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Book : Financial Accounting

 MODUL AKUNTANSI
SMA NEGERI 1KRAKSAAN
KELAS : XI IPS
================================================================
Oleh : TASRON, S.Pd, M.Pd



FINANCIAL ACCOUNTING


Introduction
The purpose of accounting is to provide the information that is needed for sound economic decision making. The main purpose of financial accounting is to prepare financial reports that provide information about a firm's performance to external parties such as investors, creditors, and tax authorities. Managerial accounting contrasts with financial accounting in that managerial accounting is for internal decision making and does not have to follow any rules issued by standard-setting bodies. Financial accounting, on the other hand, is performed according to Generally Accepted Accounting Principles (GAAP) guidelines.


CPA's
The primary accounting professional association in the U.S. is the American Institute of Certified Public Accountants (AICPA). The AICPA prepares the Uniform CPA Examination, which must be completed in order to become a certified public accountant. To be eligible to become a CPA, one needs an undergraduate degree in any major with 150 credit hours of course work. Of these 150 credit hours, a minimum of 36 credit hours must be in accounting. Only about 10% of those taking the CPA exam pass it the first time.


Accounting Standards
In order that financial statements report financial performance fairly and consistently, they are prepared according to widely accepted accounting standards. These standards are referred to as Generally Accepted Accounting Principles, or simply GAAP. Generally Accepted Accounting Principles are those that have "substantial authoritative support".


Accrual vs. Cash Method
Many small businesses utilize an accounting system that recognizes revenue and expenses on a cash basis, meaning that neither revenue nor expenses are recognized until the cash associated with them actually is received. Most larger businesses, however, use the accrual method.
Under the accrual method, revenues and expenses are recorded according to when they are earned and incurred, not necessarily when the cash is received or paid. For example, under the accrual method revenue is recognized when customers are invoiced, regardless of when payment is received. Similarly, an expense is recognized when the bill is received, not when payment is made.
Under accrual accounting, even though employees may be paid in the next accounting period for work performed near the end of the present accounting period, the expense still is recorded in the current period since the current period is when the expense was incurred.


Underlying Assumptions, Principles, and Conventions
Financial accounting relies on the following underlying concepts:
  1. Assumptions: Separate entity assumption, going-concern assumption, stable monetary unit assumption, fixed time period assumption.
  2. Principles: Historical cost principle, matching principle, revenue recognition principle, full disclosure principle.
  3. Modifying conventions: Materiality, cost-benefit, conservatism convention, industry practices convention.

Financial Statements
Businesses have two primary objectives:
  • Earn a profit
  • Remain solvent
Solvency represents the ability of the business to pay its bills and service its debt.
The four financial statements are reports that allow interested parties to evaluate the profitability and solvency of a business. These reports include the following financial statements:
  1. Balance Sheet
  2. Income Statement
  3. Statement of Owner's Equity
  4. Statement of Cash Flows
These four financial statements are the final product of the accountant's analysis of the transactions of a business. A large amount of effort goes into the preparation of the financial statements. The process begins with bookkeeping, which is just one step in the accounting process. Bookkeeping is the actual recording of the company's transactions, without any analysis of the information. Accountants evaluate and analyze the information, making sense out of the numbers.
For the reports to be useful, they must be:
  • Understandable
  • Timely
  • Relevant
  • Fair and Objective (free from bias)

Double Entry Accounting
Financial accounting is based on double-entry bookkeeping procedures in which each transaction is recorded in opposite columns of the accounts affected by the exchange. Double entry accounting is a significant improvement over simple and more error-prone single-entry bookkeeping systems.

Fundamental Accounting Model
The balance sheet is based on the following fundamental accounting equation :
Assets  =  Liabilities  +  Equity
This model has been used since the 18th century. It essentially states that a business owes all of its assets to either creditors or owners, where the assets of a business are its resources, and the creditors and owners are the sources of those resources.


Transactions
To record transactions, one must:
  1. Identify an event that affects the entity financially.
  2. Measure the event in monetary terms.
  3. Determine which accounts the transaction affects.
  4. Determine whether the transaction increases or decreases the balances in those accounts.
  5. Record the transaction in the ledgers.
Most larger business accounting systems utilize the double entry method. Under double entry, instead of recording a transaction in only a single account, the transaction is recorded in two accounts.
Financial Accounting Standards

Accounting standards are needed so that financial statements will fairly and consistently describe financial performance. Without standards, users of financial statements would need to learn the accounting rules of each company, and comparisons between companies would be difficult.
Accounting standards used today are referred to as Generally Accepted Accounting Principles (GAAP). These principles are "generally accepted" because an authoritative body has set them or the accounting profession widely accepts them as appropriate.

Securities and Exchange Commission (SEC)
The Securities and Exchange Commission is a U.S. regulatory agency that has the authority to establish accounting standards for publicly traded companies. The Securities Act of 1933 and the Securities Exchange Act of 1934 require certain reports to be filed with the SEC. For example, Forms 10-Q and 10-K must be filed quarterly and annually, respectively. The head of the SEC is appointed by the President of the United States.
When the SEC was formed there was no standards-issuing body. However, rather than set standards, the SEC encouraged the private sector to set them. The SEC has stated that FASB standards are considered to have authoritative support.


Committee on Accounting Procedure (CAP)
In 1939, encouraged by the SEC, the American Institute of Certified Public Accountants (AICPA) formed the Committee on Accounting Procedure (CAP). From 1939 to 1959, CAP issued 51 Accounting Research Bulletins that dealt with issues as they arose. CAP had only limited success because it did not develop an overall accounting framework, but rather, acted upon specific problems as they arose.

Accounting Principles Board (APB)
In 1959, the AICPA replaced CAP with the Accounting Principles Board (APB), which issued 31 opinions and 4 statements until it was dissolved in 1973. GAAP essentially arose from the opinions of the APB.
The APB was criticized for its structure and for several of its positions on controversial topics. In 1971 the Wheat Committee (chaired by Francis Wheat) was formed to evaluate the APB and propose changes.

Financial Accounting Standards Board (FASB)
The Wheat Committee recommended the replacement of the Accounting Principles Board with a new standards-setting structure. This new structure was implemented in 1973 and was made up of three organizations:
  1. Financial Accounting Foundation (FAF)
  2. Financial Accounting Standards Board (FASB)
  3. Financial Accounting Standards Advisory Council (FASAC).
Of these organizations, FASB (pronounced "FAS-B") is the primary operating organization.
Unlike the APB, FASB was designed to be an independent board comprised of members who have severed their ties with their employers and private firms. FASB issues statements of financial accounting standards, which define GAAP. The AICPA issues audit guides. When a conflict occurs, FASB rules.

International Accounting Standards Committee (IASC)
The International Accounting Standards Committee (IASC) was formed in 1973 to encourage international cooperation in developing consistent worldwide accounting principles. In 2001, the IASC was succeeded by the International Accounting Standards Board (IASB), an independent private sector body that is structured similar to FASB.

Governmental Accounting Standards Board (GASB)
The financial reports of state and local goverment entities are not directly comparable to those of businesses. In 1984, the Governmental Accounting Standards Board (GASB) was formed to set standards for the financial reports of state and local government. GASB was modeled after FASB.


Accounting Concepts

Underlying Assumptions, Principles, and Conventions

Financial accounting relies on several underlying concepts that have a significant impact on the practice of accounting.
Assumptions
The following are basic financial accounting assumptions:
1.    Separate entity assumption - the business is an entity that is separate and distinct from its owners, so that the finances of the firm are not co-mingled with the finances of the owners.
2.    Going concern assumption - the business is going to be operating for the foreseeable future.
3.    Stable monetary unit assumption - e.g. the U.S. dollar
  1. Fixed time period assumption - info prepared and reported periodically (quarterly, annually, etc.)

Principles
The basic assumptions of accounting result in the following accounting principles:
  • Historical cost principle - assets are reported and presented at their original cost and no adjustment is made for changes in market value. One never writes up the cost of an asset. Accountants are very conservative in this sense. Sometimes costs are written down, for example, for some short-term investments and marketable securities, but costs never are written up.
  • Matching principle - matching of revenues and expenses in the period earned and incurred.
  • Revenue recognition principle - revenue is realized (reported on the books as earned) when everything that is necessary to earn the revenue has been completed.
  • Full disclosure principle - all of the information about the business entity that is needed by users is disclosed in understandable form.
Modifying Conventions
Due to practical constraints and industry practice, GAAP principles are not always applied strictly but are modified as necessary. The following are some commonly observed modifying conventions:
1.    Materiality convention - a modifying convention that relaxes certain GAAP requirements if the impact is not large enough to influence decisions. Users of the information should not be overburdened with information overload.
2.    Cost-benefit convention - a modifying convention that relaxes GAAP requirements if the expected cost of reporting something exceeds the benefits of reporting it.
3.    Conservatism convention - when there is a choice of equally acceptable accounting methods, the firm should use the one that is least likely to overstate income or assets.
4.    Industry practices convention - accepted industry practices should be followed even if they differ from GAAP.

The Accounting Cycle

The sequence of activities beginning with the occurrence of a transaction is known as the accounting cycle. This process is shown in the following diagram:

Steps in The Accounting Cycle
Identify the Transaction
Identify the event as a transaction
and generate the source document.
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Analyze the Transaction
Determine the transaction amount,
which accounts are affected,
and in which direction.
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Journal Entries
The transaction is recorded in
the journal as a debit and a credit.
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Post to Ledger
The journal entries are transferred
to the appropriate T-accounts
in the ledger.
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Trial Balance
A trial balance is calculated
to verify that the sum of the debits
is equal to the sum of the credits.
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Adjusting Entries
Adjusting entries are made for
accrued and deferred items.
The entries are journalized and
posted to the T-accounts
in the ledger.
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Adjusted
Trial Balance

A new trial balance is calculated
after making the adjusting entries.
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Financial Statements
The financial statements
are prepared.
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Closing Entries
Transfer the balances of the
temporary accounts
(e.g. revenues and expenses)
to owner's equity.
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After-Closing
Trial Balance

A final trial balance is
calculated after the closing
entries are made.
The above diagram shows the financial statements as being prepared after the adjusting entries and adjusted trial balance. The financial statements also can be prepared before the adjusting entries with the help of a worksheet that calculates the impact of the adjusting entries before they actually are posted.
The Accounting Process
Once a business transaction occurs, a sequence of activities begins to identify and analyze the transaction, make the journal entries, etc. Because this process repeats over transactions and accounting periods, it is referred to as the accounting cycle.
The Accounting Process
An overview of the steps of the accounting cycle, beginning with a transaction and ending with the closing of the books and reversing entries.
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Source Documents
Examples of transaction source documents and the purpose they serve in the accounting system.
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General Journal Entries
An introduction to general journal entries, with an example of how a series of transactions would be recorded in the general journal.
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General Ledger
An introduction to the posting of transactions in the general ledger, with an example of how a series of journal entries would be posted to ledger T-accounts.
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Trial Balance
How to calculate the trial balance, with an example and explanation of how to isolate errors.
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Adjusting Entries
Explains the need for adjusting entries for accruals and deferrals and how to record them.
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Preparing the Financial Statements
A basic explanation of how to prepare the financial statements.
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Closing Entries
An introduction to closing entries with examples to illustrate their preparation.
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Reversing Entries
The purpose of reversing entries and an example illustrating their use.
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The Chart of Accounts
What to consider when setting up a chart of accounts.Includes a sample chart of accounts.
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Management Accounting and Performance Measurement:
Balanced Scorecard
Introduces the Balanced Scorecard and discusses its four performance measurement perspectives, its benefits, and a basic process for building one.
The Accounting Process
(The Accounting Cycle)
The accounting process is a series of activities that begins with a transaction and ends with the closing of the books. Because this process is repeated each reporting period, it is referred to as the accounting cycle and includes these major steps:
  1. Identify the transaction or other recognizable event.
  2. Prepare the transaction's source document such as a purchase order or invoice.
  3. Analyze and classify the transaction. This step involves quantifying the transaction in monetary terms (e.g. dollars and cents), identifying the accounts that are affected and whether those accounts are to be debited or credited.
  4. Record the transaction by making entries in the appropriate journal, such as the sales journal, purchase journal, cash receipt or disbursement journal, or the general journal. Such entries are made in chronological order.
  5. Post general journal entries to the ledger accounts.
a.       The above steps are performed throughout the accounting period as transactions occur or in periodic batch processes. The following steps are performed at the end of the accounting period:
  1. Prepare the trial balance to make sure that debits equal credits. The trial balance is a listing of all of the ledger accounts, with debits in the left column and credits in the right column. At this point no adjusting entries have been made. The actual sum of each column is not meaningful; what is important is that the sums be equal. Note that while out-of-balance columns indicate a recording error, balanced columns do not guarantee that there are no errors. For example, not recording a transaction or recording it in the wrong account would not cause an imbalance.
  2. Correct any discrepancies in the trial balance. If the columns are not in balance, look for math errors, posting errors, and recording errors. Posting errors include:
    1. posting of the wrong amount,
    2. omitting a posting,
    3. posting in the wrong column, or
    4. posting more than once.
  3. Prepare adjusting entries to record accrued, deferred, and estimated amounts.
  4. Post adjusting entries to the ledger accounts.
  5. Prepare the adjusted trial balance. This step is similar to the preparation of the unadjusted trial balance, but this time the adjusting entries are included. Correct any errors that may be found.
  6. Prepare the financial statements.
    1. Income statement: prepared from the revenue, expenses, gains, and losses.
    2. Balance sheet: prepared from the assets, liabilities, and equity accounts.
    3. Statement of retained earnings: prepared from net income and dividend information.
    4. Cash flow statement: derived from the other financial statements using either the direct or indirect method.
  7. Prepare closing journal entries that close temporary accounts such as revenues, expenses, gains, and losses. These accounts are closed to a temporary income summary account, from which the balance is transferred to the retained earnings account (capital). Any dividend or withdrawal accounts also are closed to capital.
  8. Post closing entries to the ledger accounts.
  9. Prepare the after-closing trial balance to make sure that debits equal credits. At this point, only the permanent accounts appear since the temporary ones have been closed. Correct any errors.
  10. Prepare reversing journal entries (optional). Reversing journal entries often are used when there has been an accrual or deferral that was recorded as an adjusting entry on the last day of the accounting period. By reversing the adjusting entry, one avoids double counting the amount when the transaction occurs in the next period. A reversing journal entry is recorded on the first day of the new period.
Instead of preparing the financial statements before the closing journal entries, it is possible to prepare them afterwards, using a temporary income summary account to collect the balances of the temporary ledger accounts (revenues, expenses, gains, losses, etc.) when they are closed. The temporary income summary account then would be closed when preparing the financial statements.

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

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


     Name of account being credited

     Amount

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


     Capital

7500

Owner contributes $7500 in cash
to capitalize the business.



9/8     
Bike Parts
2500


     Accounts Payable

2500

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



9/15     
Expenses
1000


     Cash

1000

Paid first month's shop rent of $1000.



9/17     
Cash
400


Accounts Receivable
700


     Revenue

1100

Repaired bikes for $1100; collected $400
cash; billed customers for the balance.



9/18     
Expenses
275


     Bike Parts

275

$275 in bike parts were used.



9/25     
Cash
425


     Accounts Receivable

425

Collected $425 from customer accounts.



9/28     
Accounts Payable
500


     Cash

500

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


Most of the above transactions are entered as simple journal entries each debiting one account and crediting another. The entry for 9/17 is a compound journal entry, composed of two lines for the debit and one line for the credit. The transaction could have been entered as two separate simple journal entries, but the compound form is more efficient.
In this example, there are no account numbers. In practice, account numbers or codes may be included in the journal entries to allow each account to be positively identified with no confusion between similar accounts.
The journal entry is the first entry of a transaction in the accounting system. Before the entry is made, the following decisions must be made:
1.      which accounts are affected by the transaction, and
2.      which account will be debited and which will be credited.
Once entered in the journal, the transactions may be posted to the appropriate T-accounts of the general ledger. Unlike the journal entry, the posting to the general ledger is a purely mechanical process - the account and debit/credit decisions already have been made.



The General Ledger
The general ledger is a collection of the firm's accounts. While the general journal is organized as a chronological record of transactions, the ledger is organized by account. In casual use the accounts of the general ledger often take the form of simple two-column T-accounts. In the formal records of the company they may contain a third or fourth column to display the account balance after each posting.
To illustrate the posting of transactions in the general ledger, consider the following transactions taken from the example on general journal entries:
Date
Account Names
     Debit
     Credit
9/1     
Cash
7500


     Capital

7500

9/8     
Bike parts
2500


     Accounts payable

2500

9/15     
Expenses
1000


     Cash

1000

9/17     
Cash
400


Accounts Receivable
700


     Revenue

1100

9/18     
Expenses
275


     Bike parts

275

9/25     
Cash
425


     Accounts receivable

425

9/28     
Accounts payable
500


     Cash

500
The above journal entries affect a total of seven different accounts and would be posted to the T-accounts of the general ledger as follows:
General Ledger
(T-Accounts)
Cash
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Sep  
1
    7500

17
400

25
425
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Sep  
15
    1000

28
500
Accounts Receivable
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Sep  
17
    700
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Sep  
25
    425

Bike Parts
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Sep  
8
    2500
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Sep  
18
    275
Accounts Payable
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Sep  
28
    500
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Sep  
8
    2500

Capital
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Sep  
1
    7500
Revenue
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Sep  
17
    1100

Expenses
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Sep  
15
    1000
Sep  
18
    275
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Note the direct mapping between the journal entries and the ledger postings. While this posting of journalized transactions in the general ledger at first may appear to be redundant since the transactions already are recorded in the general journal, the general ledger serves an important function: it allows one to view the activity and balance of each account at a glance. Because the posting to the ledger is simply a rearrangement of information requiring no additional decisions, it easily is performed by accounting software, either when the journal entry is made or as a batch process, for example, at the end of the day or week.
Finally, while such T-accounts are handy for informal use, in practice a three-column or four-column account may be used to show the running account balance, and in the case of a four column account, whether that balance is a net debit or credit. Additionally, reference numbers may be used so that each posting can be traced back to its original journal entry.

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

17
400

25
425
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Sep  
15
    1000

28
500
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Bal.    6825http://www.NetMBA.com/lib/pixel/0.gif
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Accounts Receivable
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Sep  
17
     700
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Sep  
25
    425
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Bal.    275http://www.NetMBA.com/lib/pixel/0.gif
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Parts Inventory
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Sep  
8
     2500
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Sep  
18
    275
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Bal.    2225http://www.NetMBA.com/lib/pixel/0.gif
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Accounts Payable
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Sep  
28
    500
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Sep  
8
     2500
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Bal.    2000http://www.NetMBA.com/lib/pixel/0.gif

Capital
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Sep  
1
     7500
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http://www.NetMBA.com/lib/pixel/000000.gif
Bal.    7500http://www.NetMBA.com/lib/pixel/0.gif
Revenue
http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif
  

    
http://www.NetMBA.com/lib/pixel/000000.gif
Sep  
17
    1100
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http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif

http://www.NetMBA.com/lib/pixel/000000.gif
Bal.    1100http://www.NetMBA.com/lib/pixel/0.gif




Expenses
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http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif
Sep  
15
    1000
Sep  
18
    275
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http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif
Bal.    1275http://www.NetMBA.com/lib/pixel/0.gif
http://www.NetMBA.com/lib/pixel/000000.gif


Once the account balances are known, the trial balance can be calculated as shown:
Trial Balance
Account Title
  Debits
  Credits
Cash
6825

Accounts Receivable
275

Parts Inventory
2225

Accounts Payable

2000
Capital

7500
Revenue

1100
Expenses
1275


http://www.NetMBA.com/lib/pixel/000000.gif
10600
http://www.NetMBA.com/lib/pixel/000000.gif
10600
In this example, the debits and credits balance. This result does not guarantee that there are no errors. For example, the trial balance would not catch the following types of errors:
1.      Transactions that were not recorded in the journal
2.      Transactions recorded in the wrong accounts
3.      Transactions for which the debit and credit were transposed
4.      Neglecting to post a journal entry to the ledger
If the trial balance is not in balance, then an error has been made somewhere in the accounting process. The following is listing of common errors that would result in an unbalanced trial balance; this listing can be used to assist in isolating the cause of the imbalance.
  • Summation error for the debits and credits of the trial balance
  • Error transferring the ledger account balances to the trial balance columns
    • Error in numeric value
    • Error in transferring a debit or credit to the proper column
    • Omission of an account
  • Error in the calculation of a ledger account balance
  • Error in posting a journal entry to the ledger
    • Error in numeric value
    • Error in posting a debit or credit to the proper column
  • Error in the journal entry
    • Error in a numeric value
    • Omission of part of a compound journal entry
The more often that the trial balance is calculated during the accounting cycle, the easier it is to isolate any errors; more frequent trial balance calculations narrow the time frame in which an error might have occurred, resulting in fewer transactions through which to search.

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


     Salaries payable

80,000

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


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


     Cash

12,000

12-month prepaid insurance policy.


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


     Prepaid Expenses

1,000

Insurance expense for Sep.


This adjusting entry transfers $1000 from the Prepaid Expenses asset account to the Insurance Expense expense account to properly record the insurance expense for the month of September. In this example, a similar adjusting entry would be made for each subsequent month until the insurance policy expires 11 months later.
Some deferred items for which adjusting entries would be made include:
1.      Prepaid insurance
2.      Prepaid rent
3.      Office supplies
4.      Depreciation
5.      Unearned revenue
In the case of unearned revenue, a liability account is credited when the cash is received. An adjusting entry is made once the service has been rendered or the product has been shipped, thus realizing the revenue.
Completing the Adjusting Entries
To prevent inadvertent omission of some adjusting entries, it is helpful to review the ones from the previous accounting period since such transactions often recur. It also helps to talk to various people in the company who might know about unbilled revenue or other items that might require adjustments.
Preparing the Financial Statements
Once the adjusting entries have been made or entered into a worksheet, the financial statements can be prepared using information from the ledger accounts. Because some of the financial statements use data from the other statements, the following is a logical order for their preparation:
1.      Income statement
2.      Statement of retained earnings
3.      Balance sheet
4.      Cash flow statement
Income Statement
The income statement reports revenues, expenses, and the resulting net income. It is prepared by transferring the following ledger account balances, taking into account any adjusting entries that have been or will be made:
  • Revenue
  • Expenses
  • Capital gains or losses
Statement of Retained Earnings
The retained earnings statement shows the retained earnings at the beginning and end of the accounting period. It is prepared using the following information:
1.      Beginning retained earnings, obtained from the previous statement of retained earnings.
2.      Net income, obtained from the income statement
3.      Dividends paid during the accounting period
Balance Sheet
The balance sheet reports the assets, liabilities, and shareholder equity of the company. It is constructed using the following information:
  • Balances of all asset accounts such cash, accounts receivable, etc.
  • Balances of all liability accounts such as accounts payable, notes, etc.
  • Capital stock balance
  • Retained earnings, obtained from the statement of retained earnings
Cash Flow Statement
The cash flow statement explains the reasons for changes in the cash balance, showing sources and uses of cash in the operating, financing, and investing activities of the firm. Because the cash flow statement is a cash-basis report, it cannot be derived directly from the ledger account balances of an accrual accounting system. Rather, it is derived by converting the accrual information to a cash-basis using one of the following two methods:
1.      Direct method: cash flow information is derived by directly subtracting cash disbursements from cash receipts.
2.      Indirect method: cash flow information is derived by adding or subtracting non-cash items from net income.
Closing Entries
At the end of the accounting period, the balances in temporary accounts are transferred to an income summary account and a retained earnings account, thereby resetting the balance of the temporary accounts to zero to begin the next accounting period.
First, the revenue accounts are closed by transferring their balances to the income summary account. Consider the following example for which September 30 is the end of the accounting period. If the revenue account balance is $1100, then the closing journal entry would be:
Date
Accounts
     Debit
     Credit
9/30     
Revenue
1100


     Income Summary

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


     Expenses

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


     Income Summary

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


     Dividends

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

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


     Interest Payable

50

15 days of accrued interest.


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


     Interest Expense

50

Reversing entry for 15 days
of interest accrued in Sep.


Note that the above journal entry is exactly the reverse of the adjusting entry made on September 30. Once this reversing entry is posted, the affected ledger accounts will appear as follows:
Ledger Accounts After Reversing Entry
Interest Payable
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http://www.NetMBA.com/lib/pixel/000000.gif
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Oct  
1
      50
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Sep  
30
     50
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http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif

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Bal.    0http://www.NetMBA.com/lib/pixel/0.gif
Interest Expense
http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif
  

    
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Oct  
1
      50
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http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif

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


     Interest Payable

100

Interest for Sep 16 through Oct 15.


The ledger accounts will appear as follows once the journal entries through October 15 are posted:
Interest Payable
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http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif
Oct  
1
      50
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Sep  
30
     50
Oct  
15
     100
http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif

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Bal.    100http://www.NetMBA.com/lib/pixel/0.gif
Interest Expense
http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif
http://www.NetMBA.com/lib/pixel/000000.gif
Oct  
15
    100
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Oct  
1
      50
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Bal.    50http://www.NetMBA.com/lib/pixel/0.gif
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The net interest expense for October then is $50, as it should be since the other $50 already was reported in September.
As can be seen in the ledger accounts, the net effect is that a $50 interest expense will be realized in October, and the full $100 of interest will be paid to the holder of the note.
Reversing entries are a useful tool for dealing with certain accruals and deferrals. Their use is optional and depends on the accounting practices of the particular firm and the specific responsibilities of the bookkeeping staff.

Chart of Accounts
The chart of accounts is a listing of all the accounts in the general ledger, each account accompanied by a reference number. To set up a chart of accounts, one first needs to define the various accounts to be used by the business. Each account should have a number to identify it. For very small businesses, three digits may suffice for the account number, though more digits are highly desirable in order to allow for new accounts to be added as the business grows. With more digits, new accounts can be added while maintaining the logical order. Complex businesses may have thousands of accounts and require longer account reference numbers. It is worthwhile to put thought into assigning the account numbers in a logical way, and to follow any specific industry standards. An example of how the digits might be coded is shown in this list:
Account Numbering
1000 - 1999: asset accounts
2000 - 2999: liability accounts
3000 - 3999: equity accounts
4000 - 4999: revenue accounts
5000 - 5999: cost of goods sold
6000 - 6999: expense accounts
7000 - 7999: other revenue (for example, interest income)
8000 - 8999: other expense (for example, income taxes)
By separating each account by several numbers, many new accounts can be added between any two while maintaining the logical order.
Defining Accounts
Different types of businesses will have different accounts. For example, to report the cost of goods sold a manufacturing business will have accounts for its various manufacturing costs whereas a retailer will have accounts for the purchase of its stock merchandise. Many industry associations publish recommended charts of accounts for their respective industries in order to establish a consistent standard of comparison among firms in their industry. Accounting software packages often come with a selection of predefined account charts for various types of businesses.
There is a trade-off between simplicity and the ability to make historical comparisons. Initially keeping the number of accounts to a minimum has the advantage of making the accounting system simple. Starting with a small number of accounts, as certain accounts acquired significant balances they would be split into smaller, more specific accounts. However, following this strategy makes it more difficult to generate consistent historical comparisons. For example, if the accounting system is set up with a miscellaneous expense account that later is broken into more detailed accounts, it then would be difficult to compare those detailed expenses with past expenses of the same type. In this respect, there is an advantage in organizing the chart of accounts with a higher initial level of detail.
Some accounts must be included due to tax reporting requirements. For example, in the U.S. the IRS requires that travel, entertainment, advertising, and several other expenses be tracked in individual accounts. One should check the appropriate tax regulations and generate a complete list of such required accounts.
Other accounts should be set up according to vendor. If the business has more than one checking account, for example, the chart of accounts might include an account for each of them.
Account Order
Balance sheet accounts tend to follow a standard that lists the most liquid assets first. Revenue and expense accounts tend to follow the standard of first listing the items most closely related to the operations of the business. For example, sales would be listed before non-operating income. In some cases, part or all of the expense accounts simply are listed in alphabetical order.
Sample Chart of Accounts
The following is an example of some of the accounts that might be included in a chart of accounts.
Sample Chart of Accounts
Asset Accounts
Current Assets
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1000
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Petty Cash
1010
Cash on Hand (e.g. in cash registers)
1020
Regular Checking Account
1030
Payroll Checking Account
1040
Savings Account
1050
Special Account
1060
Investments - Money Market
1070
Investments - Certificates of Deposit
1100
Accounts Receivable
1140
Other Receivables
1150
Allowance for Doubtful Accounts
1200
Raw Materials Inventory
1205
Supplies Inventory
1210
Work in Progress Inventory
1215
Finished Goods Inventory - Product #1
1220
Finished Goods Inventory - Product #2
1230
Finished Goods Inventory - Product #3
1400
Prepaid Expenses
1410
Employee Advances
1420
Notes Receivable - Current
1430
Prepaid Interest
1470
Other Current Assets
Fixed Assets
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1500
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Furniture and Fixtures
1510
Equipment
1520
Vehicles
1530
Other Depreciable Property
1540
Leasehold Improvements
1550
Buildings
1560
Building Improvements
1690
Land
1700
Accumulated Depreciation, Furniture and Fixtures
1710
Accumulated Depreciation, Equipment
1720
Accumulated Depreciation, Vehicles
1730
Accumulated Depreciation, Other
1740
Accumulated Depreciation, Leasehold
1750
Accumulated Depreciation, Buildings
1760
Accumulated Depreciation, Building Improvements
Other Assets
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1900
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Deposits
1910
Organization Costs
1915
Accumulated Amortization, Organization Costs
1920
Notes Receivable, Non-current
1990
Other Non-current Assets
Liability Accounts
Current Liabilities
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2000
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Accounts Payable
2300
Accrued Expenses
2310
Sales Tax Payable
2320
Wages Payable
2330
401-K Deductions Payable
2335
Health Insurance Payable
2340
Federal Payroll Taxes Payable
2350
FUTA Tax Payable
2360
State Payroll Taxes Payable
2370
SUTA Payable
2380
Local Payroll Taxes Payable
2390
Income Taxes Payable
2400
Other Taxes Payable
2410
Employee Benefits Payable
2420
Current Portion of Long-term Debt
2440
Deposits from Customers
2480
Other Current Liabilities

Long-term Liabilities
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2700
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Notes Payable
2702
Land Payable
2704
Equipment Payable
2706
Vehicles Payable
2708
Bank Loans Payable
2710
Deferred Revenue
2740
Other Long-term Liabilities
Equity Accounts
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3010
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Stated Capital
3020
Capital Surplus
3030
Retained Earnings

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

Cost of Goods Sold
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5000
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Product #1 Cost
5010
Product #2 Cost
5020
Product #3 Cost
5050
Raw Material Purchases
5100
Direct Labor Costs
5150
Indirect Labor Costs
5200
Heat and Power
5250
Commissions
5300
Miscellaneous Factory Costs
5700
Cost of Goods Sold, Salaries and Wages
5730
Cost of Goods Sold, Contract Labor
5750
Cost of Goods Sold, Freight
5800
Cost of Goods Sold, Other
5850
Inventory Adjustments
5900
Purchase Returns and Allowances
5950
Purchase Discounts
Expenses
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6000
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Default Purchase Expense
6010
Advertising Expense
6050
Amortization Expense
6100
Auto Expenses
6150
Bad Debt Expense
6200
Bank Fees
6250
Cash Over and Short
6300
Charitable Contributions Expense
6350
Commissions and Fees Expense
6400
Depreciation Expense
6450
Dues and Subscriptions Expense
6500
Employee Benefit Expense, Health Insurance
6510
Employee Benefit Expense, Pension Plans
6520
Employee Benefit Expense, Profit Sharing Plan
6530
Employee Benefit Expense, Other
6550
Freight Expense
6600
Gifts Expense
6650
Income Tax Expense, Federal
6660
Income Tax Expense, State
6670
Income Tax Expense, Local
6700
Insurance Expense, Product Liability
6710
Insurance Expense, Vehicle
6750
Interest Expense
6800
Laundry and Dry Cleaning Expense
6850
Legal and Professional Expense
6900
Licenses Expense
6950
Loss on NSF Checks
7000
Maintenance Expense
7050
Meals and Entertainment Expense
7100
Office Expense
7200
Payroll Tax Expense
7250
Penalties and Fines Expense
7300
Other Taxes
7350
Postage Expense
7400
Rent or Lease Expense
7450
Repair and Maintenance Expense, Office
7460
Repair and Maintenance Expense, Vehicle
7550
Supplies Expense, Office
7600
Telephone Expense
7620
Training Expense
7650
Travel Expense
7700
Salaries Expense, Officers
7750
Wages Expense
7800
Utilities Expense
8900
Other Expense
9000
Gain/Loss on Sale of Assets


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


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Financial
Performance
1.      Objectives
2.      Measures
3.      Targets
4.      Initiatives




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Customers
  • Objectives
  • Measures
  • Targets
  • Initiatives
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Strategy

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Internal
Processes
  1. Objectives
  2. Measures
  3. Targets
  4. Initiatives





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Learning
& Growth
  • Objectives
  • Measures
  • Targets
  • Initiatives







The Balanced Scorecard (BSC) was published in 1992 by Robert Kaplan and David Norton. In addition to measuring current performance in financial terms, the Balanced Scorecard evaluates the firm's efforts for future improvement using process, customer, and learning and growth metrics. The term "scorecard" signifies quantified performance measures and "balanced" signifies that the system is balanced between:
1.      short-term objectives and long-term objectives
2.      financial measures and non-financial measures
3.      lagging indicators and leading indicators
4.      internal performance and external performance perspectives
Financial Measures Are Insufficient
While financial accounting is suited to the tracking of physical assets such as manufacturing equipment and inventory, it is less capable of providing useful reports in environments with a large intangible asset base. As intangible assets constitute an ever-increasing proportion of a company's market value, there is an increase in the need for measures that better report such assets as loyal customers, proprietary processes, and highly-skilled staff.
Consider the case of a company that is not profitable but that has a very large customer base. Such a firm could be an attractive takeover target simply because the acquiring firm wants access to those customers. It is not uncommon for a company to take over a competitor with the plan to discontinue the competing product line and convert the customer base to its own products and services. The balance sheets of such takeover targets do not reflect the value of the customers who nonetheless are worth something to the acquiring firm. Clearly, additional measures are needed for such intangibles.
Scorecard Measures are Limited in Number
The Balanced Scorecard is more than a collection of measures used to identify problems. It is a system that integrates a firm's strategy with a purposely limited number of key metrics. Simply adding new metrics to the financial ones could result in hundreds of measures and would create information overload.
To avoid this problem, the Balanced Scorecard focuses on four major areas of performance and a limited number of metrics within those areas. The objectives within the four perspectives are carefully selected and are firm specific. To avoid information overload, the total number of measures should be limited to somewhere between 15 and 20, or three to four measures for each of the four perspectives. These measures are selected as the ones deemed to be critical in achieving breakthrough competitive performance; they essentially define what is meant by "performance".
A Chain of Cause-and-Effect Relationships
Before the Balanced Scorecard, some companies already used a collection of both financial and non-financial measures of critical performance indicators. However, a well-designed Balanced Scorecard is different from such a system in that the four BSC perspectives form a chain of cause-and-effect relationships. For example, learning and growth lead to better business processes that result in higher customer loyalty and thus a higher return on capital employed (ROCE).
Effectively, the cause-and-effect relationships illustrate the hypothesis behind the organization's strategy. The measures reflect a chain of performance drivers that determine the effectiveness of the strategy implementation.
Objectives, Measures, Targets, and Initiatives
Within each of the Balanced Scorecard financial, customer, internal process, and learning perspectives, the firm must define the following:
  • Strategic objectives - what the strategy is to achieve in that perspective.
  • Measures - how progress for that particular objective will be measured.
  • Targets - the target value sought for each measure.
  • Initiatives - what will be done to facilitate the reaching of the target.
The following sections provide examples of some objectives and measures for the four perspectives.
Financial Perspective
The financial perspective addresses the question of how shareholders view the firm and which financial goals are desired from the shareholder's perspective. The specific goals depend on the company's stage in the business life cycle.
For example:
  • Growth stage - goal is growth, such as revenue growth rate
  • Sustain stage - goal is profitability, such ROE, ROCE, and EVA
  • Harvest stage - goal is cash flow and reduction in capital requirements
The following table outlines some examples of financial metrics:
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Objective
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Specific Measure
Growth
Revenue growth
Profitability
Return on equity
Cost leadership
Unit cost

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

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

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

Achieving Strategic Alignment throughout the Organization
Whereas strategy is articulated in terms meaningful to top management, to be implemented it must be translated into objectives and measures that are actionable at lower levels in the organization. The Balanced Scorecard can be cascaded to make the translation of strategy possible.
While top level objectives may be expressed in terms of growth and profitability, these goals get translated into more concrete terms as they progress down the organization and each manager at the next lower level develops objectives and measures that support the next higher level. For example, increased profitability might get translated into lower unit cost, which then gets translated into better calibration of the equipment by the workers on the shop floor. Ultimately, achievement of scorecard objectives would be rewarded by the employee compensation system. The Balanced Scorecard can be cascaded in this manner to align the strategy thoughout the organization.
The Process of Building a Balanced Scorecard
While there are many ways to develop a Balanced Scorecard, Kaplan and Norton defined a four-step process that has been used across a wide range of organizations.
  • Define the measurement architecture - When a company initially introduces the Balanced Scorecard, it is more manageable to apply it on the strategic business unit level rather than the corporate level. However, interactions must be considered in order to avoid optimizing the results of one business unit at the expense of others.
  • Specify strategic objectives - The top three or four objectives for each perspective are agreed upon. Potential measures are identified for each objective.
  • Choose strategic measures - Measures that are closely related to the actual performance drivers are selected for evaluating the progress made toward achieving the objectives.
  • Develop the implementation plan - Target values are assigned to the measures. An information system is developed to link the top level metrics to lower-level operational measures. The scorecard is integrated into the management system.
Balanced Scorecard Benefits
Some of the benefits of the Balanced Scorecard system include:
  • Translation of strategy into measurable parameters.
  • Communication of the strategy to everybody in the firm.
  • Alignment of individual goals with the firm's strategic objectives - the BSC recognizes that the selected measures influence the behavior of employees.
  • Feedback of implementation results to the strategic planning process.
Since its beginnings as a peformance measurement system, the Balanced Scorecard has evolved into a strategy implementation system that not only measures performance but also describes, communicates, and aligns the strategy throughout the organization.
Potential Pitfalls
The following are potential pitfalls that should be avoided when implementing the Balanced Scorecard:
  • Lack of a well-defined strategy: The Balanced Scorecard relies on a well-defined strategy and an understanding of the linkages between strategic objectives and the metrics. Without this foundation, the implementation of the Balanced Scorecard is unlikely to be successful.
  • Using only lagging measures: Many managers believe that they will reap the benefits of the Balanced Scorecard by using a wide range of non-financial measures. However, care should be taken to identify not only lagging measures that describe past performance, but also leading measures that can be used to plan for future performance.
  • Use of generic metrics: It usually is not sufficient simply to adopt the metrics used by other successful firms. Each firm should put forth the effort to identify the measures that are appropriate for its own strategy and competitive position.






Single Entry Bookkeeping

Most of financial accounting is based on double-entry bookkeeping. To understand and appreciate the advantages of double entry, it is worthwhile to examine the simpler single-entry bookkeeping system. In its most basic form, a single-entry system is similar to a checkbook register and is characterized by the fact that there is only a single line entered in the journal for each transaction. In a simple checkbook, each transaction is recorded in one column of an account as either a positive or a negative amount in order to represent the receipt or disbursement of cash. This system is demonstrated in the following example for a repair shop business:

Single Column System
Date
Description
Amount
Jan 1
Beginning Balance
1,000.00 
Jan 2
Purchased shop supplies
(150.00)
Jan 4
Performed repair service
275.00 
Jan 7
Performed repair service
125.00 
Jan 15
Paid phone bill
(50.00)
Jan 30
Ending balance
1,200.00 



While extremely simple, because the above system uses a single column, only the difference between revenues and expenses is totaled - not the individual values of each. Knowing the individual total amounts of revenues and expenses is important to a business, for example, when formulating a budget. The revenues and expenses also are reported in the income statement. In the above example, the individual revenue and expense amounts can be determined only by sorting through the transactions and tabulating the revenue and expense totals. This process can be designed into the system by using a separate column for revenues and expenses:




Separating Revenues and Expenses
Date
Description
Revenues
Expenses
Jan 2
Purchased shop supplies

150.00 
Jan 4
Performed repair service
275.00 

Jan 7
Performed repair service
125.00 

Jan 15
Paid phone bill

50.00 

January Totals
400.00 
200.00 



While the above example now uses two columns, it still is considered to be a single-entry system since only one line is used to record each transaction in the cash account. This single-entry system often is expanded to provide more useful information. For example, additional columns can be added to classify the revenues as sales and sales tax collected, and the expenses as rent, utilities, supplies, etc. Some single-entry systems may add dozens of columns for different types of revenues and expenses. Many small businesses utilize such a system. However, even with columns to classify the revenues and expenses, single-entry bookkeeping is limited in its ability to provide detailed financial information. Some disadvantages of a single-entry system include:
  • Does not track asset and liability accounts such as inventory, accounts receivable and accounts payable. These must be tracked separately.
  • Facilitates the calculation of income but not of financial position. There is no direct linkage between income and the balance sheet.
  • Errors may go undetected and often are identified only through bank statement reconciliation.
Because of these drawbacks, a single-entry system is not practical for many organizations such as those having many thousands of transactions in a reporting period, significant assets, and external suppliers of capital. The more sophisticated double-entry bookkeeping system addresses the more demanding needs of such businesses.




Double Entry Bookkeeping

A business transaction involves an exchange between two accounts. For example, for every asset there exists a claim on that asset, either by those who own the business or those who loan money to the business. Similarly, the sale of a product affects both the amount of cash (or cash receivable) held by the business and the inventory held.
Recognizing this fundamental dual nature of transactions, merchants in medieval Venice began using a double-entry bookkeeping system that records each transaction in the two accounts affected by the exchange. In the late 1400's, Franciscan monk and mathematician Luca Pacioli documented the procedure for double-entry bookkeeping as part of his famous Summa work, which described a significant portion of the accounting cycle. Double-entry bookkeeping spread throughout Europe and became the foundation of modern accounting.
Two notable characteristics of double-entry systems are that 1) each transaction is recorded in two accounts, and 2) each account has two columns.
In a double-entry system, two entries are made for each transaction - one entry as a debit in one account and the other entry as a credit in another account. The two entries keep the accounting equation in balance so that:

Assets    =    Liabilities   +   Owners' Equity
To illustrate, consider a repair shop with a transaction involving repair service performed on Jan 4 for a cash payment of $275.00. In a single-entry bookkeeping system, the transaction would be recorded as follows:





Single Entry Example
Date
Description
Revenues
Expenses
Jan 4
Performed repair service
275.00 


In a double-entry system, the transaction would be recorded as follows:

Double Entry Example
Date
Accounts
Debit
Credit
Jan 4
Cash
275.00


     Revenue

275.00

A notation may be added to this journal entry to indicate that the revenue was from repair services.
Note that two accounts (revenue and cash) are affected by the transaction. If the customer did not pay cash but instead was extended credit, then "accounts receivable" would have been used instead of "cash."
In this system, the double entries take the form of debits and credits, with debits in the left column and credits in the right. For each debit there is an equal and opposite credit and the sum of all debits therefore must equal the sum of all credits. This principle is useful for identifying errors in the transaction recording process.
Double-entry accounting has the following advantages over single-entry:
  • Accurate calculation of profit and loss in complex organizations
  • Inclusion of assets and liabilities in the bookkeeping accounts.
  • Preparation of financial statements directly from the accounts
  • Easier detection of errors and fraud
To appreciate the importance of double-entry bookkeeping, it is interesting to note that the industrial revolution might not have been possible without it. At that time, businesses increased in size and complexity. Accurate bookkeeping was required for managers to understand the financial status of their businesses in order to keep them solvent and offer a degree of transparency to investors. While a single-entry system can be adapted by a skilled bookkeeper to meet some of these needs, only a double-entry system provides the required detail systematically and by design.









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