Accountingtools Q&A

What is the cost volume formula?

2012-05-28T20:30:45Z

The cost volume formula is a simple calculation used to derive the total cost that will be incurred at certain production volumes. The formula is useful for deriving total costs for budgeting purposes, or to identify the approximate profit or loss levels likely to be achieved at certain sales volumes.

The cost volume formula is:

Y = a + bx

Y = Total cost
a = Total fixed cost
b = Variable cost per unit of activity
x = Number of units of activity

For example, a company has fixed production costs of $1,000,000 per month, and sells a single product that costs $50 to build. If the company produces 10,000 units during a month, the cost volume formula shows that the total cost that will be incurred at this volume level will be:

$1,000,000 Fixed cost + ($50/unit x 10,000 units) = $1,500,000 Total cost

The primary failing of the cost volume formula is that it only works within a relevant range of unit volumes. Outside of that range, both the fixed and variable cost components of the formula are likely to change. For example, a high volume level may require expenditures for more fixed costs. Or, a higher volume level may result in bulk-purchasing costs that reduce the variable cost per unit. Thus, the relevant range of activity must be carefully analyzed when using the cost volume formula.

Another issue with the formula is that it is overly simplistic. In reality, there will be a number of mixed costs containing both fixed and variable elements, costs that vary with different cost drivers, and a broad range of products, rather than just one product type. Given these complexities, the formula may require considerable adjustment to properly reflect the costing environment of a business.

What is a statement of account?

2012-05-27T17:24:47Z

A statement of account is a document or electronic notification sent from a supplier to a customer, noting all sales transactions and miscellaneous credits created during a specific time period (usually one month). The purpose of the statement is to remind each customer of sales on credit that have not yet been paid to the supplier.

A sample statement of account usually includes the following information:

Beginning total of unpaid invoices
The invoice number, invoice date, and total amount of each invoice issued to the customer during the time period.
The credit number, credit date, and total amount of each miscellaneous credit issued to the customer during the time period.
The payment date and total amount of each payment received by the supplier during the time period.
The net remaining balance of all transactions listed. This is the total amount payable to the supplier.

The amount of invoices listed on the statement may also be itemized in time buckets, so that the reader can easily determine which invoices are overdue for payment, and which are not yet due. The time buckets typically used are:

0 to 30 days
31-60 days
61-90 days
90+ days

In rare cases, the presence of large credits on a statement of account may reveal that the supplier owes money to the customer, in which case a payment or ongoing credit is arranged.

The utility of the statement of account is questionable, since it requires some accounting staff time to create, as well as postage costs, and may be ignored by recipients. It is also generally issued immediately after month-end, when it interferes with the monthly closing process. It is most cost-effective in those situations where there is a history of achieving collections that are directly attributable to the issuance of statements of account.

Similar Terms

A statement of account is also known as an account statement.

What is the difference between job costing and process costing?

2012-05-25T22:52:56Z

Job costing involves the detailed accumulation of production costs attributable to specific units or groups of units. For example, the construction of a custom-designed piece of furniture would be accounted for with a job costing system. The costs of all labor worked on that specific item of furniture would be recorded on a time sheet and then compiled on a cost sheet for that job. Similarly, any wood or other parts used in the construction of the furniture would be charged to the production job linked to that piece of furniture. This information may then be used to bill the customer for work performed and materials used, or to track the extent of the company's profits on the production job associated with that specific item of furniture.

Process costing involves the accumulation of costs for lengthy production runs involving products that are indistinguishable from each other. For example, the production 100,000 gallons of gasoline would require that all oil used in the process, as well as all labor in the refinery facility be accumulated into a cost account, and then divided by the number of units produced to arrive at the cost per unit. Costs are likely to be accumulated at the department level, and no lower within the organization.

Given these descriptions of job costing and process costing, we can arrive at the following differences between the two costing methodologies:

Uniqueness of product. Job costing is used for unique products, and process costing is used for standardized products.
Size of job. Job costing is used for very small production runs, and process costing is used for large production runs.
Record keeping. Much more record keeping is required for job costing, since time and materials must be charged to specific jobs. Process costing aggregates costs, and so requires less record keeping.
Customer billing. Job costing is more likely to be used for billings to customers, since it details the exact costs consumed by projects commissioned by customers.

In situations where a company has a mixed production system that produces in large quantities but then customizes the finished product prior to shipment, it is possible to use elements of both the job costing and process costing systems, which is known as a hybrid system.

How does consolidation accounting work?

2012-05-23T18:51:33Z

Consolidation accounting is the process of combining the financial results of several subsidiary companies into the combined financial results of the parent company. The following steps document the consolidation accounting process flow:

Record intercompany loans. If the parent company has been consolidating the cash balances of its subsidiaries into an investment account, record intercompany loans from the subsidiaries to the parent company. Also record an interest income allocation for the interest earned on consolidated investments from the parent company down to the subsidiaries.
Charge corporate overhead. If the parent company allocates its overhead costs to subsidiaries, calculate the amount of the allocation and charge it to the various subsidiaries.
Charge payables. If the parent company runs a consolidated payables operation, verify that all accounts payable recorded during the period have been appropriately charged to the various subsidiaries.
Charge payroll expenses. If the parent company been using a common paymaster system to pay all employees throughout the company, ensure that the proper allocation of payroll expenses has been made to all subsidiaries.
Complete adjusting entries. At the subsidiary and corporate levels, record any adjusting entries needed to properly record revenue and expense transactions in the correct period.
Investigate asset, liability, and equity account balances. Verify that the contents of all asset, liability, and equity accounts for both the subsidiaries and the corporate parent are correct, and adjust as necessary.
Review subsidiary financial statements. Print and review the financial statements for each subsidiary, and investigate any items that appear to be unusual or incorrect. Make adjustments as necessary.
Eliminate intercompany transactions. If there have been any intercompany transactions, reverse them at the parent company level to eliminate their effects from the consolidated financial statements.
Review parent financial statements. Print and review the financial statements for the parent company, and investigate any items that appear to be unusual or incorrect. Make adjustments as necessary.
Record income tax liability. If the company earned a profit, record an income tax liability. It may be necessary to do so at the subsidiary level, as well.
Close subsidiary books. Depending upon the accounting software in use, it may be necessary to access the financial records of each subsidiary and flag them as closed. This prevents any additional transactions from being recorded in the accounting period being closed.
Close parent company books. Flag the parent company accounting period as closed, so that no additional transactions can be reported in the accounting period being closed.
Issue financial statements. Print and distribute the financial statements of the parent company.

If a subsidiary uses a different currency as its operating currency, an additional consolidation step is to convert its financial statements into the operating currency of the parent company.

How do I account for a patent?

2012-05-22T20:58:29Z

A patent is considered an intangible asset; this is because a patent does not have physical substance, and provides long-term value to the owning entity. As such, the accounting for a patent is the same as for any intangible fixed asset, which is:

Initial recordation. Record the cost to acquire the patent as the initial asset cost. If a company files for a patent application, then this cost will include the registration, documentation, and other legal fees associated with the application. If the company instead bought a patent from another party, the purchase price is the initial asset cost.
Amortization. The owner of the patent gradually charges the cost of the patent to expense over the useful life of the patent, usually using straight-line amortization.
Derecognition. Once the company is no longer making use of the patented idea, the asset can be derecognized by crediting the balance in the patent asset account and debiting the balance in the accumulated amortization account. If the asset has not been fully amortized at the time of derecognition, then any remaining unamortized balance must be recorded as a loss.

Consider the following additional points when considered the accounting for patents:

R&D expenditures. Note that the research and development (R&D) costs required to develop the idea being patented cannot be included in the capitalized cost of a patent. These R&D costs are instead charged to expense as incurred; the basis for this treatment is that R&D is inherently risky, without assurance of future benefits, so it should not be considered an asset.
Useful life. A patent asset should not be amortized for longer than the life span of the protection afforded by the patent. If the expected useful life of the patent is even shorter, then use the useful life for amortization purposes. Thus, the shorter of a patent's useful life and its legal life should be used for the amortization period.
Capitalization limit. In practice, the costs of obtaining a patent may be so small that they do not meet or exceed a company's capitalization limit. If so, charge these costs to expense as incurred. In many larger companies with higher capitalization limits, this means that patents are rarely recorded as assets unless they have been purchased from other entities.

What is the accounting for a capital lease?

2012-05-21T20:10:49Z

A capital lease is one in which the lessee records the underlying asset as though it owns the asset. This means that the lessor is treated as a party that happens to be financing an asset that the company owns. The lessor should record a lease as a capital lease if any of the following criteria are met:

The lease period covers at least 75% of the useful life of the asset; or
There is an option to buy the leased asset following the lease expiration at a below-market rate; or
Ownership of the leased asset shifts to the lessee following the lease expiration; or
The present value of the minimum lease payments totals at least 90% of the fair value of the asset at the beginning of the lease.

If an examination of these criteria indicate that a leased asset is a capital lease, the accounting for the lease is comprised of the following activities:

Initial recordation. Calculate the present value of all lease payments; this will be the recorded cost of the asset. Record the amount as a debit to the appropriate fixed asset account, and a credit to the capital lease liability account. For example, if the present value of all lease payments for a production machine is $100,000, record it as a debit of $100,000 to the production equipment account and a credit of $100,000 to the capital lease liability account.
Lease payments. As the company receives lease invoices from the lessor, record a portion of each invoice as interest expense and use the remainder to reduce the balance in the capital lease liability account. Eventually, this means that the balance in the capital lease liability account should be brought down to zero. For example, if a lease payment were for a total of $1,000 and $120 of that amount were for interest expense, then the entry would be a debit of $880 to the capital lease liability account, a debit of $120 to the interest expense account, and a credit of $1,000 to the accounts payable account.
Depreciation. Since an asset recorded through a capital lease is essentially no different from any other fixed asset, it must be depreciated in the normal manner, where periodic depreciation is based on a combination of the recorded asset cost, any salvage value, and its useful life. For example, if an asset has a cost of $100,000, no expected salvage value, and a 10-year useful life, the annual depreciation entry for it will be a debit of $10,000 to the depreciation expense account and a credit to the accumulated depreciation account.
Disposal. When the asset is disposed of, the fixed asset account in which it was originally recorded is debited and the accumulated depreciation account is credited, so that the balances in these accounts related to the asset are eliminated. If there is a difference between the net carrying amount of the asset and its sale price, it is recorded as a gain or loss in the period when the disposal transaction occurred.

In short, the accounting for a "normal" fixed asset and one acquired through a lease are the same, except for the derivation of the initial asset cost and the subsequent treatment of lease payments.

What is the difference between book value and market value?

2012-05-20T20:38:40Z

The book value of an asset is its original purchase cost, adjusted for any subsequent changes, such as for impairment or depreciation. Book value is recorded in the accounting records of a business.

Market value is the price that could be obtained by selling an asset on a competitive, open market.

There is nearly always a disparity between book value and market value, since the first is a recorded cost, and the second is based on the perceived supply and demand for an asset.

For example, a company buys a machine for $100,000 and subsequently records depreciation of $20,000 for that machine, resulting in net book value of $80,000. If the company were to then sell the machine at its current market price of $90,000, the business would record a gain on the sale of $10,000.

As indicated by the example, the disparity between book value and market value is recognized at the point of sale of an asset, since the price at which it is sold is the sale price, and its net book value is essentially the cost of goods sold. Prior to a sale transaction, there is no reason to account for any differences in value between book value and market value.

There are situations where market value is much higher than book value, such as when the market value of an office building skyrockets due to increased demand. In these situations, there is no way under Generally Accepted Accounting Principles (GAAP) to recognize the gain in a company's accounting records. However, revaluation is allowed under International Financial Reporting Standards (IFRS).

What is the accounting for a fully depreciated asset?

2012-05-17T22:35:30Z

A fixed asset is fully depreciated when all of its original recorded cost, less any salvage value, matches the total amount of accumulated depreciation that has been recorded against the fixed asset over its useful life.

If a fixed asset is still in use and is fully depreciated, there no additional accounting entry at all. The key point is to ensure that no additional depreciation is recorded against the asset, which is quite possible when depreciation is being calculated manually or with an electronic spreadsheet. A commercial fixed asset database will automatically turn off depreciation, as long as the termination date was correctly set in the system.

The absence of any further depreciation expense subsequent to the completion of depreciation for an asset will reduce the amount of depreciation expense reported in the income statement, so that non-cash profits will increase by the amount of the depreciation reduction.

The reporting of a fully depreciated asset will be in two places in the balance sheet:

Cost. The full acquisition cost of the asset will be listed in the fixed assets line item, within the assets section of the balance sheet.
Depreciation. The full amount of accumulated depreciation will be listed in the accumulated depreciation contra asset line item, located just below the fixed asset line item.

It would be incorrect accounting treatment to remove a fixed asset cost and related accumulated depreciation from the accounting records as long as the underlying asset is still being used, for two reasons:

Metrics. The presence of such a large amount of accumulated depreciation for an asset should be stated, so that someone analyzing the financial statements can discern that the company tends to retain its fixed assets for a long period of time; this can be an indicator of multiple issues, such as good maintenance or the imminent need to spend cash for replacement assets.
Asset recordation. If an asset is on the premises and in use, then it should be recorded. Its deletion would remove the asset from the fixed asset register, so that someone might conduct a fixed asset audit and observe the asset, but not see it in the company's records.

When a fixed asset is eventually disposed of, the event should be recorded by debiting the accumulated depreciation account for the full amount depreciated, crediting the fixed asset account for its full recorded cost, and using a gain or loss account to record any remaining difference. See the disposal of assets article for more information.

What is a real account?

2012-05-16T22:28:05Z

A real account is an account that retains and rolls forward its ending balance from period to period. The areas in the balance sheet in which real accounts are found are assets, liabilities, and equity. Examples of real accounts are:

Real accounts are not listed in the income statement. All of the balances in the revenue, expense, gain, and loss accounts (known as nominal or temporary accounts) listed in the income statement are flushed out to retained earnings at the end of each fiscal year, resulting in zero beginning balances in these accounts as of the beginning of the next fiscal year. Since retained earnings is a real account, this means that the balances in all nominal accounts are eventually shifted into a real account.

Similar Terms

Real accounts are also known as permanent accounts.

What is capex?

2012-05-14T20:18:26Z

Capex is a contraction of the term capital expenditure, and refers to the expenditures made by a business to add new fixed assets, replace old fixed assets, and pay for their ongoing maintenance.

The level of capex required to operate a business varies dramatically by industry. For example, a professional services business, such as a tax accountant, may not have any capex at all. Conversely, an oil shipment business must invest enormous sums in pipelines, tankers, and storage facilities, so capex comprises a large part of its annual expenditures.

The acquisition of a capex item generally requires a formal analysis and approval by management, with more expensive items possibly even requiring the approval of the board of directors.

The accounting for capex varies, depending upon the nature of the asset. The two alternatives are:

Asset treatment. If an expenditure is greater than the capitalization limit of a business, and is for an asset whose utility will be used up over a period of time, then record it as a fixed asset and depreciate it over the useful life of the asset.
Expense treatment. If an expenditure is less than the capitalization limit or the result only maintains an asset in its current condition, then charge it to expense as incurred.

Outside analysts may track the level of capex reported by a company from year to year, to see if it is investing a sufficient amount to maintain company operations. This analysis is not always accurate, for the following reasons:

Step costs. A company may have needed to buy an unusually large capex item, such as an entire production facility, which it will not have to duplicate in every subsequent year. Thus, the capex trend line tends to be lumpy.
Acquisitions and disposals. Larger companies may routinely buy and sell subsidiaries, along with their fixed assets. A high level of churn makes it difficult to ascertain the true amount of annual capex of the parent company.