accounting explanations

7/28/2019 Accounting Explanations

1/12

Accounting for Foreign Exchange Gains & LossesBy Carter McBride, eHow Contributor

Share

Print this article

A U.S. company performing

transactions in the euro may have foreign exchange gains or losses.

Companies must follow the generally accepted accounting principles when accountingfor foreign currency exchange gains and losses. The most common type of foreigncurrency exchange gains and losses occur when a company completes transactions in aforeign currency.

Other People Are Reading

What Are the Treatments for Foreign Exchange Gains & Losses?

Explain Unrealized Gains or Losses on Foreign Exchange

1.Converting Foreign Currencies

o Each time a company has a transaction in another currency, the accountant must convertthe currency to the company's currency using the foreign currency exchange rate. Thisrate is found online at sources such as X Rates and Yahoo! Finance.

Record the Initial Transaction

o When accounting for foreign currency exchanges, the accounting must first record the

initial sale. For example, a United States company buys 200 euros worth of widgets. At
http://www.ehow.com/print/facts_6728729_accounting-foreign-exchange-gains-losses.htmlhttp://www.ehow.com/print/facts_6728729_accounting-foreign-exchange-gains-losses.htmlhttp://www.ehow.com/list_6818219_treatments-foreign-exchange-gains-losses_.htmlhttp://www.ehow.com/list_6818219_treatments-foreign-exchange-gains-losses_.htmlhttp://www.ehow.com/info_8772721_explain-gains-losses-foreign-exchange.htmlhttp://www.ehow.com/info_8772721_explain-gains-losses-foreign-exchange.htmlhttp://www.ehow.com/info_8772721_explain-gains-losses-foreign-exchange.htmlhttp://www.ehow.com/list_6818219_treatments-foreign-exchange-gains-losses_.htmlhttp://www.ehow.com/info_8772721_explain-gains-losses-foreign-exchange.htmlhttp://www.ehow.com/list_6818219_treatments-foreign-exchange-gains-losses_.htmlhttp://www.ehow.com/info_8772721_explain-gains-losses-foreign-exchange.htmlhttp://www.ehow.com/list_6818219_treatments-foreign-exchange-gains-losses_.htmlhttp://www.ehow.com/info_8772721_explain-gains-losses-foreign-exchange.htmlhttp://www.ehow.com/list_6818219_treatments-foreign-exchange-gains-losses_.htmlhttp://www.ehow.com/print/facts_6728729_accounting-foreign-exchange-gains-losses.html


2/12

the time, 200 euros equals $250. The accountant would debit "Purchases" by $250 and"Accounts Payable" by $250.

o

Recording a Gain When Completing Transactiono If the foreign currency exchange rate changes favorably, record a gain. In the example, if

200 euros now equals $200, then debit "Accounts Payable" by $250, then credit "Cash"by $200 and "Foreign Exchange Gain" by $50.

Recording a Loss When Completing a Transaction

o If the foreign currency exchange rate changes unfavorably, record a loss. In the example,if 200 euros now equals $300, then debit "Accounts Payable" by $250, "ForeignExchange Loss" by $50, then credit "Cash" by $300.

Time To Revalue Currencyo The accountant must report gains or loses on the transaction at both the end of an

accounting period and when the company finishes the transaction. For example, thecompany enters a transaction on Sept. 1, 2009 and pays for the transaction on Jan. 31,2009. The company must revalue the transaction on both Jan. 1 and Jan. 31.

Read more:http://www.ehow.com/facts_6728729_accounting-foreign-exchange-gains-

losses.html#ixzz2YdmplKUf

What is Journal Entry For Foreign Currency

TransactionsForeign currency transactions are denominated in a currency other than thecompanys functional currency. Foreign currency transactions may result inreceivables or payables fixed in the amount of foreign currency to be receivedor paid. A foreign currency transaction requires settlement in a currency other thanthe functional currency! A change in exchange rates between the functional currency

and the currency in which a transaction is denominated increases or decreases theexpected amount of functional currency cash flows upon settlement of thetransaction. This change in expected functional currency cash flows is a foreigncurrency transaction gain or loss that typically is included in arriving at earningsin the income statement for the period in which the exchange rate is changed. Anexample of a transaction gain or loss is when an Italian subsidiary has areceivable denominated in lira from a British customer.Similarly, a transaction gain or loss (measured from the transaction date or the mostrecent intervening balance sheet date, whichever is later) realized upon settlement ofa foreign currency transaction usually should be included in determining net incomefor the period in which the transaction is settled.

Example:
http://www.ehow.com/facts_6728729_accounting-foreign-exchange-gains-losses.html#ixzz2YdmplKUfhttp://www.ehow.com/facts_6728729_accounting-foreign-exchange-gains-losses.html#ixzz2YdmplKUfhttp://www.ehow.com/facts_6728729_accounting-foreign-exchange-gains-losses.html#ixzz2YdmplKUfhttp://www.ehow.com/facts_6728729_accounting-foreign-exchange-gains-losses.html#ixzz2YdmplKUfhttp://www.ehow.com/facts_6728729_accounting-foreign-exchange-gains-losses.html#ixzz2YdmplKUfhttp://www.ehow.com/facts_6728729_accounting-foreign-exchange-gains-losses.html#ixzz2YdmplKUf


3/12

An exchange gain or loss occurs when the exchange rate changes betweenthe purchase date and sale date. Merchandise is bought for100,000 pounds. Theexchange rate is 4 pounds to 1 dollar.The journal entry is:

[Debit]. Purchases = 25,000

[Credit]. Accounts payable = 25,000

(Note: 100,000/4 = $25,000)

When the merchandise is paid for, the exchange rate is 5 to 1. The journal entry is:

[Debit]. Accounts payable = 25,000

[Credit].Cash= 20,000

[Credit]. Foreign exchange gain = 5,000

(Note: 100,000/5 = $20,000)

The $20,000 using an exchange rate of 5 to 1 can buy 100,000 pounds. The

transaction gain is the difference between the cash required of $20,000 and theinitial liability of $25,000.Note that a foreign transaction gain or loss has to be determined at each balancesheet date on all recorded foreign transactions that have not been settled.

Another example:A U.S. company sells goods to a customer in England on 11/15/X7 for 10,000pounds.The exchange rate is 1 pound is $0.75. Thus, the transaction is worth$7,500 (10,000 pounds 0.75).Paymentis due two months later. The entry on11/15/X7 is:

[Debit]. Accounts receivableEngland = 7,500

[Credit]. Sales = 7,500

Accounts receivable and sales are measured in U.S. dollars at the transactiondate employing the spot rate. Even though the accounts receivable is measuredand reported in U.S. dollars, the receivable is fixed in pounds. Thus, a transactiongain or loss can occur if the exchange rate changes between the transaction date(11/15/X7) and the settlement date (1/15/X8).Since thefinancialstatements are prepared between the transaction date andsettlement date, receivables that are denominated in a currency other than the

functional currency (U.S. dollar) have to be restated to reflect the spot rate onthe balance sheet date. On December 31, 20X7, the exchange rate is 1 poundequals $0.80. Hence, the 10,000 pounds are now valued at $8,000 (10,000 $.80).Therefore, the accounts receivable denominated in pounds should be upwardlyadjusted by $500.The required journal entry on 12/31/X7 is:

[Debit]. Accounts receivableEngland = 500

[Credit]. Foreign exchange gain = 500

The income statement for the year-ended 12/31/X7 shows an exchange gain of$500.Note that sales is not affected by the exchange gain since sales relates to

operational activity.On 1/15/X8, the spot rate is 1 pound = $0.78. The journal entry is:
http://accounting-financial-tax.com/category/accounting/cash/http://accounting-financial-tax.com/category/accounting/cash/http://accounting-financial-tax.com/category/accounting/cash/http://accounting-financial-tax.com/category/accounting/payment-accounting/http://accounting-financial-tax.com/category/accounting/payment-accounting/http://accounting-financial-tax.com/category/accounting/payment-accounting/http://accounting-financial-tax.com/category/financial/http://accounting-financial-tax.com/category/financial/http://accounting-financial-tax.com/category/financial/http://accounting-financial-tax.com/category/financial/http://accounting-financial-tax.com/category/accounting/payment-accounting/http://accounting-financial-tax.com/category/accounting/cash/


4/12

[Debit]. Cash = 7,800

[Debit]. Foreign exchange loss = 200

[Credit]. Accounts receivableEngland = 8,000

The 20X8 income statement shows an exchange loss of $200.

Which Transaction Gain Or Loss Should Not Be Reported In The IncomeStatement?Gains and losses on the following foreign currency transactions ARENOT included in earnings but rather are reported as translation adjustments:

1. Foreign currency transactions designated as economic hedges of a net investmentin a foreign entity, beginning as of the designation date.

2. Inter-company foreign currency transactions of a long-term investment nature(settlement is not planned or expected in the foreseeable future),when the entities

to the transaction are consolidated, combined, or accounted for by the equitymethod in the reporting companys financial statements

3. A gain or loss on a forward contract or other foreign currency transaction that isintended to hedge an identifiable foreign currency commitment (e.g., an agreementto buy or sell machinery) should be deferred and included in the measurement ofthe related foreign currency transaction.

Losses should not be deferred if deferral is expected to result in recognizinglosses in later periods. A foreign currency transaction is deemed a hedge of anidentifiable foreign currency commitment if both of these conditions are met:

1. The foreign currency transaction is designated as a hedge of a foreign currencycommitment.

2. The foreign currency commitment is firm.

Related topic: What Is A Forward Exchange Contract, And How Is It Accounted For? Foreign Currency Translation How To Determine The Functional Currency?Accounting And Reporting For Foreign Currency

Journal Entry For Inventory TransactionsThe major objectives of accounting for inventories are the matching ofappropriate costs against revenues in order to arrive at the properdetermination of periodic income, and the accurate representation ofinventories on hand as assets of the reporting entity as of the date of the

statement of financial position.
http://accounting-financial-tax.com/2008/10/what-is-a-forward-exchange-contract-and-how-is-it-accounted-for/http://accounting-financial-tax.com/2008/10/what-is-a-forward-exchange-contract-and-how-is-it-accounted-for/http://accounting-financial-tax.com/2008/10/foreign-currency-translation/http://accounting-financial-tax.com/2008/10/foreign-currency-translation/http://accounting-financial-tax.com/2008/10/how-to-determine-the-functional-currency/http://accounting-financial-tax.com/2008/10/how-to-determine-the-functional-currency/http://accounting-financial-tax.com/2008/10/accounting-and-reporting-for-foreign-currency/http://accounting-financial-tax.com/2008/10/accounting-and-reporting-for-foreign-currency/http://accounting-financial-tax.com/2008/10/accounting-and-reporting-for-foreign-currency/http://accounting-financial-tax.com/2008/10/how-to-determine-the-functional-currency/http://accounting-financial-tax.com/2008/10/foreign-currency-translation/http://accounting-financial-tax.com/2008/10/what-is-a-forward-exchange-contract-and-how-is-it-accounted-for/


5/12

Under any system of accounting, financial statements should be fullyarticulated (i.e., the statement of financial position and income statement arelinked together mechanically).And, to achieve the goal, accounts would need to record every single eventrelatedto inventory, in this casealong the inventory cycle: raw material received, raw

material moved to the line of production, finished goods moved to the finished goodwarehouse, obsolescence, stolen, and finished goods sold out or moved to otherwarehouses.So here we go with journal entries

Raw Material Inventory1. Receiving the raw material When any raw material is received means the rawmaterial inventory is increased too. So, after counting and matching the quantity withthe purchase order, you would record Receipt of Goods entries, as follows:[Debit].InventoryRaw Materials = xxx

[Credit]. Accounts Payable = xxx

(Note: xxx is amount of actual quantity received. You can replace the accountspayable with cash if it is a cash transaction).

2. Moving raw materials to the line of production When any raw materials goingout of the warehouseusually to the line of production, means the raw material isdecreased. On the other hand, it shifted the raw materials to a new form of inventorywhich will be located in the line of production, called WIPWork In ProcessInventory. So for this event, you would make the following record:[Debit]. WIPWork In Process Inventory = xxx

[Credit]. InventoryRaw Materials = xxx

3. Adjusting raw material inventory Some materials maybe damaged/obsolete,some maybe loss (stolen) time-by-time. Such risks are inevitable. Referring to theconservatism principle, you would need to make a reserve for such risks. Reservingin this case means you are charging cost in advance. So to prepare it, you wouldneed to make reserve account, or you may want to create some for more detailsreport and easier way to drill down in the future. Here are journal entries you wouldneed to make:For obsolete raw materials:

[Debit]. Cost of Goods Sold = xxx[Credit]. Obsolescence Raw Material Reserve = xxxFor stolen raw materials:[Debit]. Cost of Goods Sold = xxx[Credit]. Stolen Raw Material Reserve = xxxOR; create a single reserve:[Debit]. Cost of Goods Sold = xxx[Credit]. Raw Material Reserve = xxx

So, when actual obsolescence or loss (because of it is stolen) is occurred, you wouldmake an adjustment entry as follows:[Debit]. Raw Material Reserve = xxx

[Credit].Raw Material Inventory= xxx
http://accounting-financial-tax.com/category/accounting/inventory/http://accounting-financial-tax.com/category/accounting/inventory/http://accounting-financial-tax.com/category/financial/budgeting-financial/work-in-process-inventory-budgeting-financial-financial/http://accounting-financial-tax.com/category/financial/budgeting-financial/work-in-process-inventory-budgeting-financial-financial/http://accounting-financial-tax.com/category/financial/budgeting-financial/work-in-process-inventory-budgeting-financial-financial/http://accounting-financial-tax.com/category/financial/budgeting-financial/raw-material-inventory/http://accounting-financial-tax.com/category/financial/budgeting-financial/raw-material-inventory/http://accounting-financial-tax.com/category/financial/budgeting-financial/raw-material-inventory/http://accounting-financial-tax.com/category/financial/budgeting-financial/raw-material-inventory/http://accounting-financial-tax.com/category/financial/budgeting-financial/work-in-process-inventory-budgeting-financial-financial/http://accounting-financial-tax.com/category/financial/budgeting-financial/work-in-process-inventory-budgeting-financial-financial/http://accounting-financial-tax.com/category/accounting/inventory/


6/12

The same case could be happened to the WIPWork In Process Inventory. And, thesame steps are required to reflect those in the book, except that you need to replacethe Raw Material with WIPWork In Process.In any manufacturing process, wastes are inevitable. And, you would need toreflect the loss in the book by making the following journal entry in the current period:

[Debit]. Cost of goods sold = xxx[Credit]. WIPWork In Process Inventory = xxx

Finished Goods Inventory1.Finished Goods InventoryReceived Finished goods inventories could become from inside the companyline of production (when it is a manufacturingcompany), or from outside of the companyfinished good purchased (when it is aretail/trading company). Wherever it comes from, finished goods inventory isincreased and need to be reflected in the book. So, you would make the following

entries:Finished Goods come from line of production:[Debit]. Finished Goods Inventory = xxx

[Credit]. WIPWork In Process Inventory = xxx

Finished Goods come from outside of the company (purchased finished goods):[Debit]. Finished Goods Inventory = xxx

[Credit]. Accounts Payable = xxx

(Note: xxx is amount of actual quantity received. You can replace the accountspayable with cash if it is a cash transaction).

2. Finished Goods Shipped Out There are two possibilities of reason for shippingout the finished goods inventory: sold or moved to other warehouse location. Either itis shipped out to customers (sold) or moved to other warehouse location, it willdefinitely decrease the finished goods inventory and should be reflected on the book.So, here are journal entries you need to make:Finished good sold:[Debit].Accounts Receivable= xxxx

[Credit]. Sales = xxx

[Credit]. Sales Tax Payable = x

(Note: This is to record the sales and sales tax. xxxx is amount of the sales plus sales tax,

xxx is amount of the sales only, x is amount of the sales tax)

AND;[Debit]. Cost of Goods Sold = xxx

[Credit]. Finished Goods Inventory = xxx

(Note: This is to record the finished goods decrease. xxx is amount of the cost)

3. Finished Goods Inventory Adjustment Finished goods inventory couldbecome obsolete or stolen, and to anticipate the risk, you would need to reserve it.To do that, you would need to make the following entry:

[Debit]. Cost of Goods Sold = xxx[Credit]. Finished Goods Reserve = xxx
http://accounting-financial-tax.com/category/financial/budgeting-financial/finished-goods-inventory/http://accounting-financial-tax.com/category/financial/budgeting-financial/finished-goods-inventory/http://accounting-financial-tax.com/category/financial/budgeting-financial/finished-goods-inventory/http://accounting-financial-tax.com/category/accounting/accounts-receivable/http://accounting-financial-tax.com/category/accounting/accounts-receivable/http://accounting-financial-tax.com/category/accounting/accounts-receivable/http://accounting-financial-tax.com/category/accounting/accounts-receivable/http://accounting-financial-tax.com/category/financial/budgeting-financial/finished-goods-inventory/


7/12

So, when actual obsolescence or loss (because of it is stolen) is occurred, you wouldmake an adjustment entry as follows:[Debit]. Finished Goods Reserve = xxx


As what you do on the raw material inventory, you may want to separate theobsolescence with stolen too for easier control and analyses in the future time.

Physical Count Inventory AdjustmentThe accounting for inventories is done under either a periodic or a perpetual system.In a periodic inventory system, the inventory quantity is determined periodically by aphysical count. The quantity so determined is then priced in accordance with the costmethod used. Cost of goods sold is computed by adding beginning inventory and netpurchases (or cost of goods manufactured) and subtracting ending inventory.Alternatively, a perpetual inventory system keeps a running total of the quantity (and

possibly the cost) of inventory on hand by recording all sales and purchases as theyoccur. When inventory is purchased, the inventory account (rather than purchases)is debited. When inventory is sold, the cost of goods sold and reduction of inventoryare recorded.Periodic physical counts are necessary, howeverat least to satisfy the taxregulations (tax regulations require that a physical inventory be taken, at leastannually). Most likely, you will find variancesactual quantity vs. recorded quantity.And, you would need to make both perfectly matched, means you would need toadjust your recordeither up or down.The following entries assume that there are increases in inventory balances:[Debit]. Raw materials inventory = xxx

[Debit]. Work-in-process inventory = xxx[Debit]. Finished goods inventory = xxx

[Credit]. Cost of goods sold = xxx

(Note: If there are decreases in the inventory balances, then the debits and creditsare reversed.)

Specific Inventory Adjustment EntriesAs I have described it in the preface of this post: first, the COGS and other costs inthe Income Statement should be tightly linked with the on hand inventory balance

on the Balance Sheet which should represent the real value of the actual asset.However, for some reasons, sometime, you may find values of the inventory youverecorded become higher compare to the market price. To achieve the goal, youwould need to make the following adjustment entry:[Debit]. Loss on Inventory Valuation = xxx

[Credit]. Raw Materials Inventory = xxx

[Credit]. WIPWork In Process Inventory = xxx



8/12

What Does and Does Not Effect Working

Capital

Working capital has a deceptively simpledefinition: Current assets minus current liabilities. That is, working capital isthe amount of a companys assets that can be converted to cash in the nearfuture, taking into account the payments that have to be made. The result is

the amount of funds available for investment to generate new business.Its helpful to get a sense of what does and doesnt have an effect on theamount of working capital available, because that can clarify the concept. Thefirst aspect to notice is that any change involving only current accounts hasno net effect on working capital. As an example: paying a $100 bill reduces abank account and therefore current assets by $100. That also reducesaccounts payable by $100, so there is no net effect on working capital.

Obviously, the components of working capital are changing constantly. Satisfying an account

payable involves only current accounts, and there is no effect on working capital.

Similarly, when a customer sends a check for $200 to pay aninvoice, you reduceaccounts receivable by $200 and increase a bank account (even if only eventuallyvia undeposited funds, another current asset) by $200. No change to total currentassets, so no change to working capital.

Its easy. Am I right? Well, those are changes to the current accounts.How about change to non-

current accounts?Read on

Changes To Non-current AccountsIf you have an algebraic turn of mind, you might consider the followingsequence, beginning with the fundamental accounting equation:

Assets = Liabilities +Equity

Now, using these abbreviations:
http://accounting-financial-tax.com/category/accounting/invoice-accounting/http://accounting-financial-tax.com/category/accounting/invoice-accounting/http://accounting-financial-tax.com/category/accounting/invoice-accounting/http://accounting-financial-tax.com/category/accounting/equity/http://accounting-financial-tax.com/category/accounting/equity/http://accounting-financial-tax.com/category/accounting/equity/http://accounting-financial-tax.com/category/accounting/equity/http://accounting-financial-tax.com/category/accounting/invoice-accounting/


9/12

CA = Current Assets

NCA = Noncurrent Assets [including both fixed and other assets]

CL = Current Liabilities

NCL = Noncurrent Liabilities, including long-term and other liabilities

We can get to an algebraic definition of working capital:CA + NCA = CL + NCL + Equity

CA CL + NCA = NCL + Equity

Working Capital + NCA = NCL + Equity

Working Capital = NCL + Equity NCA

A change in the balance of a noncurrent account often, but not always,changes the amount of working capital.So, as distinct from changes involving only current accounts, a change to anoncurrent account (a noncurrent asset, a noncurrent liability, or an equity account)

can change the amount of working capital. If Lie Dharma Construction takes out athree-year loan for $15,000 and deposits the funds in a bank account for example,working capital increases by $15,000. The liability account that records the loan is along-term liability, not a current liability. So current liabilities remain unchanged andboth current assets and working capital increase by $15,000.

Of course, a companysprimary source of working capital in the long run is net income, the

excess of revenues over expenses, andthats the principalfinancialreason for being in business

at all.From an accounting perspective, how do current assets such as inventory and accounts

receivable get to be noncurrent, so that they affect working capital?Readon

Let say you starts a new company called Lie Dharma Floors, a soleproprietorship, at the end of April and provides it with startup funds bydepositing $25,000 in its bank account. At tyour point, the company has noliabilities, current or otherwise, and a current asset (and owners equity) of $25,000.The companys working capital is therefore $25,000 at the outset.You then records the following transactions:

A deposit of another $15,000 from your personal funds into the companyschecking account, and also recorded as paid-in equity.

The purchase of $28,000 in inventory for resale.

The sale of $21,000 worth of inventory for $33,000.

The receipt of $15,000 in payments from customers for their $33,000 worth ofpurchases. Those payments post first into Undeposited Funds, and then post intothe companys checking account. The total of the customers outstanding balances,$18,000, remains in accounts payable.

The receipt of bills for the $28,000 worth of inventory from your vendors and thepayment of $18,000, leaving $10,000 in accounts payable.

You pay $8,500 in various operating expenses such as travel and communications.

You also purchase a small, two-room office in a shopette for $22,000, paying for itwith $15,000 in cash and $7,000 from a six-month bank loan.

The withdrawal of $1,000 for your personal use, as an owners draw.

Upon finishing yourP&L and BalanceSheet you would find the net incomeof $3,500 during May acts as a source of working capital.
http://accounting-financial-tax.com/category/financial/http://accounting-financial-tax.com/category/financial/http://accounting-financial-tax.com/category/financial/


10/12

On the balance sheet, the net income appears in Equity, a noncurrent account.$22,000 of current assets have been converted to fixed assets by the purchase ofthe office space. Current assets of $37,500 less current liabilities of $17,000 result inworking capital of $20,500.Lie Dharma Floors started out with $25,000 in working capital. It has earned $3,500

in net income. But its cash account has fallen to $12,500 and its working capital isdown from $25,000 to $20,500.

How does this come about?

Looking into the matter helps you get a clearer understanding of how thecompany does business. Each transaction listed later has an effect on theamount of working capital available, subsequent to your initial $25,000investment. You also see that none of the transactions involves solely currentaccounts. Other activities the company undertakes, such as purchasing inventory,are not listed because they involve only current accounts and therefore have no neteffect on working capital.

Your second investment increases working capital by $15,000 to $40,000. Product sales bring in $12,000 in gross profit, increasing working capital to

$52,000.

The company pays $8,500 in operating expenses, decreasing working capital to$43,500.

A check for $15,000 is written as a partial payment for the office space. Workingcapital is now $28,500.

Accounts payable is increased by $7,000 as a result of the short-term loan to paythe remaining balance owed on the office space. Working capital is $21,500.

You withdraws $1,000 for your personal use, decreasing both your equity andworking capital by $1,000, leaving working capital at $20,500.

So, after the initial investment of $25,000, various purchases, sales, and othertransactions reduce the companys working capital to $20,500. This amountagrees with the result of subtracting, on May 31, current liabilities from currentassets. Its obviously a lot quicker to do one simple subtraction than it is totrace every transaction during the period, particularly when a companytypically has many more transactions than the six listed earlier.

This simple subtraction is informative, certainly its the quickest way to determine working

capital and therefore how it varies over time. But itdoesntgive you any real insight into how

the company is carrying out the process of investing and disinvesting that creates profit (or

loses it).

What Doesnt Affect Working CapitalTransactions involving only current accounts have no net effect on the amountof working capital. That sort of transaction affects the components of workingcapital, of course, but not the result of subtracting current liabilities fromcurrent assets.The same is true of noncurrent accounts. A transaction that does not involve acurrent account does not change the amount of working capital. An example isdepreciation. Suppose your business owns a truck that it bought for $20,000. Youkeep it on your books as a fixed asset worth $20,000. But the truck loses value overtime that is, it depreciates and you record that amount of loss periodically. The


11/12

amount of loss you record is determined by which one of several methods fordetermining depreciation you and your accountant decide on.That method might tell you to record $300 in depreciation for the first monthyour company owned the truck. You record $300 as a debit to an expenseaccount, perhaps namedDepreciation, and also as a credit to a fixed asset account,

perhaps named Truck:Accumulated Depreciation. Neither account is a current assetaccount, therefore the transaction has no effect on working capital.Note:Although depreciation is recorded in expense and in fixed asset accounts, and thusdoes not affect working capital, it still needs to be accounted for when yourecalculating working capital. This issue is explained at the end of this post.

What Does Affect Working CapitalThere are some transactions that are typical in the increase and decrease ofworking capital. Among them are the following:

Net income. The sale of product for more than it cost to acquire the product is a

typical source of working capital. But net income often must be adjusted beforeadding it in with other sources. The reason is that some expenses that aresubtracted from gross profit to arrive at net income do not involve current accounts.In fact, one of the purposes of analyzing the sources and uses of working capital isto clarify the reasons for a difference between net income and working capitalprovided by a companys operations.

Acquisition of fixed assets. Buying equipment with cash, including cash obtainedvia borrowing, is a typical use of working capital. Acquiring the asset in exchangefor stock involves no current account and has no effect on working capital.

Paying off long-term debt. Assuming, as is usually the case that a company usescurrent assets to retire a long-term debt, paying off the debt is a use of working

capital. A long-term debt is not carried in the current accounts payable liabilityaccount.

Acquiring long-term debt. When a company takes out a long-term loan, themoney borrowed goes into a current asset, usually a cash account. The companyalso acquires a noncurrent liability, the debt itself. Tyour transaction involves acurrent asset and a noncurrent liability, and is therefore a source of working capital.

Selling a fixed asset. A company might occasionally sell equipment, a building, oreven land in return for cash, because the company no longer has use for the assetor is in desperate need of funds. Tyour involves a current and a noncurrent accountand is therefore a source of working capital. Suppose the asset is sold at a loss: Abuilding purchased for $200,000 in 2005 is sold for $150,000 in 2009. Even though

the sale represents a loss, it nevertheless increases working capital by $150,000.

Tracking Changes in Working CapitalIts helpful to know that a company has increased or decreased itsworking capital from one period to the next. Knowing that is often more helpfulthan knowing the change in cash assets, or net sales, or even net income. Butmerely knowing that a companys working capital increased by $103,355.59during 2011 for example, doesnt help you to understand how its beingmanaged.Its good to know that the company has over a hundred thousand dollars moreto work with, but whetheryoure a potential employee, a manager, a

stockholder, or creditor, you should want to know more.Whats the main source of the increase in working capital?
http://accounting-financial-tax.com/category/accounting/depreciation/http://accounting-financial-tax.com/category/accounting/depreciation/http://accounting-financial-tax.com/category/accounting/depreciation/http://accounting-financial-tax.com/category/accounting/depreciation/


12/12

Long-term debt? Then maybe you should be extra careful about loaning thecompany more money.

A recent stock issue? If newly floated shares were snapped up, maybe youshould seriously consider the job offer they gave you.

Net income? The only people who are unhappy when net income builds a

companys working capital are the short-sellers.The notion of working capital focuses on assets that are available for use inthe near term as well as liabilities that must be satisfied in the near term. It isthe difference between the two amounts, so the amount of working capital isthe companys accessible assets less the near-term liabilities that it hasalready incurred. It is the amount of resources available to invest in newbusiness, by converting cash to equipment, hiring additional staff, purchasingadditional inventory, and so on.

accounting explanations

Documents