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

Joe seems puzzled by the term transaction, so Marilyn gives him five examples of transactions that Direct Delivery, Inc. will need to record:

1. Joe will no doubt start his business by putting some of his own personal money into it. In effect, he is buying shares of Direct Delivery's common stock.

2. Direct Delivery will need to buy a sturdy, dependable delivery vehicle. 3. The business will begin earning fees and billing clients for delivering their parcels. 4. The business will be collecting the fees that were earned. 5. The business will incur expenses in operating the business, such as a salary for Joe, expenses

associated with the delivery vehicle, advertising, etc.

With thousands of such transactions in a given year, Joe is smart to start using accounting software right from the beginning. Accounting software will generate sales invoices and accounting entries

simultaneously, prepare statements for customers with no additional work, write checks, automatically update accounting records, etc.

By getting into the habit of entering all of the day's business transactions into his computer, Joe will be rewarded with fast and easy access to the specific information he will need to make sound business decisions. Marilyn tells Joe that accounting's "transaction approach" is useful, reliable, and informative. She has worked with other small business owners who think it is enough to simply "know" their company made $30,000 during the year (based only on the fact that it owns $30,000 more than it did on January 1). Those are the people who start off on the wrong foot and end up in Marilyn's office looking for financial advice. If Joe enters all of Direct Delivery's transactions into his computer, good accounting software will allow Joe to print out his financial statements with a click of a button. In Parts 2 through 7 Marilyn will explain the content and purpose of the three main financial statements:

1. Income Statement 2. Balance Sheet 3. Statement of Cash Flows

Income Statement Marilyn points out that an income statement will show how profitable Direct Delivery has been during the time interval shown in the statement's heading. This period of time might be a week, a month, three months, five weeks, or a year—Joe can choose whatever time period he deems most useful. The reporting of profitability involves two things: the amount that was earned (revenues) and the expenses necessary to earn the revenues. As you will see next, the term revenues is not the same as receipts, and the term expenses

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

involves more than just writing a check to pay a bill.

A. Revenues accrual

basis of accounting (as opposed to the less-preferred cash method of accounting), revenues are recorded when they are earned, not when the company receives the money. Recording revenues when they are earned is the result of one of the basic accounting principles known as the revenue recognition principle. For example, if Joe delivers 1,000 parcels in December for $4 per delivery, he has technically earned fees totaling $4,000 for that month. He sends invoices to his clients for these fees and his terms require that his clients must pay by January 10. Even though his clients won't be paying Direct Delivery until January 10, the accrual basis of accounting requires that the $4,000 be recorded as December revenues, since that is when the delivery work actually took place. After expenses are matched with these revenues, the income statement for December will show just how profitable

When Joe receives the $4,000 worth of payment checks from his customers on January 10, he will make an accounting entry to show the money was received. This $4,000 of receipts will not be considered to be January revenues, since the

the company was in delivering parcels in December.

revenues were already reported as revenues in December when they were earned. This $4,000 of receipts will be recorded in January as a reduction in Accounts Receivable. (In December Joe had made an entry to Accounts Receivable and to Sales.)

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

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

(A) Assets Assets are things that a company owns and are sometimes referred to as the resources of the company. Joe readily understands this—off the top of his head he names things such as the company's vehicle, its cash in the bank, all of the supplies he has on hand, and the dolly he uses to help move the heavier parcels. Marilyn nods and shows Joe how these are reported in accounts called Vehicles, Cash, Supplies, andEquipment. She mentions one asset Joe hadn't considered—Accounts Receivable. If Joe delivers parcels, but isn't paid immediately for the delivery, the amount owed to Direct Delivery is an asset known as Accounts Receivable. Prepaids Marilyn brings up another less obvious asset—the unexpired portion of prepaid expenses. Suppose Direct Delivery pays $1,200 on December 1 for a six-month insurance premium on its delivery vehicle. That divides out to be $200 per month ($1,200 ÷ 6 months). Between December 1 and December 31, $200 worth of insurance premium is "used up" or "expires". The expired amount will be reported as Insurance Expenseon December's income statement. Joe asks Marilyn where the remaining $1,000 of unexpired insurance premium would be reported. On the December 31 balance sheet, Marilyn tells him, in an asset account called Prepaid Insurance. Other examples of things that might be paid for before they are used include supplies and annual dues to a trade association. The portion that expires in the current accounting period is listed as an expense on the income statement; the part that has not yet expired is listed as an asset on the balance sheet. Marilyn assures Joe that he will soon see a significant link between the income statement and balance sheet, but for now she continues with her explanation of assets.

Cost Principle and Conservatism Joe learns that each of his company's assets was recorded at its original cost, and even if the fair market value of an item increases, an accountant will not increase the recorded amount of that asset on the balance sheet. This is the result of another basic accounting principle known as the cost principle. Although accountants generally do not increase the value of an asset, they might decrease its value as a result of a concept known as conservatism. For example, after a few months in business, Joe may decide that he can help out some customers—as well as earn additional revenues—by carrying an inventory of packing boxes to sell. Let's say that Direct Delivery purchased 100 boxes wholesale for $1.00 each. Since the time when Joe bought them, however, the wholesale price of boxes has been cut by 40% and at today's price he could purchase them for $0.60 each. Because the replacement cost of his inventory ($60) is less than the original recorded

Joe also needs to know that the reported amounts on his balance sheet for assets such as equipment, vehicles, and buildings are routinely reduced by depreciation. Depreciation is required by the basic accounting principle known as the

cost ($100), the principle of conservatism directs the accountant to report the lower amount ($60) as the asset's value on the balance sheet. In short, the cost principle generally prevents assets from being reported at more than cost, while conservatism might require assets to be reported at less then their cost. Depreciation

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

As an example, assume that Direct Delivery's van has a useful life of five years and was purchased at a cost of $20,000. The accountant might match $4,000 ($20,000 ÷ 5 years) of Depreciation Expense with each year's revenues for five years. Each year the carrying amount of the van will be reduced by $4,000. (The carrying amount—or "book value"—is reported on the balance sheet and it is the cost of the van minus the total depreciation since the van was acquired.) This means that after one year the balance sheet will report the carrying amount of the delivery van as $16,000, after two years the carrying amount will be $12,000, etc. After five years—the end of the van's expected useful life—its carrying amount is zero. Joe wants to be certain that he understands what Marilyn is telling him regarding the assets on the balance sheet, so he asks Marilyn if the balance sheet is, in effect, showing what the company's assets are worth. He is surprised to hear Marilyn say that the assets are not reported on the balance sheet at their worth (fair market value). Long-term assets (such as buildings, equipment, and furnishings) are reported at their costminus the amounts already sent to the income statement as Depreciation Expense. The result is that a building's market value may actually have increased since it was acquired, but the amount on the balance sheet has been consistently reduced

Another asset,

as the accountant moved some of its cost to Depreciation Expense on the income statement in order to achieve the matching principle.

Office Equipment, may have a fair market value that is much smaller than the carrying amount reported on the balance sheet. (Accountants view depreciation as an allocation process—allocating the cost to expense in order to match the costs with the revenues generated by the asset. Accountants donot consider depreciation to be a valuation process.) The asset Land

The balance sheet reports Direct Delivery's

is not depreciated, so it will appear at its original cost even if the land is now worth one hundred times more than its cost. Short-term (current) asset amounts are likely to be close to their market values, since they tend to "turn over" in relatively short periods of time. Marilyn cautions Joe that the balance sheet reports only the assets acquired and only at the cost reported in the transaction. This means that a company's reputation—as excellent as it might be—will not be listed as an asset. It also means that Jeff Bezos will not appear as an asset on Amazon.com's balance sheet; Nike's logo will not appear as an asset on its balance sheet; etc. Joe is surprised to hear this, since in his opinion these items are perhaps the most valuable things those companies have. Marilyn tells Joe that he has just learned an important lesson that he should remember when reading a balance sheet.

(B) Liabilities liabilities as of the date noted in the heading of the balance

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

to deliver $600 of parcels within 6 months, or return the money.) Unearned Revenue. Each month,

as the 30 parcels are delivered, Direct Delivery will be earning $100, and as a result, each month $100 moves from the account Unearned Revenue to Service Revenues. Each month Direct Delivery's liability

decreases by $100 as it fulfills the agreement by delivering parcels and each month its revenues on the income statement increase by $100. (C) Stockholders' Equity

If the company is a corporation, the third section of a corporation's balance sheet is Stockholders' Equity. (If the company is a sole proprietorship, it is referred to as Owner's Equity.) The amount of Stockholders' Equity is exactly the difference between the asset amounts and the liability amounts. As a result accountants often refer to Stockholders' Equity as the difference (or residual) of assets minus liabilities. Stockholders' Equity is also the "book value" of the corporation. Since the corporation's assets are shown at cost or lower (and not at their market values) it is important that you do not

Within the Stockholders' Equity section you may see accounts such as

associate the reported amount of Stockholders' Equity with the market value of the corporation. (Hence, it is a poor choice of words to refer to Stockholders' Equity as the corporation's "net worth".) To find the market value of a corporation, you should obtain the services of a professional familiar with valuing businesses.

Common Stock, Paid-in Capital in Excess of Par Value-Common Stock, Preferred Stock, Retained Earnings, and Current Year's Net Income. The account Common Stock will be increased when the corporation issues shares of stock in exchange for cash (or some other asset). Another account Retained Earnings will increase when the corporation earns a profit. There will be a decrease when the corporation has a net loss. This means that revenues will automatically cause an increase in Stockholders' Equity and expenses will automatically cause a

atement of Cash Flows

decreasein Stockholders' Equity. This illustrates a link between a company's balance sheet and income statement.

The third financial statement that Joe needs to understand is the Statement of Cash Flows. This statement shows how Direct Delivery's cash amount has changed during the time interval shown in the heading of the statement. Joe will be able to see at a glance the cash generated and used by his company's operating activities, its investing activities, and its financing activities. Much of the information on this financial statement will come from Direct Delivery's balance sheets and income statements.

The three financial reports that Marilyn introduced to Joe—the income statement, the balance sheet, and the statement of cash flows—represent one segment of the valuable output that good accounting software can generate for business owners. Marilyn now explains to Joe the basics of getting started with recording his transactions. The field of accounting—both the older manual systems and today's basic accounting software—is based on the 500-year-old accounting procedure known as double entry. Double entry is a simple yet powerful concept: each and every one of a company's transactions will result in an amount recorded into at least

To begin the process of setting up Joe's accounting system, he will need to make a detailed listing of all the names of the accounts that Direct Delivery, Inc. might find useful for reporting transactions. This detailed listing is referred to as a

two of the accounts in the accounting system.

The Chart of Accounts

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

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

Balance Sheet accounts:

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

Income Statement accounts:

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

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

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

Direct Delivery, Inc. Balance Sheet December 1, 2010

Assets

Liabilities & Stockholders' Equity

Cash $ 20,000

Liabilities

Stockholders' Equity

Common Stock $ 20,000

Total Assets $ 20,000

Total Liab. & Stockholders' Equity

$ 20,000

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

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

$20,000 = $0 +

$20,000

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

Debit means left. Credit means right.

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

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

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

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

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

cash, the Cash account is credited.

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

Account Name Debit Credit

Cash 20,000

Common Stock

20,000

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

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

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

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

Account Name Debit Credit

Vehicles 14,000

Cash

14,000

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

Direct Delivery, Inc. Balance Sheet December 2, 2010

Assets

Liabilities & Stockholders' Equity

Cash $ 6,000

Liabilities

Vehicles 14,000

Stockholders' Equity

Common Stock $ 20,000

Total Assets $ 20,000

Total Liab. & Stockholders' Equity

$ 20,000

The balance sheet and the accounting equation remain in balance:

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

$20,000 = $0 +

$20,000

As you can see in the balance sheet, the asset Cash decreased by $14,000 and another asset Vehicles increased by $14,000. Liabilities and stockholders' equity were not involved and did not change. Sample Transaction #3

The third sample transaction also occurs on December 2 when Joe contacts an insurance agent regarding insurance coverage for the vehicle Direct Delivery just purchased. The agent informs him that $1,200 will provide insurance protection for the next six months. Joe immediately writes a check for $1,200 and mails it in. Let's consider this transaction. Using double entry, we know there must be a minimum of two accounts involved—one (or more) of the accounts must be debited, and one (or more) must be Since a check is written, we know that one of the accounts involved is Cash. Since cash was

credited. paid, the

Cash account will be credited. (Take another look at the last TIP.) While we have not yet identified the second account, what we do know for certain is that the second account will have to be debited. At this point we have most of the entry—all we are missing is the name

of the account to be debited:

Account Name Debit Credit

??? 1,200

Cash

1,200

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

Prepaid Insurance (an asset account reported on the balance sheet) and Insurance Expense

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

Account Name Debit Credit

Prepaid Insurance 1,200

Cash

1,200

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

Direct Delivery, Inc. Balance Sheet December 2, 2010

Assets

Liabilities & Stockholders' Equity

Cash $ 4,800

Liabilities

Prepaid Insurance 1,200

Stockholders' Equity

Vehicles 14,000

Common Stock $ 20,000

Total Assets $ 20,000

Total Liabilities & Stockholders' Equity

$ 20,000

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

Sample Transactions #4 - #6

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

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

Revenues accounts are credited when the company earns

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

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

Account Name Debit Credit

Cash 10

Service Revenues

10

Sample Transaction #5

Let's assume that on December 3 the company gets its second customer—a local company that needs to have 50 parcels delivered immediately. Joe's price of $250 is very appealing, so Joe's company is hired to deliver the parcels. The customer tells Joe to submit an invoice for the $250, and they will pay it within seven days. Joe delivers the 50 parcels on December 3 as agreed, meaning that on December 3 Direct Delivery hasearned $250. Hence the $250 is reported as revenues on December 3, even though the company did not receive any cash on that day. The effort

Because Direct Delivery has earned the fees, one account will be a revenues account, such as Service Revenues. (If you refer back to the last

needed to complete the job was done on December 3. (Depositing the check for $250 in the bank when it arrives seven days later is not considered to take any effort.) Let's identify the two accounts involved and determine which needs a debit and which needs a credit.

TIP, you will read that revenue accounts —such as Service Revenues—are usually credited, meaning the second account will need to be debited.)

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

Account Name Debit Credit

??? 250

Service Revenues

250

We know that the unnamed account cannot be Cash.

Account Name Debit Credit

Accounts Receivable 250

Service Revenues

250

Again, reporting revenues when they are earned results from the basic accounting principle known as therevenue recognition principle. Sample Transaction #6

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

debited.

The accounts and amounts for the temporary help are:

Account Name Debit Credit

Temporary Help Expense 80

Accounts Payable

80

Expenses are (almost) always debited.

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

Direct Delivery, Inc. Income Statement For the Three Days Ended December 3, 2010

Service Revenues $ 260

Temporary Help Expense 80

Net Income

$ 180

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

Direct Delivery, Inc. Balance Sheet December 3, 2010

Assets

Liabilities & Stockholders' Equity

Cash $ 4,810

Liabilities

Accounts Receivable 250

Accounts Payable $ 80

Prepaid Insurance 1,200

Stockholders' Equity

Vehicles 14,000

Common Stock 20,000

Retained Earnings 180

Total Stockholders' Equity 20,180

Total Assets $ 20,260

Total Liab. & Stockholders' Equity

$ 20,260

Notice that the year-to-date net income (bottom line of the income statement) increased Stockholders' Equity by the same amount, $180. This connection between the income statement and balance sheet is important. For one, it keeps the balance sheet and the accounting equation in balance. Secondly, it demonstrates that revenues will cause the stockholders' equity to increase and expenses will cause stockholders' equity to decrease. After the end of the year financial statements are prepared, you will see that the income statement accounts (revenue accounts and expense accounts) will be closed or zeroed out and their balances will be transferred into the Retained Earnings

1. When a company

account. This will mean the revenue and expense accounts will start the new year with zero balances—allowing the company "to keep score" for the new year. Marilyn suggested that perhaps this introduction was enough material for their first meeting. She wrote out the following notes, summarizing for Joe the important points of their discussion:

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

financial statements—

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

are three examples.)

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

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

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

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

financial statements—

Service Revenues or Fees Earned. If the amount received is an advance payment for a service that has not yet been

performed or earned, the account to be credited is Unearned Revenue. If the amount received is a payment from a customer for a sale or service delivered

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

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

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

3. Revenues are recorded as Service Revenues or Sales when the service or sale has been performed,not

is credited.

4. Expenses are matched with revenues or with the period of time shown in the heading of the income statement,

when the cash is received. This reflects the basic accounting principle known as the revenue recognition principle.

not in the period when the expenses were paid. This reflects the basic accounting principle known as the matching principle.

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

on the current replacement cost.

Debits and Credits Introduction to Debits and Credits If the words "debits" and "credits" sound like a foreign language to you, you are more perceptive than you realize—"debits" and "credits" are words that have been traced back five hundred years to a document describing today's double-entry accounting system. Under the double-entry system every business transaction is recorded in at least two accounts. One account will receive a "debit" entry, meaning the amount will be entered on the left side of that account. Another account will receive a "credit" entry, meaning the amount will be entered on the right

Before we explain and illustrate the debits and credits in accounting and bookkeeping, we will discuss the accounts in which the debits and credits will be entered or posted.

side of that account. The initial challenge with double-entry is to know which account should be debited and which account should be credited.

What Is An Account? To keep a company's financial data organized, accountants developed a system that sorts transactions into records called accounts. When a company's accounting system is set up, the accounts most likely to be affected by the company's transactions are identified and listed out. This list is referred to as the company'schart of accounts. Depending on the size of a company and the complexity of its business operations, the chart of accounts may list as few as thirty accounts or as many as thousands. A company has the flexibility of tailoring its chart of accounts to best meet its needs.

Within the chart of accounts the balance sheet accounts are listed first, followed by the income statement accounts. In other words, the accounts are organized in the chart of accounts as follows:

Assets Liabilities Owner's (Stockholders') Equity Revenues or Income Expenses Gains Losses

Click here to see a sample chart of accounts. Double-Entry Accounting Because every business transaction affects at least two accounts, our accounting system is known as adouble-entry

For example, when a company borrows $1,000 from a bank, the transaction will affect the company's

system. (You can refer to the company's chart of accounts to select the proper accounts. Accounts may be added to the chart of accounts when an appropriate account cannot be found.)

Cashaccount and the company's Notes Payable

If a company buys supplies for cash, its

account. When the company repays the bank loan, the Cash account and the Notes Payable account are also involved.

Supplies account and its Cash account will be affected. If the company buys supplies on credit, the accounts involved are Supplies and Accounts Payable.

If a company pays the rent for the current month, Rent Expense and Cash are the two accounts involved. If a company provides a service and gives the client 30 days in which to pay, the company's Service Revenues account and Accounts Receivable Although the system is referred to as double-entry, a transaction may involve more than two accounts. An example of a transaction that involves three accounts is a company's loan payment to its bank of $300. This transaction will involve the following accounts: Cash, Notes Payable, and Interest Expense.

are affected.

(If you use accounting software you may not actually see that two or more accounts are being affected due to the user-friendly nature of the software. For example, let's say that you write a company check by means of your accounting software. Your software automatically reduces your Cash account and prompts you only for the other ebits and Credits

accounts affected.)

After you have identified the two or more accounts involved in a business transaction, you must debit at least one account and credit at least one account. To debit an account means to enter an amount on the left side of the account. To credit an account means to enter an amount on the right side of an account.

Debit means left Credit means

right

Generally these types of accounts are increased

with a debit:

Dividends (Draws) Expenses Assets Losses

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

with a debit.

Generally these types of accounts are increased Gains Income Revenues Liabilities Stockholders' (Owner's) Equity

with a credit:

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

with a credit.

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

with a credit.

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

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

Cash

(asset account)

Debit Increases an asset Received $

Credit Decreases an asset Paid $

Notes Payable

(liability account)

Debit Decreases a liability Repaid loan

Credit Increases a liability Borrowed more

Let's demonstrate the use of these T-accounts with two transactions:

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

Cash

(asset account)

Debit Increases an asset Received $

Credit Decreases an asset Paid $

June 1, 2010 ENTRY 5,000

Notes Payable

(liability account)

Debit Decreases a liability Repaid loan

Credit Increases a liability Borrowed more

5,000

ENTRY June 1, 2010

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

Cash

(asset account)

Debit Increases an asset Received $

Credit Decreases an asset Paid $

June 1, 2010 ENTRY 5,000

2,000

ENTRY June 2, 2010

June 2, 2010 BALANCE

3,000

Notes Payable

(liability account)

Debit Decreases a liability Repaid loan

Credit Increases a liability Borrowed more

5,000

ENTRY June 1, 2010

June 2, 2010 ENTRY 2,000

3,000

BALANCE June 2, 2010

s Another way to visualize business transactions is to write a general journal entry. Each general journal entry

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

Date Account Name Debit Credit

June 1, 2010 Cash 5,000

Notes Payable

5,000

Date Account Name Debit Credit

June 2, 2010 Notes Payable 2,000

Cash

2,000

Because cash is involved in many transactions, it is helpful to memorize the following:

Whenever cash is received, debit Whenever cash is

Cash. paid out, credit

With the knowledge of what happens to the Cash account, the journal entry to record the debits and credits is easier. Let's assume that a company

Cash.

receives $500 on June 3, 2010 from a customer who was given 30 days in which to pay. (In May the company recorded the sale and an accounts

receivable.) On June 3 the company will debit Cash, because cash was received. The amount of the debit and the credit is $500. Entering this information in the general journal format, we have: Date Account Name Debit Credit

June 3, 2010 Cash 500

???

500

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

again on June 3.) paid

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

Date Account Name Debit Credit

June 4, 2010 ??? 300

Cash

300

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

again on June 4.)

Whenever cash is received, the Cash account is debited

(and another account is credited).

Whenever cash is paid out, the Cash account is credited Normal Balances

(and another account is debited).

When looking at a T-account for each of the account classifications in the general ledger, here is the debit or credit balance you would normally find in the account:

Account Classification Normal Balance

Assets Debit

Contra asset Credit

Liability Credit

Contra liability Debit

Owner's Equity Credit

Stockholders' Equity Credit

Owner's Drawing or Dividends Account

Debit

Revenues (or Income) Credit

Expenses Debit

Gains Credit

Losses Debit

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

Account Name Debit Credit

Cash 50

Service Revenues

50

Whenever cash is received, the asset account Cash is debited and another account will need to be credited. Since the service was performed at the same time as the cash was received, the revenue account Service Revenues is credited, thus increasing its account balance.

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

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

Account Name Debit Credit

Accounts Receivable 400

Service Revenues

400

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

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

Account Name Debit Credit

Rent Expense 800

Cash

800

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

Assuming the employees earned $1,900 during the last week of the year, the entry in general journal form is:

Account Name Debit Credit

Wages Expense 1,900

Wages Payable

1,900

As noted above, expenses are almost always debited, so we debit Wages Expense, increasing its account balance. Since your company did not yet pay its employees, the Cash account is not

To help you get more comfortable with debits and credits in accounting and bookkeeping, memorize the following tip:

credited, instead, the credit is recorded in the liability account Wages Payable. A credit to a liability account increases its credit balance.

To increase an expense

account, debit the account.

Permanent and Temporary Accounts Asset, liability, and most owner/stockholder equity accounts are referred to as "permanent accounts" (or "real accounts"). Permanent accounts are not closed at the end of the accounting year; their balances are automatically carried forward to the next accounting year. "Temporary accounts" (or "nominal accounts") include all of the revenue accounts, expense accounts, the owner drawing account, and the income summary account. Generally speaking, the balances in temporary accounts increase throughout the accounting year and are "zeroed out" and closed at the end of the accounting year. Balances in the revenue and expense accounts are zeroed out by closing/transferring/clearing their balances to the Income Summary account. The net amount in Income Summary is then closed/transferred/cleared to an owner equity account, such as Mary Smith, Capital (or to Retained Earnings if the company is a corporation). The owner drawing account (such as Mary Smith, Drawing) is a temporary account and it is closed directly

Because the balances in the temporary accounts are transferred out of their respective accounts at the end of the accounting year, each temporary account will have a zero balance when the next accounting year begins. This means that the new accounting year starts with no revenue amounts, no expense amounts, and no amount in the drawing account.

to the owner capital account (such as Mary Smith, Capital) without going through an income summary account.

By using many revenue accounts and a huge number of expense accounts, a company is certain to have easy access to detailed information on revenues and expenses throughout the year. This allows the management of the company to monitor the performance of all parts of the company. Once the accounting year has ended, the need to know the balances in these temporary accounts has also ended, so the accounts are closed out and reopened for the next accounting year with zero balances.

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

your account (e.g., takes a monthly service charge from your account) your checking account balance decreases.

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

your checking account to reduce its balance.

Transaction #1

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

(Debris Disposal's journal entry)

Account Name Debit Credit

Cash 100

Unearned Revenues

100

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

(Trustworthy Bank's journal entry)

to reflect the bank's obligation/liability to return the $100 to Debris Disposal on demand. In general journal format the bank's entry is:

Account Name Debit Credit

Cash 100

Deposits

(your statement) 100

As the entry shows, the bank's assets increase by the debit of $100 and the bank's liabilities increase by the credit of $100. The bank's detailed records show that Debris Disposal's checking account is the specific liability that increased. Transaction #2

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

Account Name Debit Credit

Cash 1,000

Deposits

(your statement) 1,000

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

Account Name Debit Credit

Cash 1,000

Accounts Receivable

1,000

As a result of collecting $1,000 from one of its customers, Debris Disposal's Cash balance increases and its Accounts Receivable balance decreases. Transaction #3

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

(Trustworthy Bank's general ledger)

Account Name Debit Credit

Deposits 13 (your statement)

Service Charge Revenues

13

On your company's records, the entry will look like this: (Debris Disposal's general ledger)

Account Name Debit Credit

Bank Service Charges Expense 13

Cash

13

Debris Disposal's cash is reduced with a credit of $13 and expenses are increased with a debit of $13. (If the amount of the bank's service charges is not significant a company may debit the charge to Miscellaneous Expense.) Bak's Balance Sheet Accounts such as Cash, Investment Securities, and Loans Receivable are reported as assets on the bank's balance sheet. Deposits are reported as liabilities and include the balances in its customers' checking and savings accounts as well as certificates of deposit. In effect, your bank statement

Recap

is just one of thousands of subsidiary records that account for millions of dollars in Deposits that a bank owes to its customers.

Here are some of the highlights from this major topic:

Debit means left. Credit means right. Every transaction affects two accounts or more. At least one account will be debited and at least one account will be credited. The total of the amount(s) entered as debits must equal the total of the amount(s) entered

as credits. When cash is received, debit Cash. When cash is paid out, credit Cash. To increase an asset, debit the asset account. To increase a liability, credit the liability account. To increase owner's equity, credit an owner's equity account. To increase revenues, credit the revenues account To increase expenses, debit the expense account

Chart of Accounts

Introduction to Chart of Accounts A chart of accounts is a listing of the names of the accounts that a company has identified and made available for recording transactions in its general ledger. A company has the flexibility to tailor its chart of accounts to best suit its needs, including adding accounts as needed. Within the chart of accounts you will find that the accounts are typically listed in the following order:

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

Income statement accounts

Operating Revenues Operating Expenses Non-operating Revenues and Gains Non-operating Expenses and Losses

Within the categories of operating revenues and operating expenses, accounts might be further organized by business function (such as producing, selling, administrative, financing) and/or by company divisions, product lines, etc. A company's organization chart

A chart of accounts will likely be as large and as complex as the company itself. An international corporation with several divisions may need thousands of accounts, whereas a small local retailer may need as few as one hundred accounts.

can serve as the outline for its accounting chart of accounts. For example, if a company divides its business into ten departments (production, marketing, human resources, etc.), each department will likely be accountable for its own expenses (salaries, supplies, phone, etc.). Each department will have its own phone expense account, its own salaries expense, etc.

Sample Chart of Accounts For a Large Corporation Each account in the chart of accounts is typically assigned a name and a unique number by which it can be identified. (Software for some small businesses may not require account numbers.) Account numbers are often five or more digits in length with each digit representing a division of the company, the department, the type of account, etc. As you will see, the first digit might signify if the account is an asset, liability, etc. For example, if the first digit is a "1" it is an asset. If the first digit is a "5" it is an operating expense. A gap between account numbers allows for adding accounts in the future. The following is a partial

listing of a sample chart of accounts.

Current Assets

10100 Cash - Regular Checking 10200 Cash - Payroll Checking 10600 Petty Cash Fund 12100 Accounts Receivable 12500 Allowance for Doubtful Accounts 13100 Inventory 14100 Supplies 15300 Prepaid Insurance

(account numbers 10000 - 16999)

Property, Plant, and Equipment 17000 Land 17100 Buildings 17300 Equipment 17800 Vehicles 18100 Accumulated Depreciation - Buildings 18300 Accumulated Depreciation - Equipment 18800 Accumulated Depreciation - Vehicles

(account numbers 17000 - 18999)

Current Liabilities 20100 Notes Payable - Credit Line #1 20200 Notes Payable - Credit Line #2 21000 Accounts Payable 22100 Wages Payable 23100 Interest Payable 24500 Unearned Revenues

(account numbers 20000 - 24999)

Long-term Liabilities 25100 Mortgage Loan Payable 25600 Bonds Payable 25650 Discount on Bonds Payable

(account numbers 25000 - 26999)

Stockholders' Equity 27100 Common Stock, No Par 27500 Retained Earnings 29500 Treasury Stock

(account numbers 27000 - 29999)

Operating Revenues 31010 Sales - Division #1, Product Line 010 31022 Sales - Division #1, Product Line 022 32015 Sales - Division #2, Product Line 015 33110 Sales - Division #3, Product Line 110

(account numbers 30000 - 39999)

Cost of Goods Sold 41010 COGS - Division #1, Product Line 010 41022 COGS - Division #1, Product Line 022 42015 COGS - Division #2, Product Line 015 43110 COGS - Division #3, Product Line 110

(account numbers 40000 - 49999)

Marketing Expenses 50100 Marketing Dept. Salaries 50150 Marketing Dept. Payroll Taxes 50200 Marketing Dept. Supplies 50600 Marketing Dept. Telephone

(account numbers 50000 - 50999)

Payroll Dept. Expenses (account numbers 59000 - 59999)

59100 Payroll Dept. Salaries 59150 Payroll Dept. Payroll Taxes 59200 Payroll Dept. Supplies 59600 Payroll Dept. Telephone

Other 91800 Gain on Sale of Assets 96100 Loss on Sale of Assets

(account numbers 90000 - 99999)

This is a partial listing of another sample chart of accounts. Note that each account is assigned a three-digit number followed by the account name. The first digit of the number signifies if it is an asset, liability, etc. For example, if the first digit is a "1" it is an asset, if the first digit is a "3" it is a revenue account, etc. The company decided to include a column to indicate whether a debit or credit will increase the amount in the account. This sample chart of accounts also includes a column containing a description of each account in order to assist in the selection of the most appropriate account. Asset Accounts

No. Account Title To Increase

Description/Explanation of Account

101 Cash Debit Checking account balance (as shown in company records), currency, coins, checks received from customers but not yet deposited.

120 Accounts Receivable Debit Amounts owed to the company for services performed or products sold but not yet paid for.

140 Merchandise Inventory Debit Cost of merchandise purchased but has not yet been sold.

150 Supplies Debit Cost of supplies that have not yet been used. Supplies that have been used are recorded in Supplies Expense.

160 Prepaid Insurance Debit Cost of insurance that is paid in advance and includes a future accounting period.

170 Land Debit Cost to acquire and prepare land for use by the company.

175 Buildings Debit Cost to purchase or construct buildings for use by the company.

178 Accumulated Depreciation - Buildings

Credit Amount of the buildings' cost that has been allocated to Depreciation Expense since the time the building was acquired.

180 Equipment Debit Cost to acquire and prepare equipment for use by the company.

188 Accumulated Depreciation - Equipment

Credit Amount of equipment's cost that has been allocated to Depreciation Expense since the time the equipment was acquired.

Liability Accounts

No. Account Title To Increase

Description/Explanation of Account

210 Notes Payable Credit The amount of principal due on a formal written promise to pay. Loans from banks are included in this account.

215 Accounts Payable Credit Amount owed to suppliers who provided goods and services to the company but did not require immediate payment in cash.

220 Wages Payable Credit Amount owed to employees for hours worked but not yet paid.

230 Interest Payable Credit

Amount owed for interest on Notes Payable up until the date of the balance sheet. This is computed by multiplying the amount of the note times theeffective interest rate times the time period.

240 Unearned Revenues Credit Amounts received in advance of delivering goods or providing services. When the goods are delivered or services are provided, this liability amount decreases.

250 Mortgage Loan Payable

Credit A formal loan that involves a lien on real estate until the loan is repaid.

Owner's Equity Accounts

No. Account Title To Increase

Description/Explanation of Account

290 Mary Smith, Capital Credit Amount the owner invested in the company (through cash or other assets) plus earnings of the company not withdrawn by the owner.

295 Mary Smith, Drawing Debit

Amount that the owner of the sole proprietorship has withdrawn for personal use during the current accounting year. At the end of the year, the amount in this account will be transferred into Mary Smith, Capital (account 290).

Operating Revenue Accounts

No. Account Title To Increase

Description/Explanation of Account

310 Service Revenues Credit

Amounts earned from providing services to clients, either for cash or on credit. When a service is provided on credit, both this account and Accounts Receivable will increase. When a service is provided for immediate cash, both this account and Cash will increase.

Operating Expense Accounts

No. Account Title To Increase

Description/Explanation of Account

500 Salaries Expense Debit Expenses incurred for the work performed by salaried employees during the accounting period. These employees normally receive a fixed amount on a

weekly, monthly, or annual basis.

510 Wages Expense Debit Expenses incurred for the work performed by non-salaried employees during the accounting period. These employees receive an hourly rate of pay.

540 Supplies Expense Debit Cost of supplies used up during the accounting period.

560 Rent Expense Debit Cost of occupying rented facilities during the accounting period.

570 Utilities Expense Debit Costs for electricity, heat, water, and sewer that were used during the accounting period.

576 Telephone Expense Debit Cost of telephone used during the current accounting period.

610 Advertising Expense Debit Costs incurred by the company during the accounting period for ads, promotions, and other selling and expenses (other than salaries).

750 Depreciation Expense Debit Cost of long-term assets allocated to expense during the current accounting period.

Non-Operating Revenues and Expenses, Gains, and Losses

No. Account Title To Increase

Description/Explanation of Account

810 Interest Revenues Credit

Interest and dividends earned on bank accounts, investments or notes receivable. This account is increased when the interest is earned and either Cash or Interest Receivable is also increased.

910 Gain on Sale of Assets Credit Occurs when the company sells one of its assets (other than inventory) for more than the asset's book value.

960 Loss on Sale of Assets Debit Occurs when the company sells one of its assets (other than inventory) for less than the asset's book value.

Accounting software frequently includes sample charts of accounts for various types of businesses. It is expected that a company will expand and/or modify these sample charts of accounts so that the specific needs of the company are met. Once a business is up and running and transactions are routinely being recorded, the company may add more accounts or delete accounts that are never used. At Least wo Accounts for Every Transaction The chart of accounts lists the accounts that are available for recording transactions. In keeping with thedouble-entry system of accounting, a minimum of two accounts

When a transaction is entered into a company's accounting software, it is common for the software to prompt for only one account name—this is because the software is programmed to automatically assign one of the accounts. For example, when using accounting software to write a check, the software automatically reduces the asset account

is needed for every transaction—at least one account is debited and at least one account is credited.

Cash and prompts you to designate the other account(s) such as Rent Expense, Advertising Expense, etc..

Some general rules about debiting and crediting the accounts are:

Expense accounts are debited and have Revenue

debit balances accounts are credited and have

Assetcredit balances

accounts normally have To increase an

debit balances asset account, debit

To decrease anthe account

asset account, credit Liability

the account accounts normally have

To increase acredit balances

liability account, credit To decrease a

the account liability account, debit

the account

Bookkeeping

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

accounts.

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

With the arrival of computers and accounting software, bookkeeping errors decreased and efficiency increased. For example, the accounting software will refuse a journal entry if the debit amount entered does not equal the credit amount entered. Further, because journal amounts are posted electronically and account balances are calculated electronically, the potential for human error in these tasks is eliminated. As an example of how bookkeeping has become more efficient, consider that the following tasks now occur simultaneously when a credit sale is processed with accounting software:

1. A sales invoice is prepared 2. The general ledger account Sales 3. The general ledger account

is credited Accounts Receivable

4. The customer's account in the subsidiary ledger is updated. is debited

5. In some situations, the Inventory

account is updated.

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

credited.

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

debited.

Every account has two "sides," a right side and a left side. A debit refers to an entry on the left side of an account, and a credit refers to an entry on the right

side of an account. Double entry bookkeeping requires that for every transaction, there is an entry to the left side of one (or more) account, and a corresponding entry to the right side of another account(s).

Below are some facts that will help you determine which side of an account to use:

• Expenses are always debits • Revenues are always credits • Debit the Cash account when cash is received • Credit the Cash account when cash is paid out

Here are some additional facts...

A debit will increase Assets (

these accounts: Cash, Accounts Receivable, Inventory, Land, Equipment, etc.)

Expenses (Rent Expense, Wages Expense, Interest Expense, etc.) Losses (Loss on Sale of Assets, Loss from Lawsuit, etc.) Sole proprietor's Drawing account

A debit will decrease Liabilities (

these accounts: Notes Payable, Accounts Payable, Interest Payable, etc.)

Stockholders' Equity (Common Stock, Retained Earnings)

A credit will increase Liabilities (

these accounts: Notes Payable, Accounts Payable, Interest Payable, etc.)

Revenues (Sales, Service Revenues, Fees Earned, Interest Revenues, etc.) Gains (Gain on Sale of Assets, Gain on Retirement of Bonds, etc.)

A credit will decrease Assets (

these accounts: Cash, Accounts Receivable, Supplies, Inventory, Land, etc.)

We can illustrate double entry bookkeeping with the following sample transactions:

If a company borrows $10,000 from its bank, the company debits its Cash account for $10,000 and credits its Notes Payable account for $10,000.

When a company records wages for hourly employees, it debits Wages Expense and credits Wages Payable.

If a company makes a sale "on credit," it debits Accounts Receivable and credits Sales.

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

Chart of Accounts A chart of accounts

is a listing of all the accounts available to a company to record and sort its business transactions. A chart of accounts is generally customized by an accountant to fit the needs of the company and can be modified when necessary. For example, if a new product line is introduced or a new department is started, accounts can be added to accommodate the change.

The chart of accounts consists of two types of accounts: (1) balance sheet accounts, and (2) income statement accounts. Account categories are generally listed in the following standardized order: Assets Liabilities Stockholders' (or Owner's) Equity Revenues Expenses Gains Losses atemes Accounting software has simplified the process of preparing financial statements. The balances in the asset, liability, and stockholders' equity accounts can be programmed to appear in a balance sheet format. The balances in the revenue, expense, gain, and loss accounts can be programmed to print in a variety of income statement formats. As a result, many company accountants are spending less time with the tedious and mechanical work of financial statement preparation, and more time on other responsibilities. To learn more about the responsibilities of accountants, go to our Accounting Career Center.

Accounting Equation

Introduction to the Accounting Equation We also have a Visual Tutorial, Quiz, Crosswords, and Q&A for the topic

1. Assets (what it owns)

Accounting Equation.

From the large, multi-national corporation down to the corner beauty salon, every business transaction will have an effect on a company’s financial position. The financial position of a company is measured by the following items:

2. Liabilities (what it owes to others) 3. Owner’s Equity (the difference between assets and liabilities)

The accounting equation (or basic accounting equation) offers us a simple way to understand how these three amounts relate to each other. The accounting equation for a sole proprietorship is:

Assets = Liabilities + Owner’s Equity

The accounting equation for a corporation is:

Assets = Liabilities + Stockholders’ Equity

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

Liabilities are a company’s obligations—amounts the company owes. Examples of liabilities include notes or loans payable, accounts payable, salaries and wages payable, interest payable, and income taxes payable (if the company is a regular corporation). Liabilities can be viewed in two ways: (1) as claims by creditors against the company’s assets, and (2) a source—along with owner or stockholder equity—of the company’s assets.

Owner’s equity or stockholders’ equity

Owner’s or stockholders’ equity also reports the amounts invested into the company by the owners plus the cumulative

is the amount left over after liabilities are deducted from assets: Assets – Liabilities = Owner’s (or Stockholders’) Equity.

net income of the company that has not been withdrawn or distributed to the owners.

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

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

TheBalance Sheet and Income Statement

balance sheet

The

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

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

Examples

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

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

accrual basis

Accounting Equation for a Sole Proprietorship: Transactions 1–2

of accounting is being followed.

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

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

We present nine transactions to illustrate how a company’s accounting equation stays in balance.

per se. Rather, transactions are recorded into specific accounts contained in the company’s general ledger. Each

account is designated as an asset, liability, owner's equity, revenue, expense, gain, or loss account. Thegeneral ledger accounts are then used to prepare the balance sheets and income statements throughout the accounting periods.

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

Explanation of Chart of

Accounts.)

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

Assets = Liabilities + Owner’s Equity

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

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

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

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

Date Account Titles Debit Credit

Dec. 1, 2010 Cash

10,000

J. Ott, Capital

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

10,000

Accounting Software Co.

Balance Sheet

December 1, 2010

ASSETS

LIABILITIES

Cash $ 10,000 OWNER’S EQUITY

. J. Ott, Capital $ 10,000

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

.

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

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

Assets = Liabilities + Owner’s Equity

–$100 = No Effect + –$100

The accounting equation remains in balance since ASC’s assets have been reduced by $100 and so has the owner’s equity.

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

Date Account Titles Debit

Dec. 2, 2010

Credit

J. Ott, Drawing

100

Cash

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

100

Transaction Assets = Liabilities + Owner’s Equity

1 +$10,000 = No Effect + +$10,000

2 –$100 = No Effect + –$100

Totals = $9,900 + $0 $9,900

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

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

Accounting Software Co.

Balance Sheet

December 2, 2010

ASSETS

LIABILITIES

Cash $ 9,900 OWNER’S EQUITY

. J. Ott, Capital $ 9,900*

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

.

.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income + 0

Subtotal $ 10,000

– Owner's Draws – 100

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

.

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

Accounting Equation for a Sole Proprietorship: Transactions 3–4

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

Assets = Liabilities + Owner’s Equity

+$5,000

= No Effect + No Effect

–$5,000

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

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

Date Account Titles Debit

Dec. 3, 2010

Credit

Equipment

5,000

Cash

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

5,000

Transaction Assets = Liabilities + Owner’s Equity

1 +$10,000 = No Effect + +$10,000

2 –$100 = No Effect + –$100

3 +$5,000

= No Effect + No Effect –$5,000

Totals = $9,900 + $0 $9,900

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

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

Accounting Software Co.

Balance Sheet

December 3, 2010

ASSETS

LIABILITIES $ 0

Cash $ 4,900 OWNER’S EQUITY

Equipment

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

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

.

.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income + 0

Sub Total $ 10,000

– J. Ott, Drawing – 100

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

.

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

been placed into service, therefore, no expense will appear on an income statement for the period of December 1 through December 3.

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

Assets = Liabilities + Owner’s Equity

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

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

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

Date Account Titles Debit

Dec. 4, 2010

Credit

Cash

7,000

Notes Payable

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

7,000

Transaction Assets = Liabilities + Owner’s Equity

1 +$10,000 = No Effect + +$10,000

2 –$100 = No Effect + –$100

3 +$5,000

= No Effect + No Effect –$5,000

4 +$7,000 = +$7,000 + No Effect

Totals = $16,900 + $7,000 $9,900

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

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

Accounting Software Co.

Balance Sheet

December 4, 2010

ASSETS

LIABILITIES

Cash $ 11,900 Notes Payable $ 7,000

Equipment

5,000 OWNER’S EQUITY

. J. Ott, Capital $ 9,900*

Total Assets $ 16,900 Total Liab & Owner's Equity $ 16,900

.

.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income + 0

Subtotal $ 10,000

– J. Ott, Drawing – 100

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

.

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

Accounting Equation for a Sole Proprietorship: Transactions 5–6

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

Assets = Liabilities + Owner’s Equity

–$600 = No Effect + –$600

Since ASC is paying

Date

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

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

Account Titles Debit

Dec. 5, 2010

Credit

Advertising Expense

600

Cash

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

600

Transaction Assets = Liabilities + Owner’s Equity

1 +$10,000 = No Effect + +$10,000

2 –$100 = No Effect + –$100

3 +$5,000

= No Effect + No Effect –$5,000

4 +$7,000 = +$7,000 + No Effect

5 –$600 = No Effect + –$600

Totals = $16,300 + $7,000 $9,300

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

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

Accounting Software Co.

Balance Sheet

December 5, 2010

ASSETS

LIABILITIES

Cash $ 11,300 Notes Payable $ 7,000

Equipment

5,000 OWNER’S EQUITY

. J. Ott, Capital $ 9,300*

Total Assets $ 16,300 Total Liab & Owner's Equity $ 16,300

.

.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income** + (600)

Subtotal $ 9,400

– J. Ott, Drawing – 100

Ending Owner's Equity at Dec. 5 $ 9,300*

.

**The income statement (which reports the company’s revenues, expenses, gains, and losses during a specified time interval) is a link between balance sheets. It provides the results of operations—an important part of the change in owner’s equity.

Since this transaction involves an expense, it will involve ASC’s income statement. The company’s income statement for the first five days of December is:

Accounting Software Co.

Income Statement

For the Five Days Ended December 5, 2010

REVENUES $ 0

EXPENSES

Advertising Expense

600

NET INCOME $ (600)

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

Assets = Liabilities + Owner’s Equity

+$900 = No Effect + +$900

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

Date

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

Account Titles Debit

Dec. 6, 2010

Credit

Accounts Receivable

900

Service Revenues

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

900

Transaction Assets = Liabilities + Owner’s Equity

1 +$10,000 = No Effect + +$10,000

2 –$100 = No Effect + –$100

3 +$5,000

= No Effect + No Effect –$5,000

4 +$7,000 = +$7,000 + No Effect

5 –$600 = No Effect + –$600

6 +$900 = No Effect + +$900

Totals = $17,200 + $7,000 $10,200

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

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

Accounting Software Co.

Balance Sheet

December 6, 2010

ASSETS

LIABILITIES

Cash $ 11,300 Notes Payable $ 7,000

Accounts Receivable

900 OWNER’S EQUITY

Equipment

5,000 J. Ott, Capital $ 10,200*

Total Assets $ 17,200 Total Liab & Owner's Equity $ 17,200

.

.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income** + 300

Subtotal $ 10,300

– J. Ott, Drawing – 100

Ending Owner's Equity at Dec. 6 $ 10,200*

.

**The income statement (which reports the company’s revenues, expenses, gains, and losses during a specified time interval) is a link between balance sheets. It provides the results of operations—an important part of the change in owner’s equity.

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

Accounting Software Co.

Income Statement

For the Six Days Ended December 6, 2010

REVENUES

Service Revenues $ 900

EXPENSES

Advertising Expense

600

NET INCOME $ 300

Accounting Equation for a Sole Proprietorship: Transactions 7–8

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

Assets = Liabilities + Owner’s Equity

No Effect = +$120 + –$120

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

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

Date Account Titles Debit

Dec. 7, 2010

Credit

Temp Service Expense

120

Accounts Payable

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

120

Transaction Assets = Liabilities + Owner’s Equity

1 +$10,000 = No Effect + +$10,000

2 –$100 = No Effect + –$100

3 +$5,000

= No Effect + No Effect –$5,000

4 +$7,000 = +$7,000 + No Effect

5 –$600 = No Effect + –$600

6 +$900 = No Effect + +$900

7 No Effect = +$120 + –$120

Totals = $17,200 + $7,120 $10,080

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

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

Accounting Software Co.

Balance Sheet

December 7, 2010

ASSETS

LIABILITIES

Cash $ 11,300 Notes Payable $ 7,000

Accounts Receivable

900 Accounts Payable $ 120

Equipment

5,000 Total Liabilities $ 7,120

OWNER’S EQUITY

. J. Ott, Capital $ 10,080*

Total Assets $ 17,200 Total Liab & Owner's Equity $ 17,200

.

.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income** + 180

Subtotal $ 10,180

– J. Ott, Drawing – 100

Ending Owner's Equity at Dec. 7 $ 10,080*

.

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

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

Accounting Software Co.

Income Statement

For the Seven Days Ended December 7, 2010

REVENUES

Service Revenues $ 900

EXPENSES

Advertising Expense

600

Temp Service Expense

120

Total Expenses

720

NET INCOME $ 180

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

Assets = Liabilities + Owner’s Equity

+$500

= No Effect + No Effect

–$500

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

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

Date Account Titles Debit

Dec. 8, 2010

Credit

Cash

500

Accounts Receivable

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

500

Transaction Assets = Liabilities + Owner’s Equity

1 +$10,000 = No Effect + +$10,000

2 –$100 = No Effect + –$100

3 +$5,000

= No Effect + No Effect –$5,000

4 +$7,000 = +$7,000 + No Effect

5 –$600 = No Effect + –$600

6 +$900 = No Effect + +$900

7 No Effect = +$120 + –$120

8 +$500

= No Effect + No Effect –$500

Totals = $17,200 + $7,120 $10,080

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

ASC’s balance sheet as of midnight December 8, 2010 is:

Accounting Software Co.

Balance Sheet

December 8, 2010

ASSETS

LIABILITIES

Cash $ 11,800 Notes Payable $ 7,000

Accounts Receivable

400 Accounts Payable $ 120

Equipment

5,000 Total Liabilities $ 7,120

OWNER’S EQUITY

. J. Ott, Capital $ 10,080*

Total Assets $ 17,200 Total Liab & Owner's Equity $ 17,200

.

.

Beginning Owner's Equity $ 0

+ Owner's Investment + 10,000

+ Net Income** + 180

Subtotal $ 10,180

– J. Ott, Drawing – 100

Ending Owner's Equity, at Dec. 8 $ 10,080*

.

**The income statement (which reports the company’s revenues, expenses, gains, and losses during a specified period of time) is a link between balance sheets. It provides the results of operations—an important part of the change in owner’s equity.

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

Accounting Software Co.

Income Statement

For the Eight Days Ended December 8, 2010

REVENUES

Service Revenues $ 900

EXPENSES

Advertising Expense

600

Temp Service Expense

120

Total Expenses

720

NET INCOME $ 180

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

Accounting Software Co.

Statement of Changes in Owner’s Equity

For the Year Ended December 31, 2010

Owner’s Equity at December 31, 2009 $ 0

Add: Owner’s Investment

10,000

Net Income

180

Subtotal

10,180

Deduct: Owner’s Draws

100

Owner’s Equity at December 31, 2010 $ 10,080

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

Assets as of December 31, 2009 $100,000

Liabilities as of December 31, 2009 40,000

Assets as of December 31, 2010 128,000

Liabilities as of December 31, 2010 34,000

Owner investment in business in 2010 10,000

Owner draws in 2010 40,000

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

Assets = Liabilities + Owner’s Equity

$100,000 = $40,000 + Owner’s Equity

$100,000–$40,000 = Owner’s Equity

$60,000 = Owner’s Equity at Dec. 31, 2009

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

Assets = Liabilities + Owner’s Equity

$128,000 = $34,000 + Owner’s Equity

$128,000–$34,000 = Owner’s Equity

$94,000 = Owner’s Equity at Dec. 31, 2010

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

Owner’s Equity at December 31, 2009 $ 60,000 (Step 1)

Add: Owner’s Investment + 10,000 (given)

Net Income + ?

Subtotal

?

Deduct: Owner’s Draws – 40,000 (given)

Owner’s Equity at December 31, 2010 $ 94,000 (Step

2)

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

Owner’s Equity at December 31, 2009 $ 60,000 (Step 1)

Add: Owner’s Investment + 10,000 (given)

Net Income + ?

Subtotal

134,000 (Step 4)

Deduct: Owner’s Draws – 40,000 (given)

Owner’s Equity at December 31, 2010 $ 94,000 (Step

2)

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

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

Owner’s Equity at December 31, 2009 $ 60,000 (Step 1)

Add: Owner’s Investment + 10,000 (given)

Net Income + 64,000 (Step 5)

Subtotal

134,000 (Step 4)

Deduct: Owner’s Draws – 40,000 (given)

Owner’s Equity at December 31, 2010 $ 94,000 (Step

2)

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

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

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

Accounting Equation for a Corporation: Transactions C1–C2 The accounting equation (or basic accounting equation) for a corporation is

Assets = Liabilities + Stockholders’ Equity

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

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

In the examples that follow, we will use the following accounts: Cash Accounts Receivable Equipment Notes Payable Accounts Payable Common Stock Retained Earnings Treasury Stock Service Revenues Advertising Expense Temp Service Expense

(To view a more complete listing of accounts for recording transactions, see the

Explanation of Chart of Accounts.)

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

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

Assets = Liabilities + Stockholders’ Equity

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

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

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

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

Date Account Titles Debit

Dec. 1, 2010

Credit

Cash

10,000

Common Stock

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

10,000

Accounting Software, Inc.

Balance Sheet

December 1, 2010

ASSETS

LIABILITIES

Cash $ 10,000 STOCKHOLDERS’ EQUITY

. Common Stock $ 10,000

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

.

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

On December 2, 2010 ASI purchases $100 of its stock from one of its stockholders. The stock will be held by the corporation as

Corporation Transaction C2.

Treasury Stock. The effect of the accounting equation is:

Assets = Liabilities + Stockholders’ Equity

–$100 = No Effect + –$100

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

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

Date Account Titles Debit Credit

Dec. 2, 2010 Treasury Stock

100

Cash

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

100

Transaction Assets = Liabilities + Stockholders’

Equity

C1 +$10,000 = No Effect + +$10,000

C2 –$100 = No Effect + –$100

Totals = $9,900 + $0 $9,900

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

The December 2 balance sheet will communicate the corporation’s financial position as of midnight on December 2:

Accounting Software, Inc

Balance Sheet

December 2, 2010

ASSETS

LIABILITIES

Cash $ 9,900 STOCKHOLDERS’ EQUITY

Common Stock $ 10,000

Retained Earnings

0*

. Less: Treasury Stock

(100)

Total Stockholders' Equity

9,900

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

.

.

Beginning Retained Earnings $ 0

+ Net Income + 0

Subotal $ 0

– Dividends – 0

Ending Retained Earnings at Dec. 2 $ 0*

.

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

Accounting Equation for a Corporation: Transactions C3–C4

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

Assets = Liabilities +

Stockholders’

Equity

+$5,000 = No Effect + No Effect

–$5,000

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

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

Date Account Titles Debit

Dec. 3, 2010

Credit

Equipment

5,000

Cash

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

5,000

Transaction Assets = Liabilities + Stockholders’

Equity

C1 +$10,000 = No Effect + +$10,000

C2 –$100 = No Effect + –$100

C3 +$5,000

= No Effect + No Effect –$5,000

Totals = $9,900 + $0 $9,900

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

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

Accounting Software, Inc.

Balance Sheet

December 3, 2010

ASSETS

LIABILITIES

Cash $ 4,900 STOCKHOLDERS’ EQUITY

Equipment

5,000 Common Stock $ 10,000

Retained Earnings

0*

. Less: Treasury Stock

(100)

Total Stockholders' Equity

9,900

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

.

.

Beginning Retained Earnings $ 0

+ Net Income + 0

Subtotal $ 0

– Dividends – 0

Ending Retained Earnings at Dec. 3 $ 0*

.

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

placed into service. Therefore, there is no expense in this transaction or in the earlier transactions to be reported on the income statement.

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

Assets = Liabilities +

Stockholders’

Equity

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

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

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

Date Account Titles Debit

Dec. 4, 2010

Credit

Cash

7,000

Notes Payable

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

7,000

Transaction Assets = Liabilities + Stockholders’

Equity

C1 +$10,000 = No Effect + +$10,000

C2 –$100 = No Effect + –$100

C3 +$5,000

= No Effect + No Effect –$5,000

C4 +$7,000 = +$7,000 + No Effect

Totals = $16,900 + $7,000 $9,900

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

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

Accounting Software, Inc.

Balance Sheet

December 4, 2010

ASSETS

LIABILITIES

Cash $ 11,900 Notes Payable $ 7,000

Equipment

5,000 STOCKHOLDERS’ EQUITY

Common Stock

10,000

Retained Earnings

0*

Less: Treasury Stock

(100)

. Total Stockholders' Equity

9,900

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

.

.

Beginning Retained Earnings $ 0

+ Net Income + 0

Subtotal $ 0

– Dividends – 0

Ending Retained Earnings at Dec. 4 $ 0*

.

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

Accounting Equation for a Corporation: Transactions C5–C6

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

Assets = Liabilities +

Stockholders’

Equity

–$600 = No Effect + –$600

Since ASI is paying

Date

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

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

Account Titles Debit

Dec. 5, 2010

Credit

Advertising Expense

600

Cash

The combined effect of the first five transactions is:

600

Transaction Assets = Liabilities + Stockholders’

Equity

C1 +$10,000 = No Effect + +$10,000

C2 –$100 = No Effect + –$100

C3 +$5,000

= No Effect + No Effect –$5,000

C4 +$7,000 = +$7,000 + No Effect

C5 –$600 = No Effect + –$600

Totals = $16,300 + $7,000 $9,300

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

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

Accounting Software, Inc.

Balance Sheet

December 5, 2010

ASSETS

LIABILITIES

Cash $ 11,300 Notes Payable $ 7,000

Equipment

5,000 STOCKHOLDERS’ EQUITY

Common Stock

10,000

Retained Earnings

(600)*

Less: Treasury Stock

(100)

. Total Stockholders' Equity

9,300

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

.

.

Beginning Retained Earnings $ 0

+ Net Income** + (600)

Subtotal $ 0

– Dividends – 0

Ending Retained Earnings at Dec. 5 $ (600)*

.

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

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

Accounting Software, Inc.

Income Statement

For the Five Days Ended December 5, 2010

REVENUES $ 0

EXPENSES

Advertising Expense

600

NET INCOME $ (600)

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

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

Assets = Liabilities +

Stockholders’

Equity

+$900 = No Effect + +900

Since ASI has performed the services, it has earned

Although revenues cause stockholders’ equity to increase, the revenue transaction is not recorded directly into a stockholders’ equity account at this time. Rather, the amount earned is recorded in the revenues account

revenues and it has the right to receive $900 from its clients. This right means that assets increased. The earning of revenues also causes stockholders’ equity to increase.

Service Revenues

Date

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

Account Titles Debit

Dec. 6, 2010

Credit

Accounts Receivable

900

Service Revenues

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

900

Transaction Assets = Liabilities + Stockholders’

Equity

C1 +$10,000 = No Effect + +$10,000

C2 –$100 = No Effect + –$100

C3 +$5,000

= No Effect + No Effect –$5,000

C4 +$7,000 = +$7,000 + No Effect

C5 –$600 = No Effect + –$600

C6 +$900 = No Effect + +900

Totals = $17,200 + $7,000 $10,200

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

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

Accounting Software, Inc.

Balance Sheet

December 6, 2010

ASSETS

LIABILITIES

Cash $ 11,300 Notes Payable $ 7,000

Accounts Receivable

900 STOCKHOLDERS’ EQUITY

Equipment

5,000 Common Stock

10,000

Retained Earnings

300*

Less: Treasury Stock

(100)

. Total Stockholders' Equity

10,200

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

.

.

Beginning Retained Earnings $ 0

+ Net Income** + 300

Subtotal $ 300

– Dividends – 0

Ending Retained Earnings at Dec. 6 $ 300*

.

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

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

Accounting Software, Inc.

Income Statement

For the Six Days Ended December 6, 2010

REVENUES

Service Revenues

900

EXPENSES

Advertising Expense

600

NET INCOME $ 300

Accounting Equation for a Corporation: Transactions C7–C8

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

Assets = Liabilities +

Stockholders’

Equity

No Effect = +$120 + –$120

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

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

Date Account Titles Debit

Dec. 7, 2010

Credit

Temp Service Expense

120

Accounts Payable

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

120

Transaction Assets = Liabilities + Stockholders’

Equity

C1 +$10,000 = No Effect + +$10,000

C2 –$100 = No Effect + –$100

C3 +$5,000

= No Effect + No Effect –$5,000

C4 +$7,000 = +$7,000 + No Effect

C5 –$600 = No Effect + –$600

C6 +$900 = No Effect + +$900

C7 No Effect = +$120 + –$120

Totals = $17,200 + $7,120 $10,080

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

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

Accounting Software, Inc.

Balance Sheet

December 7, 2010

ASSETS

LIABILITIES

Cash $ 11,300 Notes Payable $ 7,000

Accounts Receivable

900 Accounts Payable

120

Equipment

5,000 Total Liabilities

7,120

STOCKHOLDERS’ EQUITY

Common Stock

10,000

Retained Earnings

180*

Less: Treasury Stock

(100)

. Total Stockholders' Equity

10,080

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

.

.

Beginning Retained Earnings $ 0

+ Net Income** + 180

Subtotal $ 180

– Dividends – 0

Ending Retained Earnings at Dec. 7 $ 180*

.

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

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

Accounting Software, Inc.

Income Statement

For the Seven Days Ended December 7, 2010

REVENUES

Service Revenues $ 900

EXPENSES

Advertising Expense

600

Temp Service Expense

120

Total Expenses

720

NET INCOME $ 180

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

Assets = Liabilities + Stockholders’ Equity

+$500 = No Effect + No Effect

–$500

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

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

Date Account Titles Debit

Dec. 8, 2010

Credit

Cash

500

Accounts Receivable

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

500

Transaction Assets = Liabilities + Stockholders’

Equity

C1 +$10,000 = No Effect + +$10,000

C2 –$100 = No Effect + –$100

C3 +$5,000

= No Effect + No Effect –$5,000

C4 +$7,000 = +$7,000 + No Effect

C5 –$600 = No Effect + –$600

C6 +$900 = No Effect + +$900

C7 No Effect = +$120 + –$120

C8 +$500

= No

+ No

–$500 Effect Effect

Totals = $17,200 + $7,120 $10,080

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

ASI’s balance sheet as of midnight of December 8, 2010 is shown here:

Accounting Software, Inc.

Balance Sheet

December 8, 2010

ASSETS

LIABILITIES

Cash $ 11,800 Notes Payable $ 7,000

Accounts Receivable

400 Accounts Payable

120

Equipment

5,000 Total Liabilities

7,120

STOCKHOLDERS’ EQUITY

Common Stock

10,000

Retained Earnings

180*

Less: Treasury Stock

(100)

. Total Stockholders' Equity

10,080

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

.

.

Beginning Retained Earnings $ 0

+ Net Income** + 180

Subtotal $ 180

– Dividends – 0

Ending Retained Earnings at Dec. 8 $ 180*

.

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

The income statement for ASI’s first eight days of operations is shown here:

Accounting Software, Inc.

Income Statement

For the Eight Days Ended December 8, 2010

REVENUES

Service Revenues $ 900

EXPENSES

Advertising Expense

600

Temp Service Expense

120

Total Expenses

720

NET INCOME $ 180

Expanded Accounting Equation for a Sole Proprietorship

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

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

The eight transactions that we had listed under the basic accounting equation

is: Assets = Liabilities + Owner's Capital + Revenues – Expenses – Owner's Draws

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

Assets = Liabilities + Owner's

Capital + Revenues – Expenses – Owner's Draws

1 + 10,000 = + + 10,000

2 – 100 =

– + 100

3 + 5,000 – 5,000

=

4 + 7,000 = + 7,000

5 – 600 =

– + 600

6 + 900 =

+ + 900

7 = + 120

– + 120

8 + 500 – 500

=

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

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

Revenues $900

– Expenses 720

Net Income $180

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

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

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

Assets = Liabilities + Paid-in

Capital + Revenues – Expenses – Dividends &

Treasury Stock

1 + 10,000 = + + 10,000

2 – 100 =

– + 100

3 + 5,000 – 5,000

=

4 + 7,000 = + 7,000

5 – 600 =

– + 600

6 + 900 =

+ + 900

7 = + 120

– + 120

8 + 500 – 500

=

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

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

Revenues $900

– Expenses 720

Net Income $180

Accounting Principles

Introduction to Accounting Principles We also have Quizzes, Crosswords, and Q&A for the topic

There are general rules and concepts that govern the field of accounting. These general rules—referred to as basic accounting

Accounting Principles.

principles and guidelines—form the groundwork on which more detailed, complicated, and legalistic accounting rules are based. For example, the Financial Accounting Standards Board (FASB)

Basic Accounting Principles and Guidelines

uses the basic accounting principles and guidelines as a basis for their own detailed and comprehensive set of accounting rules and standards.

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

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

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

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

Basic Accounting

Principle What It Means in Relationship to a Financial Statement

1. Economic Entity Assumption

The accountant keeps all of the business transactions of a sole proprietorship separate from the business owner's personal transactions. For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes they are considered to be two separate entities.

2. Monetary Unit Assumption

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

Because of this basic accounting principle, it is assumed that the dollar's purchasing power has not changed over time. As a result accountants ignore the effect of inflation on recorded amounts. For example, dollars from a 1960 transaction are combined (or shown with) dollars from a 2010 transaction.

3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the five months ended May 31, 2010, or the 5 weeks ended May 1, 2010. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2010, the amount is known; but for the income statement for the three months ended March 31, 2010, the amount was not known and an estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders' equity, and statement of cash flows. Labeling one of these financial statements with "December 31" is not good enough—the reader needs to know if the statement covers the one week ending December 31, 2010 the month ending December 31, 2010 thethree months ending December 31, 2010 or the year ended December 31, 2010.

4. Cost Principle

From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cash equivalent) when an item was originally obtained, whether that purchase happened last year or thirty years ago. For this reason, the amounts shown on financial statements are referred to as historical

Because of this accounting principle asset amounts are

cost amounts.

not adjusted upward for inflation. In fact, as a general rule, asset amounts are not adjusted to reflectany type of increase in value. Hence, an asset amount does not reflect the amount of money a company would receive if it were to sell the asset at today's market value. (An exception is certain investments in stocks and

bonds that are actively traded on a stock exchange.) If you want to know the current value of a company's long-term assets, you will not get this information from a company's financial statements—you need to look elsewhere, perhaps to a third-party appraiser.

5. Full Disclosure Principle

If certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement. It is because of this basic accounting principle that numerous pages of "footnotes" are often attached to financial statements.

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

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

6. Going Concern Principle

This accounting principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. If the company's financial situation is such that the accountant believes the company will not be able to continue on, the accountant is required to disclose this assessment.

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

7. Matching Principle

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

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

advertisements (and thereby we cannot match the ad expense with related future revenues), the accountant charges the ad amount to expense in the period that the ad is run.

(To learn more about adjusting entries go to Explanation of Adjusting Entriesand Drills for Adjusting Entries.)

8. Revenue Recognition Principle

Under the accrual basis of accounting (as opposed to the cash basis of accounting), revenues

For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should recognize $1,000 of revenue as soon as its work is done—it does not matter whether the client pays the $1,000 immediately or in 30 days. Do not confuse

are recognized as soon as a product has been sold or a service has been performed, regardless of when the money is actually received. Under this basic accounting principle, a company could earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that month.

revenue with a cash receipt.

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

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

Because of materiality, financial statements usually show amounts rounded to the nearest dollar, to the nearest thousand, or to the nearest million dollars depending on the size of the company.

10. Conservatism

If a situation arises where there are two acceptable alternatives for reporting an item, conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct accountants to be conservative. Accountants are expected to be unbiased and objective.

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

Other Characteristics of Accounting Information When financial reports are generated by professional accountants, we have certain expectations of the information they present to us:

1. We expect the accounting information to be 2. We expect

reliable, verifiable, and objective. consistency

3. We expectin the accounting information.

comparability

1. Reliable, Verifiable, and Objective In addition to the basic accounting principles and guidelines listed in Part 1, accounting information should be reliable, verifiable, and objective. For example, showing land at its original cost of $10,000 (when it was purchased 50 years ago) is considered to be more

in the accounting information.

reliable, verifiable, and objective than showing it at its current market value of $250,000. Eight different accountants will wholly agree that the original cost of the land was $10,000—they can read the offer and acceptance for $10,000, see a transfer tax based on $10,000, and review documents that confirm the cost was $10,000. If you ask the same eight accountants to give you the land's current

The accounting profession has been willing to move away from the

value, you will likely receive eight different estimates. Because the current value amount is less reliable, less verifiable, and less objective than the original cost, the original cost is used.

cost principle

Accountants are expected to be

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

2. Consistency consistent when applying accounting principles, procedures, and

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

3. Comparability

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

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

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

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

Mary's Design Service Balance Sheet

September 30, 2010

Assets

Liabilities

Cash $ 300

Notes Payable $ 1,000

Accounts Receivable 1,000

Accounts Payable 325

Supplies 160

Wages Payable 75

Prepaid Insurance 90

Unearned Revenues 100

Land 10,000

Total Liabilities 1,500

Owner's Equity

M.Smith, Capital 10,050

Total Assets $11,550

Total Liabilities & Owner's Equity

$11,550

The assets listed on the balance sheet have a cost that can be measured and each amount shown is the original cost of each asset. For example, let's assume that a tract of land was purchased in 1956 for $10,000. Mary's Design Service still owns the land, and the land is now appraised at $250,000. The cost principle

If Mary's Design Service were to purchase a second piece of land, the

requires that the land be shown in the asset account Land at its original cost of $10,000 rather than at the recently appraised amount of $250,000.

monetary unit assumption

The Supplies account shows the cost of supplies (if material in amount) that were obtained by Mary's Design Service but have not yet been used. As the supplies are consumed, their cost will be moved to the Supplies Expense account on the income statement. This complies with the

dictates that the purchase price of the land bought today would simply be added to the purchase price of the land bought in 1956, and the sum of the two purchase prices would be reported as the total cost of land.

matching principle

The Prepaid Insurance account represents the cost of insurance that has not yet expired. As the insurance expires, the expired cost is moved to

which requires expenses to be matched either with revenues or with the time period when they are used. The cost of the unused supplies remains on the balance sheet in the asset account Supplies.

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

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

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

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

Mary's Design Service Income Statement

For the Nine Months Ending September 30, 2010

Revenues and Gains

Revenues $10,000

Gain on Sale of Land 5,000

Total Revenues and Gains 15,000

Expenses and Losses

Expenses 8,000

Loss on Sale of Computer 350

Total Expenses and Losses 8,350

Net Income $ 6,650

Revenues are the fees that were earned during the period of time shown in the heading. Recognizing revenues when they are earned instead of when the cash is actually received follows the revenue

recognition principle and the matching principle. (The matching principle is what steers accountants toward using the accrual basis of accounting rather than the cash basis. Small business owners should discuss these two methods with their tax advisors.)

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

Expenses

Losses

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

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

Another basic accounting principle, the

be included in the company's sales or revenues.

3. The Notes To Financial Statements full disclosure principle, requires that a company's financial

statements include disclosure notes. These notes include information that helps readers of the financial statements make investment and credit decisions. The notes to the financial statements are considered to be an integral part of the financial statements.

Financial Accounting

Introduction to Financial Accounting We also have Quizzes, Puzzles, and Q&A for the topic

Financial Accounting.

Financial accounting

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

Companies issue financial statements on a routine schedule. The statements are considered

externalbecause they are given to people outside of the company, with the primary recipients being owners/stockholders, as well as certain lenders. If a corporation's stock is publicly traded, however, its financial statements (and other financial reportings) tend to be widely circulated, and information will likely reach secondary recipients such as competitors, customers, employees, labor organizations, and investment analysts.

It's important to point out that the purpose of financial accounting is not to report the value of a company. Rather, its purpose is to provide enough information for others to assess the value of a company for themselves.

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

Recommended Financial Accounting Exams

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

• Financial Accounting Exams (PDF) Our financial accounting exams cover 16 accounting topics (640 total questions). Learn more...

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

The term "double entry" means that every transaction affects at least two accounts. For example, if a company borrows $50,000 from its bank, the company's Cash account increases, and the

company's Notes Payable account increases. Double entry also means that one of the accounts must have an amount entered as a debit, and one of the accounts must have an amount entered as a credit. For any given transaction, the debit amount must equal the credit amount. (To learn more about debits and credits, seeExplanation of Debits & Credits.)

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

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

incurred, not when they are paid. For example, although a magazine publisher receives a $24 check from a customer for an annual subscription, the publisher reports as revenue a monthly amount of $2 (one-twelfth of the annual subscription amount). In the same way, it reports its property tax expense each month as one-twelfth of the annual property tax bill.

By following the accrual basis of accounting, a company's profitability, assets, liabilities and other financial information is more in line with economic reality. (To learn more on achieving the accrual basis of accounting, see the Explanation of Adjusting Entries.)

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

(GAAP, pronounced "gap").

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

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

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

In addition to following the provisions of GAAP, any corporation whose stock is publicly traded is also subject to the reporting requirements of the Securities and Exchange Commission (SEC), an agency of

the U.S. government. These requirements mandate an annual report to stockholders as well as an annual report to the SEC. The annual report to the SEC requires that independent certified public accountants audit a company's financial statements, thus giving assurance that the company has followed GAAP.

Financial Statements Financial accounting generates the following general-purpose, external, financial statements:

1. Income statement (sometimes referred to as "results of operations" or "earnings statement" or "profit and loss [P&L] statement")

2. Balance sheet (sometimes referred to as "statement of financial position") 3. Statement of cash flows (sometimes referred to as "cash flow statement") 4. Statement of stockholders' equity

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

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

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

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

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

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

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

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

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

auditing.

Balance Sheet

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

The accounting

Balance Sheet.

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

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

Because the balance sheet informs the reader of a company's financial position as of one moment in time, it allows someone—like a creditor—to see what a company owns as well as what it owes

In

to other parties as of the date indicated in the heading. This is valuable information to the banker who wants to determine whether or not a company qualifies for additional credit or loans. Others who would be interested in the balance sheet include current investors, potential investors, company management, suppliers, some customers, competitors, government agencies, and labor unions.

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

We will begin our explanation of the accounting balance sheet with its major components, elements, or major categories:

• Assets • Liabilities • Owner's (Stockholders') Equity

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

Examples of asset accounts that are reported on a company's balance sheet include:

Cash Petty Cash Temporary Investments Accounts Receivable Inventory Supplies Prepaid Insurance Land Land Improvements Buildings Equipment Goodwill Bond Issue Costs Etc.

Usually these asset accounts will have debit

balances.

Contra assets are asset accounts with credit balances. (A credit balance in an asset account is contrary—or contra—to an asset account's usual debit balance.) Examples of contra asset accounts include:

Allowance for Doubtful Accounts Accumulated Depreciation-Land Improvements Accumulated Depreciation-Buildings Accumulated Depreciation-Equipment Accumulated Depletion Etc.

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

Current Assets Investments Property, Plant, and Equipment Intangible Assets Other Assets

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

Example Company Balance Sheet

December 31, 2010

ASSETS

LIABILITIES & OWNER'S EQUITY

Current Assets

Current Liabilities

Investments

Long-term liabilities

Property, Plant, and Equipment

Total Liabilities

Intangible Assets

Other Assets

Owner's Equity

Total Assets

Total Liabilities & Owner's Equity

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

Effect of Cost Principle and Monetary Unit Assumption The amounts reported in the asset accounts and on the balance sheet reflect actual costs recorded at the time of a transaction. For example, let's say a company acquires 40 acres of land in the year 1950 at a cost of $20,000. Then, in 1990, it pays $400,000 for an adjacent 40-acre parcel. The company's Land

There are two guidelines that oblige the accountant to report $420,000 on the balance sheet rather than the current market value of $3,000,000: (1) the

account will show a balance of $420,000 ($20,000 for the first parcel plus $400,000 for the second parcel.). This account balance of $420,000 will appear on today's balance sheet even though these parcels of land have appreciated to a current market value of $3,000,000.

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

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

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

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

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

Effect of Matching Principle The matching principle will also cause certain assets to be reported on the accounting balance sheet at lessthan cost. For example, if a company has Accounts Receivable of $50,000 but anticipates that it will collect only $48,500 due to some customers' financial problems, the company will report a credit balance of $1,500 in the contra asset account Allowance for Doubtful Accounts. The combination of the asset Accounts Receivable with a debit balance of $50,000 and the contra asset Allowance for Doubtful Accounts with acredit

The matching principle also requires that the cost of buildings and equipment be depreciated over their useful lives. This means that over time the cost of these assets will be moved from the balance sheet to Depreciation Expense on the income statement. As time goes on, the amounts reported on the balance sheet for these long-term assets will be reduced. (For a further discussion on depreciation, go to

balance will mean that the balance sheet will report the net amount of $48,500. The income statement will report the $1,500 adjustment as Bad Debts Expense.

Explanation of Depreciation.)

Liabilities

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

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

Examples of liability accounts reported on a company's balance sheet include:

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

These liability accounts will normally have credit balances.

Contra liabilities are liability accounts with debit balances. (A debit balance in a liability account is contrary—or contra—to a liability account's usual credit balance.) Examples of contra liability accounts include:

Discount on Notes Payable Discount on Bonds Payable Etc.

Classifications Of Liabilities On The Balance Sheet Liability and contra liability accounts are usually classified (put into distinct groupings, categories, or classifications) on the balance sheet. The liability classifications and their order of appearance on the balance sheet are:

Current Liabilities Long Term Liabilities Etc.

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

Commitments A company's commitments (such as signing a contract to obtain future services or to purchase goods) may be legally binding, but they are not considered a liability on the balance sheet until some services or

goods have been received. Commitments (if significant in amount) should be disclosed in the notes to the balance sheet.

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

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

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

The accounting rules for these contingencies are as follows: If the contingent loss is probable and theamount of the loss can be estimated, the company needs to record a liability on its balance sheet and a loss on its income statement. If the contingent loss is remote, no liability or loss is recorded and there is no need to include this in the notes to the financial statements. If the contingent loss lies somewhere in between, it should be disclosed

Current vs. Long-term Liabilities If a company has a loan payable that requires it to make monthly payments for several years, only theprincipal

in the notes to the financial statements.

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

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

Owner's (Stockholders') Equity Owner's Equity—along with liabilities—can be thought of as a source of the company's assets. Owner's equity is sometimes referred to as the book value of the company, because owner's equity is equal to the reported asset amounts minus

Owner's equity may also be referred to as the

the reported liability amounts.

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

Assets = Liabilities + Owner's Equity

and just rearrange the terms:

Owner's Equity = Assets – Liabilities

"Owner's Equity" are the words used on the balance sheet when the company is a sole proprietorship. If the company is a corporation, the words Stockholders' Equity are used instead of Owner's Equity. An example of an owner's equity account is Mary Smith, Capital (where Mary Smith is the owner of the sole proprietorship). Examples of stockholders' equity accounts include:

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

Both owner's equity and stockholders' equity accounts will normally have credit balances.

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

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

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

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

Paid-in Capital Retained Earnings Treasury Stock

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

STOCKHOLDERS' EQUITY

Paid-in Capital

Preferred Stock

Common Stock

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

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

Paid-in Capital from Treasury Stock

Retained Earnings

Less: Treasury Stock

TOTAL STOCKHOLDERS' EQUITY

Owner's Equity vs. Company's Market Value Since the asset amounts report the cost of the assets at the time of the transaction—or less—they do not reflect current fair market values. (For example, computers which had a cost of $100,000 two years ago may now have a book value of $60,000. However, the current value of the computers might be just $35,000. An office building purchased by the company 15 years ago at a cost of $400,000 may now have a book value of $200,000. However, the current value of the building might be $900,000.) Since the assets are not reported on the balance sheet at their current fair market value, owner's equity appearing on the balance sheet is

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

notan indication of the fair market value of the company.

performs a service and increases its assets, owner's equity will increase when the Service Revenues

Sample Balance Sheet

account is closed to owner's equity at the end of the accounting year.

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

Sample Balance Sheet:

Example Company Balance Sheet

December 31, 2010

ASSETS

LIABILITIES

Current Assets

Current Liabilities

Cash $ 2,100

Notes Payable $ 5,000

Petty Cash 100

Accounts Payable 35,900

Temporary Investments 10,000

Wages Payable 8,500

Accounts Receivable - net 40,500

Interest Payable 2,900

Inventory 31,000

Taxes Payable 6,100

Supplies 3,800

Warranty Liability 1,100

Prepaid Insurance 1,500

Unearned Revenues 1,500

Total Current Assets 89,000

Total Current Liabilities 61,000

-

Investments 36,000

Long-term Liabilities

Notes Payable 20,000

Property, Plant & Equipment

Bonds Payable 400,000

Land 5,500

Total Long-term Liabilities 420,000

Land Improvements 6,500

Buildings 180,000

Equipment 201,000

Total Liabilities 481,000

Less: Accum Depreciation (56,000)

Prop, Plant & Equip - net 337,000

-

Intangible Assets

STOCKHOLDERS' EQUITY

Goodwill 105,000

Common Stock 110,000

Trade Names 200,000

Retained Earnings 229,000

Total Intangible Assets 305,000

Less: Treasury Stock (50,000)

Total Stockholders' Equity 289,000

Other Assets 3,000

-

Total Assets $770,000

Total Liab. & Stockholders' Equity $770,000

The notes to the sample balance sheet have been omitted.

Download More Sample Balance Sheets Whether you are a business person or student of business, ourMaster Set of 87 Business Forms will assist you in preparing financial statements, financial ratios, break-even calculations, depreciation, standard cost variances, and much, much more.

Click here to learn more

Notes To Financial Statements The notes (or footnotes) to the balance sheet and to the other financial statements are considered to be part of the financial statements. The notes inform the readers about such things as significant accounting

policies, commitments made by the company, and potential liabilities and potential losses. The notes contain information that is critical to properly understanding and analyzing a company's financial statements.

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

Adjusting Entries

Introduction to Adjusting Entries We also have a Visual Tutorial, Quiz, Crosswords, and Q&A for the topic

Adjusting entries are accounting journal entries that convert a company's accounting records to the

Adjusting Entries.

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

To demonstrate the need for an accounting adjusting entry let's assume that a company borrowed money from its bank on December 1, 2010 and that the company's accounting period ends on December 31. The bank loan specifies that the first interest payment on the loan will be due on March 1, 2011. This means that the company's accounting records as of December 31 do not contain any payment to the bank for the interest the company incurred from December 1 through December 31. (Of course the loan is costing the company interest expense every day, but the actual payment for the interest will not occur until March 1.) For the company's December income statement to accurately report the company's profitability, it must include all of the company's December expenses—not just the expenses that were paid. Similarly, for the company's balance sheet on December 31 to be accurate, it must report a liability for the interest owed as of the balance sheet date. An adjusting entry is needed so that December's interest expense is included on December's income statement and the interest due as of December 31 is included on the December 31 balance sheet. The adjusting entry will debit Interest Expense and credit Interest Payable

Another situation requiring an adjusting journal entry arises when an amount has already been recorded in the company's accounting records, but the amount is for more than the current accounting period. To illustrate let's assume that on December 1, 2010 the company paid its insurance agent $2,400 for insurance protection during the period of December 1, 2010 through May 31, 2011. The $2,400 transaction was recorded in the accounting records on December 1, but the amount represents six months of coverage and expense. By December 31, one month of the insurance coverage and cost have been used up or expired. Hence the income statement for December should report just one month of insurance cost of $400 ($2,400 divided by 6 months) in the account Insurance Expense. The balance sheet dated December 31 should report the cost of five months of the insurance coverage that has not yet been used up. (The cost not used up is referred to as the asset

for the amount of interest from December 1 to December 31.

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

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

For now we want to highlight some important points.

There are two scenarios where adjusting journal entries are needed before the financial statements are issued:

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

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

Adjusting entries almost always involve a

balance sheet account (Interest Payable, Prepaid Insurance, Accounts Receivable, etc.) and an income statement account (Interest Expense, Insurance Expense, Service Revenues, etc.)

Adjusting Entries – Asset Accounts

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

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

Parcel Delivery Service Preliminary Balance Sheet–before adjusting entries

December 31, 2010

Assets

Liabilities

Cash $ 1,800

Notes Payable $ 5,000

Accounts Receivable 4,600

Accounts Payable 2,500

Supplies 1,100

Wages Payable 1,200

Prepaid Insurance 1,500

Unearned Revenues 1,300

Equipment 25,000

Total Liabilities 10,000

Accumulated Depreciation (7,500)

Owner's Equity

Mary Smith, Capital 16,500

Total Assets $26,500

Total Liabilities & Owner's Equity

$26,500

Let's begin with the asset accounts: Cash

The Cash account has a preliminary balance of $1,800—the amount in the

$1,800

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

for a thorough discussion and illustration of the likely journal entries.)

Accounts Receivable

To determine if the balance in this account is accurate the accountant might review the detailed listing of customers who have not paid their invoices for goods or services. (This is often referred to as the amount of open or unpaid sales invoices and is often found in the accounts receivable subsidiary ledger.) When those open invoices are sorted according to the date of the sale, the company can tell how old the receivables are. Such a report is referred to as an

$4,600

aging of accounts receivable. Let's assume the review indicates that the preliminary balance in Accounts Receivable of $4,600 is accurate as far as the amounts that have been billed and not yet paid.

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

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

Here is the process we will follow:

1. Draw two T-accounts. (Every journal entry involves at least two accounts. One account to be debited and one account to be credited.)

2. Indicate the account titles on each of the T-accounts. (Remember that almost always one of the accounts is a balance sheet account and one will be an income statement account. In a smaller font size we will indicate the type of account next to the account title and we will also indicate some tips about debits and credits within the T-accounts.)

3. Enter the preliminary balance in each of the T-accounts. 4. Determine what the ending balance ought to be for the balance sheet account. 5. Make an adjustment so that the ending amount in the balance sheet account is correct. 6. Enter the same adjustment amount into the related income statement account. 7. Write the adjusting journal entry.

Let's follow that process here:

Accounts Receivable

(balance sheet account)

Debit Increases an asset

Credit Decreases an asset

Preliminary Balance 4,600

ADJUSTING ENTRY 3,000

Correct Balance 7,600

Service Revenues

(income statement account)

Debit Decreases Revenues

Credit Increases Revenues

60,234

Preliminary Balance

3,000

ADJUSTING ENTRY

63,234

Correct Balance

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

Date Account Name Debit Credit

Dec. 31, 2010 Accounts Receivable 3,000

Service Revenues

3,000

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

At the end of the accounting year, the ending balances in the balance sheet accounts (assets and liabilities) will carry forward to the next accounting year. The ending balances in the income statement accounts (revenues and expenses) are closed after the year's financial statements are prepared and these accounts will start the next accounting period with zero balances. Allowance for Doubtful Accounts $0 (It's common not

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

to list accounts with $0 balances on balance sheets.)

net realizable value.)

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

Allowance for Doubtful Accounts

(balance sheet account)

Debit Decreases a contra asset

Credit Increases a contra asset

0

Preliminary Balance

600

ADJUSTING ENTRY

600

Correct Balance

Bad Debts Expense

(income statement account)

Debit Increases an expense

Credit Decreases an expense

Preliminary Balance 0

ADJUSTING ENTRY 600

Correct Balance 600

The adjusting journal entry for Allowance for Doubtful Accounts is:

Date Account Name Debit Credit

Dec. 31, 2010 Bad Debts Expense 600

Allowance for Doubtful Accounts

600

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

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

Supplies

(balance sheet account)

Debit Increases an asset

Credit Decreases an asset

Preliminary Balance 1,100

375

ADJUSTING ENTRY

Correct Balance 725

Supplies Expense

(income statement account)

Debit Increases an expense

Credit Decreases an expense

Preliminary Balance 1,600

ADJUSTING ENTRY 375

Correct Balance 1,975

The adjusting entry for Supplies in general journal format is:

Date Account Name Debit Credit

Dec. 31, 2010 Supplies Expense 375

Supplies

375

Notice that the ending balance in the asset Supplies is now $725—the correct amount of supplies that the company actually has on hand. The income statement account Supplies Expense has been increased by the $375 adjusting entry. It is assumed that the decrease in the supplies on hand means that the supplies have been used during the current accounting period. The balance in Supplies Expense will increase during the year as the account is debited. Supplies Expense will start the next accounting year with a zero balance. The balance in the asset Supplies at the end of the accounting year will carry over to the next accounting year. Prepaid Insurance $1,500

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

Prepaid Insurance

(balance sheet account)

Debit Increases an asset

Credit Decreases an asset

Preliminary Balance 1,500

900

ADJUSTING ENTRY

Correct Balance 600

Insurance Expense

(income statement account)

Debit Increase an expense

Credit Decreases an expense

Preliminary Balance 1,000

ADJUSTING ENTRY 900

Correct Balance 1,900

The adjusting journal entry for Prepaid Insurance is:

Date Account Name Debit Credit

Dec. 31, 2010 Insurance Expense 900

Prepaid Insurance

900

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

balance at the end of the accounting year in the asset Prepaid Insurance will carry over to the next accounting year. Equipment

$25,000

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

Accumulated Depreciation - Equipment

Accumulated Depreciation - Equipment is a

$7,500

contra asset account and its preliminary balance of $7,500 is the amount of depreciation

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

Accumulated Depreciation - Equipment

(balance sheet acct)

Debit Decreases a contra asset

Credit Increases a contra asset

7,500

Preliminary Balance

1,500

ADJUSTING ENTRY

9,000

Correct Balance

Depreciation Expense - Equipment

(income statement acct)

Debit Increases an expense

Credit Decreases an expense

Preliminary Balance 0

ADJUSTING ENTRY 1,500

Correct Balance 1,500

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

Date Account Name Debit Credit

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

Accumulated Depreciation - Equipment

1,500

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

Adjusting Entries – Liability Accounts Notes Payable

$5,000

Notes Payable is a liability account that reports the amount of principal owed as of the balance sheet date. (Any interest incurred but not yet paid as of the balance sheet date is reported in a separate liability account Interest Payable.) The accountant has verified that the amount of principal actually owed is the same as the amount appearing on the preliminary balance sheet. Therefore, no entry is needed for this account.

Interest Payable $0 (It's common not

Interest Payable is a liability account that reports the amount of interest the company owes as of the balance sheet date. Accountants realize that if a company has a balance in Notes Payable, the company should be reporting some amount in

to list accounts with $0 balances on balance sheets.)

Interest Expense

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

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

Interest Payable

(balance sheet account)

Debit Decreases a liability

Credit Increases a liability

0

Preliminary Balance

25

ADJUSTING ENTRY

25

Correct Balance

Interest Expense

(income statement account)

Debit Increases an expense

Credit Decreases an expense

Preliminary Balance 0

ADJUSTING ENTRY 25

Correct Balance 25

The adjusting journal entry for Interest Payable is:

Date Account Name Debit Credit

Dec. 31, 2010 Interest Expense 25

Interest Payable

25

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

Accounts Payable $2,500

Accounts Payable is a liability account that reports the amounts owed to suppliers or

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

vendors as of the balance sheet date. Amounts are routinely entered into this account after a company has received and verified all of the following: (1) an invoice from the supplier, (2) goods or services have been received,

and (3) compared the amounts to the company's purchase order. A review of the details confirms that this account's balance of $2,500 is accurate as far as invoices received from vendors.

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

Accounts Payable

(balance sheet account)

Debit Decreases a liability

Credit Increases a liability

2,500

Preliminary Balance

1,000

ADJUSTING ENTRY

3,500

Correct Balance

Repairs & Maintenance Expense

(income statement acct)

Debit Increases an expense

Credit Decreases an expense

Preliminary Balance 7,870

ADJUSTING ENTRY 1,000

Correct Balance 8,870

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

Date Account Name Debit Credit

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

Accounts Payable

1,000

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

$1,200

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

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

Wages Payable

(balance sheet account)

Debit Decreases a liability

Credit Increases a liability

1,200

Preliminary Balance

300

ADJUSTING ENTRY

1,500

Correct Balance

Wages Expense

(income statement account)

Debit Increases an expense

Credit Decreases an expense

Preliminary Balance 13,120

ADJUSTING ENTRY 300

Correct Balance 13,420

The adjusting journal entry for Wages Payable is:

Date Account Name Debit Credit

Dec. 31, 2010 Wages Expense 300

Wages Payable

300

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

$1,300

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

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

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

Unearned Revenues

(balance sheet account)

Debit Decreases a liability

Credit Increases a liability

1,300

Preliminary Balance

ADJUSTING ENTRY 800

500

Correct Balance

Service Revenues

(income statement account)

Debit Decreases revenues

Credit Increases revenues

63,234

Preliminary Balance

800

ADJUSTING ENTRY

64,034

Correct Balance

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

Date Account Name Debit Credit

Dec. 31, 2010 Unearned Revenues 800

Service Revenues

800

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

Accruals & Deferrals

Adjusting entries are often sorted into two groups:

accruals and deferrals.

Accruals Accruals (or accrual-type adjusting entries) involve both expenses and revenues and are associated with the first scenario mentioned in the introduction to this topic:

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

Accrual of Expenses An accountant might say, "We need to accrue the interest expense on the bank loan." That statement is made because nothing had been recorded in the accounts for interest expense, but the company did indeed incur interest expense during the accounting period. Further, the company has a liability or

obligation for the unpaid interest up to the end of the accounting period. What the accountant is saying is that an accrual-type adjusting journal entry needs to be recorded.

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

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

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

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

Deferrals Deferrals or deferral-type adjusting entries can pertain to both expenses and revenues and refer to the second scenario mentioned in the introduction to this topic:

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

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

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

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

Avoiding Adjusting Entries

at a rate of $100 per month.

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

Income Statement

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

The

Income Statement.

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

The income statement is important because it shows the profitability

People pay attention to the profitability of a company for many reasons. For example, if a company was not able to operate profitably—the bottom line of the income statement indicates a

of a company during the time interval specified in its heading. The period of time that the statement covers is chosen by the business and will vary. For example, the heading may state:

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

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

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

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

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

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

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

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

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

A. Revenues and Gains

net loss.

1. Revenues from primary activities are often referred to as operating revenues. The primary activities of a retailer are purchasing merchandise and selling the merchandise. The primary activities of a manufacturer are producing the products and selling them. For retailers, manufacturers, wholesalers, and distributers the revenues generating from their primary activities are referred to as sales revenues or sales. The primary activities of a company that provides services involve acquiring expertise and selling that expertise to clients. For companies providing services, the revenues from their primary services are referred to as service revenues or fees earned. (Some people use the word income

It's critical that you don't confuse revenues with

interchangeably with revenues.)

receipts. Under the accrual basis of accounting, service revenues and sales revenues are shown at the top of the income statement in the period they are earned or delivered, not in the period when the cash is collected. Put simply, revenues occur when money is earned,receipts occur when cash is

For example, if a retailer gives customers 30 days to pay, revenues occur (and are reported) when the merchandise is

received.

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

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

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

If a company sells an item to a buyer who immediately pays for it with cash, the company has both a receipt and

A company borrows $10,000 from its bank by signing a

revenues for that day—it has a cash receipt because it received cash; it has sales revenues because it sold merchandise.

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

Let's reinforce the distinction between revenues and receipts with a few more examples. (Keep in mind that all of the examples below assume the accrual basis of accounting.)

promissory note due in 90 days. The company will have a receipt

If a company provided a $1,000 service on January 31 and gave the customer until March 10 to pay for the service, the company's January income statement will show revenues of $1,000. When the money is actually received in March, the March income statement will not show revenues for this transaction. (In March the company will report a receipt of cash and a reduction/collection of an accounts receivable.)

of $10,000 at the time of the loan, but it does not have revenues because it did not earn the money from performing a service or from a sale of merchandise.

A company performs a $400 service on December 31 and receives the $400 on the very same day (December 31). This company will report $400 in revenues on December 31—not because the company had a cash receipt on December 31, but because the service was performed (earned) on that day.

On December 10, a new client asks your consulting company to provide a $2,500 service in January. You are uncertain as to whether or not this client is credit worthy, so to be on the safe side you ask for an immediate partial payment of $1,000 before you agree to schedule the work for January. Although your consulting company has a receipt of $1,000 in December, it does not have revenues in December. (In December your company will record a liability of $1,000.) Your consulting company will report the $1,000 of revenues when it performs $1,000 of services in January.

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

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

Don't confuse revenues with receipts—

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

Receipts occur when cash is received/collected.

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

Consider this example: Assume that a clothing retailer decides to dispose of the company's car and sells it for $6,000. The $6,000 received for the car (the proceeds from the disposal of the car) will not be included with sales revenues since the account Sales is used only for the sale of merchandise. Since this retailer is not in the business of buying and selling cars, the sale of the car is outside of the retailer's primary activities. Over the years, the cost of the car was being depreciated on the company's accounting records and as a result, the money received for the car ($6,000) was greater than the net amount shown for the car on the accounting records ($3,500). This means that the company must report a gain

B. Expenses and Losses

equal to the amount of the difference—in this case, the gain is reported as $2,500. This gain should not be reported as sales revenues, nor should it be shown as part of the merchandiser's primary activities. Instead, the gain will appear in a section on the income statement labeled as "nonoperating gains" or "other income". The gain is reported in the period when the disposal occurred.

1. Expenses involved in primary activities

The above examples reflect the

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

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

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

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

afterthe company has paid for them. For example, let's say a company buys a building on December 31, 2010 for $300,000 (excluding the cost of land). The building is assumed to have a useful life of 30 years. The company paid cash for the building on December 31, 2010 but it will record depreciation expense of $10,000 in each of the years 2011 through 2040.

Cash payments do not always mean that an expense has occurred. For example, a company might pay $20,000 to the bank to reduce its bank loan. This payment will reduce the company's cash and its liability to the bank, but it is not an expense.

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

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

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

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

3. Losses

Let's assume that a clothing retailer decides to dispose of the company's car. The proceeds from the disposal are $2,800. This is

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

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

gains or losses" or "other income or losses". The loss is reported in the time period when the disposal occurs.

The income statement or profit and loss statement shows revenues, expenses, gains, and losses. The income statement does not

Additional Considerations

show cash receipts and cash disbursements.

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

Expenses Do Not Equal Economic Reality. Because of the

holiday season, it may experience a poor year financially.

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

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

Single-Step Income Statement

estimates.

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

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

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

Sample Products Co.

Income Statement For the Five Months Ended May 31, 2010

Revenues & Gains $108,000

Expenses & Losses 90,000

Net Income $ 18,000

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

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

Sample Products Co. Income Statement

For the Five Months Ended May 31, 2010

Revenues & Gains

Sales Revenues $100,000

Interest Revenues 5,000

Gain on Sale of Assets 3,000

Total Revenue & Gains 108,000

Expenses & Losses

Cost of Goods Sold 75,000

Commissions Expense 5,000

Office Supplies Expense 3,500

Office Equipment Expense 2,500

Advertising Expense 2,000

Interest Expense 500

Loss from Lawsuit 1,500

Total Expenses & Losses 90,000

Net Income $ 18,000

Multiple-Step Income Statement

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

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

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

Sample Products Co.

Income Statement For the Five Months Ended May 31, 2010

Sales

$100,000

Cost of Goods Sold

75,000

Gross Profit

25,000

Operating Expenses

Selling Expenses

Advertising Expense 2,000

Commissions Expense 5,000 7,000

Administrative Expenses

Office Supplies Expense 3,500

Office Equipment Expense 2,500 6,000

Total Operating Expenses

13,000

Operating Income

12,000

Non-Operating or Other

Interest Revenues 5,000

Gain on Sale of Investments 3,000

Interest Expense (500)

Loss from Lawsuit (1,500)

Total Non-Operating

6,000

Net Income $ 18,000

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

Step 1. Cost of goods sold is subtracted from net sales to arrive at the gross profit.

Gross Profit = Net Sales – Cost of Goods Sold

Gross Profit = $100,000 – $75,000

Gross Profit = $25,000

Step 2. Operating expenses are subtracted from gross profit to arrive at operating income.

Operating Income = Gross Profit – Operating Expenses

Operating Income = $25,000 – $13,000

Operating Income = $12,000

Step 3. The net amount of nonoperating revenues, gains, nonoperating expenses and losses is combined with the operating income to arrive at the net income or net loss.

Net Income = Operating Income + Non-Operating Items

Net Income = $12,000 + $6,000

Net Income = $18,000

There are three benefits to using a multiple-step income statement instead of a single-step income statement:

1. The multiple-step income statement clearly states the gross profit amount. Many readers of financial statements monitor a company's gross margin

2. The multiple-step income statement presents the subtotal

(gross profit as a percentage of net sales). Readers may compare a company's gross margin to its past gross margins and to the gross margins of the industry.

operating income, which indicates the profit earned from the company's primary activities of buying and selling merchandise.

3. The bottom line of a multiple-step income statement reports the net amount for all the items on the income statement. If the net amount is positive, it is labeled as net income. If the net amount is negative, it is labeled as net loss.

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

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

1. Discontinued Operations

2. Extraordinary Items

When recording these items near the bottom of an income statement, it's required that you present them in the same order as they appear above. However, it is rare for a company to have either one of these items, and it is highly unlikely that a company will have both.

1. Discontinued operations pertains to the elimination of a significant part of a company's business, such as the sale of an entire division of the company. (Eliminating a small portion of product line does not qualify as a discontinued operation.)

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

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

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

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

Sample Products Co. Income Statement

For the Five Months Ended May 31, 2010

Revenues & Gains

Sales $100,000

Interest Revenues 5,000

Gain on Sale of Assets 3,000

Total Revenue & Gains 108,000

Expenses & Losses

Cost of Goods Sold 75,000

Commissions Expense 5,000

Office Supplies Expense 3,500

Office Equipment Expense 2,500

Advertising Expense 2,000

Interest Expense 500

Loss from Lawsuit 1,500

Total Expenses & Gains 90,000

Income Before Extraordinary 18,000

Extraordinary Item - Gain 7,000

Net Income $ 25,000

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

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

Sample Products Co.

Income Statement For the Five Months Ended May 31, 2010

Sales

$100,000

Cost of Goods Sold

75,000

Gross Profit

25,000

Operating Expenses

Selling Expenses

Advertising Expense 2,000

Commissions Expense 5,000 7,000

Administrative Expenses

Office Supplies Expense 3,500

Office Equipment Expense 2,500 6,000

Total Operating Expenses

13,000

Operating Income

12,000

Non-Operating or Other

Interest Revenues 5,000

Gain on Sale of Investments 3,000

Interest Expense (500)

Loss from Lawsuit (1,500)

Total Non-Operating

6,000

Income before Disc Op and Extraordinary Item

18,000

Discontinued Operations

(4,000)

Extraordinary Item

7,000

Net Income $ 21,000

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

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

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

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

Other Income Statement Formats The single-step and multiple-step income statement formats are the required formats when the statement is distributed to people and places outside of the company. The company's management, however, might prefer other formats when the profit and loss statement remains inside

For example, a company might want to prepare an income statement—for inside the company only—that focuses on the

the company.

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

Example Products Co. Income Statement in Contribution Margin Format

For the Five Months Ended May 31, 2010

Total

Product Line 1

Product Line 2

Sales $100,000 $70,000 $30,000

Variable Expenses

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

Commissions Expense 5,000 5,000 0

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

Contribution Margin 20,000 15,000 5,000

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

Subtotal 14,000 11,000 3,000

Fixed Expenses - Common 2,000

Operating Income $12,000

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

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

Cash Flow Statement

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

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

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

The cash flow statement reports the cash

1.

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

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

Operating activities – converts the items reported on the income statement from the accrual basis of accounting to cash.

2. Investing activities – reports the purchase and sale of long-term investments and property, plant and equipment.

3. Financing activities – reports the issuance and repurchase of the company's own bonds and stock and the payment of dividends.

4. Supplemental information

– reports the exchange of significant items that did not involve cash and reports the amount of income taxes paid and interest paid.

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

Here are a few ways the statement of cash flows is used.

1. The cash from operating activities is compared to the company's net income. If the cash from operating activities is consistently greater than the net income, the company's net income or earnings are said to be of a "high quality". If the cash from operating activities is less than net income, a red flag is raised as to why the reported net income is not turning into cash.

2. Some investors believe that "cash is king". The cash flow statement identifies the cash that is flowing in and out of the company. If a company is consistently generating more cash than it is using, the company will be able to increase its dividend, buy back some of its stock, reduce debt, or acquire another company. All of these are perceived to be good for stockholder value.

3. Some financial models are based upon cash flow.

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

1. When Mary Smith invests her personal money into her new company, what will happen to her company's Cash account?

Answer

2. When a company purchases inventory (merchandise purchased in order to be resold) what will happen to its Cash account?

Answer

3. What happens to the company's Cash account if it borrows money from the bank by signing a note payable?

Answer

4. What happens to a company's Cash account if it declares a dividend on its shares of stock?

Answer

5. What is the effect on its Cash account when a company pays some of itsAccounts Payable?

Answer

6. What is the effect on its Cash account when a company prepays a 6-month insurance premium?

Answer

7. What is the effect on its Cash account when a company sells merchandise, but allows the customer to pay in 30 days?

Answer

8. What is the effect on its Cash account when a company receives payment from one of its customers 30 days after the sale was recorded?

Answer

9. If a company's Accounts Payable account decreased, what is the likely effect this will have on Cash?

Answer

10. If the asset account Prepaid Insurance increased, what is the likely effect on Cash?

Answer

11. If the asset account Land increased, what's the likely effect on Cash? Answer

12. If the asset account Land decreased, what's the likely effect on Cash? Answer

13. If the liability account Bonds Payable increases, what is the likely effect on Cash?

Answer

14. If the liability account Bonds Payable decreases, what is the likely effect on Cash?

Answer

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

When an asset (other than cash) increases, the Cash account When an asset (other than cash) decreases, the Cash account

decreases.

When a liability increases, the Cash accountincreases.

When a liability decreases, the Cash account

increases.

When owner's equity increases, the Cash accountdecreases.

When owner's equity decreases, the Cash account

increases. decreases.

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

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

Format of the Statement of Cash Flows The statement of cash flows has four distinct sections:

1. Cash involving operating activities 2. Cash involving investing activities 3. Cash involving financing activities 4. Supplemental information.

Assuming that the cash flow statement is being prepared using the indirect method (the method used by most companies) the differences in a company's balance sheet accounts will provide much of the needed

information. For example, if the statement of cash flows is for the year 2010, the balance sheet accounts at December 31, 2010 will be compared to the balance sheet accounts at December 31, 2009. The changes—or differences—in these account balances will likely be entered in one of the sections of the statement of cash flows.

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

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

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

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

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

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

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

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

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

A change in this balance sheet category

...is reported in this section of the cash flow statement

Current Assets*

Operating Activities

Current Liabilities

Operating Activities

Long-term Assets

Investing Activities

Long-term Liabilities

Financing Activities

Stockholders' Equity

Financing Activities

*This refers to current assets other than Cash.

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

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

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

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

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

Good Deal Co. Income Statement

For the Month Ended January 31, 2010

Revenues $ 0

Expenses 0

Net Income

$ 0

Good Deal Co. Balance Sheet

January 31, 2010

Assets

Liabilities & Owner's Equity

Cash $1,300

Liabilities $ 0

Inventory 700

Owner's Equity

Matt Jones, Capital 2,000

Total Assets $2,000

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

Good Deal Co. Statement of Cash Flows

For the Month Ended January 31, 2010

Operating Activities

Net Income $ 0

Increase in Inventory (700)

Cash Provided (Used) in Operating Activities (700)

Investing Activities 0

Financing Activities

Investment by Owner 2,000

Net Increase in Cash 1,300

Cash at the beginning of the month 0

Cash at the end of the month $1,300

Good Deal's income statement for January showed no profit or loss, since it did not have any sales or expenses. However, the cash flow statement reports that Good Deal's operating activities resulted in a

decrease in cash of $700. The decrease in cash occurred because the company increased its inventory by $700 during January. The financing activities section shows an increase in cash of $2,000 which corresponds to the increase in Matt Jones, Capital (Matt's investment in the business). The net change in the Cash account from the owner's investment and the cash outflow for inventory is a positive $1,300.

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

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

For a change in liabilities and owner's equity—the change in the Cash account is in the same

February Transactions and Financial Statements

direction. Recall that when the owner invested cash in the company Cash increased and Owner's Equity increased.

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

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

Good Deal Co. Income Statement

For the Month Ended Feb. 28, 2010

Revenues $800

Expenses 500

Net Income

$300

The income statement for the month of February shows revenues (or sales) of $800. Under the accrual basis of accounting—revenue is recognized when title passes (at the time of shipment or time of delivery), notwhen the money is received. Expenses (such as the cost of goods sold for $500) appear on the income statement when they best match up with revenues, not when the expenses or goods are paid for. (Other expenses will also appear on the income statement when they are used, not when they are

paid for.) As a result of the accrual basis of accounting, the income statement reports $300 of net income even though there was no cash inflow or cash outflow during February.

Good Deal Co. Statement of Cash Flows

For the Month Ended February 28, 2010

Operating Activities

Net Income $ 300

Increase in Accounts Receivable (800)

Decrease in Inventory 500

Cash Provided (Used) in Operating Activities 0

Investing Activities 0

Financing Activities

Investment by Owner 0

Net Increase in Cash 0

Cash at the beginning of the month 1,300

Cash at the end of the month $1,300

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

Good Deal Co. Income Statement

For the Two Months Ended February 28, 2010

Revenues $800

Expenses 500

Net Income

$300

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

Good Deal Co. Balance Sheet

February 28, 2010

Assets

Liabilities & Owner's Equity

Cash $1,300

Liabilities $ 0

Accounts Receivable 800

Owner's Equity

Inventory 200

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

Matt Jones, Curr Yr. Net Income 300

Total Owner's Equity 2,300

Total Assets $2,300

Total Liabilities & Owner's Equity

$2,300

Good Deal Co. Statement of Cash Flows

For the Two Months Ended February 28, 2010

Operating Activities

Net Income $ 300

Increase in Accounts Receivable (800)

Increase in Inventory (200)

Cash Provided (Used) in Operating Activities (700)

Investing Activities 0

Financing Activities

Investment by Owner $2,000

Net Increase in Cash 1,300

Cash at the beginning of the year 0

Cash at February 28, 2010 $1,300

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

The cash flow statement also shows $2,000 of financing by the owner. When this is combined with the negative $700 from operating activities, the net change in cash for the first two months is a positive $1,300. This agrees to the change

March Transactions and Financial Statements

in cash on the balance sheet—none on January 1 but $1,300 on February 28.

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

The Good Deal financial statements dated March 31 are:

Good Deal Co. Income Statement

For the Month Ended March 31, 2010

Revenues $ 0

Expenses 0

Net Income

$ 0

Good Deal Co. Income Statement

For the Three Months Ended March 31, 2010

Revenues $800

Expenses 500

Net Income

$300

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

Good Deal Co. Balance Sheet March 31, 2010

Assets

Liabilities & Owner's Equity

Cash $2,100

Liabilities $ 0

Accounts Receivable 0

Owner's Equity

Inventory 200

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

Matt Jones, Curr Yr. Net Income 300

Total Owner's Equity 2,300

Total Assets $2,300

Total Liabilities & Owner's Equity

$2,300

Good Deal Co. Statement of Cash Flows

For the Three Months Ended March 31, 2010

Operating Activities

Net Income $ 300

Increase in Accounts Receivable 0

Increase in Inventory (200)

Cash Provided (Used) in Operating Activities 100

Investing Activities 0

Financing Activities

Investment by Owner $2,000

Net Increase in Cash 2,100

Cash at the beginning of the year 0

Cash at March 31, 2010 $2,100

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

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

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

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

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

Good Deal Co. Balance Sheets

March 31 and February 28, 2010

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

Cash $2,100 $1,300 $ 800

Accounts Receivable -0- 800 (800)

Inventory 200 200 -0-

Total Assets $2,300 $2,300

$ -0-

Liabilities & Owner's Equity

Liabilities $ -0- $ -0- $ -0-

Owner's Equity

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

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

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

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

$ -0-

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

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

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

Good Deal Co. Statement of Cash Flows

For the Month Ended March 31, 2010

Operating Activities

Net Income $ 0

Decrease in Accounts Receivable 800

Change in Inventory 0

Cash Provided (Used) in Operating Activities 800

Investing Activities 0

Financing Activities 0

Net Increase in Cash 800

Cash at the beginning of the month 1,300

Cash at the end of the month $2,100

Let's review the cash flow statement for the month of March 2010:

Net income for March is $0, since there were no revenues, gains, expenses, or losses. Cash increased by $800 because $800 of accounts receivable were collected during March. Inventory did not change, so Cash was not affected. (We could omit this line since it had no effect

on cash.)

There were no changes in long-term assets during March, so nothing is reported in the investing activities section.

There were no changes in long-term liabilities or owner's equity; hence, nothing is reported in the financing activities section.

The summation of the amounts on the statement of cash flows is a positive $800. This amount agrees to the increase in the Cash account balance from $1,300 on February 28 to $2,100 on March 31.

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

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

Good Deal Co. Income Statement

For the Month Ended April 30, 2010

Revenues $ 0

Expenses 0

Net Income

$ 0

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

Good Deal Co. Income Statement

For the Four Months Ended April 30, 2010

Revenues $800

Expenses 500

Net Income

$300

Good Deal Co. Balance Sheet April 30, 2010

Assets

Liabilities & Owner's Equity

Cash $2,100

Liabilities

Accounts Receivable 0

Accounts Payable $ 150

Inventory 200

Owner's Equity

Supplies 150

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

Matt Jones, Curr Yr. Net Income 300

Total Owner's Equity 2,300

Total Assets $2,450

Total Liabilities & Owner's Equity

$2,450

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

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

Good Deal Co. Balance Sheets

April 30 and March 31, 2010

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

Cash $2,100 $2,100 $ 0

Accounts Receivable 0 0 0

Inventory 200 200 0

Supplies 150 $ 0 $150

Total Assets $2,450 $2,300

$150

Liabilities & Owner's Equity

Liabilities

Accounts Payable $ 150 $ 0 $150

Owner's Equity

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

Matt Jones, Curr Yr. Net Income 300 300 0

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

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

$150

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

Good Deal Co. Statement of Cash Flows

For the Month Ended April 30, 2010

Operating Activities

Net Income $ 0

Increase in Supplies (150)

Increase in Accounts Payable 150

Cash Provided (Used) in Operating Activities 0

Investing Activities 0

Financing Activities

Investment by Owner 0

Net Increase in Cash 0

Cash at the beginning of the month 2,100

Cash at the end of the month $2,100

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

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

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

Good Deal Co. Balance Sheets

April 30, 2010 and December 31, 2009

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

Cash $2,100 $ 0 $2,100

Accounts Receivable 0 0 0

Inventory 200 0 200

Supplies 150 0 150

Total Assets $2,450 $ 0

$2,450

Liabilities & Owner's Equity

Liabilities

Accounts Payable $ 150 $ 0 $ 150

Owner's Equity

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

Matt Jones, Curr Yr. Net Income 300 0 300

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

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

$2,450

Good Deal Co. Statement of Cash Flows

For the Four Months Ended April 30, 2010

Operating Activities

Net Income $ 300

Increase in Inventory (200)

Increase in Supplies (150)

Increase in Accounts Payable 150

Cash Provided (Used) in Operating Activities 100

Investing Activities 0

Financing Activities

Investment by Owner 2,000

Net Increase in Cash 2,100

Cash at the beginning of the year 0

Cash at April 30, 2010 $2,100

Let's review the statement of cash flows for the four months ended April 30:

The operating activities section of the cash flow statement starts with the net income of $300 for the four-month period. The increase in Inventory is not good for cash, as shown by the negative $200. Similarly, the increase in Supplies is not good for cash and it is reported as a negative $150. The increase in Accounts Payable is good for cash (since some bills were not paid) so the increase in the liability account is a positive $150. Combining the amounts, the net change in cash that is explained by operating activities

There were no changes in long-term assets, hence no cash was involved in investing activities. is a positive $100.

There were no changes in long-term liabilities. There was a change in owner's equity since December 31, and as a result the financing activities section reports the owner's investment in Good Deal Co.

Combining the operating, investing, and financing activities, the cash flow statement reports a change in cash of $2,100. This agrees with the change in the Cash account from $0 on December 31, 2009 to $2,100 on April 30, 2010.

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

Good Deal Co. Income Statement

For the Month Ended May 31, 2010

Revenues $ 0

Expenses 0

Net Income

$ 0

Good Deal Co. Income Statement

For the Five Months Ended May 31, 2010

Revenues $800

Expenses 500

Net Income

$300

Good Deal Co. Balance Sheet May 31, 2010

Assets

Liabilities & Owner's Equity

Cash $ 850

Liabilities

Accounts Receivable 0

Accounts Payable $ 0

Inventory 200

Owner's Equity

Supplies 150

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

Office Equipment 1,100

Matt Jones, Curr Yr. Net Income 300

Total Owner's Equity 2,300

Total Assets $2,300

Total Liabilities & Owner's Equity

$2,300

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

Good Deal Co. Balance Sheets

May 31 and April 30, 2010

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

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

Accounts Receivable 0 0 0

Inventory 200 200 0

Supplies 150 150 0

Office Equipment 1,100 0 1,100

Total Assets $2,300 $2,450

$ (150)

Liabilities & Owner's Equity

Liabilities

Accounts Payable $ 0 $ 150 $ (150)

Owner's Equity

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

Matt Jones, Curr Yr. Net Income 300 300 0

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

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

$ (150)

Good Deal Co. Statement of Cash Flows

For the Month Ended May 31, 2010

Operating Activities

Net Income $ 0

Decrease in Accounts Payable (150)

Cash Provided (Used) in Operating Activities (150)

Investing Activities

Purchase of Office Equipment (1,100)

Financing Activities 0

Net Increase in Cash (1,250)

Cash at the beginning of the month 2,100

Cash at the end of the month $ 850

Good Deal Co. Balance Sheets

May 31, 2010 and December 31, 2009

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

Cash $ 850 $ 0 $ 850

Accounts Receivable 0 0 0

Inventory 200 0 200

Supplies 150 0 150

Office Equipment 1,100 0 1,100

Total Assets $2,300 $ 0

$2,300

Liabilities & Owner's Equity

Liabilities

Accounts Payable $ 0 $ 0 $ 0

Owner's Equity

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

Matt Jones, Curr Yr. Net Income 300 0 300

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

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

$2,300

Good Deal Co. Statement of Cash Flows

For the Five Months Ended May 31, 2010

Operating Activities

Net Income $ 300

Increase in Inventory (200)

Increase in Supplies (150)

Cash Provided (Used) in Operating Activities (50)

Investing Activities

Purchase of Office Equipment (1,100)

Financing Activities

Investment by Owner 2,000

Net Increase in Cash 850

Cash at the beginning of the year 0

Cash at May 31, 2010 $ 850

Let's review the cash flow statement for the five months ended May 31:

The operating activities section starts with the net income of $300 for the five-month period. The increase in Inventory is not good for cash, as shown by the negative $200. Similarly, the increase in Supplies is not good for cash and it is reported as a negative $150. Combining the amounts, the net change in cash that is explained by operating activities

The increase in long-term assets is reported under investing activities. is a negative $50.

There were no changes in long-term liabilities. There was a change in owner's equity since December 31, and as a result the financing activities section of the cash flow statement reports the owner's investment into the Good Deal Co.

Combining the operating, investing, and financing activities, the statement of cash flows reports an increase in cash of $850. This agrees with the change in the Cash account as shown on the balance sheets from December 31, 2009 (or January 1, 2010) and May 31, 2010.

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

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

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

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

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

June Transactions and Financial Statements The only transaction recorded by Good Deal during June was the depreciation on the office equipment. Recall that on May 31 Good Deal purchased the office equipment (a new computer and printer) for $1,100 and it was put into service on the same day. Let's assume that a depreciation expense of $20 per

month is recorded by Good Deal. As a result, Good Deal's financial statements at June 30 will be as follows:

Good Deal Co. Income Statement

For the Month Ended June 30, 2010

Revenues $ 0

Expenses

Depreciation Expense 20

Net Income

$(20)

Good Deal Co. Income Statement

For the Six Months Ended June 30, 2010

Revenues $800

Expenses

Cost of Goods Sold 500

Depreciation Expense 20

Total Expense 520

Net Income

$280

Good Deal Co. Balance Sheet June 30, 2010

Assets

Liabilities & Owner's Equity

Cash $ 850

Liabilities

Accounts Receivable 0

Accounts Payable $ 0

Inventory 200

Owner's Equity

Supplies 150

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

Office Equipment 1,100

Matt Jones, Curr Yr. Net Income 280

Less: Accum. Depreciation (20)

Total Matt Jones, Capital 2,280

Total Assets $2,280

Total Liabilities & Owner's Equity

$2,280

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

Good Deal Co. Balance Sheets

June 30 and May 31, 2010

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

Cash $ 850 $ 850 $ 0

Accounts Receivable 0 0 0

Inventory 200 200 0

Supplies 150 150 0

Office Equipment 1,100 1,100 0

Less: Accumulated Depreciation (20) 0 (20)

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

)

Liabilities & Owner's Equity

Liabilities

Accounts Payable $ 0 $ 0 $ 0

Owner's Equity

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

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

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

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

)

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

Good Deal Co. Statement of Cash Flows

For the Month Ended June 30, 2010

Operating Activities

Net Income $ (20)

Add: Depreciation Expense 20

Cash Provided (Used) in Operating Activities 0

Investing Activities 0

Financing Activities 0

Net Increase in Cash 0

Cash at the beginning of the month 850

Cash at the end of the month $850

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

Good Deal Co. Balance Sheets

June 30, 2010 and December 31, 2009

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

Cash $ 850 $ 0 $ 850

Accounts Receivable 0 0 0

Inventory 200 0 200

Supplies 150 0 150

Office Equipment 1,100 0 1,100

Less: Accumulated Depreciation (20) 0 (20)

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

Liabilities & Owner's Equity

Liabilities

Accounts Payable $ 0 $ 0 $ 0

Owner's Equity

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

Matt Jones, Curr Yr. Net Income 280 0 280

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

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

Good Deal Co. Statement of Cash Flows

For the Six Months Ended June 30, 2010

Operating Activities

Net Income $ 280

Add back: Depreciation Expense 20

Increase in Inventory (200)

Increase in Supplies (150)

Cash Provided (Used) in Operating Activities (50)

Investing Activities

Increase in Office Equipment (1,100)

Financing Activities

Investment by Owner 2,000

Net Increase in Cash 850

Cash at the beginning of the year 0

Cash at June 30, 2010 $ 850

Let's review the cash flow statement for the six months ended June 30:

The operating activities section starts with the net income of $280 for the six-month period. Depreciation expense is added back to net income because it was a noncash transaction (net income was reduced, but there was no cash spent on depreciation). The increase in the Inventory account is not good for cash, as shown by the negative $200. Similarly, the increase in Supplies is not good for cash and it is reported as a negative $150. Combining the amounts, the net change in cash that is explained by operating activities

The increase in long-term assets caused a cash outflow of $1,100 which is reported in the investing activities section.

is a negative $50.

There were no changes in long-term liabilities. There was a change in owner's equity since December 31, and as a result the financing activities section reports the owner's $2,000 investment into the Good Deal Co.

Combining the operating, investing, and financing activities, the statement of cash flows reports an increase in cash of $850. This agrees with the change in the Cash account as shown on the balance sheets from December 31, 2009 and June 30, 2010.

Disposal of Assets If a company disposes of (sells) a long-term asset for an amount different from its recorded amount in the company's accounting records (its book value), an adjustment must be made to net income on the cash flow statement.

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

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

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

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

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

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

Good Deal Co. Income Statement

For the Month Ended July 31, 2010

Revenues $ 0

Expenses

Loss on Sale of Equipment 180

Net Income $(180

)

Good Deal Co. Income Statement

For the Seven Months Ended July 31, 2010

Revenues $800

Expenses

Cost of Goods Sold 500

Depreciation Expense 20

Loss on Sale of Equipment 180

Total Expense 700

Net Income

$100

Good Deal Co. Balance Sheets

July 31, 2010 and June 30, 2010

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

Cash $1,750 $ 850 $ 900

Accounts Receivable 0 0 0

Inventory 200 200 0

Supplies 150 150 0

Office Equipment 0 1,100 (1,100)

Less: Accumulated Depreciation 0 (20) 20

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

)

Liabilities & Owner's Equity

Liabilities

Accounts Payable $ 0 $ 0 $ 0

Owner's Equity

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

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

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

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

)

Good Deal Co.

Statement of Cash Flows For the Month Ended July 31, 2010

Operating Activities

Net Income $ (180)

Add back: Depreciation Expense 0

Add back: Loss on Sale of Equipment 180

Cash Provided (Used) in Operating Activities 0

Investing Activities

Proceeds from sale of Office Equipment 900

Financing Activities 0

Net Increase in Cash 900

Cash at the beginning of the month 850

Cash at the end of the month $1,750

Let's review the cash flow statement for the month of July 2010:

Net income for July was a net loss of $180. There were no revenues, expenses, or gains, but there was an entry of $180 in the account Loss on Sale of Equipment.

There was no depreciation expense in July, and current assets and current liabilities did not change in July, so cash was not affected. (We could have omitted the line "Depreciation Expense".)

There was no cash provided or used by operating activities. Good Deal received $900 from the sale of its office equipment. There was no change in long-term liabilities or owner's equity during July.

The summation of the amounts on the cash flow statement is a positive cash inflow of $900. This amount agrees to our check figure—the increase in the Cash account balance from June 30 to July 31.

Good Deal Co. Balance Sheets

July 31, 2010 and December 31, 2009

Assets 7-31-10 12-31-09 Change

Cash $1,750 $ 0 $1,750

Accounts Receivable 0 0 0

Inventory 200 0 200

Supplies 150 0 150

Office Equipment 0 0 0

Less: Accumulated Depreciation 0 0 0

Total Assets $2,100 $ 0 $2,100

Liabilities & Owner's Equity

Liabilities

Accounts Payable $ 0 $ 0 $ 0

Owner's Equity

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

Matt Jones, Curr Yr. Net Income 100 0 100

Total Matt Jones, Capital 2,100 0 2,100

Total Liabilities & Owner's Equity $2,100 $ 0 $2,100

Good Deal Co. Statement of Cash Flows

For the Seven Months Ended July 31, 2010

Operating Activities

Net Income $ 100

Add back: Depreciation Expense 20

Add back: Loss on Sale of Equipment 180

Increase in Inventory (200)

Increase in Supplies (150)

Cash Provided (Used) in Operating Activities (50)

Investing Activities

Purchase of Office Equipment (1,100)

Proceeds from sale of Office Equipment 900

Cash Provided (Used) in Investing Activities (200)

Financing Activities

Investment by owner 2,000

Net Increase in Cash 1,750

Cash at the beginning of the year 0

Cash at July 31, 2010 $1,750

Let's review the cash flow statement for the seven months of January through July 2010:

Net income for the seven months is $100. This includes revenues, gains, expenses, and losses. Included in the net income for the seven months is $20 of depreciation expense. This expense

reduced net income but did not reduce the Cash account; therefore we add the $20 depreciation expense to the net income.

Also included in net income is the $180 entry into the Loss on Sale of Equipment account. This loss was reported on the income statement thereby reducing net income but not reducing cash. (The cash received from the sale of the equipment appears in its entirety under the investing activities section of the cash flow statement.)

Inventory on July 31 is $200 (4 calculators at a cost of $50 each). Since the company began with no inventory, this increase in the Inventory account means that $200 of cash was used to increase inventory.

Supplies increased from none to $150. The increase in the Supplies account is assumed to have had a negative effect of $150 on the Cash account.

Combining the amounts so far, we see that the cash from operating activities is a negative $50. In other words, rather than providing cash, the operating activities used

There is cash outflow (or payment) of $1,100 to purchase the office equipment on May 31 and the $900 of cash inflow (or receipt) from the sale of the office equipment on July 1. Combining these two amounts results in the net outflow ("cash used in investing activities") of $200.

$50 of cash.

There was an owner's investment of $2,000 made on January 2.

The statement of cash flow's bottom line amount of $1,750 results from combining the amount totals of the previous three sections—operating, investing, and financing activities. This $1,750 agrees to the check figure—the difference in the Cash account balance from the beginning of January to July 31.

Financial Ratios

Introduction to Financial Ratios We also have Quizzes, Crosswords, and Q&A for the topic

When computing financial ratios and when doing other financial statement analysis always keep in mind that the financial statements reflect the

Financial Ratios.

accounting principles. This means assets are generally not reported at their current value. It is also likely that many brand names and unique product lines will not be included among the assets reported on the balance sheet, even though they may be the most valuable of all the items owned by a company.

These examples are signals that financial ratios and financial statement analysis have limitations. It is also important to realize that an impressive financial ratio in one industry might be viewed as less than impressive in a different industry.

Our explanation of financial ratios and financial statement analysis is organized as follows:

• Balance Sheet o General discussion o Common-size balance sheet o Financial ratios based on the balance sheet

• Income Statement o General discussion o Common-size income statement o Financial ratios based on the income statement

• Statement of Cash Flows

General Discussion of Balance Sheet The balance sheet reports a company's assets, liabilities, and stockholders' equity as of a specific date, such as December 31, 2010, September 28, 2010, etc.

The accountants' cost principle and the monetary unit assumption will limit the assets reported on the balance sheet. Assets will be reported

(1) only if they were acquired in a transaction, and (2) generally at an amount that is not greater than the asset's cost at the time of the transaction.

This means that a company's creative and effective management team will not be listed as an asset. Similarly, a company's outstanding reputation, its unique product lines, and brand names developed within the company will not be reported on the balance sheet. As you may surmise, these items are often the most valuable of all the things owned by the company. (Brand names purchased from another company will be recorded in the company's accounting records at their cost.)

The accountants' matching principle will result in assets such as buildings, equipment, furnishings, fixtures, vehicles, etc. being reported at amounts less than cost. The reason is these assets aredepreciated. Depreciation reduces an asset's book value

While depreciation is reducing the book value of certain assets over their

each year and the amount of the reduction is reported as Depreciation Expense on the income statement.

useful lives, the current value (or fair market value) of these assets may actually be increasing. (It is also possible that the current value of some assets–such as computers–may be decreasing faster than the book value.)

Current assets such as Cash, Accounts Receivable, Inventory, Supplies, Prepaid Insurance, etc. usually have current values that are close to the amounts reported on the balance sheet.

Current liabilities such as Notes Payable (due within one year), Accounts Payable, Wages Payable, Interest Payable, Unearned Revenues, etc. are also likely to have current values that are close to the amounts reported on the balance sheet.

Long-term liabilities such as Notes Payable (not due within one year) or Bonds Payable (not maturing within one year) will often have current values that differ from the amounts reported on the balance sheet.

Stockholders' equity is the book value of the company. It is the difference between the reported amount of assets and the reported amount of liabilities. For the reasons mentioned above, the reported amount of stockholders' equity will therefore be different from the current or market value of the company.

By definition the current assets and current liabilities are "turning over" at least once per year. As a result, the reported amounts are likely to be similar to their current value. The long-term assets and long-term liabilities are not "turning over" often. Therefore, the amounts reported for long-term assets and long-term liabilities will likely be different from the current value of those items.

The remainder of our explanation of financial ratios and financial statement analysis will use information from the following balance sheet:

Example Company Balance Sheet

December 31, 2010

ASSETS

LIABILITIES

Current Assets

Current Liabilities

Cash $ 2,100

Notes Payable $ 5,000

Petty Cash 100

Accounts Payable 35,900

Temporary Investments 10,000

Wages Payable 8,500

Accounts Receivable - net 40,500

Interest Payable 2,900

Inventory 31,000

Taxes Payable 6,100

Supplies 3,800

Warranty Liability 1,100

Prepaid Insurance 1,500

Unearned Revenues 1,500

Total Current Assets 89,000

Total Current Liabilities 61,000

-

Investments 36,000

Long-term Liabilities

Notes Payable 20,000

Property, Plant & Equipment

Bonds Payable 400,000

Land 5,500

Total Long-term Liabilities 420,000

Land Improvements 6,500

Buildings 180,000

Equipment 201,000

Total Liabilities 481,000

Less: Accum Depreciation (56,000)

Prop, Plant & Equip - net 337,000

-

Intangible Assets

STOCKHOLDERS' EQUITY

Goodwill 105,000

Common Stock 110,000

Trade Names 200,000

Retained Earnings 229,000

Total Intangible Assets 305,000

Less: Treasury Stock (50,000)

Total Stockholders' Equity 289,000

Other Assets 3,000

-

Total Assets $770,000

Total Liab. & Stockholders' Equity $770,000

To learn more about the balance sheet, go to:

• Explanation of Balance Sheet • Drills for Balance Sheet • Crossword Puzzles for Balance Sheet

Common–Size Balance Sheet One technique in financial statement analysis is known as vertical analysis. Vertical analysis results in common-size financial statements. A common-size balance sheet is a balance sheet where every dollar amount has been restated to be a percentage of total assets. We will illustrate this by taking Example Company's balance sheet (shown above) and divide each item by the total asset amount $770,000. The result is the following common-size balance sheet for Example Company:

Example Company Balance Sheet

December 31, 2010

ASSETS

LIABILITIES

Current Assets

Current Liabilities

Cash 0.3%

Notes Payable 0.6%

Petty Cash 0.0%

Accounts Payable 4.7%

Temporary Investments 1.3%

Wages Payable 1.1%

Accounts Receivable - net 5.3%

Interest Payable 0.4%

Inventory 4.0%

Taxes Payable 0.8%

Supplies 0.5%

Warranty Liability 0.1%

Prepaid Insurance 0.2%

Unearned Revenues 0.2%

Total Current Assets 11.6%

Total Current Liabilities 7.9%

-

Investments 4.7%

Long-term Liabilities

Notes Payable 2.6%

Property, Plant & Equipment

Bonds Payable 52.0%

Land 0.7%

Total Long-term Liabilities 54.6%

Land Improvements 0.8%

Buildings 23.4%

Equipment 26.1%

Total Liabilities 62.5%

Less: Accum Depreciation (7.3%)

Prop, Plant & Equip - net 43.7%

-

Intangible Assets

STOCKHOLDERS' EQUITY

Goodwill 13.6%

Common Stock 14.3%

Trade Names 26.0%

Retained Earnings 29.7%

Total Intangible Assets 39.6%

Less: Treasury Stock (6.5%)

Total Stockholders' Equity 37.5%

Other Assets 0.4%

-

Total Assets 100.0%

Total Liab. & Stockholders' Equity

100.0%

The benefit of a common-size balance sheet is that an item can be compared to a similar item of another company regardless of the size of the companies. A company can also compare its percentages to the industry's average percentages. For example, a company with Inventory

Financial Ratios Based on the Balance Sheet

at 4.0% of total assets can look to its industry statistics to see if its percentage is reasonable. (Industry percentages might be available from an industry association, library reference desks, and from bankers. Generally banks have memberships in Robert Morris Associates, an organization that collects and distributes statistics by industry.) A common-size balance sheet also allows two businesspersons to compare the magnitude of a balance sheet item without either one revealing the actual dollar amounts.

Financial statement analysis includes financial ratios. Here are three financial ratios that are based solely on current asset and current liability amounts appearing on a company's balance sheet:

Financial Ratio

How to Calculate It What It Tells You

Working Capital

=

=

=

Current Assets – Current Liabilities $89,000 – $61,000 $28,000

An indicator of whether the company will be able to meet its current obligations (pay its bills, meet its payroll, make a loan payment, etc.) If a company has current assets exactly equal to

current liabilities, it has no working capital. The greater the amount of working capital the more likely it will be able to make its payments on time.

Current Ratio =

=

=

Current Assets ÷ Current Liabilities $89,000 ÷ $61,000 1.46

This tells you the relationship of current assets to current liabilities. A ratio of 3:1 is better than 2:1. A 1:1 ratio means there is no working capital.

Quick Ratio (Acid Test Ratio)

=

=

=

=

[(Cash + Temp. Investments + Accounts Receivable) ÷ Current Liabilities] : 1 [($2,100 + $100 + $10,000 + $40,500) ÷ $61,000] : 1 [$52,700 ÷ $61,000] : 1 0.86 : 1

This ratio is similar to the current ratio except that Inventory, Supplies, and Prepaid Expenses are excluded. This indicates the relationship between the amount of assets that can quickly be turned into cash versus the amount of current liabilities.

Four financial ratios relate balance sheet amounts for Accounts Receivable and Inventory to income statement amounts. To illustrate these financial ratios we will use the following income statement information:

Example Corporation

Income Statement For the year ended December 31, 2010

Sales (all on credit) $500,000

Cost of Goods Sold 380,000

Gross Profit 120,000

Operating Expenses

Selling Expenses 35,000

Administrative Expenses 45,000

Total Operating Expenses 80,000

Operating Income 40,000

Interest Expense 12,000

Income before Taxes 28,000

Income Tax Expense 5,000

Net Income after Taxes $ 23,000

To learn more about the income statement, go to:

• Explanation of Income Statement • Drills for Income Statement • Crossword Puzzle for Income Statement

Financial Ratio

How to Calculate It What It Tells You

Accounts Receivable Turnover

=

=

=

Net Credit Sales for the Year ÷Average Accounts Receivable for the Year $500,000 ÷ $42,000 (a computed average) 11.90

The number of times per year that the accounts receivables turn over. Keep in mind that the result is anaverage, since credit sales and accounts receivable are likely to fluctuate during the year. It is important to use the averagebalance of accounts receivable during the year.

Days' Sales in Accounts Receivable

=

=

365 days in Year ÷ Accounts Receivable Turnover in Year 365 days ÷ 11.90

The average number of days that it took to collect the average amount of accounts receivable during the year. This statistic is only as good as the Accounts Receivable

= 30.67 days Turnover figure.

Inventory Turnover

=

=

=

Cost of Goods Sold for the Year ÷Average Inventory for the Year $380,000 ÷ $30,000 (a computed average) 12.67

The number of times per year that Inventory turns over. Keep in mind that the result is an average, since sales and inventory levels are likely to fluctuate during the year. Since inventory is at cost (not sales value), it is important to use the Cost of Goods Sold. Also be sure to use the average balance of inventory during the year.

Days' Sales in Inventory

=

=

=

365 days in Year ÷ Inventory Turnover in Year 365 days ÷ 12.67 28.81

The average number of days that it took to sell the average inventory during the year. This statistic is only as good as the Inventory Turnover figure.

The next financial ratio involves the relationship between two amounts from the balance sheet: total liabilities and total stockholders' equity:

Financial Ratio

How to Calculate It What It Tells You

Debt to Equity =

=

=

(Total liabilities ÷ Total Stockholders' Equity) : 1 ( $481,000 ÷ $289,000) : 1 1.66 : 1

The proportion of a company's assets supplied by the company's creditors versus the amount supplied the owner or stockholders. In this example the creditors have supplied $1.66 for each $1.00 supplied by the stockholders.

General Discussion of Income Statement

The income statement has some limitations since it reflects accounting principles. For example, a company's depreciation expense is based on the cost of the assets it has acquired and is using in its business. The resulting depreciation expense may not be a good indicator of the economic value of the asset being used up. To illustrate this point let's assume that a company's buildings and equipment have been fully depreciated and therefore there will be no depreciation expense for those buildings and equipment on its income statement. Is zero expense a good indicator of the cost of using those buildings and equipment? Compare that situation to a company with new buildings and equipment where there will be large amounts of depreciation expense.

The remainder of our explanation of financial ratios and financial statement analysis will use information from the following income statement:

Example Corporation

Income Statement For the year ended December 31, 2010

Sales (all on credit) $500,000

Cost of Goods Sold 380,000

Gross Profit 120,000

Operating Expenses

Selling Expenses 35,000

Administrative Expenses 45,000

Total Operating Expenses 80,000

Operating Income 40,000

Interest Expense 12,000

Income before Taxes 28,000

Income Tax Expense 5,000

Net Income after Taxes $ 23,000

Earnings per Share (based on 100,000 shares outstanding)

$ 0.23

To learn more about the income statement, go to:

• Explanation of Income Statement • Drills for Income Statement • Crossword Puzzle for Income Statement

Common–Size Income Statement Financial statement analysis includes a technique known as vertical analysis. Vertical analysis results in common-size financial statements. A common-size income statement presents all of the income statement amounts as a percentage of net sales. Below is Example Corporation's common-size income statement after each item from the income statement above was divided by the net sales of $500,000:

Example Corporation

Income Statement For the year ended December 31, 2010

Sales (all on credit) 100.0%

Cost of Goods Sold 76.0%

Gross Profit 24.0%

Operating Expenses

Selling Expenses 7.0%

Administrative Expenses 9.0%

Total Operating Expenses 16.0%

Operating Income 8.0%

Interest Expense 2.4%

Income before Taxes 5.6%

Income Tax Expense 1.0%

Net Income after Taxes 4.6%

The percentages shown for Example Corporation can be compared to other companies and to the industry averages. Industry averages can be obtained from trade associations, bankers, and library reference desks. If a company competes with a company whose stock is publicly traded, another source of information is that company's "Management's Discussion and Analysis of Financial Condition and Results of Operations" contained in its annual report to the Securities and Exchange Commission (SEC). This annual report is the SEC Form 10-K and is usually accessible under the "Investor Relations" tab on the corporation's website.

Financial Ratios Based on the Income Statement

Financial Ratio

How to Calculate It What It Tells You

Gross Margin =

=

=

Gross Profit ÷ Net Sales $120,000 ÷ $500,000 24.0%

Indicates the percentage of sales dollars available for expenses and profit after the cost of merchandise is deducted from sales. The gross margin varies between industries and often varies between companies within the same industry.

Profit Margin (after tax)

=

=

=

Net Income after Tax ÷ Net Sales $23,000 ÷ $500,000 4.6%

Tells you the profit per sales dollar after all expenses are deducted from sales. This margin will vary between industries as well as between companies in the same industry.

Earnings Per Share (EPS)

=

=

=

Net Income after Tax ÷ Weighted Average Number of Common Shares Outstanding $23,000 ÷ 100,000 $0.23

Expresses the corporation's net income after taxes on a per share of common stock basis. The computation requires the deduction of preferred dividends from the net income if a corporation has preferred stock. Also requires the weighted average number of shares of common stock during the period of the net income.

Times Interest Earned

=

Earnings for the Year before Interest and Income Tax Expense ÷

Indicates a company's ability to meet the interest payments on its

=

=

Interest Expense for the Year $40,000 ÷ $12,000 3.3

debt. In the example the company is earning 3.3 times the amount it is required to pay its lenders for interest.

Return on Stockholders' Equity (after tax)

=

=

=

Net Income for the Year after Taxes ÷ Average Stockholders' Equity during the Year $23,000 ÷ $278,000 (a computed average) 8.3%

Reveals the percentage of profit after income taxes that the corporation earned on its average common stockholders' balances during the year. If a corporation has preferred stock, the preferred dividends must be deducted from the net income.

Statement of Cash Flows

The income statement has some limitations since it reflects accounting principles. For example, a company's depreciation expense is based on the cost of the assets it has acquired and is using in its business. The resulting depreciation expense may not be a good indicator of the economic value of the asset being used up. To illustrate this point let's assume that a company's buildings and equipment have been fully depreciated and therefore there will be no depreciation expense for those buildings and equipment on its income statement. Is zero expense a good indicator of the cost of using those buildings and equipment? Compare that situation to a company with new buildings and equipment where there will be large amounts of depreciation expense.

The statement of cash flows is a relatively new financial statement in comparison to the income statement or the balance sheet. This may explain why there are not as many well-established financial ratios associated with the statement of cash flows.

We will use the following cash flow statement for Example Corporation to illustrate a limited financial statement analysis:

Example Corporation

Statement of Cash Flows For the Year Ended December 31, 2010

Cash Flow from Operating Activities:

Net Income $23,000

Add: Depreciation Expense 4,000

Increase in Accounts Receivable (6,000)

Decrease in Inventory 9,000

Decrease in Accounts Payable (5,000)

Cash Provided (Used) in Operating Activities 25,000

Cash Flow from Investing Activities

Capital Expenditures (28,000)

Proceeds from Sale of Property 7,000

Cash Provided (Used) by Investing Activities (21,000)

Cash Flow from Financing Activities:

Borrowings of Long-term Debt 10,000

Cash Dividends (5,000)

Purchase of Treasury Stock (8,000)

Cash Provided (Used) by Financing Activities (3,000)

Net Increase in Cash 1,000

Cash at the beginning of the year 1,200

Cash at the end of the year $ 2,200

Financial Ratio

How to Calculate It What It Tells You

= Free Cash Cash Flow Provided by Operating This statistic tells you how much

Flow

=

=

Activities – Capital Expenditures $25,000 – $28,000 ( $3,000)

cash is left over from operations after a company pays for its capital expenditures (additions to property, plant and equipment). There can be variations of this calculation. For example, some would only deduct capital expenditures to keep the present level of capacity. Others would also deduct dividends that are paid to stockholders, since they are assumed to be a requirement.

The cash flow from operating activities section of the statement of cash flows is also used by some analysts to assess the quality of a company's earnings. For a company's earnings to be of "quality" the amount of cash flow from operating activities must be consistently greater than the company's net income. The reason is that under accrual accounting, various estimates and assumptions are made regarding both revenues and expenses. When it comes to cash, however, the money is either in the bank or it isn't.

Bank Reconciliation

Introduction to Bank Reconciliation We also have Quizzes, Crosswords, and Q&A for the topic

A company's

Bank Reconciliation.

general ledger account Cash contains a record of the transactions (checks written, receipts from customers, etc.) that involve its checking account. The bank also creates a record of the company's checking account when it processes the company's checks, deposits, service charges, and other items. Soon after each month ends the bank usually mails a bank statement to the company. The bank statement lists the activity in the bank account during the recent month as well as the balance in the bank account.

When the company receives its bank statement, the company should verify that the amounts on the bank statement are consistent or compatible with the amounts in the company's Cash account in its general ledger and vice versa. This process of confirming the amounts is referred to as reconciling the bank statement, bank statement reconciliation, bank reconciliation, or doing a "bank rec."

Because most companies write hundreds of checks each month and make many deposits, reconciling the amounts on the company's books with the amounts on the bank statement can be time consuming. The process is complicated because some items appear in the company's Cash account in one month, but appear on the bank statement in a different month. For example, checks written near the end of August are deducted immediately on the company's books, but those checks will likely

The benefit of reconciling the bank statement is knowing that the amount of Cash reported by the company (company's books) is consistent with the amount of cash shown in the bank's records.

clear

After you adjust the

the bank account in early September. Sometimes the bank decreases the company's bank account without informing the company of the amount. For example, a bank service charge might be deducted on the bank statement on August 31, but the company will not learn of the amount until the company receives the bank statement in early September. From these two examples, you can understand why there will likely be a difference in thebalance on the bank statement vs. the balance in the Cash account on the company's books. It is also possible (perhaps likely) that neither balance is the true balance. Both balances may need adjustment in order to report the true amount of cash.

balance per bank to be the true balance and after you adjust the balance per booksto also be the same true balance, you have reconciled the bank statement. Most accountants would simply say that you have done the bank reconciliation or the bank rec.

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

Step 1. Balance per Bank Statement on Aug. 31, 2010

Adjustments:

Add: Deposits in transit

Deduct: Outstanding checks

Add or Deduct: Bank errors

Adjusted/Corrected Balance per Bank

Deposits in transit are amounts already received and recorded by the company, but are not yet recorded by the bank. For example, a retail store deposits its cash receipts of August 31 into the bank's night depository at 10:00 p.m. on August 31. The bank will process this deposit on the morning of September 1. As of August 31 (the bank statement date) this is a deposit in transit.

Because deposits in transit are already included in the company's Cash account, there is no need to adjust the company's records. However, deposits in transit are not yet on the bank statement. Therefore, they need to be listed on the bank reconciliation as an increase to the balance per bank

• A helpful rule of thumb is "put it where it isn't." A deposit in transit is on the company's books, but it isn't on the bank statement. Put it where it isn't: as an

in order to report the true amount of cash.

adjustment to the balance on the bank statement.

Outstanding checks are checks that have been written and recorded in the company's Cash account, but have not yet cleared the bank account. Checks written during the last few days of the month plus a few older checks are likely to be among the outstanding checks.

Because all checks that have been written are immediately recorded in the company's Cash account, there is no need to adjust the company's records for the outstanding checks. However, the outstanding checks have not yet reached the bank and the bank statement. Therefore, outstanding checks are listed on the bank reconciliation as a

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

decrease in the balance per bank.

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

Step 2. Adjusting the Balance per Books The second step of the bank reconciliation is to adjust the balance in the company's Cash account so that it is the true, adjusted, or corrected balance. Examples of the items involved are shown in the following schedule:

Step 2. Balance per Books on Aug. 31, 2010

Adjustments:

Deduct: Bank service charges

Deduct: NSF checks & fees

Deduct: Check printing charges

Add: Interest earned

Add: Notes Receivable collected by bank

Add or Deduct: Errors in company's Cash account

Adjusted/Corrected Balance per Books

Bank service charges are fees deducted from the bank statement for the bank's processing of the checking account activity (accepting deposits, posting checks, mailing the bank statement, etc.) Other types of bank service charges include the fee charged when a company overdraws its checking account and the bank fee for processing a stop payment order on a company's check. The bank might deduct these charges or fees on the bank statement without notifying the company. When that occurs the company usually learns of the amounts only after receiving its bank statement.

Because the bank service charges have already been deducted on the bank statement, there is no adjustment to the balance per bank. However, the service charges will have to be entered as an adjustment to the company's books. The company's Cash account will need to be decreased by the amount of the service charges.

• Recall the helpful tip "put it where it isn't." A bank service charge is already listed on the bank statement, but it isn't on the company's books. Put it where it isn't: as an adjustment to the Cash account on the company's books.

An NSF check is a check that was not honored by the bank of the person or company writing the check because that account did not have a sufficient balance. As a result, the check is returned without being honored or paid. (NSF is the acronym for not sufficient funds. Often the bank describes the returned checkas a return item. Others refer to the NSF check as a "rubber check" because the check "bounced" back from the bank on which it was written.) When the NSF check comes back to the bank in which it was deposited, the bank will decrease the checking account of the company that had deposited the check. The amount charged will be the amount of the check plus a bank fee.

Because the NSF check and the related bank fee have already been deducted on the bank statement, there is no need to adjust the balance per the bank. However, if the company has not yet decreased its Cash account balance for the returned check and the bank fee, the company must decrease the balance per books in order to reconcile.

Check printing charges

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

occur when a company arranges for its bank to handle the reordering of its checks. The cost of the printed checks will automatically be deducted from the company's checking account.

Because the check printing charges have already been deducted on the bank statement, there is no adjustment to the balance per bank. However, the check printing charges need to be an adjustment on the company's books. They will be a deduction to the company's Cash account.

Interest earned

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

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

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

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

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

Step 3. Comparing the Adjusted Balances After adjusting the balance per bank (Step 1) and after adjusting the balance per books (Step 2), the two adjusted amounts should be equal. If they are not equal, you must repeat the process until the balances are identical. The balances should be the true, correct amount of cash as of the date of the bank reconciliation.

Step 4. Preparing Journal Entries Journal entries must be prepared for the adjustments to the balance per books

Sample Bank Reconciliation

(Step 2). Adjustments to increase the cash balance will require a journal entry that debits Cash and credits another account. Adjustments to decrease the cash balance will require a credit to Cash and a debit to another account.

With Amounts

Item #1.

In this part we will provide you with a sample bank reconciliation including the required journal entries. We will assume that a company has the following items:

The bank statement for August 2010 shows an ending balance of $3,490.

Item #2. On August 31 the bank statement shows charges of $35 for the service charge for maintaining the checking account.

Item #3. On August 28 the bank statement shows a return item of $100 plus a related bank fee of $10. The return item is a customer's check that was returned because of insufficient funds. The check was also marked "do not redeposit.

Item #4. The bank statement shows a charge of $80 for check printing on August 20.

Item #5. The bank statement shows that $8 was added to the checking account on August 31 for interest earned by the company during the month of August.

Item #6. The bank statement shows that a note receivable of $1,000 was collected by the bank on August 29 and was deposited into the company's account. On the same day, the bank withdrew $40 from the company's account as a fee for collecting the note receivable.

Item #7. The company's Cash

Item #8.

account at the end of August shows a balance of $967.

During the month of August the company wrote checks totaling more than $50,000. As of August 31 $3,021 of the checks written in August had not yet cleared

Item #9.

the bank and $200 of checks written in June had not yet cleared the bank.

The $1,450 of cash received by the company on August 31 was recorded on the company's books as of August 31. However, the $1,450 of cash receipts was deposited at the bank on the morning of September 1.

Item #10. On August 29 the company's Cash account shows cash sales of $145. The bank statement shows the amount deposited was actually $154. The company reviewed the transactions and found that $154 was the correct amount.

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

Put it where it isn't. If an item appears on the bank statement but not on the company's books, the item is probably going to be an adjustment to the Cash balance on (per) the company's books.

If an item is already in the company's Cash account, but has not yet appeared on the bank statement, the item is probably an adjustment to the balance per the bank statement.

Our approach to the bank reconciliation is to prepare two schedules. The first schedule begins with the ending balance on the bank statement. We refer to this schedule as Step 1. The second schedule begins with the ending Cash account balance in the general ledger. We call this schedule Step 2.

Items 1 through 10 above have been sorted into the following schedules labeled Step 1and Step 2. The item number is shown in the far right column of each schedule.

Step 1. Balance per Bank Statement on Aug. 31, 2010 $ 3,490 Item #1

Adjustments: 0

Deposits in transit + 1,450 Item #9

Outstanding checks – 3,221 Item #8

Bank errors 0

Adjusted/Corrected Balance per Bank $ 1,719

Step 2. Balance per Books on Aug. 31, 2010 $ 967 Item #7

Adjustments:

Bank service charges – 35 Item #2

NSF checks & fees – 110 Item #3

Check printing charges – 80 Item #4

Interest earned + 8 Item #5

Note Receivable collected by bank + 960 Item #6

Errors in company's Cash account + 9 Item #10

Adjusted/Corrected Balance per Books $ 1,719

Step 1 Amounts Let's review the schedule for Step 1. In all likelihood the balance shown on the bank statement is not the true balance to be reported on the company's balance sheet. The bank reconciliation process is to list the items that will adjust the bank statement balance to become the true cash balance. As the schedule for Step 1 indicates, the amount of deposits in transit must be added to the bank statement's balance. Also, the amount of checks that have been written, but not yet appearing on a bank statement, must besubtracted from the bank statement's balance. Next any bank errors should be listed and should be

reported to the bank for correction. (The company does not report deposits in transit and/or outstanding checks to the bank.)

Date

Step 2 Amounts and Required Journal Entries Step 2 begins with the balance in the company's Cash account found in its general ledger. The bank reconciliation process includes listing the items that will adjust the Cash account balance to become the true cash balance. We will review each item appearing in Step 2 and the related journal entry that is required. Remember that any adjustment to the company's Cash account requires a journal entry. Generally, the adjustments to the books are the result of items found on the bank statement but have not yet been entered in the company's Cash account.

Item #2 Bank service charges. Since the bank deducted $35 from the company's checking account, but the company has not yet deducted this from its Cash account, the following journal entry needs to be made.

Account Name Debit Credit

August 31, 2010 Bank Service Charge Expense 35

Cash

35

(If the annual amount of service charges is small, debit Miscellaneous Expense.)

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

Date Account Name Debit Credit

August 28, 2010 Accounts Receivable 110

Cash

110

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

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

Date Account Name Debit Credit

August 20, 2010 Supplies 80

Cash

80

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

Date Account Name Debit Credit

August 31, 2010 Cash 8

Interest Revenue

8

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

Date Account Name Debit Credit

August 29, 2010 Cash 960

Bank Service Charge Expense 40

Notes Receivable

1,000

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

Date Account Name Debit Credit

August 29, 2010 Cash 9

Sales

9

Step 3 Comparing the Adjusted Balances In the above schedules the adjusted balance for Step 1 is $1,719 and the adjusted balance for Step 2 is $1,719. The company believes that all items involving cash have been included in the schedules. As a result the company has successfully completed its bank reconciliation as of the August 31, 2010.

Accounts Receivable and Bad Debts Expense Introduction to Accounts Receivable and Bad Debts Expense We also have Quizzes, Crosswords, and Q&A for the topic Accounts Receivable and Bad Debts Expense.

If we imagine buying something, such as groceries, it's easy to picture ourselves standing at the checkout, writing out a personal check, and taking possession of the goods. It's a simple 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

1. Increase sales or sales revenues, which are reported on the income statement, and

on creditwill:

2. Increase the amount due from customers, which is reported as accounts 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

Recording Services Provided on Credit

direct write-off method.

Assume that on June 3, Malloy Design Co. provides $4,000 of graphic design service to one of its clients with credit terms of net 30 days. (Providing services with credit terms is also referred to as providing serviceson account.)

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

Date Account Name Debit Credit

June 3 Accounts Receivable 4,000

Service Revenues

4,000

In this transaction, the debit to Accounts Receivable increases Malloy's current assets, total assets, working capital, and stockholders' (or owner's) 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 theseller's dock. If the sale is made with the terms FOB Destination, the ownership of the goods is transferred at the

buyer's dock.

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

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

Account Name Debit Credit

Accounts Receivable 1,000

Sales

1,000

Cost of Goods Sold 800

Inventory

800

(While there may be additional expenses with this 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

selleris responsible for transporting the goods to the customer's dock, and will factor in the cost of shipping when it sets its price for the goods.

Let's assume that Gem Merchandise Co. makes a sale to a customer that has a sales value of $1,050 and a cost of goods sold at $800. This transaction affects the following accounts in Gem's general ledger:

Account Name Debit Credit

Accounts Receivable 1,050

Sales

1,050

Cost of Goods Sold 800

Inventory

800

Because Gem chooses to ship its goods FOB Destination, the ownership of the goods transfers at thebuyer's dock. Therefore, Gem Merchandise assumes all the risks and costs associated with transporting the goods.

Now let's assume that Gem pays an independent shipping company $50 to transport the goods from its warehouse to the buyer's dock. Gem records the $50 as an operating expense or selling expense (in an account such as Delivery Expense, Freight-Out Expense, or Transportation-Out Expense). If the shipping company allows Gem to pay in 7 days, Gem will make the following entry in its general ledger:

Account Name Debit Credit

Freight-Out Expense 50

Accounts Payable

50

Credit Terms with Discounts When a seller offers credit terms of net 30 days, the net amount for the sales transaction is due 30 days after the sales invoice date.

To illustrate the meaning of net, assume that Gem Merchandise Co. sells $1,000 of goods to a customer. Upon receiving the goods the customer finds that $100 of the goods are not acceptable. The customer contacts Gem and is instructed to return the unacceptable goods. This means that Gem's net sale ends up being $900; the customer's net purchase will also be $900 ($1,000 minus the $100 returned). It also means that Gem's net receivable from this customer will be $900.

Unfortunately, companies who sell on credit often find that they don't receive payments from customers on time. In fact, one study found that if the credit term is net 30 days, the money, on average, arrived 45 days after the invoice date. In order to speed up these payments, some companies give credit terms that offer a discount to those customers who pay within a shorter period of time. The discount is referred to as a sales discount or cash discount, and the shorter period of time is known as the discount period. For example, the term 2/10, net 30 allows a customer to deduct 2% of the net amount owed if the customer pays within 10 days of the invoice date. If a customer does not pay within the discount period of 10 days, the net purchase amount (without the discount) is due 30 days after the invoice date.

Using the example from above, let's illustrate how the credit term of 2/10, net 30 works. Gem Merchandise Co. ships $1,000 of goods and the customer returns $100 of unacceptable goods to Gem within a few days. At that point, the net amount owed by the customer is $900. If the customer pays Gem within 10 days of the invoice date, the customer is allowed to deduct $18 (2% of $900) from the net purchase of $900. In other words, the $900 amount can be settled for $882 if it is paid within the 10-day discount period.

Let's assume that the sale above took place on the first day that Gem was open for business, June 1. On June 6 Gem receives the returned goods and restocks them, and on June 11 it receives $882 from the buyer. Gem's cost of goods is 80% of their original selling prices (before discounts). The above transactions are reflected in Gem's general ledger as follows:

Date Account Name Debit Credit

June 1 Accounts Receivable 1,000

Sales

1,000

June 1 Cost of Goods Sold 800 (80% of 1,000)

Inventory

800

June 6 Sales Returns and Allowances 100

Accounts Receivable

100

June 6 Inventory 80

Cost of Goods Sold

80

June 11 Cash 882

Sales Discounts 18 (2% of 900)

Accounts Receivable

900

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

Date Account Name Debit Credit

July 1 Cash 900

Accounts Receivable

900

Examples of Amounts Due Under Varying Credit Terms The following chart shows the amounts a seller would receive under various credit terms for a merchandise sale of $1,000 and an authorized return of $100 of goods.

Credit Terms Brief Description

Amount To be Received

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

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

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

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

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

1/10, n/60 If paid within 10 days of the invoice date, the buyer may deduct 1% from the net amount. ($900 minus $9) $891

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

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

$900

Costs of Discounts

Some business people believe that the credit term of 2/10, net 30 is far too generous. They argue that when a $900 receivable is settled for $882 (simply because the customer pays 20 days early) the seller is, in effect, giving the buyer the equivalent of a 36% annual interest rate (2% for 20 days equates to 36% for 360 days). Some sellers won't offer terms such as 2/10, net 30 because of these high percentage equivalents. Other sellers are discouraged to find that some customers take the discount and ignore the obligation to pay within the stated discount period.

Credit Risk When a seller provides goods or services on credit, the resultant account receivable is normally considered to be an unsecured claim against the buyer's assets. This makes the seller (the supplier) an unsecured creditor, meaning it does not have a lien on any of the buyer's assets—not even on the goods that it just sold to the buyer.

Sometimes a supplier's customer gets into financial difficulty and is forced to liquidate its assets. In this situation the customer typically owes money to lending institutions as well as to its suppliers of goods and services. In such cases, it's the secured creditors (the banks and other lenders that have a lien on specific assets such as cash, receivables, inventory, equipment, etc.) who are paid first from the sale of the assets. Often there is not enough money to pay what is owed to the secured lenders, much less the unsecured creditors. In other words, the suppliers will never be paid what they are owed.

To avoid this kind of risk, some suppliers may decide not to sell anything on credit, but require instead that all of its goods be paid for with cash or a credit card. Such a company, however, may lose out on sales to competitors who offer to sell on credit.

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

Allowance Method for Reporting Credit Losses

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

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

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

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

Date

of $2,000 in Allowance for Doubtful Accounts. The accounting entry to adjust the balance in the allowance account will involve the income statement account Bad Debts Expense.

Since June was Gem's first month in business, its Allowance for Doubtful Accounts began June with a zero balance. At June 30, when it issues its first balance sheet and income statement, its Allowance for Doubtful Accounts will have a credit balance of $2,000. This is done using the following adjusting journal entry:

Account Name Debit Credit

June 30 Bad Debts Expense 2,000

Allowance for Doubtful Accounts

2,000

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

Accounts Receivable

Allowance for Doubtful Accounts

June 1 Balance –

– June 1 Balance

June Sales 105,000 5,000 June

Collections 2,000 June 30

Adjust

June 30 Balance 100,000

2,000 June 30

Balance

Bad Debts Expense

June 1 Balance –

June 30 Adjust 2,000

June 30 Balance 2,000

With Allowance for Doubtful Accounts now reporting a credit balance of $2,000 and Accounts Receivable reporting a debit balance of $100,000, Gem's balance sheet will report a net amount of $98,000. Since this net amount of $98,000 is the amount that is likely to turn to cash, it is referred to as the net realizable value of the accounts receivable.

Under the allowance method, the Gem Merchandise Co. does not need to know specifically which customer will not pay, nor does it need to know the exact amount. This is acceptable because accountants believe it is better to report an approximate amount that is uncollectible rather than imply that every penny of the accounts receivable will be collected.

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

Since the net realizable value of a company's accounts receivable cannot be more than the debit balance in Accounts Receivable, the balance in the Allowance for Doubtful Accounts must be a credit balance or a zero balance.

Allowance for Doubtful Accounts and Bad Debts Expense - July Now let's assume that at July 31 the Gem Merchandise Co. has a debit balance in Accounts Receivable of $230,000. (The balance increased during July by the amount of its credit sales and it decreased by the amount it collected from customers.) The Allowance for Uncollectible Accounts still has the credit balance of $2,000 from the adjustment on June 30. This means Gem's general ledger accounts before

Gem reviews the details of its accounts receivable and estimates that as of July 31 approximately $10,000 of the $230,000 will not be collectible. In other words, the net realizable value (or net cash value) of its accounts receivable as of July 31 is only $220,000 ($230,000 minus $10,000). Before the July 31 financial statements are released, Gem must adjust the Allowance for Doubtful Accounts so that its

the July 31 adjustment to Allowance for Uncollectible Accounts will be reporting a net realizable value of $228,000 ($230,000 minus $2,000).

ending balance is a credit of $10,000 (instead of the present credit balance of $2,000). This requires the following adjusting entry:

Date Account Name Debit Credit

July 31 Bad Debts Expense 8,000

Allowance for Doubtful Accounts

8,000

After this journal entry is recorded, Gem's July 31 balance sheet will report the net realizable value of its accounts receivables at $220,000 ($230,000 debit balance in Accounts Receivable minus the $10,000 credit balance in Allowance for Doubtful Accounts).

Here's a recap in T-account form:

Accounts Receivable

Allowance for Doubtful Accounts

June 1 Balance –

– June 1 Balance

June Sales 105,000 5,000 June

Collections 2,000 June 30

Adjust

June 30 Balance 100,000

2,000 June 30

Balance

July Sales 225,000 95,000 July Collections

8,000 July 31 Adjust

July 31 Balance 230,000

10,000 July 31

Balance

Bad Debts Expense

June 1 Balance –

June 30 Adjust 2,000

June 30 Balance 2,000

July 31 Adjust 8,000

July 31 Balance 10,000

As seen in the T-accounts above, Gem estimated that the total bad debts expense for the first two months of operations (June and July) is $10,000. It is likely that as of July 31 Gem will not know the precise amount of actual bad debts, nor will Gem know which customers are the ones that won't be paying their account balances. However, the matching principle

By reporting the $10,000 credit balance in Allowance for Doubtful Accounts, Gem is also adhering to the accounting principle of

is better met by Gem making these estimates and recording the credit loss as close as possible to the time the sales were made.

conservatism. In other words, if there is some doubt as to whether there are $10,000 of credit losses or no credit losses, Gem's accountant "breaks the tie" by choosing the alternative that reports a smaller amount of profit and a smaller amount of assets. (It is reporting a net realizable value of $220,000 instead of the $230,000 of accounts receivable.) If a company knows with certainty

that every penny of its accounts receivable will be collected, then the Allowance for Doubtful Accounts will report a zero balance. However, if it is likely that some of the accounts receivable will not be collected in full, the principle of conservatism requires that there be a credit balance in Allowance for Doubtful Accounts.

Writing Off an Account under the Allowance Method Under the allowance method, if a specific customer's accounts receivable is identified as uncollectible, it is written off by removing the amount from Accounts Receivable. The entry to write off a bad account affects only balance sheet accounts: a debit to Allowance for Doubtful Accounts and a credit to Accounts Receivable. No expense or loss is reported on the income statement because this write-off is "covered" under the earlier adjusting entries for estimated bad debts expense.

Let's illustrate the write-off with the following example. On June 3, a customer purchases $1,400 of goods on credit from Gem Merchandise Co. On August 24, that same customer informs Gem Merchandise Co. that it has filed for bankruptcy. The customer states that its bank has a lien on all of its assets. It also states that the liquidation value of those assets is less than the amount it owes the bank, and as a result Gem will receive nothing toward its $1,400 accounts receivable. After confirming this information, Gem concludes that it should remove, or

Date

write off, the customer's account balance of $1,400.

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

Account Name Debit Credit

Aug 24 Allowance for Doubtful Accounts 1,400

Accounts Receivable

1,400

The two accounts affected by this entry contain this information:

Accounts Receivable

Allowance for Doubtful Accounts

June 1 Balance –

– June 1 Balance

June Sales 105,000 5,000 June

Collections 2,000 June 30 Adjust

June 30 Balance 100,000

2,000 June 30

Balance

July Sales 225,000 95,000 July Collections

8,000 July 31 Adjust

July 31 Balance 230,000

10,000 July 31

Balance

Aug Sales 204,000 194,000 Aug Collections

Aug 23 Balance 240,000

10,000 Aug 23

Balance

1,400 Aug 24 W-Off

Aug 24 W-Off 1,400

Aug 24 Balance 238,600

8,600 Aug 24

Balance

Note that prior to the August 24 entry of $1,400 to write off the uncollectible amount, the net realizable value of the accounts receivables was $230,000 ($240,000 debit balance in Accounts Receivable and $10,000 credit balance in Allowance for Doubtful Accounts). After writing off the bad account on August 24, the net realizable value of the accounts receivable is still $230,000 ($238,600 debit balance in Accounts Receivable and $8,600 credit balance in Allowance for Doubtful Accounts).

The Bad Debts Expense remains at $10,000; it is not directly affected by the journal entry write-off. The bad debts expense recorded on June 30 and July 31 had anticipated a credit loss such as this. It would be double counting for Gem to record both an anticipated estimate of a credit loss and the actual credit loss.

Recovery of Account under Allowance Method After a seller has written off an accounts receivable, it is possible that the seller is paid part or all of the account balance that was written off. Under the allowance method, if such a payment is received (whether directly from the customer or as a result of a court action) the seller will take the following two steps:

1. Reinstate the account that was written off by reversing the write-off entry. If we assume that the $1,400 written off on Aug 24 is collected on October 10, the reinstatement of the account looks like this:

Date Account Name Debit Credit

Oct 10 Accounts Receivable 1,400

Allowance for Doubtful Accounts

1,400

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

Date Account Name Debit Credit

Oct 10 Cash 1,400

Accounts Receivable

1,400

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

Bad Debts Expense as a Percent of Sales Another way sellers apply the allowance method of recording bad debts expense is by using the percentage of credit

sales approach. This approach automatically expenses a percentage of its credit sales based on past history.

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

Date Account Name Debit Credit

Oct 10 Bad Debts Expense 1,500

Allowance for Doubtful Accounts

1,500

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

Difference between Expense and Allowance The account Bad Debts Expense reports the credit losses that occur during the period of time covered by the income statement. Bad Debts Expense is a temporary account on the income statement, meaning it is closed at the end of each accounting year. (Closed means the account balance is transferred to retained earnings, perhaps through an income summary account.) By closing Bad Debts Expense and resetting its balance to zero, the account is ready to receive and tally the credit losses for the next accounting year.

The Allowance for Doubtful Accounts reports on the balance sheet the estimated amount of uncollectible accounts that are included in Accounts Receivable. Balance sheet accounts are almost always

permanentaccounts, meaning their balances carry forward to the next accounting period. In other words, they are not closed and their balances are not reset to zero.

Because the Bad Debts Expense account is closed each year, while the Allowance for Doubtful Accounts is not, these two balances will most likely not be equal after the company's first year of operations.

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

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

Aging of Accounts Receivable

Download our Aging of Accounts Receivable Form and Template

The general ledger account Accounts Receivable usually contains only summary amounts and is referred to as a control account. The details for the control 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:

Gem Merchandise Co. Aging of Accounts Receivable

As of August 31, 2010

Customer Name

Total Receivable Current

Past Due 1 - 30 Days

Past Due 31 - 60 Days

Past Due 61+ Days

ABC Co. $ 62,456 $ 59,121 $3,335 $ – $ –

Extreme Co. $ 18,210 $ – $ – $ – $18,210

Main Corp. $ 48,954 $ 48,954 $ – $ – $ –

Trifect LLC $ 1,200 $ – $ – $1,200 $ –

Totals $130,820 $108,075 $3,335 $1,200 $18,210

If a customer realizes that one of its suppliers is lax about collecting its account receivable on time, it may take advantage by further postponing payment in order to pay more demanding suppliers on time. This puts the seller at risk since an older, unpaid accounts receivable is more likely to end up as a credit loss. The aging of accounts receivable report helps management monitor and collect the accounts receivable in a more timely manner.

Aging Used in Calculating the Allowance The aging of accounts receivable can also be used to estimate the credit balance needed in a company's Allowance for Doubtful Accounts. For example, based on past experience, a company might make the assumption that accounts not past due have a 99% probability of being collected in full. Accounts that are 1-30 days past due have a 97% probability of being collected in full, and the accounts 31-60 days past due have a 90% probability. The company estimates that accounts more than 60 days past due have only a 60% chance of being collected. With these probabilities of collection, the probability of not collecting is 1%, 3%, 10%, and 40% respectively.

If we multiply the totals from the aging of accounts receivable report by the probabilities of not collecting, we arrive at the expected amount of uncollectible receivables. This is illustrated below:

Gem Merchandise Co. Expected Amount of Accounts Receivable That is Uncollectible

As of August 31, 2010

Age of Accounts Receivables

Accounts Receivable

Amount

Probability of Not

Collecting

Expected Uncollectible

Amount

Current $108,075 1% $1,081

Past Due: 1 - 30 days $ 3,335 3% $ 100

Past Due: 31 - 60 days $ 1,200 10% $ 120

Past Due: 61+ days $ 18,210 40% $7,284

Totals

$130,820 $8,585

This computation estimates the balance needed for Allowance for Doubtful Accounts at August 31 to be a credit balance of $8,585.

Mailing Statements to Customers To improve the probability of collection (and avoid bad debts expense) many sellers prepare and mail monthly statements to all customers that have accounts receivable balances. If worded skillfully, the seller can use the statement to say "thank you for your continued business" while at the same time "reminding" the customer that receivables are being monitored and payment is expected. To further prompt customers to pay in a timely manner, the statement may indicate that past due accounts are assessed interest at an annual rate of 18% (1.5% per month). Because transactions are usually itemized on the statement, some customers use the statement as a means to compare its records with those of the seller.

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

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

Accounts Receivable Ratios There are two commonly used financial ratios that address the relationship between the amount of a company's accounts receivable as reported on the balance sheet and the amount of credit sales as reported on the income statement. These ratios are:

1. Accounts receivable turnover ratio, and 2. Days sales in accounts receivable.

Use the following link to learn how to calculate these ratios: Financial Ratios.

Direct Write-off Method Generally accepted accounting principles (GAAP) require that companies use the allowance method when preparing financial statements. The use of the allowance method is not permitted, however, for purposes of reporting income taxes in the United States because the Internal Revenue Service (IRS) does not allow companies to anticipate these credit losses. As a result, companies must use the direct write-off method for income tax reporting.

In the direct write-off method, a company will not use an allowance account to reduce its Accounts Receivable. Accounts Receivable is only reduced if and when a company knows with certainty that aspecific amount will not be collected from a

Date

specific customer.

For example, let's assume that on October 21, Gem Merchandise Co. is convinced that a specific customer's account receivable originating on June 5 in the amount of $1,238 is definitely uncollectible. Using the direct write-off method, the following entry is made:

Account Name Debit Credit

Oct. 21 Bad Debts Expense 1,238

Accounts Receivable

1,238

Usually many months will pass between the time of the sale on credit and the time that the seller knows with certainty that a customer is not going to pay. It is difficult to adhere to the matching principle and the concept of conservatism when a significant amount of time elapses between the time of the sales revenues and the time that the bad debts expense is reported. This is why, for purposes of financial reporting (not

taxreporting), companies should use the allowance method rather than the direct write-off

method.

Inventory and Cost of Goods Sold Introduction to Inventory and Cost of Goods Sold We also have Quizzes, Crosswords, and Q&A for the topic Inventory & Cost of Goods Sold.

Inventory is merchandise purchased by merchandisers (retailers, wholesalers, distributors) for the purpose of being sold to customers. The cost of the merchandise purchased but not yet sold is reported in the account Inventory or Merchandise Inventory.

Inventory is reported as a current asset on the company's balance sheet. Inventory is a significant asset that needs to be monitored closely. Too much inventory can result in cash flow problems, additional expenses (e.g., storage, insurance), and losses if the items become obsolete. Too little

Because of the

inventory can result in lost sales and lost customers.

cost principle, inventory is reported on the balance sheet at the amount paid to

Cost of Goods Sold

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

Inventory is also a significant asset of manufacturers. However, in order to simplify our explanation, we will focus on a retailer.

Cost of goods sold is the cost of the merchandise that was sold to customers. The cost of goods sold is reported on the income statement when the sales revenues of the goods sold are reported.

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

When Costs Change

any additional costs necessary to get the merchandise into inventory and ready for sale. For example, let's assume that Corner Shelf Bookstore purchases a college textbook from a publisher. If Corner Shelf's cost from the publisher is $80 for the textbook plus $5 in shipping costs, Corner Shelf reports $85 in its Inventory account until the book is sold. When the book is sold, the $85 is removed from inventory and is reported as cost of goods sold on the income statement.

If the publisher increases the selling prices of its books, the bookstore will have a higher cost for the nextbook it purchases from the publisher. Any books in the bookstore's inventory will continue to be reported at their cost when purchased. For example, if the Corner Shelf Bookstore has on its shelf a book that had a cost of $85, Corner Shelf will continue to report the cost of that one book at its actual cost of $85 even if the same book now has a cost of $90. The cost principle will not allow an amount higher than cost to be included in inventory.

Let's assume the Corner Shelf Bookstore had one book in inventory at the start of the year 2010 and at different times during 2010 purchased four identical books. During the year 2010 the cost of these books increased due to a paper shortage. The following chart shows the costs of the five books that have to be accounted for. It also assumes that none of the books has been sold as of December 31, 2010.

Number of

Books

Cost per

Book

Total Cost

Inventory at Dec. 31, 2009 1 @ $85 = $ 85

First purchase (January 2010) 1 @ 87 = 87

Second purchase (June 2010) 2 @ 89 = 178

Third purchase (December 2010) 1 @ 90 = 90

Total goods available for sale 5

$440

Less: Inventory at Dec. 31, 2010 5

440

Cost of goods sold 0

$ 0

Special Feature:

Review what you are learning by working the three interactive crossword puzzles dedicated to this topic. They are completely free. Inventory & Cost of Goods Sold Puzzles

Cost Flow Assumptions If the Corner Shelf Bookstore sells only one of the five books, which cost should Corner Shelf report as the cost of goods sold? Should it select $85, $87, $89, $89, $90, or an average of the five amounts? A related question is which cost should Corner Shelf report as inventory on its balance sheet for the four books that have not been sold?

Accounting rules allow the bookstore to move the cost from inventory to the cost of goods sold by using one of three

1. First In, First Out (FIFO)

cost flows:

2. Last In, First Out (LIFO) 3. Average

Note that these are cost flow assumptions. This means that the order in which costs are removed from inventory can be different from the order in which the goods are physically removed from inventory. In other words, Corner Shelf could sell the book that was on hand at December 31, 2009 but could remove from inventory the $90 cost

of the book purchased in December 2010 (if it elects the LIFO cost flow

assumption).

Inventory Systems Each of the three cost flow assumptions listed above can be used in either of two systems (or methods) of inventory:

A. Periodic

A. Periodic inventory system. Under this system the amount appearing in the

B. Perpetual

Inventory

Under the periodic inventory system, purchases of merchandise are recorded in one or more

account is not updated when purchases of merchandise are made from suppliers. Rather, the Inventory account is commonly updated or adjusted only once—at the end of the year. During the year the Inventory account will likely show only the cost of inventory at the end of the previous year.

Purchasesaccounts. At the end of the year the Purchases account(s) are closed and the Inventory account is adjusted to equal the cost of the merchandise actually on hand at the end of the year. Under the periodic system there is no Cost of Goods Sold account to be updated when a sale of merchandise occurs.

In short, under the periodic inventory system there is no way to tell from the general ledger accounts the amount of inventory or the cost of goods sold.

B. Perpetual inventory system. Under this system the Inventory account is continuously updated. The Inventory account is increased with the cost of merchandise purchased from suppliers and it is reduced by the cost of merchandise that has been sold to customers. (The Purchases account(s) do not exist.)

Under the perpetual system there is a Cost of Goods Sold account that is debited at the time of each sale for the cost of the merchandise that was sold. Under the perpetual system a sale of merchandise will result in two journal entries: one to record the sale and the cash or accounts receivable, and one to reduce inventory and to increase cost of goods sold.

Inventory Systems and Cost Flows Combined The combination of the three cost flow assumptions and the two inventory systems results in six available options when accounting for the cost of inventory and calculating the cost of goods sold:

A1. Periodic FIFO A2. Periodic LIFO A3. Periodic Average B1. Perpetual FIFO B2. Perpetual LIFO

A1. Periodic FIFO

B3. Perpetual Average

"Periodic" means that the Inventory account is not routinely updated during the accounting period. Instead, the cost of merchandise purchased from suppliers is debited to an account called Purchases. At the end of the accounting year the Inventory account is adjusted to equal the cost of the merchandise that has not been sold. The cost of goods sold that will be reported on the income statement will be computed by taking the cost of the goods purchased and subtracting the increase in inventory (or adding the decrease in inventory).

"FIFO" is an acronym for First In, First Out. Under the FIFO cost flow assumption, the first (oldest) costs are the first ones to leave inventory and become the cost of goods sold on the income statement. The last (or recent) costs will be reported as inventory on the balance sheet.

Remember that the costs can flow differently than the goods. If the Corner Shelf Bookstore uses FIFO, the owner may sell the newest book to a customer, but is allowed to report the cost of goods sold as $85 (the first, oldest cost).

Let's illustrate periodic FIFO with the amounts from the Corner Shelf Bookstore:

Number of

Books

Cost per

Book

Total Cost

Inventory at Dec. 31, 2009 1 @ $85 = $ 85

First purchase (January 2010) 1 @ 87 = 87

Second purchase (June 2010) 2 @ 89 = 178

Third purchase (December 2010) 1 @ 90 = 90

Total goods available for sale 5

$440

Less: Inventory at Dec. 31, 2010 4

- 355

Cost of goods sold 1 @ $85

$ 85

As before, we need to account for the total goods available for sale (5 books at a cost of $440). Under FIFO we assign the first cost of $85 to the one book that was sold. The remaining $355 ($440 - $85) is assigned to inventory. The $355 of inventory costs consists of $87 + $89 + $89 + $90. The $85 cost assigned to the book sold is permanently gone from inventory.

If Corner Shelf Bookstore sells the textbook for $110, its gross profit

under periodic FIFO will be $25 ($110 - $85). If the costs of textbooks continue to increase, FIFO will always result in more profit than other cost flows, because the first cost is always lower.

A2. Periodic LIFO "Periodic" means that the Inventory account is not updated during the accounting period. Instead, the cost of merchandise purchased from suppliers is debited to an account called Purchases. At the end of the accounting year the Inventory account is adjusted to equal the cost of the merchandise that is unsold. The other costs of goods will be reported on the income statement as the cost of goods sold.

"LIFO" is an acronym for Last In, First

It's important to note that under

Out. Under the LIFO cost flow assumption, the last (or recent) costs are the first ones to leave inventory and become the cost of goods sold on the income statement. The first (or oldest) costs will be reported as inventory on the balance sheet.

Remember that the costs can flow differently than the goods. In other words, if Corner Shelf Bookstore uses LIFO, the owner may sell the oldest (first) book to a customer, but can report the cost of goods sold of $90 (the last cost).

LIFO periodic (not LIFO perpetual) we wait until the entire year is over before assigning the costs. Then we flow the year's last costs first, even if those goods arrived after the last sale of the year. For example, assume the last sale of the year at the Corner Shelf Bookstore occurred on December 27. Also assume that the store's last purchase of the year arrived on December 31. Under LIFO periodic, the cost of the book purchased on December 31 is sent to the cost of goods sold first, even though it's physically impossible for that book to be the one sold on December 27. (This

reinforces our previous statement that the flow of costs does not have to correspond with the physical flow of units.)

Let's illustrate periodic LIFO by using the data for the Corner Shelf Bookstore:

Number of

Books

Cost per

Book

Total Cost

Inventory at Dec. 31, 2009 1 @ $85 = $ 85

First purchase (January 2010) 1 @ 87 = 87

Second purchase (June 2010) 2 @ 89 = 178

Third purchase (December 2010) 1 @ 90 = 90

Total goods available for sale 5

$440

Less: Inventory at Dec. 31, 2010 4

- 350

Cost of goods sold 1 @ $90

$ 90

As before we need to account for the total goods available for sale: 5 books at a cost of $440. Under periodic LIFO we assign the last cost of $90 to the one book that was sold. (If two books were sold, $90 would be assigned to the first book and $89 to the second book.) The remaining $350 ($440 - $90) is assigned to inventory. The $350 of inventory cost consists of $85 + $87 + $89 + $89. The $90 assigned to the book that was sold is permanently gone from inventory.

If the bookstore sold the textbook for $110, its gross profit under periodic LIFO will be $20 ($110 - $90). If the costs of textbooks continue to increase, LIFO will always result in the least amount of profit. (The reason is that the last costs will always be higher than the first costs. Higher costs result in less profits and usually lower income taxes.)

A3. Periodic Average Under "periodic" the Inventory account is not updated and purchases of merchandise are recorded in an account called Purchases. Under this cost flow assumption an average cost is calculated using the total goods available for sale (cost from the beginning inventory plus the costs of all subsequent purchases made during the entire year). In other words, the periodic average cost is calculated after the year is over—after all the puchases of the year have occurred. This average cost is then applied to the units sold during the year as well as to the units in inventory at the end of the year.

As you can see, our facts remain the same—there are 5 books available for sale for the year 2010 and the cost of the goods available is $440. The weighted average cost of the books is $88 ($440 of cost of goods available ÷ 5 books available) and it is used for both the cost of goods sold and for the cost of the books in inventory.

Number of

Books

Cost per

Book

Total Cost

Inventory at Dec. 31, 2009 1 @ $85 = $ 85

First purchase (January 2010) 1 @ 87 = 87

Second purchase (June 2010) 2 @ 89 = 178

Third purchase (December 2010) 1 @ 90 = 90

Total goods available for sale 5

$440

Less: Inventory at Dec. 31, 2010 4 @ $88

- 352

Cost of goods sold 1 @ $88

$ 88

Since the bookstore sold only one book, the cost of goods sold is $88 (1 x $88). The four books still on hand are reported at $352

(4 x $88) of cost in the Inventory account. The total of the cost of goods sold plus the cost of the inventory should equal the total cost of goods available ($88 + $352 = $440).

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

B1. Perpetual FIFO Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer purchases merchandise, the retailer debits its Inventory account for the cost; when the retailer sells the merchandise to its customers its Inventory account is credited and its Cost of Goods Sold account is debited for the cost of the goods sold. Rather than staying dormant

Under the perpetual system, two transactions are recorded when merchandise is sold: (1) the sales amount is debited to

as it does with the periodic method, the Inventory account balance is continuously updated.

Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic system the second entry is not made.)

With perpetual FIFO, the first (or oldest) costs are the first moved from the Inventory account and debited to the Cost of Goods Sold account. The end result under perpetual FIFO is the same as under periodic FIFO. In other words, the first costs are the same whether you move the cost out of inventory with each sale (perpetual) or whether you wait until the year is over (periodic).

B2. Perpetual LIFO Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer purchases merchandise, the retailer debits its Inventory account for the cost of the merchandise. When the retailer sells the merchandise to its customers, the retailer credits its Inventory account for the cost of the goods that were sold and debits its Cost of Goods Sold account for their cost. Rather than staying dormantas it does with the periodic method, the Inventory account balance is continuously updated.

Under the perpetual system, two transactions are recorded at the time that the merchandise is sold: (1) the sales amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic system the second entry is not made.)

With perpetual LIFO, the last costs available at the time of the sale are the first to be removed from the Inventory account and debited to the Cost of Goods Sold account. Since this is the perpetual system we cannot wait until the end of the year to determine the last cost—an entry must be recorded at the time of the sale in order to reduce the Inventory account and to increase the Cost of Goods Sold account.

If costs continue to rise throughout the entire year, perpetual LIFO will yield a lower cost of goods sold and a higher net income than periodic LIFO. Generally this means that periodic LIFO will result in less income taxes than perpetual

LIFO. (If you wish to minimize the amount paid in income taxes during periods of inflation, you should discuss LIFO with your tax adviser.)

Once again we'll use our example for the Corner Shelf Bookstore:

Number of

Books

Cost per

Book

Total Cost

Inventory at Dec. 31, 2009 1 @ $85 = $ 85

First purchase (January 2010) 1 @ 87 = 87

Second purchase (June 2010) 2 @ 89 = 178

Third purchase (December 2010) 1 @ 90 = 90

Total goods available for sale 5

$440

Less: Inventory at Dec. 31, 2010 4

- 351

Cost of goods sold 1 @ $89

$ 89

Let's assume that after Corner Shelf makes its second purchase in June 2010, Corner Shelf sells one book. This means the last cost at the time of the sale was $89. Under perpetual LIFO the following entry must be made at the time of the sale: $89 will be credited to Inventory and $89 will be debited to Cost of Goods Sold. If that was the only book sold during the year, at the end of the year the Cost of Goods Sold account will have a balance of $89 and the cost in the Inventory account will be $351

If the bookstore sells the textbook for $110, its

($85 + $87 + $89 + $90).

gross profit

B3. Perpetual Average

under perpetual LIFO will be $21 ($110 - $89). Note that this is different than the gross profit of $20 under periodic LIFO.

Under the perpetual system the Inventory account is constantly (or perpetually) changing. When a retailer purchases merchandise, the costs are debited to its Inventory account; when the retailer sells the merchandise to its customers the Inventory account is credited and the Cost of Goods Sold account is debited for the cost of the goods sold. Rather than staying dormant as it does with the periodic method, the Inventory account balance under the perpetual average is changing whenever a purchase or sale occurs.

Under the perpetual system, two sets of entries are made whenever merchandise is sold: (1) the sales amount is debited to Accounts Receivable or Cash and is credited to Sales, and (2) the cost of the merchandise sold is debited to Cost of Goods Sold and is credited to Inventory. (Note: Under the periodic system the second entry is not made.)

Under the perpetual system, "average" means the average cost of the items in inventory as of the date of the sale. This average cost is multiplied by the number of units sold and is removed from the Inventory account and debited to the Cost of Goods Sold account. We use the average as of the time of the salebecause this is a perpetual method. (Note: Under the periodic system we wait until the year is over before computing the average cost.)

Let's use the same example again for the Corner Shelf Bookstore:

Number of Books

Cost per

Book

Total Cost

Inventory at Dec. 31, 2009 1 @ $85 = $ 85

First purchase (January 2010) 1 @ 87 = 87

Second purchase (June 2010) 2 @ 89 = 178

Third purchase (December 2010) 1 @ 90 = 90

Total goods available for sale 5

$440.00

Less: Inventory at Dec. 31, 2010 4 @ $88.125

- 352.50

Cost of goods sold 1 @ $87.50

$ 87.50

Let's assume that after Corner Shelf makes its second purchase, Corner Shelf sells one book. This means the average cost at the time of the sale was $87.50 ([$85 + $87 + $89 + $89] ÷ 4]). Because this is a perpetual average, a journal entry must be made at the time of the sale for $87.50. The $87.50 (the average cost at the time of the sale) is credited to Inventory and is debited to Cost of Goods Sold. After the sale of one unit, three units remain in inventory and the balance in the Inventory account will be $262.50 (3 books at an average cost of $87.50).

After Corner Shelf makes its third purchase, the average cost per unit will change to $88.125 ([$262.50 + $90] ÷ 4). As you can see, the average cost moved from $87.50 to $88.125—this is why the perpetual average method is sometimes referred to as the moving average method. The Inventory balance is$352.50

Comparison of Cost Flow Assumptions

(4 books with an average cost of $88.125 each).

Below is a recap of the varying amounts for the cost of goods sold, gross profit, and ending inventory that were calculated above.

Periodic Perpetual

FIFO LIFO Avg. FIFO LIFO Avg.

Sales $110 $110 $110 $110 $110 $110.00

Cost of Goods Sold – 85 – 90 – 88 – 85 – 89 – 87.50

Gross Profit $ 25 $ 20 $ 22 $ 25 $ 21 $ 22.50

Ending Inventory $355 $350 $352 $355 $351

$352.50

The example assumes that costs were continually increasing. The results would be different if costs were decreasing or increasing at a slower rate. Consult with your tax advisor concerning the election of cost flow assumption.

Specific Identification In addition to the six cost flow assumptions presented in Parts 1 – 4, businesses have another option: expense to the cost of goods sold the specific cost of the specific item sold. For example, Gold Dealer, Inc. has an inventory of gold and each nugget has an identification number and the cost of the nugget. When Gold Dealer sells a nugget, it can expense to the cost of goods sold the exact cost of the specific nugget sold. The cost of the other nuggets will remain in inventory. (Alternatively, Gold Dealer could use one of the other six cost flow assumptions described in Parts 1 – 4.)

LIFO Benefits Without Tracking Units In Part 1 and Part 2 you saw that during the periods of increasing costs, LIFO will result in less profits. In the U.S. this can mean less income taxes paid by the company. Most companies view lower taxes as a significant benefit. However, the process of tracking costs and then assigning those costs to the units sold and the units on hand could be too expensive for the amount of income tax savings. To gain the benefit of LIFO without the tracking of costs, there is a method known as dollar value LIFO. This topic is discussed in intermediate accounting textbooks. The Internal Revenue Service also allows companies to use dollar value LIFO by applying price indexes. (You should seek the advice of an accounting and/or tax professional to assess the cost and benefit of these techniques.)

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

A company will realize significant benefits if it can keep its inventory levels down without losing sales or production (if the company is a manufacturer). For example, Dell Computers has greatly reduced its inventory in relationship to its sales. Since computer components have been dropping in costs as new technologies emerge, it benefits Dell to keep only a very small inventory of components on hand. It would be a financial hardship if Dell had a large quantity of parts that became obsolete or decreased in value.

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

Estimating Ending Inventory It is very time-consuming for a company to physically count the merchandise units in its inventory. In fact, it is not unusual for companies to shut down their operations near the end of their accounting year just to perform inventory counts. The company may assign one set of employees to count and tag the items and another set to verify the counts. If a company has outside auditors, they will be there to observe the process. (Even if the company's computers keep track of inventory, accountants require that the computer records be verified by actually counting the goods.)

If a company counts its inventory only once per year it must estimate

its inventory at the end of each month in order to prepare meaningful monthly financial statements. In fact, a company may need to estimate its inventory for other reasons as well. For example, if a company suffers a loss due to a disaster such as a tornado or a fire, it will need to file a claim for the approximate cost of the inventory that was lost. (An insurance adjuster will also compute this amount independently so that the company is not paid too much or too little for its loss.)

Methods of Estimating Inventory

There are two methods for estimating ending inventory: 1. Gross Profit Method 2. Retail Method

1. Gross Profit Method. The gross profit method for estimating inventory uses the information contained in the top portion of a merchandiser's multiple-step income statement:

ABC Company

Income Statement (partial) For the Year Ended Dec. 31, 2009

Sales

$100,000 100.0%

Cost of Goods Sold

Beginning Inventory $ 22,000

Purchases - net 83,000

Cost of Goods Available 105,000

Less: Ending Inventory 25,000

Cost of Goods Sold

80,000 80.0%

Gross Profit

$ 20,000

20.0%

Let's assume that we need to estimate

While an algebraic equation could be constructed to determine the estimated amount of ending inventory, we prefer to simply use the income statement format. We prepare a partial income statement for the period beginning after the date when inventory was last physically counted, and ending with the date for

the cost of inventory on hand on June 30, 2010. From the 2009 income statement shown above we can see that the company's gross profit is 20% of the sales and that the cost of goods sold is 80% of the sales. If those percentages are reasonable for the current year, we can use those percentages to help us estimate the cost of the inventory on hand as of June 30, 2010.

which we need the estimated inventory cost. In this case, the income statement will go from January 1, 2010 until June 30, 2010.

Some of the numbers that we need are easily obtained from sales records, customers, suppliers, earlier financial statements, etc. For example, sales for the first half of the year 2010 are taken from the company's records. The beginning inventory amount is the ending inventory reported on the December 31, 2009 balance sheet. The purchases information for the first half of 2010 is available from the company's records or its suppliers. The amounts that we have available are written in italics in the following partial income statement:

ABC Company

Income Statement (partial) For the Six Months Ended June 30, 2010

Sales

$ 56,000 100.0%

Cost of Goods Sold

Beginning Inventory $ 25,000

Purchases - net 46,000

Cost of Goods Available

Less: Ending Inventory

Cost of Goods Sold

80.0%

Gross Profit

20.0%

We will fill in the rest of the statement with the answers to the following calculations. The amounts in

Step 1.

italicscome from the statement above. The bold amount is the answer or result of the calculation.

Cost of Goods Available = Beginning Inventory + Net Purchases

Cost of Goods Available = $25,000 + $46,000

Cost of Goods Available = $71,000

Step 2. Gross Profit = Gross Profit Percentage (or Gross Margin) x Sales

Gross Profit = 20% x $56,000

Gross Profit = $11,200

Step 3. Cost of Goods Sold = Sales – Gross Profit

Cost of Goods Sold = $56,000 – $11,200 (from Step 2.)

Cost of Goods Sold = $44,800

This can also be calculated as 80% x Sales of $56,000 = $44,800.

Inserting this information into the income statement yields the following:

ABC Company

Income Statement (partial) For the Six Months Ended June 30, 2010

Sales

$56,000 100.0%

Cost of Goods Sold

Beginning Inventory $25,000

Purchases - net 46,000

Cost of Goods Available 71,000

Less: Ending Inventory ?

Cost of Goods Sold

44,800 80.0%

Gross Profit

$11,200

20.0%

As you can see, the ending inventory amount is not yet shown. We compute this amount by subtracting cost of goods sold from the cost of goods available: Ending Inventory = Cost of Goods Available – Cost of Goods Sold

Ending Inventory = $71,000 – $44,800

Ending Inventory = $26,200

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

ABC Company

Income Statement (partial) For the Six Months Ended June 30, 2010

Sales

$56,000 100.0%

Cost of Goods Sold

Beginning Inventory $25,000

Purchases - net 46,000

Cost of Goods Available 71,000

Less: Ending Inventory 26,200

Cost of Goods Sold

44,800 80.0%

Gross Profit

$11,200

20.0%

2. Retail Method. The retail method can be used by retailers who have their merchandise records in both cost and retail selling prices. A very simple illustration for using the retail method to estimate inventory is shown here:

Cost Retail

Beginning Inventory $ 11,000 $ 15,000

Purchases - net + 69,000 + 85,000

Goods Avail. & Cost Ratio 80,000 100,000

Less: Sales at retail

- 90,000

Est. ending inventory at retail

10,000

Est. ending inventory at cost $ 8,000

As you can see, the cost amounts are arranged into one column. The retail

To arrive at the estimated ending inventory at cost, we multiply the estimated ending inventory at retail ($10,000) times the

amounts are listed in a separate column. The Goods Available amounts are used to compute the cost-to-retail ratio. In this case the cost of goods available of $80,000 is divided by the retail amount of goods available ($100,000). This results in a cost-to-retail ratio, or cost ratio, of 80%.

cost ratio

of 80% to arrive at $8,000.

Lower of Cost or Market (LCM)

Introduction to Lower of Cost or Market (LCM) We also have Quizzes, Crosswords, and Q&A for the topic

Assume it is the end of December 2010 and your retail store has 20 digital cameras in inventory. You purchased the cameras directly from the manufacturer at a

Lower of Cost or Market.

cost

Unexpectedly, on December 31, the camera manufacturer announces a permanent price reduction–you and the other retailers can now purchase the cameras for $135 instead of $150. You know that your competitors will buy up these cameras and pass the savings on to their customers by immediately advertising a retail price reduction–selling the cameras for $185 instead of $200. If you drop

of $150 each and you planned to sell the cameras at a retail price of $200, a price that is in line with competing retailers.

your retail price to $185, however, your gross profit will be just $35 each on the 20 cameras you already have in stock, instead of the $50 per camera that you had planned on. This means your profits will be $300 less than you projected ($15 less profit times 20 cameras). Much to your dismay, you will have to drop your price to meet that of your competitors. There is nothing you can do to avoid this "holding loss" of $300.

When and how should this loss be reported on your store's income statement? Should the loss be reported as a smaller gross profit when the cameras are sold in January 2011? Or, should the entire $300 of loss be reported in December 2010, when the manufacturer announced the lower price? Should your December 31 balance sheet report inventory at $3,000 (20 cameras at the actual cost of $150) or at $2,700 (20 cameras at the lower replacement cost of $135)?

The conservatism principle and a specific accounting pronouncement, Accounting Research Bulletin No. 43 (ARB No. 43) leads to an accounting valuation method known as the lower of cost or market, or LCM. In this method the term "market" includes both the market in which the company purchases its merchandise as well as the market in which it sells

Conservatism Principle

its merchandise. We will discuss the details of the rule later, but for now, think of the lower of cost or market rule as the lower of cost or replacement cost–with certain limitations placed on the replacement cost amount.

Accountants usually associate the lower of cost or market (LCM) rule with the conservatism principle. This principle gives accountants guidance when they are faced with a choice between two divergent amounts. The conservatism principle directs them to choose the amount that results in a smaller asset amount and/or less profit.

How would the conservatism principle affect your camera "holding loss" described in the Introduction? On your December 31 balance sheet, the accountant must decide between reporting the cameras in inventory at their actual cost of $150 each, or at their replacement cost of $135 each. The conservatism principle and the Accounting Research Bulletin No. 43 direct the accountant to report them at $135 each and to recognize the $300 loss on your 2010 income statement. (In other words, the loss should be

reported as a loss in 2010, and not as a reduction in profits in 2011 when the cameras are sold.) However, there are some limitations on the replacement cost. The limitations involve the net realizable value (NRV), which will be defined in the next section.

While the conservatism principle and the lower of cost or market rule in ARB No. 43 may require that inventory be reported at less than cost, the cost principle and the revenue recognition principle prevent the reporting of inventory at more

Net Realizable Value (NRV)

than cost. (However, there are exceptions for a few select industries such as mining, commodities, securities, etc.)

Net realizable value (NRV)

Market

is defined as the expected selling price in the ordinary course of business minus the cost necessary for completion and disposal.

To illustrate NRV, let's assume that a company has an item in inventory that could be sold for $5. It will cost $0.80 to get the item ready for sale (by way of such costs as packaging the item), and to actually sell it (by way of such costs as sales commissions). This makes the net realizable value $4.20 (selling price of $5.00 less $0.80 of cost to complete and dispose).

Net realizable value is a key component in determining "market" in the lower of cost or market rule.

In the term lower of cost or market the word "market" refers to an item's

Both the upper limit (the ceiling) and the lower limit (the floor) are related to the

current replacement cost(whether through purchase or production). The market amount is constrained or limited by two amounts: (1) an upper limit, or "ceiling," and (2) a lower limit, or "floor." An item's market amount (or replacement cost) cannot be higher than the ceiling nor lower than the floor.

net realizable value(defined above) in the following ways:

1. Upper Limit or Ceiling for Market The upper limit, or ceiling, for the market amount is the net realizable value (NRV). In other words, the market amount cannot be higher than NRV. If the current replacement cost of an item in inventory is greater

2. Lower Limit or Floor for Market The lower limit, or floor, for the market amount is the

than NRV, the NRV is used as the market amount.

net realizable value (NRV) minus the normal profit. In other words, the market amount cannot be lower than NRV minus the normal profit. If the current replacement cost of an item in inventory is less

Here's a recap on how to determine the

than the NRV minus the normal profit, the NRV minus the normal profit is used as the market amount.

market amount

• If the current replacement cost is

used in the lower of cost or market rule:

between the floor and the ceiling, the current replacement cost is the market amount.

• If the current replacement cost is greater than the ceiling, the ceiling amount

• If the current replacement cost is lower than the floor, the

is the market amount.

floor amount

is the market amount.

How to Calculate the Lower of Cost or Market (LCM)

We will use the information in the following table to calculate the net realizable value and the lower of cost or market for five products:

Product: A B C D E

Cost $ 6.00 $ 5.00 $ 8.00 $ 8.75 $ 2.00

Replacement cost 4.50 3.00 8.50 9.00 2.50

Expected selling price 10.00 4.50 12.00 10.00 4.00

Cost to complete & dispose 3.00 1.00 2.50 1.50 1.00

Normal profit* 2.00 0.90 2.40 2.00 0.80

*We will assume a normal profit equal to 20% of the selling price

Recall the lower of cost or market (LCM) rule: LCM is the lower of cost or replacement cost, with the replacement cost being no higher than NRV and no lower than NRV minus the normal profit.

Since the replacement cost was given, we will begin by calculating the net realizable value (NRV) of each of the products. Recall that net realizable value is the expected selling price in the ordinary course of business minus the cost to complete and dispose. NRV will be the upper limit (the ceiling) for the replacement cost.

Net Realizable Value (NRV): The Ceiling in LCM

Product: A B C D E

Expected selling price 10.00 4.50 12.00 10.00 4.00

Less: Cost to complete & dispose 3.00 1.00 2.50 1.50 1.00

Net realizable value = CEILING* 7.00 3.50 9.50 8.50 3.00

*If the replacement cost is greater than this ceiling, use this ceiling as the market amount.

Next we will calculate the NRV minus the normal profit. This amount will be the lower limit (the floor) for the replacement cost.

NRV minus the Normal Profit: The Floor in LCM

Product: A B C D E

Net realizable value = CEILING* 7.00 3.50 9.50 8.50 3.00

Less: normal profit (20% of selling price) 2.00 0.90 2.40 2.00 0.80

NRV - normal profit = FLOOR* 5.00 2.60 7.10 6.50 2.20

*If the replacement cost is lower than this floor, use this floor as the market amount.

The following chart displays the four relevant amounts used in the lower of cost or market rule: (1) cost, (2) the upper limit, or ceiling, for the replacement cost, (3) replacement cost, and (4) the lower limit, or floor, for the replacement cost. The lower of cost or market amount appears in bold font:

Product: A B C D E

Cost $ 6.00 $ 5.00 $ 8.00 $ 8.75 $ 2.00

Market information:

NRV (ceiling) 7.00 3.50 9.50 8.50 3.00

Replacement cost 4.50 3.00 8.50 9.00 2.50

NRV - normal profit (floor) 5.00 2.60 7.10 6.50 2.20

Let's review the lower of cost or market for each of the five products shown in the above table:

Product A

Cost vs. Market

$6.00 vs. $7.00 NRV (ceiling)

$5.00 NRV - normal profit (floor)

$4.50 Replacement cost

As you can see, the $4.50 replacement cost is less than the floor of $5.00. Because it is below the floor, the replacement cost cannot be used as the market amount. Instead,the floor of $5.00 is used as the market amount for Product A. The lower of cost or market is $5.00 (the lower of the $6.00 cost vs. the $5.00 market).

Product B

Cost vs. Market

$5.00 vs. $3.50 NRV (ceiling)

$3.00 Replacement cost

$2.60 NRV - normal profit (floor)

The $3.00 replacement cost is between the floor of $2.60 and the ceiling of $3.50. As a result the $3.00 replacement cost is used as the market amount for Product B. The lower of cost or market is $3.00 (the lower of the $5.00 cost vs. the $3.00 market).

Product C

Cost vs. Market

$8.00 vs. $9.50 NRV (ceiling)

$8.50 Replacement cost

$7.10 NRV - normal profit (floor)

The $8.50 replacement cost is between the ceiling of $9.50 and the floor of $7.10. This means the $8.50 replacement cost is the market amount for Product C. However, lower of cost or market is $8.00 (the lower of the $8.00 cost vs. $8.50 market).

Product D

Cost vs. Market

$8.75 vs. $9.00 Replacement cost

$8.50 NRV (ceiling)

$6.50 NRV - normal profit (floor)

The $9.00 replacement cost is above the ceiling of $8.50. Because it is above the ceiling, the replacement cost cannot be used as the market amount. Instead, the ceiling of $8.50 is used as the market amount for Product D. The lower of cost or market is $8.50 (the lower of the $8.75 cost vs. the $8.50 market).

Product E

Cost vs. Market

$2.00 vs. $3.00 NRV (ceiling)

$2.50 Replacement cost

$2.20 NRV - normal profit (floor)

Because the $2.50 replacement cost is between the ceiling of $3.00 and the floor of

$2.20, the $2.50 replacement cost is used as the market amount for Product E. However, the lower of cost or market is $2.00 (the lower of the $2.00 cost vs. the $2.50 market).

Lower of Cost or Market - Quick and Easy

An easy way to apply the lower of cost or market (or to check your calculations) is to arrange the four relevant amounts (cost, replacement cost, NRV, and NRV minus normal profit) in descending order of amount. The third amount is the lower of cost or market, unless cost is lower. (When cost is the fourth amount, the lower of cost or market is the fourth amount.) To illustrate:

Product A's relevant amounts arranged from highest to lowest:

#1 $7.00 NRV

#2 $6.00 Cost

#3 $5.00 NRV - normal profit

#4 $4.50 Replacement Cost

The lower of cost or market is the third amount: $5.00 (since cost is not lower).

Product B's relevant amounts arranged from highest to lowest:

#1 $5.00 Cost

#2 $3.50 NRV

#3 $3.00 Replacement Cost

#4 $2.60 NRV - normal profit

The lower of cost or market is the third amount: $3.00 (since cost is not lower).

Product C's relevant amounts arranged from highest to lowest:

#1 $9.50 NRV

#2 $8.50 Replacement Cost

#3 $8.00 Cost

#4 $7.10 NRV - normal profit

The lower of cost or market is the third amount: $8.00 (since cost is not lower).

Product D's relevant amounts arranged from highest to lowest:

#1 $9.00 Replacement Cost

#2 $8.75 Cost

#3 $8.50 NRV

#4 $6.50 NRV - normal profit

The lower of cost or market is the third amount: $8.50 (since cost is not lower).

Product E's relevant amounts arranged from highest to lowest:

#1 $3.00 NRV

#2 $2.50 Replacement Cost

#3 $2.20 NRV - normal profit

#4 $2.00 Cost

The third amount is $2.20. However, cost is lower. Therefore, the lower of cost or market is $2.00.

To recap this quick and easy approach to finding the lower of cost or market...

1. Arrange the four relevant amounts in descending order.

Applying Lower of Cost or Market To Inventory

2. The lower of cost or market is the third amount, unless cost is lower.

Generally accepted accounting principles allow for the lower of cost or market rule to be applied in one of three ways: (1) on an inventory totals basis, (2) on an inventory categories basis, or (3) on an item-by-item

1. Applying LCM to inventory

basis.

totals is the least

2. Applying LCM to inventory

conservative application since it results in the smallest writedown or reduction of inventory from cost and the smallest loss on the income statement.

categories

3. Applying LCM on an

results in values that fall somewhere in between the other two methods of applying LCM.

item-by-item basis is the most

Let's use the information below to illustrate the three ways of applying LCM:

conservative application since it results in the largest writedown or reduction of inventory from cost and the largest loss on the income statement.

Category Item Number

Units on

Hand

Cost per Unit

Market per

Unit*

Total Cost

Total Market

LCM by Category

LCM Item-

By- Item

A 101 10 $ 4.00 $ 4.10 $ 40 $ 41

$ 40