which will be $11,600. The fourth step in posting process to record the account number and the reference column and the Journal which is 101. Please note, I will show only the last three transactions in the cash account due to limited space. In this presentation. Let us see our next transaction on 11 December 2019. And this entry, we debited accounts receivable by $3,000 and we credited service revenue account by $3,000. To post this entry, we open accounts receivable ledger account and start posting process by entering the date which is 11 December 2019. Then we enter the explanation which is cleaning service bill on account. Then we enter journal page number in the reference column, which is J1. After that, we enter the debit value of $3,000. Then we calculate the balance after this transaction, which will be $3,000. The second step in posting process to record the account number and the reference column in the journal, which is 112. Our third step to open service revenue account. Then we enter the date which is 11 December 2019. Then we enter the explanation which is cleaning service bill on account. Then we enter journal page number in the reference column, which is J1. After that, we entered the credit value of $3,000. Then we calculate the balance after this transaction, which will be $3,000. The fourth step and posting process to record the account number and the reference column in the journal which is 401. Let us move to our next transaction on 15 December 2019. In this entry, we debited accounts payable by $1,000 and we credited cash account by $1,000. To post this entry, we open accounts payable ledger account, and start posting process by entering the date which is 15 December 2019. Then we enter the explanation which is vendor payment by cash. Then we enter journal page number in the reference column, which is J1. After that, we enter the debit value of $1,000. Then we calculate the balance after this transaction, which will be $3,000. The second step and posting process to record the account number and the reference column in the journal, which is 201. Our third step to open cash account. Then we enter the date which is 15 December 2019. Then we enter the explanation which is vendor payment by cash. Then we enter journal page number and the reference column, which is J1. After that, we enter the credit value of $1,000. Then we calculate the balance after this transaction, which will be $10,600. The fourth step and posting process to record the account number and the reference column in The Journal which is 101. Let us see our next transaction on 18th December 2019. In this entry, we debit salaries expense by $1,500 and we credited cash account by $1,500. To post this entry, we open salaries expense account and start posting process by entering the date which is 18 December 2019. Then we enter the explanation which is salaries payment for December 2019. Then we enter journal page number in the reference column, which is J1. After that, we enter the debit value of $1,500. Then we calculate the balance after this transaction, which will be $1,500. The second step and posting process to record the account number and the reference column in the journal, which is 501. Our third step to open cash account. Then we enter the date which is 18 December 2019. Then we enter the explanation which is salaries payment for December 2019. Then we enter journal page number in the reference column, which is J1. After that, we entered the credit value of $1,500. Then we calculate the balance after this transaction, which will be $9,100. The fourth step and posting process to record the account number and the reference column and the Journal which is 101. Let us move to our next transaction on 22nd, December 2019. And this entry, we debited cash account by $1,100, The credited accounts receivable by $1,100. To post this entry, we open cash account and start posting process by entering the deed, which is 22nd, December 2019. Then we enter the explanation which is cash collection from customer. Then we enter journal page number and the reference column, which is J1. After that, we enter the debit value of $1,100. Then we calculate the balance after this transaction, which will be $10,300. The second step and posting process to record the account number and the reference column in The Journal, which is 101. Our third step to open accounts receivable ledger account. Then we enter the date which is 22nd December 2019. Then we enter the explanation, which is cash collection from customer. Then we enter journal page number and the reference column, which is J1. After that, we entered the credit value of $1,200. Then we calculate the balance after this transaction, which will be $1,800. The fourth step and posting process to record the account number and the reference column in the journal, which is 112. Let us move to our next transaction on 25th December 2019. In this entry, we debited gasoline expense account by $500 and we credited cash account by $500. To post this entry, we open gasoline expense account and start posting process by entering the date which is 25th December 2019. Then we enter the explanation which is payment of gasoline for December 2019. Then we enter journal page number and the reference column, which is J1. After that, we enter the debit value of $500. Then we calculate the balance after this transaction, which will be $500. The second step and posting process to record the account number and the reference column in the journal, which is 520. Our third step to open cash account. Then we enter the date which is 25th December 2019. Then we enter the explanation which is payment of gasoline for December 2019. Then we enter journal page number in the reference column, which is J1. After that, we enter the credit value of $500. Then we calculate the balance after this transaction, which will be $9,800. The fourth step and posting process to record the account number and the reference column and the Journal which is 101. Our last transaction was on Thursday, December 2019. We debited owners drawing account by $800 and we credited cash account by $800. To post this entry, we open owners drawing account and start posting process by entering the date which is Thursday, December 2019. Then we enter the explanation which is owners drawing by cash. Then we enter the journal page number in the reference column, which is J1. After that, we enter the debit value of $800. Then we calculate the balance after this transaction, which will be $800. The second step and posting process to record the account number and the reference column in the journal, which is 306. Our third step to open cash account. Then we enter the date which is Thursday, December 2019. Then we enter the explanation which is owners drawing by cash. Then we enter journal page number in the reference column, which is J1. After that, we entered the credit value of $800. Then we calculate the balance after this transaction, which will be $9,000. The fourth step and posting process to record the account number and the reference column and the Journal which is 101. This is the end of our lesson. In the next lesson, we will prepare the trial balance before adjustment to make sure all debit balances equal, all credit balances. Thanks for watching. 35. Exercise One The Trial Balance: Before we do adjusting entries, there is a checkpoint to prepare the trial balance before adjustment. This is step is important to make sure all debit balances equal or credit balances. So let us start by creating a four column table, which include account number, the account name, the bit value, and finally, created value. The next system to enter all debit and credit balances resulted from recording our transactions. Our trial balance will start with cash account with a debit balance of $9,000. Remember that this balance is taken from our general ledger account as of 31st, December 2019. The next account in our trial balance is accounts receivable with a debit balance of $1,800. Then we have cleaning supplies account with a debit balance of $1,000. After that, we have prepaid insurance account with a debit balance of $2,400, then we have vehicle's account with a debit balance of $9,000. After that, we have accounts payable with a credit balance of $3,000. Then we have owner's capital account with a credit balance of $20,000. After that, we have owner's drawings with a debit balance of $800. Then we have service revenue account with a credit balance of $3,000. After that, we have salaries expense account with a debit balance of $1,500. Finally, we have gasoline expense account with a debit balance of $500. Total debit and credit balances are matching with the total value of $26,000, which is mandatory under double entry system. Notice that accounts with zero balances from our chart of accounts are not shown here. Only accounts with balances are indicated in the trial balance. Notice also on the dollar sign is used in the first account of each column and also in the totals. This is the end of our lesson. In the next lesson, we will see how to record the adjusting entries. Thanks for watching. 36. Exercise One Adjusting Entries: We will record in this lesson the adjusting entries as of 31st December 2019. We have five transactions. We will start with transaction aim, which indicate and build fees for services performed was $2,500. In this case, we have two accounts get affected. Accrued revenue, service revenue accounts, which both will increase by $2,500. But why accrued revenue? Because this revenue was not recognized in our daily transactions and it was not built to our customer as of 31st, December 2019. So we have to book it as a cruel. In this case, we will debit accrued revenue account by $2,500 and credit service revenue account by $2,500. We can write an explanation and build service revenue in December 2019. To post this entry, we open accrued revenue account and start posting process by entering the date which is 31st December 2019. Then we enter the explanation which is unbuilt service revenue in December 2019. Then we enter journal page number in the reference column. As specified in our question, it was J2. After that, we enter the debit value of $2,500. Then we calculate the balance after this transaction, which will be $2,500. The second step in posting process to record the account number and the reference column in The Journal, which is 135. Our third disturb to open service revenue account. Then we enter the date which is 31st December 2019. Then we enter the explanation which is inbuilt service revenue in December 2019. Then we entered journal page number in the reference column, which is J2. After that, we enter the credit value of $2,500. Then we calculate the balance after this transaction, which will be $5,500. The fourth step in posting process to record the account number and the reference column in the journal which is 401. Let us now move to transaction B, which indicate depreciation expense on the vehicle for the month was $150. We will talk about depreciation in a separate section later in this course. But I would like to give you a brief explanation about how to record depreciation entry. Since property, plant, and equipment are reported at cost minus accumulated depreciation, there will be two accounts get affected. Depreciation expense and accumulated depreciation, which both will increase by $150. In this case, we will debit depreciation expense account by $150 and credit accumulated depreciation account by $150. We can write an explanation depreciation expense for December 2019. To post this entry, we opened the depreciation expense account and start posting process by entering the date which is 31st December 2019. Then we enter the explanation which is depreciation expense for December 2019. Then we enter journal page number in the reference column, which is J2. After that, we enter the debit value of $150. Then we calculate the balance after this transaction, which will be $150. The second step in posting process to record the account number and the reference column in the journal, which is 540. Our third step to open accumulated depreciation account. Then we enter the deed which is 31st, December 2019. Then we enter the explanation, which is the abbreviation expense for December 2019. Then we enter journal page number and the reference column, which is J2. After that, we enter the credit value of $150. Then we calculate the balance after this transaction, which will be $150. The fourth step in posting process to record the account number and the reference column in the journal, which is 158. Our next adjusting entry is a transaction siem, which indicate one month was expired out of 12 for insurance premium. In this transaction, there are two accounts get affected. Insurance expense account will increase by $200, which resulted from dividing $2,400 over 12 months. The second account is prepaid insurance, which will decrease by the same value of $200. In this case, we will debit insurance expense account by $200 and credit prepaid insurance account by $200. We can write an explanation insurance expense for December 2019. To post this entry, we open insurance expense account and start posting process by entering the date which is 31st December 2019. Then we enter the explanation which is insurance expense for December 2019. Then we enter journal page number and the reference column, which is J2. After that, we enter the debit value of $200. Then we calculate the balance after this transaction, which will be $200. The second step and posting process to record the account number and the reference column in the journal, which is 530. Our third step to open prepaid insurance account. Then we enter the date which is 31st December 2019. Then we enter the explanation which is insurance expense for December 2019. Then we enter journal page number in the reference column, which is J2. After that, we enter the credit value of $200. Then we calculate the balance after this transaction, which will be $2,200. The fourth step in posting process to record the account number and the reference column and the Journal which is 130. Let us see now transaction D, which indicate a physical inventory count, chose to 150 dollar value of cleaning supplies while they're still on hand. In this case, there are two accounts get effected. Supplies expense account will increase by $750, which resulted from calculating $1,000 of supplies purchased -250 dollar value of remaining quantities. The second account is cleaning supplies, which will decrease by the same value of $750. In this case, we will debit supplies expense account by $750 and the credit cleaning supplies account by $750. We can write an explanation supplies expense for December 2019. To post this entry, we open supplies expense account and start posting process by entering the date which is 31st, December 2019. Then we enter the explanation which is supplies expense for December 2019. Then we enter journal page number in the reference column, which is J2. After that, we enter the debit value of $750. Then we calculate the balance after this transaction, which will be $750. The second step in posting process to record the account number and the reference column in the journal, which is 510. Our third step to open cleaning supplies account. Then we enter the date which is 31st December 2019. Then we enter the explanation which is supplies expense for December 2019. Then we enter journal page number and the reference column, which is J2. After that, we enter the credit value of $750. Then we calculate the balance after this transaction, which will be $250. The fourth step in posting process to record the account number and the reference column in The Journal which is 126. Our last adjusting entry is transaction E, which indicate unpaid salaries for employees where $600. In this case, we have two accounts get affected. Salaries expense and accrued salaries accounts, which both will increase by $600. But why accrued salaries? Because this expense was not recognized in our daily transactions and it was not paid to our employees as of 31st, December 2019. So we have to book it as accrual. This transaction, we will debit salaries expense account by $600 and the credit accrued salaries account by $600. We can write an explanation, accrued salaries for December 2019. To post this entry, we open salaries expense account, and start posting process by entering the date which is 31st December 2019. Then we enter the explanation which is accrued salaries for December 2019. Then we enter journal page number and the reference column, which is J2. After that, we enter the debit value of $600. Then we calculate the balance after this transaction, which will be $2,100. The second step and posting process to record the account number and the reference column in the journal, which is 501. Our third disturb to open accrued salaries account. Then we enter the date which is 31st December 2019. Then we enter the explanation which is accrued salaries for December 2019. Then we enter journal page number and the reference column, which is J2. After that, we enter the credit value of $600. Then we calculate the balance after this transaction, which will be $600. The fourth step in posting process to record the account number and the reference column in the journal, which is 212. This is the end of our lesson. In the next lesson, we will prepare the adjusted trial balance. Then we will be ready to prepare our financial statements. Thanks for watching. 37. Exercise One Adjusted Trial Balance: After recording adjusting entries, we can now prepare the adjusted trial balance, which is important to make sure all debit balances equal or credit balances after adjustments. This trial balance is considered a tool to prepare the financial statements. We will start preparing our worksheet with an adjusted trial balance from our previous lessons, which indicate the total debit balances and the total credit balances where $26,000. After that, we will use adjustment columns to present the effect of adjusting entries as of 31st December, 2019. The first adjusting entry was related to accrued revenue, which resulted a debit value of $2,500. Then a credit to service revenue account for the same value of $2,500. The second adjusting entry was related to depreciation expense, which resulted at the bit value of $150. Then a credit to accumulated depreciation account for the same value of $150. Our third adjusting entry was related to insurance expense, which resulted at the bit value of $200. Then a credit to prepaid insurance account for the same value of $200. The next adjusting entry was related to supplies expense, which resulted a debit value of $750, then a credit to cleaning supplies account for the same value of $750. Our last adjusting entry was related to salaries expense, which resulted a debit value of $600, then a credit to accrued salaries account for the same value of $600. Notice that the total debit and credit values of adjustments is $4,200, which represent that double entry system is still maintained. Let us now calculate the balances after adjustments. We notice here cleaning supplies, original balance was $1,000, which is reduced by $750 to become 250 debit balance after adjustment. Then we have prepaid insurance account. Its original balance was $2,400, which is reduced by $200 to become 2,200 debit balance after adjustment. After that, we have service revenue account. Its original balance was $3,000, which is increased by $2,500 to become 5,500 credit balance after adjustment. Then we have salaries expense account. Its original balance was $1,500, which is increased by $600 to become 2,100 debit balance. After adjustment. After that, we have accrued revenue account with a debit balance of $2,500 after adjustment. Then we have depreciation expense account with a new debit balance of $150. After adjustment. After that, we have accumulated depreciation account with a new credit balance of $150 after adjustment. Then we have insurance expense account with a debit balance of $200. After adjustment. After that, we have supplies expense account with a debit balance of $750 after adjustment. Finally, we have accrued salaries account with a new credit balance of $600 after adjustment. Notice that total debit and credit balances are the same with a total value of 29,000 to $150. At the end. Let us see the final trial balance after adjustments. Remember that these general ledger accounts are listed here in the same order in which they appear in the chart of accounts. After completing this trial balance, we are ready to prepare our financial statements as of 31st, December, 2019, which will be our subject in the next lesson. Thanks for watching. 38. Exercise One Financial Statements: We will prepare in this lesson three financial statements, which are income statement, statement of changes in equity and the classified balance sheet. Let us start with income statement. Remember that income statement reports revenues and expenses and resulting net income or net loss for a specific period of time. It begins with revenue accounts and then followed by expenses accounts. In our exercise, we have only one revenue account, which is service revenue, with a balance of $5,500. After that, we list expenses, accounts starting with salaries, expense with a balance of $2,100, then supplies expense with a balance of $750. After that, we have gasoline expense with a balance of $500. After that, we have insurance expense with the balance of $200. Finally, we have depreciation expense with a balance of $150. The last step to prepare income statement to deduct total expenses value from total revenues which result in it income for the value of $1,800. Notice that this balance will be transferred to the Statement of Changes in Equity. Let us now move to statement of changes in equity. Remember that this statement reported changes of owner's capital account for a specific period of time. It starts with opening balance of owner's capital as of December 2019, which was zero value that date. Then we add two figures. The first one is investment by owner for the value of $20,000. After that, we add net income from income statement for the value of $1,800. The total additions will be $21,800. Finally, we deduct owners drawing account with a value of $800 to reach at the end of the period, $21,000. Notice that this balance will be transferred to the balance sheet to be under equity. Our last statement is the classified balance sheet. Remember that it reports assets, liabilities, and owners equity at a specific date. In our case, it is 31st December 2019. Statement start with current assets which are cash account with a balance of $9,000, then followed by accounts receivable with a balance of $1,800. After that, we have a cleaning supplies with a balance of $250. Then we have prepaid insurance with the balance of $2,200. And finally, we have accrued revenue with a balance of $2,500. Total current assets will be $15,750. Our next group will be non-current assets, which are in our exercise, property, plant and equipment. We have vehicles account with a balance of $9,000. Then we deduct accumulated depreciation for the value of $150. The net value for property, plant and equipment will be $8,850. To calculate total assets, we add the values of current assets and non-current assets, which will be $24,600. The next group of the classified balance sheet is current liabilities. We have under this classification to accounts, accounts payable with a balance of $3,000. Then we have accrued salaries with a balance of $600. Total current liabilities will be $3,600. Our last group, and this is statement is owner's equity. We have here only one account, which is owner's capital account, with a balance of $21,000. Notice that this balance comes from Statement of Changes in Equity. At the end, we calculate the sum of total liabilities and owner's equity, which will be $24,600. Notice that this value must match total assets, which indicate total debits and total credits are in balance. This is the end of our lesson. In the next lesson, we will prepare closing entries. Thanks for watching. 39. Exercise One Closing Entries: After completing financial statements, we can prepare closing entries to make our accounts ready for the next accounting period. In this process, we will close temporary accounts. Are permanent accounts. We will start with closing revenues to income summary account. In our case, we have only one revenue account, which is service revenue account. To close it, we debit service revenue and credit income summary for the value of $5,500. To post this entry, we open service revenue account and start posting process by entering the deed, which is 31st, December 2019. Then we enter the explanation to close the revenue accounts. Then we enter journal page number in the reference column. As a specified in our question, it was J3. After that, we enter the debit value of $5,500. Then we calculate the balance after this transaction, which will become zero. The second step and posting process to record the account number and the reference column in the journal, which is 401. Our third disturb to open income summary account. Then we enter the date which is 31st December 2019. Then we enter the explanation to close the revenues accounts. Then we enter journal patient number, and the reference column, which is J3. After that, we enter the credit value of $5,500. Then we calculate the balance after this transaction, which will be $5,500. The fourth step and posting process to record the account number in the reference column in the journal, which is 350. Let us move to the next step is to close expenses to income summary account. To close expenses, we debit income summary account for the total value of all expenses, which is $3,700. Then we credit individual expenses, starting with salaries expense account with a balance of $2,100. After that, we credit supplies expense account with a balance of $750. Then we credit gasoline expense account with a balance of $500. After that, we credit insurance expense account with a balance of $200. Finally, we credit depreciation expense account with a balance of $150. To post this entry, we open income summary account and start posting process by entering the date which is 31st December 2019. Then we enter the explanation to close expenses accounts. Then we enter journal page number and the reference column, which is J3. After that, we enter the debit value of $3,700. Then we calculate the balance after this transaction, which will be $1,100. The second step and posting process to record the account number and the reference column in the journal, which is 350. Our third disturb to open salaries expense account. Then we enter the date which is 31st December 2019. Then we enter the explanation to close expenses accounts. Then we enter journal page number in the reference column, which is J3. After that, we enter the credit value of $2,100. Then we calculate the balance after this transaction, which will become zero. The fourth step and posting process to record the account number and the reference column in the journal, which is 501. Our next system to open supplies expense account. Then we enter the date which is 31st December 2019. Then we enter the explanation to close expenses accounts. Then we enter journal page number in the reference column, which is J3. After that, we enter the credit value of $750. Then we calculate the balance after this transaction, which will become zero. After that, we record the account number and the reference column in the journal, which is 510. Our next system to open gasoline expense account. Then we enter the date which is 31st December 2019. Then we enter the explanation to close expenses accounts. Then we enter journal page number in the reference column, which is J3. After that, we enter the credit value of $500. Then we calculate the balance after this transaction, which will become zero. After that, we record the account number and the reference column in the journal, which is 520. Our next system to open insurance expense account. Then we enter the date which is 31st December 2019. Then we enter the explanation to close expenses accounts. Then we enter journal page number in the reference column, which is J3. After that, we enter the credit value of $200. Then we calculate the balance after this transaction, which will become zero. After that, we record the account number and the reference column in the journal, which is 530. Our final step to open depreciation expense account. Then we enter the date which is 31st December 2019. Then we enter the explanation to close expenses accounts. Then we enter journal page number and the reference column, which is J3. After that, we enter the credit value of $150. Then we calculate the balance after this transaction, which will become zero. After that, we record the account number and the reference column in the journal, which is 540. Letter C. Now how to close income summary account since it has a credit balance of $1,800, which indicate a profit, we debit this account to close it, and then credit owner's capital account for the value of $1,800. To post this entry, we open income summary account and start posting process by entering the date which is 31st December 2019. Then we enter the explanation to close income summary account. Then we enter journal page number and the reference column, which is J3. After that, we enter the debit value of $1,800. Then we calculate the balance after this transaction, which will become zero. The second disturb and posting process to record the account number and the reference column in the journal, which is 350. Our third disturb to open owner's capital account. Then we enter the date which is 31st December 2019. Then we enter the explanation to close income summary account. Then we enter journal page number and the reference column, which is J3. After that, we enter the credit value of $1,800. Then we calculate the balance after this transaction, which will be $21,800. The fourth step in posting process to record the account number in the reference column in the journal which is 301. The last step in the closing process to close owners drawing account. Since it has a debit balance of $800, we close it by debiting the capital account and then crediting owner's drawings account for the value of $800. To post this entry, we open owner's capital account and start posting process by entering the date which is 31st December 2019. Then we enter the explanation to close owners drawing account. Then we enter journal page number and the reference column, which is J3. After that, we enter the debit value of $800. Then we calculate the balance after this transaction, which will be $21,000. The second step in posting process to record the account number and the reference column in the journal, which is 301. Our third step to open owners drawing account. Then we enter the date which is 31st December 2019. Then we enter the explanation to close owners drawing account. Then we enter journal page number and the reference column, which is J3. After that, we enter the credit value of $800. Then we calculate the balance after this transaction, which will become zero. The fourth step and posting process to record the account number and the reference column in the journal, which is 306. After this point, all temporary accounts balances have become zero. This is the end of our lesson. In the next lesson, we will prepare a post-closing trial balance. Thanks for watching. 40. Exercise One Post Closing Trial Balance: We will prepare now the last trial balance in our exercise, which we call it post-closing trial balance. Remember that this trial balance list permanent accounts and their balances only. Since all temporary accounts balances becomes zero after closing. Let us see our adjusted trial balance, which we prepared in our previous lessons. We notice here both permanent and temporary accounts are listed. What we have to do is closing temporary accounts in the owner's capital account, which is considered a permanent account. This is what we did in our previous lesson. To complete this process, we will remove these temporary accounts since their balances becomes zero after closing. Then we will update the capital account balance, which indicate the ending balance after closing for the value of $21,000. At the end, notice that total debits must equal total credits. After closing. Up to this point, we have completed our accounting cycle. All permanent accounts now become ready to start the recording process in the next accounting period. Thanks for watching. 41. Introduction to Merchandising Operations: We learned in our previous sections about accounting for service companies. We will study in this section the accounting process for merchandising companies. Let us start by understanding what do we mean by merchandising companies? They buy and sell inventory as their primary source of revenues. And this regard, we have two types of companies, retailers that buy and sell inventory directly to consumer. Then we have wholesalers that sell inventory to retailers. Let us see next how income statement is reported for both service and merchandising companies? For a service company, it is straightforward. Sales revenue is reported first, then followed by operating expenses. Net income or loss is reported by calculating the difference value. For a merchandising company, there are two categories of expenses. Cost of goods sold and operating expenses. So what do we mean by cost of goods sold? It is the total cost of inventory sold during a period. The next item to be reported is gross profit, which is the difference value between net sales and cost of goods sold. After that, we have operating expenses, which include two categories. Selling expenses, such as advertisement and Friday outer charges. The second category is general and administrative expenses such as utilities and administration salaries. We will explain these items in detail later in this section. What I need from you now just to see the difference in reporting income statement for both service and merchandising companies. Our next subject is operating cycle. The operating cycle of a merchandising company is usually longer than a service company. But why? Because it include the process of buying and selling inventory as follows. We can see an a service company it to start with paying salaries to employees to perform services and then sell these services on credit to customers. As a result, accounts receivable will be generated. After that, it ends with receiving cash from customers. For a merchandising company, there are two additional steps to buy inventory and then sell it to customers. That's why the operating cycle is longer for merchandising companies. Let us see now inventory cost flow during a single time period. It to start with beginning inventory plus the cost of goods purchased, which resulted the cost of goods available for sale. During the period while the company sell these inventories, their cost is assigned to cost of goods sold. So what about the units of inventory which are still on hand? They are reported as ending inventory. Notice that cost of goods sold is reported in the income statement, while ending inventory is reported in the balance sheet to be under current assets. We have in this regard to systems that can be used to maintain the records of inventory cost, and cost of goods sold. These systems are perpetual system and periodic system, which will be our subject for the next lesson. Thanks for watching. 42. Perpetual vs Periodic Systems: After we learn the differences in accounting process for both service and merchandising companies. We will study in this lesson to inventory systems that are used to maintain the records of inventory costs. The first one is perpetual system. This system keeps detailed records of the cost of each inventory purchase and sale. What do we mean by that? It provides a continuous records of the balances in both inventory account and cost of goods sold account. So we can get real-time data at anytime. To explain the subject, let us say the following. We noticed that we maintain purchase record with the cost value of inventory by using inventory account. After that, when the inventory is sold, we maintain two records. The first one is a sale entry with selling price by using sales revenue account. And the second one is cost of goods sold entry after each sale transaction by using cost of goods sold account. So what we will do at the end of the accounting period, actually, there is no need to calculate cost of goods sold since it is already recognized after each sale. Companies usually perform physical inventory count at the end of the period and record any differences under cost of goods sold. These differences could exist due to human errors, theft, damage, etc. We will see all these entries in the following lessons. Just keep in mind that under perpetual system, there are two accounts. Inventory account and cost of goods sold account, which maintain the cost of each transaction of inventory in real-time. Let us move next to see periodic system. Under periodic system, companies do not keep detailed inventory records of the goods on hand. Instead, they calculate the cost of goods sold only at the end of the accounting period. To understand this process, let us see the following. We notice under periodic system that we also maintain purchase record with the cost value of inventory, but this time by using purchases account and instead of inventory account. After that, when the inventory is sold, we maintain only one record for inventory sale with the selling price by using sales revenue account. So how do we calculate the cost of ending inventory and the cost of goods sold will be done only at the end of the accounting period. But how? For ending inventory, we have to perform physical count at the end of the period. For cost of goods sold, we are using a formula which will be as follows. We start with the cost of beginning inventory, and then we add the cost of goods purchased. Then we deduct the cost of ending inventory to equal either and cost of goods sold. We notice here, periodic system does not maintain continuous data during the period. We can calculate the cost of goods on hand and the cost of goods sold only at the end of the period. In conclusion, we see how perpetual system offer better records and control of inventory. Due to technological improvements and the growing use of computerized software and barcode scanners. Most companies nowadays use perpetual system to control their inventory. That's why our journal entries in this section will be recorded by using perpetual system. The next lesson, we will start the recording purchases entries for inventory. Thanks for watching. 43. Accounting for Inventory Purchases: We learned in our previous lessons the differences between perpetual and periodic systems. We will study in this lesson all journal entries related to the purchases of inventory using perpetual system. Our first transaction is recording a purchase invoice. Let us take the following example. On first April 2020, the company purchased inventory for the value of $5,000 on account. Notice that invoice layout, that includes invoice date, seller name, by our name, the quantity, unit price, and the value for each item purchased with the total amount of $5,000. This invoice is used as a supporting document to the purchase transaction. In this case, there are two accounts get affected. Inventory account will increase by $5,000 and accounts payable will increase by the same value of $5,000. To record this transaction, we debit inventory account by $5,000. Since it is an asset account which increase in the debit side. Then we credit accounts payable by $5,000. Since it is a liability account which increase in the credit side, we can write an explanation, inventory purchase on account. Notice in this transaction, we used inventory account rather than supplies account. But why? Because inventory is purchased for the purpose of resale to customers. In contrast, supplies are purchased to be used in the business rather than to be solved. This is the main difference between inventory and supplies. Let us move to the next transaction, which is purchase returns and allowances. Sometimes when we buy inventory, we may find that some items are damaged, defective, or not matching required specification. In such cases, the purchaser may return the goods to the seller for credit if the sale was made on credit or for a cash refund if the purchase was made by cash. This transaction is known as portrays return. There is another option when the purchaser chooses to keep the goods. If the seller offers to grant an allowance, or we can say a deduction from the purchase price. This transaction is called Porsches are loans. Let us see the following example. On 3rd April 2020, the company found there are some items damaged and return these items to the seller. The cost of these items is $500. As a result, the seller issued a credit note for the same value. We notice in this transaction there are two accounts get affected. Inventory account will decrease by $500 and accounts payable will decrease by the same value of $500. To record this transaction, we debit accounts payable by $500. Since it is a liability account, which decrease in the debit side. Then we credit inventory account by $500. Since it is an asset account which decrease in the credit side, we can write an explanation, return of goods purchased on credit. Let us move to the next transaction, which is purchase discount. We have two types of discounts and accounting. The first one is called a discount and the second one is called cash discount. So what do we mean by trade discount? It is a reduction on lists, the price offered by the seller to the buyer at the time of purchase. This type of discount is normally offered for buyers who purchase bulky quantities. Or when the seller wants to attract more customers. For trade discount, there is no accounting process required. And instead, the cost of inventory is recorded with the net price after trade discount. Let us see you next, our second discount, which we call it cash discount. We can call it also an early payment discount. In this case, the seller offers and his credit term if the invoice is paid before a specific number of days, a cash discount will be granted. This is useful for both the seller and the buyer. For the seller who will be able to shorten operating cycle by converting accounts receivable into cash earlier for the buyer, you will save money in his Porsche is to understand the subject. Let us see the following example. So what do we mean by this credit term? We read it as 210 net 30. It means that the buyer may take 2% cash discount on the invoice price less any returns or allowances if the payment is done within ten days of the invoice date. Otherwise, the total invoice price less any returns or allowances is due after 30 days from the invoice date without any discount. Let us see now the following example. On tenth April 2020, the company take the option of cash discount and settle the invoice with the credit terms 210, net 30. Before we apply discount percentage, we have to open accounts payable ledger. We notice here the net amounts payable after returns and allowances is $4,500. To calculate the cash discount, we multiply two percentage by $4,500. The result will be $90. In this transaction, there are three accounts get affected. Accounts payable will decrease by $4,500. Then we have inventory account, which will decrease by the discount value of $90. Then we have cash account which will decrease by the difference value of $4,410. To record this entry, we debit accounts payable by $4,500. Since it is a liability account which decrease in the debit side, then we credit to accounts, inventory account by $90. Since it is an asset account which decrease in the credit side. Then we credit cash account by the difference value of $4,410. We can write an explanation payment within the discount period. Let us open inventory ledger to see all transactions up to this date. We notice how cash discount is recorded in the credit side of inventory account and the balance after this transaction will be $4,410. Let us move now to the last transaction, which is transportation cost and ownership transfer. The buyer and seller must agree on who is responsible for paying the freight cost and who take the risk of loss during transportation of the goods. And disregard, We have to fry terms FOB shipping point and FOB destination. But what do we mean by FOB? It means free on board, which is considered the point of ownership transfer. Under FOB shipping point, the title of the goods is passed to the buyer, wants shipped. As a result, these goods become part of buyer inventory when they are in transit. In this case, the buyer will pay freight cost, and this cost will be part of inventory cost. Normally we call it fright and charges. The second fried term is FOB destination. The title of the goods is passed to the buyer once delivered to the destination. Usually it is the buyer warehouse. As a result, these goods will be part of seller inventory when they are in transit. The seller is responsible for any damage or loss during transportation. In this case, the seller will pay freight cost and it will be reported under selling expenses rather than inventory costs. Normally we call it freight out the charges. To understand the subject, let us see the following example. On April 2020, the company paid $100 for it and charges for the goods purchased on first April 2020. This payment was done by cash. In this transaction, there are two accounts get affected. Inventory account will increase by the value of fright cost, which is $100. Then we have cash account which will decrease by the same value of hundred dollars. To record this entry, we debit inventory account by $100. Since it is an asset account which increase in the debit side. Then we credit cash account by $100. Since it is an asset account which decrease in the credit side. We can write an explanation, cash payment for fright and charges. Let us now open inventory ledger to see all transactions up to this date. We notice how inventory account is affected by four transactions. It will increase by the purchase cost of $5,000 and also will increase by fright and charges by $100. And contrast, it will decrease by purchase returns and allowances for the value of $500, and also will decrease by the cash discount for the value of $90. The ending inventory balance will be $4,510, which will be reported in the balance sheet under current assets. This is the end of our lesson. In the next lesson, we will study the accounting process for inventory sales. Thanks for watching. 44. Accounting for Inventory Sales: After we learn journal entries for inventory purchases, we will study in this lesson how to record journal entries for inventory sales under perpetual system. We will start with our first transaction, which is recording sales invoice. Before we start, remember that in accordance with revenue recognition principle, company's record sales revenue. Once performance obligation is satisfied. Normally the performance obligation is satisfied when the goods transfer from the seller to the buyer. Regarding sales invoice, it is used as a supporting document to the sale transaction, which include the same layout of portraits and voice, such as invoice number, invoice, date, seller name, by our name, the quantity, unit price, and the value for each item sold. To record a sale transaction under perpetual system, we have to make two entries for each sale. The first one to record revenue by using selling price. The second one to record cost of goods sold. To understand the subject, let us see the following example. On 18 April 2020, the company sold inventory with the total selling price of $11,000 with a credit term 210, net 60, while the cost of this inventory is $4,000. In this case, we have two entries. We will start with the sale entry, which has two accounts get affected. Accounts receivable will increase by $11,000. And we have sales revenue which will increase by the same value of $11,000. To record this transaction, we debit accounts receivable by $11,000. Since it is an asset account which increase and the debit side. Then we credit sales revenue account by $11,000. Sensitive in your accounts increase equity, which increase in the credit side. We can write an explanation and venturi sale on credit. Let us now record the second entry of this transaction, but this time by the cost. In this case, we have two accounts get affected. Cost of goods sold will increase by the cost of materials sold, which is $4,000. And the inventory account will decrease by the same value of $4,000. To record this entry, we debit cost of goods sold account by $4,000. Since it is an expense account which decrease equity and as a result, it increases in the debit side. Then we credit inventory account by $4,000. Since it is an asset account which decrease in the credit side. If we open inventory ledger, we will notice how inventory account was accredited by $4,000 and the ending balance become $510. Let us now move to the next transaction, which is sales returns and allowances. We are looking here at the opposite side of purchase returns and allowances. In this case, the seller will record it as sales returns and allowances, where the seller accept the goods back from the buyer, or grant or reduction of selling price to the buyer. So he will keep these goods in his inventory. We call this reduction and allowance. To understand the subject, let us see the following example. On 22nd, April 2020, the company accept to return goods sold on credit from the buyer. These goods sold at a price of $1,000 with a total cost of $400. The goods were in good condition. In this case, we have two entries. We will start with the sale return entry, which has two accounts get affected. Sales returns and allowances. Account will increase by $1,000 and accounts receivable will decrease by the same value of $1,000. To record this transaction, we debit sales returns and allowances account by $1,000. But why debit? Because this account is considered a contra revenue account, sales revenue. What do we mean by contra account? We mean that it will offset sales revenue account in the income statement, which we will discuss in future. Once we explain multiple step income statement. After that, we credit accounts receivable by $1,000. Since it is an asset account which decrease in the credit side, we can write an explanation, credit granted for goods returned. Let us now record the second entry of this transaction, but this time by cost. In this case, we have two accounts get affected. Inventory account will increase by the cost value of $400 and cost of goods sold account will decrease by the same value of $400. To record this entry, we debit inventory account by $400 and then credit cost of goods sold account by $400. We can write an explanation to record cost of goods returned. We consider in this transaction the goods returned, we're in good condition. But what if they were defective or damaged? In this case, the cost entry will be recorded by the fair value of return goods rather than their original cost. E.g. if the fair value of returned goods was $100, then we debit inventory account by $100. The sales return of $1,000 will be the same. Let us go now a little bit further by assuming the company granted the buyer and other ones on the selling price to keep these goods. In this case, the seller will record only one entry for sales allowance of $1,000. This allowance has no impact on inventory or cost of goods sold. But remember that for the buyer, it is different. The buyer will record this allowance by debiting accounts payable, crediting inventory account. If we open inventory ledger, we notice how this account was debited for sales returns by cost value of $400. The ending balance will become $910 after this transaction. Let us see our next transaction, which is sales discount. As mentioned in our previous lesson, for purchase discount, the seller may offer the buyer a cash discount if he paid the invoice within specific number of days. In our case here, it is called by the seller a sales discount. Like sales returns and allowances. Sales discount is a contra revenue account to sales revenue, it's normal balance is a debit which offset sales revenue account in the income statement. To understand the subject, let us see the following example. On 25th April 2020, the buyer chooses to pay the invoice within the discount period. He take the benefit of cash discount with a credit term 210, net 60, and pay the balance amount after discount. Before we calculate the discount amount, we have to open accounts receivable ledger. We see in this account there are two transactions. Debit transaction of $11,000 for a sale on credit. And we have a credit transaction by $1,000 for sales returns and allowances, the balance of accounts receivable is $10,000. To calculate discount amount, we multiply the balance of $10,000 by two per cent, which result $200. We noticed in this transaction there are three accounts get affected. Sales discount will increase by the discount amount, which is $200. Then we have accounts receivable which will decrease by $10,000, which represent the invoice price minus sales returns. Then we have cash account which will increase by the difference value of $9,800. To record this transaction, we debit to accounts sales discount by $200, since it is a contra revenue account which has a normal balance of debit. Then we debit cash account by $9,800. After that, we credit accounts receivable by $10,000. We can write an explanation collection within the discount period. Let us move now to the last transaction, which is transportation cost. As we discussed in our previous lesson, if the buyer pays frightened charges to acquire inventory, these are charges will be considered a part of inventory cost. In contrast, if the sellers pays fright out the charges to sell inventory, these are charges will be considered selling expenses, which will be reported under operating expenses in the income statement. To understand the subject, let us see the following example. On 29th April 2020, the company paid $150 cash against fright out. The charges. In this case, we have two accounts get affected. Fright out account will increase by $150. And we have cash account which will decrease by the same value of $150. To record this transaction, we debit freight out account by $150, or we can use delivery expense account instead. Then we credit cash account by $150. We can write an explanation, cash payment for Friday outer charges. Up to this point, we have completed all inventory purchase, and sale transactions. The next lesson, we will discuss closing entries under perpetual system. Thanks for watching. 45. Closing Entries under Perpetual System: We learned in our previous sections how to do closing entries for a service company. For a merchandising company, it is the same process. Revenues and expenses accounts will be closed in income summary account. After that, income summary account balance will be closed in a permanent account. For a proprietorship company, we are using owner's capital account. Remember that for a corporation company, income summary account is closed into different permanent account, which we call it retained earnings. So what is different here for a merchandising company? The only difference, we have more temporary accounts to close, such as sales returns and allowances, sales discount, cost of goods sold, and fright out the charges. To understand the subject, let us have the following trial balance before closing. Our first account is cash with a balance of 17,840. Then we have inventory account with a balance of 910. Equipment with a balance of 6,000, accumulated depreciation with a balance of 1,500, owner's capital, with a balance of 20,000, owner's drawings with a balance of 500, sales revenue with the balance of 11,000 sales returns and allowances with a balance of 1,000, sales discount with a balance of 200. Cost of goods sold with a balance of 3,600. Salaries expense with a balance of 750, fright out with a balance of 150. Advertisement expense with the balance of 250, utilities expense with a balance of 100. And finally, depreciation expense with a balance of $1,200. We will start closing process with temporary accounts that have credit balances. In our case, we have only one temporary account, which is sales revenue, with a credit balance of $11,000. On Thursday, April 2020, we debit sales revenue and credit income summary account by $11,000. We can write an explanation to close temporary accounts with a credit balances. Let us see now our next system to close them brewery accounts with debit balances. In our case, we have multiple accounts. So we debit income summary account by the total value of 7,000 to $150. Then we credit the followings. Sales returns and allowances by $1,000, sales discount by $200. Cost of goods sold by $3,600. Salaries expense by 715, fright out the charges by 115. Advertisement expense by 215, utilities expense by 100, and finally, depreciation expense by $1,200. We can write an explanation to close temporary accounts with debit balances. Our next system to close income summary account to owners capital. To record this entry, we have to open income summary account first to calculate its balance. We notice here there is one credit transaction, $11,000, and another debit transaction of $7,250. The difference value will be 3,750. Credit balance. To close this balance, we debit income summary account by 3,750 and then credit owner's capital account by 3,750. We can write an explanation to close income summary account. Our last step to close owners drawing account to owners capital. To record this entry, we debit owner's capital account by $500 and then credit owner's drawings by $500. We can write an explanation to close owners drawing account. After posting these closing entries, all temporary accounts balances will become zero after closing. Owner's capital account balance will be carried forward to the next accounting period. Thanks for watching. 46. Multiple Step Income Statement: Merchandising companies widely used multiple step income statement to calculate and report different categories of income, such as net sales, gross profit, operating income, non-operating income, and finally, net income. To understand the subject, we will use our previous lessons example. The following trial balance shows all the data needed to prepare multiple step income statement. Let us start with our first group, which is net sales. It begins with presenting sales revenue with a balance of $11,000. Then we deduct contra revenue accounts as follow, sales returns and allowances with a balance of $1,000 and then sales discount with a balance of $200. It will result at the end, the value of net sales $9,800. This is our first part. Let us now move to the next group, which is gross profit. To calculate the gross profit, we deduct cost of goods sold from net sales. To implement this calculation, in our example, we will start with net sales with a balance of $9,800. Then we deduct cost of goods sold with a balance of $3,600 to reach at the end, gross profit with a valence of $6,200. So wie gross profit calculation is important because it represents the merchandising profit of a company. Yes, it is not the overall profit, but managers and other users watch closely the amount and the trend of gross profit. They even compare the rate of gross profit with the rate of competitors and industry averages. Such competition helps to evaluate the effectiveness of the company purchasing and selling functions and also pricing policies and procedures. Let us see now our next group, which is operating income. To calculate operating income, we deduct operating expenses from gross profit. So what do we mean by operating expenses? There are two categories under operating expenses. The first one is selling expenses, and the second one is general and administrative expenses. To understand this calculation, let us apply it in our example. We will start with gross profit with a balance of $6,200. Then we deduct operating expenses, which includes selling expenses with the following accounts. Write out the charges with a balance of $150 and advertisement expense with a balance of $250. Total selling expense is $400. After that, we deduct general and administrative expenses, which include the following. Accounts. Salaries expense with a balance of $750, utilities expense with a balance of $100, and depreciation expense with a balance of $1,200. Total general and administrative expenses is $2,050. At the end, we calculate operating income, which will result a value of $3,750. There is one additional point to add here. Sometimes there are accounts that relate to both groups of selling expenses and general and administrative expenses at the same time. E.g. salaries expense may include both sales and stuff and administrative salaries. Another example, depreciation expense may include both sales showroom, Office depreciations. In such cases, these amounts should be splitted between selling expenses and general and administrative expenses. We assumed in our trial balance that we have only operating income and expenses. But sometimes the company may incur non-operating activities which result different types of revenues, gains, expenses, and losses that are unrelated to the company main line of operations. We can add here additional two groups. The first one is other revenues and gains. The second one is called other expenses and losses, e.g. and there are other revenues and gains. There are interest revenue from notes receivable, and marketable securities. We have also dividend revenue from investment and common stocks. There is also gains from sales of property, plant and equipment, and there are other expenses and losses. We have interest expense from notes payable, and bank loans. There are also losses from sales of property, plant, and equipment. To apply in an operating activities in our income statement, let us consider the following accounts are added to our trial balance as follows. There are other revenues and gains. There are two accounts, interest revenue with a balance of $500 and dividend revenue with a balance of $1,000. The total value will be $1,500. The next group is other expenses and losses. There are two accounts which are interest expense with a balance of $750 and losses from disposal of assets with a balance of $1,000, total value will be $1,750. So why reporting operating income separately from non-operating activities is important? Because non-operating activities are considered non recurring. Therefore, when the company forecast future income, the most weight we'll be on current year operating income and less weight on non-operating activities. At the end, let us see the overall income statement and how net income is calculated. It starts with sales revenues with a balance of $11,000. Then we deduct sales returns and allowances with a balance of 1,000, sales discount with a balance of 200. Total deductions from contra revenue accounts are $1,200. The result will be net sales with a balance of $9,800. Next, we deduct cost of goods sold with a balance of $3,600, which result the gross profit with a valence of $6,200. After that, we deduct operating expenses, starting with selling expenses, which include fwrite out the charges with a balance of 115. Advertisement expense with a balance of 250. Total selling expenses is $400. Then we deduct general and administrative expenses, which include salaries expense with a balance of 715, utilities expense with a balance of 100, depreciation expense with a balance of 1,200. Total general and administrative expenses is $2,050. The result will be operating income with a balance of $3,750. After that, we add other revenues and gains, which include interest revenue with a balance of 500, dividend revenue with a balance of 1,000. Total other revenues and gains is $1,500. Then we deduct other expenses and losses, which include interest expense with a balance of 750, loss on sale of assets with a balance of 1,000. Total other expenses and losses is $1,750. The end result will be net income with a balance of $3,500. This is the end of our lesson. Thanks for watching. 47. Importance of Inventory Valuation: We learned in our previous section, the accounting process for inventory purchases and sales. We will discuss in this section the valuation methods for inventory. We will start by understanding the importance of inventory valuation. Inventory is accounted at cost, which include all expenditures needed to acquire goods and place them in a condition to be ready for sale. Such expenditures include the purchase price, freight and charges, important duties and handling costs that are directly related to the acquisition of inventory, which include the cost of laborers that associated with collecting and backing the orders. It may also include the cost of loading these packages into the truck to be ready for shipment. For a manufacturing company, it includes direct materials, direct labor, and manufacturing overhead, such as depreciation and insurance. Accounting for these costs affect both the balance sheet and income statement. The main goal to match these costs with sales revenue. We use matching principle to decide how much value of goods available for sale to be allocated to cost of goods sold, and how much value to be carried forward to the next accounting period as ending inventory. Why inventory valuation is that important? Because the process of identifying unit cost for each item sold and each item of ending inventory can be complicated. But why the company is usually purchase inventory items at different times with different prices. E.g. assume that the company purchased three identical TV's on different dates at the cost of $1,000, 1,200.51500. During the period the company sold two units at a price of $2,000. The question here, how much the cost of goods sold would be? Is it unit one and unit two with the total cost of 2,250 or unit one, and unit three with a total cost of 2,500. Or Unit two and Unit three with a total cost of 2,750. To illustrate this problem, let us calculate gross profit for each case. For the first case to consider unit 1.2 are sold, cost of goods sold would be 2250 and the gross profit would be 1750. Ending inventory will be unit three with a cost of 1,500. For second case, to consider, unit 1.3 are sold, cost of goods sold would be 2,500 and gross profit would be 1,500. Ending Inventory will be unit two with a cost of 1,250. Our last case to consider unit 2.3 are sold. Cost of goods sold would be 2,750 and the gross profit would be 1250. Ending inventory will be unit one with a cost of $1,000. We notice here how gross profit and inventory balances will change based on the value we allocated to cost of goods sold and disregard. We have four costing methods as follow. Specific identification, first-in-first-out, last-in, first-out and weighted average methods. We will discuss these methods in detail in this section. Thanks for watching. 48. Specific Identification: We learned in our previous lesson the importance of inventory valuation, especially when the company purchased identical inventory items at different times, at different prices. To determine how much inventory cost will be allocated to cost of goods sold, and how much value to be allocated to ending inventory. We have four costing methods which are splitted into two categories. The first group is actual cost of flow, which include specific identification. The second group is cost flow assumptions, which include first and first out, last-in-first-out and weighted average methods. We will discuss in this lesson, our first method, which is specific identification. It requires the companies to keep records and the trace original cost of each individual inventory item. It is possible only when the company sold low quantity with high cost value that can be identified clearly from the time of purchase through the time of sale, such as selling cards and expensive furniture. To understand the subject, let us take the following example. The company purchased three identical trucks at different dates, at different prices as follow. Buying and selling trucks is the main earning activity of the company. The first subtract cost $20,000, was purchased on second May 2020. The second track cost $22,000 was purchased on May 2020. The last attract cost, $24,000, was purchased on tenth May 2021, 15 May 2020, the company sold one of these trucks at selling price $30,000. The question is, how much the value of cost of goods sold and ending inventory? As part a specific identification method, the company was able to identify the units sold, which was the first truck with a cost of $20,000. In this case, ending inventory will be the second and third the truck with a total cost of $46,000. Let us now calculate gross profit. We will start with sales revenue with a value of $30,000. Then we deduct cost of goods sold with a value of $20,000. The result will be gross profit, $10,000. We notice how specific identification method appear to be ideal. It match actual cost against actual revenue in the income statement. The company also report ending inventory at actual cost. So the cost of flow match the physical flow of the goods. On the other hand, it is difficult to implement. Tracing actual cost of each unit of inventory can be impractical. This problem related to education costs, such as freight charges, storage cost, and discounts that are related directly to a given inventory item. This type of allocation will break the principle of actual flow of cost. Another issue. This method allows the company to manipulate net income. They can choose the cost to be allocated to cost of goods sold, e.g. if the company require higher net income, they may choose the unit which has lower cost. In contrast, if they require lower net income, they will choose the higher unit cost to be allocated to cost of goods sold. This is the end of our lesson. In the next lesson, we will discuss first-in, first-out method. Thanks for watching. 49. First in First out FIFO: We learned in our previous lesson the actual cost flow method, which we call it specific identification. We saw also how it is impractical to trace the actual cost of flow of each item of inventory from the time of Porsches through the time of sale. So we will study in this lesson one of the cost flow assumptions, which we call it first-in, first-out. This method assumes that the first goods purchased are the first to be sold. As a result, the remaining inventory represent the most recent purchases. One thing to clarify here, that cost of goods sold does not reflect the cost of actual units sold. Instead, the cost of earliest units purchased are the first to be recognized to calculate the value of cost of goods sold. In other words, first and first out method does not reflect the physical cost of flow of the goods. To understand the subject, let us take the following example. We will use both periodic and perpetual systems. We noticed in the following table, we have beginning inventory of 2000 units with a total cost of $4,000. Then we made two purchases. On June 5th, the company purchased 3,000 units with a total cost of $7,500. The last purchase transaction was done on June 25th, two by 5,000 units with a total cost of $15,000. On the other hand, the company sold 4,000 units on tenth June 2020, the price of $5 each. The question here, how much value to be allocated to cost of goods sold and ending inventory. Let us start our solution by using periodic system. Remember that periodic system calculates cost of goods sold at the end of the period. This calculation is done by using the following formula. Beginning inventory plus cost of purchases minus ending inventory, which result cost of goods sold. The first step to calculate cost of goods available for sale, which represent the sum of cost of beginning inventory and the cost of purchases. In our example, we have 10,000 units available for sale with a total cost of $26,500 then existed to calculate the cost of ending inventory. Remember that ending inventory represent the most recent purchases under first-in, first-out method. So how many units are remaining as ending inventory? Total number of units is 10,000. If we deduct the number of units sold, which is 4,000, we will get the quantity of 6,000 units, which represent ending inventory. After that, we have to calculate the cost of these 6,000 units. But how? We will take the most recent units as follow, 5,000 units at the cost of $3, which was purchased on 25th June 2020. Then we add 1,000 units from the units purchased on fifth June 2020 at the cost of $2.5. To calculate the cost of ending inventory, let us see the following table. $2,500 from 1,000 units or shades on fifth June, and $15,000 from 5,000 units purchased on 25th June. The total cost of ending inventory will be $17,500. The last disturb to use our formula again to calculate the cost of goods sold as follows. $26,500 is the cost of goods available for sale minus the cost of Ending Inventory, $17,500. The result will be $9,000. The second part of our solution to use perpetual system. Remember in this system, we calculate cost of goods sold after each sale transaction. To illustrate this process, let us see the following table. We start with beginning inventory with 2000 units, which was purchased at the price of $2. Inventory balance will be $4,000. After that, we have purchased 3,000 units on 5th of June and the cost of $2.5. Inventory balance after this transaction will be as follows. 2000 units at $2 with a total cost of $4,000.03 thousand units at $2.5, with a total cost of $7,500, total units available or 5,000, with a total cost of $11,500. On tenth June, the company sold 4,000 units. So we have to calculate this time cost of goods sold. But how we would recognize the cost of old items purchased as follow, 2000 units at $2 with a total cost of $4,000. And another 2000 units at $2.5 with a total cost of $5,000. The value of cost of goods sold will be $9,000. The remaining quantity of ending inventory will be 1,000 units at $2.5 with a total cost of $2,500. The last purchase was done on 25th June for 5,000 units dollars with a total cost of $15,000. The balance of ending inventory will be 1,000 units at $2.5 with a total cost of $2,500.05 thousand units at $3, with a total cost of $15,000. Total cost of ending inventory will be $17,500. To summarize our solution, notice how cost of goods sold and ending inventory values are the same at the end of the period. Whether we use periodic or perpetual systems. But why? Simply because the same cost will always be first n. Therefore, first-out. This is true whether we calculate cost of goods sold after each sale under perpetual system or at the end of the period as a residual value under periodic system. At the end, let us see the advantages and disadvantages of this method. One objective to approximate the physical flow of the goods. Because usually the companies practice to sell the oldest unit first, which means first-in, first-out is very close to specific identification method. Next, at prevent manipulation of net income, the company cannot pick a certain cost item to charge cost of goods sold. Another advantage ending inventory balance is close to current cost in the balance sheet. Because it represents the most recent purchases. This approach approximate replacement cost in the balance sheet when there are no major price changes. However, first-in-first-out method fails to match current cost against current revenues in the income statement, the company allocate the oldest cost against most current revenues, which possibly distort gross profit and net income. This is the end of our lesson. In the next lesson, we will study last-in, first-out method. Thanks for watching. 50. Last in First out LIFO: We discussed in our previous lesson one method of the cost flow assumptions, which we call it First-In, First-Out, we will learn in today, listen another method called last-in, first-out. It assumes that the latest goods purchased are the first to be recognized to calculate the value of cost of goods sold. As a result, ending inventory is based on the prices of all these units purchased. One point to add here, last-in, first-out method does not reflect the physical flow of the goods. It is one of the cost flow assumptions. To understand the subject, let us use our previous lesson example with the following data. On June 1st, we have beginning inventory of 2000 units with a total cost of $4,000. Then we made two purchases. And June 5th, the company purchased 3,000 units with a total cost of $7,500. The last purchase was done on June 25th to buy 5,000 units with a total cost of $15,000. On the other hand, the company sold 4,000 units on June 10th at a price of $5 each. Our question here, how much value to be allocated to cost of goods sold and ending inventory by using both inventory systems. We will start our solution with periodic system. Remember that under periodic system, we calculate cost of goods sold at the end of the period which is 30 June 2020. This calculation is done by using the following formula. Cost of beginning inventory plus the cost of purchases minus the cost of ending inventory, which result cost of goods sold. The first step to calculate the cost of goods available for sale, which represent the sum of beginning inventory and the cost of purchases. In our example, we have 10,000 units available for sale with a total cost of 26,500. The next step is to calculate the cost of ending inventory. Remember that ending inventory represent the oldest units purchased under last-in, first-out method. So how many units are remaining as ending inventory? Total number of units available is 10,000 units. If we deduct the number of units sold, which is 4,000, we will get the quantity of 6,000 units, which represent ending inventory. After that, we have to calculate the cost of these 6,000 units. But how? We will take the oldest units purchased as follow, 2000 units at a cost of $2, which represent beginning inventory. Then we add 3,000 units at the cost of $2.5, which was purchased on June 5th. Finally, we add 1,000 units at the cost of $3, which was purchased on June 25th. The total cost of ending inventory will be $14,500. The last step to use our formula again to calculate the cost of goods sold as follow. 26,500 is the cost of goods available for sale minus the cost of ending inventory, $14,500. The result will be $12,000. The second part of our solution to use perpetual system. Remember in this system, we calculate cost of goods sold after each sale transaction. To illustrate this process, let us see the following table. We start with beginning inventory of 2000 units, which was purchased at the price of $2. Inventory balance will be $4,000. After that, we have purchased 3,000 units on fifth June at the price of $2.5. Inventory balance after this transaction will be as follows. 2000 units at $2 with a total cost of $4,000.03 thousand units at $2.5 with a total cost of $7,500, total units available, or 5,000 units, with a total cost of $11,500. On tenth June, the company sold 4,000 units. So we have to calculate this time cost of goods sold. But how? We will recognize the cost of recent items purchased as follow. 3,000 units at $2.5 with a total cost of 7,500, and another 1,000 units at $2, with a total cost of $2,000. The value of cost of goods sold will be $9,500. On the other hand, the remaining quantity of ending inventory will be 1,000 units at $2, with a total cost of $2,000. The last purchase was done on 25th June for 5,000 units at $3 with a total cost of $15,000. The balance of ending inventory will be 1,000 units at $2. The total cost of $2,000.05 thousand units at $3 with a total cost of $15,000. The total cost of ending inventory will be $17,000. To summarize our solution, notice how cost of goods sold and ending inventory values are different under periodic and perpetual systems. Cost of goods sold was $12,000 under periodic system, while it was $9,500 under perpetual system. For ending inventory, we have the same issue. It was 14,500 under periodic system while it was $17,000 under perpetual system. But why these differences exist? Because in perpetual system, the company allocate the latest units purchased prior to each sale to cost of goods sold. And contrast and periodic system, the latest units purchased during the whole period are allocated to cost of goods sold. What do we mean by that? When a purchase is made after the last sale, the periodic system will apply this porches to previous cell, which is not the case for perpetual system. We noticed in our example how periodic system consider all purchases during the whole period to calculate cost of goods sold. While in perpetual system, we consider only the units available before the sale transaction. In our case, they were beginning inventory. The Porsche is done on fifth June. The last purchase on 25th of June was not considered to calculate the cost of goods sold under perpetual system. At the end, let us see the advantages and disadvantages of this method. One objective to match current cost against guarantee revenues to calculate gross profit in the income statement. However, ending inventory under last-in first-out method includes the cost of oldest items purchased, which does not represent current cost in the balance sheet. Finally, this method is not allowed under IFRS at the time of inflation, companies may use this method tool our net income and gain a temporary tax advantage by delaying payment of income tax. This is the end of our lesson. In the next lesson, we will learn the last method of cost flow assumptions, which we call it the weighted average method. Thanks for watching. 51. Weighted Average: We will learn in this lesson, the last method, of course, the flow assumptions, which we call it weighted average method. Under this method, the company calculate the average cost by dividing the cost of goods available for sale by the number of units on hand. After that, the average cost will be applied to units sold to calculate cost of goods sold, and the remaining units on hand to calculate ending inventory value. Before we apply weighted average method to our example, we have to note that calculation of average cost will be different for each inventory system. Under a periodic system, that is called the same weighted average method. The calculation of average cost is done at the end of the period. As a result, we will have one average cost for the whole period to calculate cost of goods sold and ending inventory. Under perpetual system, it is different. We call it this time moving average cost. But why? Because we calculate the average cost after each purchase transaction. So the latest moving average cost will be used to calculate each value of cost of goods sold and ending inventory. To understand the subject, let us apply this method to our previous example. On June 1st, we have beginning inventory of 2000 units with a total cost of $4,000. Then we made two purchases. On June 5th, the company purchased 3,000 units with a total cost of $7,500. The last purchase was done on June 25th to buy 5,000 units with a total cost of $15,000. On the other hand, the company sold 4,000 units on June 10th at the price of $5 each. So our question here, how much value to be allocated to cost of goods sold and ending inventory by using both inventory systems. We will start our solution with periodic system. Remember that under periodic system, we calculate cost of goods sold at the end of the period which is 30 June 2020. This calculation is done by using the following formula. The cost of beginning inventory plus the cost of purchases minus the cost of ending inventory, which result cost of goods sold. The first step to calculate cost of goods available for sale, which represent the sum of beginning inventory and the cost of purchases. In our example, we have 10,000 units available for sale with a total cost of $26,500. The next system to calculate the cost of ending inventory. Remember that ending inventory represent the weighted average cost of units available on hand. So how many units are remaining as ending inventory? Total number of units is 10,000. If we deduct the number of units sold, which is 4,000, we will get the quantity of 6,000 units, which represent ending inventory. After that, we have to calculate the cost of these 6,000 units. But how we will calculate the weighted average cost by dividing the total cost available for sale, 26,500 over the number of units available at the end of the period, which is 10,000 units. The result will be $2.65 average cost for each unit. This average will be multiplied by the number of units for ending inventory, which is 6,000 units. The result will be $15,900, which represent the cost of ending inventory. The last system to use our formula again to calculate the cost of goods sold as follows. $26,500 is the cost of goods available for sale, minus the cost of ending inventory, $15,900. The result will be $10,600. The second part of our solution to use perpetual system. Remember in this system, we calculate cost of goods sold after each sale transaction. Remember also the average cost will be different after each purchase transaction. To illustrate this process, let us use the following table. We start with beginning inventory of 2000 units, which was purchased at the price of $2. Inventory balance will be $4,000. After that, we have purchased 3,000 units on fifth June at the cost of $2.5. Inventory balance after this transaction will be as follows. 2000 units at $2 with a total cost of $4,000.03 thousand units at $2.5, with a total cost of $7,500. Total units available are 5,000 units with a total cost of $11,500. Before we move to the next transaction, we have to calculate the weighted average cost. Because this transaction is a purchase of a new inventory items, we will divide the total cost of $11,500 over 5,000 units available after this porches. The weighted average cost will be $2.3 each. After that, the company sold 4,000 units, contains June. So we have to calculate this time cost of goods sold. But how we will use the latest weighted average cost before this transaction, which will be $2.3. This average cost will be multiplied by the number of units sold, which is 4,000 units. And the result will be $9,200, which represent the cost of goods sold. Then we calculate the cost of ending inventory after this transaction by multiplying 1,000 remaining units by the average cost of $2.3, and the result will be $2,300. The last purchase was done on 25th June for 5,000 units at $3 with a total cost of $15,000. The balance of ending inventory will be 6,000 units with a total cost of $17,300. We have one more step to calculate a new weighted average cost, because this transaction represent a new purchase of inventory items. To do that, we divide the total cost of $17,300 over 6,000 units and the result will be $2.88 each. If we see the totals after this transaction, we notice how we start with 10,000 units available with a total cost of $26,500. And we have 4,000 units sold with a total cost of goods sold $9,200. Finally, ending inventory quantity will be 6,000 units, the total cost of $17,300. To summarize our solution, notice how cost of goods sold and ending inventory values are different under periodic and perpetual system. Cost of goods sold was $10,600 under periodic system, while it was 9,200 under perpetual system. For ending inventory, we have the same issue. It was $15,900 under periodic system while it was 17,300 under perpetual system. But why these differences exist? As we indicated in our previous lesson, and perpetual system, the company allocate the latest units purchased prior to each sale to cost of goods sold. And contrast, in periodic system, the latest units purchased during the whole period are allocated to cost of goods sold. That's mean when a purchase is made after the last sale, the periodic system will apply this porches to previous sale. We can see how weighted average cost is different for each system. Under periodic system, we include all purchases to calculate the weighted average cost, which is $2.65. Under perpetual system, we included only the cost of latest purchases before the sale transaction. They were the beginning inventory and the Porsche is done on fifth June. The weighted average was calculated based on $11,500 over 5,000 units available before the sale. The result is $2.3. At the end. Let us see the advantages of weighted average method. It is simple to apply, more practical and objective. It avoid the subject of net income manipulation and other methods. Finally, it is considered a better costing method over specific identification. Since the last is usually considered impossible to implement. This is true, especially when dealing with similar inventory items. For the disadvantages, there is no major one. Since average cost avoid major drawbacks and other methods. This is the end of our lesson. In the next lesson, we will summarize the effect of each method on income statement. Thanks for watching. 52. Income Statement Effects: After we learned cost flow assumptions, we will study in this lesson why companies may choose a particular cost flow method over another. Let us summarize our previous example and see the effect of each costing method on the income statement. We will use the figures from our solution of perpetual system. Before we start, I will show first and first out on the left, last-in-first-out on the right. And weighted average on the middle. First-in-first-out method will have the highest net income at the time of inflation or price increasing, which is the case we have in our example. Then last-in-first-out will have the lowest net income. Finally, weighted average cost will be in the middle. Again. This is only applicable at the time of price increasing, which we saw it in our purchases, when the price is increased from $2 each until it become $3 each. If the prices are decreasing, we will have the opposite scenario. We will start our income statement with sales revenue. Remember that the company sold 4,000 units at a price of $5. Each. Total revenues value will be $20,000. For all methods. After that, we will deduct cost of goods sold. It was $9,000 under first-in, first-out, 9,200 under weighted average, and 9,500 under last-in first-out. The result will be gross profit as follow. 11,000 under first-in, first-out, 10,800 under weighted average, and 10,500 under last-in, first-out. If we deduct operating expenses, $3,000 for all methods, we will get operating income as follow. 1,000 under first-in, first-out, 7,800 under weighted average, and 7,500 under last-in, first-out. At the end. If we deduct income tax by 30 per cent for all methods, we will get the final figure of net income has fallen 5,600 under first-in, first-out, 5,460 under weighted average, and 5,250 under last-in first-out. We notice how first-in first-out method produce a higher net income at the time of inflation or price increasing. But why? Because cost of goods sold represent the oldest units purchased, which have a lower cost. In contrast, last-in first-out method produce the lowest net income at the time of inflation. Because cost of goods sold represent the most recent purchases which have a higher cost. Weighted average cost falls in the middle. Let us now summarize the reasons behind the choosing one method over another. We will begin with first and first out method. The management referred to show a higher net income to make the company more favorable for external users. Another reason, management bonus will be based on net income. So they may prefer to increase net income by choosing first-in-first-out at the time of inflation. On the other hand, the company may choose last-in, first-out method at the time of inflation for the following reasons. When the management refers to reduce payment of income tax, they will get benefit of lower income generated by last-in first-out method. Another reason when the management referred to report current cost against guaranteed revenue in the income statement. So it will avoid showing unreal gross profit or an overstated net income in the income statement. At the end, there is one more important point. Whatever cost flow method a company chooses, it should use the same method consistently from one accounting period. Another. This approach is known as consistency concept, which means that a company uses the same accounting principle from one year to another. This will help the comparability of financial statements over successive time periods. That does not mean the company will never change its inventory costing method. They can do it, but they must disclose the change in the financial statements and its effect on net income. They have to mention also the reason behind the change. This is the end of our lesson. I will see you with the next one. Thanks for watching. 53. Lower of Cost or Market: Inventories are recorded at their cost. However, if the value of inventory declines, we have to follow a conservatism approach, which we call it lower of cost or market. Remember that conservatism means losses are recognized once anticipated. Gains are not allowed to be recorded until they are earned. In our case here, gains are recorded only once inventory is sold in the market. So let us learn the role of lower of cost or market regarding inventory cost, we have already covered for costing methods of inventory, which are specific identification, first-in, first-out, last-in-first-out weighted average methods. But what do we mean by market value? Market here is defined as current replacement cost. It is not the selling price of inventory. And instead, it is the cost of purchasing the same goods at the present time from usual suppliers and the usual quantities. To illustrate this rule, let us see the following example. We will take three types of inventory and start with TVs item. The cost of these items is $100,000, while the market value is $95,000. Our question here, which value to be reported in the balance sheet? The answer will be the lower of cost or market, which is $95,000. If we apply the same rule to second item, we notice in this case, the cost is lower and the value to be reported in the balance sheet will be $50,000. For the last item, market value is lower than the cost and the value to be reported in the balance sheet will be $20,000. After we understand the basic idea of lower of cost or market. Let us see next the methods of applying this rule. In our previous example, we assume the company applied LCM rule to each individual item. But sometimes it is not possible to determine the market price for each individual item. In this case, the company may apply LCM rule on each group of similar items or to the whole inventory to understand the subject, let us take the following example. We notice in our example the cost of item one is $13,000, while the market value is $14,000. If we apply LCM rule on individual items, we were recognized in the balance sheet the lower value, which is $13,000. Next is item two, with a cost of $19,000 at market value $17,000. If we apply the same rule to individual items, we were recognized in the balance sheet, the lower value, which is $17,000. Let us consider now item one and item two as one group of similar inventory. If we apply LCM to the group value, we noticed that total cost is $32,000 and total market value is $31,000. We will choose the lower amount to be reported in the balance sheet, which is $31,000. Let us see another group of items starting with item three. We choose here the lower value of $24,000, which is the cost amount of this item. Next is item for which was in this case that our value of $23,000, which is the market value of this item. If we apply LCM rule to the group value, we noticed that total cost is $49,000, while the total market value is $51,000. In this case, we will choose that our value of $49,000, which will be reported in the balance sheet. Our last method to apply LCM rule to the whole inventory. We notice in this case, the total cost value is $81,000, while the total market value is $82,000. We will choose in this case, the lower value of $81,000, which will be reported in the balance sheet. To summarize this subject, we notice how individual item method have the lowest value of inventory, which represent the most accurate method to apply LCM rule. For the other two methods, which are similar items or the whole inventory approach, the increase of market value for one item will offset the decrease of market value of the other item. Let us now move next and see how to record the reduction of inventory value using LCM rule. There are two methods to record income effect for inventory valuation at market and instead of original cost. The first one referred to cost of goods sold method. And the second one is called the loss method. Under the first method, we debit cost of goods sold account for the write-down of inventory to market value. Which is in our case the current replacement cost. Under the loss method, we debit another account called loss due to decline of inventory to market. But how these two methods will affect the presentation of income statement. We assumed in this example, the losses from write-down of inventory is $10,000. If we start with cost of goods sold method, we notice how income statement will report sales revenue for the amount of $100,000, then followed by cost of goods sold for the amount of $80,000. Notice that this amount includes the value of the loss for $10,000. The net result will be gross profit for the amount of $20,000. If we apply the same rule, but this time by using the loss method, the presentation of income statement will change. It starts with sales revenue for the amount of hundred thousand dollars and then followed by cost of goods sold for the amount of $70,000. Notice that the loss value of $10,000 was excluded from gross profit value. Under this method, the loss value will be reported separately below gross profit and above net income. The accounting standards prefer the use of loss method because it clearly disclose the loss value that result from inventory write-down to market. The end. Let us see how to record the adjusting entry to reduce the value of inventory. There are two methods, the direct method and the allowance method. The direct method will credit inventory account directly, while the allowance method will credit a content inventory account called allowance Reduce Inventory to market. E.g. using inventory account under the loss method, the entry will be as follows. Debit the loss expense account and credit inventory account by $10,000. The other case to use allowance account under the loss method, the entry will be as follows. Debit the loss expense account and credit the allowance account. But what about the presentation of inventory in the balance sheet using allowance account? It will be reported as follow. Inventory at cost will be reported first, then followed by allowance account. Remember that inventory allowance is a contra account which will be deducted from inventory value. The result will be inventory balance at market value. The accounting standards prefer the use of allowance account for better presentation in the balance sheet. One last point to discuss, what if market value changed in the subsequent period, e.g. if the market value and increased in the next year by $2,000. In this case, we can record gains from recovery of inventory loss and reduce the allowance account as follow. We will debit the allowance account and credit gains account by $2,000. The balance of allowance account will be reduced to become $1,000. The second scenario, what if market value decreased further by $2,000? In this case, we will increase both the loss account and the allowance account as follow. We will debit the loss account and credit the allowance account by $2,000. The balance of allowance account will increase to become $12,000. This is the end of our lesson. Thanks for watching. 54. Exercise Two Introduction: After we learned merchandising, operation and costing methods for inventory, we will solve in this section a complete exercise to understand the full cycle of inventory transactions. Let us now have a look at our example. The company had the following transactions during the month of July 20, 21st July, there was a beginning inventory of 200 units at a price of $10 each. Then on Thursday, July, the company purchased 600 units at the price of $14 each. After that, on 15th July, the company sold 500 units at a price of $18 each. Next, on 17 July, the customer returned 50 units at the same selling price of $18. Finally, when 25th July, the company returned 100 units from the items purchased on 3rd July at the price of $14. Note that all sales returns from customers, we are in good condition without any damage. We assumed all sales and purchases were done on credit basis. Let us now see the requirements. First, calculate the value of ending inventory and cost of goods sold using perpetual system for each of the following cost flow assumptions. First and first out, last-in-first-out, and moving average methods. Second, record journal entries for all inventory transactions during the month of July 2020. And they're moving average method in perpetual system. Our last requirement to prepare multiple step income statement for all custom methods and assume the following. Advertisement expense was $350, utilities expense was $150, and we have 30% income tax. This is the end of our lesson. See you the next one. Thanks for watching. 55. Exercise Two FIFO Method: We will start solving the first requirement in our exercise with first-in, first-out method. Remember that the company is using perpetual system that shows the following transactions during the month of July 2020. We will use the same stock card that we used in previous lessons. But this time I will show columns, titles as in, out and balance. So let us start our first transaction, which was the beginning inventory on first July 2020. There was 200 units per shares at a price of $10 each, with a total cost of $2,000. Then on Thursday, July, the company purchased 600 units at the price of $14 each with a cost of $8,400. The balance of inventory after this transaction will be as follows. 200 units with a cost of $2,000 and another 600 units with a cost of $8,400. Total inventory balance will be $10,400. After that, on 15th July, the company sold 500 units at selling price of $18 each. But what about the cost of these 500 units? Under first and first out method, we would recognize the cost of aliased items purchased. As a result, we will consider the first 200 units at a price of $10 each with a cost of $2,000.03 hundred units at a price of $14 each with a cost of $4,200. The total value of cost of goods sold will be $6,200. In contrast, the balance of inventory will be 300 units at a price of $14, each, with a total cost of $4,200. Next, on 17 July, the customer returned 50 units at selling price of $18 each. In case of sales returns, the inventory balance will increase. And as a result, we will record it under the first column. But the main question here, how much cost to be considered for these 50 units? Under first-in, first-out method, we have to keep the cost of eldest units as cost of goods sold, which is in our case the 200 units. So we will consider the sales return as part of the recent unit sold, which is in our case, from the 300 units at the cost of $14 each. The total cost will be $700. For inventory balance, it will be after this transaction, 350 units at the price of $14, each with a total cost of $4,900. The last transaction was on 25th July. The company returned 100 units from the purchase is done with their July. Normally, the purchase returns will be shown on the vendor credit note. No need to worry about which cost to be considered for these items in our calculation. As a result, the cost of these 100 units will be $14 each. The total cost will be $1,400. For inventory balance, it will be after this transaction, 250 units at the price of $14, each with a total cost of $3,500. At the end, let us calculate cost of goods sold. It will be as follows, $6,200 from 500 units sold on 15th July, then negative 50 units which were returned from customer on 17th July with a total cost of $700. The balance of cost of goods sold will be the net value of $5,500. This calculation will be much easier to understand once we record journal entries for these transactions later on this section. This is the end of our lesson. In the next lesson, we will solve the same requirement using last-in, first-out method. Thanks for watching. 56. Exercise Two LIFO Method: After we solved our exercise with first-in-first-out method under perpetual system. We will use in this lesson the second method called last-in, first-out. So let us have a look again to our example and start the first transaction, which was the beginning inventory, unfair to July 2020, there was 200 units purchased at the price of $10, each with a cost of $2,000. Then on 3rd July, the company purchased 600 units at the price of $14 each with a cost of $8,400. The balance of inventory after this transaction will be as follows. 200 units with a cost of $2,000 and another 600 units with a cost of $8,400. Total inventory balance will be $10,400. After that, on 15th July, the company sold 500 units at selling price of $18 each. But what about the cost of these 500 units? Under last-in, first-out method, we will recognize the cost of recent purchases. As a result, we will consider the cost of $14 each, which was related to the purchase is done on their July. So the total value of cost of goods sold will be $7,000. In contrast, the balance of inventory will be as follows. 200 units at a price of $10 each with a cost of $2,000, and another 100 units at a price of $14 each with a cost of $1,400. Total value of ending inventory will be $3,400. Next, one, 17th July, the customer returns 50 units at a selling price of $18 each. In case of sales returns, the inventory balance will increase. And as a result, we will record it under the first column. But the question here, how much cost to be considered for these 50 units? Under last-in, first-out method, we have to keep the cost of recent units as cost of goods sold and take the oldest units as inventory. In our case here, we have only one group of items at the price of $14 each. So the total cost will be $700. This is totally the opposite scenario of first-in-first-out method. Again, under first-in first-out, we will consider sales returns as part of recent purchases. While under last-in, first-out, we will consider sales returns as part of the oldest units purchased. For inventory balance. It will be after this transaction as follows. 200 units at a price of $10 each with a cost of $2,000, and another 150 units at a price of $14 each with a cost of $2,100. Total value of ending inventory will be $4,100. The last transaction was on 25th July. The company returned 100 units from the purchase is done on 3rd July. As we mentioned in our previous lesson, normally the purchase returns will be shown on the vendor credit note. No need to worry about which cost to be considered for these items in our calculation. As a result, the cost of these 100 units will be $14 each. The total cost will be $1,400. For inventory balance, it will be after this transaction, 200 units at a price of $10 each with a cost of $2,000. And another 50 units at the price of $14 each with a cost of $700. Total value of ending inventory will be $2,700. At the end. Let us calculate cost of goods sold. It will be as follows, $7,000 from 500 units sold on 15th July, and then negative 50 units which were returned from customer on 17th July with a total cost of $700. The balance of cost of goods sold will be the net value of $6,300. Again, this calculation will be much easier to understand once we record journal entries for these transactions later in this section. This is the end of our lesson. In the next lesson, we will solve the same requirement using moving average method. Thanks for watching. 57. Exercise Two Moving Average Method: After we solved our exercise with both methods, first and first out and last-in-first-out. We will use in this lesson, moving average method under perpetual system. So let us have a look again to our example and the start, the first transaction, which was the beginning inventory on first July 2020, there was 200 units purchased at the price of $10 each with a cost of $2,000. Then on 3rd July, the company purchased 600 units at a price of $14 each with a cost of $8,400. If we add both transactions, the beginning inventory and purchases on 3rd July, we will get the total units available, 800 units with a total cost of $10,400. Before we move to the next transaction, we have to calculate the weighted average cost. Because this transaction is a purchase of new inventory items. We will divide the total cost of $10,400 over 800 units available. The weighted average cost will be $13 each. After that, on 15 July, the company sold 500 units at selling price of $18 each. But what about the cost of these 500 units? And they're moving average method, we will recognize the latest average rate, which is in our case here, $13 each. As a result, the cost of these units will be $6,500. In contrast, the balance of inventory will be 300 units. But at which rate? Again, we will use the latest average rate, which is $13 each. And the cost of ending inventory will be $3,900. Next, on 17 July, the customer returns 50 units as selling price of $18 each. In case of sales returns, the inventory balance will increase. And as a result, we will record it under the first column. But the question here, how much cost to be considered for these 50 units? And they're moving average method sales returns will take the latest average cost. In our case here, it had not changed at $13 each. As a result, the cost of these items will be $650. In contrast, the balance of inventory will be 350 units. Again, we will use the latest average rate, which is $13 each, and the cost of ending inventory will be $4,550. The last transaction was on 25th of July. The company returned 100 units from the purchase is done on 3rd July. As we mentioned in our previous lesson, normally the purchase returns will be shown on the vendor credit note. So I don't need to worry about which cost to be considered for these items in our calculation. As a result, the cost of these 100 units will be $14 each. The total cost will be $1,400. If we calculate both values, the previous inventory balance and the purchase return on 25th July, we will get total units available, 250 units with a total cost of $3,150. Before we move to the next transaction, we have to calculate the weighted average cost. Because this transaction affects the cost of purchases value, we will divide the total cost of $3,150 over 250 units available. The weighted average cost will be $12.6 each. To summarize this subject, at the time of sales returns, we will consider the latest average cost in our calculation. No need to calculate a new rate. For purchases returns. We will consider the price determined in the supplier credit note. And as a result, we have to calculate a new average rate. At the end, let us calculate cost of goods sold. It will be as follows, $6,500 from 500 units sold on 15 July, and then negative 50 units which were returned from customer on 17th July with a total cost of $650. The balance of cost of goods sold will be the net value of $5,850. This is the end of our lesson. In the next lesson, we will record journal entries for all inventory transactions. Thanks for watching. 58. Exercise Two Journal Entries: The next step in our solution to record journal entries for all inventory transactions using moving average method under perpetual system. Let us start with our first transaction. On 3rd July 2020. The company purchased 600 units at a price of $14 each, with a total cost of $8,400. The purchase was done with credit terms, net 30 days. In this case, there are two accounts get affected. Inventory account will increase by $8,400 and accounts payable will increase by the same value of $8,400. To record this transaction, we debit inventory account by $1,400. Since it is an asset account which increase in the debit side, then we credit accounts payable by $1,400. Since it is a liability account which increase in the credit side, we can write an explanation, inventory purchase on account. If we open inventory ledger, we noticed the beginning inventory value was $2,000, then it was debited by the purchase value of $8,400. After this transaction, the balance of inventory account will be $10,400. Our next transaction was on 15th, July 2020. The company sold 500 units at a price of $18 each with total selling price $9,000. The sale was done with credit terms, net 30 days, moving average cost of these items was $13 each. In this case, we have two entries. We will start with the sale entry, which has two accounts get affected. Accounts receivable will increase by $9,000. And we have sales revenue which will increase by the same value of $9,000. To record this transaction, we debit accounts receivable by $9,000. Since it is an asset account which increase in the debit side, then we credit sales revenue account by $9,000. Since the revenue accounts increase equity, which increase in the credit side, we can write an explanation, inventory sale on credit. Let us now record the second entry of this transaction, but this time by the cost. In this case, we have two accounts get affected. Cost of goods sold will increase by the cost of inventory sold, which is $6,500. And inventory account will decrease by the same value of $6,500. To record this entry, we debit cost of goods sold account by $6,500. Since it is an expense account which decrease equity. And as a result, it increases in the debit side. Then we credit inventory account by $6,500. Since it is an asset account which decrease in the credit side. We can write an explanation, cost of inventory sold on credit. If we open inventory ledger, we will notice how inventory account was accredited by $6,500 and the ending balance after this transaction will become $3,900. If we open cost of goods sold account, we will notice how it was debited by $6,500 and the ending balance after this transaction will become $6,500. Let us move to the next transaction, which is sales return. On 17th July 2020, the customer returned 50 units from the units sold on 15th, July at the price of $18 each. The returns units were in good condition. As a result, we will record it with the cost value. Remember in our previous lesson, we considered the latest moving average cost, which was $13 each. In this case, we have two entries. We will start with sales return and tree, which has two accounts get affected. Sales returns and allowances account will increase by $900 and accounts receivable will decrease by the same value of $900. To record this transaction, we debit sales returns and allowances by $900. But why debit? Because this account is considered a contra account. So it will offset sales revenue account and the income statement. After that, we credit accounts receivable by $900. Since it is an asset account which decrease in the credit side, we can write an explanation, credit granted for goods returned. Let us now record the second entry of this transaction, but this time by cost. In this case, we have two accounts get affected. Inventory account will increase by the cost value of $650 and cost of goods sold account will decrease by the same value of $650. To record this entry, we debit inventory account by $650 and then credit cost of goods sold account by $650. We can write an explanation to record cost of goods returned. If we open inventory ledger, we will notice how inventory account was debited by $650 and the ending balance after this transaction will become $4,550. If we open cost of goods sold account, we will notice how it was credited by $650 and the ending balance after this transaction will become $5,850. Let us move now to our last transaction, which was a purchase return on 25th of July 2020, the company returned 100 units from the units purchased on 3rd July at the price of $14 each. This case is symbol because the unit cost will be shown on the supplier credit note, which is in our case $14. We notice in our transaction there are two accounts get affected. Inventory account will decrease by $1,400 and accounts payable will decrease by the same value of $1,400. To record this transaction, we debit accounts payable by $1,400. Since it is a liability account which decrease in the debit side. Then we credit inventory account by $1,400. Since it is an asset account which decrease in the credit side. We can write an explanation, return of goods purchased on credit. If we open inventory ledger, we will notice how inventory account was accredited by $1,400 and the ending balance after this transaction will become $3,150. This is the end of our lesson. In the next lesson, we will prepare multiple step income statement. Thanks for watching. 59. Exercise Two Multiple Step Income Statement: The last step in our solution to prepare multiple step income statement for the month of July 2020 using our three inventory costing methods. First-in-first-out, last-in-first-out, and moving average methods. Let us begin with first and first out method, our income statement. We'll start with sales revenue. Remember that the company sold 500 units at a price of $18 each. Total revenues value will be $9,000. Then we deduct sales returns and allowances, which represent a contra revenue account. It was 50 units returned at selling price $18. Each. Total value of sales returns will be $900. As a result, net sales value will be $8,100. We will notice later on or solution, net sales are the same for all methods. After that, we deduct cost of goods sold was $5,500 under first-in first-out method, the result will be gross profit for the value of $2,600. If we deduct operating expenses, which were 350 for advertisement expense and 150 for utilities expense. We will get operating income for the value of $2,100. Then we apply income tax 30%. Assuming the company is subject for income tax, the ending result will be net income for the value of $1,470. The next step to use moving average method, our income statement, we'll start with the same values for net sales. It was $9,000 as sales revenue and $900 for sales returns and allowances, then it result will be $8,100 for net sales. After that, we deduct cost of goods sold. It was $5,850. Under moving average method. The result will be gross profit for the value of 2000 to $150. If we deduct operating expenses, which were the same, 354 advertisement expense and 150 for utilities expense. We will get operating income for the value of $1,750. Then we apply income tax 30 per cent. The ending result will be net income for the value of $1,225. The last system to use last-in, first-out method, our income statement, we'll start with the same values for net sales. Again, it was $9,000 as sales revenue and $900 for sales returns and allowances. The net result will be $8,100 for net sales. After that, we deduct cost of goods sold. It was $6,300 under last-in first-out method, the result will be gross profit for the value of $1,800. If we deduct operating expenses, which were the same, 350 advertisement expense and 150 for utilities expense. We will get operating income for the value of $1,300. Then we apply income tax 30 per cent. The ending result will be net income for the value of $910. At the end. We notice how first-in first-out method produce a higher net income at the time of inflation or price increasing. In contrast, last-in first-out method produce the lowest net income. Moving average cost falls in the middle. This is the end of our exercise. Thanks for watching. 60. What is Cash?: We will start our section by understanding cash and how it is reported in the financial statements. Cash is the most liquid asset in the company. It is the standard medium of exchange and the basis for measuring and accounting for all other items. Caches reported in two statements, and the balance sheet at specific point of time under current assets with a classification name, cash and cash equivalent. It is also reported in the statement of cash flows, which shows cash receipts and cash payments from operating, investing, and financing activities for a specific period of time. The main question here, what do we mean by cash and cash equivalent? There are two parts and this classification, the first part is cash and the second part is cash equivalent. Let us start with the first part, which is cash, and we will keep cash equivalent for the next lesson. Under cash category, we have cash on hand that includes coins and currency, which is the paper money. Then we have a checks, but not both dated checks, which are considered a part of receivables, not part of cash. Then we have bank draft, which is a guaranteed check issued by the bank based on its customer request that require to deduct the same amount from the bank account to cover the check value. Bank overdraft is considered a more secured option of payment since it is guaranteed by the issuing bank. After that, we have money order, which is a paper document similar to Czech, used as a form of payment. It can be purchased from Postal officers or any other financial institution such as Western Union. The face value of money order and the issuing fees must be paid in advance by cash. Or you have to do to fill the required information, such as payee name, and address. In general, many order is considered a safe form of payment. Since the issuer will demand the payment and advanced by cash, it has less risk and conversion to personal checks. Why? Because the check could be bounced in case of non-sufficient fund, then we have petty cash fund. This type of fund is assigned to specific custodian who is authorized to pay small amounts of expenses, such as postage, food, or taxi charges. Writing checks for such small amounts is considered impractical. We will talk about petty cash fund in details later in this section. Our last item and their cash category is cash and banks, which include demand deposits such as checking accounts and savings accounts. The cash values and these accounts can be withdrawn at anytime without prior notice or penalty. These are the main types of cash to be reported in the balance sheet under the classification cash and cash equivalent. The next lesson, we will study the second part, which is cash equivalent. Thanks for watching. 61. Cash Equivalent: After we learned the first part of cash and cash equivalent, we will study the second part of this classification, which we call it cash equivalent. They are short-term, highly liquid investments that are both readily convertible to known amount of cash. And so near their maturity that they present insignificant risk of a changes in value because of changes in interest rate. These are the main roles to consider short-term investment as cash equivalent. But there are two questions to ask. The first one, what do you mean by highly liquid investments? It means there is an active market for these investments which allowed to sell and convert them into cash easily. The second question here, what do we mean by so near their maturity? Normally investments with maturity period of three months or less at the time of acquisition are considered cash equivalent. To understand the subject better, see the following. We have three scenarios. The first one, when the maturity period is less than three months, these investments will be considered cash equivalent. The second scenario, when the maturity period is more than three month and less than one year. In this case, These investments are considered short-term investments and they will be reported under current assets. The last scenario when the maturity period is more than one year. In this case, these investments are considered long-term investments and they will be reported under non-current assets. To have better idea about the subject, let us take the following two examples. The company purchased a treasury bill with maturity date after 12 months. At the time of preparing the financial statements. The remaining maturity period was two months. Our question here, can we report this treasury bill under cash and cash equivalent? The answer is no. But why? Because the classification of cash equivalent is based on maturity period at the time of acquisition, not at the time of preparing financial statements. In our case, it was a twelv month maturity at the time of purchase. Let us move now to the second example. The company purchased a twelv month treasury bill before three months of maturity date. Our question here, can we report this treasury bill under cash and cash equivalent? The answer is yes. Because even though it is the 12th month treasury bill, but it was purchased three months before maturity. Again, our basis is maturity period at the time of acquisition, net at the time of issuance, at the end. Let us have a look at the most famous examples of cash equivalent. The first one is US treasury bill. Normally called T-bill. It is a short-term debt obligation issued and backed by US Treasury Department with a maturity of one year or less. It is considered a safe investment since it is secured by the US government. In general, T-bills are purchased at a discount from the face value. E.g. a. Treasury bill with face value of $1,000 can be purchased for $900. The difference of $100 is considered interest earned, which will be collected at the date of maturity. Our second example is commercial papers, which are unsecured short-term debt obligation that are issued by large corporations. Normally they are issued to finance accounts payable, payroll, inventories, and other short-term liabilities. It is considered an unsecured investment because it is not backed by the government. Instead, the issuer promises to repay the face value at maturity date. Finally, commercial papers are issued at a discount from face value, which is similar to treasury bills. This is the end of our lesson. In the next lesson, we will study how to report restricted cash in the financial statements. Thanks for watching. 62. Restricted Cash: After we learned cash and cash equivalents, we will discuss additional subject which called restricted cash. We can define it as cash amount, which is not available for general use and the business. Instead, it is restricted for special purpose. To understand the subject, let us take the following examples. The first one is cash amounts that are maintained as collateral to insurance companies to cover a portion of risk ensured. Normally this cash amount is held at a separate escrow account. But what do we mean by escrow account? It is a bank account that held money by a third party on behalf of two other parties. The payment will be released from escrow account once the contractual requirements have been completed between both parties. Our second example, when the bank requires the company to maintain a specific or a minimum amount of cash in a checking or savings account as collateral against loans or line of credit facilities. Normally it is called compensating balances, which are not available for day-to-day operations. These compensating balances will be established based on borrowing agreement between the bank and the company. Let us see now how to report restricted cash in the balance sheet. Companies report such amounts in a separate line item since it is not considered a part of cash and cash equivalent and disregard, it can be classified as current or non-current assets based on availability of cash or date of payment. In other words, how long this cash amount will be restricted? If it will be used to settle current obligation, it will be reported as current assets, which is normally within one year or operating cycle, whichever is longer. If the cash will be restricted for longer period, it will be classified as non-current assets. There is one more requirement to report the purpose of cash restriction in the notes of financial statements. This is the end of our lesson. In the next lesson, we will study overdraft accounts. Thanks for watching. 63. Bank Overdrafts: We will study in today, listen, one additional subject related to bank overdraft. There are cases where the bank account become negative balance when the company, right, it checks for more than the amount available in its bank account. The bank allows such a practice based on agreed credit line facilities signed with the company. The bank will charge certain percentage on the value that the company overdrawn. The main question here, how to report bank overdraft in the balance sheet? As far as gab, this amount is considered a short-term loan and it will be reported under current liabilities. It is not a component of cash and cash equivalent. In contrast, the International Accounting Standards allows to report bank overdraft as a component of cash and cash equivalent if certain conditions are met. These circumstances when such overdrafts are repayable on demand. The second condition, when they are an integral part of the company cash management practice. E.g. when the bank balance often fluctuate from positive to negative balance. This is the end of our lesson. In the next lesson, we will study petty cash fund. Thanks for watching. 64. Petty Cash Fund: For a better internal control, it is recommended to make payments by checks. However, using checks to pay small amounts is considered impractical. E.g. the payment for postage expenses, food, freighted charges, and low cost supplies. A better way of handling such payments to use petty cash fund. The operation of petty cash fund, usually called impressed system, which involve a three main stages. The first one to establish the fund, the second step to make payments from the petty cash. While the last stub to reimburse the fund. We will talk about these three stages in detail. Let us start with establishing petty cash fund. This system involves two important points. The first one is appointing a petty cash custodian who will be responsible for the fund. The second point, to determine the size of the fund. Normally companies estimating the value of petty cash to cover a period of time, such as one week up to one month. E.g. the company decided to establish a petty cash fund on fair September 2020 and issued a check payable to the custodian for the amount of $100. We noticed in this transaction, debit the cash account increased by $100 and cash account decreased by the same value of $100. To record this transaction, we debit petty cash account by $100 and the credit cash account by $100. We can write an explanation to establish a petty cash fund. One point to add here. Most petty cash funds are established on a fixed amount basis. The company will make no additional entries to petty cash account until the management decided to increase or decrease the original value of established one. Let us move now to the second step, which is making payments from petty cash fund. The petty cash custodian has authority to make payments in compliance with the company policies. Usually the management will limit the size and value of expenditures that are allowed to be paid from petty cash. They may not permit to use petty cash for certain types of transactions, such as short-term loans to employees. Each payment from petty cash must be documented on every number, voucher, or receipt, as shown on the following example. The signatures of both the fund custodian and the person who received the payment are required on the receipt. The custodian will keep all receipts in petty cash box or a driver until the fund is reimbursed. In this regard, the management should make a surprise count from time to time to make sure the font is being maintained properly. As we explained earlier, the company will not make an accounting entry to record the payment from petty cash. Instead, the company recognized the accounting effect for such payments at the date of reimbursement. Let us move now to the last system which is reimbursement cash fund. When petty cash amount reach the minimum level, the custodian of petty cash will initiate a request for reimbursement by preparing a summary of all payments that are made during the period. This summary will be supported by petty cash receipts and other documents such as bills or invoices. The Treasury Accountant in the main office will verify these documents and once approved, you will stamp all receipts and other documents as paid. Then he will prepare a check to reimburse the fund. To understand the subject, let us see the following example. On Thursday, September 2020, the petty cash custodian request for reimbursement of $90. The following summary. It shows $40 related to miscellaneous expenses and another $50 related to freight out the charges. The total of petty cash payments to be reimbursed is $90. To record the reimbursement entry, we debit the following accounts, miscellaneous expenses by $40 and freight out the charges by $50. Then we credit cash account by the total value of $90. We can write an explanation to re-impose petty cash fund. Notice in our example, the petty cash account does not get affected. Instead, we credit cash account directly. There is one more point. What if the custodian has shortage of $1 in his Cashbox? This could happen when the custodian fails to get a receipt for payment. In this case, we have to debit a special expense account called cash over and short are updated entry will be as follows. Debit miscellaneous expenses by $40 and the freight outer charges by $50. Then we debit cash over and shortage by $1. After that, we credit cash account by $91. In case we have the opposite scenario where the custodian has overreached value of $1. Cash over and short account will be credited. Normally, this account is reported in the income statement as other expenses if it has a debit balance, in case this account has a credit balance at the end of the period, it will be reported as other revenues. At the end, companies should reimburse a petty cash fund at the end of each accounting period, regardless of the remaining value of petty cash. This is important to recognize the effect of petty cash payments on the financial statements. If the company did not reimburse petty cash fund at the end of the period. The financial statements will show overstated cash asset and understated expenses. On the other hand, some companies do not follow this practice when that amount is considered immaterial to the users of financial statements. This is the end of our lesson. Thanks for watching. 65. Using Bank Account: They use a bank account, help companies to have a good internal controls over cash. Bank safeguard cash and used as a clearinghouse for cheques received and issued. Using bank account will minimize the amount of currency that a company must keep on hand. It will help also to reconcile all cash transactions because some entries are maintained in the bank records. Companies usually have more than one bank account to serve different needs and to handle special transactions such as payroll. We will study in this lesson three main bank services used by companies which are making bank deposits, writing checks, and using electronic funds transfer system. We will start with making bank deposits. Normally companies authorizes specific employees to make bank deposits. Each deposit is supported by deposit slip or ticket. The following example shows a deposit slip dated 25th September 2024, the value of $1,000. This deposit slip includes coins, currency, and the cheque details. These tickets are prepared and duplicate. The bank will keep the original and the company will maintain the duplicate copy. If the company wants to deposit multiple checks, we can use the backside of the slip and write all checks details. Let us move now to the second transaction which is writing checks. Checks are written orders signed by the company requesting the bank to pay a specific amount to a specific beneficiary. As shown on the following example. There are three parties indicated on the check. The maker or a driver who issued the check, the bank name, who will pay the money, and the payee to whom the check is variable. It is important to know the balance in the bank account before preparing the check to avoid any chance of bouncing due to non-sufficient fund. This practice is very important since bouncing a check is considered illegal in some countries. Let us see now another type of bank transaction called electronic funds transfer, EFT. It is an electronic system that a transfer money from one party to another without using paper documents. This type of transfer currently done using internet and telephone communications. Companies usually establish a workflow for authorized employees. One employee to initiate the transaction. Second, to verify and another employee to approve. This will help to maintain the internal control of cash. One example of electronic funds transfer is payroll for employees. Before each employee received his monthly salary by a written check. With EFT system, a payroll file will be uploaded online by the company, which include all employees name, bank, account, ID number, and salary amount. In this case, all employees will get their salary through bank transfer at the same time. These are three main services provided by the bank. But the question here, how to verify bank records? Usually companies receive monthly bank statement that shows all deposits, payments, and balances during a period. The following example shows a typical bank statement for the month of September 2020. It includes the following information. Beginning balance of the period, checks and other debits, decreasing the account deposits and other credits, increasing the account account balance after each transaction, and also at the end of the period. In our example, the opening balance as $1,500 as of September 2020. After that, on fifth September, we have a check payment for the value of $350 and the balance after this transaction will be $1,150. Then there is another check payment for $135 and the balance after this transaction will be $1,015. Next, there is a debit memo issued by the bank against check printing fees for the amount of $15. The balance after this transaction will be $1,000. After that, there is a cash deposit of $1,000 and the balance after this transaction will be $2,000. The last transaction as a credit memo issued by the bank against interest earned for the value of $25. The ending balance for this statement will be $2,025. Our question here, why check payments and bank fees were debited and the statement while cash deposit and interest earned were credited. Because this is statement represent the bank records, not the company records. And disregard the company fund is considered a liability on the bank. E.g. check number 465 for the value of $350 is accredited and the company records while it is debited and the bank records. Another example, the cash deposit of $1,000 will be debited in the company records. Since it is an asset for the company while it is accredited as liability in the bank records. To make it simple, the bank maintains the opposite records of the company books. If the company has a debit bank balance in its records, it will reflect a credit balance in the bank records. This is the end of our lesson. In the next lesson, we will discuss bank reconciliation. Thanks for watching. 66. Bank Reconciliation: After we learn the benefits of using bank account and then we got to know that both the company and the bank maintains separate records of the same checking account. It is important to make sure the balance per books agree with the balance per bank. In fact, these two balances rarely match at any given time. But why? There are two main reasons. The first one is time lags that to prevent one party from recording the transaction in the same period as the second party, e.g. the date when the company handover or male that check to the payee. The amount could be paid by the bank after several days. Another example, when the company uses the bank deposited Dropbox at night, there will be a difference of at least one day between the time the company record this deposit and the time when the bank record the same transaction. Our second reason of such differences could be errors created by either party and recording cash transactions. Let us see now how to prepare a bank reconciliation. The main point of this process, to reconcile the balance beer and the balance per bank to their adjusted cash balance, which is considered the correct or true balance. As per following our illustration, there are two parts in our reconciliation. The first part to adjust the balance as per the bank records, while the second part to adjust the balance as per the books. Let us start with the first part. It begins with the balance per bank statement, then followed by cache transactions which are not recorded by the bank, such as deposits and transit. These deposits are recorded by the company, but not yet reflected in the bank statement. As we explained, it is the U2 time lag issue. E.g. companies can make cheque deposit at the end of a business day after the bank is closed using bank deposited Dropbox. This transaction will not appear on the bank statement until the next business day. Such amount should be added to the bank balance to reflect the correct cash balance. The second adjustment to deduct outstanding checks. These are checks are retained by the company and sent to the PE, but not yet paid by the bank. This is also due to time lag issue. Such amount should be deducted to reflect the correct cash balance. The next adjustment is bank errors. It can be plus or minus, depending on the mistake itself. At the end, we will get the adjusted bank balance, which reflect the correct amount of cash. The second part of our reconciliation, to adjust the balance per books. In this part, we have to add or deduct cash transactions which are not recorded by the company, such as conviction by the bank for note receivable or electronic funds transfer or any other deposit not yet reflected in the company records. Such amount should be added. Another adjustment could be non-sufficient funds checks. When the company deposit a customer check, the bank initially credit the company account for the amount of the check. Later on. When the bank find there is not in a fund to cover the check value, it will reverse the entry, debit the company account for the same value plus any service fees. This could happen when the check is drawn from a different bank where the company deposit the check. Such amount should be deducted in our reconciliation to reflect the correct cash balance. The next adjustment would be for bank debit memo against interest paid or service charges such as check printing fees. Such amount should be deducted in our conciliation. The last type of adjustment could be for company errors, e.g. when the company created a mistake by recording, I checked value by $650, while it is correctly paid by the bank with a value of $560. Such errors should be adjusted in the bank reconciliation to reflect the correct cash balance. At the end, we will get the adjusted balance, beer books, which match exactly the same bank balance after adjustment. If these two figures do not match, that means something wrong in our reconciliation. This is the end of our lesson. Thanks for watching. 67. Exercise Three Introduction: We learned in our previous section, cash and cash equivalent and its components. We will solve in this section and exercise related to an important subject, which is bank reconciliation. Let us have a look at our exercise on Thursday, September 2020. The following bank statement was it presented to the accountant, which reflect cash payments and receipts as per bank records. At the beginning, there is a previous balance of $5,000 from last month, then followed by the payment by cheque number 510 for the value of $650. After that, we have another payment by cheque number 511 for the value of $850. Next, we have a cash deposit of $500. After that, there is a surface charge for check printing fees for $25. Then the bank debit the account for non-sufficient funds, check for the value of $1,000. After that, the bank credit that account for electronic funds transfer for the value of $225. In contrast, the following records show us cash receipts and payments from the company leisure as follow. The payment by cheque number 510 for the value of $650, then followed by another payment by cheque number 511. For the value of $580. After that, the company record a cash deposit of $500. Next abatement by cheque number 512 for the value of $700. Finally, the company deposit a customer check for the value of $430. The following information we're provided as follow. On seven September, check number 511 was correctly paid by the bank for the value of $850. However, the company recorded by mistake $580. On 22nd September. The bank issued a debit memo against serve as a charge for check printing fees for the value of $25. This amount was not recorded in the company books. On 27 September, the bank debit the account by $1,000 against non-sufficient funds check, which was previously recorded as collection from a customer in August 2021, 28 September. The bank statement shows an electronic funds transfer to $125 received from a customer, which was not recorded. The company on 29th September, the company issued a check number 512 for the value of $700, which was not yet paid by the bank to the supplier. On Thursday, September, the company deposit a check after the bank closed for the value of $430 using bank deposit, the Dropbox. This amount was not reflected in the bank statement until the next business day. At the end, let us see the requirements. First, repair bank reconciliation for the month of September 2020 based on the information provided. Second, prepare journal entries on Thursday, September 2020 to adjust the books balance to the correct cash balance after adjustment. This is the end of our lesson. In the next lesson, we will solve the first requirement and to prepare the bank reconciliation. Thanks for watching. 68. Exercise Three Bank Reconciliation: We will continue our exercise and prepare a bank reconciliation for the month of September 2020. Before we start, let us see a summary of both records, the bank statement and the company ledger. We notice at the beginning, check number 510 was recorded correctly in both records for the value of $650. If we move next to see check number 511, it was paid correctly by the bank but recorded with a mistake in the company ledger with a value of $580. The difference amount will be included in our reconciliation. After that, the cash deposit was matching in both records. Next is bank charges for printing fees by $25, which is not recorded in the company ledger. This amount will be included in our reconciliation. Then we have $1,000 for non-sufficient funds check, which was not recorded in the company lecture. It will be included also in our reconciliation. After that, there is $225 electronic funds transfer not recorded in the company integer. In contrast, there are $700 for check number 512 still outstanding, noted paid by the bank. Finally, we have $430. A cheque deposit by the company is still in transit and not yet reflected in the bank statement. Let us start our bank reconciliation, which will be as follow. The first transaction is related to error and check number 511. We have to adjust the difference. $800-50 recorded by the bank and $580 recorded by the company. The difference value of $270 will be deducted from the company cash balance. The next transaction is related to bank service charges for check printing fees by $25. This amount will be deducted from company records. After that, we have another transaction for non-sufficient funds, check for the value of $1,000. This amount should be deducted from company records. The next transaction is related to electronic font collection for the value of $225. This amount will be added to company records. At the end, we will sum these figures and result the adjusted books balance for the amount of $2,930. Let us move to the next transaction which is outstanding, check number 512, for the value of $700. This amount was not reflected in the bank statement. As a result, we have to deduct the same value from the bank balance. The last transaction is related to deposit in transit for the value of $430. This amount will be added to the bank balance. At the end. If we sum these figures, we will get the adjusted bank balance for the value of $2,930. Finally, notice how the adjusted balance per the bank and for the company must be the same. In our exercise, it is exactly matching for the value of $2,930. This is the end of our lesson. In the next lesson, we will prepare journal entries for these adjustments to reflect the correct cash balance in the company records. Thanks for watching. 69. Exercise Three Journal Entries: We will solve in today, listen, the second requirement to prepare journal entries for our bank reconciliation as of Thursday, September 2020. Let us first have a look at our conciliation from previous lesson. Focus here on four adjustments to be done on the company books to reflect the correct balance of cash. Notice that we will do only the adjustments for the company records. We will not record the outstanding check number 512 and the deposit in transit because they are already recorded in the company ledger. Our first transaction to correct the error and check number 511. In this case, there are two accounts get affected. Accounts payable will decrease by the difference amount of $270 and cash account will decrease by the same value of $270. To record this transaction, we debit accounts payable by $170 and then credit cash account by $270. We can write an explanation to correct the error and check number 511. Let us move now to the second transaction which is related to bank service charges. The bank in charge of the company for check printing fees for the value of $25. In this case, there are two accounts get affected. Miscellaneous expenses will increase by $25 and cash account will decrease by the same value of $25. To record this transaction, we debit miscellaneous expenses account by $25 and then credit cash account by $25. We can write an explanation to record the charges for printing fees are 30. Transaction is related to non-sufficient funds. Check. In this case, there are two accounts get affected. Accounts receivable will increase by $1,000 and cash account will decrease by the same value of $1,000. To record this transaction, we debit accounts receivable by $1,000 and then credit cash account by $1,000. We can write an explanation to reverse not sufficient funded check from customer. Our last transaction to record electronic funds transfer from customer. In this case, there are two accounts get affected. Cash account will increase by $225 and accounts receivable will decrease by the same value of $225. To record this transaction, we debit cash account by $225 and then credit accounts receivable by $225. We can write an explanation to record electronic funds transfer from customer. This is the end of our exercise. Thanks for watching. 70. Types of Receivables: We will start our section by understanding receivables. Receivables are important because they represent one of the most liquid assets in the company. They are claims that are expected to be collected in cash. Receivables usually classified as follow. Accounts receivable, notes receivable, and other receivables. Let us start with accounts receivable. They are amounts due from customers for credit sales of goods and services. Companies expect to collect accounts receivable within 30 to 60 days. They are usually the most significant type held by companies. Then we have notes receivable. They are a written promise for amounts to be received, usually with interests. Sellers prefer to receive promissory notes when credit period is long and when the amount is large. Notes and accounts receivable that result from sales transactions are often called trade receivables. Our last type is other receivables, which include non trade receivables, such as interest receivable, advances to employees. These amounts do not result from the operation of the business. Therefore, they are reported as separate items in the balance sheet. This is the end of our lesson. In the next lesson, we will discuss valuing accounts receivable and how to use the direct write-off method. Thanks for watching. 71. Direct Write off Method: After company's record receivables in their accounts, they may find determining the amounts to be reported is difficult because some receivables become uncollectable. E.g. a. Customer suffers from a decline in sales revenue. Another example, when individuals may lose their jobs and they will not be able to pay their bills. Company's record such losses as bad debt expense. The question here, why companies sell on credit if they expect some accounts to be uncollectible. Because they believe that granting credit will increase sales and net income, which will be enough to offset bad debts. This regard, there are two methods that are used to account for uncollectible amounts. The direct write-off method and the allowance method. We will discuss the direct method and this listen and leave the allowance method for the next lesson. Under the direct write-off method, the company charge the losses of uncollectible amounts to bad debt expense directly. To understand the subject, let us see the following example. On 31st of October 2020, the company right off uncollectible amount from customer a for the value of $500. In this case, there are two accounts get affected. Bad debt expense will increase by $500 and accounts receivable will decrease by the same value of $500. To record this transaction, we debit bad debt expense by $500 and then credit accounts receivable for customer a by $500. We can write an explanation to write off uncollectible amounts. The main problem of the direct method. It recognize bad debt expense only when actual losses incurred from uncollectible accounts. As a result, accounts receivable will be reported by the gross value. To understand the subject, let us assume the company decided in 2019 to increase its revenue by offering their product without downpayment or prior credit approval process. Therefore, the sales revenue and accounts receivable in 2019 in increased by a huge amount. Unfortunately, in the next year, 50 per cent of the customers defaulted their payments. As a result, the year 2020 shows a big decrease in the net income and accounts receivable. We notice from our example there are two main issues with direct method. The first one, there is no matching of bad debt expense with sales revenue in the income statement. Under the direct method, bad debt expense is usually recorded in a different period when sales revenue was recognized. The second problem in the balance sheet, this method does not show the amount of accounts receivable that actually expect to receive. The direct method cannot be used for the purpose of financial reporting and list the value of bad debt expense is considered a material or very small in relation to the company's sales and net income. This is the end of our lesson. In the next lesson, we will discuss the allowance method. Thanks for watching. 72. The Allowance Method: We learned in our previous lesson, the direct write-off method for valuing accounts receivable. We will learn today listen another method called the allowance method. It requires companies to estimate uncollectible accounts at the end of each period. As a result, the allowance method provides better matching in the income statement for bad debt expense against sales revenue for the same period. It also report accounts receivable in the balance sheet at their net realizable value, which is the net amount the company expects to receive in cash. Exclude any amounts that the company estimates it will not collect. The allowance method has the three main features. Company's estimated uncollectible accounts receivable at the end of each period. Then they recognize their estimate by debiting bad debt expense and crediting allowance for doubtful accounts. The allowance account is a contra account which will be deducted from accounts receivable in the balance sheet. After that, when the company decided to write off a specific account, they debit allowance for doubtful accounts and credit accounts receivable. To understand the subject, let us see the following example. As of 31st October, 2020, the company has a credit sales of $100,000 during the period and the accounts receivable balance was $20,000. The credit manager estimates that $1,000 of these balances will be uncollectible. We notice in this transaction there are two accounts get affected. Bad debt expense will increase by $1,000 and allowance for doubtful accounts will increase by the same value of $1,000. To record this transaction, we debit bad debt expense by $1,000, then credit allowance for doubtful accounts by $1,000. We can write an explanation to record estimated bad debts. Regarding bad debt expense. It is reported in the income statement as operating expenses, usually under selling expenses. So the next question here, how to report the net realizable value for accounts receivable. The following example shows how we deduct the allowance for doubtful accounts from accounts receivable balance. And then it value for receivables will be reported in the balance sheet under current assets. Note that we don't close the allowance account at the end of the period. Instead, it will be presented as contra account to accounts receivable in the balance sheet. This is how to record and report the allowance account. But what if the company decided to write off a specific account? After sending several letters, calls, and legal actions with that customer. They may find collecting the past due amount appear to be impossible. To understand the subject, let us assume the company authorized to write off a balance of $400, which is due from customer B. In this case, there are two accounts get affected. The allowance for doubtful accounts will decrease by $400 and accounts receivable will decrease by the same value of $400. To record this transaction, we debit allowance for doubtful accounts by $400 and then credit accounts receivable for customer B by $400. We can write an explanation to write off customer BI account. Notice in our example, we did not debit bad debt expense. And instead we write off the receivable value using allowance account. But why? Because we have already recognized bad debt expense when we estimated the uncollectible amounts on 31st of October 2020. To have better idea, let us see the following lectures. We will start with the allowance for doubtful accounts, which has a credit balance of $1,000 from our adjusting entry on 31st of October 2020, then followed by a debit transaction or $400 for the right of entry. The balance of this account will be $600. The second general ledger, accounts receivable, it shows an opening balance of $20,000, then followed by a credit transaction of $400 for the right of entry. The balance of this account will be $19,600. To make it symbol, the right of transaction will affect only balance sheet accounts. There is no effect on the income statement accounts. As a result, the net realizable value would be the same before and after the write-off. In our example, it is $19,000. At the end. We have one more point. What if the company collect from customer B, the amount which was already written off? In this case, we have to record two entries. The first one to reverse the original right of entry, which will increase the customer account again. The second one to record the usual collection entry. To understand the subject, let us assume on Thursday, November 2020, customer be paid the whole outstanding amount which was written off by the company. Our first entry to reverse the right of transaction by debiting accounts receivable for customer B by $400, and then credit allowance for doubtful accounts by the same value of $400. We can write an explanation to reverse right off for customer B. The second entry to record the actual collection by debiting cash account by $400. And then credit accounts receivable for customer B by the same value of $400. We can write an explanation to record collection from customer B. Notice the recovery of a bad debt will affect only balance sheet accounts under the allowance method. Again, there is no effect on the income statement accounts. This is the end of our lesson. We will study in the next lesson how to estimate uncollectible amounts for accounts receivable at the end of each period. Thanks for watching. 73. Estimating Bad Debts: We saw in our previous lesson the amount of expected uncollectibles was given in our example. In fact, the company must estimate this amount when they use the allowance method. And this regard, we have two basis to estimate as a percentage of sales or as a percentage of receivables. Both bases are acceptable. It depends on the management to decide whether to have better matching of expenses against revenues in the income statement, or to focus more on the net realizable value in the balance sheet. Let us start with the first basis, which is percentage of sales. The company has to estimate what percentage of credit sales will be uncollectible. This percentage has to be linked with past experience and credit policy. It can be applied on total credit sales or on the net value of credit sales during the period. To understand the subject, let us assume the company decided to use percentage of sales and estimated that one percentage of net credit sales will be uncollectible. The value of net credit sales during the period was $300,000. In this case, the estimated bad debt expense will be $3,000. For the period. To record this entry, we debit bad debt expense by $3,000 and then credit allowance for doubtful accounts by the same value of $3,000. We can write an explanation to record estimated bad debts. If we consider the allowance account has a previous credit balance of $1,000, the ledger accounts will be shown as follows. Bad debt expense will show a balance of $3,000, which represent the value of uncollectible amounts during the period. On the other hand, allowance for doubtful accounts will show an opening balance of $1,000 plus $3,000 estimated bad debts during the period. The balance of allowance account will be $4,000. We notice in our example, the company did not adjust the opening balance of the allowance account. But why? Because this method focused on matching expenses with the revenues. As a result, our estimated bad debts of $3,000 was the expense value for the period. Our second method is percentage of receivables. Under this method, the company estimate what percentage of receivables will result losses from uncollectible accounts and disregard the company. Prepare an aging schedule, which I classify customer balances by the length of time that you have been unpaid. We call this a schedule aging of accounts receivable. After the company prepare aging report. It's calculate the expected credit losses by applying a percentage to each category. The longer a receivable is still unpaid, the less likely it will be collected, and the higher percentage will be applied. To have better idea about the subject, let us see the following example of aging report for accounts receivable. We notice in this report the estimated percentage of uncollectible amounts increase the from 1% to reach 20 per cent because the number of days past due has increased as well. Total estimated amount for bad debt is $2,060, which represent the required balance for the allowance account in the balance sheet. What do we mean by that? It means we have to calculate bad debt expense by taking the difference value between the required balance in the aging report and the current balance for the allowance account. In our example, there was an opening balance of $1,000. In this case, we deduct this amount from $2,060 and the result will be the expense value of $160. To record this transaction, we debit bad debt expense by $1,060, and then credit allowance for doubtful accounts by the same value of $1,060. We can write an explanation to adjust estimated bad debts. After recording this entry, our ledgers will be shown as follows. Bad debt expense will show a balance of $1,060. On the other hand, allowance for doubtful accounts will show an opening balance of $1,000 plus $160 bad debt expense during the period. The balance of allowance account will be $2,060, which match exactly our estimated bad debts using percentage of receivables method. This is the end of our lesson. Thanks for watching. 74. Selling Receivables: Companies can convert receivables into cash before they become due by selling them to another company called F factor. The factor is a finance company or bank that buys receivables from other companies and then collect the payment directly from customers. Normally, the factor will charge a certain percentage to the company that is selling receivables. These are charges usually range from 1% to 3% of the amount of receivables purchased. Our question here, why companies would sell their receivables? There are two main reasons. The first one is that collecting process might be time-consuming and costly. So it will be easier to sell receivables to a third party with good experience and collection matters. The second reason, it might be the only source of cash available, e.g. when companies have short of cash or they cannot borrow money from the usual credit market, or the cost of borrowing is high. To understand the subject, let us assume and 15 November 2020, the company decided to factor a receivable value of $500,000. The factor charges the company three per cent of the amount of receivables sold. If we calculate the factoring fees, it will be $500,000 multiplied by three per cent and the result will be $15,000. To record this transaction, we debit to accounts, cash account by the net value of $485,000. Then we debit factoring expense by $15,000. After that, we credit accounts receivable by the total value of $500,000. We can write an explanation to record factoring accounts receivable. At the end. There are two options to report factoring expense in the income statement. If the company usually sells its receivables, factoring fees will be reported under selling expenses. Otherwise, the company may report factoring fees as other expenses and losses. This is the end of our lesson, we will discuss in the next lesson, credit card sales. Thanks for watching. 75. Credit Cards Sales: Credit cards are issued by banks or financial companies that allow the card holders to borrow funds and buy goods and services from retailers who accept these cards for payments. The most famous examples of credit cards or Visa, MasterCard, and American Express. There is multiple information written on the card itself, such as the issuer name, card number, expiration date, and cardholder name. On the back. There are authorized signature, security code number. There are three parties involved in credit card sales. The credit card issuer, which is the bank or financial company, the customer who buy goods and services. And finally, the seller who accept payments through credit cards. Credit card sale is considered another form of selling receivables. The seller must pay a transaction fees to the bank who issued the credit card, and then it value will be recorded as cash sales. To understand the subject, let us assume on 15 November 20. 20, the company accepted a credit card payment against services provided for the amount of $2,000. The bank of charge two per cent to process this transaction. If we calculate the bank charges, it will be $2,000 multiplied by two per cent, and the result will be $40. To record this entry, we debit to accounts, cash account by Dennett value of $1,960. Then we debit bank charges by $40. After that, we credit sales revenue by the total value of $2,000. We can write an explanation to record credit card sales. This is the end of our lesson. In the next lesson, we will discuss notes receivable. Thanks for watching. 76. Notes Receivable: Companies may grant credit sales in exchange for a credit instrument called promissory note. It is a written promise to pay a specific amount on demand or at specific future date. Usually promissory notes are paid with interest, which will be paired together with the face value at maturity date. Our question here, for what purpose promissory notes are used? They can be used in many transactions, such as paying for products and services, especially when credit period is long and the amount of purchase is large. They can be used also for lending and borrowing money. Another purpose to use promissory note to replace an account receivable when a customer request additional time to pay above the account. To have better idea about notes receivable, let us see the following symbol of promissory note, which include the following information. Face value of the note, issue date, maturity date, then make her name, who made a promise to pay, pay name, who will receive the money, and annual interest rate. These are the main information to be written on promissory notes. But we have two main issues here, Determining maturity date and computing interest value. Let us start with the maturity date. Is the date that a note receivable must be paid. Together with interests, we have three cases here. Maturity on demand, which will be D0, a bone beneficiary request for payment. The second case, when the maturity date is a specific future date, e.g. Thursday, September 2021. Our last case to have a period from issuance date and disregard. It can be expressed in terms of months or days. When months are used, the maturity date will be calculated on the same day of the month as it's original date. E.g. a. Three-month note dated September 15 will be payable on December 15. If they're not as a drawn on the last day of a month, it will be payable on the last day of subsequent month. E.g. a. Two-month naught dated July 31st will be payable on September 30. On the other hand, when these are used, we need to count the exact number of days to determine the maturity date. E.g. the maturity date of 90 days not dated August 12th will be Dion 10th November as follow. We will start by calculating the number of days for August, which will be 31 days -12, and the result will be 19 days. Then we add the number of days for September, which is 30 days. After that, we add the number of days for October, which is 31 days. Finally, we add the difference in November, which will be ten days and the maturity date will be tenth November 2020. Let us move to our next subject and see how to calculate interest, which will be as per the following formula. The face value is the amount written on the note without interest. The annual interest rate is also written and denote which represent the interest rate for one year. The main issue here is how to calculate time factor that the note is outstanding. We have three cases here. When the maturity date is expressed in days, the time factor will be divided by the total number of days in one year. To simplify the calculation, we will consider having 360 days, which we call it the banker rule. On the other hand, when due date is expressed in months, the time factor is the number of months divided by 12. Finally, if the maturity period is one year, the time factor will be one. This is the end of our lesson. In the next lesson, we will learn how to record notes receivable. Thanks for watching. 77. Recording Notes Receivable: After we understand the purposes of notes receivable and learned how to calculate interest. We will study in this lesson the accounting entries related to recognizing and collecting notes receivable. Let us start with recognizing notes receivable. We have three cases here. If the promissory note is received against the credit sale for goods and services, e.g. for the value of $15,000, the entry will be as follows. Debit notes receivable, and a credit sales revenue by $15,000. Our second case, when the company lend money against receiving note receivable for the value of $15,000. The entry will be as follows. Debit notes receivable and credit cash account by $15,000. Our third case, when the company except to receive promissory note from a customer and the grant time extension on a bus. Do you account e.g. the company received $3,000 cash and $12,000 note receivable to settle a pass. Do you account for the total value of $15,000? The entry in this case will be as follows. Debit to accounts, cash account by $3,000 and note receivable by $12,000. Then we credit accounts receivable by the total value of $15,000. Let us move now to the second subject and see how to recognize interest revenue during the period of Notes Receivable, e.g. let us assume on first July 2020, the company recognized a six month note receivable with annual interest rate of 12 per cent and face value of $15,000. The maturity date will be 31st December 2020. This not received from a customer to grant time extension of a past due account. The company in this case, should make an accrual entry to recognize interest revenue from July until November for the total amount of $750, which represent the value of interest revenue not yet collected from the customer. The entry on November 30th will be as follow. Debit accrued interest revenue by $750. Or we can use interest receivable account. Then we credit interest revenue by the same value of $750. We can write an explanation to record five months interest revenue. Finally, at maturity date, the customer usually owners the node and pay the total amount of the face value and interest. To understand the subject. Let us continue our example and consider on 31st, December 2020, the customer owner the node and paid the full amount of $15,900 by cash. Our entry will be as follows. Debit cash account by the total value including interests, which will be $15,900. Then credit accounts receivable by the face value amount of $15,000, then accrued interest revenue by $750. Or we can use interest receivable account. After that, we credit interest revenue by the balanced interests for the month of December 2020, which will be $150. We can write an explanation to record collection of the node with interest. At the end. What if the customer was not able to pay the full value at maturity date? We call this case this owner of note receivable. Even though the customer did not pay the claim, is it still exist. Therefore, the company usually transfer the full value with interests back to accounts receivable. To understand the subject, let us assume in our example, the customer did not pay that amount at maturity date. In this case, our entry will be as follows. Debit accounts receivable by the total value including interests, which will be $15,900. Then credit accounts receivable by the face value amount of $15,000, then accrued interest revenue by $750. After that, we credit interest revenue by the balance interest of $150. We can write an explanation to record the owner of note receivable. Our last point to add, if the company found there is no chance to collect the amount, it should follow the same process we learned to write off accounts receivable. The only extra entry will be required to reverse any recognition of interest revenue since it will not be collected as well. This is the end of our lesson. Thanks for watching. 78. Exercise Four Introduction: After we learned how to report accounts receivable in our previous section, we will solve an exercise related to estimating bad debts using percentage of receivables method. Let us now have a look at our exercise. On Thursday, September 2020. The company has a total balance of accounts receivable for $100,000 with the following information provided. Notice in our example, there are three columns. The date of sale, which represent the period when the sale was made. The second column shows the customer name, which are customer a, customer B, and customer see. The last column shows the value of credit sale for each customer with a grand total of $100,000. As of Thursday, September 2020, the allowance for doubtful accounts has an adjusted credit balance of $70,000 and bad debt expense balance was $2,000. The company uses percentage of receivables method for estimating bad debts, which was calculated as follows. If the age of receivable is one to 30 days, the estimated percentage of uncollectible amounts will be two per cent, 31-60 days. That's dimension will be three per cent, 61-90 days. The percentage will increase to become six per cent, 91-120 days. That estimated percentage will be 12 per cent. Finally, when the age of receivables is more than 120 days, the percentage will become 25 per cent. Let us move now to see the requirements. First, prepare aging report for accounts receivable, considering the company credit term as 210 net 30, and calculate the estimated balance of the allowance account as of Thursday, September 20, 22nd. Prepare the adjusting entry to record bad debt expense on Thursday, September 2020. This is the end of our lesson. We will see in the next lesson how to prepare aging report and how to calculate the estimated uncollectible amounts using percentage of receivable method. Thanks for watching. 79. Exercise Four Aging Report: Before we calculate estimated bad debts as of Thursday, September 2020, we need to prepare the aging report for accounts receivable. The company credit term was 210, net 30. So we can calculate the aging as follow. We will start with the first sale, which was made on 15 September. Since our cut-off date is Thursday, September 2020, we can calculate the age of this receivable, which will be 15 days. The company credit term was 30 days. As a result, the past Deal period will be the difference value, which is negative 15 days. That means this amount is not your deal for payment. We can apply the same calculation to the other transactions as follow. For the sale which was made on 20 August, the age of this receivable is 41 days, and the bus DO period will be 11 days. Next is the sale which was made on 10th July. The age of this receivable is 82 days, and the bus depot period will be 52 days. Then we have the sale which was made on 5th of June. The age of this receivable is 115 days and the bus DO period will be 85 days. Finally, the sale which was made on the age of this receivable is 135 days and the bus depot period will be 105 days. Let us move next and apply these calculations to our aging report. We will start with customer a, which has two credit sales with a total amount of $30,000. The sale which was made in July for the value of $20,000 will be reported under 31 to 60 days. But why? Because in our calculation, the bus DO period was 52 days. The second sale, which was made in June for the value of $10,000, will be reported under 61 to 90 days because the bus DO period was 85 days. For customer beam, there were two credit sales with a total amount of $65,000. The sale which was made in September for the value of $30,000 will be reported under not DO category because the bus DO period was negative 15 days. Then we have the second sale which was made in August for the value of $35,000. It will be reported under one to 30 days because the past DO period was 11 days for customer see, there was one credit sale for the value of $5,000. It will be reported under over 90 days because the bus depot period was 105 days. After we prepared the Asian report. We can now calculate the estimated uncollectible values as follow. Under not DO category, we multiply two per cent by $30,000 and the result will be $600. For second category, which is one to 30 days, we multiply three per cent by $35,000, and the result will be $1,050. Under 31 to 60 days, we multiply six per cent by $20,000 and the result will be $1,200. Then we have 61 to 90 days. We multiply 12 per cent by $10,000 and the result will be $1,200. Finally, for the last category, over 90 days, we multiply 25 per cent by $5,000 and the result will be $1,250. At the end, we calculate the total value of uncollectible amounts, which will be $5,300. Remember that we are using percentage of receivable method, which means this amount represent the balance of allowance account to be reported in the balance sheet. But how to calculate the expense value for the period? We need to deduct the opening balance of the allowance account, which was $7,000 and the result will be negative $1,700. What do we mean by a negative expense? It means we have to reduce the expense value to match the required balance of the allowance account and the balance sheet. We will pass this entry in the next lesson and see how to report accounts receivable accordingly. Thanks for watching. 80. Exercise Four Adjusting Entry: After we calculated estimated uncollectible amounts as of Thursday, September 2020, using percentage of receivable method for the value of $5,300. We can prepare the adjusting entry as follow. We notice first both the allowance account and bad debt expense will decrease by the same value of $1,700. As a result, we debit allowance for doubtful accounts by $1,700. Then we credit bad debt expense by the same value of $1,700. We can write an explanation to adjust estimated bad debts balance. To have better idea about the subject, let us see the following ledger accounts as follow. We will start with bad debt expense account. There was an opening balance of $2,000, then followed by a credit transaction of our adjusting entry for $1,700. The ending balance of this account will be $300. On the other hand, allowance for doubtful accounts started with an opening balance of $7,000, then followed by a debate the transaction of our adjusting entry for $1,700. The ending balance of the allowance account will be $5,300, which match exactly our calculation in the aging report for uncollectible amounts as of Thursday, September 2020. At the end, let us see how to report accounts receivable in the balance sheet. Under current assets. Accounts receivable balance is $100,000. Then we deduct the balance of allowance account, which is $5,300. The net realizable value will be $94,700. This is the end of our exercise. Thanks for watching. 81. The Cost of Plant Assets: We will start our section by understanding plant assets, which are resources that have three main features. First, they have physical substance with tangible size and shape. Second, they are used in the company operations, which means they are not intended for sale to customers. If they are purchased. The purpose of resale, they will be classified as inventory rather than plant assets. E.g. an agency purchased a brand new car to be used in the company operation, e.g. transportation. It will be classified as planned assets. If the same car purchased for the purpose of resale to customers, it will be classified as inventory. Our third feature, they have useful life for more than one year, which means they can be used in the company for more than one accounting period. One point to clarify that the plant assets are also called property, plant and equipment, or they can be called fixed assets. Such examples are land, land improvements, buildings, machinery and equipment, vehicles, office equipment, and finally, furniture and fixtures. Our next question, how to identify the cost of plant assets based on historical cost principle. They are recorded at cost, which include all expenditures needed to acquire the asset and make it ready for its intended use. To understand the subject. Let us see our first example of buying a new factory machine. The cost of this machine and includes the purchase price, sales taxes, freight charges, insurance while in transit, and installation, assembly, and distinct charges. E.g. on first December 2020, the company purchased a new machine for the total value of $50,000, which include the following information. Portray surprise. $40,000. Sales taxes, 3,200. Insurance while in transit 2000s, freight charges 3,000 and installation and testing $1,800. Notice that all these expenditures are required to make the asset ready for its intended use. As a result, we can include all of them and the cost of the new machine. To record the purchase entry, we debit machinery account by $50,000 and then credit cash account by the same value of $50,000. Let us see another example. On 1st December 2020, the company purchased a brand new truck for the total value of $100,000, which include the following information. Notice in our example, the last item which is related to accident insurance. This amount will not be included to calculate the cost of the track. But why? Because this amount is not needed to acquire the asset and make it ready to be used. Instead, it will be paid annually and will benefit future periods only. So the company will record it as prepaid expenses. To record this entry, we debit to accounts vehicle's account by $98,000. Then we debit prepaid insurance by $2,000. After that, we credit cash account by the total value of $100,000. This is the end of our lesson. In the next lesson, we will learn depreciation. Thanks for watching. 82. What is Depreciation?: After we learned how to identify the cost of plant assets, we will discuss one important subject called depreciation. So what do we mean by depreciation? It is the process of allocating the cost of plant asset to expense account over its useful life. Notice that depreciation is a process of cost allocation. It is not a process of asset valuation. Depreciation reflect the cost of using the asset, which enable the company to match expenses with revenues in the income statement. Our next question here, which a plant asset is applicable for depreciation? In general, all classes of plant assets are depreciated except for one item, which is land. But first, why mustard plant assets are depreciated because of their usefulness and the ability to generate revenue for each asset will decline over its useful life. This is a true because of two main issues. The first one is called weird anterior, which result I'll decline in the ability to generate revenue due to normal use and the company operations over time. E.g. a. Delivery truck that has been driven for 100,000 kilometer will be less useful to the company and conversion to another truck driven for only 1,000 km. The second issue is called absolute essence. It means the asset will become out of date before it's physically wheels out. This is mainly due to a new inventions and technical improvements. E.g. some companies replaced their computers long before they originally planned to do so. Because of improvements in the new computing technology, which make the old computers obsolete. After we understand the reasons behind depreciating assets, wild lands are not depreciated. Because of usefulness and the ability to generate revenue will not decline over time. In fact, the usefulness of the land might be greater over time due to scarcity. That's why we are not depreciating lands in our books. Let us move now to see what are the main factors in computing depreciation. There are three main factors as follow. The first one is cost, which we have already explained in our previous lesson. It includes all expenditures needed to acquire the asset and make it ready for its intended use. The second factor is useful life. It is an estimate of the expected productive life and the company operations. It is also called the service life. The useful life may be expressed in terms of time, units of activity, such as machine hours, or it might be expressed in terms of units of output. Our last factor is salvage value. It is an estimate of the asset value at the end of its useful life. It is also called the residual value. This value may represent the amount the company expects to receive from disposing the asset as a scrub. Or it can be calculated based on the expected trade and value with a new answered at the end of its useful life. At the end. Let us have a look at depreciation methods. We have three main methods as follow a straight line units of activity and finally, declining balance. Or these methods are acceptable. The company should select the best method that measure the asset contribution to revenue over its useful life. Once this method is chosen, the company should apply it consistently. This will help the comparability of financial statements over time. This is the end of our lesson. In the next lesson, we will learn the first method to calculate depreciation, which is called straight-line method. Thanks for watching. 83. Straight Line Method: We learned in our previous lesson what is depreciation? And we said, it is the process of allocating the cost of plant asset to an expense account over its useful life. We will study in today, listen, the first method to calculate depreciation expense, which we call it straight-line method. It expense the same amount of depreciation for each year over the asset's useful life. The amount of expense is measured solely based on passage of time. Let us move next and see how it is calculated. There are two steps. We first calculate the cost to be depreciated, which represent the original cost of the asset less its salvage value. Second, cost to be depreciated is divided by asset useful life to result at the end annual depreciation expense. To understand the subject, let us see the following example. On first January 2020, the company purchased a delivery car to be used in the business operations for the total cost of $16,000. The expected useful life is five years and expected salvage value is $1,000. To calculate depreciation expense using straight line method, we have to compute first the cost to be depreciated, which equal the total cost of $16,000 minus salvage value of $1,000. And the result will be $15,000, which represent the amount subject for depreciation. The next step to calculate annual depreciation expense by dividing costs to be depreciated over its useful life. In our case, it is five years and the result will be $3,000. This amount will be charged to expense account over the useful life of the asset from 2020 through 2024. There is another way to calculate this amount by using the annual rate of depreciation. In our case, we can divide 100 per cent over five years and the results will be 20 per cent. This percentage will be multiplied by the cost to be depreciated, which is $15,000. And the result will be the same value, which is $3,000. Let us see now how to record the depreciation entry. On 31st December 2020. We debit depreciation expense by $3,000 and then credit accumulated depreciation by the same value of $3,000. We can write an explanation to record depreciation expense for 2020. We notice an hour entry that we used a contra account to vehicles, which we call it accumulated depreciation. It represent the total amount of depreciation expense for current and the previous periods which will be deducted from the original cost of the asset in the balance sheet. And the result will be the book value. In our case here, it will be $13,000. To have better idea about the subject. Let us see the following. The graph on the left represent depreciation expense in the income statement. We can see in this example why we call this method straight line, because the expense amount is the same for each year. In our case, it is $3,000. On the other hand, the graph on the right represents the book value in the balance sheet. We notice how the book value declines by $3,000 each year due to depreciation expenses until it reach at the end $1,000 by December 2024, which represent the salvage value of the asset at the end. Let us summarize our example using the following depreciation schedule. What do we notice in this table? There are three points. First, the expense value of $3,000 is the same each year. Second, accumulated depreciation increased by the expense amount of $3,000 every year. Our third point is the opposite scenario for the book value, which declines by the same amount of expense for each year until it reach the salvage value of $1,000 at the end of 2024. Hour last point to add. What if the company did not purchase the asset at the beginning of the year? E.g. fairs rely instead of first January 2020. In this case, we have to consider the time factor while calculating depreciation expense. In our example, it will be $15,000 multiplied by 20 per cent, and then multiplied by 6/12 months. The result will be $1,500, which represent the expense amount for the year 2020. This is the end of our lesson. In the next lesson, we will learn the second method of depreciation, which we call it units of activity. Thanks for watching. 84. Units of Activity Method: We learned in our previous lesson the straight-line method, which a charge an equal amount of depreciation expense to each period. We will study now another method called units of activity. Under this method, the useful life is expressed in terms of units of production or use expected from the asset. The most famous examples in factories or machine hours and units of output. For vehicles. We can calculate depreciation expense based on how many kilometer driven. This method is not suitable for buildings or furniture because depreciation expense for these assets is more like function of time rather than use of the asset. Let us move next and see how to calculate depreciation expense using this method. There are three steps involved. At the beginning, we calculate cost to be depreciated by deducting salvage value from the original cost of the asset. Then we estimate the total units of activity for the entire useful life. Then divide cost to be depreciated over these units. The result represent depreciation cost per unit. After that, we calculate annual depreciation expense. To do that, we multiply depreciation per unit by the units of activity during the year. To understand the subject, let us use our previous example and assume the company drive its delivery car for 100,000 kilometer. We will start our solution by calculating costs to be depreciated, which will be the same value. We calculate it for straight-line method, which was $15,000. This amount resulted from deducting salvage value of $1,000 from the original cost of the asset, which was $16,000. Our next system to calculate depreciation cost per unit by dividing costs to be depreciated or $15,000 over total number of units, which is 100,000 kilometer. The result will be 15 cent, which represent depreciation cost for each kilometer driven. Our last step to calculate annual depreciation expense. To do that, we multiply depreciation cost per unit, which is 15 sent by the number of units during the year. Let us assume it was 10,000 kilometer in 2020 and the result will be $1,500. Let us see now how to record our entry. On 31st December 2020. We debit depreciation expense by $1,500. And then we credit accumulated depreciation by the same value of $1,500. We can write an explanation to record depreciation expense for 2020. As indicated in our previous lesson, we notice that our entry that we used a contra account to vehicles, which we call it accumulated depreciation. It represent the total amount of depreciation expense for current and the previous periods which will be deducted from the original cost of the asset in the balance sheet. And the result will be the book value. In our case here, it will be $14,500. To have better idea about the subject. Let us see the following. The graph on the left represent the appreciation expense in the income statement for the whole period of five years. We notice how depreciation expense will be different for each period. This is the U2 different units of activity are allocated for each year. This method reflect the actual usage of the asset among its useful life, which result better matching of expenses against revenues in the income statement. On the other hand, the graph on the right represents the book value in the balance sheet. We notice how it declines every year based on depreciation expense until it reach $1,000 by December 2024, which represent the salvage value of the asset at the end. Let us summarize our example using the following depreciation schedule. What do we notice in this table? There are three points. First, depreciation expense amount will vary among asset's useful life, which reflect the actual usage of the asset during the period. Second, accumulated depreciation increased by the expense amount every year. Our third point is the opposite scenario for the book value, which declined by depreciation expense for each year until it reach the salvage value of $1,000 at the end of 2024. This is the end of our lesson. And the next lesson we will discuss our third depreciation method called declining balance. Thanks for watching. 85. Declining Balance Method: After we learn two methods to calculate depreciation expense, we will discuss now another method called declining balance. It generates a decreasing depreciation expense over the asset's useful life. So the periodic depreciation will be calculated based on a declining book value. As we explained earlier, the book value represent the cost minus accumulated depreciation. As a result, this method produce higher depreciation expense in the early years of the asset's life and less depreciation values in later years. That's why it is considered an accelerated depreciation method. It is also considered a compatible method with expense recognition principle. But why? Because it matched the higher depreciation cost in early years with the higher benefits received in the same years. It also recognize lower depreciation expense in later years since the asset has less contribution to revenues. This method is more suitable for assets that lose usefulness rapidly because of absolute essence. These are the main features of this method. Let us move now and see how to calculate annual depreciation expense. But first, we have to know one important point. This method uses a special rate to calculate depreciation. A common rate which is used widely called double straight-line. In our previous example, the straight-line rate was 20 per cent. As a result, the double rate will be 40 per cent. That's why we call this method double declining balance, DDB. Let us see now the steps to calculate depreciation. This method is applied using three steps as follows. First, we calculate straight-line depreciation rate by dividing 100 per cent over asset useful life. Second step to calculate double declining rate, which will be the straight-line rate multiplied by two. Finally, we calculate depreciation expense by multiplying double declining rate by beginning balance of the book value. We notice in these steps, this method ignores salvage value in determining the amount to which the rate is applied. However, salvage value limits the total depreciation that can be taken. As a result. Depreciation will stop when the book value equal expected salvage value. To understand the subject, let us use our previous example and assume the company decided to use double-declining balance method to depreciate the asset. We will start our solution by calculating straight line rate, which will be 100 per cent over five years. The result will be 20 per cent. Then existed to calculate double declining rate, which will be 20 per cent multiplied by two, the result will be 40 per cent. After that, we can calculate depreciation expense by multiplying 40 per cent by the beginning balance of the book value, which was $16,000 in 2020, the result will be $6,400. We notice in our example, the beginning balance of the book value equals the original cost of the asset for the value of $16,000. But why? Because at beginning of 2020, there was no depreciation expense and accumulated depreciation was zero. So both figures will be the same. Let us move now to see how to record our entry. On 31st December 2020. We debit depreciation expense by $6,400. And then we credit accumulated depreciation by the same value of $6,400. We can write an explanation to record depreciation expense for 2020. To report this amount in the balance sheet, we show the original cost of the vehicle, the non-current assets. Then we deduct accumulated depreciation for the value of $6,400. The book value will be reported for $9,600 as of 31st, December 2020. To have a better idea about this subject, let us see the following. The graph on the left represent depreciation expense in the income statement for the whole period of five years. We noticed in our example, the expense amount is higher in the early years while it is lower in later years. But why? Because the double declining rate is applied on the declining balance of the book value. As we explained earlier, this method has better matching of expenses with revenues for assets that lose usefulness rapidly in early years and contribute less to revenues in the later years. On the other hand, the graph on the right represent the book value in the balance sheet. We notice how the book value declines every year based on depreciation expense until it reach $1,000 at the end of December 2024, which represent the salvage value of the asset at the end. Let us summarize our example using the following depreciation schedule. We noticed three points. First, depreciation expense amount is higher in early years and lower in the later years, which reflect accelerated depreciation method. Second, accumulated depreciation increased by the expense amount every year. Our third point is the opposite scenario for their book value, which declines by depreciation expense for each year until it reach the salvage value of $1,000 at the end of 2024. Notice in the last year, 2024, how we adjusted depreciation expense in order for the book value to equal the salvage value. If we calculate depreciation expense using double declining rate, 40 per cent, the result will be $830, but we adjusted manually to become $1,074 in order to make the book value reach at the end, $1,000. This is the end of our lesson. Thanks for watching. 86. Change in Estimate for Depreciation: Depreciation is based on two main estimates, the useful life and salvage value. During the useful life of the asset. And new information may be provided which indicate that these estimates are inaccurate. The question here, what if the useful life and salvage value has changed? The answer is to apply the new estimates to calculate depreciation expense for current and future periods. So the remaining cost to be depreciated will be allocated to remaining useful life of the asset. This approach is used for all depreciation methods to understand the subject. Let us return back to our previous example using straight line depreciation. On first January 2022. Assume that estimated numbers of years remaining for the asset's useful life, change it from three years to become four years. And salvage value change it from $1,000 to become $2,000. We will start our solution by calculating book value as of 31st December 2021, using the old estimates. To do that, we start with the original cost of $16,000. Then we deduct accumulated depreciation value after two years, which is $3,000 yearly depreciation multiplied by two years. The results will be $6,000. Finally, we can calculate the book value by deducting $6,000 from $16,000, and the result will be $10,000 as of 31st, December 2021. Our next system to apply cost to be depreciated over the remaining useful life, which will be four years from 2022 through 2025. In our example, cost to be depreciated will be the beginning book value in 2022, which is $10,000 minus the new estimate for salvage value, which is $2,000. The result will be $8,000. After that, we can calculate the new depreciation expense by dividing costs to be depreciated of $8,000 over four years, which represent the remaining useful life. The results will be $2,000 depreciation expense to be recorded from 2022 until 2025. To record our entry on 31st December 2022, we debit depreciation expense by $2,000. Then we credit accumulated depreciation by the same value of $2,000. We can write an explanation to record depreciation expense for 2022. At the end. Let us see how to report these figures in the balance sheet. We show first the original cost of the vehicle under non current assets. Then we deduct accumulated depreciation for the value of $1,000, which represent depreciation expense for the first three years. Finally, the book value will be reported for the difference amount of $8,000 as of 31st, December 2022. Note that companies must disclose the changes of their estimates and how it affects depreciation amount in the notes of financial statements. This is the end of our lesson. We will learn in the next lesson how to report expenditures during the asset's useful life. Thanks for watching. 87. Expenditures during Useful Life: After the company acquires a plant asset and put it into the service, it may incur costs for repairs, maintenance, and improvements. To record these expenditures, the company must decide whether to capitalize or expense these expenditures in the financial statements. We can split these costs into two categories, revenue expenditures and capital expenditures. Let us start with the first category, which is revenue expenditures. The most famous example here is ordinary repairs, which are expenditures incurred to maintain the operating efficiency during asset's useful life. They are small amounts that occur frequently, such as oil change, repainting of buildings and replacing consumables, spare parts on machines or vehicles. Such repairs are expensed as they are incurred. As a result, they are reported in the income statement. Our second category is capital expenditures. They are additions and improvements which encouraged to increase operating efficiency, capacity, or useful life of the plant asset. They are usually material amounts that occur infrequently, such as plant expansion and major overhauls of engines for machinery and equipment. Such expenditures are capitalized and the balance sheet, by debiting the asset account rather than expense account. The new book value will be depreciated over the remaining useful life of the asset, e.g. let us assume and fair January 2021, the company purchased a new machine with useful life of five years for a total cost of $10,000. The company use the straight-line depreciation method. After two years, the company replaced the manual control panel with the new automatic panel, which increase machine efficiency and reduce labor cost in future periods. The cost of the new panel is $1,500 paid by cash. In our case here, the new panel and increase machine efficiency, which will benefit future periods. As a result, the company capitalize this cost by recording the following entry. Debit machinery account by $1,500 and then credit cash account by the same value of $1,500. We can write an explanation to record installation of automatic system. After this entry, the machine value will be reported in the balance sheet as follows. We start with machine cost of $11,500. Then we deduct accumulated depreciation after two years with total amount of $4,000. The net amount of $7,500 represent the new book value which will be depreciated and the future. Over three remaining years. Each year, we'll allocate 2,500 as depreciation expense. Considering the salvage value in our case is zero. This is the end of our lesson. We will learn in the next lessons how to account for asset disposals. Thanks for watching. 88. Retirement of Plant Assets: Companies dispose blend assets for several reasons. They may become no longer useful. Others are disposed due to change of businesses blends, regardless of the reason, the company must determine the book value at disposal date. In order to calculate the gain or loss. The company then eliminate the book value by reducing both accumulated depreciation and asset accounts by the cost of that asset. We will learn today, listen how to account for discarding and retirement of plant assets. We have two cases here. Retirement or fully depreciated asset and retirement before it is fully depreciated. Let us start with the first case. Assume the company for retire It's photocopy machine, which cost $12,000 on 31st December 2020. The accumulated depreciation balance was $12,000. We noticed in our example, the office equipment is fully depreciated with zero book value. In this case, there will be no gain or loss from retirement of our assets. To record our entry, we debit accumulated depreciation by $12,000. And then we credit office equipment account by the same value of $12,000. We can write an explanation to record retirement of plant asset. There is one more point to add. What if they're fully depreciated asset is still useful to the company. In this case, we will not pass Retirement entry. Instead, both the asset account and accumulated depreciation will be reported in the balance sheet, with no additional depreciation to be taken until the company physically discard the asset. This disclosure in the balance sheet will inform the readers that the asset is still in use. But in no situation that accumulated depreciation exceed the cost of the asset. Let us see now the second case. When the company retire the asset before it is fully depreciated and no cash is received for salvage value. E.g. assume the company discard the office equipment, which cost $12,000 and has accumulated depreciation balance of $10,000. In this case, our entry will be as follow. We debit to accounts, accumulated depreciation by $10,000. Then we debit loss on disposal of assets by the book value balance, which is $2,000. After that, we credit office equipment by the total value of $12,000. We can write an explanation to record retirement of asset with loss. Companies report the loss on disposal of assets in the income statement under other expenses and losses. This is the end of our lesson. And the next lesson we will discuss sales of plant assets. Thanks for watching. 89. Sale of Plant Assets: We learned in our previous lesson how to account for retirement of plant asset. But what if the company sell it's a bland asset to another party and receive cash as the proceeds from the sale. The company compares the book value of the asset with the proceeds received from the sale. As a result, there will be two cases here. If the proceeds value exceed the book value, gain on disposal will occur. If the proceeds value is less than the book value, loss on disposal will occur. To understand the subject, let us assume on 31st December 2020, the company sold office furniture for $20,000 by cash. The original cost of office furniture was $80,000. Accumulated depreciation balance at disposal date was $68,000. We will start our solution by calculating the gain or loss as follow. Because of furniture is 80,000, then we deduct accumulated depreciation by 68,000. The result will be 12,000, which represent the book value at disposal date. If we compare it with the proceeds from the sale, which was $20,000, the result will be gain on disposal of plant asset for the amount of $8,000. To record our entry, we debit to accounts, cash account by $20,000. Then we debit accumulated depreciation by $68,000. After that, we credit to accounts office furniture by the original cost of $80,000. Then we credit gain on disposal of assets by $8,000. We can write an explanation to record the sale of furniture as gain. Companies report the gain on disposal of plant asset in the income statement under other revenues and gains. Let us move now. And c, The second case, but this time at loss. Assume that instead of selling the office furniture for $20,000, the company sell it for $7,000 only. In this case, we can calculate the loss as follow. Cost of furniture is $80,000. Then we deduct accumulated depreciation by 68,000. The result will be 12,000, which represent the book value at disposal date. If we compare it with the proceeds from the sale, which was $7,000, the result will be loss on disposal of plant asset for the amount of $5,000. To record our entry, we debit three accounts, cash account by 7,000. Then we debit accumulated depreciation by 68,000. After that, we debit loss on disposal of assets by 5,000. Then we credit office furniture by the original cost of $80,000. We can write an explanation to record the sale of furniture. Atlas. Companies report the loss on disposal of plant asset in the income statement under other expenses and losses. This is the end of our lesson. Thanks for watching. 90. Natural Resources: After we learned how to account for plant assets, we will discuss now another category called natural resources. They are assets that physically extracted and operations such as timber lands, mineral deposits, and oil reserves. These assets are recorded at cost, which include all expenditures needed to acquire the resource and make it ready for its intended use. The next question here, how to account for natural resources? First, we have to know that these assets do not lose value over time. Instead, they are physically consumed once used. In other words, they are depleted rather than depreciated. Depletion is the process of allocating the cost of natural resources to the period when it is consumed. Companies usually use units of activity method to calculate depletion expense, which will be based on the number of units extracted and sold during the year. To compute depletion expense, there are three steps. We have to calculate. First, the cost to be depleted, which equals total cost of natural resources minus salvage value. Second step to calculate depletion cost per unit by dividing costs to be depleted over total estimated units. After that, we multiply depletion cost per unit by the number of units extracted and sold, which results at the end annual depletion expense. To understand the subject, let us assume the company invested $10 million in a coal mine with estimation to have 8 million tons of coal with no salvage value. The first year, which was 2020, the combined extracted and sold 500,000 tons of coal. We start our solution by calculating cost to be depleted by deducting the salvage value, which was in our example, zero from the cost of coal mine, which was $10 million. The result will be the same amount for $10 million. The next system to calculate depletion cost per each ton by dividing $10 million over total estimated quantity, which was 8 million tons. The result will be 1.25 dollar cost per ton. The final step to calculate annual depletion expense. To do that, we multiply 1.25 by the number of units extracted and sold, which is 500,000 tons. The result will be $625,000. To record our entry, we debit depletion expense by 625,000. And then we credit Accumulated Depletion account by the same value of 625,000. We can write an explanation to record depletion expense for 2020. To report this amount in the balance sheet, we show the original cost of the coal mine under non-current assets, which was $10 million. Then we deduct accumulated depletion for the value of 625,000, then its value will be $9,375,000. Notice that we use the Accumulated Depletion account to report the coal mine at cost. But some companies prefer not to use the accumulated account. Instead. They credit the amount of depletion expense directly to the natural resources account. At the end. There is one more point to add. What if the company extracted the quantity of 500,000 tons in 2020, but did not solve them in the same year. In this case, the amount of $625,000 will be reported as inventory in 2020. Under current assets. The company will not expense that abolition until it's sold these quantities. This is the end of our lesson. In the next lesson, we will learn about intangible assets. Thanks for watching. 91. Intangible Assets: After we learned how to account for plant assets and natural resources, we will discuss and today listen, intangible assets. They are rights, privileges, and competitive advantages that resulted from the ownership of long lived assets which do not have physical substance. Intangibles may result due to the followings. First is government grants, such as patent, copyright, trademark, and the trade names. Second is acquisition of another business in which the portray surprise includes a payment for goodwill. Finally, intangibles may arise from contractual arrangements such as franchise and license agreements. Let us define some of these examples. We will start with patents. It is an exclusive right issued by the patent office that enable the company to manufacture, sale, and control innovations and technology improvements for a certain period of time. Buttons are recorded at cost, which include the cost of acquiring the patent and the cost to defend it. E.g. due to litigation by competitors, the company may incur legal costs and successfully defending the patent validity. This cost will be capitalized and add it to the patent account. Another example of intangible asset is copyright, which gives the owner and exclusive right to reproduce published work. It is the right to copy, which protect the owner of original material from unauthorized application. They are recorded at cost, which include the cost of acquiring and defending the copyright. Our third example is trademarks and trade names. It is award frees or symbol that identifies specific company or product. Such a trade names are Mercedes Benz, Pepsi-Cola, Honda, and ikea. The owner of trade name may obtain exclusively go right by registration with patent office. This registration provide legal protection which can be renewed for indefinite number of periods. Therefore, it may be considered to have indefinite useful life. Our last example is goodwill. It is the amount by which a company value exceeds the value of its individual assets and liabilities. But why we have this difference? The company as a whole has certain valuable attributes that are not measured among its individual assets and liabilities. These can include exceptional management, skilled workforce, good customer and supplier relationship, quality, products and services, and other competitive advantages. These attributes are linked with the business as a whole, which cannot be sold separately. So the question here, how do you determine the value of goodwill? If we try to put dollar value for each of these factors, the result will be very subjective, which will effect the reliability of financial statements. Therefore, companies record goodwill only when a whole business is purchased. It can be measured by the excess value of Porsches cost over the fair value of identifiable net assets acquired. Net assets means assets less liabilities. After we learn these examples, the next question here, how to account for intangibles? As we explained earlier, companies record intangible assets at cost. They can be categorized as having limited useful life or indefinite useful life. For intangibles with limited useful life, the company allocate its cost over the asset's useful life in a similar process to depreciation, but we call this allocation process amortization. Typically, straight-line method is used to amortize intangible assets among its useful life. In case the intangible asset has indefinite useful life, they should not be amortized. And instead, they are tested for impairment loss, such as goodwill. Goodwill is linked with the business as a whole, which has no time limit to be used in the company. That's why goodwill has indefinite useful life. And as a result, it should not be amortized. On the other hand, goodwill is tested annually for impairment loss. Let us move next and take the following example to understand how to account for intangibles. Assume on first July 2020, the company purchased a patent at the cost of $120,000. The estimated useful life of the patent is expected to be ten years. The question is, to calculate amortization expense for 2020. We can calculate amortization expense by dividing 120000/10 years and then apply the time factor of 6/12 months. The result will be $6,000. To record our entry, we debit amortization expense by $6,000. And then we credit accumulated amortization account by the same value of $6,000. We can write an explanation to record amortization expense for 2020. To report this amount in the balance sheet, we show the original cost of the patent under non-current assets, which was $120,000. Then we deduct accumulated amortization for the value of $6,000, then IT value will be $114,000. Notice that we used accumulated amortization account to report intangible assets. But some companies prefer not to use the accumulated account. Instead, they credit the amount of amortization expense directly to intangible asset account. This is the end of our lesson. Thanks for watching. 92. Exercise Five Introduction: After we learned how to report the plant assets, natural resources, and intangibles. We will solve a full exercise to cover this subject. Let us now have a look at our exercise. On 31st December 2019. The company reported the following information for plant assets. Lens with a balance of 6 million. Then we have buildings with original cost of 15 million and accumulated depreciation of 2,250,000. After that, we have machinery with original cost of 4 million and accumulated depreciation of 1,600,000. Total plant assets is reported for $21,150,000 during the year 2020. The following cash transaction incurred as follow. On first April, the company purchased additional machine for $1 million by cash. Then on first May, the company purchased additional land and paid $2 million by cash. After that, on first July, the company sold old machine that cost $500,000. When Porsche based on first January 2017, it was sold for $80,000. Then on 31st December, the company retire old machine that cost $300,000 when purchased on 31st December 2015. No salvage value was received. Finally, let us see the requirements. First. Journalize all four transactions during 2020. Considering the company uses straight-line depreciation for buildings and machinery. The buildings are estimated to have 20 years useful life with no salvage value. Machineries are estimated to have five years useful life with no salvage value. Second requirement to record depreciation entries for the year 2020. Finally, prepare the plant asset section in the balance sheet as of 31st December, 2020. This is the end of our lesson. In the next lesson, we will solve our exercise and record all journal entries. Thanks for watching. 93. Exercise Five Journal Entries: We will start solving our exercise by going through each transaction in 2020. Our first transaction was on first April. The company purchased additional machine for $1 million by cash. In this case, there are two accounts get affected. Machinery account will increase by 1 million and cash account will decrease by the same value of 1 million. To record our entry, we debit machinery account by $1 million and then we credit cash account by the same value of $1 million. We can write an explanation to record purchase of machine by cash. Our second transaction was on first May 2020. The company purchased additional land for $2 million by cash. In this case, there are two accounts get affected. Lands account will increase by $2 million and cash account will decrease by the same value of $2 million. To record our entry, we debit Lands account by 2 million, and then we credit cash account by the same value of 2 million. We can write an explanation to record purchase of land by cash. The next transaction was on first July 2020. The company sold old machine that costs $500,000. When purchased on January 2017. It was sold for $80,000. In this case, there are two entries to be recorded. The first one to depreciate the machine for additional six months in 2020. To calculate this amount, we divide the original cost of 500000/5 years. Then we multiply this value by the time factor of six months over 12. The result will be $50,000. To record our entry, we debit depreciation expense by 50,000 and then credit accumulated depreciation by the same value of 50,000. We can't write an explanation to record depreciation expense for 2020. After we recorded the additional depreciation until disposal date. We can now record the sale transaction as follow. We debit the three accounts, cash account by the cell value of 80,000. Then we debit accumulated depreciation until disposal date, which will be 350,000. After that, we debit loss on sale of assets by 70,000. Then we credit machinery account by the original cost of 500,000. We can write an explanation to record the sale of machine at loss. This is how to account for this transaction. But how we calculated the loss value. Let us see the following table. The original cost of the machine is 500,000. We deduct accumulated depreciation for 3.5 years, which will be 350,000. How this amount is calculated. The first step to calculate annual depreciation by dividing 500000/5 years. The result will be 100,000. The second step to calculate depreciation expenses from January 2017 until December 2019. We multiply annual depreciation of 100,000 by three years. The result will be $300,000. The final step to add depreciation expense for 2020, which is 50,000. The result will be total depreciation value for the amount of 350,000. After that, we calculate the book value at disposal date, which will be 150,000. If we deduct the proceeds from the sale of $80,000, the result will be loss on disposal of assets for $70,000. Our next transaction is retirement of old machine on 31st December 2020. The machine cost 300,000 when purchased on 31st December 2015. No salvage value was received. In this case. There are two entries to be recorded. The first one to depreciate the machine for additional one-year in 2020. To record this amount, we divide the original cost of 300000/5 years. The result will be $60,000. To record our entry, we debit depreciation expense by $60,000 and then credit accumulated depreciation by the same value of $60,000. We can write an explanation to record depreciation expense for 2020. After we recorded the additional depreciation until disposal date, we can now record the retirement transaction as follow. We debit accumulated depreciation by 300,000. Then we credit machinery account by the same value of 300,000. Notice that the machine is fully depreciated at disposal date. There were five years utilization period from 2016 until 2020. Let us move now and solve the second requirement to pass depreciation entries in 2020. We will start with buildings. We debit depreciation expense by 750,000. Then we credit accumulated depreciation for the same value of 750,000. Notice the annual depreciation for buildings is calculated by dividing the original cost of 15000000/20 years useful life. The result will be 750,000. Our last entry to record depreciation expense for machineries in 2020 as follow. We debit depreciation expense by 790,000. And then we credit accumulated depreciation for the same value of 790,000. Notice that annual depreciation for machines is calculated as follows. For all the machines, we calculate the original cost by removing the cost of two disposal machines, which were already considered in our previous entries. Their values where 500,000.300 thousand. Then it amount is divided by five years and the result will be $640,000. For a new machine, we calculate annual depreciation by dividing the original cost of 1000000/5 years. Then we multiply the time factor of nine months over 12. The result will be $150,000. If we add both figures, total depreciation expense will be 790,000. This is the end of our lesson. In the next lesson, we will report these amounts per plant assets in the balance sheet. Thanks for watching. 94. Exercise Five Balance Sheet: We will continue our exercise and solve the last requirement to report plant assets in the balance sheet as of 31st, December 2020. But first, we have to update the ledger account for machinery and the ledger account for accumulated depreciation. We will start with machinery account. There was an opening debit balance of 4 million, then followed by additional purchase on first April for the value of 1 million. After that, the company sold old machine on first July for the cost of $500,000. Finally, the company retire another machine which costs $300,000. The ending balance for machinery account will be debit value for the amount of $4,200,000. Let us move next and see the accumulated depreciation account. There was an opening credit balance of 1,600,000, then followed by a solid transaction for old machine, which has additional depreciation expense of $50,000 and then sold with total accumulated depreciation for $350,000. After that, the company retire another machine on 31st December 2020, which has additional depreciation expense of $60,000. Total accumulated depreciation for this machine was $300,000. Finally, we pass the entry for depreciation expense for all machines in 2020 with total value of 790,000. The ending result of this account will be credit balance of $1,850,000. At the end, we can report plant assets in the balance sheet as follow. Lands will be reported for a balance of 8 million, which represent opening balance of 6 million plus 2 million additional purchase on first May 2020. Then we report buildings with the original cost of $15 million. Accumulated depreciation balance will be 3 million, which represent opening balance of 2,250,000 plus additional depreciation expense for the amount of 750,000. The net book value for buildings will be $12 million. After that, we report machinery account with original cost of 4,200,000 and accumulated depreciation 1,850,000 than its book value will be $2,350,000 for both old and the new machines. At the end, total plant assets will be reported for $22,350,000 under non-current assets. This is the end of our lesson. Thanks for watching. 95. Importance of Financial Statements Analysis: After we learned how to record and report financial data, we will take one step further and learn the basics of analyzing financial statements. But we have to understand first, why do we need to do such analysis? It is the process of reviewing the company financial statements to evaluate the past, which help to estimate future performance and support decision-making. This analysis can be done by both internal and external users, e.g. investors, to study earning capabilities, banks to evaluate cash flows and the ability to repay loans with interest. Managers to review results and take decisions to improve profitability and growth. To help doing such analysis of financial statements, we have to understand very important subject which is comparability. We can compare financial data between different companies with different sizes in the same industry. Another option to compare the data of same company for one year or among multiple years. But there is one issue here. Our analysis will not be effective if we depend on absolute dollar values only. Especially if we analyze differences among two companies with different sizes. E.g. the following income statement for the period ended 31st December 2020 represent financial results for both company a and company B. We notice here the net income for company a is $40,000, which is higher than company B. That result $10,000 only. Comparing absolute dollar values between both companies is considered misleading. But why? We can simply say company is performing better than company B. But if we make additional analysis by converting these values into percentages, the results will change as follow. Gross profit margin for company B is 30 per cent, while it is ten per cent for company a. We notice also in profit margin for company B, is it 20%, while it is four per cent only for company a in. So doing such analysis shows better performance of company B overcome many aim. That's why analyzing financial statements is very important that help management to make effective decisions in the business. We will study in this section two common techniques known as vertical analysis and horizontal analysis. Thanks for watching. 96. Vertical Analysis: After we understand the importance to analyze financial statements, we will learn today listen, vertical analysis is a technique that express each item in the financial statements as a percentage of a base amount. The balance sheet. We are using total assets as a base amount. We can use also total liabilities and owner's equity. Since this amount equal total assets. For income statement, we are using net sales as a base amount. In both the statements. The base amount is assigned a value of 100 per cent. Each other line item in the financial statements is expressed in terms of, it's the proportion of this baseline figure. To calculate each percentage, we can use the following formula. Line item value is divided by the base amount. Then we multiply the result by 100, e.g. the following income statement for the period ended 31st December 2020 shows assemble of vertical analysis as follow. We noticed in our example that we assign the value of 100 per cent to the base amount, which is net sales in the income statement. After that, we present each other item as a proportion to this baseline figure. E.g. cost of goods sold represent 75% of net sales. But how we calculate it, this percentage, we simply divided 300000/400000 and the result will be 75 per cent. On the other hand, gross profit margin represent 25% of net sales. We calculated this percentage by dividing 100000/400000, and the result will be 25 per cent. Another example is the profit margin, which represent 14% of net sales by dividing 56000/400000. This is how we do vertical analysis in the income statement. Let us move next and take another example. But this time we will use the balance sheet. The following statement shows the company financial position as of 31st December 2020. We notice in our example that we assign the value of 100 per cent, the base amount, which is total assets in the balance sheet. The same percentage is assigned to total liabilities and owner's equity. Since it equals total assets value. After that, we present each other item as a proportion to this baseline figure. E.g. current assets represent 40 per cent of total assets. We calculated this percentage by dividing 400000/1000000. Another example is non-current assets, which represent 60 per cent of total assets. We calculate it this percentage by dividing 600000/1000000. On the other hand, total liabilities represent 25 per cent of total assets, while owner's equity represent 75 per cent. This is how we do vertical analysis and the balance sheet. But notice that both examples we saw in this lesson represent one-year vertical analysis. In general, it is recommended to compare such amounts among different time periods to analyze the trend of each line item in the financial statements, which will be our subject for the next lesson. Thanks for watching. 97. Horizontal Analysis: We learned in our previous lesson one technique to analyze financial statements, which is vertical analysis. We will discuss now another technique called horizontal analysis. It is evaluating a series of financial data over several periods, which are stated as a percentage of a Bezier amount. The main purpose to determine the increase or decrease for each line item in the financial statements. To calculate the percentage of change, we are using the following formula. Guaranteed amount minus Bezier amount. And the result will be divided by the base year amount. Then we multiply the value by 100 to have better idea about the subject. Let us see the following example of income statement. We noticed that beginning how we presented the most recent year on the left side and then previous year will follow to the right. This is applicable to all financial statements in accounting. We notice also 2019 is the base year in our analysis. So let us have a look at our example. We notice how net sales increased by $50,000 from 350,000.2019 to become 400,020 20. We can calculate the percentage of a change as follow. The difference value of $50,000 is divided by the base year value, which is 350,000. The result will be 14 per cent. If we take another line item, which is gross profit, we notice how the value of $95,000 in 2019 has increased to become $100,000 in 2020. We can calculate the percentage as follow. The difference value of $5,000 is divided by the base year value, which is $95,000. The result will be five per cent. After we calculated both percentages, we can ask important question, why sales have increased by 14 per cent while net income has zero change 2019-2020. To answer this question, we have to apply horizontal analysis on online items between sales value and net income. We can start with cost of goods sold, which has increased by a higher percentage of 17 per cent. As a result, gross profit has increased by five per cent only. Typically, an increase in sales should result the same orbiter increase in gross profit margin. But in our case here, gross profit increased by a lower percentage of five per cent, which equal to $5,000. This amount was not enough to cover the increase in operating expenses such as selling and general expenses. As a result, there was no change in current and then it income even though sales value has increased. Such analysis requires further investigation by management to take corrective action and improve future results. To recap, what we learned in this section is just a small portion of large subject financial statements analysis is a crucial process that require advanced knowledge that I cannot cover in this introduction course. I highly recommend to take advanced courses in the same subject. This is the end of our lesson. Thanks for watching.