1. Introduction to Bookkeeping

The term bookkeeping means different things to different people:

Some people think that bookkeeping is the same as accounting. They assume that keeping a company's books and preparing its financial statements and tax reports are all part of bookkeeping. Accountants do not share their view.

Others see bookkeeping as limited to recording transactions in journals or daybooks and then posting the amounts into accounts in ledgers. After the amounts are posted, the bookkeeping has ended and an accountant with a college degree takes over. The accountant will make adjusting entries and then prepare the financial statements and other reports.

The past distinctions between bookkeeping and accounting have become blurred with the use of computers and accounting software. For example, a person with little bookkeeping training can use the accounting software to record vendor invoices, prepare sales invoices, etc. and the software will update the accounts in the general ledger automatically. Once the format of the financial statements has been established, the software will be able to generate the financial statements with the click of a button.

At mid-size and larger corporations the term bookkeeping might be absent. Often corporations have accounting departments staffed with accounting clerks who process accounts payable, accounts receivable, payroll, etc. The accounting clerks will be supervised by one or more accountants.

Our explanation of bookkeeping attempts to provide you with an understanding of

bookkeeping and its relationship with accounting. Our goal is to increase your knowledge

and confidence in bookkeeping, accounting and business. In turn, we hope that you will

become more valuable in your current and future roles.

Bookkeeping: Past and Present

Bookkeeping in the Old Days

Prior to computers and software, the bookkeeping for small businesses usually began by writing entries into journals. Journals were defined as the books of original entry. In order to reduce the amount of writing in a general journal, special journals or daybooks were introduced. The

special or specialized journals consisted of a sales journal, purchases journal, cash receipts journal, and cash payments journal.The company's transactions were written in the journals in date order. Later, the amounts in the journals would be posted to the designated accounts located in the general ledger. Examples of accounts include Sales, Rent Expense, Wages Expense, Cash, Loans Payable, etc. Each account's balance had to be calculated and the account balances were used in the company's financial statements. In addition to the general ledger, a company may have had subsidiary ledgers for accounts such as Accounts Receivable.Handwriting the many transactions into journals, rewriting the amounts in the accounts, and manually calculating the account balances would likely result in some incorrect amounts. To determine whether errors had occurred, the bookkeeper prepared a trial balance. A trial balance is an internal report that lists 1) each account name, and 2) each account's balance in the appropriate debit column or credit column. If the total of the debit column did not equal the total of the credit column, there was at least one error occurring somewhere between the journal entry and the trial balance. Finding the one or more errors often meant spending hours retracing the entries and postings.After locating and correcting the errors the bookkeeping phase was completed and the accounting phase began. It began with an accountant preparing adjusting entries so that the accounts reflected the accrual basis of accounting. Adjusting entries were necessary for the following reasons:

additional revenues and assets may have been earned but were not recorded

additional expenses and liabilities may have been incurred but were not recorded

some of the amounts that had been recorded by the bookkeeper may have been prepayments which are no longer prepaid

depreciation and other non-routine adjustments needed to be computed and recorded

After all of the adjustments were made, the accountant presented the adjusted account balances in the form of financial statements.

After each year's financial statements were completed, closing entries were needed. The purpose of closing entries is to get the balances in all of the income statement accounts (revenues, expenses) to be zero before the start of the new accounting year. The net amount of the income statement account balances would ultimately be transferred to the proprietor's capital account or to the stockholders' retained earnings account.

Bookkeeping Today

The electronic speed of computers and accounting software gives the appearance that many of the bookkeeping and accounting tasks have been eliminated or are occurring simultaneously. For example, the preparation of a sales invoice will automatically update the relevant general ledger accounts (Sales, Accounts Receivable, Inventory, Cost of Goods Sold), update the customer's detailed information, and store the information for the financial statements as well as other reports.

The accounting software has been written so that every transaction must have the debit amounts equal to the credit amounts. The electronic accuracy also eliminates the errors that had occurred when amounts were manually written, rewritten and calculated. As a result, the debits will always equal the credits and the trial balance will always be in balance. No longer will hours be spent looking for errors that occurred in a manual system.

CAUTION: While the accounting software is amazingly fast and accurate in processing the information that is entered, the software is unable to detect whether some transactions have been omitted, have been entered twice, or if incorrect accounts were used. Fraudulent transactions and amounts could also be entered if a company fails to have internal controls.After the sales invoices, vendor invoices, payroll and other transactions have been processed for each accounting period, some adjusting entries are still required. The adjusting entries will involve:

revenues and assets that were earned, but not yet entered into the software

expenses and liabilities that were incurred, but not yet entered into the software

prepayments that are no longer prepaid

recording depreciation expense, bad debts expense, etc.

The adjusting entries will require a person to determine the amounts and the accounts. Without adjusting entries the accounting software will be producing incomplete, inaccurate, and perhaps misleading financial statements.After the financial statements for the year are released, the software will transfer the balances from the income statement accounts to the sole proprietor's capital account or to the stockholders' retained earnings account. This allows for the following year's income statement accounts to begin with zero balances. (The balance sheet accounts are not closed as their balances are carried forward to the next accounting year.)

Recording Transactions

Bookkeeping (and accounting) involves the recording of a company's financial transactions. The transactions will have to be identified, approved, sorted and stored in a manner so they can be retrieved and presented in the company's financial statements and other reports.

Here are a few examples of some of a company's financial transactions:

The purchase of supplies with cash.

The purchase of merchandise on credit.

The sale of merchandise on credit.

Rent for the business office.

Salaries and wages earned by employees.

Buying equipment for the office.

Borrowing money from a bank.

The transactions will be sorted into perhaps hundreds of accounts including Cash, Accounts Receivable, Loans Payable, Accounts Payable, Sales, Rent Expense, Salaries Expense, Wages Expense Dept 1, Wages Expense Dept 2, etc. The amounts in each of the accounts will be reported on the company's financial statements in detail or in summary form.

With hundreds of accounts and perhaps thousands of transactions, it is clear that once a person learns the accounting software there will be efficiencies and better information available for managing a business.

2.Accrual MethodThere are two main methods of accounting (or bookkeeping):

Accrual method

Cash method

The accrual method of accounting is the preferred method because it provides:

1. a more complete reporting of the company's assets, liabilities, and stockholders' equity at the end of an accounting period, and

2. a more realistic reporting of a company's revenues, expenses, and net income for a specific time interval such as a month, quarter or year.

As a result, US GAAP requires most corporations to use the accrual method of accounting.

The following table compares the accrual and cash methods of accounting:

Note: Some small companies may be allowed to use the cash method of accounting and in turn may experience an income tax benefit. Since our website does not provide income tax information, you should seek tax advice from a tax professional or from IRS.gov.

Revenues and ReceivablesUnder the accrual method, revenues are to be reported in the accounting period in which they are earned (which may be different from the period in which the money is received).To illustrate the reporting of revenues under the accrual method, let's assume that the hypothetical business Servco provides a service to a customer on December 27. Servco prepares a sales invoice for the agreed upon amount of $1,000. The invoice is dated December 27 and states that the amount is due in 30 days.

Under the accrual method, on December 27 Servco: has earned revenue of $1,000, and has earned a receivable of $1,000.

If Servco uses accounting software to prepare the invoice, the following will be recorded automatically as of December 27:

the income statement account Service Revenues will be increased by $1,000, and

the asset Accounts Receivable will be increased by $1,000

In addition to updating the general ledger accounts (which are used in preparing the financial statements), the software will update and store the customer's information for generating an aging of accounts receivable and a statement of each customer's activity.

Expenses and PayablesUnder the accrual method, expenses should be reported on the income statement in the period in which they best match with the revenues. If a cause and effect relationship is not obvious, the expense should be reported on the income statement when the cost is used up or expires. In any event, the payment of cash is not the primary factor for determining the accounting period in which an expense is reported on the income statement.To illustrate, let's assume that Servco uses a temporary help agency at a cost of $200 in order to assist in earning revenues on December 27. The invoice from the temp agency is received on December 27, but it will not be paid until January 4.

Under the accrual method, on December 27 Servco: has incurred an expense of $200, and has incurred a liability of $200.

If accounting software is used to record the temp agency invoice, the following will occur automatically as of December 27:

the income statement account Temporary Help Expense will be increased by $200, and

the liability Accounts Payable will be increased by $200.

When Servco issues its check on January 4:

the asset Cash will be decreased by $200, and the liability Accounts Payable will be decreased by $200.

Net IncomeIf Servco had only the two transactions described above, its net income under the accrual method for the day of December 27 will consist of the following:

Earned revenue of $1,000

Incurred an expense of $200

Earned a net income of $800 ($1,000 of revenues minus $200 of expenses).

[The cash method of accounting would have reported a much different picture:

o No revenue, expense or net income would have been reported on the December income statement.

o The revenues of $1,000 might be reported in February if the customer paid in 35 days.

o The expense of $200 will be reported in January when Servco pays the temp agency.]

Obviously, the accrual method does a better job of reporting what occurred on December 27, the date that Servco actually provided the services and incurred the expense.

3.Double-Entry, Debits and Credits

Double-EntryExcept for some very small companies, the standard method for recording transactions is double-entry. Double-entry bookkeeping or double-entry accounting means that every transaction will involve at least two accounts. To illustrate, here are a few transactions and the two accounts that will be affected:

Note: Double-entry bookkeeping means that every transaction will involve a minimum of two accounts.

Debits and Credits

The words debit and credit have been associated with double-entry bookkeeping and accounting for more than 500 years. Here are the meanings of those words:debit: an entry on the left side of an accountcredit: an entry on the right side of an account

The debit and credit rule in double-entry bookkeeping can be stated several ways:

For each and every transaction, the total amount entered on the left side of an account (or accounts) must be equal to the total amount entered on the right side of another account (or accounts).

For each and every transaction, the total of the debit amounts must be equal to the total of the credit amounts.

Debits must equal credits.

In short...Debit amounts = Credit amounts

Debit = CreditDependable accounting software will be written/coded to enforce the rule of debits equal to credits. In other words, a transaction will be accepted and processed only if the amount of the debits is equal to the amount of the credits.

The accuracy of accounting software will also ensure that the accounts and the trial balance will always be in balance. Here is an example of a partial trial balance:

Even though the accounting software has eliminated the clerical errors that occurred because amounts were handwritten and the account balances were calculated manually, some other errors can still occur. Here are some errors that will not be detected by the accounting software:

An entire transaction (both the debit amount and the credit amount) was omitted.

An entire transaction was entered twice.

An incorrect amount was entered both as a debit and as a credit. An incorrect account was debited. An incorrect account was credited.

Even with the above errors, the trial balance will remain in balance. The reason is that the total of the debit balances will still be equal to the total of the credit balances.

T-AccountsTo assist in visualizing the effect of recording a debit or credit amount and the resulting balances of general ledger accounts, it is helpful to draw a T-account, as shown here:

Debit amounts will be entered on the left side of the T-account, and credit amounts will be entered on the right side. The title of the account will appear at the top of each "T".

Since every transaction will involve at least two accounts, we recommend that you always begin by drawing two T-accounts. For example, if a company pays its rent of $2,000 for the current month, the transaction could be depicted with the following T-accounts:

Note that one T-account (Rent Expense) has a debit of 2,000 and that one T-account (Cash) has a credit amount of 2,000. Hence, the transaction had debits equal to credits.

4. General Ledger AccountsThe accounts that are used to sort and store transactions are found in the company's general ledger. The general ledger is often arranged according to the following seven classifications. (A few examples of the related account titles are shown in parentheses.)

Assets (Cash, Accounts Receivable, Land, Equipment)

Liabilities (Loans Payable, Accounts Payable, Bonds Payable)

Stockholders' equity (Common Stock, Retained Earnings)

Operating revenues (Sales, Service Fees)

Operating expenses (Salaries Expense, Rent Expense, Depreciation Expense)

Non-operating revenues and gains (Investment Income, Gain on Disposal of Truck)

Non-operating expenses and losses (Interest Expense, Loss on Disposal of Equipment)

Balance Sheet AccountsThe first three classifications are referred to as balance sheet accounts since the balances in these accounts are reported on the financial statement known as the balance sheet.

Balance sheet accounts

o Assets

o Liabilities

o Stockholders' (or Owner's) equity

The balance sheet accounts are also known as permanent accounts (or real accounts) since the balances in these accounts will not be closed at the end of an accounting year. Instead, these account balances are carried forward to the next accounting year.

Income Statement AccountsThe four remaining classifications of accounts are referred to as income statement accounts since the amounts in these accounts will be reported on the financial statement known as the income statement.

Income statement accounts

o Operating revenues

o Operating expenses

o Non-operating revenues and gains

o Non-operating expenses and losses

The income statement accounts are also known as temporary accounts since the balances in these accounts will be closed at the end of the accounting year. Each income statement account is closed in order to begin the next accounting year with a zero balance.The year-end balances from all of the income statement accounts will be combined and entered as a single net amount in Retained Earnings (a balance sheet account within stockholders' equity) or in a proprietor's capital account.

Note: If an account has not had any activity in the current or recent periods, it is often omitted from the current general ledger.

Chart of Accounts

The chart of accounts is simply a list of all of the accounts that are available for recording transactions. This means that the number of accounts in the chart of accounts will be greater than the number of accounts in the general ledger. (The reason is that accounts with zero balances and no recent entries are often omitted from the general ledger until there is a transaction for the account.)The chart of accounts is organized similar to the general ledger: balance sheet accounts followed by the income statement accounts. However, the chart of accounts does not contain any entries or account balances.

The chart of accounts allows you to find the name of an account, its account number, and perhaps a brief description. It is important to expand and/or alter the chart of accounts to accommodate the changes to an organization and when there is a need for improved reporting of information.

In some accounting software, the chart of accounts is also used to designate where an account will be reported in the financial statements.

5. Debits and Credits in the AccountsIf you already understand debits and credits, the following table summarizes how debits and

credits are used in the accounts.

If you are not familiar with debits and credits or if you want a better understanding, we will

provide a few insights to help you. We will also provide links to our visual tutorial, quiz,

puzzles, etc. that will further assist you.

Accounting Equation Can HelpThe accounting equation is a central part of bookkeeping and accounting. It can also provide

insights into debits and credits. The basic accounting equation is:

Assets = Liabilities + Stockholders' equity (if a corporation)

or

Assets = Liabilities + Owner's equity (if a sole proprietorship)

With double-entry accounting, the accounting equation should always be in balance. In other

words, not only will debits be equal to credits, but the amount of assets will be equal to the

amount of liabilities plus the amount of owner's equity.

The accounting equation is also the framework of the balance sheet, one of the main

financial statements. Hence the balance sheet must also be in balance.

We will use the accounting equation to explain why we sometimes debit an account and at

other times we credit an account.

Assets are on the left side of the accounting equation.Asset account balances should be on the left side of the accounts.In the accounting equation you can see that assets are on the left side of the equation:

Earlier you learned that debit means left side. Recall our T-account that showed debits on the left side:

Hence, asset accounts such as Cash, Accounts Receivable, Inventory, and Equipment

should have debit balances.

Liabilities are on the right side of the accounting equation.Liability account balances should be on the right side of the accounts.In the accounting equation you can see that liabilities are on the right side of the equation:

Earlier you learned that credit means right side. Recall our T-account that showed credits on the right side:

Thus liability accounts such as Accounts Payable, Notes Payable, Wages Payable, and

Interest Payable should have credit balances.

Stockholders' equity is on the right side of the accounting equation.Stockholders' equity account balances should be on the right side of the accounts.In the accounting equation you can see that stockholders' equity is on the right side of the

equation:

Again, credit means right side and our T-account showed credits on the right side. This

means that stockholders' equity accounts such as Common Stock, Retained Earnings, and

M J Smith, Capital should have credit balances.

ExampleTo demonstrate the debits and credits of double-entry with a transaction, let's assume that a

new corporation is formed and the stockholders invest $100,000 in exchange for shares of

common stock. There are two effects of this transaction:

1. The corporation receives cash, which is recorded as a corporation asset.

2. The corporation issues shares of common stock. The amount received for the shares will be recorded as part of the corporation's stockholders' equity.

Here's how the transaction will impact the accounting equation and the company's balance

sheet:

Here is what will occur in the general ledger accounts:

If this transaction is entered in a general journal, it would appear as follows:

Revenues increase stockholders' equity (which is on the right side of the accounting equation).Therefore the balances in the revenue accounts will be on the right side.To illustrate, let's assume that a company provides a service and bills the customer $400

with the amount due in 30 days. Two things occur:

1. Revenues of $400 are earned and that causes stockholders' equity to increase.

2. The company earns the right to receive $400. This increases the company's asset account Accounts Receivable.

Here's the effect on the accounting equation and the company's balance sheet as a result of

earning the revenues:

Here is what occurs in the general ledger accounts:

Note: Even though stockholders' equity will increase, the transaction is recorded in the account Service Revenues. The reason is that we want the amount of revenues to be reported on the current period's income statement. (In other words, we temporarily credit Service Revenues instead of crediting the stockholders' equity account Retained Earnings. At the end of the accounting year, the balances in all of the income statement accounts will be closed/transferred to Retained Earnings.)If this transaction were entered in a general journal, it would appear as follows:

Expenses decrease stockholders' equity (which is on the right side of the accounting equation).Therefore expense accounts will have their balances on the left side.To reduce the normal credit balance in stockholders' equity accounts, a debit will be needed.

Hence, the accounts such as Rent Expense, Advertising Expense, etc. will have their

balances on the left side.

For example, when a company pays cash of $150 for advertising materials that are

distributed immediately at a local event, two things occur:

1. An expense of $150 occurred and the expense will cause stockholders' equity to decrease.

2. The company has reduced its asset Cash by $150.

The effect on the accounting equation and the company's balance sheet is:

The effect on the company's general ledger accounts is shown here:

Note: Even though this expense causes stockholders' equity to decrease, the transaction is recorded in the account Advertising Expense. The reason is that we want the current period's income statement to report this expense. (In other words, we temporarily debit Advertising Expense instead of debiting the stockholders' equity account Retained Earnings. At the end of the accounting year, all of the balances in the income statement accounts will be closed/transferred to Retained Earnings.)If this transaction were entered in a general journal, it would appear as follows:

A few tips about debits and credits: When cash is received, debit Cash.

When cash is paid out, credit Cash.

When revenues are earned, credit a revenue account.

When expenses are incurred, debit an expense account.

Here are some common transactions with the appropriate debits and credits:

6. Asset AccountsAsset accounts are one of the three major classifications of balance sheet accounts:

Assets

Liabilities

Stockholders' equity (or owner's equity)

The ending balances in the balance sheet accounts will be carried forward to the next

accounting year. Hence the balance sheet accounts are called permanent accounts or real accounts.

The asset accounts are usually listed first in the company's chart of accounts and in the

general ledger. In the general ledger the asset accounts will normally have debit balances.

The balances in some of the asset accounts will be combined and presented as a single

amount when the balance sheet is prepared. For example, if a company has ten checking

accounts, the balances will be combined and the total amount will be reported on the

balance sheet as the asset Cash.

Assets include the things or resources that a company owns, that were acquired in a

transaction, and have a future value that can be measured. Assets also include some costs

that are prepaid or deferred and will become expenses as the costs are used up over time.

Here are some examples of asset accounts:

Cash

Short-term Investments

Accounts Receivable

Allowance for Doubtful Accounts (a contra-asset account)

Accrued Revenues/Receivables

Prepaid Expenses

Inventory

Supplies

Long-term Investments

Land

Buildings

Equipment

Vehicles

Furniture and Fixtures

Accumulated Depreciation (a contra-asset account)

Descriptions of asset accountsThe following are brief descriptions of some common asset accounts.

CashCash includes currency, coins, checking account balances, petty cash funds, and customers'

checks that have not yet been deposited. A company is likely to have a separate general

ledger account for each checking account, petty cash fund, etc. but will combine the amounts

and will report the total as Cash (or Cash and Cash Equivalents) on the balance sheet.

Short-term InvestmentsShort-term or temporary investments may include certificates of deposit, bonds, notes, etc.

that will mature in less than one year. It may also include investments in the common or

preferred stock of another corporation if the stock can be easily sold on a stock exchange.

Accounts ReceivableAccounts receivable is a right to receive an amount as the result of delivering goods or

services on credit. Under the accrual method of accounting, Accounts Receivable is debited

at the time of a credit sale. Later, when the customer pays the amount owed, the company

will credit Accounts Receivable (and will debit Cash).

Allowance for Doubtful AccountsThe Allowance for Doubtful Accounts is a contra-asset account since its balance is intended

to be a credit balance (or a zero balance). When the balance in this account is combined

with the balance in Accounts Receivable, the resulting amount is known as the net realizable

value of the receivables. The Allowance for Doubtful Accounts is used under the allowance

method of reporting bad debts expense.

Accrued Revenues/ReceivablesUnder the accrual method of accounting, revenues are to be reported when goods or

services have been delivered even if a sales invoice has not been generated. This account

will report the amounts that a company has a right to receive but the sales invoices have yet

to be prepared or entered in Accounts Receivable.

Prepaid ExpensesThese are future expenses that have already been paid. The amounts appear as assets until

the costs have been used up or expire. A common example of a prepaid expense is the

payment for vehicle insurance. To illustrate this, let's assume that on December 29, a new

company pays $6,000 for the insurance covering its vehicles for the six-month period that will

begin on January 1. As of December 31, the entire $6,000 will be aprepaid expense

because none of the cost has expired. Since none of the cost expired in December, there is

no insurance expense in December. The insurance expense will begin in January at a rate

of $1,000 per month. This is depicted in the following chart:

*The expense is the amount that is expiring during the month.

**The prepaid amounts are the unexpired amounts and should be the balance in

the asset account Prepaid Expenses or Prepaid Insurance at the end of each of the months.

InventoryInventory is the cost of goods that have been purchased or manufactured and have not yet

been sold.

SuppliesSupplies could be office supplies, manufacturing supplies, packaging supplies or other

supplies that are on hand. The cost of the supplies that remain on hand is reported as an

asset.

Long-term InvestmentsThis account or asset category will be reported on the balance sheet immediately following

current assets. It may include investments in the common stock, preferred stock, and bonds

of another corporation. It also includes real estate being held for sale and also the money

that is restricted for a long-term purpose such as a building project or the repurchase of

bonds payable. The cash surrender value of a life insurance policy owned by a company is

also reported under this asset heading.

LandThis account represents the property portion of the balance sheet heading "Property, plant

and equipment." It reports the cost of land used in a business. Since land is assumed to last

indefinitely, the cost of land is not depreciated.

BuildingsThis account will report the cost of the building used in the business. The cost of buildings

will be depreciated over their useful lives.

EquipmentThis account reports the cost of the machinery and equipment used in the business. The

cost of equipment will be depreciated over the equipment's useful life.

VehiclesThis account reports the cost of trucks, trailers, and automobiles used in the business. The

cost of vehicles is to be depreciated over the vehicles' useful lives.

Furniture and FixturesThis account reports the cost of desks, chairs, shelving, etc. that are used in the business.

The cost of furniture and fixtures is to be depreciated over the useful lives.

Accumulated DepreciationAccumulated Depreciation is known as a contra asset account because it has a credit

balance instead of a debit balance that is typical for asset accounts. Whenever Depreciation

Expense is debited for the periodic depreciation of the buildings, equipment, vehicles, etc.

the account Accumulated Depreciation is credited. The credit balance in Accumulated

Depreciation will continue to grow until an asset is sold or scrapped. However, the maximum

amount of the credit balance is the cost of the asset(s).

7. Liability and Stockholders' Equity Accounts

Liability AccountsA company's liability accounts appear in the chart of accounts, general ledger, and balance sheet immediately following the asset accounts. In the general ledger, the liability accounts will usually have credit balances.

Note: Liabilities are a company's obligations. They are the amounts that the company owes. Liabilities also include amounts received from customers in advance of being earned.Here are some examples of liability accounts:

Short-term Loans Payable

Current Portion of Long-term Debt

Accounts Payable

Accrued Expenses

Unearned or Deferred Revenues

Installment Loans Payable

Mortgage Loans Payable

Descriptions of liability accountsThe following are brief descriptions of some common liability accounts.

Short-term Loans PayableThis account will report the amount of loans which will be due within one year of the date of the balance sheet.Current Portion of Long-term DebtThis account or line description reports the principal portion of a long-

term debt that will have to be paid within one year of the date of the balance sheet. (The portion of the debt that is not due within one year is reported as a noncurrent liability.)Accounts PayableAccounts Payable is the account containing the amounts owed to suppliers for invoices that have been approved and entered for payment. The balance in this account reports the amount of those invoices which are unpaid.Accrued Expenses/LiabilitiesUnder the accrual method, the amounts in this account are owed but have not yet been recorded in Accounts Payable. This account could include the vendor invoices awaiting processing, employee wages and benefits earned but not yet recorded, and other expenses incurred but not yet recorded.Unearned or Deferred Revenues Unearned revenues reports the amounts received in advance of having been earned. For example, if a law firm requires that a client pay $4,000 in advance for future legal work, the law firm will record the cash of $4,000 and also the liability to deliver $4,000 of legal services. The law firm cannot report the $4,000 as revenue until it is earned. This liability account could have the title Unearned Revenues or Deferred Legal Fees. As the legal services are performed and therefore are earned, the law firm will reduce the liability account and will report the amount as revenues.Installment Loans PayableInstallment loans are loans that require a series of payments. A common example is a three-year automobile loan that requires monthly payments. The principal due within one year of the balance sheet date will be reported as a current liability and the remainder of the principal owed will be reported as a noncurrent liability. (The futureinterest is not recorded as a liability, since it is not due or payable as of the date of the balance sheet.)Mortgage Loans PayableMortgage loans are usually long-term loans with real estate pledged as collateral. The principal due within one year of the balance sheet will be reported as a current liability and the remainder of the principal owed is reported as a noncurrent liability. (The future interest is not recorded as a liability, since it is not due or payable as of the date of the balance sheet.)

Stockholders' Equity AccountsThe stockholders' equity accounts of a corporation will appear in the chart of accounts, general ledger, and balance sheet immediately

following the liability accounts. In the general ledger most of the stockholders' equity accounts will have credit balances. The following are brief descriptions of typical stockholders' equity accounts.

Paid-in CapitalPaid-in capital is a subheading within stockholders' equity which indicates the amount paid to the corporation at the time that shares of stock were issued. Paid-in capital is also referred to as permanent capital. Every corporation will have common stock and a small percentage of corporations will have preferred stock in addition to common stock.The paid-in capital accounts report the amounts received when the corporation's stock was issued. Often there are two accounts for the common stock:

Par value of the common stock, and

Paid-in capital in excess of the par value of the common stock

If a corporation also issued preferred stock, there will also be two additional accounts.

Common StockIf a corporation's common stock has a par value or a stated value, only the par or stated value of the shares issued will be recorded in this account. However, if a corporation's common stock has neither a par value nor a stated value, the entire amount received by the corporation at the time that the shares were issued will be recorded in this account.Paid-in Capital in Excess of Par Value - Common StockWhen a corporation issues common stock, the amount received minus the par value or stated value is recorded in this account. (The par value of common stock is recorded in the account Common Stock.)Retained EarningsGenerally, the amount of a corporation's retained earnings is the cumulative amount of earnings (net income) since the corporation was formed minus the cumulative amount of dividends that have been declared since the corporation was formed.The current accounting period's earnings (or net income) will be added to this account and the current period's dividends will be deducted.

Note: Revenues will cause retained earnings to increase, while expenses will cause retained earnings to decrease.

Retained earnings is a component of stockholders' equity, but it is separate from paid-in capital. Hence, the amounts reported under retained earnings are not considered to be permanent capital.

8. Income Statement AccountsThe income statement accounts are categorized in a variety of ways. Here are the classifications we will be using:

Operating revenues

Operating expenses

Other revenues and gains

Other expenses and losses

The amounts in these accounts at the end of an accounting year will not be carried forward to the subsequent year. Rather, the balances in the income statement accounts will be transferred to Retained Earnings (for a corporation) or to the owner's capital account (for a sole proprietorship). This will allow for all of the income statement accounts to begin each accounting year with zero balances. This explains why the income statement accounts are referred to as temporary accounts.

Operating RevenuesOperating revenues are the amounts earned from carrying out the company's main activities. For example, the sales of merchandise are a retailer's operating revenues.

A few examples of accounts for recording operating revenues include:

Sales

Sales Revenues

Service Revenues

Fees Earned

Sales - Product Line #1

Sales - Product Line #2

The revenue accounts are expected to have credit balances (since revenues cause the stockholders' or owner's equity to increase). Contra revenue accounts such as Sales Returns and Allowances and Sales Discounts will have debit balances.Under the accrual method of accounting, revenues are reported as of the date the goods are sold or the services have been performed. If a service is provided on December 27, but the customer is allowed to

pay in February, the revenues are reported on the income statement that includes December 27.At the end of the accounting year, the balance in each of the accounts for recording operating revenues will be closed in order to start the next accounting year with a zero balance.

Operating ExpensesOperating expenses are the expenses incurred in earning operating revenues. For example, advertising expense is one of the operating expenses of a retailer.

A few of the many accounts used to record operating expenses include:

Cost of Goods Sold

Cost of Goods Sold - Product Line #1

Salaries Expense

Fringe Benefit Expense

Rent Expense

Utilities Expense

Utilities Expense - Store #45

Depreciation Expense - Buildings

Depreciation Expense - Equipment

Repairs Expense

The accounts for operating expenses should have debit balances.

Under the accrual method of accounting, the expenses should be reported in the same accounting period as the related revenues. If that is not certain, then an expense should be reported in the accounting period in which its cost expires or is used up.

Expenses are often organized by function such as manufacturing, selling, and general administrative. At other times expenses will be organized by responsibility such as Department #1, Sales Region #5, Warehouse #2, Legal Department, etc.

At the end of the accounting year, the balance in each of the accounts used for recording operating expenses will be closed in order to start the next accounting year with a zero balance.

Non-Operating Revenues and GainsRevenues earned outside of a company's main business activities are referred to as non-operating revenues or as other revenues. For example, the interest earned by a retailer on its idle cash balances is part of non-operating or other revenues.Gains often occur when a company sells an asset that was used in the business, and the cash received was greater than the asset's carrying amount on the company's books. For example, if a company car is sold for $10,000 and its book value is $9,000, there will be a gain of $1,000.The accounts that report non-operating revenues, other revenues, and gains are expected to have credit balances since they cause stockholders' equity to increase.

Non-Operating Expenses and LossesThe expenses incurred in order to earn non-operating revenues are reported as non-operating expenses or other expenses. In addition, interest expense for a retailer is a non-operating expense or other expense. (On the other hand, the interest expense paid by a bank for the use of depositors' money is one of the bank's operating expenses.)Losses are reported when a company disposes of a long-term asset for the cash, and the amount of cash received is less than the book value of the asset. For example, if a company car is sold for $7,500 and its book value is $9,000, a loss of $1,500 will be reported. Another example of a loss is the loss from a lawsuit.The accounts for non-operating expenses and losses will have debit balances since they cause stockholders' equity to decrease.

9. Recording TransactionsWith sophisticated accounting software and inexpensive computers, it is no longer practical

for most businesses to manually enter transactions into journals and then to post to the

general ledger accounts and subsidiary ledger accounts. Today, software such as

QuickBooks* will update the relevant accounts and provide more information with a minimum

of data entry.

*QuickBooks is a registered trademark of Intuit Inc. AccountingCoach LLC is not affiliated

with Intuit Inc. and does not receive any affiliate marketing commissions from Intuit.

In this section we will highlight how the accounting software will capture financial

transactions and then automatically update the general ledger and store the information for

management's future use.

Accounts payableWhen accounting software is used to enter the invoices received from suppliers (vendor

invoices), the software will update Accounts Payable and will require that the account or

accounts that should be debited be entered as well. The accounting software's vendor files

also allow a company to prepare purchase orders, receiving tickets and to pay the vendors'

invoices.

A company should have internal controls so that only legitimate invoices are recorded and

paid.

Check writingWhen the accounting software is used to write checks, the software will automatically credit

the Cash account and will require that another account be designated for the debit. An

additional benefit is that the amounts will move electronically and the account balances will

be automatically calculated with speed and accuracy.

Again, a company should have internal controls to ensure that only legitimate payments are

processed.

Sales on creditWhen the accounting software is used to prepare a sales invoice for a customer who

purchased on credit, the customer's detail will be updated, the general ledger account Sales

will be credited and the general ledger account Accounts Receivable will be debited.

Statements for each customer and an aging of all of the accounts receivable can be printed

with the click of a button.

PayrollAnother source of financial transactions is the company's payroll. While many companies

process payroll on their accounting software, others opt to outsource payroll to companies

such as ADP, Paychex, Intuit, or local firms.

(AccountingCoach is not affiliated with any of these companies and it does not receive

affiliate marketing commissions from any of them.)

Bank ReconciliationThe purpose of the bank reconciliation is to be certain that the financial statements are

reporting the correct amount of cash and the proper amounts for any related accounts (since

every transaction affects a minimum of two accounts).

The bank reconciliation process involves:

1. Comparing the following amounts

o The balance on the bank statement

o The balance in the company's general ledger account. (The account

title might be Cash - checking.)

2. Determining the reasons for the difference in the amounts shown in 1.

The common reasons for a difference between the bank balance and the the general ledger

book balance are:

Outstanding checks (checks written but not yet clearing the bank)

Deposits in transit (company receipts that are not yet deposited in the bank)

Bank service charges and other bank fees

Check printing charges

Errors in entering amounts in the company's general ledger

The outstanding checks and deposits in transit do not involve errors by either the company

or the bank. Since these items are already recorded in the company's accounts, no additional entries to the company's general ledger accounts will be needed.

Bank charges, check printing fees and errors in the company's accounts do require the company to make accounting entries. The company should make the entries before the

financial statements are prepared since a minimum of two accounts have the incorrect

balances (due to double-entry accounting). Here is an entry for a bank service charge that

was listed on the bank statement:

If the reconciliation reveals that an incorrect amount has been recorded in the company's Cash account, perhaps the easiest way to correct the error is to remove the incorrect amount and then enter the correct amount.

Accounting software is likely to include a feature for reconciling the bank statement.

To learn more about bank reconciliation use any of the following links:

10. Adjusting Entries

Why adjusting entries are neededIn order for a company's financial statements to be complete and to reflect the accrual

method of accounting, adjusting entries must be processed before the financial statements

are issued. Here are three situations that describe why adjusting entries are needed:

Situation 1Not all of a company's financial transactions that pertain to an accounting period will have

been processed by the accounting software as of the end of the accounting period. For

example, the bill for the electricity used during December might not arrive until January 10.

(The reason for the 10-day lag is that the electric utility reads the meters on January 1 in

order to compute the electricity actually used in December. Next the utility has to prepare the

bill and mail it to the company.)

Situation 2Sometimes a bill is processed during the accounting period, but the amount represents the

expense for one or more future accounting periods. For example, the bill for the insurance on

the company's vehicles might be $6,000 and covers the six-month period of January 1

through June 30. If the company is required to pay the $6,000 in advance at the end of

December, the expense needs to be deferred so that $1,000 will appear on each of the

monthly income statements for January through June.

Situation 3Something similar to Situation 2 occurs when a company purchases equipment to be used in

the business. Let's assume that the equipment is acquired, paid for, and put into service on

May 1. However, the equipment is expected to be used for ten years. If the cost of the

equipment is $120,000 and will have no salvage value, then each month's income statement

needs to report $1,000 for 120 months in order to report depreciation expense under the

straight-line method.

These three situations illustrate why adjusting entries need to be entered in the accounting

software in order to have accurate financial statements. Unfortunately the accounting

software cannot compute the amounts needed for the adjusting entries. A bookkeeper or

accountant must review the situations and then determine the amounts needed in each

adjusting entry.

Steps for Recording Adjusting EntriesSome of the necessary steps for recording adjusting entries are

You must identify the two or more accounts involved

o One of the accounts will be a balance sheet account

o The other account will be an income statement account

You must calculate the amounts for the adjusting entries

You will enter both of the accounts and the adjustment in the general journal

You must designate which account will be debited and which will be credited.

Types of Adjusting EntriesWe will sort the adjusting entries into five categories.

1. Accrued revenuesUnder the accrual method of accounting, a business is to report all of the revenues (and

related receivables) that it has earned during an accounting period. A business may have

earned fees from having provided services to clients, but the accounting records do not yet

contain the revenues or the receivables. If that is the case, an accrual-type adjusting entry

must be made in order for the financial statements to report the revenues and the related

receivables.

If a business has earned $5,000 of revenues, but they are not recorded as of the end of the

accounting period, the accrual-type adjusting entry will be as follows:

2. Accrued expensesUnder the accrual method of accounting, the financial statements of a business must report

all of the expenses (and related payables) that it has incurred during an accounting period.

For example, a business needs to report an expense that has occurred even if a supplier's

invoice has not yet been received.

To illustrate, let's assume that a company utilized a worker from a temporary personnel

agency on December 27. The company expects to receive an invoice on January 2 and

remit payment on January 9. Since the expense and the payable occurred in December, the

company needs to accrue the expense and liability as of December 31 with the following

adjusting entry:

3. Deferred revenuesUnder the accrual method of accounting, the amounts received in advance of being earned

must be deferred to a liability account until they are earned.

Let's assume that Servco Company receives $4,000 on December 10 for services it will

provide at a later date. Prior to issuing its December financial statements, Servco must

determine how much of the $4,000 has been earned as of December 31. The reason is that

only the amount that has been earned can be included in December's revenues. The amount

that is not earned as of December 31 must be reported as a liability on the December 31

balance sheet.

If $3,000 has been earned, the Service Revenues account must include $3,000. The

remaining $1,000 that has not been earned will be deferred to the following accounting

period. The deferral will be evidenced by a credit of $1,000 in a liability account such as

Deferred Revenues or Unearned Revenues.

The adjusting entry for this deferral depends on how the receipt of $4,000 was recorded on

December 10. If the receipt of $4,000 was recorded with a credit to Service Revenues (and a

debit to Cash), the December 31 adjusting entry will be:

If the entire receipt of $4,000 had been credited to Deferred Revenues on December 10

(along with a debit to Cash), the adjusting entry on December 31 would be:

4. Deferred expensesUnder the accrual method of accounting, any payments for future expenses must be

deferred to an asset account until the expenses are used up or have expired.

To illustrate, let's assume that a new company pays $6,000 on December 27 for the

insurance on its vehicles for the six-month period beginning January 1. For December 27

through 31, the company should have an asset Prepaid Insurance or Prepaid Expenses of

$6,000.

In each of the months January through June, the company must reduce the asset account by

recording the following adjusting entry:

5. Depreciation expenseDepreciation is associated with fixed assets (or plant assets) that are used in the business.

Examples of fixed assets are buildings, machinery, equipment, vehicles, furniture, and other

constructed assets used in a business and having a useful life of more than one year.

(However, land is not depreciated.)

Depreciation allocates the asset's cost (minus any expected salvage value) to expense in the

accounting periods in which the asset is used. Hence, office equipment with a useful life of 5

years and no salvage value will mean monthly depreciation expense of 1/60 of the

equipment's cost. A building with a useful life of 25 years and no salvage value will result in a

monthly depreciation expense of 1/300 of the building's cost.

11. Reversing EntriesThe first two categories of adjusting entries that we had discussed above were:

1. Accrued revenues

2. Accrued expenses

These categories are also referred to as accrual-type adjusting entries or simply accruals.

Accrual-type adjusting entries are needed because some transactions had occurred but the

company had not entered them into the accounts as of the end of the accounting period. In

order for a company's financial statements to include these transactions, accrual-type

adjusting entries are needed.

In all likelihood, an actual transaction (that required an accrual-type adjusting entry) will get

routinely processed and recorded in the next accounting period. This presents a potential

problem in that the transaction could get entered into the accounting records twice: once

through the adjusting entry and also when it is routinely processed in the subsequent

accounting period. The purpose of reversing entries is to remove the accrual-type adjusting

entries.

Reversing entries will be dated as of the first day of the accounting period immediately

following the period of the accrual-type adjusting entries. In other words, for a company with

accounting periods which are calendar months, an accrual-type adjusting entry dated

December 31 will be reversed on January 2.

To illustrate, let's assume that the company had accrued repairs expenses with the following

adjusting entry on December 31:

This accrual-type adjusting entry was needed so that the December repairs would be

reported as 1) part of the expenses on the December income statement, and 2) a liability on

the December 31 balance sheet.

On January 2, the following reversing entry is recorded in order to remove the accrual-type

adjusting entry of December 31:

The reversing entry removes the liability established on December 31 and also puts a credit

balance in the Repairs Expense account on January 2. When the vendor's invoice is

processed in January, it can be debited to Repairs Expenses (as would normally happen). If

the vendor's invoice is $6,000 the balance in the account Repairs Expenses will show a $0

balance after the invoice is entered. (The $6,000 credit from the reversing entry on January

2, plus the $6,000 debit from the vendor's invoice equals $0.) Zero is the correct amount

because the expense of $6,000 belonged in December and was reported in December as

the result of the December 31 adjusting entry.

Some accounting software will allow you to indicate the adjusting entries you would like to

have reversed automatically in the next accounting period.

12. Balance SheetThe balance sheet is one of the four main financial statements of a business:

Balance Sheet

Income Statement

Cash Flow Statement

Statement of Stockholders' Equity

The balance sheet reports a company's assets, liabilities, and stockholders' equity as of a moment in time. (The other three financial statements report amounts for a period of time such as a year, quarter, month, etc.) The balance sheet is also known as

the statement of financial position and it reflects the accounting equation:

Assets = Liabilities + Stockholders' Equity.

Bankers will look at the balance sheet to determine the amount of a company's working

capital, which is the amount of current assets minus the amount of current liabilities. They

will also review the assets and the liabilities and compare these amounts to the amount of

stockholders' equity.

When a balance sheet reports at least one additional column of amounts from an earlier

balance sheet date, it is referred to as a comparative balance sheet.

Balance Sheet ClassificationsTypically, companies issue a classified balance sheet. This means that the amounts are

presented according to the following classifications:

Descriptions of the balance sheet classificationsThe following are brief descriptions of the classifications usually found on a company's

balance sheet.

Current assetsGenerally, current assets include cash and other assets that are expected to turn to cash

within one year of the date of the balance sheet. Examples of current assets are cash and

cash equivalents, short-term investments, accounts receivable, inventory and prepaid

expenses.

InvestmentsThis classification is the first of the noncurrent or long-term assets. Included are long-term

investments in other companies, the cash surrender value of life insurance, bond sinking

funds, real estate held for sale, and cash that is restricted for construction of plant and

equipment.

Property, plant and equipmentThis category of noncurrent assets includes the cost of land, buildings, machinery,

equipment, furniture, fixtures, and vehicles used in the operations of a business. Except for

land, these assets will be depreciated over their useful lives.

Intangible assetsIntangible assets include goodwill, trademarks, patents, copyrights and other non-physical

assets that were acquired at a cost. The amount reported is their cost to acquire minus any

amortization or write-down due to impairment. Valuable trademarks and logos that were

developed by a company through years of advertising are not reported because they were

not purchased from another person or company.

Other assetsThis category often includes costs that have been paid but are being expensed over a period

greater than one year. Examples include bond issue costs and certain deferred income

taxes.

Current liabilitiesCurrent liabilities are obligations of a company that are payable within one year of the date of

the balance sheet (and will require the use of a current asset or will be replaced with another

current liability).

Current liabilities include loans payable that will be due within one year of the balance sheet

date, the current portion of long-term debt, accounts payable, income taxes payable and

liabilities for accrued expenses.

Noncurrent liabilitiesThese are also referred to as long-term liabilities. In other words, these obligations will not be

due within one year of the balance sheet date. Examples include portions of automobile

loans, portions of mortgage loans, bonds payable, and deferred income taxes.

Stockholders' equityThis section of the balance sheet consists of the following major sections:

Paid-in capital (the amounts paid by investors when the original shares of a corporation were issued)

Retained earnings (the earnings of the corporation since it began minus the amounts that were distributed in the form of dividends to the stockholders)

Treasury stock (a subtraction that represents the amount paid to repurchase the corporation's own stock)

13. Income StatementThe income statement is also known as the statement of operations, the profit and loss statement, or P&L. It presents a company's revenues, expenses, gains, losses and net

income for a specified period of time such as a year, quarter, month, 13 weeks, etc.

Income Statement FormatsThere are two formats for presenting a company's income statement:

Multiple-step

Single-step

The difference in formats has to do with the number of subtractions and subtotals that

appear on the income statement before getting to the company's bottom line net income.

Multiple-step income statementNote that in the following multi-step income statement, there are three subtractions:

1. The first subtraction results in the subtotal gross profit.2. The second subtraction results in the subtotal operating income.3. The third subtraction provides the bottom line net income.

Single-step income statement

In the single-step format, the income statement will have only one subtraction—all of the

expenses (both operating and non-operating) are subtracted from all of the revenues (both

operating and non-operating). In this format, there is no subtotal for gross profit or operating

income. The bottom line, net income, results from a single subtraction (a single step) as

shown here:

Balance Sheet and Income Statement are LinkedAs we had discussed earlier, revenues cause stockholders' equity to increase while

expenses cause stockholders' equity to decrease. Therefore, a positive net income reported

on the income statement (which is the result of revenues being greater than expenses) will

cause stockholders' equity to increase. A negative net income will cause stockholders' equity

to decrease.

The income statement accounts are temporary accounts because their balances will be

closed at the end of each accounting year to the stockholders' equity account Retained

Earnings. (The balances in a sole proprietorship's income statement accounts will be closed

to the owner's capital account.)

The link between the balance sheet and income statement is helpful for bookkeepers and

accountants who want some assurance that the amount of net income appearing on the

income statement is correct. If you verify the ending balances in the relatively few balance

sheet accounts, you can have confidence that the income statement has the proper net

income. Hence, you are wise to establish a routine to verify all of the balance sheet amounts.

Note: This technique does not guarantee that the details within the income statement are perfect.Here is our suggestion for reviewing the balance sheet amounts.

Additional review

Another review that should be done routinely is to compare each item on the income

statement to the same item on an earlier income statement. For example, the amounts for

the 5-month period of the current year should be compared to the 5-month period of the

previous year. If budgets are prepared, also compare this year's 5-month period to the

budgeted amounts for the 5-month period.

The same holds for the balance sheet: compare the recent amounts to the amounts on the

balance sheets from a year earlier and from a month earlier.

14. Cash Flow StatementWhile the balance sheet and the income statement are the most frequently referenced

financial statements, thestatement of cash flows or cash flow statement is a very

important financial statement.

The cash flow statement is important because the income statement and balance sheet are

normally prepared using the accrual method of accounting. Hence the revenues reported on

the income statement were earned but the company may not have received the money from

its customers. (Many times companies allow customers to pay in 30 days or 60 days and

often customers pay later than the agreed upon terms.) Similarly the expenses that are

reported on the income statement have occurred, but the company may not have paid for the

expense in the same period. In order to understand how cash has changed, and because

many believe that "cash is king" the cash flow statement should be distributed and read at

the same time as the income statement and balance sheet.

Format of the Cash Flow StatementWithin the cash flow statement, the cash receipts or cash inflows are reported

as positive amounts. The cash paid out or cash outflows are reported

as negative amounts.

The following table provides various ways for you to think of the positive and negative

amounts that are shown on the cash flow statement:

The net total of all of the positive and negative amounts reported on the cash flow statement

should equal thechange in the amount of the company's cash and cash equivalents. (The

company's cash and cash equivalents are reported on its balance sheets.)

The cash inflows and cash outflows which explain the change in a company's cash and cash

equivalents are reported in three main sections of the cash flow statement:

1. Operating activities

2. Investing activities

3. Financing activities

In addition to the three main sections, the cash flow statement requires the following

disclosures:

the amount of interest paid the amount of income taxes paid exchanges of major items that did not involve cash (such as exchanging

land for common stock, converting bonds into common stock, etc.).1. Operating activitiesThe cash flows reported in the operating activities section of the cash flow statement can be

presented using one of two methods:

Direct method

Indirect method

The direct method is recommended by the FASB. However, a survey of 500 annual reports

of large U.S. corporations revealed that only about 1% had used the recommended direct

method. Nearly all of the U.S. corporations in the survey used the indirect method. Hence,

we will limit our discussion to the indirect method.

Indirect method, Cash Flows from Operating ActivitiesWhen the indirect method is used, the first section of the cash flow statement, Cash Flows from Operating Activities, begins with the company's net income (which is the bottom line

of the income statement). Since the net income was computed using the accrual method of

accounting, it needs to be adjusted in order to reflect the cash received and paid.

The very first adjustment involves depreciation. The amount of Depreciation Expense

reported on the income statement had reduced the company's net income, but the

depreciation entry did not involve cash. (The journal entry for the current period's

depreciation was a debit to Depreciation Expense and a credit to Accumulated Depreciation.

Cash was not used.) Since the depreciation expense reduced net income, but did not use

any cash, the amount of depreciation expense is added back to the net income amount.

So far, the Cash Flows from Operating Activities is $28,000

Any amortization or depletion expense is also added back.

Next, the operating activities will adjust the net income to reflect the changes in the amounts

of current assets and current liabilities during the accounting period. For example, if accounts

receivable increased from $9,500 to $9,800 during the period, we conclude that the company

did not collect cash for all of the sales revenues shown on the income statement. Not

collecting all of the sales amounts (or seeing accounts receivable increase) is viewed as

negative for the company's cash. Hence the $300 increase in accounts receivable is shown

as a negative adjustment of $300:

So far, the Cash Flows from Operating Activities is $27,700

If accounts payable increased from $3,100 to $3,350 during the period, that indicates that

the company did not pay all of its expenses. Not paying the bills is good for the company's

cash. Hence, the $250 increase in accounts payable will be shown as a positive amount:

So far, the Cash Flows from Operating Activities is $27,950

The changes in the current asset and the current liability accounts are reported as

adjustments to the company's net income in the operating activities section—except that the

change in short-term notes payable will be reported in the financing activities section.

2. Investing activitiesThe purchasing and selling of long-term assets are reported in the second section of the

cash flow statement,investing activities.

The cash flows that involve long-term assets include:

The cash received from selling long-term assets. These are reported as positive amounts.

The cash used to purchase long-term assets. These are reported as negative amounts.

3. Financing activitiesThe changes in the noncurrent liabilities, stockholders' (or owner's) equity, and short-term

loans are reported in the financing activities section of the cash flow statement.

The positive amounts in the financing activities section could indicate that cash was

received from:

Issuing bonds payable

Borrowing through other long-term loans

Issuing shares of stock

Borrowing through short-term loans

The negative amounts indicate that cash was used for:

Retiring (paying off) long-term debt

Purchasing shares of the company's stock (treasury stock)

Paying dividends to stockholders

Repaying short-term loans

OtherAt the bottom of the cash flow statement, the net totals of the three sections are reconciled

with the change in the cash and cash equivalents that are reported on the company's

balance sheet.

The reporting requirements for the cash flow statement also include disclosing the amounts

paid for interest and income taxes and significant noncash investing and financing activities.

(Two examples of noncash investing and financing activities are converting bonds to

common stock and exchanging bonds payable for land.)

15. Statement of Stockholders' EquityThe fourth financial statement is the statement of stockholders' equity. This statement lists the changes to the stockholders' equity section of the balance sheet during the current accounting period. A comparative statement of stockholders' equity will also report the amounts for the previous period.

To see examples of the statement of stockholders' equity we recommend that you identify a few U.S. corporations with stock that is publicly traded. On each corporation's website, select Investor Relations and then select each corporation's Form 10-K (the annual report to the Securities and Exchange Commission). Go to the section of the 10-K which presents the corporation's financial statements and view the statement of stockholders' equity.

Closing Cut-OffAt a minimum of once per year, companies must prepare financial statements. In addition companies often prepare quarterly and monthly financial statements which are referred to as interim financial statements.

For any of the financial statements to be accurate it is necessary to have a proper cut-off. This means including all of a company's business transactions in the proper accounting period. For example, the electricity bill arriving on January 10 might be the cost of the electricity that was actually used in December. (The time lag resulted from the utility company reading the electric meters and preparing and mailing the bill.) Hence under the accrual method of accounting, the bill received on January 10 needs to be included in December's expenses

and must also be reported by the company as a liability as of December 31. Similarly, the hourly payroll processed during the first few days in January and paid on January 6 is likely to include the cost of employees working during the last few days in December. The cost of the hours worked through December 31 must be included in the company's December expenses and in the liabilities as of December 31.As you read the previous paragraph, you may have been reminded of our discussion of adjusting entries. That's because the adjusting entries are part of each period's closing process. The adjusting entries are prepared in order to report a company's revenues and expenses in the proper accounting period.

The closing process

To achieve a proper cut-off and to distribute the financial statements in a timely manner, it is helpful to have a timeline (or PERT chart) that indicates the necessary steps in the closing process. The timeline will indicate what needs to be done and the sequence in which things need to occur. It will also reveal what is preventing the financial statements from being distributed sooner.

In addition, a checklist of the closing tasks should be prepared and distributed to the appropriate employees as to what is required, who is responsible, and the day it is due.

If some journal entries must be written every month, it is helpful to assign journal entry numbers to these standard journal entries or recurring journal entries. For example, a company may designate JE33 (Journal Entry #33) to be the recurring accrual of expenses that have occurred but have not yet been recorded in Accounts Payable as of the end of a month. Perhaps the timeline/checklist will indicate that JE33 must be submitted by the accounts payable clerk six days after each month ends. The company may also have its computer automatically prepare JE34 which is the entry that automatically reverses the previous month's accrual entry JE33.Some recurring journal entries will have the same amount each month. For example, a company's JE10 might be $10,800 every month of the year for the company's depreciation expense. (Some companies will refer to the entries that have the same amounts and accounts every month as standard entries.)Another recurring entry may involve the same accounts each month, but the amounts will vary from month to month. For example, a company's JE03 might be the recurring monthly entry for bad debts

expense. The company has determined in advance that the amount of JE03 will be 0.002 of the company's monthly credit sales. Since the amount of sales is different every month, the amounts on JE03 will be different each month.

Having entry numbers and standard entries should help to make the monthly closings more routine and efficient.

Importance of ControlsThe use of accounting software has eliminated some of the tedious tasks previously associated with bookkeeping. This could result in fewer people involved in the bookkeeping, accounting and administrative tasks. A side effect of fewer people handling more tasks is the potential for concealing some dishonest activity. For example, if the person who processes the cash receipts is also the person that records the amounts in customers' accounts, stealing some cash will be easier than if the tasks were separated. Having a third person mailing statements to customers with instructions to report any discrepancies to a fourth person will further safeguard the company's assets.

Accountants refer to the practices and policies for safeguarding assets as internal controls. Very large corporations may have a staff of internal auditors that ensure there are controls in place (including the separation of duties) so that fraud and misappropriation will not occur. Small companies or organizations with a small staff are therefore at a disadvantage. Nonetheless owners and managers of even the smallest companies and organizations must be aware of the need for internal controls. Here is a partial list of some internal controls that smaller organizations can implement:

Separate the handling of cash from the person processing accounts receivable.

Have the bank statement reconciled by someone who does not process the receipts or record the amounts in the general ledger cash account.

Have the owner of a small company approve all purchase orders.

Have the owner of a small company review all payments and sign all checks.

Have all credit memos to customers be approved by the owner.

We are not experts in internal controls, but we realize their importance. We strongly recommend that you seek assistance from

your professional accountant regarding internal controls that are appropriate for your business or organization.

16. 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:

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:

n 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.

17. Introduction to DepreciationBuildings, machinery, equipment, furniture, fixtures, computers, outdoor lighting, parking lots,

cars, and trucks are examples of assets that will last for more than one year, but will not last

indefinitely. During each accounting period (year, quarter, month, etc.) a portion of the cost

of these assets is being used up. The portion being used up is reported as Depreciation

Expense on the income statement. In effect depreciation is the transfer of a portion of

the asset's cost from the balance sheet to the income statement during each year of the

asset's life.

The calculation and reporting of depreciation is based upon two accounting principles:

1. Cost principle . This principle requires that the Depreciation Expense reported on the income statement, and the asset amount that is reported on the balance sheet, should be based on the historical (original) cost of the asset. (The amounts should not be based on the cost to replace the asset, or on the current market value of the asset, etc.)

2. Matching principle . This principle requires that the asset's cost be allocated to Depreciation Expense over the life of the asset. In effect the cost of the asset is divided up with some of the cost being reported on each of the income statements issued during the life of the asset. By assigning a portion of the asset's cost to various income statements, the accountant is matching a portion of the asset's cost with each period in which the asset is used. Hopefully this also means that the asset's cost is being matched with the revenues earned by using the asset.

There are several depreciation methods allowed for achieving the matching principle. The

depreciation methods can be grouped into two categories: straight-line depreciation and

accelerated depreciation.

The assets mentioned above are often referred to as fixed assets, plant assets, depreciable

assets, constructed assets, and property, plant and equipment. It is important to note that the

asset land is not depreciated, because land is assumed to last indefinitely.

Note: We developed forms and exam questions to help you learn about depreciation. They are available at AccountingCoach PRO.

Book vs. Tax DepreciationAccountingCoach.com's discussion of depreciation is limited to the depreciation entered into

the company's general ledger (or books) and reported on the company's financial

statements. These amounts are based on accounting principles. The amounts

resulting from the accounting principles are often different from the amounts based on the

Internal Revenue Service code and regulations. Hence the depreciation on the financial

statements will likely be legitimately different from the depreciation on the company's tax

returns. [To learn about the depreciation for income tax purposes, you should review the

Internal Revenue Service publications (available via the Internet) and/or consult a tax

professional.]

Book Depreciation Illustrated

Assumptions

To illustrate depreciation used in the accounting records and on the financial statements,

let's assume the following facts:

On July 1, 2012 a company purchases equipment having a cost of $10,500.

The company estimates that the equipment will have a useful life of 5 years.

At the end of its useful life, the company expects to sell the equipment for $500.

The company wants the depreciation to be reported evenly over the 5-year life.

Calculation of Straight-line Depreciation

The most common method of depreciating assets for financial statement purposes (as

opposed to the method used for income tax purposes) is the straight-line method. Under this

depreciation method, the depreciation for each full year is the same amount.

The depreciation expense for a full year when computed under the straight-line method is

illustrated here:

If a company's accounting year ends on December 31, the company will report the depreciation expense on the company's income statement as shown in the following depreciation schedule:

The actual cash paid by the company for this equipment will occur as follows:

As you can see, the company paid $10,500 in 2012, but the 2012 income statement reports

Depreciation Expense of only $1,000. (Because the asset was acquired on July 1, 2012, only

half of the annual depreciation expense amount is recorded in 2012 and 2017.) In each of

the years 2013 through 2016 the company's income statements will report $2,000 of

Depreciation Expense, thereby matching $2,000 of Depreciation Expense with the revenues

earned in each of those years. However, the company will not pay out any cash for this

expense during those years. The company's net income before income taxes will be

reduced in each of the years 2013 through 2016 by $2,000—but the Cash account will not

be reduced. This explains why Depreciation Expense is sometimes referred to as a noncash

expense.

Journal Entries For DepreciationThe depreciation for the financial statements is entered into the accounts via a general journal entry. Assuming that the company prepares only annual financial statements the

journal entries can be prepared as of the last day of each year:

If monthly financial statements were prepared, 1/12 of the annual amounts would be entered

monthly.

Note that the account credited in the journal entries is not the asset

account Equipment. Instead, the credit is entered in the contra asset account Accumulated Depreciation. The use of this contra account will allow the asset

Equipment to continue to report the equipment's cost, while also reporting in the account

Accumulated Depreciation the amount that has been charged to Depreciation Expense since

the asset was acquired. For example, as of December 31, 2013 the Equipment account will

have a debit balance of $10,500. On the same day, the account Accumulated Depreciation

will have a credit balance of $3,000. In T-account form, it looks like this:

The $10,500 debit balance in Equipment minus the $3,000 credit balance in Accumulated Depreciation equals $7,500. This net amount of $7,500 is referred to as the book value or as the carrying value of the equipment.

18.Introduction to Break-even PointA person starting a new business often asks, "At what level of sales will my company make a

profit?" Established companies that have suffered through some rough years might have a

similar question. Others ask, "At what point will I be able to draw a fair salary from my

company?" Our discussion of break-even point and break-even analysis will provide a

thought process that may help to answer those questions and to provide some insight as to

how profits change as sales increase or decrease.

Frankly, predicting a precise amount of sales or profits is nearly impossible due to a

company's many products (with varying degrees of profitability), the company's many

customers (with varying demands for service), and the interaction between price, promotion

and the number of units sold. These and other factors will complicate the break-even

analysis.

In spite of these real-world complexities, we will present a simple model or technique

referred to by several names: break-even point, break-even analysis, break-even formula,

break-even point formula, break-even model, cost-volume-profit (CVP) analysis, or expense-

volume-profit (EVP) analysis. The latter two names are appealing because the break-even

technique can be adapted to determine the sales needed to attain a specified amount of

profits. However, we will use the terms break-even point and break-even analysis.

To assist with our explanations, we will use a fictional company Oil Change Co. (a company

that provides oil changes for automobiles). The amounts and assumptions used in Oil

Change Co. are also fictional.

We developed some business forms to assist in the calculation of the break-even point. You will find these helpful forms as well as exam questions pertaining to the break-even point in AccountingCoach PRO.

Expense BehaviorAt the heart of break-even point or break-even analysis is the relationship

between expenses and revenues. It is critical to know how expenses will change as

sales increase or decrease. Some expenses will increase as sales increase, whereas some

expenses will not change as sales increase or decrease.

Variable ExpensesVariable expenses increase when sales increase. They also decrease when sales decrease.

At Oil Change Co. the following items have been identified as variable expenses. Next to

each item is the variable expense per car or per oil change:

The other expenses at Oil Change Co. (rent, heat, etc.) will not increase when an additional

car is serviced.

For the reasons shown in the above list, Oil Change Co.'s variable expenses will be $9 if it

services one car, $18 if it services two cars, $90 if it services 10 cars, $900 if it services 100

cars, etc.

Fixed ExpensesFixed expenses do not increase when sales increase. Fixed expenses do not decrease

when sales decrease. In other words, fixed expenses such as rent will not change when

sales increase or decrease.

At Oil Change Co. the following items have been identified as fixed expenses. The amount

shown is the fixed expense per week:

Mixed ExpensesSome expenses are part variable and part fixed. These are often referred to as mixed or

semi-variable expenses. An example would be a salesperson's compensation that is

composed of a salary portion (fixed expense) and a commission portion (variable expense).

Mixed expenses could be split into two parts. The variable portion can be listed with other

variable expenses and the fixed portion can be included with the other fixed expenses.

Revenues or SalesRevenues (or sales) at Oil Change Co. are the amounts earned from servicing cars. Oil

Change Co. charges one flat fee of $24 for performing the oil change service. For $24 the

company changes the oil and filter, adds needed fluids, adds air to the tires, and inspects

engine belts.

At the present time no other service is provided and the $24 fee is the same for all

automobiles regardless of engine size.

As the result of its pricing, if Oil Change Co. services 10 cars its revenues (or sales) are

$240. If it services 100 cars, its revenues will be $2,400.

19. Introduction to Nonprofit AccountingFrom churches to youth organizations to the local chambers of commerce, nonprofit

organizations make our communities more livable places. Unlike for-profit businesses that

exist to generate profits for their owners, nonprofit organizations exist to pursue missions that

address the needs of society. Nonprofit organizations serve in a variety of sectors, such as

religious, education, health, social services, commerce, amateur sports clubs, and the arts.

Nonprofits do not have commercial owners and must rely on funds from contributions,

membership dues, program revenues, fundraising events, public and private grants, and

investment income.

Our intent is to present some of the basic concepts that are unique to nonprofit accounting

and reporting, including the financial statements required by the Financial Accounting

Standards Board (FASB).

We will not dwell on the accounting that is similar to that used by for-profit businesses. If you

are not familiar with accounting for businesses or you wish to refresh your understanding,

you will find free explanations, quizzes, Q&A, and more at Accounting Topics.Accountants often refer to businesses as for-profit entities and to nonprofit organizations

as not-for-profit entities. We will be using the more common term nonprofit instead of

not-for-profit.

Again, this is not a comprehensive study of the field of nonprofit accounting. There are many

different types of nonprofits, including governmental nonprofits, which we will not address.

Note: We developed seven business forms to assist you in preparing the financial

statements of a nonprofit organization. You can find additional information

at AccountingCoach PRO.

Differences between Nonprofits and For-ProfitsThe following table highlights some of the key differences between nonprofit organizations

and for-profit corporations:

Mission, Ownership, Tax-Exempt Status

Mission and Ownership

While businesses are organized to generate profits, nonprofits are organized to address needs in society. As a result, nonprofits will issue a statement of activities instead of the income statement issued by for-profit businesses.Since nonprofits do not have owners, there is no owner's equity or stockholders' equity and there cannot be distributions to owners.

Some people mistakenly assume that if an organization is designated as a nonprofit, it cannot legally earn profits. In fact, earning profits (having revenues that exceed expenses) is almost a necessity for a nonprofit if it hopes to withstand such things as:

unexpected expenses

uneven flows of revenues

a decrease in revenues

rising costs due to inflation

an increase in staffing needs

an increase in the need for its services

a purchase or replacement of needed equipment

other needs since a nonprofit cannot issue shares of stock

Tax-Exempt Status

Nonprofit organizations may apply to the Internal Revenue Service in order to be exempt from federal income taxes.

A second issue is whether a donor's contribution to a nonprofit organization will qualify as a charitable deduction on the donor's income tax return. For example, churches, schools, and Red Cross chapters are some of the nonprofits that will qualify as tax-exempt and their donors' contributions will also qualify as charitable deductions on the donors' income tax returns.However, there are nonprofits that qualify as tax-exempt but their donors' contributions do not qualify as charitable deductions (although they may qualify as business expenses). Examples of these nonprofits

include social organizations, chambers of commerce, college fraternities and sororities, amateur sports clubs, employee organizations, and more.You can learn more about the tax-exempt status for a nonprofit, the deductibility of contributions by donors, and the taxability of activities not directly related to a nonprofit's exempt purpose in the Internal Revenue Service Publication 557, Tax-Exempt Status for Your Organization, which is available at no cost on IRS.gov.Even if a nonprofit is exempt from federal income taxes, it is likely that its employees will be subject to employment taxes. Nonprofits may or may not be exempt from sales taxes, real estate taxes, and other taxes depending on which state in the U.S. they are incorporated or operate.

20.Introduction to Payroll AccountingIt's a fact of business—if a company has employees, it has to account for payroll and fringe

benefits.

In this explanation of payroll accounting we'll introduce payroll, fringe benefits, and the

payroll-related accounts that a typical company will report on its income statement and balance sheet. (You can learn more about the income statement and balance sheet from our video seminar Understanding Financial Statements, which is included in AccountingCoach PRO.) Payroll and benefits

include items such as:

salaries

wages

bonuses & commissions to employees

overtime pay

payroll taxes and costs

o Social Security

o Medicare

o federal income tax

o state income tax

o state unemployment tax

o federal unemployment tax

o worker compensation insurance

employer paid benefits

o holidays

o vacations

o sick days

o insurance (health, dental, vision, life, disability)

o retirement plans

o profit-sharing plans

Many of these items are subject to state and federal laws; some involve labor contracts or

company policies.

Note: AccountingCoach.com focuses on financial statement reporting and not on income tax returnreporting. You should consult with a tax professional or review the Internal Revenue Service publications to learn how employers and employees are required to report salaries, wages, and fringe benefits for income tax purposes.For the years 2011 and 2012 only, the employee's tax rate for Social Security was 4.2% instead of the usual 6.2%. (The employer's rate remained at 6.2% and the employee and employer Medicare tax rates remained at 1.45%.)

Beginning in 2013 a Medicare surtax was introduced for certain employees (and self-employed individuals) who have reached a specified amount of earnings. The tax rates and wages bases for federal payroll taxes can be found at http://www.irs.gov/pub/irs-pdf/p15.pdf

Matching Principle

As we proceed with our explanation of payroll accounting, it will be helpful to recall

the matching principle of accounting. This principle will guide us to better understand

how payroll and fringe benefits are reported on financial statements. (We're assuming that a

company follows the The matching principle requires a company to match expenses to the accounting period in which the relatedrevenues are reported. If a direct connection between revenues and an expense does not exist, then the expense should appear on the income statement for the accounting period in which it was incurred. Keep in mind that expenses are often incurred (or occur) in a different accounting period than when they are paid.Let's use three payroll examples to illustrate this point:

1. A company employs a student to work a total of five days—from December 26 through December 30, 2014. On December 30 the

student submits her time card. The company issues her payroll check on the next scheduled payday, January 5, 2015.

Even though the check is dated January 5, 2015, the matching principle requires that the company report the expense and the liability in December 2014 when the work was performed (and the company incurred the liability). Because the student was only employed for the last five days of December, the company would not have any wage or fringe benefits expense for her during January. The paycheck issued on January 5 merely reduces the company's liabilities and cash.

2. Let's assume that a company gives its sales manager an annual bonus of 1% of sales, to be paid on January 15, 2015. The bonus amount is calculated by multiplying the sales from January 1 through December 31, 2014 times 1%.

The matching principle requires that the company report 1% of sales as a Bonus Expense on its income statement (and a liability for the total amount owed must be reported on its balance sheet) in every accounting period in which sales occurred in 2014. If the company violates the matching principle by ignoring the bonus expense throughout the year 2014 (when sales actually occurred) and reports the entire bonus amount as an expense for just one day (January 15, 2015), every income statement pertinent to 2014 will report too much net income and the income statement that includes January 15, 2015 will report too little net income. The matching principle requires that the bonus expense pertinent to the 2014 sales be matched with the 2014 sales on the 2014 income statement.If the entries are recorded properly, the balance sheet dated December 31, 2014 will report a current liability for the total bonus amount owed to the sales manager. On January 15, 2015 (when the company pays the bonus) the company will not have an expense; rather, the payment will reduce the company's cash and reduce the current liability that was established when the bonus was recorded as an expense in 2014.

3. A company has a vacation plan that will provide two weeks of vacation in the year 2015 if the employee worked the entire year of 2014. In the year 2014 (when the employee is working) the company reports the vacation expense on its 2014 income statement. The company's December 31, 2014 balance sheet will report a current liability for the two weeks of vacation pay that was earned by each employee but not yet taken. In 2015 (when

employees take the vacations that were earned and expensed in 2014), the company will reduce its cash and its vacation liability.

As you learn about accounting for payroll and fringe benefits, keep the matching principle in mind. As the above examples show, the date on which a company pays wages or fringe benefits is not necessarily the date on which the company reports the expense on its financial statements.

21. Salaries, Wages, & Overtime PayIn this section of payroll accounting we focus on the gross amounts earned by the employees of a company.

Salaries

Salaries are usually associated with "white-collar" workers such as office employees, managers, professionals, and executives. Salaried employees are often paid semi-monthly (e.g., on the 15th and last day of the month) or bi-weekly (e.g., every other Friday) and their salaries are often stated as a gross annual amount, such as "$48,000 per year." The "gross" amount refers to the pay an employee would receive before withholdings are made for such things as taxes, contributions to United Way, and savings plans.

Since salaried employees earn a specified annual amount, it is likely that their gross pay for each pay period is the same recurring amount. For example, if a manager's salary is $48,000 per year and salaries are paid semi-monthly, the manager's gross pay will be $2,000 for each of the 24 pay periods. (If the manager is paid bi-weekly, the gross pay would be $1,846.15 for each of the 26 pay periods.) A salaried employee's work period usually ends on payday; for example, a paycheck on January 31 usually covers the work period of January 16-31. This is convenient for accounting purposes if the company prepares financial statements on a calendar month basis.

Wages

Wages are often associated with production employees (sometimes referred to as "blue-collar" workers), non-managers, and other employees whose pay is dependent on hours worked. The pay for

these employees is generally stated as a gross, hourly rate, such as "$13.52 per hour." Again, the "gross" amount refers to the pay an employee would receive before withholdings are made for such things as taxes, contributions, and savings plans.

Employees receiving wages are often paid weekly or biweekly. To determine the gross wages earned during a work period, the employer multiplies each employee's hourly rate times the number of work hours recorded for the employee during the work period. Due to the extra time needed to make calculations for each employee, hourly-paid employees typically receive their paychecks approximately five days after the work period has ended.

When the hourly-paid employees have work periods that are weekly or biweekly, but the company's financial statements cover calendar months, the company will likely have to prepare an accrual-type adjusting entry at the end of the month. If hourly wages are a significant portion of a company's expenses, it is critical that the company report the correct amount of wages expense that pertains to the 30 or 31 days in the month, not the 28 days in a four-week work period.

Bonuses & Commissions Paid to Employees

Throughout our explanation, bonuses paid to employees and sales commissions paid to employees will be considered to be part of salaries.

Overtime Pay

Overtime refers to time worked in excess of 40 hours per week. Whether or not employees are paid for overtime depends on each employee's job responsibilities and rate of pay—some employees are exempt from overtime pay and some are not. For example, executives are considered to be "exempt"; their employers are not required to pay them for their overtime hours because (1) their compensation is high, and (2) they can control their work hours. Executives do not need state or federal wage and hour laws to protect them from company abuse.

On the other hand, a design technician earning an annual salary of $18,000 per year is probably not in control of her work hours. If she works for an executive who decides to work 60 hours per week, the design technician needs to be protected from having to work 60 hours per week for no more pay than she would receive for 40 hours of work. This employee is considered a "nonexempt" employee—she is not

exempt from being paid overtime compensation. Some unethical companies have been known to classify "hourly wage" employees as "salaried" in hopes of making them exempt from overtime pay—federal and state laws exist to prevent such unfair treatment of employees.

When processing payroll, don't assume that it's only the hourly paid employees who receive overtime pay—state and federal laws require overtime payments to lower—paid salaried employees. It is also possible that some generous employers will give overtime pay to employees who are not required by law to receive it.

Overtime Premium

An overtime premium refers to the "half" portion of "time-and-a-half" or "time-and-one-half" overtime pay. For example, assume an employee in the production department is expected to work 40 hours per week at $10 per hour. If the employer requires the employee to work 42 hours in a given week, the extra two hours are paid at time-and-a-half and the employee earns a total of $430 for the week (40 hours x $10 per hour, plus 2 overtime hours x $15 per hour). It can also be computed as 42 hours at the straight-time rate of $10 per hour plus 2 hours times the overtime premium of $5 per hour.

22.Payroll Withholdings: Taxes & Benefits Paid by EmployeesThis section of payroll accounting focuses on the amounts withheld from employees' gross pay. (In Part 4 of payroll accounting we will discuss the payroll taxes that are not withheld from employees' gross pay.)The U. S. income tax system—as well as most state income tax systems—requires employers to withhold payroll taxes from their employees' gross salaries and wages. The withholding of taxes and other deductions from employees' paychecks affects the employer in several ways: (1) it reduces the cash amount paid to employees, (2) it creates a current liability for the employer, and (3) it requires the employer to remit the withheld taxes to the federal and state government by specific deadlines. Failure to remit payroll taxes in a timely manner results in interest and penalties levied on the employer; flagrant violations trigger more severe consequences.

Payroll withholdings include:

1. Employee portion of Social Security tax

2. Employee portion of Medicare tax

3. Federal income tax

4. State income tax

5. Court-ordered withholdings

6. Other withholdings

1. Employee portion of Social Security tax

A key component of payroll accounting is the Social Security tax. (The Social Security tax along with the Medicare tax make up what is referred to as FICA.) Social Security tax is withheld from an employee's salary or wages and the employer is also required to pay a Social Security tax. In other words, the employer is responsible for remitting to the federal government both the employee and the employer portions of the Social Security tax. As a result, Social Security tax is both an employee withholding and an employer expense. (The official title for the system financed by the Social Security tax is Old Age, Survivors and Disability Insurance, or OASDI. As the name indicates, this system pays retirement, disability, family, and survivors' benefits.)In 2015, the amount of Social Security tax that an employer must withhold from an employee is 6.2% of the first $118,500 of the employee's annual wages and salary; any amount above $118,500 is not subject to Social Security tax withholdings. For example:

If an employee earns $40,000 in wages in 2015, the entire $40,000 is subject to withholdings at 6.2%, for a total annual withholding of $2,480.

If an employee earns $200,000 in salary in 2015, only the first $118,500 of the salary is subject to the Social Security tax of 6.2%, for a total annual withholding of $7,347. (The amount of salary that is greater than $118,500 is not subject to Social Security tax withholdings, although it will be subject to the Medicare tax discussed in the next section.)

The amount withheld—and the employer's portion—are reported as a current liability until the amounts are remitted to the government by the employer.Note: The employee's tax rate for Social Security and the amount subject to the tax can be found at http://www.irs.gov/pub/irs-pdf/p15.pdf.

2. Employee portion of Medicare tax

Medicare tax is also withheld from an employee's salary or wages and the employer is also required to pay a Medicare tax. In other words, the employer is responsible for remitting to the federal government both the employee and the employer portions of the Medicare tax. As a result, Medicare tax is both an

employee withholding and an employer expense. (The Medicare program helps pay for hospital care, nursing care, and doctor's fees for people age 65 and older as well as for some individuals receiving Social Security disability benefits.)The combination of the Social Security tax and the Medicare tax is referred to as FICA (an acronym for Federal Insurance Contribution Act).An employer must withhold 1.45% of each employee's annual wages and salary for Medicare tax. Unlike the Social Security tax, this percentage is applied on every employee's total salary no matter how large the salary might be—an employee's salary of $200,000 will require Medicare tax withholdings of $2,900 (the entire $200,000 times 1.45%).

Also, there is a Medicare surtax of 0.9% that is withheld from the employee on wages and salaries that are in excess of certain amounts. See IRS.gov for detail on this surtax.The employee's Medicare tax withholding plus the employer's Medicare tax are reported as a current liability until the amounts are remitted to the government by the employer.

3. Federal income tax

Another part of payroll accounting involves the employees' federal income tax. An employer is required to withhold the federal income tax that an employee is expected to owe based on salaries or wages. The amount withheld, however, is rarely the exact amount of income tax that the employee will owe to the government. The employee's year-end income tax return will dictate the exact amount owed for the year, meaning the employee will either pay in a little more in taxes, or will receive a tax refund.

The amount withheld for federal income tax is based on the employee's salary or wages as well as personal information that the employee is required to provide the employer on federal form W-4 (including marital status and the number of dependents claimed as exemptions). In cases where an employee is paid low wages and/or has a large number of personal exemptions, it may not be necessary for the employer to withhold any federal income tax. Unlike FICA, there is no employer contribution for federal income tax.

Amounts withheld from employees for federal income taxes are reported on the employer's balance sheet as a current liability. When the employer remits the amounts to the federal government, the current liability is reduced.

4. State income tax

In most states payroll accounting will involve a state income tax. In those states an employer is required to withhold the state income tax that an employee is expected to owe based on salaries or wages. Like its federal counterpart, the amount withheld is rarely the exact amount of income tax that the employee will owe to the state government. (It should be noted here that some states do not levy a personal income tax.)

The amount withheld for state income tax is based on the employee's salary or wages as well as personal information that the employee is required to provide the employer on a state version of federal form W-4 (including marital status and the number of dependents claimed as exemptions). In cases where an employee is paid low wages and/or has a large number of personal exemptions, it may not be necessary for the employer to withhold any state income tax. Like the federal income tax (and unlike the FICA tax), there is no employer contribution for state income tax.

Amounts withheld from employees for state income taxes are reported on the employer's balance sheet as a current liability. When the employer remits the amounts to the state government, the current liability is reduced.

5. Court-ordered withholdings

Payroll accounting also involves withholdings for items other than payroll taxes. For example, courts of law may order employers to garnish (withhold money from) an employee's salary or wages for purposes such as paying child support or repaying debts.The amounts withheld from employees for court-ordered withholdings are reported on the employer's balance sheet as a current liability. When the employer remits the amounts to the designated parties, the liability is reduced.

Some court orders may include a small fee to be withheld from the employee in order to reimburse the employer for administrative expenses. For example, the court order might direct the employer to withhold $101 from the employee and to remit $100 to a designated agency. The $1 difference will be a credit to the company's administrative expenses or to a miscellaneous revenue account.

6. Other withholdings

In addition to the mandatory withholdings that an employer makes for taxes and court orders, payroll accounting often includes amounts that employers may be

willing to withhold at the direction of its employees. These voluntary withholdings can include such things as:

union dues

charitable contributions

insurance premiums

401(k) and 403(b) contributions

U.S. savings bonds purchases

payments owed to the company for the purchase of company merchandise

If the voluntary withholdings are to be remitted to places outside of the company (a local charity, for example), the amounts withheld are reported on the employer's balance sheet as a current liability. When the employer remits the withholdings, the current liability will be reduced.

If the withholdings are for amounts that are due the company (such as employees' share of insurance premiums or amounts owed by employees for company merchandise), no remittance is required. Rather, the journal entry reflects a credit that reduces the company's insurance expense or reduces the company's receivables from employees. Sample journal entries are provided in Part 5 and Part 6.

Net PayNet pay is the amount that remains after withholdings are deducted from an employee's gross pay. Net pay is also referred to as "take home pay" or the amount that an employee "clears." From the company side of the transaction, it is the amount of cash the company will pay directly to the employees on payday.

23.Payroll Taxes, Costs & Benefits Paid by EmployersIn addition to salaries and wages, the employer will incur some or all of the following payroll-

related expenses:

1. Employer portion of Social Security tax

2. Employer portion of Medicare tax

3. State unemployment tax

4. Federal unemployment tax

5. Worker compensation insurance

6. Employer portion of insurance (health, dental, vision, life, disability)

7. Employer paid holidays, vacations, and sick days

8. Employer contributions toward 401(k), savings plans, & profit-sharing plans

9. Employer contributions to pension plans

10.Post-retirement health insurance

1. Employer portion of Social Security tax

Understanding the Social Security tax and the Medicare tax is critical for payroll

accounting. In this section we discuss the employers' portion of the Social Security tax.

In addition to the amount withheld from its employees for Social Security taxes, the employer

must contribute/remit an additional amount, which is an expense for the employer. In the

year 2015, the employer's portion of the Social Security tax is 6.2% of the first $118,500 of

an employee's annual wages and salary.

For example, if an employee earns $40,000 of wages, the entire $40,000 is subject to the

Social Security tax. This means that in addition to the withholding of $2,480, the employer

must also pay $2,480. The combined amount to be remitted to the federal government for

this one employee is $4,960 ($2,480 of withholding plus the employer's portion of $2,480).

For an employee with an annual salary of $200,000 in the year 2015, only the first $118,500

is subject to the Social Security tax. This means that in addition to the withholding of $7,347,

the employer must also pay $7,347. The combined amount to be remitted to the federal

government for this one employee is $14,694 ($7,347 + $7,347).

The employer's share of Social Security taxes is recorded as an expense and as an

additional current liability until the amounts are remitted.

2. Employer portion of Medicare tax

In addition to the employee's Medicare tax there is also an employer's Medicare tax. The

employer's Medicare tax is considered to be an expense for the employer. For the year

2015, the employer's portion of the Medicare tax is the same rate as the employee's

withholding—1.45% of every dollar of each employee's annual wages and salary.

Unlike the Social Security tax, there is no cap (ceiling or limit); if an employee earns a salary

of $200,000, the employer must pay a Medicare tax of $2,900 in addition to the $2,900 that

was withheld from the employee. The combined amount to be remitted to the federal

government for this one employee is $5,800.

The employer's share of Medicare taxes is recorded as an expense and as an additional

current liability until the amounts are remitted.

3. State unemployment tax

State governments administer unemployment services and determine the state

unemployment tax rate for each employer. (Some not-for-profit organizations—such as

churches without schools—may not be required to pay state unemployment taxes. You

should check with your state unemployment office to learn the specifics for your

organization.)

Generally, states require that the employers pay the entire unemployment tax. Often,

employers that have built up a large reserve in the state's unemployment fund will have

lower unemployment tax rates. Employers with a small reserve (or no reserve at all) will have

higher unemployment tax rates.

The state unemployment tax rate is applied to a wage base that is determined by each

state. (The wage bases range from $7,000 to more than $30,000.) If a state's unemployment

wage base is $14,000 then the state unemployment tax rate is applied only to the first

$14,000 of each employee's annual salary and wages. If we also assume that an employer's

state unemployment tax rate is 4%, then the employer's state unemployment tax cost will be

a maximum of $560 per year for each employee ($14,000 x 4%).

To illustrate, let's assume that a company has three employees. In 2015, Employee #1 earns

$19,000, Employee #2 earns $40,000, and Employee #3 earns $4,000. If the 2015 state

unemployment tax rate is 4% and the wage base is $14,000, the employer will pay a tax of

$1,280 to the state government:

Even though the state unemployment tax is based on employee salaries and wages,

the entire tax is paid by the employer. There is no withholding from an employee's salary or

wages for the state unemployment tax.

You should contact your state to get the rates that apply to your company.

4. Federal unemployment tax

The federal government oversees the state unemployment programs and requires

employers to pay a federal unemployment tax of 6.0% minus a credit if the employer has

paid into a state unemployment fund. If an employer is allowed the maximum credit of 5.4%,

then the federal unemployment tax rate will be 0.6%. This rate is then applied to each

employee's first $7,000 of annual salaries and wages.

Using the example of three employees with annual 2015 earnings of $19,000, $40,000, and

$4,000; with a federal unemployment tax rate of 0.6%, the employer will pay a tax of $108 to

the federal government:

Even though the federal unemployment tax is based on employee salaries and wages, the

entire tax is paid by the employer. There is no withholding from an employee's salary or

wages for the federal unemployment tax.

5. Worker compensation insurance

Worker compensation insurance provides coverage for employees who are injured on the

job. State law usually requires that employers carry this insurance. Worker compensation

insurance rates are a function of at least three variables: (1) the type of business or industry,

(2) the type of job being performed, and (3) the employer's history of claims.

For example, statistics show that a production worker in a meat packing plant has a greater-

than-average chance of suffering job-related cuts or back injuries. Because of this, worker

compensation insurance rates for these employees can be as high as 15% of wages. On the

other hand, the office staff of the meat packing plant—provided that they do not venture out

into the production area—may have a rate that is less than 1% of salaries and wages.

The worker compensation insurance rates are then applied to the wages and salaries of the

employees to arrive at the worker compensation insurance premiums or costs. Although the

insurance premiums are based on employee salaries and wages, the entire premium cost is

likely to be paid by the employer and is considered an expense for the employer. (Contact

your state's worker compensation office for the specifics in your state.)

If the employer pays the premium in advance, a current asset such as Prepaid Insurance is used. The account balance will be reduced and Worker Compensation Insurance Expense will increase as the employees work.

If the employer does not pay the premiums in advance, the company must accrue the

expense with an adjusting entry that increases Worker Compensation Insurance Expense

along with increases in a current liability such as Worker Compensation Insurance Liability.

In this situation the current liability will be reduced when the employer pays the worker

compensation insurance premiums.

Worker compensation insurance is a significant expense for the employer and therefore we

consider it an important part of payroll accounting.

6. Employer portion of insurance (health, dental, vision, life, disability)

In the past, many companies included group health, dental, vision, disability, and life

insurance in the benefit package provided to employees. Over the past few decades,

however, the cost of these group policies has risen significantly. Today the insurance

premium for family coverage could be more than $10,000 per year per employee. As a result

of these escalating costs, most companies now require employees to pay a portion of the

premium cost; this amount is usually collected by means of employee-directed payroll

withholding.

The employers' net cost (or expense) is simply the total amount of premiums paid to the

insurance company minus the portion of the cost the employer collects from its employees.

7. Employer paid holidays, vacations, and sick days

Many companies pay their permanent employees for holidays such as New Year's Day,

Memorial Day, July 4th, Labor Day, Thanksgiving, and Christmas. It is not unusual for

employees to be paid for 10 holidays per year. It is also common for employees to earn one

week of vacation after one year of service. Many employers give their employees two weeks

of vacation after three years of service, with more weeks given after 10 years of service.

Paid sick days are also a common benefit given to employees. If an employee is absent from

work due to such things as illness or surgery, the company will pay the employee for the time

missed. Employers generally set policies as to how sick days are to be used, and as to

whether or not an employee is permitted to carry over unused sick days into subsequent

years.

The matching principle requires that the cost of compensated (or paid) absences (holidays,

vacations, and sick days) be recognized as an expense during the time the employee is

present and working. In other words, the cost is expensed when the benefit is

being earned by the employee, not when the benefit is being used by the employee.

(However, the Financial Accounting Standards Board generally allows for sick days and

holidays not to be accrued.)

To illustrate, assume that an employee works full-time for the entire year 2014 and as a

result earns one week of vacation to be taken any time during the year 2015. During the year

2014 (when the employee is working), the employer records the vacation expense and the

vacation liability. In 2015, when the employee takes the vacation earned in the previous

year, the employer records the cash payment by crediting Cash and reduces the company

liability by debiting Vacation Payable.

8. Employer contributions toward 401(k), savings plans, and profit-sharing

plans

If an employer is required to contribute company money into an employee's savings program

or profit-sharing plan, the contribution should appear as an expense in the period when the

employee earned the company contribution. It is also likely that the company will have the

expense and the liability before the company actually pays the amount. This situation

requires the company to record an adjusting entry in order to match the expense to the

proper accounting period.

9. Employer contributions to pension plans

Some companies provide pensions for their employees. This means their employees will

receive ongoing monthly payments after they retire from the company. The matching

principle requires that the cost of the benefit should be recognized during the years that the

employees are working (earning the benefit), and not when the employee is retired.

Note: In effect, pensions (and other benefits) are part of the compensation package given to employees working at a company. While some parts of the compensation package are paid out during the time the employee is working, other benefits are deferred until the employee is retired. The cost of the entirecompensation package, however, must be expensed or assigned to products manufactured when the employee is working, so that the cost of the employee's work is matched with the revenue resulting from the employee's work.The concept is that in the years that the employee works, the company will charge Pension Expense and will credit either Pension Payable or Cash. For more specifics on pensions,

you are referred to an Intermediate Accounting text or to the Financial Accounting Standards

Board's website 

10. Post-retirement health insurance

Some companies continue to provide health insurance coverage to employees after they

have retired. This retiree benefit is considered to be part of the compensation package

earned by employees while they are working. Again, accrual accounting and the matching

principle require that the cost of this future insurance coverage be expensed (or assigned to

manufactured products) during the years the employees are working by debiting an expense

and crediting a liability. During the employees' retirement years, the company's payment for

insurance will reduce the company's liability and will reduce its cash.

To learn more on the accounting for post-retirement benefits, such as health insurance

coverage, you are referred to an Intermediate Accounting text and/or to the Financial

Accounting Standards Board's website www.fasb.org.

24.Introduction to Inventory and Cost of Goods SoldInventory is merchandise purchased by merchandisers (retailers, wholesalers,

distributors) for the purpose of being sold to customers. The cost of the merchandise

purchased but not yet sold is reported in the account Inventory or Merchandise Inventory.

Inventory is reported as a current asset on the company's balance sheet. Inventory is a

significant asset that needs to be monitored closely. Too much inventory can result in cash

flow problems, additional expenses (e.g., storage, insurance), and losses if the items

become obsolete. Too little inventory can result in lost sales and lost customers.

Because of the cost principle, inventory is reported on the balance sheet at the amount

paid to obtain(purchase) the merchandise, not at its selling price.

Inventory is also a significant asset of manufacturers. However, in order to simplify our

explanation, we will focus on a retailer.

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Cost of Goods SoldCost of goods sold is the cost of the merchandise that was sold to customers.

The cost of goods sold is reported on the income statement when the

sales revenues of the goods sold are reported.

A retailer's cost of goods sold includes the cost from its supplier plus any additional costs

necessary to get the merchandise into inventory and ready for sale. For example, let's

assume that Corner Shelf Bookstore purchases a college textbook from a publisher. If

Corner Shelf's cost from the publisher is $80 for the textbook plus $5 in shipping costs,

Corner Shelf reports $85 in its Inventory account until the book is sold. When the book is

sold, the $85 is removed from inventory and is reported as cost of goods sold on the income

statement.

When Costs ChangeIf the publisher increases the selling prices of its books, the bookstore will have a higher cost

for the next book it purchases from the publisher. Any books in the bookstore's inventory will

continue to be reported at their cost when purchased. For example, if the Corner Shelf

Bookstore has on its shelf a book that had a cost of $85, Corner Shelf will continue to report

the cost of that one book at its actual cost of $85 even if the same book now has a cost of

$90. The cost principle will not allow an amount higher than cost to be included in inventory.

Let's assume the Corner Shelf Bookstore had one book in inventory at the start of the year

2011 and at different times during 2011 purchased four identical books. During the year

2011 the cost of these books increased due to a paper shortage. The following chart shows

the costs of the five books that have to be accounted for. It also assumes that none of the

books has been sold as of December 31, 2011.

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Cost Flow AssumptionsIf the Corner Shelf Bookstore sells only one of the five books, which cost should Corner Shelf

report as the cost of goods sold? Should it select $85, $87, $89, $89, $90, or an average of

the five amounts? A related question is which cost should Corner Shelf report as inventory

on its balance sheet for the four books that have not been sold?

Accounting rules allow the bookstore to move the cost from inventory to the cost of goods

sold by using one of three cost flows:

1. First In, First Out (FIFO)

2. Last In, First Out (LIFO)

3. Average

Note that these are cost flow assumptions. This means that the order in which costs are

removed from inventory can be different from the order in which the goods are physically

removed from inventory. In other words, Corner Shelf could sell the book that was on hand at

December 31, 2010 but could remove from inventory the $90 cost of the book purchased in

December 2011 (if it elects the LIFO cost flow assumption).

25. Introduction to Chart of AccountsA chart of accounts is a listing of the names of the accounts that a company has identified

and made available for recording transactions in its general ledger. A company has the

flexibility to tailor its chart of accounts to best suit its needs, including adding accounts as

needed.

Within the chart of accounts you will find that the accounts are typically listed in the following

order:

Within the categories of operating revenues and operating expenses, accounts might be

further organized by business function (such as producing, selling, administrative, financing)

and/or by company divisions, product lines, etc.

A company's organization chart can serve as the outline for its accounting chart of

accounts. For example, if a company divides its business into ten departments (production,

marketing, human resources, etc.), each department will likely be accountable for its own

expenses (salaries, supplies, phone, etc.). Each department will have its own phone

expense account, its own salaries expense, etc.

A chart of accounts will likely be as large and as complex as the company itself. An

international corporation with several divisions may need thousands of accounts, whereas a

small local retailer may need as few as one hundred accounts.

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Sample Chart of Accounts For a Large CorporationEach account in the chart of accounts is typically assigned a name and a unique number by

which it can be identified. (Software for some small businesses may not require account

numbers.) Account numbers are often five or more digits in length with each digit

representing a division of the company, the department, the type of account, etc.

As you will see, the first digit might signify if the account is an asset, liability, etc. For

example, if the first digit is a "1" it is an asset. If the first digit is a "5" it is an operating

expense.

A gap between account numbers allows for adding accounts in the future. The following is

a partial listing of a sample chart of accounts.

Current Assets (account numbers 10000 - 16999)

10100 Cash - Regular Checking10200 Cash - Payroll Checking10600 Petty Cash Fund12100 Accounts Receivable12500 Allowance for Doubtful Accounts13100 Inventory14100 Supplies15300 Prepaid Insurance

Property, Plant, and Equipment (account numbers 17000 - 18999)

17000 Land17100 Buildings17300 Equipment17800 Vehicles18100 Accumulated Depreciation - Buildings18300 Accumulated Depreciation - Equipment18800 Accumulated Depreciation - Vehicles

Current Liabilities (account numbers 20000 - 24999)

20100 Notes Payable - Credit Line #120200 Notes Payable - Credit Line #221000 Accounts Payable22100 Wages Payable23100 Interest Payable24500 Unearned Revenues

Long-term Liabilities (account numbers 25000 - 26999)

25100 Mortgage Loan Payable25600 Bonds Payable25650 Discount on Bonds Payable

Stockholders' Equity (account numbers 27000 - 29999)

27100 Common Stock, No Par27500 Retained Earnings29500 Treasury Stock

Operating Revenues (account numbers 30000 - 39999)

31010 Sales - Division #1, Product Line 01031022 Sales - Division #1, Product Line 02232015 Sales - Division #2, Product Line 01533110 Sales - Division #3, Product Line 110

Cost of Goods Sold (account numbers 40000 - 49999)

41010 COGS - Division #1, Product Line 01041022 COGS - Division #1, Product Line 02242015 COGS - Division #2, Product Line 01543110 COGS - Division #3, Product Line 110

Marketing Expenses (account numbers 50000 - 50999)

50100 Marketing Dept. Salaries50150 Marketing Dept. Payroll Taxes50200 Marketing Dept. Supplies50600 Marketing Dept. Telephone

Payroll Dept. Expenses (account numbers 59000 - 59999)

59100 Payroll Dept. Salaries59150 Payroll Dept. Payroll Taxes59200 Payroll Dept. Supplies59600 Payroll Dept. Telephone

Other (account numbers 90000 - 99999)

91800 Gain on Sale of Assets96100 Loss on Sale of Assets

Introduction to Bonds PayableBonds are a form of long-term debt. You might think of a bond as an IOU issued by a

corporation and purchased by an investor for cash. The corporation issuing the bond is

borrowing money from an investor who becomes a lender and bondholder.

A bond is a formal contract that requires the issuing corporation to pay the bondholders

1. Interest every six months based on the bond's stated interest rate, and

2. The principal or face amount on the bond's maturity date.

There are two significant advantages for a corporation to issue bonds instead of common

stock:

1. Bonds will not dilute the ownership interest of the stockholders, and

2. Bonds have a lower cost than common stock.

Bonds have a lower cost than common stock because of the bond's formal contract to pay

the interest and principal payments to the bondholders and to adhere to other conditions. A

second reason for bonds having a lower cost is that the bond interest paid by the issuing

corporation is deductible on its U.S. income tax return, whereas dividends are not tax

deductible.

The market value of an existing bond will fluctuate with changes in the market interest rates

and with changes in the financial condition of the corporation that issued the bond. For

example, an existing bond that promises to pay 9% interest for the next 20 years will become

less valuable if market interest rates rise to 10%. Likewise, a 9% bond will become more

valuable if market interest rates decrease to 8%. When the financial condition of the issuing

corporation deteriorates, the market value of the bond is likely to decline as well.

Present value calculations are used to determine a bond's market value and to calculate the

true or effective interest rate paid by the corporation and earned by the investor. Present

value calculations discount a bond's fixed cash payments of interest and principal by the

market interest rate for the bond.

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26.Bond Interest and Principal PaymentsWhen a corporation issues a bond, it promises to pay the bondholder

1. Interest every six months at the bond's stated interest rate, and

2. The principal or face amount when the bond comes due at its maturity date.

Bond Interest Payments

Normally, a bond's interest payments occur semiannually. This means that the corporation

issuing a bond will pay to the bondholders one-half of the annual interest at the end of each

six-month period as long as the bond is outstanding. The formula for calculating

the semiannual interest payments is:

Face Amount of the Bond x Stated Annual Interest Rate x 6/12 of a YearThe following terms mean the same as a bond's stated interest rate:

face interest rate nominal interest rate coupon interest rate contractual interest rate

Throughout our explanation of bonds payable we will use the term stated interest rate or

stated rate. Usually a bond's stated interest rate is fixed or locked-in for the life of the bond.

Bond Principal Payment

A bond's principal payment is the dollar amount that appears on the face of a bond. This is

the amount that the issuing corporation must pay to the bondholders on the date that a bond

matures or comes due. Here are some names that refer to a bond's principal amount:

face value par or par value maturity value or maturity amount stated value

Throughout our explanation we will use these terms interchangeably. In addition, we assume

that the bond's principal amount will be due on a single date.

Timeline for Interest and Principal Payments

It is helpful to prepare a timeline to visualize the cash payments that a corporation promises

to pay its bondholders. The following timeline presents the cash payments of interest and

principal for a 9% $100,000 bond maturing in 5 years:

As the timeline indicates, the corporation will pay its bondholders 10 semiannual interest payments of $4,500 ($100,000 x 9% x 6/12 of a year). Each of the interest payments occurs at the end of each of the 10 six-month time periods. When the bond matures at the end of the 10th six-month period, the corporation must make the $100,000 principal payment to its bondholders.

Keep in mind that a bond's stated cash amounts—the ones shown in our timeline—will not change during the life of the bond.

27.Paid-in Capital or Contributed Capital

Capital stock is a term that encompasses both common stock and preferred stock. "Paid-

in" capital (or "contributed" capital) is that section of stockholders' equity that reports the

amount a corporation received when it issued its shares of stock.

State laws often require that a corporation is to record and report separately the par amount

of issued shares from the amount received that was greater than the par amount. The par

amount is credited to Common Stock. The actual amount received for the stock minus the

par value is credited to Paid-in Capital in Excess of Par Value.

To illustrate, let's assume that a corporation's common stock has a par value of $0.10 per

share. On March 10, 2013, one share of stock is issued for $13.00. (The $13 amount is

the fair market value based on supply and demand for the stock.) The accountant

makes a journal entry to record the issuance of one share of stock along with the

corporation's receipt of the money (note that the "Common Stock" account reflects the par

value of $0.10 per share):

While some states require a par value for common stock, other states do not. If there is no par value, some states require a "stated value." If this is the case, the entry will be the same as the above except that the term "stated" will be used in place of the term "par":

If a state does not require a par value or a stated value, the entire proceeds will be credited to the Common Stock account:

Generally speaking, the par value of common stock is minimal and has no economic

significance. However, if a state law requires a par (or stated) value, the accountant is

required to record the par (or stated) value of the common stock in the account Common

Stock.

Retained EarningsOver the life of a corporation it has two choices of what to do with its net income: (1) pay it

out as dividends to its stockholders, or (2) keep it and use it for business activities. The

amount it keeps is the balance in a stockholders' equity account called Retained Earnings. This general ledger account is a real or permanent account with a normal

credit balance.

The term retained earnings refers to a corporation's cumulative net income (from the date of

incorporation to the current balance sheet date) minus the cumulative amount of dividends

declared. An established corporation that has been profitable for many years will often have

a very large credit balance in its Retained Earnings account, frequently exceeding the paid-in

capital from investors. If, on the other hand, a corporation has experienced significant net

losses since it was formed, it could have negative retained earnings (reported as a debit

balance instead of the normal credit balance in its Retained Earnings account). When this is

the case, the account is described as "Deficit" or "Accumulated Deficit" on the corporation's

balance sheet.

It's important to understand that a large credit balance in retained earnings does not

necessarily mean a corporation has a large cash balance. To determine the amount of cash,

one must look at the Cash account in the current asset section of the balance sheet. (For

example, a public utility may have a huge retained earnings balance, but it has reinvested

those earnings in a new, expensive power plant. Hence, it has relatively little cash in

relationship to its retained earnings balance.)

Let's look at the stockholders' equity section of a balance sheet. We'll assume that a

corporation only issues common stock. The stock has a par value of $0.10 per share. There

are 10,000 authorized shares, and of those, 2,000 shares have been issued for $50,000. At

the balance sheet date, the corporation had cumulative net income after income taxes of

$40,000 and had paid cumulative dividends of $12,000, resulting in retained earnings of

$28,000.

28.Cash Dividends on Common StockCash dividends (usually referred to as "dividends") are a distribution of the corporation's net

income. Dividends are analogous to draws/withdrawals by the owner of a sole proprietorship.

As such, dividends are not expenses and do not appear on the corporation's income

statement.

Corporations routinely need cash in order to replace inventory and other assets whose

replacement costs have increased or to expand capacity. As a result, corporations rarely

distribute all of their net income to stockholders. Young, growing corporations may pay no

dividends at all, while more mature corporations may distribute a significant percentage of

their profits to stockholders as dividends.

Before dividends can be distributed, the corporation's board of directors must declare a

dividend. The date the board declares the dividend is known as the declaration date and it is on this date that the liability for the dividend is created. Legally, corporations

must have a credit balance in Retained Earnings in order to declare a dividend. Practically, a

corporation must also have a cash balance large enough to pay the dividend and still meet

upcoming needs, such as asset growth and payments on existing liabilities.

Let's look at an example: On March 15 a board of directors approves a motion directing the

corporation to pay its regular quarterly dividend of $0.40 per share on May 1 to stockholders

of record on April 15. The following entry is made on the declaration date of March 15

assuming that 2,000 shares of common stock are outstanding:

f the corporation wants to keep a general ledger record of the current year dividends, it could

use a temporary, contra retained earnings account, Dividends Declared. At the end of the

year, the balance in Dividends Declared will be closed to Retained Earnings. If such an

account is used, the entry on the declaration date is:

It is important to note that there is no entry to record the liability for dividends until the board

declares them. Also, there is no entry on the record date (April 15 in this case). The record date merely determines the names of the stockholders that will receive the dividends.

Dividends are only paid on outstanding shares of stock; no dividends are paid on

the treasury stock.On May 1, when the dividends are paid, the following journal entry is made.

29.Preferred StockWhen it comes to dividends and liquidation, the owners of preferred stock have preferential

treatment over the owners of common stock. Preferred stockholders receive their dividends

before the common stockholders receive theirs. In other words, if the corporation does not

declare and pay the dividends to preferred stock, there cannot be a dividend on the common

stock. In return for these preferences, the preferred stockholders usually give up the right to

share in the corporation's earnings that are in excess of their dividends.

To illustrate how preferred stock works, let's assume a corporation has issued preferred

stock with a stated annual dividend of $9 per year. The holders of these preferred shares

must receive the $9 per share dividend each year before the common stockholders can

receive a penny in dividends. But the preferred shareholders will get no more than the $9

dividend, even if the corporation's net income increases a hundredfold. (Participating

preferred stock is an exception and will be discussed later.) In times of inflation, owning

preferred stock with a fixed dividend and no maturity or redemption date makes preferred

shares less attractive than its name implies.

Par Value of Preferred Stock

The dividend on preferred stock is usually stated as a percentage of par value. Hence, the

par value of preferred stock has some economic significance. For example, if a corporation

issues 9% preferred stock with a par value of $100, the preferred stockholder will receive a

dividend of $9 (9% times $100) per share per year. If the corporation issues 10% preferred

stock having a par value of $25, the stock will pay a dividend of $2.50 (10% times $25) per

year. In each of these examples the par value is meaningful because it is a factor in

determining the dividend amounts.

If the dividend percentage on the preferred stock is close to the rate demanded by the

financial markets, the preferred stock will sell at a price that is close to its par value. In other

words, a 9% preferred stock with a par value of $50 being issued or traded in a market

demanding 9% would sell for $50. On the other hand, if the market demands 8.9% and the

stock is a 9% preferred stock with a par value of $50, then the stock will sell for slightly more

than $50 as investors see an advantage in these shares.

Issuing Preferred Stock

To comply with state regulations, the par value of preferred stock is recorded in its own paid-

in capital account Preferred Stock. If the corporation receives more than the par amount, the

amount greater than par will be recorded in another account such as Paid-in Capital in

Excess of Par - Preferred Stock. For example, if one share of 9% preferred stock having a

par value of $100 is sold for $101, the following entry will be made.

Features Offered in Preferred Stock

Corporations are able to offer a variety of features in their preferred stock, with the goal of making the stock more attractive to potential investors. All of the characteristics of each preferred stock issue are contained in a document called an indenture.

1. Nonparticipating vs. ParticipatingGenerally speaking, preferred stockholders only receive their stated dividends and nothing more. If a preferred stock is described as 10% preferred stock with a par value of $100, then its dividend will be $10 per year (whether the corporation's earnings were $10 million or $10 billion). Preferred stock that earns no more than its stated dividend is the norm; it is known as nonparticipating preferred stock.Occasionally a corporation issues participating preferred stock. Participating preferred stock allows for dividends greater than the stated dividend. Since this feature is unusual, it is prudent to assume that all preferred stock is nonparticipating unless it is clearly stated otherwise.

2. Cumulative vs. NoncumulativeIf a preferred stock is designated as cumulative, its holders must receive any past dividends that had been omitted on the preferred stock and its current year dividend, before common stockholders are paid any dividends. (A corporation might omit its dividends because it is suffering operating losses and has little cash available.) If a corporation omits a dividend on its cumulative preferred stock, the past, omitted dividends are said to be "in arrears" and this must be disclosed in the notes to the financial statements.If a preferred stock is noncumulative, its dividends will not be in arrears if a corporation omits dividends. That is, the corporation need not make up any omitted dividends on noncumulative preferred stock before declaring dividends. However, the noncumulative preferred stock must be given its current year dividend before the common stock can get a dividend.

3. CallableIf a corporation has 10% preferred stock outstanding and market rates decline to 8%, it makes sense that the corporation would like to eliminate the 10% preferred stock and replace it with 8% preferred stock. On the other hand, the holders of the 10% preferred stock bought it with the assumption of getting the 10% indefinitely. Anticipating such a situation, the preferred stock will usually have a stipulation that the corporation can "call in" (retire) the preferred stock at a certain price. This price is referred to as the call price and it might be 110% of the par amount (par plus one year's dividend).

4. ConvertibleOccasionally, a corporation's preferred stock states that it can be exchanged for a stated number of shares of the corporation's common stock. If that is the case, the preferred stock is said to be convertible preferred. For example, a corporation might issue shares of 8% convertible preferred stock which can be converted at any time into three shares of common stock. The preferred stockholder receives the usual preferences, but in addition has the potential to share in the success of the corporation. If the common stock is selling for $20 per share at the time the preferred shares are issued, the preferred stock is more valuable because of its dividend. However, if the company's success increases the value of the common stock to $40 per share, the convertibility feature is more valuable since the preferred stock is now worth $120 per share. (The preferred stock can be exchanged for 3 shares of common stock worth $40 each). The preferred stockholder could sell the preferred stock at the market price of $120 per share, or, could have the corporation issue three shares of common stock in exchange for each share of preferred stock.

5. Combination of FeaturesThe strength of the corporation, coupled with the status of key financial

markets, all influence the features that are offered with a given preferred stock. If a corporation is not attractive to potential investors, the preferred stock might need both the cumulative and the fully participating features in order to sell. On the other hand, a successful blue chip corporation might easily sell its preferred stock as noncumulative and nonparticipating. If a corporation wants to conserve its cash, it may offer a convertibility feature in order to have a lower dividend rate.

30.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.

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.

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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:

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:

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:

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.