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Scenic Video Transcript

Reconciliation Adjustment Signs

Topics

  • Concepts:
  • Asset reconciliation adjustments have the opposite sign as the net effect of operating entries
  • Liability reconciliation adjustments have the same sign as the net effect of operating entries
  • Explanation:
  • Why asset adjustment signs are the opposite of the net effect of operating entries
  • Derive Reconciliation Equation
  • Take-aways

Transcript

Introduction

Welcome to the Adjustment Signs Scenic Route. This video will help you understand the reason reconciliation adjustments associated with assets have the opposite sign of the net effect of operating entries on the related asset accounts.While, by contrast, adjustments associated with liabilities have the same sign as the net effect of operating entries on the related liability accounts. We saw these patterns earlier, and this video is going to explain them to you.

Here’s our agenda. We’re going to start with the concepts and then we’re going to give an explanation and then some takeaways. So this is a really short video.

Concepts

We begin with our observations from EasyLearn. What was the net effect of the operating entries on accounts receivable? Well, we had a $150 worth of billings on accounts receivable when we recognized revenue, customer collections of $20. So the net effect was positive, $130, yet the adjustment was -$130 for reasons explained in great detail in the big picture scenic route video. But for accounts payable we found that the net effect of the operating entries was once again positive, $45, but in this case the adjustment was positive. So the question students always ask is, “Well, why is it that when you have an asset the adjustments are the opposite in sign to the net effect of the operating entries but when you have a liability, well, they’re the same sign as the net effect of the operating entries?” And now we’re about to explain that. This is pretty straightforward.

Explanation

The first thing to understand is that we have an equation in the reconciliation. It’s an equation that runs down the page so it’s a vertical equation, and we’re going to write it up here in its horizontal form. So we have net cash from operations down at the bottom, down here, you kind of think of a big equal sign sitting right there. Net cash from operations equals net income plus the reconciliation adjustments. So that’s our Reconciliation Equation, and we’d like to come up with a way of understanding these signs that are in the reconciliation adjustments. Why is this negative, and why is that positive?

So what we’re going to do is we’re going to find another equation that kind of looks like this one and then rearrange it so we end up with exactly an understanding of the signs. So that’s our task, explain the signs. We're focusing on the net from operations row here. That’s where the numbers are coming from. So the first thing we’re going to do is we’re going to form an equation from the Balance Sheet Equation matrix but focusing on the net from operations row. Now, this is pretty straightforward, but let’s go slow.

Here’s the cash account. So the net effect of the operating entries is $5, and all we’re going to do is in words write down net cash from operations $5. And then we’re going to add to that $130, which represents the net increase in accounts receivable due to operating entries. So that’s the net effect of operating entries on accounts receivable. And then we get an equal sign, and then we do the same thing for payables, and then over here we get net income. Now, you might be saying, “Well, I thought net income was coming off the trial balance row?” It does. There’s nothing going on for EasyLearn in the investing activities and financing activities that affects income. So actually, the row is the same up here.

Now, in general, when we get to Bischoff, and we’ll explain all of this later, there can be gains or losses here from, say, selling property, plant and equipment and that will enter into income. So in that case, we’re going to have to make an adjustment for gains or losses, and we’ll do that, but for now let’s ignore that. We see that income is going to be the same on both these rows, and that’s really important because we want to form an equation based on this row right here. So when we get over here to the far item on net income, we’re going to have to say,“net income after adjusting for gains and losses,” and that’s kind of a placeholder to take care of things later. For right now, you can just think of this as net income. So over here we’ve got cash, over here we’ve got income, and in between, well, we’ve got these adjustments.

Now, let’s take this equation and rewrite it as the Reconciliation Equation we looked at earlier. Remember, this is what we’re trying to get an explanation for. That’s our indirect cash flow statement reconciliation, and here we have the equation going down here vertically. And here we have the horizontal form of the equation. So what we’re trying to do is take the BSE matrix equation, which is up here off of that one row, and rewrite it so that it looks like the Reconciliation Equation.

Now, how do we do that? Well, the reconciliation has net cash from operations isolated all by itself, remember, below the equal sign here. So we’ve got to get cash from operations by itself. But to do that we’ve got to move the asset adjustments across the Balance Sheet Equation, and, of course, when they move over they change their signs. And that’s exactly the reason the signs are different, because the asset adjustments, or more generally any adjustment that's on the assets side of balance sheet, is going to change its sign when it comes over, and we do that to isolate cash from operations because that’s the bottom row on the reconciliation. And then we move net income to this part of the equation. That’s not really important, but it does make the equation flow nicely because we end up with net cash from operations equals net income plus reconciliation adjustments. Here they are. That explains that the adjustment is going to have to be the opposite of the effect of the entries.

Now, if we had a contra asset over on this side of the equation, like accumulated depreciation, well, when it moves across the balance sheet it will go from being negativelysignedto positively signed. But that’s really the full explanation for why the signs change, and the neat thing is once you see it once you’ll never have to see it again. You’ll now believe that the asset adjustments have the opposite sign of the liabilities because these asset adjustments come across the equation, and that’ll be all you need to know.

Take-aways

What should you know? The Reconciliation Equation can be derived from the net from operations row of the BSE matrix. Assets must be transferred to the other side of the BSE equation to derive the Reconciliation Equation. Reconciliation adjustments associated with positively signed asset accounts have the same absolute value as the net effect of the operating entries but the opposite sign. Reconciliation adjustments associated with negatively signed contra asset accounts have the same absolute value as the net effect of operating entries and the same sign because negative, negative.

Where are we heading? The Reconciliation Equation can be derived from the “net from operations” row of the BSE matrix when there are no gains or losses associated with investing or financing transactions. In the SCF Entry Map module, the next module, you will learn how to accommodate gains and losses associated with investing or financing activities and to interpret the reconciliation adjustments associated with them. That’s coming up next.

Where else are we heading? Well, EasyLearn’s operating entries affect either net income or net cash from operations. Every one of the entries that are in the operating section either affect income or affect cash from operations. Customer collections affects cash, recognizing revenue affects income, advertising expense affects income, and advertising payment affects cash. This means adjustments are absolutely needed to explain why income differs from cash. If an entry affects income but doesn’t affect cash and your goal is to explain why income differs from cash, well, that entry has to affect the reconciliation.

In the SCF Entry Map module, you will learn that adjustments are not needed for operating entries that affect neither income nor net cash from operations. So if we look at the BSE matrix, here’s cash over here, here’s income over here, what if we have entries that are in between here and they don’t affect either one of these? Well, you really don’t need an adjustment. They don’t affect income. They don’t affect cash. What’s there to reconcile? But you’re also going to learn that even though they are not needed to meet the purpose of the reconciliation, offsetting, and here’s the word, redundant adjustments, when we look at the reconciliation we’re going to have net income up here, we’re going to have net cash from operations down here, and we’re going to have two adjustments, and one will have a positive effect and one a negative effect, and they offset each other. Well, if they offset each other, then with regards to the objective of explaining why income differs from cash, they’re redundant. They’re not needed. Now, why are they there? Well, we’ll explain that when we do the SCF Entry Map module. There’s a historical reason, and there’s other reasons.

Hope you’ve enjoyed this video. See you in the next one.