Perpetual vs. Periodic Inventory System Journal Entries

A. The Sale and Purchase of Products

Perpetual inventory systems show all changes in inventory in the "Inventory" account. Purchase accounts are not used in a perpetual inventory system.

Periodic inventory systems keep the inventory balance at the same value that it was at the beginning of the year. At year end, the inventory balance is adjusted to a physical count. To account for inventory purchases in a periodic inventory system, an account called "Purchases" is used rather than debiting "Inventory".

B. Cost of Goods Sold in a Periodic Inventory System

Perpetual inventory systems record cost of goods sold and keep inventory at its current balance throughout the year. Therefore, there is no need to do a year-end inventory adjustment unless the perpetual records disagree with the inventory count. In addition, a separate cost of goods sold calculation is unnecessary since cost of goods sold is recorded whenever inventory is sold.

The inventory account in a periodic inventory system keeps its beginning balance until the end of period adjustment to the physical inventory count. Therefore, a separate cost of goods sold calculation is necessary. The following calculation shows the calculation for the preceding example.

C. Purchase Returns and Allowances and Purchase Discounts

"Purchases" has a normal debit balance since it replaces the debit to "Inventory". It has two contra accounts known as "Purchase Discounts" (Purch. Disc.) and "Purchase Returns and Allowances" (Purch. R&A) that reduce it to determine "Net Purchases". The balance of these two contra accounts is a credit because "Purchases" is a debit. Remember that contra accounts always have a normal balance that is opposite to what they are contra to. Purchase-type accounts are temporary accounts (i.e., they are closed at year end) and only appear in a periodic inventory system. They simply serve to replace the corresponding inventory portion of an entry that exists in a perpetual inventory system. The following entries illustrate purchase returns and discounts in perpetual and periodic inventory systems:

D. Sales Returns and Allowances and Sales Discounts

Sales has two contra accounts known as "Sales Discounts" (Sales Disc.) and "Sales Returns and Allowances" (Sales R&A) that reduce it. The normal balance for these two contra accounts is a debit. Sales and its contra accounts may appear with either a perpetual or periodic inventory system. The following entries illustrate the accounts in perpetual and periodic inventory systems. The entries assume the gross method.

Sales on the income statement should be shown net of its contra accounts. For example, if a company has $980,000 in sales, $3,400 in sales returns and allowances, and $2,200 in sales discounts; net sales would be $974,400.

FINANCIAL STATEMENT ANALYSIS (Part 1)

Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account. (analyze finance data)

There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis.

Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. But the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements.

TOOLS AND TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS:

Following are the most important tools and techniques of financial statement analysis:

1. Horizontal and Vertical Analysis
2. Ratios Analysis   

1: Trend Analysis / Horizontal Analysis in financial Statements

Comparison of two or more year's financial data is known as horizontal analysis, or trend analysis.

Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form as has been done in the example below. Showing changes in dollar form helps the analyst focus on key factors t hat have affected profitability or financial position. Observe in the example that sales for 2002 were up $4 million over 2001, but that this increase in sales was more than negated by a $4.5 million increase in cost of goods sold. Showing changes between years in percentage form helps the analyst to gain perspective and to gain a feel for the significance of the changes that are taking place. For example a $1 million increase in sales is much more significant if the prior year's sales were $2 million than if the prior year's sales were $20 million. In the first situation, the increase would be 50% that is undoubtedly a significant increase for any firm. In the second situation, the increase would be 5% that is just a reflection of normal progress.

Example of Horizontal or Trend Analysis:

Balance Sheet:

Comparative Balance Sheet       December 31, 2002, and 2001      (dollars in thousands)
			Increase (Decrease)
	2002	2001	Amount	Percent
Assets
Current Assets:
Cash	$1,200	$2,350	$(1,150)*	(48.9)%
Accounts receivable	6,000	4,000	2000	50%
Inventory	8,000	10,000	(2000)	(20.0)%
Prepaid Expenses	300	120	180	150.0%
	----------	-----------	----------	----------
Total current assets	$15,500	$16,470	(970)	(5.9)%
	-----------	-----------	----------	---------
Property and equipment:
Land	4,000	4,000	0	0%
Building	12,000	8,500	3,500	41.2%
	-----------	-----------	----------
Total property and equipment	16,000	12,500	3,500	28%
	----------	-----------	----------	---------
Total assets	31,500	28,970	2,530	8.7%
	======	======	======	======
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payables	$5,800	$4,000	1800	45%
Accrued payables	900	400	500	125%
Notes payables	300	600	(300)	(50%)
	----------	----------	-----------	---------
Total current liabilities	7,000	5,000	2,000	40%
	----------	----------	----------	-----------
Long term liabilities:
Bonds payable 8%	7,500	8,000	(500)	(6.3)%
	----------	----------	----------	----------
Total long term liabilities	7,500	8,000	(500)	6.3%
	----------	----------	----------	----------
Total Liabilities	$14,500	13,000	1,500	(11.5)%
Stock holders equity:
Preferred stock, 100 par, 6%, $100 liquidation value	$2,000	$2,000	0	0%
Common stock, $12 par	6,000	6,000	0	0%
Additional paid in capital	1,000	1,000	0	0%
	----------	----------	---------	--------
Total paid in capital	9,000	9,000	0	0%
Retained earnings	8,000	6,970	1,030	14.8%
	----------	----------	----------	----------
Total stockholders' equity	17,000	15,970	1,030	6.4%
	----------	----------	----------	---------
Total liabilities and stockholders' equity	$31,500	$28,970	$2,530	8.7%
	=====	======	======	======

*Since we are measuring the change between 2001 and 2002, the dollar amounts for 2001 become the base figure for expressing these changes in percentage form. For example, cash decreased by figures $1,150 between 2001 and 2002. This decrease expressed in percentage form is computed as follows:

$1,150 ÷ $2,350 = 48.9%

Other percentage figures in this example are computed by the same formula.

Income Statement:

Comparative income statement and reconciliation of retained earnings For the year ended December 31, 2002, and 2001 (dollars in thousands)
			Increase (Decrease)
	2002	2001	Amount	Percent
Sales	$52,000	$48,000	$4,000	8.3%
Cost of goods sold	36,000	31,500	4,500	14.3%
	------------	------------	------------	-----------
Gross margin	16,000	16,500	(500)	(3.0)%
	------------	------------	------------	------------
Operating expenses:
Selling expenses	7,000	6,500	500	7.7%
Administrative expense	5,860	6,100	(240)	(3.9)%
	------------	------------	------------	------------
Total operating expenses	12,860	12,600	260	2.1%
	------------	------------	------------	------------
Net operating income	3,140	3,900	(760)	(19.5)%
Interest expense	640	700	(60)	(8.6)%
	------------	------------	------------	------------
Net income before taxes	2,500	3,200	(700)	(21.9)%
Less income taxes (30%)	750	960	(210)	(21.9)%
	------------	------------	------------	------------
Net income	1,750	2,240	$ (490)	21.9%
			======
Dividends to preferred stockholders, $6 per share (see balance sheet above)	120	120
	------------	------------
Net income remaining for common stockholders	1,630	2,120
Dividend to common stockholders, $1.20 per share	600	600
	------------	------------
Net income added to retained earnings	1,030	1,520
Retained earnings, beginning of year	6,970	5,450
	------------	------------
Retained earnings, end of year	$ 8,000	$ 6,970
	=======	=======

What is a reversing entry?

What is a reversing entry?

A reversing entry is a journal entry made in an accounting period, which reverses selected entries made in the immediately preceding accounting period. The reversing entry typically occurs at the beginning of a reporting period. A reversing entry is commonly used in situations when either revenue or expenses were accrued in the preceding period, and you do not want the accruals to remain in the accounting system for another period.

It is extremely easy to forget to manually reverse an entry in the following period, so it is customary to designate the original journal entry as a reversing entry in the accounting software when you create it. This is done by clicking on a "reversing entry" flag.  The software then automatically creates the reversing entry for you in the following accounting period.

Example of a Reversing Journal Entry

To explain the concept, the following entry shows an expense accrual in January for an $18,000 expense item for which the supplier's invoice has not yet arrived:

	Debit	Credit
Expense	18,000
Accrued expenses		18,000

You now create the following reversing entry at the beginning of the February accounting period. This leaves the original $18,000 expense in the income statement in January, but now creates a negative $18,000 expense in the income statement in February.

	Debit	Credit
Accrued expenses	18,000
Expense		18,000

But we are not done yet. The supplier's invoice arrives later in February, and we record it with the following entry, which offsets the negative $18,000 that would otherwise have appeared in the company's income statement in February:

	Debit	Credit
Expense	18,000
Accounts payable		18,000

The result is that the $18,000 expense appears in the company's income statement in January, which is presumably when it was supposed to appear under the accrual basis of accounting, while there is no net recognition of any expense at all in February. Thus, a reversing entry has allowed us to properly record an expense during the period when the expense was incurred, rather than in a later period, when the company obtains the supplier's invoice.

Two further examples of how to use a reversing entry are:

• Accrued revenue. You accrue $10,000 of revenue in January, because the company has earned the revenue but has not yet billed it to the customer. You expect to invoice the customer in February, so you create a reversing entry in the beginning of February to reverse the original $10,000 revenue accrual. The final billing, for a total of $12,000, is completed later in the month. The net result is the recognition of $10,000 in revenue in January, followed by the recognition of an additional $2,000 of revenue in February.
• Accrued expenses. You accrue a $20,000 expense in January for a supplier invoice that did not arrive in time for the month-end close. You expect the invoice to arrive a few days after you close the month, so you create a reversing entry in early February for $20,000. The invoice arrives, and you record it in February. The net result is the recognition of a $20,000 expense in January, with no net additional expense recognition in February.

What if you were to forget to make a reversing entry? In the first example, this means that the accounting records would already show $10,000 of revenue that was recorded in January, and will then show an additional $12,000 of revenue in February, so that revenue is overstated by $10,000 through the two-month period. The key indicator of this problem will be an accrued account receivable of $10,000 that the accounting staff should eventually spot if it is regularly examining the contents of its asset accounts.

If you were to forget to reverse the expense in the second example, the accounting records would show a $20,000 expense in January and another $20,000 expense in February, where the February amount is erroneous. The key indicator of this problem will be an accrued liability of $20,000 that the accounting staff should locate if it is periodically examining the contents of the company's liability accounts.

If you expect to keep an accrual for a long period of time before reversing it, then make note of the accrual in the journal entry records, and review it as part of every month-end closing process until you can reverse it. This is also a good reason to conduct account reconciliations for all balance sheet accounts at regular intervals, which will detect unreversed entries.

Accruals Concept

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Accrual Definition

An accrual is a journal entry that is used to recognize revenues and expenses that have been earned or consumed, respectively, and for which the related cash amounts have not yet been received or paid out. Accruals are needed to ensure that all revenues and expenses are recognized within the correct reporting period, irrespective of the timing of the related cash flows. Without accruals, the amount of revenue, expense, and profit or loss in a period will not necessarily reflect the actual level of economic activity within a business.

Accruals are a key part of the closing process used to create financial statements under the accrual basis of accounting; without accruals, financial statements are considerably less accurate.

Under the double-entry bookkeeping system, an accrued expense is offset by a liability, which appears in a line item in the balance sheet. If accrued revenue is recorded, it is offset by an asset, such as unbilled service fees, which also appears as a line item in the balance sheet.

It is most efficient to initially record most accruals as reversing entries. By doing so, the accounting software in which they are entered will automatically cancel them in the following reporting period. This is a useful feature when you are expecting to issue an invoice to a customer or receive an invoice from a supplier in the following period. For example, a business may know that a supplier invoice for $20,000 will arrive a few days after the end of a month, but the controller wants to close the books as soon as possible. Accordingly, he records a $20,000 reversing entry to recognize the expense in the current month. In the next month, the entry reverses, creating a negative $20,000 expense that is offset by the arrival and recordation of the supplier invoice.

Accrual Examples

Examples of accruals that a business might record are:

• Expense accrual for interest. A local lender issues a loan to a business, and sends the borrower an invoice each month, detailing the amount of interest owed. The borrower can record the interest expense in advance of invoice receipt by recording accrued interest.
• Expense accrual for wages. An employer pays its employees once a month for the hours they have worked through the 26th day of the month. The employer can accrue all additional wages earned from the 27th through the last day of the month, to ensure that the full amount of the wage expense is recognized.
• Expense accrual for supplier goods and services. A supplier delivers goods at the end of the month, but is remiss in sending the related invoice. The company accrues the estimated amount of the expense in the current month, in advance of invoice receipt.
• Sales accrual. A services business has a number of employees working on a major project for the federal government, which it will bill when the project has been completed. In the meantime, the company can accrue revenue for the amount of work completed to date, even though it has not yet been billed.

Other Accrual Issues

If a business records its transactions under the cash basis of accounting, then it does not use accruals. Instead, it records transactions only when it either pays out or receives cash. The cash basis yields financial statements that are noticeably different from those created under the accrual basis, since timing delays in the flow of cash can alter reported results. For example, a company could avoid recognizing expenses simply by delaying its payments to suppliers. Alternatively, a business could pay bills early in order to recognize expenses sooner, thereby reducing its short-term income tax liability.

Debits and Credits

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Debit and Credit Definitions

Business transactions are events that have a monetary impact on the financial statements of an organization. When accounting for these transactions, we record numbers in two accounts, where the debit column is on the left and the credit column is on the right.

• A debit is an accounting entry that either increases an asset or expense account, or decreases a liability or equity account. It is positioned to the left in an accounting entry.
• A credit is an accounting entry that either increases a liability or equity account, or decreases an asset or expense account. It is positioned to the right in an accounting entry.

Debit and Credit Usage

Whenever you create an accounting transaction, at least two accounts are always impacted, with a debit entry being recorded against one account and a credit entry being recorded against the other account. There is no upper limit to the number of accounts involved in a transaction - but the minimum is no less than two accounts. The totals of the debits and credits for any transaction must always equal each other, so that an accounting transaction is always said to be "in balance." If a transaction were not in balance, then it would not be possible to create financial statements. Thus, the use of debits and credits in a two-column transaction recording format is the most essential of all controls over accounting accuracy.

There can be considerable confusion about the inherent meaning of a debit or a credit. For example, if you debit a cash account, then this means that the amount of cash on hand increases. However, if you debit an accounts payable account, this means that the amount of accounts payable liability decreases. These differences arise because debits and credits have different impacts across several broad types of accounts, which are:

• Asset accounts. A debit increases the balance and a credit decreases the balance.
• Liability accounts. A debit decreases the balance and a credit increases the balance.
• Equity accounts. A debit decreases the balance and a credit increases the balance.

The reason for this seeming reversal of the use of debits and credits is caused by the underlying accounting formula upon which the entire structure of accounting transactions are built, which is:

Assets = Liabilities + Equity

Thus, in a sense, you can only have assets if you have paid for them with liabilities or equity, so you must have one in order to have the other. Consequently, if you create a transaction with a debit and a credit, you are usually increasing an asset while also increasing a liability or equity account (or vice versa). There are some exceptions, such as increasing one asset account while decreasing another asset account.

If you are more concerned with accounts that appear on the income statement, then these additional rules apply:

• Revenue accounts. A debit decreases the balance and a credit increases the balance.
• Expense accounts. A debit increases the balance and a credit decreases the balance.
• Gain accounts. A debit decreases the balance and a credit increases the balance.
• Loss accounts. A debit increases the balance and a credit decreases the balance.

If you are really confused by these issues, then just remember that debits always go in the left column, and credits always go in the right column. There are no exceptions.

Debit and Credit Rules

The rules governing the use of debits and credits are as follows:

• All accounts that normally contain a debit balance will increase in amount when a debit (left column) is added to them, and reduced when a credit (right column) is added to them. The types of accounts to which this rule applies are expenses, assets, and dividends.
• All accounts that normally contain a credit balance will increase in amount when a credit (right column) is added to them, and reduced when a debit (left column) is added to them. The types of accounts to which this rule applies are liabilities, revenues, and equity.
• The total amount of debits must equal the total amount of credits in a transaction. Otherwise, an accounting transaction is said to be unbalanced, and will not be accepted by the accounting software.

Debits and Credits in Common Accounting Transactions

The following bullet points note the use of debits and credits in the more common business transactions:

• Sale for cash: Debit the cash account | Credit the revenue account
• Sale on credit: Debit the accounts receivable account | Credit the revenue account
• Receive cash in payment of an account receivable: Debit the cash account | Credit the accounts receivable account
• Purchase supplies from supplier for cash: Debit the supplies expense account | Credit the cash account
• Purchase supplies from supplier on credit: Debit the supplies expense account | Credit the accounts payable account
• Purchase inventory from supplier for cash: Debit the inventory account | Credit the cash account
• Purchase inventory from supplier on credit: Debit the inventory account | Credit the accounts payable account
• Pay employees: Debit the wages expense and payroll tax accounts | Credit the cash account
• Take out a loan: Debit cash account | Credit loans payable account
• Repay a loan: Debit loans payable account | Credit cash account

Debit and Credit Examples

Arnold Corporation sells a product to a customer for $1,000 in cash. This results in revenue of $1,000 and cash of $1,000. Arnold must record an increase of the cash (asset) account with a debit, and an increase of the revenue account with a credit. The entry is:

	Debit	Credit
Cash	1,000
Revenue		1,000

Arnold Corporation also buys a machine for $15,000 on credit. This results in an addition to the Machinery fixed assets account with a debit, and an increase in the accounts payable (liability) account with a credit. The entry is:

	Debit	Credit
Machinery - Fixed Assets	15,000
Accounts Payable		15,000

Other Debit and Credit Issues

A debit is commonly abbreviated as dr. in an accounting transaction, while a credit is abbreviated as cr. in an accounting transaction.

Debits and credits are not used in a single entry system. In this system, only a single notation is made of a transaction; it is usually an entry in a check book or cash journal, indicating the receipt or expenditure of cash. A single entry system is only designed to produce an income statement.

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