new accounting notes by pnrkumar


									What is a contingent liability?
A contingent liability is a potential liability…it depends on a future event occurring or
not occurring. For example, if a parent guarantees a daughter’s first car loan, the
parent has a contingent liability. If the daughter makes her car payments and pays off
the loan, the parent will have no liability. If the daughter fails to make the payments,
the parent will have a liability.

If a company is sued by a former employee for $500,000 for age discrimination, the
company has a contingent liability. If the company is found guilty, it will have a
liability. However, if the company is not found guilty, the company will not have an
actual liability.

In accounting, a contingent liability and the related contingent loss are recorded with a
journal entry only if the contingency is both probable and the amount can be

Where is a contingent liability recorded?
A contingent liability that is both probable and the amount can be estimated is recorded as 1)
an expense or loss on the income statement, and 2) a liability on the balance sheet. As a
result, a contingent liability is also referred to as a loss contingency. Warranties are cited as a
contingent liability that meets both of the required conditions (probable and the amount can
be estimated). Warranties will be recorded at the time of a product’s sale with a debit to
Warranty Expense and a credit to Warranty Liability.

A loss contingency which is possible but not probable, or the amount cannot be estimated,
will not be recorded in the accounts. Rather, it will be disclosed in the notes to the financial
A loss contingency that is remote will not be recorded and will not have to be disclosed in the
notes to the financial statements.

What is a contingent asset?
A contingent asset is a potential asset associated with a contingent gain. Unlike contingent
liabilities and contingent losses, contingent assets and contingent gains are not recorded in
accounts, even when they are probable and the amount can be estimated.

An example of a contingent gain and contingent asset might be a lawsuit filed by Company A
against Company B for infringement of Company A’s patent. If it is probable that Company A
will win the lawsuit and receive an estimated amount of money, it has a contingent asset and
a contingent gain. However, it will not report the asset and gain until the lawsuit is settled. (At
most Company A will prepare a very carefully worded disclosure stating that it possibly could
win the case.) On the other hand, Company B will need to make an entry in its accounts if the
loss contingency is probable and the amount can be estimated. If one of those are missing,
Company B will have to disclose the loss contingency in the notes to its financial statements.

How do you record the sales tax on the purchase of an asset?
Accountants define the cost of an asset as all of the costs that are necessary to obtain the
asset and to get it ready for use.
If your state does not allow an exemption from sales tax for the asset you purchased, the
sales tax should be recorded as part of the cost of the asset.

Is sales tax an expense or a liability?
If a company sells $100,000 of product that is subject to a state sales tax of 7%, the company
will collect $107,000. It will record sales of merchandise of $100,000 and will record a liability
for sales tax of $7,000. In this situation the company is acting as a collection agent for the
state by charging the $7,000 in sales tax. The company will have to remit the $7,000 to the
state shortly after collecting the money. When the company remits the $7,000 to the state, the
company will reduce its cash and its sales tax liability. In this situation the sales tax is not an
expense and it is not part of the company’s sales revenues.
If a company purchases a new delivery van for $30,000 plus $2,100 of sales tax, the
company will record the truck as an asset at its total cost of $32,100. In this situation, the
sales tax of $2,100 is considered to be a necessary cost of the truck and will be part of the
depreciation expense recorded during the useful life of the truck.

Are sales discounts reported as an expense?
Sales discounts are not reported as an expense. Rather, sales discounts are reported as a
reduction of gross sales. In other words, Sales or Gross Sales minus Sales Discounts and
Sales Returns and Sales Allowances = Net Sales

What is a provision for discounts allowable?

The provision for discounts allowable is likely to be a balance sheet account that serves to
reduce the asset account Accounts Receivable. The provision account’s counter part
(remember double entry accounting) is an income statement account, such as Sales
Discounts or Discounts for xxx.
Let me give you an example from the meat industry. We had 40,000 pounds of beef without a
local customer, so we sold it to a company 1,000 miles away for the local price of say $1.50
per pound. Our accounting entry was to debit Accounts Receivable $60,000 and to credit
Sales $60,000. We also knew that the beef would shrink approximately 800 pounds as it
traveled in the refrigerated truck and that the customer would deduct $1,200 (800 pounds X
$1.50) when the customer processed and paid our invoice. In order to more accurately report
our Accounts Receivables, our Net Sales and our weekly profit, I immediately made an entry
to debit Discount for Shrinkage (a contra account to Sales) and a credit to Provision for
Discounts (a contra account to Accounts Receivable). By recording that entry, our balance
sheet would report the true amount to be collected, $58,800 ($60,000 invoiced minus the
anticipated deduction of $1,200). The income statement would report that Sales minus the
discount were only $58,800.

What is the provision for bad debts?
The provision for bad debts might refer to the balance sheet account also known as the
Allowance for Bad Debts, Allowance for Doubtful Accounts, or Allowance for Uncollectible
Accounts. In this case Provision for Bad Debts is a contra asset account (an asset account
with a credit balance). It is used along with the account Accounts Receivable in order to report
the net realizable value of the accounts receivable.
Provision for Bad Debts might also be an the income statement account also known as Bad
Debt Expense or Uncollectible Account Expense. In this situation, the Provision for Bad Debts
reports the credit losses that pertain to the period shown on the income statement.

Is the provision for doubtful debts an operating expense?
Some people use Provision for Doubtful Debts to mean the contra-asset account reported on
the balance sheet. Others use Provision for Doubtful Debts to mean the expense reported on
the income statement.
If Provision for Doubtful Debts is the current period expense associated with the losses from
normal credit sales, it will appear as an operating expense—usually as part of Selling,
General and Administrative Expenses (SG&A). If the expense is associated with extending
credit outside of a company’s main selling activities, the credit loss will be reported as a
nonoperating (or other) expense
What is bad debts?
The term bad debts usually refers to accounts receivable (or trade accounts receivable) that
will not be collected. However, bad debts can also refer to notes receivable that will not be
The bad debts associated with accounts receivable is reported on the income statement as
Bad Debts Expense or Uncollectible Accounts Expense.
When the allowance method is used, the journal entry to Bad Debts Expense will include a
credit to Allowance for Doubtful Accounts, a contra account and valuation account to the
asset Accounts Receivable. The allowance method anticipates the losses and therefore
requires the use of estimates.
Under the direct write-off method, the Allowance for Doubtful Accounts is not used. Rather,
Bad Debts Expense will be debited when an account receivable is actually written off. The
credit in this entry will be to the asset Accounts Receivable.

What is the difference between accounts payable and accounts receivable?
When a company purchases goods or services on credit, it will increase its accounts payable
(a current liability). When a company sells goods or services on credit, it will increase its
accounts receivable (a current asset).
Just as one company’s purchase is another company’s sale, the accounts payable of one
company will be the accounts receivable of another company. Some accountants refer to this
as symmetry.
To illustrate this, let’s assume that Max Corporation receives $5,000 of goods it ordered from
Super Supply Company on credit. This transaction will result in Max recording a $5,000
accounts payable (and a purchase), and Super Supply recording a $5,000 accounts
receivable (and a sale).

Is Accounts Payable a debit or a credit or both?

Since Accounts Payable is a liability account, it should have a credit balance. The credit
balance indicates the amount that company or organization owes to its suppliers or vendors.
The Accounts Payable account is credited when goods or services are purchased on credit
terms (as opposed to being purchased for cash). Accounts Payable is debited when a
payment is made to a supplier or vendor.

What is the cost of goods sold?
The cost of goods sold is the cost of the merchandise that a retailer, distributor, or
manufacturer has sold.
The cost of goods sold is reported on the income statement and can be considered as an
expense of the accounting period. By matching the cost of the goods sold with the revenues
from the goods sold, the matching principle of accounting is achieved.
The sales revenues minus the cost of goods sold is gross profit.
Cost of goods sold is calculated in one of two ways. One way is to adjust the cost of the
goods purchased or manufactured by the change in inventory of finished goods. For example,
if 1,000 units were purchased or manufactured but inventory increased by 100 units then the
cost of 900 units will be the cost of goods sold. If 1,000 units were purchased but the
inventory decreased by 100 units then the cost of 1,100 units will be the cost of goods sold.
The second way to calculate the cost of goods sold is to use the following costs: beginning
inventory + the cost of goods purchased or manufactured = cost of goods available - ending

Is the cost of goods sold an expense?
While we often think of expenses as salaries, advertising, rent, interest, and so on, the cost of
goods sold is also an expense. The cost of goods that were sold needs to be matched with
the pertinent sales on the income statement, just as commission expense must be matched
with sales or other revenues.

How do cash dividends affect the financial statements?
When a corporation declares a cash dividend on its stock, its retained earnings are decreased
and its current liabilities (Dividends Payable) are increased. When the cash dividend is paid,
the Dividends Payable account is decreased and the corporation’s Cash account is
The net result of the declaration and payment of the dividend is that the corporation’s assets
and stockholders’ equity have decreased. Specifically, the balance sheet accounts Cash and
Retained Earnings were decreased.
The income statement is not affected by the declaration and payment of cash dividends on
common stock. (The cash dividends on preferred stock are deducted from net income to
arrive at net income available for common stock.)
The cash dividends will be reported as a use of cash in the financing activities section of the
statement of cash flows.

What is the difference between stockholder and shareholder?
There is no difference between stockholder and shareholder. The terms are used
interchangeably. Both terms mean the owner of shares of stock in a corporation and a part
owner of a corporation.

What is the difference between stocks and bonds?
Stocks, or shares of stock, represent an ownership interest in a corporation. Bonds are a form
of long-term debt in which the issuing corporation promises to pay the principal amount at a
specific date.
Stocks pay dividends to the owners, but only if the corporation declares a dividend. Dividends
are a distribution of a corporation’s profits. Bonds pay interest to the bondholders. Generally,
the bond contract requires that a fixed interest payment be made every six months.
Every corporation has common stock. Some corporations issue preferred stock in addition to
its common stock. Many corporations do not issue bonds.
The stocks and bonds issued by the largest corporations are often traded on stock and bond
exchanges. Stocks and bonds of smaller corporations are often held by investors and are
never traded on an exchange.

If a company issues stocks or bonds to pay outstanding debt, should this noncash
transaction be included in the cash flow statement?
If a company issues stocks or bonds for cash and then pays off the debt, the transaction is
reported in the financing section of the statement of cash flows.
If the transaction is a direct conversion of debt to equity (shares of stock) or debt to bonds
and no cash receipts or cash payments occur, the transaction is to be disclosed as
supplementary information.

What are some examples of financing activities?
Financing activities involve long-term liabilities and stockholders’ (or owner’s) equity.
Financing activities are reported in its own section of the financial statement known as the
statement of cash flows (SCF) or cash flow statement.
Examples of financing activities that involve long-term liabilities include the issuance or
redemption of bonds. An increase in bonds payable is reported as a positive amount in the
financing activities section of the SCF. The positive amount signifies a source of cash, or that
cash was provided by issuing additional bonds. A decrease in bonds payable will be reported
as a negative amount in the financing activities section of the cash flow statement. A negative
amount connotes that cash was used to repurchase or redeem the corporation’s bonds.
Examples of financing activities involving stockholders’ equity include the issuance of
common stock or preferred stock. Increases in these stock accounts will be reported as
positive amounts in the financing activities section of the SCF. Positive amounts communicate
that cash was provided by issuing more shares of stock—a source of cash. Examples of uses
of cash (which are reported as negative amounts) in the financing activities section of the
cash flow statement include a corporation’s purchase of its own stock, and dividends declared
and paid on its stock. (The increase in retained earnings resulting from the corporation’s net
income is reported in the operating activities section of the

What is the difference between cost and price?
 Some people use cost and price interchangeably. Others use the term cost to mean one
 component of a product’s selling price. Even the same person might use the terms differently.
 For example, in standard costing the price variance of the raw materials refers to the
 difference between the standard cost and the actual cost of the materials.
 In other situations we define a product’s selling price as: product costs + expenses + profit.
 As these two examples indicate, there can be different meanings for the terms cost and price.
         Price is the final amount that customer has to pay this includes profit of the seller
     Whereas cost is the total amount spent on the final product and it does not include profit of
     the seller

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