What is an Appropriation Account?

Appropriation is the act of setting aside money for a specific purpose. In accounting, it refers to a breakdown of how a firm’s profits are divided up, or for the government, an account that shows the funds a government department has been credited with. A company or a government appropriates funds in order to delegate cash for the necessities of its business operations. 

How Appropriation Accounts Work

In general accounting, appropriation accounts are mainly prepared by partnerships and limited liability companies (LLCs). They are an extension of the profit and loss statement, showing how the profits of a firm are allocated to shareholders or to increase reserves indicated in the balance sheet. A company might appropriate money for short-term or long-term needs to finance things such as employee salaries, research and development, and dividends.

For a partnership, the primary purpose of the appropriation account is to show how profits are distributed among the partners. For an LLC, the appropriation account will start with profits before taxes and then subtract corporate taxes and dividends to arrive at retained profits.

Government appropriation accounts come into play when they create their budgets. Appropriation credits are taken out of estimated revenues from taxes and trade and allocated to the proper agencies. Credits in appropriation accounts that are unused may be redistributed to other agencies or used for other purposes.

Appropriations for the U.S. federal government are decided by Congress through various committees. The U.S. government’s fiscal year runs from October 1 through September 30 of each calendar year.

Real World Example of Appropriation Accounts

Investors can monitor appropriations of publicly listed corporations by analyzing their cash flow statements (CFS). The CFS shows if a firm is generating enough cash to pay its debt obligations and fund its operating expenses.

Here’s a breakdown of how Tobacco giant Altria Group Inc. (MO), a popular income stock, appropriated its cash and profits in the nine months to Sep. 30, 2018.

What Are Appraisal Costs?

Appraisal costs are a specific category of quality control costs. Companies pay appraisal costs as part of the quality control process to ensure that their products and services meet customer expectations and regulatory requirements. These costs could include expenses for field tests and inspections.

Understanding Appraisal Costs

Appraisal costs can be a key expense for companies seeking to maintain high levels of customer and regulatory satisfaction. Payments for secret shopper salaries, factory floor inspectors, and technical screening equipment all fall into this category. Companies that spend large amounts of money on appraisal costs show that they are concerned with their reputations.

To prevent defective inventory or products from reaching their customers, companies get creative while incurring appraisal costs to spot suspect products. In the end, it is less expensive to incur appraisal costs than to lose customers who are frustrated by the receipt of low-quality goods.

The Internet and social media now give consumers unprecedented opportunities to voice their dissatisfaction with any companies or products that fail to meet their standards. The threat of unpleasant reviews or viral PR mishaps keeps companies on their toes and investing in appraisals of their products.

Appraisal costs can simply be looked at as part of the cost of doing business as well as the cost of creating a product or service. A company’s reputation is one of the most important assets that it has. Once a company’s reputation slips into the negative after the release of faulty products and bad publicity, it is almost always impossible or extremely difficult to shift consumer opinion.

It is for this reason that management needs to pay strict attention to quality control to ensure the lasting success of their company; appraisal costs are a part of that process.

Examples of Appraisal Costs

There are many examples of appraisal costs and every industry has different types of appraisals and therefore the costs associated with them. Appraisal costs can even be driven by where the industry is in a market cycle.

A classic appraisal cost would be what is spent to inspect materials delivered from suppliers. For example, let’s say a music retailer gets a shipment of guitars from a major manufacturer. Last year, the guitar manufacturer’s first round of guitars had faulty tuners, causing customers to return opened products, file complaints with the guitar store’s corporate parent, and in some cases, switch their loyalty to a different music retailer.

So this year, when the new shipment of guitars comes in, the music retailer opens the boxes, inspects each guitar to make sure the tuners are in good shape, and then repackages them before making them available to customers. This process costs money and time, which is accounted for on the balance sheet as an appraisal cost.

Other examples of appraisal costs include:

• Inspecting work-in-process materials
• Inspecting finished goods
• The supplies used to conduct inspections
• The inventory destroyed as part of the testing process
• Supervision of the inspection staff
• Depreciation of test equipment and software
• Maintenance of any test equipment

The next best thing to incurring appraisal costs includes working on increasing the quality of the production processes of all suppliers and the company itself. The idea of vendor and supply chain management seeks to improve the entire process so that it’s inherently incapable of producing defective parts. Like a final product, suppliers need to ensure that their raw materials are in good condition, or else they risk losing supply contracts with the final producer of a good.

What Is an Amortized Bond?

An amortized bond is one in which the principal (face value) on the debt is paid down regularly, along with its interest expense over the life of the bond. A fixed-rate residential mortgage is one common example because the monthly payment remains constant over its life of, say, 30 years. However, each payment represents a slightly different percentage mix of interest versus principal. An amortized bond is different from a balloon or bullet loan, where there is a large portion of the principal that must be repaid only at its maturity.

Understanding Amortized Bonds

The principal paid off over the life of an amortized loan or bond is divvied up according to an amortization schedule, typically through calculating equal payments all along the way. This means that in the early years of a loan, the interest portion of the debt service will be larger than the principal portion. As the loan matures, however, the portion of each payment that goes towards interest will become lesser and the payment to principal will be larger. The calculations for an amortizing loan are similar to that of an annuity using the time value of money, and can be carried out quickly using an amortization calculator.

Amortization of debt affects two fundamental risks of bond investing. First, it greatly reduces the credit risk of the loan or bond because the principal of the loan is repaid over time, rather than all at once upon maturity, when the risk of default is the greatest. Second, amortization reduces the duration of the bond, lowering the debt’s sensitivity to interest rate risk, as compared with other non-amortized debt with the same maturity and coupon rate. This is because as time passes, there are smaller interest payments, so the weighted-average maturity (WAM) of the cash flows associated with the bond is lower.

Example of Amortizing a Bond

30-year fixed-rate mortgages are amortized so that each monthly payment goes towards interest and principal. Say you purchase a home with a $400,000 30-year fixed-rate mortgage with a 5% interest rate. The monthly payment is $2,147.29, or $25,767.48 per year.

At the end of year one, you have made 12 payments, most of the payments have been towards interest, and only $3,406 of the principal is paid off, leaving a loan balance of $396,593. The next year, the monthly payment amount remains the same, but the principal paid grows to $6,075. Now fast forward to year 29 when $24,566 (almost all of the $25,767.48 annual payments) will go towards principal. Free mortgage calculators or amortization calculators are easily found online to help with these calculations quickly.

Straight-Line vs. Effective-Interest Method of Amortization

Treating a bond as an amortized asset is an accounting method used by companies that issue bonds. It allows issuers to treat the bond discount as an asset over the life of the bond until its maturity date. A bond is sold at a discount when a company sells it for less than its face value and sold at a premium when the price received is greater than face value.

If a bond is issued at a discount—that is, offered for sale below its par or face value—the discount must be treated either as an expense or it can be amortized as an asset. In this way, an amortized bond is used specifically for tax purposes because the amortized bond discount is treated as part of a company’s interest expense on its income statement. The interest expense, a non-operating cost, reduces a company’s earnings before tax (EBT) and, therefore, the amount of its tax burden.

Effective-interest and straight-line amortization are the two options for amortizing bond premiums or discounts. The easiest way to account for an amortized bond is to use the straight-line method of amortization. Under this method of accounting, the bond discount that is amortized each year is equal over the life of the bond.

Companies may also issue amortized bonds and use the effective-interest method. Rather than assigning an equal amount of amortization for each period, effective-interest computes different amounts to be applied to interest expense during each period. Under this second type of accounting, the bond discount amortized is based on the difference between the bond’s interest income and its interest payable. Effective-interest method requires a financial calculator or spreadsheet software to derive.

What Are Accounting Principles?

Accounting principles are the rules and guidelines that companies and other bodies must follow when reporting financial data. These rules make it easier to examine financial data by standardizing the terms and methods that accountants must use.

The International Financial Reporting Standards (IFRS) is the most widely used set of accounting principles, with adoption in 167 jurisdictions. The United States uses a separate set of accounting principles, known as generally accepted accounting principles (GAAP).

The Purpose of Accounting Principles

The ultimate goal of any set of accounting principles is to ensure that a company’s financial statements are complete, consistent, and comparable.

This makes it easier for investors to analyze and extract useful information from the company’s financial statements, including trend data over a period of time. It also facilitates the comparison of financial information across different companies. Accounting principles also help mitigate accounting fraud by increasing transparency and allowing red flags to be identified.

Comparability

Comparability is the ability for financial statement users to review multiple companies’ financials side by side with the guarantee that accounting principles have been followed to the same set of standards.

Accounting information is not absolute or concrete, and standards are developed to minimize the negative effects of inconsistent data. Without these rules, comparing financial statements among companies would be extremely difficult, even within the same industry. Inconsistencies and errors also would be harder to spot.

What Are the Basic Accounting Principles?

Some of the most fundamental accounting principles include the following:

• Accrual principle
• Conservatism principle
• Consistency principle
• Cost principle
• Economic entity principle
• Full disclosure principle
• Going concern principle
• Matching principle
• Materiality principle
• Monetary unit principle
• Reliability principle
• Revenue recognition principle
• Time period principle

The most notable principles include the revenue recognition principle, matching principle, materiality principle, and consistency principle. Completeness is ensured by the materiality principle, as all material transactions should be accounted for in the financial statements. Consistency refers to a company’s use of accounting principles over time.

Generally Accepted Accounting Principles (GAAP)

Generally accepted accounting principles (GAAP) are uniform accounting principles for private companies and nonprofits in the U.S. These principles are largely set by the Financial Accounting Standards Board (FASB), an independent nonprofit organization whose members are chosen by the Financial Accounting Foundation.

A similar organization, the Governmental Accounting Standards Board (GASB), is responsible for setting the GAAP standards for local and state governments. And a third body, the Federal Accounting Standards Advisory Board (FASAB), publishes the accounting principles for federal agencies.

Although privately held companies are not required to abide by GAAP, publicly traded companies must file GAAP-compliant financial statements to be listed on a stock exchange. Chief officers of publicly traded companies and their independent auditors must certify that the financial statements and related notes were prepared in accordance with GAAP.

Privately held companies and nonprofit organizations also may be required by lenders or investors to file GAAP-compliant financial statements. For example, annual audited GAAP financial statements are a common loan covenant required by most banking institutions. Therefore, most companies and organizations in the U.S. comply with GAAP, even though it is not a legal requirement.

International Financial Reporting Standards (IFRS)

The International Accounting Standards Board (IASB) issues International Financial Reporting Standards (IFRS). These standards are used in more than 120 countries, including those in the European Union (EU).

The Securities and Exchange Commission (SEC), the U.S. government agency responsible for protecting investors and maintaining order in the securities markets, has expressed interest in transitioning to IFRS. However, because of the differences between the two standards, the U.S. is unlikely to switch in the foreseeable future.

However, the FASB and the IASB continue to work together to issue similar regulations on certain topics as accounting issues arise. For example, in 2014, the FASB and the IASB jointly announced new revenue recognition standards.

Since accounting principles differ around the world, investors should take caution when comparing the financial statements of companies from different countries. The issue of differing accounting principles is less of a concern in more mature markets. Still, caution should be used, as there is still leeway for number distortion under many sets of accounting principles.

The Bottom Line

Accounting principles are rules and guidelines that companies must abide by when reporting financial data. Whether it’s GAAP in the U.S. or IFRS elsewhere, the overarching goal of these principles is to boost transparency and basically make it easier for investors to compare the financial statements of different companies.

Without these rules and standards, publicly traded companies would likely present their financial information in a way that inflates their numbers and makes their trading performance look better than it actually was. If companies were able to pick and choose what information to disclose and how, it would be a nightmare for investors.