Financial accounting is about the presentation of financial information about the activities of a business. There are four primary financial statements, namely balance sheet, income statement, changes of equity statement, and cash flow statement. A balance sheet indicates the accounting equation represented in the graphic. This equation shows information regarding the resources owned by an organization- assets – and the claims placed on those resources – liabilities and shareholders’ equity at any given point.
In financial accounting, there are five types of accounts, namely assets, liabilities, owners’ equity, revenues, and expenses.
If the balance were the only statement, there would only be assets, liabilities, and owners’ equity account types. However, most firms prepare income statements necessitating the other account types.
Special Case: Insolvency
Insolvency is a term applied in business to mean that a company cannot meet its debt obligations. It occurs when a company is short of cash and is unable to meet its outstanding debts. The assets of a company can be liquidated to pay outstanding debt. Insolvency is a complex process that involves even legal proceedings. In some cases, owners could contact creditors directly to restructure part of the debt.
An income statement is used to present revenues and expenses information. This includes income as a difference between revenues and expenses. If the difference is negative, it’s referred to as a net loss.
Urban outfitters expense their advertising costs when the advertising occurs, but for direct-to-consumer advertising, they capitalize it and expense it during the mailing of catalogs or content published on the firm’s websites and mobile apps. The main source of advertising expenses is retail segment marketing costs such as web marketing, the printing of catalogs, paper, postage, and other costs, and the production of images to be used in the advertisements. Unless there is an explained future benefit, advertising costs are expensed when incurred. Advertising expenses are recorded under prepaid expenses and other current assets.
Store Opening Cost
Urban outfitters expenses store opening costs as incurred. These costs include traveling, training, recruiting, salaries, and other operating costs. All such costs are recorded under “selling, general and administrative expenses “in the income statement.”
Web Development Costs
Urban outfitters capitalize on certain costs during application and infrastructure development and also expenses costs incurred during the planning and operating stage. For instance, the company did not capitalize on any software development expenses in 2015, 2016, and 2017 because all tangible costs incurred during this period had been incurred during the planning and operating stages and costs incurred during the application and infrastructure stages were not significant.
Importance of notes in financial statements
Financial statement notes are additional notes included in published financial statements of a company to explain assumptions used in the preparation of the reports as well as accounting policies used by the organization (Droms & Wright, 2015). People who benefit from these types of information include investors and financial analysts. When an auditor is conducting their audit of financial statements, they go through all the information contained in the reports, including notes. They will use the notes to determine if the applied accounting policies are appropriate. Notes could also indicate the general health of the company. An auditor will therefore base their opinion of the company on a combination of all the information, including notes.
In cash accounting, revenues and expenses are reported as they are received and paid with cash inflows and outflows. On the other hand, accrual accounting reports revenues and expenses as they are earned and incurred through sales and credit purchases using account receivables and accounts payable.
Expensing vs. Capitalizing
In the financial statements, expensing costs are included in the income statement and are subtracted from revenue to obtain the profit. On the other hand, capitalization is an indicator that the company has determined the cost to be a capital expenditure to be recorded in the balance sheet (Droms & Wright, 2015). Advertising is a huge cost for Urban Outfitters. If they were to capitalize it, then the only charge against profits would be depreciation; this would have the effect of increasing the profits.
IRS Guide on Advertising
Deciding on whether to capitalize or expense is rarely unconstrained; the IRS and regulators have rules to watch out against tax evasion. For instance, the IRS recommends that advertisements should always be expensed except under very rare circumstances. This means that Urban Outfitters made the correct choice to expense. The circumstances under which advertising could be capitalized include when it is used to obtain future benefits as opposed to typical product advertising or usual promotion of the company’s goodwill. An example of when a company was allowed to capitalize on advertising was when Cleveland Electric was advertising to dispel public fear over nuclear power. In this case, it was determined that the company had planned to acquire future benefits that were beyond the usual product or institutional goodwill promotion.
Guidelines for Software Development
According to ASB Accounting Standards Codification (ASC), the rule governing the treatment of software depends on whether the software is intended for selling or internal usage (Bouray & Richards, 2018). One general rule is that the capitalization threshold is higher for in-house software than that intended for selling or licensing (Bouray & Richards, 2018). In the case of Urban Outfitters, their web development costs were most probably for internal use. They, therefore, made the correct choice to capitalize the cost.
Guideline on Store Opening Costs
Companies typically capitalize on those expenses that have future benefits. These are resources that will benefit the organization for multiple operation cycles ( Bouray & Richards, 2018). Store-opening costs include some fixed assets that one would expect to be on the balance sheet. However, Urban outfitters expense their store-opening costs as they happen, which is objectively not a good idea.
In a recap of general principles of accounting, it has been noted that the most important principle is that the assets of a company must equal the claims on those assets by creditors (Liabilities) and shareholders (Owner’s) equity.
It was also observed that some costs could either be capitalized or expensed. Companies can use their own criteria to decide on whether to expense or capitalize. Regulatory bodies provide guidelines on when to expense or capitalize. This nuance can be used as a loophole by companies to manipulate their books.
Bouray, R. P., & Richards, G. E. (2018). Accounting for external-use software development costs in an agile environment. Journal of Accountancy. Web.
Droms, W. G., & Wright, J. O. (2015). Finance and accounting for nonfinancial managers: All the basics you need to know (Seventh edition). Basic Books, a member of the Perseus Books Group.
Jones, D. J. (2012). Visualizing accounting transaction flows into financial statements. American Journal of Business Education (AJBE), 5(6), 753–758. Web.
Mukhopadhyay, S. (2018). Insolvency (Definition, examples) | how does it work? WallStreetMojo. Web.
Sec filing | urban outfitters, inc. – Ir site. (n.d.). Web.