Accounting for cash and cash equivalents

Companies’ balance sheets report cash and cash equivalents. In this article, I explain what this means.

Defining cash

Cash is the standard medium of exchange, the basis for measuring and accounting for everything. It may consist of coins, currency, and funds available on deposit in a bank. It may also include petty cash balances on hand and money market accounts with checking privileges. Postdated checks are receivables, not cash.

Clarifying cash equivalents

Companies frequently invest cash into highly liquid investments in order to earn a tidy return. Cash equivalents are short-term, highly liquid investments that are both:

  1. readily convertible to known amounts of cash, and
  2. so near to their maturity that they present insignificant risk of changes in value caused by changes in interest rates.

In general, investments with original maturities of three months or less will qualify as cash equivalents. Here are some examples:

  • treasury bills
  • commercial paper
  • money market funds without checking privileges

On December 31, 2016, Apple reported that it had $10,669,000,000 worth of cash and cash equivalents. If this were invested in government securities yielding just 1% interest per year, Apple would earn more than $106 million in a single year!

Reporting cash and cash equivalents

Companies usually report cash and cash equivalents in the balance sheet as the very first current asset.

Journal entries

To increase cash and cash equivalents, debit it. To decrease it, credit it. To record receipt of cash from a sale, debit the account cash and cash equivalents, and credit the account sales revenue:

JE Sale for cash

To record a payment of cash for salary expense, debit the account salary expense and credit cash and cash equivalents, as shown here:

JE Pay salary expense

Take-away for entrepreneurs

You need to have enough cash and cash equivalents on hand to pay your bills in a timely basis, plus additional funds in case of an emergency or a financial opportunity that you wish to take advantage of. In general, keep enough cash in your checking account to pay all outstanding checks and the next few days’ worth of bills. Investing additional cash into cash equivalents – such as treasury bills and money market funds – will yield you a little extra interest income.

 

Computing and interpreting inventory turnover

Inventory turnover measures how productively a company uses its merchandise inventory to generate sales and profits.

Calculating inventory turnover

Here is the formula for inventory turnover:

Inventory turnover = Cost of goods soldAverage inventory

Cost of goods sold measures the amount paid to purchase or manufacture items that were sold during the period. To find cost of goods sold, look to the second or third line item in the company’s income statement (or statement of operations). It is sometimes referred to as cost of sales.

To compute average inventory, divide the sum of beginning inventory and ending inventory by two:

Average inventory = (beginning inventory + ending inventory) / 2

Beginning inventory is the value of inventory at the end of last year. It is listed in the balance sheet under current assets. Identify the balance of inventory not at the end of the current year, but rather at the end of last year – it is usually found in the last column on the right. Note that inventory is sometimes referred to as merchandise inventory.

Ending inventory is the value of inventory at the end of this year. It appears on the balance sheet under current assets, the second-to-last column on the right.

Technical note: a more accurate way to calculate average inventory is to add inventory at the beginning of the first quarter to inventory at the end of each quarter during the year. Then divide by five.

Example

In 2016, Macy’s had cost of goods sold of $16,496. The company’s beginning inventory in 2016 was $5,417. Its ending inventory was $5,506.

Average inventory = ($5,417 + $5,506) / 2 = $5,462

Inventory turnover = $16,496 / $5,462 = 3.02

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Interpreting inventory turnover

Successful businesses rely on using their merchandise inventory to generate sales and profits. After all, merchandise inventory is an investment, like any other asset. It needs to generate profits. Too much inventory requires a greater investment – and maybe even more debt – and can result in unsold, obsolete, or spoiled goods. Stocking too little inventory can cause you to lose sales. After all, customers who can’t find what they’re looking for will shop elsewhere.

Inventory turnover describes how many times, on average, inventory “turns over” each year. Visualize a shelf with widgets. If the widgets have turnover of 4.0, that means that on average the company will stock and then sell all of its widgets four times a year. Higher turnover indicates that the company’s inventory is purchased and sold relatively quickly. It’s flying off the shelves. Lower turnover indicates that it takes a longer time for the company to sell its inventory.

Example

Macy’s inventory turnover is 3.02. Wal-Mart’s inventory turnover for the same period was 8.06. Wal-Mart’s higher inventory turnover indicates that the company sells its inventory more than twice as quickly as Macy’s.

Number of days’ inventory

Number of day’s inventory provides the same basic information as inventory, but in an easier-to-interpret figure. It indicates how many days – on average – it takes a company to sell inventory. Here’s the formula:

Number of days’ inventory = 365 / inventory turnover

For simplicity sake, some people may use the number 360 in the numerator instead of 365.

Example

As I note above, Macy’s inventory turnover is 3.02. The company’s number of days’ inventory equals 365 / 3.02 = 120.9. This means that on average it takes about 121 days from when Macy buys inventory and when it sells it. On the other hand, Wal-Mart’s inventory turnover is 8.06. Its number of day’s inventory equals 365 / 8.06 = 45.3. On average, only 45 days pass between when the company first buys inventory and when it sells it. Clearly, Wal-Mart makes more productive use of its inventory investment than Macy’s. Visualize inventory flying off the shelves of a Wal-Mart store, while it sits in the racks at Macy’s, waiting to be purchased.

Lesson for entrepreneurs

Use inventory turnover or number of days’ inventory to keep your inventory levels productive. Monitoring these ratios will help to ensure that you’re not stocking too much or too little inventory.

 

Understanding inventory

Inventory, also called merchandise inventory, is the company’s investment in products that it plans to sell to customers. It is an asset recorded on the balance sheet along with other current assets. Manufacturers make their own inventory, while retailers and other businesses buy their inventory from supplies.

Recording inventory

Under US Generally Accepted Accounting Principles, companies usually record inventory at the lower of cost or market value. This means that it is recorded at its original cost unless its market value is lower than cost.

To determine the cost of its inventory, companies must use a cost flow assumption. The four most common techniques for computing the cost of inventory are:

  1. First-in first out (FIFO),
  2. Last-in first out (LIFO),
  3. Weighted Average (also known as Moving average), and
  4. Specific identification.

To keep track of inventory costs, companies use either periodic or perpetual inventory systems. In a periodic inventory system, a company physically counts its inventory at the end of each year. To compute cost of goods sold, it uses the following formula:

Cost of goods sold = beginning inventory + purchases – ending inventory

(Note that the beginning inventory would be the same as the ending inventory last year.)

In a perpetual inventory system, a company continuously keeps track of the balance of all of its inventory activity. Every sale of every item is recorded, so that the company has a record of how many goods are in stock at any given time. Cost of goods sold is calculated based on the actual number of units that the company recorded as sold during the period.

To record a purchase of inventory, debit the account “inventory.” If you’re purchasing on credit, then credit the account “accounts payable.” Otherwise, if you’re paying for it now, credit the account “cash.” Here’s an example of purchasing inventory on credit for $1,000:

JE Purchase inventory

 

Update to Accountinator Spreadsheet

I’ve posted an updated version of the Accountinator spreadsheet.

If you already use the existing spreadsheet and get inappropriate “oops” cells, then you may wish to update to this new version. You can copy and paste your existing data into the new version, or copy the “oops” cells in column “A” from the new version into your existing document.

http://accountinator.com/wp-content/uploads/2015/05/accountinator-spreadsheet-v2.01.xlsx

 

Managing Materiality

Accounting information is material if its omission or misstatement would mislead investors. In other words, if there’s a piece of information that investors need to know, then that information is material – it makes a difference.

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Information can be material in size or importance. In size, materiality is all about the amount. A large amount of money – relative to the size of the company – is material. A small amount of money – relative to the size of the company – is not material. For example, some companies round their financial statement figures to the nearest thousand dollars (or even million dollars). They state a $500,000 expense  as $500 “in thousands.” These companies do not consider amounts less than a thousand dollars to be material.

Some items may be small in amount, but large in importance. For example, suppose that the president of the company had a $500 expense which in dollar amount was not material. What was the expense? She bribed a public official. Since this expense is illegal, it is considered material, even though the amount itself is not material.

Why is materiality important? Because accountants don’t want to overload investors with too much information that would confuse them and distract them from what is most important.

Entrepreneurs need to remember not to sweat the small stuff – focus on that portion of your business that generates the most return, and don’t waste too much time on tasks that add little or no value.

 

Understanding confirmatory value

In accounting, information has confirmatory value when it helps users to confirm or adjust prior expectations. But why is confirmatory value an important attribute for accounting information to have?

People read accounting financial statements in order to create predictions about the future. They want to predict future dividends and that the company will be able to make interest and principal payments. To make these predictions, they often make predictions about future net income. The value of information in making predictions is called predictive value. This information can then be used to make investment decisions. If you predict that a company’s income will rise significantly in the future, then perhaps it is a good investment. Similarly, if you predict that a company won’t be able to pay interest on its bonds next year, then you probably should not invest in its bonds.

Now please bear with me while I make an analogy. How does a marksman learn to hit a target? With practice. Take a shot. How close to the bulls eye did you get? Take another. Was that better? And another. A good marksman will need many many hours of practice to learn how to shoot.

The same goes for financial analysts. A financial analyst is constantly making predictions, and then – after the fact – gauging their accuracy. Make a prediction. Then see what happened. Make another prediction. How close to the bulls eye did you get? Try again, and again. Confirmatory value is the value of information to gauge how accurate your predictions are – so that you can make more accurate decisions in the future.

 

Relevance in accounting

Accounting information is relevant (“accounting relevance”) when it is capable of making a difference in a decision.

Suppose that you’re trying to decide what to eat for dinner: A hamburger? Or a salad? What information is relevant to your decision? The price of each meal, perhaps. And consider the number of calories, too. Do you have the food ready to make, or do you need to run to the store? All of this accounting relevance will help you to decide what to eat.

On the other hand, some information is not relevant. You decided to wear blue shoes today. Not relevant.

In accounting, information is used to make investment decisions – and investors who use that accounting information are interested in predicting future income, interest payments, principal payments, and dividend payments. Accounting relevance helps them to make these decisions, while irrelevant information does not. Here are three specific attributes of relevant information:

  1. Relevant information has predictive value. It helps investors to predict what will happen in the future.
  2. Relevant information has confirmatory value. It helps investors to assess the predictions, and therefore to improve their skills at making predictions.
  3. Relevant information is material. If you didn’t know about it, you might make a mistake.
 

When does accounting information have “predictive value?”

In accounting, information has “predictive value” when it can be used to help investors to form expectations about the future.

Let me give you some background. The whole point of accounting information to help investors to make decisions about loaning a company money or buying its stock. How are investors supposed to make these decisions? When you think about it, investors really want to know about the future. If you buy this stock, what are the future dividends likely to be? If you loan a company money, will it be able to pay interest and principal on time? Here’s the problem: while you want to know about the future, financial statements only tell you about the past. You have to use last year’s income statement and balance sheet in order to figure out what is likely to happen in the future – the prospects of paying dividends, interest, and principal in the future. That is predictive value.

Financial statements have predictive value when they help you to predict the future. This enables you to estimate future dividends, or the likelihood of interest and principal being paid to you on time.

 

What is the economic entity assumption?

The economic entity assumption is one of four assumptions underlying financial statements. It says that you can identify economic activity with a particular unit of accountability.

Put another way, the economic entity assumptions says that certain transactions are “inside” a business, while other transactions are “outside” of the business. Suppose that you run a candy store. Buying candy in order to resell it is “inside” of your business. Your intent is to earn a profit. On the other hand, buying candy in order to eat it is “outside” your business – your intent is to eat candy.

In taxes, a businessperson must be very careful to segregate personal expenses (“outside” the business) from business expenses (“inside” the business). Taxing authorities do not like when businesses deduct personal expenses. Ask Dennis Kozlowski.

Many businesses are actually combined “groups” of businesses. A corporation might own several dozen other corporations, each representing a different line of business. Each corporation may be its own economic entity, reporting its own financial statements. The combined group of corporations may also be an economic entity, reporting its own financial statements.