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Adjustments of Final Accounts

Posted by mbadocs on May 1, 2011

To ensure that the final accounts disclose the true trading results, it is necessary to lake into account the whole of the expenses incurred, whether paid or not, and whole of the losses sustained. Likewise the incomes and gains earned, whether actually received or not, during the period covered by the trading and profit and loss account under consideration must also be recorded.

In mercantile system of accounting, it is essential to adjust different accounts before the preparation of final accounts. It is quite common to adjust expenses paid in advance, incomes received in advance, income accrued but not received, bad debts, provision for bad debts depreciation on assets and soon. Journal entries are passed to effect the required adjustments; these entries are known as adjusting entries.

Usual Adjustments

Outstanding Expenses:

Certain expenses relating to a particular period may not have been paid in that accounting period. All such expenses which are due for payment in one accounting year but actually paid in future accounting years or payment of which is postponed are all outstanding or unpaid expenses. All such expenses must be accounted for in that accounting year in which they are incurred, irrespective of the fact whether they are paid or not. In other words, all paid and also unpaid expenses must be recorded in an accounting year if they relate to that accounting year only with a view to ascertain true trading results e.g. if salaries for the last month are not paid, no entry will appear in books of accounts unless these are paid. So profit and loss account in respect of salaries will thus be under charged than the actual expenditure, therefore the profit will be more.

Prepaid Expenses

The, benefit of some of the expenses already spent will be available in the next accounting year also, Such a portion of the expense is called pre-paid expense; since such expenses are already paid, they are also recorded in the books of accounts of that period to which they do not relate. The result shown by the final accounts of a particular period will not be correct because such expenses relate to future periods. Therefore, such prepaid expenses must be adjusted in the books of accounts to arrive at true profit. Generally insurance, taxes, telephone subscriptions, rent etc. are paid in advance, thus requiring adjustment e.g. Rent paid by x for one year on 1.7.79 when his accounting year is calendar year; thus rent for 6 months will remain unexhausted and will be c/f to the next year.

Accrued Income

There may be certain incomes which have been earned during the year but not yet received till the end of the year. Income like interest on investments, rent and commission etc. are normally earned by merchant during a particular accounting period but actually not received during that period. Such income items need adjustments before the preparation of final accounts. Such incomes should be credited to that particular income account. At the same time the income so -earned but not received is an asset because the amount is still to be received.

Income Received in Advance

Sometimes, traders receive certain amounts during a particular trading period which are to be earned by them in future periods. Such incomes though actually received and therefore, recorded i.e. not yet earned. Such incomes should be credited to the profit and loss account of the year in which these are earned. Therefore, such income though received is not the income but a liability of that period

Closing Stock

It represents the unsold stock at the end of the year. Closing stock is valued and following entry is passed at the end of the year: Closing Stock account To Trading Account Closing stock at the end appears in the balance sheet and is carried forward to the next year. At the end of the next year it appears in the trial balance as opening stock and from there it is taken to debit side of trading account and thus closed.

Depreciation

The value of fixed assets diminishes gradually with their use for business purposes. Although this decrease in the value happens every day but its accounting is done only at the end of accounting period with the help of following entry .Depreciation account To Particulars asset

Interest on Capital

The proprietor may wish to ascertain his profit after considering the interest which he losses by investing his money in the firm. Interest to be charged is an expense for the business on one hand and income to the proprietor on the other hand. Following adjusting entry is recorded at the end of accounting period: Interest on capital a/e To Capital a/c Interest on capital being an expense is debited to profit and loss account and same amount of interest on capital is added to capital.

Interest on Drawings

As business allows interest on capital it also charges interest on drawings made by the proprietor. Interest so charged is an income for the business on one hand and expense for the proprietor on the other hand. Following adjusting entry is passed at the end. of accounting period: Capital ale Dr. To Interest on drawings a/e The interest on drawings being an income is credited to profit and loss account is shown as a deduction from the capital.

Bad Debt to be written off

Bad debts are irrecoverable debts from customers, during the course of the financial year. These are recorded as follows: Bad debts a/c To Sundry Debtors a/c It results in the reduction of customers debit balance and addition to the loss i.e. Bad Debts. At the end of the year when the trial balance is drawn, these two accounts show debit balances. The balance on sundry debtors account, thus arrived, is the net balance, after deduction of any bad debts recorded during the year. But after the trial balance is prepared and before the final accounts are drawn trader may find that there are additional bad debts. Such bad debts must be recorded with the same adjusting entry and giving it following effect in ledger and final accounts.

Provision for Bad Debts

At the end of the year, after writing off the bad debts about whom we were sure of becoming irrecoverable, there may still be some customer balances from whom it is doubtful to collect the entire amount. However, it cant be written off as bad because non-recovery of such amount is not certain. But at the same time the balance in sundry debtors account should be brought down to its net realizable figure so that balance sheet may not exhibit the debtors at more than their actual realizable value. Therefore, to show the approximately correct value of the sundry debtors in the balance sheet a provision or reserve is created for possible bad debts. Such an adjustment entry is recorded at the end of accounting year.

Provision for bad debts is an attempt to anticipate possible losses due to bad debts and to keep aside an amount out of profit to meet the loss estimated in the following years. When the provision for bad debts is created, following entry is recorded:

Profit and Loss A/c Dr. To Provision for bad debts A/c

Some important considerations while creating provision for bad debts

(i) Sundry debtors account should not be credited with the amount of provision for doubtful debts because the loss has not actually been incurred.

(ii) Treatment of bad debts or provision for bad debts appearing inside the trial balance. If some balance (credit) is already appearing in provision for doubtful debts account inside the trial balance, it is the previous years unutilized balance of this account. If some bad debts are also appearing on the debit side of the trial balance, these should be transferred to provision for bad debts account, with the help of following entry: Provision for bad debts a/e To Bad debts a/e. It is important to note that, as these items appear inside the trial balance, so these are to appear only in profit and loss account as debtors have already been reduced during the year.

(iii) When bad debts and provision for bad debts appear in trial balance, new provision is to be created and further bad debts are to be written off. If already bad debts and provision for bad debts are appearing in trial balance, these should be adjusted and only difference should be taken to profit and loss account.

If bad debts written off plus bad debts to be written off plus new provision for bad debts is more than the credit balance of old provision appearing in the trial balance, the difference should be debited to profit and loss account.

Provision for discount on Debtors

It is normal practice in trade to allow discount to customers for prompt payment and it constitutes a substantial sum. Sometimes the goods are sold on credit to customers in one accounting period where as the payment of the same is made by them in the next accounting period and so discount is to be allowed. It is a prudent policy to charge this expenditure to the period in which sales have been made, so a provision is created in the same manner, as in case of provision for doubtful debts

An important point to note is that no discount win be allowed on debts that become bad. Therefore, the provision required for discount will be in respect of the other debts only. So the amount of provision for discount be calculated after deducting the provision for bad debts from sundry debtors.

Provision for discount on creditors

Prompt payment, if made, enables a businessman to receive discount. The question arises whether this discount should be treated as income of the period in which purchases were made or of the period when the payment is made, if both events are in different accounting years, it has been well decided by accountants that it should be treated as income of the period in which purchases are made. So on last date of accounting period if some amount is still payable to creditors, a provision should be created for such probable income and amount should be credited to the profit and loss account of that year in which purchases are made. Following adjusting entry is passed for it .Provision for discount on creditors a/c Dr. To Profit and loss account

Losses by Accidents

Sometimes a business suffers certain losses not because of trading but because of certain accidents. These may destroy some fixed assets of the merchant. In such a case the asset account is credited and the profit and loss account is debited.

If goods (stock-in-trade) are lost by accident the value of closing stock win be lower than otherwise. This will reduce the amount of gross profit. So the cost of goods lost by accident is credited to the trading account and debited to the profit and loss account. The increase -in gross profit will be neutralized by the debit to the profit and loss account and thus the net profit will not be effected. The entries to the passed are as follows: Loss by accident a/c To Goods lost by accident a/c

Commission to manager payable on profits

Sometimes the manager is entitled to a commission on profits.. Such commission may be :

(a) Fixed percentage on net profits before charging such commission.

(b) Fixed percentage on net profits- after charging such commission.

Such commission being an expense is debited to commission account. However, as it has not yet been paid, so commission payable account is given the credit and finally it is shown in the balance sheet as a liability. Calculation of Commission First of all trading account should be prepared in usual manner and after transferring the gross profit or loss all expenses and incomes should be debited or credited except the commission which is still to be calculated.

Goods used in business

Sometimes goods purchased for the purpose of resale are used in business as giving them away for charitable purpose or distributing them as free samples. In these conditions purchases account should be credited with an amount equal to the cost of goods used in business and same amount is debited to charity or advertisement expenses account, as the case may be.

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Rectification Of Accounting Errors

Posted by mbadocs on May 1, 2011

Accountants prepare trial balance to check the correctness of accounts. If total of debit balances does not agree with the total of credit balances, it is a clear-cut indication that certain errors have been committed while recording the transactions in the books of original entry or subsidiary books. It is our utmost duty to locate these errors and rectify them, only then we should proceed for preparing final accounts. We also know that all types of errors are not revealed by trial balance as some of the errors do not effect the total of trial balance. So these cannot be located with the help of trial balance. An accountant should invest his energy to locate both types of errors and rectify them before preparing trading, profit and loss account and balance sheet. Because if these are prepared before rectification these will not give us the correct result and profit and loss disclosed by them, shall not be the actual profit or loss.

All errors of accounting procedure can be classified as follows:

1. Errors of Principle
When a transaction is recorded against the fundamental principles of accounting, it is an error of principle. For example, if revenue expenditure is treated as capital expenditure or vice versa.

2. Clerical Errors
These errors can again be sub-divided as follows:

(i) Errors of omission
When a transaction is either wholly or partially not recorded in the books, it is an error of omission. It may be with regard to omission to enter a transaction in the books of original entry or with regard to omission to post a transaction from the books of original entry to the account concerned in the ledger.

(ii) Errors of commission
When an entry is incorrectly recorded either wholly or partially-incorrect posting, calculation, casting or balancing. Some of the errors of commission effect the trial balance whereas others do not. Errors effecting the trial balance can be revealed by preparing a trial balance.

(iii) Compensating errors
Sometimes an error is counter-balanced by another error in such a way that it is not disclosed by the trial balance. Such errors are called compensating errors.
From the point of view of rectification of the errors, these can be divided into two groups :

(a) Errors affecting one account only, and

(b) Errors affecting two or more accounts.

Errors affecting one account

Errors which affect can be :

(a) Casting errors;

(b) error of posting;

(c) carry forward;

(d) balancing; and

(e) omission from trial balance.

Such errors should, first of all, be located and rectified. These are rectified either with the help of journal entry or by giving an explanatory note in the account concerned.

Rectification

Stages of correction of accounting errors

All types of errors in accounts can be rectified at two stages:

(i) before the preparation of the final accounts; and

(ii) after the preparation of final accounts.

Errors rectified within the accounting period

The proper method of correction of an error is to pass journal entry in such a way that it corrects the mistake that has been committed and also gives effect to the entry that should have been passed. But while errors are being rectified before the preparation of final accounts, in certain cases the correction can’t be done with the help of journal entry because the errors have been such. Normally, the procedure of rectification, if being done, before the preparation of final accounts is as follows:

(a) Correction of errors affecting one side of one account Such errors do not let the trial balance agree as they effect only one side of one account so these can’t be corrected with the help of journal entry, if correction is required before the preparation of final accounts. So required amount is put on debit or credit side of the concerned account, as the case maybe. For example:

(i) Sales book under cast by Rs. 500 in the month of January. The error is only in sales account, in order to correct the sales account, we should record on the credit side of sales account ‘By under casting of. sales book for the month of January Rs. 500″.I’Explanation:As sales book was under cast by Rs. 500, it means all accounts other than sales account are correct, only credit balance of sales account is less by Rs. 500. So Rs. 500 have been credited in sales account.

(ii) Discount allowed to Marshall Rs. 50, not posted to discount account. It means that the amount of Rs. 50 which should have been debited in discount account has not been debited, so the debit side of discount account has been reduced by the same amount. We should debit Rs. 50 in discount account now, which was omitted previously and the discount account shall be corrected.

(iil) Goods sold to X wrongly debited in sales account.
This error is effecting only sales account as the amount which should have been posted on the credit side has been wrongly placed on debit side of the same account.
For rectifying it, we should put double the amount of transaction on the credit side of sales account by writing “By sales to X wrongly debited previously.”

(iv) Amount of Rs. 500 paid to Y, not debited to his personal account. This error of effecting the personal account of Y only and its debit side is less by Rs. 500 because of omission to post the amount paid. We shall now write on its debit side. “To cash (omitted to be posted) Rs. 500.

Correction of errors affecting two sides of two or more accounts

As these errors affect two or more accounts, rectification of such errors, if being done before the preparation of final accounts can often be done with the help of a journal entry. While correcting these errors the amount is debited in one account/accounts whereas similar amount is credited to some other account/ accounts.

Correction of errors in next accounting period

As stated earlier, that it is advisable to locate and rectify the errors before preparing the final accounts for the year. But in certain cases when after considerable search, the accountant fails to locate the errors and he is in a hurry to prepare the final accounts, of the business for filing the return for sales tax or income tax purposes, he transfers the amount of difference of trial balance to a newly opened ‘Suspense Account‘. In the next accounting period, as and when the errors are located these are corrected with reference to suspense account. When all the errors are discovered and rectified the suspense account shall be closed automatically. We should not forget here that only those errors which effect the totals of trial balance can be corrected with the help of suspense account. Those errors which do not effect the trial balance can’t be corrected with the help of suspense account. For example, if it is found that debit total of trial balance was less by Rs. 500 for the reason that Wilson’s account was not debited with Rs. 500, the following rectifying entry is required to be passed.

Difference in trial balance

Trial balance is affected by only errors which are rectified with the help of the suspense account. Therefore, in order to calculate the difference in suspense account a table will be prepared. If the suspense account is debited in’ the rectification entry the amount will be put on the debit side of the table. On the other hand, if the suspense account is credited, the amount will be put on the credit side of the table. In the end, the balance is calculated and is reversed in the suspense account. If the credit side exceeds, the difference would be put on the debit side of the suspense account.
Effect of Errors of Final Accounts

1. Errors effecting profit and loss account

It is important to note the effect that an en-or shall have on net profit of the firm. One point to remember here is that only those accounts which are transferred to trading and profit and loss account at the time of preparation of final accounts effect the net profit. It means that only mistakes in nominal accounts and goods account will effect the net profit. Error in the these accounts will either increase or decrease the net profit.

How the errors or their rectification effect the profit-following rules are helpful in understanding it :

(i) If because of an error a nominal account has been given some debit the profit will decrease or losses will increase, and when it is rectified the profits will increase and the losses will decrease. For example, machinery is overhauled for Rs. 10,000 but the amount debited to machinery repairs account -this error will reduce the profit. In rectifying entry the amount shall be transferred to machinery account from machinery repairs account, and it will increase the profits.

(il) If because of an error the amount is omitted from recording on the debit side of a nominal account-it results in increase of profits or decrease in losses. The rectification of this error shall have reverse effect, which means the profit will be reduced and losses will be increased. For example, rent paid to landlord but the amount has been debited to personal account of landlord-it will increase the profit as the expense on rent is reduced. When the error is rectified, we will post the necessary amount in rent account which will increase the expenditure on rent and so profits will be reduced.

(iil) Profit will increase or losses will decrease if a nominal account is wrongly credited. With the rectification of this error, the profits will decrease and losses will increase. For example, investments were sold and the amount was credited to sales account. This error will increase profits (or reduce losses) when the same error is rectified the amount shall be transferred from sales account to investments account due to which sales will be reduced which will result in decrease in profits (or increase in losses).

(iv) Profit will decrease or losses will increase if an account is omitted from posting in the credit side of a nominal or goods account. When the same will be rectified it will increase the profit or reduce the losses.
For example, commission received is omitted to be posted to the credit of commission account. This error will decrease profits ( or increase losses) as an income is not credited to profit and loss account. When the error will be rectified, it will have reverse effect on profit and loss as an additional income will be credited to profit and loss account so the profit will increase ( or the losses will decrease).
If due to any error the profit or losses are effected, it will have its effect on capital account also because profits are credited and losses are debited in the capital account and so the capital shall also increase or decrease. As capital is shown on the liabilities side of balance sheet so any error in nominal account will effect balance sheet as well. So we can say that an error in nominal account or goods account effects profit and loss account as well as balance sheet.

2. Errors effecting balance sheet only

If an error is committed in a real or personal account, it will effect assets, liabilities, debtors or creditors of the firm and as a result it will have its impact on balance sheet alone. because these items are shown in balance sheet only and balance sheet is prepared after the profit and loss account has been prepared. So if there is any error in cash account, bank account, asset or liability account it will effect only balance sheet.

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Capital and Revenue Expenditure

Posted by mbadocs on May 1, 2011

“Expense is the expired cost, directly or indirectly related to given fiscal period, of the flow of goods or services into the market and of related operations.”

(a) Expenditure incurred during the fiscal period and related to same accounting period becomes an expense i.e. expired cost of that period.

 (b) Expenditure incurred during the previous accounting period but related to current accounting period becomes an expense i.e. expired cost of the current accounting period e.g. prepaid expenses.

 (c) Expenditure related to the current accounting period but not paid becomes outstanding expenses.

Expenditure is usually of two types: (a) Capital expenditure; and (b) Revenue expenditure.

Capital Expenditure

Capital expenditure consists of expenditure, the benefit of which is not fully enjoyed in one accounting period but spread over several accounting periods. It includes assets acquired for the purpose of earning income or increasing the earning capacity of the business or effecting economy in the operation of an asset. These are not meant for sale. Expenditure incurred for improving assets and extending an existing asset is also capital expenditure.

 The sum of invoice price, freight and insurance charges, installation and erection cost and custom duty etc. will be capitalized in the books of a firm. These capital items appear on the assets side of Balance Sheet.

Examples:

(a) Interest on capital paid during the period of construction of Company (u/s 208 of Indian Companies Act)

(b) Expenditure in connection with or incidental to the purchase or installation of an asset.

 (c) Acquisition of new assets.

 (d) Expenditure incurred for putting the old asset purchased, into working condition.

 (e) Additions and extensions to existing assets.

(f) Interest and financing charges paid, brokerage and commission paid.

 (g) Betterment of fixed assets or improvement of an asset to produce more, to improve its earning capacity or to reduce its operating expenses or to increase the life of asset.

The cost of assets will be written off by way of depreciation over a period of its life. The amount of depreciation is a revenue expenditure and is debited to profit and loss account. The reason for charging depreciation to revenue i.e. profit and loss account is that the asset is used for earning revenue. Hence the depreciation is charged to profit and loss account. Thus, the benefit of capital expenditure does not exhaust in one year but extends over a number of years of its use or life of the asset.

 Revenue Expenditure Revenue expenditure consists of expenditure incurred in one period of the accounting, the full benefit of which is enjoyed in that period only. This does not increase the earning capacity of the business but it is incurred in order to maintain the existing earning capacity of the business. It includes all expenses which arise in normal course of business. The benefit of such expenditure is for a short period, say, one year only and it is not to be carried forward to the next year. The expenditure is of a recurring nature i.e. incurred every year.

Examples:

(a) Purchase of raw materials for conversion into finished goods.

(b) Selling and distribution expenses incurred for sale of finished goods e.g. sales office expenses, delivery expenses, advertisement charges, etc..

(c) Establishment expenses like salaries, wages, rent, rates, taxes, insurance, depreciation on office equipment.

(d) Depreciation of plant, machinery and equipment.

 (e) Expenses incurred in order to maintain the existing fixed assets in an efficient and workable state such’ as repairs to building, repairs to plant, white-washing and painting of building.

 All these items appear on the debit side of trading and profit and loss account, in case of trading concerns or income and expenditure account, in case of non-trading concerns.

 Deferred Revenue Expenditure (DRE) Deferred Revenue Expenditure is a revenue expenditure which has been incurred during one accounting year which is applicable either wholly or in part to further accounting years. According to Prof. A.W. Johnson, “Deferred Revenue Expenditure includes those non-recurring expenses, which are expected to be of financial nature, distributed to several accounting periods of indeterminate total length. These are of revenue nature but are deferred or postponed. It is of quasi- capital nature.” In simpler words, we can say that Deferred Revenue Expenses are those expenses, the benefit of which may be extended to a number of years, say, 3 to 5 years. These are to be charged to profit and loss account, over a period of 3 to 5 years depending upon the benefit accrued. Sometimes losses may be suffered of an exceptional nature e.g. loss of an asset (uninsured) due to accident or fire; confiscation of property in a foreign country etc. It is worth noting that the amount which has not been debited to the profit and loss account of the current year is shown in the balance sheet on the assets side and it is known as fictitious asset.

Development expenditure

 In certain units like mines, plantations and housing colonies initially heavy expenditure has to be incurred and it is only after sometime, say three to five years, that the earnings will follow. Such heavy and initial expenditure is known as ‘development expenditure’ and treated as capital expenditure.

 Purpose of Distinction

 Profit and Loss Account is debited with revenue expenditure and credited with revenue income (i.e. sales income and from other sources). If the revenue income is higher than revenue expenditure, it will be a profit and if it is less than revenue expenditure, it will be a loss. Capital expenditure is shown on the assets side of Balance Sheet. Capital and liabilities are shown on the liabilities side of Balance Sheet. The purpose of distinction is to give “True and fair” view of the accounts and financial position of the firm.

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Bank Reconciliation

Posted by mbadocs on April 17, 2011

Bank Reconciliation

Banks usually send customers a monthly statement that shows the account’s beginning balance (the previous statement’s ending balance), all transactions that affect the account’s balance during the month, and the account’s ending balance.

Quantcast

The ending balance on a bank statement almost never agrees with the balance in a company’s corresponding general ledger account. After receiving the bank statement, therefore, the company prepares a bank reconciliation, which identifies each difference between the company’s records and the bank’s records. The normal differences identified in a bank reconciliation will be discussed separately. These differences are referred to as reconciling items. A bank reconciliation begins by showing the bank statement’s ending balance and the company’s balance (book balance) in the cash account on the same date.

Vector Management Group Bank Reconciliation April 30, 20X8

Bank statement balance
$ 8,202 Book balance $ 6,370

Deposits in transit. Most companies make frequent cash deposits. Therefore, company records may show one or more deposits, usually made on the last day included on the bank statement, that do not appear on the bank statement. These deposits are called deposits in transit and cause the bank statement balance to understate the company’s actual cash balance. Since deposits in transit have already been recorded in the company’s books as cash receipts, they must be added to the bank statement balance. The Vector Management Group made a $3,000 deposit on the afternoon of April 30 that does not appear on the statement, so this deposit in transit is added to the bank statement balance.

Vector Management Group Bank Reconciliation April 30, 20X8

Bank statement balance
$8,202 Book balance $6,370
Add: Deposits in transit

Outstanding checks. A check that a company mails to a creditor may take several days to pass through the mail, be processed and deposited by the creditor, and then clear the banking system. Therefore, company records may include a number of checks that do not appear on the bank statement. These checks are called outstanding checks and cause the bank statement balance to overstate the company’s actual cash balance. Since outstanding checks have already been recorded in the company’s books as cash disbursements, they must be subtracted from the bank statement balance.

Vector Management Group Bank Reconciliation April 30, 20X8

Bank statement balance
$8,202 Book balance $6,370
Add: Deposits in transit

Less: Outstanding checks

1552
$1,057
1564 245
1565 108
1570 359
1571 802
Adjusted bank balance

Automatic withdrawals and deposits. Companies may authorize a bank to automatically transfer funds into or out of their account. Automatic withdrawals from the account are used to pay for loans (notes or mortgages payable), monthly utility bills, or other liabilities. Automatic deposits occur when the company’s checking account receives automatic fund transfers from customers or other sources or when the bank collects notes receivable payments on behalf of the company.

Banks use debit memoranda to notify companies about automatic withdrawals, and they use credit memoranda to notify companies about automatic deposits. The names applied to these memoranda may seem confusing at first glance because the company credits (decreases) its cash account upon receiving debit memoranda from the bank, and the company debits (increases) its cash account upon receiving credit memoranda from the bank. To the bank, however, a company’s checking account balance is a liability rather than an asset. Therefore, from the bank’s perspective, the terms debit and credit are correctly applied to the memoranda. If this still seems confusing, you may want to review the chart on page 19 and think about how the company classifies their account as an asset while the bank classifies the company’s account as a liability.

A credit memorandum attached to the Vector Management Group’s bank statement describes the bank’s collection of a $1,500 note receivable along with $90 in interest. The bank deducted $25 for this service, so the automatic deposit was for $1,565. The bank statement also includes a debit memorandum describing a $253 automatic withdrawal for a utility payment. Unlike deposits in transit or outstanding checks, which are already recorded in the company’s books, automatic withdrawals and deposits are often brought to the company’s attention for the first time when the bank statement is received. On the bank reconciliation, add unrecorded automatic deposits to the company’s book balance, and subtract unrecorded automatic withdrawals.

Vector Management Group Bank Reconciliation April 30,20X8

Bank statement balance
$8,202 Book balance $6,370
Add: Deposits in transit Add: Note collection plus interest less bank fee $1,565

Less: Outstanding checks
1552 $1,057
1564 245
1565 108
1570 359
1571 802
1572 1,409 (3,980)
Adjusted bank balance

Because reconciling items that affect the book balance on a bank reconciliation have not been recorded in the company’s books, they must be journalized and posted to the general ledger accounts. The $1,565 credit memorandum requires a compound journal entry involving four accounts. Cash is debited for $1,565, bank fees expense is debited for $25, notes receivable is credited for $1,500, and interest revenue is credited for $90.

If the Vector Management Group had previously made adjusting entries to accrue all of the interest revenue (by debiting interest receivable and crediting interest revenue), then interest receivable rather than interest revenue would need to be credited for $90 in the journal entry shown above.

The automatic withdrawal requires a simple journal entry that debits utilities expense and credits cash for $253.

Interest earned. Banks often pay interest on checking account balances. Interest income reported on the bank statement has usually not been accrued by the company and, therefore, must be added to the company’s book balance on the bank reconciliation. The final transaction listed on the Vector Management Group’s bank statement is for $18 in interest that has not been accrued, so this amount is added to the right side of the following bank reconciliation.

Vector Management Group Bank Reconciliation April 30,20X8

Bank statement balance
$8,202 Book balance $6,370
Add: Deposits in transit Add: Note collection
  plus interest
  less bank fee $1,565
  Interest earned 18

Less: Outstanding checks
1552 $1,057
1564 245
1565 108
1570 359
1571 802
1572 1,409 (3,980)
Adjusted bank balance

The interest revenue must be journalized and posted to the general ledger cash account. In the journal entry below, cash is debited for $18 and interest revenue is credited for $18.

Bank service charges. Banks often require customers to pay monthly account fees, check printing fees, safe-deposit box rental fees, and other fees. Unrecorded service charges must be subtracted from the company’s book balance on the bank reconciliation. The Vector Management Group’s bank statement on page 120 includes a $20 service charge for check printing and a $50 service charge for the rental of a safe-deposit box.

Vector Management Group Bank Reconciliation April 30,20X8

Bank statement balance
$8,202 Book balance $6,370
Add: Deposits in transit Add: Note collection
  plus interest
  less bank fee $1,565
  Interest earned 18

Less: Outstanding checks
1564 245   Safe-deposit box
1565 108   rental 50
1570 359
1571 802
1572 1,409 (3,980)
Adjusted bank balance

Although separate journal entries for each expense can be made, it is simpler to combine them, so bank fees expense is debited for $70 and cash is credited for $70.

NSF (not sufficient funds) checks. A check previously recorded as part of a deposit may bounce because there are not sufficient funds in the issuer’s checking account. When this happens, the bank returns the check to the depositor and deducts the check amount from the depositor’s account Therefore, NSF checks must be subtracted from the company’s book balance on the bank reconciliation. The Vector Management Group’s bank statement includes an NSF check for $345 from Hosta, Inc.

Vector Management Group Bank Reconciliation April 30,20X8

Bank statement balance
$8,202 Book balance $6,370
Add: Deposits in transit Add: Note collection
  plus interest
  less bank fee $1,565
  Interest earned 18

Less: Outstanding checks
1564 245   Safe-deposit box
1565 108   rental 50
1570 359   NSF Hosta, Inc. 345
1571 802
1572 1,409 (3,980)
Adjusted bank balance

Since the NSF check has previously been recorded as a cash receipt, a journal entry is necessary to update the company’s books. Therefore, a $345 debit is made to increase the accounts receivable balance of Hosta, Inc., and a $345 credit is made to decrease cash.

Errors. Companies and banks sometimes make errors. Therefore, each transaction on the bank statement should be double-checked. If the bank incorrectly recorded a transaction, the bank must be contacted, and the bank balance must be adjusted on the bank reconciliation. If the company incorrectly recorded a transaction, the book balance must be adjusted on the bank reconciliation and a correcting entry must be journalized and posted to the general ledger. While reviewing the bank statement, Vector Management Group discovers that check #1569 for $381, which was made payable to an advertising agency named Ad It Up, had been incorrectly entered in the cash disbursements journal for $318. This error is a reconciling item because the company’s general ledger cash account is overstated by $63.

Vector Management Group Bank Reconciliation April 30,20X8

Bank statement balance
$8,202 Book balance $6,370
Add: Deposits in transit Add: Note collection
  plus interest
  less bank fee $1,565
  Interest earned 18

Less: Outstanding checks
1552 $1,057   Check printing 20
1564 245   Safe-deposit box
1565 108   rental 50
1570 359   NSF Hosta, Inc. 345
1571 802   Error check#1569 63 731
1572 1,409 (3,980)
Adjusted bank balance Adjusted book balance

When all differences between the ending bank statement balance and book balance have been identified and entered on the bank reconciliation, the adjusted bank balance and adjusted book balance are identical.

Since the Vector Management Group paid Ad It Up $63 more than the books show, a $63 debit is made to decrease the accounts payable balance owed to Ad It Up, and a $63 credit is made to decrease cash.

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Accrual Basis of Accounting

Posted by mbadocs on April 17, 2011

THE MEANING OF “ECONOMIC” INCOME:  Economists often refer to income as a measure of “better-offness.”  In other words, economic income represents an increase in the command over goods and services.  Such notions of income capture a business’s operating successes, as well as good fortune from holding assets that may increase in value.

THE MEANING OF “ACCOUNTING” INCOME:  Accounting does not attempt to measure all value changes (e.g., land is recorded at its purchase price and that historical cost amount is maintained in the balance sheet, even though market value may increase over time — this is called the “historical cost” principle).  Whether and when accounting should measure changes in value has long been a source of debate among accountants.  Many justify historical cost measurements because they are objective and verifiable.  Others submit that market values, however imprecise, may be more relevant for decision-making purposes.  Suffice it to say that this is a long-running debate, and specific accounting rules are mixed.  For example, although land is measured at historical cost, investment securities are apt to be reported at market value.  There are literally hundreds of specific accounting rules that establish measurement principles; the more you study accounting, the more you will learn about these rules and their underlying rationale.

For introductory purposes, it is necessary to simplify and generalize: thus, accounting (a) measurements tend to be based on historical cost determined by reference to an exchange transaction with another party (such as a purchase or sale) and (b) income represents “revenues” minus “expenses” as determined by reference to those “transactions or events.” 

MORE INCOME TERMINOLOGY:  At the risk of introducing too much too soon, the following definitions may prove helpful:

  • Revenues — Inflows and enhancements from delivery of goods and services that constitute central ongoing operations
  • Expenses — Outflows and obligations arising from the production of goods and services that constitute central ongoing operations
  • Gains — Like revenues, but arising from peripheral transactions and events 
  • Losses — Like expenses, but arising from peripheral transactions and events 

Thus, it may be more precisely said that income is equal to Revenues + Gains – Expenses – Losses.  You should not worry too much about these details for now, but do take note that revenue is not synonymous with income.  And, there is a subtle distinction between revenues and gains (and expenses and losses).

AN EMPHASIS ON TRANSACTIONS AND EVENTS:  Although accounting income will typically focus on recording transactions and events that are exchange based, you should note that some items must be recorded even though there is not an identifiable exchange between the company and some external party.  Can you think of any nonexchange events that logically should be recorded to prepare correct financial statements?  How about the loss of an uninsured building from fire or storm?  Clearly, the asset is gone, so it logically should be removed from the accounting records.  This would be recorded as an immediate loss.  Even more challenging for you may be to consider the journal entry:  debit a loss (losses are increased with debits since they are like expenses), and credit the asset account (the asset is gone and is reduced with a credit).

The periodicity assumption

THE PERIODICITY ASSUMPTION:  Business activity is fluid.  Revenue and expense generating activities are in constant motion.  Just because it is time to turn a page on a calendar does not mean that all business activity ceases.  But, for purposes of measuring performance, it is necessary to “draw a line in the sand of time.”  A periodicity assumption is made that business activity can be divided into measurement intervals, such as months, quarters, and years.  

ACCOUNTING IMPLICATIONS:  Accounting must divide the continuous business process, and produce periodic reports.  An annual reporting period may follow the calendar year by running from January 1 through December 31.  Annual periods are usually further divided into quarterly periods containing activity for three months.

In the alternative, a fiscal year may be adopted, running from any point of beginning to one year later.  Fiscal years often attempt to follow natural business year cycles, such as in the retail business where a fiscal year may end on January 31 (allowing all of the Christmas rush, and corresponding returns, to cycle through).  Note in the following illustration that the “2008 Fiscal Year” is so named because it ends in 2008:

You should also consider that internal reports may be prepared on even more frequent monthly intervals.  As a general rule, the more narrowly defined a reporting period, the more challenging it becomes to capture and measure business activity.  This results because continuous business activity must be divided and apportioned among periods; the more periods, the more likely that “ongoing” transactions must be allocated to more than one reporting period.  Once a measurement period is adopted, the accountant’s task is to apply the various rules and procedures of generally accepted accounting principles (GAAP) to assign revenues and expenses to the reporting period.  This process is called “accrual basis” accounting — accrue  means to come about as a natural growth or increase — thus, accrual basis accounting is reflective of measuring revenues as earned and expenses as incurred.  

The importance of correctly assigning revenues and expenses to time periods is pivotal in the determination of income.  It probably goes without saying that reported income is of great concern to investors and creditors, and its proper determination is crucial.  These measurement issues can become highly complex.  For example, if a software company sells a product for $25,000 (in year 20X1), and agrees to provide updates at no cost to the customer for 20X2 and 20X3, then how much revenue is “earned” in 20X1, 20X2, and 20X3?  Such questions are vexing, and they make accounting far more challenging than most realize.  At this point, suffice it to say that we would need more information about the software company to answer their specific question.  But, there are several basic rules about revenue and expense recognition that you should understand, and they will be introduced in the following sections.

Before moving away from the periodicity assumption, and its accounting implications, there is one important factor for you to note.  If accounting did not require periodic measurement, and instead, took the view that we could report only at the end of a process, measurement would be easy.  For example, if the software company were to report income for the three-year period 20X1 through 20X3, then revenue of $25,000 would be easy to measure.  It is the periodicity assumption that muddies the water.  Why not just wait?  Two reasons:  first, you might wait a long time for activities to close and become measurable with certainty, and second, investors cannot wait long periods of time before learning how a business is doing.  Timeliness of data is critical to its relevance for decision making.  Therefore, procedures and assumptions are needed to produce timely data, and that is why the periodicity assumption is put in play.

basic elements of revenue recognition

REVENUE RECOGNITION:  To recognize an item is to record the item into the accounting records.  Revenue recognition normally occurs at the time services are rendered or when goods are sold and delivered to a customer.  The basic conditions of revenue recognition are to look for both (a) an exchange transaction, and (b) the earnings process being complete.

For a manufactured product, should revenue be recognized when the item rolls off of the assembly line?  The answer is no!  Although production may be complete, the product has not been sold in an exchange transaction.  Both conditions must be met.  In the alternative, if a customer ordered a product that was to be produced, would revenue be recognized at the time of the order?  Again, the answer is no!  For revenue to be recognized, the product must be manufactured and delivered.

Modern business transactions frequently involve complex terms, bundled items (e.g., a cell phone with a service contract), intangibles (e.g. a software user license), order routing (e.g., an online retailer may route an order to the manufacturer for direct shipment), and so forth. It is no wonder that many “accounting failures” involve misapplication of revenue recognition concepts. The USA Securities and Exchange Commission has additional guidance, noting that revenue recognition would normally be appropriate only when there is persuasive evidence of an arrangement, delivery has occurred (or services rendered), the seller’s price is fixed or determinable, and collectibility is reasonably assured.

PAYMENT AND REVENUE RECOGNITION:  It is important to note that receiving payment is not a criterion for initial revenue recognition.  Revenues are recognized at the point of sale, whether that sale is for cash or a receivable.  Recall the earlier definition of revenue (inflows and enhancements from delivery of goods and services), noting that it contemplates something more than simply reflecting cash receipts.  Also recall the study of journal entries from Chapter 2; specifically, you learned to record revenues on account. Much business activity is conducted on credit, and severe misrepresentations of income could result if the focus was simply on cash receipts. To be sure, if collection of a sale was in doubt, allowances would be made in the accounting records. When you study the chapter on accounts receivable you will see how to deal with these issues.

basic elements of expense recognition

EXPENSE RECOGNITION:  Expense recognition will typically follow one of three approaches, depending on the nature of the cost:

  • Associating cause and effect:  Many costs can be directly linked to the revenue they help produce.  For example, a sales commission owed to an employee is directly based on the amount of a sale.  Therefore, the commission expense should be recorded in the same accounting period as the sale.  Likewise, the cost of inventory delivered to a customer should be expensed when the sale is recognized.  This is what is meant by “associating cause and effect,” and is most often referred to as the matching principle.
  • Systematic and rational allocation:  In the absence of a clear link between a cost and revenue item, other expense recognition schemes must be employed.  Some costs benefit many periods.  Stated differently, these costs “expire” over time.  For example, a truck may last many years; determining how much cost is attributable to a particular year is difficult. In such cases, accountants may use a systematic and rational allocation scheme to spread a portion of the total cost to each period of use (in the case of a truck, through a process known as depreciation).
  • Immediate recognition:  Last, some costs cannot be linked to any production of revenue, and do not benefit future periods either.  These costs are recognized immediately.  An example would be severance pay to a fired employee, which would be expensed when the employee is terminated.

PAYMENT AND EXPENSE RECOGNITION:  It is important to note that making payment is not a criterion for initial expense recognition.  Expenses are based on one of the three approaches just described, no matter when payment of the cost occurs.  Recall the earlier definition of expense (outflows and obligations arising from the production of goods and services), noting that it contemplates something more than simply making a cash payment.

the adjusting process and Related entries

ADJUSTMENTS TO PREPARE FINANCIAL STATEMENTS:  In the previous chapter, you saw how tentative financial statements could be prepared directly from a trial balance.  However, you were also cautioned about “adjustments that may be needed to prepare a truly correct and up-to-date set of financial statements.”  This occurs because:

  • MULTI-PERIOD ITEMS:  Some revenue and expense items may relate to more than one accounting period, or
  • ACCRUED ITEMS:  Some revenue and expense items have been earned or incurred in a given period, but not yet entered into the accounts (commonly called accruals).

In other words, the ongoing business activity brings about changes in economic circumstance that have not been captured by a journal entry.  In essence, time brings about change, and an adjusting process is needed to cause the accounts to appropriately reflect those changes.  These adjustments typically occur at the end of each accounting period, and are akin to temporarily cutting off the flow through the business pipeline to take a measurement of what is in the pipeline — consistent with the revenue and expense recognition rules described in the preceding portion of this chapter.

There is simply no way to catalog every potential adjustment that a business may need to make.  What is required is firm understanding of a particular business’s operations, along with a good handle on accounting measurement principles.  The following discussion will describe “typical adjustments” that one would likely encounter.  You should strive to develop a conceptual understanding based on these examples.  Your critical thinking skills will then allow you to extend these basic principles to most any situation you are apt to encounter.  Specifically, the examples will relate to:

PREPAID EXPENSES:  It is quite common to pay for goods and services in advance.  You have probably purchased insurance this way, perhaps prepaying for an annual or semi-annual policy.  Or, rent on a building may be paid ahead of its intended use (e.g., most landlords require monthly rent to be paid at the beginning of each month).  Another example of prepaid expense relates to supplies that are purchased and stored in advance of actually needing them.

At the time of purchase, such prepaid amounts represent future economic benefits that are acquired in exchange for cash payments.  As such, the initial expenditure gives rise to an asset.  As time passes, the asset is diminished.  This means that adjustments are needed to reduce the asset account and transfer the consumption of the asset’s cost to an appropriate expense account.

As a general representation of this process, assume that you prepay $300 on June 1 for three months of lawn mowing service.  As shown in the following illustration, this transaction initially gives rise to a $300 asset on the June 1 balance sheet.  As each month passes, $100 is removed from the balance sheet account and transferred to expense (think: an asset is reduced and expense is increased, giving rise to lower income and equity — and leaving the balance sheet in balance):

Examine the journal entries for this cutting-edge illustration, and take note of the impact on the balance sheet account for Prepaid Mowing (as shown by the T-accounts at right):

Now that you have a general sense of the process of accounting for prepaid items, let’s take a closer look at some specific illustrations.

ILLUSTRATION OF PREPAID INSURANCE:  Insurance policies are usually purchased in advance.  You probably know this from your experience with automobile coverage.  Cash is paid up front to cover a future period of protection.  Assume a three-year insurance policy was purchased on January 1, 20X1, for $9,000.  The following entry would be needed to record the transaction on January 1:

1-1-X1

Prepaid Insurance

9,000

          Cash

9,000

Prepaid a three-year insurance policy for cash

By December 31, 20X1, $3,000 of insurance coverage would have expired (one of three years, or 1/3 of the $9,000). Therefore, an adjusting entry to record expense and reduce prepaid insurance would be needed by the end of the year:

12-31-X1

Insurance Expense

3,000

          Prepaid Insurance

3,000

To adjust prepaid insurance to reflect portion expired ($9,000/3 = $3,000)

As a result of the above entry and adjusting entry, the income statement for 20X1 would report insurance expense of $3,000, and the balance sheet at the end of 20X1 would report prepaid insurance of $6,000 ($9,000 debit less $3,000 credit).  The remaining $6,000 amount would be transferred to expense over the next two years by preparing similar adjusting entries at the end of 20X2 and 20X3.

ILLUSTRATION OF PREPAID RENT:  Assume a two-month lease is entered and rent paid in advance on March 1, 20X1, for $3,000.  The following entry would be needed to record the transaction on March 1:

3-1-X1

Prepaid Rent

3,000

          Cash

3,000

Prepaid a two-month lease

By March 31, 20X1, half of the rental period has lapsed. If financial statements were to be prepared at the end of March, an adjusting entry to record rent expense and reduce prepaid rent would be needed on that financial statement date:

3-31-X1

Rent Expense

1,500

          Prepaid Rent

1,500

To adjust prepaid rent for portion lapsed ($3,000/2 months = $1,500)

As a result of the above entry and adjusting entry, the income statement for March would report rent expense of $1,500, and the balance sheet at March 31, would report prepaid rent of $1,500 ($3,000 debit less $1,500 credit).  The remaining $1,500 prepaid amount would be expensed in April.

I’M A BIT CONFUSED — EXACTLY WHEN DO I ADJUST?:  In the above illustration for insurance, the adjustment was applied at the end of December, but the rent adjustment occurred at the end of March.  What’s the difference?   What was not stated in the first illustration was an assumption that financial statements were only being prepared at the end of the year, in which case the adjustments were only needed at that time.  In the second illustration, it was explicitly stated that financial statements were to be prepared at the end of March, and that necessitated an end of March adjustment.  There is a moral to this:  adjustments should be made every time financial statements are prepared, and the goal of the adjustments is to correctly assign the appropriate amount of expense to the time period in question (leaving the remainder in a balance sheet account to carry over to the next time period(s)).  Every situation will be somewhat unique, and careful analysis and thoughtful consideration must be brought to bear to determine the correct amount of adjustment.  

To extend your understanding of this concept, return to the facts of the prepaid insurance illustration, but assume monthly financial statements were to be prepared.  What adjusting entry would be needed each month? The answer is that every month would require an adjusting entry to remove (credit) an additional $250 from prepaid insurance ($9,000/36 months during the 3-year period = $250 per month), and charge (i.e., debit) insurance expense.  This would be done in lieu of the annual entry reflected above.

ILLUSTRATION OF SUPPLIES:  The initial purchase of supplies is recorded by debiting Supplies and crediting Cash.  Supplies Expense should subsequently be debited and Supplies should be credited for the amount used. This results in supplies expense on the income statement being equal to the amount of supplies used, while the remaining balance of supplies on hand is reported as an asset on the balance sheet.  The following illustrates the purchase of $900 of supplies.  Subsequently, $700 of this amount is used, leaving $200 of supplies on hand in the Supplies account:

The above example is probably not too difficult for you.  So, let’s dig a little deeper, and think about how these numbers would be produced.  Obviously, the $900 purchase of supplies would be traced to a specific transaction.  In all likelihood, the supplies were placed in a designated supply room (like a cabinet, closet, or chest).  Perhaps the storage room has a person “in charge” to make sure that supplies are only issued for legitimate purposes to authorized personnel (a log book may be maintained).  Each time someone withdraws supplies, a journal entry to record expense could be initiated; but, of course, this would be time consuming and costly (you might say that the record keeping cost would exceed the benefit).  Instead, it is more likely that supplies accounting records will only be updated at the end of an accounting period.

To determine the amount of adjustment, one might “back in” to the calculation:  Supplies in the storage room are physically counted at the end of the period (assumed to be $200); since the account has a $900 balance from the December 8 entry, one “backs in” to the $700 adjustment on December 31.  In other words, since $900 of supplies were purchased, but only $200 were left over, then $700 must have been used.

The following year becomes slightly more challenging.  If an additional $1,000 of supplies is purchased during 20X2, and the ending balance at December 31, 20X2, is physically counted at $300, then these entries would be needed:

XX-XX-X2

Supplies

1,000

          Cash

1,000

Purchased supplies for $1,000
12-31-X2

Supplies Expense

900

          Supplies

900

Adjusting entry to reflect supplies used

The $1,000 amount is clear enough, but what about the $900 of expense?  You must take into account that you started 20X2 with a $200 beginning balance (last year’s “leftovers”), purchased an additional $1,000 (giving you total “available” for the period at $1,200), and ended with only $300 of supplies.  Thus, $900 was “used up” during the period:

DEPRECIATION:  Many assets have a very long life.  Examples include buildings and equipment.  These assets will provide productive benefits to a number of accounting periods.  Accounting does not attempt to measure the change in “value” of these assets each period.  Instead, a portion of their cost is simply allocated to each accounting period.  This process is called depreciation.  A subsequent chapter will cover depreciation methods in great detail.  However, one simple approach is called the straight-line method.  Under this method, an equal amount of asset cost is assigned to each year of service life. In other words, the cost of the asset is divided by the years of useful life, resulting in annual depreciation expense.

By way of example, if a $150,000 truck with an 3-year life was purchased on January 1 of Year 1, depreciation expense would be $50,000 ($150,000/3 = $50,000) per year. $50,000 of expense would be reported on the income statement each year for three years.  Each year’s journal entry to record depreciation involves a debit to Depreciation Expense and a credit to Accumulated Depreciation (rather than crediting the asset account directly):

12-31-XX

Depreciation Expense

50,000

          Accumulated Depreciation

50,000

To record annual depreciation expense

Accumulated depreciation is a very unique account.  It is reported on the balance sheet as a contra asset.  A contra account is an account that is subtracted from a related account.  As a result, contra accounts have opposite debit/credit rules from those of the associated accounts.  In other words, accumulated deprecation is increased with a credit, because the associated asset normally has a debit balance.  This topic usually requires additional clarification.  Let’s see how this truck, the related accumulated depreciation, and depreciation expense would appear on the balance sheet and income statement for each year:

As you can see on each year’s balance sheet, the asset continues to be reported at its $150,000 cost.  However, it is also reduced each year by the ever-growing accumulated depreciation.  The asset cost minus accumulated depreciation is known as the “net book value” of the asset.  For example, at December 31, 20X2, the net book value of the truck is $50,000, consisting of $150,000 cost less $100,000 of accumulated depreciation.  By the end of the asset’s life, its cost has been fully depreciated and its net book value has been reduced to zero.  Customarily the asset could then be removed from the accounts, presuming it is then fully used up and retired.

UNEARNED REVENUES:  Often, a business will collect monies in advance of providing goods or services.  For example, a magazine publisher may sell a multi-year subscription and collect the full payment at or near the beginning of the subscription period.  Such payments received in advance are initially recorded as a debit to Cash and a credit to Unearned Revenue.  Unearned revenue is reported as a liability, reflecting the company’s obligation to deliver product in the future.  Remember, revenue cannot be recognized in the income statement until the earnings process is complete.

As goods and services are delivered (e.g., the magazines are delivered), the Unearned Revenue is reduced (debited) and Revenue is increased (credited). The balance sheet at the end of an accounting period would include the remaining unearned revenue for those goods and services not yet delivered.  The rationale for this approach is important to grasp; a liability exists to deliver goods and services in the future and should be reflected in the balance sheet.  Equally important, revenue (on the income statement) should only be reflected as goods and services are actually delivered (in contrast to recognizing them solely at the time of payment).  Unearned Revenue accounts may be found in the balance sheets of many businesses, including software companies (that license software use for multiple periods), funeral homes (that sell preneed funeral agreements), internet service providers (that sell multi-period access agreements), advertising agencies (that sell advertising services in advance), law firms (that require advance “retainer” payments), airlines (that sell tickets in advance), and so on.  Following are illustrative entries for the accounting for unearned revenues:

4-1-X1

Cash

1,200

          Unearned Revenue

1,200

Sold a one-year software license for $1,200
12-31-X1

Unearned Revenue

900

          Revenue

900

Year-end adjusting entry to reflect “earned” portion of software license (9 months at $100 per month)

ACCRUALS:  Another type of adjusting journal entry pertains to the “accrual” of unrecorded expenses and revenues.  Accruals are expenses and revenues that gradually accumulate throughout an accounting period.  Accrued expenses relate to such things as salaries, interest, rent, utilities, and so forth.  Accrued revenues might relate to such events as client services that are based on hours worked.  Because of their importance, several examples follow.

ACCRUED SALARIES:  Few, if any, businesses have daily payroll.  Typically, businesses will pay employees once or twice per month.   Suppose a business has employees that collectively earn $1,000 per day.  The last payday occurred on December 26, as shown in the 20X8 calendar at left below.  Employees worked three days the following week, but would not be paid for this time until January 9, 20X9.  As of the end of the accounting period, the company owes employees $3,000 (pertaining to December 29, 30, and 31).  As a result, the adjusting entry to record the accrued payroll would appear as follows:

12-31-X8

Salaries Expense

3,000

          Salaries Payable

3,000

To record accrued salaries

The above entry records the $3,000 of expense for services rendered by the employees to the company during year 20X8, and establishes the liability for amounts that have accumulated and will be included in the next round of paychecks.

Before moving on to the next topic, you should also consider the entry that will be needed on the next payday (January 9, 20X9).  Suppose the total payroll on that date is $10,000 ($3,000 relating to the prior year (20X8) and another $7,000 for an additional seven days in 20X9).  The journal entry on the actual payday needs to reflect that the $10,000 is partially for expense and partially to extinguish a previously established liability:

1-9-X9

Salaries Expense

7,000

Salaries Payable

3,000

          Cash

10,000

To record payment of payroll relating to two separate accounting periods

You should carefully note that the above process assigns the correct amount of expense to each of the affected accounting years (regardless of the moment of payment).  In other words, $3,000 is expensed in 20X8 and $7,000 is expensed in 20X9.

ACCRUED INTEREST:  Most loans include charges for interest.  Interest charges are usually based on agreed rates, such as 6% per year.  The amount of interest therefore depends on the amount of the borrowing (“principal”), the interest rate (“rate”), and the length of the borrowing period (“time”).  The total amount of interest on a loan is calculated as Principal X Rate X Time.  For example, if $100,000 is borrowed at 6% per year for 18 months, the total interest will amount to $9,000 ($100,000 X 6% X 1.5 years).  However, even if the interest is not payable until the end of the loan, it is still logical and appropriate to “accrue” the interest as time passes.  This is necessary to assign the correct interest cost to each accounting period.  Assume that our 18 month loan was taken out on July 1, 20X1, and was due on December 31, 20X2.  The accounting for the loan on the various dates (assume a December year end, with an appropriate year-end adjusting entry for the accrued interest) would be as follows:

20X1

——————————

7-1-X1

Cash

100,000

          Loan Payable

100,000

To record the borrowing of $100,000 at 6% per annum; principal and interest due on 12-31-X2
12-31-X1

Interest Expense

3,000

          Interest Payable

3,000

To record accrued interest for 6 months ($100,000 X 6% X 6/12)
20X2

——————————

12-31-X2

Interest Expense

6,000

Interest Payable

3,000

Loan Payable

100,000

          Cash

109,000

To record repayment of loan and interest (note that $3,000 of the total interest was previously accrued)

In reviewing the above entries, it is important to note that the loan benefited 20X1 for six months, hence $3,000 of the total interest was expensed in 20X1.  The loan benefited 20X2 for twelve months, and twice as much interest expense was recorded in 20X2.

ACCRUED RENT:  Accrued rent is the opposite of the prepaid rent discussed earlier.  Recall that prepaid rent accounting related to rent that was paid in advance.  In contrast, accrued rent relates to rent that has not yet been paid – but the utilization of the asset has already occurred.  For example, assume that office space is leased, and the terms of the agreement stipulate that rent will be paid within 10 days after the end of each month at the rate of $400 per month.  During December of 20X1, Cabul Company occupied the lease space, and the appropriate adjusting entry for December follows:

12-31-X1

Rent Expense

400

          Rent Payable

400

To record accrued rent

When the rent is paid on January 10, 20X2, this entry would be needed:

1-10-X2

Rent Payable

400

          Cash

400

To record payment of accrued rent

ACCRUED REVENUE:  Many businesses provide services to clients under an understanding that they will be periodically billed for the hours (or other units) of service provided.  For example, an accounting firm may track hours worked on various projects for their clients.  These hours are likely accumulated and billed each month, with the periodic billing occurring in the month following the month in which the service is provided.  As a result, money has been “earned” during a month, even though it won’t be billed until the following month.  Accrual accounting concepts dictate that such revenues be recorded when “earned.”  The following entry would be needed at the end of December to accrue revenue for services rendered to date (even though the physical billing of the client may not occur until January):

12-31-X2

Accounts Receivable

500

         Revenue

500

Year-end adjusting entry to reflect “earned” revenues for services provided in December

RECAP OF ADJUSTMENTS:  The preceding discussion of adjustments has been presented in great detail because it is imperative to grasp the underlying income measurement principles.  Perhaps the single most important element of accounting judgment is to develop an appreciation for the correct measurement of revenues and expenses.  These processes can be fairly straight-forward, as in the above illustrations.  At other times, the measurements can grow very complex.  A business process rarely starts and stops at the beginning and end of a month, quarter or year – yet the accounting process necessarily divides that flowing business process into measurement periods.  And, the adjusting process is all about getting it right; to assign costs and revenues to each period in a proper fashion.

THE ADJUSTED TRIAL BALANCE:  Keep in mind that the trial balance introduced in the previous chapter was prepared before considering adjusting entries. Subsequent to the adjustment process, another trial balance can be prepared. This adjusted trial balance demonstrates the equality of debits and credits after recording adjusting entries.  The adjusted trial balance would look the same as the trial balance, except that all accounts would be updated for the impact of each of the adjusting entries.  Therefore, correct financial statements can be prepared directly from the adjusted trial balance.  The next chapter looks at the adjusted trial balance in detail.

ALTERNATIVE PROCEDURES FOR CERTAIN ADJUSTMENTS:  In accounting, as in life, there is often more than one approach to the same end result.  The mechanics of accounting for prepaid expenses and unearned revenues can be carried out in several ways. No matter which method is employed, the resulting financial statements should be identical.

As an example, recall the illustration of accounting for prepaid insurance — Prepaid Insurance was debited and Cash was credited at the time of purchase.  This is referred to as a “balance sheet approach” because the expenditure was initially recorded into a prepaid account on the balance sheet.  However, an alternative approach is the “income statement approach.”  With this approach, the Expense account is debited at the time of purchase. The appropriate end-of-period adjusting entry “establishes” the Prepaid Expense account with a debit for the amount relating to future periods. The offsetting credit reduces the expense account to an amount equal to the amount consumed during the period.  Review the following comparison, noting in particular that Insurance Expense and Prepaid Insurance accounts have identical balances at December 31 under either approach:

Accounting for unearned revenue can also follow a balance sheet or income statement approach. The balance sheet approach for unearned revenue was presented earlier in this chapter, and is represented at left below.  At right is the income statement approach for the same facts.  Under the income statement approach, the initial receipt is recorded entirely to a Revenue account. Subsequent end-of-period adjusting entries reduce Revenue by the amount not yet earned and increase Unearned Revenue.  As you can see, both approaches produce the same financial statements.

The balance sheet and income statement methods result in identical financial statements.  Notice that the income statement approach does have an advantage if the entire prepaid item or unearned revenue is fully consumed or earned by the end of an accounting period.  No adjusting entry is needed because the expense or revenue was fully recorded at the date of the original transaction.

accrual- versus cash-basis accounting

ACCRUAL-BASIS:  Generally accepted accounting principles (GAAP) require that a business use the “accrual basis.”  Under this method, revenues and expenses are recognized as earned or incurred, utilizing the various principles introduced throughout this chapter.

CASH-BASIS ACCOUNTING:  An alternative method in use by some small businesses is the “cash basis.”  The cash basis is not compliant with GAAP, but a small business that does not have a broad base of shareholders or creditors does not necessarily need to comply with GAAP.  The cash basis is much simpler, but its financial statement results can be very misleading in the short run.  Under this easy approach, revenue is recorded when cash is received (no matter when it is “earned”), and expenses are recognized when paid (no matter when “incurred”).

MODIFIED APPROACHES:  The cash and accrual techniques may be merged together to form a modified cash basis system. The modified cash basis results in revenue and expense recognition as cash is received and disbursed, with the exception of large cash outflows for long-lived assets (which are recorded as assets and depreciated over time).  However, to repeat, proper income measurement and strict compliance with GAAP dictates use of the accrual basis; virtually all large companies use the accrual basis.

ILLUSTRATION OF CASH VERSUS ACCRUAL BASIS OF ACCOUNTING:  Let’s look at an example for Ortiz Company.  Ortiz provides web design services to a number of clients and has been using the cash basis of accounting.  The following spreadsheet is used by Ortiz to keep up with the business’s cash receipts and payments.  This type of spreadsheet is very common for a small business.  The “checkbook” is in green, noting the date, party, check number, check amount, deposit amount, and resulting cash balance.  The deposits are spread to the revenue column (shaded in tan) and the checks are spread to the appropriate expense columns (shaded in yellow).  Note that total cash on hand increased by $15,732.70 (from $7,911.12 to $23,643.82) during the month.

The information from this spreadsheet was used to prepare the following “cash basis” income statement for April, 20X5.  The increase in cash that is evident in the spreadsheet is mirrored as the “cash basis income”:

Ortiz has been approached by Mega Impressions, a much larger web-hosting and design firm.  Mega has offered to buy Ortiz’s business for a price equal to “100 times” the business’s monthly net income, as determined under generally accepted accounting principles.  An accounting firm has been retained to prepare Ortiz’s April income statement under the accrual basis.  The following additional information is gathered in the process of preparing the GAAP-based income statement:

  • Revenues:
    • The $9,000 deposit on April 7 was an advance payment for work to be performed equally during April, May, and June.
    • The $11,788.45 deposit on April 20 was collection of an account for which the work was performed during January and February.
    • During April, services valued at $2,000 were performed and billed, but not yet collected.
  • Expenses:
    • Payroll — The $700 payment on April 3 related $650 to the prior month.  An additional $350 is accrued by the end of April, but not paid.
    • Supplies — The amount paid corresponded to the amount used.
    • Rent — The amount paid corresponded to the amount used.
    • Server — The $1,416.22 payment on April 15 related $500 to prior month’s usage.
    • Admin — An additional $600 is accrued by the end of April, but not paid.

The accounting firm prepared the following accrual basis income statement and corresponding calculations in support of amounts found in the statement:

Although Ortiz was initially very interested in Mega’s offer, he was very disappointed with the resulting accrual-basis net income and decided to reject the deal.  This illustration highlights the important differences between cash- and accrual-basis accounting.  Cash basis statements are significantly influenced by the timing of receipts and payments, and can produce periodic statements that are not reflective of the actual economic activity of the business for the specific period in question.  The accrual basis does a much better job of portraying the results of operations during each time period.  This is why it is very important to grasp the revenue and expense recognition concepts discussed in this chapter, along with the related adjusting entries that may be needed at the end of each accounting period.

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Introduction to Financial Statements

Posted by mbadocs on April 17, 2011

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 external because 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 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 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.
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.

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.

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.

The purpose of financial statements is to provide useful and relevant accounting information in a way that may be understood and which allows users to reliably determine the financial performance and position of the company. In this introductory course I will briefly explain three financial statements found in a company’s annual report- The balance Sheet, The Income Statement, and the Statement of movements in Equity

Balance Sheet: The purpose of the balance sheet is to identify the financial position of the firm at one point in time. Simply speaking it lists the assets, liabilities and equity of a company. Equity is defined as the difference between Assets and Liabilities:

                Equity = Asset – Liability

Example: Prepare a balance sheet given the following information:

-          $5,000 in the bank

-          A house valued at $500,000

-          A mortgage valued at $400,000

-          A car worth $20,000

-          $10,000 owed to your parents

Answer:

Income Statement: Summarises how much money the company has earned in a period. In accounting it is defined as change in net wealth.

Below is an example of an income statement for a retail store:

-          An important note is the difference between “cost of goods sold” and “other expenses”. Broadly speaking cost of goods sold are expenses directly related to the sale of the assets. For a manufacturing company this might be the cost of raw materials and cost of employing people to make the product. By contrast other expenses are general expenses such as rent and insurance.

-          You may have also noticed the brackets in a number of figures. The brackets represent a negative figure or in this case an expense

Statement of Movements in Equity: As the name suggests this statement represents the changes in the value of equity during a period. Common examples of events that will affect this statement include:

-          Profit: After paying debt holders (i.e. after paying interest). The residual funds is given to equity holders

-          Dividends: When a company gives a dividend it is distributing cash to the shareholders. Broadly speaking it is giving back to shareholders part of the profit that the company has earned. It therefore causes a reduction in Equity

-          Issuing shares. When a company issues shares it is basically asking for money from shareholders. When this happens the Equity account increases as there are more shareholders

Example:

-          A company has equity of $1,000,000

-          It makes a Net profit after Tax of $100,000

-          It pays a dividend of $80,000

-          It issues $200,000 in shares

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Accounting Conventions

Posted by mbadocs on April 16, 2011

he term “conventions” includes those customs or traditions which guide the accountants while preparing the accounting statements. The following are the important accounting conventions.

  1. Convention of Disclosure

  2. Convention of Materiality

  3. Convention of Consistency

  4. Convention of Conservatism

Convention of Disclosure:

The disclosure of all significant information is one of the important accounting conventions. It implies that accounts should be prepared in such a way that all material information is clearly disclosed to the reader. The term disclosure does not imply that all information that any one could desire is to be included in accounting statements. The term only implies that there is to a sufficient disclosure of information which is of material in trust to proprietors, present and potential creditors and investors. The idea behind this convention is that any body who want to study the financial statements should not be mislead. He should be able to make a free judgment. The disclosures can be in the way of foot notes. Within the body of financial statements, in the minutes of meeting of directors etc.

Convention of Materiality:

It refers to the relative importance of an item or even. According to this convention only those events or items should be recorded which have a significant bearing and insignificant things should be ignored. This is because otherwise accounting will be unnecessarily over burden with minute details. There is no formula in making a distinction between material and immaterial events. It is a matter of judgment and it is left to the accountant for taking a decision. It should be noted that an item material for one concern may be immaterial for another. Similarly, an item material in one year may not be material in the next year.

Convention of Consistency:

This convention means that accounting practices should remain uncharged from one period to another. For example, if stock is valued at cost or market price whichever is less; this principle should be followed year after year. Similarly, if depreciation is charged on fixed assets according to diminishing balance method, it should be done year after year. This is necessary for the purpose of comparison. However, consistency does not mean inflexibility. It does not forbid introduction of improved accounting techniques. If a change becomes necessary, the change and its effect should be stated clearly.

Convention of Conservatism:

This convention means a caution approach or policy of “play safe”. This convention ensures that uncertainties and risks inherent in business transactions should be given a proper consideration. If there is a possibility of loss, it should be taken into account at the earliest. On the other hand, a prospect of profit should be ignored up to the time it does not materialise. On account of this reason, the accountants follow the rule ‘anticipate no profit but provide for all possible losses’. On account of this convention, the inventory is valued ‘at cost or market price whichever is less.’ The effect of the above is that in case market price has gone down then provide for the ‘anticipated loss’ but if the market price has gone up then ignore the ‘anticipated profits.’ Similarly a provision is made for possible bad and doubtful debt out of current year’s profits.

The theory of accounting has, therefore, developed the concept of a “true and fair view”. The true and fair view is applied in ensuring and assessing whether accounts do indeed portray accurately the business’ activities.

To support the application of the “true and fair view”, accounting has adopted certain concepts and conventions which help to ensure that accounting information is presented accurately and consistently.

Accounting Conventions

The most commonly encountered convention is the “historical cost convention”. This requires transactions to be recorded at the price ruling at the time, and for assets to be valued at their original cost.

Under the “historical cost convention”, therefore, no account is taken of changing prices in the economy.

The other conventions you will encounter in a set of accounts can be summarised as follows:

Monetary measurement Accountants do not account for items unless they can be quantified in monetary terms. Items that are not accounted for (unless someone is prepared to pay something for them) include things like workforce skill, morale, market leadership, brand recognition, quality of management etc.
Separate Entity This convention seeks to ensure that private transactions and matters relating to the owners of a business are segregated from transactions that relate to the business.
Realisation With this convention, accounts recognise transactions (and any profits arising from them) at the point of sale or transfer of legal ownership – rather than just when cash actually changes hands. For example, a company that makes a sale to a customer can recognise that sale when the transaction is legal – at the point of contract. The actual payment due from the customer may not arise until several weeks (or months) later – if the customer has been granted some credit terms.
Materiality An important convention. As we can see from the application of accounting standards and accounting policies, the preparation of accounts involves a high degree of judgement. Where decisions are required about the appropriateness of a particular accounting judgement, the “materiality” convention suggests that this should only be an issue if the judgement is “significant” or “material” to a user of the accounts. The concept of “materiality” is an important issue for auditors of financial accounts.

Accounting Concepts

Four important accounting concepts underpin the preparation of any set of accounts:

Going Concern Accountants assume, unless there is evidence to the contrary, that a company is not going broke. This has important implications for the valuation of assets and liabilities.
Consistency Transactions and valuation methods are treated the same way from year to year, or period to period. Users of accounts can, therefore, make more meaningful comparisons of financial performance from year to year. Where accounting policies are changed, companies are required to disclose this fact and explain the impact of any change.
Prudence Profits are not recognised until a sale has been completed. In addition, a cautious view is taken for future problems and costs of the business (the are “provided for” in the accounts” as soon as their is a reasonable chance that such costs will be incurred in the future.
Matching (or “Accruals”) Income should be properly “matched” with the expenses of a given accounting period.

Key Characteristics of Accounting Information

There is general agreement that, before it can be regarded as useful in satisfying the needs of various user groups, accounting information should satisfy the following criteria:

Criteria What it means for the preparation of accounting information
Understandability This implies the expression, with clarity, of accounting information in such a way that it will be understandable to users – who are generally assumed to have a reasonable knowledge of business and economic activities
Relevance This implies that, to be useful, accounting information must assist a user to form, confirm or maybe revise a view – usually in the context of making a decision (e.g. should I invest, should I lend money to this business? Should I work for this business?)
Consistency This implies consistent treatment of similar items and application of accounting policies
Comparability This implies the ability for users to be able to compare similar companies in the same industry group and to make comparisons of performance over time. Much of the work that goes into setting accounting standards is based around the need for comparability.
Reliability This implies that the accounting information that is presented is truthful, accurate, complete (nothing significant missed out) and capable of being verified (e.g. by a potential investor).
Objectivity This implies that accounting information is prepared and reported in a “neutral” way. In other words, it is not biased towards a particular user group or vested interest

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Accounting Basics

Posted by mbadocs on April 16, 2011

Introduction to Accounting Basics

In commercial enterprises accounting is involved in recording business transactions and then reporting the results in the form of financial statements.

To make the financial statements more understandable, there are some common rules known as generally accepted accounting principles (GAAP). In the USA the lead organization for researching and issuing the accounting rules is the Financial Accounting Standards Board (FASB).

All of the accounting rules are based on some underlying or basic accounting principles such as cost, matching, economic entity, going concern, revenue recognition, full disclosure, materiality, conservatism, and others. Accountants also strive for the financial reporting to be relevant and reliable.

The accounting system is known as double-entry, because every transaction will involve at least two accounts in a company’s general ledger. The accounting system requires that at least one account be debited (amount entered on the left side) and one account be credited (amount entered on the right side).

The accrual basis of accounting provides a better picture of a company’s financial results than the cash basis of accounting. Under the accrual basis of accounting, revenues and assets are reported when they are earned; expenses and liabilities are reported when they are incurred.

The output of the accounting system includes three main financial statements: balance sheet, income statement, and cash flow statement. The balance sheet reports the financial position of a company at a moment in time, such as April 30, 2010. The balance sheet reports a company’s assets, liabilities, and stockholders’ equity. The income statement reports the company’s profitability during a period of time. The statement of cash flows reports the changes in cash during the same period of time. The notes to the financial statements are an integral part of the financial statements.

Debits and Credits
These are the backbone of any accounting system. Understand how debits and credits work and you’ll understand the whole system. Every accounting entry in the general ledger contains both a debit and a credit. Further, all debits must equal all credits. If they don’t, the entry is out of balance. That’s not good. Out-of-balance entries throw your balance sheet out of balance.

Therefore, the accounting system must have a mechanism to ensure that all entries balance. Indeed, most automated accounting systems won’t let you enter an out-of-balance entry-they’ll just beep at you until you fix your error.

Depending on what type of account you are dealing with, a debit or credit will either increase or decrease the account balance. (Here comes the hardest part of accounting for most beginners, so pay attention.) Figure 1 illustrates the entries that increase or decrease each type of account.

Debits and Credits vs. Account Types

Account         Type Debit          Credit
Assets             Increases          Decreases
Liabilities         Decreases          Increases
Income            Decreases          Increases
Expenses         Increases          Decreases

Notice that for every increase in one account, there is an opposite (and equal) decrease in another. That’s what keeps the entry in balance. Also notice that debits always go on the left and credits on the right.

Let’s take a look at two sample entries and try out these debits and credits:

In the first stage of the example we’ll record a credit sale:

Accounts Receivable          $1,000
Sales Income                     $1,000

If you looked at the general ledger right now, you would see that receivables had a balance of $1,000 and income also had a balance of $1,000.

Now we’ll record the collection of the receivable:

Cash                                 $1,000
Accounts Receivable          $1,000

Notice how both parts of each entry balance? See how in the end, the receivables balance is back to zero? That’s as it should be once the balance is paid. The net result is the same as if we conducted the whole transaction in cash:

Cash                     $1,000
Sales Income         $1,000

Of course, there would probably be a period of time between the recording of the receivable and its collection.

That’s it. Accounting doesn’t really get much harder. Everything else is just a variation on the same theme. Make sure you understand debits and credits and how they increase and decrease each type of account.

Assets and Liabilities
Balance sheet accounts are the assets and liabilities. When we set up your chart of accounts, there will be separate sections and numbering schemes for the assets and liabilities that make up the balance sheet.

A quick reminder: Increase assets with a debit and decrease them with a credit. Increase liabilities with a credit and decrease them with a debit.

Identifying assets
Simply stated, assets are those things of value that your company owns. The cash in your bank account is an asset. So is the company car you drive. Assets are the objects, rights and claims owned by and having value for the firm.

Since your company has a right to the future collection of money, accounts receivable are an asset-probably a major asset, at that. The machinery on your production floor is also an asset. If your firm owns real estate or other tangible property, those are considered assets as well. If you were a bank, the loans you make would be considered assets since they represent a right of future collection.

There may also be intangible assets owned by your company. Patents, the exclusive right to use a trademark, and goodwill from the acquisition of another company are such intangible assets. Their value can be somewhat hazy.

Generally, the value of intangible assets is whatever both parties agree to when the assets are created. In the case of a patent, the value is often linked to its development costs. Goodwill is often the difference between the purchase price of a company and the value of the assets acquired (net of accumulated depreciation).

Identifying liabilities
Think of liabilities as the opposite of assets. These are the obligations of one company to another. Accounts payable are liabilities, since they represent your company’s future duty to pay a vendor. So is the loan you took from your bank. If you were a bank, your customer’s deposits would be a liability, since they represent future claims against the bank.

We segregate liabilities into short-term and long-term categories on the balance sheet. This division is nothing more than separating those liabilities scheduled for payment within the next accounting period (usually the next twelve months) from those not to be paid until later. We often separate debt like this. It gives readers a clearer picture of how much the company owes and when.

Owners’ equity
After the liability section in both the chart of accounts and the balance sheet comes owners’ equity. This is the difference between assets and liabilities. Hopefully, it’s positive-assets exceed liabilities and we have a positive owners’ equity. In this section we’ll put in things like

  • Partners’ capital accounts
  • Stock
  • Retained earnings

Another quick reminder: Owners’ equity is increased and decreased just like a liability:

  • Debits decrease
  • Credits increase

Most automated accounting systems require identification of the retained earnings account. Many of them will beep at you if you don’t do so.

By the way, retained earnings are the accumulated profits from prior years. At the end of one accounting year, all the income and expense accounts are netted against one another, and a single number (profit or loss for the year) is moved into the retained earnings account. This is what belongs to the company’s owners-that’s why it’s in the owners’ equity section. The income and expense accounts go to zero. That’s how we’re able to begin the new year with a clean slate against which to track income and expense.

The balance sheet, on the other hand, does not get zeroed out at year-end. The balance in each asset, liability, and owners’ equity account rolls into the next year. So the ending balance of one year becomes the beginning balance of the next.

Think of the balance sheet as today’s snapshot of the assets and liabilities the company has acquired since the first day of business. The income statement, in contrast, is a summation of the income and expenses from the first day of this accounting period (probably from the beginning of this fiscal year).

Income and Expenses
Further down in the chart of accounts (usually after the owners’ equity section) come the income and expense accounts. Most companies want to keep track of just where they get income and where it goes, and these accounts tell you.

A final reminder: For income accounts, use credits to increase them and debits to decrease them. For expense accounts, use debits to increase them and credits to decrease them.

Income accounts
If you have several lines of business, you’ll probably want to establish an income account for each. In that way, you can identify exactly where your income is coming from. Adding them together yields total revenue.

Typical income accounts would be

  • Sales revenue from product A
  • Sales revenue from product B (and so on for each product you want to track)
  • Interest income
  • Income from sale of assets
  • Consulting income

Most companies have only a few income accounts. That’s really the way you want it. Too many accounts are a burden for the accounting department and probably don’t tell management what it wants to know. Nevertheless, if there’s a source of income you want to track, create an account for it in the chart of accounts and use it.

Expense accounts
Most companies have a separate account for each type of expense they incur. Your company probably incurs pretty much the same expenses month after month, so once they are established, the expense accounts won’t vary much from month to month. Typical expense accounts include

  • Salaries and wages
  • Telephone
  • Electric utilities
  • Repairs
  • Maintenance
  • Depreciation
  • Amortization
  • Interest
  • Rent

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