An Accounting Certification will be the best career investment you’ll ever make

The Accounting Model – Accounting’s Rosetta Stone

As a small business owner/manager you must have an understanding of the financial end of your business. Certainly, you have a decent grasp of how the business operates, but are you able to visualize an accounting framework that your transactions fit into? To do this requires becoming familiar with how your financial statements are structured and knowing the rules for recording transactions.

Financial statements consist of a Balance Sheet and Profit & Loss Statement. These two reports act as a “container” for all your business transactions. Each transaction is recorded according to a set of rules called “The Accounting Model”.

The Accounting Model is made up of three very simple parts:

The first part is a ledger page with a line drawn down the middle (like a big T) automatically creating a left and right side of the dividing line. However, in accounting language the word “debit” is used instead of “left” and the word “credit” is used instead of “right”. The trick here is to not make this anymore complicated than it really is. Don’t try to use the words debit and credit to mean increase or decrease like you see on your bank statement. You can do this later when you fully understand how to work with these terms.

The second part is that there are five of these ledger T’s that relate to the five sections found in a set of financial statements. They are: 1) Assets; 2) Liabilities; 3) Equity; 4) Revenue; 5) Expense. The first three relate to the Balance Sheet and last two relate to the Profit & Loss Statement.

The third part is a rule that states: Any transaction that pertains to a section (Assets, Liabilities, etc.) that results in an increase or decrease has to be recorded on either the left or right side of the ledger page.

 

The next step is to memorize the model so you can visualize where transactions are to be recorded. Have you ever tried to learn how to use a ten-key calculator or computer keyboard? At some time you have to stop looking at the keys and allow your mind to memorize the keyboard. That’s when you get fast and efficient. Memorizing the accounting model is no different.

Let’s try a sample transaction so you can see how this works. A great technique is to think about what actually happened “physically” in a transaction. This is an important step because doing this will tell you what you need to know in order to convert the physical event into an accounting transaction.

For example, let’s say in your business you had a customer who walked in the door, bought some merchandise and handed you a check for $100. You deposited the $100 check in your bank account and recorded the sale in your sales journal. Keep in mind that each transaction has two parts, a debit (left side) and a credit (right side), and that double-entry accounting requires each side of the ledger to equal each other when the transaction is completed.

The first step is to identify the parts of the transaction and determine in which of the five sections each part belongs. For instance, you know that your $100 cash received is an Asset and your sale is Revenue.

The second step is to identify whether the transaction resulted in an increase or decrease to cash and the sale. In the sample transaction, it is obvious that cash was increased and sales were increased.

The third step is to look at the accounting model and let it tell you on which side of the ledger to record the transaction. Try it now. The model tells you that cash, being an Asset, goes on the left (debit) side when increased, and sales, being Revenue, goes on the right (credit) side when increased.

Since the debits equal the credits the books are said to be “in balance”. This gives you a brief idea about how the Accounting Model is used as a cipher to tell you where to record transactions in your general ledger (GL). All you have to do next is to practice using this system so that you become familiar with all of your GL accounts. Then the day will come when you become aware that you are no longer looking at the “keyboard” and realize that the accounting framework is fully integrated into your thinking process.

30 Unique Career Paths with an Accounting Degree

The senators in question are Carl Levin (D-Michigan) and Sherrod Brown (D-Ohio). A couple of weeks ago, they introduced a bill to eliminate the so-called 'excess tax benefit' from issuing stock options to employees. The two senators note that the amount of expense reported for financial reporting purposes (for example, in SEC filings) is quite often less than the amount of the tax deduction taken per the tax return, and they seem to think that the so-called 'excess tax deduction' amounts to a government giveaway to corporations. If financial reporting measures stock-based compensation 'right' (and it surely does not), then by their logic it's wrong to receive a deduction that's greater than the expense reported for financial reporting purposes.

Bless their little hearts, but Levin and Brown (and surely other senators) are oblivious to the reality that the accounting evils lie in the financial reporting rules, and not the income tax rules. It is the financial reporting rules that are fraught with inconsistencies, for they were designed to systematically understate the cost of compensating employees.

The Economic Measure of Stock Compensation Cost

I'll be the first to admit that, when it comes to taxes, I'm sort of a babe in the woods myself. But, the complexity that is misleading the senators does not lie in the tax rules. The tax rules in this respect are simple, and a review of the fundamentals ought to be sufficient to set the stage for my accounting lesson to them.

There are two kinds of deductible expenses for tax purposes. The first type is the cost of productive resources that are consumed; examples include depreciation of productive assets, rent of productive assets, costs of inventory acquired and subsequently sold, and salaries of employees. The second type, financial cost, was at one time more controversial; and the most straightforward example is interest cost of debt.

Many decades ago, interest costs were seen to be fundamentally different than the costs of using productive resources. They were merely distributions to stakeholders, i.e., more analogous to dividends than costs of production. Eventually, though, in response to political pressure from railroads and other large corporations, taxing authorities adopted a shareholder perspective to tax deductions. In regards to interest costs, they should be deductible since they reduce the maximum amount that could be distributed to shareholders. In other words, from the perspective of the shareholder, expenditures on productive resources and the interest are both costs that reduce the amount of funds available to be distributed to shareholders.

Moreover, the tax law straightforwardly provides for the amount of interest that may ultimately be deducted as the difference between the total amount borrowed and the amount ultimately paid back to the lender. There is nothing magical about this, and it is consistent with the measurement of other tax deductible costs, including the stock-based compensation rules that are being challenged by Senators Levin and Brown.

So, one problem with their bill is that if you believe that the tax deduction for stock-based compensation should be consistent with interest costs, then you should agree that the ultimate cost of stock compensation should be the intrinsic value realized by the employee when the stock options held are recognized. And, in principle, the answer should not change whether the options are net settled, physically settled, or in the form of stock appreciation rights.

The Free Accounting Lesson

The foregoing is so mundane, I feel almost ashamed to have written it. But, I needed to do that to tee up the really interesting part: somehow, these two senators (and probably a few more) are either being grossly disingenuous or are laboring under the mistaken belief that U.S. GAAP on stock-based compensation (Topic 718) must be 'right,' since it was issued by the FASB after a decade of "due process." In point of fact, it is an embarrassing political compromise that was allowed to survive because its most outstanding feature is that it generally reports only a small portion of the full cost to shareholders of such programs (as I explained in the previous section).

Surely, the senators are aware that it was only relatively recently that U.S.GAAP began to require any recognition of compensation expense for stock options. The controversy was intense, and the best the FASB could do against stiff political resistance when they promulgated FAS 123R was to require that stock compensation expense be limited to the value of the options on the date they were granted – as opposed to either the date on which they were earned ('vested') – or most accurately and consistent with the measurement of other expenses, the date the options were exercised.

30 Unique Career Paths with an Accounting Degree

There are mainly two methods of accounting for treasury stock shares: the cost method and the par value method. This section discusses the cost method.

The cost method of accounting for treasury stock shares is the most common method because of its simplicity. When companies use the cost method, the purchase of treasury stock is viewed as a temporary reduction in shareholders equity. The reason for this is that the company expects to reissue the shares instead of retiring them. When the company reissues the treasury shares, the temporary account is eliminated. The cost of treasury stock shares reacquired is charged to a contra account, in this case a contra equity account that reduces the stockholder equity balance. The purchase of treasury shares leaves the common stock and contributed balances intact.

For example, consider the following balance sheet:

Common Stock @ Par, $1
Authorized 100,000 Shares
Issued 25,000 Shares

If Sunny acquires 1,000 shares of common stock at $5 per share, he would make the following accounting journal entry:

Both stockholders equity and net assets are reduced from the purchase of treasury share stock. Debiting the contra equity account, treasury stock, reduces stockholders equity, and net assets are reduced from the decrease in the cash balance.

The cost method of accounting for treasury stock shares affects the accounting balance sheet as follows:

Common Stock @ Par, $1
Authorized 100,000 Shares
Issued 25,000 Shares,
1,000 Shares of which are Treasury StockRetained Earnings ($5,000 restricted for cost of treasury stock held)Less: Cost of 1,000 treasury shares

The stockholders equity section has decreased by $5,000. The capital accounts remain intact as originally reported, since the cost method treats the purchase of treasury share stock as a temporary reduction in stockholders equity.

In this example, Sunny issued 25,000 shares. Treasury stock is stock taken off the market and not yet retired, thereby reducing the number of shares outstanding. The amount of stock issued does not change, since the portion of the stock issued is now treasury stock held by the company, reducing only the amount outstanding by the amount of the treasury share stock.

Most states restrict earnings distributions and dividends to the balance of retained earnings less the cost of treasury shares held. GAAP therefore requires a disclosure in the form of a footnote or parenthetically which would be included with the balance sheet to signify the reduction of retained earnings from the acquisition of treasury stock. This is important since a company can only pay dividends to the extent of its available retained earnings less any treasury stock held, in this case $10,283 ($15,283 – $5,000). The amount of shareholder equity that cannot be distributed to shareholders is often referred to as legal capital.

When the shares are reissued, treasury stock is credited for the cost of the reissued shares. If the treasury stock is reissued at a price greater than the original cost, the company credits a separate contributed capital from treasury stock account. If the company reissues the treasury shares at less than cost, the difference is first taken out of the contributed capital account for treasury shares. If the difference remains after reducing the contributed capital account to zero, retained earnings is then reduced.

Companies cannot create earnings through buying or selling their own capital stock. Treasury stock transactions generally increase and decrease contributed capital. Occasionally treasury stock transactions may decrease retained earnings, but a company cannot increase retained earnings through treasury stock transactions.

Sunny reissues 200 shares of treasury shares at $7 per share.

Contributed Capital from treasury stock transactions – common

Sunny reissues 300 shares of treasury shares at $3 per share.

Contributed Capital from treasury stock transactions – common

After the above transactions, the equity section of the balance sheet for Sunny Sunglasses Shop now appears as follows:

Common Stock @ Par, $1
Authorized 100,000 Shares
Issued 25,000 Shares,
500 Shares of which are Treasury StockRetained Earnings ($2,500 restricted for cost of treasury stock held)Less: Cost of 500 treasury shares

Total treasury stock decreased by $2,500, the amount of the 500 treasury shares sold at the original cost of $5. The stockholders equity account increased by $2,300, the amount of the treasury shares sold ($2,500) less the loss to retained earnings of $200. The $200 loss occurred when Sunny reissued 300 treasury shares at $3. The loss not only absorbed the original gain recorded in the contributed capital from treasury stock transactions – common for $400, but then reduced retained earnings for the remaining loss of $200.

Since retained earnings cannot be increased in treasury share transactions, Sunny recorded the gain in the contributed capital account. However, when a loss occurred, the loss is first taken from the contributed capital account and then, if a loss remains, from retained earnings.

Sunny formally retires the remaining 500 shares of treasury shares.

Contributed Capital in excess of par – common

The common stock, contributed capital, and treasury stock shares are retired based on the original values in each account, with the difference going to retained earnings.

A Change of Career Anyone?

It is important for a company to set up the right Inventory Management practices as one of the strategic tools for driving profitability. Best practice companies add value and gain an edge of competitiveness by having control over and maintaining lean inventory. Inventory should not be too much or too less. Both situations are risky to the growth potential of any company.

However often we see that inventory is not focused upon by the management and hence a lot of inefficiencies build up over a period of time without the knowledge of the management. It is only when we embark on cost reduction that the loop holes in the management of inventory and hidden skeletons in the closet come out of the cupboard, often resulting in a call to revamp the entire business operations.

However those companies, which have always focused on implementing the right inventory management practices as a principle function and recognized the effect of inventory on sales, as well as the books of accounts and profits, have managed to introduce necessary processes to improve the management of their inventory. Inventory management to a large extent is dependant upon the supply chain efficiency as well as operations.

It is to a large extent a management cum operations function, which on the one hand requires operational processes to be followed and maintained on the floor while on the other hand requiring management to conduct continuous studies, conduct effective analysis to facilitate effective decision making that would enable mechanisms to control and adequately manage inventory levels.

Inventory management practices to keep your inventory lean and clean.

Review and periodically revise stocking patterns and norms

Inventory stocking is dependant upon the demand as well as the supply chain delivery time. Often companies follow one common stocking policy for all items. For example, companies A, B & C may be stocking inventory of 30 days, which may not be the right thing required for all. While some stock items may have a longer lead-time thus affecting the inventory holding, the demand pattern and the hit frequency in terms of past data may show up differently for each of the inventory items. Therefore, a tendency towards an all fitting standard which does not suit all may lead to over stocking of inventory as well as in efficiencies arising from poor inventory management practices.

Plan for your inventory requirements in detail - One size does not fit all

Understand the inventory types and the specific characteristics of the items you are carrying. Then build the inventory stocking parameters taking into account the unique characteristics of the particular inventory you need.

From amongst your inventory list, you will find that all types of materials are not of the same value. Some might be very expensive and need to be carried in stock for a longer period, while another item might have a shorter lead-time and may be fast moving.

Getting into the detailed understanding will help you identify the inventory management norm required to manage these characteristics to ensure optimum efficiency. The solution quite often may not be to carry stocks, rather it may involve setting up the customer service standard for such items and specifying a delivery time depending upon the frequency of demand. Quite a few items often have varying shelf lives, and hence may require separate norms and focus to manage.

Study demand pattern, movement patterns and cycles to build suitable inventory norms for different categories of inventory

Companies which are into the business of retailing and dealing with huge inventories in terms of number of parts as well as value will necessarily need to ensure they practice review of inventory lists and clean up operations on an ongoing basis.

Popularly known as catalogue management, norms for reviewing inventory management practices should be put in place based on detailed study of the sales data, demand pattern, sales cycles etc. Understanding of the business and sales cycles specific to the product category helps one manage inventories better. For example, in case of retail garments, some of which become redundant no matter how their demand was in the previous months. This helps identify those stocks which are required to be managed at a micro level and identify the high value and fast moving items that need to be always on the radar to avoid stock outs.

It does not help for example to carry standard stocks of all items including low value items as well as high value items. If the low value items are locally available and the lead-time is less, one can cut down on the inventory and change the buying pattern. Similarly high value items too can be managed by cutting down the delivery lead times and in turn reducing inventory.

It helps to periodically study the past data and extrapolate the same to identify slow moving and obsolete items. The dead stocks should be flushed out and active catalogue items should be made available.

Improving Inventory Management Practices Through ERP?s

ERP applications bring about transparency and visibility in the operations of a company. Companies having operations or branches across multiple locations can be able to manage their inventory, track dispatches, plan purchases, and monitor their financials over an ERP platform. Standardization of all processes across the organization can be achieved and data accuracy is also enhanced. This leads to tangible business benefits and directly improves the bottom line. ERP?s are especially important because they bring about efficiency in inventory management.

Having a visibility of inventory is necessary whether it?s in the factory, ware house, or depot. ERP systems can effectively track the movement of raw material, packaging material, consumables, manufacturing and sales or finished goods at all stages of procurement. Analysis of slow moving, perishable, unused inventory can help managers decide to come upon on a suitable decision. This reduction of inventory by a few percentage points can release cash to the business. It can also lead to a reduction in working capital requirements. Inventory management practices through ERP systems can help reduces plant shutdowns due to shortage of required material. The system adequately facilitates procurement planning which is dependent upon accurate information about inventory at each location in addition to Finished goods inventory management which is important for servicing customer requirements.