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Income 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 yearJoe can choose whatever time period he deems most
useful.
The reporting of profitability involves two things: the amount that was earned (revenues) and the
expenses necessary to earn the revenues. As you will see next, the term revenues is not the same
as receipts, and the termexpenses involves more than just writing a check to pay a bill.

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

B. 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 paid for the expenses. For example, if Joe hires someone to help him with December
deliveries and Joe agrees to pay him $500 on January 3, that $500 expense needs to be shown on
the December income statement. The actual date that the $500 is paid out doesn't matter. What
matters is when the work was 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 January 3. The recording of expenses with the related revenues is
associated with another basic accounting principle known as the matching principle.

Marilyn explains to Joe that showing the $500 of wages expense on the December income
statement will result in a matching of the cost of the labor used to deliver the December parcels
with the revenues from delivering the December parcels. This matching principle is very important in
measuring just how profitable a company was during a given time period.
Marilyn is delighted to see that Joe already has an intuitive grasp of this basic accounting principle.
In order to earn revenues in December, the company had to incur some business expenses in
December, even if the expenses won't be paid until January. Other expenses to be matched with
December's revenues would be such things as gas for the delivery van and advertising spots on the
radio.
Joe asks Marilyn to provide another example of a cost that wouldn't be paid in December, but would
have to be shown/matched as an expense on December's income statement. Marilyn uses
the Interest Expense on borrowed money as an example. She asks Joe to assume that on
December 1 Direct Delivery borrows $20,000 from Joe's aunt and the company agrees to pay his
aunt 6% per year in interest, or $1,200 per year. This interest is to be paid in a lump sum each on
December 1 of each year.
Now even though the interest is being paid out to his aunt only once per year as a lump sum, Joe
can see that in reality, a little bit of that interest expense is incurred each and every day he's in
business. If Joe is preparingmonthly income statements, Joe should report one month of Interest
Expense on each month's income statement. The amount that Direct Delivery will incur as Interest
Expense will be $100 per month all year long ($20,000 x 6% 12). In other words, Joe needs to
match $100 of interest expense with each month's revenues. The interest expense is considered a
cost that is necessary to earn the revenues shown on the income statements.
Marilyn explains to Joe that the income statement is a bit more complicated than what she just
explained, but for now she just wants Joe to learn some basic accounting concepts and some of the
accounting terminology. Marilyn does make sure, however, that Joe understands one simple yet
important point: an income statement, does notreport the cash coming 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. Joe 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 Joe how these are reported in accounts
called Vehicles, Cash, Supplies, and Equipment. She mentions one asset Joe hadn't
consideredAccounts Receivable. If Joe delivers parcels, but isn't paid immediately for the
delivery, the amount owed to Direct Delivery is an asset known as Accounts Receivable.

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 Insurance Expense on December's income statement.
Joe asks Marilyn where the remaining $1,000 of unexpired insurance premium would be reported.
On the December 31 balance sheet, Marilyn tells him, in an asset account called Prepaid
Insurance.
Other examples of things that might be paid for before they are used include supplies and annual
dues to a trade association. The portion that expires in the current accounting period is listed as an
expense on the income statement; the part that has not yet expired is listed as an asset on the
balance sheet.
Marilyn assures Joe that he will soon see a significant link between the income statement and
balance sheet, but for now she continues with her explanation of assets.

Cost Principle and Conservatism


Joe learns that each of his company's assets was recorded at its original cost, and even if the fair
market value of an item increases, an accountant will not increase the recorded amount of that asset
on the balance sheet. This is the result of another basic accounting principle known as the cost
principle.
Although accountants generally do not increase the value of an asset, they might decrease its
value as a result of a concept known as conservatism. For example, after a few months in
business, Joe may decide that he can help out some 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 Joe bought them, however, the wholesale

price of boxes has been cut by 40% and at today's price he could purchase them for $0.60 each.
Because the replacement cost of his inventory ($60) is less than the original recorded cost ($100),
the principle of conservatism directs the accountant to report the lower amount ($60) as the asset's
value on the balance sheet.
In short, the cost principle generally prevents assets from being reported at more than cost, while
conservatism might require assets to be reported at less than their cost.

Depreciation
Joe also needs to know that the reported amounts on his balance sheet for assets such as
equipment, vehicles, and buildings are routinely reduced by depreciation. Depreciation is required by
the basic accounting principle known as the matching principle. Depreciation is used for assets
whose life is not 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 to Depreciation Expense on the income statement over its useful life.
As an example, assume that Direct Delivery's van has a useful life of five years and was purchased
at a cost of $20,000. The accountant might match $4,000 ($20,000 5 years) of Depreciation
Expense with each year's revenues for five years. Each year the carrying amount of the van will
be reduced by $4,000. (The carrying 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.
Joe wants to be certain that he understands what Marilyn is telling him regarding the assets on the
balance sheet, so he asks Marilyn if the balance sheet is, in effect, showing what the company's
assets are worth. He is surprised to hear Marilyn say that the assets are not reported on the balance
sheet at their worth (fair market value). Long-term assets (such as buildings, equipment, and
furnishings) are reported at their cost minus the amounts already sent to the income statement as
Depreciation Expense. The result is that a building's market value may actually have increased since
it was acquired, but the amount on the balance sheet has been consistently reduced as the
accountant moved some of its cost to Depreciation Expense on the income statement in order to
achieve the matching principle.
Another asset, Office Equipment, may have a fair market value that is much smaller than the
carrying amount reported on the balance sheet. (Accountants view depreciation as
an allocation processallocating the cost to expense in order to match the costs with the revenues
generated by the asset. Accountants do not consider depreciation to be a valuation process.) The
asset Land is not depreciated, so it will appear at its original cost even if the land is now worth one
hundred times more than its cost.
Short-term (current) asset amounts are likely to be close to their market values, since they tend to
"turn over" in relatively short periods of time.

Marilyn cautions Joe that the balance sheet reports only the assets acquired and only at the cost
reported in the transaction. This means that a company's reputationas excellent as it might be
will not be listed as an asset. It also means that Jeff Bezos will not appear as an asset on
Amazon.com's balance sheet; Nike's logo will not appear as an asset on its balance sheet; etc. Joe
is surprised to hear this, since in his opinion these items are perhaps the most valuable things those
companies have. Marilyn tells Joe that he has just learned an important lesson that he should
remember when reading a balance sheet.

Balance Sheet - Liabilities and


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

(C) Stockholders' 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 associate the reported amount of Stockholders' Equity with the market
value of the corporation. (Hence, it is a poor choice of words to refer to Stockholders' Equity as the
corporation's "net worth".) To find the market value of a corporation, you should obtain the services
of a professional familiar with valuing businesses.
Within the Stockholders' Equity section you may see accounts such as Common Stock, Paid-in
Capital in Excess of Par Value-Common Stock, Preferred Stock, Retained
Earnings, and Current Year's Net Income.
The account Common Stock will be increased when the corporation issues shares of stock in
exchange for cash (or some other asset). Another account Retained Earnings will increase when the
corporation earns a profit. There will be a decrease when the corporation has a net loss. This means
that revenues will automatically cause an increase in Stockholders' Equity and expenses will
automatically cause a decrease in Stockholders' Equity. This illustrates a link between a company's
balance sheet and income statement.

Statement of Cash Flows


The third financial statement that Joe needs to understand is the Statement of Cash Flows. This
statement shows how Direct Delivery's cash amount has changed during the time interval shown in
the heading of the statement. Joe will be able to see at a glance the cash generated and used by his
company's operating activities, its investing activities, and its financing activities. Much of the
information on this financial statement will come from Direct Delivery's balance sheets and income
statements.
Note: To learn more about the statement of cash flows, visit: Explanation of Cash
Flow StatementQuiz for Cash Flow Statement
The three financial reports that Marilyn introduced to Joethe 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 Joe the basics of getting started with recording his transactions.

Double Entry System


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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 two of the accounts in the accounting system.

The Chart of Accounts


To begin the process of setting up Joe's accounting system, he will need to make a detailed listing of
all the names of the accounts that Direct Delivery, Inc. might find useful for reporting transactions.
This detailed listing is referred to as a chart of accounts. (Accounting software often provides
sample charts of accounts for various types of businesses.)
As he enters his transactions, Joe will find that the chart of accounts will help him select the two (or
more) accounts that are involved. Once Joe's business begins, he may find that he needs to add
more account names to the chart of accounts, or delete account names that are never used. Joe can
tailor his chart of accounts so that it best sorts and reports the transactions of his business.
Because of the double entry system all of Direct Delivery's transactions will involve a combination of
two or more accounts from the balance sheet and/or the income statement. Marilyn lists out some
sample accounts that Joe will probably need to include on his chart of accounts:
Note: To learn more about the chart of accounts, visit: Explanation of Chart of
AccountsQuiz for Chart of Accounts
Balance Sheet accounts:

Asset accounts (Examples: Cash, Accounts


Receivable, Supplies, Equipment)
Liability accounts (Examples: Notes Payable, Accounts Payable, Wages
Payable)
Stockholders' Equity accounts (Examples: Common Stock, Retained Earnings)

Income Statement accounts:

Revenue accounts (Examples: Service Revenues, Investment Revenues)


Expense accounts (Examples: Wages Expense, Rent Expense, Depreciation
Expense)

To help Joe really understand how this works, Marilyn illustrates the double entry with some sample
transactions that Joe will likely encounter.

Sample Transaction #1
On December 1, 2013 Joe starts his business Direct Delivery, Inc. The first transaction that Joe will
record for his company is his personal investment of $20,000 in exchange for 5,000 shares of Direct
Delivery's common stock. Direct Delivery's accounting system will show an increase in its account
Cash from zero to $20,000, and an increase in its stockholders' equity account Common Stock by
$20,000. Both of these accounts are balance sheet accounts. There are no revenues
because no delivery fees were earned by the company, and there were no expenses.
After Joe enters this transaction, Direct Delivery's balance sheet will look like this:

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

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

Debits and Credits


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

Here's a Tip
Debit means left.
Credit means right.
Joe 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 Joe that if he memorizes this simple equation, it will be easier to understand the
debits and credits.

Here's a Tip
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:

Just as assets are on the left side (or debit side) of the accounting equation, the asset accounts in
the general ledger have their balances on the left side. To increase an asset account's balance, you
put more on the left side of the asset account. In accounting jargon, you debit the asset account.
To decrease an asset account balance you credit the account, that is, you enter the amount on the
right side.
Just as liabilities and stockholders' equity are on the right side (or credit side) of the accounting
equation, the liability and equity accounts in the general ledger have their balances on the right side.
To increase the balance in a liability or stockholders' equity account, you put more on the right side

of the account. In accounting jargon, you credit the liability or the equity account. To decrease a
liability or equity, you debit the account, that is, you enter the amount on the left side of the account.
As with all rules, there are exceptions, but Marilyn's reference to the accounting equation may help
you to learn whether an account should be debited or credited.
Since many transactions involve cash, Marilyn suggests that Joe memorize how the Cash account is
affected when a transaction involves cash: if Direct Delivery receives cash, the Cash account is
debited; when Direct Delivery pays cash, the Cash account is credited.

Here's a Tip
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
Joe in exchange for 5,000 shares of common stock, one of the accounts for this transaction is Cash.
Since cash wasreceived, the Cash account will be debited.
In keeping with double entry, two (or more) accounts need to be involved. Because the first account
(Cash) wasdebited, the second account needs to be credited. All Joe needs to do is find the right
account to credit. In this case, the second account is Common Stock. Common stock is part of
stockholders' equity, which is on the right side of the accounting equation. As a result, it should have
a credit balance, and to increase its balance the account needs to be credited.
Accountants indicate accounts and amounts using the following format:

Accountants usually first show the account and amount to be debited. On the next line, the account
to be credited is indented and the amount appears further to the right than the debit amount shown
in the line above. This entry format is referred to as a general journal entry.
(With the decrease in the price of computers and accounting software, it is rare to find a small
business still using a manual system and making entries by hand. Accounting software has made

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the process of recording transactions so much easier that the general journal is rarely needed. In
fact, entries are often generated automatically when a check or sales invoice is prepared.)

Sample Transactions #2 - #3
Sample Transaction #2
Marilyn illustrates for Joe a second transaction. On December 2, Direct Delivery purchases a used
delivery van for $14,000 by writing a check for $14,000. The two accounts involved are Cash and
Vehicles (or Delivery Equipment). When the check is written, the accounting software will
automatically make the entry into these two accounts.
Marilyn explains to Joe what is happening within the software. Since the company pays $14,000, the
Cash account is credited. (Accountants consider the checking account to be Cash, and the TIP you
learned is that when cash is paid, you credit Cash.) So we know that the Cash account will
be credited for $14,000 and we know the other account will have to be debited for $14,000. We
need only identify the best account to debit. In this case we choose Vehicles (or Delivery Equipment)
and the entry is:

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

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The balance sheet and the accounting equation remain in balance:

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

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

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

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

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

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

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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.

Here's a Tip
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:

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

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

We know that the unnamed account cannot be Cash because the company did not receive money
on December 3. However, the company has earned the right to receive the money in seven days.
The account title for the money that Direct Delivery has a right to receive for having provided the
service is Accounts Receivable (an asset account).

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

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

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Here's a Tip
Expenses are (almost) always debited.

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

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

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Notice that the year-to-date net income (bottom line of the income statement) increased
Stockholders' Equity by the same amount, $180. This connection between the income statement and
balance sheet is important. For one, it keeps the balance sheet and the accounting equation in
balance. Secondly, it demonstrates that revenues will cause the stockholders' equity to increase and
expenses will cause stockholders' equity to decrease. After the end of the year financial statements
are prepared, you will see that the income statement accounts (revenue accounts and expense
accounts) will be closed or zeroed out and their balances will be transferred into the Retained
Earnings account. This will mean the revenue and expense accounts will start the new year with
zero 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 Joe the important points of their discussion:
1. When a company pays cash for something, the company will credit Cash
and will have to debit a second account. Assuming that a company
prepares monthly financial statements

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

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

If the amount reduces a company's obligations, the account to be debited


will be a liability account. (Examples include Accounts Payable, Notes
Payable, Wages Payable, and Interest Payable.)

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

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

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

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If the amount received is a payment from a customer for a sale or service


delivered earlier and has already been recorded as revenue, the account
to be credited is Accounts Receivable.

If the amount received is the proceeds from the company signing a


promissory note, the account to be credited is Notes Payable.

If the amount received is an investment of additional money by the owner


of the corporation, a stockholders' equity account such as Common
Stock is credited.

Note: To learn more about debits and credits, go to Explanation of Debits and
Credits and Quiz for Debits and Credits.
3. Revenues are recorded as Service Revenues or Sales when the service or sale
has been performed, notwhen the cash is received. This reflects the basic
accounting principle known as the revenue recognition principle.
4. Expenses are matched with revenues or with the period of time shown in the
heading of the income statement, not in the period when the expenses were
paid. This reflects the basic accounting principle known as the matching
principle.
5. The financial statements also reflect the basic accounting principle known as
the cost principle. This means assets are shown on the balance sheet at
their original cost or less and not at their current value. The income statement
expenses also reflect the cost principle. For example, the depreciation expense is
based on the original cost of the asset being depreciated and not on the current
replacement cost.

Introduction to the Accounting


Equation
From the large, multi-national corporation down to the corner beauty salon, every business
transaction will have an effect on a company's financial position. The financial position of a company
is measured by the following items:
1. Assets (what it owns)

18

2. Liabilities (what it owes to others)


3. Owner's Equity (the difference between assets and liabilities)
The accounting equation (or basic accounting equation) offers us a simple way to understand
how these three amounts relate to each other. The accounting equation for a sole proprietorship is:

The accounting equation for a corporation is:

Assets are a company's 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 owner's (or stockholders') equity.
Liabilities are a company's 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 company's assets, and
(2) a sourcealong with owner or stockholder equityof the company's assets.
Owner's equity or stockholders' equity is the amount left over after liabilities are deducted from
assets:
Assets - Liabilities = Owner's (or Stockholders') Equity.
Owner's or stockholders' equity also reports the amounts invested into the company by the owners
plus the cumulative net income of the company that has not been withdrawn or distributed to the
owners.
If a company keeps accurate records, the accounting equation will always be "in balance," meaning
the left side should always equal the right side. The balance is maintained because every business
transaction affects at least two of a company's accounts. For example, when a company
borrows money from a bank, the company's assets will increase and its liabilities will increase by the
same amount. When a company purchases inventory for cash, one asset will increase and one asset

19

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
company's general ledger.Each account in the general ledger is designated as to its type: asset,
liability, owner's equity, revenue, expense, gain, or loss account.

Balance Sheet and Income Statement


The balance sheet is also known as the statement of financial position and it reflects the
accounting equation. The balance sheet reports a company's assets, liabilities, and owner's (or
stockholders') equity at a specific point in time. Like the accounting equation, it shows that a
company's total amount of assets equals the total amount of liabilities plus owner's (or stockholders')
equity.
The income statement is the financial statement that reports a company's revenues and
expenses and the resulting net income. While the balance sheet is concerned with one point in
time, the income statement covers atime interval or period of time. The income statement will
explain part of the change in the owner's or stockholders' equity during the time interval between two
balance sheets.
Examples
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 company's general ledger.
Our examples will show the effect of each transaction on the balance sheet and income statement.
Our examples also assume that the accrual basis of accounting is being followed.
Parts 2 - 6 illustrate transactions involving a sole proprietorship.
Parts 7 - 10 illustrate almost identical transactions as they would take place in a corporation.

Accounting Equation for a Sole


Proprietorship: Transactions 12
We present nine transactions to illustrate how a company's accounting equation stays in balance.
When a company records a business transaction, it is not entered into an accounting equation, per
se. Rather, transactions are recorded into specific accounts contained in the company's general
ledger. Each account is designated as an asset, liability, owner's equity, revenue, expense, gain, or

20

loss account. The general ledgeraccounts are then used to prepare the balance sheets and
income statements throughout the accounting periods.
In the examples that follow, we will use the following accounts:

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

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

Sole Proprietorship Transaction #1.


Let's assume that J. Ott forms a sole proprietorship called Accounting Software Co. (ASC). On
December 1, 2013, J. Ott invests personal funds of $10,000 to start ASC. The effect of this
transaction on ASC's accounting equation is:

As you can see, ASC's assets increase by $10,000 and so does ASC's owner's equity. As a result,
the accounting equation will be in balance.
You can interpret the amounts in the accounting equation to mean that ASC has assets of $10,000
and the source of those assets was the owner, J. Ott. Alternatively, you can view the accounting
equation to mean that ASC has assets of $10,000 and there are no claims by creditors (liabilities)
against the assets. As a result, the owner has a claim for the remainder or residual of $10,000.
This transaction is recorded in the asset account Cash and the owner's equity account J. Ott,
Capital. The general journal entry to record the transactions in these accounts is:

21

After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASC's
financial position at the end of December 1, 2013:

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

Sole Proprietorship Transaction #2.


On December 2, 2013 J. Ott withdraws $100 of cash from the business for his personal use. The
effect of this transaction on ASC's accounting equation is:

The accounting equation remains in balance since ASC's assets have been reduced by $100 and so
has the owner's equity.
This transaction is recorded in the asset account Cash and the owner's equity account J. Ott,
Drawing. The general journal entry to record the transactions in these accounts is:

22

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

The totals indicate that ASC has assets of $9,900 and the source of those assets is the owner of the
company. You can also conclude that the company has assets or resources of $9,900 and the only
claim against those resources is the owner's claim.
The December 2 balance sheet will communicate the company's financial position as of midnight on
December 2:

23

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

Accounting Equation for a Sole


Proprietorship: Transactions 34
Sole Proprietorship Transaction #3.
On December 3, 2013 Accounting Software Co. spends $5,000 of cash to purchase computer
equipment for use in the business. The effect of this transaction on the accounting equation is:

The accounting equation reflects that one asset increases and another asset decreases. Since the
amount of the increase is the same as the amount of the decrease, the accounting equation remains
in balance.
This transaction is recorded in the asset accounts Equipment and Cash. Equipment increases by
$5,000, and Cash decreases by $5,000. The general journal entry to record the transactions in these
accounts is:

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

24

The totals tell us that the company has assets of $9,900 and the source of those assets is the owner
of the company. It also tells us that the company has assets of $9,900 and the only claim against
those assets is the owner's claim.
The balance sheet dated December 3, 2013 will reflect the financial position as of midnight on
December 3:

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

Sole Proprietorship Transaction #4.


On December 4, 2013 ASC obtains $7,000 by borrowing money from its bank. The effect of this
transaction on the accounting equation is:

25

As you can see, ASC's assets increase and ASC's liabilities increase by $7,000.
This transaction is recorded in the asset account Cash and the liability account Notes Payable as
shown in this accounting entry:

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

The totals indicate that the transactions through December 4 result in assets of $16,900. There are
two sources for those 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 ASC's financial position as of that date:

26

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, 2013 Accounting Software Co. pays $600 for ads that were run in recent days. The
effect of this advertising transaction on the accounting equation is:

27

Since ASC is paying $600, its assets decrease. The second effect is a $600 decrease in owner's
equity, because the transaction involves an expense. (An expense is a cost that is used up or its
future economic value cannot be measured.)
Although owner's equity is decreased by an expense, the transaction is not recorded directly into the
owner's capital account at this time. Instead, the amount is initially recorded in the expense account
Advertising Expense and in the asset account Cash.
The general journal entry to record the transaction is:

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

The totals now indicate that Accounting Software Co. has assets of $16,300. The creditors provided
$7,000 and the owner of the company provided $9,300. Viewed another way, the company has
assets of $16,300 with the creditors having a claim of $7,000 and the owner having a residual claim
of $9,300.
The balance sheet as of the end of December 5, 2013 is:

28

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

29

Sole Proprietorship Transaction #6.


On December 6, 2013 ASC performs consulting services for its clients. The clients are billed for the
agreed upon amount of $900. The amounts are due in 30 days. The effect on the accounting
equation is:

Since ASC has performed the services, it has earned revenues and it has the right to receive $900
from the clients. This right (known as an account receivable) causes assets to increase. The earning
of revenues causes owner's equity to increase.
Although revenues cause owner's equity to increase, the revenue transaction is not recorded into the
owner's capital account at this time. Rather, the amount earned is recorded in the revenue account
Service Revenues. This will allow the company to report the revenues on its income statement at any
time. (After the year ends, the amount in the revenue account will be transferred to the owner's
capital account.)
The general journal entry to record the transaction is:

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

30

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

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

31

Accounting Equation for a Sole


Proprietorship: Transactions 78
Sole Proprietorship Transaction #7.
On December 7, 2013 ASC uses a temporary help service for 6 hours at a cost of $20 per hour. ASC
will pay the invoice when it is due in 10 days. The effect on its accounting equation is:

ASC's liabilities increase by $120 and the expense causes owner's equity to decrease by $120.
The liability will be recorded in Accounts Payable and the expense will be reported in Temp Service
Expense. The journal entry for recording the use of the temp service is:

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

32

The totals show us that the company has assets of $17,200 and the sources are the creditors with
$7,120 and the owner of the company with $10,080. The accounting equation totals also tell us that
the company has assets of $17,200 with the creditors having a claim of $7,120. This means that the
owner's residual claim is $10,080.
The financial position of ASC as of midnight on December 7, 2013 is:

33

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

34

Sole Proprietorship Transaction #8.


On December 8, 2013 ASC receives $500 from the clients it had billed on December 6, 2013. The
collection of accounts receivables has this effect on the accounting equation:

The company's asset (cash) increases and another asset (accounts receivable) decreases. Liabilities
and owner's equity are unaffected. (There are no revenues on this date. The revenues were recorded
when they were earned on December 6.)
The general journal entry to record the increase in Cash, and the decrease in Accounts Receivable
is:

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

35

The totals for the first eight transactions indicate that the company has assets of $17,200. The
creditors provided $7,120 and the owner provided $10,080. The accounting equation also indicates
that the company's creditors have a claim of $7,120 and the owner has a residual claim of $10,080.
ASC's balance sheet as of midnight December 8, 2013 is:

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

36

Calculating a Missing Amount within


Owner's Equity
The income statement for the calendar year 2013 will explain a portion of the change in the owner's
equity between the balance sheets of December 31, 2012 and December 31, 2013. The other items
that account for the change in owner's equity are the owner's investments into the sole proprietorship
and the owner's draws (or withdrawals). A recap of these changes is the statement of changes in
owner's equity. Here is a statement of changes in owner's equity for the year 2013 assuming that
the Accounting Software Co. had only the eight transactions that we covered earlier.

37

Example of Calculating a Missing Amount


The format of the statement of changes in owner's equity can be used to determine one of these
components if it is unknown. For example, if the net income for the year 2013 is unknown, but you
know the amount of the draws and the beginning and ending balances of owner's equity, you can
calculate the net income. (This might be necessary if a company does not have complete records of
its revenues and expenses.) Let's demonstrate this by using the following amounts.

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

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

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

38

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:

Step 5.
Starting at the top of the statement we know that the owner's equity before the start of 2013 was
$60,000 and in 2013 the owner invested an additional $10,000. As a result we have $70,000 before
considering the amount of Net Income. We also know that after the amount of Net Income is added,
the Subtotal has to be $134,000 (the Subtotal calculated in Step 4). The Net Income is the difference
between $70,000 and $134,000. Net income must have been $64,000.
Step 6.
Insert the previously missing amount (in this case it is the $64,000 of net income) into the statement
of changes in owner's equity and recheck the math:

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

39

You can reinforce what you have learned by using our Quiz for the Accounting
Equation and our Crossword Puzzle on the Accounting Equation.
The remaining parts of this topic will illustrate similar transactions and their effect on the accounting
equation when the company is a corporation instead of a sole proprietorship.

Accounting Equation for a


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

In our examples below, we show how a given transaction affects the accounting equation for a
corporation. We also show how the same transaction will be recorded in the company's general
ledger accounts.
Our examples will also show the effect of each transaction on the balance sheet and income
statement. For all of our examples we assume that the accrual basis of accounting is being
followed.
In the examples that follow, we will use the following accounts:

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

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

40

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

Corporation Transaction C1
Let's assume that members of the Ott family form a corporation called Accounting Software, Inc.
(ASI). On December 1, 2013, several members of the Ott family invest a total of $10,000 to start ASI.
In exchange, the corporation issues a total of 1,000 shares of common stock. (The stock has no par
value and no stated value.) The effect on the corporation's accounting equation is:

As you see, ASI's assets increase by $10,000 and stockholders' equity increases by the same
amount. As a result, the accounting equation will be in balance.
The accounting equation tells us that ASI has assets of $10,000 and the source of those assets was
the stockholders. Alternatively, the accounting equation tells us that the corporation has assets of
$10,000 and the only claim to the assets is from the stockholders (owners).
This transaction is recorded in the asset account Cash and in the stockholders' equity account
Common Stock. The general journal entry to record the transaction is:

After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASI's
financial position at the end of December 1, 2013:

41

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

Corporation Transaction C2.


On December 2, 2013 ASI purchases $100 of its stock from one of its stockholders. The stock will be
held by the corporation as Treasury Stock. The effect of the accounting equation is:

The purchase of its own stock for cash meant that ASI's assets decrease by $100 and its
stockholders' equity decreases by $100.
This transaction is recorded in the asset account Cash and in the stockholders' equity account
Treasury Stock. The accounting entry in general journal form is:

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

42

The totals indicate that ASI has assets of $9,900 and the source of those assets is the stockholders.
The accounting equation also shows that the corporation has assets of $9,900 and the only claim
against those resources is the stockholders' claim.
The December 2 balance sheet will communicate the corporation's financial position as of midnight
on December 2:

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

Accounting Equation for a


Corporation: Transactions C3C4
43

Corporation Transaction C3.


On December 3, 2013 ASI spends $5,000 of cash to purchase computer equipment for use in the
business. The effect of this transaction on its accounting equation is:

The accounting equation indicates that one asset increases and one asset decreases. Since the
amount of the increase is the same as the amount of the decrease, the accounting equation remains
in balance.
This transaction is recorded in the asset accounts Equipment and Cash. The account increases by
$5,000 and the account decreases by $5,000. The journal entry for this transaction is:

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

The totals tell us that the corporation has assets of $9,900 and the source of those assets is the
stockholders. The totals tell us that the company has assets of $9,900 and that the only claim
against those assets is the stockholders' claim.
The balance sheet dated December 3, 2013 reflects the financial position of the corporation as of
midnight on December 3:

44

The purchase of equipment is not an immediate expense. It will become depreciation


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

Corporation Transaction C4.


On December 4, 2013 ASI obtains $7,000 by borrowing money from its bank. The effect of this
transaction on the accounting equation is:

As you see, ACI's assets increase and its liabilities increase by $7,000.
This transaction is recorded in the asset account Cash and the liability account Notes Payable with
the following journal entry:

45

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

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

46

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, 2013 Accounting Software, Inc. pays $600 for ads that were run in recent days. The
effect of the advertising transaction on the corporation's accounting equation is:

47

Since ASI is paying $600, its assets decrease. The second effect is a $600 decrease in
stockholders' equity, because the transaction involves an expense. (An expense is a cost that is
used up or its future economic value cannot be measured.)
Although stockholders' equity decreases because of an expense, the transaction is not recorded
directly into the retained earnings account. Instead, the amount is initially recorded in the expense
account Advertising Expense and in the asset account Cash. The journal entry for this transaction is:

The combined effect of the first five transactions is:

The totals now indicate that Accounting Software, Inc. has assets of $16,300. The creditors provided
$7,000 and the stockholders provided $9,300. Viewed another way, the corporation has assets of
$16,300 with the creditors having a claim of $7,000 and the stockholders having a claim of $9,300.
The balance sheet as of the end of December 5, 2013 is presented here:

48

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

49

Because we assume that Accounting Services, Inc. is a Subchapter S corporation,


income tax expense is not reported on the corporation's income statement.

Corporation Transaction C6.


On December 6, 2013 ASI performs consulting services for its clients. The clients are billed for the
agreed upon amount of $900. The amounts are due in 30 days. The effect on the accounting
equation is:

Since ASI has performed the services, it has earned revenues and it has the right to receive $900
from its clients. This right means that assets increased. The earning of revenues also causes
stockholders' equity to increase.
Although revenues cause stockholders' equity to increase, the revenue transaction is not recorded
directly into a stockholders' equity account at this time. Rather, the amount earned is recorded in the
revenues accountService Revenues . This will allow the corporation to report the revenues
account on its income statement at any time. (After the year ends, the amount in the revenues
accounts will be transferred to the retained earnings account.) The general journal entry for providing
services on credit is:

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

50

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, 2013 is presented here:

51

**The income statement (which reports the company's revenues, expenses, gains, and
losses for a specified time period) is a link between balance sheets. It provides the
results of operationsan 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 Equation for a


Corporation: Transactions C7C8
Corporation Transaction C7.
On December 7, 2013 ASI uses a temporary help service for 6 hours at a cost of $20 per hour. ASI
records the invoice immediately, but it will pay the $120 when it is due in 10 days. This transaction
has the following effect on the accounting equation:

The accounting equation shows that ASI's liabilities increase by $120 and the expense causes
stockholders' equity to decrease by $120.
The liability will be recorded in Accounts Payable and the expense will be recorded in Temp Service
Expense. The general journal entry for utilizing the temp service is:

52

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

The totals show us that the corporation has assets of $17,200 and the sources are the creditors with
$7,120 and the stockholders with $10,080. The accounting equation totals also reveal that the
corporation's creditors have a claim of $7,120 and the stockholders have a claim for the remaining
$10,080.
The financial position of ASI as of midnight of December 7, 2013 is presented in the following
balance sheet:

53

**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 operationsan important part of the change in stockholders' equity.
The income statement for the first seven days of December is shown here:

54

Corporation Transaction C8.


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

The corporation's cash increases and one of its other assets (accounts receivable) decreases.
Liabilities and stockholders' equity are unaffected. (There are no revenues on this date. The
revenues were recorded when they were earned on December 6.)
The general journal entry to record the increase in Cash and the decrease in Accounts Receivable
is:

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

55

The totals after the first eight transactions indicate that the corporation has assets of $17,200. The
creditors have provided $7,120 and the company's stockholders have provided $10,080. The
accounting equation also indicates that the company's creditors have a claim of $7,120 and the
stockholders have a residual claim of $10,080.
ASI's balance sheet as of midnight of December 8, 2013 is shown here:

56

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

57

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 equationis:

The eight transactions that we had listed under the basic accounting equation Transaction 8, are
shown in the following expanded accounting equation:

58

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

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:

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

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

Introduction to Accounting Principles


There are general rules and concepts that govern the field of accounting. These general rules
referred to as basic accounting principles and guidelinesform the groundwork on which more
detailed, complicated, and legalistic accounting rules are based. For example, the Financial
Accounting Standards Board (FASB) uses the basic accounting principles and guidelines
as a basis for their own detailed and comprehensive set of accounting rules and standards.
The phrase "generally accepted accounting principles" (or "GAAP") consists of three important sets
of rules: (1) the basic accounting principles and guidelines, (2) the detailed rules and standards
issued by FASB and its predecessor the Accounting Principles Board (APB), and (3) the generally
accepted industry practices.
If a company distributes its financial statements to the public, it is required to follow generally
accepted accounting principles in the preparation of those statements. Further, if a company's stock
is publicly traded, federal law requires the company's financial statements be audited by independent
public accountants. Both the company's management and the independent accountants must certify

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

Basic Accounting Principles and


Guidelines
Since GAAP is founded on the basic accounting principles and guidelines, we can better understand
GAAP if we understand those accounting principles. The following is a list of the ten main accounting
principles and guidelines together with a highly condensed explanation of each.
1. Economic Entity Assumption
The accountant keeps all of the business transactions of a sole proprietorship separate from the
business owner's personal transactions. For legal purposes, a sole proprietorship and its owner are
considered to be one entity, but for accounting purposes they are considered to be two separate
entities.
2. Monetary Unit Assumption
Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S.
dollars are recorded.
Because of this basic accounting principle, it is assumed that the dollar's purchasing power has not
changed over time. As a result accountants ignore the effect of inflation on recorded amounts. For
example, dollars from a 1960 transaction are combined (or shown) with dollars from a 2013
transaction.
3. Time Period Assumption
This accounting principle assumes that it is possible to report the complex and ongoing activities of a
business in relatively short, distinct time intervals such as the five months ended May 31, 2013, or
the 5 weeks ended May 1, 2013. The shorter the time interval, the more likely the need for the
accountant to estimate amounts relevant to that period. For example, the property tax bill is received

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on December 15 of each year. On the income statement for the year ended December 31, 2012, the
amount is known; but for the income statement for the three months ended March 31, 2013, the
amount was not known and an estimate had to be used.
It is imperative that the time interval (or period of time) be shown in the heading of each income
statement, statement of stockholders' equity, and statement of cash flows. Labeling one of
these financial statements with "December 31" is not good enoughthe reader needs to know
if the statement covers the one week ended December 31, 2012 the month ended December 31,
2012 the three months ended December 31, 2012 or theyear ended December 31, 2012.
4. Cost Principle
From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cash
equivalent) when an item was originally obtained, whether that purchase happened last year or
thirty years ago. For this reason, the amounts shown on financial statements are referred to
as historical cost amounts.
Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact, as
a general rule, asset amounts are not adjusted to reflect any type of increase in value. Hence, an
asset amount does not reflect the amount of money a company would receive if it were to sell the
asset at today's market value. (An exception is certain investments in stocks and bonds that are
actively traded on a stock exchange.) If you want to know the current value of a company's long-term
assets, you will not get this information from a company's financial 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.

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The going concern principle allows the company to defer some of its prepaid expenses until future
accounting periods.
7. Matching Principle
This accounting principle requires companies to use the accrual basis of accounting. The
matching principle requires that expenses be matched with revenues. For example, sales
commissions expense should be reported in the period when the sales were made (and not reported
in the period when the commissions were paid). Wages to employees are reported as an expense in
the week when the employees worked and not in the week when the employees are paid. If a
company agrees to give its employees 1% of its 2013 revenues as a bonus on January 15, 2014, the
company should report the bonus as an expense in 2013 and the amount unpaid at December 31,
2013 as a liability. (The expense is occurring as the sales are occurring.)
Because we cannot measure the future economic benefit of things such as advertisements (and
thereby we cannot match the ad expense with related future revenues), the accountant charges the
ad amount to expense in the period that the ad is run.
(To learn more about adjusting entries go to Explanation of Adjusting Entries and Quiz for
Adjusting Entries.)
8. Revenue Recognition Principle
Under the accrual basis of accounting (as opposed to the cash basis of
accounting), revenues are recognized as soon as a product has been sold or a service has
been performed, regardless of when the money is actually received. Under this basic accounting
principle, a company could earn and report $20,000 of revenue in its first month of operation but
receive $0 in actual cash in that month.
For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should
recognize $1,000 of revenue as soon as its work is doneit does not matter whether the client pays
the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.
9. Materiality
Because of this basic accounting principle or guideline, an accountant might be allowed to violate
another accounting principle if an amount is insignificant. Professional judgement is needed to
decide whether an amount is insignificant or immaterial.
An example of an obviously immaterial item is the purchase of a $150 printer by a highly profitable
multi-million dollar company. Because the printer will be used for five years, the matching principle
directs the accountant to expense the cost over the five-year period. The materiality guideline
allows this company to violate the matching principle and to expense the entire cost of $150 in the
year it is purchased. The justification is that no one would consider it misleading if $150 is expensed
in the first year instead of $30 being expensed in each of the five years that it is used.
Because of materiality, financial statements usually show amounts rounded to the nearest dollar, to
the nearest thousand, or to the nearest million dollars depending on the size of the company.

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10. Conservatism
If a situation arises where there are two acceptable alternatives for reporting an item, conservatism
directs the accountant to choose the alternative that will result in less net income and/or less asset
amount. Conservatism helps the accountant to "break a tie." It does not direct accountants to be
conservative. Accountants are expected to be unbiased and objective.
The basic accounting principle of conservatism leads accountants to anticipate or disclose losses,
but it does not allow a similar action for gains. For example, potential losses from lawsuits will be
reported on the financial statements or in the notes, but potential gains will not be reported. Also,
an accountant may write inventory downto an amount that is lower than the original cost, but will not
write inventory up to an amount higher than the original cost.

Other Characteristics of Accounting


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 reliable, verifiable, and
objective.
2. We expect consistency in the accounting information.
3. We expect comparability in the accounting information.

1. Reliable, Verifiable, and Objective


In addition to the basic accounting principles and guidelines listed in Part 1, accounting information
should be reliable, verifiable, and objective. For example, showing land at its original cost of $10,000
(when it was purchased 50 years ago) is considered to be more reliable,
verifiable, and objective than showing it at its current market value of $250,000. Eight different
accountants will wholly agree that the original cost of the land was $10,000they 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'scurrent value, you will likely receive eight different estimates. Because the current value
amount is less reliable, less verifiable, and less objective than the original cost, the original cost is
used.
The accounting profession has been willing to move away from the cost principle if there are
reliable, verifiable, and objective amounts involved. For example, if a company has an investment in

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

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

How Principles and Guidelines Affect


Financial 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 to Explanation of Balance Sheet and Quiz for Balance Sheet.)
A balance sheet is a snapshot of a company's assets, liabilities, and owner's equity at one point
in time. (In this case, that point in time is after all of the transactions through September 30, 2013
have been recorded.) Because of the economic entity assumption, only the assets, liabilities,

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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.

The assets listed on the balance sheet have a cost that can be measured and each amount shown is
the original cost of each asset. For example, let's assume that a tract of land was purchased in 1956
for $10,000. Mary's Design Service still owns the land, and the land is now appraised at $250,000.
The cost principle requires that the land be shown in the asset account Land at its original cost
of $10,000 rather than at the recently appraised amount of $250,000.
If Mary's Design Service were to purchase a second piece of land, the monetary unit
assumption dictates that the purchase price of the land bought today would simply be added to
the purchase price of the land bought in 1956, and the sum of the two purchase prices would be
reported as the total cost of land.
The Supplies account shows the cost of supplies (if material in amount) that were obtained by Mary's
Design Service but have not yet been used. As the supplies are consumed, their cost will be moved
to the Supplies Expense account on the income statement. This complies with the matching
principle which requires expenses to be matched either with revenues or with the time period
when they are used. The cost of the unused supplies remains on the balance sheet in the asset
account Supplies.
The Prepaid Insurance account represents the cost of insurance that has not yet expired. As the
insurance expires, the expired cost is moved to Insurance Expense on the income statement as
required by the matching principle. The cost of the insurance that has not yet expired remains on

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

2. Income Statement
Let's see how the basic accounting principles and guidelines might affect the income statement of
Mary's Design Service. (To learn more about the income statement go to Explanation of
Income Statement and Quiz for Income Statement.)
An income statement covers a period of time (or time interval), such as a year, quarter, month,
or four weeks. It is imperative to indicate the period of time in the heading of the income statement
such as "For the Nine Months Ended September 30, 2013". (This means for the period of January 1
through September 30, 2013.) If prepared under the accrual basis of accounting, an income
statement will show how profitable a company was during the stated time interval.

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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 are costs used up by the company in performing its main operations. The matching
principle requires that expenses be reported on the income statement when the related sales are
made or when the costs are used up (rather than in the period when they are paid).
Losses are a net amount related to transactions that are not considered part of the company's main
operating activities. For example, let's say a retail clothing company owns an old computer that is
carried on its accounting records at $650. If the company sells that computer for $300, the
company receives an asset (cash of $300) but it must also remove $650 of asset amounts from its
accounting records. The result is a Loss on Sale of Computer of $350. The $300 selling price
will not be included in the company's sales or revenues.

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3. The Notes To Financial Statements


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

Introduction to Accounts Payable


Account payable is defined in Webster's New Universal Unabridged Dictionary as:
account payable, pl. accounts payable. a liability to a creditor, carried on open account,
usually for purchases of goods and services. [1935-40]
When a company orders and receives goods (or services) in advance of paying for them, we say that
the company is purchasing the goods on account or on credit. The supplier (or vendor) of the
goods on credit is also referred to as a creditor. If the company receiving the goods does not sign a
promissory note, the vendor's bill or invoice will be recorded by the company in its liability account
Accounts Payable (or Trade Payables).
As is expected for a liability account, Accounts Payable will normally have a credit balance. Hence,
when a vendor invoice is recorded, Accounts Payable will be credited and another account must be
debited (as required by double-entry accounting). When an account payable is paid, Accounts
Payable will be debited and Cash will be credited. Therefore, the credit balance in Accounts Payable
should be equal to the amount of vendor invoices that have been recorded but have not yet been
paid.
Under the accrual method of accounting, the company receiving goods or services on credit
must report the liability no later than the date they were received. The same date is used to record
the debit entry to an expense or asset account as appropriate. Hence, accountants say that under
the accrual method of accounting expenses are reported when they are incurred (not when they are
paid).
The term accounts payable can also refer to the person or staff that processes vendor invoices
and pays the company's bills. That's why a supplier who hasn't received payment from a customer
will phone and ask to speak with "accounts payable."
The accounts payable process involves reviewing an enormous amount of detail to ensure that only
legitimate and accurate amounts are entered in the accounting system. Much of the information that
needs to be reviewed will be found in the following documents:
purchase orders issued by the company

receiving reports issued by the company

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invoices from the company's vendors

contracts and other agreements

The accuracy and completeness of a company's financial statements are dependent on the accounts
payable process. A well-run accounts payable process will include:

the timely processing of accurate and legitimate vendor invoices,

accurate recording in the appropriate general ledger accounts, and

the accrual of obligations and expenses that have not yet been completely
processed.

The efficiency and effectiveness of the accounts payable process will also affect the company's cash
position, credit rating, and relationships with its suppliers.

An Account Payable Is Another


Company's Account Receivable
It may be helpful to note that an account payable at one company is an account receivable for the
vendor that issued the sales invoice. To illustrate this, let's assume that DeliverCorp provides a
service for YourCo at a cost of $600 on May 1 and sends an invoice dated May 1 for $600. The
invoice specifies that the amount will be due in 30 days. (We will assume throughout our explanation
that the companies follow the accrual method of accounting.)
The following table highlights the symmetry between a company's account payable and its vendor's
account receivable.

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The following table focuses on the general ledger accounts: Accounts Payable and Accounts
Receivable.

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Accounts Payable Process


The accounts payable process or function is immensely important since it involves nearly all of a
company's payments outside of payroll. The accounts payable process might be carried out by an
accounts payable department in a large corporation, by a small staff in a medium-sized company, or
by a bookkeeper or perhaps the owner in a small business.
Regardless of the company's size, the mission of accounts payable is to pay only the
company's bills and invoices that are legitimate and accurate. This means that
before a vendor's invoice is entered into the accounting records and scheduled for payment, the
invoice must reflect:

what the company had ordered

what the company has received

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the proper unit costs, calculations, totals, terms, etc.

To safeguard a company's cash and other assets, the accounts payable process should
have internal controls. A few reasons for internal controls are to:

prevent paying a fraudulent invoice

prevent paying an inaccurate invoice

prevent paying a vendor invoice twice

be certain that all vendor invoices are accounted for

Periodically companies should seek professional assistance to improve its internal controls.
The accounts payable process must also be efficient and accurate in order for the company's
financial statements to be accurate and complete. Because of double-entry accounting an omission
of a vendor invoice will actually cause two accounts to report incorrect amounts. For example, if a
repair expense is not recorded in a timely manner:
1. the liability will be omitted from the balance sheet, and
2. the repair expense will be omitted from the income statement.
If the vendor invoice for a repair is recorded twice, there will be two problems as well:
1. the liabilities will be overstated, and
2. repairs expense will be overstated.
In other words, without the accounts payable process being up-to-date and well run, the company's
management and other users of the financial statements will be receiving inaccurate feedback on the
company's performance and financial position.

A poorly run accounts payable process can also mean missing a discount for paying some bills early.
If vendor invoices are not paid when they become due, supplier relationships could be strained. This
may lead to some vendors demanding cash on delivery. If that were to occur it could have extreme
consequences for a cash-strapped company.
Just as delays in paying bills can cause problems, so could paying bills too soon. If vendor invoices
are paid earlier than necessary, there may not be cash available to pay some other bills by their due
dates.

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Purchase order
A purchase order or PO is prepared by a company to communicate and document precisely what
the company is ordering from a vendor. The paper version of a purchase order is a multi-copy form
with copies distributed to several people. The people or departments receiving a copy of the PO
include:

the person requesting that a PO be issued for the goods or services

the accounts payable department

the receiving department

the vendor

the person preparing the purchase order

The purchase order will indicate a PO number, date prepared, company name, vendor name, name
and phone number of a contact person, a description of the items being purchased, the quantity, unit
prices, shipping method, date needed, and other pertinent information.
One copy of the purchase order will be used in the three-way match, which we will discuss later.

Receiving report
A receiving report is a company's documentation of the goods it has received. The receiving report
may be a paper form or it may be a computer entry. The quantity and description of the goods shown
on the receiving report should be compared to the information on the company's purchase order.
After the receiving report and purchase order information are reconciled, they need to be compared
to the vendor invoice. Hence, the receiving report is the second of the three documents in the threeway match (which will be discussed shortly).

Vendor Invoice
The supplier or vendor will send an invoice to the company that had received the goods and/or
services on credit. When the invoice or bill is received, the customer will refer to it as a vendor
invoice. Each vendor invoice is routed to accounts payable for processing. After the invoice is verified
and approved, the amount will be credited to the company's Accounts Payable account and will also
be debited to another account (often as an expense or asset).
A common technique for verifying a vendor invoice is the three-way match.

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Three-way match
The accounts payable process often uses a technique known as the three-way match to assure that
only valid and accurate vendor invoices are recorded and paid. The three-way match involves the
following:

Only when the details in the three documents are in agreement will a vendor's invoice be entered
into the Accounts Payable account and scheduled for payment.
Good internal control of a company's resources is enhanced when the company assigns a separate
employee with a specific, limited responsibility. The following chart illustrates the concept of the
separation (or segregation) of duties involving accounts payable:

When the duties are separated, it will require more than one dishonest person to steal from the
company. Hence, small companies without sufficient staff to separate employees' responsibilities will
have a greater risk of theft.
To illustrate the three-way match, let's assume that BuyerCo needs 10 cartridges of toner for its
printers. BuyerCo issues a purchase order to SupplierCorp for 10 cartridges at $60 per cartridge that
are to be delivered in 10 days. One copy of the PO is sent to SupplierCorp, one copy goes to the
person requisitioning the cartridges, one copy goes to the receiving department, one copy goes to
accounts payable, and one copy is retained by the person preparing the PO. When BuyerCo
receives the cartridges, a receiving report is prepared.
The three-way match involves comparing the following information:

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1. The description, quantity, cost and terms on the company's purchase order.
2. The description and quantity of goods shown on the receiving report.
3. The description, quantity, cost, terms, and math on the vendor invoice.
After determining that the information reconciles, the vendor invoice can be entered into the liability
account Accounts Payable. The information entered into the accounting software will include invoice
reference information (vendor name or code, invoice number and date, etc.), the amount to be
credited to Accounts Payable, the amount(s) and account(s) to be debited and the date that the
payment is to be made. The payment date is based on the terms shown on the invoice and the
company's policy for making payments.
Lastly, the documents should be stamped or perforated to indicate they have been entered into the
accounting system thus avoiding a duplicate payment.

Vouchers
Some companies use a voucher in order to document or "vouch for" the completeness of the
approval process. You can visualize a voucher as a cover sheet for attaching the supporting
documents (purchase order, receiving report, vendor's invoice, etc.) and for noting the approvals,
account numbers, and other information for each vendor invoice or bill.
When the vendor invoice is paid, the voucher and its attachments (including a copy of the check that
was issued) will be stored in a paid voucher/invoice file. If paper documents are involved, an
office machine could perforate the word "PAID" through the voucher and its attachments. This is
done to assure that a duplicate payment will not occur.
The unpaid invoices and vouchers will be held in an open file.

Vendor invoices without purchase orders or receiving reports


Not all vendor invoices will have purchase orders or receiving reports. Hence, the three-way match is
not always possible. For example, a company does not issue a purchase order to its electric utility for
a pre-established amount of electricity for the following month. The same is true for the telephone,
natural gas, sewer and water, freight-in, and so on.
There are also payments that are required every month in order to fulfill lease agreements or other
contracts. Examples include the monthly rent for a storage facility, office rent, automobile payments,
equipment leases, maintenance agreements, etc. Even though these obligations will not have
purchase orders, the responsibility is unchanged: pay only the amounts that are
legitimate and accurate.

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Statements from vendors


Vendors often send statements to their customers to indicate the amounts (listed by invoice number)
that remain unpaid. When a vendor statement is received the details on the statement should be
compared to the company's records.
The fact that a company can be receiving both invoices and statements from a vendor means there
is the potential of a duplicate payment. In order to avoid making a duplicate payment, companies
often establish the following rule: Pay only from vendor invoices; never pay from vendor statements.

Related Expense or Asset


The vendor invoices received by a company could involve the following:
1. A vendor invoice may be a bill for a repair or maintenance service. The vendor's
credit terms allow the company to pay 30 days after the date of the service.
Since repairs and maintenance do not create more assets, the cost of the service
should be reported on the income statement as an expense. Under the accrual
method of accounting the expense is reported in the accounting period in which
the service occurred (not the period in which it is paid). Other examples of
expenses include the cost of office expenses such as electricity and telephone,
consulting, and more.
2. A vendor invoice may be a bill for the purchase of expensive equipment that will
be used by the company for several years. The equipment will be recorded as an
asset and will be reported in the company's balance sheet section property, plant
and equipment. As the equipment is utilized, its cost will be moved from the
balance sheet to the income statement account Depreciation Expense.
3. Another vendor invoice may be a billing for the cost of a service that the vendor
will provide in the future, but the payment must be made in advance. A common
example is an insurance company's invoice for the premiums covering the next
six months of insurance on the company's automobiles. The company will initially
debit the invoice amount to a current asset such as Prepaid Expenses. As the
insurance expires, the cost will be allocated to Insurance Expense.
The following table illustrates an insurance premium of $6,000 that is paid in
December but the coverage is for the following January 1 through June 30:

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The three examples illustrate that some vendor invoices will be immediately recorded as expenses
while other invoices are initially recorded as assets. The accounts payable staff needs to be
instructed as to the proper accounts to be debited when vendor invoices are entered as credits to
Accounts Payable. Generally, a cost that is used up and has no future economic value that can be
measured is debited immediately to expense. Vendor invoices for property, plant and equipment are
not expensed immediately. Instead, the cost is recorded in a balance sheet asset account and will be
expensed in increments during the asset's useful life. Lastly, a prepaid expense is initially recorded in
a current asset account and will be allocated to expense as the cost expires.

End of the Period Cut-Off


At the end of every accounting period (year, quarter, month, 5-week period, etc.) it is important that
the accounts payable processing be up-to-date. If it is not up-to-date, the income statement for the
accounting period will likely be omitting some expenses and the balance sheet at the end of the
accounting period will be omitting some liabilities.
During the first few days after an accounting period ends, it is important for the accounts payable
staff to closely examine the incoming vendor invoices. For example, a $900 repair bill received on
January 6 may be a December repair expense and a liability as of December 31. Another vendor
invoice received on January 6 may not have been an obligation as of December 31 and is actually a
January expense.
It is also necessary to review the receiving reports that have not yet been matched to vendor
invoices. If items were ordered and received prior to December 31, the amounts must be recorded as
of December 31 through an accrual-type adjusting entry.
Note: The proper cut-off at the end of each accounting period becomes more
complicated and often more significant if a company has inventories of finished
products, work-in-process and raw materials. It is possible that some goods will be
included in the physical inventory counts, but the costs have not yet been recorded in
Accounts Payable and in the Inventory or Purchases account.

Accruing Expenses and Liabilities


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At the end of every accounting period there will be some vendor invoices and receiving reports that
have not yetbeen approved or fully matched. As a result these amounts will not have been entered
into the Accounts Payable account (and the related expense or asset account). These documents
should be reviewed in order to determine whether a liability and an expense have actually been
incurred by the company as of the end of the accounting period.
Since the accrual method of accounting requires that all of a company's liabilities and expenses must
be reported on the financial statements, companies should prepare an accrual-type adjusting
entry at the end of every accounting period. This adjusting entry will credit Accrued Liabilities and
will debit the appropriate expense or other account for the amounts that were incurred but are not yet
included in Accounts Payable. The balance in Accrued Liabilities will be reported in the current
liability section of the balance sheet immediately after Accounts Payable.
It is also common for companies to prepare a reversing entry every month. The reversing entry
removes the previous period's accrual adjusting entry and prevents the double-counting of an
expense that could occur when the actual vendor invoice is processed.
Note: Under the accrual method of accounting, a company's financial statements must
report all expenses and liabilities that are probable and can be measured even if the
vendors' invoices have not yet been received or fully processed.

Adding General Ledger Accounts


The general ledger accounts that are available for recording transactions are found in the
company's chart of accounts. For most businesses the general ledger accounts are listed in the
following order:
1. Balance sheet accounts
o Asset accounts
o

Liability accounts

Stockholders' or owner's equity accounts

2. Income statement accounts


o Operating revenue accounts
o

Operating expense accounts

Nonoperating revenue and gain accounts

Nonoperating expense and loss accounts

Many systems will allow for each account to have subaccounts. Subaccounts allow for summarizing
or combining amounts while also maintaining the detailed amounts.
When the existing accounts are not sufficient, new accounts should be added. In other words,
meaningful financial reporting of transactions should not be limited to a preconceived list of
accounts.

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For more information and examples see Explanation of Chart of Accounts.

Invoice Credit Terms


The invoice terms indicate when an invoice becomes due and whether a discount may be taken if the
invoice is paid sooner. The invoice terms also dictate the point at which ownership of goods will
transfer from the seller to the buyer.
The following payment terms are some of the more common ones for businesses without inventories.

Net due upon receipt


If the vendor's terms are Net due upon receipt, the invoice amount is due immediately. (Of course,
you should verify that the invoice is valid and accurate before it is entered for payment.)

Net 30 days
When the vendor invoice states Net 30 days, the amount of the invoice (minus any returns or
allowances) is due 30 days from the date of the invoice. For example, if a vendor invoice for $1,000
is dated June 1 and the company is granted a $100 allowance, the net amount of $900 should be
paid by July 1. (If there were no allowance, the company should remit $1,000 by July 1.)

1/10, n/30
When a vendor invoice includes terms of 1/10, n/30, the "1" represents 1% of the amount owed, the
"10" represents 10 days, the "n" represents the word net, and the "30" represents 30 days. The
terms 1/10, n/30indicate that the buyer may take an early payment discount of 1% of the amount
owed if the amount owed is remitted within 10 days instead of the normal 30 days. In other words,
the buyer can choose either of the following:

Pay within 10 days and deduct 1% of the net amount owed (the invoice amount
minus any authorized returns and/or allowances), or

Pay in 30 days and take no discount.

To illustrate1/10, n/30, let's assume that a vendor invoice for $1,000 is dated June 1 and the buyer
does not return any of the goods. Since there are no returns, the net amount of the purchase is the
full $1,000 and the buyer can remit either of the following amounts:

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If paying by June 10, the amount due to the vendor is $990. [The net amount of
$1,000 minus the $10 early payment discount (which is 1% of $1,000).]
If paying by July 1, the net amount of $1,000 is due.

If the buyer was given an allowance of $100, the net amount is $900. In that case the buyer can
remit either of the following amounts:

If paying by June 10, the amount due to the vendor is $891. [The net amount of
$900 minus $9 (which is 1% of $900).]
If paying by July 1, the net amount of $900 is due.

2/10, n/30
If the vendor's invoice has terms of 2/10, n/30, the "2" represents 2%, the "10" represents 10 days,
the "n" represents the word net and the "30" represents 30 days. This means that the buyer can take
an early payment discount of 2% of the amount owed if the amount is remitted within 10 days instead
of the customary 30 days. In other words, the buyer can choose either of the following:

Pay within 10 days and deduct 2% of the net amount (invoice amount minus any
authorized returns and/or allowances), or

Pay the full amount in 30 days with no discount.

To illustrate 2/10, n/30, assume that a vendor's invoice for $1,000 is dated June 1 and the vendor
has granted the buyer an allowance of $100. This means the net amount is $900 and that only $900
will be eligible for the early payment discount. Hence, the buyer can remit either of the following
amounts:

If paying by June 10, the amount due to the vendor is $882. [The net amount of
$900 minus $18 (which is 2% of $900).]

If paying by July 1, the net amount of $900 is due.

Early Payment Discounts vs. Need for


Cash
Some vendors offer an early payment discount such as 2/10, net 30. This means that the buyer
may deduct 2% of the amount owed if the vendor is paid within 10 days instead of the normal 30
days. For instance, an invoice amount of $1,000 can be settled in full if the buyer will pay $980 within
10 days. In this example, the buyer will save $20 (2% X $1,000) for paying 20 days earlier than the
normal due date. If the buyer has the opportunity to do this every 20 days, it would occur 18 times
during a year (365 days divided by 20 days = 18 times). That means the company could save up to

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$360 ($20 X 18 times per year) each year by using a single $980 amount. Hence the annual
percentage rate is approximately 36% ($360 earned divided by $980 used).
Looking at it another way, if the buyer had to borrow $980 from its bank for the 20 days at a
borrowing rate of 6% per year, the interest for 20 days would be only $3.22 ($980 X 6% X 20/365).
By paying $3.22 of interest to the bank, the buyer will save paying the vendor $20 and therefore will
be better off by $16.78 ($20.00 minus $3.22). If this occurs 18 times in a year, the net annual savings
will be approximately $301 [$16.78 X 18 times; or $360 per year saved minus the annual interest
paid to the bank of $59 ($980 X 6%)].
A discount of 1% for paying 20 days early equates to an annual interest rate of approximately18%.
It is clear that buyers with sufficient cash balances or a readily available line of credit should take
advantage of the early payment discounts. However, some buyers are operating with very little cash
and are unable to borrow additional money. These buyers may be wise to forgo the early payment
discounts in order to avoid the risk of overdrawing their checking account. One overdraft fee
could be greater than the early payment discount. If an overdraft causes several of the
buyer's checks to be returned to its vendors, the total amount of overdraft fees will be even greater.
If a buyer's checks are returned because of insufficient funds its suppliers may become concerned
about the buyer's ability to pay. This could lead to one or more of the suppliers demanding payment
at the time of delivery. The elimination of 30 days of credit from suppliers could be devastating for a
buyer with little money and a credit line that has been exhausted.
Be sure to consider your company's cash balances and cash needs before paying invoices prior to
their due dates.

Other
Vendor or employee?
Occasionally an individual will provide services for a company and submits an invoice. The invoice is
processed through accounts payable and in the U.S. the company may be required to issue the
individual an IRS Form 1099-MISC in January of the following year.
While the company views the individual as an independent contractor, the Internal Revenue Service
rules may dictate that the individual is actually a part-time employee. If a person is deemed to be an
employee, the Internal Revenue Service requires that payroll taxes be withheld and a Form W-2 be
issued instead of Form 1099-MISC.

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You can learn more about the distinction between an independent contractor and an employee
at www.IRS.gov.

Internal controls
In order to protect a company's assets it is important that a company have in place a variety of
controls over issuing purchase orders, issuing checks, adding vendors to the accounts payable
master vendor file, segregating duties, and other safeguards referred to as internal controls.
We recommend that a professional who is well-versed in internal controls perform a review of your
company's policies and procedures.

Batching the payments to vendors


In order for the accounts payable staff to operate efficiently, it is helpful to process the checks written
to vendors only on specified days each month. Writing the checks on pre-announced days will
hopefully discourage the need for "rush" checks and allow the accounts payable processing to be
more efficient.

Sales and use taxes


Certain purchases of goods and/or services may be subject to state sales taxes. If a sales tax is not
paid for thesales-taxable goods or services (even from out-of-state vendors), the buyer is likely to
be liable for a state usetax. To further complicate the situation, some organizations may be exempt
from both a sales tax and a use tax depending on the state laws.
The responsibility for compliance with sales and use taxes rests with each company. As a result,
companies must be familiar with the laws of the states in which they operate.

Travel and entertainment


Travel and entertainment, commonly known as T&E, is another area of accounts payable that needs
to be managed. Here, too, each company must establish procedures and controls and be in
compliance with Internal Revenue Service (IRS) rules which can be found at www.IRS.gov.

General Ledger Account: Accounts


Payable
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The general ledger account Accounts Payable or Trade Payables is a current liability account,
since the amounts owed are usually due in 10 days, 30 days, 60 days, etc. The balance in Accounts
Payable is usually presented as the first or second item in the current liability section of the balance
sheet. (Many companies report Notes Payable due within one year as the first item.)
As a liability account, Accounts Payable is expected to have a credit balance. Hence, a credit entry
will increase the balance in Accounts Payable and a debit entry will decrease the balance.
A bill or invoice from a supplier of goods or services on credit is often referred to as a vendor
invoice. The vendor invoices are entered as credits in the Accounts Payable account, thereby
increasing the credit balance in Accounts Payable. When a company pays a vendor, it will reduce
Accounts Payable with a debit amount. As a result, the normal credit balance in Accounts Payable
is the amount of vendor invoices that have been recorded but have not yet been paid. The unpaid
invoices are sometimes referred to as open invoices.
Accounting software allows companies to sort its accounts payable according to the dates when
payments will be due. This feature and the resulting report are known as the aging of accounts
payable.

Entering a vendor invoice into Accounts Payable


Prior to entering a vendor invoice into Accounts Payable, the invoice should be reviewed and
approved. The reason is that a vendor invoice may contain errors (incorrect quantities, incorrect
prices, math errors, etc.) and some invoices may not be legitimate.
After a vendor invoice has been approved, the recording of the invoice will include:

a credit to Accounts Payable, and


a minimum of one debit to another account. The debit amount usually involves
one of the following:

an expense (Repairs & Maintenance Expense, Advertising Expense, Rent


Expense, etc.)

a prepaid asset (Prepaid Expenses, Prepaid Insurance)

a fixed or plant asset (Equipment, Fixtures, Vehicles, etc.)

A listing of the accounts that a company has available for recording transactions is known as
the chart of accounts.
A report that lists the accounts and amounts that are debited for a group of invoices entered into the
accounting software is known as the accounts payable distribution.

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Reductions to Accounts Payable


When a company pays part or all of a previously recorded vendor invoice, the balance in Accounts
Payable will be reduced with a debit entry and Cash will be reduced with a credit entry.
Accounts Payable is also debited when a company returns goods to a vendor or when the vendor
grants an allowance.

Introduction to Accounts Receivable


and Bad Debts 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 transaction
we exchange our money for the store's groceries.
In the world of business, however, many companies must be willing to sell their goods (or
services) on credit. This would be equivalent to the grocer transferring ownership of the groceries
to you, issuing a sales invoice, and allowing you to pay for the groceries at a later date.
Whenever a seller decides to offer its goods or services on credit, two things happen: (1) the seller
boosts its potential to increase revenues since many buyers appreciate the convenience and
efficiency of making purchases on credit, and (2) the seller opens itself up to potential losses if its
customers do not pay the sales invoice amount when it becomes due.
Under the accrual basis of accounting (which we will be using throughout our discussion) a
sale on credit will:
1. Increase sales or sales revenues, which are reported on the income statement,
and
2. Increase the amount due from customers, which is reported as accounts
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 direct write-off method.

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Recording Services Provided on Credit


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 services on account.)
Under the accrual basis of accounting, revenues are considered earned at the time when the
services are provided. This means that on June 3 Malloy will record the revenues it earned, even
though Malloy will not receive the $4,000 until July. Below are the accounts affected on June 3, the
day the service transaction was completed:

In this transaction, the debit to Accounts Receivable increases Malloy's current assets, total assets,
working capital, and stockholders' (or owner's) 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 the seller's dock. If the sale is made with the terms FOB Destination, the ownership of the
goods is transferred at thebuyer's dock.
In principle, the seller should record the sales transaction when the ownership of the goods is
transferred to the buyer. Practically speaking, however, accountants typically record the transaction
at the time the sales invoice is prepared and the goods are shipped.

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FOB Shipping Point


Quality Products Co. just sold and shipped $1,000 worth of goods using the terms FOB Shipping
Point. With its cost of goods at 80% of sales value, Quality makes the following entries in its general
ledger:

(While there may be additional expenses with this 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 seller is responsible for transporting the goods to the customer's dock, and will factor in
the cost of shipping when it sets its price for the goods.
Let's assume that Gem Merchandise Co. makes a sale to a customer that has a sales value of
$1,050 and a cost of goods sold at $800. This transaction affects the following accounts in Gem's
general ledger:

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Because Gem chooses to ship its goods FOB Destination, the ownership of the goods transfers at
the buyer's dock. Therefore, Gem Merchandise assumes all the risks and costs associated with
transporting the goods.
Now let's assume that Gem pays an independent shipping company $50 to transport the goods from
its warehouse to the buyer's dock. Gem records the $50 as an operating expense or selling
expense (in an account such as Delivery Expense, Freight-Out
Expense, or Transportation-Out Expense). If the shipping company allows Gem to pay in 7
days, Gem will make the following entry in its general ledger:

Credit Terms with 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, cash discount, or an early payment
discount, and the shorter period of time is known as the discount period. For example, the
term 2/10, net 30 allows a customer to deduct 2% of the net amount owed if the customer pays
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

88

pays Gem within 10 days of the invoice date, the customer is allowed to deduct $18 (2% of $900)
from the net purchase of $900. In other words, the $900 amount can be settled for $882 if it is paid
within the 10-day discount period.
Let's assume that the sale above took place on the first day that Gem was open for business, June
1. On June 6 Gem receives the returned goods and restocks them, and on June 11 it receives $882
from the buyer. Gem's cost of goods is 80% of their original selling prices (before discounts). The
above transactions are reflected in Gem's general ledger as follows:

If the customer waits 30 days to pay Gem, the June 11 entry shown above will not occur. In its place
will be the following entry on July 1:

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.

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Credit Terms

Brief D

Net 10 days

The net

Net 30 days

The net

Net 60 days

The net

2/10, n/30

If paid w

2/10, n/30

If paid in

1/10, n/60

If paid w

1/10, n/60

If paid in

Net EOM 10

The net

Costs of Discounts
Some people believe that the credit term of 2/10, net 30 is far too generous. They argue that when a
$900 receivable is settled for $882 (simply because the customer pays 20 days early) the seller is, in
effect, giving the buyer the equivalent of a 36% annual interest rate (2% for 20 days equates to 36%
for 360 days). Some sellers won't offer terms such as 2/10, net 30 because of these high percentage
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

90

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 thedirect write-off method, which is discussed later.)

Allowance for Doubtful Accounts and Bad Debts Expense - June


As we stated above, the account Allowance for Doubtful Accounts is a contra asset account
containing the estimated amount of the accounts receivable that will not be collected. For example,
let's assume that Gem Merchandise Co.'s Accounts Receivable has a debit balance of $100,000 at

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June 30. Gem anticipates that approximately $2,000 of this is not likely to turn to cash, and as a
result, Gem reports a credit balance of $2,000 in Allowance for Doubtful Accounts. The accounting
entry to adjust the balance in the allowance account will involve the income statement account Bad
Debts Expense.
Since June was Gem's first month in business, its Allowance for Doubtful Accounts began June with
a zero balance. At June 30, when it issues its first balance sheet and income statement, its
Allowance for Doubtful Accounts will have a credit balance of $2,000. This is done using the
following adjusting journal entry:

Here are some of the accounts in a T-account format:

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With Allowance for Doubtful Accounts now reporting a credit balance of $2,000 and Accounts
Receivable reporting a debit balance of $100,000, Gem's balance sheet will report a net amount of
$98,000. Since this net amount of $98,000 is the amount that is likely to turn to cash, it is referred to
as the net realizable value of the accounts receivable.
Under the allowance method, the Gem Merchandise Co. does not need to know specifically which
customer will not pay, nor does it need to know the exact amount. This is acceptable because
accountants believe it is better to report an approximate amount that is uncollectible rather than
imply that every penny of the accounts receivable will be collected.
Gem's Bad Debts Expense will report credit losses of $2,000 on its June income statement. This
expense is being reported even though none of the accounts receivables were due in June. (Recall
the credit terms were net 30 days.) Gem is attempting to follow the matching principle by matching
the bad debts expense as best it can to the accounting period in which the credit sales took place.

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Here's a Tip
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 the July 31 adjustment to Allowance for Uncollectible Accounts will be reporting a
net realizable value of $228,000 ($230,000 minus $2,000).
Gem reviews the details of its accounts receivable and estimates that as of July 31 approximately
$10,000 of the $230,000 will not be collectible. In other words, the net realizable value (or net cash
value) of its accounts receivable as of July 31 is only $220,000 ($230,000 minus $10,000). Before
the July 31 financial statements are released, Gem must adjust the Allowance for Doubtful Accounts
so that its ending balance is a credit of $10,000 (instead of the present credit balance of $2,000).
This requires the following adjusting entry:

After this journal entry is recorded, Gem's July 31 balance sheet will report the net realizable value of
its accounts receivables at $220,000 ($230,000 debit balance in Accounts Receivable minus the
$10,000 credit balance in Allowance for Doubtful Accounts).
Here's a recap in T-account form:

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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

95

be paying their account balances. However, the matching principle is better met by Gem
making these estimates and recording the credit loss as close as possible to the time the sales were
made.
By reporting the $10,000 credit balance in Allowance for Doubtful Accounts, Gem is also adhering to
the accounting principle of conservatism. In other words, if there is some doubt as to whether
there are $10,000 of credit losses or no credit losses, Gem's accountant "breaks the tie" by choosing
the alternative that reports a smaller amount of profit and a smaller amount of assets. (It is reporting
a net realizable value of $220,000 instead of the $230,000 of accounts receivable.) If a company
knows with certainty that every penny of its accounts receivable will be collected, then the
Allowance for Doubtful Accounts will report a zero balance. However, if it is likely that some of the
accounts receivable will not be collected in full, the principle of conservatism requires that there be a
credit balance in Allowance for Doubtful Accounts.

Writing Off an Account under the


Allowance 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 write off, the customer's
account balance of $1,400.
Under the allowance method of recording credit losses, Gem's entry to write off the customer's
account balance is as follows:

The two accounts affected by this entry contain this information:

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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.

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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:

2. Process the $1,400 received on October 10:

The seller's accounting records now show that the account receivable was paid, making it more likely
that the seller might do future business with this customer.

Bad Debts Expense as a Percent of


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

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approach, this company automatically debits Bad Debts Expense and credits Allowance for Doubtful
Accounts for 0.3% of each week's credit sales. Let's assume that in the current week this company
sells $500,000 of goods on credit. It estimates its bad debts expense to be $1,500 (0.003 x
$500,000) and records the following journal entry:

The percentage of credit sales approach focuses on the income statement and the matching
principle. Sales revenues of $500,000 are immediately matched with $1,500 of bad debts expense.
The balance in the account Allowance for Doubtful Accounts is ignored at the time of the weekly
entries. However, at some later date, the balance in the allowance account must be reviewed and
perhaps further adjusted, so that the balance sheet will report the correct net realizable value. If the
seller is a new company, it might calculate its bad debts expense by using an industry average until it
develops its own experience rate.

Difference between Expense and


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

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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 theaging of accounts receivable. This report directs management's attention to
accounts that are slow to pay. It is also useful in determining the balance amount needed in the
account Allowance for Doubtful Accounts.
The aging of accounts receivable report is typically generated by sorting unpaid sales invoices in the
subsidiary 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:

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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:

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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.

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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 a specific amount will not be collected from a specific
customer.
For example, let's assume that on October 21, Gem Merchandise Co. is convinced that a
specific customer's account receivable originating on June 5 in the amount of $1,238 is
definitely uncollectible. Using the direct write-off method, the following entry is made:

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Usually many months will pass between the time of the sale on credit and the time that
the seller knows with certainty that a customer is not going to pay. It is difficult to
adhere to the matching principle and the concept of conservatism when a significant
amount of time elapses between the time of the sales revenues and the time that the
bad debts expense is reported. This is why, for purposes of financial reporting
(not tax reporting), companies should use the allowance method rather than the direct
write-off method.

Introduction to Activity Based Costing


Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical
manner than the traditional approach of simply allocating costs on the basis of machine hours.
Activity based costing first assigns costs to the activities that are the real cause of the overhead. It
then assigns the cost of those activities only to the products that are actually demanding the
activities.
Let's discuss activity based costing by looking at two products manufactured by the same company.
Product 124 is a low volume item which requires certain activities such as special engineering,
additional testing, and many machine setups because it is ordered in small quantities. A similar
product, Product 366, is a high volume productrunning continuouslyand requires little attention
and no special activities. If this company used traditional costing, it might allocate or "spread" all of
its overhead to products based on the number of machine hours. This will result in little overhead
cost allocated to Product 124, because it did not have many machine hours. However, it did demand
lots of engineering, testing, and setup activities. In contrast, Product 366 will be allocated an
enormous amount of overhead (due to all those machine hours), but it demanded little overhead
activity. The result will be a miscalculation of each product's true cost of manufacturing overhead.
Activity based costing will overcome this shortcoming by assigning overhead on more than the one
activity, running the machine.
Activity based costing recognizes that the special engineering, special testing, machine setups, and
others are activities that cause coststhey cause the company to consume resources. Under ABC,
the company will calculate the cost of the resources used in each of these activities. Next, the cost of
each of these activities will be assigned only to the products that demanded the activities. In our
example, Product 124 will be assigned some of the company's costs of special engineering, special
testing, and machine setup. Other products that use any of these activities will also be assigned
some of their costs. Product 366 will not be assigned any cost of special engineering or special
testing, and it will be assigned only a small amount of machine setup.
Activity based costing has grown in importance in recent decades because (1) manufacturing
overhead costs have increased significantly, (2) the manufacturing overhead costs no longer
correlate with the productive machine hours or direct labor hours, (3) the diversity of products and

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the diversity in customers' demands have grown, and (4) some products are produced in large
batches, while others are produced in small batches.

Activity Based Costing with Two


Activities
Let's illustrate the concept of activity based costing by looking at two common manufacturing
activities: (1) the setting up of a production machine for running batches of products, and (2) the
actual production of the units of product.
We will assume that a company has annual manufacturing overhead costs of $2,000,000of which
$200,000 is directly involved in setting up the production machines. During the year the company
expects to perform 400 machine setups. Let's also assume that the batch sizes vary considerably,
but the setup efforts for each machine are similar.
The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups per
year). Under activity based costing, $200,000 of the overhead will be viewed as a batch-level
cost. This means that $200,000 will first be allocated to batches of products to be manufactured
(referred to as a Stage 1 allocation), and then be assigned to the units of product in each batch
(referred to as Stage 2 allocation). For example, if Batch X consists of 5,000 units of product,
the setup cost per unit is $0.10 ($500 divided by 5,000 units). If Batch Y is 50,000 units, the cost per
unit for setup will be $0.01 ($500 divided by 50,000 units). For simplicity, let's assume that the
remaining $1,800,000 of manufacturing overhead is caused by the production activities that correlate
with the company's 100,000 machine hours.
For our simple two-activity example, let's see how the rates for allocating the manufacturing
overhead would lookwith activity based costing and without activity based costing:

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Next, let's see what impact these different allocation techniques and overhead rates would have on
the per unit cost of a specific unit of output. Assume that a company manufactures a batch
of 5,000 units and it produces 50 units per machine hour, here is how the cost assigned to the units
with activity based costing and without activity based costing compares:

If a company manufactures a batch of 50,000 units and produces 50 units per machine hour, here
is how the cost assigned to the units with ABC and without ABC compares:

As the tables above illustrate, with activity based costing the cost per unit decreases from $0.46 to
$0.37 because the cost of the setup activity is spread over 50,000 units instead of 5,000 units.
Without ABC, the cost per unit is $0.40 regardless of the number of units in each batch. If companies
base their selling prices on costs, a companynot using an ABC approach might lose the large batch
work to a competitor who bids a lower price based on the lower, more accurate overhead cost of
$0.37. It's also possible that a company not using ABC may find itself being the low bidder for
manufacturing small batches of product, since its $0.40 is lower than the ABC model of $0.46 for a
batch size of 5,000 units. With its bid price based on manufacturing overhead of $0.40but a true
cost of $0.46the company may end up doing lots of production for little or no profit.
Our example with just two activities (production and setup) illustrates how the cost per unit using the
activity based costing method is more accurate in reflecting the actual efforts associated with
production. As companies began measuring the costs of activities (instead of focusing on the
accountant's departmental classifications), they began using ABC cost information to
practice activity based management. For example, with the cost of setting up a machine now
being measured and discussed, managers began to ask questions such as:

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Why is the cost of setting up a production machine so expensive?


What can be done to reduce the setup cost?
If the setup costs cannot be reduced, are the selling prices adequate to cover all of the
company's costsincluding the setup cost that was previously buried in the overall
machine-hour overhead rate?

Activity Based Costing with Four


Activities
Let's add two more activities to our example: procurement and material handling. The costs of
these two activities are not caused bynor do they correlate withmachine hours. Rather, we will
assume that both of these activities are related to the physical weight of the direct material used in
making the product.
The company determines that $300,000 of its annual manufacturing overhead is associated with
procurement and material handling. As a result, the company removes $300,000 from the
manufacturing overhead that will be allocated via machine hours, and instead plans to allocate the
$300,000 to the products based on the weight of the materials used. The company expects that
during the year it will procure and handle 3,000,000 pounds of material. Under activity based costing,
the company will assign $0.10 ($300,000 divided by 3,000,000 pounds) per pound of product weight
to each unit manufactured. The end result is that the heavier parts will not only have more direct
material cost, they will also be assigned more factory overhead than the lighter parts. By assigning
some manufacturing overhead to a product based on the product's weight, the remaining
manufacturing overhead assigned via machine hours will be reduced. These points are illustrated in
the following table:

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In the table below we can see how ABC would assign costs to the following:
1. A product that weighs 0.5 pound and is produced in a batch of 50,000 units at a
rate of 50 per hour.
2. A product that weighs 1.5 pounds and is produced in a batch of 50,000 units at a
rate of 50 per hour.
3. No activity based costing allocationsall manufacturing overhead costs are
allocated entirely via machine hours.

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If the manufacturing overhead costs are caused by a number of activities such as setup,
procurement, handling, and production, then using the activity based costing method of determining
costs will give you a result that is closer to the true costs. As you can see, the product that weighs
0.5 pound is assigned $0.36 of manufacturing overhead, while the product weighing 1.5 pounds is
assigned $0.46 of manufacturing overhead. Under the traditional costing allocations the procurement
and handling costs would be assigned on production hours. Keep in mind that whenever
manufacturers have a diverse lineup of products, allocating costs on a single basis (such as machine
hours) will result in inaccurate per-unit manufacturing overhead costs.

Introduction to Adjusting Entries


Adjusting entries are accounting journal entries that convert a company's accounting records to
the accrual basis of accounting. An adjusting journal entry is typically made just prior to
issuing a company's financial statements.
To demonstrate the need for an accounting adjusting entry let's assume that a company borrowed
money from its bank on December 1, 2013 and that the company's accounting period ends on
December 31. The bank loan specifies that the first interest payment on the loan will be due on
March 1, 2014. This means that the company's accounting records as of December 31 do not
contain any payment to the bank for the interest the company incurred from December 1 through
December 31. (Of course the loan is costing the company interest expense every day, but the actual
payment for the interest will not occur until March 1.) For the company's December income
statement to accurately report the company's profitability, it must include all of the company's
December 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

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31 balance sheet. The adjusting entry will debit Interest Expense and credit Interest
Payable for the amount of interest from December 1 to December 31.
Another situation requiring an adjusting journal entry arises when an amount has already been
recorded in the company's accounting records, but the amount is for more than the current
accounting period. To illustrate let's assume that on December 1, 2013 the company paid its
insurance agent $2,400 for insurance protection during the period of December 1, 2013 through May
31, 2014. The $2,400 transaction was recorded in the accounting records on December 1, but the
amount represents six months of coverage and expense. By December 31, one month of the
insurance coverage and cost have been used up or expired. Hence the income statement for
December should report just one month of insurance cost of $400 ($2,400 divided by 6 months) in
the account Insurance Expense. The balance sheet dated December 31 should report the cost of
five months of the insurance coverage that has not yet been used up. (The cost not used up is
referred to as the asset Prepaid Insurance.The cost that is used up is referred to as the expired
cost Insurance Expense.) This means that the balance sheet dated December 31 should report five
months of insurance cost or $2,000 ($400 per month times 5 months) in the asset account Prepaid
Insurance. Since it is unlikely that the $2,400 transaction on December 1 was recorded this way, an
adjusting entry will be needed at December 31, 2013 to get the income statement and balance sheet
to report this accurately.
The two examples of adjusting entries have focused on expenses, but adjusting entries also
involve revenues.This will be discussed later when we prepare adjusting journal entries.
For now we want to highlight some important points.
There are two scenarios where adjusting journal entries are needed before the financial statements
are issued:

Nothing has been entered in the accounting records for certain expenses or
revenues, but those expenses and/or revenues did occur and must be included in
the current period's income statement and balance sheet.

Something has already been entered in the accounting records, but the amount
needs to be divided up between two or more accounting periods.

Adjusting entries almost always involve a

balance sheet account (Interest Payable, Prepaid Insurance, Accounts Receivable,


etc.) and an

income statement account (Interest Expense, Insurance Expense, Service


Revenues, etc.)

Adjusting Entries - Asset Accounts


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

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amount or balance shown in each of the balance sheet accounts. We will use the following
preliminary balance sheet, which reports the account balances prior to any adjusting entries:

Let's begin with the asset accounts:


Cash $1,800
The Cash account has a preliminary balance of $1,800the amount in the general
ledger. Before issuing the balance sheet, one must ask, "Is $1,800 the true amount of cash? Does
it agree to the amount computed on the bank reconciliation?" The accountant found that $1,800 was
indeed the true balance. (If the preliminary balance in Cash does not agree to the bank
reconciliation, entries are usually needed. For example, if the bank statement included a service
charge and a check printing 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 $4,600

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

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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:

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

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.

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Allowance for Doubtful Accounts $0


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

The adjusting journal entry for Allowance for Doubtful Accounts is:

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It is possible for one or both of the accounts to have preliminary balances. However, the balances
are likely to be different from one another. Because Allowance for Doubtful Accounts is a balance
sheet account, its ending balance will carry forward to the next accounting year. Because Bad Debts
Expense is an income statement account, its balance will not carry forward to the next year. Bad
Debts Expense will start the next accounting year with a zero balance.
Supplies $1,100

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

The adjusting entry for Supplies in general journal format is:

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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.

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The adjusting journal entry for Prepaid Insurance is:

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 $7,500

Accumulated Depreciation - Equipment is a contra asset account and its preliminary balance
of $7,500 is the amount of depreciation actually entered into the account since the Equipment
was acquired. The correct balance should be the cumulative amount of depreciation from the time
that the equipment was acquired through the date of the balance sheet. A review indicates that as of
December 31 the accumulated amount of depreciation should be $9,000. Therefore the account
Accumulated Depreciation - Equipment will need to have an ending balance of $9,000. This will
require an additional $1,500 credit to this account. The income statement account that is pertinent to
this adjusting entry and which will be debited for $1,500 is Depreciation Expense - Equipment.

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

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

Adjusting Entries - Liability 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.

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Interest Payable $0

(It's common not to list accounts with $0 balances on balance sheets.)


Interest Payable is a liability account that reports the amount of interest the company owes as of the
balance sheet date. Accountants realize that if a company has a balance in Notes Payable, the
company should be reporting some amount in Interest Expense and in Interest Payable. The
reason is that each day that the company owes money it is incurring interest expense and an
obligation to pay the interest. Unless the interest is paid up to date, the company will always owe
some interest to the lender.
Let's assume that the company borrowed the $5,000 on December 1 and agrees to make the first
interest payment on March 1. If the loan specifies an annual interest rate of 6%, the loan will cost the
company interest of $300 per year or $25 per month. On March 1 the company will be required to
pay $75 of interest. On the December income statement the company must report one month of
interest expense of $25. On the December 31 balance sheet the company must report that it owes
$25 as of December 31 for interest.

The adjusting journal entry for Interest Payable is:

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It is unusual that the amount shown for each of these accounts is the same. In the future months the
amounts will be different. Interest Expense will be closed automatically at the end of each accounting
year and will start the next accounting year with a $0 balance.
Accounts Payable $2,500

Accounts Payable is a liability account that reports the amounts owed to suppliers or vendors as of
the balance sheet date. Amounts are routinely entered into this account after a company has
received and verified all of the following: (1) an invoice from the supplier, (2) goods or services have
been received, and (3) compared the amounts to the company's purchase order. A review of the
details confirms that this account's balance of $2,500 is accurate as far as invoices received from
vendors.
However, under the accrual basis of accounting the balance sheet must report all the amounts owed
by the 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 incurred
not merely the expenses that have been entered from a vendor's invoice. To illustrate this, assume
that a company had $1,000 of plumbing repairs done in late December, but the company has not yet
received an invoice from the plumber. The company will have to make an adjusting entry to record
the expense and the liability on the December financial statements. The adjusting entry will involve
the following accounts:

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

The balance in the liability account Accounts Payable at the end of the year will carry forward to the
next accounting year. The balance in Repairs & Maintenance Expense at the end of the accounting
year will be closed and the next accounting year will begin with $0.
Wages Payable $1,200

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

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and the first day of the payroll period. The wages earned by the employees on December 30-31 will
be included in the payroll processing for the week of December 30 through January 5. However, the
December income statement and the December 31 balance sheet need to include the wages for
December 30-31, but not the wages for January 1-5. If the wages for December 30-31 amount to
$300, the following adjusting entry is required as of December 31:

The adjusting journal entry for Wages Payable is:

The $1,500 balance in Wages Payable is the true amount not yet paid to employees for their work
through December 31. The $13,420 of Wages Expense is the total of the wages used by the
company through December 31. The Wages Payable amount will be carried forward to the next
accounting year. The Wages Expense amount will be zeroed out so that the next accounting year
begins with a $0 balance.
Unearned Revenues $1,300

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Unearned Revenues is a liability account that reports the amounts received by a company but have
not yet been earned by the company. For example, if a company required a customer with a poor
credit rating to pay $1,300 before beginning any work, the company increases its asset Cash by
$1,300 and it should increase its liability Unearned Revenues by $1,300.
As the company does the work, it will reduce the Unearned Revenues account balance and increase
its Service Revenues account balance by the amount earned (work performed). A review of the
balance in Unearned Revenues reveals that the company did indeed receive $1,300 from a customer
earlier in December. However, during the month the company provided the customer with $800 of
services. Therefore, at December 31 the amount of services due to the customer is $500.
Let's visualize this situation with the following T-accounts:

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

Since Unearned Revenues is a balance sheet account, its balance at the end of the accounting year
will carry over to the next accounting year. On the other hand Service Revenues is an income

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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.

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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

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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 at
a rate of $100 per month.

Avoiding Adjusting Entries


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.

Introduction to Balance Sheet


The accounting balance sheet is one of the major financial statements used by accountants and
business owners. (The other major financial statements are the income
statement, statement of cash flows, and statement of stockholders' equity) The
balance sheet is also referred to as the statement of financial position.
The balance sheet presents a company's financial position at the end of a specified date. Some
describe the balance sheet as a "snapshot" of the company's financial position at a point (a moment
or an instant) in time. For example, the amounts reported on a balance sheet dated December 31,
2012 reflect that instant when all the transactions through December 31 have been recorded.
Because the balance sheet informs the reader of a company's financial position as of one moment in
time, it allows someonelike a creditorto see what a company owns as well as what it owes to

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other parties as of the date indicated in the heading. This is valuable information to the banker who
wants to determine whether or not a company qualifies for additional credit or loans. Others who
would be interested in the balance sheet include current investors, potential investors, company
management, suppliers, some customers, competitors, government agencies, and labor unions.
In Part 1 we will explain the components of the balance sheet and in Part 2 we will present a
sample balance sheet. If you are interested in balance sheet analysis, that is included in
the Explanation of Financial Ratios.
We will begin our explanation of the accounting balance sheet with its major components, elements,
or major categories:

Assets
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.

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Usually 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:

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

Effect of Cost Principle and Monetary Unit Assumption


The amounts reported in the asset accounts and on the balance sheet reflect actual costs recorded
at the time of a transaction. For example, let's say a company acquires 40 acres of land in the year
1950 at a cost of $20,000. Then, in 1990, it pays $400,000 for an adjacent 40-acre parcel. The
company's Land account will show a balance of $420,000 ($20,000 for the first parcel plus
$400,000 for the second parcel.). This account balance of $420,000 will appear on today's balance
sheet even though these parcels of land have appreciated to a current market value of $3,000,000.
There are two guidelines that oblige the accountant to report $420,000 on the balance sheet rather
than the current market value of $3,000,000: (1) the cost principle directs the accountant to
report the company's assets at their original historical cost, and (2) the monetary unit
assumption directs the accountant to presume the U.S. dollar is stable over timeit is not
affected by inflation or deflation. In effect, the accountant is assuming that a 1950 dollar, a 1990
dollar, and a 2013 dollar all have the same purchasing power.
The cost principle and monetary unit assumption may also mean that some very valuable resources
will not be reported on the balance sheet. A company's team of brilliant scientists will not be listed as
an asset on the company's balance sheet, because (a) the company did not purchase the team in a
transaction (cost principle) and (b) it's impossible for accountants to know how to put a dollar value
on the team (monetary unit assumption).
Coca-Cola's logo, Nike's logo, and the trade names for most consumer products companies are
likely to be their most valuable assets. If those names and logos were developed internally, it is
reasonable that they will not appear on the company balance sheet. If, however, a company
should purchase a product name and logo from another company, that cost will appear as an asset
on the balance sheet of the acquiring company.
Remember, accounting principles and guidelines place some limitations on what is reported as an
asset on the company's balance sheet.

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

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Effect of Matching Principle


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

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 asource of the company's assets. They can also be thought of as a
claim against a company's assets. For example, a company's balance sheet reports assets of
$100,000 and Accounts Payable of $40,000 and owner's equity of $60,000. The source of the
company's assets are creditors/suppliers for $40,000 and the owners for $60,000. The
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

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Interest Payable
Other Accrued Expenses Payable
Income Taxes Payable
Customer Deposits
Warranty Liability
Lawsuits Payable
Unearned Revenues
Bonds Payable
Etc.

Liability accounts will normally have credit balances.


Contra liabilities are liability accounts with debit balances. (A debit balance in a liability account
is 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 belegally binding, but they are not considered a liability on the balance sheet until some
services or goods have been received. Commitments (if significant in amount) should be disclosed in
the notes to the balance sheet.

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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 was not justified in the termination and it is clear that the company acted
improperly, the company will likely have an income statement loss and a balance sheet liability.
The accounting rules for these contingencies are as follows: If the contingent loss
is probable and the amount of the loss can be estimated, the company needs to record a
liability on its balance sheet and a loss on its income statement. If the contingent loss is remote, no
liability or loss is recorded and there is no need to include this in the notes to the financial
statements. If the contingent loss lies somewhere in between, it should be disclosed in the notes to
the financial statements.

Current vs. Long-term Liabilities


If a company has a loan payable that requires it to make monthly payments for several years, only
the principaldue in the next twelve months should be reported on the balance sheet as
a current liability. The remaining principal amount should be reported as a long-term
liability. The interest on the loan that pertains to the future is not recorded on the balance sheet;
only unpaid interest up to the date of the balance sheet is reported as a liability.

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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 the reported liability amounts.
Owner's equity may also be referred to as the residual of assets minus liabilities. These references
make sense if you think of the basic accounting equation:
Assets = Liabilities + Owner's Equity
and just rearrange the terms:
Owner's Equity = Assets - Liabilities
"Owner's Equity" are the words used on the balance sheet when the company is a sole
proprietorship. If the company is a corporation, the words Stockholders' Equity are used instead
of Owner's Equity. An example of an owner's equity account is Mary Smith, Capital (where
Mary Smith is the owner of the sole proprietorship). Examples of stockholders' equity accounts
include:

Common Stock
Preferred Stock
Paid-in Capital in Excess of Par Value
Paid-in Capital from Treasury Stock
Retained Earnings
Etc.

Both owner's equity and stockholders' equity accounts will normally have credit balances.
Contra owner's equity accounts are a category of owner equity accounts
with debit balances. (A debit balance in an owner's equity account is 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.

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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:

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 abook value of $60,000. However, the current value of the computers
might be just $35,000. An office building purchased by the company 15 years ago at a cost of
$400,000 may now have a book value of $200,000. However, the current value of the building might
be $900,000.) Since the assets are not reported on the balance sheet at their current fair market
value, owner's equity appearing on the balance sheet is not an indication of the fair market value of
the company.

Owner's Equity and Temporary Accounts


Revenues, gains, expenses, and losses are income statement accounts. Revenues and gains cause
owner's equity to increase. Expenses and losses cause owner's equity to decrease. If a company

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

Sample Balance Sheet


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.

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Download More Sample Balance Sheets


Whether you are a business person or student of business, our Master Set of 87
Business Forms will assist you in preparing financial statements, financial ratios, breakeven calculations, depreciation, standard cost variances, and much, much more.

Notes To Financial Statements


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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.

Financial Ratios
A number of important financial ratios and statistics are generated by using amounts that are taken
from the balance sheet. For an illustration of some of these computations see our Explanation of
Financial Ratios.

Introduction to Bank Reconciliation


A company's general ledger account Cash contains a record of the transactions (checks
written, receipts from customers, etc.) that involve its checking account. The bank also creates a
record of the company's checking account when it processes the company's checks, deposits,
service charges, and other items. Soon after each month ends the bank usually mails a bank
statement to the company. The bank statement lists the activity in the bank account during the
recent month as well as the balance in the bank account.
When the company receives its bank statement, the company should verify that the amounts on the
bank statement are consistent or compatible with the amounts in the company's Cash account in its
general ledger and vice versa. This process of confirming the amounts is referred to as reconciling
the bank statement, bank statement reconciliation, bank reconciliation, or doing a
"bank rec." The benefit of reconciling the bank statement is knowing that the amount of Cash
reported by the company (company's books) is consistent with the amount of cash shown in the
bank's records.
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

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written near the end of August are deducted immediately on the company's books, but those checks
will likely clear the bank account in early September. Sometimes the bank decreases the
company's bank account without informing the company of the amount. For example, a bank service
charge might be deducted on the bank statement on August 31, but the company will not learn of the
amount until the company receives the bank statement in early September. From these two
examples, you can understand why there will likely be a difference in the balance on the bank
statement vs. the balance in the Cash account on the company's books. It is also possible
(perhaps likely) that neither balance is the true balance. Both balances may need adjustment in
order to report the true amount of cash.
After you adjust the balance per bank to be the true balance and after you adjust the balance
per books to also be the same true balance, you have reconciled the bank statement. Most
accountants would simply say that you have done the bank reconciliation or the bank rec.

Bank Reconciliation Process


Step 1. Adjusting the Balance per Bank
We will demonstrate the bank reconciliation process in several steps. The first step is to adjust
the balance on the bank statement to the true, adjusted, or corrected balance. The items
necessary for this step are listed in the following schedule:

Deposits in transit are amounts already received and recorded by the company, but are not
yet recorded by the bank. For example, a retail store deposits its cash receipts of August 31 into the
bank's night depository at 10:00 p.m. on August 31. The bank will process this deposit on the
morning of September 1. As of August 31 (the bank statement date) this is a deposit in transit.
Because deposits in transit are already included in the company's Cash account, there is no need to
adjust the company's records. However, deposits in transit are not yet on the bank statement.
Therefore, they need to be listed on the bank reconciliation as an increase to the balance per
bank in order to report the true amount of cash.

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A helpful rule of thumb is "put it where it isn't." A deposit in transit is on the


company's books, but it isn't on the bank statement. Put it where it isn't: as
an adjustment to the balance on the bank statement.

Outstanding checks are checks that have been written and recorded in the company's Cash
account, but havenot yet cleared the bank account. Checks written during the last few days of the
month plus a few older checks are likely to be among the outstanding checks.
Because all checks that have been written are immediately recorded in the company's Cash account,
there is no need to adjust the company's records for the outstanding checks. However, the
outstanding checks have not yet reached the bank and the bank statement. Therefore, outstanding
checks are listed on the bank reconciliation as a decrease in the balance per bank.

Recall the helpful tip "put it where it isn't." An outstanding check is on the
company's books, but it isn't on the bank statement. Put it where it isn't: as an
adjustment to the balance on the bank statement.

Bank errors are mistakes made by the bank. Bank errors could include the bank recording an
incorrect amount, entering an amount that does not belong on a company's bank statement, or
omitting an amount from a company's bank statement. The company should notify the bank of its
errors. Depending on the error, the correction could increase or decrease the balance shown
on the bank statement. (Since the company did not make the error, the company's records are
not changed.)

Step 2. Adjusting the Balance per Books


The second step of the bank reconciliation is to adjust the balance in the company's Cash account
so that it is the true, adjusted, or corrected balance. Examples of the items involved are shown in the
following schedule:

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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 check as a return item. Others refer to the NSF check as a "rubber check" because
the check "bounced" back from the bank on which it was written.) When the NSF check comes back
to the bank in which it was deposited, the bank will decrease the checking account of the company
that had deposited the check. The amount charged will be the amount of the check plus a bank fee.
Because the NSF check and the related bank fee have already been deducted on the bank
statement, there is no need to adjust the balance per the bank. However, if the company has not yet
decreased its Cash account balance for the returned check and the bank fee, the company must
decrease the balance per books in order to reconcile.
Check printing charges occur when a company arranges for its bank to handle the reordering
of its checks. The cost of the printed checks will automatically be deducted from the company's
checking account.
Because the check printing charges have already been deducted on the bank statement, there is no
adjustment to the balance per bank. However, the check printing charges need to be an adjustment
on the company's books. They will be a deduction to the company's Cash account.

Recall the general rule, "put it where it isn't." A check printing charge is on the
bank statement, but it isn't on the company's books. Put it where it isn't: as an
adjustment to the Cash account on the company's books.

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Interest earned will appear on the bank statement when a bank gives a company interest on its
account balances. The amount is added to the checking account balance and is automatically on the
bank statement. Hence there is no need to adjust the balance per the bank statement. However, the
amount of interest earned will increase the balance in the company's Cash account on its books.

Recall "put it where it isn't." Interest received from the bank is on the bank
statement, but it isn't on the company's books. Put it where it isn't: as an
adjustment to the Cash account on the company's books.

Notes Receivable are assets of a company. When notes come due, the company might ask its
bank to collect the notes receivable. For this service the bank will charge a fee. The bank will
increase the company's checking account for the amount it collected (principal and interest) and will
decrease the account by the collection fee it charges.Since these amounts are already on the bank
statement, the company must be certain that the amounts appear on the company's books in its
Cash account.

Recall the tip "put it where it isn't." The amounts collected by the bank and the
bank's fees are on the bank statement, but they are not on the company's books.
Put them where they aren't: as adjustments to the Cash account on the
company's books.

Errors in the company's Cash account result from the company entering an incorrect amount,
entering a transaction that does not belong in the account, or omitting a transaction that should be in
the account. Since the company made these errors, the correction of the error will be either an
increase or a decrease to the balance in the Cash account on the company's books.

Step 3. Comparing the Adjusted Balances


After adjusting the balance per bank (Step 1) and after adjusting the balance per books (Step
2), the two adjusted amounts should be equal. If they are not equal, you must repeat the process
until the balances are identical. The balances should be the true, correct amount of cash as of the
date of the bank reconciliation.

Step 4. Preparing Journal Entries


Journal entries must be prepared for the adjustments to the balance per books (Step 2).
Adjustments to increase the cash balance will require a journal entry that debits Cash and credits
another account. Adjustments to decrease the cash balance will require a credit to Cash and a debit
to another account.

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Sample Bank Reconciliation with


Amounts
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:

Before we begin our sample bank reconciliation, learn the following bank reconciliation tip.

Here's a Tip
Put it where it isn't.

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Item #1.

Th

Item #2.

On

Item #3.

On

Item #4.

Th

Item #5.

Th

Item #6.

Th

Item #7.

Th

Item #8.

Du

Item #9.

Th

Item #10.

On

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 1
and Step 2. The item number is shown in the far right column of each schedule.

Step 1 Amounts
Let's review the schedule for Step 1. In all likelihood the balance shown on the bank statement
is not the true balance to be reported on the company's balance sheet. The bank reconciliation
process is to list the items that will adjust the bank statement balance to become the true cash

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balance. As the schedule for Step 1 indicates, the amount of deposits in transit must be added to
the bank statement's balance. Also, the amount of checks that have been written, but not yet
appearing on a bank statement, must be subtracted from the bank statement's balance. Next any
bank errors should be listed and should be reported to the bank for correction. (The company
does not report deposits in transit and/or outstanding checks to the bank.)

Step 2 Amounts and Required Journal Entries


Step 2 begins with the balance in the company's Cash account found in its general ledger. The bank
reconciliation process includes listing the items that will adjust the Cash account balance to become
the true cash balance. We will review each item appearing in Step 2 and the related journal entry
that is required. Remember that any adjustment to the company's Cash account requires a journal
entry. Generally, the adjustments to the books are the result of items found on the bank statement
but have not yet been entered in the company's Cash account.
Item #2 Bank service charges. Since the bank deducted $35 from the company's checking
account, but the company has not yet deducted this from its Cash account, the following journal
entry needs to be made.

(If the annual amount of service charges is small, debit Miscellaneous Expense.)
Item #3 NSF checks and fees. Since the bank deducted these legitimate amounts from the
company's bank account, the company will need to deduct these amounts from its Cash account. As
mentioned, the NSF check of $100 was from a customer. Therefore, the company will likely undo the
reduction to Accounts Receivable that took place when the company originally processed the $100
check. If the company wishes to recover the bank fee of $10 from the customer, it should add the
$10 fee to the amount that the customer owes the company. The journal entry might look like this:

(If the amount cannot be recovered from the customer, charge an expense.)

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Item #4 Check printing charges. Because this expense is not yet entered on the company's
books, but the amount has been deducted from its bank account, the company will make the
following journal entry.

Item #5 Interest earned. The bank increased the checking account balance by $8 on August
31. Since the bank did not notify the company previously, the company must now increase the
balance in its Cash account.

Item #6 Notes receivable collected. The bank increased the company's checking account
when it collected a note for the company on August 29. It was determined that the company had not
yet made an entry to its Cash account for this transaction. As a result the following journal entry is
needed.

Item #10 Company error. The company had entered $145 in its Cash account on August 29,
but the bank statement showed the correct amount: $154. The transaction involved the cash sales
for the day. As a result the company's Cash account will have to be increased by $9 as follows:

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Step 3 Comparing the Adjusted Balances


In the above schedules the adjusted balance for Step 1 is $1,719 and the adjusted balance for Step
2 is $1,719. The company believes that all items involving cash have been included in the schedules.
As a result the company has successfully completed its bank reconciliation as of the August 31,
2013.

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