Introduction to Accounts

Receivable and Bad Debts

Expense
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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 receivable—an
asset reported on the balance sheet.
If a buyer does not pay the amount it owes, the seller will report:

1. A credit loss or bad debts expense on its income statement, and

2. A reduction of accounts receivable on its balance sheet.
With respect to financial statements, the seller should report its estimated credit losses as soon as
possible using the allowance method. For income tax purposes, however, losses are reported at a
later date through the use of the direct write-off method.
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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) equity—all of which are reported on its balance sheet.
The credit to Service Revenues will increase Malloy's revenues and net income—both of which are
reported on its income statement.

Recording Sales of Goods on

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 the buyer's dock.
In principle, the seller should record the sales transaction when the ownership of the goods is
transferred to the buyer. Practically speaking, however, accountants typically record the
transaction at the time the sales invoice is prepared and the goods are shipped.

FOB Shipping Point

Quality Products Co. just sold and shipped $1,000 worth of goods using the terms FOB Shipping
Point. With its cost of goods at 80% of sales value, Quality makes the following entries in its
general ledger:
(While there may be additional expenses with this transaction—such as commission expense—
we are not considering them in our example.)

FOB Shipping Point means the ownership of the goods is transferred to the buyer
at the seller's dock. This means that the buyer is responsible for transporting the goods
from Quality Product's shipping dock. Therefore, all shipping costs (as well as any damage that
might be incurred during transit) are the responsibility of the buyer.
FOB Destination
FOB Destination means the ownership of the goods is transferred at the buyer's
dock. This means the seller is responsible for transporting the goods to the customer's dock,
and will factor in the cost of shipping when it sets its price for the goods.
Let's assume that Gem Merchandise Co. makes a sale to a customer that has a sales value of
$1,050 and a cost of goods sold at $800. This transaction affects the following accounts in Gem's
general ledger:

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:
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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 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.

Credit Amount To Be
Brief Description
Terms Received

Net 10 days The net amount is due within 10 days of the invoice date. $900

Net 30 days The net amount is due within 30 days of the invoice date. $900

Net 60 days The net amount is due within 60 days of the invoice date. $900

2/10, n/30 If paid within 10 days of the invoice date, the buyer may $882
 deduct 2% from the net amount. ($900 minus $18)

2/10, n/30 If paid in 30 days of the invoice date, the net amount is due. $900

If paid within 10 days of the invoice date, the buyer may

1/10, n/60 deduct 1% from the net amount. ($900 minus $9) $891

1/10, n/60 If paid in 60 days of the invoice date, the net amount is due. $900

The net amount is due within 10 days after the end of the
month (EOM). In other words, payment for any sale made in
Net EOM 10 June is due by July 10. $900

Costs of Discounts
Some people believe that the credit term of 2/10, net 30 is far too generous. They argue that
when a $900 receivable is settled for $882 (simply because the customer pays 20 days early) the
seller is, in effect, giving the buyer the equivalent of a 36% annual interest rate (2% for 20 days
equates to 36% for 360 days). Some sellers won't offer terms such as 2/10, net 30 because of
these high percentage 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 assets—not
even on the goods that it just sold to the buyer.
Sometimes a supplier's customer gets into financial difficulty and is forced to liquidate its assets. In
this situation the customer typically owes money to lending institutions as well as to its suppliers of
goods and services. In such cases, it's the secured creditors (the banks and other lenders that have
a lien on specific assets such as cash, receivables, inventory, equipment, etc.) who are paid first
from the sale of the assets. Often there is not enough money to pay what is owed to the secured
lenders, much less the unsecured creditors. In other words, the suppliers will never be paid what
they are owed.
To avoid this kind of risk, some suppliers may decide not to sell anything on credit, but require
instead that all of its goods be paid for with cash or a credit card. Such a company, however, may
lose out on sales to competitors who offer to sell on credit.

To minimize losses, sellers typically perform a thorough credit check on any new customer before
selling to them on credit. They obtain credit reports and check furnished references. Even when a
credit check is favorable, however, a credit loss can still occur. For example, a first-rate customer
may experience an unexpected financial hardship caused by one of its customers, something that
could not have been known when the credit check was done. The point is this: any company that
sells on credit to a large number of customers should assume that, sooner or later, it will probably
experience some credit losses along the way.
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Allowance Method for Reporting

Credit Losses
Accounts receivable are reported as a current asset on a company's balance sheet. Since current
assets by definition are expected to turn to cash within one year (or within the operating cycle,
whichever is longer), a company's balance sheet could overstate its accounts receivable (and
therefore its working capital and stockholders' equity) if any part of its accounts receivable is not
collectible.

To guard against overstatement, a company will estimate how much of its accounts receivable will
never be collected. This estimate is reported in a balance sheet contra asset account called
Allowance for Doubtful Accounts. (Some companies call this account Provision for Doubtful
Accounts or Allowance for Uncollectible Accounts.) Any increases to Allowance for Doubtful
Accounts are also recorded in the income statement account Bad Debts Expense (or Uncollectible
Accounts Expense).

This method of anticipating the uncollectible amount of receivables and recording it in the Allowance
for Doubtful Accounts is known as the allowance method. (If a company does not use an
allowance account, it is following the direct write-off method, which is discussed later.)

Allowance for Doubtful Accounts and Bad Debts Expense - June

As we stated above, the account Allowance for Doubtful Accounts is a contra asset account
containing the estimated amount of the accounts receivable that will not be collected. For example,
let's assume that Gem Merchandise Co.'s Accounts Receivable has a debit balance of $100,000 at
June 30. Gem anticipates that approximately $2,000 of this is not likely to turn to cash, and as a
result, Gem reports a credit balance 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:

With Allowance for Doubtful Accounts now reporting a credit balance of $2,000 and Accounts
Receivable reporting a debit balance of $100,000, Gem's balance sheet will report a net amount of
$98,000. Since this net amount of $98,000 is the amount that is likely to turn to cash, it is referred to
as the net realizable value of the accounts receivable.
Under the allowance method, the Gem Merchandise Co. does not need to know specifically which
customer will not pay, nor does it need to know the exact amount. This is acceptable because
accountants believe it is better to report an approximate amount that is uncollectible rather than
imply that every penny of the accounts receivable will be collected.

Gem's Bad Debts Expense will report credit losses of $2,000 on its June income statement. This
expense is being reported even though none of the accounts receivables were due in June. (Recall
the credit terms were net 30 days.) Gem is attempting to follow the matching principle by matching
the bad debts expense as best it can to the accounting period in which the credit sales took place.
Here's a 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:

As seen in the T-accounts above, Gem estimated that the total bad debts expense for the first two
months of operations (June and July) is $10,000. It is likely that as of July 31 Gem will not know
the precise amount of actual bad debts, nor will Gem know which customers are the ones that won't
be paying their account balances. However, the matching principle is better met by Gem making
these estimates and recording the credit loss as close as possible to the time the sales were made.
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:

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.

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Bad Debts Expense as a Percent

of Sales
Another way sellers apply the allowance method of recording bad debts expense is by using
the percentage of credit sales approach. This approach automatically expenses a percentage
of its credit sales based on past history.
For example, let's assume that a company prepares weekly financial statements. Past experience
indicates that 0.3% of its sales on credit will never be collected. Using the percentage of credit
sales approach, this company automatically debits Bad Debts Expense and credits Allowance for
Doubtful Accounts for 0.3% of each week's credit sales. Let's assume that in the current week
this company sells $500,000 of goods on credit. It estimates its bad debts expense to be $1,500
(0.003 x $500,000) and records the following journal entry:

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 permanent accounts, meaning their balances carry forward to the next accounting period.
In other words, they are not closed and their balances are not reset to zero.
Because the Bad Debts Expense account is closed each year, while the Allowance for Doubtful
Accounts is not, these two balances will most likely not be equal after the company's first year of
operations.

For example, let's assume that at the end of its first year of operations a company's Bad Debts
Expense had a debit balance of $14,000 and its Allowance for Doubtful Accounts had a credit
balance of $14,000. Because the income statement account balances are closed at the end of the
year, the company's opening balance in Bad Debts Expense for the second year of operations is $0.
The credit balance of $14,000 in Allowance for Doubtful Accounts, however, carries forward to the
second year. If an adjusting entry of $3,000 is made during year 2, Bad Debts Expense will report a
$3,000 debit balance, while Allowance for Doubtful Accounts might report a credit balance of
$17,000.

Again, the reasons for the account balance differences are 1) Bad Debts Expense is a temporary
account that reports credit losses only for the period shown on the income statement, and 2)
Allowance for Doubtful Accounts is a permanent account that reports an estimated amount for all of
the uncollectible receivables reported in the asset Accounts Receivable as of the balance sheet
date.

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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 account—each credit sale for every
customer—is found in the subsidiary ledger for Accounts Receivable. The total amount of all the
details in the subsidiary ledger must be equal to the total amount reported in the control account.
The detailed information in the accounts receivable subsidiary ledger is used to prepare a report
known as the aging of accounts receivable. This report directs management's attention to
accounts that are slow to pay. It is also useful in determining the balance amount needed in the
account Allowance for Doubtful Accounts.
The aging of accounts receivable report is typically generated by sorting unpaid sales invoices in the
subsidiary ledger—first by customer and then by the date of the sales invoices. If a company sells
merchandise (or provides services) and allows customers to pay 30 days later, this report will
indicate how much of its accounts receivable is past due. It also reports how far past due the
accounts are.
With the click of a mouse, most accounting software will provide the aging of accounts receivable
report. For example, Gem Merchandise Co.'s software looks at each of its customer's accounts
receivable activity and compares the date of each unpaid sales invoice to the date of the report. If
we assume the report is dated August 31 and that Gem's credit terms are net 30 days, any unpaid
sales invoices with an August date will be classified as current. Any unpaid invoices with a date in
July are classified as 1 - 30 days past due. Any unpaid invoices with a date of June are classified
as 31 - 60 days past due, and so on. The sorted information is present in a report that looks
similar to the following:
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:
This computation estimates the balance needed for Allowance for Doubtful Accounts at August 31 to
be a credit balance of $8,585.

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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.

ledging or Selling Accounts

Receivable
A company's accounts receivable are considered to be a type of asset, and as such can be pledged
as collateral for a loan. Asset-based lenders will often lend a company an amount equal to 80% of
the value of its accounts receivable.

Some companies sell their accounts receivable to a factor. A factor buys the accounts receivables at
a discount and then goes about the business of collecting and keeping the money owed through the
receivables. Sometimes the factor will purchase the accounts receivables with recourse. This
means the company that sold the receivables remains financially responsible if a customer does not
remit the full amount to the factor. When the factor purchases the receivables without recourse,
the company selling the receivables is not responsible for unpaid amounts.
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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.
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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:

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.
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Introduction to Accounts Payable
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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
 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.

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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.

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

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 three-
way match (which will be discussed shortly).

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

A common technique for verifying a vendor invoice is the three-way match.

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

Only when the details in the three documents are in agreement will a vendor's invoice be entered
into the Accounts Payable account and scheduled for payment.

Good internal control of a company's resources is enhanced when the company assigns a separate
employee with a specific, limited responsibility. The following chart illustrates the concept of the
separation (or segregation) of duties involving accounts payable:
When the duties are separated, it will require more than one dishonest person to steal from the
company. Hence, small companies without sufficient staff to separate employees' responsibilities will
have a greater risk of theft.

To illustrate the three-way match, let's assume that BuyerCo needs 10 cartridges of toner for its
printers. BuyerCo issues a purchase order to SupplierCorp for 10 cartridges at $60 per cartridge that
are to be delivered in 10 days. One copy of the PO is sent to SupplierCorp, one copy goes to the
person requisitioning the cartridges, one copy goes to the receiving department, one copy goes to
accounts payable, and one copy is retained by the person preparing the PO. When BuyerCo
receives the cartridges, a receiving report is prepared.

The three-way match involves comparing the following information:

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

Lastly, the documents should be stamped or perforated to indicate they have been entered into the
accounting system thus avoiding a duplicate payment.

Vouchers
Some companies use a voucher in order to document or "vouch for" the completeness of the
approval process. You can visualize a voucher as a cover sheet for attaching the supporting
documents (purchase order, receiving report, vendor's invoice, etc.) and for noting the approvals,
account numbers, and other information for each vendor invoice or bill.
When the vendor invoice is paid, the voucher and its attachments (including a copy of the check that
was issued) will be stored in a paid voucher/invoice file. If paper documents are involved, an
office machine could perforate the word "PAID" through the voucher and its attachments. This is
done to assure that a duplicate payment will not occur.
The unpaid invoices and vouchers will be held in an open file.
Vendor invoices without purchase orders or receiving reports
Not all vendor invoices will have purchase orders or receiving reports. Hence, the three-way match
is not always possible. For example, a company does not issue a purchase order to its electric utility
for a pre-established amount of electricity for the following month. The same is true for the
telephone, natural gas, sewer and water, freight-in, and so on.

There are also payments that are required every month in order to fulfill lease agreements or other
contracts. Examples include the monthly rent for a storage facility, office rent, automobile payments,
equipment leases, maintenance agreements, etc. Even though these obligations will not have
purchase orders, the responsibility is unchanged: pay only the amounts that are
legitimate and accurate.

Statements from vendors

Vendors often send statements to their customers to indicate the amounts (listed by invoice number)
that remain unpaid. When a vendor statement is received the details on the statement should be
compared to the company's records.

The fact that a company can be receiving both invoices and statements from a vendor means there
is the potential of a duplicate payment. In order to avoid making a duplicate payment, companies
often establish the following rule: Pay only from vendor invoices; never pay from vendor statements.

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:
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.

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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.
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Accruing Expenses and Liabilities

At the end of every accounting period there will be some vendor invoices and receiving reports that
have not yet been 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
o Stockholders' or owner's equity accounts
2. Income statement accounts
o Operating revenue accounts
o Operating expense accounts
o Nonoperating revenue and gain accounts
o Nonoperating expense and loss accounts
Many systems will allow for each account to have subaccounts. Subaccounts allow for
summarizing or combining amounts while also maintaining the detailed amounts.
When the existing accounts are not sufficient, new accounts should be added. In other words,
meaningful financial reporting of transactions should not be limited to a preconceived list of
accounts.

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

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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/30 indicate that the buyer may take an early payment discount of 1%
of the amount owed if the amount owed is remitted within 10 days instead of the normal 30 days.
In other words, the buyer can choose either of the following:
 Pay within 10 days and deduct 1% of the net amount owed (the invoice amount minus any
authorized returns and/or allowances), or
 Pay in 30 days and take no discount.
To illustrate1/10, n/30, let's assume that a vendor invoice for $1,000 is dated June 1 and the
buyer does not return any of the goods. Since there are no returns, the net amount of the purchase
is the full $1,000 and the buyer can remit either of the following amounts:
 If paying by June 10, the amount due to the vendor is $990. [The net amount of $1,000
minus the $10 early payment discount (which is 1% of $1,000).]
 If paying by July 1, the net amount of $1,000 is due.
If the buyer was given an allowance of $100, the net amount is $900. In that case the buyer can
remit either of the following amounts:

 If paying by June 10, the amount due to the vendor is $891. [The net amount of $900 minus
$9 (which is 1% of $900).]
 If paying by July 1, the net amount of $900 is due.
2/10, n/30
If the vendor's invoice has terms of 2/10, n/30, the "2" represents 2%, the "10" represents 10
days, the "n" represents the word net and the "30" represents 30 days. This means that the buyer
can take an early payment discount of 2% of the amount owed if the amount is remitted within
10 days instead of the customary 30 days. In other words, the buyer can choose either of the
following:
 Pay within 10 days and deduct 2% of the net amount (invoice amount minus any authorized
returns and/or allowances), or
 Pay the full amount in 30 days with no discount.
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
$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 approximately 18%.

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.

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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-NEC 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-NEC.

You can learn more about the distinction between an independent contractor and an employee
at [Link].

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 the sales-taxable goods or services (even from out-of-state vendors), the buyer is likely to
be liable for a state use tax. 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 [Link].

General Ledger Account:

Accounts Payable
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:
o an expense (Repairs & Maintenance Expense, Advertising Expense, Rent Expense, etc.)
 o a prepaid asset (Prepaid Expenses, Prepaid Insurance)
o a fixed or plant asset (Equipment, Fixtures, Vehicles, etc.)
A listing of the accounts that a company has available for recording transactions is known as
the chart of accounts.
A report that lists the accounts and amounts that are debited for a group of invoices entered into
the accounting software is known as the accounts payable distribution.

Reductions to Accounts Payable

When a company pays part or all of a previously recorded vendor invoice, the balance in Accounts
Payable will be reduced with a debit entry and Cash will be reduced with a credit entry.

Accounts Payable is also debited when a company returns goods to a vendor or when the vendor
grants an allowance.

Introduction to Inventory and

Cost of Goods Sold
Did you know? To make the topic of Inventory and Cost of Goods Sold even easier to
understand, we created a collection of premium materials called AccountingCoach
PRO. Our PRO users get lifetime access to our inventory and cost of goods sold cheat
sheet, flashcards, quick tests, business forms, and more.
Inventory is a key current asset for retailers, distributors, and manufacturers. Inventory consists of
goods (products, merchandise) awaiting to be sold to customers as well as a manufacturers' raw
materials and work-in-process that will become finished goods. Inventory is recorded and reported
on a company's balance sheet at its cost.
When an inventory item is sold, the item's cost is removed from inventory and the cost is reported on
the company's income statement as the cost of goods sold. Cost of goods sold is likely the largest
expense reported on the income statement. When the cost of goods sold is subtracted from sales,
the remainder is the company's gross profit.
It is critical that the items in inventory get sold relatively quickly at a price larger than its cost. Without
sales the company's cash remains in inventory and unavailable to pay the company's expenses
such as wages, salaries, rent, advertising, etc.

It is common for a company to experience rising costs for the goods it purchases. As a result, the
company's costs may be different for the same products purchased during its accounting year. When
this occurs, the company must decide which costs should be matched with its sales and which costs
should remain in inventory. In the U.S., three of the cost flow methods for removing costs from
inventory and reporting them as the cost of goods sold include:

 FIFO or first in, first out. This cost flow removes the oldest inventory costs and reports
them as the cost of goods sold on the income statement, while the most recent costs remain
in inventory.
 LIFO or last in, first out. This cost flow removes the most recent inventory costs and
reports them as the cost of goods sold on the income statement, and the oldest costs remain
in inventory.
 Weighted average. This method calculates an average per unit cost and applies it to both
the units in inventory and to the units sold.
In addition to selecting a cost flow method, the company selects one of the following inventory
systems for recording amounts in its general ledger Inventory account(s):
 The periodic system indicates that the Inventory account will be updated periodically, such
as on the last day of the accounting year. Throughout the year, the goods purchased will be
recorded in temporary general ledger accounts entitled Purchases. At the end of the year,
the cost of the ending inventory will be calculated. The Inventory account balance will be
adjusted to this amount. At this time, the cost of goods sold is also calculated.
 The perpetual system indicates that the Inventory account will be continuously or
perpetually updated. In other words, the balance in the Inventory account will be increased
by the costs of the goods purchased, and will be decreased by the cost of the goods sold.
Hence, the balance in the Inventory account should reflect the cost of the inventory items
currently on hand. However, companies should count the actual goods on hand (take a
physical inventory) at least once a year and adjust the perpetual records if necessary.
It is time consuming and costly for companies to physically count the items in inventory, determine
their unit costs, and calculate the total cost in inventory. There may also be times when it is
necessary to determine the cost of inventory that was destroyed by fire or stolen. To meet these
problems, accountants often use the gross profit method for estimating the cost of a company's
ending inventory.
We will illustrate the FIFO, LIFO, and weighted-average cost flows along with the period and
perpetual inventory systems. This will be done with simple, easy-to-understand, instructive examples
involving a hypothetical retailer Corner Bookstore.

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Inventory Is Reported at Cost

Inventory items are recorded at their cost. Cost is defined as all costs necessary to get the goods in
place and ready for sale. For instance, if a bookstore purchases a college textbook from a publisher
for $80 and pays $5 to get the book delivered to its store, the bookstore will record the cost of $85 in
its Inventory account. The recorded cost will not be increased even if the publisher announces that
additional copies will cost $100.
When the textbook is sold, the bookstore removes the cost of $85 from its inventory and reports the
$85 as the cost of goods sold on the income statement that reports the sale of the textbook.

The recorded cost for the goods remaining in inventory at the end of the accounting year are
reported as a current asset on the company's balance sheet.

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Periodic vs Perpetual Inventory

Systems
Each cost flow assumption can be used in either of the following inventory systems:

 Periodic
  Perpetual
Under the periodic inventory system:
 The amount appearing in the general ledger Inventory account is not updated when
purchases of merchandise are made from suppliers or when goods are sold.

 The Inventory account is normally adjusted only at the end of the year. During the year the
Inventory account will show only the cost of inventory as of the end of the previous year.

 Purchases of merchandise are recorded in one or more Purchases accounts.

 At the end of the year the Purchases account(s) are closed and the Inventory account is
adjusted to the cost of the merchandise actually on hand at the end of the current year.

 There is no Cost of Goods Sold account to be updated when a sale of merchandise occurs.

 There is no way to tell from the general ledger accounts the cost of the current inventory or
the cost of goods sold.

Under the perpetual inventory system:

 The Inventory account is continuously updated.

 It is increased with the cost of merchandise purchased from suppliers.

 It is reduced by the cost of merchandise that has been sold to customers.

 The Purchases account(s) are not used in the perpetual inventory system.

 There is a general ledger account Cost of Goods Sold that is debited at the time of each sale
for the cost of the merchandise that was sold.

 A sale of goods will result in a journal entry to record the amount of the sale and the cash or
accounts receivable.

 A second journal entry reduces the account Inventory and increases the account Cost of
Goods Sold.

When a Company Purchases

Identical Items at Increasing
Costs
We will use a hypothetical business Corner Bookstore to demonstrate how to flow the costs out of
inventory and into the cost of goods sold on the company's income statement. Often this is done by
using either the periodic inventory method or the perpetual method.
Before we begin, keep in mind that there can be a difference between the following:

 How the units of product are physically removed from inventory

 How the costs are removed from inventory
Generally, the units are physically removed from inventory by selling the oldest units first. Therefore,
the physical units of product are flowing first in, first out. Companies want to get the oldest items
out of inventory and keep the most recent (freshest) ones in inventory. Businesses will refer to this
as rotating the goods on hand or rotating the stock.
However, the costs of the goods in inventory does not have to flow the way the goods flowed. This
means the bookstore can remove the oldest copy of its three copies from inventory but remove the
cost of its most recently purchased copy. In other words, the goods can flow using first in, first out
while the costs flow using last in, first out. This is why accountants refer to the cost flows as cost
flow assumptions.
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Demonstrating Cost Flow

Assumptions
Let's assume the Corner Bookstore had one book in inventory at the start of the year 2022 and at
different times during 2022 it purchased four additional copies of the same book. During the year
2022, the publisher increased the price of the books due to a paper shortage. The following chart
shows Corner Bookstore's total cost of the five books was $440. It also assumes that none of the
books has been sold as of December 31, 2022.

If the Corner Bookstore sells only one of the five books, which cost should Corner Shelf report as the
cost of goods sold? Should it select $85, $87, $89, $89, $90, or the average cost of the five
amounts? Which cost should Corner Bookstore report as inventory on its balance sheet for the four
unsold books?

In the U.S., three of the most common ways to flow costs out of inventory and into the cost of goods
sold are:

 First in, first out (FIFO)

  Last in, first out (LIFO)
 Average
Note that these are cost flow assumptions. Recall that the order in which costs are removed from
inventory (and reported on the income statement as the cost of goods sold) can be different from the
order in which the goods are physically removed from inventory. In other words, if Corner Bookstore
sells one book that was on hand at the beginning of the year it can remove from inventory the $90
cost of the most recently purchased book in December 2022 (if it had elected the periodic LIFO cost
flow assumption).
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Inventory Systems with Cost

Flow Assumptions
The combination of the three cost flow assumptions and the two inventory systems means six
options for calculating the cost of inventory and the cost of goods sold:

 Periodic FIFO
 Periodic LIFO
 Periodic Average
 Perpetual FIFO
 Perpetual LIFO
 Perpetual Average

Periodic FIFO
Periodic means that the Inventory account is not routinely updated during the accounting period.
Instead, the cost of merchandise purchased from suppliers is debited to the general ledger account
Purchases. At the end of the accounting year the Inventory account is adjusted to equal the cost of
the merchandise that has not been sold.
The cost of goods sold (which is reported on the income statement) is computed by taking
the cost of the goods available for sale and subtracting the cost of the ending inventory.
FIFO is an acronym for first in, first out. Under the FIFO cost flow assumption, the first (oldest) costs
are the first costs to leave inventory and be reported as the cost of goods sold on the income
statement. The last (or recent) costs will remain in inventory and be reported as inventory on the
balance sheet.
Remember that the costs can flow differently than the physical flow of the goods. For example, if the
Corner Bookstore uses the FIFO cost flow assumption, the owner may sell any copy of the book but
report the cost of goods at the first/oldest cost as shown in the exhibit that follows.

Let's demonstrate periodic FIFO with the following information from the Corner Bookstore:
As before, we need to account for the cost of goods available for sale (5 books having a total
cost of $440). With FIFO we assign the first cost of $85 to be the cost of goods sold. The remaining
$355 ($440 - $85) will be the cost of the ending inventory. The $355 of inventory costs consists of
$87 + $89 + $89 + $90. The $85 cost that was assigned to the book sold is permanently gone from
inventory.
If Corner Bookstore sells the textbook for $110, its gross profit using periodic FIFO will be $25 ($110
- $85). If the costs of textbooks continue to increase, FIFO will always result in more gross profit than
other cost flows, because the first cost will always be lower.

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Periodic LIFO
Periodic means that the Inventory account is not updated during the accounting period. Instead, the
cost of merchandise purchased from suppliers is debited to the general ledger account Purchases.
At the end of the accounting year the Inventory account is adjusted to the cost of the merchandise
that is unsold. The remainder of the cost of goods available is reported on the income statement as
the cost of goods sold.
LIFO is an acronym for last in, first out. Under the LIFO cost flow assumption, the latest (or most
recent) costs are the first ones to leave inventory and become the cost of goods sold on the income
statement. The first/oldest costs will remain in inventory and will be reported as the cost of the
ending inventory on the balance sheet.
Remember that the costs can flow differently than the goods. In other words, if Corner Bookstore
uses periodic LIFO, the owner may sell the oldest (first) copy of the book to a customer, and report
the cost of goods sold of $90 (the cost of the most recently purchased book).

It's important to note that under periodic LIFO (not perpetual LIFO) you wait until the entire year is
over before assigning the costs. Then you flow out of inventory the year's most recent costs first,
even if those goods arrived after the last sale of the year. For example, assume the last sale of the
year at the Corner Bookstore occurred on December 27. Also assume that the store's last purchase
of the year arrived on December 31. Under periodic LIFO, the cost of the book purchased on
December 31 is removed from inventory and sent to the cost of goods sold first, even though it was
physically impossible for that book to be the one sold on December 27. (This reinforces our earlier
statements that the flow of costs does not have to correspond with the physical flow of units.)
Let's illustrate periodic LIFO by using the data for the Corner Shelf Bookstore:
As before we need to account for the cost of goods available for sale: 5 books having a total
cost of $440. Under periodic LIFO we assign the last cost of $90 to the book that was sold. (If two
books were sold, $90 would be assigned to the first book and $89 to the second book.) The
remaining $350 ($440 - $90) is reported as the cost of the ending inventory. The $350 of inventory
cost consists of $85 + $87 + $89 + $89. The $90 assigned to the book that was sold is permanently
gone from inventory.
If the bookstore sold the textbook for $110, its gross profit using periodic LIFO will be $20 ($110 -
$90). If the costs of textbooks continue to increase, periodic LIFO will always result in the least
amount of profit. The reason is that the last costs will always be higher than the first costs. Higher
costs result in less profits and often lower income taxes.

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Periodic Average
When the periodic inventory system is used, the Inventory account is not updated and purchases of
merchandise are recorded in the general ledger account Purchases.

With the average or weighted average cost flow assumption an average cost is calculated
using the cost of goods available for sale (cost from the beginning inventory plus the costs
of all the purchases made during the year). This means that the periodic average cost is calculated
after the year is over—after all the purchases for the year have occurred. This average cost is then
applied to the units sold during the year and to the units in inventory at the end of the year.
We will assume the same facts. There were 5 books available for sale for the year 2022 and the cost
of the goods available was $440. The weighted average cost of the books is $88 ($440 of cost of
goods available ÷ 5 books). The average cost of $88 is used to compute both the cost of goods sold
and the cost of the ending inventory.
Since the bookstore sold only one book, the cost of goods sold is $88 (1 x $88). The ending
inventory of four unsold books is reported at the cost of $352 (4 x $88) . The total of the cost of
goods sold plus the cost of the inventory should equal the cost of goods available ($88 + $352 =
$440).

If Corner Bookstore sells the textbook for $110, its gross profit using the periodic average method
will be $22 ($110 - $88). This gross profit of $22 lies between the $25 computed using the periodic
FIFO and the $20 computed using the periodic LIFO.

Perpetual FIFO
When using the perpetual inventory system, the general ledger account Inventory is constantly (or
perpetually) changing. For example, when a retailer purchases merchandise, the retailer debits its
Inventory account for the cost. (Under the periodic system, the account Purchases was debited.)
When the retailer sells the merchandise the Inventory account is credited and the Cost of Goods
Sold account is debited for the cost of the goods sold. Rather than the Inventory account
staying dormant as it did with the periodic method, the Inventory account balance is updated for
every purchase and sale.
Under the perpetual system, two entries are recorded when merchandise is sold: (1) the amount of
the sale is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the
merchandise sold is debited to the account Cost of Goods Sold and is credited to Inventory. (Note:
Under the periodic system the second entry is not made.)
With perpetual FIFO, the first (or oldest) costs are the first removed from the Inventory account and
debited to the Cost of Goods Sold account. Therefore, the perpetual FIFO cost flows and the
periodic FIFO cost flows will result in the same cost of goods sold and the same cost of
the ending inventory.
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Perpetual LIFO
When using the perpetual system, the Inventory account is constantly (or perpetually) changing. The
Inventory account is updated for every purchase and every sale.
Under the perpetual system, two transactions are recorded at the time that the merchandise is sold:
(1) the amount of the sale is debited to Accounts Receivable or Cash and is credited to Sales, and
(2) the cost of the merchandise sold is debited to the account Cost of Goods Sold and is credited to
Inventory. (Note: Under the periodic system the second entry is not made.)
With perpetual LIFO, the last costs available at the time of the sale are the first to be removed
from the Inventory account and debited to the Cost of Goods Sold account. Since this is
the perpetual system we cannot wait until the end of the year to determine the last cost (as is done
with periodic LIFO). An entry is needed at the time of the sale in order to reduce the balance in
the Inventory account and to increase the balance in the Cost of Goods Sold account.
If the costs of the goods purchased rise throughout the entire year, perpetual LIFO will result in a
lower cost of goods sold and a higher net income than periodic LIFO. Generally this means
that periodic LIFO will result in less income taxes than perpetual LIFO. (If you wish to minimize
the amount paid in income taxes during periods of inflation, you should discuss LIFO with your tax
adviser.)
We will demonstrate perpetual LIFO by using the same Corner Bookstore information:

Let's assume that after Corner Bookstore makes its second purchase in June 2022, Corner
Bookstore sells one book. This means the latest cost at the time of the sale was $89. Under
perpetual LIFO the following entry must be made at the time of the sale: $89 will be credited to
Inventory and $89 will be debited to Cost of Goods Sold. If that was the only book sold during the
year, at the end of the year the Cost of Goods Sold account will have a balance of $89 and the cost
in the Inventory account will be $351 ($85 + $87 + $89 + $90).
If the bookstore sells the textbook for $110, its gross profit under perpetual LIFO will be $21 ($110 -
$89). Note that this $21 is different than the gross profit of $20 under periodic LIFO.

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Perpetual Average
When using the perpetual inventory system, the Inventory account is constantly (or perpetually)
changing. The inventory account is updated for every purchase and every sale.

With the perpetual system, two sets of entries are made whenever merchandise is sold: (1) the
amount of the sale is debited to Accounts Receivable or Cash and is credited to Sales, and (2)
the cost of the merchandise sold is debited to the account Cost of Goods Sold and is credited to the
account Inventory. (Note: Under the periodic system the second entry is not made.)
In the perpetual system, "average" means the average cost of the items in inventory as of the
date of the sale. This requires calculating a new average cost per unit after every purchase. The
new average cost is multiplied by the number of units sold and is credited to the Inventory account
and debited to the Cost of Goods Sold account. (We use the average as of the time of the
sale because this is a perpetual method. Under the periodic system we wait until the year is over
before computing the average cost.)
Let's demonstrate the perpetual average method using the Corner Bookstore information:

Let's assume that on July 1 Corner Bookstore sells one book. This means the average cost at the
time of the sale was $87.50 ([$85 + $87 + $89 + $89] ÷ 4). Because this is a perpetual average,
a journal entry must be made at the time of the sale for $87.50. The $87.50 (the average cost at the
time of the sale) is credited to Inventory and is debited to Cost of Goods Sold. After the sale on July
1, three copies remain in inventory. The balance in the Inventory account will be $262.50 (3 books at
an average cost of $87.50).
After Corner Bookstore makes its third purchase of the year 2022, the average cost per unit will
change to $88.125 ([$262.50 + $90] ÷ 4). As you can see, the average cost moved from $87.50 to
$88.125—this is why the perpetual average method is sometimes referred to as the moving
average method. The Inventory balance is $352.50 (4 books with an average cost of $88.125
each).

Comparison of Cost Flow

Assumptions
Below is a recap of the varying amounts for the cost of goods sold, gross profit, and ending inventory
that were calculated above.
The examples assumed that costs were continually increasing. The results would be different if costs
were decreasing or increasing at a slower rate. Consult with your tax adviser concerning the election
of a cost flow assumption.

In past periods of inflation, many U.S. companies switched from FIFO to LIFO. However, once the
switch is made, a company cannot change back to FIFO.
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Specific Identification
In addition to the six cost flow options discussed earlier, businesses have another option: expense to
the cost of goods sold the specific cost of the specific item sold. For example, Gold Dealer, Inc.
has an inventory of gold and each gold bar has an identification number and the cost of the gold bar.
When Gold Dealer sells a gold bar, it can expense to the cost of goods sold the exact cost of the
specific gold bar sold. The cost of the other gold bars will remain in inventory. (Alternatively, Gold
Dealer could use one of the other six cost flow options described earlier.)
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LIFO Benefits Without Tracking

Units
Earlier we demonstrated that during periods of increasing costs, LIFO resulted in less profits. In the
U.S. this can mean less income taxes paid by a corporation. Most corporations view lower taxes as
a significant benefit. However, the process of tracking costs and then assigning those costs to the
units sold and the units on hand could be too expensive for the amount of income tax savings. To
gain the benefit of LIFO without tracking costs, there is a method known as dollar value LIFO. This
topic is discussed in intermediate accounting textbooks. The Internal Revenue Service also allows
companies to use dollar value LIFO by applying price indexes. (You should seek the advice of an
accounting and/or tax professional to assess the cost and benefit of these techniques.)

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Inventory Management
Over the past decades sophisticated companies have made great strides in reducing their levels of
inventory. Rather than carry large inventories, they ask their suppliers to deliver goods "just in time."
Suppliers and merchandisers have learned to coordinate their purchases and sales so that orders
and shipments occur automatically.

A company will realize significant benefits if it can keep its inventory levels down without losing sales
or production (if the company is a manufacturer). In its early days, Dell Computers greatly reduced
its inventory in relationship to its sales. Since the cost of computer components had been dropping
as new technologies emerged, it benefited Dell to keep a small inventory of components on hand. It
would be a financial hardship if Dell had a large quantity of components that became obsolete or
decreased in value.

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Financial Ratios
Keeping track of inventory is important. There are two common financial ratios for monitoring
inventory levels: (1) Inventory Turnover Ratio, and (2) Days' Sales in Inventory. These are discussed
and illustrated in the Explanation of Financial Ratios.

Estimating Ending Inventory

It is very time-consuming for a company to physically count the units of goods in its inventory. In
fact, some companies shut down their operations near the end of their accounting year just to
perform inventory counts. Often a company assigns one set of employees to count and tag the items
and another set to verify the counts. If a company has outside auditors, they will be there to observe
the process. (Even if the company's computers keep track of inventory, the computer quantities must
be verified by physically counting the goods at least once per year.)
If a company using the periodic inventory system counts its inventory only once per year, it
must estimate its inventory at the end of each month in order to prepare meaningful monthly
financial statements. In fact, a company may need to estimate its inventory for other reasons as well.
For example, if a company suffers a loss due to a disaster such as a tornado or a fire, it will need to
file a claim for the approximate cost of the inventory that was lost. (An insurance adjuster will also
compute the amount independently so that the company is not paid too much or too little for its loss.)
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Estimating Inventory: Gross

Profit Method
The gross profit method for estimating the cost of the ending inventory uses information from a
previously issued income statement. To illustrate the gross profit method we will assume that ABC
Company needs to estimate the cost of its ending inventory on June 30, 2022.
ABC's latest income statement (which is representative of current conditions) contained the following
information:

From ABC's information we see that the company's gross profit is 20% of sales, and that the cost of
goods sold is 80% of sales. If those percentages are reasonable for the current year, we can use
them to estimate the cost of the inventory on hand as of June 30, 2022.

While an algebraic equation could be used, we prefer to simply use the income statement format.
We will prepare a partial income statement for the period beginning after the date when inventory
was last physically counted, and ending with the date for which we need the estimated inventory
cost. In this case, the income statement we prepare will be from January 1, 2022 until June 30,
2022.

Some of the amounts needed can be obtained from sales records, customers, suppliers, earlier
financial statements, etc. For example, sales for the first half of the year 2022 are taken from the
company's records. The beginning inventory amount is the ending inventory reported on the
December 31, 2021 balance sheet. The purchases information for the first half of 2022 is available
from the company's records or its suppliers. The amounts that are available are shown in italics in
the following partial income statement:
We will fill in the rest of the statement with the answers from the following calculations. The
calculation amounts in italics come from the statement above. The calculation amounts in bold will
be used to complete the above section of the income statement:

Inserting this information into the income statement yields the following:
Next, we need to compute the ending inventory amount. This is done by subtracting the cost of
goods sold from the cost of goods available as shown here:

Below is the completed partial income statement with the estimated amount of ending inventory at
$26,200. (Note: Always recheck the math on the income statement to be certain you computed the
amounts correctly.)

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Estimating Inventory: Retail
Method
Another method for estimating inventory is the retail method. This method can be used by retailers
who have their merchandise records in both cost and retail selling prices. A very simple illustration of
using the retail method for estimating the cost of ending inventory (using hypothetical amounts
unrelated to earlier examples) is shown here:

Notice that the cost amounts are presented in one column and the retail amounts are listed in a
separate column. The Goods Available amounts are used to compute the cost-to-retail ratio. In
this case the cost of goods available of $80,000 is divided by the retail amount of goods available of
$100,000. Therefore, the cost-to-retail ratio, or cost ratio, is 80%. The estimated ending inventory at
cost is the estimated ending inventory at retail of $10,000 times the cost ratio of 80% equals $8,000.

Introduction to Depreciation
Did you know? To make the topic of Depreciation even easier to understand, we
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What is Depreciation?
Depreciation is a systematic process for allocating (spreading) the cost of an asset that is used in a
business to the accounting periods in which the asset is used. Depreciation is associated with
buildings, equipment, vehicles, and other physical assets which will last for more than a year but will
not last forever.

Reason for Depreciation

Depreciation is necessary for measuring a company's net income in each accounting period. To
demonstrate this, let's assume that a retailer purchases a $70,000 truck on the first day of the
current year, but the truck is expected to be used for seven years. It is not logical for the retailer to
report the $70,000 as an expense in the current year and then report $0 expense during the
remaining 6 years. However, it is logical to report $10,000 of expense in each of the 7 years that the
truck is expected to be used.

Accountants often say that the purpose of depreciation is to match the cost of the truck with
the revenues that are being earned by using the truck. Others say that the truck's cost is being
matched to the periods in which the truck is being used up.

Examples of Assets to be Depreciated

Some examples of assets that are depreciated include:

 Buildings (excluding land)

 Machinery and equipment
 Trucks and automobiles
 Computer systems
 Furniture and fixtures
 Land improvements (parking lots, outdoor lighting, etc.)
These assets are often described as depreciable assets, fixed assets, plant assets, productive
assets, tangible assets, capital assets, and constructed assets.

How These Assets are Recorded

The assets to be depreciated are initially recorded in the accounting records at their cost. Cost is
defined as all costs that were necessary to get the asset in place and ready for use.
To illustrate the cost of an asset, assume that a company paid $10,000 to purchase used equipment
located 200 miles away. The company then paid $2,000 to transport the equipment to its location.
Finally, the company paid $5,000 to get the equipment in working condition. The company will record
the equipment in its general ledger account Equipment at the cost of $17,000.

The balance in the Equipment account will be reported on the company's balance sheet under the
asset heading property, plant and equipment.

How Depreciation is Calculated

The calculation of depreciation involves the following:

 The asset's cost

The asset's cost includes all costs necessary to get the asset in place and ready for use.
 The asset's estimated salvage value
The asset's estimated salvage value is the amount that the company will receive at the
end of the asset's useful life. The estimated salvage value is also referred to as the asset's
residual value or disposal value. It is common for companies to use a salvage value of $0 in
the depreciation calculation.
 The asset's estimated useful life
The asset's estimated useful life is the number of years (or the total units of output) that
the asset is expected to be used. The useful life can be more or less than its physical life.
For example, a computer may have a physical life of 10 years, but due to expected changes
in software and hardware, the computer's useful life may be 3 years.
One formula that is commonly used to calculate depreciation expense for a year is:
(Asset's cost – estimated salvage value) / estimated years of useful life

The asset's cost minus its estimated salvage value is known as the asset's depreciable cost.
It is the depreciable cost that is systematically allocated to expense during the asset's useful life.

How Depreciation is Recorded

Depreciation is recorded in a company's accounts with an adjusting entry that is typically recorded
at the end of each accounting period. Except for equipment and facilities used in manufacturing, the
adjusting entry for depreciation will involve the following general ledger accounts:
 Depreciation Expense
 Accumulated Depreciation
For instance, if the depreciation of a company's delivery truck is $10,000 per year for 7 years and the
company prepares only annual financial statements as of December 31, the adjusting entry for each
of the 7 years will be the following:

This entry indicates that the account Depreciation Expense is being debited for $10,000 and the
account Accumulated Depreciation is being credited for $10,000.

Depreciation Expense
Depreciation Expense is an income statement account. Income statement accounts are referred to
as temporary accounts since their account balances are closed to a stockholders' equity account
after the annual income statement is prepared.

Since the balance is closed at the end of each accounting year, the account Depreciation Expense
will begin the next accounting year with a balance of $0.

Accumulated Depreciation
Accumulated Depreciation is a balance sheet account that is associated with an asset that is being
depreciated. For example, there will be an account Accumulated Depreciation – Truck that is
associated with the asset account Truck.

The account Accumulated Depreciation is known as a contra asset account, since the account will
appear in the asset section of the balance sheet, but it will have a credit balance (which is contrary
to the normal debit balance for an asset account).

To illustrate an Accumulated Depreciation account, assume that a retailer purchased a delivery truck
for $70,000 and it was recorded with a debit of $70,000 in the asset account Truck. Each year when
the truck is depreciated by $10,000, the accounting entry will credit Accumulated Depreciation –
Truck (instead of crediting the asset account Truck). This allows us to see both the truck's original
cost and the amount that has been depreciated since the time that the truck was put into service.

Unlike the account Depreciation Expense, the Accumulated Depreciation account is not closed at
the end of each year. Instead, the balance in Accumulated Depreciation is carried forward to the
next accounting period. To illustrate, let's continue with our truck example. After the truck has been
used for two years, the account Accumulated Depreciation - Truck will have a credit balance of
$20,000. After three years, Accumulated Depreciation – Truck will have a credit balance of $30,000.
Each year the credit balance in this account will increase by $10,000 until the credit balance reaches
$70,000.

The difference between the debit balance in the asset account Truck and credit balance in
Accumulated Depreciation – Truck is known as the truck's book value or carrying value. At the
end of three years the truck's book value will be $40,000 ($70,000 minus $30,000).
Both the asset account Truck and the contra asset account Accumulated Depreciation – Truck are
reported on the balance sheet under the asset heading property, plant and equipment.

Methods of Calculating Depreciation

There are many methods that a company may use to calculate the depreciation that will be reported
on its financial statements. The following is a partial list of the depreciation methods that are
available:

 Straight-line method
Straight-line depreciation is by far the most common method used for computing
and reporting depreciation on a company's financial statements. Therefore, we will
explain and demonstrate the details of calculating depreciation beginning with the straight-
line method.
After learning some of the details in calculating depreciation using the straight-line method, we will
provide examples of the following depreciation methods:

 Units-of-activity or units-of-production method

This method uses an asset's output (instead of years) as an indicator of its useful life
 Double-declining-balance (DDB) method
This method provides more depreciation expense in the early years of the asset's useful life
and therefore less depreciation expense in the later years of the asset's life. The calculation
for the DDB method uses the asset's book value (which is always declining) and multiplies
it by two times the straight-line depreciation rate. DDB is one of the accelerated methods of
depreciation.
 Sum-of-the-years'-digits (SYD) method
SYD is another accelerated method of depreciation. This means that a company will report
more depreciation expense in the earlier years of the asset's useful life and less depreciation
in the later years.
The key difference in the depreciation methods involves when the asset's cost is reported as
depreciation expense on the company's income statements:
 If a company wants the same amount of depreciation expense each year, it will use the
straight-line method.
 If the company wants more depreciation expense in the years when an asset is used more, it
will use the units-of-activity method.
 If the company wants a greater amount of depreciation expense in the early years of an
asset's useful life (and therefore less in the later years), it will use an accelerated
 depreciation method such as the double-declining-balance method or the sum-of-the-years'-
digits method.

Regardless of the depreciation method used, the total amount of depreciation expense over
the useful life of an asset cannot exceed the asset's depreciable cost (asset's cost minus
its estimated salvage value).
NOTE:
In our explanation of depreciation, we are discussing the depreciation which is reported on a
company's financial statements. This is commonly referred to as book depreciation.
We do not discuss the depreciation that is reported on a U.S. company's income tax return. To learn
about tax depreciation, visit [Link] or discuss tax depreciation with your tax adviser. (The
depreciation method used on the company's tax return can be different from the depreciation method
used on the company's financial statements...resulting in a tax benefit.)

Straight-Line Depreciation
The most common method of depreciation used on a company's financial statements is the straight-
line method. When the straight-line method is used each full year's depreciation expense will be the
same amount.

We will illustrate the details of depreciation, and specifically the straight-line depreciation method,
with the following example.

Example of Straight-Line Depreciation

A company has decided that it wants to use the straight-line method for reporting depreciation on its
financial statements. The company purchased equipment for use in its business operation and
provides the following information:

 On July 1, 2021, the company purchased equipment for $10,500

 The account Equipment was debited for $10,500 and the account Cash was credited for
$10,500
 The company estimated that the equipment's salvage value at the end of its useful life will be
$500
 The company estimated that the equipment's useful life will be 5 years

Given the above information, the straight-line depreciation expense for each full year that the asset
is used will be $2,000 as calculated here:
If a company's accounting year ends on December 31, the company's income statement will report
the depreciation expense as follows:

*Since the asset was acquired on July 1, 2021, only half of the annual depreciation expense amount
is recorded in 2021 and 2026.

The company's cash payment for the equipment took place on a single day in 2021 as shown here:

Since depreciation expense is reported in all years from 2021 through 2026, but the cash payment
took place only at the time when the equipment was purchased, each year's depreciation expense is
often described as a noncash expense.

Recording Straight-Line Depreciation

Depreciation is recorded in the company's accounting records through adjusting entries. Adjusting
entries are recorded in the general journal using the last day of the accounting period.
Assuming the company prepares only annual financial statements for its years that end on
December 31, the adjusting entries will be as follows:
If a company issues monthly financial statements, the amount of each monthly adjusting entry will be
$166.67.

Visualizing the Balances in Equipment and Accumulated Depreciation

Note that the account credited in the above adjusting entries is not the asset account Equipment.
Instead, the credit is entered in the contra asset account Accumulated Depreciation. The use of this
contra account allows the asset account Equipment to continue to report the equipment's cost, while
also reporting in Accumulated Depreciation the total amount of depreciation expense that has been
reported since the asset was acquired.
To assist in visualizing the balances in the asset account Equipment and the related contra asset
account Accumulated Depreciation as of December 31, 2022 we are providing the following T-
accounts:
Book Value or Carrying Value of Assets
The combination of an asset account's debit balance and its related contra asset account's credit
balance is the asset's book value or carrying value.
Using the account balances in the T-accounts above, the book value or carrying value of the
company's equipment as of December 31, 2022 is:

When the asset's book value is equal to the asset's estimated salvage value, the depreciation
entries will stop. If the asset continues in use, there will be $0 depreciation expense in each of the
subsequent years. The asset's cost and its accumulated depreciation balance will remain in the
general ledger accounts until the asset is disposed of.

Depreciation is Based on Estimates

It is important to realize that the amount of depreciation reported by a company is an estimated
amount. The reason is that the calculation of depreciation uses the following estimates:
 Salvage value
An asset's salvage value is also described as the asset's disposal value, scrap value or
residual value. Salvage value is an estimate of the amount the company expects to receive
when it disposes of the asset at the end of the asset's useful life. (It is common for
companies to assume that an asset will have no salvage value.)
  Useful life
The useful life of an asset is an estimate of how long the asset is expected to be used in
the business. For example, a design engineer might purchase a new computer and
estimate that the computer will be useful in the business for only 2 years (due to rapid
advances in software and hardware). At the same time, an accountant might purchase a
similar computer and estimate that it will be useful in the accounting business for 4
years. Both the design engineer's estimated useful life of 2 years and the accountant's
estimated useful life of 4 years are correct (even though the computers are similar and may
have a physical life of more than 10 years).

What Happens When an Estimated Amount Changes

For financial statements to be relevant for their users, the financial statements must be distributed
soon after the accounting period ends. To achieve this requirement, accountants must estimate
some amounts.

After the financial statements are distributed, it is reasonable to learn that some actual amounts are
different from the estimated amounts that were included in the financial statements. Unless the
differences are significant no action is required.
If there is a significant change in an asset's estimated salvage value and/or the asset's estimated
useful life, the change in the estimate will result in a new amount of depreciation expense in the
current accounting year and in the remaining years of the asset's useful life.
NOTE:
A change in the estimated salvage value or a change in the estimated useful life of an asset that is
being depreciated is not considered to be an accounting error. As a result, the financial statements
that have already been distributed are not changed.
A significant change in the estimated salvage value or estimated useful life will be reported in the
current and remaining accounting years of the asset's useful life.

Example of a Change in the Estimated Useful Life of an Asset

To illustrate a change in the estimated useful life of an asset, we will assume a company had the
following situation:

 Equipment was purchased on January 1, 2017 at a cost of $14,000

 The company originally estimated the equipment will have no salvage value
 The company originally estimated that the equipment's useful life was 7 years
 Straight-line depreciation was used (resulting in depreciation of $2,000 in each full year)
 In 2021 the company realized that the equipment would not be useful after December 31,
2022 (instead of December 31, 2023)
 The estimated salvage value at the end of the equipment's useful life remains at $0
 Instead of the original useful life of 7 years (January 1, 2017 through December 31, 2023),
the company now estimates a total useful life of only 6 years (January 1, 2017 through
December 31, 2022)
 The depreciation already reported for the years 2017 through 2020 cannot be changed since
the change is not an accounting error
 The change in the estimated useful life will affect only the depreciation being reported for
2021 and 2022

Let's first review the original straight-line depreciation using the estimates in January 2017:
Note in the following T-accounts that on December 31, 2020, the balance in the Equipment account
is $14,000 (the cost of the equipment) and the account Accumulated Depreciation has a credit
balance of $8,000:

The above accounts indicate that the book value of the equipment as of December 31, 2020 is
$6,000 ($14,000 – $8,000). We also know that only two years remain (2021 and 2022) in which to
depreciate the remaining $6,000 of book value. Since, the estimated salvage value is $0, the
remaining $6,000 is divided by the 2 years remaining = $3,000 of depreciation expense in each of
the years 2021 and 2022.

The adjusting entries for 2021 and 2022 are as follows:

As of December 31, 2022, the Accumulated Depreciation account will look like this:

Note that the depreciation amounts recorded in the years 2020 and before were not changed.

Now that you have learned the basic concepts of the depreciation reported on a company's financial
statement, we will move on to calculate depreciation using three additional depreciation methods:

 Units-of-activity (or units of production)

 Double-declining-balance
 Sum-of-the-years'-digits

Units-of-Activity Depreciation
Depreciation Not Based on Years
In most depreciation methods, an asset's estimated useful life is expressed in years. However, in
the units-of-activity method (and in the similar units-of-production method), an asset's
estimated useful life is expressed in units of output. In the units-of-activity method, the accounting
period's depreciation expense is not a function of the passage of time. Instead, each accounting
period's depreciation expense is based on the asset's usage during the accounting period.
Examples of Units-of-Activity Depreciation
To introduce the concept of the units-of-activity method, let's assume that a service business
purchases unique equipment at a cost of $20,000. Over the equipment's useful life, the business
estimates that the equipment will produce 5,000 valuable items. Assuming there is no salvage value
for the equipment, the business will report $4 ($20,000/5,000 items) of depreciation expense for
each item produced. If 80 items were produced during the first month of the equipment's use, the
depreciation expense for the month will be $320 (80 items X $4). If in the next month only 10 items
are produced by the equipment, only $40 (10 items X $4) of depreciation will be reported.

Now let's illustrate the units-of-activity method of depreciation by using a different example:

 On July 1, 2021, the company paid $10,500 to purchase special equipment to produce
elaborate images for its clients
 The company estimated that this equipment will have a useful life of 5,000 images
 The company estimated that the equipment will be sold for $500 at the end of its useful life

Using the above information, the calculation of the units-of-activity method of depreciation begins
with the following:

Over the life of the equipment, the maximum total amount of depreciation expense is $10,000.
However, the amount of depreciation expense in any year depends on the number of images.
Whether it's a partial year or a full year is not relevant.
The depreciation expense for any accounting period is calculated by multiplying the number of
images produced times $2 per image. For instance, if 400 images are produced from July 1
through December 31, 2021, the depreciation for 2021 will be recorded as follows:

If 900 images are produced in the year 2022, the depreciation entry for 2022 will be recorded as
follows:
In this example, the depreciation will continue until the credit balance in Accumulated Depreciation
reaches $10,000 (the equipment's depreciable cost). If the equipment continues to be used, no
further depreciation expense will be reported. The account balances remain in the general ledger
until the equipment is sold, scrapped, etc.

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Double-Declining-Balance (DDB)
Depreciation
DDB is an Accelerated Method of Depreciation
The double-declining-balance (DDB) method, which is also referred to as the 200%-
declining-balance method, is one of the accelerated methods of depreciation. DDB is an
accelerated method because more depreciation expense is reported in the early years of an asset's
useful life and less depreciation expense in the later years.
The "double" or "200%" means two times straight-line rate of depreciation. For instance, if an asset's
estimated useful life is 10 years, the straight-line rate of depreciation is 10% (100% divided by 10
years) per year. Therefore, the "double" or "200%" will mean a depreciation rate of 20% per year.

The "declining-balance" refers to the asset's book value or carrying value (the asset's cost minus
its accumulated depreciation). Recall that the asset's book value declines each time that
depreciation is credited to the related contra asset account Accumulated Depreciation.
Therefore, the DDB depreciation calculation for an asset with a 10-year useful life will have a DDB
depreciation rate of 20%. In the first accounting year that the asset is used, the 20% will be
multiplied times the asset's cost since there is no accumulated depreciation. In the following
accounting years, the 20% is multiplied times the asset's book value at the beginning of the
accounting year. This differs from other depreciation methods where an asset's depreciable cost is
used.
In DDB depreciation the asset's estimated salvage value is initially ignored in the calculations.
However, the depreciation will stop when the asset's book value is equal to the estimated salvage
value.

NOTE:
Although accelerated depreciation methods may more accurately coincide with the way some assets
lose value, companies are reluctant to have their income statements show less net income and
earnings per share than is required. As a result, companies are not interested in reporting larger
depreciation expense in the early years of their assets' lives (and lower depreciation in future years).
However, when it comes to taxable income and the related income tax payments, it is a
different story. In the U.S. companies are permitted to use straight-line depreciation on their income
statements while using accelerated depreciation on their income tax returns. You can find more
information on depreciation for income tax reporting at [Link].

Example of Double-Declining-Balance Depreciation

To illustrate the double-declining-balance method of depreciation, we will use the following
information:

 A retailer purchased fixtures on January 1 at a cost of $100,000

 The estimated useful life is 10 years (resulting in a straight-line depreciation rate of
10%)
 The DDB rate will be 20% (200% or double the straight-line rate of 10%)
 The estimated salvage value at the end of its useful life is $8,000

Below is a table showing the first four years of the DDB depreciation:

Note that the estimated salvage value of $8,000 was not considered in calculating each year's
depreciation expense. In our example, the depreciation expense will continue until the amount in
Accumulated Depreciation reaches a credit balance of $92,000 (cost of $100,000 minus $8,000 of
salvage value).

[In practice, companies often assume $0 salvage value and will switch from DDB to straight-line
depreciation towards the end of the asset's useful life in order to fully depreciate the asset's cost.]

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Sum-of-the-Years'-Digits (SYD)
Depreciation
SYD is An Accelerated Method of Depreciation
The sum-of-the-years'-digits (SYD) depreciation method is also another form of accelerated
depreciation since it results in more depreciation expense in the early years of the asset's useful life
and less in the later years (as compared to the straight-line method).
The "sum-of-the-years'-digits" refers to adding the digits in the years of an asset's useful life. For
example, if an asset has a useful life of 5 years, the sum of the digits 1 through 5 is equal to 15 (1 +
2 + 3 + 4 + 5).
An asset with a useful life of 10 years will have the following sum of its years' digits:

1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55
A fast way to compute the sum of the digits in the asset's useful life is to use this formula: n(n+1)
divided by 2. If an asset's useful life is 10 years, then n = 10. The sum of the digits for an asset
with a useful life of 10 years = 10(10+1)/2 = 10(11)/2 = 110/2 = 55.
In the case of an asset with a 10-year useful life, the depreciation expense in the first full year of the
asset's life will be 10/55 times the asset's depreciable cost. The depreciation for the 2nd year will be
9/55 times the asset's depreciable cost. This pattern will continue and the depreciation for the 10th
year will be 1/55 times the asset's depreciable cost.

Example of Sum-of-the-Years'-Digits Depreciation

Now we will use the following information to calculate the SYD depreciation:

 A retailer purchased fixtures on January 1 at a cost of $115,000

 The estimated useful life is 10 years
 The estimated salvage value at the end of its useful life is $5,000
 The depreciable cost of the fixtures is $110,000 (cost of $115,000 minus the estimated
salvage value of $5,000)

The depreciation amounts for the first five years of the asset's 10-year life under SYD depreciation
method are:

1st year: 10/55 times $110,000 = $20,000

2nd year: 9/55 times $110,000 = $18,000
3rd year: 8/55 times $110,000 = $16,000
4th year: 7/55 times $110,000 = $14,000
5th year: 6/55 times $110,000 = $12,000
6th year: 5/55 times $110,000 = $10,000
7th year: 4/55 times $110,000 = $8,000
8th year: 3/55 times $110,000 = $6,000
9th year: 2/55 times $110,000 = $4,000
10th year: 1/55 times $110,000 = $2,000
At the end of 10 years, the contra asset account Accumulated Depreciation will have a credit
balance of $110,000. When this is combined with the debit balance of $115,000 in the asset account
Fixtures, the book value of the fixtures will be $5,000 (which is equal to the estimated salvage
value).

Selling a Depreciable Asset

Recording Depreciation to Date of Sale
When a depreciable asset is sold (as opposed to traded-in or exchanged for another asset), a gain
or loss on the sale is likely. However, before computing the gain or loss, it is necessary to record the
asset's depreciation right up to the moment of the sale.

To amplify this step, assume that a retailer had recorded depreciation on its fleet of delivery trucks
up to December 31. Three weeks later (on January 21), the company sells one of its older delivery
trucks. The first step for the retailer is to record the depreciation for the three weeks that the truck
was used in January.

Example of a Gain on Sale of an Asset

After an asset's depreciation is recorded up to the date the asset is sold, the asset's book value is
compared to the amount received. For example, if an old delivery truck is sold and its cost was
$80,000 and its accumulated depreciation at the date of the sale is $72,000, the truck's book value
at the date of the sale is $8,000.

If the retailer receives cash of $10,000 for the truck, the retailer will increase its asset cash and will
remove from its assets, the truck's book value of $8,000. Hence, the retailer has a gain of $2,000.
This transaction will be recorded as follows:

Example of a Loss on Sale of an Asset

Now let's assume that the retailer sells the truck for $5,000 (instead of $8,000). The retailer's cash
will increase by $5,000 and its property, plant, and equipment section of the balance sheet will
decrease by the book value of $8,000. As a result, the retailer will have a loss of $3,000. This
transaction will be recorded as follows:
 Confused? Send Feedback

Other Information Regarding

Depreciable Assets
Depreciation of Manufacturing Assets
Assuming a retailer, distributor, or service provider does not manufacture goods, the depreciation
associated with its assets will be recorded and reported on its income statement as depreciation
expense.
However, if a company's depreciable assets are used in a manufacturing process, the depreciation
of the manufacturing assets will not be reported directly on the income statement as depreciation
expense. Instead, this depreciation will be initially recorded as part of manufacturing overhead,
which is then allocated (assigned) to the goods that were manufactured.
In other words, the depreciation on the manufacturing facilities and equipment will be attached to the
products manufactured. When the goods are in inventory, some of the depreciation is part of the
cost of the goods reported as the asset inventory. When the goods are sold, some of the
depreciation will move from the asset inventory to the cost of goods sold that is reported on the
manufacturer's income statement.

The depreciation on the non-manufacturing assets (these are assets used in the company's selling,
general and administrative activities) will be reported directly as depreciation expense on the
manufacturer's income statements.

Repairs and Maintenance Vs. Capital Expenditures

After a company's asset has been put into service, there will likely be some future expenditures
associated with the asset. If an expenditure merely maintains the asset (routine and preventative
maintenance, tune ups, etc.), the expenditure is immediately reported as an expense such as
Repairs and Maintenance Expense. Similarly, if a huge expenditure merely repairs a broken
machine, the amount is reported as an expense such as Repairs and Maintenance Expense.

On the other hand, if an expenditure expands or improves an asset's capabilities, the amount
is not reported as an expense. Rather, the cost of the addition or improvement is recorded as an
asset and should be depreciated over the remaining useful life of the asset.
The amounts spent to acquire, expand, or improve assets are referred to as capital expenditures.
The amount that a company spent on capital expenditures during the accounting period is reported
under investing activities on the company's statement of cash flows.

Depreciation: Allocation Not Valuation

It is important to understand that the main purpose of depreciation is to move the cost of an asset
(except the estimated salvage value) from a company's balance sheet to depreciation expense on its
income statements in a systematic manner during the asset's useful life.

Hence, it is important to understand that depreciation is a process of allocating an asset's cost to

expense over the asset's useful life. The purpose of depreciation is not to report the asset's fair
market value on the company's balance sheets.
NOTE:
The purpose of depreciation is to allocate an asset's cost to expense in a systematic manner.
The purpose of depreciation is not to report an asset's current value on the company's balance
sheets.

Impairment of Assets Used in a Business

Since depreciation is not intended to report a depreciable asset's market value, it is possible that the
asset's market value is significantly less than the asset's book value or carrying amount. The
accounting profession has addressed this situation with a mechanism to reduce the asset's book
value and to report the adjustment as an impairment loss.
There are several steps involved in determining whether an impairment loss has occurred and how
to measure and report it. You can learn more about impairment losses by reading the appropriate
parts of an Intermediate Accounting textbook or visiting the Financial Accounting Standards Board's
website.