Income StatementMarilyn points out that an income statement will show how profitable Direct Delivery has been

during the time interval shown in the statement's heading. This period of time might be a week, a

month, three months, five weeks, or a year—Joe can choose whatever time period he deems most

useful.

The reporting of profitability involves two things: the amount that was earned (revenues) and the

expenses necessary to earn the revenues. As you will see next, the term revenues is not the same

as receipts, and the termexpenses involves more than just writing a check to pay a bill.

A. RevenuesThe main revenues for Direct Delivery are the fees it earns for delivering parcels. Under

the accrual basis of accounting (as opposed to the less-preferred cash method of accounting), revenues are recorded when they are earned, not when the company receives the

money. Recording revenues when they are earned is the result of one of the basic accounting

principles known as the revenue recognition principle.For example, if Joe delivers 1,000 parcels in December for $4 per delivery, he has

technically earned fees totalling $4,000 for that month. He sends invoices to his clients for these

fees and his terms require that his clients must pay by January 10. Even though his clients won't be

paying Direct Delivery until January 10, the accrual basis of accounting requires that the $4,000 be

recorded as December revenues, since that is when the delivery work actually took place. After

expenses are matched with these revenues, the income statement for December will show just

how profitable the company was in delivering parcels in December.

When Joe receives the $4,000 worth of payment checks from his customers on January 10, he will

make an accounting entry to show the money was received. This $4,000 of receipts will not be

considered to be January revenues, since the revenues were already reported as revenues in

December when they were earned. This $4,000 of receipts will be recorded in January as a

reduction in Accounts Receivable. (In December Joe had made an entry to Accounts

Receivable and to Sales.)

B. ExpensesNow Marilyn turns to the second part of the income statement—expenses. The December income

statement should show expenses incurred during December regardless of when the company

actually paid for the expenses. For example, if Joe hires someone to help him with December

deliveries and Joe agrees to pay him $500 on January 3, that $500 expense needs to be shown on

the December income statement. The actual date that the $500 is paid out doesn't matter. What

matters is when the work was done—when the expense was incurred—and in this case, the work

was done in December. The $500 expense is counted as a December expense even though the

money will not be paid out until January 3. The recording of expenses with the related revenues is

associated with another basic accounting principle known as the matching principle.

1

Marilyn explains to Joe that showing the $500 of wages expense on the December income

statement will result in a matching of the cost of the labor used to deliver the December parcels

with the revenues from delivering the December parcels. This matching principle is very important in

measuring just how profitable a company was during a given time period.

Marilyn is delighted to see that Joe already has an intuitive grasp of this basic accounting principle.

In order to earn revenues in December, the company had to incur some business expenses in

December, even if the expenses won't be paid until January. Other expenses to be matched with

December's revenues would be such things as gas for the delivery van and advertising spots on the

radio.

Joe asks Marilyn to provide another example of a cost that wouldn't be paid in December, but would

have to be shown/matched as an expense on December's income statement. Marilyn uses

the Interest Expense on borrowed money as an example. She asks Joe to assume that on

December 1 Direct Delivery borrows $20,000 from Joe's aunt and the company agrees to pay his

aunt 6% per year in interest, or $1,200 per year. This interest is to be paid in a lump sum each on

December 1 of each year.

Now even though the interest is being paid out to his aunt only once per year as a lump sum, Joe

can see that in reality, a little bit of that interest expense is incurred each and every day he's in

business. If Joe is preparingmonthly income statements, Joe should report one month of Interest

Expense on each month's income statement. The amount that Direct Delivery will incur as Interest

Expense will be $100 per month all year long ($20,000 x 6% ÷ 12). In other words, Joe needs to

match $100 of interest expense with each month's revenues. The interest expense is considered a

cost that is necessary to earn the revenues shown on the income statements.

Marilyn explains to Joe that the income statement is a bit more complicated than what she just

explained, but for now she just wants Joe to learn some basic accounting concepts and some of the

accounting terminology. Marilyn does make sure, however, that Joe understands one simple yet

important point: an income statement, does notreport the cash coming in—rather, its purpose is to

(1) report the revenues earned by the company's efforts during the period, and (2) report

the expenses incurred by the company during the same period. The purpose of the income

statement is to show a company's profitability during a specific period of time. The difference (or

"net") between the revenues and expenses for Direct Delivery is often referred to as the bottom line and it is labeled as either Net Income or Net Loss.

Balance Sheet - AssetsMarilyn moves on to explain the balance sheet, a financial statement that reports the amount of a

company's (A)assets, (B) liabilities, and (C) stockholders' (or owner's) equity at a specific point in time. Because the balance sheet reflects a specific point in time rather than a period of time,

Marilyn likes to refer to the balance sheet as a "snapshot" of a company's financial position at a

given moment. For example, if a balance sheet is dated December 31, the amounts shown on the

2

balance sheet are the balances in the accounts after all transactions pertaining to December 31

have been recorded.

(A) AssetsAssets are things that a company owns and are sometimes referred to as the resources of the

company. Joe readily understands this—off the top of his head he names things such as the

company's vehicle, its cash in the bank, all of the supplies he has on hand, and the dolly he uses to

help move the heavier parcels. Marilyn nods and shows Joe how these are reported in accounts

called Vehicles, Cash, Supplies, and Equipment. She mentions one asset Joe hadn't

considered—Accounts Receivable. If Joe delivers parcels, but isn't paid immediately for the

delivery, the amount owed to Direct Delivery is an asset known as Accounts Receivable.

PrepaidsMarilyn brings up another less obvious asset—the unexpired portion of prepaid expenses. Suppose Direct Delivery pays $1,200 on December 1 for a six-month insurance

premium on its delivery vehicle. That divides out to be $200 per month ($1,200 ÷ 6 months).

Between December 1 and December 31, $200 worth of insurance premium is "used up" or "expires".

The expired amount will be reported as Insurance Expense on December's income statement.

Joe asks Marilyn where the remaining $1,000 of unexpired insurance premium would be reported.

On the December 31 balance sheet, Marilyn tells him, in an asset account called Prepaid Insurance.Other examples of things that might be paid for before they are used include supplies and annual

dues to a trade association. The portion that expires in the current accounting period is listed as an

expense on the income statement; the part that has not yet expired is listed as an asset on the

balance sheet.

Marilyn assures Joe that he will soon see a significant link between the income statement and

balance sheet, but for now she continues with her explanation of assets.

Cost Principle and ConservatismJoe learns that each of his company's assets was recorded at its original cost, and even if the fair

market value of an item increases, an accountant will not increase the recorded amount of that asset

on the balance sheet. This is the result of another basic accounting principle known as the cost principle.Although accountants generally do not increase the value of an asset, they might decrease its

value as a result of a concept known as conservatism. For example, after a few months in

business, Joe may decide that he can help out some customers—as well as earn additional

revenues—by carrying an inventory of packing boxes to sell. Let's say that Direct Delivery purchased

100 boxes wholesale for $1.00 each. Since the time when Joe bought them, however, the wholesale

price of boxes has been cut by 40% and at today's price he could purchase them for $0.60 each.

3

Because the replacement cost of his inventory ($60) is less than the original recorded cost ($100),

the principle of conservatism directs the accountant to report the lower amount ($60) as the asset's

value on the balance sheet.

In short, the cost principle generally prevents assets from being reported at more than cost, while

conservatism might require assets to be reported at less than their cost.

DepreciationJoe also needs to know that the reported amounts on his balance sheet for assets such as

equipment, vehicles, and buildings are routinely reduced by depreciation. Depreciation is required by

the basic accounting principle known as the matching principle. Depreciation is used for assets

whose life is not indefinite—equipment wears out, vehicles become too old and costly to maintain,

buildings age, and some assets (like computers) become obsolete. Depreciation is the allocation of

the cost of the asset to Depreciation Expense on the income statement over its useful life.

As an example, assume that Direct Delivery's van has a useful life of five years and was purchased

at a cost of $20,000. The accountant might match $4,000 ($20,000 ÷ 5 years) of Depreciation

Expense with each year's revenues for five years. Each year the carrying amount of the van will

be reduced by $4,000. (The carrying amount—or "book value"—is reported on the balance sheet

and it is the cost of the van minus the total depreciation since the van was acquired.) This means

that after one year the balance sheet will report the carrying amount of the delivery van as $16,000,

after two years the carrying amount will be $12,000, etc. After five years—the end of the van's

expected useful life—its carrying amount is zero.

Joe wants to be certain that he understands what Marilyn is telling him regarding the assets on the

balance sheet, so he asks Marilyn if the balance sheet is, in effect, showing what the company's

assets are worth. He is surprised to hear Marilyn say that the assets are not reported on the balance

sheet at their worth (fair market value). Long-term assets (such as buildings, equipment, and

furnishings) are reported at their cost minus the amounts already sent to the income statement as

Depreciation Expense. The result is that a building's market value may actually have increased since

it was acquired, but the amount on the balance sheet has been consistently reduced as the

accountant moved some of its cost to Depreciation Expense on the income statement in order to

achieve the matching principle.

Another asset, Office Equipment, may have a fair market value that is much smaller than the

carrying amount reported on the balance sheet. (Accountants view depreciation as

an allocation process—allocating the cost to expense in order to match the costs with the revenues

generated by the asset. Accountants do not consider depreciation to be a valuation process.) The

asset Land is not depreciated, so it will appear at its original cost even if the land is now worth one

hundred times more than its cost.

Short-term (current) asset amounts are likely to be close to their market values, since they tend to

"turn over" in relatively short periods of time.

Marilyn cautions Joe that the balance sheet reports only the assets acquired and only at the cost

reported in the transaction. This means that a company's reputation—as excellent as it might be—

4

will not be listed as an asset. It also means that Jeff Bezos will not appear as an asset on

Amazon.com's balance sheet; Nike's logo will not appear as an asset on its balance sheet; etc. Joe

is surprised to hear this, since in his opinion these items are perhaps the most valuable things those

companies have. Marilyn tells Joe that he has just learned an important lesson that he should

remember when reading a balance sheet.

Balance Sheet - Liabilities and Stockholders' Equity

(B) LiabilitiesThe balance sheet reports Direct Delivery's liabilities as of the date noted in the heading of the

balance sheet. Liabilities are obligations of the company; they are amounts owed to others as of the

balance sheet date. Marilyn gives Joe some examples of liabilities: the loan he received from his

aunt (Notes Payable or Loan Payable), the interest on the loan he owes to his aunt (Interest Payable), the amount he owes to the supply store for items purchased on credit (Accounts Payable), the wages he owes an employee but hasn't yet paid to him(Wages Payable).Another liability is money received in advance of actually earning the money. For example, suppose

that Direct Delivery enters into an agreement with one of its customers stipulating that the customer

prepays $600 in return for the delivery of 30 parcels every month for 6 months. Assume Direct

Delivery receives that $600 payment on December 1 for deliveries to be made between December 1

and May 31. Direct Delivery has a cash receipt of $600 on December 1, but it does not have

revenues of $600 at this point. It will have revenues only when it earnsthem by delivering the

parcels. On December 1, Direct Delivery will show that its asset Cash increased by $600, but it will

also have to show that it has a liability of $600. (It has the liability to deliver $600 of parcels within 6

months, or return the money.)

The liability account involved in the $600 received on December 1 is Unearned Revenue. Each

month, as the 30 parcels are delivered, Direct Delivery will be earning $100, and as a result, each

month $100 moves from the account Unearned Revenue to Service Revenues. Each month

Direct Delivery's liability decreases by $100 as it fulfills the agreement by delivering parcels and

each month its revenues on the income statement increase by $100.

(C) Stockholders' EquityIf the company is a corporation, the third section of a corporation's balance sheet is Stockholders'

Equity. (If the company is a sole proprietorship, it is referred to as Owner's Equity.) The amount of

Stockholders' Equity is exactly the difference between the asset amounts and the liability amounts.

As a result accountants often refer to Stockholders' Equity as the difference (or residual) of assets

minus liabilities. Stockholders' Equity is also the "book value" of the corporation.

5

Since the corporation's assets are shown at cost or lower (and not at their market values) it is

important that you do not associate the reported amount of Stockholders' Equity with the market

value of the corporation. (Hence, it is a poor choice of words to refer to Stockholders' Equity as the

corporation's "net worth".) To find the market value of a corporation, you should obtain the services

of a professional familiar with valuing businesses.

Within the Stockholders' Equity section you may see accounts such as Common Stock, Paid-in Capital in Excess of Par Value-Common Stock, Preferred Stock, Retained Earnings, and Current Year's Net Income.The account Common Stock will be increased when the corporation issues shares of stock in

exchange for cash (or some other asset). Another account Retained Earnings will increase when the

corporation earns a profit. There will be a decrease when the corporation has a net loss. This means

that revenues will automatically cause an increase in Stockholders' Equity and expenses will

automatically cause a decrease in Stockholders' Equity. This illustrates a link between a company's

balance sheet and income statement.

Statement of Cash FlowsThe third financial statement that Joe needs to understand is the Statement of Cash Flows. This

statement shows how Direct Delivery's cash amount has changed during the time interval shown in

the heading of the statement. Joe will be able to see at a glance the cash generated and used by his

company's operating activities, its investing activities, and its financing activities. Much of the

information on this financial statement will come from Direct Delivery's balance sheets and income

statements.

Note: To learn more about the statement of cash flows, visit: Explanation of Cash Flow Statement Quiz for Cash Flow Statement The three financial reports that Marilyn introduced to Joe—the income statement, the balance sheet,

and the statement of cash flows—represent one segment of the valuable output that good

accounting software can generate for business owners.

Marilyn now explains to Joe the basics of getting started with recording his transactions.

Double Entry SystemThe field of accounting—both the older manual systems and today's basic accounting software—is

based on the 500-year-old accounting procedure known as double entry. Double entry is a

simple yet powerful concept: each and every one of a company's transactions will result in an

amount recorded into at least two of the accounts in the accounting system.

6

The Chart of Accounts

To begin the process of setting up Joe's accounting system, he will need to make a detailed listing of

all the names of the accounts that Direct Delivery, Inc. might find useful for reporting transactions.

This detailed listing is referred to as a chart of accounts. (Accounting software often provides

sample charts of accounts for various types of businesses.)

As he enters his transactions, Joe will find that the chart of accounts will help him select the two (or

more) accounts that are involved. Once Joe's business begins, he may find that he needs to add

more account names to the chart of accounts, or delete account names that are never used. Joe can

tailor his chart of accounts so that it best sorts and reports the transactions of his business.

Because of the double entry system all of Direct Delivery's transactions will involve a combination of

two or more accounts from the balance sheet and/or the income statement. Marilyn lists out some

sample accounts that Joe will probably need to include on his chart of accounts:

Note: To learn more about the chart of accounts, visit: Explanation of Chart of Accounts Quiz for Chart of Accounts Balance Sheet accounts:

Asset accounts (Examples: Cash, Accounts Receivable, Supplies, Equipment)

Liability accounts (Examples: Notes Payable, Accounts Payable, Wages Payable)

Stockholders' Equity accounts (Examples: Common Stock, Retained Earnings)Income Statement accounts:

Revenue accounts (Examples: Service Revenues, Investment Revenues) Expense accounts (Examples: Wages Expense, Rent Expense, Depreciation

Expense)To help Joe really understand how this works, Marilyn illustrates the double entry with some sample

transactions that Joe will likely encounter.

Sample Transaction #1On December 1, 2013 Joe starts his business Direct Delivery, Inc. The first transaction that Joe will

record for his company is his personal investment of $20,000 in exchange for 5,000 shares of Direct

Delivery's common stock. Direct Delivery's accounting system will show an increase in its account

Cash from zero to $20,000, and an increase in its stockholders' equity account Common Stock by

7

$20,000. Both of these accounts are balance sheet accounts. There are no revenues

because no delivery fees were earned by the company, and there were no expenses.

After Joe enters this transaction, Direct Delivery's balance sheet will look like this:

Marilyn asks Joe if he can see that the balance sheet is just that-in balance. Joe looks at the total

of $20,000 on the asset side, and looks at the $20,000 on the right side, and says yes, of course, he

can see that it is indeed in balance.

Marilyn shows Joe something called the basic accounting equation, which, she explains, is

really the same concept as the balance sheet, it's just presented in an equation format:

The accounting equation (and the balance sheet) should always be in balance.

Debits and CreditsDid the first sample transaction follow the double entry system and affect two or more accounts? Joe

looks at the balance sheet again and answers yes, both Cash and Common Stock were affected by

the transaction.

Marilyn introduces the next basic accounting concept: the double entry system requires that the

same dollar amount of the transaction must be entered on both the left side of one account, and on

the right side of another account. Instead of the word left, accountants use the word debit; and

instead of the word right, accountants use the word credit. (The terms debit and credit are

derived from Latin terms used 500 years ago.)

8

Here's a TipDebit means left.Credit means right.Joe asks Marilyn how he will know which accounts he should debit—meaning he should enter the

numbers on the left side of one account—and which accounts he should credit—meaning he should

enter the numbers on the right side of another account. Marilyn points back to the basic accounting

equation and tells Joe that if he memorizes this simple equation, it will be easier to understand the

debits and credits.

Here's a TipMemorizing the simple accounting equation will help you learn the debit and credit rules for entering amounts into the accounting records.Let's take a look at the accounting equation again:

Just as assets are on the left side (or debit side) of the accounting equation, the asset accounts in

the general ledger have their balances on the left side. To increase an asset account's balance, you

put more on the left side of the asset account. In accounting jargon, you debit the asset account. To decrease an asset account balance you credit the account, that is, you enter the amount on the

right side.

Just as liabilities and stockholders' equity are on the right side (or credit side) of the accounting

equation, the liability and equity accounts in the general ledger have their balances on the right side.

To increase the balance in a liability or stockholders' equity account, you put more on the right side

of the account. In accounting jargon, you credit the liability or the equity account. To decrease a

liability or equity, you debit the account, that is, you enter the amount on the left side of the account.

As with all rules, there are exceptions, but Marilyn's reference to the accounting equation may help

you to learn whether an account should be debited or credited.

Since many transactions involve cash, Marilyn suggests that Joe memorize how the Cash account is

affected when a transaction involves cash: if Direct Delivery receives cash, the Cash account is

debited; when Direct Delivery pays cash, the Cash account is credited.

Here's a TipWhen a company receives cash, the Cash account is debited.

When the company pays cash, the Cash account is credited.Marilyn refers to the example of December 1. Since Direct Delivery received $20,000 in cash from

Joe in exchange for 5,000 shares of common stock, one of the accounts for this transaction is Cash.

Since cash wasreceived, the Cash account will be debited.

9

In keeping with double entry, two (or more) accounts need to be involved. Because the first account

(Cash) wasdebited, the second account needs to be credited. All Joe needs to do is find the right

account to credit. In this case, the second account is Common Stock. Common stock is part of

stockholders' equity, which is on the right side of the accounting equation. As a result, it should have

a credit balance, and to increase its balance the account needs to be credited.

Accountants indicate accounts and amounts using the following format:

Accountants usually first show the account and amount to be debited. On the next line, the account

to be credited is indented and the amount appears further to the right than the debit amount shown

in the line above. This entry format is referred to as a general journal entry.

(With the decrease in the price of computers and accounting software, it is rare to find a small

business still using a manual system and making entries by hand. Accounting software has made

the process of recording transactions so much easier that the general journal is rarely needed. In

fact, entries are often generated automatically when a check or sales invoice is prepared.)

Sample Transactions #2 - #3

Sample Transaction #2

Marilyn illustrates for Joe a second transaction. On December 2, Direct Delivery purchases a used

delivery van for $14,000 by writing a check for $14,000. The two accounts involved are Cash and

Vehicles (or Delivery Equipment). When the check is written, the accounting software will

automatically make the entry into these two accounts.

Marilyn explains to Joe what is happening within the software. Since the company pays $14,000,

the Cash account is credited. (Accountants consider the checking account to be Cash, and

the TIP you learned is that when cash is paid, you credit Cash.) So we know that the Cash

account will be credited for $14,000 and we know the other account will have to be debited for

$14,000. We need only identify the best account to debit. In this case we choose Vehicles (or

Delivery Equipment) and the entry is:

10

The balance sheet will look like this after the vehicle transaction is recorded:

The balance sheet and the accounting equation remain in balance:

As you can see in the balance sheet, the asset Cash decreased by $14,000 and another asset

Vehicles increased by $14,000. Liabilities and stockholders' equity were not involved and did not

change.

Sample Transaction #3

The third sample transaction also occurs on December 2 when Joe contacts an insurance agent

regarding insurance coverage for the vehicle Direct Delivery just purchased. The agent informs him

that $1,200 will provide insurance protection for the next six months. Joe immediately writes a check

for $1,200 and mails it in.

Let's consider this transaction. Using double entry, we know there must be a minimum of two

accounts involved—one (or more) of the accounts must be debited, and one (or more) must

be credited.

Since a check is written, we know that one of the accounts involved is Cash. Since cash was paid,

the Cash account will be credited. (Take another look at the last TIP.) While we have not yet

identified the second account, what we do know for certain is that the second account will have to

be debited.

At this point we have most of the entry-all we are missing is the name of the account to be debited:

11

We know the transaction involves insurance, and a quick look through the chart of accounts reveals

two possibilities:

Prepaid Insurance (an asset account reported on the balance sheet) and Insurance Expense (an expense account reported on the income statement)Assets include costs that are not yet expired (not yet used up), while expenses are costs that have

expired (have been used up). Since the $1,200 payment is for an expense that will not expire in its

entirety within the current month, it would be logical to debit the account Prepaid Insurance. (At the

end of each month, when $200 has expired, $200 will be moved from Prepaid Insurance to

Insurance Expense.)

The entry in the general journal format is:

After the first three transactions have been recorded, the balance sheet will look like this:

12

Again, the balance sheet and the accounting equation are in balance and all of the changes

occurred on the asset/left/debit side of the accounting equation. Liabilities and Stockholders' Equity

were not affected by the insurance transaction.

Sample Transactions #4 - #6

Sample Transaction #4

The fourth transaction occurs on December 3, when a customer gives Direct Delivery a check for

$10 to deliver two parcels on that day. Because of double entry, we know there must be a minimum

of two accounts involved—one of the accounts must be debited, and one of the accounts must be

credited.

Because Direct Delivery received $10, it must debit the account Cash. It must also credit a

second account for $10. The second account will be Service Revenues, an income statement

account. The reason Service Revenues is credited is because Direct Delivery must report that

it earned $10 (not because it received $10). Recording revenues when they are earned results from

a basic accounting principle known as the revenue recognition principle. The following tip reflects

that principle.

Here's a TipRevenues accounts are credited when the company earns a fee (or sells merchandise) regardless of whether cash is received at the time.Here are the two parts of the transaction as they would look in the general journal format:

Sample Transaction #5

Let's assume that on December 3 the company gets its second customer-a local company that

needs to have 50 parcels delivered immediately. Joe's price of $250 is very appealing, so Joe's

company is hired to deliver the parcels. The customer tells Joe to submit an invoice for the $250,

and they will pay it within seven days.

Joe delivers the 50 parcels on December 3 as agreed, meaning that on December 3 Direct Delivery

has earned$250. Hence the $250 is reported as revenues on December 3, even though the

company did not receive any cash on that day. The effort needed to complete the job was done on

13

December 3. (Depositing the check for $250 in the bank when it arrives seven days later is not

considered to take any effort.)

Let's identify the two accounts involved and determine which needs a debit and which needs a

credit.

Because Direct Delivery has earned the fees, one account will be a revenues account, such as

Service Revenues. (If you refer back to the last TIP, you will read that revenue accounts—such as

Service Revenues—are usually credited, meaning the second account will need to be debited.)

In the general journal format, here's what we have identified so far:

We know that the unnamed account cannot be Cash because the company did not receive money

on December 3. However, the company has earned the right to receive the money in seven days.

The account title for the money that Direct Delivery has a right to receive for having provided the

service is Accounts Receivable (an asset account).

Again, reporting revenues when they are earned results from the basic accounting principle known

as the revenue recognition principle.

Sample Transaction #6

For simplicity, let's assume that the only expense incurred by Direct Delivery so far was a fee to a

temporary help agency for a person to help Joe deliver parcels on December 3. The temp agency

fee is $80 and is due by December 12.

If a company does not pay cash immediately, you cannot credit Cash. But because the company

owes someone the money for its purchase, we say it has an obligation or liability to pay. Most

accounts involved with obligations have the word "payable" in their name, and one of the most

frequently used accounts is Accounts Payable. Also keep in mind that expenses are almost

always debited.

The accounts and amounts for the temporary help are:

14

Here's a TipExpenses are (almost) always debited.

Here's a TipIf a company does not pay cash right away for an expense or for an asset, you cannot credit Cash. Because the company owes someone the money for its purchase, we say it has an obligation or liability to pay. The most likely liability account involved in business obligations is Accounts Payable.Revenues and expenses appear on the income statement as shown below:

After the entries through December 3 have been recorded, the balance sheet will look like this:

15

Notice that the year-to-date net income (bottom line of the income statement) increased

Stockholders' Equity by the same amount, $180. This connection between the income statement and

balance sheet is important. For one, it keeps the balance sheet and the accounting equation in

balance. Secondly, it demonstrates that revenues will cause the stockholders' equity to increase and

expenses will cause stockholders' equity to decrease. After the end of the year financial statements

are prepared, you will see that the income statement accounts (revenue accounts and expense

accounts) will be closed or zeroed out and their balances will be transferred into the Retained Earnings account. This will mean the revenue and expense accounts will start the new year with

zero balances—allowing the company "to keep score" for the new year.

Marilyn suggested that perhaps this introduction was enough material for their first meeting. She

wrote out the following notes, summarizing for Joe the important points of their discussion:

1. When a company pays cash for something, the company will credit Cash and will have to debit a second account. Assuming that a company prepares monthly financial statements—

If the amount is used up or will expire in the current month, the account to be debited will be an expense account. (Advertising Expense, Rent Expense, Wages Expense are three examples.)

If the amount is not used up or does not expire in the current month, the account to be debited will be an asset account. (Examples are Prepaid Insurance, Supplies, Prepaid Rent, Prepaid Advertising, Prepaid Association Dues, Land, Buildings, and Equipment.)

If the amount reduces a company's obligations, the account to be debited will be a liability account. (Examples include Accounts Payable, Notes Payable, Wages Payable, and Interest Payable.)

16

2. When a company receives cash, the company will debit Cash and will have to credit another account. Assuming that a company will prepare monthly financial statements—

If the amount received is from a cash sale, or for a service that has just been performed but has not yet been recorded, the account to be credited is a revenue account such as Service Revenues or Fees Earned.

If the amount received is an advance payment for a service that has not yet been performed or earned, the account to be credited is Unearned Revenue.

If the amount received is a payment from a customer for a sale or service delivered earlier and has already been recorded as revenue, the account to be credited is Accounts Receivable.

If the amount received is the proceeds from the company signing a promissory note, the account to be credited is Notes Payable.

If the amount received is an investment of additional money by the owner of the corporation, a stockholders' equity account such as Common Stock is credited.

Note: To learn more about debits and credits, go to Explanation of Debits and Credits and Quiz for Debits and Credits.

3. Revenues are recorded as Service Revenues or Sales when the service or sale has been performed, notwhen the cash is received. This reflects the basic accounting principle known as the revenue recognition principle.

4. Expenses are matched with revenues or with the period of time shown in the heading of the income statement, not in the period when the expenses were paid. This reflects the basic accounting principle known as the matching principle.

5. The financial statements also reflect the basic accounting principle known as the cost principle. This means assets are shown on the balance sheet at their original cost or less and not at their current value. The income statement expenses also reflect the cost principle. For example, the depreciation expense is based on the original cost of the asset being depreciated and not on the current replacement cost.

Introduction to the Accounting Equation

17

From the large, multi-national corporation down to the corner beauty salon, every business

transaction will have an effect on a company's financial position. The financial position of a company

is measured by the following items:

1. Assets (what it owns)

2. Liabilities (what it owes to others)

3. Owner's Equity (the difference between assets and liabilities)

The accounting equation (or basic accounting equation) offers us a simple way to understand

how these three amounts relate to each other. The accounting equation for a sole proprietorship is:

The accounting equation for a corporation is:

Assets are a company's resources—things the company owns. Examples of assets include cash,

accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and

goodwill. From the accounting equation, we see that the amount of assets must equal the combined

amount of liabilities plus owner's (or stockholders') equity.

Liabilities are a company's obligations—amounts the company owes. Examples of liabilities include

notes or loans payable, accounts payable, salaries and wages payable, interest payable, and

income taxes payable (if the company is a regular corporation). Liabilities can be viewed in two

ways:

(1) as claims by creditors against the company's assets, and

(2) a source—along with owner or stockholder equity—of the company's assets.

Owner's equity or stockholders' equity is the amount left over after liabilities are deducted from

assets:

Assets - Liabilities = Owner's (or Stockholders') Equity.Owner's or stockholders' equity also reports the amounts invested into the company by the owners

plus the cumulative net income of the company that has not been withdrawn or distributed to the

owners.

If a company keeps accurate records, the accounting equation will always be "in balance," meaning

the left side should always equal the right side. The balance is maintained because every business

transaction affects at least two of a company's accounts. For example, when a company

borrows money from a bank, the company's assets will increase and its liabilities will increase by the

same amount. When a company purchases inventory for cash, one asset will increase and one

asset will decrease. Because there are two or more accounts affected by every transaction, the

accounting system is referred to as double-entry accounting.

18

A company keeps track of all of its transactions by recording them in accounts in the

company's general ledger.Each account in the general ledger is designated as to its type: asset,

liability, owner's equity, revenue, expense, gain, or loss account.

Balance Sheet and Income Statement

The balance sheet is also known as the statement of financial position and it reflects the

accounting equation. The balance sheet reports a company's assets, liabilities, and owner's (or

stockholders') equity at a specific point in time. Like the accounting equation, it shows that a

company's total amount of assets equals the total amount of liabilities plus owner's (or stockholders')

equity.

The income statement is the financial statement that reports a company's revenues and

expenses and the resulting net income. While the balance sheet is concerned with one point in

time, the income statement covers atime interval or period of time. The income statement will

explain part of the change in the owner's or stockholders' equity during the time interval between two

balance sheets.

ExamplesIn our examples in the following pages of this topic, we show how a given transaction affects the

accounting equation. We also show how the same transaction affects specific accounts by providing

the journal entry that is used to record the transaction in the company's general ledger.

Our examples will show the effect of each transaction on the balance sheet and income statement.

Our examples also assume that the accrual basis of accounting is being followed.

Parts 2 - 6 illustrate transactions involving a sole proprietorship.

Parts 7 - 10 illustrate almost identical transactions as they would take place in a corporation.

Accounting Equation for a Sole Proprietorship: Transactions 1–2We present nine transactions to illustrate how a company's accounting equation stays in balance.

When a company records a business transaction, it is not entered into an accounting equation, per se. Rather, transactions are recorded into specific accounts contained in the company's general

ledger. Each account is designated as an asset, liability, owner's equity, revenue, expense, gain, or

loss account. The general ledgeraccounts are then used to prepare the balance sheets and

income statements throughout the accounting periods.

In the examples that follow, we will use the following accounts:

Cash Accounts Receivable Equipment

19

Notes Payable Accounts Payable J. Ott, Capital J. Ott, Drawing Service Revenues Advertising Expense Temp Service Expense

(To view a more complete listing of accounts for recording transactions, see theExplanation of Chart of Accounts.)

Sole Proprietorship Transaction #1.

Let's assume that J. Ott forms a sole proprietorship called Accounting Software Co. (ASC). On

December 1, 2013, J. Ott invests personal funds of $10,000 to start ASC. The effect of this

transaction on ASC's accounting equation is:

As you can see, ASC's assets increase by $10,000 and so does ASC's owner's equity. As a result,

the accounting equation will be in balance.

You can interpret the amounts in the accounting equation to mean that ASC has assets of $10,000

and the source of those assets was the owner, J. Ott. Alternatively, you can view the accounting

equation to mean that ASC has assets of $10,000 and there are no claims by creditors (liabilities)

against the assets. As a result, the owner has a claim for the remainder or residual of $10,000.

This transaction is recorded in the asset account Cash and the owner's equity account J. Ott,

Capital. The general journal entry to record the transactions in these accounts is:

After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASC's

financial position at the end of December 1, 2013:

20

The purpose of an income statement is to report revenues and expenses. Since ASC has not yet

earned any revenues nor incurred any expenses, there are no transactions to be reported on an

income statement.

Sole Proprietorship Transaction #2.

On December 2, 2013 J. Ott withdraws $100 of cash from the business for his personal use. The

effect of this transaction on ASC's accounting equation is:

The accounting equation remains in balance since ASC's assets have been reduced by $100 and so

has the owner's equity.

This transaction is recorded in the asset account Cash and the owner's equity account J. Ott,

Drawing. The general journal entry to record the transactions in these accounts is:

Since the transactions of December 1 and 2 were each in balance, the sum of both transactions

should also be in balance:

21

The totals indicate that ASC has assets of $9,900 and the source of those assets is the owner of the

company. You can also conclude that the company has assets or resources of $9,900 and the only

claim against those resources is the owner's claim.

The December 2 balance sheet will communicate the company's financial position as of midnight on

December 2:

Withdrawals of company assets by the owner for the owner's personal use are known as "draws."

Since draws are not expenses, the transaction is not reported on the company's income statement.

Accounting Equation for a Sole Proprietorship: Transactions 3–4

22

Sole Proprietorship Transaction #3.

On December 3, 2013 Accounting Software Co. spends $5,000 of cash to purchase computer

equipment for use in the business. The effect of this transaction on the accounting equation is:

The accounting equation reflects that one asset increases and another asset decreases. Since the

amount of the increase is the same as the amount of the decrease, the accounting equation remains

in balance.

This transaction is recorded in the asset accounts Equipment and Cash. Equipment increases by

$5,000, and Cash decreases by $5,000. The general journal entry to record the transactions in these

accounts is:

The combined effect of the first three transactions is shown here:

The totals tell us that the company has assets of $9,900 and the source of those assets is the owner

of the company. It also tells us that the company has assets of $9,900 and the only claim against

those assets is the owner's claim.

The balance sheet dated December 3, 2013 will reflect the financial position as of midnight on

December 3:

23

The purchase of equipment is not an immediate expense. It will become part of depreciation expense only after it is placed into service. We will assume that as of December 3 the equipment

has not been placed into service, therefore, no expense will appear on an income statement for the

period of December 1 through December 3.

Sole Proprietorship Transaction #4.

On December 4, 2013 ASC obtains $7,000 by borrowing money from its bank. The effect of this

transaction on the accounting equation is:

As you can see, ASC's assets increase and ASC's liabilities increase by $7,000.

This transaction is recorded in the asset account Cash and the liability account Notes Payable as

shown in this accounting entry:

24

The combined effect on the accounting equation from the first four transactions is available here:

The totals indicate that the transactions through December 4 result in assets of $16,900. There are

two sources for those assets—the creditors provided $7,000 of assets, and the owner of the

company provided $9,900. You can also interpret the accounting equation to say that the company

has assets of $16,900 and the lenders have a claim of $7,000 and the owner has a claim for the

remainder.

The balance sheet dated December 4 will report ASC's financial position as of that date:

25

The proceeds of the bank loan are not considered to be revenue since ASC did not earn the money

by providing services, investing, etc. As a result, there is no income statement effect from this

transaction.

Accounting Equation for a Sole Proprietorship: Transactions 5–6

Sole Proprietorship Transaction #5.

On December 5, 2013 Accounting Software Co. pays $600 for ads that were run in recent days. The

effect of this advertising transaction on the accounting equation is:

26

Since ASC is paying $600, its assets decrease. The second effect is a $600 decrease in owner's

equity, because the transaction involves an expense. (An expense is a cost that is used up or its

future economic value cannot be measured.)

Although owner's equity is decreased by an expense, the transaction is not recorded directly into the

owner's capital account at this time. Instead, the amount is initially recorded in the expense account

Advertising Expense and in the asset account Cash.

The general journal entry to record the transaction is:

The combined effect of the first five transactions is available here:

The totals now indicate that Accounting Software Co. has assets of $16,300. The creditors provided

$7,000 and the owner of the company provided $9,300. Viewed another way, the company has

assets of $16,300 with the creditors having a claim of $7,000 and the owner having a residual claim

of $9,300.

The balance sheet as of the end of December 5, 2013 is:

27

**The income statement (which reports the company's revenues, expenses, gains, and losses during a specified time interval) is a link between balance sheets. It provides the results of operations—an important part of the change in owner's equity.Since this transaction involves an expense, it will involve ASC's income statement. The company's

income statement for the first five days of December is:

28

Sole Proprietorship Transaction #6.

On December 6, 2013 ASC performs consulting services for its clients. The clients are billed for the

agreed upon amount of $900. The amounts are due in 30 days. The effect on the accounting

equation is:

Since ASC has performed the services, it has earned revenues and it has the right to receive $900

from the clients. This right (known as an account receivable) causes assets to increase. The earning

of revenues causes owner's equity to increase.

Although revenues cause owner's equity to increase, the revenue transaction is not recorded into the

owner's capital account at this time. Rather, the amount earned is recorded in the revenue account

Service Revenues. This will allow the company to report the revenues on its income statement at

any time. (After the year ends, the amount in the revenue account will be transferred to the owner's

capital account.)

The general journal entry to record the transaction is:

The combined effect of the first six transactions can be viewed here:

29

The totals tell us that at the end of December 6, the company has assets of $17,200. It also shows

the sources of the assets: creditors providing $7,000 and the owner of the company providing

$10,200. The totals also reveal that the company has assets of $17,200 and the creditors have a

claim of $7,000 and the owner has a claim for the remaining $10,200.

Below is the balance sheet as of midnight on December 6:

**The income statement (which reports the company's revenues, expenses, gains, and losses during a specified time interval) is a link between balance sheets. It provides the results of operations—an important part of the change in owner's equity.The Income Statement for Accounting Software Co. for the period of December 1 through December

6 is:

30

Accounting Equation for a Sole Proprietorship: Transactions 7–8

Sole Proprietorship Transaction #7.

On December 7, 2013 ASC uses a temporary help service for 6 hours at a cost of $20 per hour.

ASC will pay the invoice when it is due in 10 days. The effect on its accounting equation is:

ASC's liabilities increase by $120 and the expense causes owner's equity to decrease by $120.

The liability will be recorded in Accounts Payable and the expense will be reported in Temp Service

Expense. The journal entry for recording the use of the temp service is:

The effect of the first seven transactions on the accounting equation can be viewed here:

31

The totals show us that the company has assets of $17,200 and the sources are the creditors with

$7,120 and the owner of the company with $10,080. The accounting equation totals also tell us that

the company has assets of $17,200 with the creditors having a claim of $7,120. This means that the

owner's residual claim is $10,080.

The financial position of ASC as of midnight on December 7, 2013 is:

32

**The income statement (which reports the company's revenues, expenses, gains, and losses for a specified time interval) is a link between balance sheets. It provides the results of operations—an important part of the change in owner's equity.Accounting Software Co.'s income statement for the first seven days of December is:

33

Sole Proprietorship Transaction #8.

On December 8, 2013 ASC receives $500 from the clients it had billed on December 6, 2013. The

collection of accounts receivables has this effect on the accounting equation:

The company's asset (cash) increases and another asset (accounts receivable) decreases.

Liabilities and owner's equity are unaffected. (There are no revenues on this date. The revenues

were recorded when they were earned on December 6.)

The general journal entry to record the increase in Cash, and the decrease in Accounts Receivable

is:

The combined effect of the first eight transactions is shown here:

34

The totals for the first eight transactions indicate that the company has assets of $17,200. The

creditors provided $7,120 and the owner provided $10,080. The accounting equation also indicates

that the company's creditors have a claim of $7,120 and the owner has a residual claim of $10,080.

ASC's balance sheet as of midnight December 8, 2013 is:

**The income statement (which reports the company's revenues, expenses, gains, and losses during a specified period of time) is a link between balance sheets. It provides the results of operations—an important part of the change in owner's equity.The income statement for ASC for the eight days ending on December 8 is shown here:

35

Calculating a Missing Amount within Owner's EquityThe income statement for the calendar year 2013 will explain a portion of the change in the owner's

equity between the balance sheets of December 31, 2012 and December 31, 2013. The other items

that account for the change in owner's equity are the owner's investments into the sole

proprietorship and the owner's draws (or withdrawals). A recap of these changes is the statement of changes in owner's equity. Here is a statement of changes in owner's equity for the year 2013

assuming that the Accounting Software Co. had only the eight transactions that we covered earlier.

Example of Calculating a Missing Amount

The format of the statement of changes in owner's equity can be used to determine one of these

components if it is unknown. For example, if the net income for the year 2013 is unknown, but you

36

know the amount of the draws and the beginning and ending balances of owner's equity, you can

calculate the net income. (This might be necessary if a company does not have complete records of

its revenues and expenses.) Let's demonstrate this by using the following amounts.

Step 1.The owner's equity at December 31, 2012 can be computed using the accounting equation:

Step 2.The owner's equity at December 31, 2013 can be computed as well:

Step 3.Insert into the statement of changes in owner's equity the information that was given and the

amounts calculated in Step 1 and Step 2:

Step 4.The "Subtotal" can be calculated by adding the last two numbers on the statement: $94,000 +

$40,000 = $134,000. After this calculation we have:

37

Step 5.Starting at the top of the statement we know that the owner's equity before the start of 2013 was

$60,000 and in 2013 the owner invested an additional $10,000. As a result we have $70,000 before

considering the amount of Net Income. We also know that after the amount of Net Income is added,

the Subtotal has to be $134,000 (the Subtotal calculated in Step 4). The Net Income is the difference

between $70,000 and $134,000. Net income must have been $64,000.Step 6.Insert the previously missing amount (in this case it is the $64,000 of net income) into the statement

of changes in owner's equity and recheck the math:

Since the statement is mathematically correct, we are confident that the net income was $64,000.

You can reinforce what you have learned by using our Quiz for the Accounting Equation and our Crossword Puzzle on the Accounting Equation.

The remaining parts of this topic will illustrate similar transactions and their effect on the accounting

equation when the company is a corporation instead of a sole proprietorship.

Accounting Equation for a Corporation: Transactions C1–C2The accounting equation (or basic accounting equation) for a corporation is

38

In our examples below, we show how a given transaction affects the accounting equation for a

corporation. We also show how the same transaction will be recorded in the company's general

ledger accounts.

Our examples will also show the effect of each transaction on the balance sheet and income

statement. For all of our examples we assume that the accrual basis of accounting is being

followed.

In the examples that follow, we will use the following accounts:

Cash Accounts Receivable Equipment Notes Payable Accounts Payable Common Stock Retained Earnings Treasury Stock Service Revenues Advertising Expense Temp Service Expense

(To view a more complete listing of accounts for recording transactions, see the Explanation of Chart of Accounts.)We also assume that the corporation is a Subchapter S corporation in order to avoid the income tax

accounting that would occur with a "C" corporation. (In a Subchapter S corporation the owners are

responsible for the income taxes instead of the corporation.)

Corporation Transaction C1

Let's assume that members of the Ott family form a corporation called Accounting Software, Inc.

(ASI). On December 1, 2013, several members of the Ott family invest a total of $10,000 to start

ASI. In exchange, the corporation issues a total of 1,000 shares of common stock. (The stock has no

par value and no stated value.) The effect on the corporation's accounting equation is:

As you see, ASI's assets increase by $10,000 and stockholders' equity increases by the same

amount. As a result, the accounting equation will be in balance.

39

The accounting equation tells us that ASI has assets of $10,000 and the source of those assets was

the stockholders. Alternatively, the accounting equation tells us that the corporation has assets of

$10,000 and the only claim to the assets is from the stockholders (owners).

This transaction is recorded in the asset account Cash and in the stockholders' equity account

Common Stock. The general journal entry to record the transaction is:

After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASI's

financial position at the end of December 1, 2013:

The purpose of an income statement is to report revenues and expenses. Since ASI has not yet

earned any revenues nor incurred any expenses, there are no transactions to be reported on an

income statement.

Corporation Transaction C2.

On December 2, 2013 ASI purchases $100 of its stock from one of its stockholders. The stock will

be held by the corporation as Treasury Stock. The effect of the accounting equation is:

The purchase of its own stock for cash meant that ASI's assets decrease by $100 and its

stockholders' equity decreases by $100.

40

This transaction is recorded in the asset account Cash and in the stockholders' equity account

Treasury Stock. The accounting entry in general journal form is:

Since the transactions of December 1 and 2 were each in balance, the sum of both transactions

should also be in balance:

The totals indicate that ASI has assets of $9,900 and the source of those assets is the stockholders.

The accounting equation also shows that the corporation has assets of $9,900 and the only claim

against those resources is the stockholders' claim.

The December 2 balance sheet will communicate the corporation's financial position as of midnight

on December 2:

41

The purchase of a corporation's own stock will never result in an amount to be reported on the

income statement.

Accounting Equation for a Corporation: Transactions C3–C4

Corporation Transaction C3.

On December 3, 2013 ASI spends $5,000 of cash to purchase computer equipment for use in the

business. The effect of this transaction on its accounting equation is:

The accounting equation indicates that one asset increases and one asset decreases. Since the

amount of the increase is the same as the amount of the decrease, the accounting equation remains

in balance.

42

This transaction is recorded in the asset accounts Equipment and Cash. The account increases by

$5,000 and the account decreases by $5,000. The journal entry for this transaction is:

The effect on the accounting equation from the first three transactions is:

The totals tell us that the corporation has assets of $9,900 and the source of those assets is the

stockholders. The totals tell us that the company has assets of $9,900 and that the only claim

against those assets is the stockholders' claim.

The balance sheet dated December 3, 2013 reflects the financial position of the corporation as of

midnight on December 3:

43

The purchase of equipment is not an immediate expense. It will become depreciation expense only after the equipment is placed in service. We will assume that as of December 3 the

equipment has not been placed into service. Therefore, there is no expense in this transaction or in

the earlier transactions to be reported on the income statement.

Corporation Transaction C4.

On December 4, 2013 ASI obtains $7,000 by borrowing money from its bank. The effect of this

transaction on the accounting equation is:

As you see, ACI's assets increase and its liabilities increase by $7,000.

This transaction is recorded in the asset account Cash and the liability account Notes Payable with

the following journal entry:

44

To see the effect on the accounting equation from the first four transactions, click here:

These totals indicate that the transactions through December 4 result in assets of $16,900. There

are two sources for those assets: the creditors provided $7,000 of assets, and the stockholders

provided $9,900. You can also interpret the accounting equation to say that the corporation has

assets of $16,900 and the creditors have a claim of $7,000. The residual or remainder of $9,900 is

the stockholders' claim.

The balance sheet dated December 4 reports the corporation's financial position as of that date:

45

The receipt of money from the bank loan is not revenue since ASI did not earn the money by

providing services, investing, etc. As a result, there is no income statement effect from this

transaction or earlier transactions.

Accounting Equation for a Corporation: Transactions C5–C6

Corporation Transaction C5.

On December 5, 2013 Accounting Software, Inc. pays $600 for ads that were run in recent days.

The effect of the advertising transaction on the corporation's accounting equation is:

46

Since ASI is paying $600, its assets decrease. The second effect is a $600 decrease in

stockholders' equity, because the transaction involves an expense. (An expense is a cost that is

used up or its future economic value cannot be measured.)

Although stockholders' equity decreases because of an expense, the transaction is not recorded

directly into the retained earnings account. Instead, the amount is initially recorded in the expense

account Advertising Expense and in the asset account Cash. The journal entry for this transaction is:

The combined effect of the first five transactions is:

The totals now indicate that Accounting Software, Inc. has assets of $16,300. The creditors provided

$7,000 and the stockholders provided $9,300. Viewed another way, the corporation has assets of

$16,300 with the creditors having a claim of $7,000 and the stockholders having a claim of $9,300.

The balance sheet as of the end of December 5, 2013 is presented here:

47

**The income statement (which reports the company's revenues, expenses, gains, and losses for a specified time period) is a link between balance sheets. It provides the results of operations—an important part of the change in retained earnings and stockholders' equity.Since this transaction involves an expense, it will affect ASI's income statement. The corporation's

income statement for the first five days of December is presented here:

Because we assume that Accounting Services, Inc. is a Subchapter S corporation, income tax expense is not reported on the corporation's income statement.

48

Corporation Transaction C6.

On December 6, 2013 ASI performs consulting services for its clients. The clients are billed for the

agreed upon amount of $900. The amounts are due in 30 days. The effect on the accounting

equation is:

Since ASI has performed the services, it has earned revenues and it has the right to receive $900

from its clients. This right means that assets increased. The earning of revenues also causes

stockholders' equity to increase.

Although revenues cause stockholders' equity to increase, the revenue transaction is not recorded

directly into a stockholders' equity account at this time. Rather, the amount earned is recorded in the

revenues accountService Revenues . This will allow the corporation to report the revenues

account on its income statement at any time. (After the year ends, the amount in the revenues

accounts will be transferred to the retained earnings account.) The general journal entry for providing

services on credit is:

The effect on the accounting equation from the first six transactions can be viewed here:

The totals tell us that at the end of December 6, the corporation has assets of $17,200. It also shows

that $7,000 of the assets came from creditors and that $10,200 came from stockholders. The totals

49

can also be viewed another way: ASI has assets of $17,200 with its creditors having a claim of

$7,000 and the stockholders having a claim for the remainder or residual of $10,200.

The balance sheet as of midnight on December 6, 2013 is presented here:

**The income statement (which reports the company's revenues, expenses, gains, and losses for a specified time period) is a link between balance sheets. It provides the results of operations—an important part of the change in retained earnings and stockholders' equity.The income statement for Accounting Software, Inc. for the period of December 1 through December

6 is shown here:

50

Accounting Equation for a Corporation: Transactions C7–C8

Corporation Transaction C7.

On December 7, 2013 ASI uses a temporary help service for 6 hours at a cost of $20 per hour. ASI

records the invoice immediately, but it will pay the $120 when it is due in 10 days. This transaction

has the following effect on the accounting equation:

The accounting equation shows that ASI's liabilities increase by $120 and the expense causes

stockholders' equity to decrease by $120.

The liability will be recorded in Accounts Payable and the expense will be recorded in Temp Service

Expense. The general journal entry for utilizing the temp service is:

The effect of the first seven transactions on the accounting equation can be viewed here:

51

The totals show us that the corporation has assets of $17,200 and the sources are the creditors with

$7,120 and the stockholders with $10,080. The accounting equation totals also reveal that the

corporation's creditors have a claim of $7,120 and the stockholders have a claim for the remaining

$10,080.

The financial position of ASI as of midnight of December 7, 2013 is presented in the following

balance sheet:

52

**The income statement (which reports the corporations' revenues, expenses, gains, and losses for a specified time period) is a link between balance sheets. It provides the results of operations—an important part of the change in stockholders' equity.The income statement for the first seven days of December is shown here:

53

Corporation Transaction C8.

On December 8, 2013 ASI receives $500 from the clients it had billed on December 6. The effect on

the accounting equation is:

The corporation's cash increases and one of its other assets (accounts receivable) decreases.

Liabilities and stockholders' equity are unaffected. (There are no revenues on this date. The

revenues were recorded when they were earned on December 6.)

The general journal entry to record the increase in Cash and the decrease in Accounts Receivable

is:

The effect on the accounting equation from the transactions through December 8 is shown here:

The totals after the first eight transactions indicate that the corporation has assets of $17,200. The

creditors have provided $7,120 and the company's stockholders have provided $10,080. The

54

accounting equation also indicates that the company's creditors have a claim of $7,120 and the

stockholders have a residual claim of $10,080.

ASI's balance sheet as of midnight of December 8, 2013 is shown here:

**The income statement (which reports the corporation's revenues, expenses, gains, and losses for a specified time period) is a link between balance sheets. It provides the results of operations—an important part of the change in stockholders' equity.The income statement for ASI's first eight days of operations is shown here:

55

Expanded Accounting Equation for a Sole ProprietorshipThe owner's equity in the basic accounting equation is sometimes expanded to show the accounts

that make up owner's equity: Owner's Capital, Revenues, Expenses, and Owner's Draws.

Instead of the accounting equation, Assets = Liabilities + Owner's Equity, the expanded accounting equationis:

The eight transactions that we had listed under the basic accounting equation Transaction 8, are

shown in the following expanded accounting equation:

56

With the expanded accounting equation, you can easily see the company's net income:

Expanded Accounting Equation for a CorporationThe stockholders' equity part of the basic accounting equation can also be expanded to show the

accounts that make up stockholders' equity: Paid-in Capital, Revenues, Expenses, Dividends, and

Treasury Stock.

Instead of the accounting equation, Assets = Liabilities + Stockholders' Equity, the expanded

accounting equation is:

The eight transactions that we had listed under the basic accounting equation Transaction C8 are shown in the following expanded accounting equation:

57

With the expanded accounting equation, you can easily see the corporation's net income:

Introduction to Accounting PrinciplesThere are general rules and concepts that govern the field of accounting. These general rules–

referred to as basic accounting principles and guidelines–form the groundwork on which

more detailed, complicated, and legalistic accounting rules are based. For example, the Financial Accounting Standards Board (FASB) uses the basic accounting principles and guidelines

as a basis for their own detailed and comprehensive set of accounting rules and standards.

The phrase "generally accepted accounting principles" (or "GAAP") consists of three important sets

of rules: (1) the basic accounting principles and guidelines, (2) the detailed rules and standards

issued by FASB and its predecessor the Accounting Principles Board (APB), and (3) the generally

accepted industry practices.

If a company distributes its financial statements to the public, it is required to follow generally

accepted accounting principles in the preparation of those statements. Further, if a company's stock

is publicly traded, federal law requires the company's financial statements be audited by

58

independent public accountants. Both the company's management and the independent accountants

must certify that the financial statements and the related notes to the financial statements have been

prepared in accordance with GAAP.

GAAP is exceedingly useful because it attempts to standardize and regulate accounting definitions,

assumptions, and methods. Because of generally accepted accounting principles we are able to

assume that there is consistency from year to year in the methods used to prepare a company's

financial statements. And although variations may exist, we can make reasonably confident

conclusions when comparing one company to another, or comparing one company's financial

statistics to the statistics for its industry. Over the years the generally accepted accounting principles

have become more complex because financial transactions have become more complex.

Basic Accounting Principles and GuidelinesSince GAAP is founded on the basic accounting principles and guidelines, we can better understand

GAAP if we understand those accounting principles. The following is a list of the ten main accounting

principles and guidelines together with a highly condensed explanation of each.

1. Economic Entity Assumption

The accountant keeps all of the business transactions of a sole proprietorship separate from the

business owner's personal transactions. For legal purposes, a sole proprietorship and its owner

are considered to be one entity, but for accounting purposes they are considered to be two separate

entities.2. Monetary Unit Assumption

Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S.

dollars are recorded.

Because of this basic accounting principle, it is assumed that the dollar's purchasing power has not

changed over time. As a result accountants ignore the effect of inflation on recorded amounts. For

example, dollars from a 1960 transaction are combined (or shown) with dollars from a 2013

transaction.

3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex and ongoing activities of a

business in relatively short, distinct time intervals such as the five months ended May 31, 2013, or

the 5 weeks ended May 1, 2013. The shorter the time interval, the more likely the need for the

59

accountant to estimate amounts relevant to that period. For example, the property tax bill is received

on December 15 of each year. On the income statement for the year ended December 31, 2012, the

amount is known; but for the income statement for the three months ended March 31, 2013, the

amount was not known and an estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the heading of each income

statement, statement of stockholders' equity, and statement of cash flows. Labeling one of

these financial statements with "December 31" is not good enough–the reader needs to know

if the statement covers the one week ended December 31, 2012 the month ended December 31,

2012 the three months ended December 31, 2012 or theyear ended December 31, 2012.4. Cost Principle

From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cash

equivalent) when an item was originally obtained, whether that purchase happened last year or

thirty years ago. For this reason, the amounts shown on financial statements are referred to

as historical cost amounts.

Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact, as

a general rule, asset amounts are not adjusted to reflect any type of increase in value. Hence, an

asset amount does not reflect the amount of money a company would receive if it were to sell the

asset at today's market value. (An exception is certain investments in stocks and bonds that are

actively traded on a stock exchange.) If you want to know the current value of a company's long-term

assets, you will not get this information from a company's financial statements–you need to look

elsewhere, perhaps to a third-party appraiser.5. Full Disclosure Principle

If certain information is important to an investor or lender using the financial statements, that

information should be disclosed within the statement or in the notes to the statement. It is because of

this basic accounting principle that numerous pages of "footnotes" are often attached to financial

statements.

As an example, let's say a company is named in a lawsuit that demands a significant amount of

money. When the financial statements are prepared it is not clear whether the company will be able

to defend itself or whether it might lose the lawsuit. As a result of these conditions and because of

the full disclosure principle the lawsuit will be described in the notes to the financial statements.

A company usually lists its significant accounting policies as the first note to its financial statements.

6. Going Concern Principle

This accounting principle assumes that a company will continue to exist long enough to carry out its

objectives and commitments and will not liquidate in the foreseeable future. If the company's

financial situation is such that the accountant believes the company will not be able to continue on,

the accountant is required to disclose this assessment.

60

The going concern principle allows the company to defer some of its prepaid expenses until future

accounting periods.

7. Matching Principle

This accounting principle requires companies to use the accrual basis of accounting. The

matching principle requires that expenses be matched with revenues. For example, sales

commissions expense should be reported in the period when the sales were made (and not reported

in the period when the commissions were paid). Wages to employees are reported as an expense in

the week when the employees worked and not in the week when the employees are paid. If a

company agrees to give its employees 1% of its 2013 revenues as a bonus on January 15, 2014, the

company should report the bonus as an expense in 2013 and the amount unpaid at December 31,

2013 as a liability. (The expense is occurring as the sales are occurring.)

Because we cannot measure the future economic benefit of things such as advertisements (and

thereby we cannot match the ad expense with related future revenues), the accountant charges the

ad amount to expense in the period that the ad is run.

(To learn more about adjusting entries go to Explanation of Adjusting Entries and Quiz for Adjusting Entries.)8. Revenue Recognition Principle

Under the accrual basis of accounting (as opposed to the cash basis of accounting), revenues are recognized as soon as a product has been sold or a service has

been performed, regardless of when the money is actually received. Under this basic accounting

principle, a company could earn and report $20,000 of revenue in its first month of operation but

receive $0 in actual cash in that month.

For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should

recognize $1,000 of revenue as soon as its work is done—it does not matter whether the client pays

the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.9. Materiality

Because of this basic accounting principle or guideline, an accountant might be allowed to violate

another accounting principle if an amount is insignificant. Professional judgement is needed to

decide whether an amount is insignificant or immaterial.

An example of an obviously immaterial item is the purchase of a $150 printer by a highly profitable

multi-million dollar company. Because the printer will be used for five years, the matching principle

directs the accountant to expense the cost over the five-year period. The materiality guideline

allows this company to violate the matching principle and to expense the entire cost of $150 in the

year it is purchased. The justification is that no one would consider it misleading if $150 is expensed

in the first year instead of $30 being expensed in each of the five years that it is used.

Because of materiality, financial statements usually show amounts rounded to the nearest dollar, to

the nearest thousand, or to the nearest million dollars depending on the size of the company.

61

10. Conservatism

If a situation arises where there are two acceptable alternatives for reporting an item, conservatism

directs the accountant to choose the alternative that will result in less net income and/or less asset

amount. Conservatism helps the accountant to "break a tie." It does not direct accountants to be

conservative. Accountants are expected to be unbiased and objective.

The basic accounting principle of conservatism leads accountants to anticipate or disclose losses,

but it does not allow a similar action for gains. For example, potential losses from lawsuits will be

reported on the financial statements or in the notes, but potential gains will not be reported. Also,

an accountant may write inventory downto an amount that is lower than the original cost, but will not

write inventory up to an amount higher than the original cost.

Other Characteristics of Accounting InformationWhen financial reports are generated by professional accountants, we have certain expectations of

the information they present to us:

1. We expect the accounting information to be reliable, verifiable, and objective.

2. We expect consistency in the accounting information.3. We expect comparability in the accounting information.

1. Reliable, Verifiable, and Objective

In addition to the basic accounting principles and guidelines listed in Part 1, accounting information

should be reliable, verifiable, and objective. For example, showing land at its original cost of $10,000

(when it was purchased 50 years ago) is considered to be more reliable, verifiable, and objective than showing it at its current market value of $250,000. Eight different

accountants will wholly agree that the original cost of the land was $10,000—they can read the offer

and acceptance for $10,000, see a transfer tax based on $10,000, and review documents that

confirm the cost was $10,000. If you ask the same eight accountants to give you the

land'scurrent value, you will likely receive eight different estimates. Because the current value

amount is less reliable, less verifiable, and less objective than the original cost, the original cost is

used.

The accounting profession has been willing to move away from the cost principle if there are

reliable, verifiable, and objective amounts involved. For example, if a company has an investment in

stock that is actively traded on a stock exchange, the company may be required to show the current

value of the stock instead of its original cost.

62

2. Consistency

Accountants are expected to be consistent when applying accounting principles, procedures, and

practices. For example, if a company has a history of using the FIFO cost flow assumption, readers of the company's most current financial statements have every reason to

expect that the company is continuing to use the FIFO cost flow assumption. If the company

changes this practice and begins using the LIFO cost flow assumption, that change must be

clearly disclosed.

3. Comparability

Investors, lenders, and other users of financial statements expect that financial statements of one

company can be compared to the financial statements of another company in the same

industry.Generally accepted accounting principles may provide

for comparability between the financial statements of different companies. For example,

the FASB requires that expenses related to research and development (R&D) be expensed when

incurred. Prior to its rule, some companies expensed R&D when incurred while other companies

deferred R&D to the balance sheet and expensed them at a later date.

How Principles and Guidelines Affect Financial StatementsThe basic accounting principles and guidelines directly affect the way financial statements are

prepared and interpreted. Let's look below at how accounting principles and guidelines influence the

(1) balance sheet, (2) income statement, and (3) the notes to the financial statements.

1. Balance Sheet

Let's see how the basic accounting principles and guidelines affect the balance sheet of Mary's

Design Service, a sole proprietorship owned by Mary Smith. (To learn more about the balance sheet

go to Explanation of Balance Sheet and Quiz for Balance Sheet.)A balance sheet is a snapshot of a company's assets, liabilities, and owner's equity at one point

in time. (In this case, that point in time is after all of the transactions through September 30, 2013

have been recorded.) Because of the economic entity assumption, only the assets, liabilities,

and owner's equity specifically identified with Mary's Design Service are shown—the personal assets

of the owner, Mary Smith, are not included on the company's balance sheet.

63

The assets listed on the balance sheet have a cost that can be measured and each amount shown

is the original cost of each asset. For example, let's assume that a tract of land was purchased in

1956 for $10,000. Mary's Design Service still owns the land, and the land is now appraised at

$250,000. The cost principle requires that the land be shown in the asset account Land at its

original cost of $10,000 rather than at the recently appraised amount of $250,000.

If Mary's Design Service were to purchase a second piece of land, the monetary unit assumption dictates that the purchase price of the land bought today would simply be added to

the purchase price of the land bought in 1956, and the sum of the two purchase prices would be

reported as the total cost of land.

The Supplies account shows the cost of supplies (if material in amount) that were obtained by Mary's

Design Service but have not yet been used. As the supplies are consumed, their cost will be moved

to the Supplies Expense account on the income statement. This complies with the matching principle which requires expenses to be matched either with revenues or with the time period

when they are used. The cost of the unused supplies remains on the balance sheet in the asset

account Supplies.

The Prepaid Insurance account represents the cost of insurance that has not yet expired. As the

insurance expires, the expired cost is moved to Insurance Expense on the income statement as

required by the matching principle. The cost of the insurance that has not yet expired remains on

Mary's Design Service's balance sheet (is "deferred" to the balance sheet) in the asset account

Prepaid Insurance. Deferring insurance expense to the balance sheet is possible because of another

basic accounting principle, the going concern assumption.The cost principle and monetary unit assumption prevent some very valuable assets from ever

appearing on a company's balance sheet. For example, companies that sell consumer products with

high profile brand names, trade names, trademarks, and logos are not reported on their balance

64

sheets because they were not purchased. For example, Coca-Cola's logo and Nike's logo are

probably the most valuable assets of such companies, yet they are not listed as assets on the

company balance sheet. Similarly, a company might have an excellent reputation and a very skilled

management team, but because these were not purchased for a specific cost and we cannot

objectively measure them in dollars, they are not reported as assets on the balance sheet. If a

company actually purchases the trademark of another company for a significant cost, the amount

paid for the trademark will be reported as an asset on the balance sheet of the company that bought

the trademark.

2. Income Statement

Let's see how the basic accounting principles and guidelines might affect the income statement of

Mary's Design Service. (To learn more about the income statement go to Explanation of Income Statement and Quiz for Income Statement.)An income statement covers a period of time (or time interval), such as a year, quarter, month,

or four weeks. It is imperative to indicate the period of time in the heading of the income statement

such as "For the Nine Months Ended September 30, 2013". (This means for the period of January 1

through September 30, 2013.) If prepared under the accrual basis of accounting, an income

statement will show how profitable a company was during the stated time interval.

Revenues are the fees that were earned during the period of time shown in the heading.

Recognizing revenues when they are earned instead of when the cash is actually received follows

the revenue recognition principle and the matching principle. (The matching principle

is what steers accountants toward using the accrual basis of accounting rather than the cash basis.

Small business owners should discuss these two methods with their tax advisors.)

Gains are a net amount related to transactions that are not considered part of the company's main

operations. For example, Mary's Design Service is in the business of designing, not in the land

65

development business. If the company should sell some land for $30,000 (land that is shown in the

company's accounting records at $25,000) Mary's Design Service will report a Gain on Sale of Land of $5,000. The $30,000 selling price will not be reported as part of the company's revenues.

Expenses are costs used up by the company in performing its main operations. The matching

principle requires that expenses be reported on the income statement when the related sales are

made or when the costs are used up (rather than in the period when they are paid).

Losses are a net amount related to transactions that are not considered part of the company's main

operating activities. For example, let's say a retail clothing company owns an old computer that is

carried on its accounting records at $650. If the company sells that computer for $300, the

company receives an asset (cash of $300) but it must also remove $650 of asset amounts from its

accounting records. The result is a Loss on Sale of Computer of $350. The $300 selling price

will not be included in the company's sales or revenues.

3. The Notes To Financial Statements

Another basic accounting principle, the full disclosure principle, requires that a company's

financial statements include disclosure notes. These notes include information that helps readers of

the financial statements make investment and credit decisions. The notes to the financial statements

are considered to be an integral part of the financial statements.

Introduction to Accounts PayableAccount payable is defined in Webster's New Universal Unabridged Dictionary as:

account payable, pl. accounts payable. a liability to a creditor, carried on open account,

usually for purchases of goods and services. [1935-40]

When a company orders and receives goods (or services) in advance of paying for them, we say

that the company is purchasing the goods on account or on credit. The supplier (or vendor) of the

goods on credit is also referred to as a creditor. If the company receiving the goods does not sign a

promissory note, the vendor's bill or invoice will be recorded by the company in its liability account

Accounts Payable (or Trade Payables).

As is expected for a liability account, Accounts Payable will normally have a credit balance. Hence,

when a vendor invoice is recorded, Accounts Payable will be credited and another account must be

debited (as required by double-entry accounting). When an account payable is paid, Accounts

Payable will be debited and Cash will be credited. Therefore, the credit balance in Accounts Payable

should be equal to the amount of vendor invoices that have been recorded but have not yet been

paid.

Under the accrual method of accounting, the company receiving goods or services on credit

must report the liability no later than the date they were received. The same date is used to record

66

the debit entry to an expense or asset account as appropriate. Hence, accountants say that under

the accrual method of accounting expenses are reported when they are incurred (not when they

are paid).

The term accounts payable can also refer to the person or staff that processes vendor invoices

and pays the company's bills. That's why a supplier who hasn't received payment from a customer

will phone and ask to speak with "accounts payable."

The accounts payable process involves reviewing an enormous amount of detail to ensure that only

legitimate and accurate amounts are entered in the accounting system. Much of the information that

needs to be reviewed will be found in the following documents:

purchase orders issued by the company

receiving reports issued by the company

invoices from the company's vendors

contracts and other agreements

The accuracy and completeness of a company's financial statements are dependent on the accounts

payable process. A well-run accounts payable process will include:

the timely processing of accurate and legitimate vendor invoices,

accurate recording in the appropriate general ledger accounts, and

the accrual of obligations and expenses that have not yet been completely processed.

The efficiency and effectiveness of the accounts payable process will also affect the company's cash

position, credit rating, and relationships with its suppliers.

An Account Payable Is Another Company's Account ReceivableIt may be helpful to note that an account payable at one company is an account receivable for the

vendor that issued the sales invoice. To illustrate this, let's assume that DeliverCorp provides a

service for YourCo at a cost of $600 on May 1 and sends an invoice dated May 1 for $600. The

invoice specifies that the amount will be due in 30 days. (We will assume throughout our explanation

that the companies follow the accrual method of accounting.)

The following table highlights the symmetry between a company's account payable and its vendor's

account receivable.

67

The following table focuses on the general ledger accounts: Accounts Payable and Accounts

Receivable.

68

Accounts Payable ProcessThe accounts payable process or function is immensely important since it involves nearly all of a

company's payments outside of payroll. The accounts payable process might be carried out by an

accounts payable department in a large corporation, by a small staff in a medium-sized company, or

by a bookkeeper or perhaps the owner in a small business.

Regardless of the company's size, the mission of accounts payable is to pay only the company's bills and invoices that are legitimate and accurate. This means that

before a vendor's invoice is entered into the accounting records and scheduled for payment, the

invoice must reflect:

what the company had ordered

what the company has received

the proper unit costs, calculations, totals, terms, etc.

69

To safeguard a company's cash and other assets, the accounts payable process should

have internal controls. A few reasons for internal controls are to:

prevent paying a fraudulent invoice

prevent paying an inaccurate invoice

prevent paying a vendor invoice twice

be certain that all vendor invoices are accounted for

Periodically companies should seek professional assistance to improve its internal controls.

The accounts payable process must also be efficient and accurate in order for the company's

financial statements to be accurate and complete. Because of double-entry accounting an omission

of a vendor invoice will actually cause two accounts to report incorrect amounts. For example, if a

repair expense is not recorded in a timely manner:

1. the liability will be omitted from the balance sheet, and2. the repair expense will be omitted from the income statement.

If the vendor invoice for a repair is recorded twice, there will be two problems as well:

1. the liabilities will be overstated, and2. repairs expense will be overstated.

In other words, without the accounts payable process being up-to-date and well run, the company's

management and other users of the financial statements will be receiving inaccurate feedback on

the company's performance and financial position.

A poorly run accounts payable process can also mean missing a discount for paying some bills

early. If vendor invoices are not paid when they become due, supplier relationships could be

strained. This may lead to some vendors demanding cash on delivery. If that were to occur it could

have extreme consequences for a cash-strapped company.

Just as delays in paying bills can cause problems, so could paying bills too soon. If vendor invoices

are paid earlier than necessary, there may not be cash available to pay some other bills by their due

dates.

Purchase order

A purchase order or PO is prepared by a company to communicate and document precisely what

the company is ordering from a vendor. The paper version of a purchase order is a multi-copy form

with copies distributed to several people. The people or departments receiving a copy of the PO

include:

70

the person requesting that a PO be issued for the goods or services

the accounts payable department

the receiving department

the vendor

the person preparing the purchase order

The purchase order will indicate a PO number, date prepared, company name, vendor name, name

and phone number of a contact person, a description of the items being purchased, the quantity, unit

prices, shipping method, date needed, and other pertinent information.

One copy of the purchase order will be used in the three-way match, which we will discuss later.

Receiving report

A receiving report is a company's documentation of the goods it has received. The receiving report

may be a paper form or it may be a computer entry. The quantity and description of the goods

shown on the receiving report should be compared to the information on the company's purchase

order.

After the receiving report and purchase order information are reconciled, they need to be compared

to the vendor invoice. Hence, the receiving report is the second of the three documents in the three-

way match (which will be discussed shortly).

Vendor Invoice

The supplier or vendor will send an invoice to the company that had received the goods and/or

services on credit. When the invoice or bill is received, the customer will refer to it as a vendor

invoice. Each vendor invoice is routed to accounts payable for processing. After the invoice is

verified and approved, the amount will be credited to the company's Accounts Payable account and

will also be debited to another account (often as an expense or asset).

A common technique for verifying a vendor invoice is the three-way match.

Three-way match

The accounts payable process often uses a technique known as the three-way match to assure that

only valid and accurate vendor invoices are recorded and paid. The three-way match involves the

following:

71

Only when the details in the three documents are in agreement will a vendor's invoice be entered

into the Accounts Payable account and scheduled for payment.

Good internal control of a company's resources is enhanced when the company assigns a separate

employee with a specific, limited responsibility. The following chart illustrates the concept of the

separation (or segregation) of duties involving accounts payable:

When the duties are separated, it will require more than one dishonest person to steal from the

company. Hence, small companies without sufficient staff to separate employees' responsibilities will

have a greater risk of theft.

To illustrate the three-way match, let's assume that BuyerCo needs 10 cartridges of toner for its

printers. BuyerCo issues a purchase order to SupplierCorp for 10 cartridges at $60 per cartridge that

are to be delivered in 10 days. One copy of the PO is sent to SupplierCorp, one copy goes to the

person requisitioning the cartridges, one copy goes to the receiving department, one copy goes to

accounts payable, and one copy is retained by the person preparing the PO. When BuyerCo

receives the cartridges, a receiving report is prepared.

The three-way match involves comparing the following information:

1. The description, quantity, cost and terms on the company's purchase order.2. The description and quantity of goods shown on the receiving report.3. The description, quantity, cost, terms, and math on the vendor invoice.

After determining that the information reconciles, the vendor invoice can be entered into the liability

account Accounts Payable. The information entered into the accounting software will include invoice

72

reference information (vendor name or code, invoice number and date, etc.), the amount to be

credited to Accounts Payable, the amount(s) and account(s) to be debited and the date that the

payment is to be made. The payment date is based on the terms shown on the invoice and the

company's policy for making payments.

Lastly, the documents should be stamped or perforated to indicate they have been entered into the

accounting system thus avoiding a duplicate payment.

Vouchers

Some companies use a voucher in order to document or "vouch for" the completeness of the

approval process. You can visualize a voucher as a cover sheet for attaching the supporting

documents (purchase order, receiving report, vendor's invoice, etc.) and for noting the approvals,

account numbers, and other information for each vendor invoice or bill.

When the vendor invoice is paid, the voucher and its attachments (including a copy of the check that

was issued) will be stored in a paid voucher/invoice file. If paper documents are involved, an

office machine could perforate the word "PAID" through the voucher and its attachments. This is

done to assure that a duplicate payment will not occur.

The unpaid invoices and vouchers will be held in an open file.

Vendor invoices without purchase orders or receiving reports

Not all vendor invoices will have purchase orders or receiving reports. Hence, the three-way match

is not always possible. For example, a company does not issue a purchase order to its electric utility

for a pre-established amount of electricity for the following month. The same is true for the

telephone, natural gas, sewer and water, freight-in, and so on.

There are also payments that are required every month in order to fulfill lease agreements or other

contracts. Examples include the monthly rent for a storage facility, office rent, automobile payments,

equipment leases, maintenance agreements, etc. Even though these obligations will not have

purchase orders, the responsibility is unchanged: pay only the amounts that are legitimate and accurate.

Statements from vendors

Vendors often send statements to their customers to indicate the amounts (listed by invoice number)

that remain unpaid. When a vendor statement is received the details on the statement should be

compared to the company's records.

The fact that a company can be receiving both invoices and statements from a vendor means there

is the potential of a duplicate payment. In order to avoid making a duplicate payment, companies

often establish the following rule: Pay only from vendor invoices; never pay from vendor statements.

73

Related Expense or AssetThe vendor invoices received by a company could involve the following:

1. A vendor invoice may be a bill for a repair or maintenance service. The vendor's credit terms allow the company to pay 30 days after the date of the service. Since repairs and maintenance do not create more assets, the cost of the service should be reported on the income statement as an expense. Under the accrual method of accounting the expense is reported in the accounting period in which the service occurred (not the period in which it is paid). Other examples of expenses include the cost of office expenses such as electricity and telephone, consulting, and more.

2. A vendor invoice may be a bill for the purchase of expensive equipment that will be used by the company for several years. The equipment will be recorded as an asset and will be reported in the company's balance sheet section property, plant and equipment. As the equipment is utilized, its cost will be moved from the balance sheet to the income statement account Depreciation Expense.

3. Another vendor invoice may be a billing for the cost of a service that the vendor will provide in the future, but the payment must be made in advance. A common example is an insurance company's invoice for the premiums covering the next six months of insurance on the company's automobiles. The company will initially debit the invoice amount to a current asset such as Prepaid Expenses. As the insurance expires, the cost will be allocated to Insurance Expense.

The following table illustrates an insurance premium of $6,000 that is paid in December but the coverage is for the following January 1 through June 30:

The three examples illustrate that some vendor invoices will be immediately recorded as expenses

while other invoices are initially recorded as assets. The accounts payable staff needs to be

instructed as to the proper accounts to be debited when vendor invoices are entered as credits to

Accounts Payable. Generally, a cost that is used up and has no future economic value that can be

measured is debited immediately to expense. Vendor invoices for property, plant and equipment are

not expensed immediately. Instead, the cost is recorded in a balance sheet asset account and will

74

be expensed in increments during the asset's useful life. Lastly, a prepaid expense is initially

recorded in a current asset account and will be allocated to expense as the cost expires.

End of the Period Cut-OffAt the end of every accounting period (year, quarter, month, 5-week period, etc.) it is important that

the accounts payable processing be up-to-date. If it is not up-to-date, the income statement for the

accounting period will likely be omitting some expenses and the balance sheet at the end of the

accounting period will be omitting some liabilities.

During the first few days after an accounting period ends, it is important for the accounts payable

staff to closely examine the incoming vendor invoices. For example, a $900 repair bill received on

January 6 may be a December repair expense and a liability as of December 31. Another vendor

invoice received on January 6 may not have been an obligation as of December 31 and is actually a

January expense.

It is also necessary to review the receiving reports that have not yet been matched to vendor

invoices. If items were ordered and received prior to December 31, the amounts must be recorded

as of December 31 through an accrual-type adjusting entry.

Note: The proper cut-off at the end of each accounting period becomes more complicated and often more significant if a company has inventories of finished products, work-in-process and raw materials. It is possible that some goods will be included in the physical inventory counts, but the costs have not yet been recorded in Accounts Payable and in the Inventory or Purchases account.

Accruing Expenses and LiabilitiesAt the end of every accounting period there will be some vendor invoices and receiving reports that

have not yetbeen approved or fully matched. As a result these amounts will not have been entered

into the Accounts Payable account (and the related expense or asset account). These documents

should be reviewed in order to determine whether a liability and an expense have actually been

incurred by the company as of the end of the accounting period.

Since the accrual method of accounting requires that all of a company's liabilities and expenses

must be reported on the financial statements, companies should prepare an accrual-type adjusting entry at the end of every accounting period. This adjusting entry will credit Accrued

Liabilities and will debit the appropriate expense or other account for the amounts that were incurred

but are not yet included in Accounts Payable. The balance in Accrued Liabilities will be reported in

the current liability section of the balance sheet immediately after Accounts Payable.

75

It is also common for companies to prepare a reversing entry every month. The reversing entry

removes the previous period's accrual adjusting entry and prevents the double-counting of an

expense that could occur when the actual vendor invoice is processed.

Note: Under the accrual method of accounting, a company's financial statements must report all expenses and liabilities that are probable and can be measured even if the vendors' invoices have not yet been received or fully processed.

Adding General Ledger AccountsThe general ledger accounts that are available for recording transactions are found in the

company's chart of accounts. For most businesses the general ledger accounts are listed in the

following order:

1. Balance sheet accounts o Asset accounts

o Liability accounts

o Stockholders' or owner's equity accounts

2. Income statement accounts o Operating revenue accounts

o Operating expense accounts

o Nonoperating revenue and gain accounts

o Nonoperating expense and loss accounts

Many systems will allow for each account to have subaccounts. Subaccounts allow for

summarizing or combining amounts while also maintaining the detailed amounts.

When the existing accounts are not sufficient, new accounts should be added. In other words,

meaningful financial reporting of transactions should not be limited to a preconceived list of

accounts.

For more information and examples see Explanation of Chart of Accounts.

Invoice Credit TermsThe invoice terms indicate when an invoice becomes due and whether a discount may be taken if

the invoice is paid sooner. The invoice terms also dictate the point at which ownership of goods will

transfer from the seller to the buyer.

The following payment terms are some of the more common ones for businesses without

inventories.

76

Net due upon receipt

If the vendor's terms are Net due upon receipt, the invoice amount is due immediately. (Of

course, you should verify that the invoice is valid and accurate before it is entered for payment.)

Net 30 days

When the vendor invoice states Net 30 days, the amount of the invoice (minus any returns or

allowances) is due 30 days from the date of the invoice. For example, if a vendor invoice for $1,000

is dated June 1 and the company is granted a $100 allowance, the net amount of $900 should be

paid by July 1. (If there were no allowance, the company should remit $1,000 by July 1.)

1/10, n/30

When a vendor invoice includes terms of 1/10, n/30, the "1" represents 1% of the amount owed,

the "10" represents 10 days, the "n" represents the word net, and the "30" represents 30 days. The

terms 1/10, n/30indicate that the buyer may take an early payment discount of 1% of the amount

owed if the amount owed is remitted within 10 days instead of the normal 30 days. In other words,

the buyer can choose either of the following:

Pay within 10 days and deduct 1% of the net amount owed (the invoice amount minus any authorized returns and/or allowances), or

Pay in 30 days and take no discount.

To illustrate1/10, n/30, let's assume that a vendor invoice for $1,000 is dated June 1 and the buyer

does not return any of the goods. Since there are no returns, the net amount of the purchase is the

full $1,000 and the buyer can remit either of the following amounts:

If paying by June 10, the amount due to the vendor is $990. [The net amount of $1,000 minus the $10 early payment discount (which is 1% of $1,000).]

If paying by July 1, the net amount of $1,000 is due.

If the buyer was given an allowance of $100, the net amount is $900. In that case the buyer can

remit either of the following amounts:

If paying by June 10, the amount due to the vendor is $891. [The net amount of $900 minus $9 (which is 1% of $900).]

If paying by July 1, the net amount of $900 is due.

2/10, n/30

If the vendor's invoice has terms of 2/10, n/30, the "2" represents 2%, the "10" represents 10 days,

the "n" represents the word net and the "30" represents 30 days. This means that the buyer can

take an early payment discount of 2% of the amount owed if the amount is remitted within 10 days

instead of the customary 30 days. In other words, the buyer can choose either of the following:

Pay within 10 days and deduct 2% of the net amount (invoice amount minus any authorized returns and/or allowances), or

Pay the full amount in 30 days with no discount.

77

To illustrate 2/10, n/30, assume that a vendor's invoice for $1,000 is dated June 1 and the vendor

has granted the buyer an allowance of $100. This means the net amount is $900 and that only $900

will be eligible for the early payment discount. Hence, the buyer can remit either of the following

amounts:

If paying by June 10, the amount due to the vendor is $882. [The net amount of $900 minus $18 (which is 2% of $900).]

If paying by July 1, the net amount of $900 is due.

Early Payment Discounts vs. Need for CashSome vendors offer an early payment discount such as 2/10, net 30. This means that the buyer

may deduct 2% of the amount owed if the vendor is paid within 10 days instead of the normal 30

days. For instance, an invoice amount of $1,000 can be settled in full if the buyer will pay $980 within

10 days. In this example, the buyer will save $20 (2% X $1,000) for paying 20 days earlier than the

normal due date. If the buyer has the opportunity to do this every 20 days, it would occur 18 times

during a year (365 days divided by 20 days = 18 times). That means the company could save up to

$360 ($20 X 18 times per year) each year by using a single $980 amount. Hence the annual

percentage rate is approximately 36% ($360 earned divided by $980 used).

Looking at it another way, if the buyer had to borrow $980 from its bank for the 20 days at a

borrowing rate of 6% per year, the interest for 20 days would be only $3.22 ($980 X 6% X 20/365).

By paying $3.22 of interest to the bank, the buyer will save paying the vendor $20 and therefore will

be better off by $16.78 ($20.00 minus $3.22). If this occurs 18 times in a year, the net annual

savings will be approximately $301 [$16.78 X 18 times; or $360 per year saved minus the annual

interest paid to the bank of $59 ($980 X 6%)].

A discount of 1% for paying 20 days early equates to an annual interest rate of approximately18%.

It is clear that buyers with sufficient cash balances or a readily available line of credit should take

advantage of the early payment discounts. However, some buyers are operating with very little cash

and are unable to borrow additional money. These buyers may be wise to forgo the early payment

discounts in order to avoid the risk of overdrawing their checking account. One overdraft fee could be greater than the early payment discount. If an overdraft causes several of the

buyer's checks to be returned to its vendors, the total amount of overdraft fees will be even greater.

If a buyer's checks are returned because of insufficient funds its suppliers may become concerned

about the buyer's ability to pay. This could lead to one or more of the suppliers demanding payment

at the time of delivery. The elimination of 30 days of credit from suppliers could be devastating for a

buyer with little money and a credit line that has been exhausted.

Be sure to consider your company's cash balances and cash needs before paying invoices prior to

their due dates.

78

Other

Vendor or employee?

Occasionally an individual will provide services for a company and submits an invoice. The invoice is

processed through accounts payable and in the U.S. the company may be required to issue the

individual an IRS Form 1099-MISC in January of the following year.

While the company views the individual as an independent contractor, the Internal Revenue Service

rules may dictate that the individual is actually a part-time employee. If a person is deemed to be an

employee, the Internal Revenue Service requires that payroll taxes be withheld and a Form W-2 be

issued instead of Form 1099-MISC.

You can learn more about the distinction between an independent contractor and an employee

at www.IRS.gov.

Internal controls

In order to protect a company's assets it is important that a company have in place a variety of

controls over issuing purchase orders, issuing checks, adding vendors to the accounts payable

master vendor file, segregating duties, and other safeguards referred to as internal controls.

We recommend that a professional who is well-versed in internal controls perform a review of your

company's policies and procedures.

Batching the payments to vendors

In order for the accounts payable staff to operate efficiently, it is helpful to process the checks written

to vendors only on specified days each month. Writing the checks on pre-announced days will

hopefully discourage the need for "rush" checks and allow the accounts payable processing to be

more efficient.

Sales and use taxes

Certain purchases of goods and/or services may be subject to state sales taxes. If a sales tax is not

paid for thesales-taxable goods or services (even from out-of-state vendors), the buyer is likely to

be liable for a state usetax. To further complicate the situation, some organizations may be exempt

from both a sales tax and a use tax depending on the state laws.

The responsibility for compliance with sales and use taxes rests with each company. As a result,

companies must be familiar with the laws of the states in which they operate.

79

Travel and entertainment

Travel and entertainment, commonly known as T&E, is another area of accounts payable that needs

to be managed. Here, too, each company must establish procedures and controls and be in

compliance with Internal Revenue Service (IRS) rules which can be found at www.IRS.gov.

General Ledger Account: Accounts PayableThe general ledger account Accounts Payable or Trade Payables is a current liability account,

since the amounts owed are usually due in 10 days, 30 days, 60 days, etc. The balance in Accounts

Payable is usually presented as the first or second item in the current liability section of the balance

sheet. (Many companies report Notes Payable due within one year as the first item.)

As a liability account, Accounts Payable is expected to have a credit balance. Hence, a credit entry

will increase the balance in Accounts Payable and a debit entry will decrease the balance.

A bill or invoice from a supplier of goods or services on credit is often referred to as a vendor invoice. The vendor invoices are entered as credits in the Accounts Payable account, thereby

increasing the credit balance in Accounts Payable. When a company pays a vendor, it will reduce

Accounts Payable with a debit amount. As a result, the normal credit balance in Accounts Payable

is the amount of vendor invoices that have been recorded but have not yet been paid. The unpaid

invoices are sometimes referred to as open invoices.

Accounting software allows companies to sort its accounts payable according to the dates when

payments will be due. This feature and the resulting report are known as the aging of accounts payable.

Entering a vendor invoice into Accounts Payable

Prior to entering a vendor invoice into Accounts Payable, the invoice should be reviewed and

approved. The reason is that a vendor invoice may contain errors (incorrect quantities, incorrect

prices, math errors, etc.) and some invoices may not be legitimate.

After a vendor invoice has been approved, the recording of the invoice will include:

a credit to Accounts Payable, and a minimum of one debit to another account. The debit amount usually involves

one of the following:

o an expense (Repairs & Maintenance Expense, Advertising Expense, Rent

Expense, etc.)

o a prepaid asset (Prepaid Expenses, Prepaid Insurance)

80

o a fixed or plant asset (Equipment, Fixtures, Vehicles, etc.)

A listing of the accounts that a company has available for recording transactions is known as

the chart of accounts.A report that lists the accounts and amounts that are debited for a group of invoices entered into

the accounting software is known as the accounts payable distribution.

Reductions to Accounts Payable

When a company pays part or all of a previously recorded vendor invoice, the balance in Accounts

Payable will be reduced with a debit entry and Cash will be reduced with a credit entry.

Accounts Payable is also debited when a company returns goods to a vendor or when the vendor

grants an allowance.

Introduction to Accounts Receivable and Bad Debts ExpenseIf we imagine buying something, such as groceries, it's easy to picture ourselves standing at the

checkout, writing out a personal check, and taking possession of the goods. It's a simple transaction

—we exchange our money for the store's groceries.

In the world of business, however, many companies must be willing to sell their goods (or

services) on credit. This would be equivalent to the grocer transferring ownership of the groceries

to you, issuing a sales invoice, and allowing you to pay for the groceries at a later date.

Whenever a seller decides to offer its goods or services on credit, two things happen: (1) the seller

boosts its potential to increase revenues since many buyers appreciate the convenience and

efficiency of making purchases on credit, and (2) the seller opens itself up to potential losses if its

customers do not pay the sales invoice amount when it becomes due.

Under the accrual basis of accounting (which we will be using throughout our discussion) a

sale on credit will:

1. Increase sales or sales revenues, which are reported on the income statement, and

2. Increase the amount due from customers, which is reported as accounts receivable—an asset reported on the balance sheet.

If a buyer does not pay the amount it owes, the seller will report:

81

1. A credit loss or bad debts expense on its income statement, and

2. A reduction of accounts receivable on its balance sheet.

With respect to financial statements, the seller should report its estimated credit losses as soon as

possible using the allowance method. For income tax purposes, however, losses are reported at a

later date through the use of the direct write-off method.

Recording Services Provided on CreditAssume that on June 3, Malloy Design Co. provides $4,000 of graphic design service to one of its

clients with credit terms of net 30 days. (Providing services with credit terms is also referred to as

providing services on account.)Under the accrual basis of accounting, revenues are considered earned at the time when the

services are provided. This means that on June 3 Malloy will record the revenues it earned, even

though Malloy will not receive the $4,000 until July. Below are the accounts affected on June 3, the

day the service transaction was completed:

In this transaction, the debit to Accounts Receivable increases Malloy's current assets, total assets,

working capital, and stockholders' (or owner's) equity—all of which are reported on its balance sheet.

The credit to Service Revenues will increase Malloy's revenues and net income—both of which are

reported on its income statement.

Recording Sales of Goods on CreditWhen a company sells goods on credit, it reports the transaction on both its income statement and

its balance sheet. On the income statement, increases are reported in sales revenues, cost of goods

sold, and (possibly) expenses. On the balance sheet, an increase is reported in accounts receivable,

a decrease is reported in inventory, and a change is reported in stockholders' equity for the amount

of the net income earned on the sale.

82

If the sale is made with the terms FOB Shipping Point, the ownership of the goods is transferred

at the seller's dock. If the sale is made with the terms FOB Destination, the ownership of the

goods is transferred at thebuyer's dock.

In principle, the seller should record the sales transaction when the ownership of the goods is

transferred to the buyer. Practically speaking, however, accountants typically record the transaction

at the time the sales invoice is prepared and the goods are shipped.

FOB Shipping Point

Quality Products Co. just sold and shipped $1,000 worth of goods using the terms FOB Shipping

Point. With its cost of goods at 80% of sales value, Quality makes the following entries in its general

ledger:

(While there may be additional expenses with this transaction—such as commission expense—we

are not considering them in our example.)

FOB Shipping Point means the ownership of the goods is transferred to the buyer at the seller's dock. This means that the buyer is responsible for transporting the goods from Quality

Product's shipping dock. Therefore, all shipping costs (as well as any damage that might be incurred

during transit) are the responsibility of the buyer.

FOB Destination

FOB Destination means the ownership of the goods is transferred at the buyer's dock. This

means the seller is responsible for transporting the goods to the customer's dock, and will factor in

the cost of shipping when it sets its price for the goods.

Let's assume that Gem Merchandise Co. makes a sale to a customer that has a sales value of

$1,050 and a cost of goods sold at $800. This transaction affects the following accounts in Gem's

general ledger:

83

Because Gem chooses to ship its goods FOB Destination, the ownership of the goods transfers at

the buyer's dock. Therefore, Gem Merchandise assumes all the risks and costs associated with

transporting the goods.

Now let's assume that Gem pays an independent shipping company $50 to transport the goods from

its warehouse to the buyer's dock. Gem records the $50 as an operating expense or selling expense (in an account such as Delivery Expense, Freight-Out Expense, or Transportation-Out Expense). If the shipping company allows Gem to pay in 7

days, Gem will make the following entry in its general ledger:

Credit Terms with DiscountsWhen a seller offers credit terms of net 30 days, the net amount for the sales transaction is due 30

days after the sales invoice date.

To illustrate the meaning of net, assume that Gem Merchandise Co. sells $1,000 of goods to a

customer. Upon receiving the goods the customer finds that $100 of the goods are not acceptable.

The customer contacts Gem and is instructed to return the unacceptable goods. This means that

Gem's net sale ends up being $900; the customer's net purchase will also be $900 ($1,000 minus

the $100 returned). It also means that Gem's net receivable from this customer will be $900.

Unfortunately, companies who sell on credit often find that they don't receive payments from

customers on time. In fact, one study found that if the credit term is net 30 days, the money, on

average, arrived 45 days after the invoice date. In order to speed up these payments, some

companies give credit terms that offer a discount to those customers who pay within a shorter period

of time. The discount is referred to as a sales discount, cash discount, or an early payment discount, and the shorter period of time is known as the discount period. For example, the

term 2/10, net 30 allows a customer to deduct 2% of the net amount owed if the customer pays

84

within 10 days of the invoice date. If a customer does not pay within the discount period of 10 days,

the net purchase amount (without the discount) is due 30 days after the invoice date.

Using the example from above, let's illustrate how the credit term of 2/10, net 30 works. Gem

Merchandise Co. ships $1,000 of goods and the customer returns $100 of unacceptable goods to

Gem within a few days. At that point, the net amount owed by the customer is $900. If the customer

pays Gem within 10 days of the invoice date, the customer is allowed to deduct $18 (2% of $900)

from the net purchase of $900. In other words, the $900 amount can be settled for $882 if it is paid

within the 10-day discount period.

Let's assume that the sale above took place on the first day that Gem was open for business, June

1. On June 6 Gem receives the returned goods and restocks them, and on June 11 it receives $882

from the buyer. Gem's cost of goods is 80% of their original selling prices (before discounts). The

above transactions are reflected in Gem's general ledger as follows:

If the customer waits 30 days to pay Gem, the June 11 entry shown above will not occur. In its place

will be the following entry on July 1:

85

Examples of Amounts Due Under Varying Credit Terms

The following chart shows the amounts a seller would receive under various credit terms for a

merchandise sale of $1,000 and an authorized return of $100 of goods.

Credit Terms

Brief DescriptionAmount To Be

Received

Net 10 daysThe net amount is due within 10 days of the invoice date. $900

Net 30 daysThe net amount is due within 30 days of the invoice date. $900

Net 60 daysThe net amount is due within 60 days of the invoice date. $900

2/10, n/30

If paid within 10 days of the invoice date, the buyer may deduct 2% from the net amount. ($900 minus $18) $882

2/10, n/30If paid in 30 days of the invoice date, the net amount is due. $900

1/10, n/60

If paid within 10 days of the invoice date, the buyer may deduct 1% from the net amount. ($900 minus $9) $891

1/10, n/60If paid in 60 days of the invoice date, the net amount is due. $900

Net EOM 10

The net amount is due within 10 days after the end of the month (EOM). In other words, payment for any sale made in June is due by July 10. $900

Costs of Discounts

Some people believe that the credit term of 2/10, net 30 is far too generous. They argue that when a

$900 receivable is settled for $882 (simply because the customer pays 20 days early) the seller is, in

effect, giving the buyer the equivalent of a 36% annual interest rate (2% for 20 days equates to 36%

for 360 days). Some sellers won't offer terms such as 2/10, net 30 because of these high percentage

86

equivalents. Other sellers are discouraged to find that some customers take the discount and ignore

the obligation to pay within the stated discount period.

Credit RiskWhen a seller provides goods or services on credit, the resultant account receivable is normally

considered to be an unsecured claim against the buyer's assets. This makes the seller (the

supplier) an unsecured creditor, meaning it does not have a lien on any of the buyer's assets—not

even on the goods that it just sold to the buyer.

Sometimes a supplier's customer gets into financial difficulty and is forced to liquidate its assets. In

this situation the customer typically owes money to lending institutions as well as to its suppliers of

goods and services. In such cases, it's the secured creditors (the banks and other lenders that have

a lien on specific assets such as cash, receivables, inventory, equipment, etc.) who are paid first

from the sale of the assets. Often there is not enough money to pay what is owed to the secured

lenders, much less the unsecured creditors. In other words, the suppliers will never be paid what

they are owed.

To avoid this kind of risk, some suppliers may decide not to sell anything on credit, but require

instead that all of its goods be paid for with cash or a credit card. Such a company, however, may

lose out on sales to competitors who offer to sell on credit.

To minimize losses, sellers typically perform a thorough credit check on any new customer before

selling to them on credit. They obtain credit reports and check furnished references. Even when a

credit check is favorable, however, a credit loss can still occur. For example, a first-rate customer

may experience an unexpected financial hardship caused by one of its customers, something that

could not have been known when the credit check was done. The point is this: any company that

sells on credit to a large number of customers should assume that, sooner or later, it will probably

experience some credit losses along the way.

Allowance Method for Reporting Credit LossesAccounts receivable are reported as a current asset on a company's balance sheet. Since current

assets by definition are expected to turn to cash within one year (or within the operating cycle,

whichever is longer), a company's balance sheet could overstate its accounts receivable (and

therefore its working capital and stockholders' equity) if any part of its accounts receivable is not

collectible.

To guard against overstatement, a company will estimate how much of its accounts receivable will

never be collected. This estimate is reported in a balance sheet contra asset account called

87

Allowance for Doubtful Accounts. (Some companies call this account Provision for Doubtful

Accounts or Allowance for Uncollectible Accounts.) Any increases to Allowance for Doubtful

Accounts are also recorded in the income statement account Bad Debts Expense (or Uncollectible

Accounts Expense).

This method of anticipating the uncollectible amount of receivables and recording it in the Allowance

for Doubtful Accounts is known as the allowance method. (If a company does not use an

allowance account, it is following thedirect write-off method, which is discussed later.)

Allowance for Doubtful Accounts and Bad Debts Expense - June

As we stated above, the account Allowance for Doubtful Accounts is a contra asset account

containing the estimated amount of the accounts receivable that will not be collected. For example,

let's assume that Gem Merchandise Co.'s Accounts Receivable has a debit balance of $100,000 at

June 30. Gem anticipates that approximately $2,000 of this is not likely to turn to cash, and as a

result, Gem reports a credit balance of $2,000 in Allowance for Doubtful Accounts. The accounting

entry to adjust the balance in the allowance account will involve the income statement account Bad

Debts Expense.

Since June was Gem's first month in business, its Allowance for Doubtful Accounts began June with

a zero balance. At June 30, when it issues its first balance sheet and income statement, its

Allowance for Doubtful Accounts will have a credit balance of $2,000. This is done using the

following adjusting journal entry:

Here are some of the accounts in a T-account format:

88

With Allowance for Doubtful Accounts now reporting a credit balance of $2,000 and Accounts

Receivable reporting a debit balance of $100,000, Gem's balance sheet will report a net amount of

$98,000. Since this net amount of $98,000 is the amount that is likely to turn to cash, it is referred to

as the net realizable value of the accounts receivable.

Under the allowance method, the Gem Merchandise Co. does not need to know specifically which

customer will not pay, nor does it need to know the exact amount. This is acceptable because

accountants believe it is better to report an approximate amount that is uncollectible rather than

imply that every penny of the accounts receivable will be collected.

Gem's Bad Debts Expense will report credit losses of $2,000 on its June income statement. This

expense is being reported even though none of the accounts receivables were due in June. (Recall

the credit terms were net 30 days.) Gem is attempting to follow the matching principle by matching

the bad debts expense as best it can to the accounting period in which the credit sales took place.

Here's a TipSince the net realizable value of a company's accounts receivable cannot be more than the debit balance in Accounts Receivable, the balance in the Allowance for Doubtful Accounts must be a credit balance or a zero balance.

89

Allowance for Doubtful Accounts and Bad Debts Expense - July

Now let's assume that at July 31 the Gem Merchandise Co. has a debit balance in Accounts

Receivable of $230,000. (The balance increased during July by the amount of its credit sales and it

decreased by the amount it collected from customers.) The Allowance for Uncollectible Accounts still

has the credit balance of $2,000 from the adjustment on June 30. This means Gem's general ledger

accounts before the July 31 adjustment to Allowance for Uncollectible Accounts will be reporting a

net realizable value of $228,000 ($230,000 minus $2,000).

Gem reviews the details of its accounts receivable and estimates that as of July 31 approximately

$10,000 of the $230,000 will not be collectible. In other words, the net realizable value (or net cash

value) of its accounts receivable as of July 31 is only $220,000 ($230,000 minus $10,000). Before

the July 31 financial statements are released, Gem must adjust the Allowance for Doubtful Accounts

so that its ending balance is a credit of $10,000 (instead of the present credit balance of $2,000).

This requires the following adjusting entry:

After this journal entry is recorded, Gem's July 31 balance sheet will report the net realizable value of

its accounts receivables at $220,000 ($230,000 debit balance in Accounts Receivable minus the

$10,000 credit balance in Allowance for Doubtful Accounts).

Here's a recap in T-account form:

90

As seen in the T-accounts above, Gem estimated that the total bad debts expense for the first two

months of operations (June and July) is $10,000. It is likely that as of July 31 Gem will not know

the precise amount of actual bad debts, nor will Gem know which customers are the ones that won't

be paying their account balances. However, the matching principle is better met by Gem

making these estimates and recording the credit loss as close as possible to the time the sales were

made.

91

By reporting the $10,000 credit balance in Allowance for Doubtful Accounts, Gem is also adhering to

the accounting principle of conservatism. In other words, if there is some doubt as to whether

there are $10,000 of credit losses or no credit losses, Gem's accountant "breaks the tie" by choosing

the alternative that reports a smaller amount of profit and a smaller amount of assets. (It is reporting

a net realizable value of $220,000 instead of the $230,000 of accounts receivable.) If a company

knows with certainty that every penny of its accounts receivable will be collected, then the

Allowance for Doubtful Accounts will report a zero balance. However, if it is likely that some of the

accounts receivable will not be collected in full, the principle of conservatism requires that there be a

credit balance in Allowance for Doubtful Accounts.

Writing Off an Account under the Allowance MethodUnder the allowance method, if a specific customer's accounts receivable is identified as

uncollectible, it is written off by removing the amount from Accounts Receivable. The entry to write

off a bad account affects only balance sheet accounts: a debit to Allowance for Doubtful Accounts

and a credit to Accounts Receivable. No expense or loss is reported on the income statement because this write-off is "covered" under the earlier adjusting entries for estimated bad

debts expense.

Let's illustrate the write-off with the following example. On June 3, a customer purchases $1,400 of

goods on credit from Gem Merchandise Co. On August 24, that same customer informs Gem

Merchandise Co. that it has filed for bankruptcy. The customer states that its bank has a lien on all of

its assets. It also states that the liquidation value of those assets is less than the amount it owes the

bank, and as a result Gem will receive nothing toward its $1,400 accounts receivable. After

confirming this information, Gem concludes that it should remove, or write off, the customer's

account balance of $1,400.

Under the allowance method of recording credit losses, Gem's entry to write off the customer's

account balance is as follows:

The two accounts affected by this entry contain this information:

92

Note that prior to the August 24 entry of $1,400 to write off the uncollectible amount, the net

realizable value of the accounts receivables was $230,000 ($240,000 debit balance in Accounts

Receivable and $10,000 credit balance in Allowance for Doubtful Accounts). After writing off the bad

account on August 24, the net realizable value of the accounts receivable is still $230,000 ($238,600

debit balance in Accounts Receivable and $8,600 credit balance in Allowance for Doubtful

Accounts).

The Bad Debts Expense remains at $10,000; it is not directly affected by the journal entry write-off.

The bad debts expense recorded on June 30 and July 31 had anticipated a credit loss such as

this. It would be double counting for Gem to record both an anticipated estimate of a credit

loss and the actual credit loss.

93

Recovery of Account under Allowance MethodAfter a seller has written off an accounts receivable, it is possible that the seller is paid part or all of

the account balance that was written off. Under the allowance method, if such a payment is received

(whether directly from the customer or as a result of a court action) the seller will take the following

two steps:

1. Reinstate the account that was written off by reversing the write-off entry. If we assume that the $1,400 written off on Aug 24 is collected on October 10, the reinstatement of the account looks like this:

2. Process the $1,400 received on October 10:

The seller's accounting records now show that the account receivable was paid, making it more

likely that the seller might do future business with this customer.

Bad Debts Expense as a Percent of SalesAnother way sellers apply the allowance method of recording bad debts expense is by using

the percentage of credit sales approach. This approach automatically expenses a percentage of

its credit sales based on past history.

For example, let's assume that a company prepares weekly financial statements. Past experience

indicates that 0.3% of its sales on credit will never be collected. Using the percentage of credit sales

94

approach, this company automatically debits Bad Debts Expense and credits Allowance for Doubtful

Accounts for 0.3% of each week's credit sales. Let's assume that in the current week this company

sells $500,000 of goods on credit. It estimates its bad debts expense to be $1,500 (0.003 x

$500,000) and records the following journal entry:

The percentage of credit sales approach focuses on the income statement and the matching

principle. Sales revenues of $500,000 are immediately matched with $1,500 of bad debts expense.

The balance in the account Allowance for Doubtful Accounts is ignored at the time of the weekly

entries. However, at some later date, the balance in the allowance account must be reviewed and

perhaps further adjusted, so that the balance sheet will report the correct net realizable value. If the

seller is a new company, it might calculate its bad debts expense by using an industry average until

it develops its own experience rate.

Difference between Expense and AllowanceThe account Bad Debts Expense reports the credit losses that occur during the period of time

covered by the income statement. Bad Debts Expense is a temporary account on the income

statement, meaning it is closed at the end of each accounting year. (Closed means the account

balance is transferred to retained earnings, perhaps through an income summary account.) By

closing Bad Debts Expense and resetting its balance to zero, the account is ready to receive and

tally the credit losses for the next accounting year.

The Allowance for Doubtful Accounts reports on the balance sheet the estimated amount of

uncollectible accounts that are included in Accounts Receivable. Balance sheet accounts are almost

always permanentaccounts, meaning their balances carry forward to the next accounting period. In

other words, they are not closed and their balances are not reset to zero.

Because the Bad Debts Expense account is closed each year, while the Allowance for Doubtful

Accounts is not, these two balances will most likely not be equal after the company's first year of

operations.

For example, let's assume that at the end of its first year of operations a company's Bad Debts

Expense had a debit balance of $14,000 and its Allowance for Doubtful Accounts had a credit

balance of $14,000. Because the income statement account balances are closed at the end of the

year, the company's opening balance in Bad Debts Expense for the second year of operations is $0.

The credit balance of $14,000 in Allowance for Doubtful Accounts, however, carries forward to the

95

second year. If an adjusting entry of $3,000 is made during year 2, Bad Debts Expense will report a

$3,000 debit balance, while Allowance for Doubtful Accounts might report a credit balance of

$17,000.

Again, the reasons for the account balance differences are 1) Bad Debts Expense is a temporary

account that reports credit losses only for the period shown on the income statement, and 2)

Allowance for Doubtful Accounts is a permanent account that reports an estimated amount for all of

the uncollectible receivables reported in the asset Accounts Receivable as of the balance sheet

date.

Aging of Accounts ReceivableDownload our Aging of Accounts Receivable Form and TemplateThe general ledger account Accounts Receivable usually contains only summary amounts and is

referred to as a control account. The details for the control account—each credit sale for every

customer—is found in the subsidiary ledger for Accounts Receivable. The total amount of all

the details in the subsidiary ledger must be equal to the total amount reported in the control account.

The detailed information in the accounts receivable subsidiary ledger is used to prepare a report

known as theaging of accounts receivable. This report directs management's attention to

accounts that are slow to pay. It is also useful in determining the balance amount needed in the

account Allowance for Doubtful Accounts.

The aging of accounts receivable report is typically generated by sorting unpaid sales invoices in the

subsidiary ledger—first by customer and then by the date of the sales invoices. If a company sells

merchandise (or provides services) and allows customers to pay 30 days later, this report will

indicate how much of its accounts receivable is past due. It also reports how far past due the

accounts are.

With the click of a mouse, most accounting software will provide the aging of accounts receivable

report. For example, Gem Merchandise Co.'s software looks at each of its customer's accounts

receivable activity and compares the date of each unpaid sales invoice to the date of the report. If

we assume the report is dated August 31 and that Gem's credit terms are net 30 days, any unpaid

sales invoices with an August date will be classified as current. Any unpaid invoices with a date in

July are classified as 1 - 30 days past due. Any unpaid invoices with a date of June are classified

as 31 - 60 days past due, and so on. The sorted information is present in a report that looks

similar to the following:

96

If a customer realizes that one of its suppliers is lax about collecting its account receivable on time, it

may take advantage by further postponing payment in order to pay more demanding suppliers on

time. This puts the seller at risk since an older, unpaid accounts receivable is more likely to end up

as a credit loss. The aging of accounts receivable report helps management monitor and collect the

accounts receivable in a more timely manner.

Aging Used in Calculating the Allowance

The aging of accounts receivable can also be used to estimate the credit balance needed in a

company's Allowance for Doubtful Accounts. For example, based on past experience, a company

might make the assumption that accounts not past due have a 99% probability of being collected in

full. Accounts that are 1-30 days past due have a 97% probability of being collected in full, and the

accounts 31-60 days past due have a 90% probability. The company estimates that accounts more

than 60 days past due have only a 60% chance of being collected. With these probabilities of

collection, the probability of not collecting is 1%, 3%, 10%, and 40% respectively.

If we multiply the totals from the aging of accounts receivable report by the probabilities of not

collecting, we arrive at the expected amount of uncollectible receivables. This is illustrated below:

97

This computation estimates the balance needed for Allowance for Doubtful Accounts at August 31 to

be a credit balance of $8,585.

Mailing Statements to CustomersTo improve the probability of collection (and avoid bad debts expense) many sellers prepare and

mail monthly statements to all customers that have accounts receivable balances. If worded skillfully,

the seller can use the statement to say "thank you for your continued business" while at the same

time "reminding" the customer that receivables are being monitored and payment is expected. To

further prompt customers to pay in a timely manner, the statement may indicate that past due

accounts are assessed interest at an annual rate of 18% (1.5% per month). Because transactions

are usually itemized on the statement, some customers use the statement as a means to compare

its records with those of the seller.

Pledging or Selling Accounts ReceivableA company's accounts receivable are considered to be a type of asset, and as such can be pledged

as collateral for a loan. Asset-based lenders will often lend a company an amount equal to 80% of

the value of its accounts receivable.

98

Some companies sell their accounts receivable to a factor. A factor buys the accounts receivables at

a discount and then goes about the business of collecting and keeping the money owed through the

receivables. Sometimes the factor will purchase the accounts receivables with recourse. This

means the company that sold the receivables remains financially responsible if a customer does not

remit the full amount to the factor. When the factor purchases the receivables without recourse,

the company selling the receivables is not responsible for unpaid amounts.

Accounts Receivable RatiosThere are two commonly used financial ratios that address the relationship between the amount of a company's accounts receivable as reported on the balance sheet and the amount of credit sales as reported on the income statement. These ratios are:

1. Accounts receivable turnover ratio, and

2. Days sales in accounts receivable.

Use the following link to learn how to calculate these ratios: Financial Ratios.

Direct Write-off MethodGenerally accepted accounting principles (GAAP) require that companies use the allowance method when preparing financial statements. The use of the allowance method is not permitted, however, for purposes of reporting income taxes in the United States because the Internal Revenue Service (IRS) does not allow companies to anticipate these credit losses. As a result, companies must use the direct write-off method for income tax reporting.In the direct write-off method, a company will not use an allowance account to reduce its Accounts Receivable. Accounts Receivable is only reduced if and when a company knows with certainty that a specific amount will not be collected from a specific customer.For example, let's assume that on October 21, Gem Merchandise Co. is convinced that a specific customer's account receivable originating on June 5 in the amount of $1,238 is definitely uncollectible. Using the direct write-off method, the following entry is made:

99

Usually many months will pass between the time of the sale on credit and the time that the seller knows with certainty that a customer is not going to pay. It is difficult to adhere to the matching principle and the concept of conservatism when a significant amount of time elapses between the time of the sales revenues and the time that the bad debts expense is reported. This is why, for purposes of financial reporting (not tax reporting), companies should use the allowance method rather than the direct write-off method.

Introduction to Activity Based CostingActivity based costing (ABC) assigns manufacturing overhead costs to products in a more logical

manner than the traditional approach of simply allocating costs on the basis of machine hours.

Activity based costing first assigns costs to the activities that are the real cause of the overhead. It

then assigns the cost of those activities only to the products that are actually demanding the

activities.

Let's discuss activity based costing by looking at two products manufactured by the same company.

Product 124 is a low volume item which requires certain activities such as special engineering,

additional testing, and many machine setups because it is ordered in small quantities. A similar

product, Product 366, is a high volume product—running continuously—and requires little attention

and no special activities. If this company used traditional costing, it might allocate or "spread" all of

its overhead to products based on the number of machine hours. This will result in little overhead

cost allocated to Product 124, because it did not have many machine hours. However, it did demand

lots of engineering, testing, and setup activities. In contrast, Product 366 will be allocated an

enormous amount of overhead (due to all those machine hours), but it demanded little overhead

activity. The result will be a miscalculation of each product's true cost of manufacturing overhead.

Activity based costing will overcome this shortcoming by assigning overhead on more than the one

activity, running the machine.

Activity based costing recognizes that the special engineering, special testing, machine setups, and

others are activities that cause costs—they cause the company to consume resources. Under ABC,

the company will calculate the cost of the resources used in each of these activities. Next, the cost of

each of these activities will be assigned only to the products that demanded the activities. In our

example, Product 124 will be assigned some of the company's costs of special engineering, special

testing, and machine setup. Other products that use any of these activities will also be assigned

some of their costs. Product 366 will not be assigned any cost of special engineering or special

testing, and it will be assigned only a small amount of machine setup.

100

Activity based costing has grown in importance in recent decades because (1) manufacturing

overhead costs have increased significantly, (2) the manufacturing overhead costs no longer

correlate with the productive machine hours or direct labor hours, (3) the diversity of products and

the diversity in customers' demands have grown, and (4) some products are produced in large

batches, while others are produced in small batches.

Activity Based Costing with Two ActivitiesLet's illustrate the concept of activity based costing by looking at two common manufacturing

activities: (1) the setting up of a production machine for running batches of products, and (2) the

actual production of the units of product.

We will assume that a company has annual manufacturing overhead costs of $2,000,000—of which

$200,000 is directly involved in setting up the production machines. During the year the company

expects to perform 400 machine setups. Let's also assume that the batch sizes vary

considerably, but the setup efforts for each machine are similar.

The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups per

year). Under activity based costing, $200,000 of the overhead will be viewed as a batch-level cost. This means that $200,000 will first be allocated to batches of products to be manufactured

(referred to as a Stage 1 allocation), and then be assigned to the units of product in each batch

(referred to as Stage 2 allocation). For example, if Batch X consists of 5,000 units of product,

the setup cost per unit is $0.10 ($500 divided by 5,000 units). If Batch Y is 50,000 units, the cost per

unit for setup will be $0.01 ($500 divided by 50,000 units). For simplicity, let's assume that the

remaining $1,800,000 of manufacturing overhead is caused by the production activities that correlate

with the company's 100,000 machine hours.

For our simple two-activity example, let's see how the rates for allocating the manufacturing

overhead would lookwith activity based costing and without activity based costing:

101

Next, let's see what impact these different allocation techniques and overhead rates would have on

the per unit cost of a specific unit of output. Assume that a company manufactures a batch

of 5,000 units and it produces 50 units per machine hour, here is how the cost assigned to the units

with activity based costing and without activity based costing compares:

If a company manufactures a batch of 50,000 units and produces 50 units per machine hour, here

is how the cost assigned to the units with ABC and without ABC compares:

102

As the tables above illustrate, with activity based costing the cost per unit decreases from $0.46 to

$0.37 because the cost of the setup activity is spread over 50,000 units instead of 5,000 units.

Without ABC, the cost per unit is $0.40 regardless of the number of units in each batch. If companies

base their selling prices on costs, a companynot using an ABC approach might lose the large batch

work to a competitor who bids a lower price based on the lower, more accurate overhead cost of

$0.37. It's also possible that a company not using ABC may find itself being the low bidder for

manufacturing small batches of product, since its $0.40 is lower than the ABC model of $0.46 for a

batch size of 5,000 units. With its bid price based on manufacturing overhead of $0.40—but a true

cost of $0.46—the company may end up doing lots of production for little or no profit.

Our example with just two activities (production and setup) illustrates how the cost per unit using the

activity based costing method is more accurate in reflecting the actual efforts associated with

production. As companies began measuring the costs of activities (instead of focusing on the

accountant's departmental classifications), they began using ABC cost information to

practice activity based management. For example, with the cost of setting up a machine now

being measured and discussed, managers began to ask questions such as:

Why is the cost of setting up a production machine so expensive?What can be done to reduce the setup cost?If the setup costs cannot be reduced, are the selling prices adequate to cover all of the company's costs—including the setup cost that was previously buried in the overall machine-hour overhead rate?

Activity Based Costing with Four ActivitiesLet's add two more activities to our example: procurement and material handling. The costs of

these two activities are not caused by—nor do they correlate with—machine hours. Rather, we will

assume that both of these activities are related to the physical weight of the direct material used in

making the product.

The company determines that $300,000 of its annual manufacturing overhead is associated with

procurement and material handling. As a result, the company removes $300,000 from the

manufacturing overhead that will be allocated via machine hours, and instead plans to allocate the

$300,000 to the products based on the weight of the materials used. The company expects that

during the year it will procure and handle 3,000,000 pounds of material. Under activity based

costing, the company will assign $0.10 ($300,000 divided by 3,000,000 pounds) per pound of

product weight to each unit manufactured. The end result is that the heavier parts will not only have

more direct material cost, they will also be assigned more factory overhead than the lighter parts. By

assigning some manufacturing overhead to a product based on the product's weight, the remaining

manufacturing overhead assigned via machine hours will be reduced. These points are illustrated in

the following table:

103

In the table below we can see how ABC would assign costs to the following:

1. A product that weighs 0.5 pound and is produced in a batch of 50,000 units at a rate of 50 per hour.

2. A product that weighs 1.5 pounds and is produced in a batch of 50,000 units at a rate of 50 per hour.

3. No activity based costing allocations—all manufacturing overhead costs are allocated entirely via machine hours.

104

If the manufacturing overhead costs are caused by a number of activities such as setup,

procurement, handling, and production, then using the activity based costing method of determining

costs will give you a result that is closer to the true costs. As you can see, the product that weighs

0.5 pound is assigned $0.36 of manufacturing overhead, while the product weighing 1.5 pounds is

assigned $0.46 of manufacturing overhead. Under the traditional costing allocations the procurement

and handling costs would be assigned on production hours. Keep in mind that whenever

manufacturers have a diverse lineup of products, allocating costs on a single basis (such as

machine hours) will result in inaccurate per-unit manufacturing overhead costs.

Introduction to Adjusting EntriesAdjusting entries are accounting journal entries that convert a company's accounting records to

the accrual basis of accounting. An adjusting journal entry is typically made just prior to

issuing a company's financial statements.To demonstrate the need for an accounting adjusting entry let's assume that a company borrowed

money from its bank on December 1, 2013 and that the company's accounting period ends on

December 31. The bank loan specifies that the first interest payment on the loan will be due on

March 1, 2014. This means that the company's accounting records as of December 31 do not

contain any payment to the bank for the interest the company incurred from December 1 through

December 31. (Of course the loan is costing the company interest expense every day, but the actual

payment for the interest will not occur until March 1.) For the company's December income statement to accurately report the company's profitability, it must include all of the company's

December expenses—not just the expenses that were paid. Similarly, for the company's balance sheet on December 31 to be accurate, it must report a liability for the interest owed as of the

balance sheet date. An adjusting entry is needed so that December's interest expense is included on

December's income statement and the interest due as of December 31 is included on the December

105

31 balance sheet. The adjusting entry will debit Interest Expense and credit Interest Payable for the amount of interest from December 1 to December 31.

Another situation requiring an adjusting journal entry arises when an amount has already been

recorded in the company's accounting records, but the amount is for more than the current

accounting period. To illustrate let's assume that on December 1, 2013 the company paid its

insurance agent $2,400 for insurance protection during the period of December 1, 2013 through May

31, 2014. The $2,400 transaction was recorded in the accounting records on December 1, but the

amount represents six months of coverage and expense. By December 31, one month of the

insurance coverage and cost have been used up or expired. Hence the income statement for

December should report just one month of insurance cost of $400 ($2,400 divided by 6 months) in

the account Insurance Expense. The balance sheet dated December 31 should report the cost of

five months of the insurance coverage that has not yet been used up. (The cost not used up is

referred to as the asset Prepaid Insurance.The cost that is used up is referred to as the expired

cost Insurance Expense.) This means that the balance sheet dated December 31 should report five

months of insurance cost or $2,000 ($400 per month times 5 months) in the asset account Prepaid

Insurance. Since it is unlikely that the $2,400 transaction on December 1 was recorded this way, an

adjusting entry will be needed at December 31, 2013 to get the income statement and balance sheet

to report this accurately.

The two examples of adjusting entries have focused on expenses, but adjusting entries also

involve revenues.This will be discussed later when we prepare adjusting journal entries.

For now we want to highlight some important points.

There are two scenarios where adjusting journal entries are needed before the financial statements

are issued:

Nothing has been entered in the accounting records for certain expenses or revenues, but those expenses and/or revenues did occur and must be included in the current period's income statement and balance sheet.

Something has already been entered in the accounting records, but the amount needs to be divided up between two or more accounting periods.

Adjusting entries almost always involve a

balance sheet account (Interest Payable, Prepaid Insurance, Accounts Receivable, etc.) and an

income statement account (Interest Expense, Insurance Expense, Service Revenues, etc.)

Adjusting Entries - Asset Accounts

106

Adjusting entries assure that both the balance sheet and the income statement are up-to-date on

the accrual basis of accounting. A reasonable way to begin the process is by reviewing the

amount or balance shown in each of the balance sheet accounts. We will use the following

preliminary balance sheet, which reports the account balances prior to any adjusting entries:

Let's begin with the asset accounts:

Cash $1,800The Cash account has a preliminary balance of $1,800—the amount in the general ledger. Before issuing the balance sheet, one must ask, "Is $1,800 the true amount of cash? Does

it agree to the amount computed on the bank reconciliation?" The accountant found that $1,800 was

indeed the true balance. (If the preliminary balance in Cash does not agree to the bank

reconciliation, entries are usually needed. For example, if the bank statement included a service

charge and a check printing charge—and they were not yet entered into the company's accounting

records—those amounts must be entered into the Cash account. See the major topic Bank Reconciliation for a thorough discussion and illustration of the likely journal entries.)Accounts Receivable $4,600

To determine if the balance in this account is accurate the accountant might review the detailed

listing of customers who have not paid their invoices for goods or services. (This is often referred to

as the amount of open or unpaid sales invoices and is often found in the accounts receivable

subsidiary ledger.) When those open invoices are sorted according to the date of the sale, the

company can tell how old the receivables are. Such a report is referred to as an aging of accounts receivable. Let's assume the review indicates that the preliminary balance in

107

Accounts Receivable of $4,600 is accurate as far as the amounts that have been billed and not yet

paid.

However, under the accrual basis of accounting, the balance sheet must report all the amounts the

company has an absolute right to receive—not just the amounts that have been billed on a sales

invoice. Similarly, the income statement should report all revenues that have been earned—not

just the revenues that have been billed. After further review, it is learned that $3,000 of work has

been performed (and therefore has been earned) as of December 31 but won't be billed until

January 10. Because this $3,000 was earned in December, it must be entered and reported on the

financial statements for December. An adjusting entry dated December 31 is prepared in order to get

this information onto the December financial statements.

To assist you in understanding adjusting journal entries, double entry, and debits and credits, each

example of an adjusting entry will be illustrated with a T-account.Here is the process we will follow:

1. Draw two T-accounts. (Every journal entry involves at least two accounts. One account to be debited and one account to be credited.)

2. Indicate the account titles on each of the T-accounts. (Remember that almost always one of the accounts is a balance sheet account and one will be an income statement account. In a smaller font size we will indicate the type of account next to the account title and we will also indicate some tips about debits and credits within the T-accounts.)

3. Enter the preliminary balance in each of the T-accounts.

4. Determine what the ending balance ought to be for the balance sheet account.

5. Make an adjustment so that the ending amount in the balance sheet account is correct.

6. Enter the same adjustment amount into the related income statement account.

7. Write the adjusting journal entry.

Let's follow that process here:

108

The adjusting entry for Accounts Receivable in general journal format is:

Notice that the ending balance in the asset Accounts Receivable is now $7,600—the correct amount

that the company has a right to receive. The income statement account balance has been increased

by the $3,000 adjustment amount, because this $3,000 was also earned in the accounting period but

had not yet been entered into the Service Revenues account. The balance in Service Revenues will

increase during the year as the account is credited whenever a sales invoice is prepared. The

balance in Accounts Receivable also increases if the sale was on credit (as opposed to a cash sale).

However, Accounts Receivable will decrease whenever a customer pays some of the amount owed

to the company. Therefore the balance in Accounts Receivable might be approximately the amount

of one month's sales, if the company allows customers to pay their invoices in 30 days.

At the end of the accounting year, the ending balances in the balance sheet accounts (assets and

liabilities) will carry forward to the next accounting year. The ending balances in the income

statement accounts (revenues and expenses) are closed after the year's financial statements are

prepared and these accounts will start the next accounting period with zero balances.

109

Allowance for Doubtful Accounts $0(It's common not to list accounts with $0 balances on balance sheets.)

Although the Allowance for Doubtful Accounts does not appear on the preliminary balance sheet,

experienced accountants realize that it is likely that some of the accounts receivable might not be

collected. (This could occur because some customers will have unforeseen hardships, some

customers might be dishonest, etc.) If some of the $4,600 owed to the company will not be collected,

the company's balance sheet should report less than $4,600 of accounts receivable. However, rather

than reducing the balance in Accounts Receivable by means of a credit amount, the credit amount

will be reported in Allowance for Doubtful Accounts. (The combination of the debit balance in

Accounts Receivable and the credit balance in Allowance for Doubtful Accounts is referred to as

the net realizable value.)Let's assume that a review of the accounts receivables indicates that approximately $600 of the

receivables will not be collectible. This means that the balance in Allowance for Doubtful Accounts

should be reported as a $600 credit balance instead of the preliminary balance of $0. The two

accounts involved will be the balance sheet account Allowance for Doubtful Accounts and the

income statement account Bad Debts Expense.

The adjusting journal entry for Allowance for Doubtful Accounts is:

110

It is possible for one or both of the accounts to have preliminary balances. However, the balances

are likely to be different from one another. Because Allowance for Doubtful Accounts is a balance

sheet account, its ending balance will carry forward to the next accounting year. Because Bad Debts

Expense is an income statement account, its balance will not carry forward to the next year. Bad

Debts Expense will start the next accounting year with a zero balance.

Supplies $1,100

The Supplies account has a preliminary balance of $1,100. However, a count of the supplies actually

on hand indicates that the true amount of supplies is $725. This means that the preliminary balance

is too high by $375 ($1,100 minus $725). A credit of $375 will need to be entered into the asset

account in order to reduce the balance from $1,100 to $725. The related income statement account

is Supplies Expense.

The adjusting entry for Supplies in general journal format is:

111

Notice that the ending balance in the asset Supplies is now $725—the correct amount of supplies

that the company actually has on hand. The income statement account Supplies Expense has been

increased by the $375 adjusting entry. It is assumed that the decrease in the supplies on hand

means that the supplies have been used during the current accounting period. The balance in

Supplies Expense will increase during the year as the account is debited. Supplies Expense will start

the next accounting year with a zero balance. The balance in the asset Supplies at the end of the

accounting year will carry over to the next accounting year.

Prepaid Insurance $1,500

The $1,500 balance in the asset account Prepaid Insurance is the preliminary balance. The correct

balance needs to be determined. The correct amount is the amount that has been paid by the

company for insurance coverage that will expire after the balance sheet date. If a review of the

payments for insurance shows that $600 of the insurance payments is for insurance that will expire

after the balance sheet date, then the balance in Prepaid Insurance should be $600. All other

amounts should be charged to Insurance Expense.

112

The adjusting journal entry for Prepaid Insurance is:

Note that the ending balance in the asset Prepaid Insurance is now $600—the correct amount of

insurance that has been paid in advance. The income statement account Insurance Expense has

been increased by the $900 adjusting entry. It is assumed that the decrease in the amount prepaid

was the amount being used or expiring during the current accounting period. The balance in

Insurance Expense starts with a zero balance each year and increases during the year as the

account is debited. The balance at the end of the accounting year in the asset Prepaid Insurance will

carry over to the next accounting year.

Equipment $25,000

Equipment is a long-term asset that will not last indefinitely. The cost of equipment is recorded in the

account Equipment. The $25,000 balance in Equipment is accurate, so no entry is needed in this

account. As an asset account, the debit balance of $25,000 will carry over to the next accounting

year.

Accumulated Depreciation - Equipment $7,500

Accumulated Depreciation - Equipment is a contra asset account and its preliminary balance

of $7,500 is the amount of depreciation actually entered into the account since the Equipment

was acquired. The correct balance should be the cumulative amount of depreciation from the time

that the equipment was acquired through the date of the balance sheet. A review indicates that as of

December 31 the accumulated amount of depreciation should be $9,000. Therefore the account

Accumulated Depreciation - Equipment will need to have an ending balance of $9,000. This will

require an additional $1,500 credit to this account. The income statement account that is pertinent to

this adjusting entry and which will be debited for $1,500 is Depreciation Expense - Equipment.

113

The adjusting entry for Accumulated Depreciation in general journal format is:

The ending balance in the contra asset account Accumulated Depreciation - Equipment at the end of

the accounting year will carry forward to the next accounting year. The ending balance in

Depreciation Expense - Equipment will be closed at the end of the current accounting period and this

account will begin the next accounting year with a balance of $0.

Adjusting Entries - Liability AccountsNotes Payable $5,000

Notes Payable is a liability account that reports the amount of principal owed as of the balance sheet

date. (Any interest incurred but not yet paid as of the balance sheet date is reported in a separate

liability account Interest Payable.) The accountant has verified that the amount of principal actually

114

owed is the same as the amount appearing on the preliminary balance sheet. Therefore, no entry is

needed for this account.

Interest Payable $0

(It's common not to list accounts with $0 balances on balance sheets.)

Interest Payable is a liability account that reports the amount of interest the company owes as of the

balance sheet date. Accountants realize that if a company has a balance in Notes Payable, the

company should be reporting some amount in Interest Expense and in Interest Payable. The

reason is that each day that the company owes money it is incurring interest expense and an

obligation to pay the interest. Unless the interest is paid up to date, the company will always owe

some interest to the lender.

Let's assume that the company borrowed the $5,000 on December 1 and agrees to make the first

interest payment on March 1. If the loan specifies an annual interest rate of 6%, the loan will cost the

company interest of $300 per year or $25 per month. On March 1 the company will be required to

pay $75 of interest. On the December income statement the company must report one month of

interest expense of $25. On the December 31 balance sheet the company must report that it owes

$25 as of December 31 for interest.

The adjusting journal entry for Interest Payable is:

115

It is unusual that the amount shown for each of these accounts is the same. In the future months the

amounts will be different. Interest Expense will be closed automatically at the end of each

accounting year and will start the next accounting year with a $0 balance.

Accounts Payable $2,500

Accounts Payable is a liability account that reports the amounts owed to suppliers or vendors as of

the balance sheet date. Amounts are routinely entered into this account after a company has

received and verified all of the following: (1) an invoice from the supplier, (2) goods or services have

been received, and (3) compared the amounts to the company's purchase order. A review of the

details confirms that this account's balance of $2,500 is accurate as far as invoices received from

vendors.

However, under the accrual basis of accounting the balance sheet must report all the amounts owed

by the company—not just the amounts that have been entered into the accounting system from

vendor invoices. Similarly, the income statement must report all expenses that have been incurred—

not merely the expenses that have been entered from a vendor's invoice. To illustrate this, assume

that a company had $1,000 of plumbing repairs done in late December, but the company has not yet

received an invoice from the plumber. The company will have to make an adjusting entry to record

the expense and the liability on the December financial statements. The adjusting entry will involve

the following accounts:

116

The adjusting entry for Accounts Payable in general journal format is:

The balance in the liability account Accounts Payable at the end of the year will carry forward to the

next accounting year. The balance in Repairs & Maintenance Expense at the end of the accounting

year will be closed and the next accounting year will begin with $0.

Wages Payable $1,200

Wages Payable is a liability account that reports the amounts owed to employees as of the balance

sheet date. Amounts are routinely entered into this account when the company's payroll records are

processed. A review of the details confirms that this account's balance of $1,200 is accurate as far

as the payrolls that have been processed.

However, under the accrual basis of accounting the balance sheet must report all of the payroll

amounts owed by the company—not just the amounts that have been processed. Similarly, the

income statement must report all of the payroll expenses that have been incurred—not merely the

expenses from the routine payroll processing. For example, assume that December 30 is a Sunday

117

and the first day of the payroll period. The wages earned by the employees on December 30-31 will

be included in the payroll processing for the week of December 30 through January 5. However, the

December income statement and the December 31 balance sheet need to include the wages for

December 30-31, but not the wages for January 1-5. If the wages for December 30-31 amount to

$300, the following adjusting entry is required as of December 31:

The adjusting journal entry for Wages Payable is:

The $1,500 balance in Wages Payable is the true amount not yet paid to employees for their work

through December 31. The $13,420 of Wages Expense is the total of the wages used by the

company through December 31. The Wages Payable amount will be carried forward to the next

accounting year. The Wages Expense amount will be zeroed out so that the next accounting year

begins with a $0 balance.

Unearned Revenues $1,300

118

Unearned Revenues is a liability account that reports the amounts received by a company but have

not yet been earned by the company. For example, if a company required a customer with a poor

credit rating to pay $1,300 before beginning any work, the company increases its asset Cash by

$1,300 and it should increase its liability Unearned Revenues by $1,300.

As the company does the work, it will reduce the Unearned Revenues account balance and increase

its Service Revenues account balance by the amount earned (work performed). A review of the

balance in Unearned Revenues reveals that the company did indeed receive $1,300 from a

customer earlier in December. However, during the month the company provided the customer with

$800 of services. Therefore, at December 31 the amount of services due to the customer is $500.

Let's visualize this situation with the following T-accounts:

The adjusting entry for Unearned Revenues in general journal format is:

Since Unearned Revenues is a balance sheet account, its balance at the end of the accounting year

will carry over to the next accounting year. On the other hand Service Revenues is an income

119

statement account and its balance will be closed when the current year is over. Revenues and

expenses always start the next accounting year with $0.

Accruals & DeferralsAdjusting entries are often sorted into two groups: accruals and deferrals.

Accruals

Accruals (or accrual-type adjusting entries) involve both expenses and revenues and are associated with the first scenario mentioned in the introduction to this topic:

Nothing has been entered in the accounting records for certain expenses and/or revenues, but those expenses and/or revenues did occur and must be included in the current period's income statement and balance sheet.

Accrual of Expenses

An accountant might say, "We need to accrue the interest expense on the bank loan." That statement is made because nothing had been recorded in the accounts for interest expense, but the company did indeed incur interest expense during the accounting period. Further, the company has a liability or obligation for the unpaid interest up to the end of the accounting period. What the accountant is saying is that an accrual-type adjusting journal entry needs to be recorded.

The accountant might also say, "We need to accrue for the wages earned by the employees on Sunday, December 30, and Monday, December 31." This means that an accrual-type adjusting entry is needed because the company incurred wages expenses on December 30-31 but nothing will be entered routinely into the accounting records by the end of the accounting period on December 31.

A third example is the accrual of utilities expense. Utilities provide the service (gas, electric, telephone) and then bill for the service they provided based on some type of metering. As a result the company will incur the utility expense before it receives a bill and before the accounting period ends. Hence, an accrual-type adjusting journal entry must be made in order to properly report the correct amount of utilities expenses on the current period's income statement and the correct amount of liabilities on the balance sheet.

Accrual of Revenues

Accountants also use the term "accrual" or state that they must "accrue" when discussing revenues that fit the first scenario. For example, an accountant might say,

120

"We need to accrue for the interest the company has earned on its certificate of deposit." In that situation the company probably did not receive any interest nor did the company record any amounts in its accounts, but the company did indeed earn interest revenue during the accounting period. Further the company has the right to the interest earned and will need to list that as an asset on its balance sheet.

Similarly, the accountant might say, "We need to prepare an accrual-type adjusting entry for the revenues we earned by providing services on December 31, even though they will not be billed until January."

Deferrals

Deferrals or deferral-type adjusting entries can pertain to both expenses and revenues and refer to the second scenario mentioned in the introduction to this topic:

Something has already been entered in the accounting records, but the amount needs to be divided up between two or more accounting periods.

Deferral of Expenses

An accountant might say, "We need to defer some of the insurance expense." That statement is made because the company may have paid on December 1 the entire bill for the insurance coverage for the six-month period of December 1 through May 31. However, as of December 31 only one month of the insurance is used up. Hence the cost of the remaining five months is deferred to the balance sheet account Prepaid Insurance until it is moved to Insurance Expense during the months of January through May. If the company prepares monthly financial statements, a deferral-type adjusting entry may be needed each month in order to move one-sixth of the six-month cost from the asset account Prepaid Insurance to the income statement account Insurance Expense.The accountant might also say, "We need to defer some of the cost of supplies." This deferral is necessary because some of the supplies purchased were not used or consumed during the accounting period. An adjusting entry will be necessary to defer to the balance sheet the cost of the supplies not used, and to have only the cost of supplies actually used being reported on the income statement. The costs of the supplies not yet used are reported in the balance sheet account Supplies and the cost of the supplies used during the accounting period are reported in the income statement account Supplies Expense.

Deferral of Revenues

Deferrals also involve revenues. For example if a company receives $600 on December 1 in exchange for providing a monthly service from December 1 through May 31, the accountant should "defer" $500 of the amount to a liability account Unearned

121

Revenues and allow $100 to be recorded as December service revenues. The $500 in Unearned Revenues will be deferred until January through May when it will be moved with a deferral-type adjusting entry from Unearned Revenues to Service Revenues at a rate of $100 per month.

Avoiding Adjusting EntriesIf you want to minimize the number of adjusting journal entries, you could arrange for each period's expenses to be paid in the period in which they occur. For example, you could ask your bank to charge your company's checking account at the end of each month with the current month's interest on your company's loan from the bank. Under this arrangement December's interest expense will be paid in December, January's interest expense will be paid in January, etc. You simply record the interest payment and avoid the need for an adjusting entry. Similarly, your insurance company might automatically charge your company's checking account each month for the insurance expense that applies to just that one month.

Introduction to Balance SheetThe accounting balance sheet is one of the major financial statements used by accountants and

business owners. (The other major financial statements are the income statement, statement of cash flows, and statement of stockholders' equity) The

balance sheet is also referred to as the statement of financial position.

The balance sheet presents a company's financial position at the end of a specified date. Some

describe the balance sheet as a "snapshot" of the company's financial position at a point (a moment

or an instant) in time. For example, the amounts reported on a balance sheet dated December 31,

2012 reflect that instant when all the transactions through December 31 have been recorded.

Because the balance sheet informs the reader of a company's financial position as of one moment in

time, it allows someone—like a creditor—to see what a company owns as well as what it owes to

other parties as of the date indicated in the heading. This is valuable information to the banker who

wants to determine whether or not a company qualifies for additional credit or loans. Others who

would be interested in the balance sheet include current investors, potential investors, company

management, suppliers, some customers, competitors, government agencies, and labor unions.

In Part 1 we will explain the components of the balance sheet and in Part 2 we will present a

sample balance sheet. If you are interested in balance sheet analysis, that is included in

the Explanation of Financial Ratios.We will begin our explanation of the accounting balance sheet with its major components, elements,

or major categories:

Assets

122

Liabilities Owner's (Stockholders') Equity

AssetsAssets are things that the company owns. They are the resources of the company that have been

acquired through transactions, and have future economic value that can be measured and

expressed in dollars. Assets also include costs paid in advance that have not yet expired, such as

prepaid advertising, prepaid insurance, prepaid legal fees, and prepaid rent. (For a discussion of

prepaid expenses go to Explanation of Adjusting Entries.)Examples of asset accounts that are reported on a company's balance sheet include:

Cash Petty Cash Temporary Investments Accounts Receivable Inventory Supplies Prepaid Insurance Land Land Improvements Buildings Equipment Goodwill Bond Issue Costs Etc.

Usually asset accounts will have debit balances.

Contra assets are asset accounts with credit balances. (A credit balance in an asset account is

contrary—or contra—to an asset account's usual debit balance.) Examples of contra asset accounts

include:

Allowance for Doubtful Accounts Accumulated Depreciation-Land Improvements Accumulated Depreciation-Buildings Accumulated Depreciation-Equipment Accumulated Depletion Etc.

Classifications Of Assets On The Balance SheetAccountants usually prepare classified balance sheets. "Classified" means that the balance

sheet accounts are presented in distinct groupings, categories, or classifications. The asset classifications and their order of appearance on the balance sheet are:

Current Assets

123

Investments Property, Plant, and Equipment Intangible Assets Other Assets

An outline of a balance sheet using the balance sheet classifications is shown here:

To see how various asset accounts are placed within these classifications, view the sample balance sheet in Part 4.

Effect of Cost Principle and Monetary Unit Assumption

The amounts reported in the asset accounts and on the balance sheet reflect actual costs recorded

at the time of a transaction. For example, let's say a company acquires 40 acres of land in the year

1950 at a cost of $20,000. Then, in 1990, it pays $400,000 for an adjacent 40-acre parcel. The

company's Land account will show a balance of $420,000 ($20,000 for the first parcel plus

$400,000 for the second parcel.). This account balance of $420,000 will appear on today's balance

sheet even though these parcels of land have appreciated to a current market value of $3,000,000.

There are two guidelines that oblige the accountant to report $420,000 on the balance sheet rather

than the current market value of $3,000,000: (1) the cost principle directs the accountant to

report the company's assets at their original historical cost, and (2) the monetary unit assumption directs the accountant to presume the U.S. dollar is stable over time—it is not

affected by inflation or deflation. In effect, the accountant is assuming that a 1950 dollar, a 1990

dollar, and a 2013 dollar all have the same purchasing power.

The cost principle and monetary unit assumption may also mean that some very valuable resources

will not be reported on the balance sheet. A company's team of brilliant scientists will not be listed as

an asset on the company's balance sheet, because (a) the company did not purchase the team in a

transaction (cost principle) and (b) it's impossible for accountants to know how to put a dollar value

on the team (monetary unit assumption).

124

Coca-Cola's logo, Nike's logo, and the trade names for most consumer products companies are

likely to be their most valuable assets. If those names and logos were developed internally, it is

reasonable that they will not appear on the company balance sheet. If, however, a company

should purchase a product name and logo from another company, that cost will appear as an asset

on the balance sheet of the acquiring company.

Remember, accounting principles and guidelines place some limitations on what is reported as an

asset on the company's balance sheet.

Effect of Conservatism

While the cost principle and monetary unit assumption generally prevent assets from being reported

on the balance sheet at an amount greater than cost, conservatism will result in some assets being

reported at less than cost. For example, assume the cost of a company's inventory was $30,000,

but now the current cost of the same items in inventory has dropped to $27,000. The conservatism

guideline instructs the company to report Inventory on its balance sheet at $27,000. The $3,000

difference is reported immediately as a loss on the company's income statement.

Effect of Matching Principle

The matching principle will also cause certain assets to be reported on the accounting balance sheet

at less than cost. For example, if a company has Accounts Receivable of $50,000 but anticipates

that it will collect only $48,500 due to some customers' financial problems, the company will report a

credit balance of $1,500 in the contra asset account Allowance for Doubtful Accounts. The

combination of the asset Accounts Receivable with a debit balance of $50,000 and the contra asset

Allowance for Doubtful Accounts with a credit balance will mean that the balance sheet will report

the net amount of $48,500. The income statement will report the $1,500 adjustment as Bad Debts

Expense.

The matching principle also requires that the cost of buildings and equipment be depreciated over

their useful lives. This means that over time the cost of these assets will be moved from the balance

sheet to Depreciation Expense on the income statement. As time goes on, the amounts reported on

the balance sheet for these long-term assets will be reduced. (For a further discussion on

depreciation, go to Explanation of Depreciation.)

LiabilitiesLiabilities are obligations of the company; they are amounts owed to creditors for a past transaction

and they usually have the word "payable" in their account title. Along with owner's equity, liabilities

can be thought of as asource of the company's assets. They can also be thought of as a

claim against a company's assets. For example, a company's balance sheet reports assets of

$100,000 and Accounts Payable of $40,000 and owner's equity of $60,000. The source of the

company's assets are creditors/suppliers for $40,000 and the owners for $60,000. The

125

creditors/suppliers have a claim against the company's assets and the owner can claim what

remains after the Accounts Payable have been paid.

Liabilities also include amounts received in advance for future services. Since the amount received

(recorded as the asset Cash) has not yet been earned, the company defers the reporting

of revenues and instead reports a liability such as Unearned Revenues or Customer Deposits.

(For a further discussion on deferred revenues/prepayments see the Explanation of Adjusting Entries.)Examples of liability accounts reported on a company's balance sheet include:

Notes Payable Accounts Payable Salaries Payable Wages Payable Interest Payable Other Accrued Expenses Payable Income Taxes Payable Customer Deposits Warranty Liability Lawsuits Payable Unearned Revenues Bonds Payable Etc.

Liability accounts will normally have credit balances.

Contra liabilities are liability accounts with debit balances. (A debit balance in a liability account

is contrary—or contra—to a liability account's usual credit balance.) Examples of contra liability

accounts include:

Discount on Notes Payable Discount on Bonds Payable Etc.

Classifications Of Liabilities On The Balance Sheet

Liability and contra liability accounts are usually classified (put into distinct groupings, categories, or

classifications) on the balance sheet. The liability classifications and their order of

appearance on the balance sheet are:

Current Liabilities Long Term Liabilities Etc.

To see how various liability accounts are placed within these classifications, click here to view the sample balance sheet in Part 4.

126

Commitments

A company's commitments (such as signing a contract to obtain future services or to purchase

goods) may belegally binding, but they are not considered a liability on the balance sheet until

some services or goods have been received. Commitments (if significant in amount) should be

disclosed in the notes to the balance sheet.

Form vs. Substance

The leasing of a certain asset may—on the surface—appear to be a rental of the asset, but in

substance it may involve a binding agreement to purchase the asset and to finance it through

monthly payments. Accountants must look past the form and focus on the substance of the

transaction. If, in substance, a lease is an agreement to purchase an asset and to create a note

payable, the accounting rules require that the asset and the liability be reported in the accounts and

on the balance sheet.

Contingent Liabilities

Three examples of contingent liabilities include warranty of a company's products, the guarantee of

another party's loan, and lawsuits filed against a company. Contingent liabilities are potential

liabilities. Because they are dependent upon some future event occurring or not occurring, they may

or may not become actual liabilities.

To illustrate this, let's assume that a company is sued for $100,000 by a former employee who

claims he was wrongfully terminated. Does the company have a liability of $100,000? It depends. If

the company was justified in the termination of the employee and has documentation and witnesses

to support its action, this might be considered a frivolous lawsuit and there may be no liability. On the

other hand, if the company was not justified in the termination and it is clear that the company acted

improperly, the company will likely have an income statement loss and a balance sheet liability.

The accounting rules for these contingencies are as follows: If the contingent loss

is probable and the amount of the loss can be estimated, the company needs to record a

liability on its balance sheet and a loss on its income statement. If the contingent loss is remote, no

liability or loss is recorded and there is no need to include this in the notes to the financial

statements. If the contingent loss lies somewhere in between, it should be disclosed in the notes to

the financial statements.

Current vs. Long-term Liabilities

If a company has a loan payable that requires it to make monthly payments for several years, only

the principaldue in the next twelve months should be reported on the balance sheet as

a current liability. The remaining principal amount should be reported as a long-term liability. The interest on the loan that pertains to the future is not recorded on the balance sheet;

only unpaid interest up to the date of the balance sheet is reported as a liability.

127

Notes to the Financial Statements

As the above discussion indicates, the notes to the financial statements can reveal important

information that should not be overlooked when reading a company's balance sheet.

Owner's (Stockholders') EquityOwner's Equity—along with liabilities—can be thought of as a source of the company's assets.

Owner's equity is sometimes referred to as the book value of the company, because owner's

equity is equal to the reported asset amounts minus the reported liability amounts.

Owner's equity may also be referred to as the residual of assets minus liabilities. These

references make sense if you think of the basic accounting equation:

Assets = Liabilities + Owner's Equity

and just rearrange the terms:

Owner's Equity = Assets - Liabilities

"Owner's Equity" are the words used on the balance sheet when the company is a sole proprietorship. If the company is a corporation, the words Stockholders' Equity are used instead

of Owner's Equity. An example of an owner's equity account is Mary Smith, Capital (where

Mary Smith is the owner of the sole proprietorship). Examples of stockholders' equity accounts

include:

Common Stock Preferred Stock Paid-in Capital in Excess of Par Value Paid-in Capital from Treasury Stock Retained Earnings Etc.

Both owner's equity and stockholders' equity accounts will normally have credit balances.

Contra owner's equity accounts are a category of owner equity accounts

with debit balances. (A debit balance in an owner's equity account is contrary—or contra—to an

owner's equity account's usual credit balance.) An example of a contra owner's equity account

is Mary Smith, Drawing (where Mary Smith is the owner of the sole proprietorship). An

example of a contra stockholders' equity account is Treasury Stock.

Classifications of Owner's Equity On The Balance Sheet

Owner's equity is generally represented on the balance sheet with two or three accounts (e.g., Mary

Smith, Capital; Mary Smith, Drawing; and perhaps Current Year's Net Income). See

the sample balance sheet in Part 4.

128

The stockholders' equity section of a corporation's balance sheet is:

Paid-in Capital Retained Earnings Treasury Stock

The stockholders' equity section of a corporation's balance sheet is:

Owner's Equity vs. Company's Market Value

Since the asset amounts report the cost of the assets at the time of the transaction—or less—they

do not reflect current fair market values. (For example, computers which had a cost of $100,000 two

years ago may now have abook value of $60,000. However, the current value of the computers

might be just $35,000. An office building purchased by the company 15 years ago at a cost of

$400,000 may now have a book value of $200,000. However, the current value of the building might

be $900,000.) Since the assets are not reported on the balance sheet at their current fair market

value, owner's equity appearing on the balance sheet is not an indication of the fair market value of

the company.

Owner's Equity and Temporary Accounts

Revenues, gains, expenses, and losses are income statement accounts. Revenues and gains cause

owner's equity to increase. Expenses and losses cause owner's equity to decrease. If a company

performs a service and increases its assets, owner's equity will increase when the Service Revenues account is closed to owner's equity at the end of the accounting year.

Sample Balance SheetMost accounting balance sheets classify a company's assets and liabilities into distinctive groupings

such as Current Assets; Property, Plant, and Equipment; Current Liabilities; etc. These

129

classifications make the balance sheet more useful. The following balance sheet example is

a classified balance sheet.

Download More Sample Balance Sheets Whether you are a business person or student of business, our Master Set of 87 Business Forms will assist you in preparing financial statements, financial ratios, break-even calculations, depreciation, standard cost variances, and much, much more.

130

Notes To Financial StatementsThe notes (or footnotes) to the balance sheet and to the other financial statements are considered to

be part of the financial statements. The notes inform the readers about such things as significant

accounting policies, commitments made by the company, and potential liabilities and potential

losses. The notes contain information that is critical to properly understanding and analyzing a

company's financial statements.

It is common for the notes to the financial statements to be 10-20 pages in length. Go to the website

for a company whose stock is publicly traded and locate its annual report. Review the notes near the

end of the annual report.

Financial RatiosA number of important financial ratios and statistics are generated by using amounts that are taken

from the balance sheet. For an illustration of some of these computations see our Explanation of Financial Ratios.

Introduction to Bank ReconciliationA company's general ledger account Cash contains a record of the transactions (checks

written, receipts from customers, etc.) that involve its checking account. The bank also creates a

record of the company's checking account when it processes the company's checks, deposits,

service charges, and other items. Soon after each month ends the bank usually mails a bank statement to the company. The bank statement lists the activity in the bank account during the

recent month as well as the balance in the bank account.

When the company receives its bank statement, the company should verify that the amounts on the

bank statement are consistent or compatible with the amounts in the company's Cash account in its

general ledger and vice versa. This process of confirming the amounts is referred to as reconciling the bank statement, bank statement reconciliation, bank reconciliation, or doing a "bank rec." The benefit of reconciling the bank statement is knowing that the amount of Cash

reported by the company (company's books) is consistent with the amount of cash shown in the

bank's records.

131

Because most companies write hundreds of checks each month and make many deposits,

reconciling the amounts on the company's books with the amounts on the bank statement can be

time consuming. The process is complicated because some items appear in the company's Cash

account in one month, but appear on the bank statement in a different month. For example, checks

written near the end of August are deducted immediately on the company's books, but those checks

will likely clear the bank account in early September. Sometimes the bank decreases the

company's bank account without informing the company of the amount. For example, a bank service

charge might be deducted on the bank statement on August 31, but the company will not learn of the

amount until the company receives the bank statement in early September. From these two

examples, you can understand why there will likely be a difference in the balance on the bank statement vs. the balance in the Cash account on the company's books. It is also possible

(perhaps likely) that neither balance is the true balance. Both balances may need adjustment in

order to report the true amount of cash.

After you adjust the balance per bank to be the true balance and after you adjust the balance per books to also be the same true balance, you have reconciled the bank statement. Most

accountants would simply say that you have done the bank reconciliation or the bank rec.

Bank Reconciliation Process

Step 1. Adjusting the Balance per Bank

We will demonstrate the bank reconciliation process in several steps. The first step is to adjust

the balance on the bank statement to the true, adjusted, or corrected balance. The items

necessary for this step are listed in the following schedule:

Deposits in transit are amounts already received and recorded by the company, but are not

yet recorded by the bank. For example, a retail store deposits its cash receipts of August 31 into the

bank's night depository at 10:00 p.m. on August 31. The bank will process this deposit on the

morning of September 1. As of August 31 (the bank statement date) this is a deposit in transit.

Because deposits in transit are already included in the company's Cash account, there is no need to

adjust the company's records. However, deposits in transit are not yet on the bank statement.

Therefore, they need to be listed on the bank reconciliation as an increase to the balance per bank in order to report the true amount of cash.

132

A helpful rule of thumb is "put it where it isn't." A deposit in transit is on the company's books, but it isn't on the bank statement. Put it where it isn't: as an adjustment to the balance on the bank statement.

Outstanding checks are checks that have been written and recorded in the company's Cash

account, but havenot yet cleared the bank account. Checks written during the last few days of the

month plus a few older checks are likely to be among the outstanding checks.

Because all checks that have been written are immediately recorded in the company's Cash

account, there is no need to adjust the company's records for the outstanding checks. However, the

outstanding checks have not yet reached the bank and the bank statement. Therefore, outstanding

checks are listed on the bank reconciliation as a decrease in the balance per bank.

Recall the helpful tip "put it where it isn't." An outstanding check is on the company's books, but it isn't on the bank statement. Put it where it isn't: as an adjustment to the balance on the bank statement.

Bank errors are mistakes made by the bank. Bank errors could include the bank recording an

incorrect amount, entering an amount that does not belong on a company's bank statement, or

omitting an amount from a company's bank statement. The company should notify the bank of its

errors. Depending on the error, the correction could increase or decrease the balance shown on the bank statement. (Since the company did not make the error, the company's records are

not changed.)

Step 2. Adjusting the Balance per Books

The second step of the bank reconciliation is to adjust the balance in the company's Cash account

so that it is the true, adjusted, or corrected balance. Examples of the items involved are shown in the

following schedule:

Bank service charges are fees deducted from the bank statement for the bank's processing of

the checking account activity (accepting deposits, posting checks, mailing the bank statement, etc.)

Other types of bank service charges include the fee charged when a company overdraws its

checking account and the bank fee for processing a stop payment order on a company's

check. The bank might deduct these charges or fees on the bank statement without notifying the

company. When that occurs the company usually learns of the amounts only after receiving its bank

statement.

133

Because the bank service charges have already been deducted on the bank statement, there is no

adjustment to the balance per bank. However, the service charges will have to be entered as an

adjustment to the company's books. The company's Cash account will need to be decreased by the

amount of the service charges.

Recall the helpful tip "put it where it isn't." A bank service charge is already listed on the bank statement, but it isn't on the company's books. Put it where it isn't: as an adjustment to the Cash account on the company's books.

An NSF check is a check that was not honored by the bank of the person or company writing the

check because that account did not have a sufficient balance. As a result, the check is returned

without being honored or paid. (NSF is the acronym for not sufficient funds. Often the bank

describes the returned check as a return item. Others refer to the NSF check as a "rubber

check" because the check "bounced" back from the bank on which it was written.) When the NSF

check comes back to the bank in which it was deposited, the bank will decrease the checking

account of the company that had deposited the check. The amount charged will be the amount of

the check plus a bank fee.

Because the NSF check and the related bank fee have already been deducted on the bank

statement, there is no need to adjust the balance per the bank. However, if the company has not yet

decreased its Cash account balance for the returned check and the bank fee, the company must

decrease the balance per books in order to reconcile.

Check printing charges occur when a company arranges for its bank to handle the reordering

of its checks. The cost of the printed checks will automatically be deducted from the company's

checking account.

Because the check printing charges have already been deducted on the bank statement, there is no

adjustment to the balance per bank. However, the check printing charges need to be an adjustment

on the company's books. They will be a deduction to the company's Cash account.

Recall the general rule, "put it where it isn't." A check printing charge is on the bank statement, but it isn't on the company's books. Put it where it isn't: as an adjustment to the Cash account on the company's books.

Interest earned will appear on the bank statement when a bank gives a company interest on its

account balances. The amount is added to the checking account balance and is automatically on the

bank statement. Hence there is no need to adjust the balance per the bank statement. However, the

amount of interest earned will increase the balance in the company's Cash account on its books.

Recall "put it where it isn't." Interest received from the bank is on the bank statement, but it isn't on the company's books. Put it where it isn't: as an adjustment to the Cash account on the company's books.

Notes Receivable are assets of a company. When notes come due, the company might ask its

bank to collect the notes receivable. For this service the bank will charge a fee. The bank will

increase the company's checking account for the amount it collected (principal and interest) and will

decrease the account by the collection fee it charges.Since these amounts are already on the bank

134

statement, the company must be certain that the amounts appear on the company's books in its

Cash account.

Recall the tip "put it where it isn't." The amounts collected by the bank and the bank's fees are on the bank statement, but they are not on the company's books. Put them where they aren't: as adjustments to the Cash account on the company's books.

Errors in the company's Cash account result from the company entering an incorrect amount,

entering a transaction that does not belong in the account, or omitting a transaction that should be in

the account. Since the company made these errors, the correction of the error will be either an

increase or a decrease to the balance in the Cash account on the company's books.

Step 3. Comparing the Adjusted Balances

After adjusting the balance per bank (Step 1) and after adjusting the balance per books (Step

2), the two adjusted amounts should be equal. If they are not equal, you must repeat the process

until the balances are identical. The balances should be the true, correct amount of cash as of the

date of the bank reconciliation.

Step 4. Preparing Journal Entries

Journal entries must be prepared for the adjustments to the balance per books (Step 2).

Adjustments to increase the cash balance will require a journal entry that debits Cash and credits

another account. Adjustments to decrease the cash balance will require a credit to Cash and a debit

to another account.

Sample Bank Reconciliation with AmountsIn this part we will provide you with a sample bank reconciliation including the required journal

entries. We will assume that a company has the following items:

Item #1. The bank statement for August 2013 shows an ending balance of $3,490.

Item #2.

On August 31 the bank statement shows charges of $35 for the service charge for maintaining the checking account.

Item #3. On August 28 the bank statement shows a return item of $100 plus a related bank fee of $10. The return item is a customer's check that was returned because of insufficient funds. The check was also marked "do

135

not redeposit."

Item #4.

The bank statement shows a charge of $80 for check printing on August 20.

Item #5.

The bank statement shows that $8 was added to the checking account on August 31 for interest earned by the company during the month of August.

Item #6.

The bank statement shows that a note receivable of $1,000 was collected by the bank on August 29 and was deposited into the company's account. On the same day, the bank withdrew $40 from the company's account as a fee for collecting the note receivable.

Item #7. The company's Cash account at the end of August shows a balance of $967.

Item #8.

During the month of August the company wrote checks totaling more than $50,000. As of August 31 $3,021 of the checks written in August had not yet cleared the bank and $200 of checks written in June had not yet cleared the bank.

Item #9.

The $1,450 of cash received by the company on August 31 was recorded on the company's books as of August 31. However, the $1,450 of cash receipts was deposited at the bank on the morning of September 1.

Item #10.

On August 29 the company's Cash account shows cash sales of $145. The bank statement shows the amount deposited was actually $154. The company reviewed the transactions and found that $154 was the correct amount.

Before we begin our sample bank reconciliation, learn the following bank reconciliation tip.

Here's a TipPut it where it isn't.If an item appears on the bank statement but not on the company's books, the item is probably going to be an adjustment to the Cash balance on (per) the company's books.

If an item is already in the company's Cash account, but has not yet appeared on the bank statement, the item is probably an adjustment to the balance per the bank statement.

136

Our approach to the bank reconciliation is to prepare two schedules. The first schedule begins with

the ending balance on the bank statement. We refer to this schedule as Step 1. The second

schedule begins with the ending Cash account balance in the general ledger. We call this schedule

Step 2.

Items 1 through 10 above have been sorted into the following schedules labeled Step 1 and Step 2. The item number is shown in the far right column of each schedule.

Step 1 Amounts

Let's review the schedule for Step 1. In all likelihood the balance shown on the bank statement

is not the true balance to be reported on the company's balance sheet. The bank reconciliation

process is to list the items that will adjust the bank statement balance to become the true cash

balance. As the schedule for Step 1 indicates, the amount of deposits in transit must be added to

the bank statement's balance. Also, the amount of checks that have been written, but not yet

appearing on a bank statement, must be subtracted from the bank statement's balance. Next any

bank errors should be listed and should be reported to the bank for correction. (The company

does not report deposits in transit and/or outstanding checks to the bank.)

Step 2 Amounts and Required Journal Entries

Step 2 begins with the balance in the company's Cash account found in its general ledger. The bank

reconciliation process includes listing the items that will adjust the Cash account balance to become

the true cash balance. We will review each item appearing in Step 2 and the related journal entry

that is required. Remember that any adjustment to the company's Cash account requires a journal

137

entry. Generally, the adjustments to the books are the result of items found on the bank statement

but have not yet been entered in the company's Cash account.

Item #2 Bank service charges. Since the bank deducted $35 from the company's checking

account, but the company has not yet deducted this from its Cash account, the following journal

entry needs to be made.

(If the annual amount of service charges is small, debit Miscellaneous Expense.)Item #3 NSF checks and fees. Since the bank deducted these legitimate amounts from the

company's bank account, the company will need to deduct these amounts from its Cash account. As

mentioned, the NSF check of $100 was from a customer. Therefore, the company will likely undo the

reduction to Accounts Receivable that took place when the company originally processed the $100

check. If the company wishes to recover the bank fee of $10 from the customer, it should add the

$10 fee to the amount that the customer owes the company. The journal entry might look like this:

(If the amount cannot be recovered from the customer, charge an expense.)

Item #4 Check printing charges. Because this expense is not yet entered on the company's

books, but the amount has been deducted from its bank account, the company will make the

following journal entry.

Item #5 Interest earned. The bank increased the checking account balance by $8 on August

31. Since the bank did not notify the company previously, the company must now increase the

balance in its Cash account.

138

Item #6 Notes receivable collected. The bank increased the company's checking account

when it collected a note for the company on August 29. It was determined that the company had not

yet made an entry to its Cash account for this transaction. As a result the following journal entry is

needed.

Item #10 Company error. The company had entered $145 in its Cash account on August 29,

but the bank statement showed the correct amount: $154. The transaction involved the cash sales

for the day. As a result the company's Cash account will have to be increased by $9 as follows:

Step 3 Comparing the Adjusted Balances

In the above schedules the adjusted balance for Step 1 is $1,719 and the adjusted balance for Step

2 is $1,719. The company believes that all items involving cash have been included in the

schedules. As a result the company has successfully completed its bank reconciliation as of the

August 31, 2013.

139