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Accounting Basics

Introduction to Accounting Basics


This explanation of accounting basics will introduce you to some basic accounting principles, accounting
concepts, and accounting terminology. Once you become familiar with some of these terms and
concepts, you will feel comfortable navigating through the explanations, drills, puzzles, and other features
of AccountingCoach.com.
Some of the basic accounting terms that you will learn include revenues, expenses, assets, liabilities,
income statement, balance sheet, and statement of cash flows. You will become familiar with accounting
debits and credits as we show you how to record transactions. You will also see why two basic
accounting principles, the revenue recognition principle and the matching principle, assure that a
company's income statement reports a company's profitability.
In this explanation of accounting basics, and throughout the entire website, AccountingCoach.com will
often omit some accounting details and complexities in order to present clear and concise explanations.
This means that you should always seek professional advice for your specific circumstances.
We will present the basics of accounting through a story of a person starting a new business. The person
is J oe Pereza savvy man who sees the need for a parcel delivery service in his community. J oe has
researched his idea and has prepared a business plan that documents the viability of his new business.
J oe has also met with an attorney to discuss the form of business he should use. Given his specific
situation, they concluded that a corporation will be best. J oe decides that the name for his corporation
will be Direct Delivery, Inc. The attorney also advises J oe on the various permits and government
identification numbers that will be needed for the new corporation.
J oe is a hard worker and a smart man, but admits he is not comfortable with matters of accounting. He
assumes he will use some accounting software, but wants to meet with a professional accountant before
making his selection. He asks his banker to recommend a professional accountant who is also skilled in
explaining accounting to someone without an accounting background. J oe wants to understand the
financial statements and wants to keep on top of his new business. His banker recommends Marilyn, an
accountant who has helped many of the bank's small business customers.

At his first meeting with Marilyn, J oe asks her for an overview of accounting, financial statements, and
the need for accounting software. Based on J oe's business plan, Marilyn sees that there will likely be
thousands of transactions each year. She states that accounting software will allow for the electronic
recording, storing, and retrieval of those many transactions. Accounting software will permit J oe to
generate the financial statements and other reports that he will need for running his business.

J oe seems puzzled by the term transaction, so Marilyn gives him five examples of transactions that Direct
Delivery, Inc. will need to record:
1. J oe will no doubt start his business by putting some of his own personal money into it. In effect,
he is buying shares of Direct Delivery's common stock.
2. Direct Delivery will need to buy a sturdy, dependable delivery vehicle.
3. The business will begin earning fees and billing clients for delivering their parcels.
4. The business will be collecting the fees that were earned.
5. The business will incur expenses in operating the business, such as a salary for J oe, expenses
associated with the delivery vehicle, advertising, etc.
With thousands of such transactions in a given year, J oe is smart to start using accounting software right
from the beginning. Accounting software will generate sales invoices and accounting entries
simultaneously, prepare statements for customers with no additional work, write checks, automatically
update accounting records, etc.

By getting into the habit of entering all of the day's business transactions into his computer, J oe will be
rewarded with fast and easy access to the specific information he will need to make sound business
decisions. Marilyn tells J oe that accounting's "transaction approach" is useful, reliable, and informative.
She has worked with other small business owners who think it is enough to simply "know" their company
made $30,000 during the year (based only on the fact that it owns $30,000 more than it did on J anuary
1). Those are the people who start off on the wrong foot and end up in Marilyn's office looking for
financial advice.
If J oe enters all of Direct Delivery's transactions into his computer, good accounting software will allow
J oe to print out his financial statements with a click of a button. In Parts 2 through 7 Marilyn will explain
the content and purpose of the three main financial statements:
1. Income Statement
2. Balance Sheet
3. Statement of Cash Flows
I ncome Statement
Marilyn points out that an income statement will show how profitable Direct Delivery has been during the
time interval shown in the statement's heading. This period of time might be a week, a month, three
months, five weeks, or a yearJ oe can choose whatever time period he deems most useful.
The reporting of profitability involves two things: the amount that was earned (revenues) and the
expenses necessary to earn the revenues. As you will see next, the term revenues is not the same as
receipts, and the term expenses
The main revenues for Direct Delivery are the fees it earns for delivering parcels. Under the
involves more than just writing a check to pay a bill.

A. Revenues
accrual
basis of accounting (as opposed to the less-preferred cash method of accounting), revenues are
recorded when they are earned, not when the company receives the money. Recording revenues when
they are earned is the result of one of the basic accounting principles known as the revenue
recognition principle.
For example, if J oe delivers 1,000 parcels in December for $4 per delivery, he has technically earned fees
totaling $4,000 for that month. He sends invoices to his clients for these fees and his terms require that
his clients must pay by J anuary 10. Even though his clients won't be paying Direct Delivery until J anuary
10, the accrual basis of accounting requires that the $4,000 be recorded as December revenues, since
that is when the delivery work actually took place. After expenses are matched with these revenues, the
income statement for December will show just how profitable
When J oe receives the $4,000 worth of payment checks from his customers on J anuary 10, he will make
an accounting entry to show the money was received. This $4,000 of receipts will not be considered to
be J anuary revenues, since the
the company was in delivering parcels in
December.
revenues were already reported as revenues in December when they
were earned. This $4,000 of receipts will be recorded in J anuary as a reduction in Accounts
Receivable. (In December J oe had made an entry to Accounts Receivable and to Sales.)



B. Expenses
Now Marilyn turns to the second part of the income statementexpenses. The December income
statement should show expenses incurred during December regardless of when the company
actually paidfor the expenses. For example, if J oe hires someone to help him with December deliveries
and J oe agrees to pay him $500 on J anuary 3, that $500 expense needs to be shown on
the December income statement. The actual date that the $500 is paid out doesn't matterwhat matters
is when the work was donewhen the expense was incurredand in this case, the work was done in
December. The $500 expense is counted as a December expense even though the money will not be paid
out until J anuary 3. The recording of expenses with the related revenues is associated with another basic
accounting principle known as the matching principle.
Marilyn explains to J oe that showing the $500 of wages expense on the December income statement will
result in a matching of the cost of the labor used to deliver the December parcels with the revenues from
delivering the December parcels. This matching principle is very important in measuring just how
profitable a company was during a given time period.
Marilyn is delighted to see that J oe already has an intuitive grasp of this basic accounting principle. In
order to earn revenues in December, the company had to incur some business expenses in December,
even if the expenses won't be paid until J anuary. Other expenses to be matched with December's
revenues would be such things as gas for the delivery van and advertising spots on the radio.
J oe asks Marilyn to provide another example of a cost that wouldn't be paid in December, but would have
to be shown/matched as an expense on December's income statement. Marilyn uses the Interest
Expense on borrowed money as an example. She asks J oe to assume that on December 1 Direct Delivery
borrows $20,000 from J oe's aunt and the company agrees to pay his aunt 6% per year in interest, or
$1,200 per year. This interest is to be paid in a lump sum each on December 1 of each year.
Now even though the interest is being paid out to his aunt only once per year as a lump sum, J oe can
see that in reality, a little bit of that interest expense is incurred each and every day he's in business. If
J oe is preparing monthly income statements, J oe should report one month of Interest Expense on each
month's income statement. The amount that Direct Delivery will incur as Interest Expense will be $100
per month all year long ($20,000 x 6% 12). In other words, J oe needs to match $100 of interest
expense with each month's revenues. The interest expense is considered a cost that is necessary to earn
the revenues shown on the income statements.
Marilyn explains to J oe that the income statement is a bit more complicated than what she just explained,
but for now she just wants J oe to learn some basic accounting concepts and some of the accounting
terminology. Marilyn does make sure, however, that J oe understands one simple yet important point:
anincome statement, does not report the cash coming inrather, its purpose is to (1) report
the revenues earned by the company's efforts during the period, and (2) report the expenses incurred by
the company during the same period. The purpose of the income statement is to show a
company's profitability during a specific period of time. The difference (or "net") between the revenues
and expenses for Direct Delivery is often referred to as the bottom line and it is labeled as either Net
Income or Net Loss.

Balance Sheet Assets
Marilyn moves on to explain the balance sheet, a financial statement that reports the amount of a
company's (A) assets, (B) liabilities, and (C) stockholders' (or owner's) equity at a specific point in time.
Because the balance sheet reflects a specific point in time rather than a

period of time, Marilyn likes to
refer to the balance sheet as a "snapshot" of a company's financial position at a given moment. For
example, if a balance sheet is dated December 31, the amounts shown on the balance sheet are the
balances in the accounts after all transactions pertaining to December 31 have been recorded.

(A) Assets
Assets are things that a company owns and are sometimes referred to as the resources of the company.
J oe readily understands thisoff the top of his head he names things such as the company's vehicle, its
cash in the bank, all of the supplies he has on hand, and the dolly he uses to help move the heavier
parcels. Marilyn nods and shows J oe how these are reported in accounts
called Vehicles, Cash, Supplies, andEquipment. She mentions one asset J oe hadn't considered
Accounts Receivable. If J oe delivers parcels, but isn't paid immediately for the delivery, the amount
owed to Direct Delivery is an asset known as Accounts Receivable.

Prepaids
Marilyn brings up another less obvious assetthe unexpired portion of prepaid expenses. Suppose
Direct Delivery pays $1,200 on December 1 for a six-month insurance premium on its delivery vehicle.
That divides out to be $200 per month ($1,200 6 months). Between December 1 and December 31,
$200 worth of insurance premium is "used up" or "expires". The expired amount will be reported
as I nsurance Expenseon December's income statement. J oe asks Marilyn where the remaining $1,000
of unexpired insurance premium would be reported. On the December 31 balance sheet, Marilyn tells
him, in an asset account called Prepaid I nsurance.
Other examples of things that might be paid for before they are used include supplies and annual dues to
a trade association. The portion that expires in the current accounting period is listed as an expense on
the income statement; the part that has not yet expired is listed as an asset on the balance sheet.
Marilyn assures J oe that he will soon see a significant link between the income statement and balance
sheet, but for now she continues with her explanation of assets.

Cost Principle and Conservatism
J oe learns that each of his company's assets was recorded at its original cost, and even if the fair market
value of an item increases, an accountant will not increase the recorded amount of that asset on the
balance sheet. This is the result of another basic accounting principle known as the cost principle.
Although accountants generally do not increase the value of an asset, they might decrease its value as a
result of a concept known as conservatism. For example, after a few months in business, J oe may
decide that he can help out some customersas well as earn additional revenuesby carrying an
inventory of packing boxes to sell. Let's say that Direct Delivery purchased 100 boxes wholesale for $1.00
each. Since the time when J oe bought them, however, the wholesale price of boxes has been cut by 40%
and at today's price he could purchase them for $0.60 each. Because the replacement cost of his
inventory ($60) is less than the original recorded
J oe also needs to know that the reported amounts on his balance sheet for assets such as equipment,
vehicles, and buildings are routinely reduced by depreciation. Depreciation is required by the basic
accounting principle known as the
cost ($100), the principle of conservatism directs the
accountant to report the lower amount ($60) as the asset's value on the balance sheet.
In short, the cost principle generally prevents assets from being reported at more than cost, while
conservatism might require assets to be reported at less then their cost.

Depreciation
matching principle. Depreciation is used for assets whose life is not
indefiniteequipment wears out, vehicles become too old and costly to maintain, buildings age, and
some assets (like computers) become obsolete. Depreciation is the allocation of the cost of the asset
toDepreciation Expense on the income statement over its useful life.

As an example, assume that Direct Delivery's van has a useful life of five years and was purchased at a
cost of $20,000. The accountant might match $4,000 ($20,000 5 years) of Depreciation Expense with
each year's revenues for five years. Each year the carrying amount of the van will be reduced by
$4,000. (The carrying amountor "book value"is reported on the balance sheet and it is the cost of the
van minus the total depreciation since the van was acquired.) This means that after one year the balance
sheet will report the carrying amount of the delivery van as $16,000, after two years the carrying amount
will be $12,000, etc. After five yearsthe end of the van's expected useful lifeits carrying amount is
zero.
J oe wants to be certain that he understands what Marilyn is telling him regarding the assets on the
balance sheet, so he asks Marilyn if the balance sheet is, in effect, showing what the company's assets
are worth. He is surprised to hear Marilyn say that the assets are not reported on the balance sheet at
their worth (fair market value). Long-term assets (such as buildings, equipment, and furnishings) are
reported at their costminus the amounts already sent to the income statement as Depreciation Expense.
The result is that a building's market value may actually have increased since it was acquired, but the
amount on the balance sheet has been consistently reduced
Another asset,
as the accountant moved some of its cost to
Depreciation Expense on the income statement in order to achieve the matching principle.
Office Equipment, may have a fair market value that is much smaller than the carrying
amount reported on the balance sheet. (Accountants view depreciation as an allocation process
allocating the cost to expense in order to match the costs with the revenues generated by the asset.
Accountants donot consider depreciation to be a valuation process.) The asset Land
The balance sheet reports Direct Delivery's
is not depreciated,
so it will appear at its original cost even if the land is now worth one hundred times more than its cost.
Short-term (current) asset amounts are likely to be close to their market values, since they tend to "turn
over" in relatively short periods of time.
Marilyn cautions J oe that the balance sheet reports only the assets acquired and only at the cost reported
in the transaction. This means that a company's reputationas excellent as it might bewill not be listed
as an asset. It also means that J eff Bezos will not appear as an asset on Amazon.com's balance sheet;
Nike's logo will not appear as an asset on its balance sheet; etc. J oe is surprised to hear this, since in his
opinion these items are perhaps the most valuable things those companies have. Marilyn tells J oe that he
has just learned an important lesson that he should remember when reading a balance sheet.

(B) Liabilities
liabilities as of the date noted in the heading of the balance
sheet. Liabilities are obligations of the company; they are amounts owed to others as of the balance
sheet date. Marilyn gives J oe some examples of liabilities: the loan he received from his aunt (Notes
Payable or Loan Payable), the interest on the loan he owes to his aunt (I nterest Payable), the amount
he owes to the supply store for items purchased on credit (Accounts Payable), the wages he owes an
employee but hasn't yet paid to him (Wages Payable).
Another liability is money received in advance of actually earning the money. For example, suppose that
Direct Delivery enters into an agreement with one of its customers stipulating that the customer prepays
$600 in return for the delivery of 30 parcels every month for 6 months. Assume Direct Delivery receives
that $600 payment on December 1 for deliveries to be made between December 1 and May 31. Direct
Delivery has a cash receipt of $600 on December 1, but it does not have revenues of $600 at this point.
It will have revenues only when it earns them by delivering the parcels. On December 1, Direct Delivery
will show that its asset Cash increased by $600, but it will also have to show that it has a liability of
$600. (It has theliability
The liability account involved in the $600 received on December 1 is
to deliver $600 of parcels within 6 months, or return the money.)
Unearned Revenue. Each month,
as the 30 parcels are delivered, Direct Delivery will be earning $100, and as a result, each month $100
moves from the account Unearned Revenue to Service Revenues. Each month Direct Delivery's liability
decreases by $100 as it fulfills the agreement by delivering parcels and each month its revenues on the
income statement increase by $100.

(C) Stockholders' Equity
If the company is a corporation, the third section of a corporation's balance sheet is Stockholders' Equity.
(If the company is a sole proprietorship, it is referred to as Owner's Equity.) The amount of Stockholders'
Equity is exactly the difference between the asset amounts and the liability amounts. As a result
accountants often refer to Stockholders' Equity as the difference (or residual) of assets minus liabilities.
Stockholders' Equity is also the "book value" of the corporation.
Since the corporation's assets are shown at cost or lower (and not at their market values) it is important
that you do not
Within the Stockholders' Equity section you may see accounts such as
associate the reported amount of Stockholders' Equity with the market value of the
corporation. (Hence, it is a poor choice of words to refer to Stockholders' Equity as the corporation's "net
worth".) To find the market value of a corporation, you should obtain the services of a professional
familiar with valuing businesses.
Common Stock, Paid-in Capital
in Excess of Par Value-Common Stock, Preferred Stock, Retained Earnings, and Current
Year's Net Income.
The account Common Stock will be increased when the corporation issues shares of stock in exchange for
cash (or some other asset). Another account Retained Earnings will increase when the corporation earns
a profit. There will be a decrease when the corporation has a net loss. This means that revenues will
automatically cause an increase in Stockholders' Equity and expenses will automatically cause
a
atement of Cash Flows
decreasein Stockholders' Equity. This illustrates a link between a company's balance sheet and income
statement.
The third financial statement that J oe needs to understand is the Statement of Cash Flows. This
statement shows how Direct Delivery's cash amount has changed during the time interval shown in the
heading of the statement. J oe will be able to see at a glance the cash generated and used by his
company's operating activities, its investing activities, and its financing activities. Much of the information
on this financial statement will come from Direct Delivery's balance sheets and income statements.

The three financial reports that Marilyn introduced to J oethe income statement, the balance sheet, and
the statement of cash flowsrepresent one segment of the valuable output that good accounting
software can generate for business owners.
Marilyn now explains to J oe the basics of getting started with recording his transactions.
The field of accountingboth the older manual systems and today's basic accounting softwareis based
on the 500-year-old accounting procedure known as double entry. Double entry is a simple yet
powerful concept: each and every one of a company's transactions will result in an amount recorded
into at least
To begin the process of setting up J oe's accounting system, he will need to make a detailed listing of all
the names of the accounts that Direct Delivery, Inc. might find useful for reporting transactions. This
detailed listing is referred to as a
two of the accounts in the accounting system.

The Chart of Accounts
chart of accounts. (Accounting software often provides sample charts
of accounts for various types of businesses.)

As he enters his transactions, J oe will find that the chart of accounts will help him select the two (or
more) accounts that are involved. Once J oe's business begins, he may find that he needs to add more
account names to the chart of accounts, or delete account names that are never used. J oe can tailor his
chart of accounts so that it best sorts and reports the transactions of his business.
Because of the double entry system all of Direct Delivery's transactions will involve a combination of two
or more accounts from the balance sheet and/or the income statement. Marilyn lists out some sample
accounts that J oe will probably need to include on his chart of accounts:

Balance Sheet accounts:
Asset accounts (Examples: Cash, Accounts Receivable, Supplies, Equipment)
Liability accounts (Examples: Notes Payable, Accounts Payable, Wages Payable)
Stockholders' Equity accounts (Examples: Common Stock, Retained Earnings)
Income Statement accounts:
Revenue accounts (Examples: Service Revenues, I nvestment Revenues)
Expense accounts (Examples: Wages Expense, Rent Expense, Depreciation Expense)

To help J oe really understand how this works, Marilyn illustrates the double entry with some sample
transactions that J oe will likely encounter.
SampleTransactions #1
On December 1, 2010 J oe starts his business Direct Delivery, Inc. The first transaction that J oe will
record for his company is his personal investment of $20,000 in exchange for 5,000 shares of Direct
Delivery's common stock. Direct Delivery's accounting system will show an increase in its account Cash
from zero to $20,000, and an increase in its stockholders' equity account Common Stock by $20,000.
Both of these accounts are balance sheet accounts. There are no revenues because no delivery fees
were earned by the company, and there were no expenses.

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

Direct Delivery, I nc.
Balance Sheet
December 1, 2010

Assets

Liabilities & Stockholders' Equity


Cash $ 20,000

Liabilities


Stockholders' Equity




Common Stock $ 20,000

Total Assets $ 20,000

Total Liab. & Stockholders' Equity

$ 20,000

Marilyn asks J oe if he can see that the balance sheet is just thatin balance. J oe looks at the total of
$20,000 on the asset side, and looks at the $20,000 on the right side, and says yes, of course, he can
see that it is indeed in balance.
Marilyn shows J oe something called the basic accounting equation, which, she explains, is really the
same concept as the balance sheet, it's just presented in an equation format:

Assets = Liabilities + Stockholders' (or Owner's) Equity
$20,000 = $0 +

$20,000

The accounting equation (and the balance sheet) should always be in balance.
Debits and Credits
Did the first sample transaction follow the double entry system and affect two or more accounts? J oe
looks at the balance sheet again and answers yes, both Cash and Common Stock were affected by the
transaction.
Marilyn introduces the next basic accounting concept: the double entry system requires that the same
dollar amount of the transaction must be entered on both the left side of one account, and on
the right side of another account. Instead of the word left, accountants use the word debit; and instead
of the word right, accountants use the word credit. (The terms debit and credit are derived from Latin
terms used 500 years ago.)


Debit means left.
Credit means right.

J oe asks Marilyn how he will know which accounts he should debitmeaning he should enter the
numbers on the left side of one accountand which accounts he should creditmeaning he should enter
the numbers on the right side of another account. Marilyn points back to the basic accounting equation
and tells J oe that if he memorizes this simple equation, it will be easier to understand the debits and
credits.




Memorizing the simple accounting equation will
help you learn the debit and credit rules for
entering amounts into the accounting records.

Let's take a look at the accounting equation again:

Assets = Liabilities + Stockholders' (or Owner's) Equity

J ust as assets are on the left side (or debit side) of the accounting equation, the asset accounts in the
general ledger have their balances on the left side. To increase an asset account's balance, you put more
on the left side of the asset account. In accounting jargon, you debit the asset account. To decrease an
asset account balance you credit the account, that is, you enter the amount on the right side.
J ust as liabilities and stockholders' equity are on the right side (or credit side) of the accounting equation,
the liability and equity accounts in the general ledger have their balances on the right side.
To increase the balance in a liability or stockholders' equity account, you put more on the right side of
the account. In accounting jargon, you credit the liability or the equity account. To decrease a liability or
equity, you debit the account, that is, you enter the amount on the left side of the account.
As with all rules, there are exceptions, but Marilyn's reference to the accounting equation may help you
to learn whether an account should be debited or credited.
Since many transactions involve cash, Marilyn suggests that J oe memorize how the Cash account is
affected when a transaction involves cash: if Direct Delivery receives cash, the Cash account is debited;
when Direct Delivery pays

cash, the Cash account is credited.

When a company receives cash, the Cash account is debited.
When the company pays cash, the Cash account is credited.
Marilyn refers to the example of December 1. Since Direct Delivery received $20,000 in cash from J oe in
exchange for 5,000 shares of common stock, one of the accounts for this transaction is Cash. Since cash
was received, the Cash account will be debited.
In keeping with double entry, two (or more) accounts need to be involved. Because the first account
(Cash) was debited, the second account needs to be credited. All J oe needs to do is find the right
account to credit. In this case, the second account is Common Stock. Common stock is part of
stockholders' equity, which is on the right side of the accounting equation. As a result, it should have a
credit balance, and to increase its balance the account needs to be credited.



Accountants indicate accounts and amounts using the following format:


Account Name Debit Credit


Cash 20,000


Common Stock

20,000

Accountants usually first show the account and amount to be debited. On the next line, the account to be
credited is indented and the amount appears further to the right than the debit amount shown in the line
above. This entry format is referred to as a general journal entry.
(With the decrease in the price of computers and accounting software, it is rare to find a small business
still using a manual system and making entries by hand. Accounting software has made the process of
recording transactions so much easier that the general journal is rarely needed. In fact, entries are often
generated automatically when a check or sales invoice is prepared.)
ame Transactions #2 - #3

Sample Transaction #2
Marilyn illustrates for J oe a second transaction. On December 2, Direct Delivery purchases a used delivery
van for $14,000 by writing a check for $14,000. The two accounts involved are Cash and Vehicles
(orDelivery Equipment). When the check is written, the accounting software will automatically make
the entry into these two accounts.

Marilyn explains to J oe what is happening within the software. Since the company pays $14,000, the
Cash account is credited. (Accountants consider the checking account to be Cash, and the TI P you
learned is that when cash is paid, you credit Cash.) So we know that the Cash account will be credited for
$14,000 and we know the other account will have to be debited

for $14,000. We need only identify the
best account to debit. In this case we choose Vehicles (or Delivery Equipment) and the entry is:
Account Name Debit Credit


Vehicles 14,000


Cash

14,000
The balance sheet will look like this after the vehicle transaction is recorded:

Direct Delivery, I nc.
Balance Sheet
December 2, 2010
Assets

Liabilities & Stockholders' Equity


Cash $ 6,000

Liabilities


Vehicles 14,000

Stockholders' Equity





Common Stock $ 20,000
Total Assets $ 20,000

Total Liab. & Stockholders' Equity

$ 20,000

The balance sheet and the accounting equation remain in balance:

Assets = Liabilities + Stockholders' (or Owner's) Equity
$20,000 = $0 +

$20,000

As you can see in the balance sheet, the asset Cash decreased by $14,000 and another asset Vehicles
increased by $14,000. Liabilities and stockholders' equity were not involved and did not change.

Sample Transaction #3
The third sample transaction also occurs on December 2 when J oe contacts an insurance agent regarding
insurance coverage for the vehicle Direct Delivery just purchased. The agent informs him that $1,200 will
provide insurance protection for the next six months. J oe immediately writes a check for $1,200 and
mails it in.
Let's consider this transaction. Using double entry, we know there must be a minimum of two accounts
involvedone (or more) of the accounts must be debited, and one (or more) must be
Since a check is written, we know that one of the accounts involved is Cash. Since cash was
credited.
paid, the
Cash account will be credited. (Take another look at the last TI P.) While we have not yet identified the
second account, what we do know for certain is that the second account will have to be debited.
At this point we have most of the entryall we are missing is the name

of the account to be debited:

Account Name Debit Credit


??? 1,200


Cash

1,200

We know the transaction involves insurance, and a quick look through the chart of accounts reveals two
possibilities:
Prepaid I nsurance (an asset account reported on the balance sheet) and I nsurance Expense

(an
expense account reported on the income statement)
Assets include costs that are not yet expired (not yet used up), while expenses are costs that have
expired (have been used up). Since the $1,200 payment is for an expense that will not expire in its
entirety within the current month, it would be logical to debit the account Prepaid Insurance. (At the end
of each month, when $200 has expired, $200 will be moved from Prepaid Insurance to Insurance
Expense.)
The entry in the general journal format is:

Account Name Debit Credit


Prepaid I nsurance 1,200


Cash

1,200

After the first three transactions have been recorded, the balance sheet will look like this:
Direct Delivery, I nc.
Balance Sheet
December 2, 2010
Assets

Liabilities & Stockholders' Equity


Cash $ 4,800

Liabilities


Prepaid Insurance 1,200

Stockholders' Equity


Vehicles 14,000

Common Stock $ 20,000
Total Assets
$ 20,000

Total Liabilities & Stockholders'
Equity

$ 20,000

Again, the balance sheet and the accounting equation are in balance and all of the changes occurred on
the asset/left/debit side of the accounting equation. Liabilities and Stockholders' Equity were not affected
by the insurance transaction.

Sample Transactions #4 - #6



Sample Transaction #4
The fourth transaction occurs on December 3, when a customer gives Direct Delivery a check for $10 to
deliver two parcels on that day. Because of double entry, we know there must be a minimum of two
accounts involvedone of the accounts must be debited, and one of the accounts must be credited.
Because Direct Delivery received $10, it must debit the account Cash. It must also credit a second
account for $10. The second account will be Service Revenues, an income statement account. The reason
Service Revenues is credited is because Direct Delivery must report that it earned

$10 (not because it
received $10). Recording revenues when they are earned results from a basic accounting principle known
as the revenue recognition principle. The following tip reflects that principle.

Revenues accounts are credited when the company earns

a fee (or sells merchandise) regardless of
whether cash is received at the time.

Here are the two parts of the transaction as they would look in the general journal format:

Account Name Debit Credit


Cash 10


Service Revenues

10

Sample Transaction #5
Let's assume that on December 3 the company gets its second customera local company that needs to
have 50 parcels delivered immediately. J oe's price of $250 is very appealing, so J oe's company is hired to
deliver the parcels. The customer tells J oe to submit an invoice for the $250, and they will pay it within
seven days.
J oe delivers the 50 parcels on December 3 as agreed, meaning that on December 3 Direct Delivery
hasearned $250. Hence the $250 is reported as revenues on December 3, even though the company did
not receive any cash on that day. The effort
Because Direct Delivery has earned the fees, one account will be a revenues account, such as Service
Revenues. (If you refer back to the last
needed to complete the job was done on December 3.
(Depositing the check for $250 in the bank when it arrives seven days later is not considered to take any
effort.)
Let's identify the two accounts involved and determine which needs a debit and which needs a credit.
TI P, you will read that revenue accounts such as Service
Revenuesare usually credited, meaning the second account will need to be debited.)







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


Account Name Debit Credit


??? 250


Service Revenues

250


We know that the unnamed account cannot be Cash.


Account Name Debit Credit


Accounts Receivable 250


Service Revenues

250

Again, reporting revenues when they are earned results from the basic accounting principle known as
therevenue recognition principle.

Sample Transaction #6
For simplicity, let's assume that the only expense incurred by Direct Delivery so far was a fee to a
temporary help agency for a person to help J oe deliver parcels on December 3. The temp agency fee is
$80 and is due by December 12.
If a company does not pay cash immediately, you cannot credit Cash. But because the company owes
someone the money for its purchase, we say it has an obligation or liability to pay. Most accounts
involved with obligations have the word "payable" in their name, and one of the most frequently used
accounts is Accounts Payable. Also keep in mind that expenses are almost always

debited.

The accounts and amounts for the temporary help are:

Account Name Debit Credit


Temporary Help Expense 80


Accounts Payable

80


Expenses are (almost) always debited.


If a company does not pay cash right away for an expense or for an asset, you cannot credit Cash.
Because the company owessomeone the money for its purchase, we say it has an obligation or liability to
pay. The most likely liability account involved in business obligations is Accounts Payable.

Revenues and expenses appear on the income statement as shown below:


Direct Delivery, I nc.
I ncome Statement
For the Three Days Ended December 3, 2010
Service Revenues $ 260
Temporary Help Expense 80

Net Income

$ 180

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

Direct Delivery, I nc.
Balance Sheet
December 3, 2010
Assets

Liabilities & Stockholders' Equity


Cash $ 4,810

Liabilities


Accounts Receivable 250

Accounts Payable $ 80

Prepaid Insurance 1,200

Stockholders' Equity


Vehicles 14,000

Common Stock 20,000

Retained Earnings 180

Total Stockholders' Equity 20,180
Total Assets

$ 20,260

Total Liab. & Stockholders' Equity


$ 20,260

Notice that the year-to-date net income (bottom line of the income statement) increased
Stockholders' Equity by the same amount, $180. This connection between the income statement and
balance sheet is important. For one, it keeps the balance sheet and the accounting equation in balance.
Secondly, it demonstrates that revenues will cause the stockholders' equity to increase and expenses will
cause stockholders' equity to decrease. After the end of the year financial statements are prepared, you
will see that the income statement accounts (revenue accounts and expense accounts) will be closed or
zeroed out and their balances will be transferred into the Retained Earnings
1. When a company
account. This will mean
the revenue and expense accounts will start the new year with zero balancesallowing the company "to
keep score" for the new year.
Marilyn suggested that perhaps this introduction was enough material for their first meeting. She wrote
out the following notes, summarizing for J oe the important points of their discussion:

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

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

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

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

2. When a company receives cash, the company will debit Cash and will have to credit another
account. Assuming that a company will prepare monthly
If the amount received is from a cash sale, or for a service that has just been performed
but has not yet been recorded, the account to be credited is a revenue account such
as
financial statements
Service Revenues or Fees Earned.
If the amount received is an advance payment for a service that has not yet been
performed or earned, the account to be credited is Unearned Revenue.
If the amount received is a payment from a customer for a sale or service delivered
earlier and has already been recorded as revenue, the account to be credited
is Accounts Receivable.
If the amount received is the proceeds from the company signing a promissory note, the
account to be credited is Notes Payable.
If the amount received is an investment of additional money by the owner of the
corporation, a stockholders' equity account such as Common Stock
3. Revenues are recorded as Service Revenues or Sales when the service or sale has been
performed,not
is credited.

4. Expenses are matched with revenues or with the period of time shown in the heading of the
income statement,
when the cash is received. This reflects the basic accounting principle known as
the revenue recognition principle.
not in the period when the expenses were paid. This reflects the basic
accounting principle known as the matching principle.
5. The financial statements also reflect the basic accounting principle known as the cost principle.
This means assets are shown on the balance sheet at their original cost or less and not at their
current value. The income statement expenses also reflect the cost principle. For example, the
depreciation expense is based on the original cost of the asset being depreciated and not

on the
current replacement cost.
Debits and Credits
Introduction to Debits and Credits
If the words "debits" and "credits" sound like a foreign language to you, you are more perceptive
than you realize"debits" and "credits" are words that have been traced back five hundred years to a
document describing today's double-entry accounting system.
Under the double-entry system every business transaction is recorded in at least two accounts. One
account will receive a "debit" entry, meaning the amount will be entered on the left side of that
account. Another account will receive a "credit" entry, meaning the amount will be entered on
the right
Before we explain and illustrate the debits and credits in accounting and bookkeeping, we will discuss
the accounts in which the debits and credits will be entered or posted.
side of that account. The initial challenge with double-entry is to know which account should
be debited and which account should be credited.
What I s An Account?
To keep a company's financial data organized, accountants developed a system that sorts
transactions into records called accounts. When a company's accounting system is set up, the
accounts most likely to be affected by the company's transactions are identified and listed out. This
list is referred to as the company'schart of accounts. Depending on the size of a company and the
complexity of its business operations, the chart of accounts may list as few as thirty accounts or as
many as thousands. A company has the flexibility of tailoring its chart of accounts to best meet its
needs.

Within the chart of accounts the balance sheet accounts are listed first, followed by the income
statement accounts. In other words, the accounts are organized in the chart of accounts as follows:
Assets
Liabilities
Owner's (Stockholders') Equity
Revenues or Income
Expenses
Gains
Losses
Click here to see a sample chart of accounts.
Double-Entry Accounting
Because every business transaction affects at least two accounts, our accounting system is known as
adouble-entry
For example, when a company borrows $1,000 from a bank, the transaction will affect the
company's
system. (You can refer to the company's chart of accounts to select the proper
accounts. Accounts may be added to the chart of accounts when an appropriate account cannot be
found.)
Cashaccount and the company's Notes Payable
If a company buys supplies for cash, its
account. When the company repays the
bank loan, the Cash account and the Notes Payable account are also involved.
Supplies account and its Cash account will be affected. If
the company buys supplies on credit, the accounts involved are Supplies and Accounts Payable.

If a company pays the rent for the current month, Rent Expense and Cash are the two accounts
involved. If a company provides a service and gives the client 30 days in which to pay, the
company's Service Revenues account and Accounts Receivable
Although the system is referred to as double-entry, a transaction may involve more than two
accounts. An example of a transaction that involves three accounts is a company's loan payment to
its bank of $300. This transaction will involve the following accounts: Cash, Notes Payable, and
Interest Expense.
are affected.
(If you use accounting software you may not actually see that two or more accounts are being
affected due to the user-friendly nature of the software. For example, let's say that you write a
company check by means of your accounting software. Your software automatically reduces your
Cash account and prompts you only for the other
ebits and Credits
accounts affected.)
After you have identified the two or more accounts involved in a business transaction, you must debit
at least one account and credit at least one account.
To debit an account means to enter an amount on the left side of the account. To credit an account
means to enter an amount on the right side of an account.


Debit means left
Credit means

right
Generally these types of accounts are increased

with a debit:
Dividends (Draws)
Expenses
Assets
Losses

You might think of D E A L when recalling the accounts that are increased

with a debit.
Generally these types of accounts are increased
Gains
I ncome
Revenues
Liabilities
Stockholders' (Owner's) Equity
with a credit:

You might think of G I R L S when recalling the accounts that are increased

with a credit.
To decrease an account you do the opposite of what was done to increase the account. For example,
an asset account is increased with a debit. Therefore it is decreased
The abbreviation for debit is dr. and the abbreviation for credit is cr.
with a credit.

Accountants and bookkeepers often use T-accounts as a visual aid for seeing the effect of the debit
and credit on the two (or more) accounts. (Learn more about accountants and bookkeepers in
our Accounting Careers

area.) We will begin with two T-accounts: Cash and Notes Payable.
Cash

(asset account)
Debit
I ncreases an asset
Received $
Credit
Decreases an asset
Paid $

Notes Payable

(liability account)
Debit
Decreases a liability
Repaid loan
Credit
I ncreases a liability
Borrowed more

Let's demonstrate the use of these T-accounts with two transactions:
1. On J une 1, 2010 a company borrows $5,000 from its bank. This causes the company's asset
Cash to increase by $5,000 and its liability Notes Payable to also increase by $5,000. To
increase the asset Cash the account needs to be debited. To increase the company's liability
Notes Payable this account needs to be credited. After entering the debits and credits the T-
accounts look like this:
Cash

(asset account)
Debit
I ncreases an asset
Received $
Credit
Decreases an asset
Paid $
J une 1, 2010 ENTRY 5,000



Notes Payable

(liability account)
Debit
Decreases a liability
Repaid loan
Credit
I ncreases a liability
Borrowed more

5,000

ENTRY J une 1, 2010

2. On J une 2, 2010 the company repaid $2,000 of the bank loan. This causes the company's
asset Cash to decrease by $2,000 and its liability Notes Payable to also decrease by $2,000.
To reduce the asset Cash the account will need to be credited for $2,000. To decrease the
liability Notes Payable that account will need to be debited. The T-accounts now look like this:
Cash

(asset account)
Debit
I ncreases an asset
Received $
Credit
Decreases an asset
Paid $
J une 1, 2010 ENTRY 5,000



2,000

ENTRY J une 2, 2010
J une 2, 2010
BALANCE
3,000



Notes Payable

(liability account)
Debit
Decreases a liability
Repaid loan
Credit
I ncreases a liability
Borrowed more

5,000

ENTRY J une 1, 2010
J une 2, 2010 ENTRY 2,000



3,000

BALANCE J une 2,
2010
s
Another way to visualize business transactions is to write a general journal entry. Each general
journal entry

lists the date, the account title(s) to be debited and the corresponding amount(s)
followed by the account title(s) to be credited and the corresponding amount(s). The accounts to be
credited are indented. Let's illustrate the general journal entries for the two transactions that were
shown in the T-accounts above.
Date Account Name Debit Credit

J une 1, 2010 Cash 5,000


Notes Payable

5,000



Date Account Name Debit Credit

J une 2, 2010 Notes Payable 2,000


Cash

2,000
Because cash is involved in many transactions, it is helpful to memorize the following:
Whenever cash is received, debit
Whenever cash is
Cash.
paid out, credit
With the knowledge of what happens to the Cash account, the journal entry to record the debits and
credits is easier. Let's assume that a company
Cash.
receives $500 on J une 3, 2010 from a customer who
was given 30 days in which to pay. (In May the company recorded the sale and an accounts
receivable.) On J une 3 the company will debit Cash, because cash was received. The amount of the
debit and the credit is $500. Entering this information in the general journal format, we have:
Date Account Name Debit Credit

J une 3, 2010 Cash 500


???

500
All that remains to be entered is the name of the account to be credited. Since this was the collection
of an account receivable, the credit should be Accounts Receivable. (Because the sale was already
recorded in May, you cannot enter Sales
On J une 4 the company
again on J une 3.)
paid

$300 to a supplier for merchandise the company received in May. (In
May the company recorded the purchase and the accounts payable.) On J une 4 the company will
credit Cash, because cash was paid. The amount of the debit and credit is $300. Entering them in the
general journal format, we have:
Date Account Name Debit Credit

J une 4, 2010 ??? 300


Cash

300

All that remains to be entered is the name of the account to be debited. Since this was the payment
on an account payable, the debit should be Accounts Payable. (Because the purchase was already
recorded in May, you cannot enter Purchases or I nventory
To help you become comfortable with the debits and credits in accounting, memorize the following
tip:
again on J une 4.)


Whenever cash is received, the Cash account is debited

(and another account is credited).
Whenever cash is paid out, the Cash account is credited
Normal Balances
(and another account is debited).
When looking at a T-account for each of the account classifications in the general ledger, here is the
debit or credit balance you would normally find in the account:

Account Classification
Normal
Balance
Assets Debit
Contra asset Credit
Liability Credit
Contra liability Debit
Owner's Equity Credit
Stockholders' Equity Credit
Owner's Drawing or
Dividends Account
Debit
Revenues (or Income) Credit
Expenses Debit
Gains Credit
Losses Debit


Revenues and Gains Are Usually Credited
Revenues and gains are recorded in accounts such as Sales, Service Revenues, I nterest
Revenues (or Interest Income), and Gain on Sale of Assets. These accounts normally have credit
balances that are increased with a credit entry.
The exceptions to this rule are the accounts Sales Returns, Sales Allowances, and Sales
Discounts--these accounts have debit balances because they are reductions to sales. Accounts with
balances that are the opposite of the normal balance are called contra accounts; hence contra
revenue accounts will have debit balances.
Let's illustrate revenue accounts by assuming your company performed a service and was
immediately paid the full amount of $50 for the service. The debits and credits are presented in the
following general journal format:

Account Name Debit Credit


Cash 50


Service Revenues

50
Whenever cash is received, the asset account Cash is debited and another account will need to be
credited. Since the service was performed at the same time as the cash was received, the revenue
account Service Revenues is credited, thus increasing its account balance.
Let's illustrate how revenues are recorded when a company performs a service on credit (i.e., the
company allows the client to pay for the service at a later date, such as 30 days from the date of the
invoice). At the time the service is performed the revenues are considered to have been earned and
they are recorded in the revenue account Service Revenues with a credit. The other account involved,
however, cannot be the asset Cash since cash was not

received. The account to be debited is the
asset account Accounts Receivable. Assuming the amount of the service performed is $400, the entry
in general journal form is:

Account Name Debit Credit


Accounts Receivable 400


Service Revenues

400

Accounts Receivable is an asset account and is increased with a debit; Service Revenues is increased
with a credit.





Expenses and Losses are Usually Debited
Expenses normally have their account balances on the debit side (left side). A debit increases the
balance in an expense account; a credit decreases the balance. Since expenses are usually
increasing, think "debit" when expenses are incurred. (We credit expenses only to reduce them,
adjust them, or to close the expense accounts.) Examples of expense accounts include Salaries
Expense, Wages Expense,Rent Expense, Supplies Expense, and I nterest Expense.
To illustrate an expense let's assume that on J une 1 your company paid $800 to the landlord for the
J une rent. The debits and credits are shown in the following journal entry:


Account Name Debit Credit


Rent Expense 800


Cash

800

Since cash was paid out, the asset account Cash is credited and another account needs to be debited.
Because the rent payment will be used up in the current period (the month of J une) it is considered
to be an expense, and Rent Expense is debited. If the payment was made on J une 1 for a future
month (for example, J uly) the debit would go to the asset account Prepaid Rent.
As a second example of an expense, let's assume that your hourly paid employees work the last week
in the year but will not be paid until the first week of the next year. At the end of the year, the
company makes an entry to record the amount the employees earned but have not been paid.
Assuming the employees earned $1,900 during the last week of the year, the entry in general journal
form is:


Account Name Debit Credit


Wages Expense 1,900


Wages Payable

1,900

As noted above, expenses are almost always debited, so we debit Wages Expense, increasing its
account balance. Since your company did not yet pay its employees, the Cash account is not
To help you get more comfortable with debits and credits in accounting and bookkeeping, memorize
the following tip:
credited,
instead, the credit is recorded in the liability account Wages Payable. A credit to a liability account
increases its credit balance.


To increase an expense

account, debit the account.
Permanent and Temporary Accounts
Asset, liability, and most owner/stockholder equity accounts are referred to as "permanent
accounts" (or "real accounts"). Permanent accounts are not closed at the end of the accounting
year; their balances are automatically carried forward to the next accounting year.
"Temporary accounts" (or "nominal accounts") include all of the revenue accounts, expense
accounts, the owner drawing account, and the income summary account. Generally speaking, the
balances in temporary accounts increase throughout the accounting year and are "zeroed out" and
closed at the end of the accounting year.
Balances in the revenue and expense accounts are zeroed out by closing/transferring/clearing their
balances to the I ncome Summary account. The net amount in Income Summary is then
closed/transferred/cleared to an owner equity account, such as Mary Smith, Capital (or
to Retained Earnings if the company is a corporation). The owner drawing account (such as Mary
Smith, Drawing) is a temporary account and it is closed directly
Because the balances in the temporary accounts are transferred out of their respective accounts at
the end of the accounting year, each temporary account will have a zero balance when the next
accounting year begins. This means that the new accounting year starts with no revenue amounts, no
expense amounts, and no amount in the drawing account.
to the owner capital account (such
as Mary Smith, Capital) without going through an income summary account.
By using many revenue accounts and a huge number of expense accounts, a company is certain to
have easy access to detailed information on revenues and expenses throughout the year. This allows
the management of the company to monitor the performance of all parts of the company. Once the
accounting year has ended, the need to know the balances in these temporary accounts has also
ended, so the accounts are closed out and reopened for the next accounting year with zero balances.

When you hear your banker say, "I 'll credit your checking account," it means the
transaction will increaseyour checking account balance. Conversely, if your
bank debits

your account (e.g., takes a monthly service charge from your account) your
checking account balance decreases.
If you are new to the study of debits and credits in accounting, this may seem puzzling. After all, you
learned that debiting the Cash account in the general ledger increases its balance, yet your bank
says it iscrediting your checking account to increase its balance. Similarly, you learned
that crediting the Cash account in the general ledger reduces its balance, yet your bank says it
is debiting
Although the above may seem contradictory, we will illustrate below that a bank's treatment of debits
and credits is indeed consistent with the basic accounting principles you learned. Let's look at three
transactions and consider the resultant journal entries from both the bank's perspective and the
company's perspective.
your checking account to reduce its balance.

Transaction #1
Let's say that your company, Debris Disposal, receives $100 of currency from a customer as a down
payment for a future site cleanup service. When the money is received your company makes the
following entry:

(Debris Disposal's journal entry)


Account Name Debit Credit


Cash 100


Unearned Revenues

100
Because it has received cash, Debris Disposal increases its Cash account with a debit of $100. The
rules of double entry accounting require Debris Disposal to also enter a credit of $100 into another of
its general ledger accounts. Since the company has not yet earned the $100, it cannot credit a
revenue account. Instead, the liability account Unearned Revenues is credited because Debris
Disposal has a liability to do the work or to return the $100. (An alternate title for the Unearned
Revenues account is Customer Deposits.)
Now let's say you take that $100 to Trustworthy Bank and deposit it into Debris Disposal's checking
account. Trustworthy Bank debits the bank's general ledger Cash account for $100, thereby
increasing the bank's assets. The rules of double entry accounting require the bank to also enter a
credit of $100 into another of bank's general ledger accounts. Because the bank has not earned the
$100, it cannot credit a revenue account. Instead, the bank credits its liability account Deposits
(Trustworthy Bank's journal entry)
to
reflect the bank's obligation/liability to return the $100 to Debris Disposal on demand. In general
journal format the bank's entry is:


Account Name Debit Credit


Cash 100


Deposits

(your statement) 100
As the entry shows, the bank's assets increase by the debit of $100 and the bank's liabilities increase
by the credit of $100. The bank's detailed records show that Debris Disposal's checking account is the
specific liability that increased.

Transaction #2
Let's say Trustworthy Bank receives a $1,000 wire transfer on your company's behalf from a person
who owes money to Debris Disposal. Two things happen at the bank: (1) The bank receives $1,000,
and (2) the bank records its obligation to give the money to Debris Disposal on demand. These two
facts are entered into the bank's general ledger as follows:
(Trustworthy Bank's journal entry)


Account Name Debit Credit


Cash 1,000


Deposits

(your statement) 1,000
The debit increases the bank's assets by $1,000 and the credit increases the bank's liabilities by
$1,000. The bank's detailed records show that Debris Disposal's checking account is the specific
liability that increased.
At the same time the $1,000 wire transfer is received at the bank, Debris Disposal makes the
following entry into its general ledger:
(Debris Disposal's journal entry)


Account Name Debit Credit


Cash 1,000


Accounts Receivable

1,000

As a result of collecting $1,000 from one of its customers, Debris Disposal's Cash balance increases
and its Accounts Receivable balance decreases.

Transaction #3
Many banks charge a monthly fee on checking accounts. If Trustworthy Bank decreases Debris
Disposal's checking account balance by $13.00 to pay for the bank's monthly service charge, this
might be itemized on Debris Disposal's bank statement as a "debit memo." The entry in the bank's
records will show the bank's liability being reduced (because the bank owes Debris Disposal $13 less).
It also shows that the bank earned revenues of $13 by servicing the checking account.

(Trustworthy Bank's general ledger)


Account Name Debit Credit


Deposits 13 (your statement)


Service Charge Revenues

13

On your company's records, the entry will look like this:

(Debris Disposal's general ledger)


Account Name Debit Credit


Bank Service Charges Expense 13


Cash

13

Debris Disposal's cash is reduced with a credit of $13 and expenses are increased with a debit of $13.
(If the amount of the bank's service charges is not significant a company may debit the charge
to Miscellaneous Expense.)
Bak's Balance Sheet
Accounts such as Cash, I nvestment Securities, and Loans Receivable are reported as assets on
the bank's balance sheet. Deposits are reported as liabilities and include the balances in its customers'
checking and savings accounts as well as certificates of deposit. In effect, your bank statement
Recap
is just
one of thousands of subsidiary records that account for millions of dollars in Deposits that a bank
owes to its customers.
Here are some of the highlights from this major topic:
Debit means left.
Credit means right.
Every transaction affects two accounts or more.
At least one account will be debited and at least one account will be credited.
The total of the amount(s) entered as debits must equal the total of the amount(s) entered
as credits.
When cash is received, debit Cash.
When cash is paid out, credit Cash.
To increase an asset, debit the asset account.
To increase a liability, credit the liability account.
To increase owner's equity, credit an owner's equity account.
To increase revenues, credit the revenues account
To increase expenses, debit the expense account

Chart of Accounts

Introduction to Chart of Accounts
A 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:

Balance sheet accounts Assets
Liabilities
Owner's (Stockholders') Equity


I ncome statement
accounts
Operating Revenues
Operating Expenses
Non-operating Revenues and Gains
Non-operating Expenses and Losses
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
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.
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.
Sample Chart of Accounts For a Large Corporation
Each 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
10100 Cash - Regular Checking
10200 Cash - Payroll Checking
10600 Petty Cash Fund
12100 Accounts Receivable
12500 Allowance for Doubtful Accounts
13100 Inventory
14100 Supplies
15300 Prepaid Insurance
(account numbers 10000 - 16999)
Property, Plant, and Equipment
17000 Land
17100 Buildings
17300 Equipment
17800 Vehicles
18100 Accumulated Depreciation - Buildings
18300 Accumulated Depreciation - Equipment
18800 Accumulated Depreciation - Vehicles
(account numbers 17000 - 18999)
Current Liabilities
20100 Notes Payable - Credit Line #1
20200 Notes Payable - Credit Line #2
21000 Accounts Payable
22100 Wages Payable
23100 Interest Payable
24500 Unearned Revenues
(account numbers 20000 - 24999)
Long-term Liabilities
25100 Mortgage Loan Payable
25600 Bonds Payable
25650 Discount on Bonds Payable
(account numbers 25000 - 26999)
Stockholders' Equity
27100 Common Stock, No Par
27500 Retained Earnings
29500 Treasury Stock
(account numbers 27000 - 29999)
Operating Revenues
31010 Sales - Division #1, Product Line 010
31022 Sales - Division #1, Product Line 022
32015 Sales - Division #2, Product Line 015
33110 Sales - Division #3, Product Line 110
(account numbers 30000 - 39999)
Cost of Goods Sold
41010 COGS - Division #1, Product Line 010
41022 COGS - Division #1, Product Line 022
42015 COGS - Division #2, Product Line 015
43110 COGS - Division #3, Product Line 110
(account numbers 40000 - 49999)
Marketing Expenses
50100 Marketing Dept. Salaries
50150 Marketing Dept. Payroll Taxes
50200 Marketing Dept. Supplies
50600 Marketing Dept. Telephone
(account numbers 50000 - 50999)
Payroll Dept. Expenses (account numbers 59000 - 59999)
59100 Payroll Dept. Salaries
59150 Payroll Dept. Payroll Taxes
59200 Payroll Dept. Supplies
59600 Payroll Dept. Telephone
Other
91800 Gain on Sale of Assets
96100 Loss on Sale of Assets
(account numbers 90000 - 99999)
This is a partial listing of another sample chart of accounts. Note that each account is assigned a three-
digit number followed by the account name. The first digit of the number signifies if it is an asset,
liability, etc. For example, if the first digit is a "1" it is an asset, if the first digit is a "3" it is a revenue
account, etc. The company decided to include a column to indicate whether a debit or credit will increase
the amount in the account. This sample chart of accounts also includes a column containing a description
of each account in order to assist in the selection of the most appropriate account.

Asset Accounts
No. Account Title
To
Increase
Description/Explanation of Account
101 Cash Debit
Checking account balance (as shown in company
records), currency, coins, checks received from
customers but not yet deposited.
120 Accounts Receivable Debit
Amounts owed to the company for services
performed or products sold but not yet paid for.
140 Merchandise I nventory Debit
Cost of merchandise purchased but has not yet been
sold.
150 Supplies Debit
Cost of supplies that have not yet been used.
Supplies that have been used are recorded in
Supplies Expense.
160 Prepaid I nsurance Debit
Cost of insurance that is paid in advance and
includes a future accounting period.
170 Land Debit
Cost to acquire and prepare land for use by the
company.
175 Buildings Debit
Cost to purchase or construct buildings for use by the
company.
178
Accumulated
Depreciation -
Buildings
Credit
Amount of the buildings' cost that has been allocated
to Depreciation Expense since the time the building
was acquired.
180 Equipment Debit
Cost to acquire and prepare equipment for use by
the company.
188
Accumulated
Depreciation -
Equipment
Credit
Amount of equipment's cost that has been allocated
to Depreciation Expense since the time the
equipment was acquired.



Liability Accounts
No. Account Title
To
Increase
Description/Explanation of Account
210 Notes Payable Credit
The amount of principal due on a formal written
promise to pay. Loans from banks are included in this
account.
215 Accounts Payable Credit
Amount owed to suppliers who provided goods and
services to the company but did not require
immediate payment in cash.
220 Wages Payable Credit
Amount owed to employees for hours worked but not
yet paid.
230 I nterest Payable Credit
Amount owed for interest on Notes Payable up until
the date of the balance sheet. This is computed by
multiplying the amount of the note times
theeffective interest rate times the time period.
240 Unearned Revenues Credit
Amounts received in advance of delivering goods or
providing services. When the goods are delivered or
services are provided, this liability amount decreases.
250
Mortgage Loan
Payable
Credit
A formal loan that involves a lien on real estate until
the loan is repaid.



Owner's Equity Accounts
No. Account Title
To
Increase
Description/Explanation of Account
290 Mary Smith, Capital Credit
Amount the owner invested in the company (through
cash or other assets) plus earnings of the company
not withdrawn by the owner.
295 Mary Smith, Drawing Debit
Amount that the owner of the sole proprietorship has
withdrawn for personal use during the current
accounting year. At the end of the year, the amount
in this account will be transferred into Mary Smith,
Capital (account 290).



Operating Revenue Accounts
No. Account Title
To
Increase
Description/Explanation of Account
310 Service Revenues Credit
Amounts earned from providing services to clients,
either for cash or on credit. When a service is
provided on credit, both this account and Accounts
Receivable will increase. When a service is provided
for immediate cash, both this account and Cash will
increase.



Operating Expense Accounts
No. Account Title
To
Increase
Description/Explanation of Account
500 Salaries Expense Debit
Expenses incurred for the work performed by salaried
employees during the accounting period. These
employees normally receive a fixed amount on a
weekly, monthly, or annual basis.
510 Wages Expense Debit
Expenses incurred for the work performed by non-
salaried employees during the accounting period.
These employees receive an hourly rate of pay.
540 Supplies Expense Debit
Cost of supplies used up during the accounting
period.
560 Rent Expense Debit
Cost of occupying rented facilities during the
accounting period.
570 Utilities Expense Debit
Costs for electricity, heat, water, and sewer that
were used during the accounting period.
576 Telephone Expense Debit
Cost of telephone used during the current accounting
period.
610 Advertising Expense Debit
Costs incurred by the company during the accounting
period for ads, promotions, and other selling and
expenses (other than salaries).
750 Depreciation Expense Debit
Cost of long-term assets allocated to expense during
the current accounting period.



Non-Operating Revenues and Expenses, Gains, and Losses
No. Account Title
To
Increase
Description/Explanation of Account
810 I nterest Revenues Credit
Interest and dividends earned on bank accounts,
investments or notes receivable. This account is
increased when the interest is earned and either Cash
or Interest Receivable is also increased.
910 Gain on Sale of Assets Credit
Occurs when the company sells one of its assets
(other than inventory) for more than the
asset's book value.
960 Loss on Sale of Assets Debit
Occurs when the company sells one of its assets
(other than inventory) for less than the asset's book
value.


Accounting software frequently includes sample charts of accounts for various types of businesses. It is
expected that a company will expand and/or modify these sample charts of accounts so that the specific
needs of the company are met. Once a business is up and running and transactions are routinely being
recorded, the company may add more accounts or delete accounts that are never used.
At Least wo Accounts for Every Transaction
The chart of accounts lists the accounts that are available for recording transactions. In keeping with
thedouble-entry system of accounting, a minimum of two accounts
When a transaction is entered into a company's accounting software, it is common for the software to
prompt for only one account namethis is because the software is programmed to automatically assign
one of the accounts. For example, when using accounting software to write a check, the software
automatically reduces the asset account
is needed for every
transactionat least one account is debited and at least one account is credited.
Cash and prompts you to designate the other account(s) such
as Rent Expense, Advertising Expense, etc..

Some general rules about debiting and crediting the accounts are:
Expense accounts are debited and have
Revenue
debit balances
accounts are credited and have
Asset
credit balances
accounts normally have
To increase an
debit balances
asset account, debit
To decrease an
the account
asset account, credit
Liability
the account
accounts normally have
To increase a
credit balances
liability account, credit
To decrease a
the account
liability account, debit

the account

Bookkeeping

Introduction to Bookkeeping
Before computers were in common use, bookkeeping was done by an actual bookkeeper. This person
kept a company's day-to-day financial records by manually recording every business transaction into a
journal. The journal entry included the date, the name of the accounts to be debited and credited, and
the amounts. The bookkeeping process further required that all journal amounts be rewritten in (or
"posted" to) the company's general ledger and subsidiary ledger

accounts.
With the writing and rewriting of so many amounts (as well as the manual calculations) it was realistic to
assume that some errors would occur in the bookkeeping process. This potential for errors created the
need to periodically "prove" that a company's accounts were "in balance," meaning the total of
the debit balance accounts was equal to the total of the credit balance accounts. An internal document
called a trial balancewas designed to give that proof. If the trial balance did not balance, the
bookkeeper had to go back, transaction by transaction, to find and correct the cause of any disparity.
Once the trial balance was in balance, the bookkeeping phase was completed and the "books" were
turned over to the company's accountant for the preparation of financial statements.

okkeeping Has Changed
With the arrival of computers and accounting software, bookkeeping errors decreased and efficiency
increased. For example, the accounting software will refuse a journal entry if the debit amount entered
does not equal the credit amount entered. Further, because journal amounts are posted electronically
and account balances are calculated electronically, the potential for human error in these tasks is
eliminated.
As an example of how bookkeeping has become more efficient, consider that the following tasks now
occur simultaneously when a credit sale is processed with accounting software:
1. A sales invoice is prepared
2. The general ledger account Sales
3. The general ledger account
is credited
Accounts Receivable
4. The customer's account in the subsidiary ledger is updated.
is debited
5. In some situations, the I nventory

account is updated.
At large companies, the bookkeeping function is likely to be divided among a number of clerking
specialists, such as accounts payable clerks, accounts receivable clerks, payroll clerks, and accounting
clerks, each of whom use the accounting software to carry out their specific responsibilities.
Debits and Credits
Whether bookkeeping tasks are performed manually by a bookkeeper or electronically by clerks, one
thing remains the same: every business transaction involves at least two accounts. This is known
as double entry bookkeeping (or "double entry accounting"). Double entry bookkeeping requires that
for each transaction, one (or more) account must be debited, and one (or more) account must
be

credited.
When you are using accounting software, it may not be obvious to you that two accounts are involved
with each transaction. This is because the software often updates one of the two accounts automatically.
For example, whenever you enter an amount from a vendor's invoice, the computer "recognizes" it as an
Accounts Payable and automatically enters the amount as a credit in that account. What you see on the
computer screen is a prompt to enter only the "other" account, the one to be debited. Similarly, if you
use software to generate checks, the system will automatically credit Cash and prompt you to enter only
the account (or accounts) to be
Debits on the Left, Credits on the Right
debited.
Every account has two "sides," a right side and a left side. A debit refers to an entry on the left side of
an account, and a credit refers to an entry on the right

side of an account. Double entry bookkeeping
requires that for every transaction, there is an entry to the left side of one (or more) account, and a
corresponding entry to the right side of another account(s).
Below are some facts that will help you determine which side of an account to use:
Expenses are always debits
Revenues are always credits
Debit the Cash account when cash is received
Credit the Cash account when cash is paid out

Here are some additional facts...
A debit will increase
Assets (
these accounts:
Cash, Accounts Receivable, I nventory, Land, Equipment, etc.)
Expenses (Rent Expense, Wages Expense, I nterest Expense, etc.)
Losses (Loss on Sale of Assets, Loss from Lawsuit, etc.)
Sole proprietor's Drawing account
A debit will decrease
Liabilities (
these accounts:
Notes Payable, Accounts Payable, I nterest Payable, etc.)
Stockholders' Equity (Common Stock, Retained Earnings)
A credit will increase
Liabilities (
these accounts:
Notes Payable, Accounts Payable, I nterest Payable, etc.)
Revenues (Sales, Service Revenues, Fees Earned, I nterest Revenues, etc.)
Gains (Gain on Sale of Assets, Gain on Retirement of Bonds, etc.)
A credit will decrease
Assets (
these accounts:
Cash, Accounts Receivable, Supplies, I nventory, Land, etc.)

We can illustrate double entry bookkeeping with the following sample transactions:
If a company borrows $10,000 from its bank, the company debits its Cash account for $10,000
and credits its Notes Payable account for $10,000.
When a company records wages for hourly employees, it debits Wages Expense and credits
Wages Payable.
If a company makes a sale "on credit," it debits Accounts Receivable and credits Sales.

(Debits and credits are covered in greater detail in the Explanation of Debits and Credits.)

Chart of Accounts
A chart of accounts

is a listing of all the accounts available to a company to record and sort its
business transactions. A chart of accounts is generally customized by an accountant to fit the needs of
the company and can be modified when necessary. For example, if a new product line is introduced or a
new department is started, accounts can be added to accommodate the change.
The chart of accounts consists of two types of accounts: (1) balance sheet accounts, and (2) income
statement accounts. Account categories are generally listed in the following standardized order:
Assets
Liabilities
Stockholders' (or Owner's) Equity
Revenues
Expenses
Gains
Losses

atemes
Accounting software has simplified the process of preparing financial statements. The balances in the
asset, liability, and stockholders' equity accounts can be programmed to appear in a balance sheet
format. The balances in the revenue, expense, gain, and loss accounts can be programmed to print in a
variety of income statement formats. As a result, many company accountants are spending less time with
the tedious and mechanical work of financial statement preparation, and more time on other
responsibilities. To learn more about the responsibilities of accountants, go to our Accounting Career
Center.
Accounting Equation

Introduction to the Accounting Equation
We also have a Visual Tutorial, Quiz, Crosswords, and Q&A for the topic
1. Assets (what it owns)
Accounting Equation.

From the large, multi-national corporation down to the corner beauty salon, every business transaction
will have an effect on a companys financial position. The financial position of a company is measured by
the following items:
2. Liabilities (what it owes to others)
3. Owners Equity (the difference between assets and liabilities)
The accounting equation (or basic accounting equation) offers us a simple way to understand how
these three amounts relate to each other. The accounting equation for a sole proprietorship is:

Assets = Liabilities + Owners Equity

The accounting equation for a corporation is:

Assets = Liabilities + Stockholders Equity

Assets are a companys resourcesthings the company owns. Examples of assets include cash,
accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and goodwill.
From the accounting equation, we see that the amount of assets must equal the combined amount of
liabilities plus owners (or stockholders) equity.

Liabilities are a companys obligationsamounts the company owes. Examples of liabilities include notes
or loans payable, accounts payable, salaries and wages payable, interest payable, and income taxes
payable (if the company is a regular corporation). Liabilities can be viewed in two ways:
(1) as claims by creditors against the companys assets, and
(2) a sourcealong with owner or stockholder equityof the companys assets.

Owners equity or stockholders equity
Owners or stockholders equity also reports the amounts invested into the company by the owners plus
the cumulative
is the amount left over after liabilities are deducted from assets:
Assets Liabilities = Owners (or Stockholders) Equity.
net income of the company that has not been withdrawn or distributed to the owners.

If a company keeps accurate records, the accounting equation will always be in balance, meaning the
left side should always equal the right side. The balance is maintained because every business
transactionaffects at least two of a companys accounts. For example, when a company borrows money
from a bank, the companys assets will increase and its liabilities will increase by the same amount. When
a company purchases inventory for cash, one asset will increase and one asset will decrease. Because
there are two or more accounts affected by every transaction, the accounting system is referred to
as double entry accounting.

A company keeps track of all of its transactions by recording them in accounts in the companys general
ledger. Each account in the general ledger is designated as to its type: asset, liability, owners equity,
revenue, expense, gain, or loss account.


The
Balance Sheet and Income Statement
balance sheet
The
is also known as the statement of financial position and it reflects the accounting
equation. The balance sheet reports a companys assets, liabilities, and owners (or stockholders) equity
at a specific point in time. Like the accounting equation, it shows that a companys total amount of assets
equals the total amount of liabilities plus owners (or stockholders) equity.

income statement is the financial statement that reports a companys revenues and expenses and
the resulting net income. While the balance sheet is concerned with one point in time, the income
statement covers a time interval or period of time. The income statement will explain part of the change in
the owners or stockholders equity during the time interval between two balance sheets.

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

In our examples in the following pages of this topic, we show how a given transaction affects the
accounting equation. We also show how the same transaction affects specific accounts by providing the
journal entry that is used to record the transaction in the companys general ledger.

accrual basis
Accounting Equation for a Sole Proprietorship: Transactions 12
of accounting is being followed.

Parts 2 6 illustrate transactions involving a sole proprietorship.
Parts 7 10 illustrate almost identical transactions as they would take place in a corporation.


When a company records a business transaction, it is not entered into an accounting equation,

We present nine transactions to illustrate how a companys accounting equation stays in balance.

per se.
Rather, transactions are recorded into specific accounts contained in the companys general ledger. Each
account is designated as an asset, liability, owner's equity, revenue, expense, gain, or loss account.
Thegeneral ledger accounts are then used to prepare the balance sheets and income statements
throughout the accounting periods.

In the examples that follow, we will use the following accounts:
Cash
Accounts Receivable
Equipment
Notes Payable
Accounts Payable
J. Ott, Capital
J. Ott, Drawing
Service Revenues
Advertising Expense
Temp Service Expense
(To view a more complete listing of accounts for recording transactions, see the Explanation of Chart of
Accounts.)


Sole Proprietorship Transaction #1.
Lets assume that J. Ott forms a sole proprietorship called Accounting Software Co. (ASC). On December
1, 2010, J. Ott invests personal funds of $10,000 to start ASC. The effect of this transaction on ASCs
accounting equation is:


Assets = Liabilities + Owners Equity

+$10,000 = No Effect + +$10,000

As you can see, ASCs assets increase by $10,000 and so does ASCs owner's equity. As a result, the
accounting equation will be in balance.

You can interpret the amounts in the accounting equation to mean that ASC has assets of $10,000 and
the source of those assets was the owner, J. Ott. Alternatively, you can view the accounting equation to
mean that ASC has assets of $10,000 and there are no claims by creditors (liabilities) against the assets.
As a result, the owner has a claim for the remainder or residual of $10,000.

This transaction is recorded in the asset account Cash and the owners equity account J. Ott, Capital. The
general journal entry to record the transactions in these accounts is:

Date Account Titles Debit Credit
Dec. 1, 2010 Cash

10,000

J. Ott, Capital


After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASCs
financial position at the end of December 1, 2010:

10,000
Accounting Software Co.
Balance Sheet
December 1, 2010
ASSETS

LIABILITIES

Cash $ 10,000 OWNERS EQUITY


. J. Ott, Capital $ 10,000

Total Assets $
10,000
Total Liab & Owner's Equity $
10,000

.


The purpose of an income statement is to report revenues and expenses. Since ASC has not yet earned
any revenues nor incurred any expenses, there are no transactions to be reported on an income
statement.


Sole Proprietorship Transaction #2.
On December 2, 2010 J. Ott withdraws $100 of cash from the business for his personal use. The effect of
this transaction on ASCs accounting equation is:


Assets = Liabilities + Owners Equity

$100 = No Effect + $100

The accounting equation remains in balance since ASCs assets have been reduced by $100 and so has
the owners equity.

This transaction is recorded in the asset account Cash and the owners equity account J. Ott, Drawing.
The general journal entry to record the transactions in these accounts is:

Date Account Titles Debit
Dec. 2, 2010
Credit
J. Ott, Drawing

100

Cash


Since the transactions of December 1 and 2 were each in balance, the sum of both transactions should
also be in balance:

100
Transaction Assets = Liabilities + Owners Equity
1 +$10,000 = No Effect + +$10,000
2 $100 = No Effect + $100
Totals = $9,900 + $0 $9,900

The totals indicate that ASC has assets of $9,900 and the source of those assets is the owner of the
company. You can also conclude that the company has assets or resources of $9,900 and the only claim
against those resources is the owners claim.

The December 2 balance sheet will communicate the companys financial position as of midnight on
December 2:

Accounting Software Co.
Balance Sheet
December 2, 2010
ASSETS

LIABILITIES

Cash $ 9,900 OWNERS EQUITY


. J. Ott, Capital $ 9,900*

Total Assets $
9,900
Total Liab & Owner's Equity $
9,900

.

.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income + 0

Subtotal $ 10,000

Owner's Draws 100


Ending Owner's Equity at Dec. 2 $
9,900*
.

Withdrawals of company assets by the owner for the owners personal use are known as draws. Since
draws are not expenses, the transaction is not reported on the companys income statement.

Accounting Equation for a Sole Proprietorship: Transactions 34

Sole Proprietorship Transaction #3.
On December 3, 2010 Accounting Software Co. spends $5,000 of cash to purchase computer equipment
for use in the business. The effect of this transaction on the accounting equation is:


Assets = Liabilities + Owners Equity

+$5,000
= No Effect + No Effect

$5,000

The accounting equation reflects that one asset increases and another asset decreases. Since the
amount of the increase is the same as the amount of the decrease, the accounting equation remains in
balance.

This transaction is recorded in the asset accounts Equipment and Cash. Equipment increases by $5,000,
and Cash decreases by $5,000. The general journal entry to record the transactions in these accounts is:

Date Account Titles Debit
Dec. 3, 2010
Credit
Equipment

5,000

Cash



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

5,000
Transaction Assets = Liabilities + Owners Equity
1 +$10,000 = No Effect + +$10,000
2 $100 = No Effect + $100
3
+$5,000
= No Effect + No Effect
$5,000
Totals = $9,900 + $0 $9,900

The totals tell us that the company has assets of $9,900 and the source of those assets is the owner of
the company. It also tells us that the company has assets of $9,900 and the only claim against those
assets is the owners claim.

The balance sheet dated December 3, 2010 will reflect the financial position as of midnight on December
3:

Accounting Software Co.
Balance Sheet
December 3, 2010
ASSETS

LIABILITIES $ 0
Cash $ 4,900 OWNERS EQUITY

Equipment

5,000 J. Ott, Capital $ 9,900*

Total Assets $
9,900
Total Liab & Owner's Equity $
9,900

.

.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income + 0

Sub Total $ 10,000

J. Ott, Drawing 100


Ending Owner's Equity at Dec. 3 $
9,900*
.

The purchase of equipment is not an immediate expense. It will become part of depreciation
expense only after it is placed into service. We will assume that as of December 3 the equipment has not
been placed into service, therefore, no expense will appear on an income statement for the period of
December 1 through December 3.




Sole Proprietorship Transaction #4.
On December 4, 2010 ASC obtains $7,000 by borrowing money from its bank. The effect of this
transaction on the accounting equation is:


Assets = Liabilities + Owners Equity

+$7,000 = +$7,000 + No Effect

As you can see, ASCs assets increase and ASCs liabilities increase by $7,000.

This transaction is recorded in the asset accountCash and the liability account Notes Payable as shown
in this accounting entry:

Date Account Titles Debit
Dec. 4, 2010
Credit
Cash

7,000

Notes Payable



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

7,000
Transaction Assets = Liabilities + Owners Equity
1 +$10,000 = No Effect + +$10,000
2 $100 = No Effect + $100
3
+$5,000
= No Effect + No Effect
$5,000
4 +$7,000 = +$7,000 + No Effect
Totals = $16,900 + $7,000 $9,900

The totals indicate that the transactions through December 4 result in assets of $16,900. There are two
sources for those assetsthe creditors provided $7,000 of assets, and the owner of the company provided
$9,900. You can also interpret the accounting equation to say that the company has assets of $16,900
and the lenders have a claim of $7,000 and the owner has a claim for the remainder.

The balance sheet dated December 4 will report ASCs financial position as of that date:

Accounting Software Co.
Balance Sheet
December 4, 2010
ASSETS

LIABILITIES

Cash $ 11,900 Notes Payable $ 7,000
Equipment

5,000 OWNERS EQUITY


. J. Ott, Capital $ 9,900*
Total Assets $
16,900
Total Liab & Owner's Equity $
16,900
.
.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income + 0

Subtotal $ 10,000

J. Ott, Drawing 100


Ending Owner's Equity at Dec. 4 $
9,900*
.

The proceeds of the bank loan are not considered to be revenue since ASC did not earn the money by
providing services, investing, etc. As a result, there is no income statement effect from this transaction.

Accounting Equation for a Sole Proprietorship: Transactions 56


Sole Proprietorship Transaction #5.
On December 5, 2010 Accounting Software Co. pays $600 for ads that were run in recent days. The
effect of this advertising transaction on the accounting equation is:


Assets = Liabilities + Owners Equity

$600 = No Effect + $600

Since ASC is paying
Date
$600, its assets decrease. The second effect is a $600 decrease in owners equity,
because the transaction involves an expense. (An expense is a cost that is used up or its future economic
value cannot be measured.)

Although owners equity is decreased by an expense, the transaction is not recorded directly into the
owners capital account at this time. Instead, the amount is initially recorded in the expense account
Advertising Expense and in the asset account Cash. The general journal entry to record the transaction
is:

Account Titles Debit
Dec. 5, 2010
Credit
Advertising Expense

600

Cash


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

600
Transaction Assets = Liabilities + Owners Equity
1 +$10,000 = No Effect + +$10,000
2 $100 = No Effect + $100
3
+$5,000
= No Effect + No Effect
$5,000
4 +$7,000 = +$7,000 + No Effect
5 $600 = No Effect + $600
Totals = $16,300 + $7,000 $9,300

The totals now indicate that Accounting Software Co. has assets of $16,300. The creditors provided
$7,000 and the owner of the company provided $9,300. Viewed another way, the company has assets of
$16,300 with the creditors having a claim of $7,000 and the owner having a residual claim of $9,300.

The balance sheet as of the end of December 5, 2010 is:

Accounting Software Co.
Balance Sheet
December 5, 2010
ASSETS

LIABILITIES

Cash $ 11,300 Notes Payable $ 7,000
Equipment

5,000 OWNERS EQUITY


. J. Ott, Capital $ 9,300*
Total Assets $
16,300
Total Liab & Owner's Equity $
16,300
.
.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income** + (600)

Subtotal $ 9,400

J. Ott, Drawing 100


Ending Owner's Equity at Dec. 5 $
9,300*
.
**The income statement (which reports the companys revenues, expenses, gains, and losses during a
specified time interval) is a link between balance sheets. It provides the results of operationsan
important part of the change in owners equity.

Since this transaction involves an expense, it will involve ASCs income statement. The companys
income statement for the first five days of December is:


Accounting Software Co.
Income Statement
For the Five Days Ended December 5, 2010
REVENUES $ 0
EXPENSES

Advertising Expense

600
NET INCOME $
(600)




Sole Proprietorship Transaction #6.
On December 6, 2010 ASC performs consulting services for its clients. The clients are billed for the
agreed upon amount of $900. The amounts are due in 30 days. The effect on the accounting equation is:


Assets = Liabilities + Owners Equity

+$900 = No Effect + +$900

Since ASC has performed the services, it has earned revenues and it has the right to receive $900 from
the clients. This right (known as an account receivable) causes assets to increase. The earning of
revenues causes owners equity to increase.
Date


Although revenues cause owners equity to increase, the revenue transaction is not recorded into the
owners capital account at this time. Rather, the amount earned is recorded in the revenue account
Service Revenues. This will allow the company to report the revenues on its income statement at any
time. (After the year ends, the amount in the revenue account will be transferred to the owners capital
account.) The general journal entry to record the transaction is:

Account Titles Debit
Dec. 6, 2010
Credit
Accounts Receivable

900

Service Revenues


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

900
Transaction Assets = Liabilities + Owners Equity
1 +$10,000 = No Effect + +$10,000
2 $100 = No Effect + $100
3
+$5,000
= No Effect + No Effect
$5,000
4 +$7,000 = +$7,000 + No Effect
5 $600 = No Effect + $600
6 +$900 = No Effect + +$900
Totals = $17,200 + $7,000 $10,200

The totals tell us that at the end of December 6, the company has assets of $17,200. It also shows the
sources of the assets: creditors providing $7,000 and the owner of the company providing $10,200. The
totals also reveal that the company has assets of $17,200 and the creditors have a claim of $7,000 and
the owner has a claim for the remaining $10,200.

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

Accounting Software Co.
Balance Sheet
December 6, 2010
ASSETS

LIABILITIES

Cash $ 11,300 Notes Payable $ 7,000
Accounts Receivable

900 OWNERS EQUITY

Equipment

5,000 J. Ott, Capital $ 10,200*
Total Assets $
17,200
Total Liab & Owner's Equity $
17,200
.
.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income** + 300

Subtotal $ 10,300

J. Ott, Drawing 100


Ending Owner's Equity at Dec. 6 $
10,200*
.
**The income statement (which reports the companys revenues, expenses, gains, and losses during a
specified time interval) is a link between balance sheets. It provides the results of operationsan
important part of the change in owners equity.

The Income Statement for Accounting Software Co. for the period of December 1 through December 6 is:


Accounting Software Co.
Income Statement
For the Six Days Ended December 6, 2010
REVENUES

Service Revenues $ 900
EXPENSES

Advertising Expense

600
NET INCOME $
300


Accounting Equation for a Sole Proprietorship: Transactions 78

Sole Proprietorship Transaction #7.
On December 7, 2010 ASC uses a temporary help service for 6 hours at a cost of $20 per hour. ASC will
pay the invoice when it is due in 10 days. The effect on its accounting equation is:


Assets = Liabilities + Owners Equity

No Effect = +$120 + $120

ASCs liabilities increase by $120 and the expense causes owners equity to decrease by $120.

The liability will be recorded in Accounts Payable and the expense will be reported in Temp Service
Expense. The journal entry for recording the use of the temp service is:

Date Account Titles Debit
Dec. 7, 2010
Credit
Temp Service Expense

120

Accounts Payable


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

120
Transaction Assets = Liabilities + Owners Equity
1 +$10,000 = No Effect + +$10,000
2 $100 = No Effect + $100
3
+$5,000
= No Effect + No Effect
$5,000
4 +$7,000 = +$7,000 + No Effect
5 $600 = No Effect + $600
6 +$900 = No Effect + +$900
7 No Effect = +$120 + $120
Totals = $17,200 + $7,120 $10,080

The totals show us that the company has assets of $17,200 and the sources are the creditors with $7,120
and the owner of the company with $10,080. The accounting equation totals also tell us that the company
has assets of $17,200 with the creditors having a claim of $7,120. This means that the owners residual
claim is $10,080.

The financial position of ASC as of midnight on December 7, 2010 is:

Accounting Software Co.
Balance Sheet
December 7, 2010
ASSETS

LIABILITIES

Cash $ 11,300 Notes Payable $ 7,000
Accounts Receivable

900 Accounts Payable $ 120
Equipment

5,000 Total Liabilities $ 7,120

OWNERS EQUITY


. J. Ott, Capital $ 10,080*
Total Assets $
17,200
Total Liab & Owner's Equity $
17,200
.
.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income** + 180

Subtotal $ 10,180

J. Ott, Drawing 100


Ending Owner's Equity at Dec. 7 $
10,080*
.
**The income statement (which reports the companys revenues, expenses, gains, and losses for
a specified time interval) is a link between balance sheets. It provides the results of operations
an important part of the change in owners equity.

Accounting Software Co.s income statement for the first seven days of December is:


Accounting Software Co.
Income Statement
For the Seven Days Ended December 7, 2010
REVENUES

Service Revenues $ 900
EXPENSES

Advertising Expense

600
Temp Service Expense

120
Total Expenses

720
NET INCOME $
180




Sole Proprietorship Transaction #8.
On December 8, 2010 ASC receives $500 from the clients it had billed on December 6, 2010. The
collection of accounts receivables has this effect on the accounting equation:


Assets = Liabilities + Owners Equity

+$500
= No Effect + No Effect

$500

The companys asset (cash) increases and another asset (accounts receivable) decreases. Liabilities and
owners equity are unaffected. (There are no revenues on this date. The revenues were recorded when
they were earned on December 6.)

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

Date Account Titles Debit
Dec. 8, 2010
Credit
Cash

500

Accounts Receivable


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

500
Transaction Assets = Liabilities + Owners Equity
1 +$10,000 = No Effect + +$10,000
2 $100 = No Effect + $100
3
+$5,000
= No Effect + No Effect
$5,000
4 +$7,000 = +$7,000 + No Effect
5 $600 = No Effect + $600
6 +$900 = No Effect + +$900
7 No Effect = +$120 + $120
8
+$500
= No Effect + No Effect
$500
Totals = $17,200 + $7,120 $10,080

The totals for the first eight transactions indicate that the company has assets of $17,200. The creditors
provided $7,120 and the owner provided $10,080. The accounting equation also indicates that the
companys creditors have a claim of $7,120 and the owner has a residual claim of $10,080.

ASCs balance sheet as of midnight December 8, 2010 is:

Accounting Software Co.
Balance Sheet
December 8, 2010
ASSETS

LIABILITIES

Cash $ 11,800 Notes Payable $ 7,000
Accounts Receivable

400 Accounts Payable $ 120
Equipment

5,000 Total Liabilities $ 7,120

OWNERS EQUITY


. J. Ott, Capital $ 10,080*
Total Assets $
17,200
Total Liab & Owner's Equity $
17,200
.
.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income** + 180

Subtotal $ 10,180

J. Ott, Drawing 100


Ending Owner's Equity, at Dec. 8 $
10,080*
.
**The income statement (which reports the companys revenues, expenses, gains, and losses during a
specified period of time) is a link between balance sheets. It provides the results of operationsan
important part of the change in owners equity.

The income statement for ASC for the eight days ending on December 8 is shown here:


Accounting Software Co.
Income Statement
For the Eight Days Ended December 8, 2010
REVENUES

Service Revenues $ 900
EXPENSES

Advertising Expense

600
Temp Service Expense

120
Total Expenses

720
NET INCOME $
180


Calculating a Missing Amount within Owners Equity
The income statement for the calendar year 2010 will explain a portion of the change in the owners
equity between the balance sheets of December 31, 2009 and December 31, 2010. The other items that
account for the change in owners equity are the owners investments into the sole proprietorship and the
owners draws (or withdrawals). A recap of these changes is the statement of changes in owners equity.
Here is a statement of changes in owners equity for the year 2010 assuming that the Accounting
Software Co. had only the eight transactions that we covered earlier.


Accounting Software Co.
Statement of Changes in Owners Equity
For the Year Ended December 31, 2010
Owners Equity at December 31, 2009 $ 0
Add: Owners Investment

10,000
Net Income

180
Subtotal

10,180
Deduct: Owners Draws

100
Owners Equity at December 31, 2010 $
10,080


Example of Calculating a Missing Amount
The format of the statement of changes in owners equity can be used to determine one of these
components if it is unknown. For example, if the net income for the year 2010 is unknown, but you know
the amount of the draws and the beginning and ending balances of owners equity, you can calculate the
net income. (This might be necessary if a company does not have complete records of its revenues and
expenses.) Lets demonstrate this by using the following amounts.

Assets as of December 31, 2009 $100,000
Liabilities as of December 31, 2009 40,000
Assets as of December 31, 2010 128,000
Liabilities as of December 31, 2010 34,000
Owner investment in business in 2010 10,000
Owner draws in 2010 40,000


Step 1.
The owners equity at December 31, 2009 can be computed using the accounting equation:

Assets = Liabilities + Owners Equity
$100,000 = $40,000 + Owners Equity
$100,000$40,000 = Owners Equity
$60,000 = Owners Equity at Dec. 31, 2009


Step 2.
The owners equity at December 31, 2010 can be computed as well:

Assets = Liabilities + Owners Equity
$128,000 = $34,000 + Owners Equity
$128,000$34,000 = Owners Equity
$94,000 = Owners Equity at Dec. 31, 2010


Step 3.
Insert into the statement of changes in owners equity the information that was given and the amounts
calculated in Step 1 and Step 2:

Owners Equity at December 31, 2009 $ 60,000
(Step
1)
Add: Owners Investment + 10,000 (given)
Net Income + ?

Subtotal

?

Deduct: Owners Draws 40,000 (given)
Owners Equity at December 31, 2010 $
94,000
(Step
2)


Step 4.
The Subtotal can be calculated by adding the last two numbers on the statement: $94,000 + $40,000 =
$134,000. After this calculation we have:

Owners Equity at December 31, 2009 $ 60,000
(Step
1)
Add: Owners Investment + 10,000 (given)
Net Income + ?

Subtotal

134,000
(Step
4)
Deduct: Owners Draws 40,000 (given)
Owners Equity at December 31, 2010 $
94,000
(Step
2)


Step 5.
Starting at the top of the statement we know that the owners equity before the start of 2010 was $60,000
and in 2010 the owner invested an additional $10,000. As a result we have $70,000 before considering
the amount of Net Income. We also know that after the amount of Net Income is added, the Subtotal has
to be $134,000 (the Subtotal calculated in Step 4). The Net Income is the difference between $70,000
and $134,000. Net income must have been $64,000.


Step 6.
Insert the previously missing amount (in this case it is the $64,000 of net income) into the statement of
changes in owners equity and recheck the math:

Owners Equity at December 31, 2009 $ 60,000
(Step
1)
Add: Owners Investment + 10,000 (given)
Net Income + 64,000
(Step
5)
Subtotal

134,000
(Step
4)
Deduct: Owners Draws 40,000 (given)
Owners Equity at December 31, 2010 $
94,000
(Step
2)

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

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

The remaining parts of this topic will illustrate similar transactions and their effect on the accounting
equation when the company is a corporation instead of a sole proprietorship.

Accounting Equation for a Corporation: Transactions C1C2
The accounting equation (or basic accounting equation) for a corporation is

Assets = Liabilities + Stockholders Equity

In our examples below, we show how a given transaction affects the accounting equation for a
corporation. We also show how the same transaction will be recorded in the companys general ledger
accounts.

Our examples will also show the effect of each transaction on the balance sheet and income statement.
For all of our examples we assume that the accrual basis of accounting is being followed.

In the examples that follow, we will use the following accounts:
Cash
Accounts Receivable
Equipment
Notes Payable
Accounts Payable
Common Stock
Retained Earnings
Treasury Stock
Service Revenues
Advertising Expense
Temp Service Expense
(To view a more complete listing of accounts for recording transactions, see the

Explanation of Chart of
Accounts.)

We also assume that the corporation is a Subchapter S corporation in order to avoid the income tax
accounting that would occur with a C corporation. (In a Subchapter S corporation the owners are
responsible for the income taxes instead of the corporation.)


Corporation Transaction C1.
Lets assume that members of the Ott family form a corporation called Accounting Software, Inc. (ASI).
On December 1, 2010, several members of the Ott family invest a total of $10,000 to start ASI. In
exchange, the corporation issues a total of 1,000 shares of common stock. (The stock has no par value
and no stated value.) The effect on the corporations accounting equation is:

Assets = Liabilities + Stockholders Equity
+$10,000 = No Effect + +$10,000

As you see, ASIs assets increase by $10,000 and stockholders equity increases by the same amount.
As a result, the accounting equation will be in balance.

The accounting equation tells us that ASI has assets of $10,000 and the source of those assets was the
stockholders. Alternatively, the accounting equation tells us that the corporation has assets of $10,000
and the only claim to the assets is from the stockholders (owners).

This transaction is recorded in the asset account Cash and in the stockholders' equity account Common
Stock. The general journal entry to record the transaction is:

Date Account Titles Debit
Dec. 1, 2010
Credit
Cash

10,000

Common Stock


After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASIs
financial position at the end of December 1, 2010:

10,000
Accounting Software, Inc.
Balance Sheet
December 1, 2010
ASSETS

LIABILITIES

Cash $ 10,000 STOCKHOLDERS EQUITY


. Common Stock $ 10,000

Total Assets $
10,000
Total Liabilities & Stkrs' Equity $
10,000

.


The purpose of an income statement is to report revenues and expenses. Since ASI has not yet earned
any revenues nor incurred any expenses, there are no transactions to be reported on an income
statement.


On December 2, 2010 ASI purchases $100 of its stock from one of its stockholders. The stock will be held
by the corporation as
Corporation Transaction C2.
Treasury Stock. The effect of the accounting equation is:

Assets = Liabilities + Stockholders Equity
$100 = No Effect + $100

The purchase of its own stock for cash meant that ASIs assets decrease by $100 and its stockholders
equity decreases by $100.

This transaction is recorded in the asset account Cash and in the stockholders equity account Treasury
Stock. The accounting entry in general journal form is:

Date Account Titles Debit Credit
Dec. 2, 2010 Treasury Stock

100

Cash


Since the transactions of December 1 and 2 were each in balance, the sum of both transactions should
also be in balance:

100
Transaction Assets = Liabilities +
Stockholders
Equity
C1 +$10,000 = No Effect + +$10,000
C2 $100 = No Effect + $100
Totals = $9,900 + $0 $9,900

The totals indicate that ASI has assets of $9,900 and the source of those assets is the stockholders. The
accounting equation also shows that the corporation has assets of $9,900 and the only claim against
those resources is the stockholders claim.

The December 2 balance sheet will communicate the corporations financial position as of midnight on
December 2:

Accounting Software, Inc
Balance Sheet
December 2, 2010
ASSETS

LIABILITIES

Cash $ 9,900 STOCKHOLDERS EQUITY


Common Stock $ 10,000


Retained Earnings

0*


. Less: Treasury Stock

(100)


Total Stockholders' Equity

9,900

Total Assets $
9,900
Total Liabilities & Stkrs Equity $
9,900

.

.

Beginning Retained Earnings $ 0

+ Net Income + 0

Subotal $ 0

Dividends 0


Ending Retained Earnings at Dec. 2 $
0*
.

The purchase of a corporations own stock will never result in an amount to be reported on the income
statement.

Accounting Equation for a Corporation: Transactions C3C4

Corporation Transaction C3.
On December 3, 2010 ASI spends $5,000 of cash to purchase computer equipment for use in the
business. The effect of this transaction on its accounting equation is:


Assets = Liabilities +
Stockholders
Equity

+$5,000 = No Effect + No Effect

$5,000

The accounting equation indicates that one asset increases and one asset decreases. Since the amount
of the increase is the same as the amount of the decrease, the accounting equation remains in balance.

This transaction is recorded in the asset accounts Equipment and Cash. The account increases by
$5,000 and the account decreases by $5,000. The journal entry for this transaction is:

Date Account Titles Debit
Dec. 3, 2010
Credit
Equipment

5,000

Cash


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

5,000
Transaction Assets = Liabilities +
Stockholders
Equity
C1 +$10,000 = No Effect + +$10,000
C2 $100 = No Effect + $100
C3
+$5,000
= No Effect + No Effect
$5,000
Totals = $9,900 + $0 $9,900

The totals tell us that the corporation has assets of $9,900 and the source of those assets is the
stockholders. The totals tell us that the company has assets of $9,900 and that the only claim against
those assets is the stockholders claim.

The balance sheet dated December 3, 2010 reflects the financial position of the corporation as of
midnight on December 3:

Accounting Software, Inc.
Balance Sheet
December 3, 2010
ASSETS

LIABILITIES

Cash $ 4,900 STOCKHOLDERS EQUITY

Equipment

5,000 Common Stock $ 10,000


Retained Earnings

0*


. Less: Treasury Stock

(100)


Total Stockholders' Equity

9,900

Total Assets $
9,900
Total Liabilities & Stkrs' Equity $
9,900

.

.

Beginning Retained Earnings $ 0

+ Net Income + 0

Subtotal $ 0

Dividends 0


Ending Retained Earnings at Dec. 3 $
0*
.

The purchase of equipment is not an immediate expense. It will become depreciation expense only after
the equipment is placed in service. We will assume that as of December 3 the equipment has not been
placed into service. Therefore, there is no expense in this transaction or in the earlier transactions to be
reported on the income statement.





Corporation Transaction C4.
On December 4, 2010 ASI obtains $7,000 by borrowing money from its bank. The effect of this
transaction on the accounting equation is:


Assets = Liabilities +
Stockholders
Equity

+$7,000 = +$7,000 + No Effect

As you see, ACIs assets increase and its liabilities increase by $7,000.

This transaction is recorded in the asset account Cash and the liability account Notes Payable with the
following journal entry:

Date Account Titles Debit
Dec. 4, 2010
Credit
Cash

7,000

Notes Payable


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

7,000
Transaction Assets = Liabilities +
Stockholders
Equity
C1 +$10,000 = No Effect + +$10,000
C2 $100 = No Effect + $100
C3
+$5,000
= No Effect + No Effect
$5,000
C4 +$7,000 = +$7,000 + No Effect
Totals = $16,900 + $7,000 $9,900

These totals indicate that the transactions through December 4 result in assets of $16,900. There are two
sources for those assets: the creditors provided $7,000 of assets, and the stockholders provided $9,900.
You can also interpret the accounting equation to say that the corporation has assets of $16,900 and the
creditors have a claim of $7,000. The residual or remainder of $9,900 is the stockholders claim.

The balance sheet dated December 4 reports the corporations financial position as of that date:

Accounting Software, Inc.
Balance Sheet
December 4, 2010
ASSETS

LIABILITIES

Cash $ 11,900 Notes Payable $ 7,000
Equipment

5,000 STOCKHOLDERS EQUITY


Common Stock

10,000

Retained Earnings

0*

Less: Treasury Stock

(100)

. Total Stockholders' Equity

9,900
Total Assets $
16,900
Total Liabilities & Stkrs' Equity $
16,900
.
.

Beginning Retained Earnings $ 0

+ Net Income + 0

Subtotal $ 0

Dividends 0


Ending Retained Earnings at Dec. 4 $
0*
.

The receipt of money from the bank loan is not revenue since ASI did not earn the money by providing
services, investing, etc. As a result, there is no income statement effect from this transaction or earlier
transactions.

Accounting Equation for a Corporation: Transactions C5C6

Corporation Transaction C5.
On December 5, 2010 Accounting Software, Inc. pays $600 for ads that were run in recent days. The
effect of the advertising transaction on the corporations accounting equation is:


Assets = Liabilities +
Stockholders
Equity

$600 = No Effect + $600

Since ASI is paying
Date
$600, its assets decrease. The second effect is a $600 decrease in stockholders
equity, because the transaction involves an expense. (An expense is a cost that is used up or its future
economic value cannot be measured.)

Although stockholders equity decreases because of an expense, the transaction is not recorded directly
into the retained earnings account. Instead, the amount is initially recorded in the expense account
Advertising Expense and in the asset account Cash. The journal entry for this transaction is:

Account Titles Debit
Dec. 5, 2010
Credit
Advertising Expense

600

Cash


The combined effect of the first five transactions is:

600
Transaction Assets = Liabilities +
Stockholders
Equity
C1 +$10,000 = No Effect + +$10,000
C2 $100 = No Effect + $100
C3
+$5,000
= No Effect + No Effect
$5,000
C4 +$7,000 = +$7,000 + No Effect
C5 $600 = No Effect + $600
Totals = $16,300 + $7,000 $9,300

The totals now indicate that Accounting Software, Inc. has assets of $16,300. The creditors provided
$7,000 and the stockholders provided $9,300. Viewed another way, the corporation has assets of
$16,300 with the creditors having a claim of $7,000 and the stockholders having a claim of $9,300.

The balance sheet as of the end of December 5, 2010 is presented here:

Accounting Software, Inc.
Balance Sheet
December 5, 2010
ASSETS

LIABILITIES

Cash $ 11,300 Notes Payable $ 7,000
Equipment

5,000 STOCKHOLDERS EQUITY


Common Stock

10,000

Retained Earnings

(600)*

Less: Treasury Stock

(100)

. Total Stockholders' Equity

9,300
Total Assets $
16,300
Total Liabilities & Stkrs' Equity $
16,300
.
.

Beginning Retained Earnings $ 0

+ Net Income** + (600)

Subtotal $ 0

Dividends 0


Ending Retained Earnings at Dec. 5 $
(600)*
.
**The income statement (which reports the companys revenues, expenses, gains, and losses for
a specified time period) is a link between balance sheets. It provides the results of operations
an important part of the change in retained earnings and stockholders equity.

Since this transaction involves an expense, it will affect ASIs income statement. The corporations
income statement for the first five days of December is presented here:


Accounting Software, Inc.
Income Statement
For the Five Days Ended December 5, 2010
REVENUES $ 0
EXPENSES

Advertising Expense

600
NET INCOME $
(600)

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



Corporation Transaction C6.
On December 6, 2010 ASI performs consulting services for its clients. The clients are billed for the agreed
upon amount of $900. The amounts are due in 30 days. The effect on the accounting equation is:


Assets = Liabilities +
Stockholders
Equity

+$900 = No Effect + +900

Since ASI has performed the services, it has earned
Although revenues cause stockholders equity to increase, the revenue transaction is not recorded
directly into a stockholders equity account at this time. Rather, the amount earned is recorded in the
revenues account
revenues and it has the right to receive $900 from its
clients. This right means that assets increased. The earning of revenues also causes stockholders equity
to increase.

Service Revenues
Date
. This will allow the corporation to report the revenues account on
its income statement at any time. (After the year ends, the amount in the revenues accounts will be
transferred to the retained earnings account.) The general journal entry for providing services on credit is:

Account Titles Debit
Dec. 6, 2010
Credit
Accounts Receivable

900

Service Revenues


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

900
Transaction Assets = Liabilities +
Stockholders
Equity
C1 +$10,000 = No Effect + +$10,000
C2 $100 = No Effect + $100
C3
+$5,000
= No Effect + No Effect
$5,000
C4 +$7,000 = +$7,000 + No Effect
C5 $600 = No Effect + $600
C6 +$900 = No Effect + +900
Totals = $17,200 + $7,000 $10,200

The totals tell us that at the end of December 6, the corporation has assets of $17,200. It also shows that
$7,000 of the assets came from creditors and that $10,200 came from stockholders. The totals can also
be viewed another way: ASI has assets of $17,200 with its creditors having a claim of $7,000 and the
stockholders having a claim for the remainder or residual of $10,200.

The balance sheet as of midnight on December 6, 2010 is presented here:

Accounting Software, Inc.
Balance Sheet
December 6, 2010
ASSETS

LIABILITIES

Cash $ 11,300 Notes Payable $ 7,000
Accounts Receivable

900 STOCKHOLDERS EQUITY

Equipment

5,000 Common Stock

10,000

Retained Earnings

300*

Less: Treasury Stock

(100)

. Total Stockholders' Equity

10,200
Total Assets $
17,200
Total Liabilities & Stkrs' Equity $
17,200
.
.

Beginning Retained Earnings $ 0

+ Net Income** + 300

Subtotal $ 300

Dividends 0


Ending Retained Earnings at Dec.
6
$
300*
.
**The income statement (which reports the companys revenues, expenses, gains, and losses for
a specified time period) is a link between balance sheets. It provides the results of operations
an important part of the change in retained earnings and stockholders equity.

The income statement for Accounting Software, Inc. for the period of December 1 through December 6 is
shown here:


Accounting Software, Inc.
Income Statement
For the Six Days Ended December 6, 2010
REVENUES

Service Revenues

900
EXPENSES

Advertising Expense

600
NET INCOME $
300

Accounting Equation for a Corporation: Transactions C7C8

Corporation Transaction C7.
On December 7, 2010 ASI uses a temporary help service for 6 hours at a cost of $20 per hour. ASI
records the invoice immediately, but it will pay the $120 when it is due in 10 days. This transaction has
the following effect on the accounting equation:


Assets = Liabilities +
Stockholders
Equity

No Effect = +$120 + $120

The accounting equation shows that ASIs liabilities increase by $120 and the expense causes
stockholders equity to decrease by $120.

The liability will be recorded in Accounts Payable and the expense will be recorded in Temp Service
Expense. The general journal entry for utilizing the temp service is:

Date Account Titles Debit
Dec. 7, 2010
Credit
Temp Service Expense

120

Accounts Payable


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

120
Transaction Assets = Liabilities +
Stockholders
Equity
C1 +$10,000 = No Effect + +$10,000
C2 $100 = No Effect + $100
C3
+$5,000
= No Effect + No Effect
$5,000
C4 +$7,000 = +$7,000 + No Effect
C5 $600 = No Effect + $600
C6 +$900 = No Effect + +$900
C7 No Effect = +$120 + $120
Totals = $17,200 + $7,120 $10,080

The totals show us that the corporation has assets of $17,200 and the sources are the creditors with
$7,120 and the stockholders with $10,080. The accounting equation totals also reveal that the
corporations creditors have a claim of $7,120 and the stockholders have a claim for the remaining
$10,080.

The financial position of ASI as of midnight of December 7, 2010 is presented in the following balance
sheet:

Accounting Software, Inc.
Balance Sheet
December 7, 2010
ASSETS

LIABILITIES

Cash $ 11,300 Notes Payable $ 7,000
Accounts Receivable

900 Accounts Payable

120
Equipment

5,000 Total Liabilities

7,120

STOCKHOLDERS EQUITY


Common Stock

10,000

Retained Earnings

180*

Less: Treasury Stock

(100)

. Total Stockholders' Equity

10,080
Total Assets $
17,200
Total Liabilities & Stkrs' Equity $
17,200
.
.

Beginning Retained Earnings $ 0

+ Net Income** + 180

Subtotal $ 180

Dividends 0


Ending Retained Earnings at Dec.
7
$
180*
.
**The income statement (which reports the corporations revenues, expenses, gains, and losses for
a specified time period) is a link between balance sheets. It provides the results of operations
an important part of the change in stockholders equity.

The income statement for the first seven days of December is shown here:


Accounting Software, Inc.
Income Statement
For the Seven Days Ended December 7, 2010
REVENUES

Service Revenues $ 900
EXPENSES

Advertising Expense

600
Temp Service Expense

120
Total Expenses

720
NET INCOME $
180




Corporation Transaction C8.
On December 8, 2010 ASI receives $500 from the clients it had billed on December 6. The effect on the
accounting equation is:

Assets = Liabilities + Stockholders Equity
+$500
= No Effect + No Effect
$500

The corporations cash increases and one of its other assets (accounts receivable) decreases. Liabilities
and stockholders equity are unaffected. (There are no revenues on this date. The revenues were
recorded when they were earned on December 6.)

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

Date Account Titles Debit
Dec. 8, 2010
Credit
Cash

500

Accounts Receivable


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

500
Transaction Assets = Liabilities +
Stockholders
Equity
C1 +$10,000 = No Effect + +$10,000
C2 $100 = No Effect + $100
C3
+$5,000
= No Effect + No Effect
$5,000
C4 +$7,000 = +$7,000 + No Effect
C5 $600 = No Effect + $600
C6 +$900 = No Effect + +$900
C7 No Effect = +$120 + $120
C8
+$500
=
No
+
No
$500 Effect Effect
Totals = $17,200 + $7,120 $10,080

The totals after the first eight transactions indicate that the corporation has assets of $17,200. The
creditors have provided $7,120 and the companys stockholders have provided $10,080. The accounting
equation also indicates that the companys creditors have a claim of $7,120 and the stockholders have a
residual claim of $10,080.

ASIs balance sheet as of midnight of December 8, 2010 is shown here:

Accounting Software, Inc.
Balance Sheet
December 8, 2010
ASSETS

LIABILITIES

Cash $ 11,800 Notes Payable $ 7,000
Accounts Receivable

400 Accounts Payable

120
Equipment

5,000 Total Liabilities

7,120

STOCKHOLDERS EQUITY


Common Stock

10,000

Retained Earnings

180*

Less: Treasury Stock

(100)

. Total Stockholders' Equity

10,080
Total Assets $
17,200
Total Liabilities & Stkrs' Equity $
17,200
.
.

Beginning Retained Earnings $ 0

+ Net Income** + 180

Subtotal $ 180

Dividends 0


Ending Retained Earnings at Dec.
8
$
180*
.
**The income statement (which reports the corporations revenues, expenses, gains, and losses for
a specified time period) is a link between balance sheets. It provides the results of operations
an important part of the change in stockholders equity.


The income statement for ASIs first eight days of operations is shown here:


Accounting Software, Inc.
Income Statement
For the Eight Days Ended December 8, 2010
REVENUES

Service Revenues $ 900
EXPENSES

Advertising Expense

600
Temp Service Expense

120
Total Expenses

720
NET INCOME $
180


Expanded Accounting Equation for a Sole Proprietorship


The owner's equity in the basic accounting equation is sometimes expanded to show the accounts that
make up owner's equity: Owner's Capital, Revenues, Expenses, and Owner's Draws.

Instead of the accounting equation, Assets = Liabilities + Owner's Equity, the expanded accounting
equation
The eight transactions that we had listed under the basic accounting equation
is:
Assets = Liabilities + Owner's Capital + Revenues Expenses Owner's Draws

Transaction 8, are shown
in the following expanded accounting equation:


Assets = Liabilities +
Owner's
Capital
+ Revenues Expenses
Owner's
Draws
1 + 10,000 =

+ + 10,000

2 100 =

+ 100
3
+ 5,000
5,000

=

4 + 7,000 = + 7,000

5 600 =

+ 600

6 + 900 =

+ + 900

7

= + 120

+ 120

8
+ 500
500

=

T 17,200 = 7,120 + 10,000 + 900 720 100

With the expanded accounting equation, you can easily see the company's net income:
Revenues $900
Expenses 720
Net Income $180

Expanded Accounting Equation for a Corporation
The stockholders' equity part of the basic accounting equation can also be expanded to show the
accounts that make up stockholders' equity: Paid-in Capital, Revenues, Expenses, Dividends, and
Treasury Stock.

Instead of the accounting equation, Assets = Liabilities + Stockholders' Equity, the expanded accounting
equation is:
Assets = Liabilities + Paid-in Capital + Revenues Expenses Dividends Treasury Stock

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


Assets = Liabilities +
Paid-in
Capital
+ Revenues Expenses
Dividends &
Treasury
Stock
1 + 10,000 =

+ + 10,000

2 100 =

+ 100
3
+ 5,000
5,000

=

4 + 7,000 = + 7,000

5 600 =

+ 600

6 + 900 =

+ + 900

7

= + 120

+ 120

8
+ 500
500

=

T 17,200 = 7,120 + 10,000 + 900 720 100

With the expanded accounting equation, you can easily see the corporation's net income:
Revenues $900
Expenses 720
Net Income $180


Accounting Principles

Introduction to Accounting Principles
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There are general rules and concepts that govern the field of accounting. These general rulesreferred
to as basic accounting
Accounting Principles.

principles and guidelinesform the groundwork on which more detailed,
complicated, and legalistic accounting rules are based. For example, the Financial Accounting
Standards Board (FASB)
Basic Accounting Principles and Guidelines
uses the basic accounting principles and guidelines as a basis for their own
detailed and comprehensive set of accounting rules and standards.

The phrase "generally accepted accounting principles" (or "GAAP") consists of three important sets of
rules: (1) the basic accounting principles and guidelines, (2) the detailed rules and standards issued by
FASB and its predecessor the Accounting Principles Board (APB), and (3) the generally accepted
industry practices.

If a company distributes its financial statements to the public, it is required to follow generally accepted
accounting principles in the preparation of those statements. Further, if a company's stock is publicly
traded, federal law requires the company's financial statements be audited by independent public
accountants. Both the company's management and the independent accountants must certify that the
financial statements and the related notes to the financial statements have been prepared in accordance
with GAAP.

GAAP is exceedingly useful because it attempts to standardize and regulate accounting definitions,
assumptions, and methods. Because of generally accepted accounting principles we are able to assume
that there is consistency from year to year in the methods used to prepare a company's financial
statements. And although variations may exist, we can make reasonably confident conclusions when
comparing one company to another, or comparing one company's financial statistics to the statistics for its
industry. Over the years the generally accepted accounting principles have become more complex
because financial transactions have become more complex.

Since GAAP is founded on the basic accounting principles and guidelines, we can better understand
GAAP if we understand those accounting principles. The table below lists the ten main accounting
principles and guidelines together with a highly condensed explanation of each.

Basic
Accounting
Principle
What It Means in Relationship to a Financial Statement

1. Economic
Entity
Assumption
The accountant keeps all of the business transactions of a sole proprietorship
separate from the business owner's personal transactions.
For legal purposes, a sole proprietorship and its owner are considered to be
one entity, but for accounting purposes they are considered to be two
separate entities.
2. Monetary
Unit
Assumption
Economic activity is measured in U.S. dollars, and only transactions that can
be expressed in U.S. dollars are recorded.

Because of this basic accounting principle, it is assumed that the dollar's
purchasing power has not changed over time. As a result accountants ignore
the effect of inflation on recorded amounts. For example, dollars from a 1960
transaction are combined (or shown with) dollars from a 2010 transaction.
3. Time Period
Assumption
This accounting principle assumes that it is possible to report the complex
and ongoing activities of a business in relatively short, distinct time intervals
such as the five months ended May 31, 2010, or the 5 weeks ended May 1,
2010. The shorter the time interval, the more likely the need for the
accountant to estimate amounts relevant to that period. For example, the
property tax bill is received on December 15 of each year. On the income
statement for the year ended December 31, 2010, the amount is known; but
for the income statement for the three months ended March 31, 2010, the
amount was not known and an estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the
heading of each income statement, statement of stockholders' equity, and
statement of cash flows. Labeling one of these financial statements with
"December 31" is not good enoughthe reader needs to know if the
statement covers the one week ending December 31, 2010 the month ending
December 31, 2010 thethree months ending December 31, 2010 or the year
ended December 31, 2010.
4. Cost
Principle
From an accountant's point of view, the term "cost" refers to the amount
spent (cash or the cash equivalent) when an item was originally obtained,
whether that purchase happened last year or thirty years ago. For this
reason, the amounts shown on financial statements are referred to
as historical
Because of this accounting principle asset amounts are
cost amounts.

not adjusted upward
for inflation. In fact, as a general rule, asset amounts are not adjusted to
reflectany type of increase in value. Hence, an asset amount does not reflect
the amount of money a company would receive if it were to sell the asset at
today's market value. (An exception is certain investments in stocks and
bonds that are actively traded on a stock exchange.) If you want to know the
current value of a company's long-term assets, you will not get this
information from a company's financial statementsyou need to look
elsewhere, perhaps to a third-party appraiser.
5. Full
Disclosure
Principle
If certain information is important to an investor or lender using the financial
statements, that information should be disclosed within the statement or in
the notes to the statement. It is because of this basic accounting principle
that numerous pages of "footnotes" are often attached to financial
statements.

As an example, let's say a company is named in a lawsuit that demands a
significant amount of money. When the financial statements are prepared it is
not clear whether the company will be able to defend itself or whether it might
lose the lawsuit. As a result of these conditions and because of the full
disclosure principle the lawsuit will be described in the notes to the financial
statements.

A company usually lists its significant accounting policies as the first note to
its financial statements.
6. Going
Concern
Principle
This accounting principle assumes that a company will continue to exist long
enough to carry out its objectives and commitments and will not liquidate in
the foreseeable future. If the company's financial situation is such that the
accountant believes the company will not be able to continue on, the
accountant is required to disclose this assessment.

The going concern principle allows the company to defer some of its prepaid
expenses until future accounting periods.
7. Matching
Principle
This accounting principle requires companies to use the accrual basis of
accounting. The matching principle requires that expenses be matched with
revenues. For example, sales commissions expense should be reported in
the period when the sales were made (and not reported in the period when
the commissions were paid). Wages to employees are reported as an
expense in the week when the employees worked and not in the week when
the employees are paid. If a company agrees to give its employees 1% of its
2010 revenues as a bonus on January 15, 2011, the company should report
the bonus as an expense in 2010 and the amount unpaid at December 31,
2010 as a liability. (The expense is occurring as the sales are occurring.)

Because we cannot measure the future economic benefit of things such as
advertisements (and thereby we cannot match the ad expense with related
future revenues), the accountant charges the ad amount to expense in the
period that the ad is run.

(To learn more about adjusting entries go to Explanation of Adjusting
Entriesand Drills for Adjusting Entries.)
8. Revenue
Recognition
Principle
Under the accrual basis of accounting (as opposed to the cash basis of
accounting), revenues
For example, if ABC Consulting completes its service at an agreed price of
$1,000, ABC should recognize $1,000 of revenue as soon as its work is
doneit does not matter whether the client pays the $1,000 immediately or
in 30 days. Do not confuse
are recognized as soon as a product has been sold
or a service has been performed, regardless of when the money is actually
received. Under this basic accounting principle, a company could earn and
report $20,000 of revenue in its first month of operation but receive $0 in
actual cash in that month.

revenue with a cash receipt.
9. Materiality
Because of this basic accounting principle or guideline, an accountant might
be allowed to violate another accounting principle if an amount is
insignificant. Professional judgement is needed to decide whether an amount
is insignificant or immaterial.

An example of an obviously immaterial item is the purchase of a $150 printer
by a highly profitable multi-million dollar company. Because the printer will be
used for five years, the matching principle directs the accountant to expense
the cost over the five-year period. The materiality guideline allows this
company to violate the matching principle and to expense the entire cost of
$150 in the year it is purchased. The justification is that no one would
consider it misleading if $150 is expensed in the first year instead of $30
being expensed in each of the five years that it is used.

Because of materiality, financial statements usually show amounts rounded
to the nearest dollar, to the nearest thousand, or to the nearest million dollars
depending on the size of the company.
10.
Conservatism
If a situation arises where there are two acceptable alternatives for reporting
an item, conservatism directs the accountant to choose the alternative that
will result in less net income and/or less asset amount. Conservatism helps
the accountant to "break a tie." It does not direct accountants to be
conservative. Accountants are expected to be unbiased and objective.

The basic accounting principle of conservatism leads accountants to
anticipate or disclose losses, but it does not allow a similar action for gains.
For example,potential losses from lawsuits will be reported on the financial
statements or in the notes, but potential gains will not be reported. Also, an
accountant may write inventory down to an amount that is lower than the
original cost, but will not write inventory up to an amount higher than the
original cost.

Other Characteristics of Accounting Information
When financial reports are generated by professional accountants, we have certain expectations of the
information they present to us:
1. We expect the accounting information to be
2. We expect
reliable, verifiable, and objective.
consistency
3. We expect
in the accounting information.
comparability

1. Reliable, Verifiable, and Objective
In addition to the basic accounting principles and guidelines listed in Part 1, accounting information
should be reliable, verifiable, and objective. For example, showing land at its original cost of $10,000
(when it was purchased 50 years ago) is considered to be more
in the accounting information.
reliable, verifiable, and objective than
showing it at its current market value of $250,000. Eight different accountants will wholly agree that the
original cost of the land was $10,000they can read the offer and acceptance for $10,000, see a transfer
tax based on $10,000, and review documents that confirm the cost was $10,000. If you ask the same
eight accountants to give you the land's current
The accounting profession has been willing to move away from the
value, you will likely receive eight different estimates.
Because the current value amount is less reliable, less verifiable, and less objective than the original cost,
the original cost is used.

cost principle
Accountants are expected to be
if there are reliable,
verifiable, and objective amounts involved. For example, if a company has an investment in stock that is
actively traded on a stock exchange, the company may be required to show the current value of the stock
instead of its original cost.

2. Consistency
consistent when applying accounting principles, procedures, and
practices. For example, if a company has a history of using the FIFO cost flow assumption, readers of
the company's most current financial statements have every reason to expect that the company is
continuing to use the FIFO cost flow assumption. If the company changes this practice and begins using
the LIFO cost flow assumption, that change must be clearly disclosed.

3. Comparability
Investors, lenders, and other users of financial statements expect that financial statements of one
company can be compared to the financial statements of another company in the same
industry. Generally accepted accounting principles may provide for comparability between the
financial statements of different companies. For example, the FASB requires that expenses related to
research and development (R&D) be expensed when incurred. Prior to its rule, some companies
expensed R&D when incurred while other companies deferred R&D to the balance sheet and expensed
them at a later date.




How Principles and Guidelines Affect Financial Statements
The basic accounting principles and guidelines directly affect the way financial statements are prepared
and interpreted. Let's look below at how accounting principles and guidelines influence the (1) balance
sheet, (2) income statement, and (3) the notes to the financial statements.

1. Balance Sheet
Let's see how the basic accounting principles and guidelines affect the balance sheet of Mary's Design
Service, a sole proprietorship owned by Mary Smith. (To learn more about the balance sheet go
toExplanation of Balance Sheet and Drills for Balance Sheet.)

A balance sheet is a snapshot of a company's assets, liabilities, and owner's equity at one point in time.
(In this case, that point in time is after all of the transactions through September 30, 2010 have been
recorded.) Because of the economic entity assumption, only the assets, liabilities, and owner's equity
specifically identified with Mary's Design Service are shownthe personal assets of the owner, Mary
Smith, are not included on the company's balance sheet.

Mary's Design Service
Balance Sheet
September 30, 2010

Assets

Liabilities

Cash $ 300

Notes Payable $ 1,000
Accounts Receivable 1,000

Accounts Payable 325
Supplies 160

Wages Payable 75
Prepaid Insurance 90

Unearned Revenues 100
Land 10,000

Total Liabilities 1,500

Owner's Equity


M.Smith, Capital 10,050
Total Assets $11,550

Total Liabilities & Owner's Equity

$11,550

The assets listed on the balance sheet have a cost that can be measured and each amount shown is the
original cost of each asset. For example, let's assume that a tract of land was purchased in 1956 for
$10,000. Mary's Design Service still owns the land, and the land is now appraised at $250,000. The cost
principle
If Mary's Design Service were to purchase a second piece of land, the
requires that the land be shown in the asset account Land at its original cost of $10,000 rather
than at the recently appraised amount of $250,000.

monetary unit
assumption
The Supplies account shows the cost of supplies (if material in amount) that were obtained by Mary's
Design Service but have not yet been used. As the supplies are consumed, their cost will be moved to the
Supplies Expense account on the income statement. This complies with the
dictates that the purchase price of the land bought today would simply be added to the
purchase price of the land bought in 1956, and the sum of the two purchase prices would be reported as
the total cost of land.

matching principle
The Prepaid Insurance account represents the cost of insurance that has not yet expired. As the
insurance expires, the expired cost is moved to
which
requires expenses to be matched either with revenues or with the time period when they are used. The
cost of the unused supplies remains on the balance sheet in the asset account Supplies.

Insurance Expense on the income statement as required
by the matching principle. The cost of the insurance that has not yet expired remains on Mary's Design
Service's balance sheet (is "deferred" to the balance sheet) in the asset account Prepaid Insurance.
Deferring insurance expense to the balance sheet is possible because of another basic accounting
principle, thegoing concern assumption.

The cost principle and monetary unit assumption prevent some very valuable assets from ever appearing
on a company's balance sheet. For example, companies that sell consumer products with high profile
brand names, trade names, trademarks, and logos are not reported on their balance sheets because they
were not purchased. For example, Coca-Cola's logo and Nike's logo are probably the most valuable
assets of such companies, yet they are not listed as assets on the company balance sheet. Similarly, a
company might have an excellent reputation and a very skilled management team, but because these
were not purchased for a specific cost and we cannot objectively measure them in dollars, they are not
reported as assets on the balance sheet. If a company actually purchases the trademark of another
company for a significant cost, the amount paid for the trademark will be reported as an asset on the
balance sheet of the company that bought the trademark.





2. Income Statement
Let's see how the basic accounting principles and guidelines might affect the income statement of Mary's
Design Service. (To learn more about the income statement go to Explanation of Income
Statement andDrills for Income Statement.)

An income statement covers a period of time (or time interval), such as a year, quarter, month, or four
weeks. It is imperative to indicate the period of time in the heading of the income statement such as "For
the Nine Months Ended September 30, 2010". (This means for the period of January 1 through
September 30, 2010.) If prepared under the accrual basis of accounting, an income statement will
show how profitable a company was during the stated time interval.

Mary's Design Service
Income Statement
For the Nine Months Ending September 30, 2010
Revenues and Gains


Revenues $10,000


Gain on Sale of Land 5,000


Total Revenues and Gains 15,000

Expenses and Losses


Expenses 8,000


Loss on Sale of Computer 350


Total Expenses and Losses 8,350


Net Income $ 6,650



Revenues are the fees that were earned during the period of time shown in the heading. Recognizing
revenues when they are earned instead of when the cash is actually received follows the revenue
recognition principle and the matching principle. (The matching principle is what steers accountants
toward using the accrual basis of accounting rather than the cash basis. Small business owners should
discuss these two methods with their tax advisors.)

Gains are a net amount related to transactions that are not considered part of the company's main
operations. For example, Mary's Design Service is in the business of designing, not in the land
development business. If the company should sell some land for $30,000 (land that is shown in the
company's accounting records at $25,000) Mary's Design Service will report a Gain on Sale of Land of
$5,000. The $30,000 selling price will not be reported as part of the company's revenues.

Expenses
Losses
are costs used up by the company in performing its main operations. The matching principle
requires that expenses be reported on the income statement when the related sales are made or when
the costs are used up (rather than in the period when they are paid).

are a net amount related to transactions that are not considered part of the company's main
operating activities. For example, let's say a retail clothing company owns an old computer that is carried
on its accounting records at $650. If the company sells that computer for $300, the company receives an
asset (cash of $300) but it must also remove $650 of asset amounts from its accounting records. The
result is aLoss on Sale of Computer of $350. The $300 selling price will not
Another basic accounting principle, the
be included in the
company's sales or revenues.

3. The Notes To Financial Statements
full disclosure principle, requires that a company's financial
statements include disclosure notes. These notes include information that helps readers of the financial
statements make investment and credit decisions. The notes to the financial statements are considered to
be an integral part of the financial statements.


Financial Accounting

Introduction to Financial Accounting
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Financial Accounting.
Financial accounting

is a specialized branch of accounting that keeps track of a company's financial
transactions. Using standardized guidelines, the transactions are recorded, summarized, and presented
in a financial report or financial statement such as an income statement or a balance sheet.
Companies issue financial statements on a routine schedule. The statements are
considered

externalbecause they are given to people outside of the company, with the primary recipients
being owners/stockholders, as well as certain lenders. If a corporation's stock is publicly traded, however,
its financial statements (and other financial reportings) tend to be widely circulated, and information will
likely reach secondary recipients such as competitors, customers, employees, labor organizations, and
investment analysts.
It's important to point out that the purpose of financial accounting is not to report the value of a company.
Rather, its purpose is to provide enough information for others to assess the value of a company for
themselves.

Because external financial statements are used by a variety of people in a variety of ways, financial
accounting has common rules known as accounting standards and as


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generally accepted accounting
principles (GAAP). In the U.S., the Financial Accounting Standards Board (FASB) is the organization
that develops the accounting standards and principles. Corporations whose stock is publicly traded must
also comply with the reporting requirements of the Securities and Exchange Commission (SEC), an
agency of the U.S. government.

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Double Entry and the Accrual Basis of Accounting
At the heart of financial accounting is the system known as double entry bookkeeping (or "double entry
accounting"). Each financial transaction that a company makes is recorded by using this system.

The term "double entry" means that every transaction affects at least two accounts. For example, if a
company borrows $50,000 from its bank, the company's Cash account increases, and the
company's Notes Payable account increases. Double entry also means that one of the accounts must
have an amount entered as a debit, and one of the accounts must have an amount entered as a credit.
For any given transaction, the debit amount must equal the credit amount. (To learn more about debits
and credits, seeExplanation of Debits & Credits.)

The advantage of double entry accounting is this: at any given time, the balance of a company's asset
accounts will equal the balance of its liability and stockholders' (or owner's) equity accounts. (To learn
more on how this equality is maintained, see the Explanation of Accounting Equation.)

Financial accounting is required to follow the accrual basis of accounting (as opposed to the "cash
basis" of accounting). Under the accrual basis, revenues are reported when they are earned, not when
the money is received. Similarly, expenses are reported when they are

incurred, not when they are paid.
For example, although a magazine publisher receives a $24 check from a customer for an annual
subscription, the publisher reports as revenue a monthly amount of $2 (one-twelfth of the annual
subscription amount). In the same way, it reports its property tax expense each month as one-twelfth of
the annual property tax bill.
By following the accrual basis of accounting, a company's profitability, assets, liabilities and other financial
information is more in line with economic reality. (To learn more on achieving the accrual basis of
accounting, see the Explanation of Adjusting Entries.)

Accounting Principles
If financial accounting is going to be useful, a company's reports need to be credible, easy to understand,
and comparable to those of other companies. To this end, financial accounting follows a set of common
rules known as accounting standards or generally accepted accounting principles

(GAAP,
pronounced "gap").
GAAP is based on the fundamental principles of accounting-concepts such as cost principle, matching
principle, full disclosure, going concern, economic entity, conservatism, relevance, and reliability. (You
can learn more about the basic principles in Explanation of Accounting Principles.)

GAAP, however, is not static. It includes some very complex standards that were issued in response to
some very complicated business transactions. GAAP also addresses accounting practices that may be
unique to particular industries, such as utility, banking, and insurance. Often these practices are a
response to changes in government regulations of the industry.

GAAP includes many specific pronouncements as issued by the Financial Accounting Standards Board
(FASB, pronounced "fas-bee"). The FASB is a non-government group that researches current needs and
develops accounting rules to meet those needs. (You can learn more about FASB and its accounting
pronouncements at www.FASB.org.)

In addition to following the provisions of GAAP, any corporation whose stock is publicly traded is also
subject to the reporting requirements of the Securities and Exchange Commission (SEC), an agency of
the U.S. government. These requirements mandate an annual report to stockholders as well as an annual
report to the SEC. The annual report to the SEC requires that independent certified public accountants
audit a company's financial statements, thus giving assurance that the company has followed GAAP.

Financial Statements
Financial accounting generates the following general-purpose, external, financial statements:
1. Income statement (sometimes referred to as "results of operations" or "earnings statement" or
"profit and loss [P&L] statement")
2. Balance sheet (sometimes referred to as "statement of financial position")
3. Statement of cash flows (sometimes referred to as "cash flow statement")
4. Statement of stockholders' equity

Income Statement
The income statement reports a company's profitability during a specified period of time. The period of
time could be one year, one month, three months, 13 weeks, or any other time interval chosen by the
company.

The main components of the income statement are revenues, expenses, gains, and losses. Revenues
include such things as sales, service revenues, and interest revenue. Expenses include the cost of goods
sold, operating expenses (such as salaries, rent, utilities, advertising), and nonoperating expenses (such
as interest expense). If a corporation's stock is publicly traded, the earnings per share of its common
stock are reported on the income statement. (You can learn more about the income statement
at Explanation of Income Statement.)


Balance Sheet
The balance sheet is organized into three parts: (1) assets, (2) liabilities, and (3) stockholders' equity at a
specified date (typically, this date is the last day of an accounting period).

The first section of the balance sheet reports the company's assets and includes such things as cash,
accounts receivable, inventory, prepaid insurance, buildings, and equipment. The next section reports the
company's liabilities; these are obligations that are due at the date of the balance sheet and often include
the word "payable" in their title (Notes Payable, Accounts Payable, Wages Payable, and Interest
Payable). The final section is stockholders' equity, defined as the difference between the amount of
assets and the amount of liabilities. (You can learn more about the balance sheet at Explanation of
Balance Sheet.)


Statement of Cash Flows
The statement of cash flows explains the change in a company's cash (and cash equivalents) during the
time interval indicated in the heading of the statement. The change is divided into three parts: (1)
operating activities, (2) investing activities, and (3) financing activities.

The operating activities section explains how a company's cash (and cash equivalents) have changed
due to operations. Investing activities refer to amounts spent or received in transactions involving long-
term assets. The financing activities section reports such things as cash received through the issuance of
long-term debt, the issuance of stock, or money spent to retire long-term liabilities. (You can learn more
about the statement of cash flows at Explanation of Cash Flow Statement.)


Statement of Stockholders' Equity
The statement of stockholders' (or shareholders') equity lists the changes in stockholders' equity for the
same period as the income statement and the cash flow statement. The changes will include items such
as net income, other comprehensive income, dividends, the repurchase of common stock, and the
exercise of stock options.

Financial Reporting
Financial reporting is a broader concept than financial statements. In addition to the financial statements,
financial reporting includes the company's annual report to stockholders, its annual report to the
Securities and Exchange Commission (Form 10-K), its proxy statement, and other financial information
reported by the company.

Financial Accounting vs. " Other" Accounting
Financial accounting represents just one sector in the field of business accounting. Another
sector,managerial accounting, is so named because it provides financial information to a company's
management. This information is generally internal (not distributed outside of the company) and is
primarily used by management to make decisions. Other sectors of the accounting field include cost
accounting, tax accounting, and

auditing.
Balance Sheet

Introduction to Balance Sheet
We also have Quizzes, Crosswords, and Q&A for the topic
The accounting
Balance Sheet.

balance sheet is one of the major financial statements used by accountants and
business owners. (The other major financial statements are the income statement, statement of cash
flows, andstatement of stockholders' equity) The balance sheet is also referred to as the statement of
financial position.

The balance sheet presents a company's financial position at the end of a specified date. Some describe
the balance sheet as a "snapshot" of the company's financial position at a point (a moment or an instant)
in time. For example, the amounts reported on a balance sheet dated December 31, 2010 reflect that
instant when all the transactions through December 31 have been recorded.

Because the balance sheet informs the reader of a company's financial position as of one moment in
time, it allows someonelike a creditorto see what a company owns as well as what it owes
In
to other
parties as of the date indicated in the heading. This is valuable information to the banker who wants to
determine whether or not a company qualifies for additional credit or loans. Others who would be
interested in the balance sheet include current investors, potential investors, company management,
suppliers, some customers, competitors, government agencies, and labor unions.

Part 1 we will explain the components of the balance sheet and in Part 2 we will present a sample
balance sheet. If you are interested in balance sheet analysis, that is included in the Explanation of
Financial Ratios.

We will begin our explanation of the accounting balance sheet with its major components, elements, or
major categories:
Assets
Liabilities
Owner's (Stockholders') Equity

Assets
Assets are things that the company owns. They are the resources of the company that have been
acquired through transactions, and have future economic value that can be measured and expressed in
dollars. Assets also include costs paid in advance that have not yet expired, such as prepaid advertising,
prepaid insurance, prepaid legal fees, and prepaid rent. (For a discussion of prepaid expenses go
to Explanation of Adjusting Entries.)

Examples of asset accounts that are reported on a company's balance sheet include:
Cash
Petty Cash
Temporary Investments
Accounts Receivable
Inventory
Supplies
Prepaid Insurance
Land
Land Improvements
Buildings
Equipment
Goodwill
Bond Issue Costs
Etc.

Usually these asset accounts will have debit


balances.
Contra assets are asset accounts with credit balances. (A credit balance in an asset account is
contraryor contrato an asset account's usual debit balance.) Examples of contra asset accounts
include:
Allowance for Doubtful Accounts
Accumulated Depreciation-Land Improvements
Accumulated Depreciation-Buildings
Accumulated Depreciation-Equipment
Accumulated Depletion
Etc.

Classifications Of Assets On The Balance Sheet
Accountants usually prepare classified balance sheets. "Classified" means that the balance sheet
accounts are presented in distinct groupings, categories, or classifications. The asset
classifications and their order of appearance on the balance sheet are:
Current Assets
Investments
Property, Plant, and Equipment
Intangible Assets
Other Assets

An outline of a balance sheet using the balance sheet classifications is shown here:

Example Company
Balance Sheet
December 31, 2010
ASSETS

LIABILITIES & OWNER'S EQUITY
Current Assets

Current Liabilities
Investments

Long-term liabilities
Property, Plant, and Equipment

Total Liabilities
Intangible Assets

Other Assets

Owner's Equity
Total Assets

Total Liabilities & Owner's Equity


To see how various asset accounts are placed within these classifications, view the sample balance
sheet in Part 4.


Effect of Cost Principle and Monetary Unit Assumption
The amounts reported in the asset accounts and on the balance sheet reflect actual costs recorded at the
time of a transaction. For example, let's say a company acquires 40 acres of land in the year 1950 at a
cost of $20,000. Then, in 1990, it pays $400,000 for an adjacent 40-acre parcel. The
company's Land
There are two guidelines that oblige the accountant to report $420,000 on the balance sheet rather than
the current market value of $3,000,000: (1) the
account will show a balance of $420,000 ($20,000 for the first parcel plus $400,000 for
the second parcel.). This account balance of $420,000 will appear on today's balance sheet even though
these parcels of land have appreciated to a current market value of $3,000,000.

cost principle directs the accountant to report the
company's assets at their original historical cost, and (2) the monetary unit assumption directs the
accountant to presume the U.S. dollar is stable over timeit is not affected by inflation or deflation. In
effect, the accountant is assuming that a 1950 dollar, a 1990 dollar, and a 2011 dollar all have the same
purchasing power.

The cost principle and monetary unit assumption may also mean that some very valuable resources will
not be reported on the balance sheet. A company's team of brilliant scientists will not be listed as an asset
on the company's balance sheet, because (a) the company did not purchase the team in a transaction
(cost principle) and (b) it's impossible for accountants to know how to put a dollar value on the team
(monetary unit assumption).

Coca-Cola's logo, Nike's logo, and the trade names for most consumer products companies are likely to
be their most valuable assets. If those names and logos were developed internally, it is reasonable that
they will not appear on the company balance sheet. If, however, a company should purchase a product
name and logo from another company, that cost will appear as an asset on the balance sheet of the
acquiring company.

Remember, accounting principles and guidelines place some limitations on what is reported as an asset
on the company's balance sheet.

Effect of Conservatism
While the cost principle and monetary unit assumption generally prevent assets from being reported on
the balance sheet at an amount greater than cost, conservatism will result in some assets being reported
atless than cost. For example, assume the cost of a company's inventory was $30,000, but now
the current cost of the same items in inventory has dropped to $27,000. The conservatism guideline
instructs the company to report Inventory on its balance sheet at $27,000. The $3,000 difference is
reported immediately as a loss on the company's income statement.

Effect of Matching Principle
The matching principle will also cause certain assets to be reported on the accounting balance sheet
at lessthan cost. For example, if a company has Accounts Receivable of $50,000 but anticipates that it
will collect only $48,500 due to some customers' financial problems, the company will report a credit
balance of $1,500 in the contra asset account Allowance for Doubtful Accounts. The combination of the
asset Accounts Receivable with a debit balance of $50,000 and the contra asset Allowance for Doubtful
Accounts with acredit
The matching principle also requires that the cost of buildings and equipment be depreciated over their
useful lives. This means that over time the cost of these assets will be moved from the balance sheet to
Depreciation Expense on the income statement. As time goes on, the amounts reported on the balance
sheet for these long-term assets will be reduced. (For a further discussion on depreciation, go
to
balance will mean that the balance sheet will report the net amount of $48,500. The
income statement will report the $1,500 adjustment as Bad Debts Expense.

Explanation of Depreciation.)

Liabilities


Liabilities are obligations of the company; they are amounts owed to creditors for a past transaction and
they usually have the word "payable" in their account title. Along with owner's equity, liabilities can be
thought of as a source of the company's assets. They can also be thought of as a claim against a
company's assets. For example, a company's balance sheet reports assets of $100,000 and Accounts
Payable of $40,000 and owner's equity of $60,000. The source of the company's assets are
creditors/suppliers for $40,000 and the owners for $60,000. The creditors/suppliers have a claim against
the company's assets and the owner can claim what remains after the Accounts Payable have been paid.

Liabilities also include amounts received in advance for future services. Since the amount received
(recorded as the asset Cash) has not yet been earned, the company defers the reporting
of revenues and instead reports a liability such as Unearned Revenues or Customer Deposits. (For a
further discussion on deferred revenues/prepayments see the Explanation of Adjusting Entries.)

Examples of liability accounts reported on a company's balance sheet include:
Notes Payable
Accounts Payable
Salaries Payable
Wages Payable
Interest Payable
Other Accrued Expenses Payable
Income Taxes Payable
Customer Deposits
Warranty Liability
Lawsuits Payable
Unearned Revenues
Bonds Payable
Etc.
These liability accounts will normally have credit balances.

Contra liabilities are liability accounts with debit balances. (A debit balance in a liability account is
contraryor contrato a liability account's usual credit balance.) Examples of contra liability accounts
include:
Discount on Notes Payable
Discount on Bonds Payable
Etc.

Classifications Of Liabilities On The Balance Sheet
Liability and contra liability accounts are usually classified (put into distinct groupings, categories, or
classifications) on the balance sheet. The liability classifications and their order of appearance on the
balance sheet are:
Current Liabilities
Long Term Liabilities
Etc.
To see how various liability accounts are placed within these classifications, click here to view the
sample balance sheet in Part 4.

Commitments
A company's commitments (such as signing a contract to obtain future services or to purchase goods)
may be legally binding, but they are not considered a liability on the balance sheet until some services or
goods have been received. Commitments (if significant in amount) should be disclosed in the notes to the
balance sheet.

Form vs. Substance
The leasing of a certain asset mayon the surfaceappear to be a rental of the asset, but in substance
it may involve a binding agreement to purchase the asset and to finance it through monthly payments.
Accountants must look past the form and focus on the substance of the transaction. If, in substance, a
lease is an agreement to purchase an asset and to create a note payable, the accounting rules require
that the asset and the liability be reported in the accounts and on the balance sheet.

Contingent Liabilities
Three examples of contingent liabilities include warranty of a company's products, the guarantee of
another party's loan, and lawsuits filed against a company. Contingent liabilities are potential liabilities.
Because they are dependent upon some future event occurring or not occurring, they may or may not
become actual liabilities.

To illustrate this, let's assume that a company is sued for $100,000 by a former employee who claims he
was wrongfully terminated. Does the company have a liability of $100,000? It depends. If the company
was justified in the termination of the employee and has documentation and witnesses to support its
action, this might be considered a frivolous lawsuit and there may be no liability. On the other hand, if the
company wasnot justified in the termination and it is clear that the company acted improperly, the
company will likely have an income statement loss and a balance sheet liability.

The accounting rules for these contingencies are as follows: If the contingent loss
is probable and theamount of the loss can be estimated, the company needs to record a liability on its
balance sheet and a loss on its income statement. If the contingent loss is remote, no liability or loss is
recorded and there is no need to include this in the notes to the financial statements. If the contingent
loss lies somewhere in between, it should be disclosed
Current vs. Long-term Liabilities
If a company has a loan payable that requires it to make monthly payments for several years, only
theprincipal
in the notes to the financial statements.

due in the next twelve months should be reported on the balance sheet as a current liability.
The remaining principal amount should be reported as a long-term liability. The interest on the loan that
pertains to the future is not recorded on the balance sheet; only unpaid interest up to the date of the
balance sheet is reported as a liability.

Notes to the Financial Statements
As the above discussion indicates, the notes to the financial statements can reveal important information
that should not be overlooked when reading a company's balance sheet.

Owner's (Stockholders') Equity
Owner's Equityalong with liabilitiescan be thought of as a source of the company's assets. Owner's
equity is sometimes referred to as the book value of the company, because owner's equity is equal to
the reported asset amounts minus
Owner's equity may also be referred to as the
the reported liability amounts.

residual of assets minus liabilities. These references make
sense if you think of the basic accounting equation:

Assets = Liabilities + Owner's Equity

and just rearrange the terms:

Owner's Equity = Assets Liabilities

"Owner's Equity" are the words used on the balance sheet when the company is a sole proprietorship. If
the company is a corporation, the words Stockholders' Equity are used instead of Owner's Equity. An
example of an owner's equity account is Mary Smith, Capital (where Mary Smith is the owner of the sole
proprietorship). Examples of stockholders' equity accounts include:
Common Stock
Preferred Stock
Paid-in Capital in Excess of Par Value
Paid-in Capital from Treasury Stock
Retained Earnings
Etc.
Both owner's equity and stockholders' equity accounts will normally have credit balances.

Contra owner's equity accounts are a category of owner equity accounts with debit balances. (A debit
balance in an owner's equity account is contraryor contrato an owner's equity account's usual credit
balance.) An example of a contra owner's equity account is Mary Smith, Drawing (where Mary Smith is
the owner of the sole proprietorship). An example of a contra stockholders' equity account is Treasury
Stock.

Classifications of Owner's Equity On The Balance Sheet
Owner's equity is generally represented on the balance sheet with two or three accounts (e.g., Mary
Smith, Capital; Mary Smith, Drawing; and perhaps

Current Year's Net Income). See the sample
balance sheet in Part 4.

The stockholders' equity section of a corporation's balance sheet is:
Paid-in Capital
Retained Earnings
Treasury Stock

The stockholders' equity section of a corporation's balance sheet is:


STOCKHOLDERS' EQUITY

Paid-in Capital

Preferred Stock

Common Stock

Paid-in Capital in Excess of Par Value - Preferred Stock

Paid-in Capital in Excess of Par Value - Common Stock

Paid-in Capital from Treasury Stock

Retained Earnings

Less: Treasury Stock

TOTAL STOCKHOLDERS' EQUITY



Owner's Equity vs. Company's Market Value
Since the asset amounts report the cost of the assets at the time of the transactionor lessthey do not
reflect current fair market values. (For example, computers which had a cost of $100,000 two years ago
may now have a book value of $60,000. However, the current value of the computers might be just
$35,000. An office building purchased by the company 15 years ago at a cost of $400,000 may now have
a book value of $200,000. However, the current value of the building might be $900,000.) Since the
assets are not reported on the balance sheet at their current fair market value, owner's equity appearing
on the balance sheet is
Owner's Equity and Temporary Accounts
Revenues, gains, expenses, and losses are income statement accounts. Revenues and gains cause
owner's equity to increase. Expenses and losses cause owner's equity to decrease. If a company
notan indication of the fair market value of the company.

performs a service and increases its assets, owner's equity will increase when the Service
Revenues
Sample Balance Sheet
account is closed to owner's equity at the end of the accounting year.

Most accounting balance sheets classify a company's assets and liabilities into distinctive groupings such
as Current Assets; Property, Plant, and Equipment; Current Liabilities; etc. These classifications make the
balance sheet more useful. The following balance sheet example is a classified balance sheet.

Sample Balance Sheet:


Example Company
Balance Sheet
December 31, 2010

ASSETS

LIABILITIES
Current Assets

Current Liabilities


Cash $ 2,100

Notes Payable $ 5,000

Petty Cash 100

Accounts Payable 35,900

Temporary Investments 10,000

Wages Payable 8,500

Accounts Receivable - net 40,500

Interest Payable 2,900

Inventory 31,000

Taxes Payable 6,100

Supplies 3,800

Warranty Liability 1,100

Prepaid Insurance 1,500

Unearned Revenues 1,500

Total Current Assets 89,000

Total Current Liabilities 61,000
-
Investments 36,000

Long-term Liabilities


Notes Payable 20,000
Property, Plant & Equipment

Bonds Payable 400,000

Land 5,500

Total Long-term Liabilities 420,000

Land Improvements 6,500


Buildings 180,000


Equipment 201,000

Total Liabilities 481,000

Less: Accum Depreciation (56,000)


Prop, Plant & Equip - net 337,000

-
Intangible Assets

STOCKHOLDERS' EQUITY


Goodwill 105,000

Common Stock 110,000

Trade Names 200,000

Retained Earnings 229,000

Total Intangible Assets 305,000

Less: Treasury Stock (50,000)

Total Stockholders' Equity 289,000
Other Assets 3,000

-
Total Assets $770,000

Total Liab. & Stockholders' Equity $770,000


The notes to the sample balance sheet have been omitted.




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Notes To Financial Statements
The notes (or footnotes) to the balance sheet and to the other financial statements are considered to be
part of the financial statements. The notes inform the readers about such things as significant accounting
policies, commitments made by the company, and potential liabilities and potential losses. The notes
contain information that is critical to properly understanding and analyzing a company's financial
statements.

It is common for the notes to the financial statements to be 10-20 pages in length. Go to the website for a
company whose stock is publicly traded and locate its annual report. Review the notes near the end of
the annual report.


Adjusting Entries

Introduction to Adjusting Entries
We also have a Visual Tutorial, Quiz, Crosswords, and Q&A for the topic
Adjusting entries are accounting journal entries that convert a company's accounting records to
the
Adjusting Entries.

accrual basis of accounting. An adjusting journal entry is typically made just prior to issuing a
company'sfinancial statements.

To demonstrate the need for an accounting adjusting entry let's assume that a company borrowed money
from its bank on December 1, 2010 and that the company's accounting period ends on December 31. The
bank loan specifies that the first interest payment on the loan will be due on March 1, 2011. This means
that the company's accounting records as of December 31 do not contain any payment to the bank for the
interest the company incurred from December 1 through December 31. (Of course the loan is costing the
company interest expense every day, but the actual payment for the interest will not occur until March 1.)
For the company's December income statement to accurately report the company's profitability, it must
include all of the company's December expensesnot just the expenses that were paid. Similarly, for the
company's balance sheet on December 31 to be accurate, it must report a liability for the interest owed
as of the balance sheet date. An adjusting entry is needed so that December's interest expense is
included on December's income statement and the interest due as of December 31 is included on the
December 31 balance sheet. The adjusting entry will debit Interest Expense and credit Interest
Payable
Another situation requiring an adjusting journal entry arises when an amount has already been recorded
in the company's accounting records, but the amount is for more than the current accounting period. To
illustrate let's assume that on December 1, 2010 the company paid its insurance agent $2,400 for
insurance protection during the period of December 1, 2010 through May 31, 2011. The $2,400
transaction was recorded in the accounting records on December 1, but the amount represents six
months of coverage and expense. By December 31, one month of the insurance coverage and cost have
been used up or expired. Hence the income statement for December should report just one month of
insurance cost of $400 ($2,400 divided by 6 months) in the account Insurance Expense. The balance
sheet dated December 31 should report the cost of five months of the insurance coverage that has not
yet been used up. (The cost not used up is referred to as the asset
for the amount of interest from December 1 to December 31.

Prepaid Insurance. The cost that is
used up is referred to as the expired cost Insurance Expense.) This means that the balance sheet dated
December 31 should report five months of insurance cost or $2,000 ($400 per month times 5 months) in
the asset account Prepaid Insurance. Since it is unlikely that the $2,400 transaction on December 1 was
recorded this way, an adjusting entry will be needed at December 31, 2010 to get the income statement
and balance sheet to report this accurately.

The two examples of adjusting entries have focused on expenses, but adjusting entries also
involverevenues. This will be discussed later when we prepare adjusting journal entries.

For now we want to highlight some important points.

There are two scenarios where adjusting journal entries are needed before the financial statements are
issued:
Nothing has been entered in the accounting records for certain expenses or revenues, but those
expenses and/or revenues did occur and must be included in the current period's income
statement and balance sheet.
Something has already been entered in the accounting records, but the amount needs to be
divided up between two or more accounting periods.

Adjusting entries almost always involve a
balance sheet account (Interest Payable, Prepaid Insurance, Accounts Receivable, etc.) and an
income statement account (Interest Expense, Insurance Expense, Service Revenues, etc.)

Adjusting Entries Asset Accounts

Adjusting entries assure that both the balance sheet and the income statement are up-to-date on
the

accrual basis of accounting. A reasonable way to begin the process is by reviewing the amount or
balance shown in each of the balance sheet accounts. We will use the following preliminary balance
sheet, which reports the account balances prior to any adjusting entries:

Parcel Delivery Service
Preliminary Balance Sheetbefore adjusting entries
December 31, 2010

Assets

Liabilities

Cash $ 1,800

Notes Payable $ 5,000
Accounts Receivable 4,600

Accounts Payable 2,500
Supplies 1,100

Wages Payable 1,200
Prepaid Insurance 1,500

Unearned Revenues 1,300
Equipment 25,000

Total Liabilities 10,000
Accumulated Depreciation (7,500)


Owner's Equity





Mary Smith, Capital 16,500

Total Assets $26,500

Total Liabilities & Owner's Equity

$26,500

Let's begin with the asset accounts:



Cash
The Cash account has a preliminary balance of $1,800the amount in the
$1,800
general ledger. Before
issuing the balance sheet, one must ask, "Is $1,800 the true amount of cash? Does it agree to the amount
computed on the bank reconciliation?" The accountant found that $1,800 was indeed the true balance. (If
the preliminary balance in Cash does not agree to the bank reconciliation, entries are usually needed. For
example, if the bank statement included a service charge and a check printing chargeand they were not
yet entered into the company's accounting recordsthose amounts must be entered into the Cash
account. See the major topic Bank Reconciliation



for a thorough discussion and illustration of the likely
journal entries.)
Accounts Receivable
To determine if the balance in this account is accurate the accountant might review the detailed listing of
customers who have not paid their invoices for goods or services. (This is often referred to as the amount
of open or unpaid sales invoices and is often found in the accounts receivable subsidiary ledger.) When
those open invoices are sorted according to the date of the sale, the company can tell how old the
receivables are. Such a report is referred to as an
$4,600
aging of accounts receivable. Let's assume the
review indicates that the preliminary balance in Accounts Receivable of $4,600 is accurate as far as the
amounts that have been billed and not yet paid.

However, under the accrual basis of accounting, the balance sheet must report all the amounts the
company has an absolute right to receivenot just the amounts that have been billed on a sales invoice.
Similarly, the income statement should report all revenues that have been earnednot just the revenues
that have been billed. After further review, it is learned that $3,000 of work has been performed (and
therefore has been earned) as of December 31 but won't be billed until January 10. Because this $3,000
was earned in December, it must be entered and reported on the financial statements for December. An
adjusting entry dated December 31 is prepared in order to get this information onto the December
financial statements.

To assist you in understanding adjusting journal entries, double entry, and debits and credits, each
example of an adjusting entry will be illustrated with a T-account.

Here is the process we will follow:
1. Draw two T-accounts. (Every journal entry involves at least two accounts. One account to be
debited and one account to be credited.)
2. Indicate the account titles on each of the T-accounts. (Remember that almost always one of the
accounts is a balance sheet account and one will be an income statement account. In a
smaller font size we will indicate the type of account next to the account title and we will also
indicate some tips about debits and credits within the T-accounts.)
3. Enter the preliminary balance in each of the T-accounts.
4. Determine what the ending balance ought to be for the balance sheet account.
5. Make an adjustment so that the ending amount in the balance sheet account is correct.
6. Enter the same adjustment amount into the related income statement account.
7. Write the adjusting journal entry.

Let's follow that process here:

Accounts Receivable

(balance sheet account)
Debit
Increases an asset

Credit
Decreases an asset
Preliminary Balance 4,600


ADJUSTING ENTRY 3,000


Correct Balance 7,600



Service Revenues

(income statement account)
Debit
Decreases Revenues

Credit
Increases Revenues

60,234

Preliminary Balance

3,000

ADJUSTING ENTRY

63,234

Correct Balance

The adjusting entry for Accounts Receivable in general journal format is:

Date Account Name Debit Credit

Dec. 31, 2010 Accounts Receivable 3,000


Service Revenues

3,000

Notice that the ending balance in the asset Accounts Receivable is now $7,600the correct amount that
the company has a right to receive. The income statement account balance has been increased by the
$3,000 adjustment amount, because this $3,000 was also earned in the accounting period but had not yet
been entered into the Service Revenues account. The balance in Service Revenues will increase during
the year as the account is credited whenever a sales invoice is prepared. The balance in Accounts
Receivable also increases if the sale was on credit (as opposed to a cash sale). However, Accounts
Receivable will decrease whenever a customer pays some of the amount owed to the company.
Therefore the balance in Accounts Receivable might be approximately the amount of one month's sales,
if the company allows customers to pay their invoices in 30 days.

At the end of the accounting year, the ending balances in the balance sheet accounts (assets and
liabilities) will carry forward to the next accounting year. The ending balances in the income statement
accounts (revenues and expenses) are closed after the year's financial statements are prepared and
these accounts will start the next accounting period with zero balances.




Allowance for Doubtful Accounts $0

(It's common not
Although the Allowance for Doubtful Accounts does not appear on the preliminary balance sheet,
experienced accountants realize that it is likely that some of the accounts receivable might not be
collected. (This could occur because some customers will have unforeseen hardships, some customers
might be dishonest, etc.) If some of the $4,600 owed to the company will not be collected, the company's
balance sheet should report less than $4,600 of accounts receivable. However, rather than reducing the
balance in Accounts Receivable by means of a credit amount, the credit amount will be reported in
Allowance for Doubtful Accounts. (The combination of the debit balance in Accounts Receivable and the
credit balance in Allowance for Doubtful Accounts is referred to as the
to list accounts with $0 balances on balance sheets.)
net realizable value.)

Let's assume that a review of the accounts receivables indicates that approximately $600 of the
receivables will not be collectible. This means that the balance in Allowance for Doubtful Accounts should
be reported as a $600 credit balance instead of the preliminary balance of $0. The two accounts involved
will be the balance sheet account Allowance for Doubtful Accounts and the income statement account
Bad Debts Expense.

Allowance for Doubtful Accounts

(balance sheet account)
Debit
Decreases a contra asset

Credit
Increases a contra asset

0

Preliminary Balance

600

ADJUSTING ENTRY

600

Correct Balance

Bad Debts Expense

(income statement account)
Debit
Increases an expense

Credit
Decreases an expense
Preliminary Balance 0


ADJUSTING ENTRY 600


Correct Balance 600



The adjusting journal entry for Allowance for Doubtful Accounts is:

Date Account Name Debit Credit

Dec. 31, 2010 Bad Debts Expense 600


Allowance for Doubtful Accounts

600

It is possible for one or both of the accounts to have preliminary balances. However, the balances are
likely to be different from one another. Because Allowance for Doubtful Accounts is a balance sheet
account, its ending balance will carry forward to the next accounting year. Because Bad Debts Expense is
an income statement account, its balance will not carry forward to the next year. Bad Debts Expense will
start the next accounting year with a zero balance.



Supplies $1,100
The Supplies account has a preliminary balance of $1,100. However, a count of the supplies actually on
hand indicates that the true amount of supplies is $725. This means that the preliminary balance is too
high by $375 ($1,100 minus $725). A credit of $375 will need to be entered into the asset account in order
to reduce the balance from $1,100 to $725. The related income statement account is Supplies Expense.

Supplies

(balance sheet account)
Debit
Increases an asset

Credit
Decreases an asset
Preliminary Balance 1,100



375

ADJUSTING ENTRY
Correct Balance 725



Supplies Expense

(income statement account)
Debit
Increases an expense

Credit
Decreases an expense
Preliminary Balance 1,600


ADJUSTING ENTRY 375


Correct Balance 1,975



The adjusting entry for Supplies in general journal format is:

Date Account Name Debit Credit

Dec. 31, 2010 Supplies Expense 375


Supplies

375

Notice that the ending balance in the asset Supplies is now $725the correct amount of supplies that the
company actually has on hand. The income statement account Supplies Expense has been increased by
the $375 adjusting entry. It is assumed that the decrease in the supplies on hand means that the supplies
have been used during the current accounting period. The balance in Supplies Expense will increase
during the year as the account is debited. Supplies Expense will start the next accounting year with a zero
balance. The balance in the asset Supplies at the end of the accounting year will carry over to the next
accounting year.



Prepaid Insurance $1,500
The $1,500 balance in the asset account Prepaid Insurance is the preliminary balance. The correct
balance needs to be determined. The correct amount is the amount that has been paid by the company
for insurance coverage that will expire after the balance sheet date. If a review of the payments for
insurance shows that $600 of the insurance payments is for insurance that will expire after the balance
sheet date, then the balance in Prepaid Insurance should be $600. All other amounts should be charged
to Insurance Expense.

Prepaid Insurance

(balance sheet account)
Debit
Increases an asset

Credit
Decreases an asset
Preliminary Balance 1,500



900

ADJUSTING ENTRY
Correct Balance 600



Insurance Expense

(income statement account)
Debit
Increase an expense

Credit
Decreases an expense
Preliminary Balance 1,000


ADJUSTING ENTRY 900


Correct Balance 1,900



The adjusting journal entry for Prepaid Insurance is:

Date Account Name Debit Credit

Dec. 31, 2010 Insurance Expense 900


Prepaid Insurance

900

Note that the ending balance in the asset Prepaid Insurance is now $600the correct amount of
insurance that has been paid in advance. The income statement account Insurance Expense has been
increased by the $900 adjusting entry. It is assumed that the decrease in the amount prepaid was the
amount being used or expiring during the current accounting period. The balance in Insurance Expense
starts with a zero balance each year and increases during the year as the account is debited. The
balance at the end of the accounting year in the asset Prepaid Insurance will carry over to the next
accounting year.



Equipment



$25,000
Equipment is a long-term asset that will not last indefinitely. The cost of equipment is recorded in the
account Equipment. The $25,000 balance in Equipment is accurate, so no entry is needed in this
account. As an asset account, the debit balance of $25,000 will carry over to the next accounting year.
Accumulated Depreciation - Equipment
Accumulated Depreciation - Equipment is a
$7,500
contra asset account and its preliminary balance of $7,500
is the amount of depreciation

actually entered into the account since the Equipment was acquired. The
correct balance should be the cumulative amount of depreciation from the time that the equipment was
acquired through the date of the balance sheet. A review indicates that as of December 31 the
accumulated amount of depreciation should be $9,000. Therefore the account Accumulated Depreciation
- Equipment will need to have an ending balance of $9,000. This will require an additional $1,500 credit to
this account. The income statement account that is pertinent to this adjusting entry and which will be
debited for $1,500 is Depreciation Expense - Equipment.

Accumulated Depreciation - Equipment

(balance sheet acct)
Debit
Decreases a contra asset

Credit
Increases a contra asset

7,500

Preliminary Balance

1,500

ADJUSTING ENTRY

9,000

Correct Balance

Depreciation Expense - Equipment

(income statement acct)
Debit
Increases an expense

Credit
Decreases an expense
Preliminary Balance 0


ADJUSTING ENTRY 1,500


Correct Balance 1,500



The adjusting entry for Accumulated Depreciation in general journal format is:

Date Account Name Debit Credit

Dec. 31, 2010 Depreciation Expense - Equipment 1,500


Accumulated Depreciation - Equipment

1,500

The ending balance in the contra asset account Accumulated Depreciation - Equipment at the end of the
accounting year will carry forward to the next accounting year. The ending balance in Depreciation
Expense - Equipment will be closed at the end of the current accounting period and this account will
begin the next accounting year with a balance of $0.

Adjusting Entries Liability Accounts

Notes Payable



$5,000
Notes Payable is a liability account that reports the amount of principal owed as of the balance sheet
date. (Any interest incurred but not yet paid as of the balance sheet date is reported in a separate liability
account Interest Payable.) The accountant has verified that the amount of principal actually owed is the
same as the amount appearing on the preliminary balance sheet. Therefore, no entry is needed for this
account.
Interest Payable $0 (It's common not
Interest Payable is a liability account that reports the amount of interest the company owes as of the
balance sheet date. Accountants realize that if a company has a balance in Notes Payable, the company
should be reporting some amount in
to list accounts with $0 balances on balance sheets.)
Interest Expense

and in Interest Payable. The reason is that each
day that the company owes money it is incurring interest expense and an obligation to pay the interest.
Unless the interest is paid up to date, the company will always owe some interest to the lender.

Let's assume that the company borrowed the $5,000 on December 1 and agrees to make the first interest
payment on March 1. If the loan specifies an annual interest rate of 6%, the loan will cost the company
interest of $300 per year or $25 per month. On March 1 the company will be required to pay $75 of
interest. On the December income statement the company must report one month of interest expense of
$25. On the December 31 balance sheet the company must report that it owes $25 as of December 31
for interest.

Interest Payable

(balance sheet account)
Debit
Decreases a liability

Credit
Increases a liability

0

Preliminary Balance

25

ADJUSTING ENTRY

25

Correct Balance

Interest Expense

(income statement account)
Debit
Increases an expense

Credit
Decreases an expense
Preliminary Balance 0


ADJUSTING ENTRY 25


Correct Balance 25



The adjusting journal entry for Interest Payable is:

Date Account Name Debit Credit

Dec. 31, 2010 Interest Expense 25


Interest Payable

25

It is unusual that the amount shown for each of these accounts is the same. In the future months the
amounts will be different. Interest Expense will be closed automatically at the end of each accounting
year and will start the next accounting year with a $0 balance.






Accounts Payable $2,500
Accounts Payable is a liability account that reports the amounts owed to suppliers or
(It is common not to list accounts with $0 balances on balance sheets.)
vendors as of the
balance sheet date. Amounts are routinely entered into this account after a company has received and
verified all of the following: (1) an invoice from the supplier, (2) goods or services have been received,
and (3) compared the amounts to the company's purchase order. A review of the details confirms that
this account's balance of $2,500 is accurate as far as invoices received from vendors.

However, under the accrual basis of accounting the balance sheet must report all the amounts owed by
the companynot just the amounts that have been entered into the accounting system from vendor
invoices. Similarly, the income statement must report all expenses that have been incurrednot merely
the expenses that have been entered from a vendor's invoice. To illustrate this, assume that a company
had $1,000 of plumbing repairs done in late December, but the company has not yet received an invoice
from the plumber. The company will have to make an adjusting entry to record the expense and the
liability on the December financial statements. The adjusting entry will involve the following accounts:

Accounts Payable

(balance sheet account)
Debit
Decreases a liability

Credit
Increases a liability

2,500

Preliminary Balance

1,000

ADJUSTING ENTRY

3,500

Correct Balance

Repairs & Maintenance Expense

(income statement acct)
Debit
Increases an expense

Credit
Decreases an expense
Preliminary Balance 7,870


ADJUSTING ENTRY 1,000


Correct Balance 8,870



The adjusting entry for Accounts Payable in general journal format is:

Date Account Name Debit Credit

Dec. 31, 2010 Repairs & Maintenance Expense 1,000


Accounts Payable

1,000

The balance in the liability account Accounts Payable at the end of the year will carry forward to the next
accounting year. The balance in Repairs & Maintenance Expense at the end of the accounting year will
be closed and the next accounting year will begin with $0.



Wages Payable

$1,200
Wages Payable is a liability account that reports the amounts owed to employees as of the balance sheet
date. Amounts are routinely entered into this account when the company's payroll records are processed.
A review of the details confirms that this account's balance of $1,200 is accurate as far as the payrolls
that have been processed.

However, under the accrual basis of accounting the balance sheet must report all of the payroll amounts
owed by the companynot just the amounts that have been processed. Similarly, the income statement
must report all of the payroll expenses that have been incurrednot merely the expenses from the
routine payroll processing. For example, assume that December 30 is a Sunday and the first day of the
payroll period. The wages earned by the employees on December 30-31 will be included in the payroll
processing for the week of December 30 through January 5. However, the December income statement
and the December 31 balance sheet need to include the wages for December 30-31, but not the wages
for January 1-5. If the wages for December 30-31 amount to $300, the following adjusting entry is
required as of December 31:

Wages Payable

(balance sheet account)
Debit
Decreases a liability

Credit
Increases a liability

1,200

Preliminary Balance

300

ADJUSTING ENTRY

1,500

Correct Balance

Wages Expense

(income statement account)
Debit
Increases an expense

Credit
Decreases an expense
Preliminary Balance 13,120


ADJUSTING ENTRY 300


Correct Balance 13,420



The adjusting journal entry for Wages Payable is:

Date Account Name Debit Credit

Dec. 31, 2010 Wages Expense 300


Wages Payable

300

The $1,500 balance in Wages Payable is the true amount not yet paid to employees for their work
through December 31. The $13,420 of Wages Expense is the total of the wages used by the company
through December 31. The Wages Payable amount will be carried forward to the next accounting year.
The Wages Expense amount will be zeroed out so that the next accounting year begins with a $0
balance.



Unearned Revenues

$1,300
Unearned Revenues is a liability account that reports the amounts received by a company but have not
yet been earned by the company. For example, if a company required a customer with a poor credit rating
to pay $1,300 before beginning any work, the company increases its asset Cash by $1,300 and it should
increase its liability Unearned Revenues by $1,300.

As the company does the work, it will reduce the Unearned Revenues account balance and increase its
Service Revenues account balance by the amount earned (work performed). A review of the balance in
Unearned Revenues reveals that the company did indeed receive $1,300 from a customer earlier in
December. However, during the month the company provided the customer with $800 of services.
Therefore, at December 31 the amount of services due to the customer is $500.

Let's visualize this situation with the following T-accounts:

Unearned Revenues

(balance sheet account)
Debit
Decreases a liability

Credit
Increases a liability

1,300

Preliminary Balance
ADJUSTING ENTRY 800



500

Correct Balance

Service Revenues

(income statement account)
Debit
Decreases revenues

Credit
Increases revenues

63,234

Preliminary Balance

800

ADJUSTING ENTRY

64,034

Correct Balance

The adjusting entry for Unearned Revenues in general journal format is:

Date Account Name Debit Credit

Dec. 31, 2010 Unearned Revenues 800


Service Revenues

800

Since Unearned Revenues is a balance sheet account, its balance at the end of the accounting year will
carry over to the next accounting year. On the other hand Service Revenues is an income statement
account and its balance will be closed when the current year is over. Revenues and expenses always
start the next accounting year with $0.

Accruals & Deferrals

Adjusting entries are often sorted into two groups:

accruals and deferrals.

Accruals
Accruals (or accrual-type adjusting entries) involve both expenses and revenues and are associated with
the first scenario mentioned in the introduction to this topic:
Nothing has been entered in the accounting records for certain expenses and/or revenues, but
those expenses and/or revenues did occur and must be included in the current period's income
statement and balance sheet.

Accrual of Expenses
An accountant might say, "We need to accrue the interest expense on the bank loan." That statement is
made because nothing had been recorded in the accounts for interest expense, but the company did
indeed incur interest expense during the accounting period. Further, the company has a liability or
obligation for the unpaid interest up to the end of the accounting period. What the accountant is saying is
that an accrual-type adjusting journal entry needs to be recorded.

The accountant might also say, "We need to accrue for the wages earned by the employees on Sunday,
December 30, and Monday, December 31." This means that an accrual-type adjusting entry is needed
because the company incurred wages expenses on December 30-31 but nothing will be entered routinely
into the accounting records by the end of the accounting period on December 31.

A third example is the accrual of utilities expense. Utilities provide the service (gas, electric, telephone)
and then bill for the service they provided based on some type of metering. As a result the company will
incur the utility expense before it receives a bill and before the accounting period ends. Hence, an
accrual-type adjusting journal entry must be made in order to properly report the correct amount of utilities
expenses on the current period's income statement and the correct amount of liabilities on the balance
sheet.

Accrual of Revenues
Accountants also use the term "accrual" or state that they must "accrue" when discussing revenues that
fit the first scenario. For example, an accountant might say, "We need to accrue for the interest the
company has earned on its certificate of deposit." In that situation the company probably did not receive
any interest nor did the company record any amounts in its accounts, but the company did indeed earn
interest revenue during the accounting period. Further the company has the right to the interest earned
and will need to list that as an asset on its balance sheet.

Similarly, the accountant might say, "We need to prepare an accrual-type adjusting entry for the revenues
we earned by providing services on December 31, even though they will not be billed until January."

Deferrals
Deferrals or deferral-type adjusting entries can pertain to both expenses and revenues and refer to the
second scenario mentioned in the introduction to this topic:
Something has already been entered in the accounting records, but the amount needs to be
divided up between two or more accounting periods.

Deferral of Expenses
An accountant might say, "We need to defer some of the insurance expense." That statement is made
because the company may have paid on December 1 the entire bill for the insurance coverage for the six-
month period of December 1 through May 31. However, as of December 31 only one month of the
insurance is used up. Hence the cost of the remaining five months is deferred to the balance sheet
account Prepaid Insurance until it is moved to Insurance Expense during the months of January
through May. If the company prepares monthly financial statements, a deferral-type adjusting entry may
be needed each month in order to move one-sixth of the six-month cost from the asset account Prepaid
Insurance to the income statement account Insurance Expense.

The accountant might also say, "We need to defer some of the cost of supplies." This deferral is
necessary because some of the supplies purchased were not used or consumed during the accounting
period. An adjusting entry will be necessary to defer to the balance sheet the cost of the supplies not
used, and to have only the cost of supplies actually used being reported on the income statement. The
costs of the supplies not yet used are reported in the balance sheet account Supplies and the cost of the
supplies used during the accounting period are reported in the income statement account Supplies
Expense.

Deferral of Revenues
Deferrals also involve revenues. For example if a company receives $600 on December 1 in exchange for
providing a monthly service from December 1 through May 31, the accountant should "defer" $500 of the
amount to a liability account Unearned Revenues and allow $100 to be recorded as December service
revenues. The $500 in Unearned Revenues will be deferred until January through May when it will be
moved with a deferral-type adjusting entry from Unearned Revenues to Service Revenues
Avoiding Adjusting Entries
at a rate of
$100 per month.

If you want to minimize the number of adjusting journal entries, you could arrange for each period's
expenses to be paid in the period in which they occur. For example, you could ask your bank to charge
your company's checking account at the end of each month with the current month's interest on your
company's loan from the bank. Under this arrangement December's interest expense will be paid in
December, January's interest expense will be paid in January, etc. You simply record the interest
payment and avoid the need for an adjusting entry. Similarly, your insurance company might
automatically charge your company's checking account each month for the insurance expense that
applies to just that one month.


Income Statement

Introduction to Income Statement
We also have Quizzes, Crosswords, and Q&A for the topic
The
Income Statement.

income statement is one of the major financial statements used by accountants and business
owners. (The other major financial statements are the balance sheet, statement of cash flows, and
the statement of stockholders' equity.) The income statement is sometimes referred to as the profit
and loss statement (P&L), statement of operations, or statement of income. We will use income statement
and profit and loss statement throughout this explanation.

The income statement is important because it shows the profitability
People pay attention to the profitability of a company for many reasons. For example, if a company was
not able to operate profitablythe bottom line of the income statement indicates a
of a company during the time interval
specified in its heading. The period of time that the statement covers is chosen by the business and will
vary. For example, the heading may state:

"For the Three Months Ended December 31, 2010" (The period of October 1 through December 31,
2010.)

"The Four Weeks Ended December 27, 2010" (The period of November 29 through December 27,
2010.)

"The Fiscal Year Ended September 30, 2010" (The period of October 1, 2009 through September 30,
2010.)

Keep in mind that the income statement shows revenues, expenses, gains, and losses; it does not show
cash receipts (money you receive) nor cash disbursements (money you pay out).

net lossa
banker/lender/creditor may be hesitant to extend additional credit to the company. On the other hand, a
company that has operated profitablythe bottom line of the income statement indicates a net income
demonstrated its ability to use borrowed and invested funds in a successful manner. A company's ability
to operate profitably is important to current lenders and investors, potential lenders and investors,
company management, competitors, government agencies, labor unions, and others.

The format of the income statement or the profit and loss statement will vary according to the complexity
of the business activities. However, most companies will have the following elements in their income
statements:

A. Revenues and Gains
1. Revenues from primary activities
2. Revenues or income from secondary activities
3. Gains (e.g., gain on the sale of long-term assets, gain on lawsuits)

B. Expenses and Losses
1. Expenses involved in primary activities
2. Expenses from secondary activities
3. Losses (e.g., loss on the sale of long-term assets, loss on lawsuits)

If the net amount of revenues and gains minus expenses and losses is positive, the bottom line of the
profit and loss statement is labeled as net income. If the net amount (or bottom line) is negative, there is
a
A. Revenues and Gains
net loss.

1. Revenues from primary activities are often referred to as operating revenues. The primary activities
of a retailer are purchasing merchandise and selling the merchandise. The primary activities of a
manufacturer are producing the products and selling them. For retailers, manufacturers, wholesalers, and
distributers the revenues generating from their primary activities are referred to as sales revenues or
sales. The primary activities of a company that provides services involve acquiring expertise and selling
that expertise to clients. For companies providing services, the revenues from their primary services are
referred to as service revenues or fees earned. (Some people use the word income
It's critical that you don't confuse revenues with
interchangeably with
revenues.)

receipts. Under the accrual basis of accounting,
service revenues and sales revenues are shown at the top of the income statement in the period they are
earned or delivered, not in the period when the cash is collected. Put simply, revenues occur when
money is earned,receipts occur when cash is
For example, if a retailer gives customers 30 days to pay, revenues occur (and are reported) when the
merchandise is
received.

sold to the buyer, not when the cash is received 30 days later. If merchandise is sold in
December, the sale is reported on the December income statement. When the retailer receives the check
in January for the December sale, the retailer has a January receiptnot January revenues.

Similarly, if a consulting company asks clients to pay within 30 days of receiving their service, revenues
occur (and are reported) when the service is performed (earned), not 30 days later when the consulting
company receives the cash from the client.

If an attorney requires a client to prepay $1,000 before beginning to research the client's case, the
attorney has a receipt, but does not have revenues until some of the research is done.

If a company sells an item to a buyer who immediately pays for it with cash, the company has both a
receipt and
A company borrows $10,000 from its bank by signing a
revenues for that dayit has a cash receipt because it received cash; it has sales revenues
because it sold merchandise.

By knowing the difference between receipts and revenues, we make certain that revenues from a
transaction are reported only oncewhen the primary activities have been completed (and not
necessarily when the cash is collected).

Let's reinforce the distinction between revenues and receipts with a few more examples. (Keep in mind
that all of the examples below assume the accrual basis of accounting.)
promissory note due in 90 days. The
company will have a receipt
If a company provided a $1,000 service on January 31 and gave the customer until March 10 to
pay for the service, the company's January income statement will show revenues of $1,000.
When the money is actually received in March, the March income statement will not show
revenues for this transaction. (In March the company will report a receipt of cash and a
reduction/collection of an accounts receivable.)
of $10,000 at the time of the loan, but it does not have revenues
because it did not earn the money from performing a service or from a sale of merchandise.
A company performs a $400 service on December 31 and receives the $400 on the very same
day (December 31). This company will report $400 in revenues on December 31not because
the company had a cash receipt on December 31, but because the service was performed
(earned) on that day.
On December 10, a new client asks your consulting company to provide a $2,500 service in
January. You are uncertain as to whether or not this client is credit worthy, so to be on the safe
side you ask for an immediate partial payment of $1,000 before you agree to schedule the work
for January. Although your consulting company has a receipt of $1,000 in December, it does not
have revenues in December. (In December your company will record a liability of $1,000.) Your
consulting company will report the $1,000 of revenues when it performs $1,000 of services in
January.

2. Revenues from secondary activities are often referred to as nonoperating revenues. These are the
amounts a business earns outside of purchasing and selling goods and services. For example, when a
retail business earns interest on some of its idle cash, or earns rent from some vacant space, these
revenues result from an activity outside of buying and selling merchandise. As a result the revenues are
reported on the income statement separate from its primary activity of sales or service revenues.

As is true with operating revenues, nonoperating revenues are reported on the profit and loss statement
during the period when they are earned, not when the cash is collected.


Don't confuse revenues with receipts

Revenues (operating and nonoperating) occur when a sale is made or when they are earned. Revenues
are frequently earned and reported on the income statement prior to receiving the cash.

Receipts occur when cash is received/collected.

3. Gains such as the gain on the sale of long-term assets, or lawsuits result from a transaction that is
outside of the primary activities of most businesses. A gain is reported on the income statement as the
net of two amounts: the proceeds received from the sale of a long-term asset minus the amount listed for
that item on the company's books (book value). A gain occurs when the proceeds are more than the book
value.

Consider this example: Assume that a clothing retailer decides to dispose of the company's car and sells
it for $6,000. The $6,000 received for the car (the proceeds from the disposal of the car) will not be
included with sales revenues since the account Sales is used only for the sale of merchandise. Since this
retailer is not in the business of buying and selling cars, the sale of the car is outside of the retailer's
primary activities. Over the years, the cost of the car was being depreciated on the company's accounting
records and as a result, the money received for the car ($6,000) was greater than the net amount shown
for the car on the accounting records ($3,500). This means that the company must report a gain
B. Expenses and Losses
equal to
the amount of the differencein this case, the gain is reported as $2,500. This gain should not be
reported as sales revenues, nor should it be shown as part of the merchandiser's primary activities.
Instead, the gain will appear in a section on the income statement labeled as "nonoperating gains" or
"other income". The gain is reported in the period when the disposal occurred.

1. Expenses involved in primary activities
The above examples reflect the
are expenses that are incurred in order to earn normal
operating revenues. Under the accrual basis of accounting sales commissions expense should appear on
the income statement in the same period that the related sales are reported, regardless of when the
commission is actually paid. In the same way, the cost of goods sold is matched with the related sales on
the income statement, regardless of when the supplier of the merchandise is paid.

Costs used up (or expiring) in the accounting period shown in the heading of the income statement are
also considered to be expenses of that period. For example, the utilities used in a retail store in
December should appear on the December income statement, even if the utility's meters are not read
until January 1 and the bill is paid on February 1.

matching principle and show that under the accrual basis of accounting,
expenses on the income statement are likely to be reported at different times than the cash
expenditures/disbursements.

It is common for expenses to occur before the company pays for them (e.g., wages earned by
employees, employee bonuses and vacations, utilities, and sales commissions). However, some
expenses occur

afterthe company has paid for them. For example, let's say a company buys a building on
December 31, 2010 for $300,000 (excluding the cost of land). The building is assumed to have a useful
life of 30 years. The company paid cash for the building on December 31, 2010 but it will record
depreciation expense of $10,000 in each of the years 2011 through 2040.
Cash payments do not always mean that an expense has occurred. For example, a company might pay
$20,000 to the bank to reduce its bank loan. This payment will reduce the company's cash and its liability
to the bank, but it is not an expense.

Some expenses are matched against sales on the income statement because there is a cause and effect
linkagethe sale of the merchandise caused the cost of goods sold and the sales commission expense.
Other expenses are not directly linked to sales and as a result they are matched to the accounting period
when they are consumed or usedexamples include utilities expense, office salaries expense, and
depreciation expense. Some expenses such as advertising expense and research and development
expense can neither be linked with sales nor a specific accounting period and as a result, they are
reported as expenses as soon as they occur.


Under the accrual basis of accounting, the cost of goods sold and expenses are matched to sales and/or
the accounting period when they are used, not the period in which they are paid.

The income statements or profit and loss statements of merchandisers and manufacturers will use a
separate line for the cost of goods sold. The other expenses involved in their primary activities will either
be grouped together as operating expenses or subdivided into the categories "selling" and
"administrative."





2. Expenses from secondary activities are referred to as nonoperating expenses. For example,
interest expense is a nonoperating expense because it involves the finance function of the business,
rather than the primary activities of buying/producing and selling.

3. Losses
Let's assume that a clothing retailer decides to dispose of the company's car. The proceeds from the
disposal are $2,800. This is
such as the loss from the sale of long-term assets, or the loss on lawsuits result from a
transaction that is outside of a business's primary activities. A loss is reported as the net of two amounts:
the amount listed for the item on the company's books (book value) minus the proceeds received from the
sale. A loss occurs when the proceeds are less than the book value.

less than the $3,500 amount shown in the company's accounting records.
Since this retailer is not in the business of buying and selling cars (the sale of the car is outside of the
operating activities of buying and selling clothing), the money received for the car will not be included in
sales revenues, and the loss experienced on the sale of the car ($700) will not be included in operating
expenses. Instead, the $700 loss will appear in a section on the income statement labeled "nonoperating
gains or losses" or "other income or losses". The loss is reported in the time period when the disposal
occurs.


The income statement or profit and loss statement shows revenues, expenses, gains, and losses.
The income statement does not
Additional Considerations
show cash receipts and cash disbursements.

Then vs. Now. The income statement covers a past period of time, and the past may or may not be
indicative of the future. For example, a company supplying a high-demand fad item for the recent holiday
season may have had a great year financially, but if it does not produce a similarly successful item for
thenext
Expenses Do Not Equal Economic Reality. Because of the
holiday season, it may experience a poor year financially.

cost principle and inflation, the expenses
shown on the income statement reflect old costs. For example, assume that a company is operating a
forty-year-old manufacturing plant that had a cost of $400,000. The depreciation expense for this plant
may be zero on the current income statement because the plant was depreciated over 30 years. The cost
of a new plant might be $4,000,000 today and the depreciation expense on the new plant might be
$130,000 per year. The cost principle, however, prohibits showing the depreciation based on the cost of a
new plant.

Using Estimates. An accountant is not allowed the luxury of waiting until things are known with certainty.
In order to recognize revenues when they are earned, recognize expenses when they are incurred, or
match expenses with revenues, accountants must often use
Single-Step Income Statement
estimates.



A single-step income statement is one of two commonly used formats for the income statement or profit
and loss statement. The single-step format uses only one subtraction to arrive at net income.

Net Income = (Revenues + Gains) (Expenses + Losses)

An extremely condensed income statement in the single-step format would look like this:

Sample Products Co.
Income Statement
For the Five Months Ended May 31, 2010

Revenues & Gains $108,000
Expenses & Losses 90,000

Net Income $ 18,000


The heading of the income statement conveys critical information. The name of the company appears
first, followed by the title "Income Statement." The third line tells the reader the time interval reported on
the profit and loss statement. Since income statements can be prepared for any period of time,
you must inform the reader of the precise period of time being covered. (For example, an income
statement may cover any one of the following time periods: "Year Ended May 31," "Five Months Ended
May 31," "Quarter Ended May 31," "Month Ended May 31, or "Five Weeks Ended May 31".)

A sample income statement in the single-step format would look like this:

Sample Products Co.
Income Statement
For the Five Months Ended May 31, 2010

Revenues & Gains


Sales Revenues $100,000

Interest Revenues 5,000

Gain on Sale of Assets 3,000

Total Revenue & Gains 108,000

Expenses & Losses


Cost of Goods Sold 75,000

Commissions Expense 5,000

Office Supplies Expense 3,500

Office Equipment Expense 2,500

Advertising Expense 2,000

Interest Expense 500

Loss from Lawsuit 1,500

Total Expenses & Losses 90,000

Net Income $ 18,000


Multiple-Step Income Statement


An alternative to the single-step income statement is the multiple-step income statement, because it
uses multiple subtractions in computing the net income shown on the bottom line.

The multiple-step profit and loss statement segregates the operating revenues and operating expenses
from the nonoperating revenues, nonoperating expenses, gains, and losses. The multiple-step income
statement also shows the gross profit (net sales minus the cost of goods sold).

Here is a sample income statement in the multiple-step format:


Sample Products Co.
Income Statement
For the Five Months Ended May 31, 2010

Sales

$100,000
Cost of Goods Sold

75,000

Gross Profit

25,000

Operating Expenses


Selling Expenses


Advertising Expense 2,000


Commissions Expense 5,000 7,000

Administrative Expenses


Office Supplies Expense 3,500


Office Equipment Expense 2,500 6,000

Total Operating Expenses

13,000

Operating Income

12,000

Non-Operating or Other


Interest Revenues 5,000

Gain on Sale of Investments 3,000

Interest Expense (500)

Loss from Lawsuit (1,500)

Total Non-Operating

6,000

Net Income $ 18,000


Using the above multiple-step income statement as an example, we see that there are three steps
needed to arrive at the bottom line Net Income:

Step 1. Cost of goods sold is subtracted from net sales to arrive at the gross profit.
Gross Profit = Net Sales Cost of Goods Sold
Gross Profit = $100,000 $75,000
Gross Profit = $25,000



Step 2. Operating expenses are subtracted from gross profit to arrive at operating income.
Operating Income = Gross Profit Operating Expenses
Operating Income = $25,000 $13,000
Operating Income = $12,000



Step 3. The net amount of nonoperating revenues, gains, nonoperating expenses and losses is
combined with the operating income to arrive at the net income or net loss.
Net Income = Operating Income + Non-Operating Items
Net Income = $12,000 + $6,000
Net Income = $18,000



There are three benefits to using a multiple-step income statement instead of a single-step income
statement:
1. The multiple-step income statement clearly states the gross profit amount. Many readers of
financial statements monitor a company's gross margin
2. The multiple-step income statement presents the subtotal
(gross profit as a percentage of net
sales). Readers may compare a company's gross margin to its past gross margins and to the
gross margins of the industry.
operating income, which indicates the
profit earned from the company's primary activities of buying and selling merchandise.
3. The bottom line of a multiple-step income statement reports the net amount for all the items on
the income statement. If the net amount is positive, it is labeled as net income. If the net amount
is negative, it is labeled as net loss.

Reporting Unusual Items
Income statements (whether single-step or multiple-step) report nearly all revenues, expenses, gains, and
losses.

Sometimes rare or extraordinary events will occur during the income statement's time interval along with
the normally recurring events. It's helpful to the reader of the statement if these unique items are
segregated into a special section near the bottom of either the single-step or multiple-step income
statement. These unique or rare items are:

1. Discontinued Operations


2. Extraordinary Items

When recording these items near the bottom of an income statement, it's required that you present them
in the same order as they appear above. However, it is rare for a company to have either one of these
items, and it is highly unlikely that a company will have both.
1. Discontinued operations pertains to the elimination of a significant part of a company's business,
such as the sale of an entire division of the company. (Eliminating a small portion of product line does not
qualify as a discontinued operation.)

2. Extraordinary items includes things that are unusual in nature and infrequent in occurrence. A loss
due to an earthquake in Wisconsin would certainly be extraordinary. A loss due to a foreign country taking
over a U.S. oil refinery in that country would be an extraordinary item.

If an item is unique and significant but it does not meet the criteria for being both "unusual and
infrequent," the item must remain in the main section of the income statement; it can however be shown
as a separate line item. For example, if a company suffers a $40,000 loss due to a strike by its workers,
the $40,000 cannot be shown as an extraordinary item since it is not unusual in nature for a strike to
occur. The $40,000 may be shown as a separate line item, but it must be positioned in the main portion of
the income statement.

Two additional examples of situations that do not qualify as extraordinary items are (1) the loss from frost
damage to a Florida citrus crop and (2) the write-down of inventory from cost to a lower amount.
Apparently the frost in Florida is not unusual in nature and not infrequent. Similarly, it's not unusual for
items in inventory to have a current value lower than its cost. Although these things maybe significant,
unusual, and important, they do not belong in the section containing extraordinary items.




Below is an example of a single-step income statement containing an extraordinary item. (If this were a
corporation, income tax expenses would be part of the income statement and an extraordinary gain would
be reduced by the income tax expense associated with the gain; an extraordinary loss would be reduced
by the income tax savings associated with the loss.) See net of tax.

Sample Products Co.
Income Statement
For the Five Months Ended May 31, 2010

Revenues & Gains


Sales $100,000

Interest Revenues 5,000

Gain on Sale of Assets 3,000

Total Revenue & Gains 108,000

Expenses & Losses


Cost of Goods Sold 75,000

Commissions Expense 5,000

Office Supplies Expense 3,500

Office Equipment Expense 2,500

Advertising Expense 2,000

Interest Expense 500

Loss from Lawsuit 1,500

Total Expenses & Gains 90,000

Income Before Extraordinary 18,000

Extraordinary Item - Gain 7,000

Net Income $ 25,000


Note that even in a single-step format shown above, the extraordinary item is separated out and added to
the end of the income statement. The same would be true for discontinued operations.

Below is a multiple-step income statement containing discontinued operations and an extraordinary item.
(If this were a corporation, income tax expenses would be part of the income statement; the two unique
items would be reduced by the income tax effect associated with each item.)


Sample Products Co.
Income Statement
For the Five Months Ended May 31, 2010

Sales

$100,000
Cost of Goods Sold

75,000

Gross Profit

25,000

Operating Expenses


Selling Expenses


Advertising Expense 2,000


Commissions Expense 5,000 7,000

Administrative Expenses


Office Supplies Expense 3,500


Office Equipment Expense 2,500 6,000

Total Operating Expenses

13,000

Operating Income

12,000

Non-Operating or Other


Interest Revenues 5,000

Gain on Sale of Investments 3,000

Interest Expense (500)

Loss from Lawsuit (1,500)

Total Non-Operating

6,000

Income before Disc Op and
Extraordinary Item

18,000

Discontinued Operations

(4,000)
Extraordinary Item

7,000

Net Income $ 21,000


Note that the two unique items are shown near the bottom of the income statement. This is where the
items should appear on both single-step and multiple-step statements.

Earnings Per Share of Common Stock
If the business is a corporation with common stock that is publicly traded, it is required that the net
income, discontinued operations, and extraordinary items be shown on the income statement on an after-
tax, per-share basis.

Notes To Financial Statements
The notes (or footnotes) to the income statement and to the other financial statements are considered to
be part of the financial statements. The notes inform the readers about such things as significant
accounting policies, commitments made by the company, and potential liabilities and potential losses.
The notes contain information that is critical to properly understanding and analyzing a company's
financial statements.

It is common for the notes to the financial statements of large companies to be 10-20 pages in length. Go
to the website for a company whose stock is publicly traded and locate its annual report. Look at the
notes near the end of the annual report.




Other Income Statement Formats
The single-step and multiple-step income statement formats are the required formats when the statement
is distributed to people and places outside of the company. The company's management, however, might
prefer other formats when the profit and loss statement remains inside
For example, a company might want to prepare an income statementfor inside the company onlythat
focuses on the
the company.

contribution margin instead of the gross profit or gross margin. Such a format may
provide insight on how the company's profits change as sales change. This format also shows the total
amount offixed expenses (those expenses that will not change as sales change). This type of internal
income statement is shown below (and columns have been added to show the amounts by product line).

Example Products Co.
Income Statement in Contribution Margin Format
For the Five Months Ended May 31, 2010



Total
Product
Line 1
Product
Line 2

Sales $100,000 $70,000 $30,000
Variable Expenses


Cost of Goods Sold 75,000 50,000 25,000

Commissions Expense 5,000 5,000 0

Total Variable Expenses 80,000 55,000 25,000

Contribution Margin 20,000 15,000 5,000

Fixed Expenses - Prod. Line 6,000 4,000 2,000

Subtotal 14,000 11,000 3,000

Fixed Expenses - Common 2,000

Operating Income $12,000



As you can see above, $2,000 of fixed expenses are common to both product lines. In other words they
cannot be traced directly to Product Line 1 or Product Line 2. Rather than mislead someone, the
expenses are not arbitrarily divided up between the product lines.

Remember that this format is not acceptable for distribution outside of the companyits accessibility
should be limited to the members of the company's management. In fact, this type of income statement is
usually covered as part of managerial accounting, not financial accounting. It is shown here to let you
know that income statement formats other than the single-step and multiple-step are permissible when
they stay within a company, and may prove very useful to a company's managers.


Cash Flow Statement

Introduction to Cash Flow Statement
We also have Quizzes, Crosswords, and Q&A for the topic Cash Flow Statement.

The official name for the cash flow statement is the statement of cash flows. We will use both names
throughout AccountingCoach.com.

The statement of cash flows is one of the main financial statements. (The other financial statements are
the balance sheet, income statement, and statement of stockholders' equity.)

The cash flow statement reports the cash
1.
generated and used during the time interval specified in its
heading. The period of time that the statement covers is chosen by the company. For example, the
heading may state "For the Three Months Ended December 31, 2010" or "The Fiscal Year Ended
September 30, 2010".

The cash flow statement organizes and reports the cash generated and used in the following categories:

Operating activities converts the items reported on the income statement from the
accrual basis of accounting to cash.
2. Investing activities reports the purchase and sale of long-term investments and
property, plant and equipment.
3. Financing activities reports the issuance and repurchase of the company's own bonds
and stock and the payment of dividends.
4. Supplemental
information
reports the exchange of significant items that did not involve cash
and reports the amount of income taxes paid and interest paid.


What Can The Statement of Cash Flows Tell Us?
Because the income statement is prepared under the accrual basis of accounting, the revenues reported
may not have been collected. Similarly, the expenses reported on the income statement might not have
been paid. You could review the balance sheet changes to determine the facts, but the cash flow
statement already has integrated all that information. As a result, savvy business people and investors
utilize this important financial statement.

Here are a few ways the statement of cash flows is used.
1. The cash from operating activities is compared to the company's net income. If the cash from
operating activities is consistently greater than the net income, the company's net income or
earnings are said to be of a "high quality". If the cash from operating activities is less than net
income, a red flag is raised as to why the reported net income is not turning into cash.
2. Some investors believe that "cash is king". The cash flow statement identifies the cash that is
flowing in and out of the company. If a company is consistently generating more cash than it is
using, the company will be able to increase its dividend, buy back some of its stock, reduce debt,
or acquire another company. All of these are perceived to be good for stockholder value.
3. Some financial models are based upon cash flow.

Understanding The Changes In Cash
We often enhance our comprehension of a topic when we have to think through solutions to problems, so
to help you really understand the cash flow statement, we've put together some questions for you to
answer. As you formulate your response you will be learning to think about cash flows the way an
accountant does.

1.
When Mary Smith invests her personal money into her new company, what will
happen to her company's Cash account?
Answer
2.
When a company purchases inventory (merchandise purchased in order to be
resold) what will happen to its Cash account?
Answer
3.
What happens to the company's Cash account if it borrows money from the bank
by signing a note payable?
Answer
4.
What happens to a company's Cash account if it declares a dividend on its shares
of stock?
Answer
5.
What is the effect on its Cash account when a company pays some of
itsAccounts Payable?
Answer
6.
What is the effect on its Cash account when a company prepays a 6-month
insurance premium?
Answer
7.
What is the effect on its Cash account when a company sells merchandise, but
allows the customer to pay in 30 days?
Answer
8.
What is the effect on its Cash account when a company receives payment from
one of its customers 30 days after the sale was recorded?
Answer
9.
If a company's Accounts Payable account decreased, what is the likely effect this
will have on Cash?
Answer
10.
If the asset account Prepaid Insurance increased, what is the likely effect on
Cash?
Answer
11.
If the asset account Land increased, what's the likely effect on Cash?
Answer
12.
If the asset account Land decreased, what's the likely effect on Cash?
Answer
13.
If the liability account Bonds Payable increases, what is the likely effect on
Cash?
Answer
14.
If the liability account Bonds Payable decreases, what is the likely effect on
Cash?
Answer

Much of what you learned in the practice questions above is common sense. For example, when you use
cash to buy a book, you now own the book (you've increased your "assets") but you also have less
money (you've decreased your cash). Based on what you learned, you can make the following general
assumptions:
When an asset (other than cash) increases, the Cash account
When an asset (other than cash) decreases, the Cash account
decreases.

When a liability increases, the Cash account
increases.

When a liability decreases, the Cash account
increases.

When owner's equity increases, the Cash account
decreases.

When owner's equity decreases, the Cash account
increases.
decreases.

For a change in assets (other than cash)the change in the Cash account is in the opposite direction.

For a change in liabilities and owner's equitythe change in the Cash account is in the same direction.





Format of the Statement of Cash Flows
The statement of cash flows has four distinct sections:
1. Cash involving operating activities
2. Cash involving investing activities
3. Cash involving financing activities
4. Supplemental information.

Assuming that the cash flow statement is being prepared using the indirect method (the method used by
most companies) the differences in a company's balance sheet accounts will provide much of the needed
information. For example, if the statement of cash flows is for the year 2010, the balance sheet accounts
at December 31, 2010 will be compared to the balance sheet accounts at December 31, 2009. The
changesor differencesin these account balances will likely be entered in one of the sections of the
statement of cash flows.

Shown below is each of the four sections of the statement of cash flows, followed by a list of those
balance sheet accounts which affect it.

1. Cash Provided From or Used By Operating Activities
This section of the cash flow statement reports the company's net income and then converts it from the
accrual basis to the cash basis by using the changes in the balances of current asset and current
liabilityaccounts, such as:
Accounts Receivable
Inventory
Supplies
Prepaid Insurance
Other Current Assets
Notes Payable (generally due within one year)
Accounts Payable
Wages Payable
Payroll Taxes Payable
Interest Payable
Income Taxes Payable
Unearned Revenues
Other Current Liabilities

In addition to using the changes in current assets and current liabilities, the operating activities section
has adjustments for depreciation expense and for the gains and losses on the sale of long-term assets.

2. Cash Provided From or Used By Investing Activities
This section of the cash flow statement reports changes in the balances of long-term asset accounts,
such as:
Long-term Investments
Land
Buildings
Equipment
Furniture & Fixtures
Vehicles

In short, investing activities involve the purchase and/or sale of long-term investments and property, plant,
and equipment.

3. Cash Provided From or Used By Financing Activities
This section of the cash flow statement reports changes in balances of the long-term
liability andstockholders' equity accounts, such as:
Notes Payable (generally due after one year)
Bonds Payable
Deferred Income Taxes
Preferred Stock
Paid-in Capital in Excess of Par-Preferred Stock
Common Stock
Paid-in Capital in Excess of Par-Common Stock
Paid-in Capital from Treasury Stock
Retained Earnings
Treasury Stock

In short, financing activities involve the issuance and/or the repurchase of a company's own bonds or
stock. Dividend payments are also reported in this section.

4. Supplemental Information
This section of the cash flow statement discloses the amount of interest and income taxes paid. Also
reported are significant exchanges not involving cash. For example, the exchange of company stock for
company bonds would be reported in this section.

Where To Enter The Balance Sheet Changes
Take a look at the summary belowit shows where the changes in balance sheet accounts should be
entered on your statement of cash flows:


A change in this
balance sheet category

...is reported in this section
of the cash flow statement
Current Assets*

Operating Activities
Current Liabilities

Operating Activities
Long-term Assets

Investing Activities
Long-term Liabilities

Financing Activities
Stockholders' Equity

Financing Activities

*This refers to current assets other than Cash.


Adjustments Within The Operating Activities Section
When we use the indirect method to prepare a statement of cash flows we begin with the net income
figure from the company's income statement as our starting point. We then make adjustments to that
figure to arrive at the cash amount.

If all of a company's revenues were cash sales (no credit sales), and if the company paid out cash for all
of its expenses, then net income would equal the cash from operating activities. However, since some of
the revenues and expenses on the income statement were not cash transactions, we must include
depreciation, gain or losses on sales of assets, and the changes in current assets and current liabilities.
These adjustments will be illustrated in the hypothetical story presented in Part 3.

Story To Illustrate
Matt is a college student who enjoys buying and selling merchandise using the Internet. On January 2,
2010, he decides to turn his hobby into a business called "Good Deal Co." Each month the Good Deal
Co. will have one or two transactions. At the end of each month we will prepare an income statement,
balance sheet, and a statement of cash flows for the current month and for the year-to-date period. The
purpose is to show how these transactions are reported on the cash flow statement.

January Transactions and Financial Statements
On January 2, 2010 Matt invests $2,000 of his personal money into his sole proprietorship, Good Deal
Co. On January 20, Good Deal buys 14 graphing calculators for $50 per calculatorthis is about 50%
less than the selling price Matt has observed at the retail stores. The total cost to Good Deal for all 14
calculators is $700. Good Deal has no other transactions during January.

Matt prepares financial statements for his new business as of January 31, 2010:

Good Deal Co.
Income Statement
For the Month Ended January 31, 2010
Revenues $ 0
Expenses 0

Net Income

$ 0



Good Deal Co.
Balance Sheet
January 31, 2010
Assets

Liabilities & Owner's Equity

Cash $1,300

Liabilities $ 0

Inventory 700

Owner's Equity


Matt Jones, Capital 2,000


Total Assets $2,000

Total Liab. & Owner's Equity $2,000


Good Deal Co.
Statement of Cash Flows
For the Month Ended January 31, 2010
Operating Activities


Net Income $ 0


Increase in Inventory (700)


Cash Provided (Used) in Operating Activities (700)

Investing Activities 0

Financing Activities


Investment by Owner 2,000


Net Increase in Cash 1,300

Cash at the beginning of the month 0

Cash at the end of the month $1,300


Good Deal's income statement for January showed no profit or loss, since it did not have any sales or
expenses. However, the cash flow statement reports that Good Deal's operating activities resulted in a
decrease in cash of $700. The decrease in cash occurred because the company increased its inventory
by $700 during January. The financing activities section shows an increase in cash of $2,000 which
corresponds to the increase in Matt Jones, Capital (Matt's investment in the business). The net change
in the Cash account from the owner's investment and the cash outflow for inventory is a positive $1,300.

This net change of a positive $1,300 is verified at the bottom of the cash flow statement and on the
balance sheet. There was a $0 cash at January 1, but at January 31, the Cash balance is $1,300.


For a change in assets (other than cash)the change in the Cashaccount is in the opposite direction.
Recall that when Inventoryincreased by $700, Cash decreased by $700.

For a change in liabilities and owner's equitythe change in the Cash account is in the same
February Transactions and Financial Statements
direction.
Recall that when the owner invested cash in the company Cash increased and Owner's Equity increased.


On February 25, 2010, Good Deal sells 10 calculators to a nearby high school for $80 each. Matt delivers
the calculators on February 25 and gives the school an $800 invoice due by March 10. Matt receives
$800 from the school on March 8.

Matt prepared financial statements for his new business as of February 28, 2010:

Good Deal Co.
Income Statement
For the Month Ended Feb. 28, 2010
Revenues $800
Expenses 500

Net Income

$300



The income statement for the month of February shows revenues (or sales) of $800. Under the accrual
basis of accountingrevenue is recognized when title passes (at the time of shipment or time of
delivery), notwhen the money is received. Expenses (such as the cost of goods sold for $500) appear on
the income statement when they best match up with revenues, not when the expenses or goods are paid
for. (Other expenses will also appear on the income statement when they are used, not when they are
paid for.) As a result of the accrual basis of accounting, the income statement reports $300 of net income
even though there was no cash inflow or cash outflow during February.

Good Deal Co.
Statement of Cash Flows
For the Month Ended February 28, 2010
Operating Activities


Net Income $ 300


Increase in Accounts Receivable (800)


Decrease in Inventory 500


Cash Provided (Used) in Operating Activities 0

Investing Activities 0

Financing Activities


Investment by Owner 0


Net Increase in Cash 0

Cash at the beginning of the month 1,300

Cash at the end of the month $1,300


As you can see above, the cash flow statement for the month of February reports no change in cash.
That agrees with the company's balance sheet that reported Cash of $1,300 on January 31 and will show
$1,300 on February 28.

Good Deal Co.
Income Statement
For the Two Months Ended February 28, 2010
Revenues $800

Expenses 500

Net Income

$300


The year-to-date net income of $300 increases the owner's equity on the balance sheet. Please note the
connection between the bottom line of the year-to-date income statement and the change in Matt Jones,
Capital on the balance sheet. Matt Jones, Capital has increased from $2,000 to $2,300.

Good Deal Co.
Balance Sheet
February 28, 2010
Assets

Liabilities & Owner's Equity

Cash $1,300

Liabilities $ 0
Accounts Receivable 800

Owner's Equity

Inventory 200

Matt Jones, Capital (excl. net inc.) 2,000

Matt Jones, Curr Yr. Net Income 300



Total Owner's Equity 2,300

Total Assets $2,300

Total Liabilities & Owner's Equity

$2,300

Good Deal Co.
Statement of Cash Flows
For the Two Months Ended February 28, 2010
Operating Activities


Net Income $ 300


Increase in Accounts Receivable (800)


Increase in Inventory (200)


Cash Provided (Used) in Operating Activities (700)

Investing Activities 0

Financing Activities


Investment by Owner $2,000


Net Increase in Cash 1,300

Cash at the beginning of the year 0

Cash at February 28, 2010 $1,300


Good Deal's income statement for the first two months shows a positive net income of $300. However,
the fact that the company's Accounts Receivable increased by $800 means the company did not collect
the cash from its sales. And because Inventory increased by $200, the company's Cash had also
decreased in order to pay for the Inventory increase. As a result, the cash flows for the two-month period
shows that Good Deal's cash from operating activities is a negative $700. Recall that Good Deal has
not received any money yet from its operations (buying and selling merchandise) and it paid out $700 for
the 14 calculators it purchased.

The cash flow statement also shows $2,000 of financing by the owner. When this is combined with the
negative $700 from operating activities, the net change in cash for the first two months is a positive
$1,300. This agrees to the change
March Transactions and Financial Statements
in cash on the balance sheetnone on January 1 but $1,300 on
February 28.

On March 8 Good Deal receives $800 for the calculators sold to the school on February 25. No other
transactions occurred in March.

The Good Deal financial statements dated March 31 are:

Good Deal Co.
Income Statement
For the Month Ended March 31, 2010
Revenues $ 0
Expenses 0

Net Income

$ 0



Good Deal Co.
Income Statement
For the Three Months Ended March 31, 2010
Revenues $800
Expenses 500

Net Income

$300



Note that the year-to-date net income causes the amount in the owner's capital account (on the balance
sheet) to increase from $2,000 to $2,300.

Good Deal Co.
Balance Sheet
March 31, 2010
Assets

Liabilities & Owner's Equity

Cash $2,100

Liabilities $ 0
Accounts Receivable 0

Owner's Equity

Inventory 200

Matt Jones, Capital (excl. net inc.) 2,000

Matt Jones, Curr Yr. Net Income 300



Total Owner's Equity 2,300

Total Assets $2,300

Total Liabilities & Owner's Equity

$2,300

Good Deal Co.
Statement of Cash Flows
For the Three Months Ended March 31, 2010
Operating Activities


Net Income $ 300


Increase in Accounts Receivable 0


Increase in Inventory (200)


Cash Provided (Used) in Operating Activities 100

Investing Activities 0

Financing Activities


Investment by Owner $2,000


Net Increase in Cash 2,100

Cash at the beginning of the year 0

Cash at March 31, 2010 $2,100


The income statement for the first three months of the business shows a net income of $300. The
operating activities section of the statement of cash flows begins with the $300 in net income, but then
shows that $200 of cash was used to increase inventory. As a result, only $100 of cash was provided
from operating activities.

The statement of cash flows also shows that $2,000 was received from the owner's investment in the
company. The net cash inflow from the company's operating, investing, and financing activities for the
three months ended March 31, 2010 was $2,100.

The figure of $2,100 represents the change in cash from the beginning of the accounting year through
March 31. If you look at the March 31 balance sheet, you will find that it confirms thisthere is $2,100 in
the Cash account on March 31 and there was $0 on January 1.

The statement of cash flows presented above was for the three months ended March 31, 2010. Let's look
at how the statement of cash flows would be prepared for just one monthMarch 2010.

Since much of the information for the cash flow statement comes from changes in balance sheet
accounts, we need to have the balance sheet amounts for both February 28, 2010 and March 31, 2010.
Thedifferences in these account balances from February 28 to March 31 will provide us with information
we need on the activities in March.

Good Deal Co.
Balance Sheets
March 31 and February 28, 2010

Assets 3-31-10 2-28-10 Change

Cash $2,100 $1,300 $ 800

Accounts Receivable -0- 800 (800)

Inventory 200 200 -0-

Total Assets $2,300 $2,300

$ -0-
Liabilities & Owner's Equity

Liabilities $ -0- $ -0- $ -0-
Owner's Equity


Matt Jones, Capital (excl. net inc.) 2,000 2,000 -0-

Matt Jones, Curr Yr. Net Income 300 300 -0-

Total Owner's Equity 2,300 2,300 -0-

Total Liabilities & Owner's Equity $2,300 $2,300

$ -0-
(If you are wondering why March 31 is shown before February 28, it is because accountants usually
place the most current amounts closest to the account names. This is a courtesy to the reader in
that these are assumed to be the more important amounts and will be easier to read if placed
closest to the words.)


Focus on the "Change" column above. The first amount, a positive $800 change in the Cash account, will
serve as a "check figure" for the bottom line of the cash flow statement for the month of March. In other
words, the cash flow statement for March must end up explaining this $800 increase in the Cash account.
The other amounts in the "Change" column will be used on the statement of cash flows to identify the
reasons for the $800 increase in cash.

Since there were no sales and no expenses in March, the income statement for the one month of March
(see above) reported no net income. This $0 of net income is the first amount reported on the statement
of cash flows. The changes in the balance sheet accounts from February 28 to March 31 provided the
other information needed for the month of March:

Good Deal Co.
Statement of Cash Flows
For the Month Ended March 31, 2010
Operating Activities


Net Income $ 0


Decrease in Accounts Receivable 800


Change in Inventory 0


Cash Provided (Used) in Operating Activities 800

Investing Activities 0

Financing Activities 0


Net Increase in Cash 800

Cash at the beginning of the month 1,300

Cash at the end of the month $2,100


Let's review the cash flow statement for the month of March 2010:
Net income for March is $0, since there were no revenues, gains, expenses, or losses.
Cash increased by $800 because $800 of accounts receivable were collected during March.
Inventory did not change, so Cash was not affected. (We could omit this line since it had no effect
on cash.)
There were no changes in long-term assets during March, so nothing is reported in the investing
activities section.
There were no changes in long-term liabilities or owner's equity; hence, nothing is reported in the
financing activities section.
The summation of the amounts on the statement of cash flows is a positive $800. This amount
agrees to the increase in the Cash account balance from $1,300 on February 28 to $2,100 on
March 31.

April Transactions and Financial Statements
On April 28 Good Deal orders $150 of supplies on account. The supplies arrive on April 30 along with an
invoice showing that the full $150 is due by May 30. None of the supplies were used in April. This was the
only transaction during April.

Matt prepared the following financial statements for Good Deal Co. as of April 30:

Good Deal Co.
Income Statement
For the Month Ended April 30, 2010
Revenues $ 0
Expenses 0

Net Income

$ 0



Since no supplies were used in April, there is no change to the Supplies Expense account. The $150 is
reported on the balance sheet in the asset account Supplies.

Good Deal Co.
Income Statement
For the Four Months Ended April 30, 2010
Revenues $800
Expenses 500

Net Income

$300



Good Deal Co.
Balance Sheet
April 30, 2010
Assets

Liabilities & Owner's Equity

Cash $2,100

Liabilities

Accounts Receivable 0

Accounts Payable $ 150
Inventory 200

Owner's Equity

Supplies 150

Matt Jones, Capital (excl. net inc.) 2,000

Matt Jones, Curr Yr. Net Income 300

Total Owner's Equity 2,300

Total Assets $2,450

Total Liabilities & Owner's Equity

$2,450

As you can see from the balance sheet the company added assets of $150 (Supplies) and added its first
liability of $150 (Accounts Payable).

A balance sheet comparing April 30 to March 31 and the resulting differences or changes is shown below:

Good Deal Co.
Balance Sheets
April 30 and March 31, 2010

Assets 4-30-10 3-31-10 Change

Cash $2,100 $2,100 $ 0

Accounts Receivable 0 0 0

Inventory 200 200 0

Supplies 150 $ 0 $150

Total Assets $2,450 $2,300

$150
Liabilities & Owner's Equity

Liabilities


Accounts Payable $ 150 $ 0 $150
Owner's Equity


Matt Jones, Capital (excl. net inc.) 2,000 2,000 0

Matt Jones, Curr Yr. Net Income 300 300 0

Total Owner's Equity 2,300 2,300 0

Total Liabilities & Owner's Equity $2,450 $2,300

$150
(If you are wondering why April 30 is shown before March 31, it is because accountants usually
place the most current amounts closest to the account names. This is a courtesy to the reader in
that these are assumed to be the more important amounts and will be easier to read if placed
closest to the words.)


Good Deal Co.
Statement of Cash Flows
For the Month Ended April 30, 2010
Operating Activities


Net Income $ 0


Increase in Supplies (150)


Increase in Accounts Payable 150


Cash Provided (Used) in Operating Activities 0

Investing Activities 0

Financing Activities


Investment by Owner 0


Net Increase in Cash 0

Cash at the beginning of the month 2,100

Cash at the end of the month $2,100


The cash flow statement for the month of April reports that there was no change in the Cash account from
March 31 through April 30. The operating activities section reports the increase in Supplies, but also
reports the increase in Accounts Payable.


On the statement of cash flows, think of the positive amounts (the numbers not in parentheses)
as good for your cash balance. For example, if you don't pay your bills, that's good for your cash balance
(but bad for the liability Accounts Payable which increases).

Think of the negative amounts (the numbers within parentheses) asnot good for cash. For example, if you
pay a bill, that's not good for your cash balance (but good for the liability Accounts Payable which
decreases).

Good Deal Co.
Balance Sheets
April 30, 2010 and December 31, 2009

Assets 4-30-10 12-31-09 Change

Cash $2,100 $ 0 $2,100

Accounts Receivable 0 0 0

Inventory 200 0 200

Supplies 150 0 150

Total Assets $2,450 $ 0

$2,450
Liabilities & Owner's Equity

Liabilities


Accounts Payable $ 150 $ 0 $ 150
Owner's Equity


Matt Jones, Capital (excl. net inc.) 2,000 0 2,000

Matt Jones, Curr Yr. Net Income 300 0 300

Total Owner's Equity 2,300 0 2,300

Total Liabilities & Owner's Equity $2,450 $ 0

$2,450

Good Deal Co.
Statement of Cash Flows
For the Four Months Ended April 30, 2010
Operating Activities


Net Income $ 300


Increase in Inventory (200)


Increase in Supplies (150)


Increase in Accounts Payable 150


Cash Provided (Used) in Operating Activities 100

Investing Activities 0

Financing Activities


Investment by Owner 2,000


Net Increase in Cash 2,100

Cash at the beginning of the year 0

Cash at April 30, 2010 $2,100


Let's review the statement of cash flows for the four months ended April 30:
The operating activities section of the cash flow statement starts with the net income of $300 for
the four-month period. The increase in Inventory is not good for cash, as shown by the negative
$200. Similarly, the increase in Supplies is not good for cash and it is reported as a negative
$150. The increase in Accounts Payable is good for cash (since some bills were not paid) so the
increase in the liability account is a positive $150. Combining the amounts, the net change in
cash that is explained by operating activities
There were no changes in long-term assets, hence no cash was involved in investing activities.
is a positive $100.
There were no changes in long-term liabilities. There was a change in owner's equity since
December 31, and as a result the financing activities section reports the owner's investment in
Good Deal Co.
Combining the operating, investing, and financing activities, the cash flow statement reports a
change in cash of $2,100. This agrees with the change in the Cash account from $0 on
December 31, 2009 to $2,100 on April 30, 2010.

May Transactions and Financial Statements
On May 30 Good Deal pays its accounts payable of $150. On May 31 Good Deal purchases office
equipment (a new computer and printer) that will be used exclusively in the business. The cost of the
office equipment is $1,100 and is paid for in cash. The equipment is put into service on May 31. There
were no other transactions in May.

Good Deal Co.
Income Statement
For the Month Ended May 31, 2010
Revenues $ 0
Expenses 0


Net Income

$ 0


Good Deal Co.
Income Statement
For the Five Months Ended May 31, 2010
Revenues $800
Expenses 500

Net Income

$300



Good Deal Co.
Balance Sheet
May 31, 2010
Assets

Liabilities & Owner's Equity

Cash $ 850

Liabilities

Accounts Receivable 0

Accounts Payable $ 0
Inventory 200

Owner's Equity

Supplies 150

Matt Jones, Capital (excl. net inc.) 2,000
Office Equipment 1,100

Matt Jones, Curr Yr. Net Income 300

Total Owner's Equity 2,300

Total Assets $2,300

Total Liabilities & Owner's Equity

$2,300

A balance sheet comparing May 31 to April 30 and the resulting differences or changes is shown below:

Good Deal Co.
Balance Sheets
May 31 and April 30, 2010

Assets 5-31-10 4-30-10 Change

Cash $ 850 $2,100 $(1,250)

Accounts Receivable 0 0 0

Inventory 200 200 0

Supplies 150 150 0

Office Equipment 1,100 0 1,100

Total Assets $2,300 $2,450

$ (150)
Liabilities & Owner's Equity

Liabilities


Accounts Payable $ 0 $ 150 $ (150)
Owner's Equity


Matt Jones, Capital (excl. net inc.) 2,000 2,000 0

Matt Jones, Curr Yr. Net Income 300 300 0

Total Owner's Equity 2,300 2,300 0

Total Liabilities & Owner's Equity $2,300 $2,450

$ (150)

Good Deal Co.
Statement of Cash Flows
For the Month Ended May 31, 2010
Operating Activities


Net Income $ 0


Decrease in Accounts Payable (150)


Cash Provided (Used) in Operating Activities (150)

Investing Activities


Purchase of Office Equipment (1,100)

Financing Activities 0


Net Increase in Cash (1,250)

Cash at the beginning of the month 2,100

Cash at the end of the month $ 850


Good Deal Co.
Balance Sheets
May 31, 2010 and December 31, 2009

Assets 5-31-10 12-31-09 Change

Cash $ 850 $ 0 $ 850

Accounts Receivable 0 0 0

Inventory 200 0 200

Supplies 150 0 150

Office Equipment 1,100 0 1,100

Total Assets $2,300 $ 0

$2,300
Liabilities & Owner's Equity

Liabilities


Accounts Payable $ 0 $ 0 $ 0
Owner's Equity


Matt Jones, Capital (excl. net inc.) 2,000 0 2,000

Matt Jones, Curr Yr. Net Income 300 0 300

Total Owner's Equity 2,300 0 $2,300

Total Liabilities & Owner's Equity $2,300 $ 0

$2,300

Good Deal Co.
Statement of Cash Flows
For the Five Months Ended May 31, 2010
Operating Activities


Net Income $ 300


Increase in Inventory (200)


Increase in Supplies (150)


Cash Provided (Used) in Operating Activities (50)

Investing Activities


Purchase of Office Equipment (1,100)

Financing Activities


Investment by Owner 2,000


Net Increase in Cash 850

Cash at the beginning of the year 0

Cash at May 31, 2010 $ 850


Let's review the cash flow statement for the five months ended May 31:
The operating activities section starts with the net income of $300 for the five-month period. The
increase in Inventory is not good for cash, as shown by the negative $200. Similarly, the increase
in Supplies is not good for cash and it is reported as a negative $150. Combining the amounts,
the net change in cash that is explained by operating activities
The increase in long-term assets is reported under investing activities.
is a negative $50.
There were no changes in long-term liabilities. There was a change in owner's equity since
December 31, and as a result the financing activities section of the cash flow statement reports
the owner's investment into the Good Deal Co.
Combining the operating, investing, and financing activities, the statement of cash flows reports
an increase in cash of $850. This agrees with the change in the Cash account as shown on the
balance sheets from December 31, 2009 (or January 1, 2010) and May 31, 2010.

Depreciation moves the cost of an asset to Depreciation Expense during the asset's useful life. The
accounts involved in recording depreciation are Depreciation Expense and Accumulated Depreciation.
As you can see, cash is not involved. In other words, depreciation reduces net income on the income
statement, but it does not reduce the Cash account on the balance sheet.

Because we begin preparing the statement of cash flows using the net income figure taken from the
income statement, we need to adjust the net income figure so that it is not reduced by Depreciation
Expense. To do this, we add back the amount of the Depreciation Expense.

Depletion Expense and Amortization Expense are accounts similar to Depreciation Expense, as all
three involve allocating the cost of a long-term asset to an expense over the useful life of the asset. There
is no cash involved.


In the operating activities section of the cash flow statement, add back expenses that did not require the
use of cash. Examples are depreciation, depletion, and amortization expense.

Let's illustrate how a depreciation expense is handled by continuing with the Good Deal Co.

June Transactions and Financial Statements
The only transaction recorded by Good Deal during June was the depreciation on the office equipment.
Recall that on May 31 Good Deal purchased the office equipment (a new computer and printer) for
$1,100 and it was put into service on the same day. Let's assume that a depreciation expense of $20 per
month is recorded by Good Deal. As a result, Good Deal's financial statements at June 30 will be as
follows:

Good Deal Co.
Income Statement
For the Month Ended June 30, 2010
Revenues $ 0
Expenses


Depreciation Expense 20

Net Income

$(20)



Good Deal Co.
Income Statement
For the Six Months Ended June 30, 2010
Revenues $800
Expenses


Cost of Goods Sold 500

Depreciation Expense 20

Total Expense 520

Net Income

$280



Good Deal Co.
Balance Sheet
June 30, 2010
Assets

Liabilities & Owner's Equity

Cash $ 850

Liabilities

Accounts Receivable 0

Accounts Payable $ 0
Inventory 200

Owner's Equity

Supplies 150

Matt Jones, Capital (excl. net inc.) 2,000
Office Equipment 1,100

Matt Jones, Curr Yr. Net Income 280
Less: Accum. Depreciation (20)

Total Matt Jones, Capital 2,280

Total Assets $2,280

Total Liabilities & Owner's Equity

$2,280

A balance sheet comparing June 30 to May 31 and the resulting differences or changes is shown below:

Good Deal Co.
Balance Sheets
June 30 and May 31, 2010

Assets 6-30-10 5-31-10 Change

Cash $ 850 $ 850 $ 0

Accounts Receivable 0 0 0

Inventory 200 200 0

Supplies 150 150 0

Office Equipment 1,100 1,100 0

Less: Accumulated Depreciation (20) 0 (20)

Total Assets $2,280 $2,300 $(20

)
Liabilities & Owner's Equity

Liabilities


Accounts Payable $ 0 $ 0 $ 0
Owner's Equity


Matt Jones, Capital (excl. net inc.) 2,000 2,000 0

Matt Jones, Curr Yr. Net Income 280 300 (20)

Total Matt Jones, Capital 2,280 2,300 (20)

Total Liabilities & Owner's Equity $2,280 $2,300 $(20

)
(If you are wondering why J une 30 is shown before May 31, it is because accountants usually
place the most current amounts closest to the account names. This is a courtesy to the reader in
that these are assumed to be the more important amounts and will be easier to read if placed
closest to the words.)


Good Deal Co.
Statement of Cash Flows
For the Month Ended June 30, 2010
Operating Activities


Net Income $ (20)


Add: Depreciation Expense 20


Cash Provided (Used) in Operating Activities 0

Investing Activities 0

Financing Activities 0


Net Increase in Cash 0

Cash at the beginning of the month 850

Cash at the end of the month $850


The cash flow statement for the month of June illustrates why depreciation expense needs to be added
back to net income. Good Deal did not spend any cash in June, however, the entry in the Depreciation
Expense account resulted in a net loss on the income statement. To convert the bottom line of the income
statement (a loss of $20) to the amount of cash provided or used in operating activities ($0) we need to
add back or remove the depreciation expense amount.

Good Deal Co.
Balance Sheets
June 30, 2010 and December 31, 2009

Assets 6-30-10 12-31-09 Change

Cash $ 850 $ 0 $ 850

Accounts Receivable 0 0 0

Inventory 200 0 200

Supplies 150 0 150

Office Equipment 1,100 0 1,100

Less: Accumulated Depreciation (20) 0 (20)

Total Assets $2,280 $ 0 $2,280


Liabilities & Owner's Equity

Liabilities


Accounts Payable $ 0 $ 0 $ 0
Owner's Equity


Matt Jones, Capital (excl. net inc.) 2,000 0 2,000

Matt Jones, Curr Yr. Net Income 280 0 280

Total Matt Jones, Capital 2,280 0 2,280

Total Liabilities & Owner's Equity $2,280 $ 0 $2,280



Good Deal Co.
Statement of Cash Flows
For the Six Months Ended June 30, 2010
Operating Activities


Net Income $ 280


Add back: Depreciation Expense 20


Increase in Inventory (200)


Increase in Supplies (150)


Cash Provided (Used) in Operating Activities (50)

Investing Activities


Increase in Office Equipment (1,100)

Financing Activities


Investment by Owner 2,000


Net Increase in Cash 850

Cash at the beginning of the year 0

Cash at June 30, 2010 $ 850


Let's review the cash flow statement for the six months ended June 30:
The operating activities section starts with the net income of $280 for the six-month period.
Depreciation expense is added back to net income because it was a noncash transaction (net
income was reduced, but there was no cash spent on depreciation). The increase in the Inventory
account is not good for cash, as shown by the negative $200. Similarly, the increase in Supplies
is not good for cash and it is reported as a negative $150. Combining the amounts, the net
change in cash that is explained by operating activities
The increase in long-term assets caused a cash outflow of $1,100 which is reported in the
investing activities section.
is a negative $50.
There were no changes in long-term liabilities. There was a change in owner's equity since
December 31, and as a result the financing activities section reports the owner's $2,000
investment into the Good Deal Co.
Combining the operating, investing, and financing activities, the statement of cash flows reports
an increase in cash of $850. This agrees with the change in the Cash account as shown on the
balance sheets from December 31, 2009 and June 30, 2010.
Disposal of Assets
If a company disposes of (sells) a long-term asset for an amount different from its recorded amount in the
company's accounting records (its book value), an adjustment must be made to net income on the cash
flow statement.

For example, let's say a company sells one of its delivery trucks for $3,000. That truck is shown on the
company records at its original cost of $20,000 less accumulated depreciation of $18,000. When these
two amounts are combined ("netted together") the net amount is known as the book value (or
the carrying value) of the asset. In the example, the book value of the truck is $2,000 ($20,000 -
$18,000).

Because the proceeds from the sale of the truck are $3,000 and the book value is $2,000 the difference
of $1,000 is recorded in the account Gain on Sale of Truckan income statement account. The
transaction has the effect of increasing the company's net income. If the truck had sold for $1,500
($500 less than its $2,000 book value), the difference of $500 would be reported in the account Loss on
Sale of Truck and would reduce the company's net income.

One of the rules in preparing a statement of cash flows is that the entire proceeds received from the sale
of a long-term asset must be reported in the second section of the statement, the investing activities
section. This presents a problem because any gain or loss on the sale of an asset is also included in the
company's net income which is reported in the first sectionoperating activities. To avoid double
counting, each gain isdeducted from net income and each loss is added to net income in the operating
activities section of the cash flow statement.

Let's illustrate this by returning to Good Deal Co.'s activities.




July Transactions and Financial Statements
On July 1 Matt decides that his company no longer needs its office equipment. Good Deal used the
equipment for one month (May 31 through June 30) and had recorded one month's depreciation of $20.
This means the book value of the equipment is $1,080 (the original cost of $1,100 less the $20 of
accumulated depreciation). On July 1 Good Deal sells the equipment for $900 in cash and records a loss
of $180 in the account Loss on Sale of Equipment on its income statement. There were no other
transactions in July.

The income statement and the statement of cash flows for the month of July illustrate how the disposal of
the equipment is reported:

Good Deal Co.
Income Statement
For the Month Ended July 31, 2010
Revenues $ 0
Expenses


Loss on Sale of Equipment 180
Net Income $(180

)



Good Deal Co.
Income Statement
For the Seven Months Ended July 31, 2010
Revenues $800
Expenses


Cost of Goods Sold 500

Depreciation Expense 20

Loss on Sale of Equipment 180

Total Expense 700

Net Income

$100



Good Deal Co.
Balance Sheets
July 31, 2010 and June 30, 2010

Assets 7-31-10 6-30-10 Change

Cash $1,750 $ 850 $ 900

Accounts Receivable 0 0 0

Inventory 200 200 0

Supplies 150 150 0

Office Equipment 0 1,100 (1,100)

Less: Accumulated Depreciation 0 (20) 20

Total Assets $2,100 $2,280 $ (180

)
Liabilities & Owner's Equity

Liabilities


Accounts Payable $ 0 $ 0 $ 0
Owner's Equity


Matt Jones, Capital (excl. net inc.) 2,000 2,000 0

Matt Jones, Curr Yr. Net Income 100 280 (180)

Total Matt Jones, Capital 2,100 2,280 (180)

Total Liabilities & Owner's Equity $2,100 $2,280 $ (180

)


Good Deal Co.
Statement of Cash Flows
For the Month Ended July 31, 2010
Operating Activities


Net Income $ (180)


Add back: Depreciation Expense 0


Add back: Loss on Sale of Equipment 180


Cash Provided (Used) in Operating Activities 0

Investing Activities


Proceeds from sale of Office Equipment 900

Financing Activities 0


Net Increase in Cash 900

Cash at the beginning of the month 850

Cash at the end of the month $1,750


Let's review the cash flow statement for the month of July 2010:
Net income for July was a net loss of $180. There were no revenues, expenses, or gains, but
there was an entry of $180 in the account Loss on Sale of Equipment.
There was no depreciation expense in July, and current assets and current liabilities did not
change in July, so cash was not affected. (We could have omitted the line "Depreciation
Expense".)
There was no cash provided or used by operating activities.
Good Deal received $900 from the sale of its office equipment.
There was no change in long-term liabilities or owner's equity during July.
The summation of the amounts on the cash flow statement is a positive cash inflow of $900. This amount
agrees to our check figurethe increase in the Cash account balance from June 30 to July 31.

Good Deal Co.
Balance Sheets
July 31, 2010 and December 31, 2009

Assets 7-31-10 12-31-09 Change

Cash $1,750 $ 0 $1,750

Accounts Receivable 0 0 0

Inventory 200 0 200

Supplies 150 0 150

Office Equipment 0 0 0

Less: Accumulated Depreciation 0 0 0

Total Assets $2,100 $ 0 $2,100


Liabilities & Owner's Equity

Liabilities


Accounts Payable $ 0 $ 0 $ 0
Owner's Equity


Matt Jones, Capital (excl. net inc.) 2,000 0 2,000

Matt Jones, Curr Yr. Net Income 100 0 100

Total Matt Jones, Capital 2,100 0 2,100

Total Liabilities & Owner's Equity $2,100 $ 0 $2,100



Good Deal Co.
Statement of Cash Flows
For the Seven Months Ended July 31, 2010
Operating Activities


Net Income $ 100


Add back: Depreciation Expense 20


Add back: Loss on Sale of Equipment 180


Increase in Inventory (200)


Increase in Supplies (150)


Cash Provided (Used) in Operating Activities (50)

Investing Activities


Purchase of Office Equipment (1,100)


Proceeds from sale of Office Equipment 900


Cash Provided (Used) in Investing Activities (200)

Financing Activities


Investment by owner 2,000


Net Increase in Cash 1,750

Cash at the beginning of the year 0

Cash at July 31, 2010 $1,750


Let's review the cash flow statement for the seven months of January through July 2010:
Net income for the seven months is $100. This includes revenues, gains, expenses, and losses.
Included in the net income for the seven months is $20 of depreciation expense. This expense
reduced net income but did not reduce the Cash account; therefore we add the $20 depreciation
expense to the net income.
Also included in net income is the $180 entry into the Loss on Sale of Equipment account. This
loss was reported on the income statement thereby reducing net income but not reducing cash.
(The cash received from the sale of the equipment appears in its entirety under the investing
activities section of the cash flow statement.)
Inventory on July 31 is $200 (4 calculators at a cost of $50 each). Since the company began with
no inventory, this increase in the Inventory account means that $200 of cash was used to
increase inventory.
Supplies increased from none to $150. The increase in the Supplies account is assumed to have
had a negative effect of $150 on the Cash account.
Combining the amounts so far, we see that the cash from operating activities is a negative $50. In
other words, rather than providing cash, the operating activities used
There is cash outflow (or payment) of $1,100 to purchase the office equipment on May 31 and the
$900 of cash inflow (or receipt) from the sale of the office equipment on July 1. Combining these
two amounts results in the net outflow ("cash used in investing activities") of $200.
$50 of cash.
There was an owner's investment of $2,000 made on January 2.

The statement of cash flow's bottom line amount of $1,750 results from combining the amount totals of
the previous three sectionsoperating, investing, and financing activities. This $1,750 agrees to the
check figurethe difference in the Cash account balance from the beginning of January to July 31.


Financial Ratios

Introduction to Financial Ratios
We also have Quizzes, Crosswords, and Q&A for the topic
When computing financial ratios and when doing other financial statement analysis always keep in mind
that the financial statements reflect the
Financial Ratios.

accounting principles. This means assets are generally not
reported at their current value. It is also likely that many brand names and unique product lines will not be
included among the assets reported on the balance sheet, even though they may be the most valuable of
all the items owned by a company.

These examples are signals that financial ratios and financial statement analysis have limitations. It is
also important to realize that an impressive financial ratio in one industry might be viewed as less than
impressive in a different industry.

Our explanation of financial ratios and financial statement analysis is organized as follows:

Balance Sheet
o General discussion
o Common-size balance sheet
o Financial ratios based on the balance sheet

Income Statement
o General discussion
o Common-size income statement
o Financial ratios based on the income statement

Statement of Cash Flows

General Discussion of Balance Sheet
The balance sheet reports a company's assets, liabilities, and stockholders' equity as of a specific date,
such as December 31, 2010, September 28, 2010, etc.

The accountants' cost principle and the monetary unit assumption will limit the assets reported on the
balance sheet. Assets will be reported

(1) only if they were acquired in a transaction, and
(2) generally at an amount that is not greater than the asset's cost at the time of the transaction.

This means that a company's creative and effective management team will not be listed as an asset.
Similarly, a company's outstanding reputation, its unique product lines, and brand names developed
within the company will not be reported on the balance sheet. As you may surmise, these items are often
the most valuable of all the things owned by the company. (Brand names purchased from another
company will be recorded in the company's accounting records at their cost.)

The accountants' matching principle will result in assets such as buildings, equipment, furnishings,
fixtures, vehicles, etc. being reported at amounts less than cost. The reason is these assets
aredepreciated. Depreciation reduces an asset's book value
While depreciation is reducing the book value of certain assets over their
each year and the amount of the reduction
is reported as Depreciation Expense on the income statement.

useful lives, the current value
(or fair market value) of these assets may actually be increasing. (It is also possible that the current
value of some assetssuch as computersmay be decreasing faster than the book value.)

Current assets such as Cash, Accounts Receivable, Inventory, Supplies, Prepaid Insurance, etc. usually
have current values that are close to the amounts reported on the balance sheet.

Current liabilities such as Notes Payable (due within one year), Accounts Payable, Wages Payable,
Interest Payable, Unearned Revenues, etc. are also likely to have current values that are close to the
amounts reported on the balance sheet.

Long-term liabilities such as Notes Payable (not due within one year) or Bonds Payable (not maturing
within one year) will often have current values that differ from the amounts reported on the balance sheet.

Stockholders' equity is the book value of the company. It is the difference between the reported
amount of assets and the reported amount of liabilities. For the reasons mentioned above, the reported
amount of stockholders' equity will therefore be different from the current or market value of the company.

By definition the current assets and current liabilities are "turning over" at least once per year. As a result,
the reported amounts are likely to be similar to their current value. The long-term assets and long-term
liabilities are not "turning over" often. Therefore, the amounts reported for long-term assets and long-term
liabilities will likely be different from the current value of those items.

The remainder of our explanation of financial ratios and financial statement analysis will use information
from the following balance sheet:


Example Company
Balance Sheet
December 31, 2010

ASSETS

LIABILITIES
Current Assets

Current Liabilities


Cash $ 2,100

Notes Payable $ 5,000

Petty Cash 100

Accounts Payable 35,900

Temporary Investments 10,000

Wages Payable 8,500

Accounts Receivable - net 40,500

Interest Payable 2,900

Inventory 31,000

Taxes Payable 6,100

Supplies 3,800

Warranty Liability 1,100

Prepaid Insurance 1,500

Unearned Revenues 1,500

Total Current Assets 89,000

Total Current Liabilities 61,000
-

Investments 36,000

Long-term Liabilities


Notes Payable 20,000
Property, Plant & Equipment

Bonds Payable 400,000

Land 5,500

Total Long-term Liabilities 420,000

Land Improvements 6,500


Buildings 180,000


Equipment 201,000

Total Liabilities 481,000

Less: Accum Depreciation (56,000)


Prop, Plant & Equip - net 337,000

-

Intangible Assets

STOCKHOLDERS' EQUITY


Goodwill 105,000

Common Stock 110,000

Trade Names 200,000

Retained Earnings 229,000

Total Intangible Assets 305,000

Less: Treasury Stock (50,000)

Total Stockholders' Equity 289,000
Other Assets 3,000

-

Total Assets $770,000

Total Liab. & Stockholders' Equity $770,000



To learn more about the balance sheet, go to:
Explanation of Balance Sheet
Drills for Balance Sheet
Crossword Puzzles for Balance Sheet

CommonSize Balance Sheet
One technique in financial statement analysis is known as vertical analysis. Vertical analysis results in
common-size financial statements. A common-size balance sheet is a balance sheet where every dollar
amount has been restated to be a percentage of total assets. We will illustrate this by taking Example
Company's balance sheet (shown above) and divide each item by the total asset amount $770,000. The
result is the following common-size balance sheet for Example Company:


Example Company
Balance Sheet
December 31, 2010

ASSETS

LIABILITIES
Current Assets

Current Liabilities


Cash 0.3%

Notes Payable 0.6%

Petty Cash 0.0%

Accounts Payable 4.7%

Temporary Investments 1.3%

Wages Payable 1.1%

Accounts Receivable - net 5.3%

Interest Payable 0.4%

Inventory 4.0%

Taxes Payable 0.8%

Supplies 0.5%

Warranty Liability 0.1%

Prepaid Insurance 0.2%

Unearned Revenues 0.2%

Total Current Assets 11.6%

Total Current Liabilities 7.9%
-

Investments 4.7%

Long-term Liabilities


Notes Payable 2.6%
Property, Plant & Equipment

Bonds Payable 52.0%

Land 0.7%

Total Long-term Liabilities 54.6%

Land Improvements 0.8%


Buildings 23.4%


Equipment 26.1%

Total Liabilities 62.5%

Less: Accum Depreciation (7.3%)


Prop, Plant & Equip - net 43.7%

-

Intangible Assets

STOCKHOLDERS' EQUITY


Goodwill 13.6%

Common Stock 14.3%

Trade Names 26.0%

Retained Earnings 29.7%

Total Intangible Assets 39.6%

Less: Treasury Stock (6.5%)

Total Stockholders' Equity 37.5%
Other Assets 0.4%

-

Total Assets 100.0%

Total Liab. & Stockholders' Equity

100.0%

The benefit of a common-size balance sheet is that an item can be compared to a similar item of another
company regardless of the size of the companies. A company can also compare its percentages to the
industry's average percentages. For example, a company with Inventory
Financial Ratios Based on the Balance Sheet
at 4.0% of total assets can look
to its industry statistics to see if its percentage is reasonable. (Industry percentages might be available
from an industry association, library reference desks, and from bankers. Generally banks have
memberships in Robert Morris Associates, an organization that collects and distributes statistics by
industry.) A common-size balance sheet also allows two businesspersons to compare the magnitude of a
balance sheet item without either one revealing the actual dollar amounts.



Financial statement analysis includes financial ratios. Here are three financial ratios that are based solely
on current asset and current liability amounts appearing on a company's balance sheet:


Financial Ratio

How to Calculate It What It Tells You
Working
Capital
=

=

=
Current Assets Current Liabilities

$89,000 $61,000

$28,000
An indicator of whether the
company will be able to meet its
current obligations (pay its bills,
meet its payroll, make a loan
payment, etc.) If a company has
current assets exactly equal to
current liabilities, it has no working
capital. The greater the amount of
working capital the more likely it will
be able to make its payments on
time.
Current Ratio =

=

=
Current Assets Current Liabilities

$89,000 $61,000

1.46
This tells you the relationship of
current assets to current liabilities.
A ratio of 3:1 is better than 2:1. A
1:1 ratio means there is no working
capital.
Quick Ratio
(Acid Test
Ratio)
=



=


=

=
[(Cash + Temp. Investments +
Accounts Receivable) Current
Liabilities] : 1

[($2,100 + $100 + $10,000 +
$40,500) $61,000] : 1

[$52,700 $61,000] : 1

0.86 : 1
This ratio is similar to the current
ratio except that Inventory,
Supplies, and Prepaid Expenses
are excluded. This indicates the
relationship between the amount of
assets that can quickly be turned
into cash versus the amount of
current liabilities.

Four financial ratios relate balance sheet amounts for Accounts Receivable and Inventory to income
statement amounts. To illustrate these financial ratios we will use the following income statement
information:


Example Corporation
Income Statement
For the year ended December 31, 2010

Sales (all on credit) $500,000
Cost of Goods Sold 380,000

Gross Profit 120,000

Operating Expenses


Selling Expenses 35,000

Administrative Expenses 45,000

Total Operating Expenses 80,000

Operating Income 40,000

Interest Expense 12,000

Income before Taxes 28,000

Income Tax Expense 5,000

Net Income after Taxes $ 23,000


To learn more about the income statement, go to:
Explanation of Income Statement
Drills for Income Statement
Crossword Puzzle for Income Statement



Financial Ratio

How to Calculate It What It Tells You
Accounts
Receivable
Turnover
=



=


=
Net Credit Sales for the Year
Average Accounts
Receivable for the Year

$500,000 $42,000 (a computed
average)

11.90
The number of times per year that
the accounts receivables turn over.
Keep in mind that the result is
anaverage, since credit sales and
accounts receivable are likely to
fluctuate during the year. It is
important to use
the averagebalance of accounts
receivable during the year.
Days' Sales in
Accounts
Receivable
=


=

365 days in Year Accounts
Receivable Turnover in Year

365 days 11.90

The average number of days that it
took to collect the average amount
of accounts receivable during the
year. This statistic is only as good
as the Accounts Receivable
= 30.67 days Turnover figure.
Inventory
Turnover
=


=


=
Cost of Goods Sold for the Year
Average Inventory for the Year

$380,000 $30,000 (a computed
average)

12.67
The number of times per year that
Inventory turns over. Keep in mind
that the result is an average, since
sales and inventory levels are likely
to fluctuate during the year. Since
inventory is at cost (not sales
value), it is important to use the
Cost of Goods Sold. Also be sure
to use the average balance of
inventory during the year.
Days' Sales in
Inventory
=


=

=
365 days in Year Inventory
Turnover in Year

365 days 12.67

28.81
The average number of days that it
took to sell the average inventory
during the year. This statistic is
only as good as the Inventory
Turnover figure.

The next financial ratio involves the relationship between two amounts from the balance sheet: total
liabilities and total stockholders' equity:


Financial Ratio

How to Calculate It What It Tells You
Debt to Equity =


=

=
(Total liabilities Total
Stockholders' Equity) : 1

( $481,000 $289,000) : 1

1.66 : 1
The proportion of a company's
assets supplied by the company's
creditors versus the amount
supplied the owner or stockholders.
In this example the creditors have
supplied $1.66 for each $1.00
supplied by the stockholders.

General Discussion of Income Statement


The income statement has some limitations since it reflects accounting principles. For example, a
company's depreciation expense is based on the cost of the assets it has acquired and is using in its
business. The resulting depreciation expense may not be a good indicator of the economic value of the
asset being used up. To illustrate this point let's assume that a company's buildings and equipment have
been fully depreciated and therefore there will be no depreciation expense for those buildings and
equipment on its income statement. Is zero expense a good indicator of the cost of using those buildings
and equipment? Compare that situation to a company with new buildings and equipment where there will
be large amounts of depreciation expense.

The remainder of our explanation of financial ratios and financial statement analysis will use information
from the following income statement:


Example Corporation
Income Statement
For the year ended December 31, 2010

Sales (all on credit) $500,000
Cost of Goods Sold 380,000

Gross Profit 120,000

Operating Expenses


Selling Expenses 35,000

Administrative Expenses 45,000

Total Operating Expenses 80,000

Operating Income 40,000

Interest Expense 12,000

Income before Taxes 28,000

Income Tax Expense 5,000
Net Income after Taxes $ 23,000

Earnings per Share
(based on 100,000 shares outstanding)
$ 0.23


To learn more about the income statement, go to:
Explanation of Income Statement
Drills for Income Statement
Crossword Puzzle for Income Statement

CommonSize Income Statement
Financial statement analysis includes a technique known as vertical analysis. Vertical analysis results in
common-size financial statements. A common-size income statement presents all of the income
statement amounts as a percentage of net sales. Below is Example Corporation's common-size income
statement after each item from the income statement above was divided by the net sales of $500,000:


Example Corporation
Income Statement
For the year ended December 31, 2010

Sales (all on credit) 100.0%
Cost of Goods Sold 76.0%

Gross Profit 24.0%

Operating Expenses


Selling Expenses 7.0%

Administrative Expenses 9.0%

Total Operating Expenses 16.0%

Operating Income 8.0%

Interest Expense 2.4%

Income before Taxes 5.6%

Income Tax Expense 1.0%
Net Income after Taxes 4.6%


The percentages shown for Example Corporation can be compared to other companies and to the
industry averages. Industry averages can be obtained from trade associations, bankers, and library
reference desks. If a company competes with a company whose stock is publicly traded, another source
of information is that company's "Management's Discussion and Analysis of Financial Condition and
Results of Operations" contained in its annual report to the Securities and Exchange Commission (SEC).
This annual report is the SEC Form 10-K and is usually accessible under the "Investor Relations" tab on
the corporation's website.

Financial Ratios Based on the Income Statement


Financial Ratio

How to Calculate It What It Tells You
Gross Margin =

=

=
Gross Profit Net Sales

$120,000 $500,000

24.0%
Indicates the percentage of sales
dollars available for expenses and
profit after the cost of merchandise
is deducted from sales. The gross
margin varies between industries
and often varies between
companies within the same
industry.
Profit Margin
(after tax)
=

=

=
Net Income after Tax Net Sales

$23,000 $500,000

4.6%
Tells you the profit per sales dollar
after all expenses are deducted
from sales. This margin will vary
between industries as well as
between companies in the same
industry.
Earnings Per
Share (EPS)
=



=

=
Net Income after Tax Weighted
Average Number of Common
Shares Outstanding

$23,000 100,000

$0.23
Expresses the corporation's net
income after taxes on a per share
of common stock basis. The
computation requires the deduction
of preferred dividends from the net
income if a corporation has
preferred stock. Also requires the
weighted average number of
shares of common stock during the
period of the net income.
Times Interest
Earned
=

Earnings for the Year before
Interest and Income Tax Expense
Indicates a company's ability to
meet the interest payments on its


=

=
Interest Expense for the Year

$40,000 $12,000

3.3
debt. In the example the company
is earning 3.3 times the amount it
is required to pay its lenders for
interest.
Return on
Stockholders'
Equity (after
tax)
=



=


=
Net Income for the Year after Taxes
Average Stockholders' Equity
during the Year

$23,000 $278,000 (a computed
average)

8.3%
Reveals the percentage of profit
after income taxes that the
corporation earned on its average
common stockholders' balances
during the year. If a corporation
has preferred stock, the preferred
dividends must be deducted from
the net income.

Statement of Cash Flows


The income statement has some limitations since it reflects accounting principles. For example, a
company's depreciation expense is based on the cost of the assets it has acquired and is using in its
business. The resulting depreciation expense may not be a good indicator of the economic value of the
asset being used up. To illustrate this point let's assume that a company's buildings and equipment have
been fully depreciated and therefore there will be no depreciation expense for those buildings and
equipment on its income statement. Is zero expense a good indicator of the cost of using those buildings
and equipment? Compare that situation to a company with new buildings and equipment where there will
be large amounts of depreciation expense.

The statement of cash flows is a relatively new financial statement in comparison to the income statement
or the balance sheet. This may explain why there are not as many well-established financial ratios
associated with the statement of cash flows.

We will use the following cash flow statement for Example Corporation to illustrate a limited financial
statement analysis:


Example Corporation
Statement of Cash Flows
For the Year Ended December 31, 2010
Cash Flow from Operating Activities:


Net Income $23,000


Add: Depreciation Expense 4,000


Increase in Accounts Receivable (6,000)


Decrease in Inventory 9,000


Decrease in Accounts Payable (5,000)


Cash Provided (Used) in Operating Activities 25,000


Cash Flow from Investing Activities


Capital Expenditures (28,000)


Proceeds from Sale of Property 7,000


Cash Provided (Used) by Investing Activities (21,000)


Cash Flow from Financing Activities:


Borrowings of Long-term Debt 10,000


Cash Dividends (5,000)


Purchase of Treasury Stock (8,000)


Cash Provided (Used) by Financing Activities (3,000)


Net Increase in Cash 1,000

Cash at the beginning of the year 1,200

Cash at the end of the year $ 2,200





Financial Ratio

How to Calculate It What It Tells You
= Free Cash Cash Flow Provided by Operating This statistic tells you how much
Flow

=

=
Activities Capital Expenditures

$25,000 $28,000

( $3,000)
cash is left over from operations
after a company pays for its capital
expenditures (additions to property,
plant and equipment). There can be
variations of this calculation. For
example, some would only deduct
capital expenditures to keep the
present level of capacity. Others
would also deduct dividends that
are paid to stockholders, since they
are assumed to be a requirement.

The cash flow from operating activities section of the statement of cash flows is also used by some
analysts to assess the quality of a company's earnings. For a company's earnings to be of "quality" the
amount of cash flow from operating activities must be consistently greater than the company's net
income. The reason is that under accrual accounting, various estimates and assumptions are made
regarding both revenues and expenses. When it comes to cash, however, the money is either in the bank
or it isn't.

Bank Reconciliation

Introduction to Bank Reconciliation
We also have Quizzes, Crosswords, and Q&A for the topic
A company's
Bank Reconciliation.

general ledger account Cash contains a record of the transactions (checks written,
receipts from customers, etc.) that involve its checking account. The bank also creates a record of the
company's checking account when it processes the company's checks, deposits, service charges, and
other items. Soon after each month ends the bank usually mails a bank statement to the company. The
bank statement lists the activity in the bank account during the recent month as well as the balance in the
bank account.

When the company receives its bank statement, the company should verify that the amounts on the bank
statement are consistent or compatible with the amounts in the company's Cash account in its general
ledger and vice versa. This process of confirming the amounts is referred to as reconciling the bank
statement, bank statement reconciliation, bank reconciliation, or doing a "bank rec."
Because most companies write hundreds of checks each month and make many deposits, reconciling the
amounts on the company's books with the amounts on the bank statement can be time consuming. The
process is complicated because some items appear in the company's Cash account in one month, but
appear on the bank statement in a different month. For example, checks written near the end of August
are deducted immediately on the company's books, but those checks will likely
The benefit of
reconciling the bank statement is knowing that the amount of Cash reported by the company (company's
books) is consistent with the amount of cash shown in the bank's records.

clear
After you adjust the
the bank account in
early September. Sometimes the bank decreases the company's bank account without informing the
company of the amount. For example, a bank service charge might be deducted on the bank statement
on August 31, but the company will not learn of the amount until the company receives the bank
statement in early September. From these two examples, you can understand why there will likely be a
difference in thebalance on the bank statement vs. the balance in the Cash account on the company's
books. It is also possible (perhaps likely) that neither balance is the true balance. Both balances may
need adjustment in order to report the true amount of cash.

balance per bank to be the true balance and after you adjust the balance per
booksto also be the same true balance, you have reconciled the bank statement. Most accountants
would simply say that you have done the bank reconciliation or the bank rec.

Bank Reconciliation Process
Step 1. Adjusting the Balance per Bank
We will demonstrate the bank reconciliation process in several steps. The first step is to adjust
the balance on the bank statement to the true, adjusted, or corrected balance. The items necessary for
this step are listed in the following schedule:

Step 1. Balance per Bank Statement on Aug. 31, 2010

Adjustments:

Add: Deposits in transit

Deduct: Outstanding checks

Add or Deduct: Bank errors

Adjusted/Corrected Balance per Bank

Deposits in transit are amounts already received and recorded by the company, but are not yet
recorded by the bank. For example, a retail store deposits its cash receipts of August 31 into the bank's
night depository at 10:00 p.m. on August 31. The bank will process this deposit on the morning of
September 1. As of August 31 (the bank statement date) this is a deposit in transit.

Because deposits in transit are already included in the company's Cash account, there is no need to
adjust the company's records. However, deposits in transit are not yet on the bank statement. Therefore,
they need to be listed on the bank reconciliation as an increase to the balance per bank
A helpful rule of thumb is "put it where it isn't." A deposit in transit is on the company's books, but
it isn't on the bank statement. Put it where it isn't: as an
in order to report
the true amount of cash.



adjustment to the balance on the bank
statement.
Outstanding checks are checks that have been written and recorded in the company's Cash account,
but have not yet cleared the bank account. Checks written during the last few days of the month plus a
few older checks are likely to be among the outstanding checks.

Because all checks that have been written are immediately recorded in the company's Cash account,
there is no need to adjust the company's records for the outstanding checks. However, the outstanding
checks have not yet reached the bank and the bank statement. Therefore, outstanding checks are listed
on the bank reconciliation as a
Recall the helpful tip "put it where it isn't." An outstanding check is on the company's books, but it
isn't on the bank statement. Put it where it isn't: as an adjustment to the balance on the bank
statement.
decrease in the balance per bank.


Bank errors are mistakes made by the bank. Bank errors could include the bank recording an incorrect
amount, entering an amount that does not belong on a company's bank statement, or omitting an amount
from a company's bank statement. The company should notify the bank of its errors. Depending on the
error, the correction could increase or decrease the balance shown on the bank statement. (Since the
company did not make the error, the company's records are not changed.)

Step 2. Adjusting the Balance per Books
The second step of the bank reconciliation is to adjust the balance in the company's Cash account so that
it is the true, adjusted, or corrected balance. Examples of the items involved are shown in the following
schedule:

Step 2. Balance per Books on Aug. 31, 2010

Adjustments:

Deduct: Bank service charges

Deduct: NSF checks & fees

Deduct: Check printing charges

Add: Interest earned

Add: Notes Receivable collected by bank

Add or Deduct: Errors in company's Cash account

Adjusted/Corrected Balance per Books

Bank service charges are fees deducted from the bank statement for the bank's processing of the
checking account activity (accepting deposits, posting checks, mailing the bank statement, etc.) Other
types of bank service charges include the fee charged when a company overdraws its checking account
and the bank fee for processing a stop payment order on a company's check. The bank might deduct
these charges or fees on the bank statement without notifying the company. When that occurs the
company usually learns of the amounts only after receiving its bank statement.

Because the bank service charges have already been deducted on the bank statement, there is no
adjustment to the balance per bank. However, the service charges will have to be entered as an
adjustment to the company's books. The company's Cash account will need to be decreased by the
amount of the service charges.

Recall the helpful tip "put it where it isn't." A bank service charge is already listed on the bank
statement, but it isn't on the company's books. Put it where it isn't: as an adjustment to the Cash
account on the company's books.

An NSF check is a check that was not honored by the bank of the person or company writing the check
because that account did not have a sufficient balance. As a result, the check is returned without being
honored or paid. (NSF is the acronym for not sufficient funds. Often the bank describes the returned
checkas a return item. Others refer to the NSF check as a "rubber check" because the check "bounced"
back from the bank on which it was written.) When the NSF check comes back to the bank in which it was
deposited, the bank will decrease the checking account of the company that had deposited the check.
The amount charged will be the amount of the check plus a bank fee.

Because the NSF check and the related bank fee have already been deducted on the bank statement,
there is no need to adjust the balance per the bank. However, if the company has not yet decreased its
Cash account balance for the returned check and the bank fee, the company must decrease the balance
per books in order to reconcile.

Check printing charges
Recall the general rule, "put it where it isn't." A check printing charge is on the bank statement,
but it isn't on the company's books. Put it where it isn't: as an adjustment to the Cash account on
the company's books.
occur when a company arranges for its bank to handle the reordering of its
checks. The cost of the printed checks will automatically be deducted from the company's checking
account.

Because the check printing charges have already been deducted on the bank statement, there is no
adjustment to the balance per bank. However, the check printing charges need to be an adjustment on
the company's books. They will be a deduction to the company's Cash account.


Interest earned
Recall "put it where it isn't." Interest received from the bank is on the bank statement, but it isn't
on the company's books. Put it where it isn't: as an adjustment to the Cash account on the
company's books.
will appear on the bank statement when a bank gives a company interest on its account
balances. The amount is added to the checking account balance and is automatically on the bank
statement. Hence there is no need to adjust the balance per the bank statement. However, the amount of
interest earned will increase the balance in the company's Cash account on its books.


Notes Receivable are assets of a company. When notes come due, the company might ask its bank to
collect the notes receivable. For this service the bank will charge a fee. The bank will increase the
company's checking account for the amount it collected (principal and interest) and will decrease the
account by the collection fee it charges.Since these amounts are already on the bank statement, the
company must be certain that the amounts appear on the company's books in its Cash account.

Recall the tip "put it where it isn't." The amounts collected by the bank and the bank's fees are on
the bank statement, but they are not on the company's books. Put them where they aren't: as
adjustments to the Cash account on the company's books.

Errors in the company's Cash account result from the company entering an incorrect amount, entering a
transaction that does not belong in the account, or omitting a transaction that should be in the account.
Since the company made these errors, the correction of the error will be either an increase or a decrease
to the balance in the Cash account on the company's books.

Step 3. Comparing the Adjusted Balances
After adjusting the balance per bank (Step 1) and after adjusting the balance per books (Step 2), the two
adjusted amounts should be equal. If they are not equal, you must repeat the process until the balances
are identical. The balances should be the true, correct amount of cash as of the date of the bank
reconciliation.

Step 4. Preparing Journal Entries
Journal entries must be prepared for the adjustments to the balance per books
Sample Bank Reconciliation
(Step 2). Adjustments to
increase the cash balance will require a journal entry that debits Cash and credits another account.
Adjustments to decrease the cash balance will require a credit to Cash and a debit to another account.



With Amounts
Item #1.

In this part we will provide you with a sample bank reconciliation including the required journal entries. We
will assume that a company has the following items:

The bank statement for August 2010 shows an ending balance of $3,490.

Item #2.
On August 31 the bank statement shows charges of $35 for the service charge for maintaining
the checking account.

Item #3.
On August 28 the bank statement shows a return item of $100 plus a related bank fee of $10.
The return item is a customer's check that was returned because of insufficient funds. The
check was also marked "do not redeposit.

Item #4.
The bank statement shows a charge of $80 for check printing on August 20.

Item #5.
The bank statement shows that $8 was added to the checking account on August 31 for
interest earned by the company during the month of August.

Item #6.
The bank statement shows that a note receivable of $1,000 was collected by the bank on
August 29 and was deposited into the company's account. On the same day, the bank
withdrew $40 from the company's account as a fee for collecting the note receivable.

Item #7.
The company's Cash
Item #8.
account at the end of August shows a balance of $967.

During the month of August the company wrote checks totaling more than $50,000. As of
August 31 $3,021 of the checks written in August had not yet cleared
Item #9.
the bank and $200 of
checks written in June had not yet cleared the bank.

The $1,450 of cash received by the company on August 31 was recorded on the company's
books as of August 31. However, the $1,450 of cash receipts was deposited at the bank on the
morning of September 1.

Item #10.
On August 29 the company's Cash account shows cash sales of $145. The bank statement
shows the amount deposited was actually $154. The company reviewed the transactions and
found that $154 was the correct amount.


Before we begin our sample bank reconciliation, learn the following bank reconciliation tip.


Put it where it isn't.
If an item appears on the bank statement but not on the company's books, the item is probably going to
be an adjustment to the Cash balance on (per) the company's books.

If an item is already in the company's Cash account, but has not yet appeared on the bank statement, the
item is probably an adjustment to the balance per the bank statement.

Our approach to the bank reconciliation is to prepare two schedules. The first schedule begins with the
ending balance on the bank statement. We refer to this schedule as Step 1. The second schedule begins
with the ending Cash account balance in the general ledger. We call this schedule Step 2.

Items 1 through 10 above have been sorted into the following schedules labeled Step 1and Step 2. The
item number is shown in the far right column of each schedule.

Step 1. Balance per Bank Statement on Aug. 31, 2010 $ 3,490 Item #1

Adjustments: 0


Deposits in transit + 1,450 Item #9

Outstanding checks 3,221 Item #8

Bank errors 0


Adjusted/Corrected Balance per Bank $ 1,719


Step 2. Balance per Books on Aug. 31, 2010 $ 967 Item #7

Adjustments:


Bank service charges 35 Item #2

NSF checks & fees 110 Item #3

Check printing charges 80 Item #4

Interest earned + 8 Item #5

Note Receivable collected by bank + 960 Item #6

Errors in company's Cash account + 9 Item #10

Adjusted/Corrected Balance per Books $ 1,719


Step 1 Amounts
Let's review the schedule for Step 1. In all likelihood the balance shown on the bank statement is not the
true balance to be reported on the company's balance sheet. The bank reconciliation process is to list
the items that will adjust the bank statement balance to become the true cash balance. As the schedule
for Step 1 indicates, the amount of deposits in transit must be added to the bank statement's balance.
Also, the amount of checks that have been written, but not yet appearing on a bank statement, must
besubtracted from the bank statement's balance. Next any bank errors should be listed and should be
reported to the bank for correction. (The company does not report deposits in transit and/or outstanding
checks to the bank.)


Date


Step 2 Amounts and Required Journal Entries
Step 2 begins with the balance in the company's Cash account found in its general ledger. The bank
reconciliation process includes listing the items that will adjust the Cash account balance to become the
true cash balance. We will review each item appearing in Step 2 and the related journal entry that is
required. Remember that any adjustment to the company's Cash account requires a journal entry.
Generally, the adjustments to the books are the result of items found on the bank statement but have not
yet been entered in the company's Cash account.

Item #2 Bank service charges. Since the bank deducted $35 from the company's checking account, but
the company has not yet deducted this from its Cash account, the following journal entry needs to be
made.

Account Name Debit Credit

August 31, 2010 Bank Service Charge Expense 35


Cash

35
(If the annual amount of service charges is small, debit Miscellaneous Expense.)

Item #3 NSF checks and fees. Since the bank deducted these legitimate amounts from the company's
bank account, the company will need to deduct these amounts from its Cash account. As mentioned, the
NSF check of $100 was from a customer. Therefore, the company will likely undo the reduction to
Accounts Receivable that took place when the company originally processed the $100 check. If the
company wishes to recover the bank fee of $10 from the customer, it should add the $10 fee to the
amount that the customer owes the company. The journal entry might look like this:

Date Account Name Debit Credit

August 28, 2010 Accounts Receivable 110


Cash

110
(If the amount cannot be recovered from the customer, charge an expense.)

Item #4 Check printing charges. Because this expense is not yet entered on the company's books, but
the amount has been deducted from its bank account, the company will make the following journal entry.

Date Account Name Debit Credit

August 20, 2010 Supplies 80


Cash

80


Item #5 Interest earned. The bank increased the checking account balance by $8 on August 31. Since
the bank did not notify the company previously, the company must now increase the balance in its Cash
account.

Date Account Name Debit Credit

August 31, 2010 Cash 8


Interest Revenue

8


Item #6 Notes receivable collected. The bank increased the company's checking account when it
collected a note for the company on August 29. It was determined that the company had not yet made an
entry to its Cash account for this transaction. As a result the following journal entry is needed.

Date Account Name Debit Credit

August 29, 2010 Cash 960


Bank Service Charge Expense 40


Notes Receivable

1,000


Item #10 Company error. The company had entered $145 in its Cash account on August 29, but the
bank statement showed the correct amount: $154. The transaction involved the cash sales for the day. As
a result the company's Cash account will have to be increased by $9 as follows:

Date Account Name Debit Credit

August 29, 2010 Cash 9


Sales

9


Step 3 Comparing the Adjusted Balances
In the above schedules the adjusted balance for Step 1 is $1,719 and the adjusted balance for Step 2 is
$1,719. The company believes that all items involving cash have been included in the schedules. As a
result the company has successfully completed its bank reconciliation as of the August 31, 2010.

Accounts Receivable and Bad Debts Expense

Introduction to Accounts Receivable and Bad Debts Expense
We also have Quizzes, Crosswords, and Q&A for the topic Accounts Receivable and Bad Debts
Expense.

If 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 transactionwe
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
1. Increase sales or sales revenues, which are reported on the income statement, and
on
creditwill:
2. Increase the amount due from customers, which is reported as accounts receivablean 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
Recording Services Provided on Credit
direct write-off method.

Assume 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
serviceson 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:

Date Account Name Debit Credit

June 3 Accounts Receivable 4,000


Service Revenues

4,000

In this transaction, the debit to Accounts Receivable increases Malloy's current assets, total assets,
working capital, and stockholders' (or owner's) equityall of which are reported on its balance sheet. The
credit to Service Revenues will increase Malloy's revenues and net incomeboth of which are reported
on its income statement.

Recording Sales of Goods on Credit
When a company sells goods on credit, it reports the transaction on both its income statement and its
balance sheet. On the income statement, increases are reported in sales revenues, cost of goods sold,
and (possibly) expenses. On the balance sheet, an increase is reported in accounts receivable, a
decrease is reported in inventory, and a change is reported in stockholders' equity for the amount of the
net income earned on the sale.

If the sale is made with the terms FOB Shipping Point, the ownership of the goods is transferred at
theseller's dock. If the sale is made with the terms FOB Destination, the ownership of the goods is
transferred at the

buyer's dock.

In principle, the seller should record the sales transaction when the ownership of the goods is transferred
to the buyer. Practically speaking, however, accountants typically record the transaction at the time the
sales invoice is prepared and the goods are shipped.


FOB Shipping Point
Quality Products Co. just sold and shipped $1,000 worth of goods using the terms FOB Shipping Point.
With its cost of goods at 80% of sales value, Quality makes the following entries in its general ledger:

Account Name Debit Credit


Accounts Receivable 1,000


Sales

1,000


Cost of Goods Sold 800


Inventory

800

(While there may be additional expenses with this transactionsuch as commission expensewe are
not considering them in our example.)

FOB Shipping Point means the ownership of the goods is transferred to the buyer at the seller's dock.
This means that the buyer is responsible for transporting the goods from Quality Product's shipping dock.
Therefore, all shipping costs (as well as any damage that might be incurred during transit) are the
responsibility of the buyer


FOB Destination
FOB Destination means the ownership of the goods is transferred at the buyer's dock. This means
the

selleris responsible for transporting the goods to the customer's dock, and will factor in the cost of
shipping when it sets its price for the goods.

Let's assume that Gem Merchandise Co. makes a sale to a customer that has a sales value of $1,050
and a cost of goods sold at $800. This transaction affects the following accounts in Gem's general ledger:

Account Name Debit Credit


Accounts Receivable 1,050


Sales

1,050


Cost of Goods Sold 800


Inventory

800

Because Gem chooses to ship its goods FOB Destination, the ownership of the goods transfers at
thebuyer's dock. Therefore, Gem Merchandise assumes all the risks and costs associated with
transporting the goods.

Now let's assume that Gem pays an independent shipping company $50 to transport the goods from its
warehouse to the buyer's dock. Gem records the $50 as an operating expense or selling expense (in an
account such as Delivery Expense, Freight-Out Expense, or Transportation-Out Expense). If the
shipping company allows Gem to pay in 7 days, Gem will make the following entry in its general ledger:


Account Name Debit Credit


Freight-Out Expense 50


Accounts Payable

50





Credit Terms with Discounts
When a seller offers credit terms of net 30 days, the net amount for the sales transaction is due 30 days
after the sales invoice date.

To illustrate the meaning of net, assume that Gem Merchandise Co. sells $1,000 of goods to a customer.
Upon receiving the goods the customer finds that $100 of the goods are not acceptable. The customer
contacts Gem and is instructed to return the unacceptable goods. This means that Gem's net sale ends
up being $900; the customer's net purchase will also be $900 ($1,000 minus the $100 returned). It also
means that Gem's net receivable from this customer will be $900.

Unfortunately, companies who sell on credit often find that they don't receive payments from customers
on time. In fact, one study found that if the credit term is net 30 days, the money, on average, arrived 45
days after the invoice date. In order to speed up these payments, some companies give credit terms that
offer a discount to those customers who pay within a shorter period of time. The discount is referred to as
a sales discount or cash discount, and the shorter period of time is known as the discount period. For
example, the term 2/10, net 30 allows a customer to deduct 2% of the net amount owed if the customer
pays within 10 days of the invoice date. If a customer does not pay within the discount period of 10 days,
the net purchase amount (without the discount) is due 30 days after the invoice date.

Using the example from above, let's illustrate how the credit term of 2/10, net 30 works. Gem
Merchandise Co. ships $1,000 of goods and the customer returns $100 of unacceptable goods to Gem
within a few days. At that point, the net amount owed by the customer is $900. If the customer pays Gem
within 10 days of the invoice date, the customer is allowed to deduct $18 (2% of $900) from the net
purchase of $900. In other words, the $900 amount can be settled for $882 if it is paid within the 10-day
discount period.

Let's assume that the sale above took place on the first day that Gem was open for business, June 1. On
June 6 Gem receives the returned goods and restocks them, and on June 11 it receives $882 from the
buyer. Gem's cost of goods is 80% of their original selling prices (before discounts). The above
transactions are reflected in Gem's general ledger as follows:

Date Account Name Debit Credit

June 1 Accounts Receivable 1,000


Sales

1,000

June 1 Cost of Goods Sold 800 (80% of 1,000)


Inventory

800

June 6 Sales Returns and Allowances 100


Accounts Receivable

100

June 6 Inventory 80


Cost of Goods Sold

80

June 11 Cash 882


Sales Discounts 18 (2% of 900)


Accounts Receivable

900


If the customer waits 30 days to pay Gem, the June 11 entry shown above will not occur. In its place will
be the following entry on July 1:

Date Account Name Debit Credit

July 1 Cash 900


Accounts Receivable

900



Examples of Amounts Due Under Varying Credit Terms
The following chart shows the amounts a seller would receive under various credit terms for a
merchandise sale of $1,000 and an authorized return of $100 of goods.

Credit
Terms Brief Description
Amount To
be Received
Net 10 days The net amount is due within 10 days of the invoice date. $900
Net 30 days The net amount is due within 30 days of the invoice date. $900
Net 60 days The net amount is due within 60 days of the invoice date. $900
2/10, n/30
If paid within 10 days of the invoice date, the buyer may deduct
2% from the net amount. ($900 minus $18)
$882
2/10, n/30 If paid in 30 days of the invoice date, the net amount is due. $900
1/10, n/60
If paid within 10 days of the invoice date, the buyer may deduct
1% from the net amount. ($900 minus $9)
$891
1/10, n/60 If paid in 60 days of the invoice date, the net amount is due. $900
Net EOM 10
The net amount is due within 10 days after the end of the month
(EOM). In other words, payment for any sale made in June is
due by July 10.
$900


Costs of Discounts
Some business people believe that the credit term of 2/10, net 30 is far too generous. They argue that
when a $900 receivable is settled for $882 (simply because the customer pays 20 days early) the seller
is, in effect, giving the buyer the equivalent of a 36% annual interest rate (2% for 20 days equates to 36%
for 360 days). Some sellers won't offer terms such as 2/10, net 30 because of these high percentage
equivalents. Other sellers are discouraged to find that some customers take the discount and ignore the
obligation to pay within the stated discount period.

Credit Risk
When a seller provides goods or services on credit, the resultant account receivable is normally
considered to be an unsecured claim against the buyer's assets. This makes the seller (the supplier)
an unsecured creditor, meaning it does not have a lien on any of the buyer's assetsnot even on the
goods that it just sold to the buyer.

Sometimes a supplier's customer gets into financial difficulty and is forced to liquidate its assets. In this
situation the customer typically owes money to lending institutions as well as to its suppliers of goods and
services. In such cases, it's the secured creditors (the banks and other lenders that have a lien on specific
assets such as cash, receivables, inventory, equipment, etc.) who are paid first from the sale of the
assets. Often there is not enough money to pay what is owed to the secured lenders, much less the
unsecured creditors. In other words, the suppliers will never be paid what they are owed.

To avoid this kind of risk, some suppliers may decide not to sell anything on credit, but require instead
that all of its goods be paid for with cash or a credit card. Such a company, however, may lose out on
sales to competitors who offer to sell on credit.

To minimize losses, sellers typically perform a thorough credit check on any new customer before selling
to them on credit. They obtain credit reports and check furnished references. Even when a credit check is
favorable, however, a credit loss can still occur. For example, a first-rate customer may experience an
unexpected financial hardship caused by one of its customers, something that could not have been
known when the credit check was done. The point is this: any company that sells on credit to a large
number of customers should assume that, sooner or later, it will probably experience some credit losses
along the way.

Allowance Method for Reporting Credit Losses

Accounts receivable are reported as a current asset on a company's balance sheet. Since current assets
by definition are expected to turn to cash within one year (or within the operating cycle, whichever is
longer), a company's balance sheet could overstate its accounts receivable (and therefore its working
capital and stockholders' equity) if any part of its accounts receivable is not collectible.

To guard against overstatement, a company will estimate how much of its accounts receivable will never
be collected. This estimate is reported in a balance sheet contra asset account called Allowance for
Doubtful Accounts. (Some companies call this account Provision for Doubtful Accounts or Allowance for
Uncollectible Accounts.) Any increases to Allowance for Doubtful Accounts are also recorded in the
income statement account Bad Debts Expense (or Uncollectible Accounts Expense).

This method of anticipating the uncollectible amount of receivables and recording it in the Allowance for
Doubtful Accounts is known as the allowance method. (If a company does not use an allowance account,
it is following the direct write-off method, which is discussed later.)


Allowance for Doubtful Accounts and Bad Debts Expense - June
As we stated above, the account Allowance for Doubtful Accounts is a contra asset account containing
the estimated amount of the accounts receivable that will not be collected. For example, let's assume that
Gem Merchandise Co.'s Accounts Receivable has a debit balance of $100,000 at June 30. Gem
anticipates that approximately $2,000 of this is not likely to turn to cash, and as a result, Gem reports
a credit balance
Date
of $2,000 in Allowance for Doubtful Accounts. The accounting entry to adjust the balance
in the allowance account will involve the income statement account Bad Debts Expense.

Since June was Gem's first month in business, its Allowance for Doubtful Accounts began June with a
zero balance. At June 30, when it issues its first balance sheet and income statement, its Allowance for
Doubtful Accounts will have a credit balance of $2,000. This is done using the following adjusting journal
entry:

Account Name Debit Credit

June 30 Bad Debts Expense 2,000


Allowance for Doubtful Accounts

2,000


Here are some of the accounts in a T-account format:

Accounts Receivable

Allowance for Doubtful Accounts
June 1 Balance

June 1 Balance

June Sales 105,000 5,000
June
Collections

2,000
June 30
Adjust
June 30
Balance
100,000

2,000
June 30
Balance




Bad Debts Expense

June 1 Balance



June 30 Adjust 2,000


June 30 Balance 2,000



With Allowance for Doubtful Accounts now reporting a credit balance of $2,000 and Accounts Receivable
reporting a debit balance of $100,000, Gem's balance sheet will report a net amount of $98,000. Since
this net amount of $98,000 is the amount that is likely to turn to cash, it is referred to as the net realizable
value of the accounts receivable.

Under the allowance method, the Gem Merchandise Co. does not need to know specifically which
customer will not pay, nor does it need to know the exact amount. This is acceptable because
accountants believe it is better to report an approximate amount that is uncollectible rather than imply that
every penny of the accounts receivable will be collected.

Gem's Bad Debts Expense will report credit losses of $2,000 on its June income statement. This expense
is being reported even though none of the accounts receivables were due in June. (Recall the credit
terms werenet 30 days.) Gem is attempting to follow the matching principle by matching the bad debts
expense as best it can to the accounting period in which the credit sales took place.


Since the net realizable value of a company's accounts receivable cannot be more than the debit balance
in Accounts Receivable, the balance in the Allowance for Doubtful Accounts must be a credit balance or a
zero balance.


Allowance for Doubtful Accounts and Bad Debts Expense - July
Now let's assume that at July 31 the Gem Merchandise Co. has a debit balance in Accounts Receivable
of $230,000. (The balance increased during July by the amount of its credit sales and it decreased by the
amount it collected from customers.) The Allowance for Uncollectible Accounts still has the credit balance
of $2,000 from the adjustment on June 30. This means Gem's general ledger accounts before
Gem reviews the details of its accounts receivable and estimates that as of July 31 approximately
$10,000 of the $230,000 will not be collectible. In other words, the net realizable value (or net cash value)
of its accounts receivable as of July 31 is only $220,000 ($230,000 minus $10,000). Before the July 31
financial statements are released, Gem must adjust the Allowance for Doubtful Accounts so that its
the July 31
adjustment to Allowance for Uncollectible Accounts will be reporting a net realizable value of $228,000
($230,000 minus $2,000).

ending balance is a credit of $10,000 (instead of the present credit balance of $2,000). This requires the
following adjusting entry:

Date Account Name Debit Credit

July 31 Bad Debts Expense 8,000


Allowance for Doubtful Accounts

8,000

After this journal entry is recorded, Gem's July 31 balance sheet will report the net realizable value of its
accounts receivables at $220,000 ($230,000 debit balance in Accounts Receivable minus the $10,000
credit balance in Allowance for Doubtful Accounts).

Here's a recap in T-account form:

Accounts Receivable

Allowance for Doubtful Accounts
June 1 Balance

June 1 Balance

June Sales 105,000 5,000
June
Collections

2,000
June 30
Adjust
June 30
Balance
100,000

2,000
June 30
Balance

July Sales 225,000 95,000 July Collections

8,000 July 31 Adjust
July 31
Balance
230,000

10,000
July 31
Balance




Bad Debts Expense

June 1 Balance



June 30 Adjust 2,000


June 30 Balance 2,000



July 31 Adjust 8,000


July 31 Balance 10,000


As seen in the T-accounts above, Gem estimated that the total bad debts expense for the first two
months of operations (June and July) is $10,000. It is likely that as of July 31 Gem will not know
the precise amount of actual bad debts, nor will Gem know which customers are the ones that won't be
paying their account balances. However, the matching principle
By reporting the $10,000 credit balance in Allowance for Doubtful Accounts, Gem is also adhering to the
accounting principle of
is better met by Gem making these
estimates and recording the credit loss as close as possible to the time the sales were made.

conservatism. In other words, if there is some doubt as to whether there are
$10,000 of credit losses or no credit losses, Gem's accountant "breaks the tie" by choosing the alternative
that reports a smaller amount of profit and a smaller amount of assets. (It is reporting a net realizable
value of $220,000 instead of the $230,000 of accounts receivable.) If a company knows with certainty

that
every penny of its accounts receivable will be collected, then the Allowance for Doubtful Accounts will
report a zero balance. However, if it is likely that some of the accounts receivable will not be collected in
full, the principle of conservatism requires that there be a credit balance in Allowance for Doubtful
Accounts.
Writing Off an Account under the Allowance Method
Under the allowance method, if a specific customer's accounts receivable is identified as uncollectible, it
is written off by removing the amount from Accounts Receivable. The entry to write off a bad account
affects only balance sheet accounts: a debit to Allowance for Doubtful Accounts and a credit to Accounts
Receivable. No expense or loss is reported on the income statement because this write-off is "covered"
under the earlier adjusting entries for estimated bad debts expense.

Let's illustrate the write-off with the following example. On June 3, a customer purchases $1,400 of goods
on credit from Gem Merchandise Co. On August 24, that same customer informs Gem Merchandise Co.
that it has filed for bankruptcy. The customer states that its bank has a lien on all of its assets. It also
states that the liquidation value of those assets is less than the amount it owes the bank, and as a result
Gem will receive nothing toward its $1,400 accounts receivable. After confirming this information, Gem
concludes that it should remove, or
Date
write off, the customer's account balance of $1,400.

Under the allowance method of recording credit losses, Gem's entry to write off the customer's account
balance is as follows:

Account Name Debit Credit

Aug 24 Allowance for Doubtful Accounts 1,400


Accounts Receivable

1,400


The two accounts affected by this entry contain this information:

Accounts Receivable

Allowance for Doubtful Accounts
June 1 Balance

June 1 Balance

June Sales 105,000 5,000
June
Collections

2,000 June 30 Adjust
June 30
Balance
100,000

2,000
June 30
Balance

July Sales 225,000 95,000 July Collections

8,000 July 31 Adjust
July 31
Balance
230,000

10,000
July 31
Balance

Aug Sales 204,000 194,000 Aug Collections

Aug 23
Balance
240,000

10,000
Aug 23
Balance


1,400 Aug 24 W-Off

Aug 24 W-Off 1,400

Aug 24
Balance
238,600

8,600
Aug 24
Balance


Note that prior to the August 24 entry of $1,400 to write off the uncollectible amount, the net realizable
value of the accounts receivables was $230,000 ($240,000 debit balance in Accounts Receivable and
$10,000 credit balance in Allowance for Doubtful Accounts). After writing off the bad account on August
24, the net realizable value of the accounts receivable is still $230,000 ($238,600 debit balance in
Accounts Receivable and $8,600 credit balance in Allowance for Doubtful Accounts).

The Bad Debts Expense remains at $10,000; it is not directly affected by the journal entry write-off. The
bad debts expense recorded on June 30 and July 31 had anticipated a credit loss such as this. It would
be double counting for Gem to record both an anticipated estimate of a credit loss and the actual credit
loss.




Recovery of Account under Allowance Method
After a seller has written off an accounts receivable, it is possible that the seller is paid part or all of the
account balance that was written off. Under the allowance method, if such a payment is received
(whether directly from the customer or as a result of a court action) the seller will take the following two
steps:

1. Reinstate the account that was written off by reversing the write-off entry. If we assume that the
$1,400 written off on Aug 24 is collected on October 10, the reinstatement of the account looks
like this:

Date Account Name Debit Credit

Oct 10 Accounts Receivable 1,400


Allowance for Doubtful Accounts

1,400

2. Process the $1,400 received on October 10:

Date Account Name Debit Credit

Oct 10 Cash 1,400


Accounts Receivable

1,400

The seller's accounting records now show that the account receivable was paid, making it more likely that
the seller might do future business with this customer.


Bad Debts Expense as a Percent of Sales
Another way sellers apply the allowance method of recording bad debts expense is by using
the percentage of credit

sales approach. This approach automatically expenses a percentage of its credit
sales based on past history.
For example, let's assume that a company prepares weekly financial statements. Past experience
indicates that 0.3% of its sales on credit will never be collected. Using the percentage of credit sales
approach, this company automatically debits Bad Debts Expense and credits Allowance for Doubtful
Accounts for 0.3% of each week's credit sales. Let's assume that in the current week this company sells
$500,000 of goods on credit. It estimates its bad debts expense to be $1,500 (0.003 x $500,000) and
records the following journal entry:

Date Account Name Debit Credit

Oct 10 Bad Debts Expense 1,500


Allowance for Doubtful Accounts

1,500

The percentage of credit sales approach focuses on the income statement and the matching principle.
Sales revenues of $500,000 are immediately matched with $1,500 of bad debts expense. The balance in
the account Allowance for Doubtful Accounts is ignored at the time of the weekly entries. However, at
some later date, the balance in the allowance account must be reviewed and perhaps further adjusted, so
that the balance sheet will report the correct net realizable value. If the seller is a new company, it might
calculate its bad debts expense by using an industry average until it develops its own experience rate.

Difference between Expense and Allowance
The account Bad Debts Expense reports the credit losses that occur during the period of time covered by
the income statement. Bad Debts Expense is a temporary account on the income statement, meaning it is
closed at the end of each accounting year. (Closed means the account balance is transferred to retained
earnings, perhaps through an income summary account.) By closing Bad Debts Expense and resetting its
balance to zero, the account is ready to receive and tally the credit losses for the next accounting year.

The Allowance for Doubtful Accounts reports on the balance sheet the estimated amount of uncollectible
accounts that are included in Accounts Receivable. Balance sheet accounts are almost
always

permanentaccounts, meaning their balances carry forward to the next accounting period. In other
words, they are not closed and their balances are not reset to zero.

Because the Bad Debts Expense account is closed each year, while the Allowance for Doubtful Accounts
is not, these two balances will most likely not be equal after the company's first year of operations.

For example, let's assume that at the end of its first year of operations a company's Bad Debts Expense
had a debit balance of $14,000 and its Allowance for Doubtful Accounts had a credit balance of $14,000.
Because the income statement account balances are closed at the end of the year, the company's
opening balance in Bad Debts Expense for the second year of operations is $0. The credit balance of
$14,000 in Allowance for Doubtful Accounts, however, carries forward to the second year. If an adjusting
entry of $3,000 is made during year 2, Bad Debts Expense will report a $3,000 debit balance, while
Allowance for Doubtful Accounts might report a credit balance of $17,000.
Again, the reasons for the account balance differences are 1) Bad Debts Expense is a temporary account
that reports credit losses only for the period shown on the income statement, and 2) Allowance for
Doubtful Accounts is a permanent account that reports an estimated amount for all of the uncollectible
receivables reported in the asset Accounts Receivable as of the balance sheet date.

Aging of Accounts Receivable

Download our Aging of Accounts Receivable Form and Template

The general ledger account Accounts Receivable usually contains only summary amounts and is referred
to as a control account. The details for the control accounteach credit sale for every customeris
found in the subsidiary ledger for Accounts Receivable. The total amount of all the details in the
subsidiary ledger must be equal to the total amount reported in the control account.

The detailed information in the accounts receivable subsidiary ledger is used to prepare a report known
as the aging of accounts receivable. This report directs management's attention to accounts that are
slow to pay. It is also useful in determining the balance amount needed in the account Allowance for
Doubtful Accounts.

The aging of accounts receivable report is typically generated by sorting unpaid sales invoices in the
subsidiary ledgerfirst by customer and then by the date of the sales invoices. If a company sells
merchandise (or provides services) and allows customers to pay 30 days later, this report will
indicate how much of its accounts receivable is past due. It also reports how far past due the accounts
are.

With the click of a mouse, most accounting software will provide the aging of accounts receivable report.
For example, Gem Merchandise Co.'s software looks at each of its customer's accounts receivable
activity and compares the date of each unpaid sales invoice to the date of the report. If we assume the
report is dated August 31 and that Gem's credit terms are net 30 days, any unpaid sales invoices with an
August date will be classified as current. Any unpaid invoices with a date in July are classified as 1 - 30
days past due. Any unpaid invoices with a date of June are classified as 31 - 60 days past due, and so
on. The sorted information is present in a report that looks similar to the following:

Gem Merchandise Co.
Aging of Accounts Receivable
As of August 31, 2010

Customer
Name
Total
Receivable Current
Past Due
1 - 30 Days
Past Due
31 - 60 Days
Past Due
61+ Days
ABC Co. $ 62,456 $ 59,121 $3,335 $ $
Extreme Co. $ 18,210 $ $ $ $18,210
Main Corp. $ 48,954 $ 48,954 $ $ $
Trifect LLC $ 1,200 $ $ $1,200 $
Totals $130,820 $108,075 $3,335 $1,200 $18,210

If a customer realizes that one of its suppliers is lax about collecting its account receivable on time, it may
take advantage by further postponing payment in order to pay more demanding suppliers on time. This
puts the seller at risk since an older, unpaid accounts receivable is more likely to end up as a credit loss.
The aging of accounts receivable report helps management monitor and collect the accounts receivable
in a more timely manner.


Aging Used in Calculating the Allowance
The aging of accounts receivable can also be used to estimate the credit balance needed in a company's
Allowance for Doubtful Accounts. For example, based on past experience, a company might make the
assumption that accounts not past due have a 99% probability of being collected in full. Accounts that are
1-30 days past due have a 97% probability of being collected in full, and the accounts 31-60 days past
due have a 90% probability. The company estimates that accounts more than 60 days past due have only
a 60% chance of being collected. With these probabilities of collection, the probability of not collecting is
1%, 3%, 10%, and 40% respectively.

If we multiply the totals from the aging of accounts receivable report by the probabilities of not collecting,
we arrive at the expected amount of uncollectible receivables. This is illustrated below:

Gem Merchandise Co.
Expected Amount of Accounts Receivable That is Uncollectible
As of August 31, 2010

Age of Accounts Receivables
Accounts
Receivable
Amount
Probability of
Not
Collecting
Expected
Uncollectible
Amount
Current $108,075 1% $1,081
Past Due: 1 - 30 days $ 3,335 3% $ 100
Past Due: 31 - 60 days $ 1,200 10% $ 120
Past Due: 61+ days $ 18,210 40% $7,284
Totals

$130,820 $8,585

This computation estimates the balance needed for Allowance for Doubtful Accounts at August 31 to be a
credit balance of $8,585.


Mailing Statements to Customers
To improve the probability of collection (and avoid bad debts expense) many sellers prepare and mail
monthly statements to all customers that have accounts receivable balances. If worded skillfully, the seller
can use the statement to say "thank you for your continued business" while at the same time "reminding"
the customer that receivables are being monitored and payment is expected. To further prompt
customers to pay in a timely manner, the statement may indicate that past due accounts are assessed
interest at an annual rate of 18% (1.5% per month). Because transactions are usually itemized on the
statement, some customers use the statement as a means to compare its records with those of the seller.

Pledging or Selling Accounts Receivable
A company's accounts receivable are considered to be a type of asset, and as such can be pledged as
collateral for a loan. Asset-based lenders will often lend a company an amount equal to 80% of the value
of its accounts receivable.

Some companies sell their accounts receivable to a factor. A factor buys the accounts receivables at a
discount and then goes about the business of collecting and keeping the money owed through the
receivables. Sometimes the factor will purchase the accounts receivables with recourse. This means the
company that sold the receivables remains financially responsible if a customer does not remit the full
amount to the factor. When the factor purchases the receivables without recourse, the company selling
the receivables is not responsible for unpaid amounts.


Accounts Receivable Ratios
There are two commonly used financial ratios that address the relationship between the amount of a
company's accounts receivable as reported on the balance sheet and the amount of credit sales as
reported on the income statement. These ratios are:
1. Accounts receivable turnover ratio, and
2. Days sales in accounts receivable.

Use the following link to learn how to calculate these ratios: Financial Ratios.


Direct Write-off Method
Generally accepted accounting principles (GAAP) require that companies use the allowance method
when preparing financial statements. The use of the allowance method is not permitted, however, for
purposes of reporting income taxes in the United States because the Internal Revenue Service (IRS)
does not allow companies to anticipate these credit losses. As a result, companies must use the direct
write-off method for income tax reporting.

In the direct write-off method, a company will not use an allowance account to reduce its Accounts
Receivable. Accounts Receivable is only reduced if and when a company knows with certainty that
aspecific amount will not be collected from a
Date
specific customer.

For example, let's assume that on October 21, Gem Merchandise Co. is convinced that a specific
customer's account receivable originating on June 5 in the amount of $1,238 is definitely uncollectible.
Using the direct write-off method, the following entry is made:

Account Name Debit Credit

Oct. 21 Bad Debts Expense 1,238


Accounts Receivable

1,238

Usually many months will pass between the time of the sale on credit and the time that the seller knows
with certainty that a customer is not going to pay. It is difficult to adhere to the matching principle and the
concept of conservatism when a significant amount of time elapses between the time of the sales
revenues and the time that the bad debts expense is reported. This is why, for purposes of financial
reporting (not

taxreporting), companies should use the allowance method rather than the direct write-off
method.


Inventory and Cost of Goods Sold

Introduction to Inventory and Cost of Goods Sold
We also have Quizzes, Crosswords, and Q&A for the topic Inventory & Cost of Goods Sold.

Inventory 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
Because of the
inventory can
result in lost sales and lost customers.

cost principle, inventory is reported on the balance sheet at the amount paid
to
Cost of Goods Sold
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.

Cost 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
When Costs Change
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.

If the publisher increases the selling prices of its books, the bookstore will have a higher cost for
the nextbook 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 2010 and at
different times during 2010 purchased four identical books. During the year 2010 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, 2010.


Number
of
Books

Cost
per
Book

Total
Cost
Inventory at Dec. 31, 2009 1 @ $85 = $ 85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 = 90
Total goods available for sale 5

$440
Less: Inventory at Dec. 31, 2010 5

440
Cost of goods sold 0

$ 0


Special Feature:

Review what you are learning by working the three interactive
crossword puzzles dedicated to this topic. They are completely
free.

Inventory & Cost of Goods Sold Puzzles


Cost Flow Assumptions
If 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
1. First In, First Out (FIFO)
cost flows:
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, 2009 but could remove
from inventory the $90 cost

of the book purchased in December 2010 (if it elects the LIFO cost flow
assumption).
Inventory Systems
Each of the three cost flow assumptions listed above can be used in either of two systems (or methods)
of inventory:
A. Periodic
A. Periodic inventory system. Under this system the amount appearing in the

B. Perpetual

Inventory
Under the periodic inventory system, purchases of merchandise are recorded in one or
more
account is not
updated when purchases of merchandise are made from suppliers. Rather, the Inventory account is
commonly updated or adjusted only onceat the end of the year. During the year the Inventory account
will likely show only the cost of inventory at the end of the previous year.

Purchasesaccounts. At the end of the year the Purchases account(s) are closed and the Inventory
account is adjusted to equal the cost of the merchandise actually on hand at the end of the year. Under
the periodic system there is no Cost of Goods Sold account to be updated when a sale of merchandise
occurs.

In short, under the periodic inventory system there is no way to tell from the general ledger accounts the
amount of inventory or the cost of goods sold.

B. Perpetual inventory system. Under this system the Inventory account is continuously updated. The
Inventory account is increased with the cost of merchandise purchased from suppliers and it is reduced
by the cost of merchandise that has been sold to customers. (The Purchases account(s) do not exist.)

Under the perpetual system there is a Cost of Goods Sold account that is debited at the time of each sale
for the cost of the merchandise that was sold. Under the perpetual system a sale of merchandise will
result in two journal entries: one to record the sale and the cash or accounts receivable, and one to
reduce inventory and to increase cost of goods sold.




Inventory Systems and Cost Flows Combined
The combination of the three cost flow assumptions and the two inventory systems results in six available
options when accounting for the cost of inventory and calculating the cost of goods sold:
A1. Periodic FIFO
A2. Periodic LIFO
A3. Periodic Average

B1. Perpetual FIFO
B2. Perpetual LIFO
A1. Periodic FIFO

B3. Perpetual Average

"Periodic" means that the Inventory account is not routinely updated during the accounting period.
Instead, the cost of merchandise purchased from suppliers is debited to an account called Purchases. At
the end of the accounting year the Inventory account is adjusted to equal the cost of the merchandise that
has not been sold. The cost of goods sold that will be reported on the income statement will be computed
by taking the cost of the goods purchased and subtracting the increase in inventory (or adding the
decrease in inventory).

"FIFO" is an acronym for First In, First Out. Under the FIFO cost flow assumption, the first (oldest) costs
are the first ones to leave inventory and become the cost of goods sold on the income statement. The last
(or recent) costs will be reported as inventory on the balance sheet.

Remember that the costs can flow differently than the goods. If the Corner Shelf Bookstore uses FIFO,
the owner may sell the newest book to a customer, but is allowed to report the cost of goods sold as $85
(the first, oldest cost).

Let's illustrate periodic FIFO with the amounts from the Corner Shelf Bookstore:


Number
of
Books

Cost
per
Book

Total
Cost
Inventory at Dec. 31, 2009 1 @ $85 = $ 85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 = 90
Total goods available for sale 5

$440
Less: Inventory at Dec. 31, 2010 4

- 355
Cost of goods sold 1 @ $85


$ 85

As before, we need to account for the total goods available for sale (5 books at a cost of $440). Under
FIFO we assign the first cost of $85 to the one book that was sold. The remaining $355 ($440 - $85) is
assigned to inventory. The $355 of inventory costs consists of $87 + $89 + $89 + $90. The $85 cost
assigned to the book sold is permanently gone from inventory.

If Corner Shelf Bookstore sells the textbook for $110, its gross profit

under periodic FIFO will be $25
($110 - $85). If the costs of textbooks continue to increase, FIFO will always result in more profit than
other cost flows, because the first cost is always lower.
A2. Periodic LIFO
"Periodic" means that the Inventory account is not updated during the accounting period. Instead, the
cost of merchandise purchased from suppliers is debited to an account called Purchases. At the end of
the accounting year the Inventory account is adjusted to equal the cost of the merchandise that is unsold.
The other costs of goods will be reported on the income statement as the cost of goods sold.

"LIFO" is an acronym for Last In, First
It's important to note that under
Out. Under the LIFO cost flow assumption, the last (or recent)
costs are the first ones to leave inventory and become the cost of goods sold on the income statement.
The first (or oldest) costs will be reported as inventory on the balance sheet.

Remember that the costs can flow differently than the goods. In other words, if Corner Shelf Bookstore
uses LIFO, the owner may sell the oldest (first) book to a customer, but can report the cost of goods sold
of $90 (the last cost).

LIFO periodic (not LIFO perpetual) we wait until the entire year is over
before assigning the costs. Then we flow the year's last costs first, even if those goods arrived after the
last sale of the year. For example, assume the last sale of the year at the Corner Shelf Bookstore
occurred on December 27. Also assume that the store's last purchase of the year arrived on December
31. Under LIFO periodic, the cost of the book purchased on December 31 is sent to the cost of goods
sold first, even though it's physically impossible for that book to be the one sold on December 27. (This
reinforces our previous statement that the flow of costs does not have to correspond with the physical
flow of units.)

Let's illustrate periodic LIFO by using the data for the Corner Shelf Bookstore:


Number
of
Books

Cost
per
Book

Total
Cost
Inventory at Dec. 31, 2009 1 @ $85 = $ 85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 = 90
Total goods available for sale 5

$440
Less: Inventory at Dec. 31, 2010 4

- 350
Cost of goods sold 1 @ $90


$ 90

As before we need to account for the total goods available for sale: 5 books at a cost of $440. Under
periodic LIFO we assign the last cost of $90 to the one book that was sold. (If two books were sold, $90
would be assigned to the first book and $89 to the second book.) The remaining $350 ($440 - $90) is
assigned to inventory. The $350 of inventory cost consists of $85 + $87 + $89 + $89. The $90 assigned to
the book that was sold is permanently gone from inventory.

If the bookstore sold the textbook for $110, its gross profit under periodic LIFO will be $20 ($110 - $90).
If the costs of textbooks continue to increase, LIFO will always result in the least amount of profit. (The
reason is that the last costs will always be higher than the first costs. Higher costs result in less profits
and usually lower income taxes.)




A3. Periodic Average
Under "periodic" the Inventory account is not updated and purchases of merchandise are recorded in an
account called Purchases. Under this cost flow assumption an average cost is calculated using the total
goods available for sale (cost from the beginning inventory plus the costs of all subsequent purchases
made during the entire year). In other words, the periodic average cost is calculated after the year is
overafter all the puchases of the year have occurred. This average cost is then applied to the units sold
during the year as well as to the units in inventory at the end of the year.

As you can see, our facts remain the samethere are 5 books available for sale for the year 2010 and
the cost of the goods available is $440. The weighted average cost of the books is $88 ($440 of cost of
goods available 5 books available) and it is used for both the cost of goods sold and for the cost of the
books in inventory.


Number
of
Books

Cost
per
Book

Total
Cost
Inventory at Dec. 31, 2009 1 @ $85 = $ 85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 = 90
Total goods available for sale 5

$440
Less: Inventory at Dec. 31, 2010 4 @ $88

- 352
Cost of goods sold 1 @ $88


$ 88

Since the bookstore sold only one book, the cost of goods sold is $88 (1 x $88). The four books still on
hand are reported at $352

(4 x $88) of cost in the Inventory account. The total of the cost of goods sold
plus the cost of the inventory should equal the total cost of goods available ($88 + $352 = $440).

If Corner Shelf Bookstore sells the textbook for $110, its gross profit under the periodic average method
will be $22 ($110 - $88). This gross profit is between the $25 computed under periodic FIFO and the $20
computed under periodic LIFO.
B1. Perpetual FIFO
Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a
retailer purchases merchandise, the retailer debits its Inventory account for the cost; when the retailer
sells the merchandise to its customers its Inventory account is credited and its Cost of Goods
Sold account is debited for the cost of the goods sold. Rather than staying dormant
Under the perpetual system, two transactions are recorded when merchandise is sold: (1) the sales
amount is debited to
as it does with the
periodic method, the Inventory account balance is continuously updated.

Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the
merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic
system the second entry is not made.)

With perpetual FIFO, the first (or oldest) costs are the first moved from the Inventory account and debited
to the Cost of Goods Sold account. The end result under perpetual FIFO is the same as under periodic
FIFO. In other words, the first costs are the same whether you move the cost out of inventory with each
sale (perpetual) or whether you wait until the year is over (periodic).




B2. Perpetual LIFO
Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer
purchases merchandise, the retailer debits its Inventory account for the cost of the merchandise. When
the retailer sells the merchandise to its customers, the retailer credits its Inventory account for the cost of
the goods that were sold and debits its Cost of Goods Sold account for their cost. Rather than
staying dormantas it does with the periodic method, the Inventory account balance is continuously
updated.

Under the perpetual system, two transactions are recorded at the time that the merchandise is sold: (1)
the sales amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of
the merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the
periodic system the second entry is not made.)

With perpetual LIFO, the last costs available at the time of the sale are the first to be removed from the
Inventory account and debited to the Cost of Goods Sold account. Since this is the perpetual system we
cannot wait until the end of the year to determine the last costan entry must be recorded at the time of
the sale in order to reduce the Inventory account and to increase the Cost of Goods Sold account.

If costs continue to rise throughout the entire year, perpetual LIFO will yield a lower cost of goods sold
and a higher net income than periodic LIFO. Generally this means that periodic LIFO will result in less
income taxes than perpetual

LIFO. (If you wish to minimize the amount paid in income taxes during
periods of inflation, you should discuss LIFO with your tax adviser.)
Once again we'll use our example for the Corner Shelf Bookstore:


Number
of
Books

Cost
per
Book

Total
Cost
Inventory at Dec. 31, 2009 1 @ $85 = $ 85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 = 90
Total goods available for sale 5

$440
Less: Inventory at Dec. 31, 2010 4

- 351
Cost of goods sold 1 @ $89


$ 89

Let's assume that after Corner Shelf makes its second purchase in June 2010, Corner Shelf sells one
book. This means the last cost at the time of the sale was $89. Under perpetual LIFO the following entry
must be made at the time of the sale: $89 will be credited to Inventory and $89 will be debited to Cost of
Goods Sold. If that was the only book sold during the year, at the end of the year the Cost of Goods Sold
account will have a balance of $89 and the cost in the Inventory account will be $351
If the bookstore sells the textbook for $110, its
($85 + $87 + $89 +
$90).

gross profit
B3. Perpetual Average
under perpetual LIFO will be $21 ($110 -
$89). Note that this is different than the gross profit of $20 under periodic LIFO.

Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer
purchases merchandise, the costs are debited to its Inventory account; when the retailer sells the
merchandise to its customers the Inventory account is credited and the Cost of Goods Sold account is
debited for the cost of the goods sold. Rather than staying dormant as it does with the periodic method,
the Inventory account balance under the perpetual average is changing whenever a purchase or sale
occurs.

Under the perpetual system, two sets of entries are made whenever merchandise is sold: (1) the sales
amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the
merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic
system the second entry is not made.)

Under the perpetual system, "average" means the average cost of the items in inventory as of the date of
the sale. This average cost is multiplied by the number of units sold and is removed from the Inventory
account and debited to the Cost of Goods Sold account. We use the average as of the time of the
salebecause this is a perpetual method. (Note: Under the periodic system we wait until the year is over
before computing the average cost.)

Let's use the same example again for the Corner Shelf Bookstore:


Number
of Books

Cost
per
Book

Total
Cost
Inventory at Dec. 31, 2009 1 @ $85 = $ 85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 = 90
Total goods available for sale 5

$440.00
Less: Inventory at Dec. 31, 2010 4 @ $88.125

-
352.50
Cost of goods sold 1 @ $87.50


$ 87.50

Let's assume that after Corner Shelf makes its second purchase, Corner Shelf sells one book. This
means the average cost at the time of the sale was $87.50 ([$85 + $87 + $89 + $89] 4]). Because this is
a perpetual average, a journal entry must be made at the time of the sale for $87.50. The $87.50 (the
average cost at the time of the sale) is credited to Inventory and is debited to Cost of Goods Sold. After
the sale of one unit, three units remain in inventory and the balance in the Inventory account will be
$262.50 (3 books at an average cost of $87.50).

After Corner Shelf makes its third purchase, the average cost per unit will change to $88.125 ([$262.50 +
$90] 4). As you can see, the average cost moved from $87.50 to $88.125this is why the perpetual
average method is sometimes referred to as the moving average method. The Inventory balance
is$352.50
Comparison of Cost Flow Assumptions
(4 books with an average cost of $88.125 each).

Below is a recap of the varying amounts for the cost of goods sold, gross profit, and ending inventory that
were calculated above.



Periodic Perpetual

FIFO LIFO Avg. FIFO LIFO Avg.

Sales $110 $110 $110 $110 $110 $110.00
Cost of Goods Sold 85 90 88 85 89 87.50

Gross Profit $ 25 $ 20 $ 22 $ 25 $ 21 $ 22.50

Ending Inventory $355 $350 $352 $355 $351

$352.50

The example assumes that costs were continually increasing. The results would be different if costs were
decreasing or increasing at a slower rate. Consult with your tax advisor concerning the election of cost
flow assumption.

Specific Identification
In addition to the six cost flow assumptions presented in Parts 1 4, businesses have another option:
expense to the cost of goods sold the specific cost of the specific item sold. For example, Gold Dealer,
Inc. has an inventory of gold and each nugget has an identification number and the cost of the nugget.
When Gold Dealer sells a nugget, it can expense to the cost of goods sold the exact cost of the specific
nugget sold. The cost of the other nuggets will remain in inventory. (Alternatively, Gold Dealer could use
one of the other six cost flow assumptions described in Parts 1 4.)




LIFO Benefits Without Tracking Units
In Part 1 and Part 2 you saw that during the periods of increasing costs, LIFO will result in less profits. In
the U.S. this can mean less income taxes paid by the company. Most companies view lower taxes as a
significant benefit. However, the process of tracking costs and then assigning those costs to the units sold
and the units on hand could be too expensive for the amount of income tax savings. To gain the benefit of
LIFO without the tracking of costs, there is a method known as dollar value LIFO. This topic is discussed
in intermediate accounting textbooks. The Internal Revenue Service also allows companies to use dollar
value LIFO by applying price indexes. (You should seek the advice of an accounting and/or tax
professional to assess the cost and benefit of these techniques.)

Inventory Management
Over the past few decades sophisticated companies have made great strides in reducing their levels of
inventory. Rather than carry large inventories, they ask their suppliers to deliver goods "just in time."
Suppliers and merchandisers have learned to coordinate their purchases and sales so that orders and
shipments occur automatically.

A company will realize significant benefits if it can keep its inventory levels down without losing sales or
production (if the company is a manufacturer). For example, Dell Computers has greatly reduced its
inventory in relationship to its sales. Since computer components have been dropping in costs as new
technologies emerge, it benefits Dell to keep only a very small inventory of components on hand. It would
be a financial hardship if Dell had a large quantity of parts that became obsolete or decreased in value.

Financial Ratios
Keeping track of inventory is important. There are two common financial ratios for monitoring inventory
levels: (1) the Inventory Turnover Ratio, and (2) the Days' Sales in Inventory. (These are discussed and
illustrated in the Explanation of Financial Ratios.)

Estimating Ending Inventory
It is very time-consuming for a company to physically count the merchandise units in its inventory. In fact,
it is not unusual for companies to shut down their operations near the end of their accounting year just to
perform inventory counts. The company may assign one set of employees to count and tag the items and
another set to verify the counts. If a company has outside auditors, they will be there to observe the
process. (Even if the company's computers keep track of inventory, accountants require that the
computer records be verified by actually counting the goods.)

If a company counts its inventory only once per year it must estimate

its inventory at the end of each
month in order to prepare meaningful monthly financial statements. In fact, a company may need to
estimate its inventory for other reasons as well. For example, if a company suffers a loss due to a disaster
such as a tornado or a fire, it will need to file a claim for the approximate cost of the inventory that was
lost. (An insurance adjuster will also compute this amount independently so that the company is not paid
too much or too little for its loss.)
Methods of Estimating Inventory


There are two methods for estimating ending inventory:
1. Gross Profit Method
2. Retail Method

1. Gross Profit Method. The gross profit method for estimating inventory uses the information contained
in the top portion of a merchandiser's multiple-step income statement:


ABC Company
Income Statement (partial)
For the Year Ended Dec. 31, 2009
Sales

$100,000 100.0%

Cost of Goods Sold


Beginning Inventory $ 22,000


Purchases - net 83,000


Cost of Goods Available 105,000


Less: Ending Inventory 25,000


Cost of Goods Sold

80,000 80.0%

Gross Profit

$ 20,000

20.0%

Let's assume that we need to estimate
While an algebraic equation could be constructed to determine the estimated amount of ending inventory,
we prefer to simply use the income statement format. We prepare a partial income statement for the
period beginning after the date when inventory was last physically counted, and ending with the date for
the cost of inventory on hand on June 30, 2010. From the 2009
income statement shown above we can see that the company's gross profit is 20% of the sales and that
the cost of goods sold is 80% of the sales. If those percentages are reasonable for the current year, we
can use those percentages to help us estimate the cost of the inventory on hand as of June 30, 2010.

which we need the estimated inventory cost. In this case, the income statement will go from January 1,
2010 until June 30, 2010.

Some of the numbers that we need are easily obtained from sales records, customers, suppliers, earlier
financial statements, etc. For example, sales for the first half of the year 2010 are taken from the
company's records. The beginning inventory amount is the ending inventory reported on the December
31, 2009 balance sheet. The purchases information for the first half of 2010 is available from the
company's records or its suppliers. The amounts that we have available are written in italics in the
following partial income statement:


ABC Company
Income Statement (partial)
For the Six Months Ended June 30, 2010
Sales

$ 56,000 100.0%

Cost of Goods Sold


Beginning Inventory $ 25,000


Purchases - net 46,000


Cost of Goods Available


Less: Ending Inventory


Cost of Goods Sold

80.0%

Gross Profit

20.0%

We will fill in the rest of the statement with the answers to the following calculations. The amounts
in
Step 1.
italicscome from the statement above. The bold amount is the answer or result of the calculation.

Cost of Goods Available = Beginning Inventory + Net Purchases

Cost of Goods Available = $25,000 + $46,000

Cost of Goods Available = $71,000


Step 2. Gross Profit = Gross Profit Percentage (or Gross Margin) x Sales

Gross Profit = 20% x $56,000

Gross Profit = $11,200


Step 3. Cost of Goods Sold = Sales Gross Profit

Cost of Goods Sold = $56,000 $11,200 (from Step 2.)

Cost of Goods Sold = $44,800


This can also be calculated as 80% x Sales of $56,000 = $44,800.


Inserting this information into the income statement yields the following:


ABC Company
Income Statement (partial)
For the Six Months Ended June 30, 2010
Sales

$56,000 100.0%

Cost of Goods Sold


Beginning Inventory $25,000


Purchases - net 46,000


Cost of Goods Available 71,000


Less: Ending Inventory ?


Cost of Goods Sold

44,800 80.0%

Gross Profit

$11,200

20.0%

As you can see, the ending inventory amount is not yet shown. We compute this amount by subtracting
cost of goods sold from the cost of goods available:
Ending Inventory = Cost of Goods Available Cost of Goods Sold
Ending Inventory = $71,000 $44,800
Ending Inventory = $26,200


Below is the completed partial income statement with the estimated amount of ending inventory at
$26,200. (Note: It is always a good idea to recheck the math on the income statement to be certain you
computed the amounts correctly.)


ABC Company
Income Statement (partial)
For the Six Months Ended June 30, 2010
Sales

$56,000 100.0%

Cost of Goods Sold


Beginning Inventory $25,000


Purchases - net 46,000


Cost of Goods Available 71,000


Less: Ending Inventory 26,200


Cost of Goods Sold

44,800 80.0%

Gross Profit

$11,200

20.0%


2. Retail Method. The retail method can be used by retailers who have their merchandise records in
both cost and retail selling prices. A very simple illustration for using the retail method to estimate
inventory is shown here:


Cost Retail
Beginning Inventory $ 11,000 $ 15,000
Purchases - net + 69,000 + 85,000

Goods Avail. & Cost Ratio 80,000 100,000
Less: Sales at retail

- 90,000
Est. ending inventory at retail

10,000
Est. ending inventory at cost $ 8,000


As you can see, the cost amounts are arranged into one column. The retail
To arrive at the estimated ending inventory at cost, we multiply the estimated ending inventory at retail
($10,000) times the
amounts are listed in a
separate column. The Goods Available amounts are used to compute the cost-to-retail ratio. In this case
the cost of goods available of $80,000 is divided by the retail amount of goods available ($100,000). This
results in a cost-to-retail ratio, or cost ratio, of 80%.

cost ratio

of 80% to arrive at $8,000.

Lower of Cost or Market (LCM)

Introduction to Lower of Cost or Market (LCM)
We also have Quizzes, Crosswords, and Q&A for the topic
Assume it is the end of December 2010 and your retail store has 20 digital cameras in inventory. You
purchased the cameras directly from the manufacturer at a
Lower of Cost or Market.

cost
Unexpectedly, on December 31, the camera manufacturer announces a permanent price reductionyou
and the other retailers can now purchase the cameras for $135 instead of $150. You know that your
competitors will buy up these cameras and pass the savings on to their customers by immediately
advertising a retail price reductionselling the cameras for $185 instead of $200. If you drop
of $150 each and you planned to sell the
cameras at a retail price of $200, a price that is in line with competing retailers.

your retail
price to $185, however, your gross profit will be just $35 each on the 20 cameras you already have in
stock, instead of the $50 per camera that you had planned on. This means your profits will be $300 less
than you projected ($15 less profit times 20 cameras). Much to your dismay, you will have to drop your
price to meet that of your competitors. There is nothing you can do to avoid this "holding loss" of $300.

When and how should this loss be reported on your store's income statement? Should the loss be
reported as a smaller gross profit when the cameras are sold in January 2011? Or, should the entire $300
of loss be reported in December 2010, when the manufacturer announced the lower price? Should your
December 31 balance sheet report inventory at $3,000 (20 cameras at the actual cost of $150) or at
$2,700 (20 cameras at the lower replacement cost of $135)?

The conservatism principle and a specific accounting pronouncement, Accounting Research Bulletin No.
43 (ARB No. 43) leads to an accounting valuation method known as the lower of cost or market,
or LCM. In this method the term "market" includes both the market in which the company purchases its
merchandise as well as the market in which it sells
Conservatism Principle
its merchandise. We will discuss the details of the rule
later, but for now, think of the lower of cost or market rule as the lower of cost or replacement costwith
certain limitations placed on the replacement cost amount.

Accountants usually associate the lower of cost or market (LCM) rule with the conservatism principle.
This principle gives accountants guidance when they are faced with a choice between two divergent
amounts. The conservatism principle directs them to choose the amount that results in a smaller asset
amount and/or less profit.

How would the conservatism principle affect your camera "holding loss" described in the Introduction? On
your December 31 balance sheet, the accountant must decide between reporting the cameras in
inventory at their actual cost of $150 each, or at their replacement cost of $135 each. The conservatism
principle and the Accounting Research Bulletin No. 43 direct the accountant to report them at $135 each
and to recognize the $300 loss on your 2010 income statement. (In other words, the loss should be
reported as a loss in 2010, and not as a reduction in profits in 2011 when the cameras are sold.)
However, there are some limitations on the replacement cost. The limitations involve the net realizable
value (NRV), which will be defined in the next section.

While the conservatism principle and the lower of cost or market rule in ARB No. 43 may require that
inventory be reported at less than cost, the cost principle and the revenue recognition principle prevent
the reporting of inventory at more
Net Realizable Value (NRV)
than cost. (However, there are exceptions for a few select industries
such as mining, commodities, securities, etc.)

Net realizable value (NRV)
Market
is defined as the expected selling price in the ordinary course of business
minus the cost necessary for completion and disposal.

To illustrate NRV, let's assume that a company has an item in inventory that could be sold for $5. It will
cost $0.80 to get the item ready for sale (by way of such costs as packaging the item), and to actually sell
it (by way of such costs as sales commissions). This makes the net realizable value $4.20 (selling price of
$5.00 less $0.80 of cost to complete and dispose).

Net realizable value is a key component in determining "market" in the lower of cost or market rule.

In the term lower of cost or market the word "market" refers to an item's
Both the upper limit (the ceiling) and the lower limit (the floor) are related to the
current replacement
cost(whether through purchase or production). The market amount is constrained or limited by two
amounts: (1) an upper limit, or "ceiling," and (2) a lower limit, or "floor." An item's market amount (or
replacement cost) cannot be higher than the ceiling nor lower than the floor.

net realizable
value(defined above) in the following ways:
1. Upper Limit or Ceiling for Market
The upper limit, or ceiling, for the market amount is the net realizable value (NRV). In other
words, the market amount cannot be higher than NRV. If the current replacement cost of an item
in inventory is greater
2. Lower Limit or Floor for Market
The lower limit, or floor, for the market amount is the
than NRV, the NRV is used as the market amount.
net realizable value (NRV) minus the
normal profit. In other words, the market amount cannot be lower than NRV minus the normal
profit. If the current replacement cost of an item in inventory is less

Here's a recap on how to determine the
than the NRV minus the
normal profit, the NRV minus the normal profit is used as the market amount.
market amount
If the current replacement cost is
used in the lower of cost or market rule:
between the floor and the ceiling, the current replacement
cost is the market amount.
If the current replacement cost is greater than the ceiling, the ceiling amount
If the current replacement cost is lower than the floor, the
is the market
amount.
floor amount

is the market amount.
How to Calculate the Lower of Cost or Market (LCM)


We will use the information in the following table to calculate the net realizable value and the lower of cost
or market for five products:

Product: A B C D E
Cost $ 6.00 $ 5.00 $ 8.00 $ 8.75 $ 2.00
Replacement cost 4.50 3.00 8.50 9.00 2.50
Expected selling price 10.00 4.50 12.00 10.00 4.00
Cost to complete & dispose 3.00 1.00 2.50 1.50 1.00
Normal profit* 2.00 0.90 2.40 2.00 0.80
*We will assume a normal profit equal to 20% of the selling price


Recall the lower of cost or market (LCM) rule: LCM is the lower of cost or replacement cost, with the
replacement cost being no higher than NRV and no lower than NRV minus the normal profit.

Since the replacement cost was given, we will begin by calculating the net realizable value (NRV) of
each of the products. Recall that net realizable value is the expected selling price in the ordinary course
of business minus the cost to complete and dispose. NRV will be the upper limit (the ceiling) for the
replacement cost.

Net Realizable Value (NRV): The Ceiling in LCM
Product: A B C D E
Expected selling price 10.00 4.50 12.00 10.00 4.00
Less: Cost to complete & dispose 3.00 1.00 2.50 1.50 1.00
Net realizable value = CEILING* 7.00 3.50 9.50 8.50 3.00
*If the replacement cost is greater than this ceiling, use this ceiling as the market amount.


Next we will calculate the NRV minus the normal profit. This amount will be the lower limit (the floor) for
the replacement cost.

NRV minus the Normal Profit: The Floor in LCM
Product: A B C D E
Net realizable value = CEILING* 7.00 3.50 9.50 8.50 3.00
Less: normal profit (20% of selling
price)
2.00 0.90 2.40 2.00 0.80
NRV - normal profit = FLOOR* 5.00 2.60 7.10 6.50 2.20
*If the replacement cost is lower than this floor, use this floor as the market amount.


The following chart displays the four relevant amounts used in the lower of cost or market rule: (1) cost,
(2) the upper limit, or ceiling, for the replacement cost, (3) replacement cost, and (4) the lower limit,
or floor, for the replacement cost. The lower of cost or market amount appears in bold font:

Product: A B C D E
Cost $ 6.00 $ 5.00 $ 8.00 $ 8.75 $ 2.00

Market information:

NRV (ceiling) 7.00 3.50 9.50 8.50 3.00
Replacement cost 4.50 3.00 8.50 9.00 2.50
NRV - normal profit (floor) 5.00 2.60 7.10 6.50 2.20


Let's review the lower of cost or market for each of the five products shown in the above table:

Product A
Cost vs. Market

$6.00 vs. $7.00 NRV (ceiling)

$5.00 NRV - normal profit (floor)

$4.50 Replacement cost

As you can see, the $4.50 replacement cost is less than the floor of $5.00. Because it
is below the floor, the replacement cost cannot be used as the market amount.
Instead,the floor of $5.00 is used as the market amount for Product A.

The lower of cost or market is $5.00 (the lower of the $6.00 cost vs. the $5.00
market).

Product B
Cost vs. Market

$5.00 vs. $3.50 NRV (ceiling)

$3.00 Replacement cost

$2.60 NRV - normal profit (floor)

The $3.00 replacement cost is between the floor of $2.60 and the ceiling of $3.50. As a
result the $3.00 replacement cost is used as the market amount for Product B.

The lower of cost or market is $3.00 (the lower of the $5.00 cost vs. the $3.00
market).

Product C
Cost vs. Market

$8.00 vs. $9.50 NRV (ceiling)

$8.50 Replacement cost

$7.10 NRV - normal profit (floor)

The $8.50 replacement cost is between the ceiling of $9.50 and the floor of $7.10. This
means the $8.50 replacement cost is the market amount for Product C.

However, lower of cost or market is $8.00 (the lower of the $8.00 cost vs. $8.50
market).

Product D
Cost vs. Market

$8.75 vs. $9.00 Replacement cost

$8.50 NRV (ceiling)

$6.50 NRV - normal profit (floor)

The $9.00 replacement cost is above the ceiling of $8.50. Because it is above the
ceiling, the replacement cost cannot be used as the market amount. Instead, the
ceiling of $8.50 is used as the market amount for Product D.

The lower of cost or market is $8.50 (the lower of the $8.75 cost vs. the $8.50
market).

Product E
Cost vs. Market

$2.00 vs. $3.00 NRV (ceiling)

$2.50 Replacement cost

$2.20 NRV - normal profit (floor)

Because the $2.50 replacement cost is between the ceiling of $3.00 and the floor of
$2.20, the $2.50 replacement cost is used as the market amount for Product E.

However, the lower of cost or market is $2.00 (the lower of the $2.00 cost vs. the
$2.50 market).

Lower of Cost or Market - Quick and Easy


An easy way to apply the lower of cost or market (or to check your calculations) is to arrange the four
relevant amounts (cost, replacement cost, NRV, and NRV minus normal profit) in descending order of
amount. The third amount is the lower of cost or market, unless cost is lower. (When cost is the fourth
amount, the lower of cost or market is the fourth amount.) To illustrate:


Product A's relevant amounts arranged from highest to lowest:

#1 $7.00 NRV

#2 $6.00 Cost

#3 $5.00 NRV - normal profit

#4 $4.50 Replacement Cost



The lower of cost or market is the third amount: $5.00 (since
cost is not lower).



Product B's relevant amounts arranged from highest to lowest:

#1 $5.00 Cost

#2 $3.50 NRV

#3 $3.00 Replacement Cost

#4 $2.60 NRV - normal profit



The lower of cost or market is the third amount: $3.00 (since
cost is not lower).



Product C's relevant amounts arranged from highest to lowest:

#1 $9.50 NRV

#2 $8.50 Replacement Cost

#3 $8.00 Cost

#4 $7.10 NRV - normal profit



The lower of cost or market is the third amount: $8.00 (since
cost is not lower).



Product D's relevant amounts arranged from highest to lowest:

#1 $9.00 Replacement Cost

#2 $8.75 Cost

#3 $8.50 NRV

#4 $6.50 NRV - normal profit



The lower of cost or market is the third amount: $8.50 (since
cost is not lower).



Product E's relevant amounts arranged from highest to lowest:

#1 $3.00 NRV

#2 $2.50 Replacement Cost

#3 $2.20 NRV - normal profit

#4 $2.00 Cost



The third amount is $2.20. However, cost is lower. Therefore, the
lower of cost or market is $2.00.

To recap this quick and easy approach to finding the lower of cost or market...

1. Arrange the four relevant amounts in descending order.

Applying Lower of Cost or Market To Inventory
2. The lower of cost or market is the third amount, unless cost is lower.



Generally accepted accounting principles allow for the lower of cost or market rule to be applied in one of
three ways: (1) on an inventory totals basis, (2) on an inventory categories basis, or (3) on an item-by-
item
1. Applying LCM to inventory
basis.
totals is the least
2. Applying LCM to inventory
conservative application since it results in the
smallest writedown or reduction of inventory from cost and the smallest loss on the income
statement.
categories
3. Applying LCM on an
results in values that fall somewhere in between the other
two methods of applying LCM.
item-by-item basis is the most

Let's use the information below to illustrate the three ways of applying LCM:

conservative application since it results in
the largest writedown or reduction of inventory from cost and the largest loss on the income
statement.
Category
Item
Number
Units
on
Hand
Cost
per Unit
Market
per
Unit*
Total
Cost
Total
Market
LCM by
Category
LCM
Item-
By- Item
A 101 10 $ 4.00 $ 4.10 $ 40 $ 41

$ 40
A 102 40 6.00 6.00 240 240

240
A 108 100 8.00 7.00 800 700

700
Total A

1,080 981 $ 981

B 202 5 13.00 13.00 65 65

65
B 212 8 20.00 21.00 160 168

160
B 250 60 15.00 14.00 900 840

840
B 260 10 17.00 20.00 170 200

170
Total B

1,295 1,273 1,273

C 302 20 50.00 51.00 1,000 1,020

1,000
C 305 30 38.00 39.00 1,140 1,170

1,140
C 310 10 56.00 50.00 560 500

500
C 315 15 32.00 32.00 480 480

480
C 327 20 35.00 36.00 700 720

700
Total C

3,880 3,890 3,880

D 404 40 30.00 31.00 1,200 1,240

1,200
D 406 50 40.00 38.00 2,000 1,900

1,900
Total D

3,200 3,140 3,140

Grand
Total

$9,455 $9,284 $9,274 $9,135

*The "Market per unit" amounts that are less than cost appear in bold


The Total Cost column shows a grand total of $9,455. This is the cost of the items held in inventory. In
most industries, the inventory reported on the balance sheet cannot exceed this amount. However,
because of the lower of cost or market rule, the inventory reported on the balance sheet might be smaller
than this amount. The smaller

amount could be based on the lower of cost or market applied to the
inventory totals, inventory categories, or each individual item in inventory.
If the LCM rule is applied to the inventory totals, the Grand Total Cost ($9,455) is compared to Grand
Total Market ($9,284). The lower of cost or market is the lower of these two amounts. Therefore $9,284 is
the amount to be reported on the company's balance sheet. The difference of $171 ($9,455 minus
$9,284) is reported as a loss on the company's income statements in the accounting periods when the
loss took place.

If the LCM rule is applied to the inventory categories, the lower of each category's total cost and total
market amount is selected. For example, the Category A Total Market amount of $981 is selected over
Category A Total Cost amount of $1,080 and is entered in the column "LCM by Category." The Grand
Total LCM by Category of $9,274 is less than the Grand Total Cost of $9,455. Therefore, $9,274 is the
amount reported on the company's balance sheet. The amount of the writedown or reduction from $9,455
to $9,274 is $181. This $181 will be reported on the income statements in the periods when the market
amount dropped below cost.

If the LCM is applied on an item-by-item basis
Accounting For Lower of Cost or Market
, the lower of each item's total cost and total market
amount is selected. For example, the Item 212 Total Cost amount of $160 is selected over Item 212 Total
Market amount of $168 and is entered in the column "LCM Item-by-Item." The Grand Total LCM Item-by-
Item of $9,135 is the amount reported on the company's balance sheet. The difference between this
amount and the Grand Total Cost of $9,455 is $320. This $320 reduction from cost is reported as a loss
on the company's income statements in the accounting periods when the loss took place. As mentioned
earlier, this is the most conservative way in which to apply the lower of cost or market rule.


For companies reporting inventory under the lower of cost or market rule, it is common to use the

contra
asset inventory account Allowance to Reduce Inventory to LCM. This balance sheet account is used to
report the amount that the inventory's market amount is below the inventory's cost amount. In other
words, the combination of the Inventory account balance and the Allowance account balance will equal
the lower of cost or market. The result is the account Allowance to Reduce Inventory to LCM will have a
credit balance for the amount that the market value of the inventory is less than the cost shown in the
Inventory account. If the market value of the inventory is greater than cost, a zero balance appears in the
account Allowance to Reduce Inventory to LCM. (There cannot be a debit balance in Allowance account
because of the cost principle and the revenue recognition principle.)

Because of the rules of double-entry accounting, whenever the balance in the Allowance account is
adjusted, a second account is needed. The second account will be an income statement account, such as
Loss from Reducing Inventory to LCM.

We'll use the following information to illustrate accounting for lower of cost or market (LCM):


Cost
(These
Market
(These
Credit
Balance
amounts are in
the accounting
records.)
amounts are
determined
from
information
outside of the
accounting
records.)
needed in the
Allowance
account.
Inventory at Dec. 31,
2010
$80,000 $82,990 $ 0
Inventory at Jan. 31 2011 76,000 75,000 1,000
Inventory at Feb. 28 2011 72,000 71,800 200
Inventory at Mar. 31, 2011 70,000 70,400 0

At December 31, 2010 the company's balance sheet will report Inventory of $80,000 since this amount is
the lower of cost ($80,000) or market ($82,900). The general ledger accounts show these balances:

(balance sheet account) Inventory


Balance at Dec. 31, 2010

80,000




(bal. sheet account) Allowance to Reduce Inventory to LCM




0

Balance at Dec. 31, 2010


(inc. stmt. account) Loss From Reducing Inventory to LCM


Balance at Dec. 31, 2010

0



No adjustment was needed at December 31 because 1) market was greater than the cost, and 2) the
balance in the Allowance account was previously at $0.



At January 31, 2011 the company's balance sheet needs to report Inventory of $75,000 since this
amount is the lower of cost or market on that date. The company's income statement for the month of
January 2011 should report a Loss of $1,000, since the decline below market occurred in January and the
market is expected to remain lower than cost. If the company uses the Allowance account for valuation,
the pertinent general ledger accounts will have the following adjustment:

(balance sheet account) Inventory


Balance at Jan. 31, 2011

76,000




(bal. sheet account) Allowance to Reduce Inventory to LCM




0

Balance at Dec. 31, 2010

1,000 Adjustment at Jan. 31, 2011

1,000

Bal. Needed at Jan. 31, 2011


(inc. stmt. account) Loss From Reducing Inventory to LCM


Balance at Jan. 1, 2011

0


Adjustment at Jan. 31, 2011

1,000


Balance at Jan. 31, 2011 1,000





In general journal format, the adjusting entry at January 31, 2011 is:

Date Account Name Debit Credit

Jan. 31, 2011 Loss from Reducing Inv to LCM 1,000


Allowance to Reduce Inv to LCM

1,000


This entry is similar to other adjusting entries (see Explanation of Adjusting Entries) in that it involves a
balance sheet account (Allowance to Reduce Inventory to LCM) and an income statement account (Loss
from Reducing Inventory to LCM).

We used the T-accounts to make certain we got the correct amounts into the balance sheet account. We
asked ourself: What should the balance be in the account Allowance to Reduce Inv to LCM at January
31, 2011? The answer is that the balance at January 31 should be a credit balance of $1,000 because
the market value at that date is $1,000 below the cost being reported in the Inventory account. The
second question we asked was: What is the present balance in the Allowance account? The answer was
that prior to an adjustment on January 31, the balance was $-0-. So how do we get the Allowance
account from a balance of $-0- to the $1,000 credit balance that is needed as of January 31? The solution
is to enter a credit of $1,000 in the Allowance account. (That of course means a debit of $1,000 will be
entered into the Loss account.) After we record that January 31 adjusting entry the balance sheet will
report the ending account balances as follows:

Inventory at cost $76,000
Less: Allowance to Reduce Inv to LCM 1,000
Inventory at the lower of cost or
market
$75,000



On February 28, 2011 the balance sheet needs to report the lower of cost or market of $71,800. (Earlier,
we assumed that on Feb. 28 the cost was $72,000 and the market was $71,800.) Throughout February
there were transactions in the Inventory account that resulted in the ending cost balance on February 28
of $72,000. In order for the balance sheet to report the correct lower of cost or market of $71,800 as
shown next, the balance in the Allowance account at February 28 will need to be a credit balance of
$200:

Inventory at cost $72,000
Less: Allowance to Reduce Inv to LCM 200
Inventory at the lower of cost or
market
$71,800



The journal entry needed at February 28 can be determined by using T-accounts:

(balance sheet account) Inventory


Balance at Feb. 28, 2011

72,000




(bal. sheet account) Allowance to Reduce Inventory to LCM




0

Balance at Dec. 31, 2010

1,000 Adjustment at Jan. 31, 2011

1,000

Bal. at Jan. 31, 2011
Adjustment at Feb. 28, 2011 800



200

Bal. Needed at Feb. 28, 2011


(inc. stmt. account) Loss From Reducing Inventory to LCM


Balance at Jan. 1, 2011

0


Adjustment at Jan. 31, 2011

1,000


Balance at Jan. 31, 2011 1,000



800

Adjustment at Feb. 28, 2011
Balance at Feb. 28, 2011 200




In general journal format, the adjusting entry at February 28, 2011 is:

Date Account Name Debit Credit

Feb. 28, 2011 Allowance to Reduce Inv to LCM 800


Loss from Reducing Inv to LCM

800

This journal entry shows a recovery of $800 of the $1,000 loss recorded in January.



On March 31, 2011 the balance sheet needs to report the lower of cost or market of $70,000. (Recall that
our assumptions were cost of $70,000 and market of $70,400.) Throughout March there were
transactions in the Inventory account and our assumptions meant that the ending balance in Inventory at
March 31 was $70,000. In order for the balance sheet to report the correct LCM of $70,000, the balance
in the Allowance account at March 31 will need to be a balance of $0.

Inventory at cost $70,000
Less: Allowance to Reduce Inv to LCM 0
Inventory at the lower of cost or
market
$70,000


Again, the journal entry needed at March 31 can be determined by using T-accounts:

(balance sheet account) Inventory


Balance at March 31, 2011

70,000




(bal. sheet account) Allowance to Reduce Inventory to LCM






0 Balance at Dec. 31, 2010

1,000 Adjustment at Jan. 31, 2011

1,000

Bal. at Jan. 31, 2011
Adjustment at Feb. 28, 2011 800



200

Bal. at Feb. 28, 2011
Adjustment at March 31, 2011 200



0

Bal. Needed at March 31, 2011


(inc. stmt. account) Loss From Reducing Inventory to LCM


Balance at Jan. 1, 2011

0


Adjustment at Jan. 31, 2011

1,000


Balance at Jan. 31, 2011 1,000



800

Adjustment at Feb. 28, 2011
Balance at Feb. 28, 2011 200



200

Adjustment at March 31,
2011
Balance at March 31, 2011 0




In general journal format, the adjusting entry at March 31, 2011 is:

Date Account Name Debit Credit

March 31, 2011 Allowance to Reduce Inv to LCM 200


Loss from Reducing Inv to LCM

200


Our March 31 journal entry shows the remaining $200 recovery from the $1,000 loss previously recorded
in January 2011. (Note: We did not report the recovery as a "gain" of $200 during March nor did we report
a "gain" of $800 in February. We avoided the word "gain" since the company did not increase its inventory
carrying amount above its cost; it merely restored the inventory amount back to its cost.)

Depreciation

Introduction to Depreciation
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Buildings, 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
Depreciation.

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

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.

earned by using the asset.
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
Book vs Tax Depreciation
is not
depreciated, because land is assumed to last indefinitely.

AccountingCoach.com's discussion of depreciation is limited to the depreciation entered into the
company'sgeneral 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, 2010 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 5year 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:

Cost of the asset

$10,500
Less: Expected salvage value

500
Depreciable Cost (amount to be
depreciated over the estimated useful life)

$10,000
Years of estimated useful life

5
Depreciation Expense per year

$ 2,000

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:


2010 2011 2012 2013 2014 2015
Depreciation Expense: $1,000 $2,000 $2,000 $2,000 $2,000 $1,000

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


2010 2011 2012 2013 2014 2015
Cash Paid: $10,500 $ 0 $ 0 $ 0 $ 0 $ 0

As you can see, the company paid $10,500 in 2010, but the 2010 income statement reports Depreciation
Expense of only $1,000. (Because the asset was acquired on July 1, 2010, only half of the annual
depreciation expense amount is recorded in 2010 and 2015.) In each of the years 2011 through 2014 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
Journal Entries For Depreciation
before income taxes
will be reduced in each of the years 2011 through 2014 by $2,000but the Cash account will not be
reduced. This explains why Depreciation Expense is sometimes referred to as a noncash expense.


The 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:

Date Account Name Debit Credit

December 31, 2010 Depreciation Expense 1,000


Accumulated Depreciation

1,000

December 31, 2011 Depreciation Expense 2,000


Accumulated Depreciation

2,000

December 31, 2012 Depreciation Expense 2,000


Accumulated Depreciation

2,000

December 31, 2013 Depreciation Expense 2,000


Accumulated Depreciation

2,000

December 31, 2014 Depreciation Expense 2,000


Accumulated Depreciation

2,000

December 31, 2015 Depreciation Expense 1,000


Accumulated Depreciation

1,000

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, 2011 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:

Equipment

(balance sheet account)
Debit
Increases an asset


Credit
Decreases an asset

July 1, 2010 ENTRY 10,500








Accumulated Depreciation Equipment

(balance sheet acct.)
Debit
Decreases a contra asset

Credit
Increases a contra asset


1,000

ENTRY Dec. 31, 2010

2,000

ENTRY Dec. 31, 2011


3,000

Balance Dec. 31, 2011

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.

Use of Estimates


Examples of Estimates
The calculation of depreciation shown above included two estimates:
1. Salvage value. Salvage value is the estimated amount that a company will receive when it
disposes of an asset at the end of the asset's useful life. Often the salvage value is estimated to
be zero. However, we assumed $500 in order to demonstrate how an amount would be handled.
Salvage value is also referred to as disposal value, scrap value, or residual value.
2. Useful life. The useful life of an asset is an estimate of how long the asset will be used (as
opposed to how long the asset will last). For example, a graphic artist might purchase a computer
in 2010 and expects to replace it in 2012 with a more advanced computer. Hence the graphic
artist's computer will have an estimated useful

Changes in Estimates
Whenever estimates are used in accounting, it is possible they will change as time moves forward. For
example, a company bought a machine for $14,000 on January 1, 2006. At the time it was estimated to
have no salvage value at the end of its useful life estimated to be 7 years. The company used straight-line
depreciation. In 2010 the company realizes that technology will cause the machine to be obsolete by
December 31, 2011 and there will be no salvage value at that time. Instead of the original useful life of 7
years, the company now estimates a total useful life of only 6 years (January 1, 2006 through December
31, 2011). This change in the estimated useful life affects only the current and future years. In other
words, in this example the depreciation for 2010 and 2011 will be affected. The depreciation already
reported for the years 2006, 2007, 2008, and 2009 cannot be changed. Any amount not depreciated as of
December 31, 2009 will have to be depreciated over the years 2010 and 2011.

Let's first calculate the straight-line depreciation using the estimates in January 2006:

life of 2 years. An accountant purchasing a similar
computer in 2010 expects to use it until 2014. The accountant will use an estimated useful life of
4 years when computing depreciation. Both the graphic artist and the accountant are correctthe
graphic artist in using 2 years and the accountant in using 4 yearseven if the computers will be
in working order for many years after their useful lives end.
Cost of the asset

$14,000
Less: Expected salvage value

0
Depreciable Cost (amount to be
depreciated over the estimated useful life)

$14,000
Years of estimated useful life

7
Depreciation Expense per year

$ 2,000

In the T-accounts we can see the cost of the Equipment $14,000 and the Accumulated Depreciation of
$8,000 as of December 31, 2009:

Equipment

(balance sheet account)
Debit
Increases an asset

Credit
Decreases an asset

Jan. 1, 2006 ENTRY 14,000








Accumulated Depreciation Equipment

(balance sheet acct.)
Debit
Decreases a contra asset

Credit
Increases a contra asset


2,000

ENTRY Dec. 31, 2006

2,000

ENTRY Dec. 31, 2007

2,000

ENTRY Dec. 31, 2008

2,000

ENTRY Dec. 31, 2009


8,000

Balance Dec. 31, 2009

These accounts show that $6,000 ($14,000 $8,000) remains on the books at December 31, 2009 and
there are only two years remaining (2010 and 2011) in which to depreciate the remaining $6,000. The
remaining $6,000 will be divided by the 2 years remaining and will result in $3,000 of depreciation in each
of the years 2010 and 2011.

In general journal format the entries will be:

Date Account Name Debit Credit

December 31, 2010 Depreciation Expense 3,000


Accumulated Depreciation

3,000

December 31, 2011 Depreciation Expense 3,000


Accumulated Depreciation

3,000


At the end of 2011 the Accumulated Depreciation account will look like this:

Accumulated Depreciation Equipment

(balance sheet acct.)
Debit
Decreases a contra asset

Credit
Increases a contra asset


2,000

ENTRY Dec. 31, 2006

2,000

ENTRY Dec. 31, 2007

2,000

ENTRY Dec. 31, 2008

2,000

ENTRY Dec. 31, 2009

3,000

ENTRY Dec. 31, 2010

3,000

ENTRY Dec. 31, 2011


14,000

Balance Dec. 31, 2011

Note that the depreciation amounts recorded in the years 2009 and before were not changed.

Accelerated Depreciation
What Is It?
Accelerated depreciation is an alternative to the straight-line depreciation method. Compared to the
straight-line method, accelerated depreciation methods provide for more depreciation in the early years of
an asset's life but then less depreciation in the later years. Under any depreciation method, the maximum
depreciation during the life of an asset is limited to the cost of the asset. The difference in depreciation
methods involves when you will report the depreciation. It's a matter of timing. Again,
the total
As stated earlier, most companies use the straight-line method of depreciation for their financial
statements. It is easy to compute and to understand. With straight-line depreciation the company will
have the same amount of depreciation in each of the years of the asset's life. Accelerated depreciation
will mean larger Depreciation Expense in the early years of the asset's life and then smaller Depreciation
Expense in the later years. This larger expense in the earlier years will mean the company will report less
profits in the earlier years of an asset's life (and greater profits in later years). Generally this is not
depreciation during the life of the asset is the same regardless of the depreciation method used.

appealing to most companies. As a result most companies will opt for the straight-line depreciation for
their financial statements.

However, using an accelerated depreciation method on the company's income tax returns is very
appealing. Higher depreciation in the early years of the asset means immediate income tax savings.
Smaller depreciation in later years is far into the future. Generally, it is better to take the income tax
savings sooner rather than later.

Fortunately a company is permitted to use straight-line depreciation on its financial statements and at the
same time it can use accelerated depreciation on its income tax returns.

Various Accelerated Depreciation Methods
There are various methods of accelerated depreciation. Here are some of them:
Double-declining balance (also known as the 200% declining balance)
150% declining balance
125% declining balance
Sum-of-the-years' digits


Payroll Accounting

Introduction to Payroll Accounting
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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
Payroll Accounting.

It's a fact of businessif a company has employees, it has to account for payroll and fringe benefits.

income statement and balance sheet. 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
return reporting. 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.

In December 2010, the U.S. government reduced the 2011 employee's tax rate for Social Security from
6.2% to 4.2%. (The employer's rate remains at 6.2% and the employee and employer Medicare tax rates
remain at 1.45%.)


Matching Principle
As we proceed with our explanation of payroll accounting, it will be helpful to recall the matching
principleof 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 accrual method of
accounting.)

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
1. A company employs a student to work a total of five daysfrom December 26 through December
30, 2010. On December 30 the student submits her time card. The company issues her payroll
check on the next scheduled payday, January 5, 2011.
paid.

Let's use three payroll examples to illustrate this point:

Even though the check is dated January 5, 2011, the matching principle requires that the
company report the expense and the liability in December 2010 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, 2011. The bonus amount is calculated by multiplying the sales from January 1
through December 31, 2010 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 2010. If the company violates the matching
principle by ignoring the bonus expense throughout the year 2010 (when sales actually occurred)
and reports the entire bonus amount as an expense for just one day (January 15, 2011), every
income statement pertinent to 2010 will report too much net income and the income statement
that includes January 15, 2011 will report too little net income. The matching principle requires
that the bonus expense pertinent to the 2010 sales be matched with the 2010 sales on the 2010
income statement.

If the entries are recorded properly, the balance sheet dated December 31, 2010 will report a
current liability for the total bonus amount owed to the sales manager. On January 15, 2011
(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 2010.

3. A company has a vacation plan that will provide two weeks of vacation in the year 2011 if the
employee worked the entire year of 2010. In the year 2010 (when the employee is working) the
company reports the vacation expense on its 2010 income statement. The company's December
31, 2010 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 2011 (when employees take the vacations that
were earned and expensed in 2010), 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.

Salaries, Wages, & Overtime Pay
In 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 1631. 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. (This will be discussed later in Illustration
of Accounting for Wages.)


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 paysome 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" employeeshe 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 payfederal 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
paystate 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
$10 per hour, plus 2 overtime hours $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.

Payroll Withholdings: Taxes & Benefits Paid by Employees
This section of payroll accounting focuses on the amounts withheld from employees' gross pay. (In Part
4
1. Employee portion of Social Security tax
of payroll accounting we will discuss the payroll taxes that are not withheld from employees' gross pay.)

The U. S. income tax systemas well as most state income tax systemsrequires 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:
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
If an employee earns $40,000 in wages in 2011, the entire $40,000 is subject to withholdings at
4.2%, for a total annual withholding of $1,680.
(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 2011, the amount of Social Security tax that an employer must withhold from an employee is 4.2% of
the first $106,800 of the employee's annual wages and salary; any amount above $106,800 is not subject
to Social Security tax withholdings. For example:
If an executive earns $300,000 in salary in 2011, only the first $106,800 of the salary is subject to
the Social Security tax of 4.2%, for a total annual withholding of $4,485.60. (The remaining
$193,200 of salary is not subject to Social Security tax withholdings, although it will be subject to
the Medicare tax discussed in the next section.)
The amount withheldand the employer's portionare reported as a current liability until the amounts
are remitted to the government by the employer.


2. Employee portion of Medicare tax
Medicare tax
The combination of the Social Security tax and the Medicare tax is referred to as
is also withheld from an employee's salary or wages and is matched by a contribution from
the employer. In other words, the employer is responsible for remitting to the federal government two
times the amount of Medicare tax withheld from each employee. 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.)

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 bean executive's salary of $300,000 has Medicare tax withholdings of $4,350 (the
entire $300,000 times 1.45%).

The amount withheldand the employer's matching amountare 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 W4
(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, this tax is not matched by a contribution
from the employer.

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 W4
(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),
this tax is not matched by a contribution from the employer.

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.
Net Pay


Net pay
Payroll Taxes, Costs & Benefits Paid by Employers
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.

In addition to salaries and wages, the employer will incur some or all of the following payroll-related
expenses:
1. Employer portion (matching) of Social Security tax
2. Employer portion (matching) 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

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 2011, the
employer's portion of the Social Security tax is 6.2% of the first $106,800 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 $1,680, the employer must also pay $2,480. The
combined amount to be remitted to the federal government for this one employee is $4,160 ($1,680 of
withholding plus the employer's portion of $2,480).

For an executive with an annual salary of $300,000 in the year 2011, only the first $106,800 is subject to
the Social Security tax. This means that in addition to the withholding of $4,485.60, the employer must
also pay $6,621.60. The combined amount to be remitted to the federal government for this one
employee is $11,107.20 ($4,485.60 + $6,621.60).

The employer's share of Social Security taxes (the match) is recorded as an expense and as an
additional current liability until the amounts are remitted.




2. Employer portion (matching) of Medicare tax
Every employer must contribute/remit to the federal government an amount identical to the Medicare tax
withheld from each employee's pay. This match is considered to be an expense for the employer. For the
year 2011, 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 a top executive earns a salary of
$300,000, the employer must pay a Medicare tax of $4,350 in addition to the $4,350 that was withheld
from the executive. The combined amount to be remitted to the federal government for this one employee
is $8,700.

The employer's share of Medicare taxes (the match) 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 organizationssuch as churches without schoolsmay 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;
conversely, employers with a small reserve (or no reserve at all) will have higher unemployment tax rates.

The unemployment tax rate is often applied only to the first $7,000 of each employee's annual salary and
wages (this amount will differ from state to state). If we assume that an employer's unemployment tax rate
is 4% and that this is applied to the first $7,000 of annual salaries and wages, then the employer's state
unemployment tax cost will be a maximum of $280 per year for each employee ($7,000 4%).

To illustrate, let's assume that a company has three employees. In 2011, Employee #1 earned $19,000,
Employee #2 earned $40,000, and Employee #3 (who only recently joined the company) earned $4,000.
If the 2011 state unemployment tax rate is 4%, the employer will pay a tax of $720 to the state
government:
Employee #1 $7,000 4% = $280
Employee #2 $7,000 4% = $280
Employee #3 $4,000 4% = $160
Total for
2011
$720
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.


4. Federal unemployment tax
The federal government oversees the state unemployment programs and requires employers to pay a
federal unemployment tax of 0.8% on each employee's first $7,000 of annual salaries and wages.

Using the example of three employees with annual 2011 earnings of $19,000, $40,000, and $4,000; with
a federal unemployment tax rate of 0.8%, the employer will pay a tax of $144 to the federal government:
Employee #1 $7,000 0.8% = $56
Employee #2 $7,000 0.8% = $56
Employee #3 $4,000 0.8% = $32
Total for
2011
$144
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 plantprovided that they do not venture out into the production areamay 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
If the employer pays the premium in advance, a current asset such as
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.)

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 significantlyin 2010, it was not uncommon to see an insurance premium for family
coverage at $12,000 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
To illustrate, assume that an employee works full-time for the entire year 2010 and as a result earns one
week of vacation to be taken any time during the year 2011. During the year 2010 (when the employee is
working), the employer records the vacation expense and the vacation liability. In 2011, when the
employee takes the vacation earned in the previous year, the employer records the cash payment by
crediting Cash and the reduction of the company liability by debiting
by the employee. (However, the Financial Accounting Standards Boards statement
of Financial Accounting Standards No. 43, Accounting for Compensated Absences, generally allows for
sick days and holidays not to be accrued.)

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
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
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.

employee is working, other benefits are deferred until the employee is retired. The cost of
the entire compensation 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
The concept is that in the years that the employee works, the company will charge
resulting from the employee's work.

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 official accounting pronouncements involving
pensions. (To read the pronouncements from the Financial Accounting Standards Board go to its
website www.fasb.org, then select FASB Pronouncements from the left panel.)


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 the official standard available at www.fasb.org. The
main accounting pronouncement on this topic is Statement of Financial Accounting Standards No.
106,Employers' Accounting for Postretirement Benefits Other Than Pensions. It can be found by
going towww.fasb.org
Example of Payroll Journal Entries For Wages
and then clicking the "Standards" tab at the top of the screen. Also be sure to
review the listing of FASB Pronouncements for any amendments or revisions that may have been issued
since the date of the original pronouncement.

In this section of payroll accounting we will provide examples of the journal entries for recording the gross
amount of wages and salaries, payroll withholdings, and employer costs related to payroll.

Let's assume that a distributor has hourly-paid employees working in two departments: delivery and
warehouse. The company's workweek is Sunday through Saturday and paychecks are dated and
distributed on the Thursday following the workweek.

For the workweek of December 1824, the gross wages are $1,000 for hourly employees in the delivery
department and $1,300 for employees in the warehouse. Tax withholdings are determined by consulting
government payroll guidelines; other withholdings are based on agreements with employees and court
orders. Paychecks are dated and distributed on December 29.

The journal entry to record the hourly payroll's wages and withholdings for the work period of December
1824 is illustrated in Hourly Payroll Entry #1. In accordance with accrual accounting and the matching
principle, the date used to record the hourly payroll is the last day of the work period.

Hourly Payroll Entry #1: To record hourly-paid employees' wages and withholdings for the
workweek of December 18-24 that will be paid on December 29.

Date Account Name Debit Credit

Dec. 24 Wages Expense: Delivery Dept 1,000.00


Wages Expense: Warehouse Dept 1,300.00


FICA Tax Payable

129.95

Federal Inc Tax Withholdings Payable

300.00

State Inc Tax Withholdings Payable

110.00

401(k) Payable

70.00

Health Ins. Expense: Delivery

90.00

Health Ins. Expense: Warehouse

80.00

United Way Payable

30.00

Garnishment Payable

50.00

Net Payroll Payable

1,440.05


In addition to the wages and withholdings in the above entry, the employer has incurred additional
expenses that pertain to the above workweek. These are shown next in Hourly Payroll Entry #2, which is
also dated the last day of the work period. The items included are the employer's share of FICA, the
employer's estimated cost for unemployment tax, worker compensation insurance, compensated
absences, and company contributions for the company's 401(k) plan. The company is recognizing these
additional expenses and the related liability in the period in which the employees are working and earning
them. Later, when the company pays for them, it will reduce the liability and reduce its cash. (Our journal
entry assumes that this company does not provide post-retirement benefitslike pensions or health
insuranceto its employees.)

Hourly Payroll Entry #2: To record the company's additional payroll-related expense for hourly-
paid employees for the workweek of December 18-24.

Date Account Name Debit Credit

Dec. 24 FICA Expense: Delivery 76.50


FICA Expense: Warehouse 99.45


Unemployment Tax Expense: Warehouse 4.00


Worker Compensation Insurance Expense 46.00


Holiday, Vac., Sick Days Expense: Delivery 100.00


Holiday, Vac., Sick Days Expense: Warehouse 130.00


401(k) Expense: Delivery 10.00


401(k) Expense: Warehouse 25.00


FICA Tax Payable

175.95

Unemployment Tax Payable

4.00

Worker Comp Insurance Payable

46.00

Holiday, Vacation, Sick Days Payable

230.00

401(k) Payable

35.00


On payday, December 29, the checks will be distributed to the hourly-paid employees. The following entry
will record the issuance of those payroll checks.

Hourly Payroll Entry #3: To record the distribution of the hourly-paid employees' payroll checks
on Dec. 29. (These checks reflect the net pay for the wages earned during the workweek of Dec.
18-24).

Date Account Name Debit Credit

Dec. 29 Net Payroll Payable 1,440.05


Cash

1,440.05


Some withholdings and the employer matching of FICA were remitted on payday; others are not due until
a later date. Some withholdings, such as health insurance, were recorded as reductions of the company's
expenses in Hourly Payroll Entry #1. We will assume the amounts in Hourly Payroll Entry #4 were
remitted on payday.

Hourly Payroll Entry #4: To record the remittance of some of the payroll withholdings and
company matching pertaining to the hourly-paid workweek of Dec. 18-24.

Date Account Name Debit Credit

Dec. 29 FICA Tax Payable 305.90


Federal Inc Tax Withholdings Payable 300.00


State Inc Tax Withholdings Payable 110.00


401(k) Payable 105.00


Cash

820.90



End of Month and End of Year
Let's continue with our example of the payroll for the hourly-paid employees. We'll assume that this
distributor's accounting month and accounting year both end on Saturday, December 31. The matching
principle requires the company to report all of its December expenses
Let's assume that during the workweek of December 2531, delivery department employees took $300
worth of their holiday and vacation days. Since a portion of the employer's estimated cost of holiday and
vacation days was recorded as an expense and liability via each week's Hourly Payroll Entry #2, the $300
associated with the days actually taken this week will not be recorded as an expenserather, the $300
associated with the days taken this week will reduce the liability that is recorded with each week's Hourly
Payroll Entry #2. In other words, only $700 of the delivery department's employee gross wages of $1,000
(not simply its cash payments) on
its December financial statements. This means the company must report on its income statement the
hourly wages and other payroll expenses that the company incurred (and the employees earned) through
December 31.

Recall that the paychecks issued on December 29 covered the work done by hourly employees through
December 24. The company must now record the cost of work done during the week of December 2531
(a week that includes a Christmas holiday plus a number of employees taking vacation days).

is for the work performed this week. The warehouse department had a similar situation. Of the warehouse
department's $1,300 of weekly wages, only $1,050 is the expense for the work performed this week. The
wages associated with the days off with pay reduces the company's liability that was provided for each
week in Hourly Payroll Entry #2. Except for the holiday and vacation days, the workweek payroll for
December 25-31 is similar to the previous week.

Hourly Payroll Entry #1: To record hourly-paid employees' wages and withholdings for the
workweek of December 25-31 that will be paid on January 5.

Date Account Name Debit Credit

Dec. 31 Wages Expense: Delivery Dept 700.00


Holiday, Vacation, Sick Days Payable 300.00


Wages Expense: Warehouse Dept 1,050.00


Holiday, Vacation, Sick Days Payable 250.00


FICA Tax Payable

129.95

Federal Inc Tax Withholdings Payable

300.00

State Inc Tax Withholdings Payable

110.00

401(k) Payable

70.00

Health Ins. Expense: Delivery

90.00

Health Ins. Expense: Warehouse

80.00

United Way Payable

30.00

Garnishment Payable

50.00

Net Payroll Payable

1,440.05


In addition to the wages and withholdings in Hourly Payroll Entry #1, the employer has incurred additional
expenses that pertain to the above workweek. These are shown next in Hourly Payroll Entry #2, which is
also dated the last day of the work period. The items included are the employer's share of FICA, the
employer's estimated cost for unemployment tax, worker compensation insurance, compensated
absences, and company contributions for the company's 401(k) plan. The company is recognizing these
additional expenses and the related liability in the period in which the employees are working and earning
them. Later, when the company pays for them, it will reduce the liability and reduce its cash. (Our journal
entry assumes that this company does not provide post-retirement benefitslike pensions or health
insuranceto its employees.)

Hourly Payroll Entry #2: To record the company's additional payroll-related expense for hourly-
paid employees for the workweek of December 25-31.

Date Account Name Debit Credit

Dec. 31 FICA Expense: Delivery 76.50


FICA Expense: Warehouse 99.45


Unemployment Tax Expense: Warehouse 4.00


Worker Compensation Insurance Expense 46.00


Holiday, Vac., Sick Days Expense: Delivery 100.00


Holiday, Vac., Sick Days Expense: Warehouse 130.00


401(k) Expense: Delivery 10.00


401(k) Expense: Warehouse 25.00


FICA Tax Payable

175.95

Unemployment Tax Payable

4.00

Worker Comp Insurance Payable

46.00

Holiday, Vacation, Sick Days Payable

230.00

401(k) Payable

35.00


On payday, January 5, the checks will be distributed to the hourly-paid employees. The following entry
will record the issuance of those payroll checks.

Hourly Payroll Entry #3: To record the distribution of the hourly-paid employees' payroll checks
on Jan 5. (These checks reflect the hourly-paid employees' take home pay from their wages
earned during the workweek of Dec. 25-31).

Date Account Name Debit Credit

Jan. 5 Net Payroll Payable 1,440.05


Cash

1,440.05


Some withholdings and the employer matching of FICA were remitted on payday; others are not due until
a later date. Some withholdings, such as health insurance, were recorded as reductions of the company's
expenses in Hourly Payroll Entry #1. We will assume the amounts in Payroll Entry #4 were remitted on
payday.

Hourly Payroll Entry #4: To record the remittance of some of the payroll withholdings and
company matching pertaining to the hourly-paid workweek of Dec. 25-31.

Date Account Name Debit Credit

Jan. 5 FICA Tax Payable 305.90


Federal Inc Tax Withholdings Payable 300.00


State Inc Tax Withholdings Payable 110.00


401(k) Payable 105.00


Worker Comp Insurance Payable 600.00


Cash

1,420.90



Additional Accrual of Wages
In our example above, the workweek ended on the same day as the calendar month and year: December
31. In other months and in some years, the last full workweek might end on the 28th of the month. In that
case, the employer will need to estimate the payroll and payroll-related expenses for the 29th, 30th, and
31st days of the month. Those estimates will be used to record an accrual-type adjusting entry on the
31st. This is required so that all of the expenses actually occurring during the month are matched with the
revenues of the month. Recording wages expense in the proper period is critical for accurate financial
statements and therefore a very important part of payroll accounting.

Example of Payroll Journal Entries For Salaries

Date

Let's assume our company also has salaried employees who are paid semimonthly on the 15th and the
last day of each month. The pay period for these employees is the half-month that ends on payday. There
is one salaried employee in the warehouse department with a gross salary of $48,000 per year, or $2,000
per pay period. There are four salaried employees in the Selling & Administrative Department with
combined salaries of $9,000 per pay period.

Because the salaried employees are paid on the last day of the month and their pay period ends right on
payday, there is no need to accrue for salaries at the end of December (or any other calendar month).
The salaried payroll entry for the work period of December 1631 will be dated December 31 and will look
like this:

Salaried Payroll Entry #1: To record the salaries and withholdings for the work period of
December 16-31 that will be paid on December 31.

Account Name Debit Credit

Dec. 31 Salaries Expense: Delivery Dept 2,000.00


Salaries Expense: Selling & Admin Dept 9,000.00


FICA Tax Payable

621.50

Federal Inc Tax Withholdings Payable

1,800.00

State Inc Tax Withholdings Payable

400.00

401(k) Payable

200.00

Health Ins Expense: Delivery

40.00

Health Ins. Expense: Selling & Admin

200.00

United Way Payable

100.00

Net Payroll Payable

7,638.50


In addition to the salaries recorded above, the company has incurred additional expenses pertaining to
the salaried payroll for this semi-monthly period of December 1631. These expenses must be included
in the December financial statements, as shown in the next journal entry:

Salaried Payroll Entry #2: To record additional payroll-related expense for salaried employees for
the work period of December 16-31.

Date Account Name Debit Credit

Dec. 31 FICA Expense: Delivery 153.00


FICA Expense: Selling & Admin 688.50


401(k) Expense: Delivery 20.00


401(k) Expense: Selling & Admin 80.00


FICA Tax Payable

841.50

401(k) Payable

100.00


Some withholdings and the employer's portion of FICA are remitted on payday; others are not due until a
later date. Some withholdings, such as health insurance, were recorded in Salaried Payroll Entry #1 as
reductions of the company's expenses. We will assume the following amounts were remitted on payday:

Salaried Payroll Entry #3: To record the distribution of the salaried employees' payroll checks on
Dec. 31. (These checks reflect the take-home pay for the salaries earned during the work period of
Dec. 16-31).

Date Account Name Debit Credit

Dec. 31 Net Payroll Payable 7,638.50


Cash

7,638.50


Some withholdings and the employer matching of FICA were remitted on payday; others are not due until
a later date. Some withholdings, such as health insurance, were recorded as reductions of the company's
expenses in Salaried Payroll Entry #1. We will assume the amounts in Payroll Entry #4 were remitted on
payday.

Salaried Payroll Entry #4: To record the remittance of some of the payroll withholdings and
company matching pertaining to the salaried employees during the work period of Dec. 15-31.

Date Account Name Debit Credit

Dec. 31 FICA Tax Payable 1,463.00


Federal Inc Tax Withholdings Payable 1,800.00


State Inc Tax Withholdings Payable 400.00


401(k) Payable 300.00


United Way Payable 100.00


Cash

4,063.00