ACCT 301: FINANCIAL

ACCOUNTING (BLACK)
ACCT 301: Financial Accounting (Black)
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TABLE OF CONTENTS
Licensing

1: Rules of the Game

1.1: Accounting is the Language of Business
1.2: Internal and External Users
1.3: Users of Accounting Information
1.4: Ethics in Accounting
1.5: Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements

2: Business Transactions
2.1: Reviewing and Analyzing Transactions
2.2: Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
2.3: Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
2.4: General Rules for Debits and Credits
2.5: Debit and Credit Review

3: The Accounting System

3.1: Define and Describe the Components of an Accounting Information System
3.2: Define and Describe the Initial Steps in the Accounting Cycle
3.3: Use Journal Entries to Record Transactions and Post to T-Accounts
3.4: Prepare a Trial Balance
3.5: Preparing Financial Statements

4: Adjusting Journal Entries (AJE's)

4.1: Explain the Concepts and Guidelines Affecting Adjusting Entries
4.2: Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
4.3: Record and Post the Common Types of Adjusting Entries
4.4: Use the Ledger Balances to Prepare an Adjusted Trial Balance
4.5: Prepare Financial Statements Using the Adjusted Trial Balance
4.6: Describe and Prepare Closing Entries for a Business
4.7: Prepare a Post-Closing Trial Balance

5: Merchandising
5.1: Compare and Contrast Merchandising versus Service Activities and Transactions
5.2: Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
5.3: Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
5.4: Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods

6: Inventory
6.1: Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
6.2: Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method

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7: Bad Debt
7.1: Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches

8: Internal Controls
8.1: Analyze Fraud in the Accounting Workplace
8.2: Define and Explain Internal Controls and Their Purpose within an Organization
8.3: Describe Internal Controls within an Organization
8.4: Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
8.5: Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements

9: Fixed Assets
9.1: Long Term Assets
9.2: Entries for Cash and Lump-Sum Purchases of Property, Plant and Equipment
9.3: Analyze and Classify Capitalized Costs versus Expenses
9.4: Explain and Apply Depreciation Methods to Allocate Capitalized Costs
9.5: Describe Some Special Issues in Accounting for Long-Term Assets

10: Intangible Assets

10.1: Distinguish between Tangible and Intangible Assets
10.2: Describe Accounting for Intangible Assets and Record Related Transactions

11: Current Liabilities

11.1: Identify and Describe Current Liabilities
11.2: Analyze, Journalize, and Report Current Liabilities
11.3: Define and Apply Accounting Treatment for Contingent Liabilities
11.4: Prepare Journal Entries to Record Short-Term Notes Payable

12: Bonds Payable

12.1: Comparison Between Equity and Debt Financing
12.2: Explain the Pricing of Long-Term Liabilities
12.3: Recording Entries for Bonds
12.4: Explain the Pricing of Long-Term Liabilities
12.5: Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
12.6: Prepare Journal Entries to Reflect the Life Cycle of Bonds

13: Equity
13.1: Types of Businesses and Business Activities
13.2: Explain the Process of Securing Equity Financing through the Issuance of Stock
13.3: Analyze and Record Transactions for the Issuance and Repurchase of Stock
13.4: Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock
Dividends, and Stock Splits
13.5: Compare and Contrast Owners’ Equity versus Retained Earnings

14: Statement of Cash Flows

14.1: Explain the Purpose of the Statement of Cash Flows
14.2: Differentiate between Operating, Investing, and Financing Activities
14.3: Prepare the Statement of Cash Flows Using the Indirect Method
14.4: Prepare the Completed Statement of Cash Flows Using the Indirect Method

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15: Financial Statement Analysis
15.1: Analyzing Comparative Financial Statements
15.2: Common-Size Financial Statements
15.3: Calculate Ratios That Analyze a Company’s Short-Term Debt-Paying Ability
15.4: Ratio Analysis
15.5: Time Value of Money

Index
Glossary

Glossary
Detailed Licensing

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Licensing
A detailed breakdown of this resource's licensing can be found in Back Matter/Detailed Licensing.

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 CHAPTER OVERVIEW

1: Rules of the Game

Learning Objectives
Explain the nature and purpose of United States generally accepted accounting principles (USGAAP) and International
Financial Reporting Standards (IFRS)
Explain and apply the components of the conceptual framework for financial accounting and reporting, including:
The qualitative characteristics of accounting information
The assumptions underlying accounting
The basic principles of financial accounting
The constraints and limitations on accounting information
Define and use accounting and business terminology

1.1: Accounting is the Language of Business

1.2: Internal and External Users
1.3: Users of Accounting Information
1.4: Ethics in Accounting
1.5: Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements

1: Rules of the Game is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

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1.1: Accounting is the Language of Business
Accounting is the Language of Business
Every profit-seeking business organization that has economic resources, such as money, machinery, and buildings, uses accounting
information. For this reason, accounting is called the language of business. Accounting also serves as the language providing
financial information about not-for-profit organizations such as governments, churches, charities, fraternities, and hospitals.
However, these entities are not businesses because they do not operate in a for-profit manner. In this textbook, we will focus on
accounting for business firms.
The accounting process provides financial data for a broad range of individuals whose objectives in studying the data vary widely.
Bank officials, for example, may study a company’s financial statements to evaluate the company’s ability to repay a loan.
Prospective investors may compare accounting data from several companies to decide which company represents the best
investment. Accounting also supplies management with significant financial data useful for decision making.
Financial accounting information appears in financial statements that are intended primarily for external use (although
management also uses them for certain internal decisions). Stockholders and creditors are two of the outside parties who need
financial accounting information. These outside parties decide on matters pertaining to the entire company, such as whether to
increase or decrease their investment in a company or to extend credit to a company. Consequently, financial accounting
information relates to the company as a whole, while managerial accounting focuses on the parts or segments of the company.
Managerial accounting information is for internal use and provides special information for the managers of a company. The
information managers use may range from broad, long-range planning data to detailed explanations of why actual costs varied from
cost estimates. Management accountants in a company prepare the financial statements. Thus, management accountants must be
knowledgeable concerning financial accounting and reporting. The financial statements are the representations of management, not
the CPA firm that performs the audit.

1.1: Accounting is the Language of Business is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

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1.2: Internal and External Users
Internal and External Users
Users of accounting information are separated into two groups, internal and external. Internal users are the people within a business
organization who use accounting information. External users are people outside the business entity that use accounting information.
Accounting information is valuable because decision-makers both internally and externally can use it to evaluate the financial
consequences of various alternatives. Accountants reduce uncertainty by using professional judgment to quantify the future
financial impact of taking action or delaying action. Although accounting information plays a significant role in reducing
uncertainty within an organization, it also provides financial data for persons outside the company.

1.2: Internal and External Users is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1.2.1 [Link]
1.3: Users of Accounting Information
Users of Accounting Information
The accounting process provides financial data for a broad range of individuals whose objectives in studying the data vary widely.
Three primary users of accounting information were previously identified, internal users, external users, and government/IRS. Each
group uses accounting information differently and requires the information to be presented differently.

Internal Users
Accounting supplies managers and owners with significant financial data that is useful for decision making. This type of
accounting is generally referred to as managerial accounting.
Some of the ways internal users employ accounting information include the following:
Assessing how management has discharged its responsibility for protecting and managing the company’s resources
Shaping decisions about when to borrow or invest company resources
Shaping decisions about expansion or downsizing

External Users
Typically called financial accounting, the record of a business’ financial history for use by external entities is used for many
purposes. The external users of accounting information fall into six groups; each has different interests in the company and wants
answers to unique questions. The groups and some of their possible questions are:
Owners and prospective owners. Has the company earned satisfactory income on its total investment? Should an investment
be made in this company? Should the present investment be increased, decreased, or retained at the same level? Can the
company install costly pollution control equipment and still be profitable?
Creditors and lenders. Should a loan be granted to the company? Will the company be able to pay its debts as they become
due?
Employees and their unions. Does the company have the ability to pay increased wages? Is the company financially able to
provide long-term employment for its workforce?
Customers. Does the company offer useful products at fair prices? Will the company survive long enough to honor its product
warranties?
Governmental units. Is the company, such as a local public utility, charging a fair rate for its services?
General public. Is the company providing useful products and gainful employment for citizens without causing serious
environmental problems?
Some of the ways external users employ accounting information include the following:
Stockholders have the right to know how a company is managing its investments
Federal and State Governments require tax returns and other documents often prepared by accountants
Banks or lending institutions may use accounting information to guide decisions such as whether to lend or how much to lend a
business
Investors will also use accounting information to guide investment decisions
General-purpose financial statements provide much of the information needed by external users of financial accounting. These
financial statements are formal reports providing information on a company’s financial position, cash inflows and outflows, and the
results of operations. Many companies publish these statements in annual reports, also known as a 10-K or a 10-Q (quarterly
report). The annual report contains the independent auditor’s opinion as to the fairness of the financial statements, as well as
information about the company’s activities, products, and plans. Typically, the best place to find these reports for a public company
can be on their website under the Investor relations section. Financial statements used by external entities are prepared using
generally accepted accounting principles, or GAAP. We will discuss the language of GAAP further in later sections.

Government/IRS
Government agencies that track and use taxes are interested in the financial story of a business. They want to know whether the
business is paying taxes according to current tax laws. The language in which tax-related financial statements are prepared is called
IRC or Internal Revenue Code. Tax preparation will be outside the scope of this course.

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Important Points to Remember
Internal users are people within a business organization who use financial information. Examples of internal users are owners,
managers, and employees.
External users are people outside the business entity (organization) who use accounting information. Examples of external
users are suppliers, banks, customers, investors, potential investors, and tax authorities.

1.3: Users of Accounting Information is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1.3.2 [Link]
1.4: Ethics in Accounting
Ethics in Accounting
Most of those who write about ethics do not make a clear distinction between ethics and morality. The question of what is “right”
or “morally correct” or “ethically correct” or “morally desirable” in any situation is variously phrased, but all of the words and
phrases are after the same thing: what act is “better” in a moral or ethical sense than some other act? People sometimes speak of
morality as something personal but view ethics as having wider social implications. Others see morality as the subject of a field of
study, that field being ethics. Ethics would be morality as applied to any number of subjects, including journalistic ethics, business
ethics, or the ethics of professionals such as doctors, attorneys, and accountants. We will venture a definition of ethics, but for our
purposes, ethics and morality will be used as equivalent terms.
People often speak about the ethics or morality of individuals and also about the morality or ethics of businesses. There are clearly
differences in the kind of moral responsibility that we can fairly ascribe to businesses and accountants; we tend to see individuals
as having a soul, or at least a conscience, but there is no general agreement that businesses have either. Still, our ordinary use of
language does point to something significant: if we say that some businesses are “evil” and others are “corrupt,” then we make
moral judgments about the quality of actions undertaken by the business. For example, if we conclude that WorldCom or Enron
acted “unethically” in certain respects, then we are making judgments that their collective actions are morally deficient.

Why Should a Business or Accountant Be Ethical?

The usual answer is that good ethics is good business. In the long run, businesses that pay attention to ethics do better; they are
viewed more favorably by customers. But this is a difficult claim to measure scientifically, because “the long run” is an indistinct
period of time and because there are as yet no generally accepted criteria by which ethical excellence can be measured. In addition,
life is still lived in the short run, and there are many occasions when something short of perfect conduct is a lot more profitable.
Several accounting organizations have codes of ethics governing the behavior of their members. For instance, both the American
Institute of Certified Public Accountants and the Institute of Management Accountants have formulated such codes. It is important
to maintain ethical behavior both personally and professionally in business, therefore many business firms have also developed
codes of ethics for their employees to follow.
Ethical behavior involves more than merely making sure you are not violating a code of ethics. Most of us sense what is right and
wrong. Yet get-rich-quick opportunities can tempt many of us. Almost any day, newspaper headlines reveal public officials and
business leaders who did not do the right thing. Greed won out over their sense of right and wrong. These individuals followed
slogans such as: “Get yours while the getting is good”; “Do unto others before they do unto you”; and “You have done wrong only
if you get caught”. More appropriate slogans might be: “If it seems too good to be true, it usually is”; “There are no free lunches”;
and the golden rule, “Do unto others as you would have them do unto you”.
An accountant’s most valuable asset is an honest reputation. Those who take the high road of ethical behavior receive praise and
honor; they are sought out for their advice and services. They also like themselves and what they represent. Occasionally,
accountants do take the low road and suffer the consequences. They sometimes find their names mentioned in The Wall Street
Journal and news programs in an unfavorable light, and former friends and colleagues look down on them. Some of these
individuals are removed from the profession. Fortunately, the accounting profession has many leaders who have taken the high
road, gained the respect of friends and colleagues, and become role models for all of us to follow.

Case Study: The Sarbanes-Oxley Act

Sarbanes–Oxley was named after sponsors U.S. Senator Paul Sarbanes and U.S. Representative Michael G. Oxley. As a result of
SOX, top management must individually certify the accuracy of financial information. In addition, penalties for fraudulent
financial activity are much more severe. Also, SOX increased the oversight role of boards of directors and the independence of the
outside auditors who review the accuracy of corporate financial statements.
The bill, which contains eleven sections, was enacted as a reaction to a number of major corporate and accounting scandals,
including those affecting Enron, Tyco International, Adelphia, Peregrine Systems, and WorldCom. These scandals cost investors
billions of dollars when the share prices of affected companies collapsed and shook public confidence in the US securities markets.
The act contains eleven titles, or sections, ranging from additional corporate board responsibilities to criminal penalties, and
requires the Securities and Exchange Commission (SEC) to implement rulings on requirements to comply with the law. “The

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mission of the SEC is to protect investors, maintain fair orderly, and efficient markets, and facilitate capital formation.”[1]
Harvey Pitt, the 26th chairman of the SEC, led the SEC in the adoption of dozens of rules to implement the Sarbanes–Oxley Act. It
created a new, quasi-public agency, the Public Company Accounting Oversight Board, or PCAOB, charged with overseeing,
regulating, inspecting, and disciplining accounting firms in their roles as auditors of public companies. The act also covers issues
such as auditor independence, corporate governance, internal control assessment, and enhanced financial disclosure. The nonprofit
arm of Financial Executives International (FEI), Financial Executives Research Foundation (FERF), completed extensive research
studies to help support the foundations of the act.
Debate continued as of 2007 over the perceived benefits and costs of SOX. Opponents of the bill have claimed it has reduced
America’s international competitive edge against foreign financial service providers because it has introduced an overly complex
regulatory environment into US financial markets. A study commissioned by NYC Mayor Michael Bloomberg and US Sen.
Charles Schumer cited this as one reason America’s financial sector is losing market share to other financial centers worldwide.
Proponents of the measure said that SOX has been a “godsend” for improving the confidence of fund managers and other investors
with regard to the veracity of corporate financial statements.
This information about the Sarbanes-Oxley Act was taken from Wikipedia, where you can learn more about it if you are interested.

Important Points to Remember

Business ethics can be described as a set of moral behaviors that influence principles within a business or organizational
environment.
The Sarbanes-Oxley Act was created to prevent and limit corporate accounting scandals after Enron financial crimes were
revealed in 2001

1. The US Securities and Exchange Commission, [Link]

1.4: Ethics in Accounting is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1.4.2 [Link]
1.5: Describe Principles, Assumptions, and Concepts of Accounting and Their
Relationship to Financial Statements
Accounting Principles, Assumptions, and Concepts
The Financial Accounting Standards Board (FASB) is an independent, nonprofit organization that sets the standards for financial
accounting and reporting, including generally accepted accounting principles (GAAP), for both public- and private-sector
businesses in the United States.
GAAP are the concepts, standards, and rules that guide the preparation and presentation of financial statements. If US accounting
rules are followed, the accounting rules are called US GAAP. International accounting rules are called International Financial
Reporting Standards (IFRS). Publicly traded companies (those that offer their shares for sale on exchanges in the United States)
have the reporting of their financial operations regulated by the Securities and Exchange Commission (SEC).
The SEC is an independent federal agency that is charged with protecting the interests of investors, regulating stock markets, and
ensuring companies adhere to GAAP requirements. By having proper accounting standards such as US GAAP or IFRS,
information presented publicly is considered comparable and reliable. As a result, financial statement users are more informed
when making decisions. The SEC not only enforces the accounting rules but also delegates the process of setting standards for US
GAAP to the FASB.
Some companies that operate on a global scale may be able to report their financial statements using IFRS. The SEC regulates the
financial reporting of companies selling their shares in the United States, whether US GAAP or IFRS are used. The basics of
accounting discussed in this chapter are the same under either set of guidelines.

Ethical Considerations: Auditing of Publicly Traded Companies

When a publicly-traded company in the United States issues its financial statements, the financial statements have been audited
by a Public Company Accounting Oversight Board (PCAOB) approved auditor. The PCAOB is the organization that sets the
auditing standards, after approval by the SEC. It is important to remember that auditing is not the same as accounting. The role
of the Auditor is to examine and provide assurance that financial statements are reasonably stated under the rules of
appropriate accounting principles. The auditor conducts the audit under a set of standards known as Generally Accepted
Auditing Standards. The accounting department of a company and its auditors are employees of two different companies. The
auditors of a company are required to be employed by a different company so that there is independence.
The nonprofit Center for Audit Quality explains auditor independence: “Auditors’ independence from company management is
essential for a successful audit because it enables them to approach the audit with the necessary professional skepticism.”1 The
center goes on to identify a key practice to protect independence by which an external auditor reports not to a company’s
management, which could make it more difficult to maintain independence, but to a company’s audit committee. The audit
committee oversees the auditors’ work and monitors disagreements between management and the auditor about financial
reporting. Internal auditors of a company are not the auditors that provide an opinion on the financial statements of a company.
According to the Center for Audit Quality, “By law, public companies’ annual financial statements are audited each year by
independent auditors—accountants who examine the data for conformity with U.S. Generally Accepted Accounting Principles
(GAAP).”2 The opinion from the independent auditors regarding a publicly-traded company is filed for public inspection,
along with the financial statements of the publicly-traded company.

The Conceptual Framework

The FASB uses a conceptual framework, which is a set of concepts that guide financial reporting. These concepts can help ensure
information is comparable and reliable to stakeholders. Guidance may be given on how to report transactions, measurement
requirements, and application on financial statements, among other things.3
The conceptual framework sets the basis for accounting standards set by rule-making bodies that govern how the financial
statements are prepared. Here are a few of the principles, assumptions, and concepts that provide guidance in developing GAAP.

Revenue Recognition Principle

The revenue recognition principle directs a company to recognize revenue in the period in which it is earned; revenue is not
considered earned until a product or service has been provided. This means the period of time in which you performed the service

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or gave the customer the product is the period in which revenue is recognized.
There also does not have to be a correlation between when cash is collected and when revenue is recognized. A customer may not
pay for the service on the day it was provided. Even though the customer has not yet paid cash, there is a reasonable expectation
that the customer will pay in the future. Since the company has provided the service, it would recognize the revenue as earned,
even though cash has yet to be collected.
For example, Lynn Sanders owns a small printing company, Printing Plus. She completed a print job for a customer on August 10.
The customer did not pay cash for the service at that time and was billed for the service, paying at a later date. When should Lynn
recognize the revenue, on August 10 or at the later payment date? Lynn should record revenue as earned on August 10. She
provided the service to the customer, and there is a reasonable expectation that the customer will pay at the later date.

Expense Recognition (Matching) Principle

The expense recognition principle (also referred to as the matching principle) states that we must match expenses with associated
revenues in the period in which the revenues were earned. A mismatch in expenses and revenues could be an understated net
income in one period with an overstated net income in another period. There would be no reliability in statements if expenses were
recorded separately from the revenues generated.
For example, if Lynn earned printing revenue in April, then any associated expenses to the revenue generation (such as paying an
employee) should be recorded on the same income statement. The employee worked for Lynn in April, helping her earn revenue in
April, so Lynn must match the expense with the revenue by showing both on the April income statement.

Cost Principle
The cost principle, also known as the historical cost principle, states that virtually everything the company owns or controls
(assets) must be recorded at its value at the date of acquisition. For most assets, this value is easy to determine as it is the price
agreed to when buying the asset from the vendor. There are some exceptions to this rule but always apply the cost principle unless
FASB has specifically stated that a different valuation method should be used in a given circumstance.
The primary exceptions to this historical cost treatment, at this time, are financial instruments, such as stocks and bonds, which
might be recorded at their fair market value. This is called mark-to-market accounting or fair value accounting and is more
advanced than the general basic concepts underlying the introduction to basic accounting concepts; therefore, it is addressed in
more advanced accounting courses.
Once an asset is recorded on the books, the value of that asset must remain at its historical cost, even if its value in the market
changes. For example, Lynn Sanders purchases a piece of equipment for $40,000. She believes this is a bargain and perceives the
value to be more at $60,000 in the current market. Even though Lynn feels the equipment is worth $60,000, she may only record
the cost she paid for the equipment of $40,000.

Full Disclosure Principle

The full disclosure principle states that a business must report any business activities that could affect what is reported on the
financial statements. These activities could be nonfinancial in nature or be supplemental details not readily available on the main
financial statement. Some examples of this include any pending litigation, acquisition information, methods used to calculate
certain figures, or stock options. These disclosures are usually recorded in footnotes on the statements, or in addenda to the
statements.

Separate Entity Concept

The separate entity concept prescribes that a business may only report activities on financial statements that are specifically
related to company operations, not those activities that affect the owner personally. This concept is called the separate entity
concept because the business is considered an entity separate and apart from its owner(s).
For example, Lynn Sanders purchases two cars; one is used for personal use only, and the other is used for business use only.
According to the separate entity concept, Lynn may record the purchase of the car used by the company in the company’s
accounting records, but not the car for personal use.

Conservatism
This concept is important when valuing a transaction for which the dollar value cannot be as clearly determined, as when using the
cost principle. Conservatism states that if there is uncertainty in a potential financial estimate, a company should err on the side of

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caution and report the most conservative amount. This would mean that any uncertain or estimated expenses/losses should be
recorded, but uncertain or estimated revenues/gains should not. This understates net income, therefore reducing profit. This gives
stakeholders a more reliable view of the company’s financial position and does not overstate income.

Monetary Measurement Concept

In order to record a transaction, we need a system of monetary measurement or a monetary unit by which to value the transaction.
In the United States, this monetary unit is the US dollar. Without a dollar amount, it would be impossible to record information in
the financial records. It also would leave stakeholders unable to make financial decisions, because there is no comparability
measurement between companies. This concept ignores any change in the purchasing power of the dollar due to inflation.

Going Concern Assumption

The going concern assumption assumes a business will continue to operate in the foreseeable future. A common time frame might
be twelve months. However, one should presume the business is doing well enough to continue operations unless there is evidence
to the contrary. For example, a business might have certain expenses that are paid off (or reduced) over several time periods. If the
business will stay operational in the foreseeable future, the company can continue to recognize these long-term expenses over
several time periods. Some red flags that a business may no longer be a going concern are defaults on loans or a sequence of losses.

Time Period Assumption

The time period assumption states that a company can present useful information in shorter time periods, such as years, quarters,
or months. The information is broken into time frames to make comparisons and evaluations easier. The information will be timely
and current and will give a meaningful picture of how the company is operating.
For example, a school year is broken down into semesters or quarters. After each semester or quarter, your grade point average
(GPA) is updated with new information on your performance in the classes you completed. This gives you timely grading
information with which to make decisions about your schooling.
A potential or existing investor wants timely information by which to measure the performance of the company and to help decide
whether to invest. Because of the time period assumption, we need to be sure to recognize revenues and expenses in the proper
period. This might mean allocating costs over more than one accounting or reporting period.
The use of the principles, assumptions, and concepts in relation to the preparation of financial statements is better understood when
looking at the full accounting cycle and its relation to the detailed process required to record business activities (Figure 1.5.1).

Figure 1.5.1 : GAAP Accounting Standards Connection Tree. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-
SA 4.0 license)

The Accounting Equation

The accounting equation is important to the study of accounting because it shows what the organization owns and the sources of (or
claims against) those resources. The accounting equation is expressed as follows:

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The accounting equation can be thought of from a “sources and claims” perspective; that is, the assets (items owned by the
organization) were obtained by incurring liabilities or were provided by owners. Stated differently, everything a company owns
must equal everything the company owes to creditors (lenders) and owners (individuals for sole proprietors or stockholders for
companies or corporations).
You may recall from mathematics courses that an equation must always be in balance. Therefore, we must ensure that the two sides
of the accounting equation are always equal. We explore the components of the accounting equation in more detail shortly. First,
we need to examine several underlying concepts that form the foundation for the accounting equation: the double-entry accounting
system, debits and credits, and the “normal” balance for each account that is part of a formal accounting system.

Footnotes
1 Center for Audit Quality. Guide to Public Company Auditing. [Link]
2 Center for Audit Quality. Guide to Public Company Auditing. [Link]
3 Financial Accounting Standards Board. “The Conceptual Framework.”
[Link]

1.5: Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements is shared under a CC BY-NC-
SA license and was authored, remixed, and/or curated by LibreTexts.

1.5.4 [Link]
 CHAPTER OVERVIEW

2: Business Transactions
Learning Objectives
Define and use accounting and business terminology

2.1: Reviewing and Analyzing Transactions

2.2: Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
2.3: Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
2.4: General Rules for Debits and Credits
2.5: Debit and Credit Review

2: Business Transactions is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1
2.1: Reviewing and Analyzing Transactions
Reviewing and Analyzing Transactions
Let us assume our business is a service-based company. We use Lynn Sanders’ small printing company, Printing Plus, as our
example. Please notice that since Printing Plus is a corporation, we are using the Common Stock account, instead of Owner’s
Equity. The following are several transactions from this business’s current month:
1. Issues $20,000 shares of common stock for cash.
2. Purchases equipment on account for $3,500, payment due within the month.
3. Receives $4,000 cash in advance from a customer for services not yet rendered.
4. Provides $5,500 in services to a customer who asks to be billed for the services.
5. Pays a $300 utility bill with cash.
6. Distributed $100 cash in dividends to stockholders.
We now analyze each of these transactions, paying attention to how they impact the accounting equation and corresponding
financial statements.
Transaction 1: Issues $20,000 shares of common stock for cash.

Analysis: Looking at the accounting equation, we know cash is an asset and common stock is stockholder’s equity. When a
company collects cash, this will increase assets because cash is coming into the business. When a company issues common stock,
this will increase a stockholder’s equity because he or she is receiving investments from owners.
Remember that the accounting equation must remain balanced, and assets need to equal liabilities plus equity. On the asset side of
the equation, we show an increase of $20,000. On the liabilities and equity side of the equation, there is also an increase of
$20,000, keeping the equation balanced. Changes to assets, specifically cash, will increase assets on the balance sheet and increase
cash on the statement of cash flows. Changes to stockholder’s equity, specifically common stock, will increase stockholder’s equity
on the balance sheet.
Transaction 2: Purchases equipment on account for $3,500, payment due within the month.

Analysis: We know that the company purchased equipment, which is an asset. We also know that the company purchased the
equipment on account, meaning it did not pay for the equipment immediately and asked for payment to be billed instead and paid
later. Since the company owes money and has not yet paid, this is a liability, specifically labeled as accounts payable. There is an
increase to assets because the company has equipment it did not have before. There is also an increase to liabilities because the
company now owes money. The more money the company owes, the more that liability will increase.
The accounting equation remains balanced because there is a $3,500 increase on the asset side, and a $3,500 increase on the
liability and equity side. This change to assets will increase assets on the balance sheet. The change to liabilities will increase
liabilities on the balance sheet.
Transaction 3: Receives $4,000 cash in advance from a customer for services not yet rendered.

2.1.1 [Link]
Analysis: We know that the company collected cash, which is an asset. This collection of $4,000 increases assets because money is
coming into the business.
The company has yet to provide the service. According to the revenue recognition principle, the company cannot recognize that
revenue until it provides the service. Therefore, the company has a liability to the customer to provide the service and must record
the liability as unearned revenue. The liability of $4,000 worth of services increases because the company has more unearned
revenue than previously.
The equation remains balanced, as assets and liabilities increase. The balance sheet would experience an increase in assets and an
increase in liabilities.
Transaction 4: Provides $5,500 in services to a customer who asks to be billed for the services.

Analysis: The customer asked to be billed for the service, meaning the customer did not pay with cash immediately. The customer
owes money and has not yet paid, signaling an accounts receivable. Accounts receivable is an asset that is increasing in this case.
This customer obligation of $5,500 adds to the balance in accounts receivable.
The company did provide the services. As a result, the revenue recognition principle requires recognition as revenue, which
increases equity for $5,500. The increase to assets would be reflected on the balance sheet. The increase to equity would affect
three statements. The income statement would see an increase to revenues, changing net income (loss). Net income (loss) is
computed into retained earnings on the statement of retained earnings. This change to retained earnings is shown on the balance
sheet under stockholder’s equity.
Transaction 5: Pays a $300 utility bill with cash.

Analysis: The company paid with cash, an asset. Assets are decreasing by $300 since cash was used to pay for this utility bill. The
company no longer has that money.
Utility payments are generated from bills for services that were used and paid for within the accounting period, thus recognized as
an expense. The expense decreases equity by $300. The decrease to assets, specifically cash, affects the balance sheet and statement
of cash flows. The decrease to equity as a result of the expense affects three statements. The income statement would see a change
to expenses, changing net income (loss). Net income (loss) is computed into retained earnings on the statement of retained
earnings. This change to retained earnings is shown on the balance sheet under stockholder’s equity.
Transaction 6: Distributed $100 cash in dividends to stockholders.

Analysis: The company paid the distribution with cash, an asset. Assets decrease by $100 as a result. Dividends affect equity and,
in this case, decrease equity by $100. The decrease to assets, specifically cash, affects the balance sheet and statement of cash
flows. The decrease to equity because of the dividend payout affects the statement of retained earnings by reducing ending retained
earnings, and the balance sheet by reducing stockholder’s equity.
Let’s summarize the transactions and make sure the accounting equation has remained balanced. Shown are each of the
transactions.

2.1.2 [Link]
As you can see, assets total $32,600, while liabilities added to equity also equal $32,600. Our accounting equation remains
balanced.

Your Turn: Debbie's Dairy Farm

Debbie’s Dairy Farm had the following transactions:
1. Debbie ordered shelving worth $750.
2. Debbie’s selling price on a gallon of milk is $3.00. She finds out that most local stores are charging $3.50. Based on this
information, she decides to increase her price to $3.25. She has an employee put a new price sticker on each gallon.
3. A customer buys a gallon of milk paying cash.
4. The shelving is delivered with an invoice for $750.
Which events will be recorded in the accounting system?

Answer
1. Debbie did not yet receive the shelving—it has only been ordered. As of now, there is no new asset owned by the
company. Since the shelving has not yet been delivered, Debbie does not owe any money to the other company. Debbie
will not record the transaction.
2. Changing prices does not have an impact on the company at the time the price is changed. All that happened was that a
new price sticker was placed on the milk. Debbie still has all the milk and has not received any money. Debbie will not
record the transaction.
3. Debbie now has a transaction to record. She has received cash and the customer has taken some of her inventory of
milk. She has an increase in one asset (cash) and a decrease in another asset (inventory.) She also has earned revenue.
4. Debbie has taken possession of the shelving and is the legal owner. She also has an increase in her liabilities as she
accepted delivery of the shelving but has not paid for it. Debbie will record this transaction.

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2.1.3 [Link]
2.2: Describe Principles, Assumptions, and Concepts of Accounting and Their
Relationship to Financial Statements
Double-Entry Bookkeeping
The basic components of even the simplest accounting system are accounts and a general ledger. An account is a record showing
increases and decreases to assets, liabilities, and equity—the basic components found in the accounting equation. Each of these
categories, in turn, includes many individual accounts, all of which a company maintains in its general ledger. A general ledger is
a comprehensive listing of all of a company’s accounts with their individual balances.
Accounting is based on what we call a double-entry accounting system, which requires the following:
Each time we record a transaction, we must record a change in at least two different accounts. Having two or more accounts
change will allow us to keep the accounting equation in balance.
Not only will at least two accounts change, but there must also be at least one debit and one credit side impacted.
The sum of the debits must equal the sum of the credits for each transaction.
In order for companies to record the myriad of transactions they have each year, there is a need for a simple but detailed system.
Journals are useful tools to meet this need.

Debits and Credits

Each account can be represented visually by splitting the account into left and right sides as shown. This graphic representation of a
general ledger account is known as a T-account. A T-account is called a “T-account” because it looks like a “T,” as you can see
with the T-account shown here.

A debit records financial information on the left side of each account. A credit records financial information on the right side of an
account. One side of each account will increase and the other side will decrease. The ending account balance is found by
calculating the difference between debits and credits for each account. You will often see the terms debit and credit represented in
shorthand, written as DR or dr and CR or cr, respectively. Depending on the account type, the sides that increase and decrease may
vary. We can illustrate each account type and its corresponding debit and credit effects in the form of an expanded accounting
equation.

As we can see from this expanded accounting equation, Assets accounts increase on the debit side and decrease on the credit side.
This is also true of Dividends and Expenses accounts. Liabilities increase on the credit side and decrease on the debit side. This is
also true of Common Stock and Revenues accounts. This becomes easier to understand as you become familiar with the normal
balance of an account.

2.2.1 [Link]
Normal Balance of an Account
The normal balance is the expected balance each account type maintains, which is the side that increases. As assets and expenses
increase on the debit side, their normal balance is a debit. Dividends paid to shareholders also have a normal balance that is a debit
entry. Since liabilities, equity (such as common stock), and revenues increase with a credit, their “normal” balance is a credit. Table
2.2.1 shows the normal balances and increases for each account type.
Account Normal Balances and Increases

Type of account Increases with Normal balance

Asset Debit Debit

Liability Credit Credit

Common Stock Credit Credit

Dividends Debit Debit

Revenue Credit Credit

Expense Debit Debit

Table 2.2.1
When an account produces a balance that is contrary to what the expected normal balance of that account is, this account has an
abnormal balance. Let’s consider the following example to better understand abnormal balances.
Let’s say there was a credit of $4,000 and a debit of $6,000 in the Accounts Payable account. Since Accounts Payable increases on
the credit side, one would expect a normal balance on the credit side. However, the difference between the two figures, in this case,
would be a debit balance of $2,000, which is an abnormal balance. This situation could possibly occur with an overpayment to a
supplier or an error in recording.

2.2: Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements is shared under a CC BY-NC-
SA license and was authored, remixed, and/or curated by LibreTexts.

2.2.2 [Link]
2.3: Define and Describe the Expanded Accounting Equation and Its Relationship to
Analyzing Transactions
Before we explore how to analyze transactions, we first need to understand what governs the way transactions are recorded.
As you have learned, the accounting equation represents the idea that a company needs assets to operate, and there are two major
sources that contribute to operations: liabilities and equity. The company borrows the funds, creating liabilities, or the company can
take the funds provided by the profits generated in the current or past periods, creating retained earnings or some other form of
stockholder’s equity. Recall the accounting equation’s basic form.

Expanded Accounting Equation

The expanded accounting equation breaks down the equity portion of the accounting equation into more detail. This expansion of
the equity section allows a company to see the impact to equity from changes to revenues and expenses, and to owner investments
and payouts. It is important to have more detail in this equity category to understand the effect on financial statements from period
to period. For example, an increase in revenue can increase net income on the income statement, increase retained earnings on the
statement of retained earnings, and change the distribution of stockholder’s equity on the balance sheet. This may be difficult to
understand where these changes have occurred without revenue recognized individually in this expanded equation.
The expanded accounting equation is shown here.

Figure 2.3.1 : Expanded Accounting Equation. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0
license)
Note that this expanded accounting equation breaks down Equity into four categories: common stock, dividends, revenues, and
expenses. This considers each element of contributed capital and retained earnings individually to better illustrate each one’s
impact on changes in equity.
A business can now use this equation to analyze transactions in more detail. But first, it may help to examine the many accounts
that can fall under each of the main categories of Assets, Liabilities, and Equity, in terms of their relationship to the expanded
accounting equation. We can begin this discussion by looking at the chart of accounts.

Chart of Accounts
Recall that the basic components of even the simplest accounting system are accounts and a general ledger. Accounts shows all the
changes made to assets, liabilities, and equity—the three main categories in the accounting equation. Each of these categories, in
turn, includes many individual accounts, all of which a company maintains in its general ledger.
When a company first starts the analysis process, it will make a list of all the accounts used in day-to-day transactions. For
example, a company may have accounts such as cash, accounts receivable, supplies, accounts payable, unearned revenues, common
stock, dividends, revenues, and expenses. Each company will make a list that works for its business type, and the transactions it
expects to engage in. The accounts may receive numbers using the system presented in Table 2.3.1.

2.3.1 [Link]
Account Numbering System

Assigned account number will Account numbers for a small Account numbers for a large
Account category
start with company company

Assets 1 100–199 1000–1999

Liabilities 2 200–299 2000–2999

Stockholders’ equity 3 300–399 3000–3999

Revenues 4 400–499 4000–4999

Expenses 5 500–599 5000–5999

Table 2.3.1
We call this account numbering system a chart of accounts. The accounts are presented in the chart of accounts in the order in
which they appear on the financial statements, beginning with the balance sheet accounts and then the income statement accounts.
Additional numbers starting with six and continuing might be used in large merchandising and manufacturing companies. The
information in the chart of accounts is the foundation of a well-organized accounting system.

Breaking Down the Expanded Accounting Equation

Refer to the expanded accounting equation (Figure 2.3.1). We begin with the left side of the equation, the assets, and work toward
the right side of the equation to liabilities and equity.

Assets and the Expanded Accounting Equation

On the left side of the equation are assets. Assets are resources a company owns that have an economic value. Assets are
represented on the balance sheet financial statement. Some common examples of assets are cash, accounts receivable, inventory,
supplies, prepaid expenses, notes receivable, equipment, buildings, machinery, and land.
Cash includes paper currency as well as coins, checks, bank accounts, and money orders. Anything that can be quickly liquidated
into cash is considered cash. Cash activities are a large part of any business, and the flow of cash in and out of the company is
reported on the statement of cash flows.
Accounts receivable is money that is owed to the company, usually from a customer. The customer has not yet paid with cash for
the provided good or service but will do so in the future. Common phrasing to describe this situation is that a customer purchased
something “on account,” meaning that the customer has asked to be billed and will pay at a later date: “Account” because a
customer has not paid us yet but instead has asked to be billed; “Receivable” because we will receive the money in the future.
Inventory refers to the goods available for sale. Service companies do not have goods for sale and would thus not have inventory.
Merchandising and manufacturing businesses do have inventory.
Examples of supplies (office supplies) include pens, paper, and pencils. Supplies are considered assets until an employee uses them.
At the point they are used, they no longer have an economic value to the organization, and their cost is now an expense to the
business.
Prepaid expenses are items paid for in advance of their use. They are considered assets until used. Some examples can include
insurance and rent. Insurance, for example, is usually purchased for more than one month at a time (six months typically). The
company does not use all six months of the insurance at once, it uses it one month at a time. However, the company prepays for all
of it upfront. As each month passes, the company will adjust its records to reflect the cost of one month of insurance usage.
Notes receivable is similar to accounts receivable in that it is money owed to the company by a customer or other entity. The
difference here is that a note typically includes interest and specific contract terms, and the amount may be due in more than one
accounting period.
Equipment examples include desks, chairs, and computers; anything that has a long-term value to the company that is used in the
office. Equipment is considered a long-term asset, meaning you can use it for more than one accounting period (a year for
example). Equipment will lose value over time, in a process called depreciation.

2.3.2 [Link]
Buildings, machinery, and land are all considered long-term assets. Machinery is usually specific to a manufacturing company that
has a factory producing goods. Machinery and buildings also depreciate. Unlike other long-term assets such as machinery,
buildings, and equipment, land is not depreciated. The process to calculate the loss on land value could be very cumbersome,
speculative, and unreliable; therefore, the treatment in accounting is for land to not be depreciated over time.

Figure 2.3.2 : Assets. Cash, buildings, inventory, and equipment are all types of assets. (credit clockwise from top left: modification
of “Cash money! 140606-A-CA521-021” by Sgt. Michael Selvage/Wikimedia Commons, Public Domain; modification of “41
Cherry Orchard Road” by “Pafcool2”/Wikimedia Commons, Public Domain; modification of “ASM-e1516805109201” by Jeff
Green, Rethink Robotics/ Wikimedia Commons, CC BY 4.0; modification of “Gfp-inventory-space” by Yinan Chen/Wikimedia
Commons, CC0)

Liabilities and the Expanded Accounting Equation

The accounting equation emphasizes a basic idea in business; that is, businesses need assets in order to operate. There are two ways
a business can finance the purchase of assets. First, it can sell shares of its stock to the public to raise money to purchase the assets,
or it can use profits earned by the business to finance its activities. Second, it can borrow the money from a lender such as a
financial institution. You will learn about other assets as you progress through the book. Let’s now take a look at the right side of
the accounting equation.
Liabilities are obligations to pay an amount owed to a lender (creditor) based on a past transaction. Liabilities are reported on the
balance sheet. It is important to understand that when we talk about liabilities, we are not just talking about loans. Money collected
for gift cards, subscriptions, or as advance deposits from customers could also be liabilities. Essentially, anything a company owes
and has yet to pay within a period is considered a liability, such as salaries, utilities, and taxes.
For example, a company uses $400 worth of utilities in May but is not billed for the usage, or asked to pay for the usage, until June.
Even though the company does not have to pay the bill until June, the company owed money for the usage that occurred in May.
Therefore, the company must record the usage of electricity, as well as the liability to pay the utility bill, in May.
Eventually, that debt must be repaid by performing the service, fulfilling the subscription, or providing an asset such as
merchandise or cash. Some common examples of liabilities include accounts payable, notes payable, and unearned revenue.
Accounts payable recognizes that the company owes money and has not paid. Remember, when a customer purchases something
“on account” it means the customer has asked to be billed and will pay at a later date. In this case, the purchasing company is the
“customer.” The company will have to pay the money due in the future, so we use the word “payable.” The debt owed is usually
paid off in less than one accounting period (less than a year typically) if it is classified as an account payable.
A notes payable is similar to accounts payable in that the company owes money and has not yet paid. Some key differences are that
the contract terms are usually longer than one accounting period, interest is included, and there is typically a more formalized

2.3.3 [Link]
contract that dictates the terms of the transaction.
Unearned revenue represents a customer’s advanced payment for a product or service that has yet to be provided by the company.
Since the company has not yet provided the product or service, it cannot recognize the customer’s payment as revenue, according
to the revenue recognition principle. Thus, the account is called unearned revenue. The company owing the product or service
creates the liability to the customer.

Equity and the Expanded Accounting Equation

Stockholder’s equity refers to the owner’s (stockholders) investments in the business and earnings. These two components are
contributed capital and retained earnings.
The owner’s investments in the business typically come in the form of common stock and are called contributed capital. There is
a hybrid owner’s investment labeled as preferred stock that is a combination of debt and equity (a concept covered in more
advanced accounting courses). The company will issue shares of common stock to represent stockholder ownership.
Another component of stockholder’s equity is company earnings. These retained earnings are what the company holds onto at the
end of a period to reinvest in the business, after any distributions to ownership occur. Stated more technically, retained earnings are
a company’s cumulative earnings since the creation of the company minus any dividends that it has declared or paid since its
creation. One tricky point to remember is that retained earnings are not classified as assets. Instead, they are a component of the
stockholder’s equity account, placing it on the right side of the accounting equation.
Distribution of earnings to ownership is called a dividend. The dividend could be paid with cash or be a distribution of more
company stock to current shareholders. Either way, dividends will decrease retained earnings.
Also affecting retained earnings are revenues and expenses, by way of net income or net loss. Revenues are earnings from the sale
of goods and services. An increase in revenues will also contribute to an increase in retained earnings. Expenses are the cost of
resources associated with earning revenues. An increase in expenses will contribute to a decrease in retained earnings. Recall that
this concept of recognizing expenses associated with revenues is the expense recognition principle. Some examples of expenses
include bill payments for utilities, employee salaries, and loan interest expense. A business does not have an expense until it is
“incurred.” Incurred means the resource is used or consumed. For example, you will not recognize utilities as an expense until you
have used the utilities. The difference between revenues earned and expenses incurred is called net income (loss) and can be found
on the income statement.
Net income reported on the income statement flows into the statement of retained earnings. If a business has net income (earnings)
for the period, then this will increase its retained earnings for the period. This means that revenues exceeded expenses for the
period, thus increasing retained earnings. If a business has net loss for the period, this decreases retained earnings for the period.
This means that the expenses exceeded the revenues for the period, thus decreasing retained earnings.
You will notice that stockholder’s equity increases with common stock issuance and revenues, and decreases from dividend payouts
and expenses. Stockholder’s equity is reported on the balance sheet in the form of contributed capital (common stock) and retained
earnings. The statement of retained earnings computes the retained earnings balance at the beginning of the period, adds net income
or subtracts net loss from the income statement, and subtracts dividends declared, to result in an ending retained earnings balance
reported on the balance sheet.
Now that you have a basic understanding of the accounting equation, and examples of assets, liabilities, and stockholder’s equity,
you will be able to analyze the many transactions a business may encounter and determine how each transaction affects the
accounting equation and corresponding financial statements.

Link to Learning

The Financial Accounting Standards Board had a policy that allowed companies to reduce their tax liability from share-based
compensation deductions. This led companies to create what some call the “contentious debit,” to defer tax liability and
increase tax expense in a current period. See the article “The contentious debit—seriously” on continuous debt for further
discussion of this practice.

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2.3.4 [Link]
2.4: General Rules for Debits and Credits
One of the first steps in analyzing a business transaction is deciding if the accounts involved increase or decrease. However, we do
not use the concept of increase or decrease in accounting. We use the words “debit” and “credit” instead of increase or decrease.
The meaning of debit and credit will change depending on the account type. Debit simply means left side; credit means right
side. Remember the accounting equation? ASSETS = LIABILITIES + EQUITY The accounting equation must always be in
balance and the rules of debit and credit enforce this balance.
In each business transaction we record, the total dollar amount of debits must equal the total dollar amount of credits. When we
debit one account (or accounts) for $100, we must credit another account (or accounts) for a total of $100. The accounting
requirement that each transaction be recorded by an entry that has equal debits and credits is called double-entry procedure, or
duality. Watch this video to help you remember this concept:

A YouTube element has been excluded from this version of the text. You can view it online here.

Review this quick guide to recording debits and credits. It will be necessary for you to commit the rules for debits and credits to
memory before you move forward in this course. Note: These are general guidelines and we will have exceptions to these rules.
After recognizing a business event as a business transaction, we analyze it to determine its increase or decrease effects on the
assets, liabilities, stockholders’ equity items, dividends, revenues, or expenses of the business. Then we translate these increase or
decrease effects into debits and credits.

Recording Changes in Balance Sheet Accounts

Balance Sheet accounts are assets and liabilities and equity. The balance sheet proves the accounting equation. Recording
transactions into journal entries is easier when you focus on the equal sign in the accounting equation. Assets, which are on the left
of the equal sign, increase on the left side or DEBIT side. Liabilities and stockholders’ equity, to the right of the equal sign,
increase on the right or CREDIT side.

Assets Liabilities & Equity

DEBIT increases CREDIT increases

CREDIT decreases DEBIT decreases

There is an exception to this rule: Dividends (or withdrawals for a non-corporation) is an equity account but it reduces equity since
the owner is taking equity from the company. This is called a contra-account because it works opposite the way the account

2.4.1 [Link]
normally works. For Dividends, it would be an equity account but have a normal DEBIT balance (meaning, debit will increase and
credit will decrease).

Recording changes in Income Statement Accounts

We learned that net income is added to equity. We also learned that net income is revenues – expenses and calculated on the income
statement. The recording rules for revenues and expenses are:

Revenues Expenses

CREDIT increases DEBIT increases

DEBIT decreases CREDIT decreases

The reasoning behind this rule is that revenues increase retained earnings, and increases in retained earnings are recorded on the
right side. Expenses decrease retained earnings, and decreases in retained earnings are recorded on the left side.
The side that increases (debit or credit) is referred to as an account’s normal balance. Remember, any account can have both debits
and credits. Here is another summary chart of each account type and the normal balances.

Account Type Normal Balance

Asset DEBIT

Liability CREDIT

Equity CREDIT

Revenue CREDIT

Expense DEBIT

Exception:

Dividends DEBIT

Regardless of what elements are present in the business transaction, a journal entry will always have AT least one debit and one
credit. You should be able to complete the debit/credit columns of your chart of accounts spreadsheet (click Chart of Accounts).
Next, we look at how to apply this concept in journal entries.
An Open Assessments element has been excluded from this version of the text. You can view it online here.

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2.4.2 [Link]
2.5: Debit and Credit Review
Four Steps to Determine What to Debit or Credit
Here is a handy list of questions to help guide students through the thought process involved with determining what to debit or
credit in a given transaction.
Step 1: Pick ONE account that is affected by this transaction
Step 2: Is this account you picked in Step 1 INCREASING or DECREASING?
Step 3: What type of account is this?
CHOICES
Assets – something that has future economic benefit – Cash, Accounts Receivable, Inventory, Prepaid Insurance, Equipment,
etc.
Liabilities – a debt owed to others – Accounts Payable, Unearned Revenue, Notes Payable, Bonds Payable, Long-term
Mortgage Payable
Equity – Common Stock, Retained Earnings
Revenues – Sales Revenue, Service Revenue, Sales
Expenses – Cost of Goods Sold, Salaries Expense, Insurance Expense
Dividends – these are dividends that the company has declared and has, or will, pay to its stockholders
Step 4: Combine your answer from Step 2 and Step 3 to find whether you DEBIT or CREDIT the account you identified in Step 1

Type of account How to INCREASE How to DECREASE

Assets Debit Credit

Liabilities Credit Debit

Equity Credit Debit

Revenues Credit Debit

Expenses Debit Credit

Dividends Debit Credit

Repeat Steps 1 through 4 for the OTHER account in this transaction

Remember:
Total debits in a journal entry (transaction) must equal the total credits in that transaction
You need at least one debit and one credit for every journal entry
Debits are on the left, credits are on the right

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2.5.1 [Link]
 CHAPTER OVERVIEW

3: The Accounting System

Learning Objectives
Explain what a system is and how an accounting system is designed to satisfy the needs of specific businesses and users
Apply transaction analysis, input transactions into the accounting system, process this input, and prepare and interpret the
basic financial statements
Summarize the purpose of journals and ledgers

3.1: Define and Describe the Components of an Accounting Information System

3.2: Define and Describe the Initial Steps in the Accounting Cycle
3.3: Use Journal Entries to Record Transactions and Post to T-Accounts
3.4: Prepare a Trial Balance
3.5: Preparing Financial Statements

3: The Accounting System is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

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3.1: Define and Describe the Components of an Accounting Information System
Today, when we refer to an accounting information system (AIS), we usually mean a computerized accounting system, because
computers and computer software that help us process accounting transactions have become relatively inexpensive. The benefits of
using a computerized accounting system outweigh the costs of purchasing one, and almost all companies, even very small ones, can
afford to and do use a computerized accounting system. That is not to say that paper-based or manual accounting systems and
processes have disappeared. Most businesses have some form of both noncomputerized and computerized systems. QuickBooks is
an example of a relatively inexpensive accounting software application that is popular with small and medium-sized businesses.

Manual and Computerized Accounting Information Systems

Interestingly, the term accounting information system predates computers. Technically, an AIS is a system or set of processes for
collecting data about accounting transactions; recording, organizing, and summarizing the data; and culminating with the
preparation of financial statements and other reports for internal and external users. These systems or processes can exist as a series
of paper ledgers, computer databases, or some combination of the two. Examples of external users include banks that might lend
the company money, investors, and the Securities and Exchange Commission (SEC), which requires that publicly traded companies
submit audited financial statements. Since business enterprises needed to produce financial statements long before computers
existed, they used manual accounting systems to gather the data needed. Data is the term for parts of accounting transactions that
constitute the input to an AIS. You have examined many forms of data in this course, for example, the cash received upon the sale
of an item is one data point, the reduction of the inventory account related to that specific sold item is another data point, and both
the revenue and the cost of goods sold would be additional data points associated with that single transaction of a sale. These data
points are summarized and aggregated (in other words “processed”) into more meaningful and useful numbers that appear in the
financial statements, and all this data is typically referred to as financial information. A company that may have used a manual AIS
years ago likely uses a computerized AIS today. It is important to remember that a computerized accounting system does not
change what we do with accounting transactions, it only changes how we do it, and how we can present the information to different
users.
Let’s consider the example of a company that came into existence before we had computers, the department store Macy’s, which
currently operates stores in nearly all fifty US states. Macy’s began as a small, fancy dry goods store that opened in New York City
in 1858, became a department store, R.H. Macy & Co., in 1877 using the same red star logo it still uses today. We can assume that
even one hundred years ago, Macy’s needed to perform the same tasks it does today:
purchase merchandise inventory to sell to customers;
record returns of some of the inventory;
record sales made to customers at the sales price;
record the cost of the goods sold at the amount Macy’s paid to purchase them;
record payments from customers;
record returns from customers;
purchase other kinds of items needed for operations, like office supplies and fixed assets;
pay for prior purchases;
pay for rent, utilities, and other services;
pay employees;
enter all of these transactions;
post all transactions;
record adjusting journal entries;
record closing journal entries;
keep track of its receivables, payables, and inventory; and
produce financial statements for internal and external users as well as other reports useful to managers in assessing various
performance measures needed to evaluate the success of the company.
As you might imagine, doing all this without computers is quite different than performing these tasks with the aid of computers. In
a manual system, each business transaction is recorded, in the form of a journal entry in the general journal or one of the four
common other special journals, using pen and paper. Journal entries are then posted to a general ledger; balances would be
computed by hand or with an adding machine/calculator for each general ledger account; a trial balance is prepared; adjusting
journal entries are prepared; and finally, financial statements prepared, all manually.

3.1.1 [Link]
Concepts in Practice: Modernization of Accounting Systems
In 1955, in one of the earliest uses of a true computer to facilitate accounting tasks, General Electric Company used a
UNIVAC computer to process its payroll. Initially, it took the computer forty hours just to process payroll for one pay period.
The first modern-era spreadsheet software for personal computers, VisiCalc, became available in 1978. Thus, between these
time periods, there were minor improvements to the use of computerized accounting tools, but it was not until the mid-1980s
that comprehensive computerized accounting programs became widely used. Thus, prior to the mid-1980s, much accounting
was done manually or using a variety of less-advanced computer systems in conjunction with manual systems. Imagine the
number of bookkeepers it would take to record the transactions of many companies. For example, on the first day of business
at Macy’s in 1858, the store had revenues of $11.06.1 The actual accounting ledger used to record those sales is shown in
Figure 3.1.1, which seems quite simple. Today Macy’s has over $24 billion in sales revenue—can you imagine accounting for
all of those transactions (along with all expenses) by hand?

Figure 3.1.1 : Macy’s Accounting Ledger. Accounting ledger showing the transactions for Macy’s first day. Total revenues
were $11.06 or a little over $340 in today’s dollars. (credit: used with permission of Macy’s Corporation)
Today, Macy’s and other large and small companies perform the same accounting tasks using computer hardware (computers,
printers, and keyboards), and software. For example, cashiers can enter transactions into a computer using a keyboard, scanner,
or touch screen. The screen displays the data entered or fields available for data entry. As an example, most retail stores have a

3.1.2 [Link]
 point-of-sale system (POS) that enters the sale by scanning the item at the point of sale, meaning at the time the transaction is
made. This system records the sale and at the same time updates inventory by reducing it based on the number of items
purchased.

Later, you will be provided with a series of transactions for a small business and you will be asked to first enter the transactions
manually into the appropriate journal, post the information from the journals to the general ledger, prepare trial balances, adjusting
and closing entries, and manually produce financial statements just as Macy’s or any other business would have done prior to the
use of various computer technologies. You will then perform the same tasks using QuickBooks, a popular accounting software
program used by many small and medium-sized businesses. A company as large as Macy’s has stores in locations all over the
country and a large volume of transactions, so it is more likely to use a software package designed to meet the needs of a very large
business. This is often referred to as an enterprise resource planning (ERP)system which stands for enterprise resource planning
(ERP) system. An ERP system integrates all of the company’s computerized systems including accounting systems and
nonaccounting systems. That is, large companies have various accounting subsystems such as the revenue system (sales/accounts
receivable/cash receipts), the expenditure system (purchasing/accounts payable/cash disbursements), the production system, the
payroll system, and the general ledger system. Nonaccounting systems might include research and development, marketing, and
human resources, which, while not an integral part of the accounting system, in a large companywide ERP system are integrated
with the accounting modules. Examples of popular ERP software systems are PeopleSoft and SAP.
Like many businesses today, Macy’s also maintains a company website and engages in e-commerce by offering the sale of many
company products online. Accounting software companies like QuickBooks and larger software vendors have upgraded the ways
in which they can provide AIS software to meet these needs. For example, a small local retail shoe store can purchase QuickBooks
software provided on an electronic storage device such as a CD and upload it to be stored on the hard drive of the company’s
computers, or the store can purchase a “cloud” version. The cloud version provides the shoe store purchasing the software with
access to the QuickBooks software online via a user ID and password with no need to load the software on the store’s computers.
QuickBooks updates the software when new versions are released and stores the company’s accounting data in the cloud. Cloud
computing refers to using the internet to access software and information storage facilities provided by companies rather than, or
in addition to, storing this data on the company’s computer hard drive or in paper form. An advantage of cloud computing is that
company employees can access the software and enter transactions from any device with an internet connection at any location.
The company pays a monthly fee for access to updated software, which can be less costly than buying software stored on individual
computers. Potential disadvantages include security concerns because an outside company is storing company programs and data,
and if the hosting company experiences technical difficulties, companies paying for these services may temporarily be unable to
access their own data or conduct business. Nevertheless, cloud services are increasingly popular.
Here, we illustrate the concepts and practices of an AIS using Intuit QuickBooks, a popular and widely used AIS.
While a company typically selects an AIS to suit its specific needs, all systems should have components capable of:
inputting/entering data (e.g., entering a sale to a customer);
storing data;
processing data and computing additional amounts related to transactions (e.g., computing sales tax on the sale, as well as
shipping costs and insurance fees; computing an employee’s pay by multiplying hours worked by hourly pay rate; processing
inventory changes from both inventory purchases and inventory sales and data from any other transaction that occurs in the
business);
aggregating/summarizing data (e.g., computing total sales for the year);
presenting data (e.g., producing a balance sheet and other financial statements and reports for the year); and
storing data (such as the customer’s name, address, shipping address, and credit limit).
AISs, whether computerized or manual, generally involve three stages: input, processing, and output. We enter raw data into our
system at the input stage and try to correct any errors prior to going on to the next stage of processing the data. We ultimately
produce “output,” which is in the form of useful information.

Inputting/Entering Data
A source document is an original document that provides evidence that a transaction occurred. If you hire a company to paint your
house, it will most likely provide a document showing how much you owe. That is the company’s sales document and your

3.1.3 [Link]
invoice. When you pay, your check or digital transaction record is also a source document for the company that provided the
service, in this case, the home painter.
Assume you go into the university bookstore to purchase a school sweatshirt, and it is sold out. You then fill out a document
ordering a size medium sweatshirt in blue. The form you fill out is a purchase order to you, and it is a sales order to the university
bookstore. It is also a source document that provides evidence that you have ordered the sweatshirt. Assume the bookstore does not
ask you to pay in advance because it is not sure it will be able to obtain the sweatshirt for you. At that point, no sale has been made,
and you owe no money to the bookstore. A few days later, the bookstore manages to acquire the sweatshirt you ordered and sends
you an email notifying you of this. When you return to the bookstore, you are presented with the sweatshirt and an invoice (also
known as a bill) that you must pay in order to take your sweatshirt home. This invoice/bill is also a source document. It provides
evidence of the sale and your obligation to pay that amount. Let’s look at an example.
Figure 3.1.2 is a source document—an invoice (bill) from Symmetry Mold Design for mold design services. Note the terms
(agreements about payments) are listed at the top and how the company calculates those outcomes at the bottom.

Figure 3.1.2 : Invoice from Symmetry Mold Design showing payment terms. (credit: modification of "Invoice" by James
Ceszyk/Flickr, CC B 4.0)

3.1.4 [Link]
Some companies send paper bills in the mail, often asking the recipient to tear off part of the bill and return it with the payment.
This tear-off portion is a turn-around document and helps ensure that the payment is applied to the correct customer account and
invoice. Generally, this document began as printed output, an invoice, from the billing part of the AIS. When the customer tears off
a part of it and returns it in the envelope with a check to the company, it has now been “turned around” and will be used as an input
source document, called a remittance advice. A remittance advice is a document that customers send along with checks and informs
the recipient as to which invoice the customer is paying for. Figure 3.1.3 is an example of a turn-around document.

Figure 3.1.3 : Turn-Around Document from Kohl’s. The use of automation (bar codes) saves time and ensures accuracy since a
machine can read the address, the account number, and even the amount on the check. (credit: modification of “Bill” by Kerry
Ceszyk/Flickr, CC BY 4.0)
Both manual and computerized accounting systems utilized source documents. E-commerce systems have some additional source
documents related to online transactions. Source documents help to establish an audit trail, which is a trail of evidence
documenting the history of a specific transaction starting from its inception/source document and showing all the steps it went
through until its final disposition. The trail of source documents and other records (the audit trail) makes it easier to investigate
errors or questions by customers, vendors, employees, and others. For example, when a customer places an order by phone, by
mail, or online, the sales order becomes the source document. If the customer does not receive the product ordered, the company
can locate the original order, see if a picking ticket was generated (a picking ticket tells warehouse employees what inventory items
the customer ordered, that now need to be picked off the shelf), locate the shipping documents, which provide evidence that the
product was given to the shipper, and check for customer signature confirming receipt of goods. The trail of documents and entries
in journals and ledgers and their electronic equivalent generated by this transaction provides evidence of all the steps that took
place along the way. This makes it easy for anyone to verify or investigate, and perhaps find the weak links, where the process may
have broken down. It allows the company to identify the reason why the customer never received the goods ordered. Maybe the
order was never shipped because the company was out of stock of this specific product, maybe it was shipped and left at the
customer’s doorstep with no signature requested, or maybe the order was shipped to the wrong customer or to an incorrect address.
An audit trail will help company personnel investigate any of these common issues. It should also help them identify weaknesses in
their processes and precipitate improvements.
Businesses need a way to input data from the source document such as a sales invoice or purchase order. This was previously done
with pen and paper and is currently done by keying it in on a computer keyboard; scanning, with a scanner such as one that reads
MICR (magnetic ink character recognition) symbols (found on bank checks) or POS system scanners at cash registers that scan
product bar codes/UPC symbols; or receiving it by e-transmission (or electronic funds transfer [EFT]). Input often involves the use
of hardware such as scanners, keypads, keyboards, touch screens, or fingerprint readers called biometric devices. Once data has
been input, it must be processed in order to be useful.

3.1.5 [Link]
Processing Data
Companies need the accounting system to process the data that has been entered and transform it into useful information. In manual
accounting systems, employees process all transaction data by journalizing, posting, and creating financial reports using paper.
However, as technology has advanced, it became easier to keep records by using computers with software programs specifically
developed for accounting transactions. Computers are good at repetition and calculations, both of which are involved in accounting,
and computers can perform these calculations and analyses more quickly, and with fewer errors, thus making them a very effective
tool for accounting from both an input and an output standpoint.

Link to Learning
See a list of popular bookkeeping software packages. With this information, potential options for sample accounting software
options can be evaluated.

Output: Presenting Information

An AIS should provide a way to present system output (printed page, screen image, e-transmission). Any accounting software
application such as that used by large companies (an ERP system) or one used by smaller businesses (QuickBooks) can easily print
financial statements and other documents as well as display them on the screen.
Some financial information must be provided to other sources such as banks or government agencies, and though in past decades
everything was presented and submitted on paper, today, most of this information is submitted electronically, and AISs help
facilitate having the information in the necessary electronic format. Many banks require electronic data, and the Internal Revenue
System (IRS) accepts your information as a digital transmission instead of a paper form. In 2017, 92 percent of all taxpayers who
filed their own taxes did so electronically.2 Most corporations choose to file their taxes electronically, and those with assets over
$10 million are required to file electronically with the IRS.3 Since May 5, 1996, all publicly traded companies are required to
submit their filings, such as financial statements and stock offerings, to the SEC electronically.4 The SEC places all the data into an
electronic database known as the Electronic Data Gathering, Analysis, and Retrieval System (EDGAR). This database allows
anyone to search the database for financial and other information about any publicly traded company. Thus, AISs facilitate not only
internal access to financial information, but the sharing of that information externally as needed or required. Just as the EDGAR
system used by the SEC stores data for retrieval, an AIS must provide a way to store and retrieve data.

Storing Data
Data can be stored by an AIS in paper, digital, or cloud formats. Before computers were widely used, financial data was stored on
paper, like the journal and ledger shown in Figure 3.1.4.

Figure 3.1.4 : Data Storage. (a) General journal and (b) general ledger. (credit a: modification of “Entry in Barent Roseboom’s
ledger detailing transactions with John Fluno in 1764” by National Park Service, Public Domain; credit b: modification of “Print
Order Book, Holmes McDougall” by Edinburgh City of Print/Flickr, CC BY 2.0)
As technology has evolved, so have storage systems—from floppy disks to CDs, thumb drives, and the cloud. The hard drive on
your computer is a data storage device, as is an external hard drive you can purchase. Data that is stored must have the ability to be
retrieved when needed. As you can see from Figure 3.1.5, stored data comes from and/or flows through the three main functions of
an AIS (input, processes, and output) with the end result being the use of the data in forms needed for decision-making, such as
financial statements. Access to the ability to input data, manage processes, or retrieve data requires adequate controls to prevent
fraud or unauthorized access and requires the implementation of data security measures. Figure 3.1.5 illustrates the key functions
performed by an AIS.

3.1.6 [Link]
 Figure 3.1.5 : Accounting Information System. The four key functions performed by an accounting information system.
(attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Your Turn: The Steps in an Accounting Information System

The three steps of an accounting information system are input, processing, and output. Data is the raw ingredient used in these
processes. Some of the data may be obtained from a source document, and other data is obtained from the database where it
had previously been stored. When the data has been processed, the final result is usually information. Information is more
useful than data. Take, for example, another process that a bakery might use to bake chocolate chip cookies. While computers
might not necessarily need to be involved, we begin the process by assembling a bunch of raw ingredients such as eggs, sugar,
flour, chocolate chips, and oil, in a large bowl. Taking a spoonful of what is in the bowl at the time is not very pleasing to the
taste buds or “useful” to someone craving a chocolate chip cookie. We process the raw ingredients by mixing them well and
turning them into dough, cutting them into shapes, baking them, and glazing them. Similarly, raw data about a single sale
contained on the sales invoice, such as customer name, date of sale, and amount of sale, is individually not very useful to a
financial statement user such as an investor. However, by processing the data related to the sale, making sure it is correct by
checking that the number of items ordered were in stock and actually shipped, aggregating it with other sales for the period,
and producing an income statement containing the sales for the period is substantially more useful than the individual pieces of
data relating to a single sale.
Can you give an example of each of the three steps, as well as a source document that might be used in the input stage and
stored data that might be used in the input and processing stages, first for a grocery store, and then a medical office?

Answer
Grocery store
Source Document: This would include a check to be deposited; totals from each cash register, including total cash; an
invoice for produce; an application for employment by a potential new employee; time card information; a W-4 form
(employment information); and so on.
Input: This includes entering the data from the source document on the computer keyboard, electronically scanning the
bar code of each product purchased at the grocery store (at checkout counter and to receive goods from vendor off the
truck), maybe fingerprinting at the time clock, or keying in a price on the register.
Processing: A cash register processes (accumulates and totals) different categories of items (coupons, checks, and
charges) by the user; inventory can be tracked by RFID (radio-frequency identification); and software programs can
process information gathered by individual cash registers as well as employee information.
Output: Data that has been processed can be viewed on a computer screen, printed as a hard copy (paper output), or sent
as electronic output from the cash register to the computer (can be done wirelessly or with a cable).
Storage: Data can be stored in the company database on its computer hard drive or as cloud storage. Hopefully, the store
is also paying for safe backup storage offsite (in case of fire at the store or hackers attempting to obtain information),
generally accessed through the internet and stored in “the cloud.” Otherwise, storage can be on paper printouts, the

3.1.7 [Link]
 computer hard drive, disks, or external drives. The data that is stored may be retrieved and used at the input, processing,
and output stages.
Doctor’s office:
Source Document: This includes a check to be deposited from the patient; the patient’s insurance information on file; a
doctor’s record of the diagnosis and procedures performed on the patient, to be submitted to the insurance company; and
an invoice for medical supplies.
Input: Data from the source document, for example, containing the diagnosis and a treatment plan, would be entered on
the computer keyboard.
Processing: The system might retrieve the treatment codes corresponding to every procedure the doctor performed, so it
contains the appropriate information for the insurance company.
Output: The treatment form is printed and then mailed to the insurance company for payment.
Storage: The diagnosis and treatment plan are stored on the computer database for retrieval on the next visit for this
patient. The form to be sent to the insurance company is also stored electronically so there can be follow-up until the
payment from the insurance company is received. Also note that during processing, the system had to retrieve the
treatment codes from a file of all of the codes that was stored in the database.

Your Turn: The Accounting Information System (AIS)

What are some of the types of information the accounting information system should be able to provide to the owners,
managers, and employees of business, at the end of the day, or week, or month, which they, in turn, may need to provide to
other external users?

Answer
Information for internal purposes will include total sales and how much it cost to generate the sales. Also considered is
how much inventory is on hand so a decision can be made as to whether or not to order more inventory.
The company will need to record all of the economic events of the business in order to find total sales, cost of goods
sold, expenses, and net income, as well as the number of hours employees worked, the employee’s social security
number, and how much the company promised to pay the employee per hour.
Information for external users, such as the IRS or state and local government agencies, would include income tax
returns and sales and payroll tax forms. The business owners and managers will need all sales and expenses, sales tax
collected, and employees’ earnings.
In other words, the company needs an AIS.

While an AIS has the primary functions of input, processing, output, and storage, each company or system will decide on the exact
steps and processes under each of these broad functions. We know that data is used to create the types of information needed by
users to make decisions. One way in which a retail organization may obtain, input, process, and store data related to a sales
transaction is through a point-of-sale system (POS). When a customer is ready to buy an item, the cashier scans the product being
purchased, the price is retrieved from the price file, the sale is recorded, and inventory is updated. Most POS systems include a
scanner, a computer screen, or a tablet with a touch screen. Customer payments are stored in the cash drawer. For noncash sales,
credit card readers allow customers to insert, swipe, or tap their cards to pay (which also helps prevent keyboard input errors and
keeps the information safer).

Ethical Considerations: Ethical Standards in Retail Stores

Professional sales employees operate the POS systems. There is an ethical code for sales professionals created by the
Association of Professional Sales to help sales professionals maintain good judgment.5 The organization sets forth standards
such as the following:
Maintain the highest standards of integrity in all business relationships.
Provide our customers with a buying experience in which we “do the right thing and thereby help get the right results.”
Promote and protect good sales practices.
Always act in line with my organization’s codes and within the law.

3.1.8 [Link]
 Accountants can assist sales professionals in creating an ethical environment. The ethical environment will permit the users of
accounting data to make solid business decisions and to better operate a company.

However, the POS is just part of the AIS. As each sale is entered into the register, other data is collected, recorded, and processed
by the AIS and becomes information. Data about each sale is recorded in the information system: what was sold, how much it cost,
the sales price, and any sales tax. It also records the time of day, the clerk, and anything else the company programmed the cash
register to record. When all the sales for the day are totaled, it provides information in the form of organized and processed data
with meaning to the company. A business might want to see which hour of the day resulted in the most sales, or to know which
product was the best seller. An AIS can provide this information.
A system is created when processes work together to generate information for the business. The sales process accesses customers,
accounts receivable, and inventory data and updates the appropriate files. The purchases process also accesses inventory and
accounts payable and updates them, because most companies buy goods on credit. Since no two companies operate exactly the
same way, you would expect each company to have a slightly different AIS. Some businesses do not have a cash register, but they
will still have a Sales account. Some companies only have cash sales, so they would not have an Accounts Receivable account.
Regardless of the type of business—retail, manufacturing, or service—an AIS is an important component of the business as it is
this system that provides the information needed by internal and external decision-makers.

Concepts in Practice: Is This an Accounting Information System?

Do you think your average food truck proprietor has an accounting information system?

Figure 3.1.6 : Food Truck. (credit: modification of “Food Trucks” by Daniel Lobo/Flickr, Public Domain)
Food trucks will have some type of accounting information system whether paper-based or electronic. One common method of
creating an accounting information system in this type of business environment is to use an app, such as Square Point of Sale
(Square Inc.). The Square Point of Sale (POS) software system keeps track of the sales. With this type of system, a food truck
will likely have a Square Stand (a tablet-based POS), a cash drawer, and printers. The information input into the Square Stand
is stored on Square servers using the cloud (online storage space offered by different companies and products) and is accessible
by the company via an online dashboard. This system allows the handling of both cash sales and credit card sales. These
components—the Square Point of Sale software, the Square Stand, cash drawer, and the printers—make up part of the
accounting information system for a food truck.

IFRS Connection: Accounting Information Systems in an International Business Environment

All companies, regardless of whether they are domestic or international, will have an accounting information system with the
features described in this chapter. It would be easy to assume that the accounting information systems created by public
companies in the United States are created based on US generally accepted accounting principles (GAAP). This implies that
these companies design their processes and controls so that in addition to meeting the reporting and monitoring goals of the
company, the system also collects, measures, and reports the information that is required under US GAAP. But is this true?
What about companies that have subsidiaries or a portion of their operations in another country? Do purely international
companies use accounting information systems similar to their US counterparts?
As previously indicated, all companies will create some sort of accounting information system. General Electric (GE), as a
US-based manufacturer, uses an accounting information system that allows it to record, collect, produce, and analyze the
operations of its various businesses. Since GE is a US corporation, headquartered in Boston, Massachusetts, its accounting

3.1.9 [Link]
 information system is designed around the rules set out by US GAAP. Fiat Chrysler Automobiles (FCA) is headquartered in
the United Kingdom, and it designs its accounting information system to produce financials under International Financial
Reporting Standards (IFRS). On the surface, it looks as though each company will create an information system based on the
accounting rules in its own home country. However, it is not quite that simple. Today, companies take advantage of the ability
to borrow money across borders. The lenders often require the financial statements of the borrower to be presented using the
accounting rules required by the lender’s country. For example, if GE wanted to borrow money from the Royal Bank of
Scotland, it would likely have to present its financial statements based on IFRS rules. Similarly, if FCA wanted to borrow
from Citibank, it would need its financial statements in US GAAP form.
Borrowing is not the only reason a company may need to present financial statements based on a different set of accounting
principles. As of 2017, GE had over 130 subsidiaries, and these businesses were located across 130 countries. A subsidiary is a
business over which the parent company has decision-making control, usually indicated by an ownership interest of more than
50 percent. Many of these GE subsidiaries established their accounting information systems based on the accepted accounting
principles in the countries in which they were located, as required in order to be in compliance with local regulations such as
for local taxes. Thus, GE must convert the financial information obtained from the subsidiary’s accounting information system,
often based on IFRS, to US GAAP in order to consolidate the transactions and operations of all of the subsidiaries with those
of the parent company to create one set of financial statements.
We have basically become a two GAAP world—IFRS and US GAAP—and many companies will find it necessary to have
accounting information systems that can handle both sets of rules due to the global nature of business and the global nature of
raising money through borrowing and issuing stock. This may seem crazy, to have two systems, but a little over ten years ago
there were more than seventy different GAAP. Today, since many countries now use IFRS, the quality and consistency of
financial reporting have improved. As a result, the cost associated with having accounting information systems that can
combine many different sets of accounting rules has decreased.

Footnotes
1 Fraser Sherman. “The History of Computerized Accounting.” Career Trend. January 14, 2019. [Link]
632821...[Link]
2 Income Tax Return Statistics. eFile. May 2018. [Link]
3 Income Tax Return Statistics. eFile. May 2018. [Link]
4 There is a hardship exemption for companies that cannot file their documents electronically. See U.S. Securities and
Exchange Commission. Important Information about EDGAR. February 16, 2010. [Link]
5 Association of Professional Sales. “APS Sales Code of Conduct.” n.d. [Link]...-code-conduct/

3.1: Define and Describe the Components of an Accounting Information System is shared under a CC BY-NC-SA license and was authored,
remixed, and/or curated by LibreTexts.

3.1.10 [Link]
3.2: Define and Describe the Initial Steps in the Accounting Cycle
The accounting cycle is a step-by-step process to record business activities and events to keep financial records up to date. The
process occurs over one accounting period and will begin the cycle again in the following period. A period is one operating cycle
of a business, which could be a month, quarter, or year. Review the accounting cycle in Figure 3.2.1.

Figure 3.2.1 : The Accounting Cycle. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
As you can see, the cycle begins with identifying and analyzing transactions and culminates in reversing entries. The entire cycle is
meant to keep financial data organized and easily accessible to both internal and external users of information. In this chapter, we
focus on the first four steps in the accounting cycle: identify and analyze transactions, record transactions to a journal, post journal
information to a ledger, and prepare an unadjusted trial balance.

Ethical Considerations: Turning Hacked Gift Card Accounts into Cash

Gift cards are a great way for a company to presell its products and to create cash flow. One of the problems with gift cards is
that fraudsters are using the retailer’s weak internal controls to defraud the retailer’s customers. A fraudster can hack into
autoloading gift cards and drain a customer’s bank account by buying new, physical gift cards through the autoloading gift card
account. This is a real problem, and an internal control to reduce this type of fraud is to use a double verification system for the
transfer of money from a bank account to reloadable gift card account. Accountants can help their organization limit gift card
fraud by reviewing their company’s internal controls over the gift card process.
A simple explanation of this fraud is that a fraudster will gain access to an individual’s email account through phishing or by
other means, such as a fraudster putting a key logger on a public computer or in a corrupted public Wi-Fi. The individual uses
the same password for the reloadable gift card as his or her email account, and the fraudster will see emails about the gift card.
The fraudster contacts the retailer posing as the individual, and the retailer creates an in-store gift card redemption code, and

3.2.1 [Link]
 the fraudster or his or her accomplice will go to the store posing as the individual and buy physical gift cards with the
redemption code. The customer’s bank account will be drained, and the customer will be upset. In another gift card fraud, the
individual’s credit card is stolen and used to buy physical gift cards from a retailer. This type of fraud causes problems for the
retailer, for the retailer’s reputation is damaged through the implementation of poor internal controls.
Does the fraudster use the fraudulently acquired gift cards? No, there is an entire market for selling gift cards on Craigslist,
just go look and see how easy it is to buy discounted gift cards on Craigslist. Also, there are companies such as [Link]
and [Link] that buy and resell gift cards. The fraudster just sells the gift cards, and the retailer has no idea it is
redeeming fraudulently acquired gift cards. Through the implementation of proper internal controls, the accountant can help
limit this fraud and protect his or her employer’s reputation.

First Four Steps in the Accounting Cycle

The first four steps in the accounting cycle are (1) identify and analyze transactions, (2) record transactions to a journal, (3) post
journal information to a ledger, and (4) prepare an unadjusted trial balance. We begin by introducing the steps and their related
documentation.

Figure 3.2.2 : Accounting Cycle. The first four steps in the accounting cycle. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)
These first four steps set the foundation for the recording process.
Step 1. Identifying and analyzing transactions is the first step in the process. This takes information from original sources or
activities and translates that information into usable financial data. An original source is a traceable record of information that
contributes to the creation of a business transaction. For example, a sales invoice is considered an original source. Activities would
include paying an employee, selling products, providing a service, collecting cash, borrowing money, and issuing stock to company
owners. Once the original source has been identified, the company will analyze the information to see how it influences financial
records.
Let’s say that Mark Summers of Supreme Cleaners provides cleaning services to a customer. He generates an invoice for $200, the
amount the customer owes, so he can be paid for the service. This sales receipt contains information such as how much the
customer owes, payment terms, and dates. This sales receipt is an original source containing financial information that creates a
business transaction for the company.
Step 2. The second step in the process is recording transactions to a journal. This takes analyzed data from step 1 and organizes it
into a comprehensive record of every company transaction. A transaction is a business activity or event that has an effect on
financial information presented on financial statements. The information to record a transaction comes from an original source. A
journal (also known as the book of original entry or general journal) is a record of all transactions.
For example, in the previous transaction, Supreme Cleaners had the invoice for $200. Mark Summers needs to record this $200 in
his financial records. He needs to choose what accounts represent this transaction, whether or not this transaction will increase or
decreases the accounts, and how that impacts the accounting equation before he can record the transaction in his journal. He needs
to do this process for every transaction occurring during the period.
Figure 3.2.3 includes information such as the date of the transaction, the accounts required in the journal entry, and columns for
debits and credits.

Figure 3.2.3 : General Journal. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

3.2.2 [Link]
Step 3. The third step in the process is posting journal information to a ledger. Posting takes all transactions from the journal
during a period and moves the information to a general ledger, or ledger. As you’ve learned, account balances can be represented
visually in the form of T-accounts.
Returning to Supreme Cleaners, Mark identified the accounts needed to represent the $200 sale and recorded them in his journal.
He will then take the account information and move it to his general ledger. All of the accounts he used during the period will be
shown on the general ledger, not only those accounts impacted by the $200 sale.

Figure 3.2.4 : General Ledger in T-Account Form. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0
license)
Step 4. The fourth step in the process is to prepare an unadjusted trial balance. This step takes information from the general ledger
and transfers it onto a document showing all account balances, and ensuring that debits and credits for the period balance (debit and
credit totals are equal).
Mark Summers from Supreme Cleaners needs to organize all of his accounts and their balances, including the $200 sale, onto a
trial balance. He also needs to ensure his debits and credits are balanced at the culmination of this step.

Figure 3.2.5 : Unadjusted Trial Balance. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
It is important to note that recording the entire process requires strong attention to detail. Any mistakes early on in the process can
lead to incorrect reporting information on financial statements. If this occurs, accountants may have to go all the way back to the
beginning of the process to find their error. Make sure that as you complete each step, you are careful and really take the time to

3.2.3 [Link]
understand how to record information and why you are recording it. In the next section, you will learn how the accounting equation
is used to analyze transactions.

Concepts in Practice: Forensic Accounting

Ever dream about working for the Federal Bureau of Investigation (FBI)? As a forensic accountant, that dream might just be
possible. A forensic accountant investigates financial crimes, such as tax evasion, insider trading, and embezzlement, among
other things. Forensic accountants review financial records looking for clues to bring about charges against potential criminals.
They consider every part of the accounting cycle, including original source documents, looking through journal entries, general
ledgers, and financial statements. They may even be asked to testify to their findings in a court of law.
To be a successful forensic accountant, one must be detailed, organized, and naturally inquisitive. This position will need to
retrace the steps a suspect may have taken to cover up fraudulent financial activities. Understanding how a company operates
can help identify fraudulent activities that veer from the company’s position. Some of the best forensic accountants have put
away major criminals such as Al Capone, Bernie Madoff, Ken Lay, and Ivan Boesky.

Link to Learning
A tool that can be helpful to businesses looking for an easier way to view their accounting processes is to have drillable
financial statements. This feature can be found in several software systems, allowing companies to go through the accounting
cycle from transaction entry to financial statement construction. Read this Journal of Accountancy column on drillable
financial statements to learn more.

3.2: Define and Describe the Initial Steps in the Accounting Cycle is shared under a CC BY-NC-SA license and was authored, remixed, and/or
curated by LibreTexts.

3.2.4 [Link]
3.3: Use Journal Entries to Record Transactions and Post to T-Accounts
When we introduced debits and credits, you learned about the usefulness of T-accounts as a graphic representation of any account
in the general ledger. But before transactions are posted to the T-accounts, they are first recorded using special forms known as
journals.

Journals
Accountants use special forms called journals to keep track of their business transactions. A journal is the first place information is
entered into the accounting system. A journal is often referred to as the book of original entry because it is the place the
information originally enters into the system. A journal keeps a historical account of all recordable transactions with which the
company has engaged. In other words, a journal is similar to a diary for a business. When you enter information into a journal, we
say you are journalizing the entry. Journaling the entry is the second step in the accounting cycle. Here is a picture of a journal.

You can see that a journal has columns labeled debit and credit. The debit is on the left side, and the credit is on the right. Let’s
look at how we use a journal.
When filling in a journal, there are some rules you need to follow to improve journal entry organization.

Formatting When Recording Journal Entries

Include the date of when the transaction occurred
The debit account title(s) always come first and on the left
The credit account title(s) always come after all debit titles are entered, and on the right
The titles of the credit accounts will be indented below the debit accounts
You will have at least one debit (possibly more)
You will always have at least one credit (possibly more)
The dollar value of the debits must equal the dollar value of the credits or else the equation will go out of balance
You will write a short description after each journal entry
Skip a space after the description before starting the next journal entry
An example journal entry format is as follows. It is not taken from previous examples but is intended to stand alone.

Note that this example has only one debit account and one credit account, which is considered a simple entry. A compound
entry is when there is more than one account listed under the debit and/or credit column of a journal entry (as seen in the
following).

Notice that for this entry, the rules for recording journal entries have been followed. There is a date of April 1, 2018, the debit
account titles are listed first with Cash and Supplies, the credit account title of Common Stock is indented after the debit account
titles, there are at least one debit and one credit, the debit amounts equal the credit amount, and there is a short description of the
transaction.
Let’s now look at a few transactions from Printing Plus and record their journal entries.

3.3.1 [Link]
Recording Transactions
We now return to our company example of Printing Plus, Lynn Sanders’ printing service company. We will analyze and record each
of the transactions for her business and discuss how this impacts the financial statements. Some of the listed transactions have been
ones we have seen throughout this chapter. More detail for each of these transactions is provided, along with a few new
transactions.
1. On January 3, 2019, issues $20,000 shares of common stock for cash.
2. On January 5, 2019, purchases equipment on account for $3,500, payment due within the month.
3. On January 9, 2019, receives $4,000 cash in advance from a customer for services not yet rendered.
4. On January 10, 2019, provides $5,500 in services to a customer who asks to be billed for the services.
5. On January 12, 2019, pays a $300 utility bill with cash.
6. On January 14, 2019, distributed $100 cash in dividends to stockholders.
7. On January 17, 2019, receives $2,800 cash from a customer for services rendered.
8. On January 18, 2019, paid in full, with cash, for the equipment purchase on January 5.
9. On January 20, 2019, paid $3,600 cash in salaries expense to employees.
10. On January 23, 2019, received cash payment in full from the customer on the January 10 transaction.
11. On January 27, 2019, provides $1,200 in services to a customer who asks to be billed for the services.
12. On January 30, 2019, purchases supplies on account for $500, payment due within three months.
Transaction 1: On January 3, 2019, issues $20,000 shares of common stock for cash.
Analysis:
This is a transaction that needs to be recorded, as Printing Plus has received money, and the stockholders have invested in the
firm.
Printing Plus now has more cash. Cash is an asset, which in this case is increasing. Cash increases on the debit side.
When the company issues stock, stockholders purchase common stock, yielding a higher common stock figure than before
issuance. The common stock account is increasing and affects equity. Looking at the expanded accounting equation, we see that
Common Stock increases on the credit side.

Impact on the financial statements: Both of these accounts are balance sheet accounts. You will see total assets increase and total
stockholders’ equity will also increase, both by $20,000. With both totals increasing by $20,000, the accounting equation, and
therefore our balance sheet, will be in balance. There is no effect on the income statement from this transaction as there were no
revenues or expenses recorded.

Transaction 2: On January 5, 2019, purchases equipment on account for $3,500, payment due within the month.
Analysis:
In this case, equipment is an asset that is increasing. It increases because Printing Plus now has more equipment than it did
before. Assets increase on the debit side; therefore, the Equipment account would show a $3,500 debit.
The company did not pay for the equipment immediately. Lynn asked to be sent a bill for payment at a future date. This creates
a liability for Printing Plus, who owes the supplier money for the equipment. Accounts Payable is used to recognize this
liability. This liability is increasing, as the company now owes money to the supplier. A liability account increases on the credit
side; therefore, Accounts Payable will increase on the credit side in the amount of $3,500.

3.3.2 [Link]
Impact on the financial statements: Since both accounts in the entry are balance sheet accounts, you will see no effect on the
income statement.

Transaction 3: On January 9, 2019, receives $4,000 cash in advance from a customer for services not yet rendered.
Analysis:
Cash was received, thus increasing the Cash account. Cash is an asset that increases on the debit side.
Printing Plus has not yet provided the service, meaning it cannot recognize the revenue as earned. The company has a liability
to the customer until it provides the service. The Unearned Revenue account would be used to recognize this liability. This is a
liability the company did not have before, thus increasing this account. Liabilities increase on the credit side; thus, Unearned
Revenue will recognize the $4,000 on the credit side.

Impact on the financial statements: Since both accounts in the entry are balance sheet accounts, you will see no effect on the
income statement.

Transaction 4: On January 10, 2019, provides $5,500 in services to a customer who asks to be billed for the services.
Analysis:
The company provided service to the client; therefore, the company may recognize the revenue as earned (revenue recognition
principle), which increases revenue. Service Revenue is a revenue account affecting equity. Revenue accounts increase on the
credit side; thus, Service Revenue will show an increase of $5,500 on the credit side.
The customer did not immediately pay for the services and owes Printing Plus payment. This money will be received in the
future, increasing Accounts Receivable. Accounts Receivable is an asset account. Asset accounts increase on the debit side.
Therefore, Accounts Receivable will increase for $5,500 on the debit side.

Impact on the financial statements: You have revenue of $5,500. Revenue is reported on your income statement. The more
revenue you have, the more net income (earnings) you will have. The more earnings you have, the more retained earnings you will

3.3.3 [Link]
keep. Retained earnings is a stockholders’ equity account, so total equity will increase $5,500. Accounts receivable is going up so
total assets will increase by $5,500. The accounting equation, and therefore the balance sheet, remain in balance.

Transaction 5: On January 12, 2019, pays a $300 utility bill with cash.
Analysis:
Cash was used to pay the utility bill, which means cash is decreasing. Cash is an asset that decreases on the credit side.
Paying a utility bill creates an expense for the company. Utility Expense increases, and does so on the debit side of the
accounting equation.

Impact on the financial statements: You have an expense of $300. Expenses are reported on your income statement. More
expenses lead to a decrease in net income (earnings). The fewer earnings you have, the fewer retained earnings you will end up
with. Retained earnings is a stockholders’ equity account, so total equity will decrease by $300. Cash is decreasing, so total assets
will decrease by $300, impacting the balance sheet.

Transaction 6: On January 14, 2019, distributed $100 cash in dividends to stockholders.

Analysis:
Cash was used to pay the dividends, which means cash is decreasing. Cash is an asset that decreases on the credit side.
Dividends distribution occurred, which increases the Dividends account. Dividends is a part of stockholder’s equity and is
recorded on the debit side. This debit entry has the effect of reducing stockholder’s equity.

Impact on the financial statements: You have dividends of $100. An increase in dividends leads to a decrease in stockholders’
equity (retained earnings). Cash is decreasing, so total assets will decrease by $100, impacting the balance sheet.

Transaction 7: On January 17, 2019, receives $2,800 cash from a customer for services rendered.
Analysis:
The customer used cash as the payment method, thus increasing the amount in the Cash account. Cash is an asset that is
increasing, and it does so on the debit side.

3.3.4 [Link]
 Printing Plus provided the services, which means the company can recognize revenue as earned in the Service Revenue
account. Service Revenue increases equity; therefore, Service Revenue increases on the credit side.

Impact on the financial statements: Revenue is reported on the income statement. More revenue will increase net income
(earnings), thus increasing retained earnings. Retained earnings is a stockholders’ equity account, so total equity will increase
$2,800. Cash is increasing, which increases total assets on the balance sheet.

Transaction 8: On January 18, 2019, paid in full, with cash, for the equipment purchase on January 5.
Analysis:
Cash is decreasing because it was used to pay for the outstanding liability created on January 5. Cash is an asset and will
decrease on the credit side.
Accounts Payable recognized the liability the company had to the supplier to pay for the equipment. Since the company is now
paying off the debt it owes, this will decrease Accounts Payable. Liabilities decrease on the debit side; therefore, Accounts
Payable will decrease on the debit side by $3,500.

Impact on the financial statements: Since both accounts in the entry are balance sheet accounts, you will see no effect on the
income statement.

Transaction 9: On January 20, 2019, paid $3,600 cash in salaries expense to employees.
Analysis:
Cash was used to pay for salaries, which decreases the Cash account. Cash is an asset that decreases on the credit side.
Salaries are an expense to the business for employee work. This will increase Salaries Expense, affecting equity. Expenses
increase on the debit side; thus, Salaries Expense will increase on the debit side.

Impact on the financial statements: You have an expense of $3,600. Expenses are reported on the income statement. More
expenses lead to a decrease in net income (earnings). The fewer earnings you have, the fewer retained earnings you will end up
with. Retained earnings is a stockholders’ equity account, so total equity will decrease by $3,600. Cash is decreasing, so total assets
will decrease by $3,600, impacting the balance sheet.

3.3.5 [Link]
Transaction 10: On January 23, 2019, received cash payment in full from the customer on the January 10 transaction.
Analysis:
Cash was received, thus increasing the Cash account. Cash is an asset, and assets increase on the debit side.
Accounts Receivable was originally used to recognize the future customer payment; now that the customer has paid in full,
Accounts Receivable will decrease. Accounts Receivable is an asset, and assets decrease on the credit side.

Impact on the financial statements: In this transaction, there was an increase to one asset (Cash) and a decrease to another asset
(Accounts Receivable). This means total assets change by $0, because the increase and decrease to assets in the same amount
cancel each other out. There are no changes to liabilities or stockholders’ equity, so the equation is still in balance. Since there are
no revenues or expenses affected, there is no effect on the income statement.

Transaction 11: On January 27, 2019, provides $1,200 in services to a customer who asks to be billed for the services.
Analysis:
The customer does not pay immediately for the services but is expected to pay at a future date. This creates an Accounts
Receivable for Printing Plus. The customer owes the money, which increases Accounts Receivable. Accounts Receivable is an
asset, and assets increase on the debit side.
Printing Plus provided the service, thus earning revenue. Service Revenue would increase on the credit side.

Impact on the financial statements: Revenue is reported on the income statement. More revenue will increase net income
(earnings), thus increasing retained earnings. Retained earnings is a stockholders’ equity account, so total equity will increase
$1,200. Cash is increasing, which increases total assets on the balance sheet.

Transaction 12: On January 30, 2019, purchases supplies on account for $500, payment due within three months.
Analysis:
The company purchased supplies, which are assets to the business until used. Supplies is increasing, because the company has
more supplies than it did before. Supplies is an asset that is increasing on the debit side.

3.3.6 [Link]
 Printing Plus did not pay immediately for the supplies and asked to be billed for the supplies, payable at a later date. This
creates a liability for the company, Accounts Payable. This liability increases Accounts Payable; thus, Accounts Payable
increases on the credit side.

Impact on the financial statements: There is an increase to a liability and an increase to assets. These accounts both impact the
balance sheet but not the income statement.

The complete journal for these transactions is as follows:

3.3.7 [Link]
We now look at the next step in the accounting cycle, step 3: post journal information to the ledger.

Continuing Application: Colfax Market

Colfax Market is a small corner grocery store that carries a variety of staple items such as meat, milk, eggs, bread, and so on.
As a smaller grocery store, Colfax does not offer the variety of products found in a larger supermarket or chain. However, it
records journal entries in a similar way.
Grocery stores of all sizes must purchase product and track inventory. While the number of entries might differ, the recording
process does not. For example, Colfax might purchase food items in one large quantity at the beginning of each month,
payable by the end of the month. Therefore, it might only have a few accounts payable and inventory journal entries each
month. Larger grocery chains might have multiple deliveries a week, and multiple entries for purchases from a variety of
vendors on their accounts payable weekly.

3.3.8 [Link]
 This similarity extends to other retailers, from clothing stores to sporting goods to hardware. No matter the size of a company
and no matter the product a company sells, the fundamental accounting entries remain the same.

Posting to the General Ledger

Recall that the general ledger is a record of each account and its balance. Reviewing journal entries individually can be tedious and
time-consuming. The general ledger is helpful in that a company can easily extract account and balance information. Here is a
small section of a general ledger.

You can see at the top is the name of the account “Cash,” as well as the assigned account number “101.” Remember, all asset
accounts will start with the number 1. The date of each transaction related to this account is included, a possible description of the
transaction, and a reference number if available. There are debit and credit columns, storing the financial figures for each
transaction, and a balance column that keeps a running total of the balance in the account after every transaction.
Let’s look at one of the journal entries from Printing Plus and fill in the corresponding ledgers.

As you can see, there is one ledger account for Cash and another for Common Stock. Cash is labeled account number 101 because
it is an asset account type. The date of January 3, 2019, is in the far left column, and a description of the transaction follows in the
next column. Cash had a debit of $20,000 in the journal entry, so $20,000 is transferred to the general ledger in the debit column.
The balance in this account is currently $20,000, because no other transactions have affected this account yet.
Common Stock has the same date and description. Common Stock had a credit of $20,000 in the journal entry, and that information
is transferred to the general ledger account in the credit column. The balance at that time in the Common Stock ledger account is
$20,000.
Another key element to understanding the general ledger, and the third step in the accounting cycle, is how to calculate balances in
ledger accounts.

Link to Learning

It is a good idea to familiarize yourself with the type of information companies report each year. Peruse Best Buy’s 2017
annual report to learn more about Best Buy. Take note of the company’s balance sheet on page 53 of the report and the income

3.3.9 [Link]
 statement on page 54. These reports have much more information than the financial statements we have shown you; however,
if you read through them you may notice some familiar items.

Calculating Account Balances

When calculating balances in ledger accounts, one must take into consideration which side of the account increases and which side
decreases. To find the account balance, you must find the difference between the sum of all figures on the side that increases and
the sum of all figures on the side that decreases.
For example, the Cash account is an asset. We know from the accounting equation that assets increase on the debit side and
decrease on the credit side. If there was a debit of $5,000 and a credit of $3,000 in the Cash account, we would find the difference
between the two, which is $2,000 (5,000 – 3,000). The debit is the larger of the two sides ($5,000 on the debit side as opposed to
$3,000 on the credit side), so the Cash account has a debit balance of $2,000.
Another example is a liability account, such as Accounts Payable, which increases on the credit side and decreases on the debit
side. If there were a $4,000 credit and a $2,500 debit, the difference between the two is $1,500. The credit is the larger of the two
sides ($4,000 on the credit side as opposed to $2,500 on the debit side), so the Accounts Payable account has a credit balance of
$1,500.
The following are selected journal entries from Printing Plus that affect the Cash account. We will use the Cash ledger account to
calculate account balances.

The general ledger account for Cash would look like the following:

3.3.10 [Link]
In the last column of the Cash ledger account is the running balance. This shows where the account stands after each transaction, as
well as the final balance in the account. How do we know on which side, debit or credit, to input each of these balances? Let’s
consider the general ledger for Cash.
On January 3, there was a debit balance of $20,000 in the Cash account. On January 9, a debit of $4,000 was included. Since both
are on the debit side, they will be added together to get a balance on $24,000 (as is seen in the balance column on the January 9
row). On January 12, there was a credit of $300 included in the Cash ledger account. Since this figure is on the credit side, this
$300 is subtracted from the previous balance of $24,000 to get a new balance of $23,700. The same process occurs for the rest of
the entries in the ledger and their balances. The final balance in the account is $24,800.
Checking to make sure the final balance figure is correct; one can review the figures in the debit and credit columns. In the debit
column for this cash account, we see that the total is $32,300 (20,000 + 4,000 + 2,800 + 5,500). The credit column totals $7,500
(300 + 100 + 3,500 + 3,600). The difference between the debit and credit totals is $24,800 (32,300 – 7,500). The balance in this
Cash account is a debit of $24,800. Having a debit balance in the Cash account is the normal balance for that account.

Posting to the T-Accounts

The third step in the accounting cycle is to post journal information to the ledger. To do this we can use a T-account format. A
company will take information from its journal and post to this general ledger. Posting refers to the process of transferring data
from the journal to the general ledger. It is important to understand that T-accounts are only used for illustrative purposes in a
textbook, classroom, or business discussion. They are not official accounting forms. Companies will use ledgers for their official
books, not T-accounts.
Let’s look at the journal entries for Printing Plus and post each of those entries to their respective T-accounts.
The following are the journal entries recorded earlier for Printing Plus.
Transaction 1: On January 3, 2019, issues $20,000 shares of common stock for cash.

In the journal entry, Cash has a debit of $20,000. This is posted to the Cash T-account on the debit side (left side). Common Stock
has a credit balance of $20,000. This is posted to the Common Stock T-account on the credit side (right side).
Transaction 2: On January 5, 2019, purchases equipment on account for $3,500, payment due within the month.

3.3.11 [Link]
In the journal entry, Equipment has a debit of $3,500. This is posted to the Equipment T-account on the debit side. Accounts
Payable has a credit balance of $3,500. This is posted to the Accounts Payable T-account on the credit side.
Transaction 3: On January 9, 2019, receives $4,000 cash in advance from a customer for services not yet rendered.

In the journal entry, Cash has a debit of $4,000. This is posted to the Cash T-account on the debit side. You will notice that the
transaction from January 3 is listed already in this T-account. The next transaction figure of $4,000 is added directly below the
$20,000 on the debit side. Unearned Revenue has a credit balance of $4,000. This is posted to the Unearned Revenue T-account on
the credit side.
Transaction 4: On January 10, 2019, provides $5,500 in services to a customer who asks to be billed for the services.

In the journal entry, Accounts Receivable has a debit of $5,500. This is posted to the Accounts Receivable T-account on the debit
side. Service Revenue has a credit balance of $5,500. This is posted to the Service Revenue T-account on the credit side.
Transaction 5: On January 12, 2019, pays a $300 utility bill with cash.

3.3.12 [Link]
In the journal entry, Utility Expense has a debit balance of $300. This is posted to the Utility Expense T-account on the debit side.
Cash has a credit of $300. This is posted to the Cash T-account on the credit side. You will notice that the transactions from January
3 and January 9 are listed already in this T-account. The next transaction figure of $300 is added on the credit side.
Transaction 6: On January 14, 2019, distributed $100 cash in dividends to stockholders.

In the journal entry, Dividends has a debit balance of $100. This is posted to the Dividends T-account on the debit side. Cash has a
credit of $100. This is posted to the Cash T-account on the credit side. You will notice that the transactions from January 3, January
9, and January 12 are listed already in this T-account. The next transaction figure of $100 is added directly below the January 12
record on the credit side.
Transaction 7: On January 17, 2019, receives $2,800 cash from a customer for services rendered.

In the journal entry, Cash has a debit of $2,800. This is posted to the Cash T-account on the debit side. You will notice that the
transactions from January 3, January 9, January 12, and January 14 are listed already in this T-account. The next transaction figure
of $2,800 is added directly below the January 9 record on the debit side. Service Revenue has a credit balance of $2,800. This too
has a balance already from January 10. The new entry is recorded under the Jan 10 record, posted to the Service Revenue T-account
on the credit side.

3.3.13 [Link]
Transaction 8: On January 18, 2019, paid in full, with cash, for the equipment purchase on January 5.

On this transaction, Cash has a credit of $3,500. This is posted to the Cash T-account on the credit side beneath the January 14
transaction. Accounts Payable has a debit of $3,500 (payment in full for the Jan. 5 purchase). You notice there is already a credit in
Accounts Payable, and the new record is placed directly across from the January 5 record.
Transaction 9: On January 20, 2019, paid $3,600 cash in salaries expense to employees.

On this transaction, Cash has a credit of $3,600. This is posted to the Cash T-account on the credit side beneath the January 18
transaction. Salaries Expense has a debit of $3,600. This is placed on the debit side of the Salaries Expense T-account.
Transaction 10: On January 23, 2019, received cash payment in full from the customer on the January 10 transaction.

On this transaction, Cash has a debit of $5,500. This is posted to the Cash T-account on the debit side beneath the January 17
transaction. Accounts Receivable has a credit of $5,500 (from the Jan. 10 transaction). The record is placed on the credit side of the
Accounts Receivable T-account across from the January 10 record.
Transaction 11: On January 27, 2019, provides $1,200 in services to a customer who asks to be billed for the services.

3.3.14 [Link]
On this transaction, Accounts Receivable has a debit of $1,200. The record is placed on the debit side of the Accounts Receivable
T-account underneath the January 10 record. Service Revenue has a credit of $1,200. The record is placed on the credit side of the
Service Revenue T-account underneath the January 17 record.
Transaction 12: On January 30, 2019, purchases supplies on account for $500, payment due within three months.

On this transaction, Supplies has a debit of $500. This will go on the debit side of the Supplies T-account. Accounts Payable has a
credit of $500. You notice there are already figures in Accounts Payable, and the new record is placed directly underneath the
January 5 record.

T-Accounts Summary
Once all journal entries have been posted to T-accounts, we can check to make sure the accounting equation remains balanced. A
summary showing the T-accounts for Printing Plus is presented in Figure 3.3.1.

3.3.15 [Link]
 Figure 3.3.1 : Summary of T-Accounts for Printing Plus. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA
4.0 license)
The sum on the assets side of the accounting equation equals $30,000, found by adding together the final balances in each asset
account (24,800 + 1,200 + 500 + 3,500). To find the total on the liabilities and equity side of the equation, we need to find the
difference between debits and credits. Credits on the liabilities and equity side of the equation total $34,000 (500 + 4,000 + 20,000
+ 9,500). Debits on the liabilities and equity side of the equation total $4,000 (100 + 3,600 + 300). The difference $34,000 – $4,000
= $30,000. Thus, the equation remains balanced with $30,000 on the asset side and $30,000 on the liabilities and equity side. Now
that we have the T-account information, and have confirmed the accounting equation remains balanced, we can create the
unadjusted trial balance.

Your Turn: Journalizing Transactions

You have the following transactions the last few days of April.

You stop by your uncle’s gas station to refill both gas cans for
Apr. 25 your company, Watson’s Landscaping. Your uncle adds the total
of $28 to your account.
You record another week’s revenue for the lawns mowed over
Apr. 26 the past week. You earned $1,200. You received cash equal to
75% of your revenue.
You pay your local newspaper $35 to run an advertisement in
Apr. 27
this week’s paper.
Apr. 29 You make a $25 payment on account.

Table 3.3.1
1. Prepare the necessary journal entries for these four transactions.
2. Explain why you debited and credited the accounts you did.
3. What will be the new balance in each account used in these entries?

Answer

3.3.16 [Link]
 April 25
You have incurred more gas expense. This means you have an increase in the total amount of gas expense for April.
Expenses go up with debit entries. Therefore, you will debit gas expense.
You purchased the gas on account. This will increase your liabilities. Liabilities increase with credit entries. Credit
accounts payable to increase the total in the account.
April 26
You have received more cash from customers, so you want the total cash to increase. Cash is an asset, and assets
increase with debit entries, so debit cash.
You also have more money owed to you by your customers. You have performed the services, your customers owe you
the money, and you will receive the money in the future. Debit accounts receivable as asset accounts increase with
debits.
You have mowed lawns and earned more revenue. You want the total of your revenue account to increase to reflect this
additional revenue. Revenue accounts increase with credit entries, so credit lawn-mowing revenue.
April 27
Advertising is an expense of doing business. You have incurred more expenses, so you want to increase an expense
account. Expense accounts increase with debit entries. Debit advertising expense.
You paid cash for the advertising. You have less cash, so credit the cash account. Cash is an asset, and asset account
totals decrease with credits.
April 29
You paid “on account.” Remember that “on account” means a service was performed or an item was received without
being paid for. The customer asked to be billed. You were the customer in this case. You made a purchase of gas on
account earlier in the month, and at that time you increased accounts payable to show you had a liability to pay this
amount sometime in the future. You are now paying down some of the money you owe on that account. Since you paid
this money, you now have less of a liability so you want to see the liability account, accounts payable, decrease by the
amount paid. Liability accounts decrease with debit entries.
You paid, which means you gave cash (or wrote a check or electronically transferred) so you have less cash. To decrease
the total cash, credit the account because asset accounts are reduced by recording credit entries.

Your Turn: Normal Account Balances

Calculate the balances in each of the following accounts. Do they all have the normal balance they should have? If not, which
one? How do you know this?
A General Ledger titled “Cash Account No. 101” with six columns. Date: 2019. Six columns labeled left to right: Date, Item, Reference, Debit, Credit, Balance. Debit: 9,500; Balance: 9,500. Credit: 3,500;
Balance: 6,000. Debit: 1,750; Balance: 7,750. Credit: 5,800; Balance: 1,950. Debit: 500; Balance: 2,450. Credit: 1,500; Balance: 950.

3.3.17 [Link]
 A General Ledger titled “Accounts Receivable No. 111” with six columns. Date: 2019. Debt column entries: 4,500, 3,650, 825. Credit column entries: 4,250, 3,500.

A General Ledger titled “Accounts Payable No. 201” with six columns. Date: 2019. Debit column entries: 500, 650. Credit column entries: 1,500, 875, 325.

Answer

A General Ledger titled “Accounts Payable No. 201” with six columns. Date: 2019. Six columns labeled left to right: Date, Item, Reference, Debit, Credit, Balance. Credit: 1,500; Balance: 1,500. Credit:
875; Balance: 2,375. Debit: 500; Balance: 1,875. Credit: 325; Balance: 2,200. Debit: 650; Balance: 1,550.

Think It Through: Gift Cards

Gift cards have become an important topic for managers of any company. Understanding who buys gift cards, why, and when
can be important in business planning. Also, knowing when and how to determine that a gift card will not likely be redeemed
will affect both the company’s balance sheet (in the liabilities section) and the income statement (in the revenues section).
According to a 2017 holiday shopping report from the National Retail Federation, gift cards are the most-requested presents for
the eleventh year in a row, with 61% of people surveyed saying they are at the top of their wish lists, according to the National
Retail Federation.6 CEB TowerGroup projects that total gift card volume will reach $160 billion by 2018.7
How are all of these gift card sales affecting one of America’s favorite specialty coffee companies, Starbucks?
In 2014 one in seven adults received a Starbucks gift card. On Christmas Eve alone $2.5 million gift cards were sold. This is a
rate of 1,700 cards per minute.8
The following discussion about gift cards is taken from Starbucks’s 2016 annual report:
“When an amount is loaded onto a stored value card we recognize a corresponding liability for the full amount loaded onto the
card, which is recorded within stored value card liability on our consolidated balance sheets. When a stored value card is
redeemed at a company-operated store or online, we recognize revenue by reducing the stored value card liability. When a
stored value card is redeemed at a licensed store location, we reduce the corresponding stored value card liability and cash,
which is reimbursed to the licensee. There are no expiration dates on our stored value cards, and in most markets, we do not
charge service fees that cause a decrement to customer balances. While we will continue to honor all stored value cards
presented for payment, management may determine the likelihood of redemption, based on historical experience, is deemed to
be remote for certain cards due to long periods of inactivity. In these circumstances, unredeemed card balances may be
recognized as breakage income. In fiscal 2016, 2015, and 2014, we recognized breakage income of $60.5 million, $39.3
million, and $38.3 million, respectively.9”
As of October 1, 2017, Starbucks had a total of $1,288,500,000 in stored value card liability.

3.3.18 [Link]
Footnotes
6 National Retail Federation (NRF). “NRF Consumer Survey Points to Busy Holiday Season, Backs Up Economic Forecast and
Import Numbers.” October 27, 2017. [Link]
7 CEB Tower Group. “2015 Gift Card Sales to Reach New Peak of $130 Billion.” PR Newswire. December 8, 2015.
[Link]
8 Sara Haralson. “Last-Minute Shoppers Rejoice! Starbucks Has You Covered.” Fortune. December 22, 2015.
[Link]/video/2015/12/22/...ks-gift-cards/
9 U.S. Securities and Exchange Commission. Communication from Starbucks Corporation regarding 2014 10-K Filing.
November 14, 2014. [Link]

3.3: Use Journal Entries to Record Transactions and Post to T-Accounts is shared under a CC BY-NC-SA license and was authored, remixed,
and/or curated by LibreTexts.

3.3.19 [Link]
3.4: Prepare a Trial Balance
Once all the monthly transactions have been analyzed, journalized, and posted on a continuous day-to-day basis over the
accounting period (a month in our example), we are ready to start working on preparing a trial balance (unadjusted). Preparing an
unadjusted trial balance is the fourth step in the accounting cycle. A trial balance is a list of all accounts in the general ledger that
have nonzero balances. A trial balance is an important step in the accounting process, because it helps identify any computational
errors throughout the first three steps in the cycle.
Note that for this step, we are considering our trial balance to be unadjusted. The unadjusted trial balance in this section includes
accounts before they have been adjusted.
When constructing a trial balance, we must consider a few formatting rules, akin to those requirements for financial statements:
The header must contain the name of the company, the label of a Trial Balance (Unadjusted), and the date.
Accounts are listed in the accounting equation order with assets listed first followed by liabilities and finally equity.
Amounts at the top of each debit and credit column should have a dollar sign.
When amounts are added, the final figure in each column should be underscored.
The totals at the end of the trial balance need to have dollar signs and be double-underscored.
Transferring information from T-accounts to the trial balance requires consideration of the final balance in each account. If the final
balance in the ledger account (T-account) is a debit balance, you will record the total in the left column of the trial balance. If the
final balance in the ledger account (T-account) is a credit balance, you will record the total in the right column.
Once all ledger accounts and their balances are recorded, the debit and credit columns on the trial balance are totaled to see if the
figures in each column match each other. The final total in the debit column must be the same dollar amount that is determined in
the final credit column. For example, if you determine that the final debit balance is $24,000 then the final credit balance in the trial
balance must also be $24,000. If the two balances are not equal, there is a mistake in at least one of the columns.

3.4.1 [Link]
Let’s now take a look at the T-accounts and unadjusted trial balance for Printing Plus to see how the information is transferred from
the T-accounts to the unadjusted trial balance.
For example, Cash has a final balance of $24,800 on the debit side. This balance is transferred to the Cash account in the debit
column on the unadjusted trial balance. Accounts Receivable ($1,200), Supplies ($500), Equipment ($3,500), Dividends ($100),
Salaries Expense ($3,600), and Utility Expense ($300) also have debit final balances in their T-accounts, so this information will be
transferred to the debit column on the unadjusted trial balance. Accounts Payable ($500), Unearned Revenue ($4,000), Common
Stock ($20,000), and Service Revenue ($9,500) all have credit final balances in their T-accounts. These credit balances would
transfer to the credit column on the unadjusted trial balance.
Once all balances are transferred to the unadjusted trial balance, we will sum each of the debit and credit columns. The debit and
credit columns both total $34,000, which means they are equal and in balance. However, just because the column totals are equal
and in balance, we are still not guaranteed that a mistake is not present.

3.4.2 [Link]
What happens if the columns are not equal?

Concepts in Practice: Enron and Arthur Andersen

One of the most well-known financial schemes is that involving the companies Enron Corporation and Arthur Andersen.
Enron defrauded thousands by intentionally inflating revenues that did not exist. Arthur Andersen was the auditing firm in
charge of independently verifying the accuracy of Enron’s financial statements and disclosures. This meant they would review
statements to make sure they aligned with GAAP principles, assumptions, and concepts, among other things.
It has been alleged that Arthur Andersen was negligent in its dealings with Enron and contributed to the collapse of the
company. Arthur Andersen was brought up on a charge of obstruction of justice for shredding important documents related to
criminal actions by Enron. They were found guilty but had that conviction overturned. However, the damage was done, and
the company’s reputation prevented it from operating as it had.10

Locating Errors
Sometimes errors may occur in the accounting process, and the trial balance can make those errors apparent when it does not
balance.
One way to find the error is to take the difference between the two totals and divide the difference by two. For example, let’s
assume the following is the trial balance for Printing Plus.

3.4.3 [Link]
You notice that the balances are not the same. Find the difference between the two totals: $34,100 – $33,900 = $200 difference.
Now divide the difference by two: $200/2 = $100. Since the credit side has a higher total, look carefully at the numbers on the
credit side to see if any of them are $100. The Dividends account has a $100 figure listed in the credit column. Dividends normally
have a debit balance, but here it is a credit. Look back at the Dividends T-account to see if it was copied onto the trial balance
incorrectly. If the answer is the same as the T-account, then trace it back to the journal entry to check for mistakes. You may
discover in your investigation that you copied the number from the T-account incorrectly. Fix your error, and the debit total will go
up $100 and the credit total down $100 so that they will both now be $34,000.
Another way to find an error is to take the difference between the two totals and divide by nine. If the outcome of the difference is a
whole number, then you may have transposed a figure. For example, let’s assume the following is the trial balance for Printing
Plus.

3.4.4 [Link]
Find the difference between the two totals: $35,800 – 34,000 = $1,800 difference. This difference divided by nine is $200 ($1,800/9
= $200). Looking at the debit column, which has the higher total, we determine that the Equipment account had transposed figures.
The account should be $3,500 and not $5,300. We transposed the three and the five.
What do you do if you have tried both methods and neither has worked? Unfortunately, you will have to go back through one step
at a time until you find the error.
If a trial balance is in balance, does this mean that all of the numbers are correct? Not necessarily. We can have errors and still be
mathematically in balance. It is important to go through each step very carefully and recheck your work often to avoid mistakes
early on in the process.
After the unadjusted trial balance is prepared and it appears error-free, a company might look at its financial statements to get an
idea of the company’s position before adjustments are made to certain accounts. A more complete picture of company position
develops after adjustments occur, and an adjusted trial balance has been prepared.

Your Turn: Completing a Trial Balance

Complete the trial balance for Magnificent Landscaping Service using the following T-account final balance information for
April 30, 2018.

3.4.5 [Link]
 Answer

Think It Through: Correcting Errors in the Trial Balance

You own a small consulting business. Each month, you prepare a trial balance showing your company’s position. After
preparing your trial balance this month, you discover that it does not balance. The debit column shows $2,000 more dollars
than the credit column. You decide to investigate this error.
What methods could you use to find the error? What are the ramifications if you do not find and fix this error? How can you
minimize these types of errors in the future?

3.4.6 [Link]
Footnotes
10 James Titcomb. “Arthur Andersen Returns 12 Years after Enron Scandal.” The Telegraph. September 2, 2014.
[Link]

3.4: Prepare a Trial Balance is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by LibreTexts.

3.4.7 [Link]
3.5: Preparing Financial Statements
Preparing Financial Statements
After the adjusted trial balance, we will prepare the financial statements. The financial statements are how a business
communicates or publishes its story. We will be focusing on three financial statements:
1. Income Statement: Calculates net income or loss of a company by showing revenues – expenses. If revenues are greater than
expenses, you have net income. If revenues are less than expenses, you have net loss.
2. Statement of Retained Earnings: Calculates an ending balance in the retained earnings account using net income or loss
calculated on the income statement. This statement takes the beginning balance in retained earnings + net income (or – net loss)
– dividends to get the ending retained earnings balance. The ending retained earnings balance is reported on the balance sheet.
3. Balance Sheet: Proves the accounting equation of Assets = Liabilities + Equity and uses ending retained earnings calculated on
the statement of retained earnings in equity.
This video will review the basic financial statements after the adjusted trial balance.

Preparing the Financial Statements (Fin…

(Fin…

The balance sheet shown in the video is the simplified version we learned at the beginning of the course. If you look at the balance
sheets produced by companies now, they are a little more detailed. A classified balance sheet adds groupings and subtotals to
make the balance sheet easier for investors to read and analyze. The balance sheet can be done in report form where assets are first
and liabilities and equity are below. Or in a side-by-side presentation. The classified balance sheet still proves the accounting
equation but it separates assets and liabilities into subgroups:
Current Assets: Can be converted to cash within a year or the operating cycle whichever is longer. Current assets include cash,
accounts receivable, interest receivable, supplies, inventory, and other prepaid expenses.
Long Term Investments: Investments that do not come due for more than a year are reported in this section. Long term
investments would include notes receivable or investments in bonds or stocks.
Plant Assets: Plant assets (also called Property, Plant, and Equipment or Fixed Assets) refer to property that is tangible (can be
seen and touched) and is used in the business to generate revenue. Plant assets include depreciable assets and land used in the
business. The plant asset is recorded with its accumulated depreciation (if any) subtracted below it to get the asset’s book value.
Intangible Assets: Intangible assets are items that have a financial value but do not have a physical form. These would be
things like trademarks, patents, and copyrights.
Current Liabilities: Like current assets, these are liabilities that are due to be paid within a year or the operating cycle
whichever is longer. Current liabilities include accounts payable, salaries payable, taxes payable, unearned revenue, etc.
Long Term Liabilities: Liabilities due more than a year from now would be reported here. These would include notes payable,
mortgage payable, bonds payable, etc.
The Equity section of a classified balance sheet does not change. Using the information for MicroTrain, the financial statements
would be:

MicroTrain Company
Income Statement

3.5.1 [Link]
 For Year Ended December 31
Revenues:

Service Revenue $ 36,500

Interest Revenue 600

Total Revenues $ 37,100

Expenses:

Salaries Expense 18,360

Rent Expense 1,200

Utilities Expense 500

Insurance Expense 200

Supplies Expense 7,000

Depreciation Expense 750

Total Expenses 28,010

Net Income (37,100 – 28,010) $ 9,090

The net income gets carried over to the statement of retained earnings. We will also use the retained earnings balance from the
adjusted trial balance as the beginning balance. There are no dividends listed on the adjusted trial balance so MicroTrain did not
pay dividends.

MicroTrain Company
Statement of Retained Earnings
For Year Ended December 31

Beginning Retained Earnings $ 6,100 from the adjusted trial balance

Net Income 9,090 from the income statement

$ 15,190

Dividends –0 No dividends paid this year

Ending Retained Earnings $ 15,190 goes to the balance sheet

The calculated ending balance will be reported as the Retained Earnings amount on the balance sheet. We are doing the Classified
Balance Sheet showing the subgroups for assets and liabilities in report form.

MicroTrain Company
Classified Balance Sheet
December 31
Assets

Current Assets

Cash $ 10,000

Accounts Receivable 25,000

Interest Receivable 600

3.5.2 [Link]
 Supplies 1,500

Prepaid Insurance 2,200

Total Current Assets $ 39,300

Plant Assets

Trucks 40,000

Less: Accum. Depreciation – Trucks ( 750)

Total Plant Assets 39,250

TOTAL ASSETS $ 78,550

Liabilities and Equity

Current Liabilities

Accounts Payable 25,000

Unearned Revenue 3,000

Salaries Payable 360

Total Current Liabilities 28,360

Equity

Common Stock 35,000

Retained Earnings 15,190

Total Equity 50,190

TOTAL LIABILITIES AND EQUITY $ 78,550

Notice how accumulated depreciation, a contra-account, reduces the asset account it is related to in the plant asset section.
Remember, the balance sheet proves the accounting equation (ASSETS = LIABILITIES + EQUITY) and must always be in
balance. Why do we need these groupings? It makes it easier for investors to quickly calculate ratios, for example, the current
ratio.
The current ratio measures how much in assets the company has available now to pay liabilities due in the next year. The current
ratio uses current assets and current liabilities:

Current Assets
Current Ratio =
Current Liabilities

We can calculate MicroTrain’s current ratio as follows:

Current Assets = 39,300 = 1.39

Current Liabilities 28,360

The current ratio has been rounded to 2-decimal places to get a current ratio of 1.39 or 1.39 to 1. This means MicroTrain has
approximately $1.39 in current assets available to pay every $1 of current liabilities. Investors like to see a ratio of between 1.5 and
2 so MicroTrain’s current ratio is a little low but still good since we have more assets than liabilities.

3.5: Preparing Financial Statements is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

3.5.3 [Link]
 CHAPTER OVERVIEW

4: Adjusting Journal Entries (AJE's)

Learning Objectives
Distinguish between cash basis and accrual basis accounting and explain their impact on the financial statements, including
the revenue recognition and matching principles

4.1: Explain the Concepts and Guidelines Affecting Adjusting Entries

4.2: Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
4.3: Record and Post the Common Types of Adjusting Entries
4.4: Use the Ledger Balances to Prepare an Adjusted Trial Balance
4.5: Prepare Financial Statements Using the Adjusted Trial Balance
4.6: Describe and Prepare Closing Entries for a Business
4.7: Prepare a Post-Closing Trial Balance

4: Adjusting Journal Entries (AJE's) is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1
4.1: Explain the Concepts and Guidelines Affecting Adjusting Entries
Explain the Concepts and Guidelines Affecting Adjusting Entries
Earlier, we discussed the first four steps in the accounting cycle: identify and analyze transactions, record transactions to a journal,
post journal information to the general ledger, and prepare an (unadjusted) trial balance (Figure 4.1.1).

Figure 4.1.1 : The Basic Accounting Cycle. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
This section examines the next three steps in the cycle: record adjusting entries (journalizing and posting), prepare an adjusted trial
balance, and prepare the financial statements (Figure 4.1.2).

Figure 4.1.2 : Steps 5, 6, and 7 in the Accounting Cycle. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA
4.0 license)
As we progress through these steps, you learn why the trial balance in this phase of the accounting cycle is referred to as an
“adjusted” trial balance. We also discuss the purpose of adjusting entries and the accounting concepts supporting their need. One of
the first concepts we discuss is accrual accounting.

4.1.1 [Link]
Accrual Accounting
Public companies reporting their financial positions use either US generally accepted accounting principles (GAAP) or
International Financial Reporting Standards (IFRS), as allowed under the Securities and Exchange Commission (SEC) regulations.
Also, companies, public or private, using US GAAP or IFRS prepare their financial statements using the rules of accrual
accounting. Accrual basis accounting prescribes that revenues and expenses must be recorded in the accounting period in which
they were earned or incurred, no matter when cash receipts or payments occur. It is because of accrual accounting that we have the
revenue recognition principle and the expense recognition principle (also known as the matching principle).
The accrual method is considered to better match revenues and expenses and standardizes reporting information for comparability
purposes. Having comparable information is important to external users of information trying to make investment or lending
decisions, and to internal users trying to make decisions about company performance, budgeting, and growth strategies.
Some nonpublic companies may choose to use cash basis accounting rather than accrual basis accounting to report financial
information. Cash basis accounting is a method of accounting in which transactions are not recorded in the financial statements
until there is an exchange of cash. Cash basis accounting sometimes delays or accelerates revenue and expense reporting until cash
receipts or outlays occur. With this method, cash flows are used to measure business performance in a given period and can be
simpler to track than accrual basis accounting.
There are several other accounting methods or concepts that accountants will sometimes apply. The first is modified accrual
accounting, which is commonly used in governmental accounting and merges accrual basis and cash basis accounting. The second
is tax basis accounting that is used in establishing the tax effects of transactions in determining the tax liability of an organization.
One fundamental concept to consider related to the accounting cycle—and to accrual accounting in particular—is the idea of the
accounting period.

The Accounting Period

As we discussed, accrual accounting requires companies to report revenues and expenses in the accounting period in which they
were earned or incurred. An accounting period breaks down company financial information into specific time spans, and can
cover a month, a quarter, a half-year, or a full year. Public companies governed by GAAP are required to present quarterly (three-
month) accounting period financial statements called 10-Qs. However, most public and private companies keep monthly, quarterly,
and yearly (annual) period information. This is useful to users needing up-to-date financial data to make decisions about company
investment and growth. When the company keeps yearly information, the year could be based on a fiscal or calendar year. This is
explained shortly.

Continuing Application: Adjustment Process for Grocery Stores

In every industry, adjustment entries are made at the end of the period to ensure revenue matches expenses. Companies with an
online presence need to account for items sold that have not yet been shipped or are in the process of reaching the end user. But
what about the grocery industry? At first glance, it might seem that no such adjustment entries are necessary. However, grocery
stores have adapted to the current retail environment. For example, your local grocery store might provide catering services for
a graduation party. If the contract requires the customer to put down a 50% deposit, and occurs near the end of a period, the
grocery store will have unearned revenue until it provides the catering service. Once the party occurs, the grocery store needs
to make an adjusting entry to reflect that revenue has been earned.

The Fiscal Year and the Calendar Year

A company may choose its yearly reporting period to be based on a calendar or fiscal year. If a company uses a calendar year, it is
reporting financial data from January 1 to December 31 of a specific year. This may be useful for businesses needing to coincide
with a traditional yearly tax schedule. It can also be easier to track for some businesses without formal reconciliation practices, and
for small businesses.
A fiscal year is a twelve-month reporting cycle that can begin in any month and records financial data for that consecutive twelve-
month period. For example, a business may choose its fiscal year to begin on April 1, 2019, and end on March 31, 2020. This can
be common practice for corporations and may best reflect the operational flow of revenues and expenses for a particular business.
In addition to annual reporting, companies often need or choose to report financial statement information in interim periods.

4.1.2 [Link]
Interim Periods
An interim period is any reporting period shorter than a full year (fiscal or calendar). This can encompass monthly, quarterly, or
half-year statements. The information contained in these statements is timelier than waiting for a yearly accounting period to end.
The most common interim period is three months, or a quarter. For companies whose common stock is traded on a major stock
exchange, meaning these are publicly traded companies, quarterly statements must be filed with the SEC on a Form 10-Q. The
companies must file a Form 10-K for their annual statements. As you’ve learned, the SEC is an independent agency of the federal
government that provides oversight of public companies to maintain fair representation of company financial activities for investors
to make informed decisions.
In order for information to be useful to the user, it must be timely—that is, the user has to get it quickly enough so it is relevant to
decision-making. This is the basis of the time period assumption in accounting. For example, a potential or existing investor wants
timely information by which to measure the performance of the company, and to help decide whether to invest, to stay invested, or
to sell their stockholdings and invest elsewhere. This requires companies to organize their information and break it down into
shorter periods. Internal and external users can then rely on the information that is both timely and relevant to decision-making.
The accounting period a company chooses to use for financial reporting will impact the types of adjustments they may have to
make to certain accounts.

Ethical Considerations: Illegal Cookie Jar Accounting Used to Manage Earnings

From 2000 through the end of 2001, Bristol-Myers Squibb engaged in “Cookie Jar Accounting,” resulting in $150 million in
SEC fines. The company manipulated its accounting to create a false indication of income and growth to create the appearance
that it was meeting its own targets and Wall Street analysts’ earnings estimates during the years 2000 and 2001. The SEC
describes some of what occurred:
“Bristol-Myers inflated its results primarily by (1) stuffing its distribution channels with excess inventory near the end of every
quarter in amounts sufficient to meet its targets by making pharmaceutical sales to its wholesalers ahead of demand; and (2)
improperly recognizing $1.5 billion in revenue from such pharmaceutical sales to its two biggest wholesalers. In connection
with the $1.5 billion in revenue, Bristol-Myers covered these wholesalers’ carrying costs and guaranteed them a return on
investment until they sold the products. When Bristol-Myers recognized the $1.5 billion in revenue upon shipment, it did so
contrary to generally accepted accounting principles.1”
In addition to the improper distribution of product to manipulate earnings numbers, which was not enough to meet earnings
targets, the company improperly used divestiture reserve funds (a “cookie jar” fund that is funded by the sale of assets such as
product lines or divisions) to meet those targets. In this circumstance, earnings management was considered illegal, costing the
company millions of dollars in fines.

Footnotes
1 U.S. Securities and Exchange Commission. “Bristol-Myers Squibb Company Agrees to Pay $150 Million to Settle Fraud
Charges.” August 4, 2004. [Link]

4.1: Explain the Concepts and Guidelines Affecting Adjusting Entries is shared under a CC BY-NC-SA license and was authored, remixed, and/or
curated by LibreTexts.

4.1.3 [Link]
4.2: Discuss the Adjustment Process and Illustrate Common Types of Adjusting
Entries
When a company reaches the end of a period, it must update certain accounts that have either been left unattended throughout the
period or have not yet been recognized. Adjusting entries update accounting records at the end of a period for any transactions that
have not yet been recorded. One important accounting principle to remember is that just as the accounting equation (Assets =
Liabilities + Owner’s equity/or common stock/or capital) must be equal, it must remain equal after you make adjusting entries.
Also note that in this equation, owner’s equity represents an individual owner (sole proprietorship), common stock represents a
corporation’s owners’ interests, and capital represents a partnership’s owners’ interests. We discuss the effects of adjusting entries
in greater detail throughout this chapter.
There are several steps in the accounting cycle that require the preparation of a trial balance: step 4, preparing an unadjusted trial
balance; step 6, preparing an adjusted trial balance; and step 9, preparing a post-closing trial balance. You might question the
purpose of more than one trial balance. For example, why can we not go from the unadjusted trial balance straight into preparing
financial statements for public consumption? What is the purpose of the adjusted trial balance? Does preparing more than one trial
balance mean the company made a mistake earlier in the accounting cycle? To answer these questions, let’s first explore the
(unadjusted) trial balance, and why some accounts have incorrect balances.

Why Some Accounts Have Incorrect Balances on the Trial Balance

The unadjusted trial balance may have incorrect balances in some accounts.

Figure 4.2.1 : Unadjusted Trial Balance for Printing Plus. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA
4.0 license)
The trial balance for Printing Plus shows Supplies of $500, which were purchased on January 30. Since this is a new company,
Printing Plus would more than likely use some of their supplies right away, before the end of the month on January 31. Supplies are
only an asset when they are unused. If Printing Plus used some of its supplies immediately on January 30, then why is the full $500
still in the supply account on January 31? How do we fix this incorrect balance?

4.2.1 [Link]
Similarly, what about Unearned Revenue? On January 9, the company received $4,000 from a customer for printing services to be
performed. The company recorded this as a liability because it received payment without providing the service. To clear this
liability, the company must perform the service. Assume that as of January 31 some of the printing services have been provided. Is
the full $4,000 still a liability? Since a portion of the service was provided, a change to unearned revenue should occur. The
company needs to correct this balance in the Unearned Revenue account.
Having incorrect balances in Supplies and in Unearned Revenue on the company’s January 31 trial balance is not due to any error
on the company’s part. The company followed all of the correct steps of the accounting cycle up to this point. So why are the
balances still incorrect?
Journal entries are recorded when an activity or event occurs that triggers the entry. Usually, the trigger is from an original source.
Recall that an original source can be a formal document substantiating a transaction, such as an invoice, purchase order, canceled
check, or employee time sheet. Not every transaction produces an original source document that will alert the bookkeeper that it is
time to make an entry.
When a company purchases supplies, the original order, receipt of the supplies, and receipt of the invoice from the vendor will all
trigger journal entries. This trigger does not occur when using supplies from the supply closet. Similarly, for unearned revenue,
when the company receives an advance payment from the customer for services yet provided, the cash received will trigger a
journal entry. When the company provides the printing services for the customer, the customer will not send the company a
reminder that revenue has now been earned. Situations such as these are why businesses need to make adjusting entries.

Think It Through: Keep Calm and Adjust...

Elliot Simmons owns a small law firm. He does the accounting himself and uses an accrual basis for accounting. At the end of
his first month, he reviews his records and realizes there are a few inaccuracies on this unadjusted trial balance.
One difference is the supplies account; the figure on paper does not match the value of the supplies inventory still available.
Another difference was interest earned from his bank account. He did not have anything recognizing these earnings.
Why did his unadjusted trial balance have these errors? What can be attributed to the differences in supply figures? What can
be attributed to the differences in interest earned?

The Need for Adjusting Entries

Adjusting entries update accounting records at the end of a period for any transactions that have not yet been recorded. These
entries are necessary to ensure the income statement and balance sheet present the correct, up-to-date numbers. Adjusting entries
are also necessary because the initial trial balance may not contain complete and current data due to several factors:
The inefficiency of recording every single day-to-day event, such as the use of supplies.
Some costs are not recorded during the period but must be recognized at the end of the period, such as depreciation, rent, and
insurance.
Some items are forthcoming for which original source documents have not yet been received, such as a utility bill.
There are a few other guidelines that support the need for adjusting entries.

Guidelines Supporting Adjusting Entries

Several guidelines support the need for adjusting entries:
Revenue recognition principle: Adjusting entries are necessary because the revenue recognition principle requires revenue
recognition when earned, thus the need for an update to unearned revenues.
Expense recognition (matching) principle: This requires matching expenses incurred to generate the revenues earned, which
affects accounts such as insurance expense and supplies expense.
Time period assumption: This requires useful information be presented in shorter time periods such as years, quarters, or
months. This means a company must recognize revenues and expenses in the proper period, requiring adjustment to certain
accounts to meet these criteria.
The required adjusting entries depend on what types of transactions the company has, but there are some common types of
adjusting entries. Before we look at recording and posting the most common types of adjusting entries, we briefly discuss the
various types of adjusting entries.

4.2.2 [Link]
Types of Adjusting Entries
Adjusting entries requires updates to specific account types at the end of the period. Not all accounts require updates, only those
not naturally triggered by an original source document. There are two main types of adjusting entries that we explore further,
deferrals and accruals.

Deferrals
Deferrals are prepaid expense and revenue accounts that have delayed recognition until they have been used or earned. This
recognition may not occur until the end of a period or future periods. When deferred expenses and revenues have yet to be
recognized, their information is stored on the balance sheet. As soon as the expense is incurred and the revenue is earned, the
information is transferred from the balance sheet to the income statement. Two main types of deferrals are prepaid expenses and
unearned revenues.

Prepaid Expenses
Prepaid expenses (prepayments) are assets for which advanced payment has occurred, before the company can benefit from use. As
soon as the asset has provided benefit to the company, the value of the asset used is transferred from the balance sheet to the
income statement as an expense. Some common examples of prepaid expenses are supplies, depreciation, insurance, and rent.
When a company purchases supplies, it may not use all supplies immediately, but chances are the company has used some of the
supplies by the end of the period. It is not worth it to record every time someone uses a pencil or piece of paper during the period,
so at the end of the period, this account needs to be updated for the value of what has been used.
Let’s say a company paid for supplies with cash in the amount of $400. At the end of the month, the company took an inventory of
supplies used and determined the value of those supplies used during the period to be $150. The following entry occurs for the
initial payment.

Supplies increases (debit) for $400, and Cash decreases (credit) for $400. When the company recognizes the supplies usage, the
following adjusting entry occurs.

Supplies Expense is an expense account, increasing (debit) for $150, and Supplies is an asset account, decreasing (credit) for $150.
This means $150 is transferred from the balance sheet (asset) to the income statement (expense). Notice that not all of the supplies
are used. There is still a balance of $250 (400 – 150) in the Supplies account. This amount will carry over to future periods until
used. The balances in the Supplies and Supplies Expense accounts show as follows.

4.2.3 [Link]
Depreciation may also require an adjustment at the end of the period. Recall that depreciation is the systematic method to record
the allocation of cost over a given period of certain assets. This allocation of cost is recorded over the useful life of the asset, or the
time period over which an asset cost is allocated. The allocated cost up to that point is recorded in Accumulated Depreciation, a
contra asset account. A contra account is an account paired with another account type, has an opposite normal balance to the
paired account, and reduces the balance in the paired account at the end of a period.
Accumulated Depreciation is contrary to an asset account, such as Equipment. This means that the normal balance for Accumulated
Depreciation is on the credit side. It houses all depreciation expensed in current and prior periods. Accumulated Depreciation will
reduce the asset account for depreciation incurred up to that point. The difference between the asset’s value (cost) and accumulated
depreciation is called the book value of the asset. When depreciation is recorded in an adjusting entry, Accumulated Depreciation
is credited and Depreciation Expense is debited.
For example, let’s say a company pays $2,000 for equipment that is supposed to last four years. The company wants to depreciate
the asset over those four years equally. This means the asset will lose $500 in value each year ($2,000/four years). In the first year,
the company would record the following adjusting entry to show depreciation of the equipment.

Depreciation Expense increases (debit) and Accumulated Depreciation, Equipment, increases (credit). If the company wanted to
compute the book value, it would take the original cost of the equipment and subtract accumulated depreciation.
Book value of equipment = $2,000 – $500 = $1,500
This means that the current book value of the equipment is $1,500, and depreciation will be subtracted from this figure the next
year. The following account balances after adjustment are as follows:

The book value of an asset is not necessarily the price at which the asset would sell. For example, you might have a building for
which you paid $1,000,000 that currently has been depreciated to a book value of $800,000. However, today it could sell for more
than, less than, or the same as its book value. The same is true about just about any asset you can name, except, perhaps, cash itself.
Insurance policies can require advanced payment of fees for several months at a time, six months, for example. The company does
not use all six months of insurance immediately but over the course of the six months. At the end of each month, the company
needs to record the amount of insurance expired during that month.
For example, a company pays $4,500 for an insurance policy covering six months. It is the end of the first month and the company
needs to record an adjusting entry to recognize the insurance used during the month. The following entries show the initial payment
for the policy and the subsequent adjusting entry for one month of insurance usage.

4.2.4 [Link]
In the first entry, Cash decreases (credit) and Prepaid Insurance increases (debit) for $4,500. In the second entry, Prepaid Insurance
decreases (credit) and Insurance Expense increases (debit) for one month’s insurance usage found by taking the total $4,500 and
dividing by six months (4,500/6 = 750). The account balances after adjustment are as follows:

Similar to prepaid insurance, rent also requires advanced payment. Usually, to rent a space, a company will need to pay rent at the
beginning of the month. The company may also enter into a lease agreement that requires several months, or years, of rent in
advance. Each month that passes, the company needs to record rent used for the month.
Let’s say a company pays $8,000 in advance for four months of rent. After the first month, the company records an adjusting entry
for the rent used. The following entries show initial payment for four months of rent and the adjusting entry for one month’s usage.

In the first entry, Cash decreases (credit) and Prepaid Rent increases (debit) for $8,000. In the second entry, Prepaid Rent decreases
(credit) and Rent Expense increases (debit) for one month’s rent usage found by taking the total $8,000 and dividing by four
months (8,000/4 = 2,000). The account balances after adjustment are as follows:

Another type of deferral requiring adjustment is unearned revenue.

Unearned Revenues
Unearned revenue represents a customer’s advanced payment for a product or service that has yet to be provided by the company.
Since the company has not yet provided the product or service, it cannot recognize the customer’s payment as revenue. At the end
of a period, the company will review the account to see if any of the unearned revenue has been earned. If so, this amount will be
recorded as revenue in the current period.
For example, let’s say the company is a law firm. During the year, it collected retainer fees totaling $48,000 from clients. Retainer
fees are money lawyers collect in advance of starting work on a case. When the company collects this money from its clients, it
will debit cash and credit unearned fees. Even though not all of the $48,000 was probably collected on the same day, we record it as
if it was for simplicity’s sake.

4.2.5 [Link]
In this case, Unearned Fee Revenue increases (credit) and Cash increases (debit) for $48,000.
At the end of the year after analyzing the unearned fees account, 40% of the unearned fees have been earned. This 40% can now be
recorded as revenue. Total revenue recorded is $19,200 ($48,000 × 40%).

For this entry, Unearned Fee Revenue decreases (debit) and Fee Revenue increases (credit) for $19,200, which is the 40% earned
during the year. The company will have the following balances in the two accounts:

Besides deferrals, other types of adjusting entries include accruals.

Accruals
Accruals are types of adjusting entries that accumulate during a period, where amounts were previously unrecorded. The two
specific types of adjustments are accrued revenues and accrued expenses.

Accrued Revenues
Accrued revenues are revenues earned in a period but have yet to be recorded, and no money has been collected. Some examples
include interest, and services completed but a bill has yet to be sent to the customer.
Interest can be earned from bank account holdings, notes receivable, and some accounts receivables (depending on the contract).
Interest had been accumulating during the period and needs to be adjusted to reflect interest earned at the end of the period. Note
that this interest has not been paid at the end of the period, only earned. This aligns with the revenue recognition principle to
recognize revenue when earned, even if cash has yet to be collected.
For example, assume that a company has one outstanding note receivable in the amount of $100,000. Interest on this note is 5% per
year. Three months have passed, and the company needs to record interest earned on this outstanding loan. The calculation for the
interest revenue earned is $100,000 × 5% × 3/12 = $1,250. The following adjusting entry occurs.

Interest Receivable increases (debit) for $1,250 because interest has not yet been paid. Interest Revenue increases (credit) for
$1,250 because interest was earned in the three-month period but had been previously unrecorded.

4.2.6 [Link]
Previously unrecorded service revenue can arise when a company provides a service but did not yet bill the client for the work.
This means the customer has also not yet paid for services. Since there was no bill to trigger a transaction, an adjustment is required
to recognize revenue earned at the end of the period.
For example, a company performs landscaping services in the amount of $1,500. However, they have not yet received payment. At
the period end, the company would record the following adjusting entry.

Accounts Receivable increases (debit) for $1,500 because the customer has not yet paid for services completed. Service Revenue
increases (credit) for $1,500 because service revenue was earned but had been previously unrecorded.

Accrued Expenses
Accrued expenses are expenses incurred in a period but have yet to be recorded, and no money has been paid. Some examples
include interest, tax, and salary expenses.
Interest expense arises from notes payable and other loan agreements. The company has accumulated interest during the period but
has not recorded or paid the amount. This creates a liability that the company must pay at a future date.
For example, a company accrued $300 of interest during the period. The following entry occurs at the end of the period.

Interest Expense increases (debit) and Interest Payable increases (credit) for $300. The following are the updated ledger balances
after posting the adjusting entry.

4.2.7 [Link]
Taxes are only paid at certain times during the year, not necessarily every month. Taxes the company owes during a period that are
unpaid require adjustment at the end of a period. This creates a liability for the company. Some tax expense examples are income
and sales taxes.
For example, a company has accrued income taxes for the month for $9,000. The company would record the following adjusting
entry.

Income Tax Expense increases (debit) and Income Tax Payable increases (credit) for $9,000. The following are the updated ledger
balances after posting the adjusting entry.

Many salaried employees are paid once a month. The salary that the employee earned during the month might not be paid until the
following month. For example, the employee is paid for the prior month’s work on the first of the next month. The financial
statements must remain up to date, so an adjusting entry is needed during the month to show salaries previously unrecorded and
unpaid at the end of the month.
Let’s say a company has five salaried employees, each earning $2,500 per month. In our example, assume that they do not get paid
for this work until the first of the next month. The following is the adjusting journal entry for salaries.

Salaries Expense increases (debit) and Salaries Payable increases (credit) for $12,500 ($2,500 per employee × five employees). The
following are the updated ledger balances after posting the adjusting entry.

4.2.8 [Link]
Your Turn: Adjusting Entries

Example Income Statement Account Balance Sheet Account Cash in Entry?

Table 4.2.1
Review the three adjusting entries that follow. Using the table provided, for each entry write down the income statement
account and balance sheet account used in the adjusting entry in the appropriate column. Then in the last column answer yes or
no.

Answer
Example Income Statement Account Balance Sheet Account Cash in Entry?

1 Supplies expense Supplies no

2 Service Revenue Unearned Revenue no

3 Rent Expense Prepaid machine rent no

Table 4.2.2

Your Turn: Adjusting Entries Take Two

Did we continue to follow the rules of adjusting entries in these two examples? Explain.

Example Income Statement Account Balance Sheet Account Cash in Entry?

Table 4.2.3

4.2.9 [Link]
 Answer
Yes, we did. Each entry has one income statement account and one balance sheet account, and cash does not appear in
either of the adjusting entries.

Example Income Statement Account Balance Sheet Account Cash in Entry?

1 Electricity Expense Accounts Payable no

2 Salaries Expense Salaries Payable no

Table 4.2.4

4.2: Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries is shared under a CC BY-NC-SA license and was
authored, remixed, and/or curated by LibreTexts.

4.2.10 [Link]
4.3: Record and Post the Common Types of Adjusting Entries
Before beginning adjusting entry examples for Printing Plus, let’s consider some rules governing adjusting entries:
Every adjusting entry will have at least one income statement account and one balance sheet account.
Cash will never be in an adjusting entry.
The adjusting entry records the change in amount that occurred during the period.
What are “income statement” and “balance sheet” accounts? Income statement accounts include revenues and expenses. Balance
sheet accounts are assets, liabilities, and stockholders’ equity accounts, since they appear on a balance sheet. The second rule tells
us that cash can never be in an adjusting entry. This is true because paying or receiving cash triggers a journal entry. This means
that every transaction with cash will be recorded at the time of the exchange. We will not get to the adjusting entries and have cash
paid or received which has not already been recorded. If accountants find themselves in a situation where the cash account must be
adjusted, the necessary adjustment to cash will be a correcting entry and not an adjusting entry.
With an adjusting entry, the amount of change occurring during the period is recorded. For example, if the supplies account had a
$300 balance at the beginning of the month and $100 is still available in the supplies account at the end of the month, the company
would record an adjusting entry for the $200 used during the month (300 – 100). Similarly for unearned revenues, the company
would record how much of the revenue was earned during the period.
Let’s now consider new transaction information for Printing Plus.

Concepts in Practice: Earnings Management

Recording adjusting entries seems so cut and dry. It looks like you just follow the rules and all of the numbers come out 100
percent correct on all financial statements. But in reality, this is not always the case. Just the fact that you have to make
estimates in some cases, such as depreciation estimating residual value and useful life, tells you that numbers will not be 100
percent correct unless the accountant has ESP. Some companies engage in something called earnings management, where they
follow the rules of accounting mostly but they stretch the truth a little to make it look like they are more profitable. Some
companies do this by recording revenue before they should. Others leave assets on the books instead of expensing them when
they should to decrease total expenses and increase profit.
Take Mexico-based home-building company Desarrolladora Homex S.A.B. de C.V. This company reported revenue earned
on more than 100,000 homes they had not even build yet. The SEC’s complaint states that Homex reported revenues from a
project site where every planned home was said to have been “built and sold by Dec. 31, 2011. Satellite images of the project
site on March 12, 2012, show it was still largely undeveloped and the vast majority of supposedly sold homes remained
unbuilt.”2
Is managing your earnings illegal? In some situations, it is just an unethical stretch of the truth easy enough to do because of
the estimates made in adjusting entries. You can simply change your estimate and insist the new estimate is really better when
maybe it is your way to improve the bottom line, for example, changing your annual depreciation expense calculated on
expensive plant assets from assuming a ten-year useful life, a reasonable estimated expectation, to a twenty-year useful life, not
so reasonable but you insist your company will be able to use these assets twenty years while knowing that is a slim possibility.
Doubling the useful life will cause 50% of the depreciation expense you would have had. This will make a positive impact on
net income. This method of earnings management would probably not be considered illegal but is definitely a breach of ethics.
In other situations, companies manage their earnings in a way that the SEC believes is actual fraud and charges the company
with illegal activity.

Recording Common Types of Adjusting Entries

Recall the transactions for Printing Plus.

Jan. 3, 2019 issues $20,000 shares of common stock for cash

purchases equipment on account for $3,500, payment due within
Jan. 5, 2019
the month
receives $4,000 cash in advance from a customer for services not
Jan. 9, 2019
yet rendered

4.3.1 [Link]
 provides $5,500 in services to a customer who asks to be billed for
Jan. 10, 2019
the services
Jan. 12, 2019 pays a $300 utility bill with cash

Jan. 14, 2019 distributed $100 cash in dividends to stockholders

Jan. 17, 2019 receives $2,800 cash from a customer for services rendered

Jan. 18, 2019 paid in full, with cash, for the equipment purchase on January 5

Jan. 20, 2019 paid $3,600 cash in salaries expense to employees

received cash payment in full from the customer on the January 10
Jan. 23, 2019
transaction
provides $1,200 in services to a customer who asks to be billed for
Jan. 27, 2019
the services
purchases supplies on account for $500, payment due within three
Jan. 30, 2019
months

On January 31, 2019, Printing Plus makes adjusting entries for the following transactions.
1. On January 31, Printing Plus took an inventory of its supplies and discovered that $100 of supplies had been used during the
month.
2. The equipment purchased on January 5 depreciated $75 during the month of January.
3. Printing Plus performed $600 of services during January for the customer from the January 9 transaction.
4. Reviewing the company bank statement, Printing Plus discovers $140 of interest earned during the month of January that was
previously uncollected and unrecorded.
5. Employees earned $1,500 in salaries for the period of January 21–January 31 that had been previously unpaid and unrecorded.
We now record the adjusting entries from January 31, 2019, for Printing Plus.
Transaction 13: On January 31, Printing Plus took an inventory of its supplies and discovered that $100 of supplies had been used
during the month.
Analysis:
$100 of supplies were used during January. Supplies is an asset that is decreasing (credit).
Supplies is a type of prepaid expense that, when used, becomes an expense. Supplies Expense would increase (debit) for the
$100 of supplies used during January.

Impact on the financial statements: Supplies is a balance sheet account, and Supplies Expense is an income statement account.
This satisfies the rule that each adjusting entry will contain an income statement and balance sheet account. We see total assets
decrease by $100 on the balance sheet. Supplies Expense increases overall expenses on the income statement, which reduces net
income.

4.3.2 [Link]
Transaction 14: The equipment purchased on January 5 depreciated $75 during the month of January.
Analysis:
Equipment lost value in the amount of $75 during January. This depreciation will impact the Accumulated Depreciation–
Equipment account and the Depreciation Expense–Equipment account. While we are not doing depreciation calculations here,
you will come across more complex calculations in the future.
Accumulated Depreciation–Equipment is a contra asset account (contrary to Equipment) and increases (credit) for $75.
Depreciation Expense–Equipment is an expense account that is increasing (debit) for $75.

Impact on the financial statements: Accumulated Depreciation–Equipment is a contra account to Equipment. When calculating
the book value of Equipment, Accumulated Depreciation–Equipment will be deducted from the original cost of the equipment.
Therefore, total assets will decrease by $75 on the balance sheet. Depreciation Expense will increase overall expenses on the
income statement, which reduces net income.

Transaction 15: Printing Plus performed $600 of services during January for the customer from the January 9 transaction.
Analysis:
The customer from the January 9 transaction gave the company $4,000 in advanced payment for services. By the end of
January, the company had earned $600 of the advanced payment. This means that the company still has yet to provide $3,400 in
services to that customer.
Since some of the unearned revenue is now earned, Unearned Revenue would decrease. Unearned Revenue is a liability account
and decreases on the debit side.
The company can now recognize the $600 as earned revenue. Service Revenue increases (credit) for $600.

Impact on the financial statements: Unearned revenue is a liability account and will decrease total liabilities and equity by $600
on the balance sheet. Service Revenue will increase overall revenue on the income statement, which increases net income.

4.3.3 [Link]
Transaction 16: Reviewing the company bank statement, Printing Plus discovers $140 of interest earned during the month of
January that was previously uncollected and unrecorded.
Analysis:
Interest is revenue for the company on money kept in a savings account at the bank. The company only sees the bank statement
at the end of the month and needs to record interest revenue that has not yet been collected or recorded.
Interest Revenue is a revenue account that increases (credit) for $140.
Since Printing Plus has yet to collect this interest revenue, it is considered a receivable. Interest Receivable increases (debit) for
$140.

Impact on the financial statements: Interest Receivable is an asset account and will increase total assets by $140 on the balance
sheet. Interest Revenue will increase overall revenue on the income statement, which increases net income.

Transaction 17: Employees earned $1,500 in salaries for the period of January 21–January 31 that had been previously unpaid and
unrecorded.
Analysis:
Salaries have accumulated since January 21 and will not be paid in the current period. Since the salaries expense occurred in
January, the expense recognition principle requires recognition in January.
Salaries Expense is an expense account that is increasing (debit) for $1,500.
Since the company has not yet paid salaries for this time period, Printing Plus owes the employees this money. This creates a
liability for Printing Plus. Salaries Payable increases (credit) for $1,500.

Impact on the financial statements: Salaries Payable is a liability account and will increase total liabilities and equity by $1,500
on the balance sheet. Salaries expense will increase overall expenses on the income statement, which decreases net income.

We now explore how these adjusting entries impact the general ledger (T-accounts).

Your Turn: Deferrals Versus Accruals

Label each of the following as a deferral or an accrual, and explain your answer.
1. The company recorded supplies usage for the month.
2. A customer paid in advance for services, and the company recorded revenue earned after providing service to that customer.

4.3.4 [Link]
 3. The company recorded salaries that had been earned by employees but were previously unrecorded and have not yet been
paid.

Answer
1. The company is recording a deferred expense. The company was deferring the recognition of supplies from supplies
expense until it had used the supplies.
2. The company has deferred revenue. It deferred the recognition of the revenue until it was actually earned. The customer
already paid the cash and is currently on the balance sheet as a liability.
3. The company has an accrued expense. The company is bringing the salaries that have been incurred, added up since the
last paycheck, onto the books for the first time during the adjusting entry. Cash will be given to the employees at a later
time.

Link to Learning
Several internet sites can provide additional information for you on adjusting entries. One very good site where you can find
many tools to help you study this topic is Accounting Coach which provides a tool that is available to you free of charge. Visit
the website and take a quiz on accounting basics to test your knowledge.

Posting Adjusting Entries

Once you have journalized all of your adjusting entries, the next step is posting the entries to your ledger. Posting adjusting entries
is no different than posting the regular daily journal entries. T-accounts will be the visual representation for the Printing Plus
general ledger.
Transaction 13: On January 31, Printing Plus took an inventory of its supplies and discovered that $100 of supplies had been used
during the month.
Journal entry and T-accounts:

In the journal entry, Supplies Expense has a debit of $100. This is posted to the Supplies Expense T-account on the debit side (left
side). Supplies has a credit balance of $100. This is posted to the Supplies T-account on the credit side (right side). You will notice
there is already a debit balance in this account from the purchase of supplies on January 30. The $100 is deducted from $500 to get
a final debit balance of $400.
Transaction 14: The equipment purchased on January 5 depreciated $75 during the month of January.
Journal entry and T-accounts:

4.3.5 [Link]
In the journal entry, Depreciation Expense–Equipment has a debit of $75. This is posted to the Depreciation Expense–Equipment
T-account on the debit side (left side). Accumulated Depreciation–Equipment has a credit balance of $75. This is posted to the
Accumulated Depreciation–Equipment T-account on the credit side (right side).
Transaction 15: Printing Plus performed $600 of services during January for the customer from the January 9 transaction.
Journal entry and T-accounts:

In the journal entry, Unearned Revenue has a debit of $600. This is posted to the Unearned Revenue T-account on the debit side
(left side). You will notice there is already a credit balance in this account from the January 9 customer payment. The $600 debit is
subtracted from the $4,000 credit to get a final balance of $3,400 (credit). Service Revenue has a credit balance of $600. This is
posted to the Service Revenue T-account on the credit side (right side). You will notice there is already a credit balance in this
account from other revenue transactions in January. The $600 is added to the previous $9,500 balance in the account to get a new
final credit balance of $10,100.
Transaction 16: Reviewing the company bank statement, Printing Plus discovers $140 of interest earned during the month of
January that was previously uncollected and unrecorded.
Journal entry and T-accounts:

4.3.6 [Link]
In the journal entry, Interest Receivable has a debit of $140. This is posted to the Interest Receivable T-account on the debit side
(left side). Interest Revenue has a credit balance of $140. This is posted to the Interest Revenue T-account on the credit side (right
side).
Transaction 17: Employees earned $1,500 in salaries for the period of January 21–January 31 that had been previously unpaid and
unrecorded.
Journal entry and T-accounts:

In the journal entry, Salaries Expense has a debit of $1,500. This is posted to the Salaries Expense T-account on the debit side (left
side). You will notice there is already a debit balance in this account from the January 20 employee salary expense. The $1,500
debit is added to the $3,600 debit to get a final balance of $5,100 (debit). Salaries Payable has a credit balance of $1,500. This is
posted to the Salaries Payable T-account on the credit side (right side).

T-accounts Summary
Once all adjusting journal entries have been posted to T-accounts, we can check to make sure the accounting equation remains
balanced. Following is a summary showing the T-accounts for Printing Plus including adjusting entries.

4.3.7 [Link]
 Figure 4.3.1 : Printing Plus summary of T-accounts with Adjusting Entries. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)
The sum on the assets side of the accounting equation equals $29,965, found by adding together the final balances in each asset
account (24,800 + 1,200 + 140 + 400 + 3,500 – 75). To find the total on the liabilities and equity side of the equation, we need to
find the difference between debits and credits. Credits on the liabilities and equity side of the equation total $35,640 (500 + 1,500 +
3,400 + 20,000 + 10,100 + 140). Debits on the liabilities and equity side of the equation total $5,675 (100 + 100 + 5,100 + 300 +
75). The difference between $35,640 – $5,675 = $29,965. Thus, the equation remains balanced with $29,965 on the asset side and
$29,965 on the liabilities and equity side. Now that we have the T-account information, and have confirmed the accounting
equation remains balanced, we can create the adjusted trial balance in our sixth step in the accounting cycle.

Link to Learning

When posting any kind of journal entry to a general ledger, it is important to have an organized system for recording to avoid
any account discrepancies and misreporting. To do this, companies can streamline their general ledger and remove any
unnecessary processes or accounts. Check out this article “Encourage General Ledger Efficiency” from the Journal of
Accountancy that discusses some strategies to improve general ledger efficiency.

Footnotes
2 U.S. Securities and Exchange Commission. “SEC Charges Mexico-Based Homebuilder in $3.3 Billion Accounting Fraud.
Press Release.” March 3, 2017. [Link]

4.3: Record and Post the Common Types of Adjusting Entries is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated
by LibreTexts.

4.3.8 [Link]
4.4: Use the Ledger Balances to Prepare an Adjusted Trial Balance
Once all of the adjusting entries have been posted to the general ledger, we are ready to start working on preparing the adjusted trial
balance. Preparing an adjusted trial balance is the sixth step in the accounting cycle. An adjusted trial balance is a list of all
accounts in the general ledger, including adjusting entries, which have nonzero balances. This trial balance is an important step in
the accounting process because it helps identify any computational errors throughout the first five steps in the cycle.
As with the unadjusted trial balance, transferring information from T-accounts to the adjusted trial balance requires consideration of
the final balance in each account. If the final balance in the ledger account (T-account) is a debit balance, you will record the total
in the left column of the trial balance. If the final balance in the ledger account (T-account) is a credit balance, you will record the
total in the right column.
Once all ledger accounts and their balances are recorded, the debit and credit columns on the adjusted trial balance are totaled to
see if the figures in each column match. The final total in the debit column must be the same dollar amount that is determined in the
final credit column.
Let’s now take a look at the adjusted T-accounts and adjusted trial balance for Printing Plus to see how the information is
transferred from these T-accounts to the adjusted trial balance. We only focus on those general ledger accounts that had balance
adjustments.

For example, Interest Receivable is an adjusted account that has a final balance of $140 on the debit side. This balance is
transferred to the Interest Receivable account in the debit column on the adjusted trial balance. Supplies ($400), Supplies Expense
($100), Salaries Expense ($5,100), and Depreciation Expense–Equipment ($75) also have debit final balances in their adjusted T-

4.4.1 [Link]
accounts, so this information will be transferred to the debit column on the adjusted trial balance. Accumulated Depreciation–
Equipment ($75), Salaries Payable ($1,500), Unearned Revenue ($3,400), Service Revenue ($10,100), and Interest Revenue ($140)
all have credit final balances in their T-accounts. These credit balances would transfer to the credit column on the adjusted trial
balance.
Once all balances are transferred to the adjusted trial balance, we sum each of the debit and credit columns. The debit and credit
columns both total $35,715, which means they are equal and in balance.

After the adjusted trial balance is complete, we next prepare the company’s financial statements.

THINK IT THROUGH
Cash or Accrual Basis Accounting?
You are a new accountant at a salon. The salon had previously used cash basis accounting to prepare its financial records but now
considers switching to an accrual basis method. You have been tasked with determining if this transition is appropriate.
When you go through the records you notice that this transition will greatly impact how the salon reports revenues and expenses.
The salon will now report some revenues and expenses before it receives or pays cash.
How will change positively impact its business reporting? How will it negatively impact its business reporting? If you were the
accountant, would you recommend the salon transition from cash basis to accrual basis?

CONCEPTS IN PRACTICE
Why Is the Adjusted Trial Balance So Important?
As you have learned, the adjusted trial balance is an important step in the accounting process. But outside of the accounting
department, why is the adjusted trial balance important to the rest of the organization? An employee or customer may not
immediately see the impact of the adjusted trial balance on his or her involvement with the company.

4.4.2 [Link]
The adjusted trial balance is the key point to ensure all debits and credits are in the general ledger accounts balance before
information is transferred to financial statements. Financial statements drive decision-making for a business. Budgeting for
employee salaries, revenue expectations, sales prices, expense reductions, and long-term growth strategies are all impacted by what
is provided on the financial statements.
So if the company skips over creating an adjusted trial balance to make sure all accounts are balanced or adjusted, it runs the risk of
creating incorrect financial statements and making important decisions based on inaccurate financial information.

4.4: Use the Ledger Balances to Prepare an Adjusted Trial Balance is shared under a CC BY-NC-SA license and was authored, remixed, and/or
curated by LibreTexts.
4.4: Use the Ledger Balances to Prepare an Adjusted Trial Balance by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

4.4.3 [Link]
4.5: Prepare Financial Statements Using the Adjusted Trial Balance
Once you have prepared the adjusted trial balance, you are ready to prepare the financial statements. Preparing financial statements
is the seventh step in the accounting cycle. Remember that we have four financial statements to prepare: an income statement, a
statement of retained earnings, a balance sheet, and the statement of cash flows. These financial statements were introduced in
Introduction to Financial Statements and Statement of Cash Flows dedicates in-depth discussion to that statement.
To prepare the financial statements, a company will look at the adjusted trial balance for account information. From this
information, the company will begin constructing each of the statements, beginning with the income statement. Income statements
will include all revenue and expense accounts. The statement of retained earnings will include beginning retained earnings, any net
income (loss) (found on the income statement), and dividends. The balance sheet is going to include assets, contra assets, liabilities,
and stockholder equity accounts, including ending retained earnings and common stock.

YOUR TURN
Magnificent Adjusted Trial Balance

Go over the adjusted trial balance for Magnificent Landscaping Service. Identify which income statement each account will go on:
Balance Sheet, Statement of Retained Earnings, or Income Statement.
Solution
Balance Sheet: Cash, accounts receivable, office supplied, prepaid insurance, equipment, accumulated depreciation (equipment),
accounts payable, salaries payable, unearned lawn mowing revenue, and common stock. Statement of Retained Earnings:
Dividends. Income Statement: Lawn mowing revenue, gas expense, advertising expense, depreciation expense (equipment),
supplies expense, and salaries expense.

Income Statement
An income statement shows the organization’s financial performance for a given period of time. When preparing an income
statement, revenues will always come before expenses in the presentation. For Printing Plus, the following is its January 2019

4.5.1 [Link]
Income Statement.

Revenue and expense information is taken from the adjusted trial balance as follows:

4.5.2 [Link]
Total revenues are $10,240, while total expenses are $5,575. Total expenses are subtracted from total revenues to get a net income
of $4,665. If total expenses were more than total revenues, Printing Plus would have a net loss rather than a net income. This net
income figure is used to prepare the statement of retained earnings.

CONCEPTS IN PRACTICE
The Importance of Accurate Financial Statements
Financial statements give a glimpse into the operations of a company, and investors, lenders, owners, and others rely on the
accuracy of this information when making future investing, lending, and growth decisions. When one of these statements is
inaccurate, the financial implications are great.
For example, Celadon Group misreported revenues over the span of three years and elevated earnings during those years. The
total overreported income was approximately $200–$250 million. This gross misreporting misled investors and led to the removal
of Celadon Group from the New York Stock Exchange. Not only did this negatively impact Celadon Group’s stock price and
lead to criminal investigations, but investors and lenders were left to wonder what might happen to their investment.
That is why it is so important to go through the detailed accounting process to reduce errors early on and hopefully prevent
misinformation from reaching financial statements. The business must have strong internal controls and best practices to ensure the
information is presented fairly.3

Statement of Retained Earnings

The statement of retained earnings (which is often a component of the statement of stockholders’ equity) shows how the equity (or
value) of the organization has changed over a period of time. The statement of retained earnings is prepared second to determine
the ending retained earnings balance for the period. The statement of retained earnings is prepared before the balance sheet because
the ending retained earnings amount is a required element of the balance sheet. The following is the Statement of Retained
Earnings for Printing Plus.

4.5.3 [Link]
Net income information is taken from the income statement, and dividends information is taken from the adjusted trial balance as
follows.

The statement of retained earnings always leads with beginning retained earnings. Beginning retained earnings carry over from the
previous period’s ending retained earnings balance. Since this is the first month of business for Printing Plus, there is no beginning

4.5.4 [Link]
retained earnings balance. Notice the net income of $4,665 from the income statement is carried over to the statement of retained
earnings. Dividends are taken away from the sum of beginning retained earnings and net income to get the ending retained earnings
balance of $4,565 for January. This ending retained earnings balance is transferred to the balance sheet.

LINK TO LEARNING
Concepts Statements give the Financial Accounting Standards Board (FASB) a guide to creating accounting principles and consider
the limitations of financial statement reporting. See the FASB’s “Concepts Statements” page to learn more.

Balance Sheet
The balance sheet is the third statement prepared after the statement of retained earnings and lists what the organization owns
(assets), what it owes (liabilities), and what the shareholders control (equity) on a specific date. Remember that the balance sheet
represents the accounting equation, where assets equal liabilities plus stockholders’ equity. The following is the Balance Sheet for
Printing Plus.

Ending retained earnings information is taken from the statement of retained earnings, and asset, liability, and common stock
information is taken from the adjusted trial balance as follows.

4.5.5 [Link]
Looking at the asset section of the balance sheet, Accumulated Depreciation–Equipment is included as a contra asset account to
equipment. The accumulated depreciation ($75) is taken away from the original cost of the equipment ($3,500) to show the book
value of equipment ($3,425). The accounting equation is balanced, as shown on the balance sheet, because total assets equal
$29,965 as do the total liabilities and stockholders’ equity.
There is a worksheet approach a company may use to make sure end-of-period adjustments translate to the correct financial
statements.

IFRS CONNECTION
Financial Statements
Both US-based companies and those headquartered in other countries produce the same primary financial statements—Income
Statement, Balance Sheet, and Statement of Cash Flows. The presentation of these three primary financial statements is largely
similar with respect to what should be reported under US GAAP and IFRS, but some interesting differences can arise, especially
when presenting the Balance Sheet.
While both US GAAP and IFRS require the same minimum elements that must be reported on the Income Statement, such as
revenues, expenses, taxes, and net income, to name a few, publicly traded companies in the United States have further requirements
placed by the SEC on the reporting of financial statements. For example, IFRS-based financial statements are only required to
report the current period of information and the information for the prior period. US GAAP has no requirement for reporting prior
periods, but the SEC requires that companies present one prior period for the Balance Sheet and three prior periods for the Income
Statement. Under both IFRS and US GAAP, companies can report more than the minimum requirements.
Presentation differences are most noticeable between the two forms of GAAP in the Balance Sheet. Under US GAAP there is no
specific requirement on how accounts should be presented. However, the SEC requires that companies present their Balance Sheet
information in liquidity order, which means current assets listed first with cash being the first account presented, as it is a
company’s most liquid account. Liquidity refers to how easily an item can be converted to cash. IFRS requires that accounts be
classified into current and noncurrent categories for both assets and liabilities, but no specific presentation format is required. Thus,
for US companies, the first category always seen on a Balance Sheet is Current Assets, and the first account balance reported is

4.5.6 [Link]
cash. This is not always the case under IFRS. While many Balance Sheets of international companies will be presented in the same
manner as those of a US company, the lack of a required format means that a company can present noncurrent assets first, followed
by current assets. The accounts of a Balance Sheet using IFRS might appear as shown here.

Review the annual report of Stora Enso which is an international company that utilizes the illustrated format in presenting its
Balance Sheet, also called the Statement of Financial Position. The Balance Sheet is found on page 31 of the report.
Some of the biggest differences that occur on financial statements prepared under US GAAP versus IFRS relate primarily to
measurement or timing issues: in other words, how a transaction is valued and when it is recorded.

Ten-Column Worksheets
The 10-column worksheet is an all-in-one spreadsheet showing the transition of account information from the trial balance
through the financial statements. Accountants use the 10-column worksheet to help calculate end-of-period adjustments. Using a
10-column worksheet is an optional step companies may use in their accounting process.
Here is a picture of a 10-column worksheet for Printing Plus.

4.5.7 [Link]
There are five sets of columns, each set having a column for debit and credit, for a total of 10 columns. The five column sets are the
trial balance, adjustments, adjusted trial balance, income statement, and the balance sheet. After a company posts its day-to-day
journal entries, it can begin transferring that information to the trial balance columns of the 10-column worksheet.

4.5.8 [Link]
The trial balance information for Printing Plus is shown previously. Notice that the debit and credit columns both equal $34,000. If
we go back and look at the trial balance for Printing Plus, we see that the trial balance shows debits and credits equal to $34,000.

4.5.9 [Link]
Once the trial balance information is on the worksheet, the next step is to fill in the adjusting information from the posted adjusted
journal entries.

4.5.10 [Link]
The adjustments total of $2,415 balances in the debit and credit columns.
The next step is to record information in the adjusted trial balance columns.

4.5.11 [Link]
To get the numbers in these columns, you take the number in the trial balance column and add or subtract any number found in the
adjustment column. For example, Cash shows an unadjusted balance of $24,800. There is no adjustment in the adjustment columns,
so the Cash balance from the unadjusted balance column is transferred over to the adjusted trial balance columns at $24,800.
Interest Receivable did not exist in the trial balance information, so the balance in the adjustment column of $140 is transferred
over to the adjusted trial balance column.
Unearned revenue had a credit balance of $4,000 in the trial balance column, and a debit adjustment of $600 in the adjustment
column. Remember that adding debits and credits is like adding positive and negative numbers. This means the $600 debit is
subtracted from the $4,000 credit to get a credit balance of $3,400 that is translated to the adjusted trial balance column.
Service Revenue had a $9,500 credit balance in the trial balance column, and a $600 credit balance in the Adjustments column. To
get the $10,100 credit balance in the adjusted trial balance column requires adding together both credits in the trial balance and
adjustment columns (9,500 + 600). You will do the same process for all accounts. Once all accounts have balances in the adjusted
trial balance columns, add the debits and credits to make sure they are equal. In the case of Printing Plus, the balances equal
$35,715. If you check the adjusted trial balance for Printing Plus, you will see the same equal balance is present.

4.5.12 [Link]
Next you will take all of the figures in the adjusted trial balance columns and carry them over to either the income statement
columns or the balance sheet columns.

YOUR TURN
Income Statement and Balance Sheet

4.5.13 [Link]
Take a couple of minutes and fill in the income statement and balance sheet columns. Total them when you are done. Do not panic
when they do not balance. They will not balance at this time.
Solution

4.5.14 [Link]
Every other account title has been highlighted to help your eyes focus better while checking your work.
Looking at the income statement columns, we see that all revenue and expense accounts are listed in either the debit or credit
column. This is a reminder that the income statement itself does not organize information into debits and credits, but we do use this
presentation on a 10-column worksheet.

4.5.15 [Link]
You will notice that when debit and credit income statement columns are totaled, the balances are not the same. The debit balance
equals $5,575, and the credit balance equals $10,240. Why do they not balance?
If the debit and credit columns equal each other, it means the expenses equal the revenues. This would happen if a company broke
even, meaning the company did not make or lose any money. If there is a difference between the two numbers, that difference is the
amount of net income, or net loss, the company has earned.
In the Printing Plus case, the credit side is the higher figure at $10,240. The credit side represents revenues. This means revenues
exceed expenses, thus giving the company a net income. If the debit column were larger, this would mean the expenses were larger
than revenues, leading to a net loss. You want to calculate the net income and enter it onto the worksheet. The $4,665 net income is
found by taking the credit of $10,240 and subtracting the debit of $5,575. When entering net income, it should be written in the
column with the lower total. In this instance, that would be the debit side. You then add together the $5,575 and $4,665 to get a
total of $10,240. This balances the two columns for the income statement. If you review the income statement, you see that net
income is in fact $4,665.

4.5.16 [Link]
4.5.17 [Link]
We now consider the last two columns for the balance sheet. In these columns we record all asset, liability, and equity accounts.
When adding the total debits and credits, you notice they do not balance. The debit column equals $30,140, and the credit column
equals $25,475. How do we get the columns to balance?
Treat the income statement and balance sheet columns like a double-entry accounting system, where if you have a debit on the
income statement side, you must have a credit equaling the same amount on the credit side. In this case we added a debit of $4,665
to the income statement column. This means we must add a credit of $4,665 to the balance sheet column. Once we add the $4,665
to the credit side of the balance sheet column, the two columns equal $30,140.
You may notice that dividends are included in our 10-column worksheet balance sheet columns even though this account is not
included on a balance sheet. So why is it included here? There is actually a very good reason we put dividends in the balance sheet
columns.
When you prepare a balance sheet, you must first have the most updated retained earnings balance. To get that balance, you take
the beginning retained earnings balance + net income – dividends. If you look at the worksheet for Printing Plus, you will notice
there is no retained earnings account. That is because they just started business this month and have no beginning retained earnings
balance.
If you look in the balance sheet columns, we do have the new, up-to-date retained earnings, but it is spread out through two
numbers. You have the dividends balance of $100 and net income of $4,665. If you combine these two individual numbers ($4,665
– $100), you will have your updated retained earnings balance of $4,565, as seen on the statement of retained earnings.

You will not see a similarity between the 10-column worksheet and the balance sheet, because the 10-column worksheet is
categorizing all accounts by the type of balance they have, debit or credit. This leads to a final balance of $30,140.
The balance sheet is classifying the accounts by type of accounts, assets and contra assets, liabilities, and equity. This leads to a
final balance of $29,965. Even though they are the same numbers in the accounts, the totals on the worksheet and the totals on the
balance sheet will be different because of the different presentation methods.

LINK TO LEARNING
Publicly traded companies release their financial statements quarterly for open viewing by the general public, which can usually be
viewed on their websites. One such company is Alphabet, Inc. (trade name Google). Take a look at Alphabet’s quarter ended March
31, 2018, financial statements from the SEC Form 10-Q.

YOUR TURN
Frank’s Net Income and Loss
What amount of net income/loss does Frank have?

4.5.18 [Link]
Solution

4.5.19 [Link]
In Completing the Accounting Cycle, we continue our discussion of the accounting cycle, completing the last steps of journalizing
and posting closing entries and preparing a post-closing trial balance.

Footnotes
3 James Jaillet. “Celadon under Criminal Investigation over Financial Statements.” Commercial Carrier Journal. July 25, 2018.
[Link]

4.5: Prepare Financial Statements Using the Adjusted Trial Balance is shared under a CC BY-NC-SA license and was authored, remixed, and/or
curated by LibreTexts.
4.5: Prepare Financial Statements Using the Adjusted Trial Balance by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

4.5.20 [Link]
4.6: Describe and Prepare Closing Entries for a Business
In this chapter, we complete the final steps (steps 8 and 9) of the accounting cycle, the closing process. You will notice that we do
not cover step 10, reversing entries. This is an optional step in the accounting cycle that you will learn about in future courses.
Steps 1 through 4 were covered in Analyzing and Recording Transactions and Steps 5 through 7 were covered in The Adjustment
Process.

Our discussion here begins with journalizing and posting the closing entries (Figure 5.2). These posted entries will then translate
into a post-closing trial balance, which is a trial balance that is prepared after all of the closing entries have been recorded.

Figure 5.2 Final steps in the accounting cycle. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

4.6.1 [Link]
THINK IT THROUGH
Should You Compromise to Please Your Supervisor?
You are an accountant for a small event-planning business. The business has been operating for several years but does not have the
resources for accounting software. This means you are preparing all steps in the accounting cycle by hand.
It is the end of the month, and you have completed the post-closing trial balance. You notice that there is still a service revenue
account balance listed on this trial balance. Why is it considered an error to have a revenue account on the post-closing trial
balance? How do you fix this error?

Introduction to the Closing Entries

Companies are required to close their books at the end of each fiscal year so that they can prepare their annual financial statements
and tax returns. However, most companies prepare monthly financial statements and close their books annually, so they have a
clear picture of company performance during the year, and give users timely information to make decisions.
Closing entries prepare a company for the next accounting period by clearing any outstanding balances in certain accounts that
should not transfer over to the next period. Closing, or clearing the balances, means returning the account to a zero balance. Having
a zero balance in these accounts is important so a company can compare performance across periods, particularly with income. It
also helps the company keep thorough records of account balances affecting retained earnings. Revenue, expense, and dividend
accounts affect retained earnings and are closed so they can accumulate new balances in the next period, which is an application of
the time period assumption.
To further clarify this concept, balances are closed to assure all revenues and expenses are recorded in the proper period and then
start over the following period. The revenue and expense accounts should start at zero each period, because we are measuring how
much revenue is earned and expenses incurred during the period. However, the cash balances, as well as the other balance sheet
accounts, are carried over from the end of a current period to the beginning of the next period.
For example, a store has an inventory account balance of $100,000. If the store closed at 11:59 p.m. on January 31, 2019, then the
inventory balance when it reopened at 12:01 a.m. on February 1, 2019, would still be $100,000. The balance sheet accounts, such
as inventory, would carry over into the next period, in this case February 2019.
The accounts that need to start with a clean or $0 balance going into the next accounting period are revenue, income, and any
dividends from January 2019. To determine the income (profit or loss) from the month of January, the store needs to close the
income statement information from January 2019. Zeroing January 2019 would then enable the store to calculate the income (profit
or loss) for the next month (February 2019), instead of merging it into January’s income and thus providing invalid information
solely for the month of February.
However, if the company also wanted to keep year-to-date information from month to month, a separate set of records could be
kept as the company progresses through the remaining months in the year. For our purposes, assume that we are closing the books
at the end of each month unless otherwise noted.
Let’s look at another example to illustrate the point. Assume you own a small landscaping business. It is the end of the year,
December 31, 2018, and you are reviewing your financials for the entire year. You see that you earned $120,000 this year in
revenue and had expenses for rent, electricity, cable, internet, gas, and food that totaled $70,000.
You also review the following information:

4.6.2 [Link]
The next day, January 1, 2019, you get ready for work, but before you go to the office, you decide to review your financials for
2019. What are your year-to-date earnings? So far, you have not worked at all in the current year. What are your total expenses for
rent, electricity, cable and internet, gas, and food for the current year? You have also not incurred any expenses yet for rent,
electricity, cable, internet, gas or food. This means that the current balance of these accounts is zero, because they were closed on
December 31, 2018, to complete the annual accounting period.
Next, you review your assets and liabilities. What is your current bank account balance? What is the current book value of your
electronics, car, and furniture? What about your credit card balances and bank loans? Are the value of your assets and liabilities
now zero because of the start of a new year? Your car, electronics, and furniture did not suddenly lose all their value, and
unfortunately, you still have outstanding debt. Therefore, these accounts still have a balance in the new year, because they are not
closed, and the balances are carried forward from December 31 to January 1 to start the new annual accounting period.
This is no different from what will happen to a company at the end of an accounting period. A company will see its revenue and
expense accounts set back to zero, but its assets and liabilities will maintain a balance. Stockholders’ equity accounts will also
maintain their balances. In summary, the accountant resets the temporary accounts to zero by transferring the balances to permanent
accounts.

LINK TO LEARNING
Understanding the accounting cycle and preparing trial balances is a practice valued internationally. The Philippines Center for
Entrepreneurship and the government of the Philippines hold regular seminars going over this cycle with small business owners.
They are also transparent with their internal trial balances in several key government offices. Check out this article talking about
the seminars on the accounting cycle and this public pre-closing trial balance presented by the Philippines Department of Health.

Temporary and Permanent Accounts

All accounts can be classified as either permanent (real) or temporary (nominal) (Figure 5.3).
Permanent (real) accounts are accounts that transfer balances to the next period and include balance sheet accounts, such as
assets, liabilities, and stockholders’ equity. These accounts will not be set back to zero at the beginning of the next period; they will
keep their balances. Permanent accounts are not part of the closing process.
Temporary (nominal) accounts are accounts that are closed at the end of each accounting period, and include income statement,
dividends, and income summary accounts. The new account, Income Summary, will be discussed shortly. These accounts are
temporary because they keep their balances during the current accounting period and are set back to zero when the period ends.
Revenue and expense accounts are closed to Income Summary, and Income Summary and Dividends are closed to the permanent
account, Retained Earnings.

4.6.3 [Link]
 Figure 5.3 Location Chart for Financial Statement Accounts. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-
SA 4.0 license)
The income summary account is an intermediary between revenues and expenses, and the Retained Earnings account. It stores all
of the closing information for revenues and expenses, resulting in a “summary” of income or loss for the period. The balance in the
Income Summary account equals the net income or loss for the period. This balance is then transferred to the Retained Earnings
account.
Income summary is a nondefined account category. This means that it is not an asset, liability, stockholders’ equity, revenue, or
expense account. The account has a zero balance throughout the entire accounting period until the closing entries are prepared.
Therefore, it will not appear on any trial balances, including the adjusted trial balance, and will not appear on any of the financial
statements.
You might be asking yourself, “is the Income Summary account even necessary?” Could we just close out revenues and expenses
directly into retained earnings and not have this extra temporary account? We could do this, but by having the Income Summary
account, you get a balance for net income a second time. This gives you the balance to compare to the income statement, and
allows you to double check that all income statement accounts are closed and have correct amounts. If you put the revenues and
expenses directly into retained earnings, you will not see that check figure. No matter which way you choose to close, the same
final balance is in retained earnings.

YOUR TURN
Permanent versus Temporary Accounts
Following is a list of accounts. State whether each account is a permanent or temporary account.
A. rent expense
B. unearned revenue
C. accumulated depreciation, vehicle
D. common stock
E. fees revenue
F. dividends
G. prepaid insurance
H. accounts payable
Solution
A, E, and F are temporary; B, C, D, G, and H are permanent.
Let’s now look at how to prepare closing entries.

Journalizing and Posting Closing Entries

The eighth step in the accounting cycle is preparing closing entries, which includes journalizing and posting the entries to the
ledger.
Four entries occur during the closing process. The first entry closes revenue accounts to the Income Summary account. The second
entry closes expense accounts to the Income Summary account. The third entry closes the Income Summary account to Retained
Earnings. The fourth entry closes the Dividends account to Retained Earnings. The information needed to prepare closing entries
comes from the adjusted trial balance.

4.6.4 [Link]
Let’s explore each entry in more detail using Printing Plus’s information from Analyzing and Recording Transactions and The
Adjustment Process as our example. The Printing Plus adjusted trial balance for January 31, 2019, is presented in Figure 5.4.

Figure 5.4 Adjusted Trial Balance for Printing Plus. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0
license)
The first entry requires revenue accounts close to the Income Summary account. To get a zero balance in a revenue account, the
entry will show a debit to revenues and a credit to Income Summary. Printing Plus has $140 of interest revenue and $10,100 of
service revenue, each with a credit balance on the adjusted trial balance. The closing entry will debit both interest revenue and
service revenue, and credit Income Summary.

The T-accounts after this closing entry would look like the following.

4.6.5 [Link]
Notice that the balances in interest revenue and service revenue are now zero and are ready to accumulate revenues in the next
period. The Income Summary account has a credit balance of $10,240 (the revenue sum).
The second entry requires expense accounts close to the Income Summary account. To get a zero balance in an expense account,
the entry will show a credit to expenses and a debit to Income Summary. Printing Plus has $100 of supplies expense, $75 of
depreciation expense–equipment, $5,100 of salaries expense, and $300 of utility expense, each with a debit balance on the adjusted
trial balance. The closing entry will credit Supplies Expense, Depreciation Expense–Equipment, Salaries Expense, and Utility
Expense, and debit Income Summary.

The T-accounts after this closing entry would look like the following.

Notice that the balances in the expense accounts are now zero and are ready to accumulate expenses in the next period. The Income
Summary account has a new credit balance of $4,665, which is the difference between revenues and expenses (Figure 5.5). The
balance in Income Summary is the same figure as what is reported on Printing Plus’s Income Statement.

Figure 5.5 Income Statement for Printing Plus. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0
license)

4.6.6 [Link]
Why are these two figures the same? The income statement summarizes your income, as does income summary. If both summarize
your income in the same period, then they must be equal. If they do not match, then you have an error.
The third entry requires Income Summary to close to the Retained Earnings account. To get a zero balance in the Income Summary
account, there are guidelines to consider.
If the balance in Income Summary before closing is a credit balance, you will debit Income Summary and credit Retained
Earnings in the closing entry. This situation occurs when a company has a net income.
If the balance in Income Summary before closing is a debit balance, you will credit Income Summary and debit Retained
Earnings in the closing entry. This situation occurs when a company has a net loss.
Remember that net income will increase retained earnings, and a net loss will decrease retained earnings. The Retained Earnings
account increases on the credit side and decreases on the debit side.
Printing Plus has a $4,665 credit balance in its Income Summary account before closing, so it will debit Income Summary and
credit Retained Earnings.

The T-accounts after this closing entry would look like the following.

Notice that the Income Summary account is now zero and is ready for use in the next period. The Retained Earnings account
balance is currently a credit of $4,665.
The fourth entry requires Dividends to close to the Retained Earnings account. Remember from your past studies that dividends are
not expenses, such as salaries paid to your employees or staff. Instead, declaring and paying dividends is a method utilized by
corporations to return part of the profits generated by the company to the owners of the company—in this case, its shareholders.
If dividends were not declared, closing entries would cease at this point. If dividends are declared, to get a zero balance in the
Dividends account, the entry will show a credit to Dividends and a debit to Retained Earnings. As you will learn in Corporation
Accounting, there are three components to the declaration and payment of dividends. The first part is the date of declaration, which
creates the obligation or liability to pay the dividend. The second part is the date of record that determines who receives the
dividends, and the third part is the date of payment, which is the date that payments are made. Printing Plus has $100 of dividends
with a debit balance on the adjusted trial balance. The closing entry will credit Dividends and debit Retained Earnings.

The T-accounts after this closing entry would look like the following.

Why was income summary not used in the dividends closing entry? Dividends are not an income statement account. Only income
statement accounts help us summarize income, so only income statement accounts should go into income summary.
Remember, dividends are a contra stockholders’ equity account. It is contra to retained earnings. If we pay out dividends, it means
retained earnings decreases. Retained earnings decreases on the debit side. The remaining balance in Retained Earnings is $4,565

4.6.7 [Link]
(Figure 5.6). This is the same figure found on the statement of retained earnings.

Figure 5.6 Statement of Retained Earnings for Printing Plus. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-
SA 4.0 license)
The statement of retained earnings shows the period-ending retained earnings after the closing entries have been posted. When you
compare the retained earnings ledger (T-account) to the statement of retained earnings, the figures must match. It is important to
understand retained earnings is not closed out, it is only updated. Retained Earnings is the only account that appears in the closing
entries that does not close. You should recall from your previous material that retained earnings are the earnings retained by the
company over time—not cash flow but earnings. Now that we have closed the temporary accounts, let’s review what the post-
closing ledger (T-accounts) looks like for Printing Plus.

T-Account Summary
The T-account summary for Printing Plus after closing entries are journalized is presented in Figure 5.7.

4.6.8 [Link]
 Figure 5.7T-Account Summary. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Notice that revenues, expenses, dividends, and income summary all have zero balances. Retained earnings maintains a $4,565
credit balance. The post-closing T-accounts will be transferred to the post-closing trial balance, which is step 9 in the accounting
cycle.

THINK IT THROUGH
Closing Entries
A company has revenue of $48,000 and total expenses of $52,000. What would the third closing entry be? Why?

YOUR TURN
Frasker Corp. Closing Entries
Prepare the closing entries for Frasker Corp. using the adjusted trial balance provided.

4.6.9 [Link]
Solution

4.6: Describe and Prepare Closing Entries for a Business is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by
LibreTexts.
5.1: Describe and Prepare Closing Entries for a Business by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

4.6.10 [Link]
4.7: Prepare a Post-Closing Trial Balance
The ninth, and typically final, step of the process is to prepare a post-closing trial balance. The word “post” in this instance means
“after.” You are preparing a trial balance after the closing entries are complete.
Like all trial balances, the post-closing trial balance has the job of verifying that the debit and credit totals are equal. The post-
closing trial balance has one additional job that the other trial balances do not have. The post-closing trial balance is also used to
double-check that the only accounts with balances after the closing entries are permanent accounts. If there are any temporary
accounts on this trial balance, you would know that there was an error in the closing process. This error must be fixed before
starting the new period.
The process of preparing the post-closing trial balance is the same as you have done when preparing the unadjusted trial balance
and adjusted trial balance. Only permanent account balances should appear on the post-closing trial balance. These balances in
post-closing T-accounts are transferred over to either the debit or credit column on the post-closing trial balance. When all accounts
have been recorded, total each column and verify the columns equal each other.
The post-closing trial balance for Printing Plus is shown in Figure 5.8.

Figure 5.8 Printing Plus’s Post-Closing Trial Balance. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0
license)
Notice that only permanent accounts are included. All temporary accounts with zero balances were left out of this statement.
Unlike previous trial balances, the retained earnings figure is included, which was obtained through the closing process.
At this point, the accounting cycle is complete, and the company can begin a new cycle in the next period. In essence, the
company’s business is always in operation, while the accounting cycle utilizes the cutoff of month-end to provide financial
information to assist and review the operations.
It is worth mentioning that there is one step in the process that a company may or may not include, step 10, reversing entries.
Reversing entries reverse an adjusting entry made in a prior period at the start of a new period. We do not cover reversing entries in
this chapter, but you might approach the subject in future accounting courses.
Now that we have completed the accounting cycle, let’s take a look at another way the adjusted trial balance assists users of
information with financial decision-making.

LINK TO LEARNING
If you like quizzes, crossword puzzles, fill-in-the-blank, matching exercise, and word scrambles to help you learn the material in
this course, go to My Accounting Course for more. This website covers a variety of accounting topics including financial

4.7.1 [Link]
accounting basics, accounting principles, the accounting cycle, and financial statements, all topics introduced in the early part of
this course.

CONCEPTS IN PRACTICE
The Importance of Understanding How to Complete the Accounting Cycle
Many students who enroll in an introductory accounting course do not plan to become accountants. They will work in a variety of
jobs in the business field, including managers, sales, and finance. In a real company, most of the mundane work is done by
computers. Accounting software can perform such tasks as posting the journal entries recorded, preparing trial balances, and
preparing financial statements. Students often ask why they need to do all of these steps by hand in their introductory class,
particularly if they are never going to be an accountant. It is very important to understand that no matter what your position, if you
work in business you need to be able to read financial statements, interpret them, and know how to use that information to better
your business. If you have never followed the full process from beginning to end, you will never understand how one of your
decisions can impact the final numbers that appear on your financial statements. You will not understand how your decisions can
affect the outcome of your company.
As mentioned previously, once you understand the effect your decisions will have on the bottom line on your income statement and
the balances in your balance sheet, you can use accounting software to do all of the mundane, repetitive steps and use your time to
evaluate the company based on what the financial statements show. Your stockholders, creditors, and other outside professionals
will use your financial statements to evaluate your performance. If you evaluate your numbers as often as monthly, you will be able
to identify your strengths and weaknesses before any outsiders see them and make any necessary changes to your plan in the
following month

4.7: Prepare a Post-Closing Trial Balance is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by LibreTexts.
5.2: Prepare a Post-Closing Trial Balance by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

4.7.2 [Link]
 CHAPTER OVERVIEW

5: Merchandising
5.1: Compare and Contrast Merchandising versus Service Activities and Transactions
5.2: Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
5.3: Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
5.4: Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods

5: Merchandising is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1
5.1: Compare and Contrast Merchandising versus Service Activities and
Transactions
Every week, you run errands for your household. These errands may include buying products and services from local retailers, such
as gas, groceries, and clothing. As a consumer, you are focused solely on purchasing your items and getting home to your family.
You are probably not thinking about how your purchases impact the businesses you frequent. Whether the business is a service or a
merchandising company, it tracks sales from customers, purchases from manufacturers or other suppliers, and costs that affect their
everyday operations. There are some key differences between these business types in the manner and detail required for transaction
recognition.

Comparison of Merchandising Transactions versus Service Transactions

Some of the biggest differences between a service company and a merchandising company are what they sell, their typical financial
transactions, their operating cycles, and how these translate to financial statements.
A service company provides intangible services to customers and does not have inventory. Some examples of service companies
include lawyers, doctors, consultants, and accountants. Service companies often have simple financial transactions that involve
taking customer deposits, billing clients after services have been provided, providing the service, and processing payments. These
activities may occur frequently within a company’s accounting cycle and make up a portion of the service company’s operating
cycle.
An operating cycle is the amount of time it takes a company to use its cash to provide a product or service and collect payment
from the customer. Completing this cycle faster puts the company in a more stable financial position. A typical operating cycle for
a service company begins with having cash available, providing service to a customer, and then receiving cash from the customer
for the service (Figure 6.2).

Figure 6.2 Typical Operating Cycle for a Service Firm. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA
4.0 license)
The income statement format is fairly simple as well (see Figure 6.3). Revenues (sales) are reported first, followed by any period
operating expenses. The outcome of sales less expenses, which is net income (loss), is calculated from these accounts.

5.1.1 [Link]
 Figure 6.3 Service Company Income Statement. Expenses are subtracted directly from Sales to produce net income (loss).
(attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
A merchandising company resells finished goods (inventory) produced by a manufacturer (supplier) to customers. Some
examples of merchandising companies include Walmart, Macy’s, and Home Depot. Merchandising companies have financial
transactions that include: purchasing merchandise, paying for merchandise, storing inventory, selling merchandise, and collecting
customer payments. A typical operating cycle for a merchandising company starts with having cash available, purchasing
inventory, selling the merchandise to customers, and finally collecting payment from customers (Figure 6.4).

Figure 6.4 Typical Operating Cycle for a Merchandising Company. (attribution: Copyright Rice University, OpenStax, under CC
BY-NC-SA 4.0 license)
Their income statement format is a bit more complicated than for a service company and is discussed in greater detail in Describe
and Prepare Multi-Step and Simple Income Statements for Merchandising Companies. Note that unlike a service company, the
merchandiser, also sometimes labeled as a retailer, must first resolve any sale reductions and merchandise costs, known as Cost of
Goods Sold, before determining other expenses and net income (loss). A simple retailer income statement is shown in Figure 6.5
for comparison.

5.1.2 [Link]
 Figure 6.5 Merchandise Company Income Statement. Cost of Goods Sold is deducted from net sales to calculate gross margin.
(attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Characteristics of Merchandising Transactions

Merchandising transactions are separated into two categories: purchases and sales. In general, a purchase transaction occurs
between a manufacturer and the merchandiser, also called a retailer. A sales transaction occurs between a customer and the
merchandiser or retailer. We will now discuss the characteristics that create purchase and sales transactions for a retailer. A
merchandiser will need to purchase merchandise for its business to continue operations and can use several purchase situations to
accomplish this.

Purchases with Cash or on Credit

A retailer typically conducts business with a manufacturer or with a supplier who buys from a manufacturer. The retailer will
purchase their finished goods for resale. When the purchase occurs, the retailer may pay for the merchandise with cash or on credit.
If the retailer pays for the merchandise with cash, they would be trading one current asset, Cash, for another current asset,
Merchandise Inventory or just Inventory, depending upon the company’s account titles. In this example, they would record a debit
entry to Merchandise Inventory and a credit entry to Cash. If they decide to pay on credit, a liability would be created, and
Accounts Payable would be credited rather than Cash. For example, a clothing store may pay a jeans manufacturer cash for 50 pairs
of jeans, costing $25 each. The following entry would occur.

If this same company decides to purchase merchandise on credit, Accounts Payable is credited instead of Cash.

Merchandise Inventory is a current asset account that houses all purchase costs associated with the transaction. This includes the
cost of the merchandise, shipping charges, insurance fees, taxes, and any other costs that gets the products ready for sale. Gross
purchases are defined as the original amount of the purchase without considering reductions for purchase discounts, returns, or
allowances. Once the purchase reductions are adjusted at the end of a period, net purchases are calculated. Net purchases (see
Figure 6.6) equals gross purchases less purchase discounts, purchase returns, and purchase allowances.

5.1.3 [Link]
 Figure 6.6 Purchase Transactions’ Effects on Gross Purchases. Deducting purchase discounts, returns, and allowances from gross
purchases will result in net purchases. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Purchase Discounts
If a retailer, pays on credit, they will work out payment terms with the manufacturer. These payment terms establish the purchase
cost, an invoice date, any discounts, shipping charges, and the final payment due date.
Purchase discounts provide an incentive for the retailer to pay early on their accounts by offering a reduced rate on the final
purchase cost. Receiving payment in a timely manner allows the manufacturer to free up cash for other business opportunities and
decreases the risk of nonpayment.
To describe the discount terms, the manufacturer can write descriptions such as 2/10, n/30 on the invoice. The “2” represents a
discount rate of 2%, the “10” represents the discount period in days, and the “n/30” means “net of 30” days, representing the entire
payment period without a discount application. So, “2/10, n/30” reads as, “The company will receive a 2% discount on their
purchase if they pay in 10 days. Otherwise, they have 30 days from the date of the sale to pay in full, no discount received.” In
some cases, if the retailer exceeds the full payment period (30 days in this example), the manufacturer may charge interest as a
penalty for late payment. The number of days allowed for both the discount period and the full payment period begins counting
from the invoice date.
If a merchandiser pays an invoice within the discount period, they receive a discount, which affects the cost of the inventory. Let’s
say a retailer pays within the discount window. They would need to show a credit to the Merchandise Inventory account,
recognizing the decreased final cost of the merchandise. This aligns with the cost principle, which requires a company to record an
asset’s value at the cost of acquisition. In addition, since cash is used to pay the manufacturer, Cash is credited. The debit to
Accounts Payable does not reflect the discount taken: it reflects fulfillment of the liability in full, and the credits to Merchandise
Inventory and Cash reflect the discount taken, as demonstrated in the following example.
If the retailer does not pay within the discount window, they do not receive a discount but are still required to pay the full invoice
price at the end of the term. In this case, Accounts Payable is debited and Cash is credited, but no reductions are made to
Merchandise Inventory.
For example, suppose a kitchen appliances retailer purchases merchandise for their store from a manufacturer on September 1 in
the amount of $1,600. Credit terms are 2/10, n/30 from the invoice date of September 1. The retailer makes payment on September
5 and receives the discount. The following entry occurs.

Let’s consider the same situation except the retailer did not make the discount window and paid in full on September 30. The entry
would recognize the following instead.

5.1.4 [Link]
There are two kinds of purchase discounts, cash discounts and trade discounts. Cash discount provides a discount on the final
price after purchase if a retailer pays within a discount window. On the other hand, a trade discount is a reduction to the advertised
manufacturer’s price that occurs during negotiations of a final purchase price before the inventory is purchased. The trade discount
may become larger if the retailer purchases more in one transaction. While the cash discount is recognized in journal entries, a trade
discount is not, since it is negotiated before purchase.
For example, assume that a retailer is considering an order for $4,000 in inventory on September 1. The manufacturer offers the
retailer a 15% discount on the price if they place the order by September 5. Assume that the retailer places the $4,000 order on
September 3. The purchase price would be $4,000 less the 15% discount of $600, or $3,400. Since the trade discount is based on
when the order was placed and not on any potential payment discounts, the initial journal entry to record the purchase would reflect
the discounted amount of $3,400. Even if the retailer receives a trade discount, they may still be eligible for an additional purchase
discount if they pay within the discount window of the invoice.

Purchase Returns and Allowances

If a retailer is unhappy with their purchase—for example, if the order is incorrect or if the products are damaged—they may receive
a partial or full refund from the manufacturer in a purchase returns and allowances transaction. A purchase return occurs when
merchandise is returned and a full refund is issued. A purchase allowance occurs when merchandise is kept and a partial refund is
issued. In either case, a manufacturer will issue a debit memo to acknowledge the change in contract terms and the reduction in the
amount owed.
To recognize a return or allowance, the retailer will reduce Accounts Payable (or increase Cash) and reduce Merchandise Inventory.
Accounts Payable decreases if the retailer has yet to pay on their account, and Cash increases if they had already paid and received
a subsequent refund. Merchandise Inventory decreases to show the reduction of inventory cost from the retailer’s inventory stock.
Note that if a retailer receives a refund before they make a payment, any discount taken must be from the new cost of the
merchandise less the refund.
To illustrate, assume that Carter Candle Company received a shipment from a manufacturer that had 150 candles that cost $150.
Assume that they have not yet paid for these candles and 100 of the candles are badly damaged and must be returned. The other 50
candles are marketable, but are not the right style. The candle company returned the 100 defective candles for a full refund and
requested and received an allowance of $20 for the 50 improper candles they kept. The first entry shows the return and the second
entry shows the allowance.

It is possible to show these entries as one, since they affect the same accounts and were requested at the same time. From a
manager’s standpoint, though, it may be better to record these as separate transactions to better understand the specific reasons for
the reduction to inventory (either return or allowance) and restocking needs.

5.1.5 [Link]
ETHICAL CONSIDERATIONS
Internal Controls over Merchandise Returns1
Returning merchandise requires more than an accountant making journal entries or a clerk restocking items in a warehouse or store.
An ethical accountant understands that there must be internal controls governing the return of items. As used in accounting, the
term “internal control” describes the methodology of implementing accounting and operational checkpoints in a system to ensure
compliance with sound business and operational practices while permitting the proper recording of accounting information. All
transactions require both operational and accounting actions to ensure that the amounts have been recorded in the accounting
records and that operational requirements have been met.
Merchandise return controls require that there be a separation of duties between the employee approving the return and the person
recording the return of merchandise in the accounting records. Basically, the person performing the return should not be the person
recording the event in the accounting records. This is called separation of duties and is just one example of an internal control that
should be used when merchandise is returned.
Every company faces different challenges with returns, but one of the most common challenges includes fake or fictitious returns.
The use of internal controls is a protective action the company undertakes, with the assistance of professional accountants, to
ensure that fictitious returns do not occur. The internal controls may include prescribed actions of employees, special tags on
merchandise, specific store layouts that ensure customers pass checkout points before leaving the store, cameras to record activity
in the facility, and other activities and internal controls that go beyond accounting and journal entries to ensure that assets of a
company are protected.

Characteristics of Sales Transactions

Business owners may encounter several sales situations that can help meet customer needs and control inventory operations. For
example, some customers will expect the opportunity to buy using short-term credit and often will assume that they will receive a
discount for paying within a brief period. The mechanics of sales discounts are demonstrated later in this section.

Sales with Cash or on Credit

As previously mentioned, a sale is usually considered a transaction between a merchandiser or retailer and a customer. When a sale
occurs, a customer has the option to pay with cash or credit. For our purposes, let’s consider “credit” as credit extended from the
business directly to the customer.
Whether or not a customer pays with cash or credit, a business must record two accounting entries. One entry recognizes the sale
and the other recognizes the cost of the sale. The sales entry consists of a debit to either Cash or Accounts Receivable (if paying on
credit), and a credit to the revenue account, Sales.
The amount recorded in the Sales account is the gross amount. Gross sales is the original amount of the sale without factoring in
any possible reductions for discounts, returns, or allowances. Once those reductions are recorded at the end of a period, net sales
are calculated. Net sales (see Figure 6.7) equals gross sales less sales discounts, sales returns, and sales allowances. Recording the
sale as it occurs allows the company to align with the revenue recognition principle. The revenue recognition principle requires
companies to record revenue when it is earned, and revenue is earned when a product or service has been provided.

5.1.6 [Link]
 Figure 6.7 Sales Transactions’ Effect on Gross Sales. Deducting sales discounts, returns, and allowances from gross sales, will
result in net sales. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
The second accounting entry that is made during a sale describes the cost of sales. The cost of sales entry includes decreasing
Merchandise Inventory and increasing Cost of Goods Sold (COGS). The decrease to Merchandise Inventory reflects the reduction
in the inventory account value due to the sold merchandise. The increase to COGS represents the expense associated with the sale.
The cost of goods sold (COGS) is an expense account that houses all costs associated with getting the product ready for sale. This
could include purchase costs, shipping, taxes, insurance, stocking fees, and overhead related to preparing the product for sale. By
recording the cost of sale when the sale occurs, the company aligns with the matching principle. The matching principlerequires
companies to match revenues generated with related expenses in the period in which they are incurred.
For example, when a shoe store sells 150 pairs of athletic cleats to a local baseball league for $1,500 (cost of $900), the league may
pay with cash or credit. If the baseball league elects to pay with cash, the shoe store would debit Cash as part of the sales entry. If
the baseball league decides to use a line of credit extended by the shoe store, the shoe store would debit Accounts Receivable as
part of the sales entry instead of Cash. With the sales entry, the shoe store must also recognize the $900 cost of the shoes sold and
the $900 reduction in Merchandise Inventory.

You may have noticed that sales tax has not been discussed as part of the sales entry. Sales taxes are liabilities that require a portion
of every sales dollar be remitted to a government entity. This would reduce the amount of cash the company keeps after the sale.
Sales tax is relevant to consumer sales and is discussed in detail in Current Liabilities.
There are a few transactional situations that may occur after a sale is made that have an effect on reported sales at the end of a
period.

Sales Discounts
Sales discounts are incentives given to customers to entice them to pay off their accounts early. Why would a retailer offer this?
Wouldn’t they rather receive the entire amount owed? The discount serves several purposes that are similar to the rationale
manufacturers consider when offering discounts to retailers. It can help solidify a long-term relationship with the customer,
encourage the customer to purchase more, and decreases the time it takes for the company to see a liquid asset (cash). Cash can be
used for other purposes immediately such as reinvesting in the business, paying down loans quicker, and distributing dividends to
shareholders. This can help grow the business at a more rapid rate.
Similar to credit terms between a retailer and a manufacturer, a customer could see credit terms offered by the retailer in the form
of 2/10, n/30. This particular example shows that if a customer pays their account within 10 days, they will receive a 2% discount.
Otherwise, they have 30 days to pay in full but do not receive a discount. If the customer does not pay within the discount window,

5.1.7 [Link]
but pays within 30 days, the retailing company records a credit to Accounts Receivable, and a debit to Cash for the full amount
stated on the invoice. If the customer is able to pay the account within the discount window, the company records a credit to
Accounts Receivable, a debit to Cash, and a debit to Sales Discounts.
The sales discounts account is a contra revenue account that is deducted from gross sales at the end of a period in the calculation of
net sales. Sales Discounts has a normal debit balance, which offsets Sales that has a normal credit balance.
Let’s assume that a customer purchased 10 emergency kits from a retailer at $100 per kit on credit. The retailer offered the
customer 2/10, n/30 terms, and the customer paid within the discount window. The retailer recorded the following entry for the
initial sale.

Since the retail doesn’t know at the point of sale whether or not the customer will qualify for the sales discount, the entire account
receivable of $1,000 is recorded on the retailer’s journal.
Also assume that the retail’s costs of goods sold in this example were $560 and we are using the perpetual inventory method. The
journal entry to record the sale of the inventory follows the entry for the sale to the customer.

Since the customer paid the account in full within the discount qualification period of ten days, the following journal entry on the
retailer’s books reflects the payment.

Now, assume that the customer paid the retailer within the 30-day period but did not qualify for the discount. The following entry
reflects the payment without the discount.

Please note that the entire $1,000 account receivable created is eliminated under both payment options. When the discount is
missed, the retail received the entire $1,000. However, when the discount was received by the customer, the retailer received $980,
and the remaining $20 is recorded in the sales discount account.

ETHICAL CONSIDERATIONS
Ethical Discounts
Should employees or companies provide discounts to employees of other organizations? An accountant’s employing organization
usually has a code of ethics or conduct that addresses policies for employee discounts. While many companies offer their
employees discounts as a benefit, some companies also offer discounts or free products to non-employees who work for
governmental organizations. Accountants may need to work in situations where other entities’ codes of ethics/conduct do not

5.1.8 [Link]
permit employees to accept discounts or free merchandise. What should the accountant’s company do when an outside
organization’s code of ethics and conduct does not permit its employees to accept discounts or free merchandise?
The long-term benefits of discounts are contrasted with organizational codes of ethics and conduct that limit others from accepting
discounts from your organization. The International Association of Chiefs of Police’s Law Enforcement Code of Ethics limits the
ability of police officers to accept discounts.2 These discounts may be as simple as a free cup of coffee, other gifts, rewards points,
and hospitality points or discounts for employees or family members of the governmental organization’s employees. Providing
discounts may create ethical dilemmas. The ethical dilemma may not arise from the accountant’s employer, but from the employer
of the person outside the organization receiving the discount.
The World Customs Organization’s Model Code of Ethics and Conduct states that “customs employees are called upon to use their
best judgment to avoid situations of real or perceived conflict. In doing so, they should consider the following criteria on gifts,
hospitality and other benefits, bearing in mind the full context of this Code. Public servants shall not accept or solicit any gifts,
hospitality or other benefits that may have a real or apparent influence on their objectivity in carrying out their official duties or that
may place them under obligation to the donor.”3
At issue is that the employee of the outside organization is placed in a conflict between their personal interests and the interest of
their employer. The accountant’s employer’s discount has created this conflict. In these situations, it is best for the accountant’s
employer to respect the other organization’s code of conduct. As well, it might be illegal for the accountant’s employer to provide
discounts to a governmental organization’s employees. The professional accountant should always be aware of the discount policy
of any outside company prior to providing discounts to the employees of other companies or organizations.

Sales Returns and Allowances

If a customer purchases merchandise and is dissatisfied with their purchase, they may receive a refund or a partial refund,
depending on the situation. When the customer returns merchandise and receives a full refund, it is considered a sales return. When
the customer keeps the defective merchandise and is given a partial refund, it is considered a sales allowance. The biggest
difference is that a customer returns merchandise in a sales return and keeps the merchandise in a sales allowance.
When a customer returns the merchandise, a retailer issues a credit memo to acknowledge the change in contract and reduction to
Accounts Receivable, if applicable. The retailer records an entry acknowledging the return by reducing either Cash or Accounts
Receivable and increasing Sales Returns and Allowances. Cash would decrease if the customer had already paid for the
merchandise and cash was thus refunded to the customer. Accounts Receivable would decrease if the customer had not yet paid on
their account. Like Sales Discounts, the sales returns and allowances account is a contra revenue account with a normal debit
balance that reduces the gross sales figure at the end of the period.
Beyond recording the return, the retailer must also determine if the returned merchandise is in “sellable condition.” An item is in
sellable condition if the merchandise is good enough to warrant a sale to another customer in the future. If so, the company would
record a decrease to Cost of Goods Sold (COGS) and an increase to Merchandise Inventory to return the merchandise back to the
inventory for resale. This is recorded at the merchandise’s costs of goods sold value. If the merchandise is in sellable condition but
will not realize the original cost of the good, the company must estimate the loss at this time.
On the other hand, when the merchandise is returned and is not in sellable condition, the retailer must estimate the value of the
merchandise in its current condition and record a loss. This would increase Merchandise Inventory for the assessed value of the
merchandise in its current state, decrease COGS for the original expense amount associated with the sale, and increase Loss on
Defective Merchandise for the unsellable merchandise lost value.

Let’s say a customer purchases 300 plants on credit from a nursery for $3,000 (with a cost of $1,200). The first entry reflects the
initial sale by the nursery. The second entry reflects the cost of goods sold.

5.1.9 [Link]
Upon receipt, the customer discovers the plants have been infested with bugs and they send all the plants back. Assuming that the
customer had not yet paid the nursery any of the $3,000 accounts receivable and assuming that the nursery determines the condition
of the returned plants to be sellable, the retailer would record the following entries.

For another example, let’s say the plant customer was only dissatisfied with 100 of the plants. After speaking with the nursery, the
customer decides to keep 200 of the plants for a partial refund of $1,000. The nursery would record the following entry for sales
allowance associated with 100 plants.

The nursery would also record a corresponding entry for the inventory and the cost of goods sold for the 100 returned plants.

For both the return and the allowance, if the customer had already paid their account in full, Cash would be affected rather than
Accounts Receivable.
There are differing opinions as to whether sales returns and allowances should be in separate accounts. Separating the accounts
would help a retailer distinguish between items that are returned and those that the customer kept. This can better identify quality
control issues, track whether a customer was satisfied with their purchase, and report how many resources are spent on processing
returns. Most companies choose to combine returns and allowances into one account, but from a manager’s perspective, it may be
easier to have the accounts separated to make current determinations about inventory.
You may have noticed our discussion of credit sales did not include third-party credit card transactions. This is when a customer
pays with a credit or debit card from a third-party, such as Visa, MasterCard, Discover, or American Express. These entries and
discussion are covered in more advanced accounting courses. A more comprehensive example of merchandising purchase and sale
transactions occurs in Calculate Activity-Based Product Costs and Compare and Contrast Traditional and Activity-Based Costing
Systems, applying the perpetual inventory method.

LINK TO LEARNING
Major retailers must find new ways to manage inventory and reduce operating cycles to stay competitive. Companies such as
[Link] Inc., have been able to reduce their operating cycles and increase their receivable collection rates to a level better

5.1.10 [Link]
than many of their nearest competitors. Check out Stock Analysis on Net to find out how they do this and to see a comparison of
operating cycles for top retail brands.

Footnotes
1 Committee of Sponsoring Organizations of the Treadway Commission (COSO). Internal Control—Integrated Framework.
May 2013. [Link]
2 International Association of Chiefs of Police (IACP). Law Enforcement Code of Ethics. October, 1957.
[Link]
3 World Customs Organization. Model Code of Ethics and Conduct. n.d. [Link]
la=en

5.1: Compare and Contrast Merchandising versus Service Activities and Transactions is shared under a CC BY-NC-SA license and was authored,
remixed, and/or curated by LibreTexts.
6.1: Compare and Contrast Merchandising versus Service Activities and Transactions by OpenStax is licensed CC BY-NC-SA 4.0.
Original source: [Link]

5.1.11 [Link]
5.2: Analyze and Record Transactions for Merchandise Purchases Using the
Perpetual Inventory System
The following example transactions and subsequent journal entries for merchandise purchases are recognized using a perpetual
inventory system. The periodic inventory system recognition of these example transactions and corresponding journal entries are
shown in Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System.

Basic Analysis of Purchase Transaction Journal Entries

To better illustrate merchandising activities, let’s follow California Business Solutions (CBS), a retailer providing electronic
hardware packages to meet small business needs. Each electronics hardware package (see Figure 6.9) contains a desktop computer,
tablet computer, landline telephone, and a 4-in-1 desktop printer with a printer, copier, scanner, and fax machine.

Figure 6.9 California Business Solutions. Providing businesses electronic hardware solutions. (credit: modification of
“Professionnal desk” by “reynermedia”/Flickr, CC BY 2.0)
CBS purchases each electronic product from a manufacturer. The following are the per-item purchase prices from the manufacturer.

Cash and Credit Purchase Transaction Journal Entries

On April 1, CBS purchases 10 electronic hardware packages at a cost of $620 each. CBS has enough cash-on-hand to pay
immediately with cash. The following entry occurs.

Merchandise Inventory-Packages increases (debit) for 6,200 ($620 × 10), and Cash decreases (credit) because the company paid
with cash. It is important to distinguish each inventory item type to better track inventory needs.
On April 7, CBS purchases 30 desktop computers on credit at a cost of $400 each. The credit terms are n/15 with an invoice date of
April 7. The following entry occurs.

5.2.1 [Link]
Merchandise Inventory is specific to desktop computers and is increased (debited) for the value of the computers by $12,000 ($400
× 30). Since the computers were purchased on credit by CBS, Accounts Payable increases (credit).
On April 17, CBS makes full payment on the amount due from the April 7 purchase. The following entry occurs.

Accounts Payable decreases (debit), and Cash decreases (credit) for the full amount owed. The credit terms were n/15, which is net
due in 15 days. No discount was offered with this transaction. Thus the full payment of $12,000 occurs.

Purchase Discount Transaction Journal Entries

On May 1, CBS purchases 67 tablet computers at a cost of $60 each on credit. The payment terms are 5/10, n/30, and the invoice is
dated May 1. The following entry occurs.

Merchandise Inventory-Tablet Computers increases (debit) in the amount of $4,020 (67 × $60). Accounts Payable also increases
(credit) but the credit terms are a little different than the previous example. These credit terms include a discount opportunity
(5/10), meaning, CBS has 10 days from the invoice date to pay on their account to receive a 5% discount on their purchase.
On May 10, CBS pays their account in full. The following entry occurs.

Accounts Payable decreases (debit) for the original amount owed of $4,020 before any discounts are taken. Since CBS paid on May
10, they made the 10-day window and thus received a discount of 5%. Cash decreases (credit) for the amount owed, less the
discount. Merchandise Inventory-Tablet Computers decreases (credit) for the amount of the discount ($4,020 × 5%). Merchandise
Inventory decreases to align with the Cost Principle, reporting the value of the merchandise at the reduced cost.
Let’s take the same example purchase with the same credit terms, but now CBS paid their account on May 25. The following entry
would occur instead.

Accounts Payable decreases (debit) and Cash decreases (credit) for $4,020. The company paid on their account outside of the
discount window but within the total allotted timeframe for payment. CBS does not receive a discount in this case but does pay in
full and on time.

5.2.2 [Link]
Purchase Returns and Allowances Transaction Journal Entries
On June 1, CBS purchased 300 landline telephones with cash at a cost of $60 each. On June 3, CBS discovers that 25 of the phones
are the wrong color and returns the phones to the manufacturer for a full refund. The following entries occur with the purchase and
subsequent return.

Both Merchandise Inventory-Phones increases (debit) and Cash decreases (credit) by $18,000 ($60 × 300).

Since CBS already paid in full for their purchase, a full cash refund is issued. This increases Cash (debit) and decreases (credit)
Merchandise Inventory-Phones because the merchandise has been returned to the manufacturer or supplier.
On June 8, CBS discovers that 60 more phones from the June 1 purchase are slightly damaged. CBS decides to keep the phones but
receives a purchase allowance from the manufacturer of $8 per phone. The following entry occurs for the allowance.

Since CBS already paid in full for their purchase, a cash refund of the allowance is issued in the amount of $480 (60 × $8). This
increases Cash (debit) and decreases (credit) Merchandise Inventory-Phones because the merchandise is less valuable than before
the damage discovery.
CBS purchases 80 units of the 4-in-1 desktop printers at a cost of $100 each on July 1 on credit. Terms of the purchase are 5/15,
n/40, with an invoice date of July 1. On July 6, CBS discovers 15 of the printers are damaged and returns them to the manufacturer
for a full refund. The following entries show the purchase and subsequent return.

Both Merchandise Inventory-Printers increases (debit) and Accounts Payable increases (credit) by $8,000 ($100 × 80).

Both Accounts Payable decreases (debit) and Merchandise Inventory-Printers decreases (credit) by $1,500 (15 × $100). The
purchase was on credit and the return occurred before payment, thus decreasing Accounts Payable. Merchandise Inventory
decreases due to the return of the merchandise back to the manufacturer.
On July 10, CBS discovers that 4 more printers from the July 1 purchase are slightly damaged but decides to keep them, with the
manufacturer issuing an allowance of $30 per printer. The following entry recognizes the allowance.

5.2.3 [Link]
Both Accounts Payable decreases (debit) and Merchandise Inventory-Printers decreases (credit) by $120 (4 × $30). The purchase
was on credit and the allowance occurred before payment, thus decreasing Accounts Payable. Merchandise Inventory decreases due
to the loss in value of the merchandise.
On July 15, CBS pays their account in full, less purchase returns and allowances. The following payment entry occurs.

Accounts Payable decreases (debit) for the amount owed, less the return of $1,500 and the allowance of $120 ($8,000 – $1,500 –
$120). Since CBS paid on July 15, they made the 15-day window, thus receiving a discount of 5%. Cash decreases (credit) for the
amount owed, less the discount. Merchandise Inventory-Printers decreases (credit) for the amount of the discount ($6,380 × 5%).
Merchandise Inventory decreases to align with the Cost Principle, reporting the value of the merchandise at the reduced cost.

Summary of Purchase Transaction Journal Entries

The chart in Figure 6.10 represents the journal entry requirements based on various merchandising purchase transactions using the
perpetual inventory system.

Figure 6.10 Purchase Transaction Journal Entries Using a Perpetual Inventory System. (attribution: Copyright Rice University,
OpenStax, under CC BY-NC-SA 4.0 license)
Note that Figure 6.10 considers an environment in which inventory physical counts and matching books records align. This is not
always the case given concerns with shrinkage (theft), damages, or obsolete merchandise. In this circumstance, an adjustment is
recorded to inventory to account for the differences between the physical count and the amount represented on the books.

YOUR TURN
Recording a Retailer’s Purchase Transactions
Record the journal entries for the following purchase transactions of a retailer.

5.2.4 [Link]
 Purchased $500 worth of inventory on credit with terms 2/10,
Dec. 3
n/30, and invoice dated December 3.
Returned $150 worth of damaged inventory to the manufacturer
Dec. 6
and received a full refund.
Dec. 9 Paid the account in full

Solution

LINK TO LEARNING
Bean Counter is a website that offers free, fun and interactive games, simulations, and quizzes about accounting. You can “Fling
the Teacher,” “Walk the Plank,” and play “Basketball” while learning the fundamentals of accounting topics. Check out Bean
Counter to see what you can learn

5.2: Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System is shared under a CC BY-NC-SA license
and was authored, remixed, and/or curated by LibreTexts.
6.3: Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System by OpenStax is licensed CC
BY-NC-SA 4.0. Original source: [Link]

5.2.5 [Link]
5.3: Analyze and Record Transactions for the Sale of Merchandise Using the
Perpetual Inventory System
The following example transactions and subsequent journal entries for merchandise sales are recognized using a perpetual
inventory system. The periodic inventory system recognition of these example transactions and corresponding journal entries are
shown in Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System.

Basic Analysis of Sales Transaction Journal Entries

Let’s continue to follow California Business Solutions (CBS) and their sales of electronic hardware packages to business
customers. As previously stated, each package contains a desktop computer, tablet computer, landline telephone, and a 4-in-1
printer. CBS sells each hardware package for $1,200. They offer their customers the option of purchasing extra individual hardware
items for every electronic hardware package purchase. Figure 6.11 lists the products CBS sells to customers; the prices are per-
package, and per unit.

Figure 6.11 CBS’s Product Line. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Cash and Credit Sales Transaction Journal Entries

On July 1, CBS sells 10 electronic hardware packages to a customer at a sales price of $1,200 each. The customer pays
immediately with cash. The following entries occur.

In the first entry, Cash increases (debit) and Sales increases (credit) for the selling price of the packages, $12,000 ($1,200 × 10). In
the second entry, the cost of the sale is recognized. COGS increases (debit) and Merchandise Inventory-Packages decreases (credit)
for the cost of the packages, $6,200 ($620 × 10).
On July 7, CBS sells 20 desktop computers to a customer on credit. The credit terms are n/15 with an invoice date of July 7. The
following entries occur.

Since the computers were purchased on credit by the customer, Accounts Receivable increases (debit) and Sales increases (credit)
for the selling price of the computers, $15,000 ($750 × 20). In the second entry, Merchandise Inventory-Desktop Computers
decreases (credit), and COGS increases (debit) for the cost of the computers, $8,000 ($400 × 20).
On July 17, the customer makes full payment on the amount due from the July 7 sale. The following entry occurs.

5.3.1 [Link]
Accounts Receivable decreases (credit) and Cash increases (debit) for the full amount owed. The credit terms were n/15, which is
net due in 15 days. No discount was offered with this transaction; thus the full payment of $15,000 occurs.

Sales Discount Transaction Journal Entries

On August 1, a customer purchases 56 tablet computers on credit. The payment terms are 2/10, n/30, and the invoice is dated
August 1. The following entries occur.

In the first entry, both Accounts Receivable (debit) and Sales (credit) increase by $16,800 ($300 × 56). These credit terms are a
little different than the earlier example. These credit terms include a discount opportunity (2/10), meaning the customer has 10 days
from the invoice date to pay on their account to receive a 2% discount on their purchase. In the second entry, COGS increases
(debit) and Merchandise Inventory–Tablet Computers decreases (credit) in the amount of $3,360 (56 × $60).
On August 10, the customer pays their account in full. The following entry occurs.

Since the customer paid on August 10, they made the 10-day window and received a discount of 2%. Cash increases (debit) for the
amount paid to CBS, less the discount. Sales Discounts increases (debit) for the amount of the discount ($16,800 × 2%), and
Accounts Receivable decreases (credit) for the original amount owed, before discount. Sales Discounts will reduce Sales at the end
of the period to produce net sales.
Let’s take the same example sale with the same credit terms, but now assume the customer paid their account on August 25. The
following entry occurs.

Cash increases (debit) and Accounts Receivable decreases (credit) by $16,800. The customer paid on their account outside of the
discount window but within the total allotted timeframe for payment. The customer does not receive a discount in this case but does
pay in full and on time.

YOUR TURN
Recording a Retailer’s Sales Transactions
Record the journal entries for the following sales transactions by a retailer.

5.3.2 [Link]
 Sold $2,450 of merchandise on credit (cost of $1,000), with terms
Jan. 5
2/10, n/30, and invoice dated January 5.
The customer returned $500 worth of slightly damaged
Jan. 9 merchandise to the retailer and received a full refund. The retailer
returned the merchandise to its inventory at a cost of $130.
Jan. 14 Account paid in full.

Solution

Sales Returns and Allowances Transaction Journal Entries

On September 1, CBS sold 250 landline telephones to a customer who paid with cash. On September 3, the customer discovers that
40 of the phones are the wrong color and returns the phones to CBS in exchange for a full refund. CBS determines that the returned
merchandise can be resold and returns the merchandise to inventory at its original cost. The following entries occur for the sale and
subsequent return.

In the first entry on September 1, Cash increases (debit) and Sales increases (credit) by $37,500 (250 × $150), the sales price of the
phones. In the second entry, COGS increases (debit), and Merchandise Inventory-Phones decreases (credit) by $15,000 (250 ×
$60), the cost of the sale.

5.3.3 [Link]
Since the customer already paid in full for their purchase, a full cash refund is issued on September 3. This increases Sales Returns
and Allowances (debit) and decreases Cash (credit) by $6,000 (40 × $150). The second entry on September 3 returns the phones
back to inventory for CBS because they have determined the merchandise is in sellable condition at its original cost. Merchandise
Inventory–Phones increases (debit) and COGS decreases (credit) by $2,400 (40 × $60).
On September 8, the customer discovers that 20 more phones from the September 1 purchase are slightly damaged. The customer
decides to keep the phones but receives a sales allowance from CBS of $10 per phone. The following entry occurs for the
allowance.

Since the customer already paid in full for their purchase, a cash refund of the allowance is issued in the amount of $200 (20 ×
$10). This increases (debit) Sales Returns and Allowances and decreases (credit) Cash. CBS does not have to consider the
condition of the merchandise or return it to their inventory because the customer keeps the merchandise.
A customer purchases 55 units of the 4-in-1 desktop printers on October 1 on credit. Terms of the sale are 10/15, n/40, with an
invoice date of October 1. On October 6, the customer returned 10 of the printers to CBS for a full refund. CBS returns the printers
to their inventory at the original cost. The following entries show the sale and subsequent return.

In the first entry on October 1, Accounts Receivable increases (debit) and Sales increases (credit) by $19,250 (55 × $350), the sales
price of the printers. Accounts Receivable is used instead of Cash because the customer purchased on credit. In the second entry,
COGS increases (debit) and Merchandise Inventory–Printers decreases (credit) by $5,500 (55 × $100), the cost of the sale.

The customer has not yet paid for their purchase as of October 6. Therefore, the return increases Sales Returns and Allowances
(debit) and decreases Accounts Receivable (credit) by $3,500 (10 × $350). The second entry on October 6 returns the printers back
to inventory for CBS because they have determined the merchandise is in sellable condition at its original cost. Merchandise
Inventory–Printers increases (debit) and COGS decreases (credit) by $1,000 (10 × $100).
On October 10, the customer discovers that 5 printers from the October 1 purchase are slightly damaged, but decides to keep them,
and CBS issues an allowance of $60 per printer. The following entry recognizes the allowance.

Sales Returns and Allowances increases (debit) and Accounts Receivable decreases (credit) by $300 (5 × $60). A reduction to
Accounts Receivable occurs because the customer has yet to pay their account on October 10. CBS does not have to consider the

5.3.4 [Link]
condition of the merchandise or return it to their inventory because the customer keeps the merchandise.
On October 15, the customer pays their account in full, less sales returns and allowances. The following payment entry occurs.

Accounts Receivable decreases (credit) for the original amount owed, less the return of $3,500 and the allowance of $300 ($19,250
– $3,500 – $300). Since the customer paid on October 15, they made the 15-day window, thus receiving a discount of 10%. Sales
Discounts increases (debit) for the discount amount ($15,450 × 10%). Cash increases (debit) for the amount owed to CBS, less the
discount.

Summary of Sales Transaction Journal Entries

The chart in Figure 6.12 represents the journal entry requirements based on various merchandising sales transactions.

Figure 6.12Journal Entry Requirements for Merchandise Sales Transaction. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)

YOUR TURN
Recording a Retailer’s Sales Transactions
Record the journal entries for the following sales transactions of a retailer.

Sold $8,600 of merchandise on credit (cost of $2,650), with terms

May 10
5/10, n/30, and invoice dated May 10.
The customer returned $1,250 worth of slightly damaged
May 13 merchandise to the retailer and received a full refund. The retailer
returned the merchandise to its inventory at a cost of $380.

5.3.5 [Link]
 The customer discovered some merchandise were the wrong color
May 15
and received an allowance from the retailer of $230.
The customer paid the account in full, less the return and
May 20
allowance.

Solution

5.3: Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System is shared under a CC BY-NC-SA license
and was authored, remixed, and/or curated by LibreTexts.
6.4: Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System by OpenStax is licensed CC
BY-NC-SA 4.0. Original source: [Link]

5.3.6 [Link]
5.4: Discuss and Record Transactions Applying the Two Commonly Used Freight-In
Methods
When you buy merchandise online, shipping charges are usually one of the negotiated terms of the sale. As a consumer, anytime
the business pays for shipping, it is welcomed. For businesses, shipping charges bring both benefits and challenges, and the terms
negotiated can have a significant impact on inventory operations.

Figure 6.13 Shipping Merchandise. (credit: “Guida Siebert Dairy Milk Delivery Truck tractor trailer!” by Mike Mozart/Flickr, CC
BY 2.0)

IFRS CONNECTION
Shipping Term Effects
Companies applying US GAAP as well as those applying IFRS can choose either a perpetual or periodic inventory system to track
purchases and sales of inventory. While the tracking systems do not differ between the two methods, they have differences in when
sales transactions are reported. If goods are shipped FOB shipping point, under IFRS, the total selling price of the item would be
allocated between the item sold (as sales revenue) and the shipping (as shipping revenue). Under US GAAP, the seller can elect
whether the shipping costs will be an additional component of revenue (separate performance obligation) or whether they will be
considered fulfillment costs (expensed at the time shipping as shipping expense). In an FOB destination scenario, the shipping
costs would be considered a fulfillment activity and expensed as incurred rather than be treated as a part of revenue under both
IFRS and US GAAP.
Example
Wally’s Wagons sells and ships 20 deluxe model wagons to Sam’s Emporium for $5,000. Assume $400 of the total costs represents
the costs of shipping the wagons and consider these two scenarios: (1) the wagons are shipped FOB shipping point or (2) the
wagons are shipped FOB destination. If Wally’s is applying IFRS, the $400 shipping is considered a separate performance
obligation, or shipping revenue, and the other $4,600 is considered sales revenue. Both revenues are recorded at the time of
shipping and the $400 shipping revenue is offset by a shipping expense. If Wally’s used US GAAP instead, they would choose
between using the same treatment as described under IFRS or considering the costs of shipping to be costs of fulfilling the order
and expense those costs at the time they are incurred. In this latter case, Wally’s would record Sales Revenue of $5,000 at the time
the wagons are shipped and $400 as shipping expense at the time of shipping. Notice that in both cases, the total net revenues are
the same $4,600, but the distribution of those revenues is different, which impacts analyses of sales revenue versus total revenues.
What happens if the wagons are shipped FOB destination instead? Under both IFRS and US GAAP, the $400 shipping would be
treated as an order fulfillment cost and recorded as an expense at the time the goods are shipped. Revenue of $5,000 would be
recorded at the time the goods are received by Sam’s emporium.
Financial Statement Presentation of Cost of Goods Sold
IFRS allows greater flexibility in the presentation of financial statements, including the income statement. Under IFRS, expenses
can be reported in the income statement either by nature (for example, rent, salaries, depreciation) or by function (such as COGS or
Selling and Administrative). US GAAP has no specific requirements regarding the presentation of expenses, but the SEC requires

5.4.1 [Link]
that expenses be reported by function. Therefore, it may be more challenging to compare merchandising costs (cost of goods sold)
across companies if one company’s income statement shows expenses by function and another company shows them by nature.

The Basics of Freight-in Versus Freight-out Costs

Shipping is determined by contract terms between a buyer and seller. There are several key factors to consider when determining
who pays for shipping, and how it is recognized in merchandising transactions. The establishment of a transfer point and ownership
indicates who pays the shipping charges, who is responsible for the merchandise, on whose balance sheet the assets would be
recorded, and how to record the transaction for the buyer and seller.
Ownership of inventory refers to which party owns the inventory at a particular point in time—the buyer or the seller. One
particularly important point in time is the point of transfer, when the responsibility for the inventory transfers from the seller to
the buyer. Establishing ownership of inventory is important to determine who pays the shipping charges when the goods are in
transit as well as the responsibility of each party when the goods are in their possession. Goods in transit refers to the time in
which the merchandise is transported from the seller to the buyer (by way of delivery truck, for example). One party is responsible
for the goods in transit and the costs associated with transportation. Determining whether this responsibility lies with the buyer or
seller is critical to determining the reporting requirements of the retailer or merchandiser.
Freight-in refers to the shipping costs for which the buyer is responsible when receiving shipment from a seller, such as delivery
and insurance expenses. When the buyer is responsible for shipping costs, they recognize this as part of the purchase cost. This
means that the shipping costs stay with the inventory until it is sold. The cost principle requires this expense to stay with the
merchandise as it is part of getting the item ready for sale from the buyer’s perspective. The shipping expenses are held in
inventory until sold, which means these costs are reported on the balance sheet in Merchandise Inventory. When the merchandise is
sold, the shipping charges are transferred with all other inventory costs to Cost of Goods Sold on the income statement.
For example, California Business Solutions (CBS) may purchase computers from a manufacturer and part of the agreement is that
CBS (the buyer) pays the shipping costs of $1,000. CBS would record the following entry to recognize freight-in.

Merchandise Inventory increases (debit), and Cash decreases (credit), for the entire cost of the purchase, including shipping,
insurance, and taxes. On the balance sheet, the shipping charges would remain a part of inventory.
Freight-out refers to the costs for which the seller is responsible when shipping to a buyer, such as delivery and insurance
expenses. When the seller is responsible for shipping costs, they recognize this as a delivery expense. The delivery expense is
specifically associated with selling and not daily operations; thus, delivery expenses are typically recorded as a selling and
administrative expense on the income statement in the current period.
For example, CBS may sell electronics packages to a customer and agree to cover the $100 cost associated with shipping and
insurance. CBS would record the following entry to recognize freight-out.

Delivery Expense increases (debit) and Cash decreases (credit) for the shipping cost amount of $100. On the income statement, this
$100 delivery expense will be grouped with Selling and Administrative expenses.

5.4.2 [Link]
LINK TO LEARNING
Shipping term agreements provide clarity for buyers and sellers with regards to inventory responsibilities. Use the animation on
FOB Shipping Point and FOB Destination to learn more.

Discussion and Application of FOB Destination

As you’ve learned, the seller and buyer will establish terms of purchase that include the purchase price, taxes, insurance, and
shipping charges. So, who pays for shipping? On the purchase contract, shipping terms establish who owns inventory in transit, the
point of transfer, and who pays for shipping. The shipping terms are known as “free on board,” or simply FOB. Some refer to FOB
as the point of transfer, but really, it incorporates more than simply the point at which responsibility transfers. There are two FOB
considerations: FOB Destination and FOB Shipping Point.
If FOB destination point is listed on the purchase contract, this means the seller pays the shipping charges (freight-out). This also
means goods in transit belong to, and are the responsibility of, the seller. The point of transfer is when the goods reach the buyer’s
place of business.
To illustrate, suppose CBS sells 30 landline telephones at $150 each on credit at a cost of $60 per phone. On the sales contract,
FOB Destination is listed as the shipping terms, and shipping charges amount to $120, paid as cash directly to the delivery service.
The following entries occur.

Accounts Receivable (debit) and Sales (credit) increases for the amount of the sale (30 × $150). Cost of Goods Sold increases
(debit) and Merchandise Inventory decreases (credit) for the cost of sale (30 × $60). Delivery Expense increases (debit) and Cash
decreases (credit) for the delivery charge of $120.

Discussion and Application of FOB Shipping Point

If FOB shipping point is listed on the purchase contract, this means the buyer pays the shipping charges (freight-in). This also
means goods in transit belong to, and are the responsibility of, the buyer. The point of transfer is when the goods leave the seller’s
place of business.
Suppose CBS buys 40 tablet computers at $60 each on credit. The purchase contract shipping terms list FOB Shipping Point. The
shipping charges amount to an extra $5 per tablet computer. All other taxes, fees, and insurance are included in the purchase price
of $60. The following entry occurs to recognize the purchase.

Merchandise Inventory increases (debit) and Accounts Payable increases (credit) by the amount of the purchase, including all
shipping, insurance, taxes, and fees [(40 × $60) + (40 × $5)].
Figure 6.14 shows a comparison of shipping terms.

5.4.3 [Link]
 Figure 6.14 FOB Shipping Point versus FOB Destination. A comparison of shipping terms. (attribution: Copyright Rice University,
OpenStax, under CC BY-NC-SA 4.0 license)

THINK IT THROUGH
Choosing Suitable Shipping Terms
You are a seller and conduct business with several customers who purchase your goods on credit. Your standard contract requires
an FOB Shipping Point term, leaving the buyer with the responsibility for goods in transit and shipping charges. One of your long-
term customers asks if you can change the terms to FOB Destination to help them save money.
Do you change the terms, why or why not? What positive and negative implications could this have for your business, and your
customer? What, if any, restrictions might you consider if you did change the terms

5.4: Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods is shared under a CC BY-NC-SA license and was
authored, remixed, and/or curated by LibreTexts.
6.5: Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods by OpenStax is licensed CC BY-NC-SA
4.0. Original source: [Link]

5.4.4 [Link]
 CHAPTER OVERVIEW

6: Inventory
6.1: Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
6.2: Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method

6: Inventory is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1
6.1: Describe and Demonstrate the Basic Inventory Valuation Methods and Their
Cost Flow Assumptions
Accounting for inventory is a critical function of management. Inventory accounting is significantly complicated by the fact that it
is an ongoing process of constant change, in part because (1) most companies offer a large variety of products for sale, (2) product
purchases occur at irregular times, (3) products are acquired for differing prices, and (4) inventory acquisitions are based on sales
projections, which are always uncertain and often sporadic. Merchandising companies must meticulously account for every
individual product that they sell, equipping them with essential information, for decisions such as these:
What is the quantity of each product that is available to customers?
When should inventory of each product item be replenished and at what quantity?
How much should the company charge customers for each product to cover all costs plus profit margin?
How much of the inventory cost should be allocated toward the units sold (cost of goods sold) during the period?
How much of the inventory cost should be allocated toward the remaining units (ending inventory) at the end of the period?
Is each product moving robustly or have some individual inventory items’ activity decreased?
Are some inventory items obsolete?
The company’s financial statements report the combined cost of all items sold as an offset to the proceeds from those sales,
producing the net number referred to as gross margin (or gross profit). This is presented in the first part of the results of operations
for the period on the multi-step income statement. The unsold inventory at period end is an asset to the company and is therefore
included in the company’s financial statements, on the balance sheet, as shown in Figure 10.2. The total cost of all the inventory
that remains at period end, reported as merchandise inventory on the balance sheet, plus the total cost of the inventory that was
sold or otherwise removed (through shrinkage, theft, or other loss), reported as cost of goods sold on the income statement (see
Figure 10.2), represent the entirety of the inventory that the company had to work with during the period, or goods available for
sale.

Figure 10.2 Financial Statement Effects of Inventory Transactions. (attribution: Copyright Rice University, OpenStax, under CC
BY-NC-SA 4.0 license)

Fundamentals of Inventory
Although our discussion will consider inventory issues from the perspective of a retail company, using a resale or merchandising
operation, inventory accounting also encompasses recording and reporting of manufacturing operations. In the manufacturing
environment, there would be separate inventory calculations for the various process levels of inventory, such as raw materials,
work in process, and finished goods. The manufacturer’s finished goods inventory is equivalent to the merchandiser’s inventory
account in that it includes finished goods that are available for sale.
In merchandising companies, inventory is a company asset that includes beginning inventory plus purchases, which include all
additions to inventory during the period. Every time the company sells products to customers, they dispose of a portion of the
company’s inventory asset. Goods available for sale refers to the total cost of all inventory that the company had on hand at any
time during the period, including beginning inventory and all inventory purchases. These goods were normally either sold to
customers during the period (occasionally lost due to spoilage, theft, damage, or other types of shrinkages) and thus reported as
cost of goods sold, an expense account on the income statement, or these goods are still in inventory at the end of the period and
reported as ending merchandise inventory, an asset account on the balance sheet. As an example, assume that Harry’s Auto Parts
Store sells oil filters. Suppose that at the end of January 31, 2018, they had 50 oil filters on hand at a cost of $7 per unit. This
means that at the beginning of February, they had 50 units in inventory at a total cost of $350 (50 × $7). During the month, they

6.1.1 [Link]
purchased 20 filters at a cost of $7, for a total cost of $140 (20 × $7). At the end of the month, there were 18 units left in inventory.
Therefore, during the month of February, they sold 52 units. Figure 10.3 illustrates how to calculate the goods available for sale and
the cost of goods sold.

Figure 10.3 Fundamentals of Inventory Accounting. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0
license)
Inventory costing is accomplished by one of four specific costing methods: (1) specific identification, (2) first-in, first-out, (3) last-
in, first-out, and (4) weighted-average cost methods. All four methods are techniques that allow management to distribute the costs
of inventory in a logical and consistent manner, to facilitate matching of costs to offset the related revenue item that is recognized
during the period, in accordance with GAAP expense recognition and matching concepts. Note that a company’s cost allocation
process represents management’s chosen method for expensing product costs, based strictly on estimates of the flow of inventory
costs, which is unrelated to the actual flow of the physical inventory. Use of a cost allocation strategy eliminates the need for often
cost-prohibitive individual tracking of costs of each specific inventory item, for which purchase prices may vary greatly. In this
chapter, you will be provided with some background concepts and explanations of terms associated with inventory as well as a
basic demonstration of each of the four allocation methods, and then further delineation of the application and nuances of the
costing methods.
A critical issue for inventory accounting is the frequency for which inventory values are updated. There are two primary methods
used to account for inventory balance timing changes: the periodic inventory method and the perpetual inventory method. These
two methods were addressed in depth in Merchandising Transactions).

Periodic Inventory Method

A periodic inventory system updates the inventory balances at the end of the reporting period, typically the end of a month,
quarter, or year. At that point, a journal entry is made to adjust the merchandise inventory asset balance to agree with the physical
count of inventory, with the corresponding adjustment to the expense account, cost of goods sold. This adjustment shifts the costs
of all inventory items that are no longer held by the company to the income statement, where the costs offset the revenue from
inventory sales, as reflected by the gross margin. As sales transactions occur throughout the period, the periodic system requires
that only the sales entry be recorded because costs will only be updated during end-of-period adjustments when financial
statements are prepared. However, any additional goods for sale acquired during the month are recorded as purchases. Following
are examples of typical journal entries for periodic transactions. The first is an example entry for an inventory sales transaction
when using periodic inventory, and the second records the purchase of additional inventory when using the periodic method. Note:
Periodic requires no corresponding cost entry at the time of sale, since the inventory is adjusted only at period end.

A purchase of inventory for sale by a company under the periodic inventory method would necessitate the following journal entry.
(This is discussed in more depth in Merchandising Transactions.)

6.1.2 [Link]
Perpetual Inventory Method
A perpetual inventory system updates the inventory account balance on an ongoing basis, at the time of each individual sale. This
is normally accomplished by use of auto-ID technology, such as optical-scan barcode or radio frequency identification (RFIF)
labels. As transactions occur, the perpetual system requires that every sale is recorded with two entries, first recording the sales
transaction as an increase to Accounts Receivable and a decrease to Sales Revenue, and then recording the cost associated with the
sale as an increase to Cost of Goods Sold and a decrease to Merchandise Inventory. The journal entries made at the time of sale
immediately shift the costs relating to the goods being sold from the merchandise inventory account on the balance sheet to the cost
of goods sold account on the income statement. Little or no adjustment is needed to inventory at period end because changes in the
inventory balances are recorded as both the sales and purchase transactions occur. Any necessary adjustments to the ending
inventory account balances would typically be caused by one of the types of shrinkage you’ve learned about. These are example
entries for an inventory sales transaction when using perpetual inventory updating:

A purchase of inventory for sale by a company under the perpetual inventory method would necessitate the following journal entry.
(Greater detail is provided in Merchandising Transactions.)

CONTINUING APPLICATION
Inventory
As previously discussed, Gearhead Outfitters is a retail chain selling outdoor gear and accessories. As such, the company is faced
with many possible questions related to inventory. How much inventory should be carried? What products are the most profitable?
Which products have the most sales? Which products are obsolete? What timeframe should the company allow for inventory to be
replenished? Which products are the most in demand at each location?
In addition to questions related to type, volume, obsolescence, and lead time, there are many issues related to accounting for
inventory and the flow of goods. As one of the biggest assets of the company, the way inventory is tracked can have an effect on
profit. Which method of accounting—first-in first-out, last-in first out, specific identification, weighted average— provides the
most accurate reflection of inventory and cost of goods sold is important in determining gross profit and net income. The method
selected affects profits, taxes, and can even change the opinion of potential lenders concerning the financial strength of the
company. In choosing a method of accounting for inventory, management should consider many factors, including the accurate

6.1.3 [Link]
reflection of costs, taxes on profits, decision-making about purchases, and what effect a point-of-sale (POS) system may have on
tracking inventory.
Gearhead exists to provide a positive shopping experience for its customers. Offering a clear picture of its goods, and maintaining
an appealing, timely supply at competitive prices is one way to keep the shopping experience positive. Thus, accounting for
inventory plays an instrumental role in management’s ability to successfully run a company and deliver the company’s promise to
customers.

Data for Demonstration of the Four Basic Inventory Valuation Methods

The following dataset will be used to demonstrate the application and analysis of the four methods of inventory accounting.
Company: Spy Who Loves You Corporation
Product: Global Positioning System (GPS) Tracking Device
Description: This product is an economical real-time GPS tracking device, designed for individuals who wish to monitor others’
whereabouts. It is marketed to parents of middle school and high school students as a safety measure. Parents benefit by being
apprised of the child’s location, and the student benefits by not having to constantly check in with parents. Demand for the product
has spiked during the current fiscal period, while supply is limited, causing the selling price to escalate rapidly.

Specific Identification Method

The specific identification method refers to tracking the actual cost of the item being sold and is generally used only on expensive
items that are highly customized (such as tracking detailed costs for each individual car in automobiles sales) or inherently
distinctive (such as tracking origin and cost for each unique stone in diamond sales). This method is too cumbersome for goods of
large quantity, especially if there are not significant feature differences in the various inventory items of each product type.
However, for purposes of this demonstration, assume that the company sold one specific identifiable unit, which was purchased in
the second lot of products, at a cost of $27.
Three separate lots of goods are purchased:

First-in, First-out (FIFO) Method

The first-in, first-out method (FIFO) records costs relating to a sale as if the earliest purchased item would be sold first.
However, the physical flow of the units sold under both the periodic and perpetual methods would be the same. Due to the
mechanics of the determination of costs of goods sold under the perpetual method, based on the timing of additional purchases of
inventory during the accounting period, it is possible that the costs of goods sold might be slightly different for an accounting
period. Since FIFO assumes that the first items purchased are sold first, the latest acquisitions would be the items that remain in
inventory at the end of the period and would constitute ending inventory.
Three separate lots of goods are purchased:

6.1.4 [Link]
Last-in, First-out (LIFO) Method
The last-in, first out method (LIFO) records costs relating to a sale as if the latest purchased item would be sold first. As a result,
the earliest acquisitions would be the items that remain in inventory at the end of the period.
Three separate lots of goods are purchased:

IFRS CONNECTION
Inventory
For many companies, inventory is a significant portion of the company’s assets. In 2018, the inventory of Walmart, the world’s
largest international retailer, was 70% of current assets and 21% of total assets. Because inventory also affects income as it is sold
through the cost of goods sold account, inventory plays a significant role in the analysis and evaluation of many companies. Ending
inventory affects both the balance sheet and the income statement. As you’ve learned, the ending inventory balance is reflected as a
current asset on the balance sheet and the ending inventory balance is used in the calculation of costs of goods sold. Understanding
how companies report inventory under US GAAP versus under IFRS is important when comparing companies reporting under the
two methods, particularly because of a significant difference between the two methods.
Similarities
When inventory is purchased, it is accounted for at historical cost and then evaluated at each balance sheet date to adjust to the
lower of cost or net realizable value.
Both IFRS and US GAAP allow FIFO and weighted-average cost flow assumptions as well as specific identification where
appropriate and applicable.
Differences
IFRS does not permit the use of LIFO. This is a major difference between US GAAP and IFRS. The AICPA estimates that
roughly 35–40% of all US companies use LIFO, and in some industries, such as oil and gas, the use of LIFO is more prevalent.
Because LIFO generates lower taxable income during times of rising prices, it is estimated that eliminating LIFO would
generate an estimated $102 billion in tax revenues in the US for the period 2017–2026. In creating IFRS, the IASB chose to
eliminate LIFO, arguing that FIFO more closely matches the flow of goods. In the US, FASB believes the choice between LIFO
and FIFO is a business model decision that should be left up to each company. In addition, there was significant pressure by
some companies and industries to retain LIFO because of the significant tax liability that would arise for many companies from
the elimination of LIFO.

Weighted-Average Cost Method

The weighted-average cost method (sometimes referred to as the average cost method) requires a calculation of the average cost
of all units of each particular inventory items. The average is obtained by multiplying the number of units by the cost paid per unit
for each lot of goods, then adding the calculated total value of all lots together, and finally dividing the total cost by the total
number of units for that product. As a caveat relating to the average cost method, note that a new average cost must be calculated
after every change in inventory to reassess the per-unit weighted-average value of the goods. This laborious requirement might
make use of the average method cost-prohibitive.
Three separate lots of goods are purchased:

6.1.5 [Link]
Comparing the various costing methods for the sale of one unit in this simple example reveals a significant difference that the
choice of cost allocation method can make. Note that the sales price is not affected by the cost assumptions; only the cost amount
varies, depending on which method is chosen. Figure 10.4 depicts the different outcomes that the four methods produced.

Figure 10.4 Comparison of the Four Costing Methods. One unit sold for $36. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)
Once the methods of costing are determined for the company, that methodology would typically be applied repeatedly over the
remainder of the company’s history to accomplish the generally accepted accounting principle of consistency from one period to
another. It is possible to change methods if the company finds that a different method more accurately reflects results of operations,
but the change requires disclosure in the company’s notes to the financial statements, which alerts financial statement users of the
impact of the change in methodology. Also, it is important to realize that although the Internal Revenue Service generally allows
differing methods of accounting treatment for tax purposes than for financial statement purposes, an exception exists that prohibits
the use of LIFO inventory costing on the company tax return unless LIFO is also used for the financial statement costing
calculations.

ETHICAL CONSIDERATIONS
Auditors Look for Inventory Fraud
Inventory fraud can be used to book false revenue or to increase the amount of assets to obtain additional lending from a bank or
other sources. In the typical chain of accounting events, inventory ultimately becomes an expense item known as cost of goods
sold.1 In a manipulated accounting system, a trail of fraudulent transactions can point to accounting misrepresentation in the sales
cycle, which may include
recording fictitious and nonexistent inventory,
manipulation of inventory counts during a facility audit,
recording of sales but no recording of purchases, and/or
fraudulent inventory capitalization,
to list a few.2 All these elaborate schemes have the same goal: to improperly manipulate inventory values to support the creation of
a fraudulent financial statement. Accountants have an ethical, moral, and legal duty to not commit accounting and financial
statement fraud. Auditors have a duty to look for such inventory fraud.
Auditors follow the Statement on Auditing Standards (SAS) No. 99 and AU Section 316 Consideration of Fraud in a Financial
Statement Audit when auditing a company’s books. Auditors are outside accountants hired to “obtain reasonable assurance about
whether the financial statements are free of material misstatement, whether caused by error or fraud.”3 Ultimately, an auditor will
prepare an audit report based on the testing of the balances in a company’s books, and a review of the company’s accounting
system. The auditor is to perform “procedures at locations on a surprise or unannounced basis, for example, observing inventory on
unexpected dates or at unexpected locations or counting cash on a surprise basis.”4 Such testing of a company’s inventory system is
used to catch accounting fraud. It is the responsibility of the accountant to present accurate accounting records to the auditor, and
for the auditor to create auditing procedures that reasonably ensure that the inventory balances are free of material misstatements in
the accounting balances.

6.1.6 [Link]
Additional Inventory Issues
Various other issues that affect inventory accounting include consignment sales, transportation and ownership issues, inventory
estimation tools, and the effects of inflationary versus deflationary cycles on various methods.

Consignment
Consigned goods refer to merchandise inventory that belongs to a third party but which is displayed for sale by the company.
These goods are not owned by the company and thus must not be included on the company’s balance sheet nor be used in the
company’s inventory calculations. The company’s profit relating to consigned goods is normally limited to a percentage of the sales
proceeds at the time of sale.
For example, assume that you sell your office and your current furniture doesn’t match your new building. One way to dispose of
the furniture would be to have a consignment shop sell it. The shop would keep a percentage of the sales revenue and pay you the
remaining balance. Assume in this example that the shop will keep one-third of the sales proceeds and pay you the remaining two-
thirds balance. If the furniture sells for $15,000, you would receive $10,000 and the shop would keep the remaining $5,000 as its
sales commission. A key point to remember is that until the inventory, in this case your office furniture, is sold, you still own it, and
it is reported as an asset on your balance sheet and not an asset for the consignment shop. After the sale, the buyer is the owner, so
the consignment shop is never the property’s owner.

Free on Board (FOB) Shipping and Destination

Transportation costs are commonly assigned to either the buyer or the seller based on the free on board (FOB) terms, as the terms
relate to the seller. Transportation costs are part of the responsibilities of the owner of the product, so determining the owner at the
shipping point identifies who should pay for the shipping costs. The seller’s responsibility and ownership of the goods ends at the
point that is listed after the FOB designation. Thus, FOB shipping point means that the seller transfers title and responsibility to
the buyer at the shipping point, so the buyer would owe the shipping costs. The purchased goods would be recorded on the buyer’s
balance sheet at this point.
Similarly, FOB destination means the seller transfers title and responsibility to the buyer at the destination, so the seller would
owe the shipping costs. Ownership of the product is the trigger that mandates that the asset be included on the company’s balance
sheet. In summary, the goods belong to the seller until they transition to the location following the term FOB, making the seller
responsible for everything about the goods to that point, including recording purchased goods on the balance sheet . If something
happens to damage or destroy the goods before they reach the FOB location, the seller would be required to replace the product or
reverse the sales transaction.

Lower-of-Cost-or-Market (LCM)
Reporting inventory values on the balance sheet using the accounting concept of conservatism (which discourages overstatement
of net assets and net income) requires inventory to be calculated and adjusted to a value that is the lower of the cost calculated
using the company’s chosen valuation method or the market value based on the market or replacement value of the inventory items.
Thus, if traditional cost calculations produce inventory values that are overstated, the lower-of-cost-or-market (LCM) concept
requires that the balance in the inventory account should be decreased to the more conservative replacement value rather than be
overstated on the balance sheet.

Estimating Inventory Costs: Gross Profit Method and Retail Inventory Method
Sometimes companies have a need to estimate inventory values. These estimates could be needed for interim reports, when
physical counts are not taken. The need could be result from a natural disaster that destroys part or all of the inventory or from an
error that causes inventory counts to be compromised or omitted. Some specific industries (such as select retail businesses) also
regularly use these estimation tools to determine cost of goods sold. Although the method is predictable and simple, it is also less
accurate since it is based on estimates rather than actual cost figures.
The gross profit method is used to estimate inventory values by applying a standard gross profit percentage to the company’s sales
totals when a physical count is not possible. The resulting gross profit can then be subtracted from sales, leaving an estimated cost
of goods sold. Then the ending inventory can be calculated by subtracting cost of goods sold from the total goods available for sale.
Likewise, the retail inventory method estimates the cost of goods sold, much like the gross profit method does, but uses the retail
value of the portions of inventory rather than the cost figures used in the gross profit method.

6.1.7 [Link]
Inflationary Versus Deflationary Cycles
As prices rise (inflationary times), FIFO ending inventory account balances grow larger even when inventory unit counts are
constant, while the income statement reflects lower cost of goods sold than the current prices for those goods, which produces
higher profits than if the goods were costed with current inventory prices. Conversely, when prices fall (deflationary times), FIFO
ending inventory account balances decrease and the income statement reflects higher cost of goods sold and lower profits than if
goods were costed at current inventory prices. The effect of inflationary and deflationary cycles on LIFO inventory valuation are
the exact opposite of their effects on FIFO inventory valuation.

LINK TO LEARNING
Accounting Coach does a great job in explaining inventory issues (and so many other accounting topics too): Learn more about
inventory and cost of goods sold on their website.

THINK IT THROUGH
First-in, First-out (FIFO)
Suppose you are the assistant controller for a retail establishment that is an independent bookseller. The company uses manual,
periodic inventory updating, using physical counts at year end, and the FIFO method for inventory costing. How would you
approach the subject of whether the company should consider switching to computerized perpetual inventory updating? Can you
present a persuasive argument for the benefits of perpetual? Explain.

Footnotes
1 “Inventory Fraud: Knowledge Is Your First Line of Defense.” Weaver. Mar. 27, 2015. [Link]
line-defense
2 Wells, Joseph T. “Ghost Goods: How to Spot Phantom Inventory.” Journal of Accountancy. June 1, 2001.
[Link]
3 American Institute of Certified Public Accountants (AICPA). Consideration of Fraud in a Financial Statement Audit (AU
Section 316). [Link]
4 American Institute of Certified Public Accountants (AICPA). Consideration of Fraud in a Financial Statement Audit (AU
Section 316). [Link]

6.1: Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions is shared under a CC BY-NC-SA
license and was authored, remixed, and/or curated by LibreTexts.
10.1: Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions by OpenStax is licensed CC
BY-NC-SA 4.0. Original source: [Link]

6.1.8 [Link]
6.2: Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual
Method
As you’ve learned, the perpetual inventory system is updated continuously to reflect the current status of inventory on an ongoing
basis. Modern sales activity commonly uses electronic identifiers—such as bar codes and RFID technology—to account for
inventory as it is purchased, monitored, and sold. Specific identification inventory methods also commonly use a manual form of
the perpetual system. Here we’ll demonstrate the mechanics implemented when using perpetual inventory systems in inventory
accounting, whether those calculations are orchestrated in a laborious manual system or electronically (in the latter, the inventory
accounting operates effortlessly behind the scenes but nonetheless utilizes the same perpetual methodology).

CONCEPTS IN PRACTICE
Perpetual Inventory’s Advancements through Technology
Perpetual inventory has been seen as the wave of the future for many years. It has grown since the 1970s alongside the
development of affordable personal computers. Universal product codes, commonly known as UPC barcodes, have advanced
inventory management for large and small retail organizations, allowing real-time inventory counts and reorder capability that
increased popularity of the perpetual inventory system. These UPC codes identify specific products but are not specific to the
particular batch of goods that were produced. Electronic product codes (EPCs) such as radio frequency identifiers (RFIDs) are
essentially an evolved version of UPCs in which a chip/identifier is embedded in the EPC code that matches the goods to the actual
batch of product that was produced. This more specific information allows better control, greater accountability, increased
efficiency, and overall quality monitoring of goods in inventory. The technology advancements that are available for perpetual
inventory systems make it nearly impossible for businesses to choose periodic inventory and forego the competitive advantages
that the technology offers.

Information Relating to All Cost Allocation Methods, but Specific to Perpetual Inventory Updating
Let’s return to The Spy Who Loves You Corporation data to demonstrate the four cost allocation methods, assuming inventory is
updated on an ongoing basis in a perpetual system.

Cost Data for Calculations

Company: Spy Who Loves You Corporation
Product: Global Positioning System (GPS) Tracking Device
Description: This product is an economical real-time GPS tracking device, designed for individuals who wish to monitor others’
whereabouts. It is being marketed to parents of middle school and high school students as a safety measure. Parents benefit by
being apprised of the child’s location, and the student benefits by not having to constantly check in with parents. Demand for the
product has spiked during the current fiscal period, while supply is limited, causing the selling price to escalate rapidly. Note: For
simplicity of demonstration, beginning inventory cost is assumed to be $21 per unit for all cost assumption methods.

Calculations for Inventory Purchases and Sales during the Period, Perpetual Inventory Updating
Regardless of which cost assumption is chosen, recording inventory sales using the perpetual method involves recording both the
revenue and the cost from the transaction for each individual sale. As additional inventory is purchased during the period, the cost

6.2.1 [Link]
of those goods is added to the merchandise inventory account. Normally, no significant adjustments are needed at the end of the
period (before financial statements are prepared) since the inventory balance is maintained to continually parallel actual counts.

ETHICAL CONSIDERATIONS
Ethical Short-Term Decision Making
When management and executives participate in unethical or fraudulent short-term decision making, it can negatively impact a
company on many levels. According to Antonia Chion, Associate Director of the SEC’s Division of Enforcement, those who
participate in such activities will be held accountable.5 For example, in 2015, the Securities and Exchange Commission (SEC)
charged two former top executives of OCZ Technology Group Inc. for accounting failures.6 The SEC alleged that OCZ’s former
CEO Ryan Petersen engaged in a scheme to materially inflate OCZ’s revenues and gross margins from 2010 to 2012, and that
OCZ’s former chief financial officer Arthur Knapp participated in certain accounting, disclosure, and internal accounting controls
failures.
Petersen and Knapp allegedly participated in channel stuffing, which is the process of recognizing and recording revenue in a
current period that actually will be legally earned in one or more future fiscal periods. A common example is to arrange for
customers to submit purchase orders in the current year, often with the understanding that if they don’t need the additional
inventory then they may return the inventory received or cancel the order if delivery has not occurred.7When the intention behind
channel stuffing is to mislead investors, it crosses the line into fraudulent practice. This and other unethical short-term accounting
decisions made by Petersen and Knapp led to the bankruptcy of the company they were supposed to oversee and resulted in fraud
charges from the SEC. Practicing ethical short-term decision making may have prevented both scenarios.

Specific Identification
For demonstration purposes, the specific units assumed to be sold in this period are designated as follows, with the specific
inventory distinction being associated with the lot numbers:
Sold 120 units, all from Lot 1 (beginning inventory), costing $21 per unit
Sold 180 units, 20 from Lot 1 (beginning inventory), costing $21 per unit; 160 from Lot 2 (July 10 purchase), costing $27 per
unit
The specific identification method of cost allocation directly tracks each of the units purchased and costs them out as they are sold.
In this demonstration, assume that some sales were made by specifically tracked goods that are part of a lot, as previously stated for
this method. For The Spy Who Loves You, the first sale of 120 units is assumed to be the units from the beginning inventory, which
had cost $21 per unit, bringing the total cost of these units to $2,520. Once those units were sold, there remained 30 more units of
the beginning inventory. The company bought 225 more units for $27 per unit. The second sale of 180 units consisted of 20 units at
$21 per unit and 160 units at $27 per unit for a total second-sale cost of $4,740. Thus, after two sales, there remained 10 units of
inventory that had cost the company $21, and 65 units that had cost the company $27 each. The last transaction was an additional
purchase of 210 units for $33 per unit. Ending inventory was made up of 10 units at $21 each, 65 units at $27 each, and 210 units at
$33 each, for a total specific identification perpetual ending inventory value of $8,895.

Calculations of Costs of Goods Sold, Ending Inventory, and Gross Margin, Specific Identification
The specific identification costing assumption tracks inventory items individually so that, when they are sold, the exact cost of the
item is used to offset the revenue from the sale. The cost of goods sold, inventory, and gross margin shown in Figure 10.13 were
determined from the previously-stated data, particular to specific identification costing.

6.2.2 [Link]
 Figure 10.13 Specific Identification Costing Assumption Cost of Goods Sold, Inventory, and Cost Value. (attribution: Copyright
Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Figure 10.14 shows the gross margin, resulting from the specific identification perpetual cost allocations of $7,260.

Figure 10.14 Specific Identification Perpetual Cost Allocations Gross Margin. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)

Description of Journal Entries for Inventory Sales, Perpetual, Specific Identification

Journal entries are not shown, but the following discussion provides the information that would be used in recording the necessary
journal entries. Each time a product is sold, a revenue entry would be made to record the sales revenue and the corresponding
accounts receivable or cash from the sale. Because of the choice to apply perpetual inventory updating, a second entry made at the
same time would record the cost of the item based on the actual cost of the items, which would be shifted from merchandise
inventory (an asset) to cost of goods sold (an expense).

First-in, First-out (FIFO)

The first-in, first-out method (FIFO) of cost allocation assumes that the earliest units purchased are also the first units sold. For The
Spy Who Loves You, using perpetual inventory updating, the first sale of 120 units is assumed to be the units from the beginning
inventory, which had cost $21 per unit, bringing the total cost of these units to $2,520. Once those units were sold, there remained
30 more units of beginning inventory. The company bought 225 more units for $27 per unit. At the time of the second sale of 180
units, the FIFO assumption directs the company to cost out the last 30 units of the beginning inventory, plus 150 of the units that
had been purchased for $27. Thus, after two sales, there remained 75 units of inventory that had cost the company $27 each. The
last transaction was an additional purchase of 210 units for $33 per unit. Ending inventory was made up of 75 units at $27 each,
and 210 units at $33 each, for a total FIFO perpetual ending inventory value of $8,955.

6.2.3 [Link]
Calculations of Costs of Goods Sold, Ending Inventory, and Gross Margin, First-in, First-out (FIFO)
The FIFO costing assumption tracks inventory items based on lots of goods that are tracked, in the order that they were acquired, so
that when they are sold the earliest acquired items are used to offset the revenue from the sale. The cost of goods sold, inventory,
and gross margin shown in Figure 10.15 were determined from the previously-stated data, particular to perpetual FIFO costing.

Figure 10.15 FIFO Costing Assumption Cost of Goods Purchased, Cost of Goods Sold, and Cost of Inventory Remaining.
(attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Figure 10.16 shows the gross margin, resulting from the FIFO perpetual cost allocations of $7,200.

Figure 10.16 FIFO Perpetual Cost Allocations Gross Margin. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-
SA 4.0 license)

Description of Journal Entries for Inventory Sales, Perpetual, First-in, First-out (FIFO)
Journal entries are not shown, but the following discussion provides the information that would be used in recording the necessary
journal entries. Each time a product is sold, a revenue entry would be made to record the sales revenue and the corresponding
accounts receivable or cash from the sale. When applying perpetual inventory updating, a second entry made at the same time
would record the cost of the item based on FIFO, which would be shifted from merchandise inventory (an asset) to cost of goods
sold (an expense).

Last-in, First-out (LIFO)

The last-in, first-out method (LIFO) of cost allocation assumes that the last units purchased are the first units sold. For The Spy
Who Loves You, using perpetual inventory updating, the first sale of 120 units is assumed to be the units from the beginning
inventory (because this was the only lot of good available, so it represented the last purchased lot), which had cost $21 per unit,
bringing the total cost of these units in the first sale to $2,520. Once those units were sold, there remained 30 more units of
beginning inventory. The company bought 225 more units for $27 per unit. At the time of the second sale of 180 units, the LIFO
assumption directs the company to cost out the 180 units from the latest purchased units, which had cost $27 for a total cost on the
second sale of $4,860. Thus, after two sales, there remained 30 units of beginning inventory that had cost the company $21 each,
plus 45 units of the goods purchased for $27 each. The last transaction was an additional purchase of 210 units for $33 per unit.

6.2.4 [Link]
Ending inventory was made up of 30 units at $21 each, 45 units at $27 each, and 210 units at $33 each, for a total LIFO perpetual
ending inventory value of $8,775.

Calculations of Costs of Goods Sold, Ending Inventory, and Gross Margin, Last-in, First-out (LIFO)
The LIFO costing assumption tracks inventory items based on lots of goods that are tracked in the order that they were acquired, so
that when they are sold, the latest acquired items are used to offset the revenue from the sale. The following cost of goods sold,
inventory, and gross margin were determined from the previously-stated data, particular to perpetual, LIFO costing.

Figure 10.17 LIFO Costing Assumption Cost of Goods Purchased, Cost of Goods Sold, and Cost of Inventory Remaining.
(attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Figure 10.18 shows the gross margin resulting from the LIFO perpetual cost allocations of $7,380.

Figure 10.18 LIFO Perpetual Cost Allocations Gross Margin. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-
SA 4.0 license)

Description of Journal Entries for Inventory Sales, Perpetual, Last-in, First-out (LIFO)
Journal entries are not shown, but the following discussion provides the information that would be used in recording the necessary
journal entries. Each time a product is sold, a revenue entry would be made to record the sales revenue and the corresponding
accounts receivable or cash from the sale. When applying apply perpetual inventory updating, a second entry made at the same
time would record the cost of the item based on LIFO, which would be shifted from merchandise inventory (an asset) to cost of
goods sold (an expense).

LINK TO LEARNING
Visit this Amazon inventory video for a little insight into some of the inventory challenges experienced by retail giant Amazon to
learn more.

6.2.5 [Link]
Weighted-Average Cost (AVG)
Weighted-average cost allocation requires computation of the average cost of all units in goods available for sale at the time the
sale is made for perpetual inventory calculations. For The Spy Who Loves You, the first sale of 120 units is assumed to be the units
from the beginning inventory (because this was the only lot of good available, so the price of these units also represents the average
cost), which had cost $21 per unit, bringing the total cost of these units in the first sale to $2,520. Once those units were sold, there
remained 30 more units of the inventory, which still had a $21 average cost. The company bought 225 more units for $27 per unit.
Recalculating the average cost, after this purchase, is accomplished by dividing total cost of goods available for sale (which totaled
$6,705 at that point) by the number of units held, which was 255 units, for an average cost of $26.29 per unit. At the time of the
second sale of 180 units, the AVG assumption directs the company to cost out the 180 at $26.29 for a total cost on the second sale
of $4,732. Thus, after two sales, there remained 75 units at an average cost of $26.29 each. The last transaction was an additional
purchase of 210 units for $33 per unit. Recalculating the average cost again resulted in an average cost of $31.24 per unit. Ending
inventory was made up of 285 units at $31.24 each for a total AVG perpetual ending inventory value of $8,902 (rounded).8

Calculations of Costs of Goods Sold, Ending Inventory, and Gross Margin, Weighted Average (AVG)
The AVG costing assumption tracks inventory items based on lots of goods that are combined and re-averaged after each new
acquisition to determine a new average cost per unit so that, when they are sold, the latest averaged cost items are used to offset the
revenue from the sale. The cost of goods sold, inventory, and gross margin shown in Figure 10.19 were determined from the
previously-stated data, particular to perpetual, AVG costing.

Figure 10.19 AVG Costing Assumption Cost of Goods Purchased, Cost of Goods Sold, and Cost of Inventory Remaining.
(attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Figure 10.20 shows the gross margin, resulting from the weighted-average perpetual cost allocations of $7,253.

Figure 10.20 Weighted AVG Perpetual Cost Allocations Gross Margin. (attribution: Copyright Rice University, OpenStax, under
CC BY-NC-SA 4.0 license)

Description of Journal Entries for Inventory Sales, Perpetual, Weighted Average (AVG)
Journal entries are not shown, but the following discussion provides the information that would be used in recording the necessary
journal entries. Each time a product is sold, a revenue entry would be made to record the sales revenue and the corresponding
accounts receivable or cash from the sale. When applying perpetual inventory updating, a second entry would be made at the same
time to record the cost of the item based on the AVG costing assumptions, which would be shifted from merchandise inventory (an
asset) to cost of goods sold (an expense).

6.2.6 [Link]
Comparison of All Four Methods, Perpetual
The outcomes for gross margin, under each of these different cost assumptions, is summarized in Figure 10.21.

Figure 10.21 Gross Margin Comparison. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

THINK IT THROUGH
Last-in, First-out (LIFO)
Two-part consideration: 1) Why do you think a company would ever choose to use perpetual LIFO as its costing method? It is
clearly more trouble to calculate than other methods and doesn’t really align with the natural flow of the merchandise, in most
cases. 2) Should the order in which the items are actually sold determine which costs are used to offset sales revenues from those
goods? Explain your understanding of these issues.

Footnotes
5 U.S. Securities and Exchange Commission (SEC). “SEC Charges Former Executives with Accounting Fraud and Other
Accounting Failures.” October 6, 2015. [Link]
6 SEC v. Ryan Petersen, No. 15-cv-04599 (N.D. Cal. filed October 6, 2015).
[Link]
7 George B. Parizek and Madeleine V. Findley. Charting a Course: Revenue Recognition Practices for Today’s Business
Environment. 2008. [Link]/-/media/files...[Link]
8 Note that there is a $1 rounding difference due to the rounding of cents inherent in the cost determination chain process.

6.2: Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method is shared under a CC BY-NC-SA license and was
authored, remixed, and/or curated by LibreTexts.
10.3: Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method by OpenStax is licensed CC BY-NC-SA 4.0.
Original source: [Link]

6.2.7 [Link]
 CHAPTER OVERVIEW

7: Bad Debt
7.1: Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches

7: Bad Debt is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

7.1 [Link]
7.1: Account for Uncollectible Accounts Using the Balance Sheet and Income
Statement Approaches
You lend a friend $500 with the agreement that you will be repaid in two months. At the end of two months, your friend has not
repaid the money. You continue to request the money each month, but the friend has yet to repay the debt. How does this affect
your finances?
Think of this on a larger scale. A bank lends money to a couple purchasing a home (mortgage). The understanding is that the
couple will make payments each month toward the principal borrowed, plus interest. As time passes, the loan goes unpaid. What
happens when a loan that was supposed to be paid is not paid? How does this affect the financial statements for the bank? The bank
may need to consider ways to recognize this bad debt.

Fundamentals of Bad Debt Expenses and Allowances for Doubtful Accounts

Bad debts are uncollectible amounts from customer accounts. Bad debt negatively affects accounts receivable (see Figure 9.2).
When future collection of receivables cannot be reasonably assumed, recognizing this potential nonpayment is required. There are
two methods a company may use to recognize bad debt: the direct write-off method and the allowance method.

Figure 9.2 Bad Debt Expenses. Uncollectible customer accounts produce bad debt. (credit: modification of “Past Due Bills” by
“Maggiebug 21”/Wikimedia Commons, CC0)
The direct write-off method delays recognition of bad debt until the specific customer accounts receivable is identified. Once this
account is identified as uncollectible, the company will record a reduction to the customer’s accounts receivable and an increase to
bad debt expense for the exact amount uncollectible.
Under generally accepted accounting principles (GAAP), the direct write-off method is not an acceptable method of recording bad
debts, because it violates the matching principle. For example, assume that a credit transaction occurs in September 2018 and is
determined to be uncollectible in February 2019. The direct write-off method would record the bad debt expense in 2019, while the
matching principle requires that it be associated with a 2018 transaction, which will better reflect the relationship between revenues
and the accompanying expenses. This matching issue is the reason accountants will typically use one of the two accrual-based
accounting methods introduced to account for bad debt expenses.
It is important to consider other issues in the treatment of bad debts. For example, when companies account for bad debt expenses
in their financial statements, they will use an accrual-based method; however, they are required to use the direct write-off method
on their income tax returns. This variance in treatment addresses taxpayers’ potential to manipulate when a bad debt is recognized.
Because of this potential manipulation, the Internal Revenue Service (IRS) requires that the direct write-off method must be used
when the debt is determined to be uncollectible, while GAAP still requires that an accrual-based method be used for financial
accounting statements.
For the taxpayer, this means that if a company sells an item on credit in October 2018 and determines that it is uncollectible in June
2019, it must show the effects of the bad debt when it files its 2019 tax return. This application probably violates the matching
principle, but if the IRS did not have this policy, there would typically be a significant amount of manipulation on company tax

7.1.1 [Link]
returns. For example, if the company wanted the deduction for the write-off in 2018, it might claim that it was actually
uncollectible in 2018, instead of in 2019.
The final point relates to companies with very little exposure to the possibility of bad debts, typically, entities that rarely offer credit
to its customers. Assuming that credit is not a significant component of its sales, these sellers can also use the direct write-off
method. The companies that qualify for this exemption, however, are typically small and not major participants in the credit
market. Thus, virtually all of the remaining bad debt expense material discussed here will be based on an allowance method that
uses accrual accounting, the matching principle, and the revenue recognition rules under GAAP.
For example, a customer takes out a $15,000 car loan on August 1, 2018 and is expected to pay the amount in full before December
1, 2018. For the sake of this example, assume that there was no interest charged to the buyer because of the short-term nature or life
of the loan. When the account defaults for nonpayment on December 1, the company would record the following journal entry to
recognize bad debt.

Bad Debt Expense increases (debit), and Accounts Receivable decreases (credit) for $15,000. If, in the future, any part of the debt
is recovered, a reversal of the previously written-off bad debt, and the collection recognition is required. Let’s say this customer
unexpectedly pays in full on May 1, 2019, the company would record the following journal entries (note that the company’s fiscal
year ends on June 30)

The first entry reverses the bad debt write-off by increasing Accounts Receivable (debit) and decreasing Bad Debt Expense (credit)
for the amount recovered. The second entry records the payment in full with Cash increasing (debit) and Accounts Receivable
decreasing (credit) for the amount received of $15,000.
As you’ve learned, the delayed recognition of bad debt violates GAAP, specifically the matching principle. Therefore, the direct
write-off method is not used for publicly traded company reporting; the allowance method is used instead.
The allowance method is the more widely used method because it satisfies the matching principle. The allowance methodestimates
bad debt during a period, based on certain computational approaches. The calculation matches bad debt with related sales during
the period. The estimation is made from past experience and industry standards. When the estimation is recorded at the end of a
period, the following entry occurs.

The journal entry for the Bad Debt Expense increases (debit) the expense’s balance, and the Allowance for Doubtful Accounts
increases (credit) the balance in the Allowance. The allowance for doubtful accounts is a contra asset account and is subtracted
from Accounts Receivable to determine the Net Realizable Value of the Accounts Receivable account on the balance sheet. A
contra account has an opposite normal balance to its paired account, thereby reducing or increasing the balance in the paired
account at the end of a period; the adjustment can be an addition or a subtraction from a controlling account. In the case of the
allowance for doubtful accounts, it is a contra account that is used to reduce the Controlling account, Accounts Receivable.

7.1.2 [Link]
At the end of an accounting period, the Allowance for Doubtful Accounts reduces the Accounts Receivable to produce Net
Accounts Receivable. Note that allowance for doubtful accounts reduces the overall accounts receivable account, not a specific
accounts receivable assigned to a customer. Because it is an estimation, it means the exact account that is (or will become)
uncollectible is not yet known.
To demonstrate the treatment of the allowance for doubtful accounts on the balance sheet, assume that a company has reported an
Accounts Receivable balance of $90,000 and a Balance in the Allowance of Doubtful Accounts of $4,800. The following table
reflects how the relationship would be reflected in the current (short-term) section of the company’s Balance Sheet.

There is one more point about the use of the contra account, Allowance for Doubtful Accounts. In this example, the $85,200 total is
the net realizable value, or the amount of accounts anticipated to be collected. However, the company is owed $90,000 and will still
try to collect the entire $90,000 and not just the $85,200.
Under the balance sheet method of calculating bad debt expenses, if there is already a balance in Allowance for Doubtful Accounts
from a previous period and accounts written off in the current year, this must be considered before the adjusting entry is made. For
example, if a company already had a credit balance from the prior period of $1,000, plus any accounts that have been written off
this year, and a current period estimated balance of $2,500, the company would need to subtract the prior period’s credit balance
from the current period’s estimated credit balance in order to calculate the amount to be added to the Allowance for Doubtful
Accounts.

Therefore, the adjusting journal entry would be as follows.

If a company already had a debit balance from the prior period of $1,000, and a current period estimated balance of $2,500, the
company would need to add the prior period’s debit balance to the current period’s estimated credit balance.

Therefore, the adjusting journal entry would be as follows.

7.1.3 [Link]
When a specific customer has been identified as an uncollectible account, the following journal entry would occur.

Allowance for Doubtful Accounts decreases (debit) and Accounts Receivable for the specific customer also decreases (credit).
Allowance for doubtful accounts decreases because the bad debt amount is no longer unclear. Accounts receivable decreases
because there is an assumption that no debt will be collected on the identified customer’s account.
Let’s say that the customer unexpectedly pays on the account in the future. The following journal entries would occur.

The first entry reverses the previous entry where bad debt was written off. This reinstatement requires Accounts Receivable:
Customer to increase (debit), and Allowance for Doubtful Accounts to increase (credit). The second entry records the payment on
the account. Cash increases (debit) and Accounts Receivable: Customer decreases (credit) for the amount received.
To compute the most accurate estimation possible, a company may use one of three methods for bad debt expense recognition: the
income statement method, balance sheet method, or balance sheet aging of receivables method.

THINK IT THROUGH
Bad Debt Estimation
As the accountant for a large publicly traded food company, you are considering whether or not you need to change your bad debt
estimation method. You currently use the income statement method to estimate bad debt at 4.5% of credit sales. You are
considering switching to the balance sheet aging of receivables method. This would split accounts receivable into three past- due
categories and assign a percentage to each group.
While you know that the balance sheet aging of receivables method is more accurate, it does require more company resources (e.g.,
time and money) that are currently applied elsewhere in the business. Using the income statement method is acceptable under
generally accepted accounting principles (GAAP), but should you switch to the more accurate method even if your resources are
constrained? Do you have a responsibility to the public to change methods if you know one is a better estimation?

Income Statement Method for Calculating Bad Debt Expenses

The income statement method (also known as the percentage of sales method) estimates bad debt expenses based on the
assumption that at the end of the period, a certain percentage of sales during the period will not be collected. The estimation is
typically based on credit sales only, not total sales (which include cash sales). In this example, assume that any credit card sales that
are uncollectible are the responsibility of the credit card company. It may be obvious intuitively, but, by definition, a cash sale
cannot become a bad debt, assuming that the cash payment did not entail counterfeit currency. The income statement method is a
simple method for calculating bad debt, but it may be more imprecise than other measures because it does not consider how long a
debt has been outstanding and the role that plays in debt recovery.

7.1.4 [Link]
To illustrate, let’s continue to use Billie’s Watercraft Warehouse (BWW) as the example. Billie’s end-of-year credit sales totaled
$458,230. BWW estimates that 5% of its overall credit sales will result in bad debt. The following adjusting journal entry for bad
debt occurs.

Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $22,911.50 ($458,230 × 5%). This
means that BWW believes $22,911.50 will be uncollectible debt. Let’s say that on April 8, it was determined that Customer Robert
Craft’s account was uncollectible in the amount of $5,000. The following entry occurs.

In this case, Allowance for Doubtful Accounts decreases (debit) and Accounts Receivable: Craft decreases (credit) for the known
uncollectible amount of $5,000. On June 5, Craft unexpectedly makes a partial payment on his account in the amount of $3,000.
The following journal entries show the reinstatement of bad debt and the subsequent payment.

The outstanding balance of $2,000 that Craft did not repay will remain as bad debt.

YOUR TURN
Heating and Air Company
You run a successful heating and air conditioning company. Your net credit sales, accounts receivable, and allowance for doubtful
accounts figures for year-end 2018, follow.

A. Compute bad debt estimation using the income statement method, where the percentage uncollectible is 5%.
B. Prepare the journal entry for the income statement method of bad debt estimation.
C. Compute bad debt estimation using the balance sheet method of percentage of receivables, where the percentage uncollectible is
9%.
D. Prepare the journal entry for the balance sheet method bad debt estimation.
Solution
A. $41,570; $831,400 × 5%

7.1.5 [Link]
B.
C. $20,056.50; $222,850 × 9%

D.

Balance Sheet Method for Calculating Bad Debt Expenses

The balance sheet method (also known as the percentage of accounts receivable method) estimates bad debt expenses based on
the balance in accounts receivable. The method looks at the balance of accounts receivable at the end of the period and assumes
that a certain amount will not be collected. Accounts receivable is reported on the balance sheet; thus, it is called the balance sheet
method. The balance sheet method is another simple method for calculating bad debt, but it too does not consider how long a debt
has been outstanding and the role that plays in debt recovery. There is a variation on the balance sheet method, however, called the
aging method that does consider how long accounts receivable have been owed, and it assigns a greater potential for default to
those debts that have been owed for the longest period of time.
Continuing our examination of the balance sheet method, assume that BWW’s end-of-year accounts receivable balance totaled
$324,850. This entry assumes a zero balance in Allowance for Doubtful Accounts from the prior period. BWW estimates 15% of
its overall accounts receivable will result in bad debt. The following adjusting journal entry for bad debt occurs.

Bad Debt Expense increases (debit), and Allowance for Doubtful Accounts increases (credit) for $48,727.50 ($324,850 × 15%).
This means that BWW believes $48,727.50 will be uncollectible debt. Let’s consider that BWW had a $23,000 credit balance from
the previous period. The adjusting journal entry would recognize the following.

This is different from the last journal entry, where bad debt was estimated at $48,727.50. That journal entry assumed a zero balance
in Allowance for Doubtful Accounts from the prior period. This journal entry takes into account a credit balance of $23,000 and
subtracts the prior period’s balance from the estimated balance in the current period of $48,727.50.

7.1.6 [Link]
Balance Sheet Aging of Receivables Method for Calculating Bad Debt Expenses
The balance sheet aging of receivables method estimates bad debt expenses based on the balance in accounts receivable, but it
also considers the uncollectible time period for each account. The longer the time passes with a receivable unpaid, the lower the
probability that it will get collected. An account that is 90 days overdue is more likely to be unpaid than an account that is 30 days
past due.
With this method, accounts receivable is organized into categories by length of time outstanding, and an uncollectible percentage is
assigned to each category. The length of uncollectible time increases the percentage assigned. For example, a category might
consist of accounts receivable that is 0–30 days past due and is assigned an uncollectible percentage of 6%. Another category might
be 31–60 days past due and is assigned an uncollectible percentage of 15%. All categories of estimated uncollectible amounts are
summed to get a total estimated uncollectible balance. That total is reported in Bad Debt Expense and Allowance for Doubtful
Accounts, if there is no carryover balance from a prior period. If there is a carryover balance, that must be considered before
recording Bad Debt Expense. The balance sheet aging of receivables method is more complicated than the other two methods, but
it tends to produce more accurate results. This is because it considers the amount of time that accounts receivable has been owed,
and it assumes that the longer the time owed, the greater the possibility that individual accounts receivable will prove to be
uncollectible.
Looking at BWW, it has an accounts receivable balance of $324,850 at the end of the year. The company splits its past-due
accounts into three categories: 0–30 days past due, 31–90 days past due, and over 90 days past due. The uncollectible percentages
and the accounts receivable breakdown are shown here.

For each of the individual categories, the accountant multiplies the uncollectible percentage by the accounts receivable total for that
category to get the total balance of estimated accounts that will prove to be uncollectible for that category. Then all of the category
estimates are added together to get one total estimated uncollectible balance for the period. The entry for bad debt would be as
follows, if there was no carryover balance from the prior period.

Bad Debt Expense increases (debit) as does Allowance for Doubtful Accounts (credit) for $58,097. BWW believes that $58,097
will be uncollectible debt.
Let’s consider a situation where BWW had a $20,000 debit balance from the previous period. The adjusting journal entry would
recognize the following.

This is different from the last journal entry, where bad debt was estimated at $58,097. That journal entry assumed a zero balance in
Allowance for Doubtful Accounts from the prior period. This journal entry takes into account a debit balance of $20,000 and adds
the prior period’s balance to the estimated balance of $58,097 in the current period.

7.1.7 [Link]
You may notice that all three methods use the same accounts for the adjusting entry; only the method changes the financial
outcome. Also note that it is a requirement that the estimation method be disclosed in the notes of financial statements so
stakeholders can make informed decisions.

CONCEPTS IN PRACTICE
Generally Accepted Accounting Principles
As of January 1, 2018, GAAP requires a change in how health-care entities record bad debt expense. Before this change, these
entities would record revenues for billed services, even if they did not expect to collect any payment from the patient. This
uncollectible amount would then be reported in Bad Debt Expense. Under the new guidance, the bad debt amount may only be
recorded if there is an unexpected circumstance that prevented the patient from paying the bill, and it may only be calculated from
the amount that the providing entity anticipated collecting.
For example, a patient receives medical services at a local hospital that cost $1,000. The hospital knows in advance that the patient
will pay only $100 of the amount owed. The previous GAAP rules would allow the company to write off $900 to bad debt. Under
the current rule, the company may only consider revenue to be the expected amount of $100. For example, if the patient ran into an
unexpected job loss and is able to pay only $20 of the $100 expected, the hospital would record the $20 to revenue and the $80
($100 – $20) as a write-off to bad debt. This is a significant change in revenue reporting and bad debt expense. Health-care entities
will more than likely see a decrease in bad debt expense and revenues as a result of this change.3

Footnotes
3 Tara Bannow. “New Bad Debt Accounting Standards Likely to Remake Community Benefit Reporting.” Modern Healthcare.
March 17, 2018. [Link]

7.1: Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches is shared under a CC BY-NC-SA license
and was authored, remixed, and/or curated by LibreTexts.
9.2: Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches by OpenStax is licensed CC BY-
NC-SA 4.0. Original source: [Link]

7.1.8 [Link]
 CHAPTER OVERVIEW

8: Internal Controls
8.1: Analyze Fraud in the Accounting Workplace
8.2: Define and Explain Internal Controls and Their Purpose within an Organization
8.3: Describe Internal Controls within an Organization
8.4: Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
8.5: Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements

8: Internal Controls is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1
8.1: Analyze Fraud in the Accounting Workplace
In this chapter, one of the major issues examined is the concept of fraud. Fraud can be defined in many ways, but for the purposes
of this course we define it as the act of intentionally deceiving a person or organization or misrepresenting a relationship in order to
secure some type of benefit, either financial or nonfinancial. We initially discuss it in a broader sense and then concentrate on the
issue of fraud as it relates to the accounting environment and profession.
Workplace fraud is typically detected by anonymous tips or by accident, so many companies use the fraud triangle to help in the
analysis of workplace fraud. Donald Cressey, an American criminologist and sociologist, developed the fraud triangle to help
explain why law-abiding citizens sometimes commit serious workplace-related crimes. He determined that people who embezzled
money from banks were typically otherwise law-abiding citizens who came into a “non-sharable financial problem.” A non-
sharable financial problem is when a trusted individual has a financial issue or problem that he or she feels can't be shared.
However, it is felt that the problem can be alleviated by surreptitiously violating the position of trust through some type of illegal
response, such as embezzlement or other forms of misappropriation. The guilty party is typically able to rationalize the illegal
action. Although they committed serious financial crimes, for many of them, it was their first offense.
The fraud triangle consists of three elements: incentive, opportunity, and rationalization (Figure 8.2). When an employee commits
fraud, the elements of the fraud triangle provide assistance in understanding the employee’s methods and rationale. Each of the
elements needs to be present for workplace fraud to occur.

Figure 8.2 Fraud Triangle. The three components identified in the fraud triangle are perceived opportunity, incentive, and
rationalization. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Perceived opportunity is when a potential fraudster thinks that the internal controls are weak or sees a way to override them. This is
the area in which an accountant has the greatest ability to mitigate fraud, as the accountant can review and test internal controls to
locate weaknesses. After identifying a weak, circumvented, or nonexistent internal control, management, along with the
accountant, can implement stronger internal controls.
Rationalization is a way for the potential fraudster to internalize the concept that the fraudulent actions are acceptable. A typical
fraudster finds ways to personally justify his or her illegal and unethical behavior. Using rationalization as a tool to locate or
combat fraud is difficult, because the outward signs may be difficult to recognize.
Incentive (or pressure) is another element necessary for a person to commit fraud. The different types of pressure are typically
found in (1) vices, such as gambling or drug use; (2) financial pressures, such as greed or living beyond their means; (3) work
pressure, such as being unhappy with a job; and (4) other pressures, such as the desire to appear successful. Pressure may be more
recognizable than rationalization, for instance, when coworkers seem to be living beyond their means or complain that they want to
get even with their employer because of low pay or other perceived slights.
Typically, all three elements of the triangle must be in place for an employee to commit fraud, but companies usually focus on the
opportunity aspect of mitigating fraud because, they can develop internal controls to manage the risk. The rationalization and
pressure to commit fraud are harder to understand and identify. Many organizations may recognize that an employee may be under
pressure, but many times the signs of pressure are missed.

8.1.1 [Link]
Virtually all types of businesses can fall victim to fraudulent behavior. For example, there have been scams involving grain silos in
Texas inflating their inventory, the sale of mixed oils labeled as olive oil across the globe, and the tens of billions of dollars that
Bernie Madoff swindled out of investors and not-for-profits.
To demonstrate how a fraud can occur, let’s examine a sample case in a little more detail. In 2015, a long-term employee of the
SCICAP Federal Credit Union in Iowa was convicted of stealing over $2.7 million in cash over a 37-year period. The employee
maintained two sets of financial records: one that provided customers with correct information as to how much money they had on
deposit within their account, and a second set of books that, through a complex set of transactions, moved money out of customer
accounts and into the employee’s account as well as those of members of her family. To ensure that no other employee within the
small credit union would have access to the duplicate set of books, the employee never took a vacation over the 37-year period, and
she was the only employee with password-protected access to the system where the electronic records were stored.
There were, at least, two obvious violations of solid internal control principles in this case. The first was the failure to require more
than one person to have access to the records, which the employee was able to maintain by not taking a vacation. Allowing the
employee to not share the password-protected access was a second violation. If more than one employee had access to the system,
the felonious employee probably would have been caught much earlier. What other potential failures in the internal control system
might have been present? How does this example of fraud exhibit the three components of the fraud triangle?
Unfortunately, this is one of many examples that occur on a daily basis. In almost any city on almost any day, there are articles in
local newspapers about a theft from a company by its employees. Although these thefts can involve assets such as inventory, most
often, employee theft involves cash that the employee has access to as part of his or her day-to-day job.

LINK TO LEARNING
Small businesses have few employees, but often they have certain employees who are trusted with responsibilities that may not
have complete internal control systems. This situation makes small businesses especially vulnerable to fraud. The article “Small
Business Fraud and the Trusted Employee” from the Association of Certified Fraud Examinersdescribes how a trusted employee
may come to commit fraud, and how a small business can prevent it from happening.
Accountants, and other members of the management team, are in a good position to control the perceived opportunity side of the
fraud triangle through good internal controls, which are policies and procedures used by management and accountants of a
company to protect assets and maintain proper and efficient operations within a company with the intent to minimize fraud. An
internal auditor is an employee of an organization whose job is to provide an independent and objective evaluation of the
company’s accounting and operational activities. Management typically reviews the recommendations and implements stronger
internal controls.
Another important role is that of an external auditor, who generally works for an outside certified public accountant (CPA) firm or
his or her own private practice and conducts audits and other assignments, such as reviews. Importantly, the external auditor is not
an employee of the client. The external auditor prepares reports and then provides opinions as to whether or not the financial
statements accurately reflect the financial conditions of the company, subject to generally accepted accounting principles (GAAP).
External auditors can maintain their own practice, or they might be employed by national or regional firms.

ETHICAL CONSIDERATIONS
Internal Auditors and Their Code of Ethics
Internal auditors are employees of an organization who evaluate internal controls and other operational metrics, and then ethically
report their findings to management. An internal auditor may be a Certified Internal Auditor (CIA), an accreditation granted by the
Institute of Internal Auditors (IIA). The IIA defines internal auditing as “an independent, objective assurance and consulting
activity designed to add value and improve an organization’s operations. It helps an organization accomplish its objectives by
bringing a systematic, disciplined approach to evaluate and improve the effectiveness of risk management, control, and governance
processes.”2
Internal auditors have their own organizational code of ethics. According to the IIA, “the purpose of The Institute’s Code of Ethics
is to promote an ethical culture in the profession of internal auditing.”3 Company management relies on a disciplined and truthful
approach to reporting. The internal auditor is expected to keep confidential any received information, while reporting results in an
objective fashion. Management trusts internal auditors to perform their work in a competent manner and with integrity, so that the
company can make the best decisions moving forward.

8.1.2 [Link]
One of the issues faced by any organization is that internal control systems can be overridden and can be ineffective if not followed
by management or employees. The use of internal controls in both accounting and operations can reduce the risk of fraud. In the
unfortunate event that an organization is a victim of fraud, the internal controls should provide tools that can be used to identify
who is responsible for the fraud and provide evidence that can be used to prosecute the individual responsible for the fraud. This
chapter discusses internal controls in the context of accounting and controlling for cash in a typical business setting. These
examples are applicable to the other ways in which an organization may protect its assets and protect itself against fraud.

Footnotes
2 The Institute of Internal Auditors (IIA). “Code of Ethics.” n.d. [Link]
3 The Institute of Internal Auditors (IIA). “Code of Ethics.” n.d. [Link]

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LibreTexts.
8.1: Analyze Fraud in the Accounting Workplace by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

8.1.3 [Link]
8.2: Define and Explain Internal Controls and Their Purpose within an Organization
Internal controls are the systems used by an organization to manage risk and diminish the occurrence of fraud. The internal
control structure is made up of the control environment, the accounting system, and procedures called control activities. Several
years ago, the Committee of Sponsoring Organizations (COSO), which is an independent, private-sector group whose five
sponsoring organizations periodically identify and address specific accounting issues or projects, convened to address the issue of
internal control deficiencies in the operations and accounting systems of organizations. They subsequently published a report that is
known as COSO’s Internal Control-Integrated Framework. The five components that they determined were necessary in an
effective internal control system make up the components in the internal controls triangle shown in Figure 8.3.

Figure 8.3 The Internal Control Environment. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Here we address some of the practical aspects of internal control systems. The internal control system consists of the formal
policies and procedures that do the following:
ensure assets are properly used
ensure that the accounting system is functioning properly
monitor operations of the organization to ensure maximum efficiency
ensure that assets are kept secure
ensure that employees are in compliance with corporate policies
A properly designed and functioning internal control system will not eliminate the risk of loss, but it will reduce the risk.
Different organizations face different types of risk, but when internal control systems are lacking, the opportunity arises for fraud,
misuse of the organization’s assets, and employee or workplace corruption. Part of an accountant’s function is to understand and
assist in maintaining the internal control in the organization.

LINK TO LEARNING
See the Institute of Internal Auditors website to learn more about many of the professional functions of the internal auditor.
Internal control keeps the assets of a company safe and keeps the company from violating any laws, while fairly recording the
financial activity of the company in the accounting records. Proper accounting records are used to create the financial statements
that the owners use to evaluate the operations of a company, including all company and employee activities. Internal controls are
more than just reviews of how items are recorded in the company’s accounting records; they also include comparing the accounting
records to the actual operations of the company.
For example, a movie theater earns most of its profits from the sale of popcorn and soda at the concession stand. The prices of the
items sold at the concession stand are typically high, even though the costs of popcorn and soda are low. Internal controls allow the
owners to ensure that their employees do not give away the profits by giving away sodas and popcorn.
If you were to go to the concession stand and ask for a cup of water, typically, the employee would give you a clear, small plastic
cup called a courtesy cup. This internal control, the small plastic cup for nonpaying customers, helps align the accounting system
and the theater’s operations. A movie theater does not use a system to directly account for the sale of popcorn, soda, or ice used.

8.2.1 [Link]
Instead, it accounts for the containers. A point-of-sale system compares the number of soda cups used in a shift to the number of
sales recorded in the system to ensure that those numbers match. The same process accounts for popcorn buckets and other
containers. Providing a courtesy cup ensures that customers drinking free water do not use the soda cups that would require a
corresponding sale to appear in the point-of-sale system. The cost of the popcorn, soda, and ice will be recorded in the accounting
system as an inventory item, but the internal control is the comparison of the recorded sales to the number of containers used. This
is just one type of internal control. As we discuss the internal controls, we see that the internal controls are used both in accounting,
to provide information for management to properly evaluate the operations of the company, and in business operations, to reduce
fraud.
It should be clear how important internal control is to all businesses, regardless of size. An effective internal control system allows
a business to monitor its employees, but it also helps a company protect sensitive customer data. Consider the 2017 massive data
breach at Equifax that compromised data of over 143 million people. With proper internal controls functioning as intended, there
would have been protective measures to ensure that no unauthorized parties had access to the data. Not only would internal controls
prevent outside access to the data, but proper internal controls would protect the data from corruption, damage, or misuse.

Example 8.2.1 : Bank Fraud in Enid, Oklahoma

The retired mayor of Enid, Oklahoma, Ernst Currier, had a job as a loan officer and then as a senior vice president at Security
National Bank. In his bank job, he allegedly opened 61 fraudulent loans. He used the identities of at least nine real people as
well as eight fictitious people and stole about $6.2 million.4 He was sentenced to 13 years in prison on 33 felony counts.
Currier was able to circumvent one of the most important internal controls: segregation of duties. The American Institute of
Certified Public Accountants (AICPA) states that segregation of duties “is based on shared responsibilities of a key process that
disperses the critical functions of that process to more than one person or department. Without this separation in key processes,
fraud and error risks are far less manageable.”5 Currier used local residents’ identities and created false documents to open loans
for millions of dollars and then collect the funds himself, without any oversight by any other employee. Creating these loans
allowed him to walk up to the bank vault and take cash out of the bank without anyone questioning him. There was no
segregation of duties for opening loans, or if there was, he was able to easily override those internal controls.
How could internal controls have helped prevent Currier’s bank fraud in Enid, Oklahoma?
Solution
Simply having someone else confirm the existence of the borrower and make the payment for the loan directly to the borrower
would have saved this small bank millions of dollars.

Consider a bank that has to track deposits for thousands of customers. If a fire destroys the building housing the bank’s servers,
how can the bank find the balances of each customer? Typically, organizations such as banks mirror their servers at several
locations around the world as an internal control. The bank might have a main server in Tennessee but also mirror all data in real
time to identical servers in Arizona, Montana, and even offshore in Iceland. With multiple copies of a server at multiple locations
across the country, or even the world, in the event of disaster to one server, a backup server can take control of operations,
protecting customer data and avoiding any service interruptions.
Internal controls are the basic components of an internal control system, the sum of all internal controls and policies within an
organization that protect assets and data. A properly designed system of internal controls aims to ensure the integrity of assets,
allows for reliable accounting information and financial reporting, enhances efficiency within an organization, and provides
guidelines and possible consequences for dealing with breaches. Internal controls drive many decisions and overall operational
procedures within an organization. A properly designed internal control system will not prevent all loss from occurring, but it will
significantly reduce the risk of loss and increase the chance of identifying the responsible party.

CONTINUING APPLICATION
Fraud Controls for Grocery Stores
All businesses are concerned with internal controls over reporting and assets. For the grocery industry this concern is even greater,
because profit margins on items are so small that any lost opportunity hurts profitability. How can an individual grocery store
develop effective controls?

8.2.2 [Link]
Consider the two biggest items that a grocery store needs to control: food (inventory) and cash. Inventory controls are set up to stop
shrinkage (theft). While it is not profitable for each aisle to be patrolled by a security guard, cameras throughout the store linked to
a central location allow security staff to observe customers. More controls are placed on cash registers to prevent employees from
stealing cash. Cameras at each register, cash counts at each shift change, and/or a supervisor who observes cashiers are some
potential internal control methods. Grocery stores invest more resources in controlling cash because they have determined it to be
the greatest opportunity for fraudulent activity.

The Role of Internal Controls

The accounting system is the backbone of any business entity, whether it is profit based or not. It is the responsibility of
management to link the accounting system with other functional areas of the business and ensure that there is communication
among employees, managers, customers, suppliers, and all other internal and external users of financial information. With a proper
understanding of internal controls, management can design an internal control system that promotes a positive business
environment that can most effectively serve its customers.
For example, a customer enters a retail store to purchase a pair of jeans. As the cashier enters the jeans into the point-of-sale
system, the following events occur internally:
1. A sale is recorded in the company’s journal, which increases revenue on the income statement. If the transaction occurred by
credit card, the bank typically transfers the funds into the store’s bank account in a timely manner.
2. The pair of jeans is removed from the inventory of the store where the purchase was made.
3. A new pair of jeans is ordered from the distribution center to replace what was purchased from the store’s inventory.
4. The distribution center orders a new pair of jeans from the factory to replace its inventory.
5. Marketing professionals can monitor over time the trend and volume of jeans sold in a specific size. If an increase or decrease
in sales volume of a specific size is noted, store inventory levels can be adjusted.
6. The company can see in real time the exact inventory levels of all products in all stores at all times, and this can ensure the best
customer access to products.
Because many systems are linked through technology that drives decisions made by many stakeholders inside and outside of the
organization, internal controls are needed to protect the integrity and ensure the flow of information. An internal control system
also assists all stakeholders of an organization to develop an understanding of the organization and provide assurance that all assets
are being used efficiently and accurately.

Environment Leading to the Sarbanes-Oxley Act

Internal controls have grown in their importance as a component of most business decisions. This importance has grown as many
company structures have grown in complexity. Despite their importance, not all companies have given maintenance of controls top
priority. Additionally, many small businesses do not have adequate understanding of internal controls and therefore use inferior
internal control systems. Many large companies have nonformalized processes, which can lead to systems that are not as efficient
as they could be. The failure of the SCICAP Credit Union discussed earlier is a direct result of a small financial institution having
a substandard internal control system leading to employee theft. One of the largest corporate failures of all time was Enron, and the
failure can be directly attributed to poor internal controls.
Enron was one of the largest energy companies in the world in the late twentieth century. However, a corrupt management
attempted to hide weak financial performance by manipulating revenue recognition, valuation of assets on the balance sheet, and
other financial reporting disclosures so that the company appeared to have significant growth. When this practice was uncovered,
the owners of Enron stock lost $40 billion as the stock price dropped from $91 per share to less than $1 per share, as shown in
Figure 8.4.6 This failure could have been prevented had proper internal controls been in place.
For example, Enron and its accounting firm, Arthur Andersen, did not maintain an adequate degree of independence. Arthur
Andersen provided a significant amount of services in both auditing and consulting, which prevented them from approaching the
audit of Enron with a proper degree of independence. Also, among many other violations, Enron avoided the proper use of several
acceptable reporting requirements.

8.2.3 [Link]
 Figure 8.4 Change in Enron Stock Price. The Enron scandal was one of the largest frauds in the history of modern business. It was
the main fraud that was responsible for creation of the Sarbanes-Oxley Act as well as the Public Company Accounting Oversight
Board (PCAOB). (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
As a result of the Enron failure and others that occurred during the same time frame, Congress passed the Sarbanes-Oxley Act
(SOX) to regulate practice to manage conflicts of analysts, maintain governance, and impose guidelines for criminal conduct as
well as sanctions for violations of conduct. It ensures that internal controls are properly documented, tested, and used consistently.
The intent of the act was to ensure that corporate financial statements and disclosures are accurate and reliable. It is important to
note that SOX only applies to public companies. A publicly traded company is one whose stock is traded (bought and sold) on an
organized stock exchange. Smaller companies still struggle with internal control development and compliance due to a variety of
reasons, such as cost and lack of resources.

Major Accounting Components of the Sarbanes-Oxley Act

As it pertains to internal controls, the SOX requires the certification and documentation of internal controls. Specifically, the act
requires that the auditor do the following:
1. Issue an internal control report following the evaluation of internal controls.
2. Limit nonaudit services, such as consulting, that are provided to a client.
3. Rotate who can lead the audit. The person in charge of the audit can serve for a period of no longer than seven years without a
break of two years.
Additionally, the work conducted by the auditor is to be overseen by the Public Company Accounting Oversight Board
(PCAOB). The PCAOB is a congressionally established, nonprofit corporation. Its creation was included in the Sarbanes-Oxley
Act of 2002 to regulate conflict, control disclosures, and set sanction guidelines for any violation of regulations. The PCAOB was
assigned the responsibilities of ensuring independent, accurate, and informative audit reports, monitoring the audits of securities
brokers and dealers, and maintaining oversight of the accountants and accounting firms that audit publicly traded companies.

LINK TO LEARNING
Visit the Public Company Accounting Oversight Board (PCAOB) website to learn more about what it does.
Any employee found to violate SOX standards can be subject to very harsh penalties, including $5 million in fines and up to 20 to
25 years in prison. The penalty is more severe for securities fraud (25 years) than for mail or wire fraud (20 years).
The SOX is relatively long and detailed, with Section 404 having the most application to internal controls. Under Section 404,
management of a company must perform annual audits to assess and document the effectiveness of all internal controls that have an
impact on the financial reporting of the organization. Also, selected executives of the firm under audit must sign the audit report
and state that they attest that the audit fairly represents the financial records and conditions of the company.
The financial reports and internal control system must be audited annually. The cost to comply with this act is very high, and there
is debate as to how effective this regulation is. Two primary arguments that have been made against the SOX requirements is that

8.2.4 [Link]
complying with their requirements is expensive, both in terms of cost and workforce, and the results tend not to be conclusive.
Proponents of the SOX requirements do not accept these arguments.
One available potential response to mandatory SOX compliance is for a company to decertify (remove) its stock for trade on the
available stock exchanges. Since SOX affects publicly traded companies, decertifying its stock would eliminate the SOX
compliance requirement. However, this has not proven to be a viable option, primarily because investors enjoy the protection SOX
provides, especially the requirement that the companies in which they invest undergo a certified audit prepared by CPAs employed
by national or regional accounting firms. Also, if a company takes its stock off of an organized stock exchange, many investors
assume that a company is in trouble financially and that it wants to avoid an audit that might detect its problems.

Example 8.2.1 : The Growing Importance of the Report on Internal Controls

Internal controls have become an important aspect of financial reporting. As part of the financial statements, the auditor has to
issue a report with an opinion on the financial statements, as well as internal controls. Use the internet and locate the annual
report of a company, specifically the report on internal controls. What does this report tell the user of financial information?
Solution
The annual report informs the user about the financial results of the company, both in discussion by management as well as the
financial statements. Part of the financial statements involves an independent auditor’s report on the integrity of the financial
statements as well as the internal controls.

LINK TO LEARNING
Many companies have their own internal auditors on staff. The role of the internal auditor is to test and ensure that a company has
proper internal controls in place, and that they are functioning. Read about how the internal audit works from I.S. Partners to learn
more.

Footnotes
4 Jack Money. “Fraudulent Loans Lead to Enid Banker’s Arrest on Numerous Felony Complaints.” The Oklahoman. November
15, 2017. [Link]
5 American Institute of Certified Public Accountants (AICPA). “Segregation of Duties.” n.d.
[Link]
6 Douglas O. Linder, ed. “Enron Historical Stock Price.” Famous Trials. n.d. [Link]
[Link]/images...[Link]

8.2: Define and Explain Internal Controls and Their Purpose within an Organization is shared under a CC BY-NC-SA license and was authored,
remixed, and/or curated by LibreTexts.
8.2: Define and Explain Internal Controls and Their Purpose within an Organization by OpenStax is licensed CC BY-NC-SA 4.0.
Original source: [Link]

8.2.5 [Link]
8.3: Describe Internal Controls within an Organization
The use of internal controls differs significantly across organizations of different sizes. In the case of small businesses,
implementation of internal controls can be a challenge, due to cost constraints, or because a small staff may mean that one manager
or owner will have full control over the organization and its operations. An owner in charge of all functions has enough knowledge
to keep a close eye on all aspects of the organization and can track all assets appropriately. In smaller organizations in which
responsibilities are delegated, procedures need to be developed in order to ensure that assets are tracked and used properly.
When an owner cannot have full oversight and control over an organization, internal control systems need to be developed. When
an appropriate internal control system is in place, it is interlinked to all aspects of the entity’s operations. An appropriate internal
control system links the accounting, finance, operations, human resources, marketing, and sales departments within an
organization. It is important that the management team, as well as employees, recognize the importance of internal controls and
their role in preventing losses, monitoring performance, and planning for the future.

Elements of Internal Control

A strong internal control system is based on the same consistent elements:
establishment of clear responsibilities
proper documentation
adequate insurance
separation of assets from custody
separation of duties
use of technology

Establishment of Clear Responsibilities

A properly designed system of internal control clearly dictates responsibility for certain roles within an organization. When there is
a clear statement of responsibility, issues that are uncovered can be easily traced and responsibility placed where it belongs.
As an example, imagine that you are the manager of the Galaxy’s Best Yogurt. On any shift, you have three employees working in
the store. One employee is designated as the shift supervisor who oversees the operations of the other two employees on the shift
and ensures that the store is presented and functioning properly. Of the other two employees, one may be solely responsible for
management of the cash register, while the others serve the customers. When only one employee has access to an individual cash
register, if there is an overage or shortage of cash, it can be traced to the one employee who is in charge of the cash register.

Proper Documentation
An effective internal control system maintains proper documentation, including backups, to trace all transactions. The
documentation can be paper copies, or documents that are computer generated and stored, on flash drives or in the cloud, for
example. Given the possibility of some type of natural (tornado or flood) or man-made (arson) disasters, even the most basic of
businesses should create backup copies of documentation that are stored off-site.
In addition, any documentation generated by daily operations should be managed according to internal controls. For example, when
the Galaxy’s Best Yogurt closes each day, one employee should close out and reconcile the cash drawer using prenumbered forms
in pen to ensure that no forms can be altered or changed by another employee who may have access to the cash. In case of an error,
the employee responsible for making the change should initial any changes on the form. If there are special orders for cakes or
other products, the order forms should be prenumbered. The use of prenumbered documents provides assurance that all sales are
recorded. If a form is not prenumbered, an order can be prepared, and the employee can then take the money without ringing the
order into the cash register, leaving no record of the sale.

Adequate Insurance
Insurance may be a significant cost to an organization (especially liability coverage), but it is necessary. With adequate insurance
on an asset, if it is lost or destroyed, an outside party will recoup the company for the loss. If assets are lost to fraud or theft, an
insurance company will investigate the loss and will press criminal charges against any employee found to be involved. Very often,
the employer will be hesitant to pursue criminal charges against an employee due to the risk of lawsuit or bad publicity. For
example, an employee might assume that the termination was age related and is going to sue the company. Also, there might be a

8.3.1 [Link]
situation where the company experienced a loss, such as theft, and it does not want to let the general public know that there are
potential deficiencies in its security system.
If the insurance company presses charges on behalf of the company, this protects the organization and also acts as a deterrent if
employees know that the insurance company will always prosecute theft. For example, suppose the manager of the Galaxy’s Best
Yogurt stole $10,000 cash over a period of two years. The owner of the yogurt store will most likely file an insurance claim to
recover the $10,000 that was stolen. With proper insurance, the insurance company will reimburse the yogurt store for the money
but then has the right to press charges and recover its losses from the employee who was caught stealing. The store owner will have
no control over the insurance company’s efforts to recover the $10,000 and will likely be forced to fire the employee in order to
keep the insurance policy.

Separation of Assets from Custody

Separation of assets from custody ensures that the person who controls an asset cannot also keep the accounting records. This
action prevents one employee from taking income from the business and entering a transaction on the accounting records to cover it
up. For example, one person within an organization may open an envelope that contains a check, but a different person would enter
the check into the organization’s accounting system. In the case of the Galaxy’s Best Yogurt, one employee may count the money
in the cash register drawer at the end of the night and reconcile it with the sales, but a different employee would recount the money,
prepare the bank deposit, and ensure that the deposit is made at the bank.

Separation of Duties
A properly designed internal control system assures that at least two (if not more) people are involved with most transactions. The
purpose of separating duties is to ensure that there is a check and balance in place. One common internal control is to have one
employee place an inventory order and a different employee receive the order as it is delivered. For example, assume that an
employee at the Galaxy’s Best Yogurt places an inventory order. In addition to the needed inventory, the employee orders an extra
box of piecrusts. If that employee also receives the order, he or she can take the piecrusts home, and the store will still pay for
them. Check signing is another important aspect of separation of duties. Typically, the person who writes a check should not also
sign the check. Additionally, the person who places supply orders should not write checks to pay the bills for these supplies.

Use of Technology
Technology has made the process of internal control simpler and more approachable to all businesses. There are two reasons that
the use of technology has become more prevalent. The first is the development of more user-friendly equipment, and the second is
the reduction in costs of security resources. In the past, if a company wanted a security system, it often had to go to an outside
security firm, and the costs of providing and monitoring the system were prohibitive for many small businesses. Currently, security
systems have become relatively inexpensive, and not only do many small businesses now have them, they are now commonly used
by residential homeowners.
In terms of the application of security resources, some businesses use surveillance cameras focused on key areas of the
organization, such as the cash register and areas where a majority of work is performed. Technology also allows businesses to use
password protection on their data or systems so that employees cannot access systems and change data without authorization.
Businesses may also track all employee activities within an information technology system.
Even if a business uses all of the elements of a strong internal control system, the system is only as good as the oversight. As
responsibilities, staffing, and even technology change, internal control systems need to be constantly reviewed and refined. Internal
control reviews are typically not conducted by inside management but by internal auditors who provide an impartial perspective of
where controls are working and where they can be improved.

Purposes of Internal Controls within a Governmental Entity

Internal controls apply not only to public and private corporations but also to governmental entities. Often, a government controls
one of the most important assets of modern times: data. Unprotected financial information, including tax data, social security, and
governmental identifications, could lead to identity theft and could even provide rogue nations access to data that could
compromise the security of our country. Governmental entities require their contractors to have proper internal controls and to
maintain proper codes of ethics.

8.3.2 [Link]
ETHICAL CONSIDERATIONS
Ethics in Governmental Contractors
Government entities are not the only organizations required to implement proper internal controls and codes of ethics. As part of
the business relationship between different organizations, governmental agencies also require contractors and their subcontractors
to implement internal controls to ensure compliance with proper ethical conduct. The Federal Acquisition Regulation (FAR)
Council outlines regulations under FAR 3.10,7 which require governmental contractors and their subcontractors to implement a
written “Contractor Code of Business Ethics and Conduct,” and the proper internal controls to ensure that the code of ethics is
followed. An employee training program, posting of agency inspector general hotline posters, and an internal control system to
promote compliance with the established ethics code are also required. Contractors must disclose violations of federal criminal law
involving fraud, conflicts of interest, bribery, or gratuity violations; violations of the civil False Claims Act; and significant
overpayments on a contract not resulting from contract financing payments.8 Such internal controls help ensure that an organization
and its business relationships are properly managed.
To recognize the significant need for internal controls within the government, and to ensure and enforce compliance, the US
Government Accountability Office (GAO) has its own standards for internal control within the federal government. All
government agencies are subject to governance under these standards, and one of the objectives of the GAO is to provide audits on
agencies to ensure that proper controls are in place and within compliance. Standards for internal control within the federal
government are located within a publication referred to as the “Green Book,” or Standards for Internal Control in the Federal
Government.

LINK TO LEARNING
Government organizations have their own needs for internal controls. Read the GAO “Green Book” to learn more about these
internal control procedures.

Purposes of Internal Controls within a Not-for-Profit

Not-for-profit (NFP) organizations have the same needs for internal control as many traditional for-profit entities. At the same time,
there are unique challenges that these entities face. Based on the objectives and charters of NFP organizations, in many cases, those
who run the organizations are volunteers. As volunteers, leaders of NFPs may not have the same training background and
qualifications as those in a similar for-profit position. Additionally, a volunteer leader often splits time between the organization
and a full-time career. For these reasons, internal controls in an NFP often are not properly implemented, and there may be a
greater risk of control lapse. A control lapse occurs when there is a deviation from standard control protocol that leads to a failure
in the internal control and/or fraud prevention processes or systems. A failure occurs in a situation when results did not achieve
predetermined goals or meet expectations.
Not-for-profit organizations have an extra category of finances that need protection, in addition to their assets. They need to ensure
that incoming donations are used as intended. For example, many colleges and universities are classified as NFP organizations, and
donations are a significant source of revenue. However, donations are often directed to a specific source. For example, suppose an
alumnus of Alpha University wants to make a $1,000,000 donation to the business school for undergraduate student scholarships.
Internal controls would track that donation to ensure it paid for scholarships for undergraduate students in the business school and
was not used for any other purpose at the school, in order to avoid potential legal issues.

Identify and Apply Principles of Internal Controls to the Receipt and Disbursement of Cash
Cash can be a major part of many business operations. Imagine a Las Vegas casino, or a large grocery store, such as Publix Super
Markets, Wegmans Food Markets, or ShopRite; in any of these settings, millions of dollars in cash can change hands within a
matter of minutes, and it can pass through the hands of thousands of employees. Internal controls ensure that all of this cash reaches
the bank account of the business entity. The first control is monitoring. Not only are cameras strategically placed throughout the
store to prevent shoplifting and crime by customers, but cameras are also located over all areas where cash changes hands, such as
over every cash register, or in a casino over every gaming table. These cameras are constantly monitored, often offsite at a central
location by personnel who have no relationship with the employees who handle the cash, and all footage is recorded. This close
monitoring makes it more difficult for misuse of cash to occur.
Additionally, access to cash is tightly controlled. Within a grocery store, each employee has his or her own cash drawer with a set
amount of cash. At any time, any employee can reconcile the sales recorded within the system to the cash balance that should be in

8.3.3 [Link]
the drawer. If access to the drawer is restricted to one employee, that employee is responsible when cash is missing. If one specific
employee is consistently short on cash, the company can investigate and monitor the employee closely to determine if the shortages
are due to theft or if they are accidental, such as if they resulted from errors in counting change. Within a casino, each time a
transaction occurs and when there is a shift change for the dealers, cash is counted in real time. Casino employees dispersed on the
gaming floor are constantly monitoring play, in addition to those monitoring cameras behind the scenes.
Technology plays a major role in the maintenance of internal controls, but other principles are also important. If an employee
makes a mistake involving cash, such as making an error in a transaction on a cash register, the employee who made the mistake
typically cannot correct the mistake. In most cases, a manager must review the mistake and clear it before any adjustments are
made. These changes are logged to ensure that managers are not clearing mistakes for specific employees in a pattern that could
signify collusion, which is considered to be a private cooperation or agreement primarily for a deceitful, illegal, or immoral cause
or purpose. Duties are also separated to count cash on hand and ensure records are accurate. Often, at the end of the shift, a
manager or employee other than the person responsible for the cash is responsible for counting cash on hand within the cash
drawer. For example, at a grocery store, it is common for an employee who has been checking out customers for a shift to then
count the money in the register and prepare a document providing the counts for the shift. This employee then submits the counted
tray to a supervisor, such as a head cashier, who then repeats the counting and documentation process. The two counts should be
equal. If there is a discrepancy, it should immediately be investigated. If the store accepts checks and credit/debit card payments,
these methods of payments are also incorporated into the verification process.
In many cases, the sales have also been documented either by a paper tape or by a computerized system. The ultimate goal is to
determine if the cash, checks, and credit/debit card transactions equal the amount of sales for the shift. For example, if the shift’s
register had sales of $800, then the documentation of counted cash and checks, plus the credit/debit card documentation should also
add up to $800.
Despite increased use of credit cards by consumers, our economy is still driven by cash. As cash plays a very important role in
society, efforts must be taken to control it and ensure that it makes it to the proper areas within an organization. The cost of
developing, maintaining, and monitoring internal controls is significant but important. Considering the millions of dollars of cash
that can pass through the hands of employees on any given day, the high cost can be well worth it to protect the flow of cash within
an organization.

LINK TO LEARNING
Internal controls are as important for not-for-profit businesses as they are within the for-profit sector. See this guide for not-for-
profit businesses to set up and maintain proper internal control systems provided by the National Council of Nonprofits.

THINK IT THROUGH
Hiring Approved Vendors
One internal control that companies often have is an official “approved vendor” list for purchases. Why is it important to have an
approved vendor list?

Footnotes
7 Federal Acquisition Regulation. “Subpart 3.10: Contractor Code of Business Ethics and Conduct.” January 22, 2019.
[Link]
8 National Contract Management Association. [Link]

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[Link]

8.3.4 [Link]
8.4: Discuss Management Responsibilities for Maintaining Internal Controls within an
Organization
Because internal controls do protect the integrity of financial statements, large companies have become highly regulated in their
implementation. In addition to Section 404 of the SOX, which addresses reporting and testing requirements for internal controls,
there are other sections of the act that govern management responsibility for internal controls. Although the auditor reviews internal
controls and advises on the improvement of controls, ultimate responsibility for the controls is on the management of the company.
Under SOX Section 302, in order to provide additional assurance to the financial markets, the chief executive officer (CEO), who
is the executive within a company with the highest-ranking title and the overall responsibility for management of the company, and
the chief financial officer (CFO), who is the corporation officer who reports to the CEO and oversees all of the accounting and
finance concerns of a company, must personally certify that (1) they have reviewed the internal control report provided by the
auditor; (2) the report does not contain any inaccurate information; and (3) they believe that all financial information fairly states
the financial conditions, income, and cash flows of the entity. The sign-off under Section 302 makes the CEO and CFO personally
responsible for financial reporting as well as internal control structure.
While the executive sign-offs seem like they would be just a formality, they actually have a great deal of power in court cases. Prior
to SOX, when an executive swore in court that he or she was not aware of the occurrence of some type of malfeasance, either
committed by his or her firm or against his or her firm, the executive would claim a lack of knowledge of specific circumstances.
The typical response was, “I can’t be expected to know everything.” In fact, in virtually all of the trials involving potential
malfeasance, this claim was made and often was successful in a not-guilty verdict.
The initial response to the new SOX requirements by many people was that there was already sufficient affirmation by the CEO
and CFO and other executives to the accuracy and fairness of the financial statements and that the SOX requirements were
unnecessary. However, it was determined that the SOX requirements provided a degree of legal responsibility that previously might
have been assumed but not actually stated.
Even if a company is not public and not governed by the SOX, it is important to note that the tone is set at the managerial level,
called the tone at the top. If management respects the internal control system and emphasizes the importance of maintaining proper
internal controls, the rest of the staff will follow and create a cohesive environment. A proper tone at the top demonstrates
management’s commitment toward openness, honesty, integrity, and ethical behavior.

YOUR TURN
Defending the Sarbanes-Oxley Act
You are having a conversation with the CFO of a public company. Imagine that the CFO complains that there is no benefit to
Sections 302 and 404 of the Sarbanes-Oxley Act relative to the cost, as “our company has always valued internal controls before
this regulation and never had an issue.” He believes that this regulation is an unnecessary overstep. How would you respond and
defend the need for Sections 302 and 404 of the Sarbanes-Oxley Act?
Solution
I would tell the CFO the following:
1. Everyone says that they have always valued internal controls, even those who did not.
2. Better security for the public is worth the cost.
3. The cost of compliance is more than recovered in the company’s market price for its stock.

THINK IT THROUGH
Personal Internal Controls
Technology plays a very important role in internal controls. One recent significant security breach through technology was the
Equifax breach. What is an internal control that you can personally implement to protect your personal data as a result of this
breach, or any other future breach?

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was authored, remixed, and/or curated by LibreTexts.

8.4.1 [Link]
8.5: Discuss Management Responsibilities for Maintaining Internal Controls within an Organization by OpenStax is licensed CC BY-
NC-SA 4.0. Original source: [Link]

8.4.2 [Link]
8.5: Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
Financial statements are the end result of an accountant’s work and are the responsibility of management. Proper internal controls
help the accountant determine that the financial statements fairly present the financial position and performance of a company.
Financial statement fraud occurs when the financial statements are used to conceal the actual financial condition of a company or
to hide specific transactions that may be illegal. Financial statement fraud may take on many different methods, but it is generally
called cooking the books. This issue may occur for many purposes.
A common reason to cook the books is to create a false set of a company’s books used to convince investors or lenders to provide
money to the company. Investors and lenders rely on a properly prepared set of financial statements in making their decision to
provide the company with money. Another reason to misstate a set of financial statements is to hide corporate looting such as
excessive retirement perks of top executives, unpaid loans to top executives, improper stock options, and any other wrongful
financial action. Yet another reason to misreport a company’s financial data is to drive the stock price higher. Internal controls assist
the accountant in locating and identifying when management of a company wants to mislead the inventors or lenders.
The financial accountant or members of management who set out to cook the books are intentionally attempting to deceive the user
of the financial statements. The actions of upper management are being concealed, and in most cases, the entire financial position
of the company is being purposely misreported. Regardless of the reason for misstating the true condition of a company’s financial
position, doing so misleads any person using the financial statements of a company to evaluate the company and its operations.

How Companies Cook the Books to Misrepresent Their Financial Condition

One of the most common ways companies cook the books is by manipulating revenue accounts or accounts receivables. Proper
revenue recognition involves accounting for revenue when the company has met its obligation on a contract. Financial statement
fraud involves early revenue recognition, or recognizing revue that does not exist, and receivable accountings, used in tandem with
false revenue reporting. HealthSouth used a combination of false revenue accounts and misstated accounts receivable in a direct
manipulation of the revenue accounts to commit a multibillion-dollar fraud between 1996 and 2002. Several chief financial officers
and other company officials went to prison as a result.9

CONCEPTS IN PRACTICE
Internal Controls at HealthSouth
The fraud at HealthSouth was possible because some of the internal controls were ignored. The company failed to maintain
standard segregation of duties and allowed management override of internal controls. The fraud required the collusion of the entire
accounting department, concealing hundreds of thousands of fraudulent transactions through the use of falsified documents and
fraudulent accounting schemes that included revenue recognition irregularities (such as recognizing accounts receivables to be
recorded as revenue before collection), misclassification of expenses and asset acquisitions, and fraudulent merger and acquisition
accounting. The result was billions of dollars of fraud. Simply implementing and following proper internal control procedures
would have stopped this massive fraud.10
Many companies may go to great lengths to perpetuate financial statement fraud. Besides the direct manipulation of revenue
accounts, there are many other ways fraudulent companies manipulate their financial statements. Companies with large inventory
balances can misrepresent their inventory account balances and use this misrepresentation to overstate the amount of their assets to
get larger loans or use the increased balance to entice investors through claims of exaggerated revenues. The inventory accounts
can also be used to overstate income. Such inventory manipulations can include the following:
Channel stuffing: encouraging customers to buy products under favorable terms. These terms include allowing the customer to
return or even not pick up goods sold, without a corresponding reserve to account for the returns.
Sham sales: sales that have not occurred and for which there are no customers.
Bill-and-hold sales: recognition of income before the title transfers to the buyer, and holding the inventory in the seller’s
warehouse.
Improper cutoff: recording sales of inventory in the wrong period and before the inventory is sold; this is a type of early revenue
recognition.
Round-tripping: selling items with the promise to buy the items back, usually on credit, so there is no economic benefit.
These are just a few examples of the way an organization might manipulate inventory or sales to create false revenue.

8.5.1 [Link]
One of the most famous financial statement frauds involved Enron, as discussed previously. Enron started as an interstate pipeline
company, but then branched out into many different ventures. In addition to the internal control deficiencies discussed earlier, the
financial statement fraud started when the company began to attempt to hide its losses.
The fraudulent financial reporting schemes included building assets and immediately taking as income any projected profits on
construction and hiding the losses from operating assets in an off-the-balance sheet transaction called special purpose entities,
which are separate, often complicated legal entities that are often used to absorb risk for a corporation. Enron moved assets that
were losing money off of its books and onto the books of the Special Purpose Entity. This way, Enron could hide its bad business
decisions and continue to report a profit, even though its assets were losing money. Enron’s financial statement fraud created false
revenues with the misstatement of assets and liability balances. This was further supported by inadequate balance sheet footnotes
and the related disclosures. For example, required disclosures were ramped up as a result of these special purpose entities.

Sarbanes-Oxley Act Compliance Today

The Enron scandal and related financial statement frauds led to investors requiring that public companies maintain better internal
controls and develop stronger governance systems, while auditors perform a better job at auditing public companies. These
requirements, in turn, led to the regulations developed under SOX that were intended to protect the investing public.
Since SOX was first passed, it has adapted to changing technology and now requires public companies to protect their accounting
and financial data from hackers and other outside or internal forces through stronger internal controls designed to protect the data.
The Journal of Accountancy supported these new requirements and reported that the results of SOX have been positive for both
companies and investors.
As discussed in the Journal of Accountancy article,11 there are three conditions that are increasingly affecting compliance with
SOX requirements:
PCAOB requirements. The PCAOB has increased the requirements for inspection reports, with a greater emphasis on
deficiency evaluation.
Revenue recognition. The Financial Accounting Standards Board has introduced a new standard for revenue recognition. This
requirement has led to the need for companies to update control documentation.
Cybersecurity. Cybersecurity is the practice of protecting software, hardware, and data from digital attacks. As would be
expected in today’s environment, the number of recent cybersecurity disclosures has significantly grown.
Under current guidelines, instead of the SOX requiring compliance with just the financial component of reporting and internal
control, the guidelines now allow application to information technology (IT) activities as well. A major change under the SOX
guidelines involves the method of storage of a company’s electronic records. While the act did not specifically require a particular
storage method, it did provide guidance on which records were to be stored and for how long they should be stored.
The SOX now requires that all business records, electronic records, and electronic messages must be stored for at least five years.
The penalties for noncompliance include either imprisonment or fines, or a combination of the two options.

Footnotes
9 Melinda Dickinson. “Former HealthSouth Boss Found Liable for $2.9 Billion.” Reuters. June 18, 2009.
[Link]
10 David McCann. “Two CFOs Tell a Tale of Fraud at HealthSouth.” [Link]. March 27, 2017.
.[Link]
11 Ken Tysiac. “Companies Spending More Time on SOX Compliance.” Journal of Accountancy. June 12, 2017.
[Link]

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8.5.2 [Link]
 CHAPTER OVERVIEW

9: Fixed Assets
9.1: Long Term Assets
9.2: Entries for Cash and Lump-Sum Purchases of Property, Plant and Equipment
9.3: Analyze and Classify Capitalized Costs versus Expenses
9.4: Explain and Apply Depreciation Methods to Allocate Capitalized Costs
9.5: Describe Some Special Issues in Accounting for Long-Term Assets

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1
9.1: Long Term Assets
On a classified balance sheet, the asset section contained long term assets including things:
1. Plant assets (also called property, plant and equipment or fixed assets)
2. Long term investments
3. Intangible assets
Plant assets are long-lived assets because they are expected to last for more than one year. Long-lived assets consist of tangible
assets and intangible assets. Tangible assets have physical characteristics that we can see and touch; they include plant assets such
as buildings and furniture, and natural resources such as gas and oil. Intangible assets have no physical characteristics that we can
see and touch but represent exclusive privileges and rights to their owners.
In this section, we will look at the accounting treatment for plant assets, natural resources and intangible assets. Investments will be
covered in other chapters.

Plant assets
To be classified as a plant asset, an asset must: (1) be tangible, that is, capable of being seen and touched; (2) have a useful service
life of more than one year; and (3) be used in business operations rather than held for resale. Common plant assets are buildings,
machines, tools, and office equipment. On the balance sheet, these assets appear under the heading “Property, plant, and
equipment”.
Natural resources
Resources supplied by nature, such as ore deposits, mineral deposits, oil reserves, gas deposits, and timber stands, are natural
resources or wasting assets. Natural resources represent inventories of raw materials that can be consumed (exhausted) through
extraction or removal from their natural setting (e.g. removing oil from the ground).
Intangible assets
Although they have no physical characteristics, intangible assets have value because of the advantages or exclusive privileges and
rights they provide to a business. Intangible assets generally arise from two sources: (1) exclusive privileges granted by
governmental authority or by legal contract, such as patents, copyrights, franchises, trademarks and trade names, and leases; and
(2) superior entrepreneurial capacity or management know-how and customer loyalty, which is called goodwill.
All intangible assets are nonphysical, but not all nonphysical assets are intangibles. For example, accounts receivable and prepaid
expenses are nonphysical, yet classified as current assets rather than intangible assets. Intangible assets are generally both
nonphysical and noncurrent; they appear in a separate long-term section of the balance sheet entitled “Intangible assets”.
Examples of intangible assets include:
Research and development (R&D)
Amortization
A patent
A copyright
A franchise
A trademark
A lease
A leasehold improvement
Goodwill

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9.1.1 [Link]
9.2: Entries for Cash and Lump-Sum Purchases of Property, Plant and Equipment
Property, plant, and equipment (fixed assets or operating assets) compose more than one-half of total assets in many corporations.
These resources are necessary for the companies to operate and ultimately make a profit. It is the efficient use of these resources
that in many cases determines the amount of profit corporations will earn.
On a classified balance sheet, the asset section contains: (1) current assets; (2) property, plant, and equipment; and (3) other
categories such as intangible assets and long-term investments. Previous chapters discussed current assets. Property, plant, and
equipment are often called plant and equipment or simply plant assets. Plant assets are long-lived assets because they are
expected to last for more than one year. Long-lived assets consist of tangible assets and intangible assets. Tangible assets have
physical characteristics that we can see and touch; they include plant assets such as buildings and furniture, and natural resources
such as gas and oil. Intangible assets have no physical characteristics that we can see and touch but represent exclusive privileges
and rights to their owners.

Nature of plant assets

To be classified as a plant asset, an asset must: (1) be tangible, that is, capable of being seen and touched; (2) have a useful service
life of more than one year; and (3) be used in business operations rather than held for resale. Common plant assets are buildings,
machines, tools, and office equipment. On the balance sheet, these assets appear under the heading “Property, plant, and
equipment”.
Initial recording of plant assets
When a company acquires a plant asset, accountants record the asset at the cost of acquisition (historical cost). When a plant asset
is purchased for cash, its acquisition cost is simply the agreed on cash price. This cost is objective, verifiable, and the best measure
of an asset’s fair market value at the time of purchase. Fair market value is the price received for an item sold in the normal
course of business (not at a forced liquidation sale). Even if the market value of the asset changes over time, accountants continue
to report the acquisition cost in the asset account in subsequent periods.
The acquisition cost of a plant asset is the amount of cost incurred to acquire and place the asset in operating condition at its
proper location. Cost includes all normal, reasonable, and necessary expenditures to obtain the asset and get it ready for use.
Acquisition cost also includes the repair and reconditioning costs for used or damaged assets as longs as the item was not damaged
after purchase. Unnecessary costs (such as traffic tickets or fines or repairs that occurred after purchase) that must be paid as a
result of hauling machinery to a new plant are not part of the acquisition cost of the asset.
Recording Land
The cost of land includes its purchase price and other many other costs including:
real estate commissions,
title search and title transfer fees,
title insurance premiums,
existing mortgage note or unpaid taxes (back taxes) assumed by the purchaser,
costs of surveying, clearing, and grading;
and local assessments for sidewalks, streets, sewers, and water mains.
Sometimes land purchased as a building site contains an unusable building that must be removed.
The accountant debits the entire costs to Land, including the cost of removing the building less any cash received from the sale of
salvaged items while the land is being readied for use. Land is considered to have an unlimited life and is therefore not
depreciable. However, land improvements, including driveways, temporary landscaping, parking lots, fences, lighting systems,
and sprinkler systems, are attachments to the land. They have limited lives and therefore are depreciable. Owners record
depreciable land improvements in a separate account called Land Improvements. They record the cost of permanent landscaping,
including leveling and grading, in the Land account.
To illustrate, assume that Spivey Company purchased an old farm on the outskirts of San Diego as a factory site. The company paid
$225,000 for the property. In addition, the company agreed to pay unpaid property taxes from previous periods (called back taxes)
of $12,000. Attorneys’ fees and other legal costs relating to the purchase of the farm totaled $1,800. Spivey demolished (razed) the
farm buildings at a cost of $18,000. The company salvaged some of the structural pieces of the building and sold them for $3,000.

9.2.1 [Link]
Because the firm was constructing a new building at the site, the city assessed Spivey Company $9,000 for water mains, sewers,
and street paving. Spivey computed the cost of the land as follows:

Cost of factory site $225,000

Back taxes 12,000

Attorneys’ fees and other legal costs 1,800

Demolition 18,000

Sale of salvaged parts -3,000

City assessment 9,000

Total Land Cost $262,800

The journal entry to record the purchase of this land for cash would be:

Debit Credit

Land 262,800

Cash 262,800
To record purchase of land with cash.

Recording Building
When a business buys a building, its cost includes:
the purchase price,
repair and remodeling costs,
unpaid taxes assumed by the purchaser,
legal costs,
and real estate commissions paid.
Determining the cost of constructing a new building is often more difficult. Usually this cost includes architect’s fees; building
permits; payments to contractors; and the cost of digging the foundation. Also included are labor and materials to build the
building; salaries of officers supervising the construction; and insurance, taxes, and interest during the construction period. Any
miscellaneous amounts earned from the building during construction reduce the cost of the building. For example, an owner who
could rent out a small completed portion during construction of the remainder of the building, would credit the rental proceeds to
the Buildings account rather than to a revenue account.
Recording Equipment or Machinery
Often companies purchase machinery or other equipment such as delivery or office equipment. Its cost includes:
the seller’s net invoice price (whether the discount is taken or not),
transportation charges incurred,
insurance in transit,
cost of installation,
costs of accessories,
and testing costs.
Also included are other costs needed to put the machine or equipment in operating condition in its intended location.
The cost of machinery does not include removing and disposing of a replaced, old machine that has been used in operations. Such
costs are part of the gain or loss on disposal of the old machine.
To illustrate, assume that Clark Company purchased new equipment to replace equipment that it has used for five years. The
company paid a net purchase price of $150,000, brokerage fees of $5,000, legal fees of $2,000, and freight and insurance in transit

9.2.2 [Link]
of $3,000. In addition, the company paid $1,500 to remove old equipment and $2,000 to install new equipment. Clark would
compute the cost of new equipment as follows:

Net purchase price $150,000

Brokerage fees 5,000

Legal fees 2,000

Freight and insurance in transit 3,000

Installation costs 2,000

Total Equipment cost $162,000

The journal entry to record the purchase of the equipment paying $50,000 cash and by signing a note for the balance would be:

Debit Credit

Equipment 162,000

Cash 50,000

Note Payable (162,000 – 50,000) 162,000

To record purchase of equipment by paying cash and signing note.

Lump Sum Purchases

Sometimes a company buys land and other assets for a lump sum. When land and buildings purchased together are to be used, the
firm divides the total cost and establishes separate ledger accounts for land and for buildings. This division of cost establishes the
proper balances in the appropriate accounts. This is especially important later because the depreciation recorded on the buildings
affects reported income, while no depreciation is taken on the land.
Let’s look at an example: Assume a company purchases land, machinery and a building for $4,000,000 cash. The land has a market
value of $1,350,000, machinery of $675,000 and the building for $2,475,000 for a total value of $4,500,000. We cannot report the
assets at market value since the market value is less than we paid for the assets. We will do a 2-step process to get the cost of each
asset.
1. Calculate each asset’s percent of market value (Asset market value / total market value of all assets)

Asset Appraisal (or Market) Value % of MV

Land 1,350,000 /4,500,000 = 30%

Machinery 675,000 /4,500,000 = 15%

Building 2,475,000 /4,500,000 = 55%

Total
4,500,000

2. Calculate the cost of each asset (total price paid for all assets x % of market value)

Asset % of MV Purchase Price Asset Cost

Land 30% 4,000,000 $ 1,200,000

Machinery 15% 4,000,000 $ 600,000

Building 55% 4,000,000 $ 2,200,000

Total $ 4,000,000

9.2.3 [Link]
The journal entry to record this purchase for cash would be:

Account Debit Credit

Land $ 1,200,000

Machinery 600,000

Building 2,200,000

Cash $ 4,000,000

CC licensed content, Shared previously

Accounting Principles: A Business Perspective.. Authored by: James Don Edwards, University of Georgia & Roger H.
Hermanson, Georgia State University.. Provided by: Endeavour International Corporation.. Project: The Global Text Project..
License: CC BY: Attribution

9.2: Entries for Cash and Lump-Sum Purchases of Property, Plant and Equipment is shared under a not declared license and was authored,
remixed, and/or curated by LibreTexts.

9.2.4 [Link]
9.3: Analyze and Classify Capitalized Costs versus Expenses
When a business purchases a long-term asset (used for more than one year), it classifies the asset based on whether the asset is used
in the business’s operations. If a long-term asset is used in the business operations, it will belong in property, plant, and equipment
or intangible assets. In this situation the asset is typically capitalized. Capitalization is the process by which a long-term asset is
recorded on the balance sheet and its allocated costs are expensed on the income statement over the asset’s economic life. Explain
and Apply Depreciation Methods to Allocate Capitalized Costs addresses the available methods that companies may choose for
expensing capitalized assets.
Long-term assets that are not used in daily operations are typically classified as an investment. For example, if a business owns
land on which it operates a store, warehouse, factory, or offices, the cost of that land would be included in property, plant, and
equipment. However, if a business owns a vacant piece of land on which the business conducts no operations (and assuming no
current or intermediate-term plans for development), the land would be considered an investment.

YOUR TURN
Classifying Assets and Related Expenditures
You work at a business consulting firm. Your new colleague, Marielena, is helping a client organize his accounting records by types
of assets and expenditures. Marielena is a bit stumped on how to classify certain assets and related expenditures, such as capitalized
costs versus expenses. She has given you the following list and asked for your help to sort through it. Help her classify the
expenditures as either capitalized or expensed, and note which assets are property, plant, and equipment.
Expenditures:
normal repair and maintenance on the manufacturing facility
cost of taxes on new equipment used in business operations
shipping costs on new equipment used in business operations
cost of a minor repair on existing equipment used in business operations
Assets:
land next to the production facility held for use next year as a place to build a warehouse
land held for future resale when the value increases
equipment used in the production process
Solution
Expenditures:
normal repair and maintenance on the manufacturing facility: expensed
cost of taxes on new equipment used in business operations: capitalized
shipping costs on new equipment used in business operations: capitalized
cost of a minor repair on existing equipment used in business operations: expensed
Assets:
land next to the production facility held for use next year as a place to build a warehouse: property, plant, and equipment
land held for future resale when the value increases: investment
equipment used in the production process: property, plant, and equipment

Property, Plant, and Equipment (Fixed Assets)

Why are the costs of putting a long-term asset into service capitalized and written off as expenses (depreciated) over the economic
life of the asset? Let’s return to Liam’s start-up business as an example. Liam plans to buy a silk-screening machine to help create
clothing that he will sell. The machine is a long-term asset, because it will be used in the business’s daily operation for many years.
If the machine costs Liam $5,000 and it is expected to be used in his business for several years, generally accepted accounting
principles (GAAP) require the allocation of the machine’s costs over its useful life, which is the period over which it will produce
revenues. Overall, in determining a company’s financial performance, we would not expect that Liam should have an expense of
$5,000 this year and $0 in expenses for this machine for future years in which it is being used. GAAP addressed this through the
expense recognition (matching) principle, which states that expenses should be recorded in the same period with the revenues that

9.3.1 [Link]
the expense helped create. In Liam’s case, the $5,000 for this machine should be allocated over the years in which it helps to
generate revenue for the business. Capitalizing the machine allows this to occur. As stated previously, to capitalize is to record a
long-term asset on the balance sheet and expense its allocated costs on the income statement over the asset’s economic life.
Therefore, when Liam purchases the machine, he will record it as an asset on the financial statements.

When capitalizing an asset, the total cost of acquiring the asset is included in the cost of the asset. This includes additional costs
beyond the purchase price, such as shipping costs, taxes, assembly, and legal fees. For example, if a real estate broker is paid
$8,000 as part of a transaction to purchase land for $100,000, the land would be recorded at a cost of $108,000.
Over time as the asset is used to generate revenue, Liam will need to depreciate the asset.
Depreciation is the process of allocating the cost of a tangible asset over its useful life, or the period of time that the business
believes it will use the asset to help generate revenue. This process will be described in Explain and Apply Depreciation Methods
to Allocate Capitalized Costs.

ETHICAL CONSIDERATIONS
How WorldCom’s Improper Capitalization of Costs Almost Shut Down the Internet
In 2002, telecommunications giant WorldCom filed for the largest Chapter 11 bankruptcy to date, a situation resulting from
manipulation of its accounting records. At the time, WorldCom operated nearly a third of the bandwidth of the twenty largest US
internet backbone routes, connecting over 3,400 global networks that serviced more than 70,000 businesses in 114 countries.4
WorldCom used a number of accounting gimmicks to defraud investors, mainly including capitalizing costs that should have been
expensed. Under normal circumstances, this might have been considered just another account fiasco leading to the end of a
company. However, WorldCom controlled a large percentage of backbone routes, a major component of the hardware supporting
the internet, as even the Securities and Exchange Commission recognized.5 If WorldCom’s bankruptcy due to accounting
malfeasance shut the company down, then the internet would no longer be functional.
If such an event was to happen today, it could shut down international commerce and would be considered a national emergency.
As demonstrated by WorldCom, the unethical behavior of a few accountants could have shut down the world’s online businesses
and international commerce. An accountant’s job is fundamental and important: keep businesses operating in a transparent fashion.

Investments
A short-term or long-term asset that is not used in the day-to-day operations of the business is considered an investment and is not
expensed, since the company does not expect to use up the asset over time. On the contrary, the company hopes that the assets
(investment) would grow in value over time. Short-term investments are investments that are expected to be sold within a year and
are recorded as current assets.

CONTINUING APPLICATION
Investment in Property in the Grocery Industry
To remain viable, companies constantly look to invest in upgrades in long-term assets. Such acquisitions might include new
machinery, buildings, warehouses, or even land in order to expand operations or make the work process more efficient. Think back
to the last time you walked through a grocery store. Were you mostly focused on getting the food items on your list? Or did you
plan to pick up a prescription and maybe a coffee once you finished?
Grocery stores have become a one-stop shopping environment, and investments encompass more than just shelving and floor
arrangement. Some grocery chains purchase warehouses to distribute inventory as needed to various stores. Machinery upgrades
can help automate various departments. Some supermarkets even purchase large parcels of land to build not only their stores, but
also surrounding shopping plazas to draw in customers. All such investments help increase the company’s net profit.

9.3.2 [Link]
CONCEPTS IN PRACTICE
Vehicle Repairs and Enhancements
Automobiles are a useful way of looking at the difference between repair and maintenance expenses and capitalized modifications.
Routine repairs such as brake pad replacements are recorded as repair and maintenance expense. They are an expected part of
owning a vehicle. However, a car may be modified to change its appearance or performance. For example, if a supercharger is
added to a car to increase its horsepower, the car’s performance is increased, and the cost should be included as a part of the vehicle
asset. Likewise, if replacing the engine of an older car extends its useful life, that cost would also be capitalized.

Repair and Maintenance Costs of Property, Plant, and Equipment

Long-term assets may have additional costs associated with them over time. These additional costs may be capitalized or expensed
based on the nature of the cost. For example, Walmart’s financial statements explain that major improvements are capitalized,
while costs of normal repairs and maintenance are charged to expense as incurred.
An amount spent is considered a current expense, or an amount charged in the current period, if the amount incurred did not help
to extend the life of or improve the asset. For example, if a service company cleans and maintains Liam’s silk-screening machine
every six months, that service does not extend the useful life of the machine beyond the original estimate, increase the capacity of
the machine, or improve the quality of the silk-screening performed by the machine. Therefore, this maintenance would be
expensed within the current period. In contrast, if Liam had the company upgrade the circuit board of the silk-screening machine,
thereby increasing the machine’s future capabilities, this would be capitalized and depreciated over its useful life.

THINK IT THROUGH
Correcting Errors in Classifying Assets
You work at a business consulting firm. Your new colleague, Marielena, helped a client organize his accounting records last year by
types of assets and expenditures. Even though Marielena was a bit stumped on how to classify certain assets and related
expenditures, such as capitalized costs versus expenses, she did not come to you or any other more experienced colleagues for help.
Instead, she made the following classifications and gave them to the client who used this as the basis for accounting transactions
over the last year. Thankfully, you have been asked this year to help prepare the client’s financial reports and correct errors that
were made. Explain what impact these errors would have had over the last year and how you will correct them so you can prepare
accurate financial statements.
Expenditures:
Normal repair and maintenance on the manufacturing facility were capitalized.
The cost of taxes on new equipment used in business operations was expensed.
The shipping costs on new equipment used in business operations were expensed.
The cost of a minor repair on existing equipment used in business operations was capitalized.
Assets:
Land next to the production facility held for use next year as a place to build a warehouse was depreciated.
Land held for future resale when the value increases was classified as Property, Plant, and Equipment but not depreciated.
Equipment used in the production process was classified as an investment.

LINK TO LEARNING
Many businesses invest a lot of money in production facilities and operations. Some production processes are more automated than
others, and they require a greater investment in property, plant, and equipment than production facilities that may be more labor
intensive. Watch this video of the operation of a Georgia-Pacific lumber mill and note where you see all components of property,
plant, and equipment in operations in this fascinating production process. There’s even a reference to an intangible asset—if you
watch and listen closely, you just might catch it.

Footnotes
4 Cybertelecom. “WorldCom (UNNET).” n.d. [Link]
5 Dennis R. Beresford, Nicholas DeB. Katzenbach, and C.B. Rogers, Jr. “Special Investigative Committee of the Board of
Directors of WorldCom.” Report of Investigation. March 31, 2003. [Link]

9.3.3 [Link]
9.3: Analyze and Classify Capitalized Costs versus Expenses is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated
by LibreTexts.
11.2: Analyze and Classify Capitalized Costs versus Expenses by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

9.3.4 [Link]
9.4: Explain and Apply Depreciation Methods to Allocate Capitalized Costs
In this section, we concentrate on the major characteristics of determining capitalized costs and some of the options for allocating
these costs on an annual basis using the depreciation process. In the determination of capitalized costs, we do not consider just the
initial cost of the asset; instead, we determine all of the costs necessary to place the asset into service. For example, if our company
purchased a drill press for $22,000, and spent $2,500 on sales taxes and $800 for delivery and setup, the depreciation calculation
would be based on a cost of $22,000 plus $2,500 plus $800, for a total cost of $25,300.
We also address some of the terminology used in depreciation determination that you want to familiarize yourself with. Finally, in
terms of allocating the costs, there are alternatives that are available to the company. We consider three of the most popular options,
the straight-line method, the units-of-production method, and the double-declining-balance method.

YOUR TURN

Calculating Depreciation Costs

Liam buys his silk screen machine for $10,000. He estimates that he can use this machine for five years or 100,000 presses,
and that the machine will only be worth $1,000 at the end of its life. He also estimates that he will make 20,000 clothing items
in year one and 30,000 clothing items in year two. Determine Liam’s depreciation costs for his first two years of business
under straight-line, units-of-production, and double-declining-balance methods. Also, record the journal entries.
Solution
Straight-line method: ($10,000 – $1,000)/5 = $1,800 per year for both years.

Units-of-production method: ($10,000 – $1,000)/100,000= $0.09 per press

Year 1 expense: $0.09 × 20,000 = $1,800

Year 2 expense: $0.09 × 30,000 = $2,700

Double-declining-balance method:
Year 1 expense: [($10,000 – 0)/5] × 2 = $4,000

Year 2 expense: [($10,000 – $4,000)/5] × 2 = $2,400

9.4.1 [Link]
Fundamentals of Depreciation
As you have learned, when accounting for a long-term fixed asset, we cannot simply record an expense for the cost of the asset and
record the entire outflow of cash in one accounting period. Like all other assets, when purchasing or acquiring a long-term asset, it
must be recorded at the historical (initial) cost, which includes all costs to acquire the asset and put it into use. The initial recording
of an asset has two steps:
1. Record the initial purchase on the date of purchase, which places the asset on the balance sheet (as property, plant, and
equipment) at cost, and record the amount as notes payable, accounts payable, or an outflow of cash.
2. At the end of the period, make an adjusting entry to recognize the depreciation expense. Companies may record depreciation
expense incurred annually, quarterly, or monthly.
Following GAAP and the expense recognition principle, the depreciation expense is recognized over the asset’s estimated useful
life.

Recording the Initial Purchase of an Asset

Assets are recorded on the balance sheet at cost, meaning that all costs to purchase the asset and to prepare the asset for operation
should be included. Costs outside of the purchase price may include shipping, taxes, installation, and modifications to the asset.
The journal entry to record the purchase of a fixed asset (assuming that a note payable is used for financing and not a short-term
account payable) is shown here.

Applying this to Liam’s silk-screening business, we learn that he purchased his silk-screening machine for $5,000 by paying $1,000
cash and the remainder in a note payable over five years. The journal entry to record the purchase is shown here.

CONCEPTS IN PRACTICE

Estimating Useful Life and Salvage Value

Useful life and salvage value are estimates made at the time an asset is placed in service. It is common and expected that the
estimates are inaccurate with the uncertainty involved in estimating the future. Sometimes, however, a company may attempt
to take advantage of estimating salvage value and useful life to improve earnings. A larger salvage value and longer useful life
decrease annual depreciation expense and increase annual net income. An example of this behavior is Waste Management,
which was disciplined by the Securities and Exchange Commission for fraudulently altering its estimates to reduce
depreciation expense and overstate net income by $1.7 billion.6

Components Used in Calculating Depreciation

The expense recognition principle that requires that the cost of the asset be allocated over the asset’s useful life is the process of
depreciation. For example, if we buy a delivery truck to use for the next five years, we would allocate the cost and record
depreciation expense across the entire five-year period. The calculation of the depreciation expense for a period is not based on
anticipated changes in the fair market value of the asset; instead, the depreciation is based on the allocation of the cost of owning
the asset over the period of its useful life.
The following items are important in determining and recording depreciation:

9.4.2 [Link]
 Book value: the asset’s original cost less accumulated depreciation.
Useful life: the length of time the asset will be productively used within operations.
Salvage (residual) value: the price the asset will sell for or be worth as a trade-in when its useful life expires. The
determination of salvage value can be an inexact science, since it requires anticipating what will occur in the future. Often, the
salvage value is estimated based on past experiences with similar assets.
Depreciable base (cost): the depreciation expense over the asset’s useful life. For example, if we paid $50,000 for an asset and
anticipate a salvage value of $10,000, the depreciable base is $40,000. We expect $40,000 in depreciation over the time period
in which the asset was used, and then it would be sold for $10,000.
Depreciation records an expense for the value of an asset consumed and removes that portion of the asset from the balance sheet.
The journal entry to record depreciation is shown here.

Depreciation expense is a common operating expense that appears on an income statement. Accumulated depreciation is a contra
account, meaning it is attached to another account and is used to offset the main account balance that records the total depreciation
expense for a fixed asset over its life. In this case, the asset account stays recorded at the historical value but is offset on the balance
sheet by accumulated depreciation. Accumulated depreciation is subtracted from the historical cost of the asset on the balance sheet
to show the asset at book value. Book value is the amount of the asset that has not been allocated to expense through depreciation.

In this case, the asset’s book value is $20,000: the historical cost of $25,000 less the accumulated depreciation of $5,000.
It is important to note, however, that not all long-term assets are depreciated. For example, land is not depreciated because
depreciation is the allocating of the expense of an asset over its useful life. How can one determine a useful life for land? It is
assumed that land has an unlimited useful life; therefore, it is not depreciated, and it remains on the books at historical cost.
Once it is determined that depreciation should be accounted for, there are three methods that are most commonly used to calculate
the allocation of depreciation expense: the straight-line method, the units-of-production method, and the double-declining-balance
method. A fourth method, the sum-of-the-years-digits method, is another accelerated option that has been losing popularity and can
be learned in intermediate accounting courses. Let’s use the following scenario involving Kenzie Company to work through these
three methods.
Assume that on January 1, 2019, Kenzie Company bought a printing press for $54,000. Kenzie pays shipping costs of $1,500 and
setup costs of $2,500, assumes a useful life of five years or 960,000 pages. Based on experience, Kenzie Company anticipates a
salvage value of $10,000.
Recall that determination of the costs to be depreciated requires including all costs that prepare the asset for use by the company.
The Kenzie example would include shipping and setup costs. Any costs for maintaining or repairing the equipment would be
treated as regular expenses, so the total cost would be $58,000, and, after allowing for an anticipated salvage value of $10,000 in
five years, the business could take $48,000 in depreciation over the machine’s economic life.

9.4.3 [Link]
 CONCEPTS IN PRACTICE

Fixed Assets
You work for Georgia-Pacific as an accountant in charge of the fixed assets subsidiary ledger at a production and warehouse
facility in Pennsylvania. The facility is in the process of updating and replacing several asset categories, including warehouse
storage units, fork trucks, and equipment on the production line. It is your job to keep the information in the fixed assets
subsidiary ledger up to date and accurate. You need information on original historical cost, estimated useful life, salvage value,
depreciation methods, and additional capital expenditures. You are excited about the new purchases and upgrades to the facility
and how they will help the company serve its customers better. However, you have been in your current position for only a few
years and have never overseen extensive updates, and you realize that you will have to gather a lot of information at once to
keep the accounting records accurate. You feel overwhelmed and take a minute to catch your breath and think through what
you need. After a few minutes, you realize that you have many people and many resources to work with to tackle this project.
Whom will you work with and how will you go about gathering what you need?

Straight-Line Depreciation
Straight-line depreciation is a method of depreciation that evenly splits the depreciable amount across the useful life of the asset.
Therefore, we must determine the yearly depreciation expense by dividing the depreciable base of $48,000 by the economic life of
five years, giving an annual depreciation expense of $9,600. The journal entries to record the first two years of expenses are shown,
along with the balance sheet information. Here are the journal entry and information for year one:

After the journal entry in year one, the press would have a book value of $48,400. This is the original cost of $58,000 less the
accumulated depreciation of $9,600. Here are the journal entry and information for year two:

Kenzie records an annual depreciation expense of $9,600. Each year, the accumulated depreciation balance increases by $9,600,
and the press’s book value decreases by the same $9,600. At the end of five years, the asset will have a book value of $10,000,
which is calculated by subtracting the accumulated depreciation of $48,000 (5 × $9,600) from the cost of $58,000.

9.4.4 [Link]
Units-of-Production Depreciation
Straight-line depreciation is efficient, accounting for assets used consistently over their lifetime, but what about assets that are used
with less regularity? The units-of-production depreciation method bases depreciation on the actual usage of the asset, which is
more appropriate when an asset’s life is a function of usage instead of time. For example, this method could account for
depreciation of a printing press for which the depreciable base is $48,000 (as in the straight-line method), but now the number of
pages the press prints is important.
In our example, the press will have total depreciation of $48,000 over its useful life of 960,000 pages. Therefore, we would divide
$48,000 by 960,000 pages to get a cost per page of $0.05. If Kenzie printed 180,000 pages in the first year, the depreciation
expense would be 180,000 pages × $0.05 per page, or $9,000. The journal entry to record this expense would be the same as with
straight-line depreciation: only the dollar amount would have changed. The presentation of accumulated depreciation and the
calculation of the book value would also be the same. Kenzie would continue to depreciate the asset until a total of $48,000 in
depreciation was taken after printing 960,000 total pages.

THINK IT THROUGH

Deciding on a Depreciation Method

Liam is struggling to determine which deprecation method he should use for his new silk-screening machine. He expects sales
to increase over the next five years. He also expects (hopes) that in two years he will need to buy a second silk-screening
machine to keep up with the demand for products of his growing company. Which depreciation method makes more sense for
Liam: higher expenses in the first few years, or keeping expenses consistent over time? Or would it be better for him to not
think in terms of time, but rather in the usage of the machine?

IFRS CONNECTION

Accounting for Depreciation

Both US GAAP and International Financial Reporting Standards (IFRS) account for long-term assets (tangible and intangible)
by recording the asset at the cost necessary to make the asset ready for its intended use. Additionally, both sets of standards
require that the cost of the asset be recognized over the economic, useful, or legal life of the asset through an allocation process
such as depreciation. However, there are some significant differences in how the allocation process is used as well as how the
assets are carried on the balance sheet.
IFRS and US GAAP allow companies to choose between different methods of depreciation, such as even allocation (straight-
line method), depreciation based on usage (production methods), or an accelerated method (double-declining balance). The
mechanics of applying these methods do not differ between the two standards. However, IFRS requires companies to use
“component depreciation” if it is feasible. Component depreciation would apply to assets with components that have differing
lives. Consider the following example using a plane owned by Southwest Airlines. Let’s divide this plane into three
components: the interior, the engines, and the fuselage. Suppose the average life of the interior of a plane is ten years, the
average life of the engines is fifteen years, and the average life of the fuselage is twenty-five years. Given this, what should be
the depreciable life of the asset? In that case, under IFRS, the costs associated with the interior would be depreciated over ten
years, the costs associated with the engines would be depreciated over fifteen years, and the costs associated with the fuselage
would be depreciated over twenty-five years. Under US GAAP, the total cost of the airplane would likely be depreciated over
twenty years. Obviously, component depreciation involves more record keeping and differing amounts of depreciation per year
for the life of the asset. But the same amount of total depreciation, the cost of the asset less residual value, would be taken over
the life of the asset under both US GAAP and IFRS.
Probably one of the most significant differences between IFRS and US GAAP affects long-lived assets. This is the ability,
under IFRS, to adjust the value of those assets to their fair value as of the balance sheet date. The adjustment to fair value is to
be done by “class” of asset, such as real estate, for example. A company can adjust some classes of assets to fair value but not
others. Under US GAAP, almost all long-lived assets are carried on the balance sheet at their depreciated historical cost,
regardless of how the actual fair value of the asset changes. Consider the following example. Suppose your company owns a
single building that you bought for $1,000,000. That building currently has $200,000 in accumulated depreciation. This
building now has a book value of $800,000. Under US GAAP, this is how this building would appear in the balance sheet.
Even if the fair value of the building is $875,000, the building would still appear on the balance sheet at its depreciated

9.4.5 [Link]
 historical cost of $800,000 under US GAAP. Alternatively, if the company used IFRS and elected to carry real estate on the
balance sheet at fair value, the building would appear on the company’s balance sheet at its new fair value of $875,000.
It is difficult to determine an accurate fair value for long-lived assets. This is one reason US GAAP has not permitted the fair
valuing of long-lived assets. Different appraisals can result in different determinations of “fair value.” Thus, the Financial
Accounting Standards Board (FASB) elected to continue with the current method of carrying assets at their depreciated
historical cost. The thought process behind the adjustments to fair value under IFRS is that fair value more accurately
represents true value. Even if the fair value reported is not known with certainty, reporting the class of assets at a reasonable
representation of fair value enhances decision-making by users of the financial statements.

Summary of Depreciation
Table 9.4.1 compares the three methods discussed. Note that although each time-based (straight-line and double-declining balance)
annual depreciation expense is different, after five years the total amount depreciated (accumulated depreciation) is the same. This
occurs because at the end of the asset’s useful life, it was expected to be worth $10,000: thus, both methods depreciated the asset’s
value by $48,000 over that time period.
The sum-of-the-years-digits is different from the two above methods in that while those methods are based on time factors, the
sum-of-the-years-digits is based on usage. However, the total amount of depreciation taken over an asset’s economic life will still
be the same. In our example, the total depreciation will be $48,000, even though the sum-of-the-years-digits method could take
only two or three years or possibly six or seven years to be allocated.
Calculation of Depreciation Expense

Depreciation Method Calculation

Straight line (Cost – salvage value)/Useful life

(Cost – salvage value) × (Units produced in current
Units of production
period/Estimated total units to be produced)
Double declining balance Book value × Straight-line annual depreciation percentage × 2

Table 9.4.1

ETHICAL CONSIDERATIONS

Depreciation Analysis Requires Careful Evaluation

When analyzing depreciation, accountants are required to make a supportable estimate of an asset’s useful life and its salvage
value. However, “management teams typically fail to invest either time or attention into making or periodically revisiting and
revising reasonably supportable estimates of asset lives or salvage values, or the selection of depreciation methods, as
prescribed by GAAP.”7 This failure is not an ethical approach to properly accounting for the use of assets.
Accountants need to analyze depreciation of an asset over the entire useful life of the asset. As an asset supports the cash flow
of the organization, expensing its cost needs to be allocated, not just recorded as an arbitrary calculation. An asset’s
depreciation may change over its life according to its use. If asset depreciation is arbitrarily determined, the recorded “gains or
losses on the disposition of depreciable property assets seen in financial statements”8 are not true best estimates. Due to
operational changes, the depreciation expense needs to be periodically reevaluated and adjusted.

9.4.6 [Link]
 Any mischaracterization of asset usage is not proper GAAP and is not proper accrual accounting. Therefore, “financial
statement preparers, as well as their accountants and auditors, should pay more attention to the quality of depreciation-related
estimates and their possible mischaracterization and losses of credits and charges to operations as disposal gains.”9 An
accountant should always follow GAAP guidelines and allocate the expense of an asset according to its usage.

Partial-Year Depreciation
A company will usually only own depreciable assets for a portion of a year in the year of purchase or disposal. Companies must be
consistent in how they record depreciation for assets owned for a partial year. A common method is to allocate depreciation
expense based on the number of months the asset is owned in a year. For example, a company purchases an asset with a total cost
of $58,000, a five-year useful life, and a salvage value of $10,000. The annual depreciation is $9,600 ([$58,000 – 10,000]/5).
However, the asset is purchased at the beginning of the fourth month of the fiscal year. The company will own the asset for nine
months of the first year. The depreciation expense of the first year is $7,200 ($9,600 × 9/12). The company will depreciate the asset
$9,600 for the next four years, but only $2,400 in the sixth year so that the total depreciation of the asset over its useful life is the
depreciable amount of $48,000 ($7,200 + 9,600 + 9,600 + 9,600 + 9,600 + 2,400).

THINK IT THROUGH

Choosing Appropriate Depreciation Methods

You are part of a team reviewing the financial statements of a new computer company. Looking over the fixed assets accounts,
one long-term tangible asset sticks out. It is labeled “USB” and valued at $10,000. You ask the company’s accountant for more
detail, and he explains that the asset is a USB drive that holds the original coding for a game the company developed during the
year. The company expects the game to be fairly popular for the next few years, and then sales are expected to trail off.
Because of this, they are planning on depreciating this asset over the next five years using the double-declining method. Does
this recording seem appropriate, or is there a better way to categorize the asset? How should this asset be expensed over time?

Special Issues in Depreciation

While you’ve now learned the basic foundation of the major available depreciation methods, there are a few special issues. Until
now, we have assumed a definite physical or economically functional useful life for the depreciable assets. However, in some
situations, depreciable assets can be used beyond their useful life. If so desired, the company could continue to use the asset beyond
the original estimated economic life. In this case, a new remaining depreciation expense would be calculated based on the
remaining depreciable base and estimated remaining economic life.
Assume in the earlier Kenzie example that after five years and $48,000 in accumulated depreciation, the company estimated that it
could use the asset for two more years, at which point the salvage value would be $0. The company would be able to take an
additional $10,000 in depreciation over the extended two-year period, or $5,000 a year, using the straight-line method.
As with the straight-line example, the asset could be used for more than five years, with depreciation recalculated at the end of year
five using the double-declining balance method. While the process of calculating the additional depreciation for the double-
declining-balance method would differ from that of the straight-line method, it would also allow the company to take an additional
$10,000 after year five, as with the other methods, so long as the cost of $58,000 is not exceeded.
As a side note, there often is a difference in useful lives for assets when following GAAP versus the guidelines for depreciation
under federal tax law, as enforced by the Internal Revenue Service (IRS). This difference is not unexpected when you consider that
tax law is typically determined by the United States Congress, and there often is an economic reason for tax policy.
For example, if we want to increase investment in real estate, shortening the economic lives of real estate for taxation calculations
can have a positive increasing effect on new construction. If we want to slow down new production, extending the economic life
can have the desired slowing effect. In this course, we concentrate on financial accounting depreciation principles rather than tax
depreciation.

Fundamentals of Depletion of Natural Resources

Another type of fixed asset is natural resources, assets a company owns that are consumed when used. Examples include lumber,
mineral deposits, and oil/gas fields. These assets are considered natural resources while they are still part of the land; as they are
extracted from the land and converted into products, they are then accounted for as inventory (raw materials). Natural resources are

9.4.7 [Link]
recorded on the company’s books like a fixed asset, at cost, with total costs including all expenses to acquire and prepare the
resource for its intended use.
As the resource is consumed (converted to a product), the cost of the asset must be expensed: this process is called depletion. As
with depreciation of nonnatural resource assets, a contra account called accumulated depletion, which records the total depletion
expense for a natural resource over its life, offsets the natural resource asset account. Depletion expense is typically calculated
based on the number of units extracted from cutting, mining, or pumping the resource from the land, similar to the units-of-
production method. For example, assume a company has an oil well with an estimated 10,000 gallons of crude oil. The company
purchased this well for $1,000,000, and the well is expected to have no salvage value once it is pumped dry. The depletion cost per
gallon will be $1,000,000/10,000 = $100. If the company extracts 4,000 gallons of oil in a given year, the depletion expense will be
$400,000.

Fundamentals of Amortization of an Intangible

Recall that intangible assets are recorded as long-term assets at their cost. As with tangible assets, many intangible assets have a
finite (limited) life span so their costs must be allocated over their useful lives: this process is amortization. Depreciation and
amortization are similar in nature but have some important differences. First, amortization is typically only done using the straight-
line method. Second, there is usually no salvage value for intangible assets because they are completely used up over their life
span. Finally, an accumulated amortization account is not required to record yearly expenses (as is needed with depreciation);
instead, the intangible asset account is written down each period.
For example, a company called Patents-R-Us purchased a product patent for $10,000, granting the company exclusive use of that
product for the next twenty years. Therefore, unless the company does not think the product will be useful for all twenty years (at
that point the company would use the shorter useful life of the product), the company will record amortization expense of $500 a
year ($10,000/20 years). Assuming that it was placed into service on October 1, 2019, the journal entry would be as follows:

LINK TO LEARNING
See Form 10-K that was filed with the SEC to determine which depreciation method McDonald’s Corporation used for its
long-term assets in 2017.

Footnotes
6 U.S. Securities and Exchange Commission. “Judge Enters Final Judgment against Former CFO of Waste Management, Inc.
Following Jury Verdict in SEC’s Favor.” January 3, 2008. [Link]
7 Howard B. Levy. “Depreciable Asset Lives.” The CPA Journal. September 2016. [Link]
asset-lives/
8 Howard B. Levy. “Depreciable Asset Lives.” The CPA Journal. September 2016. [Link]
asset-lives/
9 Howard B. Levy. “Depreciable Asset Lives.” The CPA Journal. September 2016. [Link]
asset-lives/

9.4: Explain and Apply Depreciation Methods to Allocate Capitalized Costs is shared under a CC BY-NC-SA license and was authored, remixed,
and/or curated by LibreTexts.

9.4.8 [Link]
9.5: Describe Some Special Issues in Accounting for Long-Term Assets
A company will account for some events for long-term assets that are less routine than recording purchase and depreciation or
amortization. For example, a company may realize that its original estimate of useful life or salvage value is no longer accurate. A
long-term asset may lose its value, or a company may sell a long-term asset.

Revision of Remaining Life or Salvage Value

As you have learned, depreciation is based on estimating both the useful life of an asset and the salvage value of that asset. Over
time, these estimates may be proven inaccurate and need to be adjusted based on new information. When this occurs, the
depreciation expense calculation should be changed to reflect the new (more accurate) estimates. For this entry, the remaining
depreciable balance of the net book value is allocated over the new useful life of the asset. To work through this process with data,
let’s return to the example of Kenzie Company.
Kenzie has a press worth $58,000.
Its salvage value was originally estimated to be $10,000.
Its economic life was originally estimated to be five years.
Kenzie uses straight-line depreciation.
After three years, Kenzie determines that the estimated useful life would have been more accurately estimated at eight years, and
the salvage value at that time would be $6,000. The revised depreciation expense is calculated as shown:

These revised calculations show that Kenzie should now be recording a depreciation of $4,640 per year for the next five years.

YOUR TURN
Useful Life
Georgia-Pacific is a global company that employs a wide variety of property, plant, and equipment assets in its production
facilities. You work for Georgia-Pacific as an accountant in charge of the fixed assets subsidiary ledger at a warehouse facility in
Pennsylvania. You find out that the useful lives for the fork trucks need to be adjusted. As an asset category, the trucks were bought
at the same time and had original useful lives of seven years. However, after depreciating them for two years, the company makes
improvements to the trucks that allow them to be used outdoors in what can be harsh winters. The improvements also extend their
useful lives by two additional years. What is the remaining useful life after the improvements?
Solution
Seven original years – two years depreciated + two additional years = seven years remaining.

Obsolescence
Obsolescence refers to the reduction in value and/or use of the asset. Obsolescence has traditionally resulted from the physical
deterioration of the asset—called physical obsolescence. In current application—and considering the role of modern technology
and tech assets—accounting for functional obsolescence is becoming more common. Functional obsolescence is the loss of value
from all causes within a property except those due to physical deterioration. With functional obsolescence, the useful life still needs
to be adjusted downward: although the asset physically still works, its functionality makes it less useful for the company. Also, an
adjustment might be necessary in the salvage value. This potential adjustment depends on the specific details of each obsolescence
determination or decision.

9.5.1 [Link]
Sale of an Asset
When an asset is sold, the company must account for its depreciation up to the date of sale. This means companies may be required
to record a depreciation entry before the sale of the asset to ensure it is current. After ensuring that the net book value of an asset is
current, the company must determine if the asset has sold at a gain, at a loss, or at book value. We look at examples of each
accounting alternative using the Kenzie Company data.
Recall that Kenzie’s press has a depreciable base of $48,000 and an economic life of five years. If Kenzie sells the press at the end
of the third year, the company would have taken three years of depreciation amounting to $28,800 ($9,600 × 3 years). With an
original cost of $58,000, and after subtracting the accumulated depreciation of $28,800, the press would have a book value of
$29,200. If the company sells the press for $31,000, it would realize a gain of $1,800, as shown.

The journal entry to record the sale is shown here.

If Kenzie sells the printing press for $27,100, what would the journal entries be? The book value of the press is $29,200, so Kenzie
would be selling the press at a loss. The journal entry to record the sale is shown here.

What if Kenzie sells the press at exactly book value? In this case, the company will realize neither a gain nor a loss. Here is the
journal entry to record the sale.

While it would be ideal to estimate a salvage value that provides neither a gain nor a loss upon the retirement and sale of a long-
term asset, this type of accuracy is virtually impossible to reach, unless you negotiate a fixed future sales price. For example, you
might buy a truck for $80,000 and lock in a five-year life with 100,000 or fewer miles driven. Under these conditions, the dealer
might agree to pay you $20,000 for the truck in five years.
Under these conditions, you could justify calculating your depreciation over a five-year period, using a depreciable base of
$60,000. Under the straight-line method, this would provide an annual depreciation amount of $12,000. Also, when you sell the

9.5.2 [Link]
truck to the dealer after five years, the sales price will be $20,000, and the book value will be $20,000, so there would be neither a
gain nor a loss on the sale.
In the Kenzie example where the asset was sold for $31,000 after three years, Kenzie should have recorded a total of $27,000 in
depreciation (cost of $58,000 less the sales value of $31,000). However, the company recorded $28,800 in depreciation over the
three-year period. Subtracting the gain of $1,800 from the total depreciation expense of $28,800 shows the true cost of using the
asset as $27,000, and not the depreciation amount of $28,800.
When the asset was sold for $27,100, the accounting records would show $30,900 in depreciation (cost of $58,000 less the sales
price of $27,100). However, depreciation is listed as $28,800 over the three-year period. Adding the loss of $2,100 to the total
depreciation expense of $28,800 results in a cost of $30,900 for use of the asset rather than the $28,800 depreciation.
If the asset sells for exactly the book value, its depreciation expense was estimated perfectly, and there is no gain or loss. If it sells
for $29,200 and had a book value of $29,200, its depreciation expense of $28,800 matches the original estimate.

THINK IT THROUGH
Depreciation of Long-Term Assets
You are a new staff accountant at a large construction company. After a rough year, management is seeking ways to minimize
expenses or increase revenues before year-end to help increase the company’s earnings per share. Your boss has asked staff to think
“outside the box” and has asked to you look through the list of long-term assets to find ones that have been fully depreciated in
value but may still have market value. Why would your manager be looking for these specific assets? How significantly might
these items impact your company’s overall performance? What ethical issues might come into play in the task you have been
assigned?

LINK TO LEARNING
The management of fixed assets can be quite a challenge for any business, from sole proprietorships to global corporations. Not
only do companies need to track their asset purchases, depreciation, sales, disposals, and capital expenditures, they also need to be
able to generate a variety of reports. Read this Finances Online post for more details on software packages that help companies
steward their fixed assets no matter what their size.

9.5: Describe Some Special Issues in Accounting for Long-Term Assets is shared under a CC BY-NC-SA license and was authored, remixed,
and/or curated by LibreTexts.
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[Link]

9.5.3 [Link]
 CHAPTER OVERVIEW

10: Intangible Assets

10.1: Distinguish between Tangible and Intangible Assets
10.2: Describe Accounting for Intangible Assets and Record Related Transactions

10: Intangible Assets is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1
10.1: Distinguish between Tangible and Intangible Assets
Assets are items a business owns.1 For accounting purposes, assets are categorized as current versus long term, and tangible versus
intangible. Assets that are expected to be used by the business for more than one year are considered long-term assets. They are
not intended for resale and are anticipated to help generate revenue for the business in the future. Some common long-term assets
are computers and other office machines, buildings, vehicles, software, computer code, and copyrights. Although these are all
considered long-term assets, some are tangible and some are intangible.

Tangible Assets
An asset is considered a tangible asset when it is an economic resource that has physical substance—it can be seen and touched.
Tangible assets can be either short term, such as inventory and supplies, or long term, such as land, buildings, and equipment. To be
considered a long-term tangible asset, the item needs to be used in the normal operation of the business for more than one year, not
be near the end of its useful life, and the company must have no plan to sell the item in the near future. The useful life is the time
period over which an asset cost is allocated. Long-term tangible assets are known as fixed assets.
Businesses typically need many different types of these assets to meet their objectives. These assets differ from the company’s
products. For example, the computers that Apple Inc. intends to sell are considered inventory (a short-term asset), whereas the
computers Apple’s employees use for day-to-day operations are long-term assets. In Liam’s case, the new silk-screening machine
would be considered a long-term tangible asset as he plans to use it over many years to help him generate revenue for his business.
Long-term tangible assets are listed as noncurrent assets on a company’s balance sheet. Typically, these assets are listed under the
category of Property, Plant, and Equipment (PP&E), but they may be referred to as fixed assets or plant assets.
Apple Inc. lists a total of $33,783,000,000 in total Property, Plant and Equipment (net) on its 2017 consolidated balance sheet (see
Figure 11.2).2 As shown in the figure, this net total includes land and buildings, machinery, equipment and internal-use software,
and leasehold improvements, resulting in a gross PP&E of $75,076,000,000—less accumulated depreciation and amortization of
$41,293,000,000—to arrive at the net amount of $33,783,000,000.

Figure 11.2Apple Inc.’s Property, Plant and Equipment, Net. This report shows the company’s consolidated financial statement
details as of September 30, 2017, and September 24, 2016 (in millions). (attribution: Copyright Rice University, OpenStax, under
CC BY-NC-SA 4.0 license)

LINK TO LEARNING
Recently, there has been a trend involving an increase in the number of intangibles on companies’ balance sheets. As a result,
investors need a better understanding of how this will affect their valuation of these companies. Read this article on intangible
assets from The Economist for more information.

Intangible Assets
Companies may have other long-term assets used in the operations of the business that they do not intend to sell, but that do not
have physical substance; these assets still provide specific rights to the owner and are called intangible assets. These assets
typically appear on the balance sheet following long-term tangible assets (see Figure 11.3.)3 Examples of intangible assets are
patents, copyrights, franchises, licenses, goodwill, sometimes software, and trademarks (Table 11.1). Because the value of
intangible assets is very subjective, it is usually not shown on the balance sheet until there is an event that indicates value
objectively, such as the purchase of an intangible asset.

10.1.1 [Link]
A company often records the costs of developing an intangible asset internally as expenses, not assets, especially if there is
ambiguity in the expense amounts or economic life of the asset. However, there are also conditions under which the costs can be
allocated over the anticipated life of the asset. (The treatment of intangible asset costs can be quite complex and is taught in
advanced accounting courses.)

Figure 11.3Consolidated Balance Sheets for Apple, Inc. in 2017 and 2016. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)
Types of Intangible Assets

Asset Useful Life

Patents Twenty years

Trademarks Renewable every ten years

Copyrights Seventy years beyond death of creator

Goodwill Indefinite

Table11.1

THINK IT THROUGH
Categorizing Intangible Assets
Your company has recently hired a star scientist who has a history of developing new technologies. The company president is
excited with the new hire, and questions you, the company accountant, why the scientist cannot be recorded as an intangible asset,
as the scientist will probably provide more value to the company in the future than any of its other assets. Discuss why the scientist,
and employees in general, who often provide the greatest value for a company, are not recorded as intangible assets.

Patents
A patent is a contract that provides a company exclusive rights to produce and sell a unique product. The rights are granted to the
inventor by the federal government and provide exclusivity from competition for twenty years. Patents are common within the
pharmaceutical industry as they provide an opportunity for drug companies to recoup the significant financial investment on
research and development of a new drug. Once the new drug is produced, the company can sell it for twenty years with no direct
competition.

10.1.2 [Link]
THINK IT THROUGH
Research and Development Costs
Jane works in product development for a technology company. She just heard that her employer is slashing research and
development costs. When she asks why, the marketing senior vice president tells her that current research and development costs
are reducing net income in the current year for a potential but unknown benefit in future years, and that management is concerned
about the effect on stock price. Jane wonders why research and development costs are not capitalized so that the cost would be
matched with the future revenues. Why do you think research and development costs are not capitalized?

Trademarks and Copyrights

A company’s trademark is the exclusive right to the name, term, or symbol it uses to identify itself or its products. Federal law
allows companies to register their trademarks to protect them from use by others. Trademark registration lasts for ten years with
optional 10-year renewable periods. This protection helps prevent impersonators from selling a product similar to another or using
its name. For example, a burger joint could not start selling the “Big Mac.” Although it has no physical substance, the exclusive
right to a term or logo has value to a company and is therefore recorded as an asset.
A copyright provides the exclusive right to reproduce and sell artistic, literary, or musical compositions. Anyone who owns the
copyright to a specific piece of work has exclusive rights to that work. Copyrights in the United States last seventy years beyond
the death of the original author. While you might not be overly interested in what seems to be an obscure law, it actually directly
affects you and your fellow students. It is one of the primary reasons that your copy of the Collected Works of William Shakespeare
costs about $40 in your bookstore or online, while a textbook, such as Principles of Biology or Principles of Accounting, can run in
the hundreds of dollars.

Goodwill
Goodwill is a unique intangible asset. Goodwill refers to the value of certain favorable factors that a business possesses that allows
it to generate a greater rate of return or profit. Such factors include superior management, a skilled workforce, quality products or
service, great geographic location, and overall reputation. Companies typically record goodwill when they acquire another business
in which the purchase price is in excess of the fair value of the identifiable net assets. The difference is recorded as goodwill on the
purchaser’s balance sheet. For example, the goodwill of $5,717,000,000 that we see on Apple’s consolidated balance sheets for
2017 (see Figure 11.3) was created when Apple purchased another business for a purchase price exceeding the book value of its net
assets.

YOUR TURN
Classifying Long-Term Assets as Tangible or Intangible
Your cousin started her own business and wants to get a small loan from a local bank to expand production in the next year. The
bank has asked her to prepare a balance sheet, and she is having trouble classifying the assets properly. Help her sort through the
list below and note the assets that are tangible long-term assets and those that are intangible long-term assets.
Cash
Patent
Accounts Receivable
Land
Investments
Software
Inventory
Note Receivable
Machinery
Equipment
Marketable Securities
Owner Capital
Copyright
Building
Accounts Payable

10.1.3 [Link]
 Mortgage Payable
Solution
Tangible long-term assets include land, machinery, equipment, and building. Intangible long-term assets include patent, software,
and copyright.

Footnotes
1 The Financial Accounting Standards Board (FASB) defines assets as “probable future economic benefits obtained or
controlled by a particular entity as a result of past transactions or events” (SFAC No. 6, p. 12).
2 Apple, Inc. U.S. Securities and Exchange Commission 10-K Filing. November 3, 2017.
[Link]
3 Apple, Inc. U.S. Securities and Exchange Commission 10-K Filing. November 3, 2017.
[Link]

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LibreTexts.
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[Link]

10.1.4 [Link]
10.2: Describe Accounting for Intangible Assets and Record Related Transactions
Intangible assets can be difficult to understand and incorporate into the decision-making process. In this section we explain them in
more detail and provide examples of how to amortize each type of intangible asset.

Fundamentals of Intangible Assets

Intangibles are recorded at their acquisition cost, as are tangible assets. The costs of internally generated intangible assets, such as a
patent developed through research and development, are recorded as expenses when incurred. An exception is legal costs to register
or defend an intangible asset. For example, if a company incurs legal costs to defend a patent it has developed internally, the costs
associated with developing the patent are recorded as an expense, but the legal costs associated with defending the patent would be
capitalized as a patent intangible asset.
Amortization of intangible assets is handled differently than depreciation of tangible assets. Intangible assets are typically
amortized using the straight-line method; there is typically no salvage value, as the usefulness of the asset is used up over its
lifetime, and no accumulated amortization account is needed. Additionally, based on regulations, certain intangible assets are
restricted and given limited life spans, while others are infinite in their economic life and not amortized.

Copyrights
While copyrights have a finite life span of 70 years beyond the author’s death, they are amortized over their estimated useful life.
Therefore, if a company acquired a copyright on a new graphic novel for $10,000 and estimated it would be able to sell that graphic
novel for the next ten years, it would amortize $1,000 a year ($10,000/ten years), and the journal entry would be as shown. Assume
that the novel began sales on January 1, 2019.

Patents
Patents are issued to the inventor of the product by the federal government and last twenty years. All costs associated with creating
the product being patented (such as research and development costs) are expensed; however, direct costs to obtain the patent could
be capitalized. Otherwise, patents are capitalized only when purchased. Like copyrights, patents are amortized over their useful life,
which can be shorter than twenty years due to changing technology. Assume Mech Tech purchased the patent for a new pump
system. The patent cost $20,000, and the company expects the pump to be a useful product for the next twenty years. Mech Tech
will then amortize the $20,000 over the next twenty years, which is $1,000 a year.

Trademarks
Companies can register their trademarks with the federal government for ten years with the opportunity to renew the trademark
every ten years. Trademarks are recorded as assets only when they are purchased from another company and are valued based on
market price at the time of purchase. In this case, these trademarks are amortized over the expected useful life. In some cases, the
trademark may be seen as having an indefinite life, in which case there would be no amortization.

Goodwill
From an accounting standpoint, goodwill is internally generated and is not recorded as an asset unless it is purchased during the
acquisition of another company. The purchase of goodwill occurs when one company buys another company for an amount greater
than the total value of the company’s net assets. The value difference between net assets and the purchase price is then recorded as
goodwill on the purchaser’s financial statements. For example, say the London Hoops professional basketball team was sold for

10.2.1 [Link]
$10 million. The new owner received net assets of $7 million, so the goodwill (value of the London Hoops above its net assets) is
$3 million. The following journal entry shows how the new owner would record this purchase.

Goodwill does not have an expected life span and therefore is not amortized. However, a company is required to compare the book
value of goodwill to its market value at least annually to determine if it needs to be adjusted. This comparison process is called
testing for impairment. If the market value of goodwill is found to be lower than the book value, then goodwill needs to be reduced
to its market value. If goodwill is impaired, it is reduced with a credit, and an impairment loss is debited. Goodwill is never
increased beyond its original cost. For example, if the new owner of London Hoops assesses that London Hoops now has a fair
value of $9,000,000 rather than the $10,000,000 of the original purchase, the owner would need to record the impairment as shown
in the following journal entry.

CONCEPTS IN PRACTICE
Microsoft’s Goodwill
In 2016, Microsoft bought LinkedIn for $25 billion. Microsoft wanted the brand, website platform, and software, which are
intangible assets of LinkedIn, and therefore Microsoft only received $4 billion in net assets. The overpayment by Microsoft is not
necessarily a bad business decision, but rather the premium or value of those intangible assets that LinkedIn owned and Microsoft
wanted. The $21 billion difference will be listed on Microsoft’s balance sheet as goodwill.

LINK TO LEARNING
Apple Inc. had goodwill of $5,717,000,000 on its 2017 balance sheet. Explore Apple, Inc.’s U.S. Securities and Exchange
Commission 10-K Filing for notes that discuss goodwill and whether Apple has had to adjust for the impairment of this asset in
recent years.

10.2: Describe Accounting for Intangible Assets and Record Related Transactions is shared under a CC BY-NC-SA license and was authored,
remixed, and/or curated by LibreTexts.
11.4: Describe Accounting for Intangible Assets and Record Related Transactions by OpenStax is licensed CC BY-NC-SA 4.0. Original
source: [Link]

10.2.2 [Link]
 CHAPTER OVERVIEW

11: Current Liabilities

11.1: Identify and Describe Current Liabilities
11.2: Analyze, Journalize, and Report Current Liabilities
11.3: Define and Apply Accounting Treatment for Contingent Liabilities
11.4: Prepare Journal Entries to Record Short-Term Notes Payable

11: Current Liabilities is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1
11.1: Identify and Describe Current Liabilities
To assist in understanding current liabilities, assume that you own a landscaping company that provides landscaping maintenance
services to clients. As is common for landscaping companies in your area, you require clients to pay an initial deposit of 25% for
services before you begin working on their property. Asking a customer to pay for services before you have provided them creates
a current liability transaction for your business. As you’ve learned, liabilities require a future disbursement of assets or services
resulting from a prior business activity or transaction. For companies to make more informed decisions, liabilities need to be
classified into two specific categories: current liabilities and noncurrent (or long-term) liabilities. The differentiating factor between
current and long-term is when the liability is due. The focus of this chapter is on current liabilities, while Long-Term
Liabilitiesemphasizes long-term liabilities.

Fundamentals of Current Liabilities

A current liability is a debt or obligation due within a company’s standard operating period, typically a year, although there are
exceptions that are longer or shorter than a year. A company’s typical operating period (sometimes called an operating cycle) is a
year, which is used to delineate current and noncurrent liabilities, and current liabilities are considered short term and are typically
due within a year or less.
Noncurrent liabilities are long-term obligations with payment typically due in a subsequent operating period. Current liabilities are
reported on the classified balance sheet, listed before noncurrent liabilities. Changes in current liabilities from the beginning of an
accounting period to the end are reported on the statement of cash flows as part of the cash flows from operations section. An
increase in current liabilities over a period increases cash flow, while a decrease in current liabilities decreases cash flow.
Current vs. Noncurrent Liabilities

Current Liabilities Noncurrent Liabilities

Due within one year or less for a typical one-year operating period Due in more than one year or longer than one operating period

Short-term accounts such as:

Accounts Payable
Salaries Payable
Unearned Revenues Long-term portion of obligations such as:
Interest Payable Noncurrent portion of a longer-term account such as Notes
Taxes Payable Payable or Bonds Payable
Notes Payable within one operating period
Current portion of a longer-term account such as Notes
Payable or Bonds Payable

Table12.1 A delineator between current and noncurrent liabilities is one year or the company’s operating period, whichever is
longer.

Examples of Current Liabilities

Common current liabilities include accounts payable, unearned revenues, the current portion of a note payable, and taxes payable.
Each of these liabilities is current because it results from a past business activity, with a disbursement or payment due within a
period of less than a year.

ETHICAL CONSIDERATIONS
Proper Current Liabilities Reporting and Calculating Burn Rate
When using financial information prepared by accountants, decision-makers rely on ethical accounting practices. For example,
investors and creditors look to the current liabilities to assist in calculating a company’s annual burn rate. The burn rate is the
metric defining the monthly and annual cash needs of a company. It is used to help calculate how long the company can maintain
operations before becoming insolvent. The proper classification of liabilities as current assists decision-makers in determining the
short-term and long-term cash needs of a company.

11.1.1 [Link]
Another way to think about burn rate is as the amount of cash a company uses that exceeds the amount of cash created by the
company’s business operations. The burn rate helps indicate how quickly a company is using its cash. Many start-ups have a high
cash burn rate due to spending to start the business, resulting in low cash flow. At first, start-ups typically do not create enough
cash flow to sustain operations.
Proper reporting of current liabilities helps decision-makers understand a company’s burn rate and how much cash is needed for the
company to meet its short-term and long-term cash obligations. If misrepresented, the cash needs of the company may not be met,
and the company can quickly go out of business. Therefore, it is important that the accountant appropriately report current
liabilities because a creditor, investor, or other decision-maker’s understanding of a company’s specific cash needs helps them
make good financial decisions.

Accounts Payable
Accounts payable accounts for financial obligations owed to suppliers after purchasing products or services on credit. This
account may be an open credit line between the supplier and the company. An open credit line is a borrowing agreement for an
amount of money, supplies, or inventory. The option to borrow from the lender can be exercised at any time within the agreed time
period.
An account payable is usually a less formal arrangement than a promissory note for a current note payable. Long-term debt is
covered in depth in Long-Term Liabilities. For now, know that for some debt, including short-term or current, a formal contract
might be created. This contract provides additional legal protection for the lender in the event of failure by the borrower to make
timely payments. Also, the contract often provides an opportunity for the lender to actually sell the rights in the contract to another
party.
An invoice from the supplier (such as the one shown in Figure 12.2) detailing the purchase, credit terms, invoice date, and shipping
arrangements will suffice for this contractual relationship. In many cases, accounts payable agreements do not include interest
payments, unlike notes payable.

Figure 12.2 Accounts Payable. Contract terms for accounts payable transactions are usually listed on an invoice. (attribution:
Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
For example, assume the owner of a clothing boutique purchases hangers from a manufacturer on credit. The organizations may
establish an ongoing purchase agreement, which includes purchase details (such as hanger prices and quantities), credit terms (2/10,
n/60), an invoice date, and shipping charges (free on board [FOB] shipping) for each order. The basics of shipping charges and
credit terms were addressed in Merchandising Transactions if you would like to refresh yourself on the mechanics. Also, to review
accounts payable, you can also return to Merchandising Transactions for detailed explanations.

11.1.2 [Link]
Unearned Revenue
Unearned revenue, also known as deferred revenue, is a customer’s advance payment for a product or service that has yet to be
provided by the company. Some common unearned revenue situations include subscription services, gift cards, advance ticket
sales, lawyer retainer fees, and deposits for services. As you learned when studying the accounting cycle (Analyzing and Recording
Transactions, The Adjustment Process, and Completing the Accounting Cycle), we are applying the principles of accrual
accounting when revenues and expenses are recognized in different months or years. Under accrual accounting, a company does
not record revenue as earned until it has provided a product or service, thus adhering to the revenue recognition principle. Until the
customer is provided an obligated product or service, a liability exists, and the amount paid in advance is recognized in the
Unearned Revenue account. As soon as the company provides all, or a portion, of the product or service, the value is then
recognized as earned revenue.
For example, assume that a landscaping company provides services to clients. The company requires advance payment before
rendering service. The customer’s advance payment for landscaping is recognized in the Unearned Service Revenue account, which
is a liability. Once the company has finished the client’s landscaping, it may recognize all of the advance payment as earned
revenue in the Service Revenue account. If the landscaping company provides part of the landscaping services within the operating
period, it may recognize the value of the work completed at that time.
Perhaps at this point a simple example might help clarify the treatment of unearned revenue. Assume that the previous landscaping
company has a three-part plan to prepare lawns of new clients for next year. The plan includes a treatment in November 2019,
February 2020, and April 2020. The company has a special rate of $120 if the client prepays the entire $120 before the November
treatment. In real life, the company would hope to have dozens or more customers. However, to simplify this example, we analyze
the journal entries from one customer. Assume that the customer prepaid the service on October 15, 2019, and all three treatments
occur on the first day of the month of service. We also assume that $40 in revenue is allocated to each of the three treatments.
Before examining the journal entries, we need some key information. Because part of the service will be provided in 2019 and the
rest in 2020, we need to be careful to keep the recognition of revenue in its proper period. If all of the treatments occur, $40 in
revenue will be recognized in 2019, with the remaining $80 recognized in 2020. Also, since the customer could request a refund
before any of the services have been provided, we need to ensure that we do not recognize revenue until it has been earned. While
it is nice to receive funding before you have performed the services, in essence, all you have received when you get the money is a
liability (unearned service revenue), with the hope of it eventually becoming revenue. The following journal entries are built upon
the client receiving all three treatments. First, for the prepayment of future services and for the revenue earned in 2019, the journal
entries are shown.

For the revenue earned in 2020, the journal entries would be.

11.1.3 [Link]
 Figure 12.3 Advance Ticket Sales. Season ticket sales are considered unearned revenue because customers pay for them in advance
of any games played. (credit: “Fans in Razorback Stadium (Fayetteville, AR)” by Rmcclen/Wikimedia Commons, Public Domain)

CONCEPTS IN PRACTICE
Thinking about Unearned Revenue
When thinking about unearned revenue, consider the example of [Link], Inc. Amazon has a large business portfolio that
includes a widening presence in the online product and service space. Amazon has two services in particular that contribute to their
unearned revenue account: Amazon Web Services and Prime membership.
According to Business Insider, Amazon had $4.8 billion in unearned revenue recognized in their fourth quarter report (December
2016), with most of that contribution coming from Amazon Web Services.1 This is an increase from prior quarters. The growth is
due to larger and longer contracts for web services. The advance payment for web services is transferred to revenue over the term
of the contract. The same is true for Prime membership. Amazon receives $99 in advance pay from customers, which is amortized
over the twelve-month period of the service agreement. This means that each month, Amazon only recognizes $8.25 per Prime
membership payment as earned revenue.

Current Portion of a Note Payable

A note payable is a debt to a lender with specific repayment terms, which can include principal and interest. A note payable has
written contractual terms that make it available to sell to another party. The principal on a note refers to the initial borrowed
amount, not including interest. In addition to repayment of principal, interest may accrue. Interest is a monetary incentive to the
lender, which justifies loan risk.
Let’s review the concept of interest. Interest is an expense that you might pay for the use of someone else’s money. For example, if
you have a credit card and you owe a balance at the end of the month it will typically charge you a percentage, such as 1.5% a
month (which is the same as 18% annually) on the balance that you owe. Assuming that you owe $400, your interest charge for the
month would be $400 × 1.5%, or $6.00. To pay your balance due on your monthly statement would require $406 (the $400 balance
due plus the $6 interest expense).
We make one more observation about interest: interest rates are typically quoted in annual terms. For example, if you borrowed
money to buy a car, your interest expense might be quoted as 9%. Note that this is an annual rate. If you are making monthly
payments, the monthly charge for interest would be 9% divided by twelve, or 0.75% a month. For example, if you borrowed
$20,000, and made sixty equal monthly payments, your monthly payment would be $415.17, and your interest expense component
of the $415.17 payment would be $150.00. The formula to calculate interest on either an annual or partial-year basis is:

11.1.4 [Link]
In our example this would be
$20,000×9%×112=$150$20,000×9%×112=$150
The good news is that for a loan such as our car loan or even a home loan, the loan is typically what is called fully amortizing. At
this point, you just need to know that in our case the amount that you owe would go from a balance due of $20,000 down to $0
after the twentieth payment and the part of your $415.17 monthly payment allocated to interest would be less each month. For
example, your last (sixtieth) payment would only incur $3.09 in interest, with the remaining payment covering the last of the
principle owed. See Figure 13.7 for an exhibit that demonstrates this concept.

CONCEPTS IN PRACTICE
Applying Amortization
Car loans, mortgages, and education loans have an amortization process to pay down debt. Amortization of a loan requires periodic
scheduled payments of principal and interest until the loan is paid in full. Every period, the same payment amount is due, but
interest expense is paid first, with the remainder of the payment going toward the principal balance. When a customer first takes
out the loan, most of the scheduled payment is made up of interest, and a very small amount goes to reducing the principal balance.
Over time, more of the payment goes toward reducing the principal balance rather than interest.
For example, let’s say you take out a car loan in the amount of $10,000. The annual interest rate is 3%, and you are required to
make scheduled payments each month in the amount of $400. You first need to determine the monthly interest rate by dividing 3%
by twelve months (3%/12), which is 0.25%. The monthly interest rate of 0.25% is multiplied by the outstanding principal balance
of $10,000 to get an interest expense of $25. The scheduled payment is $400; therefore, $25 is applied to interest, and the
remaining $375 ($400 – $25) is applied to the outstanding principal balance. This leaves an outstanding principal balance of
$9,625. Next month, interest expense is computed using the new principal balance outstanding of $9,625. The new interest expense
is $24.06 ($9,625 × 0.25%). This means $24.06 of the $400 payment applies to interest, and the remaining $375.94 ($400 – $24.06)
is applied to the outstanding principal balance to get a new balance of $9,249.06 ($9,625 – $375.94). These computations occur
until the entire principal balance is paid in full.
A note payable is usually classified as a long-term (noncurrent) liability if the note period is longer than one year or the standard
operating period of the company. However, during the company’s current operating period, any portion of the long-term note due
that will be paid in the current period is considered a current portion of a note payable. The outstanding balance note payable
during the current period remains a noncurrent note payable. Note that this does not include the interest portion of the payments.
On the balance sheet, the current portion of the noncurrent liability is separated from the remaining noncurrent liability. No journal
entry is required for this distinction, but some companies choose to show the transfer from a noncurrent liability to a current
liability.
For example, a bakery company may need to take out a $100,000 loan to continue business operations. The bakery’s outstanding
note principal is $100,000. Terms of the loan require equal annual principal repayments of $10,000 for the next ten years. Payments
will be made on July 1 of each of the ten years. Even though the overall $100,000 note payable is considered long term, the
$10,000 required repayment during the company’s operating cycle is considered current (short term). This means $10,000 would be
classified as the current portion of a noncurrent note payable, and the remaining $90,000 would remain a noncurrent note payable.
The portion of a note payable due in the current period is recognized as current, while the remaining outstanding balance is a
noncurrent note payable. For example, Figure 12.4 shows that $18,000 of a $100,000 note payable is scheduled to be paid within
the current period (typically within one year). The remaining $82,000 is considered a long-term liability and will be paid over its
remaining life.

11.1.5 [Link]
 Figure 12.4 Current Portion of a Noncurrent Note Payable. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-
SA 4.0 license)
In addition to the $18,000 portion of the note payable that will be paid in the current year, any accrued interest on both the current
portion and the long-term portion of the note payable that is due will also be paid. Assume, for example, that for the current year
$7,000 of interest will be accrued. In the current year the debtor will pay a total of $25,000—that is, $7,000 in interest and $18,000
for the current portion of the note payable. A similar type of payment will be paid each year for as long as any of the note payable
remains; however, the annual interest expense would be reduced since the remaining note payable owed will be reduced by the
previous payments.
Interest payable can also be a current liability if accrual of interest occurs during the operating period but has yet to be paid. An
annual interest rate is established as part of the loan terms. Interest accrued is recorded in Interest Payable (a credit) and Interest
Expense (a debit). To calculate interest, the company can use the following equations. This method assumes a twelve-month
denominator in the calculation, which means that we are using the calculation method based on a 360-day year. This method was
more commonly used prior to the ability to do the calculations using calculators or computers, because the calculation was easier to
perform. However, with today’s technology, it is more common to see the interest calculation performed using a 365-day year. We
will demonstrate both methods.

For example, we assume the bakery has an annual interest rate on its loan of 7%. The loan interest began accruing on July 1 and it
is now December 31. The bakery has accrued six months of interest and would compute the interest liability as
$100,000×7%×612=$3,500$100,000×7%×612=$3,500
The $3,500 is recognized in Interest Payable (a credit) and Interest Expense (a debit).

Taxes Payable
Taxes payable refers to a liability created when a company collects taxes on behalf of employees and customers or for tax
obligations owed by the company, such as sales taxes or income taxes. A future payment to a government agency is required for the
amount collected. Some examples of taxes payable include sales tax and income taxes.

11.1.6 [Link]
Sales taxes result from sales of products or services to customers. A percentage of the sale is charged to the customer to cover the
tax obligation (see Figure 12.5). The sales tax rate varies by state and local municipalities but can range anywhere from 1.76% to
almost 10% of the gross sales price. Some states do not have sales tax because they want to encourage consumer spending. Those
businesses subject to sales taxation hold the sales tax in the Sales Tax Payable account until payment is due to the governing body.

Figure 12.5 Sales Tax. Many businesses are required to charge a sales tax on products or services sold. (credit: modification of
“Sales Tax” by Kerry Ceszyk/Flickr, CC BY 4.0)
For example, assume that each time a shoe store sells a $50 pair of shoes, it will charge the customer a sales tax of 8% of the sales
price. The shoe store collects a total of $54 from the customer. The $4 sales tax is a current liability until distributed within the
company’s operating period to the government authority collecting sales tax.
Income taxes are required to be withheld from an employee’s salary for payment to a federal, state, or local authority (hence they
are known as withholding taxes). This withholding is a percentage of the employee’s gross pay. Income taxes are discussed in

11.1.7 [Link]
greater detail in Record Transactions Incurred in Preparing Payroll.

LINK TO LEARNING
Businesses can use the Internal Revenue Service’s Sales Tax Deduction Calculator and associated tips and guidance to determine
their estimated sales tax obligation owed to the state and local government authority.

Footnotes
1 Eugene Kim. “An Overlooked Part of Amazon Will Be in the Spotlight When the Company Reports Earnings.” Business
Insider. April 28, 2016. [Link]

11.1: Identify and Describe Current Liabilities is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by LibreTexts.
12.1: Identify and Describe Current Liabilities by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

11.1.8 [Link]
11.2: Analyze, Journalize, and Report Current Liabilities
To illustrate current liability entries, we use transaction information from Sierra Sports (see Figure 12.6). Sierra Sports owns and
operates a sporting goods store in the Southwest specializing in sports apparel and equipment. The company engages in regular
business activities with suppliers, creditors, customers, and employees.

Figure 12.6 Sierra Sports Logo. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Accounts Payable
On August 1, Sierra Sports purchases $12,000 of soccer equipment from a manufacturer (supplier) on credit. Assume for the
following examples that Sierra Sports uses the perpetual inventory method, which uses the Inventory account when the company
buys, sells, or adjusts the inventory balance, such as in the following example where they qualified for a discount. In the current
transaction, credit terms are 2/10, n/30, the invoice date is August 1, and shipping charges are FOB shipping point (which is
included in the purchase cost).
Recall from Merchandising Transactions, that credit terms of 2/10, n/30 signal the payment terms and discount, and FOB shipping
point establishes the point of merchandise ownership, the responsibility during transit, and which entity pays shipping charges.
Therefore, 2/10, n/30 means Sierra Sports has ten days to pay its balance due to receive a 2% discount, otherwise Sierra Sports has
net thirty days, in this case August 31, to pay in full but not receive a discount. FOB shipping point signals that since Sierra Sports
takes ownership of the merchandise when it leaves the manufacturer, it takes responsibility for the merchandise in transit and will
pay the shipping charges.
Sierra Sports would make the following journal entry on August 1.

The merchandise is purchased from the supplier on credit. In this case, Accounts Payable would increase (a credit) for the full
amount due. Inventory, the asset account, would increase (a debit) for the purchase price of the merchandise.
If Sierra Sports pays the full amount owed on August 10, it qualifies for the discount, and the following entry would occur.

11.2.1 [Link]
Assume that the payment to the manufacturer occurs within the discount period of ten days (2/10, n/30) and is recognized in the
entry. Accounts Payable decreases (debit) for the original amount due, Inventory decreases (credit) for the discount amount of $240
($12,000 × 2%), and Cash decreases (credit) for the remaining balance due after discount.
Note that Inventory is decreased in this entry because the value of the merchandise (soccer equipment) is reduced. When applying
the perpetual inventory method, this reduction is required by generally accepted accounting principles (GAAP) (under the cost
principle) to reflect the actual cost of the merchandise.
A second possibility is that Sierra will return part of the purchase before the ten-day discount window has expired. Assume in this
example that $1,000 of the $12,000 purchase was returned to the seller on August 8 and the remaining account payable due was
paid by Sierra to the seller on August 10, which means that Sierra qualified for the remaining eligible discount. The following two
journal entries represent the return of inventory and the subsequent payment for the remaining account payable owed. The initial
journal entry from August 1 will still apply, because we assume that Sierra intended to keep the full $12,000 of inventory when the
purchase was made.
When the $1,000 in inventory was returned on August 8, the accounts payable account and the inventory accounts should be
reduced by $1,000 as demonstrated in this journal entry.

After this transaction, Sierra still owed $11,000 and still had $11,000 in inventory from the purchase, assuming that Sierra had not
sold any of it yet.
When Sierra paid the remaining balance on August 10, the company qualified for the discount. However, since Sierra only owed a
remaining balance of $11,000 and not the original $12,000, the discount received was 2% of $11,000, or $220, as demonstrated in
this journal entry. Since Sierra owed $11,000 and received a discount of $220, the supplier was paid $10,780. This second journal
entry is the same as the one that would have recognized an original purchase of $11,000 that qualified for a discount.

Remember that since we are assuming that Sierra was using the perpetual inventory method, purchases, payments, and adjustments
in goods available for sale are reflected in the company’s Inventory account. In our example, one of the potential adjustments is
that discounts received are recorded as reductions to the Inventory account.
To demonstrate this concept, after buying $12,000 in inventory, returning $1,000 in inventory, and then paying for the remaining
balance and qualifying for the discount, Sierra’s Inventory balance increased by $10,780, as shown.

11.2.2 [Link]
If Sierra had bought $11,000 of inventory on August 1 and paid cash and taken the discount, after taking the $220 discount, the
increase of Inventory on their balance sheet would have been $10,780, as it finally ended up being in our more complicated set of
transactions on three different days. The important factor is that the company qualified for a 2% discount on inventory that had a
retail price before discounts of $11,000.
In a final possible scenario, assume that Sierra Sports remitted payment outside of the discount window on August 28, but inside of
thirty days. In this case, they did not qualify for the discount, and assuming that they made no returns they paid the full,
undiscounted balance of $12,000.

If this occurred, both Accounts Payable and Cash decreased by $12,000. Inventory is not affected in this instance because the full
cost of the merchandise was paid; so, the increase in value for the inventory was $12,000, and not the $11,760 value determined in
our beginning transactions where they qualified for the discount.

YOUR TURN
Accounting for Advance Payments
You are the owner of a catering company and require advance payments from clients before providing catering services. You
receive an order from the Coopers, who would like you to cater their wedding on June 10. The Coopers pay you $5,500 cash on
March 25. Record your journal entries for the initial payment from the Coopers, and when the catering service has been provided
on June 10.
Solution

Unearned Revenue
Sierra Sports has contracted with a local youth football league to provide all uniforms for participating teams. The league pays for
the uniforms in advance, and Sierra Sports provides the customized uniforms shortly after purchase. The following situation shows

11.2.3 [Link]
the journal entry for the initial purchase with cash. Assume the league pays Sierra Sports for twenty uniforms (cost per uniform is
$30, for a total of $600) on April 3.

Sierra Sports would see an increase to Cash (debit) for the payment made from the football league. The revenue from the sale of the
uniforms is $600 (20 uniforms × $30 per uniform). Unearned Uniform Revenue accounts reflect the prepayment from the league,
which cannot be recognized as earned revenue until the uniforms are provided. Unearned Uniform Revenue is a current liability
account that increases (credit) with the increase in outstanding product debt.
Sierra provides the uniforms on May 6 and records the following entry.

Now that Sierra has provided all of the uniforms, the unearned revenue can be recognized as earned. This satisfies the revenue
recognition principle. Therefore, Unearned Uniform Revenue would decrease (debit), and Uniform Revenue would increase
(credit) for the total amount.
Let’s say that Sierra only provides half the uniforms on May 6 and supplies the rest of the order on June 2. The company may not
recognize revenue until a product (or a portion of a product) has been provided. This means only half the revenue can be
recognized on May 6 ($300) because only half of the uniforms were provided. The rest of the revenue recognition will have to wait
until June 2. Since only half of the uniforms were delivered on May 6, only half of the costs of goods sold would be recognized on
May 6. The other half of the costs of goods sold would be recognized on June 2 when the other half of the uniforms were delivered.
The following entries show the separate entries for partial revenue recognition.

In another scenario using the same cost information, assume that on April 3, the league contracted for the production of the
uniforms on credit with terms 5/10, n/30. They signed a contract for the production of the uniforms, so an account receivable was
created for Sierra, as shown.

11.2.4 [Link]
Sierra and the league have worked out credit terms and a discount agreement. As such, the league can delay cash payment for ten
days and receive a discount, or for thirty days with no discount assessed. Instead of cash increasing for Sierra, Accounts Receivable
increases (debit) for the amount the football league owes.
The league pays for the uniforms on April 15, and Sierra provides all uniforms on May 6. The following entry shows the payment
on credit.

The football league made payment outside of the discount period, since April 15 is more than ten days from the invoice date. Thus,
they do not receive the 5% discount. Cash increases (debit) for the $600 paid by the football league, and Accounts Receivable
decreases (credit).
In the next example, let’s assume that the league made payment within the discount window, on April 13. The following entry
occurs.

In this case, Accounts Receivable decreases (credit) for the original amount owed, Sales Discount increases (debit) for the discount
amount of $30 ($600 × 5%), and Cash increases (debit) for the $570 paid by the football league less discount.
When the company provides the uniforms on May 6, Unearned Uniform Revenue decreases (debit) and Uniform Revenue increases
(credit) for $600.

ETHICAL CONSIDERATIONS
Stock Options and Unearned Revenue Manipulation
The anticipated income of public companies is projected by stock market analysts through whisper-earnings, or forecasted
earnings. It can be advantageous for a company to have its stock beat the stock market’s expectation of earnings. Likewise, falling
below the market’s expectation can be a disadvantage. If a company’s whisper-earnings are not going to be met, there could be
pressure on the chief financial officer to misrepresent earnings through manipulation of unearned revenue accounts to better match
the stock market’s expectation.
Because many executives, other top management, and even employees have stock options, this can also provide incentive to
manipulate earnings. A stock option sets a minimum price for the stock on a certain date. This is the date the option vests, at what
is commonly called the strike price. Options are worthless if the stock price on the vesting date is lower than the price at which
they were granted. This could result in a loss of income, potentially incentivizing earnings manipulation to meet the stock market’s
expectations and exceed the vested stock price in the option.
Researchers have found that when executive options are about to vest, companies are more likely to present financial statements
meeting or just slightly beating the earnings forecasts of analysts. The proximity of the actual earnings to earnings forecasts
suggests they were manipulated because of the vesting.2 As Douglas R. Carmichael points out, “public companies that fail to report
quarterly earnings which meet or exceed analysts’ expectations often experience a drop in their stock prices. This can lead to
practices that sometimes include fraudulent overstatement of quarterly revenue.”3 If earnings meet or exceed expectations, a stock

11.2.5 [Link]
price can hit or surpass the vested stock price in the option. For company members with stock options, this could result in higher
income. Thus, financial statements that align closely with analysts’ estimates, rather than showing large projections above or below
whisper-earnings, could indicate that accounting information has possibly been adjusted to meet the expected numbers. Such
manipulations can be made in unearned revenue accounts.
In November 1998, the Securities and Exchange Commission (SEC) issued Practice Alert 98-3, Revenue Recognition Issues, SEC
Practice Section Professional Issues Task Force, recognizing and discussing the manipulation of earnings used to exceed stock
market and analysts’ expectations. Accountants should watch for revenue recognition related issues in preparing the financial
statements of their company or client, especially when employees’ or management’s stock options are about to vest.

Current Portion of a Noncurrent Note Payable

Sierra Sports takes out a bank loan on January 1, 2017 to cover expansion costs for a new store. The note amount is $360,000. The
note has terms of repayment that include equal principal payments annually over the next twenty years. The annual interest rate on
the loan is 9%. Interest accumulates each month based on the standard interest rate formula discussed previously, and on the current
outstanding principal balance of the loan. Sierra records interest accumulation every three months, at the end of each third month.
The initial loan (note) entry follows.

Notes Payable increases (credit) for the full loan principal amount. Cash increases (debit) as well. On March 31, the end of the first
three months, Sierra records their first interest accumulation.

Interest Expense increases (debit) as does Interest Payable (credit) for the amount of interest accumulated but unpaid at the end of
the three-month period. The amount $8,100 is found by using the interest formula, where the outstanding principal balance is
$360,000, interest rate of 9%, and the part of the year being three out of twelve months: $360,000 × 9% × (3/12).
The same entry for interest will occur every three months until year-end. When accumulated interest is paid on January 1 of the
following year, Sierra would record this entry.

Both Interest Payable and Cash decrease for the total interest amount accumulated during 2017. This is calculated by taking each
three-month interest accumulation of $8,100 and multiplying by the four recorded interest entries for the periods. You could also
compute this by taking the original principal balance and multiplying by 9%.
On December 31, 2017, the first principal payment is due. The following entry occurs to show payment of this principal amount
due in the current period.

11.2.6 [Link]
Notes Payable decreases (debit), as does Cash (credit), for the amount of the noncurrent note payable due in the current period.
This amount is calculated by dividing the original principal amount ($360,000) by twenty years to get an annual current principal
payment of $18,000 ($360,000/20).
While the accounts used to record a reduction in Notes Payable are the same as the accounts used for a noncurrent note, the
reporting on the balance sheet is classified in a different area. The current portion of the noncurrent note payable ($18,000) is
reported under Current Liabilities, and the remaining noncurrent balance of $342,000 ($360,000 – $18,000) is classified and
displayed under noncurrent liabilities, as shown in Figure 12.7.

Figure 12.7 Sierra Sports Balance Sheet. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Taxes Payable
Let’s consider our previous example where Sierra Sports purchased $12,000 of soccer equipment in August. Sierra now sells the
soccer equipment to a local soccer league for $18,000 cash on August 20. The sales tax rate is 6%. The following revenue entry
would occur.

Cash increases (debit) for the sales amount plus sales tax. Sales Tax Payable increases (credit) for the 6% tax rate ($18,000 × 6%).
Sierra’s tax liability is owed to the State Tax Board. Sales increases (credit) for the original amount of the sale, not including sales
tax. If Sierra’s customer pays on credit, Accounts Receivable would increase (debit) for $19,080 rather than Cash.
When Sierra remits payment to the State Tax Board on October 1, the following entry occurs.

Sales Tax Payable and Cash decrease for the payment amount of $1,080. Sales tax is not an expense to the business because the
company is holding it on account for another entity.
Sierra Sports payroll tax journal entries will appear in Record Transactions Incurred in Preparing Payroll.

YOUR TURN

11.2.7 [Link]
Accounting for Purchase Discounts
You own a shipping and packaging facility and provide shipping services to customers. You have worked out a contract with a local
supplier to provide your business with packing materials on an ongoing basis. Terms of your agreement allow for delayed payment
of up to thirty days from the invoice date, with an incentive to pay within ten days to receive a 5% discount on the packing
materials. On April 3, you purchase 1,000 boxes (Box Inventory) from this supplier at a cost per box of $1.25. You pay the amount
due to the supplier on April 11. Record the journal entries to recognize the initial purchase on April 3, and payment of the amount
due on April 11.
Solution

Footnotes
2 Jena McGregor. “How Stock Options Lead CEOs to Put Their Own Interests First.” Washington Post. February 11, 2014.
[Link]
3 Douglas R. Carmichael. “Hocus-Pocus Accounting.” Journal of Accountancy. October 1, 1999.
[Link]

11.2: Analyze, Journalize, and Report Current Liabilities is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by
LibreTexts.
12.2: Analyze, Journalize, and Report Current Liabilities by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

11.2.8 [Link]
11.3: Define and Apply Accounting Treatment for Contingent Liabilities
What happens if your business anticipates incurring a loss or debt? Do you need to report this if you are uncertain it will occur?
What if you know the loss or debt will occur but it has not happened yet? Do you have to report this event now, or in the future?
These are questions businesses must ask themselves when exploring contingencies and their effect on liabilities.
A contingency occurs when a current situation has an outcome that is unknown or uncertain and will not be resolved until a future
point in time. The outcome could be positive or negative. A contingent liability can produce a future debt or negative obligation
for the company. Some examples of contingent liabilities include pending litigation (legal action), warranties, customer insurance
claims, and bankruptcy.
While a contingency may be positive or negative, we only focus on outcomes that may produce a liability for the company
(negative outcome), since these might lead to adjustments in the financial statements in certain cases. Positive contingencies do not
require or allow the same types of adjustments to the company’s financial statements as do negative contingencies, since
accounting standards do not permit positive contingencies to be recorded.
Pending litigation involves legal claims against the business that may be resolved at a future point in time. The outcome of the
lawsuit has yet to be determined but could have negative future impact on the business.
Warranties arise from products or services sold to customers that cover certain defects (see Figure 12.8). It is unclear if a customer
will need to use a warranty, and when, but this is a possibility for each product or service sold that includes a warranty. The same
idea applies to insurance claims (car, life, and fire, for example), and bankruptcy. There is an uncertainty that a claim will transpire,
or bankruptcy will occur. If the contingencies do occur, it may still be uncertain when they will come to fruition, or the financial
implications.

Figure 12.8 One-Year Warranty. Companies may offer product or service warranties. (credit: modification of “Seal Guaranteed” by
“harshahars”/Pixabay, CC0)
The answer to whether or not uncertainties must be reported comes from Financial Accounting Standards Board (FASB)
pronouncements.

11.3.1 [Link]
Two Financial Accounting Standards Board (FASB) Requirements for Recognition of a Contingent
Liability
There are two requirements for contingent liability recognition:
1. There is a likelihood of occurrence.
2. Measurement of the occurrence is classified as either estimable or inestimable.

Application of Likelihood of Occurrence Requirement

Let’s explore the likelihood of occurrence requirement in more detail.
According to the FASB, if there is a probable liability determination before the preparation of financial statements has occurred,
there is a likelihood of occurrence, and the liability must be disclosed and recognized. This financial recognition and disclosure
are recognized in the current financial statements. The income statement and balance sheet are typically impacted by contingent
liabilities.
For example, Sierra Sports has a one-year warranty on part repairs and replacements for a soccer goal they sell. The warranty is
good for one year. Sierra Sports notices that some of its soccer goals have rusted screws that require replacement, but they have
already sold goals with this problem to customers. There is a probability that someone who purchased the soccer goal may bring it
in to have the screws replaced. Not only does the contingent liability meet the probability requirement, it also meets the
measurement requirement.

Application of Measurement Requirement

The measurement requirement refers to the company’s ability to reasonably estimate the amount of loss. Even though a
reasonable estimate is the company’s best guess, it should not be a frivolous number. For a financial figure to be reasonably
estimated, it could be based on past experience or industry standards (see Figure 12.9). It could also be determined by the potential
future, known financial outcome.

Figure 12.9 Contingent Liabilities Estimation Checklist. These are possible ways to determine a contingent liability financial
estimate. (credit: modification of “Checklist” by Alan Cleaver/Flickr, CC BY 2.0)
Let’s continue to use Sierra Sports’ soccer goal warranty as our example. If the warranties are honored, the company should know
how much each screw costs, labor cost required, time commitment, and any overhead costs incurred. This amount could be a
reasonable estimate for the parts repair cost per soccer goal. Since not all warranties may be honored (warranty expired), the
company needs to make a reasonable determination for the amount of honored warranties to get a more accurate figure.
Another way to establish the warranty liability could be an estimation of honored warranties as a percentage of sales. In this
instance, Sierra could estimate warranty claims at 10% of its soccer goal sales.

11.3.2 [Link]
When determining if the contingent liability should be recognized, there are four potential treatments to consider.
Let’s expand our discussion and add a brief example of the calculation and application of warranty expenses. To begin, in many
ways a warranty expense works similarly to the bad debt expense concept covered in Accounting for Receivables in that the
anticipated expense is determined by examining past period expense experiences and then basing the current expense on current
sales data. Also, as with bad debts, the warranty repairs typically are made in an accounting period sometimes months or even years
after the initial sale of the product, which means that we need to estimate future costs to comply with the revenue recognition and
matching principles of generally accepted accounting principles (GAAP).
Some industries have such a large number of transactions and a vast data bank of past warranty claims that they have an easier time
estimating potential warranty claims, while other companies have a harder time estimating future claims. In our case, we make
assumptions about Sierra Sports and build our discussion on the estimated experiences.
For our purposes, assume that Sierra Sports has a line of soccer goals that sell for $800, and the company anticipates selling 500
goals this year (2019). Past experience for the goals that the company has sold is that 5% of them will need to be repaired under
their three-year warranty program, and the cost of the average repair is $200. To simplify our example, we concentrate strictly on
the journal entries for the warranty expense recognition and the application of the warranty repair pool. If the company sells 500
goals in 2019 and 5% need to be repaired, then 25 goals will be repaired at an average cost of $200. The average cost of $200 × 25
goals gives an anticipated future repair cost of $5,000 for 2019. Assume for the sake of our example that in 2020 Sierra Sports
made repairs that cost $2,800. Following are the necessary journal entries to record the expense in 2019 and the repairs in 2020.
The resources used in the warranty repair work could have included several options, such as parts and labor, but to keep it simple
we allocated all of the expenses to repair parts inventory. Since the company’s inventory of supply parts (an asset) went down by
$2,800, the reduction is reflected with a credit entry to repair parts inventory. First, following is the necessary journal entry to
record the expense in 2019.

Next, here is the journal entry to record the repairs in 2020.

Before we finish, we need to address one more issue. Our example only covered the warranty expenses anticipated from the 2019
sales. Since the company has a three-year warranty, and it estimated repair costs of $5,000 for the goals sold in 2019, there is still a
balance of $2,200 left from the original $5,000. However, its actual experiences could be more, the same, or less than $2,200. If it
is determined that too much is being set aside in the allowance, then future annual warranty expenses can be adjusted downward. If
it is determined that not enough is being accumulated, then the warranty expense allowance can be increased.
Since this warranty expense allocation will probably be carried on for many years, adjustments in the estimated warranty expenses
can be made to reflect actual experiences. Also, sales for 2020, 2021, 2022, and all subsequent years will need to reflect the same
types of journal entries for their sales. In essence, as long as Sierra Sports sells the goals or other equipment and provides a
warranty, it will need to account for the warranty expenses in a manner similar to the one we demonstrated.

THINK IT THROUGH
Product Recalls: Contingent Liabilities?
Consider the following scenario: A hoverboard is a self-balancing scooter that uses body position and weight transfer to control the
device. Hoverboards use a lithium-ion battery pack, which was found to overheat causing an increased risk for the product to catch
fire or explode. Several people were badly injured from these fires and explosions. As a result, a recall was issued in mid-2016 on
most hoverboard models. Customers were asked to return the product to the original point of sale (the retailer). Retailers were
required to accept returns and provide repair when available. In some cases, retailers were held accountable by consumers, and not

11.3.3 [Link]
the manufacturer of the hoverboards. You are the retailer in this situation and must decide if the hoverboard scenario creates any
contingent liabilities. If so, what are the contingent liabilities? Do the conditions meet FASB requirements for contingent liability
reporting? Which of the four possible treatments are best suited for the potential liabilities identified? Are there any journal entries
or note disclosures necessary?

Four Potential Treatments for Contingent Liabilities

If the contingency is probable and estimable, it is likely to occur and can be reasonably estimated. In this case, the liability and
associated expense must be journalized and included in the current period’s financial statements (balance sheet and income
statement) along with note disclosures explaining the reason for recognition. The note disclosures are a GAAP requirement
pertaining to the full disclosure principle, as detailed in Analyzing and Recording Transactions.
If the contingent liability is probable and inestimable, it is likely to occur but cannot be reasonably estimated. In this case, a note
disclosure is required in financial statements, but a journal entry and financial recognition should not occur until a reasonable
estimate is possible.
If the contingency is reasonably possible, it could occur but is not probable. The amount may or may not be estimable. Since this
condition does not meet the requirement of likelihood, it should not be journalized or financially represented within the financial
statements. Rather, it is disclosed in the notes only with any available details, financial or otherwise.
If the contingent liability is considered remote, it is unlikely to occur and may or may not be estimable. This does not meet the
likelihood requirement, and the possibility of actualization is minimal. In this situation, no journal entry or note disclosure in
financial statements is necessary.
Financial Statement Treatments

Journalize Note Disclosure

Probable and estimable Yes Yes

Probable and inestimable No Yes

Reasonably possible No Yes

Remote No No

Table12.2 Four Treatments of Contingent Liabilities. Proper recognition of the four contingent liability treatments.

LINK TO LEARNING
Google, a subsidiary of Alphabet Inc., has expanded from a search engine to a global brand with a variety of product and service
offerings. Like many other companies, contingent liabilities are carried on Google’s balance sheet, report expenses related to these
contingencies on its income statement, and note disclosures are provided to explain its contingent liability treatments. Check out
Google’s contingent liability considerations in this press release for Alphabet Inc.’s First Quarter 2017 Results to see a financial
statement package, including note disclosures.
Let’s review some contingent liability treatment examples as they relate to our fictitious company, Sierra Sports.

Probable and Estimable

If Sierra Sports determines the cost of the soccer goal screws are $30, the labor requirement is one hour at a rate of $40 per hour,
and there is no extra overhead applied, then the total estimated warranty repair cost would be $70 per goal: $30 + (1 hour × $40 per
hour). Sierra Sports sold ten goals before it discovered the rusty screw issue. The company believes that only six of those goals will
have their warranties honored, based on past experience. This means Sierra will incur a warranty liability of $420 ($70 × 6 goals).
The $420 is considered probable and estimable and is recorded in Warranty Liability and Warranty Expense accounts during the
period of discovery (current period).

11.3.4 [Link]
An example of determining a warranty liability based on a percentage of sales follows. The sales price per soccer goal is $1,200,
and Sierra Sports believes 10% of sales will result in honored warranties. The company would record this warranty liability of $120
($1,200 × 10%) to Warranty Liability and Warranty Expense accounts.

When the warranty is honored, this would reduce the Warranty Liability account and decrease the asset used for repair (Parts:
Screws account) or Cash, if applicable. The recognition would happen as soon as the warranty is honored. This first entry shown is
to recognize honored warranties for all six goals.

This second entry recognizes an honored warranty for a soccer goal based on 10% of sales from the period.

As you’ve learned, not only are warranty expense and warranty liability journalized, but they are also recognized on the income
statement and balance sheet. The following examples show recognition of Warranty Expense on the income statement Figure
12.10and Warranty Liability on the balance sheet Figure 12.11 for Sierra Sports.

11.3.5 [Link]
 Figure 12.10 Sierra Sports’ Income Statement. Warranty Expense is recognized on the income statement. (attribution: Copyright
Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Figure 12.11 Sierra Sports’ Balance Sheet. Warranty Liability is recognized on the balance sheet. (attribution: Copyright Rice
University, OpenStax, under CC BY-NC-SA 4.0 license)

Probable and Not Estimable

Assume that Sierra Sports is sued by one of the customers who purchased the faulty soccer goals. A settlement of responsibility in
the case has been reached, but the actual damages have not been determined and cannot be reasonably estimated. This is considered
probable but inestimable, because the lawsuit is very likely to occur (given a settlement is agreed upon) but the actual damages are
unknown. No journal entry or financial adjustment in the financial statements will occur. Instead, Sierra Sports will include a note
describing any details available about the lawsuit. When damages have been determined, or have been reasonably estimated, then
journalizing would be appropriate.
Sierra Sports could say the following in its financial statement disclosures: “There is pending litigation against our company with
the likelihood of settlement probable. Detailed terms and damages have not yet reached agreement, and a reasonable assessment of
financial impact is currently unknown.”

11.3.6 [Link]
Reasonably Possible
Sierra Sports may have more litigation in the future surrounding the soccer goals. These lawsuits have not yet been filed or are in
the very early stages of the litigation process. Since there is a past precedent for lawsuits of this nature but no establishment of guilt
or formal arrangement of damages or timeline, the likelihood of occurrence is reasonably possible. The outcome is not probable but
is not remote either. Since the outcome is possible, the contingent liability is disclosed in Sierra Sports’ financial statement notes.
Sierra Sports could say the following in their financial statement disclosures: “We anticipate more claimants filing legal action
against our company with the likelihood of settlement reasonably possible. Assignment of guilt, detailed terms, and potential
damages have not been established. A reasonable assessment of financial impact is currently unknown.”

Remote
Sierra Sports worries that as a result of pending litigation and losses associated with the faulty soccer goals, the company might
have to file for bankruptcy. After consulting with a financial advisor, the company is pretty certain it can continue operating in the
long term without restructuring. The chances are remote that a bankruptcy would occur. Sierra Sports would not recognize this
remote occurrence on the financial statements or provide a note disclosure.

IFRS CONNECTION
Current Liabilities
US GAAP and International Financial Reporting Standards (IFRS) define “current liabilities” similarly and use the same reporting
criteria for most all types of current liabilities. However, two primary differences exist between US GAAP and IFRS: the reporting
of (1) debt due on demand and (2) contingencies.
Liquidity and solvency are measures of a company’s ability to pay debts as they come due. Liquidity measures evaluate a
company’s ability to pay current debts as they come due, while solvency measures evaluate the ability to pay debts long term. One
common liquidity measure is the current ratio, and a higher ratio is preferred over a lower one. This ratio—current assets divided
by current liabilities—is lowered by an increase in current liabilities (the denominator increases while we assume that the
numerator remains the same). When lenders arrange loans with their corporate customers, limits are typically set on how low
certain liquidity ratios (such as the current ratio) can go before the bank can demand that the loan be repaid immediately.
In theory, debt that has not been paid and that has become “on demand” would be considered a current liability. However, in
determining how to report a loan that has become “on-demand,” US GAAP and IFRS differ:
Under US GAAP, debts on which payment has been demanded because of violations of the contractual agreement between the
lender and creditor are only included in current liabilities if, by the financial statement presentation date, there have been no
arrangements made to pay off or restructure the debt. This allows companies time between the end of the fiscal year and the
actual publication of the financial statements (typically two months) to make arrangements for repayment of the loan. Most
often these loans are refinanced.
Under IFRS, any payment or refinancing arrangements must be made by the fiscal year-end of the debtor. This difference means
that companies reporting under IFRS must be proactive in assessing whether their debt agreements will be violated and make
appropriate arrangements for refinancing or differing payment options prior to final year-end numbers being reported.
A second set of differences exist regarding reporting contingencies. Where US GAAP uses the term “contingencies,” IFRS uses
“provisions.” In both cases, gain contingencies are not recorded until they are essentially realized. Both systems want to avoid
prematurely recording or overstating gains based on the principles of conservatism. Loss contingencies are recorded (accrued) if
certain conditions are met:
Under US GAAP, loss contingencies are accrued if they are probable and can be estimated. Probable means “likely” to occur
and is often assessed as an 80% likelihood by practitioners.
Under IFRS, probable is defined as “more likely than not” and is typically assessed at 50% by practitioners.
The determination of whether a contingency is probable is based on the judgment of auditors and management in both situations.
This means a contingent situation such as a lawsuit might be accrued under IFRS but not accrued under US GAAP. Finally, how a
loss contingency is measured varies between the two options as well. For example, if a company is told it will be probable that it
will lose an active lawsuit, and the legal team gives a range of the dollar value of that loss, under IFRS, the discounted midpoint of
that range would be accrued, and the range disclosed. Under US GAAP, the low end of the range would be accrued, and the range
disclosed.

11.3.7 [Link]
11.3: Define and Apply Accounting Treatment for Contingent Liabilities is shared under a CC BY-NC-SA license and was authored, remixed,
and/or curated by LibreTexts.
12.3: Define and Apply Accounting Treatment for Contingent Liabilities by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

11.3.8 [Link]
11.4: Prepare Journal Entries to Record Short-Term Notes Payable
If you have ever taken out a payday loan, you may have experienced a situation where your living expenses temporarily exceeded
your assets. You need enough money to cover your expenses until you get your next paycheck. Once you receive that paycheck,
you can repay the lender the amount you borrowed, plus a little extra for the lender’s assistance.
There is an ebb and flow to business that can sometimes produce this same situation, where business expenses temporarily exceed
revenues. Even if a company finds itself in this situation, bills still need to be paid. The company may consider a short-term note
payable to cover the difference.
A short-term note payable is a debt created and due within a company’s operating period (less than a year). Some key
characteristics of this written promise to pay (see Figure 12.12) include an established date for repayment, a specific payable
amount, interest terms, and the possibility of debt resale to another party. A short-term note is classified as a current liability
because it is wholly honored within a company’s operating period. This payable account would appear on the balance sheet under
Current Liabilities.

Figure 12.12 Short-Term Promissory Note. A promissory note includes terms of repayment, such as the date and interest rate.
(attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Debt sale to a third party is a possibility with any loan, which includes a short-term note payable. The terms of the agreement will
state this resale possibility, and the new debt owner honors the agreement terms of the original parties. A lender may choose this
option to collect cash quickly and reduce the overall outstanding debt.
We now consider two short-term notes payable situations; one is created by a purchase, and the other is created by a loan.

THINK IT THROUGH
Promissory Notes: Time to Issue More Debt?
A common practice for government entities, particularly schools, is to issue short-term (promissory) notes to cover daily
expenditures until revenues are received from tax collection, lottery funds, and other sources. School boards approve the note
issuances, with repayments of principal and interest typically met within a few months.
The goal is to fully cover all expenses until revenues are distributed from the state. However, revenues distributed fluctuate due to
changes in collection expectations, and schools may not be able to cover their expenditures in the current period. This leads to a
dilemma—whether or not to issue more short-term notes to cover the deficit.
Short-term debt may be preferred over long-term debt when the entity does not want to devote resources to pay interest over an
extended period of time. In many cases, the interest rate is lower than long-term debt, because the loan is considered less risky with
the shorter payback period. This shorter payback period is also beneficial with amortization expenses; short-term debt typically
does not amortize, unlike long-term debt.
What would you do if you found your school in this situation? Would you issue more debt? Are there alternatives? What are some
positives and negatives to the promissory note practice?

11.4.1 [Link]
Recording Short-Term Notes Payable Created by a Purchase
A short-term notes payable created by a purchase typically occurs when a payment to a supplier does not occur within the
established time frame. The supplier might require a new agreement that converts the overdue accounts payable into a short-term
note payable (see Figure 12.13), with interest added. This gives the company more time to make good on outstanding debt and
gives the supplier an incentive for delaying payment. Also, the creation of the note payable creates a stronger legal position for the
owner of the note, since the note is a negotiable legal instrument that can be more easily enforced in court actions.

Figure 12.13 Accounts Payable Conversion. Accounts Payable may be converted into a short-term notes payable, if there is a
default on payment. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
To illustrate, let’s revisit Sierra Sports’ purchase of soccer equipment on August 1. Sierra Sports purchased $12,000 of soccer
equipment from a supplier on credit. Credit terms were 2/10, n/30, invoice date August 1. Let’s assume that Sierra Sports was
unable to make the payment due within 30 days. On August 31, the supplier renegotiates terms with Sierra and converts the
accounts payable into a written note, requiring full payment in two months, beginning September 1. Interest is now included as part
of the payment terms at an annual rate of 10%. The conversion entry from an account payable to a Short-Term Note Payable in
Sierra’s journal is shown.

Accounts Payable decreases (debit) and Short-Term Notes Payable increases (credit) for the original amount owed of $12,000.
When Sierra pays cash for the full amount due, including interest, on October 31, the following entry occurs.

Since Sierra paid the full amount due, Short-Term Notes Payable decreases (debit) for the principal amount of the debt. Interest
Expense increases (debit) for two months of interest accumulation. Interest Expense is found from our earlier equation, where
Interest = Principal × Annual interest rate × Part of year ($12,000 × 10% × [2/12]), which is $200. Cash decreases (credit) for
$12,200, which is the principal plus the interest due.
The other short-term note scenario is created by a loan.

Recording Short-Term Notes Payable Created by a Loan

A short-term notes payable created by a loan transpires when a business incurs debt with a lender Figure 12.14. A business may
choose this path when it does not have enough cash on hand to finance a capital expenditure immediately but does not need long-

11.4.2 [Link]
term financing. The business may also require an influx of cash to cover expenses temporarily. There is a written promise to pay
the principal balance and interest due on or before a specific date. This payment period is within a company’s operating period (less
than a year). Consider a short-term notes payable scenario for Sierra Sports.

Figure 12.14 Bank Loan. A short-term note can be created from a loan. (credit: “Business Paperwork Deal” by “rawpixel”/Pixabay,
CC0)
Sierra Sports requires a new apparel printing machine after experiencing an increase in custom uniform orders. Sierra does not have
enough cash on hand currently to pay for the machine, but the company does not need long-term financing. Sierra borrows
$150,000 from the bank on October 1, with payment due within three months (December 31), at a 12% annual interest rate. The
following entry occurs when Sierra initially takes out the loan.

Cash increases (debit) as does Short-Term Notes Payable (credit) for the principal amount of the loan, which is $150,000. When
Sierra pays in full on December 31, the following entry occurs.

Short-Term Notes Payable decreases (a debit) for the principal amount of the loan ($150,000). Interest Expense increases (a debit)
for $4,500 (calculated as $150,000 principal × 12% annual interest rate × [3/12 months]). Cash decreases (a credit) for the principal
amount plus interest due.

LINK TO LEARNING
Loan calculators can help businesses determine the amount they are able to borrow from a lender given certain factors, such as loan
amount, terms, interest rate, and payback categorization (payback periodically or at the end of the loan, for example). A group of

11.4.3 [Link]
information technology professionals provides one such loan calculator with definitions and additional information and tools to
provide more information.

11.4: Prepare Journal Entries to Record Short-Term Notes Payable is shared under a CC BY-NC-SA license and was authored, remixed, and/or
curated by LibreTexts.
12.4: Prepare Journal Entries to Record Short-Term Notes Payable by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

11.4.4 [Link]
 CHAPTER OVERVIEW

12: Bonds Payable

12.1: Comparison Between Equity and Debt Financing
12.2: Explain the Pricing of Long-Term Liabilities
12.3: Recording Entries for Bonds
12.4: Explain the Pricing of Long-Term Liabilities
12.5: Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
12.6: Prepare Journal Entries to Reflect the Life Cycle of Bonds

12: Bonds Payable is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1
12.1: Comparison Between Equity and Debt Financing
Brief Comparison between Equity and Debt Financing
Debt financing means borrowing money that will be repaid on a specific date in the future. Many companies have started by
incurring debt. To decide whether this is a viable option, the owners need to determine whether they can afford the monthly
payments to repay the debt. One positive to this scenario is that interest paid on the debt is tax-deductible and can lower the
company’s tax liability. On the other hand, businesses can struggle to make these payments every month, especially as they are
starting out.
With equity financing, a business owner sells part of the business to obtain money to finance business operations. With this type of
financing, the original owner gives up some portion of ownership in the company in return for cash. Each partner’s share is based
on their financial or other contributions.
If a business owner forms a corporation, each owner will receive shares of stock. Typically, those making the largest financial
investment have the largest say in decisions about business operations. The issuance of dividends should also be considered in this
set-up. Paying dividends to shareholders is not tax-deductible, but dividend payments are also not required. Additionally, a
company does not have to buy back any stock it sells.

ETHICAL CONSIDERATIONS

Debt versus Equity Financing

Many start-ups and small companies with just one or two owners struggle to obtain the cash to run their operations. Owners
may want to use lending, or debt financing, to obtain the money to run operations, but have to turn to investors, or equity
financing. Ethical and legal obligations to investors are typically greater than ethical and legal obligations to lenders. This is
because a company’s owners have an ethical and legal responsibility to take investors’ interests into account when making
business decisions, even if the decision is not in the founding owners’ best interest. The primary obligation to lenders,
however, is only to pay back the money borrowed with interest. When determining which type of financing is appropriate for a
business operation, the different ethical and legal obligations between having lenders or investors need to be considered.9

Equity Financing
For a corporation, equity financing involves trading or selling shares of stock in the business to raise funds to run the business. For
a sole proprietorship, selling part of the business means it is no longer a sole proprietorship: the subsequent transaction could create
either a corporation or partnership. The owners would choose which of the two to create. Equity means ownership. However,
business owners can be creative in selling interest in their venture.
The main benefit of financing with equity is that the business owner is not required to pay back the invested funds, so revenue can
be re-invested in the company’s growth. Companies funded this way are also more likely to succeed through their initial years. The
Small Business Administration suggests a new business should have access to enough cash to operate for six months without
having to borrow. The disadvantages of this funding method are that someone else owns part of the business and, depending on the
arrangement, may have ideas that conflict with the original owner’s ideas but that cannot be disregarded.
The following characteristics are specific to equity financing:
1. No required payment to owners or shareholders; dividends or other distributions are optional. Stock owners typically invest in
stocks for two reasons: the dividends that many stocks pay or the appreciation in the market value of the stocks. For example, a
stock holder might buy Walmart stock for $100 per share with the expectation of selling it for much more than $100 per share at
some point in the future.
2. Ownership interest held by the original or current owners can be diluted by issuing additional new shares of common stock.
3. Unlike bonds that mature, common stocks do not have a definite life. To convert the stock to cash, some of the shares must be
sold.
4. In the past, common stocks were typically sold in even 100-share lots at a given market price per share. However, with Internet
brokerages today, investors can buy any particular quantity they want.

12.1.1 [Link]
Debt Financing
As you have learned, debt is an obligation to pay back an amount of money at some point in the future. Generally, a term of less
than one year is considered short-term, and a term of one year or longer is considered long-term. Borrowing money for college or a
car with a promise to pay back the amount to the lender generates debt. Formal debt involves a signed written document with a due
date, an interest rate, and the amount of the loan. A student loan is an example of a formal debt.
The following characteristics are specific to debt financing:
1. The company is required to make timely interest payments to the holders of the bonds or notes payable.
2. The interest in cash that is to be paid by the company is generally locked in at the agreed-upon rate, and thus the same dollar
payments will be made over the life of the bond. Virtually all bonds will have a maturity point. When the bond matures, the
maturity value, which was the same as the contract or issuance value, is paid to whoever owns the bond.
3. The interest paid is deductible on the company’s income tax return.
4. Bonds or notes payable do not dilute the company’s ownership interest. The holders of the long-term liabilities do not have an
ownership interest.
5. Bonds are typically sold in $1,000 increments.

Footnotes
9 Nolo. “Financing a Small Business: Equity or Debt?” Forbes. January 5, 2007.
[Link]

12.1: Comparison Between Equity and Debt Financing is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by
LibreTexts.

12.1.2 [Link]
12.2: Explain the Pricing of Long-Term Liabilities
Businesses have several ways to secure financing and, in practice, will use a combination of these methods to finance the business.
As you’ve learned, net income does not necessarily mean cash. In some cases, in the long-run, profitable operations will provide
businesses with sufficient cash to finance current operations and to invest in new opportunities. However, situations might arise
where the cash flow generated is insufficient to cover future anticipated expenses or expansion, and the company might need to
secure additional funding.
If the extra amount needed is somewhat temporary or small, a short-term source, such as a loan, might be appropriate. When
additional long-term funding needs arise, a business can choose to sell stock in the company (equity-based financing) or obtain a
long-term liability (debt-based financing), such as a loan that is spread over a period longer than a year.

Types of Long-Term Funding

If a company needs additional funding for a major expenditure, such as expansion, the source of funding would typically be repaid
over several years, or in the case of equity-based financing, over an indefinite period of time. With equity-based financing, the
company sells an interest in the company’s ownership by issuing shares of the company’s common stock. This financing option is
equity financing. Here, we will focus on two major long-term debt-based options: long-term loans and bonds.
Debt as an option for financing is an important source of funding for businesses. If a company chooses a debt-based option, the
business can borrow money on an intermediate (typically two to four years) or long-term (longer than four years) basis from
lenders. In the case of bonds, the funds would be provided by investors. While loans and bonds are similar in that they borrow
money on which the borrower will pay interest and eventually repay the lenders, they have some important differences. First, a
company can raise funds by borrowing from an individual, bank, or other lender, while a bond is typically sold to numerous
investors. When a company chooses a loan, the business signs what is known as a note, and a legal relationship called a note
payable is created between the borrower and the lender. The document lists the conditions of the financial arrangement, a fixed
predetermined interest rate (or, if the agreement allows, a variable interest rate), the amount borrowed, the borrowing costs to be
charged, and the timing of the payments. In some cases, companies will secure an interest-only loan, which means that for the life
of the loan the organization pays only the interest expense that has accrued and upon maturity repays the original amount that it
borrowed and still owes. For individuals, a student loan, car loan, or a mortgage can all be types of notes payable. For Olivia’s car
purchase in Why It Matters, a document such as a promissory note is typically created, representing a personal loan agreement
between a lender and borrower. Figure 12.2.1 shows a sample promissory note that might be used for a simple, relatively
intermediate-term loan. If we were considering a loan that would be repaid over a several-year period the document might be a
little more complicated, although it would still have many of the same components of Olivia’s loan document.

12.2.1 [Link]
 Figure 12.2.1 : Promissary Note. A personal loan agreement is a formal contract between a lender and borrower. The document lists
the conditions of the loan, including the amount borrowed, the borrowing costs to be charged, and the timing of the payments.
(attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
If debt instruments are created with a variable interest rate that can fluctuate up or down, depending upon predetermined factors, an
inflation measurement must also be included in the documentation. The Federal Funds Rate, for example, is a commonly used tool
for potential adjustments in interest rates. To keep our discussion simple, we will use a fixed interest rate in our subsequent
calculations.
Another difference between loans and bonds is that the note payable creates an obligation for the borrower to repay the lender on a
specified date. To demonstrate the mechanics of a loan, with loans, a note payable is created for the borrower when the loan is
initiated. This example assumes the loan will be paid in full by the maturity or due date. Typically, over the life of the loan,
payments will be composed of both principal and interest components. The principal component paid typically reduces the amount
that the borrower owes the lender. For example, assume that a company borrowed $10,000 from a lender under the following
terms: a five-year life, an annual interest rate of 10%, and five annual payments at the end of the year.
Under these terms, the annual payment would be $2,637.97. The first year’s payment would be allocated to an interest expense of
$1,000, and the remaining amount of the payment would go to reduce the amount borrowed (principal) by $1,637.97. After the first
year’s payment, the company would owe a remaining balance of $8,362.03 ($10,000 – $1637.97.)
Typical long-term loans have other characteristics. For example, most long-term notes are held by one entity, meaning one party
provides all of the financing. If a company bought heavy-duty equipment from Caterpillar, it would be common for the seller of the
equipment to also have a division that would provide the financing for the transaction. An additional characteristic of a long-term
loan is that in many, if not most, situations, the initial creator of the loan will hold it and receive and process payments until it
matures.
Returning to the differences between long-term debt and bonds, another difference is that the process for issuing (selling) bonds
can be very complicated, especially for companies that are subject to regulation. The bond issue must be approved by the
appropriate regulatory agency, and then outside parties such as investment banks sell the bonds to, typically, a large audience of
investors. It is not unusual for several months to pass between the time that the company’s board of directors approves the bond
offering, gets regulatory approval, and then markets and issues the bonds. This additional time is often the reason that the market
rate for similar bonds in the outside business environment is higher or lower than the stated interest rate that the company
committed to pay when the bond process was first begun. This difference can lead to bonds being issued (sold) at a discount or
premium.
Finally, while loans can normally be paid off before they are due, in most cases bonds must be held by an owner until they mature.
Because of this last characteristic, a bond, such as a thirty-year bond, might have several owners over its lifetime, while most long-
term notes payable will only have one owner.

12.2.2 [Link]
 ETHICAL CONSIDERATIONS

Bond Fraud
The U.S. Department of the Treasury (DOT) defines historical bonds as “those bonds that were once valid obligations of
American entities but are now worthless as securities and are quickly becoming a favorite tool of scam artists.”1 The DOT also
warns against scams selling non-existent “limited edition” U.S. Treasury securities. The scam involves approaching broker-
dealers and banks to act as fiduciaries for transactions. Further, the DOT notes: “The proposal to sell these fictitious securities
makes misrepresentations about the way marketable securities are bought and sold, and it also misrepresents the role that we
play in the original sale and issuance of our securities.”2 Many fraudulent attempts are made to sell such bonds.
According to Business Insider, in the commonest scam, a fake bearer bond is offered for sale for far less than its stated cover
price. The difference in the cost and the cover price entices the victim to buy the bond. Again, from Business Insider: “Another
variation is a flavor of the ‘Nigerian prince’ scheme; the fraudster will ask for the victim’s help in depositing a recently
obtained ‘fortune’ in bonds, promising the victim a cut in return.”3
A diligent accountant is both educated about the investments of their company or organization and is skeptical about any
investment that looks too good to be true.

YOUR TURN

Current versus Long-Term Liabilities

Below is a portion of the 2017 Balance Sheet of Emerson, Inc. (shown in millions of dollars).4 There are several observations
we can make from this information.

Notice the company lists separately the Current Liabilities (listed as “Short-term borrowings and current maturities of long-
term debt”) and Long-term Liabilities (listed as “Long-term debt”). Also, under the “Current liabilities” heading, notice the
“Short-term borrowings and current maturities of long-term debt” decreased significantly from 2016 to 2017. In 2016,
Emerson held $2.584 billion in short-term borrowings and current maturities of long-term debt. This amount decreased by
$1.722 billion in 2017, which is a 67% decrease. During the same timeframe, long-term debt decreased $257 million, going
from $4.051 billion to $3.794 billion, which is a 6.3% decrease.
Thinking about the primary purpose of accounting, why do you think accountants separate liabilities into current liabilities and
long-term liabilities?

Answer
The primary purpose of accounting is to provide stakeholders with financial information that is useful for decision making.
It is important for stakeholders to understand how much cash will be required to satisfy liabilities within the next year
(liquidity) as well as how much will be required to satisfy long-term liabilities (solvency). Stakeholders, especially lenders
and owners, are concerned with both liquidity and solvency of the business.

Fundamentals of Bonds
Now let us look at bonds in more depth. A bond is a type of financial instrument that a company issues directly to investors,
bypassing banks or other lending institutions, with a promise to pay the investor a specified rate of interest over a specified period
of time. When a company borrows money by selling bonds, it is said the company is “issuing” bonds. This means the company
exchanges cash for a promise to repay the cash, along with interest, over a set period of time. As you’ve learned, bonds are formal
legal documents that contain specific information related to the bond. In short, it is a legal contract—called a bond certificate (as
shown in Figure 12.2.2) or an indenture—between the issuer (the business borrowing the money) and the lender (the investor
lending the money). Bonds are typically issued in relatively small denominations, such as $1,000 so they can be placed in the
market and are accessible to a greater market of investors compared to notes. The bond indenture is a contract that lists the

12.2.3 [Link]
features of the bond, such as the amount of money that will be repaid in the future, called the principal (also called face value or
maturity value); the maturity date, the day the bond holder will receive the principal amount; and the stated interest rate, which
is the rate of interest the issuer agrees to pay the bondholder throughout the term of the bond.

Figure 12.2.2 : Bond Certificate. If you bought this $1,000 bond on July 1, 2018 and received this bond certificate, it had three
important pieces of information: the maturity date (June 30, 2023, 5 years from the issue date when the company will pay back the
$1,000; the principal amount ($1,000) which is the amount you will receive in 2023; and the stated annual interest rate (5%) which
they will use to determine how much cash to send you each year (0.05 × $1,000 = $50 interest a year for 5 years). (attribution:
Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
For a typical bond, the issuer commits to paying a stated interest rate either once a year (annually) or twice a year (semiannually). It
is important to understand that the stated rate will not go up or down over the life of the bond. This means the borrower will pay the
same semiannual or annual interest payment on the same dates for the life of the bond. In other words, when an investor buys a
typical bond, the investor will receive, in the future, two major cash flows: periodic interest payments paid either annually or
semiannually based on the stated rate of the bond, and the maturity value, which is the total amount paid to the owner of the bond
on the maturity date.

LINK TO LEARNING
The website for the nonprofit Kiva allows you to lend money to people around the world. The borrower makes monthly
payments to pay the loan back. The companies Prosper and LendingClub let you borrow or lend money to people in the U.S.
who then make monthly payments, with interest, to pay it back.

The process of preparing a bond issuance for sale and then selling on the primary market is lengthy, complex, and is usually
performed by underwriters—finance professionals who specialize in issuing bonds and other financial instruments. Here, we will
only examine transactions concerning issuance, interest payments, and the sale of existing bonds.
There are two other important characteristics of bonds to discuss. First, for most companies, the total value of bonds issued can
often range from hundreds of thousands to several million dollars. The primary reason for this is that bonds are typically used to
help finance significant long-term projects or activities, such as the purchase of equipment, land, buildings, or another company.

CONCEPTS IN PRACTICE

Apple Inc. Issues Bonds

On May 11, 2017, Apple Inc. issued bonds to get cash. Apple Inc. submitted a form to the Securities and Exchange
Commission ([Link]) to announce their intentions.

12.2.4 [Link]
 On May 3 of the same year, Apple Inc. had issued their 10-Q (quarterly report) that showed the following assets.

Apple Inc. reported it had $15 billion dollars in cash and a total of $101 billion in Current Assets. Why did it need to issue
bonds to raise $7 billion more?
Analysts suggested that Apple would use the cash to pay shareholder dividends. Even though Apple reported billions of
dollars in cash, most of the cash was in foreign countries because that was where the products had been sold. Tax laws vary by
country, but if Apple transferred the cash to a US bank account, they would have to pay US income tax on it, at a tax rate as
high as 39%. So, Apple was much better off borrowing and paying 3.2% interest, which is tax deductible, than bringing the
cash to the US and paying a 39% income tax.
However, it’s important to remember that in the United States, Congress can change tax laws at any time, so what was then
current tax law when this transaction occurred could change in the future.

The second characteristic of bonds is that bonds are often sold to several investors instead of to one individual investor.
When establishing the stated rate of interest the business will pay on a bond, bond underwriters consider many factors, including
the interest rates on government treasury bonds (which are assumed to be risk-free), rates on comparable bond offerings, and firm-
specific factors related to the business’s risk (including its ability to repay the bond). The more likely the possibility that a company
will default on the bond, meaning they either miss an interest payment or do not return the maturity amount to the bond’s owner
when it matures, the higher the interest rate is on the bond. It is important to understand that the stated rate will not change over the
life of any one bond once it is issued. However, the stated rate on future new bonds may change as economic circumstances and the
company’s financial position changes.
Bonds themselves can have different characteristics. For example, a debenture is an unsecured bond issued based on the good
name and reputation of the company. These companies are not pledging other assets to cover the amount in case they fail to pay the
debt, or default. The opposite of a debenture is a secured bond, meaning the company is pledging a specific asset as collateral for
the bond. With a secured bond, if the company goes under and cannot pay back the bond, the pledged asset would be sold, and the
proceeds would be distributed to the bondholders.
There are term bonds, or single-payment bonds, meaning the entire bond will be repaid all at once, rather than in a series of
payments. And there are serial bonds, or bonds that will mature over a period of time and will be repaid in a series of payments.
A callable bond (also known as a redeemable bond) is one that can be repurchased or “called” by the issuer of the bond. If a
company sells callable bonds with an 8% interest rate and the interest rate the bank is offering subsequently drops to 5%, the
company can borrow at that new rate of 5%, call the 8% bonds, and pay them off (even if the purchaser does not want to sell them
back). In essence, the institution would be lowering its rate of interest to borrow money from 8% to 5% by calling the bond.

12.2.5 [Link]
Putable bonds give the bondholder the right to decide whether to sell it back early or keep it until it matures. It is essentially the
opposite of a callable bond.
A convertible bond can be converted to common stock in a one-way, one-time conversion. Under what conditions would it make
sense to convert? Suppose the face-value interest rate of the bond is 8%. If the company is doing well this year, such that there is an
expectation that shareholders will receive a significant dividend and the stock price will rise, the stock might appear to be more
valuable than the return on the bond.

THINK IT THROUGH

Callable versus Putable Bonds

Which type of bond is better for the corporation issuing the bond: callable or putable?

ETHICAL CONSIDERATIONS

Junk Bonds
Junk bonds, which are also called speculative or high-yield bonds, are a specific type of bond that can be attractive to certain
investors. On one hand, junk bonds are attractive because the bonds pay a rate of interest that is significantly higher than the
average market rate. On the other hand, the bonds are riskier because the issuing company is deemed to have a higher risk of
defaulting on the bonds. If the economy or the company’s financial condition deteriorates, the company will be unable to repay
the money borrowed. In short, junk bonds are deemed to be high risk, high reward investments.
The development of the junk bond market, which occurred during the 1970s and 1980s, is attributed to Michael Milken, the so-
called “junk bond king.” Milken amassed a large fortune by using junk bonds as a means of financing corporate mergers and
acquisitions. It is estimated that during the 1980s, Milken earned between $200 million and $550 million per year.5 In 1990,
however, Milken’s winning streak came to an end when, according to the New York Times, he was indicted on “98 counts of
racketeering, securities fraud, mail fraud and other crimes.”6 He later pleaded guilty to six charges, resulting in a 10-year
prison sentence, of which he served two, and was as also forced to pay over $600 million in fines and settlements.7
Today, Milken remains active in philanthropic activities and, as a cancer survivor, remains committed to medical research.

Pricing Bonds
Imagine a concert-goer who has an extra ticket for a good seat at a popular concert that is sold out. The concert-goer purchased the
ticket from the box office at its face value of $100. Because the show is sold out, the ticket could be resold at a premium. But what
happens if the concert-goer paid $100 for the ticket and the show is not popular and does not sell out? To convince someone to
purchase the ticket from her instead of the box office, the concert-goer will need to sell the ticket at a discount. Bonds behave in the
same way as this concert ticket.
Bond quotes can be found in the financial sections of newspapers or on the Internet on many financial websites. Bonds are quoted
as a percentage of the bond’s maturity value. The percentage is determined by dividing the current market (selling) price by the
maturity value, and then multiplying the value by 100 to convert the decimal into a percentage. In the case of a $30,000 bond
discounted to $27,591.94 because of an increase in the market rate of interest, the bond quote would be $27,591.24/$30,000 × 100,
or 91.9708. Using another example, a quote of 88.50 would mean that the bonds in question are selling for 88.50% of the maturity
value. If an investor were considering buying a bond with a $10,000 maturity value, the investor would pay 88.50% of the maturity
value of $10,000, or $8,850.00. If the investor was considering bonds with a maturity value of $100,000, the price would be
$88,500. If the quote were over 100, this would indicate that the market interest rate has decreased from its initial rate. For
example, a quote of 123.45 indicates that the investor would pay $123,450 for a $100,000 bond.
Figure 12.2.3 shows a bond issued on July 1, 2018. It is a promise to pay the holder of the bond $1,000 on June 30, 2023, and 5%
of $1,000 every year. We will use this bond to explore how a company addresses interest rate changes when issuing bonds.

12.2.6 [Link]
 Figure 12.2.3 : Bond Certificate. A bond certificate shows the terms of the bond. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)
On this bond certificate, we see the following:
The $1,000 principal or maturity value.
The interest rate printed on the face of the bond is the stated interest rate, the contract rate, the face rate, or the coupon rate.
This rate is the interest rate used to calculate the interest payment on bonds.

Footnotes
1 U.S. Department of the Treasury. “Historical Bond Fraud.” September 21, 2012. [Link]
[Link]
2 U.S. Department of the Treasury. “Examples of Known Phony Securities.” April 5, 2013.
[Link]
3 Lawrence Delavigne. “Fake Bearer Bonds Were Just the Beginning of Huge Wave of Bond-Fraud.” Business Insider. October
12, 2009. [Link]
4 Emerson. 2017 Annual Report. Emerson Electric Company. 2017. [Link]
5 James Chen. “Micheal Milken.” January 22, 2018. [Link]
6 Kurt Eichenwald. “Milken Set to Pay a $600 Million Fine in Wall St. Fraud.” April 21, 1990.
[Link]
7 Michael Buchanan. “November 21, 1990, Michael Milken Sentenced to 10 Years for Security Law Violations.” November 20,
2011. [Link]/criminall...rime-history-1

12.2: Explain the Pricing of Long-Term Liabilities is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by
LibreTexts.

12.2.7 [Link]
12.3: Recording Entries for Bonds
Bond Prices and Interest Rates
The price of a bond issue often differs from its face value. The amount a bond sells for above face value is a premium. The amount
a bond sells for below face value is a discount. A difference between face value and issue price exists whenever the market rate of
interest for similar bonds differs from the contract rate of interest on the bonds. The effective interest rate (also called the yield) is
the minimum rate of interest that investors accept on bonds of a particular risk category. The higher the risk category, the higher the
minimum rate of interest that investors accept. The contract rate of interest is also called the stated, coupon, or nominal rate is the
rate used to pay interest. Firms state this rate in the bond indenture, print it on the face of each bond, and use it to determine the
amount of cash paid each interest period. The market rate fluctuates from day to day, responding to factors such as the interest rate
the Federal Reserve Board charges banks to borrow from it; government actions to finance the national debt; and the supply of, and
demand for, money.
Market and contract rates of interest are likely to differ. Issuers must set the contract rate before the bonds are actually sold to allow
time for such activities as printing the bonds. Assume, for instance, that the contract rate for a bond issue is set at 12%. If the
market rate is equal to the contract rate, the bonds will sell at their face value. However, by the time the bonds are sold, the market
rate could be higher or lower than the contract rate.

Market Rate = Contract Rate Bond sells at par (or face or 100%)

Market Rate < Contract Rate Bonds sells at premium (price greater than 100%)

Market Rate > Contract Rate Bond sells at discount (price less than 100%)

As shown above, if the market rate is lower than the contract rate, the bonds will sell for more than their face value. Thus, if the
market rate is 10% and the contract rate is 12%, the bonds will sell at a premium as the result of investors bidding up their price.
However, if the market rate is higher than the contract rate, the bonds will sell for less than their face value. Thus, if the market rate
is 14% and the contract rate is 12%, the bonds will sell at a discount. Investors are not interested in bonds bearing a contract rate
less than the market rate unless the price is reduced. Selling bonds at a premium or a discount allows the purchasers of the bonds to
earn the market rate of interest on their investment.

12.3: Recording Entries for Bonds is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

12.3.1 [Link]
12.4: Explain the Pricing of Long-Term Liabilities
Issuing Bonds When the Contract and Market Rates Are the Same
If the stated rate and the market rate are both 5%, the bond will be issued at par value, which is the value assigned to stock in the
company’s charter, typically set at a very small arbitrary amount, which serves as legal capital; in our example, the part value is
$1,000. The purchaser will give the company $1,000 today and will receive $50 at the end of every year for 5 years. In 5 years, the
purchaser will receive the maturity value of the $1,000. The bond’s quoted price is 100.00. That is, the bond will sell at 100% of
the $1,000 face value, which means the seller of the bond will receive (and the investor will pay) $1,000.00. You will learn the
calculations used to determine a bond’s quoted price later; here, we will provide the quoted price for any calculations.

LINK TO LEARNING
The Securities and Exchange Commission website [Link] provides an explanation of corporate bonds to learn more.

Issuing Bonds at a Premium

The stated interest rate is not the only rate affecting bonds. There is also the market interest rate, also called the effective interest
rate or bond yield. The amount of money that borrowers receive on the date the bonds are issued is influenced by the terms stated
on the bond indenture and on the market interest rate, which is the rate of interest that investors can earn on similar investments.
The market interest rate is influenced by many factors external to the business, such as the overall strength of the economy, the
value of the U.S. dollar, and geopolitical factors.
This market interest rate is the rate determined by supply and demand, the current overall economic conditions, and the credit
worthiness of the borrower, among other factors. Suppose that, while a company has been busy during the long process of getting
its bonds approved and issued (it might take several months), the interest rate changed because circumstances in the market
changed. At this point, the company cannot change the rate used to market the bond issue. Instead, the company might have to sell
the bonds at a price that will be the equivalent of having a different stated rate (one that is equivalent to a market rate based on the
company’s financial characteristics at the time of the issuance (sale) of the bonds).
If the company offers 5% (the bond rate used to market the bond issue) and the market rate prior to issuance drops to 4%, the bonds
will be in high demand. The company is scheduled to pay a higher interest rate than everyone else, so it can issue them for more
than face value, or at a premium. In this example, where the stated interest rate is higher than the market interest rate, let’s say the
bond’s quoted price is 104.46. That is, the bond will sell at 104.46% of the $1,000 face value, which means the seller of the bond
will receive and the investor will pay $1,044.60.

Issuing Bonds at a Discount

Now let’s consider a situation when the company’s bonds prior to issuance are scheduled to pay 5% and the market rate jumps to
7% at issuance. No one will want to buy the bonds at 5% when they can earn more interest elsewhere. The company will have to
sell the $1,000 bond for less than $1,000, or at a discount. In this example, where the stated interest rate is lower than the market
interest rate, the bond’s quoted price is 91.80. That is, the bond will sell at 91.80% of the $1,000 face value, which means the seller
of the bond will receive (and the investor will pay) $918.00.

Sale of Bonds before Maturity

Let’s look at bonds from the perspective of the issuer and the investor. As we previously discussed, bonds are often classified as
long-term liabilities because the money is borrowed for long periods of time, up to 30 years in some cases. This provides the
business with the money necessary to fund long-term projects and investments in the business. Due to unanticipated circumstances,
the investors, on the other hand, may not want to wait up to 30 years to receive the maturity value of the bond. While the investor
will receive periodic interest payments while the bond is held, investors may want to receive the current market value prior to the
maturity date. Therefore, from the investor’s perspective, one of the advantages of investing in bonds is that they are typically easy
to sell in the secondary market should the investor need the money before the maturity date, which may be many years in the
future. The secondary market is an organized market where previously issued stocks and bonds can be traded after they are
issued.
If a bond sells on the secondary market after it has been issued, the terms of the bond (a particular interest rate, at a determined
timeframe, and a given maturity value) do not change. If an investor buys a bond after it is issued or sells it before it matures, there

12.4.1 [Link]
is the possibility that the investor will receive more or less for the bond than the amount the bond was originally sold for. This
change in value may occur if the market interest rate differs from the stated interest rate.

CONTINUING APPLICATION

Debt Considerations for Grocery Stores

Every company faces internal decisions when it comes to borrowing funds for improvements and/or expansions. Consider the
improvements your local grocery stores have made over the past couple of years. Just like any large retail business, if grocery
stores don’t invest in each property by adding services, upgrading the storefront, or even making more energy-efficient
changes, the location can fall out of popularity.
Such investments require large amounts of capital infusion. The primary available investment funds for privately-owned
grocery chains are bank loans or owners’ capital. This limitation often restricts the expansions or upgrades such a company can
do at any one time. Publicly-traded grocery chains can also borrow funds from a bank, but other options, like issuing bonds or
more stock can also help fund development. Thus publicly-traded grocery chains have more options to fund improvements and
can therefore expand their share of the market more easily, unlike their private smaller counterparts who must decide what
improvement is the most critical.

Fundamentals of Interest Calculation

Since interest is paid on long-term liabilities, we now need to examine the process of calculating interest. Interest can be calculated
in several ways, some more common than others. For our purposes, we will explore interest calculations using the simple method
and the compounded method. Regardless of the method involved, there are three components that we need when calculating
interest:
1. Amount of money borrowed (called the principal).
2. Interest rate for the time frame of the loan. Note that interest rates are usually stated in annual terms (e.g., 8% per year). If the
timeframe is excluded, an annual rate should be assumed. Pay particular attention to how often the interest is to be paid because
this will affect the rate used in the calculation:

For example, if the rate on a bond is 6% per year but the interest is paid semi-annually, the rate used in the interest calculation
should be 3% because the interest applies to a 6-month timeframe (6% ÷ 2). Similarly, if the rate on a bond is 8% per year but
the interest is paid quarterly, the rate used in the interest calculation should be 2% (8% ÷ 4).
3. Time period for which we are calculating the interest.
Let’s explore simple interest first. We use the following formula to calculate interest in dollars:

Principal is the amount of money invested or borrowed, interest rate is the interest rate paid or earned, and time is the length of
time the principal is borrowed or invested. Consider a bank deposit of $100 that remains in the account for 3 years, earning 6% per
year with the bank paying simple interest. In this calculation, the interest rate is 6% a year, paid once at the end of the year. Using
the interest rate formula from above, the interest rate remains 6% (6% ÷ 1). Using 6% interest per year earned on a $100 principal
provides the following results in the first three years (Figure 12.4.1):
Year 1: The $100 in the bank earns 6% interest, and at the end of the year, the bank pays $6.00 in interest, making the amount in
the bank account $106 ($100 principal + $6 interest).
Year 2: Assuming we do not withdraw the interest, the $106 in the bank earns 6% interest on the principal ($100), and at the
end of the year, the bank pays $6 in interest, making the total amount $112.
Year 3: Again, assuming we do not withdraw the interest, $112 in the bank earns 6% interest on the principal ($100), and at the
end of the year, the bank pays $6 in interest, making the total amount $118.

12.4.2 [Link]
 Figure 12.4.1 : Simple Interest. Simple interest earns money only on the principal. (attribution: Copyright Rice University,
OpenStax, under CC BY-NC-SA 4.0 license)
With simple interest, the amount paid is always based on the principal, not on any interest earned.
Another method commonly used for calculating interest involves compound interest. Compound interest means that the interest
earned also earns interest. Figure 12.4.2 shows the same deposit with compounded interest.

Figure 12.4.2 : Compund Interest. Compound interest earns money on the principal plus interest earned in a previous period.
(attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
In this case, investing $100 today in a bank that pays 6% per year for 3 years with compound interest will produce $119.10 at the
end of the three years, instead of $118.00, which was earned with simple interest.
At this point, we need to provide an assumption we make in this chapter. Since financial institutions typically cannot deal in
fractions of a cent, in calculations such as the above, we will round the final answer to the nearest cent, if necessary. For example,
the final cash total at the end of the third year in the above example would be $119.1016. However, we rounded the answer to the
nearest cent for convenience. In the case of a car or home loan, the rounding can lead to a higher or lower adjustment in your final
payment. For example, you might finance a car loan by borrowing $20,000 for 48 months with monthly payments of $469.70 for
the first 47 months and $469.74 for the final payment.

LINK TO LEARNING
Go to the Securities and Exchange Commission website for an explanation of US Savings Bonds to learn more.

12.4: Explain the Pricing of Long-Term Liabilities is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by
LibreTexts.

12.4.3 [Link]
12.5: Compute Amortization of Long-Term Liabilities Using the Effective-Interest
Method
Bonds Payable
As you’ve learned, each time a company issues an interest payment to bondholders, amortization of the discount or premium, if one
exists, impacts the amount of interest expense that is recorded. Amortization of the discounts increases the amount of interest
expense and premiums reduce the amount of interest expense. There are two methods used to amortize bond discounts or
premiums: the effective-interest method and the straight-line method.
Our calculations have used what is known as the effective-interest method, a method that calculates interest expense based on the
carrying value of the bond and the market interest rate. Generally accepted accounting principles (GAAP) require the use of the
effective-interest method unless there is no significant difference between the effective-interest method and the straight-line
method, a method that allocates the same amount of the bond discount or premium for each interest payment. The effective interest
amortization method is more accurate than the straight-line method. International Financial Reporting Standards (IFRS) require the
use of the effective-interest method, with no exceptions.
The straight-line method doesn’t base its calculation of amortization for a period base on a changing carrying value like the
effective-interest method does; instead, it allocates the same amount of premium or discount amortation for each of the bond’s
payment periods.
For example, assume that $500,000 in bonds were issued at a price of $540,000 on January 1, 2019, with the first annual interest
payment to be made on December 31, 2019. Assume that the stated interest rate is 10% and the bond has a four-year life. If the
straight-line method is used to amortize the $40,000 premium, you would divide the premium of $40,000 by the number of
payments, in this case four, giving a $10,000 per year amortization of the premium. Figure 12.5.1 shows the effects of the premium
amortization after all of the 2019 transactions are considered. The net effect of creating the $40,000 premium and writing off
$10,000 of it gives the company an interest expense of $40,000 instead of $50,000, since the $50,000 expense is reduced by the
$10,000 premium write down at the end of the year.

Figure 12.5.1 : Premium Amortization Using the Straight-Line Method. (attribution: Copyright Rice University, OpenStax, under
CC BY-NC-SA 4.0 license)

Issued When Market Rate Equals Contract Rate

Assume a company issues a $100,000 bond with a 5% stated rate when the market rate is also 5%. The bond was issued at par,
meaning it sold for $100,000. There was no premium or discount to amortize, so there is no application of the effective-interest
method in this example.

Issued at a Premium
The same company also issued a 5-year, $100,000 bond with a stated rate of 5% when the market rate was 4%. This bond was
issued at a premium, for $104,460. The amount of the premium is $4,460, which will be amortized over the life of the bond using
the effective-interest method. This method of amortizing the interest expense associated with a bond is similar to the amortization
of the note payable described earlier, in which the principal was separated from the interest payments using the interest rate times
the principal.
Begin by assuming the company issued all the bonds on January 1 of year 1 and the first interest payment will be made on
December 31 of year 1. The amortization table begins on January 1, year 1, with the carrying value of the bond: the face value of

12.5.1 [Link]
the bond plus the bond premium.
On December 31, year 1, the company will have to pay the bondholders $5,000 (0.05 × $100,000). The cash interest payment is the
amount of interest the company must pay the bondholder. The company promised 5% when the market rate was 4% so it received
more money. But the company is only paying interest on $100,000—not on the full amount received. The difference in the sale
price was a result of the difference in the interest rates so both rates are used to compute the true interest expense.

The interest on the carrying value is the market rate of interest times the carrying value: 0.04 × $104,460 = $4,178. If the company
had issued the bonds with a stated rate of 4%, and received $104,460, it would be paying $4,178 in interest. The difference between
the cash interest payment and the interest on the carrying value is the amount to be amortized the first year. The complete
amortization table for the bond is shown in Figure 12.5.2. The table is necessary to provide the calculations needed for the
adjusting journal entries.

Figure 12.5.2 : Bond Amortization Table. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

12.5.2 [Link]
Issued at a Discount
The company also issued $100,000 of 5% bonds when the market rate was 7%. It received $91,800 cash and recorded a Discount
on Bonds Payable of $8,200. This amount will need to be amortized over the 5-year life of the bonds. Using the same format for an
amortization table, but having received $91,800, interest payments are being made on $100,000.

The cash interest payment is still the stated rate times the principal. The interest on carrying value is still the market rate times the
carrying value. The difference in the two interest amounts is used to amortize the discount, but now the amortization of discount
amount is added to the carrying value.

Figure 12.5.3 illustrates the relationship between rates whenever a premium or discount is created at bond issuance.

Figure 12.5.3 : Stated Rate and Market Rate. When the stated rate is higher than the market rate, the bond is issued at a premium.
When the stated rate is lower than the market rate, the bond is issued at a discount. (attribution: Copyright Rice University,
OpenStax, under CC BY-NC-SA 4.0 license)

CONCEPTS IN PRACTICE

Bond Ratings
Investors intending to purchase corporate bonds may find it overwhelming to decide which company would be the best to
invest in. Investors are concerned with two primary factors: the return on the investment (meaning, the periodic interest
payments) and the return of the investment (meaning, payment of the face value on the maturity date). While there are risks
with any investment, attempting to maximize the return on the investment and maximizing the likelihood receiving the return
of the investment would take a significant amount of time for the investor. To become informed and make a wise investment,
the investor would have to spend many hours analyzing the financial statements of potential companies to invest in.
One resource investors find useful when screening investment opportunities is through the use of rating agencies. Rating
agencies specialize in analyzing financial and other company information in order to assess and rate a company’s riskiness as
an investment. A particularly useful website is Investopedia which highlights the rating system for three large rating agencies
—Moody’s, Standard & Poor’s, and Fitch Ratings. The rating systems, shown below, are somewhat similar to academic
grading scales, with rankings ranging from A (highest quality) to D (lowest quality):
Rating Agencies8

12.5.3 [Link]
 Credit Risk Moody’s Standard & Poor’s Fitch Ratings

Investment Grade — — —

Highest Quality Aaa AAA AAA

High Quality Aa1, Aa2, Aa3 AA+, AA, AA– AA+, AA, A–

Upper Medium A1, A2, A3 A+, A, A– A+, A, A–

Medium Baa1, Baa2, Baa3 BBB+, BBB, BBB– BBB+, BBB, BBB–

Not Investment Grade Ba1 BB+ BB+

Speculative Medium Ba2, Ba3 BB, BB– BB, BB–

Speculative Lower Grade B1, B2, B3 B+, B, B– B+, B, B–

Speculative Risky Caa1 CCC+ CCC

Speculative Poor Standing Caa2, Caa3 CCC, CCC– —

No Payments / Bankruptcy Ca / C — —

In Default — D DDD, DD, D

Table 12.5.1

Footnotes
8 Michael Schmidt. “When to Trust Bond Rating Agencies.” Investopedia. September 29, 2018.
[Link]

12.5: Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method is shared under a CC BY-NC-SA license and was
authored, remixed, and/or curated by LibreTexts.

12.5.4 [Link]
12.6: Prepare Journal Entries to Reflect the Life Cycle of Bonds
Recall from the discussion in Explain the Pricing of Long-Term Liabilities that one way that businesses can generate long-term
financing is by borrowing from lenders.
In this section, we will explore the journal entries related to bonds. Earlier, we found that cash flows related to a bond include the
following:
1. The receipt of cash when the bond is issued
2. Payment of interest each period
3. Repayment of the bond at maturity
A journal entry must be made for each of these transactions. As we go through the journal entries, it is important to understand that
we are analyzing the accounting transactions from the perspective of the issuer of the bond. These are considered long-term
liabilities. The investor would make the opposite journal entries. For example, on the issue date of a bond, the borrower receives
cash while the lender pays cash.
A final point to consider relates to accounting for the interest costs on the bond. Recall that the bond indenture specifies how much
interest the borrower will pay with each periodic payment based on the stated rate of interest. The periodic interest payments to the
buyer (investor) will be the same over the course of the bond. It may help to think of personal loan examples. For example, if you
or your family have ever borrowed money from a bank for a car or home, the payments are typically the same each month. The
interest payments will be the same because of the rate stipulated in the bond indenture, regardless of what the market rate does. The
amount of interest cost that we will recognize in the journal entries, however, will change over the course of the bond term,
assuming that we are using the effective interest.

IFRS CONNECTION

Defining Long-Term Liabilities

Under both IFRS and US GAAP, the general definition of a long-term liability is similar. However, there are many types of
long-term liabilities, and various types have specific measurement and reporting criteria that may differ between the two sets of
accounting standards. With two exceptions, bonds payable are primarily the same under the two sets of standards.
The first difference pertains to the method of interest amortization. Beyond FASB’s preferred method of interest amortization
discussed here, there is another method, the straight-line method. This method is permitted under US GAAP if the results
produced by its use would not be materially different than if the effective-interest method were used. IFRS does not permit
straight-line amortization and only allows the effective-interest method.
The second difference pertains to how the bonds are reported on the books. Under US GAAP, bonds are recorded at face value
and the premium or discount is recorded in a separate account. IFRS does not use “premium” or “discount” accounts. Instead,
under IFRS, the carrying value of bonds issued at either a premium or discount is shown on the balance sheet at its net. For
example, $100,000 bonds issued at a discount of $4,000 would be recorded under US GAAP as
Journal entry: debit cash 94,000, debit Discount on Bonds Payabl 6,000, credit Bonds Payable 100,000.

Under IFRS, these bonds would be reported as

Journal entry: debit Cash and credit Bonds Payable each for 94,000.

Obviously, the above example implies that, in the subsequent entries to recognize interest expense, under IFRS, the Bonds
Payable account is amortized directly for the increase or reduction in bond principal. Suppose in this example that the cash
interest was $200 and the interest expense for the first interest period was $250. The entry to record the transaction under the
two different standards would be as follows:
Under US GAAP:
Journal entry: Debit Bond Interest Expense 250, credit Discount on Bonds Payable 50, and Credit Cash 200.

Under IFRS:
Journal entry: Debit Bond Interest Expense 250, credit Bonds Payable 50, and Credit Cash 200.

Note that under either method, the interest expense and the carrying value of the bonds stays the same.

12.6.1 [Link]
Issuance of Bonds
Since the process of underwriting a bond issuance is lengthy and extensive, there can be several months between the determination
of the specific characteristics of a bond issue and the actual issuance of the bond. Before the bonds can be issued, the underwriters
perform many time-consuming tasks, including setting the bond interest rate. The bond interest rate is influenced by specific factors
relating to the company, such as existing debt balances and the ability of the company to repay the funds, as well as the market rate,
which is influenced by many external economic factors.
Because of the time lag caused by underwriting, it is not unusual for the market rate of the bond to be different from the stated
interest rate. The difference in the stated rate and the market rate determine the accounting treatment of the transactions involving
bonds. When the bond is issued at par, the accounting treatment is simplest. It becomes more complicated when the stated rate and
the market rate differ.

Issued When Market Rate Equals Contract Rate

First, we will explore the case when the stated interest rate is equal to the market interest rate when the bonds are issued.
Returning to our example of a $1,000, 5-year bond with a stated interest rate of 5%, at issuance, the market rate was 5% and the
sales price was quoted at 100, which means the seller of the bond will receive (and the investor will pay) 100% of the $1,000 face
value of the bond. The journal entry to record the sale of 100 of these bonds is:
Journal entry: debit Cash and credit Bonds Payable 100,000 each. Explanation: “To record issuance of 100, $1,000, 5 percent bonds with an effective interest rate of 5 percent.”

Since the book value is equal to the amount that will be owed in the future, no other account is included in the journal entry.
Assets equals Liabilities plus Equity; T account for Cash showing 100,000 on the debit side equals T account for Bonds Payable showing 100,000 on the credit side.
Balance Sheet Presentation is Bonds Payable $100,000

Issued at a Premium
If, during the timeframe of establishing the bond stated rate and issuing the bonds, the market rate drops below the stated interest,
the bonds would become more valuable. In other words, the investors will earn a higher rate on these bonds than if the investors
purchased similar bonds elsewhere in the market. Naturally, investors would want to purchase these bonds and earn a higher
interest rate. The increased demand drives up the bond price to a point where investors earn the same interest as similar bonds.
Earlier, we found that the sale price of a $1,000, 5-year bond with a stated rate of 5% and a market rate of 4% is 104.46. That is, the
bond will sell at 104.46% of the $1,000 face value, which means the seller of the bond will receive (and the investor will pay)
$1,044.60.
Selling 100 of these bonds, would yield $104,460.
Journal entry: debit Cash 104,460, credit Premium on Bonds Payable 4,460, and credit Bonds Payable 100,000. Explanation: “To record issuance of 100, $1,000, 5 percent bonds with an effective interest rate of 4
percent.”

The financial statement presentation looks like this:

Balance Sheet Presentation: Bonds Payable 100,000, Plus: Premium on Bonds Payable 4,460, equals Carrying (Book) Value $104,460.

On the date that the bonds were issued, the company received cash of $104,460.00 but agreed to pay $100,000.00 in the future for
100 bonds with a $1,000 face value. The difference in the amount received and the amount owed is called the premium. Since they
promised to pay 5% while similar bonds earn 4%, the company received more cash upfront. In other words, they sold the bond at a
premium. They did this because the cost of the premium plus the 5% interest on the face value is mathematically the same as
receiving the face value but paying 4% interest. The interest rate was effectively the same.
The premium on bonds payable account is a contra liability account. It is contra because it increases the amount of the Bonds
Payable liability account. It is “married” to the Bonds Payable account on the balance sheet. If one of the accounts appears, both
must appear. The Premium will disappear over time as it is amortized, but it will decrease the interest expense, which we will see in
subsequent journal entries.
Taken together, the Bond Payable liability of $100,000 and the Premium on Bond Payable contra liability of $4,460 show the
bond’s carrying value or book value—the value that assets or liabilities are recorded at in the company’s financial statements.
The effect on the accounting equation looks like this:
Assets equals Liabilites plus Equity; T account for Cash showing 104,460 on the debit side equals T account for Bonds Payable showing 100,000 on the credit side and Premium on Bonds Payable T account showing
4,460 on the credit side.

12.6.2 [Link]
It looks like the issuer will have to pay back $104,460, but this is not quite true. If the bonds were to be paid off today, the full
$104,460 would have to be paid back. But as time passes, the Premium account is amortized until it is zero. The bondholders have
bonds that say the issuer will pay them $100,000, so that is all that is owed at maturity. The premium will disappear over time and
will reduce the amount of interest incurred.

Issued at a Discount
Bonds issued at a discount are the exact opposite in concept as bonds issued at a premium. If, during the timeframe of establishing
the bond stated rate and issuing the bonds, the market rate rises above the stated interest on the bonds, the bonds become less
valuable because investors can earn a higher rate of interest on other similar bonds. In other words, the investors will earn a lower
rate on these bonds than if the investors purchased similar bonds elsewhere in the market. Naturally, investors would not want to
purchase these bonds and earn a lower interest rate than could be earned elsewhere. The decreased demand drives down the bond
price to a point where investors earn the same interest for similar bonds. Earlier, we found the sale price of a $1,000, 5-year bond
with a stated interest rate of 5% and a market rate of 7% is 91.80. That is, the bond will sell at 91.80% of the $1,000 face value,
which means the seller of the bond will receive (and the investor will pay) $918.00. On selling 100 of the $1,000 bonds today, the
journal entry would be:
Journal entry: debit Cash 91,800, debit Discount on Bonds Payable 8,200, and credit Bonds Payable 100,000. Explanation: “To record issuance of 100, $1,000, 5 percent bonds with an effective interest rate of 7
percent.”
Balance Sheet Presentation: Bonds Payable 100,000, Less: Discount on Bonds Payable 8,200, equals Carrying (Book) Value $91,800.

Today, the company receives cash of $91,800.00, and it agrees to pay $100,000.00 in the future for 100 bonds with a $1,000 face
value. The difference in the amount received and the amount owed is called the discount. Since they promised to pay 5% while
similar bonds earn 7%, the company, accepted less cash up front. In other words, they sold the bond at a discount. They did this
because giving a discount but still paying only 5% interest on the face value is mathematically the same as receiving the face value
but paying 7% interest. The interest rate was effectively the same.
Like the Premium on Bonds Payable account, the discount on bonds payable account is a contra liability account and is “married”
to the Bonds Payable account on the balance sheet. The Discount will disappear over time as it is amortized, but it will increase the
interest expense, which we will see in subsequent journal entries.
The effect on the accounting equation looks like this:
Assets equals Liabilites plus Equity; T account for Cash showing 91,800 on the debit side equals T account for Bonds Payable showing 100,000 on the credit side and Discount on Bonds Payable T account showing
8,200 on the debit side.

First and Second Semiannual Interest Payment

When a company issues bonds, they make a promise to pay interest annually or sometimes more often. If the interest is paid
annually, the journal entry is made on the last day of the bond’s year. If interest was promised semiannually, entries are made twice
a year.

CONCEPTS IN PRACTICE

Municipal Bonds
Municipal bonds are a specific type of bonds that are issued by governmental entities such as towns and school districts. These
bonds are issued in order to finance specific projects (such as water treatment plants and school building construction) that
require a large investment of cash. The primary benefit to the issuing entity (i.e., the town or school district) is that cash can be
obtained more quickly than, for example, collecting taxes and fees over a long period of time. This allows the project to be
completed sooner, which is a benefit to the community.
Municipal bonds, like other bonds, pay periodic interest based on the stated interest rate and the face value at the end of the
bond term. However, corporate bonds often pay a higher rate of interest than municipal bonds. Despite the lower interest rate,
one benefit of municipal bonds relates to the tax treatment of the periodic interest payments for investors. With corporate
bonds, the periodic interest payments are considered taxable income to the investor. For example, if an investor receives $1,000
of interest and is in the 25% tax bracket, the investor will have to pay $250 of taxes on the interest, leaving the investor with an
after-tax payment of $750. With municipal bonds, interest payments are exempt from federal tax. So the same investor
receiving $1,000 of interest from a municipal bond would pay no income tax on the interest income. This tax-exempt status of
municipal bonds allows the entity to attract investors and fund projects more easily.

12.6.3 [Link]
Interest Payment: Issued When Market Rate Equals Contract Rate
Recall that the Balance Sheet presentation of the bond when the market rate equals the stated rate is as follows:
Balance Sheet Presentation is Bonds Payable $100,000.

In this example, the company issued 100 bonds with a face value of $1,000, a 5-year term, and a stated interest rate of 5% when the
market rate was 5% and received $100,000. As previously discussed, since the bonds were sold when the market rate equals the
stated rate, the carrying value of the bonds is $100,000. These bonds did not specify when interest was paid, so we can assume that
it is an annual payment. If the bonds were issued on January 1, the company would pay interest on December 31 and the journal
entry would be:
Journal entry: debit Interest Expense (0.05 times $100,000) and credit Cash for 5,000 each. Explanation: “To record interest expense on 5 percent bonds sold with effective interest rate of 5 percent.”

The interest expense is calculated by taking the Carrying Value ($100,000) multiplied by the market interest rate (5%). The stated
rate is used when calculating the interest cash payment. The company is obligated by the bond indenture to pay 5% per year based
on the face value of the bond. When the situation changes and the bond is sold at a discount or premium, it is easy to get confused
and incorrectly use the market rate here. Since the market rate and the stated rate are the same in this example, we do not have to
worry about any differences between the amount of interest expense and the cash paid to bondholders. This journal entry will be
made every year for the 5-year life of the bond.
When performing these calculations, the rate is adjusted for more frequent interest payments. If the company had issued 5% bonds
that paid interest semiannually, interest payments would be made twice a year, but each interest payment would only be half an
annual interest payment. Earning interest for a full year at 5% annually is the equivalent of receiving half of that amount each six
months. So, for semiannual payments, we would divide 5% by 2 and pay 2.5% every six months.

CONCEPTS IN PRACTICE

Mortgage Debt
According to Statista the amount of mortgage debt—debt incurred to purchase homes—in the United States was $14.9 trillion
on 2017. This value does not include the interest cost—the cost of borrowing—related to the debt.
A common loan term for those borrowing money to buy a house is 30 years. Each month, the borrower must make payments
on the loan, which would add up to 360 payments for a 30-year loan. Recall from previous discussions on amortization that
each payment can be divided into two components: the interest expense and the amount that is applied to reduce the principal.
In order to calculate the amount of interest and principal reduction for each payment, banks and borrowers often use
amortization tables. While amortization tables are easily created in Microsoft Excel or other spreadsheet applications, there are
many websites that have easy-to-use amortization tables. The popular lending website Zillow has a loan calculator to calculate
the monthly payments of a loan as well as an amortization table that shows how much interest and principal reduction is
applied for each payment.
For example, borrowing $200,000 for 30 years at an interest rate of 5% would require the borrow to repay a total $386,513.
The monthly payment on this loan is $1,073.64. This amount represents the $200,000 borrowed and $186,513 of interest cost.
If the borrower chose a 15-year loan, the total payments drops significantly to $266,757, but the monthly payments increase to
$1,581.59.
Because interest is calculated based on the outstanding loan balance, the amount of interest paid in the first payment is much
more than the amount of interest in the final payment. The pie charts below show the amount of the $1,073.64 payment
allocated to interest and loan reduction for the first and final payments, respectively, on the 30-year loan.
Two pie charts showing the first and final payments on a 30-year loan. The pie chart on the left shows the first payment. A little over three quarters of the chart is “Interest” and the rest is “Principal.” The pie
chart on the right shows the final payment. The majority of the chart is “Principal” and a very small portion is “Interest.”

Interest Payment: Issued at a Premium

Recall that the Balance Sheet presentation of the bond when the market rate at issue is lower than the stated rate is as follows:
Balance Sheet Presentation: Bonds Payable 100,000, Plus: Premium on Bonds Payable 4,460, equals Carrying (Book) Value $104,460.

In this scenario, the sale price of a $1,000, 5-year bond with a stated rate of 5% and a market rate of 4% was $1,044.60. If the
company sold 100 of these bonds, it would receive $104,460 and the journal entry would be:

12.6.4 [Link]
 Journal entry: debit Cash 104,460, credit Premium on Bonds Payable 4,460, and credit Bonds Payable 100,000. Explanation: “To record issuance of 100, $1,000, 5 percent bonds with an effective interest rate of 4
percent.”

Again, let’s assume that the bonds pay interest annually. At the end of the bond’s year, we would record the interest expense:
Journal entry: debit Interest Expense (0.04 times $104,460) 4,178, debit Premium on Bonds Payable (Difference) 822, and credit Cash for 5,000. Explanation: “To record payment of interest on bonds payable and
amortization of premium.”

The interest expense determination is calculated using the effective interest amortization interest method. Under the effective-
interest method, the interest expense is calculated by taking the Carrying (or Book) Value ($104,460) multiplied by the market
interest rate (4%). The amount of the cash payment in this example is calculated by taking the face value of the bond ($100,000)
multiplied by the stated rate.
Since the market rate and the stated rate are different, we need to account for the difference between the amount of interest expense
and the cash paid to bondholders. The amount of the premium amortization is simply the difference between the interest expense
and the cash payment. Another way to think about amortization is to understand that, with each cash payment, we need to reduce
the amount carried on the books in the Bond Premium account. Since we originally credited Bond Premium when the bonds were
issued, we need to debit the account each time the interest is paid to bondholders because the carrying value of the bond has
changed. Note that the company received more for the bonds than face value, but it is only paying interest on $100,000.
The partial effect of the first period’s interest payment on the company’s accounting equation in year one is:
Assets equals Liabilites plus Equity plus Revenue minus Expenses; T account for Cash showing 104,460 on the debit side, 5,000 on the credit side and a debit balance of 99,460 equals T account for Bonds Payable
showing 100,000 on the credit side plus the Premium on Bonds Payable T account showing 4,460 on the credit side, 822 on the debit side and a 3,638 balance minus the Interest Expense T account with 5,000 on the
debit side and 822 on the credit side with a 4,178 debit balance.

And the financial-statement presentation at the end of year 1 is:

Balance Sheet Presentation: Bonds Payable 100,000, plus Premium on Bonds Payable 3,638, equals Carrying (Book) Value $103,638. Income Statement Presentation; Bonds Interest Expense $4,178.

The journal entry for year 2 is:

Journal entry: debit Interest Expense (0.04 times $103,638) 4,146, debit Premium on Bonds Payable (Difference) 854, and credit Cash for 5,000. Explanation: “To record payment of interest on bonds payable and to
amortization the bond premium.”

The interest expense is calculated by taking the Carrying (or Book) Value ($103,638) multiplied by the market interest rate (4%).
The amount of the cash payment in this example is calculated by taking the face value of the bond ($100,000) multiplied by the
stated rate (5%). Since the market rate and the stated rate are different, we again need to account for the difference between the
amount of interest expense and the cash paid to bondholders.
The partial effect on the accounting equation in year two is:
Assets equals Liabilites plus Equity plus Revenue minus Expenses; T account for Cash showing 104,460 on the debit side, two 5,000 entries on the credit side and a debit balance of 94,460 equals T account for Bonds
Payable showing 100,000 on the credit side plus the Premium on Bonds Payable T account showing 3,638 on the credit side, 854 on the debit side and a 2,784 balance minus the Interest Expense T account with two
5,000’s on the debit side and 822 and 854 on the credit side with a 8,324 debit balance.

And the financial-statement presentation at the end of year 2 is:

Balance Sheet Presentation: Bonds Payable 100,000, plus Premium on Bonds Payable 2,784, equals Carrying (Book) Value $102,784. Income Statement Presentation: Bonds Interest Expense $4,146.

By the end of the 5th year, the bond premium will be zero, and the company will only owe the Bonds Payable amount of $100,000.

LINK TO LEARNING

A mortgage calculator provides monthly payment estimates for a long-term loan like a mortgage. To use the calculator, enter
the cost of the house to be purchased, the amount of cash to be borrowed, the number of years over which the mortgage is to be
paid back (generally 30 years), and the current interest rate. The calculator returns the amount of the mortgage payment.
Mortgages are long-term liabilities that are used to finance real estate purchases. We tend to think of them as home loans, but
they can also be used for commercial real estate purchases.

Interest Payment: Issued at a Discount

Recall that the Balance Sheet presentation of the bond when the market rate at issue was higher than the stated rate is as follows:
Balance Sheet Presentation: Bonds Payable 100,000, minus Discount on Bonds Payable (8,200), equals Carrying (Book) Value $91,800.

We found the sale price of a $1,000, 5-year bond with a stated interest rate of 5% and a market rate of 7% was $918.00. We then
showed the journal entry to record sale of 100 bonds:
Journal entry: debit Cash 91,800, debit Discount on Bonds Payable 8,200, and credit Bonds Payable 100,000. Explanation: “To record issuance of 100, $1,000, 5 percent bonds with an effective interest rate of 7
percent.”

At the end of the bond’s first year, we make this journal entry:

12.6.5 [Link]
 Journal entry: debit Interest Expense (0.07 times $91,800) 6,426, credit Cash for 5,000 (0.05 times $100,000), and credit Disount on Bonds Payable (difference) 1,426. Explanation: “To record payment of interest on
bonds payable and amortize the discount.”

The interest expense is calculated by taking the Carrying Value ($91,800) multiplied by the market interest rate (7%). The amount
of the cash payment in this example is calculated by taking the face value of the bond ($100,000) and multiplying it by the stated
rate (5%). Since the market rate and the stated rate are different, we need to account for the difference between the amount of
interest expense and the cash paid to bondholders. The amount of the discount amortization is simply the difference between the
interest expense and the cash payment. Since we originally debited Bond Discount when the bonds were issued, we need to credit
the account each time the interest is paid to bondholders because the carrying value of the bond has changed. Note that the
company received less for the bonds than face value but is paying interest on the $100,000.
The partial effect on the accounting equation in year one is:
Assets equals Liabilites plus Equity plus Revenue minus Expenses; T account for Cash showing 91,800 on the debit side, 5,000 on the credit side and a debit balance of 86,800 equals T account for Bonds Payable
showing 100,000 on the credit side less the Discount on Bonds Payable T account showing 8,200 on the debit side, 1,426 on the credit side and a 6,774 debit balance minus the Interest Expense T account with 5,000
on the debit side and 1,426 on the debit side with a 6,426 debit balance.

And the financial-statement presentation at the end of year 1 is:

Balance Sheet Presentation: Bonds Payable 100,000, minus Discount on Bonds Payable 6,774, equals Carrying (Book) Value $93,226. Income Statement Presentation: Bonds Interest Expense $6,426.

The journal entry for year 2 is:

Journal entry: debit Interest Expense (0.07 times $93,226) 6,526, credit Cash for 5,000 (0.05 times $100,000), and credit Disount on Bonds Payable (difference) 1,526. Explanation: “To record payment of interest on
bonds payable and amortize the discount.”

The interest expense is calculated by taking the Carrying Value ($93,226) multiplied by the market interest rate (7%). The amount
of the cash payment in this example is calculated by taking the face value of the bond ($100,000) multiplied by the stated rate
(5%). Again, we need to account for the difference between the amount of interest expense and the cash paid to bondholders by
crediting the Bond Discount account.
The partial effect on the accounting equation in year two is:
Assets equals Liabilites plus Equity plus Revenue minus Expenses; T account for Cash showing 5,000 on the credit side equals T account for Bonds Payable showing 100,000 on the credit side less the Discount on
Bonds Payable T account showing 6,774 on the debit side, 1,526 on the credit side, and a 5,248 debit balance minus the Interest Expense T account with 5,000 and 1,526 on the debit side with a 6,526 debit balance.

And the financial statement presentation at the end of year 2 is:

Balance Sheet Presentation: Bonds Payable 100,000, Less: Discount on Bonds Payable 5,248, equals Carrying (Book) Value $94,752. Income Statement Presentation: Bonds Interest Expense $6,526.

By the end of the 5th year, the bond premium will be zero and the company will only owe the Bonds Payable amount of $100,000.

Retirement of Bonds When the Bonds Were Issued at Par

At some point, a company will need to record bond retirement, when the company pays the obligation. Often, they will retire
bonds when they mature. For example, earlier we demonstrated the issuance of a five-year bond, along with its first two interest
payments. If we had carried out recording all five interest payments, the next step would have been the maturity and retirement of
the bond. At this stage, the bond issuer would pay the maturity value of the bond to the owner of the bond, whether that is the
original owner or a secondary investor.
This example demonstrates the least complicated method of a bond issuance and retirement at maturity. There are other
possibilities that can be much more complicated and beyond the scope of this course. For example, a bond might be callable by the
issuing company, in which the company may pay a call premium paid to the current owner of the bond. Also, a bond might be
called while there is still a premium or discount on the bond, and that can complicate the retirement process. Situations like these
will be addressed in later accounting courses.
To continue with our example, assume that the company issued 100 bonds with a face value of $1,000, a 5-year term, and a stated
interest rate of 5% when the market rate was 5% and received $100,000. It was recorded in this way:
Journal entry: debit Cash and credit Bonds Payable 100,000 each. Explanation: “To record issuance of 100, $1,000, 5 percent bonds with an effective interest rate of 5 percent.”

At the end of 5 years, the company will retire the bonds by paying the amount owed. To record this action, the company would
debit Bonds Payable and credit Cash. Remember that the bond payable retirement debit entry will always be the face amount of the
bonds since, when the bond matures, any discount or premium will have been completely amortized.
Journal entry: debit Bonds Payable and credit Cash 100,000 each. Explanation: “ To record the retirement of bonds payable.”

12.6: Prepare Journal Entries to Reflect the Life Cycle of Bonds is shared under a not declared license and was authored, remixed, and/or curated
by LibreTexts.

12.6.6 [Link]
 CHAPTER OVERVIEW

13: Equity
13.1: Types of Businesses and Business Activities
13.2: Explain the Process of Securing Equity Financing through the Issuance of Stock
13.3: Analyze and Record Transactions for the Issuance and Repurchase of Stock
13.4: Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends,
and Stock Splits
13.5: Compare and Contrast Owners’ Equity versus Retained Earnings

13: Equity is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1
13.1: Types of Businesses and Business Activities
Forms of Business Organizations
Accountants frequently refer to a business organization as an accounting entity or a business entity. A business entity is any
business organization, such as a hardware store or grocery store, that exists as an economic unit. For accounting purposes, each
business organization or entity has an existence separate from its owner(s), creditors, employees, customers, and other businesses.
This separate existence of the business organization is known as the business entity concept. Thus, in the accounting records of
the business entity, the activities of each business should be kept separate from the activities of other businesses and from the
personal financial activities of the owner(s).
As you will see shortly, the business entity concept applies to the four main forms of businesses—single proprietorships,
partnerships, and corporations. Thus, for accounting purposes, all four business forms are separate from other business entities and
from their owner(s).
A single proprietorship is an unincorporated business owned by an individual and often managed by that same person. Single
proprietors include physicians, lawyers, electricians, and other people in business for themselves. Many small service
businesses and retail establishments are also single proprietorships. No legal formalities are necessary to organize such
businesses, and usually business operations can begin with only a limited investment. The most attractive feature of a
proprietorship is that there is no “double taxation”. Both proprietorships and partnerships do not pay taxes on profits at the
business level. The only taxes paid are at the personal level—this occurs when proprietors and partners pay taxes on their share
of their company’s income. On the other hand, a business owner is personally liable for all debts of his or her company. This is
called unlimited liability. If you’re a sole proprietorship and the debts of your business exceed its assets, creditors can seize your
personal assets to cover the proprietorship’s outstanding business debt.
A partnership is an unincorporated business owned by two or more persons associated as partners. Often the same persons
who own the business also manage the business. Many small retail establishments and professional practices, such as dentists,
physicians, attorneys, and many CPA firms, are partnerships. Unlimited liability is even riskier in the case of a partnership.
Each partner is personally liable not only for his or her own actions but also for the actions of all the partners. If, through
mismanagement by one of your partners, the partnership is forced into bankruptcy, the creditors can go after you for all
outstanding debts of the partnership.
A corporation is a business incorporated under the laws of a state and owned by a few stockholders or thousands of
stockholders. Almost all large businesses and many small businesses are incorporated. The corporation is unique in that it is a
separate legal business entity. The owners of the corporation are stockholders, or shareholders. Stockholders do not directly
manage the corporation. They elect a board of directors to represent their interests.
Accounting is necessary for all forms of business organizations, and each company must follow generally accepted accounting
principles (GAAP).

13.1: Types of Businesses and Business Activities is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

13.1.1 [Link]
13.2: Explain the Process of Securing Equity Financing through the Issuance of
Stock
A corporation is a legal business structure involving one or more individuals (owners) who are legally distinct (separate) from the
business that is created under state laws. The owners of a corporation are called stockholders (or shareholders) and may or may not
be employees of the corporation. Most corporations rely on a combination of debt (liabilities) and equity (stock) to raise capital.
Both debt and equity financing have the goal of obtaining funding, often referred to as capital, to be used to acquire other assets
needed for operations or expansion. Capital consists of the total cash and other assets owned by a company found on the left side
of the accounting equation. The method of financing these assets is evidenced by looking at the right side of the accounting
equation, either recorded as liabilities or shareholders’ equity.

The Organization of a Corporation

Incorporation is the process of forming a company into a corporate legal entity. The advantages of incorporating are available to a
corporation regardless of size, from a corporation with one shareholder to those with hundreds of thousands of shareholders. To
issue stock, an entity must first be incorporated in a state.
The process of incorporating requires filing the appropriate paperwork and receiving approval from a governmental entity to
operate as a corporation. Each state has separate requirements for creating a corporation, but ultimately, each state grants a
corporation the right to conduct business in the respective state in which the corporation is formed. The steps to incorporate are
similar in most states:
1. The founders (incorporators) choose an available business name that complies with the state’s corporation rules. A state will not
allow a corporation to choose a name that is already in use or that has been in use in recent years. Also, similar names might be
disallowed.
2. The founders of a corporation prepare articles of incorporation called a “charter,” which defines the basic structure and
purpose of the corporation and the amount of capital stock that can be issued or sold.
3. The founders file the articles of incorporation with the Department of State of the state in which the incorporation is desired.
Once the articles are filed and any required fees are paid, the government approves the incorporation.
4. The incorporators hold an organizational meeting to elect the board of directors. Board meetings must be documented with
formal board minutes (a written record of the items discussed, decisions made, and action plans resulting from the meeting).
The board of directors generally meets at least annually. Microsoft, for example, has 14 directors on its board.1 Boards may
have more or fewer directors than this, but most boards have a minimum of at least three directors.
5. The board of directors prepares and adopts corporate bylaws. These bylaws lay out the operating rules for the corporation.
Templates for drawing up corporate bylaws are usually available from the state to ensure that they conform with that state’s
requirements.
6. The board of directors agrees upon a par value price for the stock. Par value is a legal concept discussed later in this section.
The price that the company receives (the initial market value) will be determined by what the purchasing public is willing to
pay. For example, the company might set the par value at $1 per share, while the investing public on the day of issuance might
be willing to pay $30 per share for the stock.

CONCEPTS IN PRACTICE
Deciding Where to Incorporate
With 50 states to choose from, how do corporations decide where to incorporate? Many corporations are formed in either Delaware
or Nevada for several reasons. Delaware is especially advantageous for large corporations because it has some of the most flexible
business laws in the nation and its court system has a division specifically for handling business cases that operates without juries.
Additionally, companies formed in Delaware that do not transact business in the state do not need to pay state corporate income
tax. Delaware imposes no personal tax for non-residents, and shareholders can be non-residents. In addition, stock shares owned by
non-Delaware residents are not subject to Delaware state taxation.
Because of these advantages, Delaware dominated the share of business incorporation for several decades. In recent years, though,
other states are seeking to compete for these businesses by offering similarly attractive benefits of incorporation. Nevada in
particular has made headway. It has no state corporate income tax and does not impose any fees on shares or shareholders. After the
initial set up fees, Nevada has no personal or franchise tax for corporations or their shareholders. Nevada, like Delaware, does not

13.2.1 [Link]
require shareholders to be state residents. If a corporation chooses to incorporate in Delaware, Nevada, or any state that is not its
home state, it will need to register to do business in its home state. Corporations that transact in states other than their state of
incorporation are considered foreign and may be subject to fees, local taxes, and annual reporting requirements that can be time
consuming and expensive.

Advantages of the Corporate Form

Compared to other forms of organization for businesses, corporations have several advantages. A corporation is a separate legal
entity, it provides limited liability for its owner or owners, ownership is transferable, it has a continuing existence, and capital is
generally easy to raise.

Separate Legal Entity

A sole proprietorship, a partnership, and a corporation are different types of business entities. However, only a corporation is a
legal entity. As a separate legal entity, a corporation can obtain funds by selling shares of stock, it can incur debt, it can become a
party to a contract, it can sue other parties, and it can be sued. The owners are separate from the corporation. This separate legal
status complies with one of the basic accounting concepts—the accounting entity concept, which indicates that the economic
activity of an entity (the corporation) must be kept separate from the personal financial affairs of the owners.

Limited Liability
Many individuals seek to incorporate a business because they want the protection of limited liability. A corporation usually limits
the liability of an investor to the amount of his or her investment in the corporation. For example, if a corporation enters into a loan
agreement to borrow a sum of money and is unable to repay the loan, the lender cannot recover the amount owed from the
shareholders (owners) unless the owners signed a personal guarantee. This is the opposite of partnerships and sole proprietorships.
In partnerships and sole proprietorships, the owners can be held responsible for any unpaid financial obligations of the business and
can be sued to pay obligations.

Transferable Ownership
Shareholders in a corporation can transfer shares to other parties without affecting the corporation’s operations. In effect, the
transfer takes place between the parties outside of the corporation. In most corporations, the company generally does not have to
give permission for shares to be transferred to another party. No journal entry is recorded in the corporation’s accounting records
when a shareholder sells his or her stock to another shareholder. However, a memo entry must be made in the corporate stock
ownership records so any dividends can be issued to the correct shareholder.

Continuing Existence
From a legal perspective, a corporation is granted existence forever with no termination date. This legal aspect falls in line with the
basic accounting concept of the going concern assumption, which states that absent any evidence to the contrary, a business will
continue to operate in the indefinite future. Because ownership of shares in a corporation is transferrable, re-incorporation is not
necessary when ownership changes hands. This differs from a partnership, which ends when a partner dies, or from a sole
proprietorship, which ends when the owner terminates the business.

Ease of Raising Capital

Because shares of stock can be easily transferred, corporations have a sizeable market of investors from whom to obtain capital.
More than 65 million American households2 hold investments in the securities markets. Compared to sole proprietorships (whose
owners must obtain loans or invest their own funds) or to partnerships (which must typically obtain funds from the existing
partners or seek other partners to join; although some partnerships are able borrow from outside parties), a corporation will find
that capital is relatively easy to raise.

Disadvantages of the Corporate Form

As compared to other organizations for businesses, there are also disadvantages to operating as a corporation. They include the
costs of organization, regulation, and taxation.

Costs of Organization
Corporations incur costs associated with organizing the corporate entity, which include attorney fees, promotion costs, and filing
fees paid to the state. These costs are debited to an account called organization costs. Assume that on January 1, Rayco

13.2.2 [Link]
Corporation made a payment for $750 to its attorney to prepare the incorporation documents and paid $450 to the state for filing
fees. Rayco also incurred and paid $1,200 to advertise and promote the stock offering. The total organization costs are $2,400
($750 + $450 + $1,200). The journal entry recorded by Rayco is a $2,400 debit to Organization Costs and a $2,400 credit to Cash.

Organization costs are reported as part of the operating expenses on the corporation’s income statement.

Regulation
Compared to partnerships and sole proprietorships, corporations are subject to considerably more regulation both by the states in
which they are incorporated and the states in which they operate. Each state provides limits to the powers that a corporation may
exercise and specifies the rights and liabilities of shareholders. The Securities and Exchange Commission (SEC) is a federal
agency that regulates corporations whose shares are listed and traded on security exchanges such as the New York Stock Exchange
(NYSE), the National Association of Securities Dealers Automated Quotations Exchange (NASDAQ), and others; it accomplishes
this through required periodic filings and other regulations. States also require the filing of periodic reports and payment of annual
fees.

Taxation
As legal entities, typical corporations (C corporations, named after the specific subchapter of the Internal Revenue Service code
under which they are taxed), are subject to federal and state income taxes (in those states with corporate taxes) based on the income
they earn. Stockholders are also subject to income taxes, both on the dividends they receive from corporations and any gains they
realize when they dispose of their stock. The income taxation of both the corporate entity’s income and the stockholder’s dividend
is referred to as double taxation because the income is taxed to the corporation that earned the income and then taxed again to
stockholders when they receive a distribution of the corporation’s income.
Corporations that are closely held (with fewer than 100 stockholders) can be classified as S corporations, so named because they
have elected to be taxed under subchapter S of the Internal Revenue Service code. For the most part, S corporations pay no income
taxes because the income of the corporation is divided among and passed through to each of the stockholders, each of whom pays
income taxes on his or her share. Both Subchapter S (Sub S) and similar Limited Liability Companies (LLCs) are not taxed at the
business entity but instead pass their taxable income to their owners.

Financing Options: Debt versus Equity

Before exploring the process for securing corporate financing through equity, it is important to review the advantages and
disadvantages of acquiring capital through debt. When deciding whether to raise capital by issuing debt or equity, a corporation
needs to consider dilution of ownership, repayment of debt, cash obligations, budgeting impacts, administrative costs, and credit
risks.

Dilution of Ownership
The most significant consideration of whether a company should seek funding using debt or equity financing is the effect on the
company’s financial position. Issuance of debt does not dilute the company’s ownership as no additional ownership shares are
issued. Issuing debt, or borrowing, creates an increase in cash, an asset, and an increase in a liability, such as notes payable or
bonds payable. Because borrowing is independent of an owner’s ownership interest in the business, it has no effect on
stockholders’ equity, and ownership of the corporation remains the same as illustrated in the accounting equation in Figure 14.2.

Figure 14.2 Debt Financing. Debt financing increases assets and liabilities but has no effect on stockholders’ equity. (attribution:
Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

13.2.3 [Link]
On the other hand, when a corporation issues stock, it is financing with equity. The same increase in cash occurs, but financing
causes an increase in a capital stock account in stockholders’ equity as illustrated in the accounting equation in Figure 14.3.

Figure 14.3 Equity Financing. Equity financing increases assets and stockholders’ equity but has no effect on liabilities.
(attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
This increase in stockholders’ equity implies that more shareholders will be allowed to vote and will participate in the distribution
of profits and assets upon liquidation.

Repayment of Debt
A second concern when choosing between debt and equity financing relates to the repayment to the lender. A lender is a debt
holder entitled to repayment of the original principal amount of the loan plus interest. Once the debt is paid, the corporation has no
additional obligation to the lender. This allows owners of a corporation to claim a larger portion of the future earnings than would
be possible if more stock were sold to investors. In addition, the interest component of the debt is an expense, which reduces the
amount of income on which a company’s income tax liability is calculated, thereby lowering the corporation’s tax liability and the
actual cost of the loan to the company.

Cash Obligations
The most obvious difference between debt and equity financing is that with debt, the principal and interest must be repaid, whereas
with equity, there is no repayment requirement. The decision to declare dividends is solely up to the board of directors, so if a
company has limitations on cash, it can skip or defer the declaration of dividends. When a company obtains capital through debt, it
must have sufficient cash available to cover the repayment. This can put pressure on the company to meet debt obligations when
cash is needed for other uses.

Budgeting
Except in the case of variable interest loans, loan and interest payments are easy to estimate for the purpose of budgeting cash
payments. Loan payments do not tend to be flexible; instead the principal payment is required month after month. Moreover,
interest costs incurred with debt are an additional fixed cost to the company, which raises the company’s break-even point (total
revenue equals total costs) as well as its cash flow demands.

Cost Differences
Issuing debt rather than equity may reduce additional administration costs associated with having additional shareholders. These
costs may include the costs for informational mailings, processing and direct-depositing dividend payments, and holding
shareholder meetings. Issuing debt also saves the time associated with shareholder controversies, which can often defer certain
management actions until a shareholder vote can be conducted.

Risk Assessment by Creditors

Borrowing commits the borrower to comply with debt covenants that can restrict both the financing options and the opportunities
that extend beyond the main business function. This can limit a company’s vision or opportunities for change. For example, many
debt covenants restrict a corporation’s debt-to-equity ratio, which measures the portion of debt used by a company relative to the
amount of stockholders’ equity, calculated by dividing total debt by total equity.

When a company borrows additional funds, its total debt (the numerator) rises. Because there is no change in total equity, the
denominator remains the same, causing the debt-to-equity ratio to increase. Because an increase in this ratio usually means that the

13.2.4 [Link]
company will have more difficulty in repaying the debt, lenders and investors consider this an added risk. Accordingly, a business
is limited in the amount of debt it can carry. A debt agreement may also restrict the company from borrowing additional funds.
To increase the likelihood of debt repayment, a debt agreement often requires that a company’s assets serve as collateral, or for the
company’s owners to guarantee repayment. Increased risks to the company from high-interest debt and high amounts of debt,
particularly when the economy is unstable, include obstacles to growth and the potential for insolvency resulting from the costs of
holding debt. These important considerations should be assessed prior to determining whether a company should choose debt or
equity financing.

THINK IT THROUGH
Financing a Business Expansion
You are the CFO of a small corporation. The president, who is one of five shareholders, has created an innovative new product that
is testing well with substantial demand. To begin manufacturing, $400,000 is needed to acquire the equipment. The corporation’s
balance sheet shows total assets of $2,400,000 and total liabilities of $600,000. Most of the liabilities relate to debt that carries a
covenant requiring that the company maintain a debt-to-equity ratio not exceeding 0.50 times. Determine the effect that each of the
two options of obtaining additional capital will have on the debt covenant. Prepare a brief memo outlining the advantages of
issuing shares of common stock.

How Stocks Work

The Securities and Exchange Commission (SEC) ([Link]) is a government agency that regulates large and small public
corporations. Its mission is “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”3 The
SEC identifies these as its five primary responsibilities:
Inform and protect investors
Facilitate capital information
Enforce federal securities laws
Regulate securities markets
Provide data
Under the Securities Act of 1933,4 all corporations that make their shares available for sale publicly in the United States are
expected to register with the SEC. The SEC’s registration requirement covers all securities—not simply shares of stock—including
most tradable financial instruments. The Securities Act of 1933, also known as the “truth in securities law,” aims to provide
investors with the financial data they need to make informed decisions. While some companies are exempt from filing documents
with the SEC, those that offer securities for sale in the U.S. and that are not exempt must file a number of forms along with
financial statements audited by certified public accountants.

Private versus Public Corporations

Both private and public corporations become incorporated in the same manner through the state governmental agencies that
handles incorporation. The journal entries and financial reporting are the same whether a company is a public or a private
corporation. A private corporation is usually owned by a relatively small number of investors. Its shares are not publicly traded,
and the ownership of the stock is restricted to only those allowed by the board of directors.
The SEC defines a publicly traded company as a company that “discloses certain business and financial information regularly to
the public” and whose “securities trade on public markets.”5 A company can initially operate as private and later decide to “go
public,” while other companies go public at the point of incorporation. The process of going public refers to a company
undertaking an initial public offering (IPO) by issuing shares of its stock to the public for the first time. After its IPO, the
corporation becomes subject to public reporting requirements and its shares are frequently listed on a stock exchange.6

CONCEPTS IN PRACTICE
Spreading the Risk
The East India Company became the world’s first publicly traded company as the result of a single factor—risk. During the
1600s, single companies felt it was too risky to sail from the European mainland to the East Indies. These islands held vast
resources and trade opportunities, enticing explorers to cross the Atlantic Ocean in search of fortunes. In 1600, several shipping
companies joined forces and formed “Governor and Company of Merchants of London trading with the East Indies,” which was

13.2.5 [Link]
referred to as the East India Company. This arrangement allowed the shipping companies—the investors—to purchase shares in
multiple companies rather than investing in a single voyage. If a single ship out of a fleet was lost at sea, investors could still
generate a profit from ships that successfully completely their voyages.7

The Secondary Market

A corporation’s shares continue to be bought and sold by the public after the initial public offering. Investors interested in
purchasing shares of a corporation’s stock have several options. One option is to buy stock on the secondary market, an organized
market where previously issued stocks and bonds can be traded after they are issued. Many investors purchase through stock
exchanges like the New York Stock Exchange or NASDAQ using a brokerage firm. A full-service brokerage firm provides
investment advice as well as a variety of financial planning services, whereas a discount brokerage offers a reduced commission
and often does not provide investment advice. Most of the stock trading—buying and selling of shares by investors—takes place
through brokers, registered members of the stock exchange who buy and sell stock on behalf of others. Online access to trading
has broadened the secondary market significantly over the past few decades. Alternatively, stocks can be purchased from
investment bankers, who provide advice to companies wishing to issue new stock, purchase the stock from the company issuing
the stock, and then resell the securities to the public.8

Marketing a Company’s Stock

Once a corporation has completed the incorporation process, it can issue stock. Each share of stock sold entitles the shareholder
(the investor) to a percentage of ownership in the company. Private corporations are usually owned by a small number of investors
and are not traded on a public exchange. Regardless of whether the corporation is public or private, the steps to finding investors
are similar:
1. Have a trusted and reliable management team. These should be experienced professionals who can guide the corporation.
2. Have a financial reporting system in place. Accurate financial reporting is key to providing potential investors with reliable
information.
3. Choose an investment banker to provide advice and to assist in raising capital. Investment bankers are individuals who work in
a financial institution that is primarily in the business of raising capital for corporations.
4. Write the company’s story. This adds personality to the corporation. What is the mission, why it will be successful, and what
sets the corporation apart?
5. Approach potential investors. Selecting the right investment bankers will be extremely helpful with this step.

Capital Stock
A company’s corporate charter specifies the classes of shares and the number of shares of each class that a company can issue.
There are two classes of capital stock—common stock and preferred stock. The two classes of stock enable a company to attract
capital from investors with different risk preferences. Both classes of stock can be sold by either public or non-public companies;
however, if a company issues only one class, it must be common stock. Companies report both common and preferred stock in the
stockholders’ equity section of the balance sheet.

Common Stock
A company’s primary class of stock issued is common stock, and each share represents a partial claim to ownership or a share of
the company’s business. For many companies, this is the only class of stock they have authorized. Common stockholders have four
basic rights.
1. Common stockholders have the right to vote on corporate matters, including the selection of corporate directors and other issues
requiring the approval of owners. Each share of stock owned by an investor generally grants the investor one vote.
2. Common stockholders have the right to share in corporate net income proportionally through dividends.
3. If the corporation should have to liquidate, common stockholders have the right to share in any distribution of assets after all
creditors and any preferred stockholders have been paid.
4. In some jurisdictions, common shareholders have a preemptive right, which allows shareholders the option to maintain their
ownership percentage when new shares of stock are issued by the company. For example, suppose a company has 1,000 shares
of stock issued and plans to issue 200 more shares. A shareholder who currently owns 50 shares will be given the right to buy a
percentage of the new issue equal to his current percentage of ownership. His current percentage of ownership is 5%:
Original ownership percentage=501,000=5%Original ownership percentage=501,000=5%

13.2.6 [Link]
This shareholder will be given the right to buy 5% of the new issue, or 10 new shares.
Number of new shares to be purchases=5%×200shares=10sharesNumber of new shares to be purchases=5%×200shares=10shares
Should the shareholder choose not to buy the shares, the company can offer the shares to other investors. The purpose of the
preemptive right is to prevent new issuances of stock from reducing the ownership percentage of the current shareholders. If the
shareholder in our example is not offered the opportunity to buy 5% of the additional shares (his current ownership percentage) and
the new shares are sold to other investors, the shareholder’s ownership percentage will drop because the total shares issued will
increase.
Total number of issues shares after the new issue=1,000+200=1,200sharesTotal number of issues shares after the new
issue=1,000+200=1,200shares
New ownership percentage=501,200=4.17%New ownership percentage=501,200=4.17%
The shareholder would now own only 4.17% of the corporation, compared to the previous 5%.

Preferred Stock
A company’s charter may authorize more than one class of stock. Preferred stock has unique rights that are “preferred,” or more
advantageous, to shareholders than common stock. The classification of preferred stock is often a controversial area in accounting
as some researchers believe preferred stock has characteristics closer to that of a stock/bond hybrid security, with characteristics of
debt rather than a true equity item. For example, unlike common stockholders, preferred shareholders typically do not have voting
rights; in this way, they are similar to bondholders. In addition, preferred shares do not share in the common stock dividend
distributions. Instead, the “preferred” classification entitles shareholders to a dividend that is fixed (assuming sufficient dividends
are declared), similar to the fixed interest rate associated with bonds and other debt items. Preferred stock also mimics debt in that
preferred shareholders have a priority of dividend payments over common stockholders. While there may be characteristics of both
debt and equity, preferred stock is still reported as part of stockholders’ equity on the balance sheet.
Not every corporation authorizes and issues preferred stock, and there are some important characteristics that corporations should
consider when deciding to issue preferred stock. The price of preferred stock typically has less volatility in the stock market. This
makes it easier for companies to more reliably budget the amount of the expected capital contribution since the share price is not
expected to fluctuate as freely as for common stock. For the investor, this means there is less chance of large gains or losses on the
sale of preferred stock.

The Status of Shares of Stock

The corporate charter specifies the number of authorized shares, which is the maximum number of shares that a corporation can
issue to its investors as approved by the state in which the company is incorporated. Once shares are sold to investors, they are
considered issued shares. Shares that are issued and are currently held by investors are called outstanding shares because they are
“out” in the hands of investors. Occasionally, a company repurchases shares from investors. While these shares are still issued, they
are no longer considered to be outstanding. These repurchased shares are called treasury stock.
Assume that Waystar Corporation has 2,000 shares of capital stock authorized in its corporate charter. During May, Waystar issues
1,500 of these shares to investors. These investors are now called stockholders because they “hold” shares of stock. Because the
other 500 authorized shares have not been issued they are considered unissued shares. Now assume that Waystar buys back 100
shares of stock from the investors who own the 1,500 shares. Only 1,400 of the issued shares are considered outstanding, because
100 shares are now held by the company as treasury shares.

13.2.7 [Link]
Stock Values
Two of the most important values associated with stock are market value and par value. The market value of stock is the price at
which the stock of a public company trades on the stock market. This amount does not appear in the corporation’s accounting
records, nor in the company’s financial statements.
Most corporate charters specify the par value assigned to each share of stock. This value is printed on the stock certificates and is
often referred to as a face value because it is printed on the “face” of the certificate. Incorporators typically set the par value at a
very small arbitrary amount because it is used internally for accounting purposes and has no economic significance. Because par
value often has some legal significance, it is considered to be legal capital. In some states, par value is the minimum price at which
the stock can be sold. If for some reason a share of stock with a par value of one dollar was issued for less than its par value of one
dollar known as issuing at a stock discount, the shareholder could be held liable for the difference between the issue price and the
par value if liquidation occurs and any creditors remain unpaid.
Under some state laws, corporations are sometimes allowed to issue no-par stock—a stock with no par value assigned. When this
occurs, the company’s board of directors typically assigns a stated value to each share of stock, which serves as the company’s
legal capital. Companies generally account for stated value in the accounting records in the same manner as par value. If the
company’s board fails to assign a stated value to no-par stock, the entire proceeds of the stock sale are treated as legal capital. A
portion of the stockholders’ equity section of Frontier Communications Corporation’s balance sheet as of December 31, 2017
displays the reported preferred and common stock. The par value of the preferred stock is $0.01 per share and $0.25 per share for
common stock. The legal capital of the preferred stock is $192.50, while the legal capital of the common stock is $19,883.9

13.2.8 [Link]
ETHICAL CONSIDERATIONS
Shareholders, Stakeholders, and the Business Judgment Rule
Shareholders are the owners of a corporation, whereas stakeholders have an interest in the outcome of decisions of the corporation.
Courts have ruled that, “A business corporation is organized and carried on primarily for the profit of the stockholders” as initially
ruled in the early case Dodge v. Ford Motor Co., 204 Mich. 459, 170 N.W. 668 (Mich. 1919). This early case outlined the “business
judgment rule.” It allows for a corporation to use its judgment in how to run the company in the best interests of the shareholders,
but also allows the corporation the ability to make decisions for the benefit of the company’s stakeholders. The term known as the
“business judgment rule” has been expanded in numerous cases to include making decisions directly for the benefit of stakeholders,
thereby allowing management to run a company in a prudent fashion. The stakeholder theories started in the Dodge case have been
expended to allow corporations to make decisions for the corporation’s benefit, including decisions that support stakeholder rights.
Prudent management of a corporation includes making decisions that support stakeholders and shareholders. A shareholder is also a
stakeholder in any decision. A stakeholder is anyone with an interest in the outcome in the corporation’s decision, even if the
person owns no financial interest in the corporation. Corporations need to take a proactive step in managing stakeholder concerns
and issues. Strategies on how to manage stakeholder needs have been developed from both a moral perspective and a risk
management perspective. Both approaches allow management to understand the issues related to their stakeholders and to make
decisions in the best interest of the corporation and its owners. Proper stakeholder management should allow corporations to
develop profitable long-term plans that lead to greater viability of the corporation.

Footnotes
1 Microsoft Corporation. “Board of Directors.” [Link]
2 Financial Samurai. “What Percent of Americans Hold Stocks?” February 18, 2019.
[Link]
3 U.S. Securities and Exchange Commission. “What We Do.” June 10, 2013. [Link]
4 U.S. Securities and Exchange Commission. “Registration under the Securities Act of 1933.”
[Link]
5 U. S. Securities and Exchange Commission. “Public Companies.” [Link]
6 U.S. Securities and Exchange Commission. “Companies, Going Public.” October 14, 2014. [Link]
answers/ans...[Link]
7 Johnson Hur. “History of The Stock Market.” [Link]. October 2016. [Link]
market/
8 Dr. Econ. “Why Do Investment Banks Syndicate a New Securities Issue (and Related Questions).” Federal Reserve Bank of
San Francisco. December 1999. [Link]
9 Frontier Communications Corporation. 10-K Filing. February 28, 2018.
[Link]

13.2: Explain the Process of Securing Equity Financing through the Issuance of Stock is shared under a CC BY-NC-SA license and was authored,
remixed, and/or curated by LibreTexts.
14.1: Explain the Process of Securing Equity Financing through the Issuance of Stock by OpenStax is licensed CC BY-NC-SA 4.0.
Original source: [Link]

13.2.9 [Link]
13.3: Analyze and Record Transactions for the Issuance and Repurchase of Stock
Chad and Rick have successfully incorporated La Cantina and are ready to issue common stock to themselves and the newly
recruited investors. The proceeds will be used to open new locations. The corporate charter of the corporation indicates that the par
value of its common stock is $1.50 per share. When stock is sold to investors, it is very rarely sold at par value. Most often, shares
are issued at a value in excess of par. This is referred to as issuing stock at a premium. Stock with no par value that has been
assigned a stated value is treated very similarly to stock with a par value.
Stock can be issued in exchange for cash, property, or services provided to the corporation. For example, an investor could give a
delivery truck in exchange for a company’s stock. Another investor could provide legal fees in exchange for stock. The general rule
is to recognize the assets received in exchange for stock at the asset’s fair market value.

Typical Common Stock Transactions

The company plans to issue most of the shares in exchange for cash, and other shares in exchange for kitchen equipment provided
to the corporation by one of the new investors. Two common accounts in the equity section of the balance sheet are used when
issuing stock—Common Stock and Additional Paid-in Capital from Common Stock. Common Stock consists of the par value of all
shares of common stock issued. Additional paid-in capital from common stock consists of the excess of the proceeds received
from the issuance of the stock over the stock’s par value. When a company has more than one class of stock, it usually keeps a
separate additional paid-in capital account for each class.

Issuing Common Stock with a Par Value in Exchange for Cash

When a company issues new stock for cash, assets increase with a debit, and equity accounts increase with a credit. To illustrate,
assume that La Cantina issues 8,000 shares of common stock to investors on January 1 for cash, with the investors paying cash of
$21.50 per share. The total cash to be received is $172,000.
8,000shares×$21.50=$172,0008,000shares×$21.50=$172,000
The transaction causes Cash to increase (debit) for the total cash received. The Common Stock account increases (credit) with a
credit for the par value of the 8,000 shares issued: 8,000 × $1.50, or $12,000. The excess received over the par value is reported in
the Additional Paid-in Capital from Common Stock account. Since the shares were issued for $21.50 per share, the excess over par
value per share of $20 ($21.50 − $1.50) is multiplied by the number of shares issued to arrive at the Additional Paid-in Capital
from Common Stock credit.
($21.50−$1.50)×8,000=$160,000($21.50−$1.50)×8,000=$160,000

Issuing Common Stock with a Par Value in Exchange for Property or Services
When a company issues stock for property or services, the company increases the respective asset account with a debit and the
respective equity accounts with credits. The asset received in the exchange—such as land, equipment, inventory, or any services
provided to the corporation such as legal or accounting services—is recorded at the fair market value of the stock or the asset or
services received, whichever is more clearly determinable.
To illustrate, assume that La Cantina issues 2,000 shares of authorized common stock in exchange for legal services provided by an
attorney. The legal services have a value of $8,000 based on the amount the attorney would charge. Because La Cantina’s stock is
not actively traded, the asset will be valued at the more easily determinable market value of the legal services. La Cantina must
recognize the market value of the legal services as an increase (debit) of $8,000 to its Legal Services Expense account. Similar to
recording the stock issued for cash, the Common Stock account is increased by the par value of the issued stock, $1.50 × 2,000
shares, or $3,000. The excess of the value of the legal services over the par value of the stock appears as an increase (credit) to the
Additional Paid-in Capital from Common Stock account:
$8,000−$3,000=$5,000$8,000−$3,000=$5,000

13.3.1 [Link]
Just after the issuance of both investments, the stockholders’ equity account, Common Stock, reflects the total par value of the
issued stock; in this case, $3,000 + $12,000, or a total of $15,000. The amounts received in excess of the par value are accumulated
in the Additional Paid-in Capital from Common Stock account in the amount of $5,000 + $160,000, or $165,000. A portion of the
equity section of the balance sheet just after the two stock issuances by La Cantina will reflect the Common Stock account stock
issuances as shown in Figure 14.4.

Figure 14.4 Partial Stockholder’s Equity for La Cantina. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA
4.0 license)

Issuing No-Par Common Stock with a Stated Value

Not all stock has a par value specified in the company’s charter. In most cases, no-par stock is assigned a stated value by the board
of directors, which then becomes the legal capital value. Stock with a stated value is treated as if the stated value is a par value.
Assume that La Cantina’s 8,000 shares of common stock issued on June 1 for $21.50 were issued at a stated value of $1.50 rather
than at a par value. The total cash to be received remains $172,000 (8,000 shares × $21.50), which is recorded as an increase
(debit) to Cash. The Common Stock account increases with a credit for the stated value of the 8,000 shares issued: 8,000 × $1.50,
or $12,000. The excess received over the stated value is reported in the Additional Paid-in Capital from Common Stock account at
$160,000, based on the issue price of $21.50 per share less the stated value of $1.50, or $20, times the 8,000 shares issued:
($21.50−$1.50)×8,000=$160,000($21.50−$1.50)×8,000=$160,000
The transaction looks identical except for the explanation.

If the 8,000 shares of La Cantina’s common stock had been no-par, and no stated value had been assigned, the $172,000 would be
debited to Cash, with a corresponding increase in the Common Stock account as a credit of $172,000. No entry would be made to
Additional Paid-in Capital account as it is reserved for stock issue amounts above par or stated value. The entry would appear as:

13.3.2 [Link]
Issuing Preferred Stock
A few months later, Chad and Rick need additional capital to develop a website to add an online presence and decide to issue all
1,000 of the company’s authorized preferred shares. The 5%, $8 par value, preferred shares are sold at $45 each. The Cash account
increases with a debit for $45 times 1,000 shares, or $45,000. The Preferred Stock account increases for the par value of the
preferred stock, $8 times 1,000 shares, or $8,000. The excess of the issue price of $45 per share over the $8 par value, times the
1,000 shares, is credited as an increase to Additional Paid-in Capital from Preferred Stock, resulting in a credit of $37,000.
($45−$8)×1,000=$37,000($45−$8)×1,000=$37,000
The journal entry is:

Figure 14.5 shows what the equity section of the balance sheet will reflect after the preferred stock is issued.

Figure 14.5 Partial Stockholders’ Equity for La Cantina. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA
4.0 license)
Notice that the corporation presents preferred stock before common stock in the Stockholders’ Equity section of the balance sheet
because preferred stock has preference over common stock in the case of liquidation. GAAP requires that each class of stock
displayed in this section of the balance sheet includes several items that must be disclosed along with the respective account names.
The required items to be disclosed are:
Par or stated value
Number of shares authorized
Number of shares issued
Number of shares outstanding
If preferred stock, the dividend rate

Treasury Stock
Sometimes a corporation decides to purchase its own stock in the market. These shares are referred to as treasury stock. A company
might purchase its own outstanding stock for a number of possible reasons. It can be a strategic maneuver to prevent another
company from acquiring a majority interest or preventing a hostile takeover. A purchase can also create demand for the stock,
which in turn raises the market price of the stock. Sometimes companies buy back shares to be used for employee stock options or
profit-sharing plans.

THINK IT THROUGH

13.3.3 [Link]
Walt Disney Buys Back Stock
The Walt Disney Company has consistently spent a large portion of its cash flows in buying back its own stock. According to The
Motley Fool, the Walt Disney Company bought back 74 million shares in 2016 alone. Read the Motley Fool article and comment
on other options that Walt Disney may have had to obtain financing.

Acquiring Treasury Stock

When a company purchases treasury stock, it is reflected on the balance sheet in a contra equity account. As a contra equity
account, Treasury Stock has a debit balance, rather than the normal credit balances of other equity accounts. The total cost of
treasury stock reduces total equity. In substance, treasury stock implies that a company owns shares of itself. However, owning a
portion of one’s self is not possible. Treasury shares do not carry the basic common shareholder rights because they are not
outstanding. Dividends are not paid on treasury shares, they provide no voting rights, and they do not receive a share of assets upon
liquidation of the company. There are two methods possible to account for treasury stock—the cost method, which is discussed
here, and the par value method, which is a more advanced accounting topic. The cost method is so named because the amount in
the Treasury Stock account at any point in time represents the number of shares held in treasury times the original cost paid to
acquire each treasury share.
Assume Duratech’s net income for the first year was $3,100,000, and that the company has 12,500 shares of common stock issued.
During May, the company’s board of directors authorizes the repurchase of 800 shares of the company’s own common stock as
treasury stock. Each share of the company’s common stock is selling for $25 on the open market on May 1, the date that Duratech
purchases the stock. Duratech will pay the market price of the stock at $25 per share times the 800 shares it purchased, for a total
cost of $20,000. The following journal entry is recorded for the purchase of the treasury stock under the cost method.

Even though the company is purchasing stock, there is no asset recognized for the purchase. An entity cannot own part of itself, so
no asset is acquired. Immediately after the purchase, the equity section of the balance sheet (Figure 14.6) will show the total cost of
the treasury shares as a deduction from total stockholders’ equity.

Figure 14.6 Partial Stockholders’ Equity Section of the Balance Sheet for Duratech. After the purchase of treasury stock, the
stockholders’ equity section of the balance sheet is shown as a deduction from total stockholders’ equity. (attribution: Copyright
Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Notice on the partial balance sheet that the number of common shares outstanding changes when treasury stock transactions occur.
Initially, the company had 10,000 common shares issued and outstanding. The 800 repurchased shares are no longer outstanding,
reducing the total outstanding to 9,200 shares.

13.3.4 [Link]
CONCEPTS IN PRACTICE
Reporting Treasury Stock for Nestlé Holdings Group
Nestlé Holdings Group sells a number of major brands of food and beverages including Gerber, Häagen-Dazs, Purina, and
Lean Cuisine. The company’s statement of stockholders’ equity shows that it began with 990 million Swiss francs (CHF) in
treasury stock at the beginning of 2016. In 2017, it acquired additional shares at a cost of 3,547 million CHF, raising its total
treasury stock to 4,537 million CHF at the end of 2017, primarily due to a share buy-back program.10

Reissuing Treasury Stock above Cost

Management typically does not hold treasury stock forever. The company can resell the treasury stock at cost, above cost, below
cost, or retire it. If La Cantina reissues 100 of its treasury shares at cost ($25 per share) on July 3, a reversal of the original purchase
for the 100 shares is recorded. This has the effect of increasing an asset, Cash, with a debit, and decreasing the Treasury Stock
account with a credit. The original cost paid for each treasury share, $25, is multiplied by the 100 shares to be resold, or $2,500.
The journal entry to record this sale of the treasury shares at cost is:

If the treasury stock is resold at a price higher than its original purchase price, the company debits the Cash account for the amount
of cash proceeds, reduces the Treasury Stock account with a credit for the cost of the treasury shares being sold, and credits the
Paid-in Capital from Treasury Stock account for the difference. Even though the difference—the selling price less the cost—looks
like a gain, it is treated as additional capital because gains and losses only result from the disposition of economic resources
(assets). Treasury Stock is not an asset. Assume that on August 1, La Cantina sells another 100 shares of its treasury stock, but this
time the selling price is $28 per share. The Cash Account is increased by the selling price, $28 per share times the number of shares
resold, 100, for a total debit to Cash of $2,800. The Treasury Stock account decreases by the cost of the 100 shares sold, 100 × $25
per share, for a total credit of $2,500, just as it did in the sale at cost. The difference is recorded as a credit of $300 to Additional
Paid-in Capital from Treasury Stock.

Reissuing Treasury Stock Below Cost

If the treasury stock is reissued at a price below cost, the account used for the difference between the cash received from the resale
and the original cost of the treasury stock depends on the balance in the Paid-in Capital from Treasury Stock account. Any balance
that exists in this account will be a credit. The transaction will require a debit to the Paid-in Capital from Treasury Stock account to
the extent of the balance. If the transaction requires a debit greater than the balance in the Paid-in Capital account, any additional
difference between the cost of the treasury stock and its selling price is recorded as a reduction of the Retained Earnings account as

13.3.5 [Link]
a debit. If there is no balance in the Additional Paid-in Capital from Treasury Stock account, the entire debit will reduce retained
earnings.
Assume that on October 9, La Cantina sells another 100 shares of its treasury stock, but this time at $23 per share. Cash is
increased for the selling price, $23 per share times the number of shares resold, 100, for a total debit to Cash of $2,300. The
Treasury Stock account decreases by the cost of the 100 shares sold, 100 × $25 per share, for a total credit of $2,500. The
difference is recorded as a debit of $200 to the Additional Paid-in Capital from Treasury Stock account. Notice that the balance in
this account from the August 1 transaction was $300, which was sufficient to offset the $200 debit. The transaction is recorded as:

Treasury stock transactions have no effect on the number of shares authorized or issued. Because shares held in treasury are not
outstanding, each treasury stock transaction will impact the number of shares outstanding. A corporation may also purchase its own
stock and retire it. Retired stock reduces the number of shares issued. When stock is repurchased for retirement, the stock must be
removed from the accounts so that it is not reported on the balance sheet. The balance sheet will appear as if the stock was never
issued in the first place.

YOUR TURN
Understanding Stockholders’ Equity
Wilson Enterprises reports the following stockholders’ equity:

Figure 14.7 Wilson Enterprises, Inc., Stockholders’ Equity Section of the Balance Sheet, For the Month Ended December 31, 2020.
(attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Based on the partial balance sheet presented, answer the following questions:
A. At what price was each share of treasury stock purchased?
B. What is reflected in the additional paid-in capital account?
C. Why is there a difference between the common stock shares issued and the shares outstanding?
Solution
A. $240,000 ÷ 20,000 = $12 per share. B. The difference between the market price and the par value when the stock was issued. C.
Treasury stock.

Footnotes
10 Nestlé. “Annual Report 2017.” 2017. [Link]/investors/annual-report
11 Julie Bort. “Twitter’s IPO Created 1,600 New Millionaires and a $2.2 Billion Tax Bill, Analyst Says.” Business Insider.
November 11, 2013. [Link]

13.3.6 [Link]
13.3: Analyze and Record Transactions for the Issuance and Repurchase of Stock is shared under a CC BY-NC-SA license and was authored,
remixed, and/or curated by LibreTexts.
14.2: Analyze and Record Transactions for the Issuance and Repurchase of Stock by OpenStax is licensed CC BY-NC-SA 4.0. Original
source: [Link]

13.3.7 [Link]
13.4: Record Transactions and the Effects on Financial Statements for Cash
Dividends, Property Dividends, Stock Dividends, and Stock Splits
Do you remember playing the board game Monopoly when you were younger? If you landed on the Chance space, you picked a
card. The Chance card may have paid a $50 dividend. At the time, you probably were just excited for the additional funds.

Figure 14.8 Chance Card. A Chance card from a Monopoly game indicates that the bank pays you a dividend of $50. (credit:
modification of “Monopoly Chance Card” by Kerry Ceszyk/Flickr, CC BY 4.0)
For corporations, there are several reasons to consider sharing some of their earnings with investors in the form of dividends. Many
investors view a dividend payment as a sign of a company’s financial health and are more likely to purchase its stock. In addition,
corporations use dividends as a marketing tool to remind investors that their stock is a profit generator.
This section explains the three types of dividends—cash dividends, property dividends, and stock dividends—along with stock
splits, showing the journal entries involved and the reason why companies declare and pay dividends.

The Nature and Purposes of Dividends

Stock investors are typically driven by two factors—a desire to earn income in the form of dividends and a desire to benefit from
the growth in the value of their investment. Members of a corporation’s board of directors understand the need to provide investors
with a periodic return, and as a result, often declare dividends up to four times per year. However, companies can declare dividends
whenever they want and are not limited in the number of annual declarations. Dividends are a distribution of a corporation’s
earnings. They are not considered expenses, and they are not reported on the income statement. They are a distribution of the net
income of a company and are not a cost of business operations.

CONCEPTS IN PRACTICE
So Many Dividends
The declaration and payment of dividends varies among companies. In December 2017 alone, 4,506 U.S. companies declared
either cash, stock, or property dividends—the largest number of declarations since 2004.12 It is likely that these companies waited
to declare dividends until after financial statements were prepared, so that the board and other executives involved in the process
were able to provide estimates of the 2017 earnings.
Some companies choose not to pay dividends and instead reinvest all of their earnings back into the company. One common
scenario for situation occurs when a company experiencing rapid growth. The company may want to invest all their retained
earnings to support and continue that growth. Another scenario is a mature business that believes retaining its earnings is more
likely to result in an increased market value and stock price. In other instances, a business may want to use its earnings to purchase
new assets or branch out into new areas. Most companies attempt dividend smoothing, the practice of paying dividends that are

13.4.1 [Link]
relatively equal period after period, even when earnings fluctuate. In exceptional circumstances, some corporations pay a special
dividend, which is a one-time extra distribution of corporate earnings. A special dividend usually stems from a period of
extraordinary earnings or a special transaction, such as the sale of a division. Some companies, such as Costco Wholesale
Corporation, pay recurring dividends and periodically offer a special dividend. While Costco’s regular quarterly dividend is $0.57
per share, the company issued a $7.00 per share cash dividend in 2017.13 Companies that have both common and preferred stock
must consider the characteristics of each class of stock.
Note that dividends are distributed or paid only to shares of stock that are outstanding. Treasury shares are not outstanding, so no
dividends are declared or distributed for these shares. Regardless of the type of dividend, the declaration always causes a decrease
in the retained earnings account.

Dividend Dates
A company’s board of directors has the power to formally vote to declare dividends. The date of declaration is the date on which
the dividends become a legal liability, the date on which the board of directors votes to distribute the dividends. Cash and property
dividends become liabilities on the declaration date because they represent a formal obligation to distribute economic resources
(assets) to stockholders. On the other hand, stock dividends distribute additional shares of stock, and because stock is part of equity
and not an asset, stock dividends do not become liabilities when declared.
At the time dividends are declared, the board establishes a date of record and a date of payment. The date of record establishes
who is entitled to receive a dividend; stockholders who own stock on the date of record are entitled to receive a dividend even if
they sell it prior to the date of payment. Investors who purchase shares after the date of record but before the payment date are not
entitled to receive dividends since they did not own the stock on the date of record. These shares are said to be sold ex dividend.
The date of payment is the date that payment is issued to the investor for the amount of the dividend declared.

Cash Dividends
Cash dividends are corporate earnings that companies pass along to their shareholders. To pay a cash dividend, the corporation
must meet two criteria. First, there must be sufficient cash on hand to fulfill the dividend payment. Second, the company must have
sufficient retained earnings; that is, it must have enough residual assets to cover the dividend such that the Retained Earnings
account does not become a negative (debit) amount upon declaration. On the day the board of directors votes to declare a cash
dividend, a journal entry is required to record the declaration as a liability.

Accounting for Cash Dividends When Only Common Stock Is Issued

Small private companies like La Cantina often have only one class of stock issued, common stock. Assume that on December 16,
La Cantina’s board of directors declares a $0.50 per share dividend on common stock. As of the date of declaration, the company
has 10,000 shares of common stock issued and holds 800 shares as treasury stock. The total cash dividend to be paid is based on
the number of shares outstanding, which is the total shares issued less those in treasury. Outstanding shares are 10,000 – 800, or
9,200 shares. The cash dividend is:
9,200shares×$0.50=$4,6009,200shares×$0.50=$4,600
The journal entry to record the declaration of the cash dividends involves a decrease (debit) to Retained Earnings (a stockholders’
equity account) and an increase (credit) to Cash Dividends Payable (a liability account).

While a few companies may use a temporary account, Dividends Declared, rather than Retained Earnings, most companies debit
Retained Earnings directly. Ultimately, any dividends declared cause a decrease to Retained Earnings.
The second significant dividend date is the date of record. The date of record determines which shareholders will receive the
dividends. There is no journal entry recorded; the company creates a list of the stockholders that will receive dividends.
The date of payment is the third important date related to dividends. This is the date that dividend payments are prepared and sent
to shareholders who owned stock on the date of record. The related journal entry is a fulfillment of the obligation established on the

13.4.2 [Link]
declaration date; it reduces the Cash Dividends Payable account (with a debit) and the Cash account (with a credit).

Property Dividends
A property dividend occurs when a company declares and distributes assets other than cash. The dividend typically involves
either the distribution of shares of another company that the issuing corporation owns (one of its assets) or a distribution of
inventory. For example, Walt Disney Company may choose to distribute tickets to visit its theme parks. Anheuser-Busch InBev,
the company that owns the Budweiser and Michelob brands, may choose to distribute a case of beer to each shareholder. A
property dividend may be declared when a company wants to reward its investors but doesn’t have the cash to distribute, or if it
needs to hold onto its existing cash for other investments. Property dividends are not as common as cash or stock dividends. They
are recorded at the fair market value of the asset being distributed. To illustrate accounting for a property dividend, assume that
Duratech Corporation has 60,000 shares of $0.50 par value common stock outstanding at the end of its second year of operations,
and the company’s board of directors declares a property dividend consisting of a package of soft drinks that it produces to each
holder of common stock. The retail value of each case is $3.50. The amount of the dividend is calculated by multiplying the
number of shares by the market value of each package:
60,000shares×$3.50=$210,00060,000shares×$3.50=$210,000
The declaration to record the property dividend is a decrease (debit) to Retained Earnings for the value of the dividend and an
increase (credit) to Property Dividends Payable for the $210,000.

The journal entry to distribute the soft drinks on January 14 decreases both the Property Dividends Payable account (debit) and the
Cash account (credit).

Comparing Small Stock Dividends, Large Stock Dividends, and Stock Splits
Companies that do not want to issue cash or property dividends but still want to provide some benefit to shareholders may choose
between small stock dividends, large stock dividends, and stock splits. Both small and large stock dividends occur when a company
distributes additional shares of stock to existing stockholders.
There is no change in total assets, total liabilities, or total stockholders’ equity when a small stock dividend, a large stock dividend,
or a stock split occurs. Both types of stock dividends impact the accounts in stockholders’ equity. A stock split causes no change in
any of the accounts within stockholders’ equity. The impact on the financial statement usually does not drive the decision to choose
between one of the stock dividend types or a stock split. Instead, the decision is typically based on its effect on the market. Large
stock dividends and stock splits are done in an attempt to lower the market price of the stock so that it is more affordable to
potential investors. A small stock dividend is viewed by investors as a distribution of the company’s earnings. Both small and large
stock dividends cause an increase in common stock and a decrease to retained earnings. This is a method of capitalizing (increasing
stock) a portion of the company’s earnings (retained earnings).

13.4.3 [Link]
Stock Dividends
Some companies issue shares of stock as a dividend rather than cash or property. This often occurs when the company has
insufficient cash but wants to keep its investors happy. When a company issues a stock dividend, it distributes additional shares of
stock to existing shareholders. These shareholders do not have to pay income taxes on stock dividends when they receive them;
instead, they are taxed when the investor sells them in the future.
A stock dividend distributes shares so that after the distribution, all stockholders have the exact same percentage of ownership that
they held prior to the dividend. There are two types of stock dividends—small stock dividends and large stock dividends. The key
difference is that small dividends are recorded at market value and large dividends are recorded at the stated or par value.

Small Stock Dividends

A small stock dividend occurs when a stock dividend distribution is less than 25% of the total outstanding shares based on the
shares outstanding prior to the dividend distribution. To illustrate, assume that Duratech Corporation has 60,000 shares of $0.50 par
value common stock outstanding at the end of its second year of operations. Duratech’s board of directors declares a 5% stock
dividend on the last day of the year, and the market value of each share of stock on the same day was $9. Figure 14.9 shows the
stockholders’ equity section of Duratech’s balance sheet just prior to the stock declaration.

Figure 14.9 Stockholders’ Equity for Duratech. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0
license)
The 5% common stock dividend will require the distribution of 60,000 shares times 5%, or 3,000 additional shares of stock. An
investor who owns 100 shares will receive 5 shares in the dividend distribution (5% × 100 shares). The journal entry to record the
stock dividend declaration requires a decrease (debit) to Retained Earnings for the market value of the shares to be distributed:
3,000 shares × $9, or $27,000. An increase (credit) to the Common Stock Dividends Distributable is recorded for the par value of
the stock to be distributed: 3,000 × $0.50, or $1,500. The excess of the market value over the par value is reported as an increase
(credit) to the Additional Paid-in Capital from Common Stock account in the amount of $25,500.

If the company prepares a balance sheet prior to distributing the stock dividend, the Common Stock Dividend Distributable account
is reported in the equity section of the balance sheet beneath the Common Stock account. The journal entry to record the stock
dividend distribution requires a decrease (debit) to Common Stock Dividend Distributable to remove the distributable amount from
that account, $1,500, and an increase (credit) to Common Stock for the same par value amount.

13.4.4 [Link]
To see the effects on the balance sheet, it is helpful to compare the stockholders’ equity section of the balance sheet before and after
the small stock dividend.

After the distribution, the total stockholders’ equity remains the same as it was prior to the distribution. The amounts within the
accounts are merely shifted from the earned capital account (Retained Earnings) to the contributed capital accounts (Common
Stock and Additional Paid-in Capital). However, the number of shares outstanding has changed. Prior to the distribution, the
company had 60,000 shares outstanding. Just after the distribution, there are 63,000 outstanding. The difference is the 3,000
additional shares of the stock dividend distribution. The company still has the same total value of assets, so its value does not
change at the time a stock distribution occurs. The increase in the number of outstanding shares does not dilute the value of the
shares held by the existing shareholders. The market value of the original shares plus the newly issued shares is the same as the
market value of the original shares before the stock dividend. For example, assume an investor owns 200 shares with a market
value of $10 each for a total market value of $2,000. She receives 10 shares as a stock dividend from the company. She now has
210 shares with a total market value of $2,000. Each share now has a theoretical market value of about $9.52.

Large Stock Dividends

A large stock dividend occurs when a distribution of stock to existing shareholders is greater than 25% of the total outstanding
shares just before the distribution. The accounting for large stock dividends differs from that of small stock dividends because a
large dividend impacts the stock’s market value per share. While there may be a subsequent change in the market price of the stock
after a small dividend, it is not as abrupt as that with a large dividend.
To illustrate, assume that Duratech Corporation’s balance sheet at the end of its second year of operations shows the following in
the stockholders’ equity section prior to the declaration of a large stock dividend.

Also assume that Duratech’s board of directors declares a 30% stock dividend on the last day of the year, when the market value of
each share of stock was $9. The 30% stock dividend will require the distribution of 60,000 shares times 30%, or 18,000 additional
shares of stock. An investor who owns 100 shares will receive 30 shares in the dividend distribution (30% × 100 shares). The
journal entry to record the stock dividend declaration requires a decrease (debit) to Retained Earnings and an increase (credit) to
Common Stock Dividends Distributable for the par or stated value of the shares to be distributed: 18,000 shares × $0.50, or $9,000.
The journal entry is:

13.4.5 [Link]
The subsequent distribution will reduce the Common Stock Dividends Distributable account with a debit and increase the Common
Stock account with a credit for the $9,000.

There is no consideration of the market value in the accounting records for a large stock dividend because the number of shares
issued in a large dividend is large enough to impact the market; as such, it causes an immediate reduction of the market price of the
company’s stock.
In comparing the stockholders’ equity section of the balance sheet before and after the large stock dividend, we can see that the
total stockholders’ equity is the same before and after the stock dividend, just as it was with a small dividend (Figure 14.10).

Figure 14.10 Stockholders’ Equity Section of the Balance Sheet for Duratech. (attribution: Copyright Rice University, OpenStax,
under CC BY-NC-SA 4.0 license)
Similar to distribution of a small dividend, the amounts within the accounts are shifted from the earned capital account (Retained
Earnings) to the contributed capital account (Common Stock) though in different amounts. The number of shares outstanding has
increased from the 60,000 shares prior to the distribution, to the 78,000 outstanding shares after the distribution. The difference is
the 18,000 additional shares in the stock dividend distribution. No change to the company’s assets occurred; however, the potential
subsequent increase in market value of the company’s stock will increase the investor’s perception of the value of the company.

Stock Splits
A traditional stock split occurs when a company’s board of directors issue new shares to existing shareholders in place of the old
shares by increasing the number of shares and reducing the par value of each share. For example, in a 2-for-1 stock split, two shares
of stock are distributed for each share held by a shareholder. From a practical perspective, shareholders return the old shares and
receive two shares for each share they previously owned. The new shares have half the par value of the original shares, but now the
shareholder owns twice as many. If a 5-for-1 split occurs, shareholders receive 5 new shares for each of the original shares they
owned, and the new par value results in one-fifth of the original par value per share.
While a company technically has no control over its common stock price, a stock’s market value is often affected by a stock split.
When a split occurs, the market value per share is reduced to balance the increase in the number of outstanding shares. In a 2-for-1
split, for example, the value per share typically will be reduced by half. As such, although the number of outstanding shares and the
price change, the total market value remains constant. If you buy a candy bar for $1 and cut it in half, each half is now worth $0.50.
The total value of the candy does not increase just because there are more pieces.
A stock split is much like a large stock dividend in that both are large enough to cause a change in the market price of the stock.
Additionally, the split indicates that share value has been increasing, suggesting growth is likely to continue and result in further

13.4.6 [Link]
increase in demand and value. Companies often make the decision to split stock when the stock price has increased enough to be
out of line with competitors, and the business wants to continue to offer shares at an attractive price for small investors.

CONCEPTS IN PRACTICE
Samsung Boasts a 50-to-1 Stock Split
In May of 2018, Samsung Electronics14 had a 50-to-1 stock split in an attempt to make it easier for investors to buy its stock.
Samsung’s market price of each share prior to the split was an incredible 2.65 won (“won” is a Japanese currency), or $2,467.48.
Buying one share of stock at this price is rather expensive for most people. As might be expected, even after a slight drop in trading
activity just after the split announcement, the reduced market price of the stock generated a significant increase to investors by
making the price per share less expensive. The split caused the price to drop to 0.053 won, or $49.35 per share. This made the stock
more accessible to potential investors who were previously unable to afford a share at $2,467.
A reverse stock split occurs when a company attempts to increase the market price per share by reducing the number of shares of
stock. For example, a 1-for-3 stock split is called a reverse split since it reduces the number of shares of stock outstanding by two-
thirds and triples the par or stated value per share. The effect on the market is to increase the market value per share. A primary
motivator of companies invoking reverse splits is to avoid being delisted and taken off a stock exchange for failure to maintain the
exchange’s minimum share price.
Accounting for stock splits is quite simple. No journal entry is recorded for a stock split. Instead, the company prepares a memo
entry in its journal that indicates the nature of the stock split and indicates the new par value. The balance sheet will reflect the new
par value and the new number of shares authorized, issued, and outstanding after the stock split. To illustrate, assume that
Duratech’s board of directors declares a 4-for-1 common stock split on its $0.50 par value stock. Just before the split, the company
has 60,000 shares of common stock outstanding, and its stock was selling at $24 per share. The split causes the number of shares
outstanding to increase by four times to 240,000 shares (4 × 60,000), and the par value to decline to one-fourth of its original value,
to $0.125 per share ($0.50 ÷ 4). No change occurs to the dollar amount of any general ledger account.

The split typically causes the market price of stock to decline immediately to one-fourth of the original value—from the $24 per
share pre-split price to approximately $6 per share post-split ($24 ÷ 4), because the total value of the company did not change as a
result of the split. The total stockholders’ equity on the company’s balance sheet before and after the split remain the same.

THINK IT THROUGH
Accounting for a Stock Split
You have just obtained your MBA and obtained your dream job with a large corporation as a manager trainee in the corporate
accounting department. Your employer plans to offer a 3-for-2 stock split. Briefly indicate the accounting entries necessary to
recognize the split in the company’s accounting records and the effect the split will have on the company’s balance sheet.

13.4.7 [Link]
YOUR TURN
Dividend Accounting
Cynadyne, Inc.’s has 4,000 shares of $0.20 par value common stock authorized, 2,800 issued, and 400 shares held in treasury at the
end of its first year of operations. On May 1, the company declared a $1 per share cash dividend, with a date of record on May 12,
to be paid on May 25. What journal entries will be prepared to record the dividends?
Solution
A journal entry for the dividend declaration and a journal entry for the cash payout:
To record the declaration:

Date of declaration, May 12, no entry.

To record the payment:

THINK IT THROUGH
Recording Stock Transactions
In your first year of operations the following transactions occur for a company:
Net profit for the year is $16,000
100 shares of $1 par value common stock are issued for $32 per share
The company purchases 10 shares at $35 per share
The company pays a cash dividend of $1.50 per share
Prepare journal entries for the above transactions and provide the balance in the following accounts: Common Stock, Dividends,
Paid-in Capital, Retained Earnings, and Treasury Stock.

Footnotes
12 Ironman at Political Calculations. “Dividends by the Numbers through January 2018.” Seeking Alpha. February 9, 2018.
[Link]/article/414...s-january-2018
13 Jing Pan. “Will Costco Wholesale Corporation Pay a Special Dividend in 2018?” Income Investors. May 9, 2018.
[Link]
14 Joyce Lee. “Trading in Samsung Electronics Shares Surges after Stock Split.” Reuters. May 3, 2018.
[Link]

13.4: Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits is
shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by LibreTexts.
14.3: Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and
Stock Splits by OpenStax is licensed CC BY-NC-SA 4.0. Original source: [Link]

13.4.8 [Link]
13.5: Compare and Contrast Owners’ Equity versus Retained Earnings
Owners’ equity represents the business owners’ share of the company. It is often referred to as net worth or net assets in the
financial world and as stockholders’ equity or shareholders’ equity when discussing businesses operations of corporations. From a
practical perspective, it represents everything a company owns (the company’s assets) minus all the company owes (its liabilities).
While “owners’ equity” is used for all three types of business organizations (corporations, partnerships, and sole proprietorships),
only sole proprietorships name the balance sheet account “owner’s equity” as the entire equity of the company belongs to the sole
owner. Partnerships (to be covered more thoroughly in Partnership Accounting) often label this section of their balance sheet as
“partners’ equity.” All three forms of business utilize different accounting for the respective equity transactions and use different
equity accounts, but they all rely on the same relationship represented by the basic accounting equation (Figure 14.11).

Figure 14.11 Accounting Equation. The relationship among assets, liabilities, and equity is represented in the accounting equation.
(attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Three Forms of Business Ownership

Businesses operate in one of three forms—sole proprietorships, partnerships, or corporations. Sole proprietorships utilize a single
account in owners’ equity in which the owner’s investments and net income of the company are accumulated and distributions to
the owner are withdrawn. Partnerships utilize a separate capital account for each partner, with each capital account holding the
respective partner’s investments and the partner’s respective share of net income, with reductions for the distributions to the
respective partners. Corporations differ from sole proprietorships and partnerships in that their operations are more complex, often
due to size. Unlike these other entity forms, owners of a corporation usually change continuously.
The stockholders’ equity section of the balance sheet for corporations contains two primary categories of accounts. The first is
paid-in capital, or contributed capital—consisting of amounts paid in by owners. The second category is earned capital,
consisting of amounts earned by the corporation as part of business operations. On the balance sheet, retained earnings is a key
component of the earned capital section, while the stock accounts such as common stock, preferred stock, and additional paid-in
capital are the primary components of the contributed capital section.

CONCEPTS IN PRACTICE
Contributed Capital and Earned Capital
The stockholders’ equity section of Cracker Barrel Old Country Store, Inc.’s consolidated balance sheet as of July 28, 2017, and
July 29, 2016, shows the company’s contributed capital and the earned capital accounts.15

Characteristics and Functions of the Retained Earnings Account

Retained earnings is the primary component of a company’s earned capital. It generally consists of the cumulative net income
minus any cumulative losses less dividends declared. A basic statement of retained earnings is referred to as an analysis of retained
earnings because it shows the changes in the retained earnings account during the period. A company preparing a full set of

13.5.1 [Link]
financial statements may choose between preparing a statement of retained earnings, if the activity in its stock accounts is
negligible, or a statement of stockholders’ equity, for corporations with activity in their stock accounts. A statement of retained
earnings for Clay Corporation for its second year of operations (Figure 14.12) shows the company generated more net income than
the amount of dividends it declared.

Figure 14.12 Statement of Retained Earnings for Clay Corporation. (attribution: Copyright Rice University, OpenStax, under CC
BY-NC-SA 4.0 license)
When the retained earnings balance drops below zero, this negative or debit balance is referred to as a deficit in retained earnings.

Restrictions to Retained Earnings

Retained earnings is often subject to certain restrictions. Restricted retained earnings is the portion of a company’s earnings that
has been designated for a particular purpose due to legal or contractual obligations. Some of the restrictions reflect the laws of the
state in which a company operates. Many states restrict retained earnings by the cost of treasury stock, which prevents the legal
capital of the stock from dropping below zero. Other restrictions are contractual, such as debt covenants and loan arrangements;
these exist to protect creditors, often limiting the payment of dividends to maintain a minimum level of earned capital.

Appropriations of Retained Earnings

A company’s board of directors may designate a portion of a company’s retained earnings for a particular purpose such as future
expansion, special projects, or as part of a company’s risk management plan. The amount designated for a particular purpose is
classified as appropriated retained earnings.
There are two options in accounting for appropriated retained earnings, both of which allow the corporation to inform the financial
statement users of the company’s future plans. The first accounting option is to make no journal entry and disclose the amount of
appropriation in the notes to the financial statement. The second option is to record a journal entry that transfers part of the
unappropriated retained earnings into an Appropriated Retained Earnings account. To illustrate, assume that on March 3, Clay
Corporation’s board of directors appropriates $12,000 of its retained earnings for future expansion. The company’s retained
earnings account is first renamed as Unappropriated Retained Earnings. The journal entry decreases the Unappropriated Retained
Earnings account with a debit and increases the Appropriated Retained Earnings account with a credit for $12,000.

The company will report the appropriate retained earnings in the earned capital section of its balance sheet. It should be noted that
an appropriation does not set aside funds nor designate an income statement, asset, or liability effect for the appropriated amount.
The appropriation simply designates a portion of the company’s retained earnings for a specific purpose, while signaling that the
earnings are being retained in the company and are not available for dividend distributions.

Statement of Stockholders’ Equity

The statement of retained earnings is a subsection of the statement of stockholders’ equity. While the retained earnings statement
shows the changes between the beginning and ending balances of the retained earnings account during the period, the statement of
stockholders’ equity provides the changes between the beginning and ending balances of each of the stockholders’ equity

13.5.2 [Link]
accounts, including retained earnings. The format typically displays a separate column for each stockholders’ equity account, as
shown for Clay Corporation in Figure 14.13. The key events that occurred during the year—including net income, stock issuances,
and dividends—are listed vertically. The stockholders’ equity section of the company’s balance sheet displays only the ending
balances of the accounts and does not provide the activity or changes during the period.

Figure 14.13 Statement of Stockholders’ Equity for Clay Corporation. (attribution: Copyright Rice University, OpenStax, under CC
BY-NC-SA 4.0 license)
Nearly all public companies report a statement of stockholders’ equity rather than a statement of retained earnings because GAAP
requires disclosure of the changes in stockholders’ equity accounts during each accounting period. It is significantly easier to see
the changes in the accounts on a statement of stockholders’ equity rather than as a paragraph note to the financial statements.

IFRS CONNECTION
Corporate Accounting and IFRS
Both U.S. GAAP and IFRS require the reporting of the various owners’ accounts. Under U.S. GAAP, these accounts are presented
in a statement that is most often called the Statement of Stockholders’ Equity. Under IFRS, this statement is usually called the
Statement of Changes in Equity. Some of the biggest differences between U.S. GAAP and IFRS that arise in reporting the various
accounts that appear in those statements relate to either categorization or terminology differences.
U.S. GAAP divides owners’ accounts into two categories: contributed capital and retained earnings. IFRS uses three categories:
share capital, accumulated profits and losses, and reserves. The first two IFRS categories correspond to the two categories used
under U.S. GAAP. What about the third category, reserves? Reserves is a category that is used to report items such as revaluation
surpluses from revaluing long-term assets (see the Long-Term Assets Feature Box: IFRS Connection for details), as well as other
equity transactions such as unrealized gains and losses on available-for-sale securities and transactions that fall under Other
Comprehensive Income (topics typically covered in more advanced accounting classes). U.S. GAAP does not use the term
“reserves” for any reporting.
There are also differences in terminology between U.S. GAAP and IFRS shown in Table 14.1.
Terminology Differences between U.S. GAAP and IFRS

U.S. GAAP IFRS

Common stock Share capital

Preferred stock Preference shares

Additional paid-in capital Share premium

Stockholders Shareholders

Retained earnings Retained profits or accumulated profits

Retained earnings deficit Accumulated losses

Table14.1

13.5.3 [Link]
All of this information pertains to publicly traded corporations, but what about corporations that are not publicly traded? Most
corporations in the U.S. are not publicly traded, so do these corporations use U.S. GAAP? Some do; some do not. A non-public
corporation can use cash basis, tax basis, or full accrual basis of accounting. Most corporations would use a full accrual basis of
accounting such as U.S. GAAP. Cash and tax basis are most likely used only by sole proprietors or small partnerships.
However, U.S. GAAP is not the only full accrual method available to non-public corporations. Two alternatives are IFRS and a
simpler form of IFRS, known as IFRS for Small and Medium Sized Entities, or SMEs for short. In 2008, the AICPA recognized the
IASB as a standard setter of acceptable GAAP and designated IFRS and IFRS for SMEs as an acceptable set of generally accepted
accounting principles. However, it is up to each State Board of Accountancy to determine if that state will allow the use of IFRS or
IFRS for SMEs by non-public entities incorporated in that state.
What is a SME? Despite the use of size descriptors in the title, qualifying as a small or medium-sized entity has nothing to do with
size. A SME is any entity that publishes general purpose financial statements for public use but does not have public accountability.
In other words, the entity is not publicly traded. In addition, the entity, even if it is a partnership, cannot act as a fiduciary; for
example, it cannot be a bank or insurance company and use SME rules.
Why might a non-public corporation want to use IFRS for SMEs? First, IFRS for SMEs contains fewer and simpler standards.
IFRS for SMEs has only about 300 pages of requirements, whereas regular IFRS is over 2,500 pages and U.S. GAAP is over
25,000 pages. Second, IFRS for SMEs is only modified every three years. This means entities using IFRS for SMEs don’t have to
frequently adjust their accounting systems and reporting to new standards, whereas U.S. GAAP and IFRS are modified more
frequently. Finally, if a corporation transacts business with international businesses, or hopes to attract international partners, seek
capital from international sources, or be bought out by an international company, then having their financial statements in IFRS
form would make these transactions easier.

Prior Period Adjustments

Prior period adjustments are corrections of errors that appeared on previous periods’ financial statements. These errors can stem
from mathematical errors, misinterpretation of GAAP, or a misunderstanding of facts at the time the financial statements were
prepared. Many errors impact the retained earnings account whose balance is carried forward from the previous period. Since the
financial statements have already been issued, they must be corrected. The correction involves changing the financial statement
amounts to the amounts they would have been had no errors occurred, a process known as restatement. The correction may impact
both balance sheet and income statement accounts, requiring the company to record a transaction that corrects both. Since income
statement accounts are closed at the end of every period, the journal entry will contain an entry to the Retained Earnings account.
As such, prior period adjustments are reported on a company’s statement of retained earnings as an adjustment to the beginning
balance of retained earnings. By directly adjusting beginning retained earnings, the adjustment has no effect on current period net
income. The goal is to separate the error correction from the current period’s net income to avoid distorting the current period’s
profitability. In other words, prior period adjustments are a way to go back and correct past financial statements that were misstated
because of a reporting error.

CONCEPTS IN PRACTICE
Are Companies Making Fewer Errors in Financial Reporting?
According to Kevin LaCroix, additional reporting requirements created by the Sarbanes Oxley Act prompted a surge in 2005 and
2006 of the number of companies that had to make corrections and reissue financial statements. However, since that time, the
number of companies making corrections has dropped over 60%, partially due to the number of U.S. companies listed on stock
exchanges, and partially due to tighter regulations. The severity of the errors that caused restatements has declined as well,
primarily due to tighter regulation, which has forced companies to improve their internal controls.16
To illustrate how to correct an error requiring a prior period adjustment, assume that in early 2020, Clay Corporation’s controller
determined it had made an error when calculating depreciation in the preceding year, resulting in an understatement of depreciation
of $1,000. The entry to correct the error contains a decrease to Retained Earnings on the statement of retained earnings for $1,000.
Depreciation expense would have been $1,000 higher if the correct depreciation had been recorded. The entry to Retained Earnings
adds an additional debit to the total debits that were previously part of the closing entry for the previous year. The credit is to the
balance sheet account in which the $1,000 would have been recorded had the correct depreciation entry occurred, in this case,
Accumulated Depreciation.

13.5.4 [Link]
Because the adjustment to retained earnings is due to an income statement amount that was recorded incorrectly, there will also be
an income tax effect. The tax effect is shown in the statement of retained earnings in presenting the prior period adjustment.
Assuming that Clay Corporation’s income tax rate is 30%, the tax effect of the $1,000 is a $300 (30% × $1,000) reduction in
income taxes. The increase in expenses in the amount of $1,000 combined with the $300 decrease in income tax expense results in
a net $700 decrease in net income for the prior period. The $700 prior period correction is reported as an adjustment to beginning
retained earnings, net of income taxes, as shown in Figure 14.14.

Figure 14.14 Statement of Retained Earnings for Clay Corporation. (attribution: Copyright Rice University, OpenStax, under CC
BY-NC-SA 4.0 license)
Generally accepted accounting principles (GAAP), the set of accounting rules that companies are required to follow for financial
reporting, requires companies to disclose in the notes to the financial statements the nature of any prior period adjustment and the
related impact on the financial statement amounts.

LINK TO LEARNING
The correction of errors in financial statements is a complicated situation. Both shareholders and investors tend to view these with
deep suspicion. Many believe corporations are attempting to smooth earnings, hide possible problems, or cover up mistakes. The
Journal of Accountancy, a periodical published by the AICPA, offers guidance in how to manage this process. Browse the Journal
of Accountancy website for articles and cases of prior period adjustment issues.

CONCEPTS IN PRACTICE
Tune into Financial News
Tune into a financial news program like Squawk Box or Mad Money on CNBC or Bloomberg’s. Notice the terminology used to
describe the corporations being analyzed. Notice the speed at which topics are discussed. Are these shows for the novice investor?
How could this information impact potential investors?

LINK TO LEARNING
Log onto the Annual Reports website to access a comprehensive collection of more than 5,000 annual reports produced by
publicly-traded companies. The site is a tremendous resource for both school and investment-related research. Reading annual
reports provides a different type of insight into corporations. Beyond the financial statements, annual reports give shareholders and
the public a glimpse into the operations, mission, and charitable giving of a corporation.

13.5.5 [Link]
Footnotes
15 Cracker Barrel. Cracker Barrel Old Country Store Annual Report 2017. September 22, 2017.
[Link]
16 Kevin M. LaCroix. “Financial Statements Continue to Decline for U.S. Reporting Companies.” The D & O Diary. June 12,
2017. [Link]

13.5: Compare and Contrast Owners’ Equity versus Retained Earnings is shared under a CC BY-NC-SA license and was authored, remixed,
and/or curated by LibreTexts.
14.4: Compare and Contrast Owners’ Equity versus Retained Earnings by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

13.5.6 [Link]
 CHAPTER OVERVIEW

14: Statement of Cash Flows

14.1: Explain the Purpose of the Statement of Cash Flows
14.2: Differentiate between Operating, Investing, and Financing Activities
14.3: Prepare the Statement of Cash Flows Using the Indirect Method
14.4: Prepare the Completed Statement of Cash Flows Using the Indirect Method

14: Statement of Cash Flows is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1
14.1: Explain the Purpose of the Statement of Cash Flows
The statement of cash flows is a financial statement listing the cash inflows and cash outflows for the business for a period of
time. Cash flow represents the cash receipts and cash disbursements as a result of business activity. The statement of cash flows
enables users of the financial statements to determine how well a company’s income generates cash and to predict the potential of a
company to generate cash in the future.
Accrual accounting creates timing differences between income statement accounts and cash. A revenue transaction may be
recorded in a different fiscal year than the year the cash related to that revenue is received. One purpose of the statement of cash
flows is that users of the financial statements can see the amount of cash inflows and outflows during a year in addition to the
amount of revenue and expense shown on the income statement. This is important because cash flows often differ significantly
from accrual basis net income. For example, assume in 2019 that Amazon showed a loss of approximately $720 million, yet
Amazon’s cash balance increased by more than $91 million. Much of the change can be explained by timing differences between
income statement accounts and cash receipts and distributions.
A related use of the statement of cash flows is that it provides information about the quality of a company’s net income. A company
that has records that show significantly less cash inflow on the statement of cash flows than the reported net income on the income
statement could very well be reporting revenue for which cash will never be received from the customer or underreporting
expenses.
A third use of the statement of cash flows is that it provides information about a company’s sources and uses of cash not related to
the income statement. For example, assume in 2019 that Amazon spent $287 million on purchasing fixed assets and almost $370
million acquiring other businesses. This indicated to financial statement users that Amazon was expanding even as it was losing
money. Investors must have thought that spending was good news as Amazon was able to raise more than $1 billion in borrowings
or stock issuances in 2019.

ETHICAL CONSIDERATIONS
Cash Flow Statement Reporting
US generally accepted accounting principles (GAAP) has codified how cash flow statements are to be presented to users of
financial statements. This was codified in Topic 230: Statement of Cash Flows as part of US GAAP.1 Accountants in the United
States should follow US GAAP. Accountants working internationally must report in accordance with International Accounting
Standard (IAS) 7 Statement of Cash Flows.2 The ethical accountant understands the users of a company’s financial statement and
properly prepares a Statement of Cash Flow. There is often more than one way that financial statements can be presented, such as
US GAAP and International Financial Reporting Standards (IFRS). What if a company under US GAAP showed reporting issues
on their financial statements and switched to IFRS where results looked better. Is this proper? Does this occur?
The statement of cash flows identifies the sources of cash as well as the uses of cash, for the period being reported, which leads the
user of the financial statement to the period’s net cash flows, which is a method used to determine profitability by measuring the
difference between an entity’s cash inflows and cash outflows. The statement answers the following two questions: What are the
sources of cash (where does the cash come from)? What are the uses of cash (where does the cash go)? A positive net cash flow
indicates an increase in cash during the reporting period, whereas a negative net cash flow indicates a decrease in cash during the
reporting period. The statement of cash flows is also used as a predictive tool for external users of the financial statements, for
estimated future cash flows, based on cash flow results in the past.

LINK TO LEARNING
This video from Khan Academy explains cash flows in a unique way.

Approaches to Preparing the Statement of Cash Flows

The statement of cash flows can be prepared using the indirect approach or the direct approach. The indirect method approach
reconciles net income to cash flows by subtracting noncash expenses and adjusting for changes in current assets and liabilities,
which reflects timing differences between accrual-based net income and cash flows. A noncash expense is an expense that reduces
net income but is not associated with a cash flow; the most common example is depreciation expense. The direct methodlists net
cash flows from revenue and expenses, whereby accrual basis revenue and expenses are converted to cash basis collections and
payments. Because the vast majority of financial statements are presented using the indirect method, the indirect approach will be

14.1.1 [Link]
demonstrated within the chapter, and the direct method will be demonstrated in Appendix: Prepare a Completed Statement of Cash
Flows Using the Direct Method.

LINK TO LEARNING
AccountingCoach is a great resource for many accounting topics, including cash flow issues.

Footnotes
1 Financial Accounting Standards Board (FASB). “Statement of Cash Flows (Topic 230) Classification of Certain Cash
Receipts and Cash Payments.” An Amendment of the FASB Accounting Standards Codification. August 2016.
[Link]
2 International Financial Reporting Standards (IFRS). “IAS 7 Statement of Cash Flows.” n.d. [Link]/issued-standard...of-
cash-flows/

14.1: Explain the Purpose of the Statement of Cash Flows is shared under a CC BY-NC-SA license and was authored, remixed, and/or curated by
LibreTexts.
16.1: Explain the Purpose of the Statement of Cash Flows by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

14.1.2 [Link]
14.2: Differentiate between Operating, Investing, and Financing Activities
The statement of cash flows presents sources and uses of cash in three distinct categories: cash flows from operating activities, cash
flows from investing activities, and cash flows from financing activities. Financial statement users are able to assess a company’s
strategy and ability to generate a profit and stay in business by assessing how much a company relies on operating, investing, and
financing activities to produce its cash flows.

THINK IT THROUGH
Classification of Cash Flows Makes a Difference
Assume you are the chief financial officer of T-Shirt Pros, a small business that makes custom-printed T-shirts. While reviewing the
financial statements that were prepared by company accountants, you discover an error. During this period, the company had
purchased a warehouse building, in exchange for a $200,000 note payable. The company’s policy is to report noncash investing and
financing activities in a separate statement, after the presentation of the statement of cash flows. This noncash investing and
financing transaction was inadvertently included in both the financing section as a source of cash, and the investing section as a use
of cash.
T-Shirt Pros’ statement of cash flows, as it was prepared by the company accountants, reported the following for the period, and
had no other capital expenditures.

Because of the misplacement of the transaction, the calculation of free cash flow by outside analysts could be affected significantly.
Free cash flow is calculated as cash flow from operating activities, reduced by capital expenditures, the value for which is normally
obtained from the investing section of the statement of cash flows. As their manager, would you treat the accountants’ error as a
harmless misclassification, or as a major blunder on their part? Explain.

Cash Flows from Operating Activities

Cash flows from operating activities arise from the activities a business uses to produce net income. For example, operating cash
flows include cash sources from sales and cash used to purchase inventory and to pay for operating expenses such as salaries and
utilities. Operating cash flows also include cash flows from interest and dividend revenue interest expense, and income tax.

Cash Flows from Investing Activities

Cash flows from investing activities are cash business transactions related to a business’ investments in long-term assets. They can
usually be identified from changes in the Fixed Assets section of the long-term assets section of the balance sheet. Some examples
of investing cash flows are payments for the purchase of land, buildings, equipment, and other investment assets and cash receipts
from the sale of land, buildings, equipment, and other investment assets.

Cash Flows from Financing Activities

Cash flows from financing activities are cash transactions related to the business raising money from debt or stock, or repaying
that debt. They can be identified from changes in long-term liabilities and equity. Examples of financing cash flows include cash
proceeds from issuance of debt instruments such as notes or bonds payable, cash proceeds from issuance of capital stock, cash
payments for dividend distributions, principal repayment or redemption of notes or bonds payable, or purchase of treasury stock.
Cash flows related to changes in equity can be identified on the Statement of Stockholder’s Equity, and cash flows related to long-
term liabilities can be identified by changes in long-term liabilities on the balance sheet.

14.2.1 [Link]
CONCEPTS IN PRACTICE
Can a Negative Be Positive?
Investors do not always take a negative cash flow as a negative. For example, assume in 2018 Amazon showed a loss of $124
billion and a net cash outflow of $262 billion from investing activities. Yet during the same year, Amazon was able to raise a net
$254 billion through financing. Why would investors and lenders be willing to place money with Amazon? For one thing, despite
having a net loss, Amazon produced $31 billion cash from operating activities. Much of this was through delaying payment on
inventories. Amazon’s accounts payable increased by $78 billion, while its inventory increased by $20 billion.
Another reason lenders and investors were willing to fund Amazon is that investing payments are often signs of a company
growing. Assume that in 2018 Amazon paid almost $50 billion to purchase fixed assets and to acquire other businesses; this is a
signal of a company that is growing. Lenders and investors interpreted Amazon’s cash flows as evidence that Amazon would be
able to produce positive net income in the future. In fact, Amazon had net income of $19 billion in 2017. Furthermore, Amazon is
still showing growth through its statement of cash flows; it spent about $26 billion in fixed equipment and acquisitions.

14.2: Differentiate between Operating, Investing, and Financing Activities is shared under a CC BY-NC-SA license and was authored, remixed,
and/or curated by LibreTexts.
16.2: Differentiate between Operating, Investing, and Financing Activities by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

14.2.2 [Link]
14.3: Prepare the Statement of Cash Flows Using the Indirect Method
The statement of cash flows is prepared by following these steps:
Step 1: Determine Net Cash Flows from Operating Activities
Using the indirect method, operating net cash flow is calculated as follows:
Begin with net income from the income statement.
Add back noncash expenses, such as depreciation, amortization, and depletion.
Remove the effect of gains and/or losses from disposal of long-term assets, as cash from the disposal of long-term assets is
shown under investing cash flows.
Adjust for changes in current assets and liabilities to remove accruals from operating activities.
Step 2: Determine Net Cash Flows from Investing Activities
Investing net cash flow includes cash received and cash paid relating to long-term assets.
Step 3: Present Net Cash Flows from Financing Activities
Financing net cash flow includes cash received and cash paid relating to long-term liabilities and equity.
Step 4: Reconcile Total Net Cash Flows to Change in Cash Balance during the Period
To reconcile beginning and ending cash balances:
The net cash flows from the first three steps are combined to be total net cash flow.
The beginning cash balance is presented from the prior year balance sheet.
Total net cash flow added to the beginning cash balance equals the ending cash balance.
Step 5: Present Noncash Investing and Financing Transactions
Transactions that do not affect cash but do affect long-term assets, long-term debt, and/or equity are disclosed, either as a notation
at the bottom of the statement of cash flow, or in the notes to the financial statements.
The remainder of this section demonstrates preparation of the statement of cash flows of the company whose financial statements
are shown in Figure 16.2, Figure 16.3, and Figure 16.4.

Figure 16.2Comparative Balance Sheet. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

14.3.1 [Link]
 Figure 16.3 Income Statement. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)
Additional Information:
1. Propensity Company sold land with an original cost of $10,000, for $14,800 cash.
2. A new parcel of land was purchased for $20,000, in exchange for a note payable.
3. Plant assets were purchased for $40,000 cash.
4. Propensity declared and paid a $440 cash dividend to shareholders.
5. Propensity issued common stock in exchange for $45,000 cash.

14.3.2 [Link]
 Figure 16.4Statement of Cash Flows. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Prepare the Operating Activities Section of the Statement of Cash Flows Using the Indirect Method
In the following sections, specific entries are explained to demonstrate the items that support the preparation of the operating
activities section of the Statement of Cash Flows (Indirect Method) for the Propensity Company example financial statements.
Begin with net income from the income statement.
Add back noncash expenses, such as depreciation, amortization, and depletion.
Reverse the effect of gains and/or losses from investing activities.
Adjust for changes in current assets and liabilities, to reflect how those changes impact cash in a way that is different than is
reported in net income.0

Start with Net Income

The operating activities cash flow is based on the company’s net income, with adjustments for items that affect cash differently
than they affect net income. The net income on the Propensity Company income statement for December 31, 2018, is $4,340. On
Propensity’s statement of cash flows, this amount is shown in the Cash Flows from Operating Activities section as Net Income.

Add Back Noncash Expenses

Net income includes deductions for noncash expenses. To reconcile net income to cash flow from operating activities, these
noncash items must be added back, because no cash was expended relating to that expense. The sole noncash expense on
Propensity Company’s income statement, which must be added back, is the depreciation expense of $14,400. On Propensity’s
statement of cash flows, this amount is shown in the Cash Flows from Operating Activities section as an adjustment to reconcile
net income to net cash flow from operating activities.

14.3.3 [Link]
Reverse the Effect of Gains and/or Losses
Gains and/or losses on the disposal of long-term assets are included in the calculation of net income, but cash obtained from
disposing of long-term assets is a cash flow from an investing activity. Because the disposition gain or loss is not related to normal
operations, the adjustment needed to arrive at cash flow from operating activities is a reversal of any gains or losses that are
included in the net income total. A gain is subtracted from net income and a loss is added to net income to reconcile to cash from
operating activities. Propensity’s income statement for the year 2018 includes a gain on sale of land, in the amount of $4,800, so a
reversal is accomplished by subtracting the gain from net income. On Propensity’s statement of cash flows, this amount is shown
in the Cash Flows from Operating Activities section as Gain on Sale of Plant Assets.

Adjust for Changes in Current Assets and Liabilities

Because the Balance Sheet and Income Statement reflect the accrual basis of accounting, whereas the statement of cash flows
considers the incoming and outgoing cash transactions, there are continual differences between (1) cash collected and paid and (2)
reported revenue and expense on these statements. Changes in the various current assets and liabilities can be determined from
analysis of the company’s comparative balance sheet, which lists the current period and previous period balances for all assets and
liabilities. The following four possibilities offer explanations of the type of difference that might arise, and demonstrate examples
from Propensity Company’s statement of cash flows, which represent typical differences that arise relating to these current assets
and liabilities.

Increase in Noncash Current Assets

Increases in current assets indicate a decrease in cash, because either (1) cash was paid to generate another current asset, such as
inventory, or (2) revenue was accrued, but not yet collected, such as accounts receivable. In the first scenario, the use of cash to
increase the current assets is not reflected in the net income reported on the income statement. In the second scenario, revenue is
included in the net income on the income statement, but the cash has not been received by the end of the period. In both cases,
current assets increased and net income was reported on the income statement greater than the actual net cash impact from the
related operating activities. To reconcile net income to cash flow from operating activities, subtract increases in current assets.
Propensity Company had two instances of increases in current assets. One was an increase of $700 in prepaid insurance, and the
other was an increase of $2,500 in inventory. In both cases, the increases can be explained as additional cash that was spent, but
which was not reflected in the expenses reported on the income statement.

14.3.4 [Link]
Decrease in Noncash Current Assets
Decreases in current assets indicate lower net income compared to cash flows from (1) prepaid assets and (2) accrued revenues. For
decreases in prepaid assets, using up these assets shifts these costs that were recorded as assets over to current period expenses that
then reduce net income for the period. Cash was paid to obtain the prepaid asset in a prior period. Thus, cash from operating
activities must be increased to reflect the fact that these expenses reduced net income on the income statement, but cash was not
paid this period. Secondarily, decreases in accrued revenue accounts indicates that cash was collected in the current period but was
recorded as revenue on a previous period’s income statement. In both scenarios, the net income reported on the income statement
was lower than the actual net cash effect of the transactions. To reconcile net income to cash flow from operating activities, add
decreases in current assets.
Propensity Company had a decrease of $4,500 in accounts receivable during the period, which normally results only when
customers pay the balance, they owe the company at a faster rate than they charge new account balances. Thus, the decrease in
receivable identifies that more cash was collected than was reported as revenue on the income statement. Thus, an addback is
necessary to calculate the cash flow from operating activities.

Current Operating Liability Increase

Increases in current liabilities indicate an increase in cash, since these liabilities generally represent (1) expenses that have been
accrued, but not yet paid, or (2) deferred revenues that have been collected, but not yet recorded as revenue. In the case of accrued
expenses, costs have been reported as expenses on the income statement, whereas the deferred revenues would arise when cash was
collected in advance, but the revenue was not yet earned, so the payment would not be reflected on the income statement. In both
cases, these increases in current liabilities signify cash collections that exceed net income from related activities. To reconcile net
income to cash flow from operating activities, add increases in current liabilities.
Propensity Company had an increase in the current operating liability for salaries payable, in the amount of $400. The payable
arises, or increases, when an expense is recorded but the balance due is not paid at that time. An increase in salaries payable
therefore reflects the fact that salaries expenses on the income statement are greater than the cash outgo relating to that expense.
This means that net cash flow from operating is greater than the reported net income, regarding this cost.

Current Operating Liability Decrease

Decreases in current liabilities indicate a decrease in cash relating to (1) accrued expenses, or (2) deferred revenues. In the first
instance, cash would have been expended to accomplish a decrease in liabilities arising from accrued expenses, yet these cash
payments would not be reflected in the net income on the income statement. In the second instance, a decrease in deferred revenue
means that some revenue would have been reported on the income statement that was collected in a previous period. As a result,
cash flows from operating activities must be decreased by any reduction in current liabilities, to account for (1) cash payments to
creditors that are higher than the expense amounts on the income statement, or (2) amounts collected that are lower than the
amounts reflected as income on the income statement. To reconcile net income to cash flow from operating activities, subtract
decreases in current liabilities.
Propensity Company had a decrease of $1,800 in the current operating liability for accounts payable. The fact that the payable
decreased indicates that Propensity paid enough payments during the period to keep up with new charges, and also to pay down on

14.3.5 [Link]
amounts payable from previous periods. Therefore, the company had to have paid more in cash payments than the amounts shown
as expense on the Income Statements, which means net cash flow from operating activities is lower than the related net income.

Analysis of Change in Cash

Although the net income reported on the income statement is an important tool for evaluating the success of the company’s efforts
for the current period and their viability for future periods, the practical effectiveness of management is not adequately revealed by
the net income alone. The net cash flows from operating activities adds this essential facet of information to the analysis, by
illuminating whether the company’s operating cash sources were adequate to cover their operating cash uses. When combined with
the cash flows produced by investing and financing activities, the operating activity cash flow indicates the feasibility of
continuance and advancement of company plans.

Determining Net Cash Flow from Operating Activities (Indirect Method)

Net cash flow from operating activities is the net income of the company, adjusted to reflect the cash impact of operating activities.
Positive net cash flow generally indicates adequate cash flow margins exist to provide continuity or ensure survival of the
company. The magnitude of the net cash flow, if large, suggests a comfortable cash flow cushion, while a smaller net cash flow
would signify an uneasy comfort cash flow zone. When a company’s net cash flow from operations reflects a substantial negative
value, this indicates that the company’s operations are not supporting themselves and could be a warning sign of possible
impending doom for the company. Alternatively, a small negative cash flow from operating might serve as an early warning that
allows management to make needed corrections, to ensure that cash sources are increased to amounts in excess of cash uses, for
future periods.
For Propensity Company, beginning with net income of $4,340, and reflecting adjustments of $9,500, delivers a net cash flow from
operating activities of $13,840.

Figure 16.5 Cash from Operating. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

YOUR TURN
Cash Flow from Operating Activities
Assume you own a specialty bakery that makes gourmet cupcakes. Excerpts from your company’s financial statements are shown.

14.3.6 [Link]
How much cash flow from operating activities did your company generate?
Solution

THINK IT THROUGH
Explaining Changes in Cash Balance
Assume that you are the chief financial officer of a company that provides accounting services to small businesses. You are called
upon by the board of directors to explain why your cash balance did not increase much from the beginning of 2018 until the end of
2018, since the company produced a reasonably strong profit for the year, with a net income of $88,000. Further assume that there
were no investing or financing transactions, and no depreciation expense for 2018. What is your response? Provide the calculations
to back up your answer.

Prepare the Investing and Financing Activities Sections of the Statement of Cash Flows
Preparation of the investing and financing sections of the statement of cash flows is an identical process for both the direct and
indirect methods, since only the technique used to arrive at net cash flow from operating activities is affected by the choice of the
direct or indirect approach. The following sections discuss specifics regarding preparation of these two nonoperating sections, as
well as notations about disclosure of long-term noncash investing and/or financing activities. Changes in the various long-term

14.3.7 [Link]
assets, long-term liabilities, and equity can be determined from analysis of the company’s comparative balance sheet, which lists
the current period and previous period balances for all assets and liabilities.

Investing Activities
Cash flows from investing activities always relate to long-term asset transactions and may involve increases or decreases in cash
relating to these transactions. The most common of these activities involve purchase or sale of property, plant, and equipment, but
other activities, such as those involving investment assets and notes receivable, also represent cash flows from investing. Changes
in long-term assets for the period can be identified in the Noncurrent Assets section of the company’s comparative balance sheet,
combined with any related gain or loss that is included on the income statement.
In the Propensity Company example, the investing section included two transactions involving long-term assets, one of which
increased cash, while the other one decreased cash, for a total net cash flow from investing of ($25,200). Analysis of Propensity
Company’s comparative balance sheet revealed changes in land and plant assets. Further investigation identified that the change in
long-term assets arose from three transactions:
1. Investing activity: A tract of land that had an original cost of $10,000 was sold for $14,800.
2. Investing activity: Plant assets were purchased, for $40,000 cash.
3. Noncash investing and financing activity: A new parcel of land was acquired, in exchange for a $20,000 note payable.
Details relating to the treatment of each of these transactions are provided in the following sections.

Investing Activities Leading to an Increase in Cash

Increases in net cash flow from investing usually arise from the sale of long-term assets. The cash impact is the cash proceeds
received from the transaction, which is not the same amount as the gain or loss that is reported on the income statement. Gain or
loss is computed by subtracting the asset’s net book value from the cash proceeds. Net book value is the asset’s original cost, less
any related accumulated depreciation. Propensity Company sold land, which was carried on the balance sheet at a net book value of
$10,000, representing the original purchase price of the land, in exchange for a cash payment of $14,800. The data set explained
these net book value and cash proceeds facts for Propensity Company. However, had these facts not been stipulated in the data set,
the cash proceeds could have been determined by adding the reported $4,800 gain on the sale to the $10,000 net book value of the
asset given up, to arrive at cash proceeds from the sale.

Investing Activities Leading to a Decrease in Cash

Decreases in net cash flow from investing normally occur when long-term assets are purchased using cash. For example, in the
Propensity Company example, there was a decrease in cash for the period relating to a simple purchase of new plant assets, in the
amount of $40,000.

14.3.8 [Link]
Financing Activities
Cash flows from financing activities always relate to either long-term debt or equity transactions and may involve increases or
decreases in cash relating to these transactions. Stockholders’ equity transactions, like stock issuance, dividend payments, and
treasury stock buybacks are very common financing activities. Debt transactions, such as issuance of bonds payable or notes
payable, and the related principal payback of them, are also frequent financing events. Changes in long-term liabilities and equity
for the period can be identified in the Noncurrent Liabilities section and the Stockholders’ Equity section of the company’s
Comparative Balance Sheet, and in the retained earnings statement.
In the Propensity Company example, the financing section included three transactions. One long-term debt transaction decreased
cash. Two transactions related to equity, one of which increased cash, while the other one decreased cash, for a total net cash flow
from financing of $34,560. Analysis of Propensity Company’s Comparative Balance Sheet revealed changes in notes payable and
common stock, while the retained earnings statement indicated that dividends were distributed to stockholders. Further
investigation identified that the change in long-term liabilities and equity arose from three transactions:
1. Financing activity: Principal payments of $10,000 were paid on notes payable.
2. Financing activity: New shares of common stock were issued, in the amount of $45,000.
3. Financing activity: Dividends of $440 were paid to shareholders.
Specifics about each of these three transactions are provided in the following sections.

Financing Activities Leading to an Increase in Cash

Increases in net cash flow from financing usually arise when the company issues share of stock, bonds, or notes payable to raise
capital for cash flow. Propensity Company had one example of an increase in cash flows, from the issuance of common stock.

Financing Activities Leading to a Decrease in Cash

Decreases in net cash flow from financing normally occur when (1) long-term liabilities, such as notes payable or bonds payable
are repaid, (2) when the company reacquires some of its own stock (treasury stock), or (3) when the company pays dividends to
shareholders. In the case of Propensity Company, the decreases in cash resulted from notes payable principal repayments and cash
dividend payments.

Noncash Investing and Financing Activities

Sometimes transactions can be very important to the company, yet not involve any initial change to cash. Disclosure of these
noncash investing and financing transactions can be included in the notes to the financial statements, or as a notation at the bottom
of the statement of cash flows, after the entire statement has been completed. These noncash activities usually involve one of the
following scenarios:
exchanges of long-term assets for long-term liabilities or equity, or
exchanges of long-term liabilities for equity.
Propensity Company had a noncash investing and financing activity, involving the purchase of land (investing activity) in exchange
for a $20,000 note payable (financing activity).

14.3.9 [Link]
Summary of Investing and Financing Transactions on the Cash Flow Statement
Investing and financing transactions are critical activities of business, and they often represent significant amounts of company
equity, either as sources or uses of cash. Common activities that must be reported as investing activities are purchases of land,
equipment, stocks, and bonds, while financing activities normally relate to the company’s funding sources, namely, creditors and
investors. These financing activities could include transactions such as borrowing or repaying notes payable, issuing or retiring
bonds payable, or issuing stock or reacquiring treasury stock, to name a few instances.

YOUR TURN
Cash Flow from Investing Activities
Assume your specialty bakery makes gourmet cupcakes and has been operating out of rented facilities in the past. You owned a
piece of land that you had planned to someday use to build a sales storefront. This year your company decided to sell the land and
instead buy a building, resulting in the following transactions.

What are the cash flows from investing activities relating to these transactions?
Solution

Note: Interest earned on investments is an operating activity.

14.3: Prepare the Statement of Cash Flows Using the Indirect Method is shared under a CC BY-NC-SA license and was authored, remixed, and/or
curated by LibreTexts.
16.3: Prepare the Statement of Cash Flows Using the Indirect Method by OpenStax is licensed CC BY-NC-SA 4.0. Original source:
[Link]

14.3.10 [Link]
14.4: Prepare the Completed Statement of Cash Flows Using the Indirect Method
In this section, we use the example of Virtual Co. to work through the entire process of preparing the company’s statement of cash
flows using the indirect method. Virtual’s comparative balance sheet and income statement are provided as a base for the
preparation of the statement of cash flows.

Review Problem: Preparing the Virtual Co. Statement of Cash Flows

Figure 16.6Comparative Balance Sheet. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Figure 16.7Income Statement. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

14.4.1 [Link]
Additional Information
The following additional information is provided:
1. Investments that originally cost $30,000 were sold for $47,500 cash.
2. Investments were purchased for $50,000 cash.
3. Plant assets were purchased for $66,000 cash.
4. Cash dividends were declared and paid to shareholders in the amount of $8,000.
Directions:
Prepare the statement of cash flows (indirect method), for the year ended December 31, 2018.

Figure 16.8Statement of Cash Flows. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

14.4: Prepare the Completed Statement of Cash Flows Using the Indirect Method is shared under a CC BY-NC-SA license and was authored,
remixed, and/or curated by LibreTexts.
16.4: Prepare the Completed Statement of Cash Flows Using the Indirect Method by OpenStax is licensed CC BY-NC-SA 4.0. Original
source: [Link]

14.4.2 [Link]
 CHAPTER OVERVIEW

15: Financial Statement Analysis

15.1: Analyzing Comparative Financial Statements
15.2: Common-Size Financial Statements
15.3: Calculate Ratios That Analyze a Company’s Short-Term Debt-Paying Ability
15.4: Ratio Analysis
15.5: Time Value of Money

15: Financial Statement Analysis is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

1
15.1: Analyzing Comparative Financial Statements
This chapter discusses several common methods of analyzing and relating the data in financial statements and, as a result, gaining a
clear picture of the solvency and profitability of a company. Internally, management analyzes a company’s financial statements as
do external investors, creditors, and regulatory agencies. Although these users have different immediate goals, their overall
objective in financial statement analysis is the same—to make predictions about an organization as an aid in decision making.

What is Financial Statement Analysis? - …

Objectives of financial statement analysis

Management’s analysis of financial statements primarily relates to parts of the company. Using this approach, management can
plan, evaluate, and control operations within the company. Management obtains any information it wants about the company’s
operations by requesting special-purpose reports. It uses this information to make difficult decisions, such as which employees to
lay off and when to expand operations. Our primary focus in this chapter, however, is not on the special reports accountants prepare
for management. Rather, it is on the information needs of persons outside the firm.
Investors, creditors, and regulatory agencies generally focus their analysis of financial statements on the company as a whole. Since
they cannot request special-purpose reports, external users must rely on the general-purpose financial statements that companies
publish. These statements include a balance sheet, an income statement, a statement of stockholders’ equity, a statement of cash
flows, and the explanatory notes that accompany the financial statements.
Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to
obtain useful information. This information reveals significant relationships between data and trends in those data that assess the
company’s past performance and current financial position. The information shows the results or consequences of prior
management decisions. In addition, analysts use the information to make predictions that may have a direct effect on decisions
made by users of financial statements.
Comparative financial statements present the same company’s financial statements for one or two successive periods in side-by-
side columns. The calculation of dollar changes or percentage changes in the statement items or totals is horizontal analysis. This
analysis detects changes in a company’s performance and highlights trends.
The good news is you have already been performing the first part of horizontal analysis without realizing it when you were
preparing the statement of cash flows. Horizontal analysis consists of 2 things:
Dollar amount of change (calculated as Current Year amount – Previous Year amount)
Percentage of change (calculated as Dollar amount of change / previous year amount)

15.1.1 [Link]
Horizontal analysis is called horizontal because we look at one account at a time across time. We can perform this type of analysis
on the balance sheet or the income statement. Let’s look at this video followed by another example.

What is Financial Statement Analysis: H…

H…

The comparative financial statements of Synotech, Inc., will serve as a basis for an example of horizontal analysis and vertical
analysis of a balance sheet and a statement of income and retained earnings. Recall that horizontal analysis calculates changes in
comparative statement items or totals. Here is an example of Synotech, Inc. current asset section (in millions) of the balance sheet
with horizontal analysis performed:

2015 2014 Increase (or Decrease) Percent of Change

Current assets:

Cash $ 298.00 $ 250.50 $ 47.50 19.0%

Marketable securities 71.30 57.50 $ 13.80 24.0%

Receivables, net 1,277.30 1,340.30 $ (63.00) -4.7%

Inventories 924.80 929.80 $ (5.00) -0.5%

Other current assets 275.30 254.30 $ 21.00 8.3%

Total current assets $ 2,846.70 $ 2,832.40 $ 14.30 0.5%

What does this tell us? Notice total current assets have increased $ 14.3 million, consisting largely of increases in cash, marketable
securities, and other current assets despite a $63.0 million decrease in net receivables.
Next, study Column (4), which expresses as a percentage the dollar change in Column (3). Frequently, these percentage increases
are more informative than absolute amounts, as illustrated by the current asset changes. The percentages reveal that current assets
increased .5% which if we compared this to current liabilities would give us an idea if the company could pay their debt in the
future.
Studying the percentages on the balance sheet could lead to several other observations. For instance, if there was a 6.9% decrease
in long-term debt indicates that interest charges will be lower in the future, having a positive effect on future net income. An
increase in retained earnings could be a sign of increased dividends in the future; in addition, the increase in cash of 19% could
support this conclusion.
CC licensed content, Shared previously

15.1.2 [Link]
 Accounting Principles: A Business Perspective. Authored by: James Don Edwards, University of Georgia & Roger H.
Hermanson, Georgia State University. Provided by: Endeavour International Corporation. Project: The Global Text Project.
License: CC BY: Attribution
All rights reserved content
What is Financial Statement Analysis? - Accounting Video. Authored by: Brian Routh TheAccountingDr. Located at:
[Link]/8DmChanpSmw. License: All Rights Reserved. License Terms: Standard YouTube License
What is Financial Statement Analysis: Horizontal Analysis? - Accounting video . Authored by: Brian Routh TheAccountingDr.
Located at: [Link]/x_ltrzpz4Ew. License: All Rights Reserved. License Terms: Standard YouTube License

15.1: Analyzing Comparative Financial Statements is shared under a not declared license and was authored, remixed, and/or curated by
LibreTexts.

15.1.3 [Link]
15.2: Common-Size Financial Statements
Analysts also use vertical analysis of a single financial statement, such as an income statement. Vertical analysis consists of the
study of a single financial statement in which each item is expressed as a percentage of a significant total. Vertical analysis is
especially helpful in analyzing income statement data such as the percentage of cost of goods sold to sales. Where horizontal
analysis looked at one account at a time, vertical analysis will look at one YEAR at a time.
Financial statements that show only percentages and no absolute dollar amounts are common-size statements. All percentage
figures in a common-size balance sheet are percentages of total assets while all the items in a common-size income statement
are percentages of net sales. The use of common-size statements facilitates vertical analysis of a company’s financial statements.

Financial Statement Analysis: Vertical A…

A…

The calculation for common-size percentages is: (Amount / Base amount) and multiply by 100 to get a percentage. Remember, on
the balance sheet the base is total assets and on the income statement the base is net sales. The video showed an example using the
balance sheet so we will look at Synotech, Inc.’s income statement with common-size percentages (calculations provided in last
column).

Synotech, Inc.

Income Statement

For year ended December 31

( 10,498.8
Net Sales $10,498.8 100.0%
10,498.8 )
( 5,341.3
Cost of goods sold 5,341.3 50.9%
10,498.8 )
( 5,157.5
Gross profit 5,157.5 49.1%
10,498.8 )

Selling, general and admin ( 3,662.5

3,662.5 34.9%
expenses 10,498.8 )
( 112.6
Other expense, net 112.6 1.1%
10,498.8 )

15.2.1 [Link]
 ( 236.9
Interest expense 236.9 2.3%
10,498.8 )
( 1,145.5
Income before taxes 1145.5 10.9%
10,498.8 )
( 383.5
Income tax expense 383.5 3.7%
10,498.8 )
( 762
Net Income 762 7.3%
10,498.8 )

What does this common-size percentage tell you about the company? Since we use net sales as the base on the income statement, it
tells us how every dollar of net sales is spent by the company. For Synotech, Inc., approximately 51 cents of every sales dollar is
used by cost of goods sold and 49 cents of every sales dollar is left in gross profit to cover remaining expenses. Of the 49 cents
remaining, almost 35 cents is used by operating expenses (selling, general and administrative), 1 cent by other and 2 cents in
interest. We earn almost 11 cents of net income before taxes and over 7 cents in net income after taxes on every sales dollar. This is
a little easier to understand than the larger numbers showing Synotech earned $762 million dollars.
The same process would apply on the balance sheet but the base is total assets. The common-size percentages on the balance sheet
explain how our assets are allocated OR how much of every dollar in assets we owe to others (liabilities) and to owners (equity).
Many computerized accounting systems automatically calculate common-size percentages on financial statements.
CC licensed content, Shared previously
Accounting Principles: A Business Perspective. Authored by: James Don Edwards, University of Georgia & Roger H.
Hermanson, Georgia State University. Provided by: Endeavour International Corporation. Project: The Global Text Project.
License: CC BY: Attribution
All rights reserved content
Financial Statement Analysis: Vertical Analysis - Financial Accounting video . Authored by: Brian Routh TheAccountingDr.
Located at: [Link]/OT1BVZPNfks. License: All Rights Reserved. License Terms: Standard YouTube License

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15.2.2 [Link]
15.3: Calculate Ratios That Analyze a Company’s Short-Term Debt-Paying Ability
Ratios are expressions of logical relationships between items in the financial statements of a single period. Analysts can compute
many ratios from the same set of financial statements. A ratio can show a relationship between two items on the same financial
statement or between two items on different financial statements (e.g. balance sheet and income statement). The only limiting
factor in choosing ratios is the requirement that the items used to construct a ratio have a logical relationship to one another.

Ratio analysis
Logical relationships exist between certain accounts or items in a company’s financial statements. These accounts may appear on
the same statement or on two different statements. We set up the dollar amounts of the related accounts or items in fraction form
called ratios. These ratios include: (1) liquidity ratios; (2) equity, or long-term solvency, ratios; (3) profitability tests; and (4) market
tests.
Liquidity ratios indicate a company’s short-term debt-paying ability. Thus, these ratios show interested parties the company’s
capacity to meet maturing current liabilities.

Financial Statement Analysis: Ability to …

Current (or working capital) ratio

Working capital is the excess of current assets over current liabilities. The ratio that relates current assets to current liabilities is the
current (or working capital) ratio. The current ratio indicates the ability of a company to pay its current liabilities from current
assets and, thus, shows the strength of the company’s working capital position. You calculate the current ratio by:
Current Assets
current ratio =
Current Liabilities

The ratio is usually stated as a number of dollars of current assets available to pay every dollar of current liabilities (although the
dollar signs usually are omitted). Thus, for Synotech, when current assets totaled $2,846.7 million and current liabilities totaled
$2,285.2 million, the ratio is 1.25:1 (or 1.25 to 1), meaning that the company has $1.25 of current assets available to pay every
$1.00 of current liabilities.
Short-term creditors are particularly interested in the current ratio since the conversion of inventories and accounts receivable into
cash is the primary source from which the company obtains the cash to pay short-term creditors. Long-term creditors are also
interested in the current ratio because a company that is unable to pay short-term debts may be forced into bankruptcy. For this
reason, many bond indentures, or contracts, contain a provision requiring that the borrower maintain at least a certain minimum
current ratio. A company can increase its current ratio by issuing long-term debt or capital stock or by selling noncurrent assets.

15.3.1 [Link]
A company must guard against a current ratio that is too high, especially if caused by idle cash, slow-paying customers, and/or
slow-moving inventory. Decreased net income can result when too much capital that could be used profitably elsewhere is tied up
in current assets.

Acid-test (quick) ratio

The current ratio is not the only measure of a company’s short-term debt-paying ability. Another measure, called the acid-test
(quick) ratio, is the ratio of quick assets (cash, marketable securities, and net receivables) to current liabilities. Analysts exclude
inventories and prepaid expenses from current assets to compute quick assets because they might not be readily convertible into
cash. The formula for the acid-test ratio is:
Cash + Short-term investments + net current receivables
acid-test ratio =
Current Liabilities

Short-term creditors are particularly interested in this ratio, which relates the pool of cash and immediate cash inflows to immediate
cash outflows. In deciding whether the acid-test ratio is satisfactory, investors consider the quality of the marketable securities and
receivables. An accumulation of poor-quality marketable securities or receivables, or both, could cause an acid-test ratio to appear
deceptively favorable. When referring to marketable securities, poor quality means securities likely to generate losses when sold.
Poor-quality receivables may be uncollectible or not collectible until long past due.
Since inventory and accounts receivable are a large part of a company’s current assets, it is important to understand the company’s
ability to collect from their customers and the company’s efficiency in buying and selling inventory.

Financial Statement Analysis: Ability to …

Video 2: [Link]

Accounts receivable turnover

Turnover is the relationship between the amount of an asset and some measure of its use. Accounts receivable turnover is the
number of times per year that the average amount of receivables is collected. To calculate this ratio:
Net Sales
Accounts receivable turnover =
AVERAGE Accounts receivable, net

Net accounts receivable is accounts receivable after deducting the allowance for uncollectible accounts. Calculate average accounts
receivable by taking the beginning balance in accounts receivable (or ending amount from the previous year) + the ending
balance of the current year and divide by 2.
The accounts receivable turnover ratio provides an indication of how quickly the company collects receivables. For Synotech, Inc.,
we have the following information:

Net Sales $ 10,498.80

15.3.2 [Link]
 Accounts Receivable, Net
January 1 $ 1,340.30

December 31 1,277.30

We first need to calculate average accounts receivable. Jan 1 accounts receivable $1,340.30 + Dec 31 Accounts receivable
$1,277.30 = $2,617.60 / 2 gives us average accounts receivable of $1,308.80. We calculate the AR Turnover of 8.02 times:
Net Sales
Accounts receivable turnover =
AVERAGE Accounts receivable, net

$10, 498.80
=
$1, 308.80

= 8.02

The accounts receivable turnover ratio indicates Synotech collected, or turned over, its accounts receivable slightly more than eight
times. The ratio is better understood and more easily compared with a company’s credit terms if we convert it into a number of
days, as is illustrated in the next ratio.

Number of days’ sales in accounts receivable

The number of days’ sales in accounts receivable ratio is also called the average collection period for accounts receivable.
Calculate it as follows:
Avg Accounts Receivable × 365 days
Number of days’ sales in accounts receivable =
Net Sales

We use a 365 days in a year for this calculation. Notice we are using Average accounts receivable here as well, but it can also be
calculated with ending accounts receivable instead. Still using Synotech, Inc.’s information from above, we calculate 45.5 or 46
days from:
Avg Accounts Receivable × days
Number of days’ sales in accounts receivable =
Net Sales

$1, 308.80 × days

=
$10, 498.80

= 45.5 days

It can also be calculated as (365 days / AR Turnover). This ratio tells us it takes 46 days to collect on accounts receivable. Standard
credit terms are 30 days but 46 days is not too bad.
What about how a company handles inventory? We can prepare similar ratios for inventory turnover and number of days’ sales in
inventory.

Inventory turnover
A company’s inventory turnover ratio shows the number of times its average inventory is sold during a period. You can
calculate inventory turnover as follows:
Cost of Goods Sold
Inventory turnover =
Average Inventory

When comparing an income statement item and a balance sheet item, measure both in comparable dollars. Notice that we measure
the numerator and denominator in cost rather than sales dollars. (Earlier, when calculating accounts receivable turnover, we
measured both numerator and denominator in sales dollars.) We will calculate average inventory by taking the beginning inventory
+ ending inventory and divide by 2. Let’s look at the following information for Synotech, Inc.:

Cost of goods sold $ 5,341.30

15.3.3 [Link]
 Inventory

January 1 $ 929.80

December 31 924.80

We first calculate average inventory as Jan 1 inventory $929.80 + Dec 31 inventory $924.80 = total inventory of $1,854.60 and
divide by 2 for average inventory of $927.30. Next, we calculate inventory turnover:
Cost of Goods Sold
Inventory turnover =
Average Inventory

$5, 341.30
=
$927.30

Synotech was able to sell average inventory 5.76 times during the year. This ratio can better be understood by looking at the
number of days’ sales in inventory. Calculated as 365 days / inventory turnover or by this formula:
Average Inventory × 365 days
number of days in inventory =
Cost of goods sold

We will calculate Synotech’s number of days in inventory using average inventory (but can also be calculated using ending
inventory) of 63.4 or just 63 days as follows:
$1, 854.60 × 365 days
number of days in inventory =
$5, 341.30

This means it takes 63 days to sell our inventory. This is a very useful ratio to determine how quickly a company’s inventory moves
through the company.
Other things being equal, a manager who maintains the highest inventory turnover ratio (and lowest number of days) is the most
efficient. Yet, other things are not always equal. For example, a company that achieves a high inventory turnover ratio by keeping
extremely small inventories on hand may incur larger ordering costs, lose quantity discounts, and lose sales due to lack of adequate
inventory. In attempting to earn satisfactory income, management must balance the costs of inventory storage and obsolescence and
the cost of tying up funds in inventory against possible losses of sales and other costs associated with keeping too little inventory
on hand.
CC licensed content, Shared previously
Accounting Principles: A Business Perspective. Authored by: James Don Edwards, University of Georgia & Roger H.
Hermanson, Georgia State University. Provided by: Endeavour International Corporation. Project: The Global Text Project.
License: CC BY: Attribution

15.3: Calculate Ratios That Analyze a Company’s Short-Term Debt-Paying Ability is shared under a not declared license and was authored,
remixed, and/or curated by LibreTexts.

15.3.4 [Link]
15.4: Ratio Analysis
Ratio Analysis
Horizontal and vertical analyses present data about each line item on the financial statements in a uniform way across the board.
Additional insight about a corporation’s financial performance and health can be revealed by calculating targeted ratios that use
specific amounts that relate to one another. Again, as stated earlier, no ratio is meaningful by itself; it needs to be compared to
something, such as desired or expected results, previous results, other companies’ results, or industry standards.
There are a series of ratios that are commonly used by corporations. These will be classified as liquidity, solvency, profitability, and
return on investment.
Liquidity analysis looks at a company’s available cash and its ability to quickly convert other current assets into cash to meet
short-term operating needs such as paying expenses and debts as they become due. Cash is the most liquid asset; other current
assets such as accounts receivable and inventory may also generate cash in the near future.
Creditors and investors often use liquidity ratios to gauge how well a business is performing. Since creditors are primarily
concerned with a company’s ability to repay its debts, they want to see if there is enough cash and equivalents available to meet the
current portions of debt.
Six liquidity ratios follow. The current and quick ratios evaluate a company’s ability to pay its current liabilities. Accounts
receivable turnover and number of days’ sales in receivables look at the firm’s ability to collect its accounts receivable. Inventory
turnover and number of days’ sales in inventory gauge how effectively a company manages its inventory.

CURRENT RATIO
What it measures: The ability of a firm to pay its current liabilities with its cash and/or other current assets that can be
converted to cash within a relatively short period of time.
Current assets 911,000
Calculation: = = 2.5
Current liabilities 364,000

Interpretation: This company has 2.5 times more in current assets than it has in current liabilities. The premise is that current
assets are liquid; that is, they can be converted to cash in a relatively short period of time to cover short-term debt. A current
ratio is judged as satisfactory on a relative basis. If the company prefers to have a lot of debt and not use its own money, it may
consider 2.5 to be too high – too little debt for the amount of assets it has. If a company is conservative in terms of debt and
wants to have as little as possible, 2.5 may be considered low – too little asset value for the amount of liabilities it has. For an
average tolerance for debt, a current ratio of 2.5 may be considered satisfactory. The point is that whether the current ratio is
considered acceptable is subjective and will vary from company to company.

15.4.1 [Link]
QUICK RATIO
What it measures: the ability of a firm to pay its current liabilities with its cash and other current assets that can be converted
to cash within an extremely short period of time. Quick assets include cash, accounts receivable, and marketable securities but
do not include inventory or prepaid items.
Quick assets 373,000+248,000+108,000
Calculation: = = 2.0
Current liabilities 364,000

Interpretation: This company has 2.0 times more in its highly liquid current assets, which include cash, marketable securities,
and accounts receivable, than it has in current liabilities. The premise is these current assets are the most liquid and can be
immediately converted to cash to cover short-term debt. Current assets such as inventory and prepaid items would take too
long to sell to be considered quick assets. A quick ratio is judged as satisfactory on a relative basis. If the company prefers to
have a lot of debt and not use its own money, it may consider 2.0 to be too high – too little debt for the amount of assets it has.
If a company is conservative in terms of debt and wants to have as little as possible, 2.0 may be considered low – too little
asset value for the amount of liabilities it has. For an average tolerance for debt, a current ratio of 2.0 may be considered
satisfactory. The point is that whether the quick ratio is considered acceptable is subjective and will vary from company to
company.

ACCOUNTS RECEIVABLE TURNOVER

What it measures: the number of times the entire amount of a firm’s accounts receivable, which is the monies owed to the
company by its customers, is collected in a year.
Sales 994,000
Calculation: = = 10.0
Average accounts receivable (108,000+91,000)/2

15.4.2 [Link]
Interpretation: The higher the better.
The more often customers pay off their invoices, the more cash available to the firm to pay bills and debts and less possibility
that customers will never pay at all.

NUMBER OF DAYS’ SALES IN RECEIVABLES

What it measures: the number of days it typically takes for customers to pay on account.
Average accounts receivable (108,000+91,000)/2
Calculation: = = 36.5days
Sales / 365 994,000/365

The denominator of “Sales / 365” represents the dollar amount of sales per day in a 365-day year.

Interpretation: The lower the better.

The less time it takes customers to pay off their invoices, the more cash available to the firm to pay bills and debts and less
possibility that customers will never pay at all.

INVENTORY TURNOVER
What it measures: the number of times the average amount of a firm’s inventory is sold in a year.
Cost of merchandise sold 414,000
Calculation: = = 8.0
Average inventory (55,000+48,000)/2

Interpretation: The higher the better.

The more often inventory is sold, the more cash generated by the firm to pay bills and debts. Inventory turnover is also a
measure of a firm’s operational performance. If the company’s line of business is to sell merchandise, the more often it does so,
the more operationally successful it is.

15.4.3 [Link]
 NUMBER OF DAYS’ SALES IN INVENTORY
What it measures: the number of days it typically takes for a typical batch of inventory to be sold.
Average inventory (55,000+48,000)/2
Calculation : = = 45.4 days
Cost of merchandise sold/365 (414,000/365)

The denominator of “Cost of merchandise sold / 365” represents the dollar amount of cost per day in a 365-day year.

Interpretation: The lower the better.

The less time it takes for the inventory in stock to be sold, the more cash available to the firm to pay bills and debts. There is
also less of a need to pay storage, insurance, and other holding costs and less of a chance that inventory on hand will become
outdated and less attractive to customers.

Solvency analysis evaluates a company’s future financial stability by looking at its ability to pay its long-term debts.
Both investors and creditors are interested in the solvency of a company. Investors want to make sure the company is in a strong
financial position and can continue to grow, generate profits, distribute dividends, and provide a return on investment. Creditors are
concerned with being repaid and look to see that a company can generate sufficient revenues to cover both short and long-term
obligations.
Four solvency ratios follow.

RATIO OF LIABILITIES TO STOCKHOLDERS’ EQUITY

What it measures: the ability of a company to pay its creditors.

Total liabilities 1,275,000
Calculation : = =5
Total stockholders’ equity 2,675,000

15.4.4 [Link]
Interpretation: Favorable vs. unfavorable results are based on company’s level of tolerance for debt
Assets are acquired either by investments from stockholders or through borrowing from other parties. Companies that are
adverse to debt would prefer a lower ratio. Companies that prefer to use “other people’s money” to finance assets would favor
a higher ratio. In this example, the company’s debt is about half of what its stockholders’ equity is. Approximately 1/3 of the
assets are paid for through borrowing.

RATIO OF FIXED ASSETS TO LONG-TERM LIABILITIES

What it measures: the availability of investments in property, plant, and equipment that are financed by long-term debt and to
generate earnings that may be used to pay off long-term debt.
Book value of fixed assets 1,093,000
Calculation : = = 1.2
Long-term liabilities 911,000

The denominator of “Cost of merchandise sold / 365” represents the dollar amount of cost per day in a 365-day year.

15.4.5 [Link]
Interpretation: The higher the better.
The more that has been invested in fixed assets, which are often financed by long- term debt, the more potential there is for a
firm to perform well operationally and generate the cash it needs to make debt payments.

NUMBER OF TIMES INTEREST CHARGES ARE EARNED

What it measures: the ability to generate sufficient pre-tax income to pay interest charges on debt.
Income before income tax + interest expense 314,000+55,000
Calculation : = = 6.7
Interest expense 55,000

Since interest expense had been deducted in arriving at income before income tax on the income statement, it is added back in
the calculation of the ratio.
Interpretation: The higher the better.
The ratio looks at income that is available to pay interest expense after all other expenses have been covered by the sales that
were generated. The number of times anything is earned is always more favorable when it is higher since it impacts the margin
of safety and the ability to pay as earnings fluctuate, particulary if they decline.

NUMBER OF TIMES PREFERRED DIVIDENDS ARE EARNED

What it measures: the ability to generate sufficient net income to pay dividends to preferred stockholders
Net income 248,000
Calculation : = = 20.7
Preferred dividends 12,000

15.4.6 [Link]
 Interpretation: The higher the better.
The ratio looks at net income that is available to pay preferred dividends, which are paid on an after-tax basis, and after all
expenses have been covered by the sales that were generated. The number of times anything is earned is always more favorable
when it is higher since it impacts the margin of safety and the ability to pay as earnings fluctuate.

Profitability analysis evaluates a corporation’s operational ability to generate revenues that exceed associated costs in a given
period of time.
Profitability ratios may incorporate the concept of leverage, which is how effectively one financial element generates a
progressively larger return on another element. Thes first five ratios that follow look at how well the assets, liabilities, or equities in
the denominator of each ratio are able produce a relatively high value in the respective numerator. Ths final two ratios evaluate how
well sales translate into gross profit and net income.

ASSET TURNOVER

What it measures: how effectively a company uses its assets to generate revenue.
994,000
Calculation :
Sales

Average total assets (excluding long-term investments)

= = 52.5
(3,950,000−1,946,000+3,606,000−1,822,000)/2
%

Long-term investments are not included in the calculation because they are not productivity assets used to generate sales to
customers.

Interpretation: The higher the better.

The ratio looks at the value of most of a company’s assets and how well they are leveraged to produce sales. The goal of
owning the assets is that they should generate revenue that ultimately results in cash flow and profit.

15.4.7 [Link]
RETURN ON TOTAL ASSETS
What it measures: how effectively a company uses its assets to generate net income.
Net income + Interest expense 248,000+55,000
Calculation :
Average total assets
=
(3,950,000+3,606,000)/2
= 8.0 %

Interest expense relates to financed assets, so it is added back to net income since how the assets are paid for should be
irrelevant.

Interpretation: The higher the better.

The ratio looks at the value of a company’s assets and how well they are leveraged to produce net income. The goal of owning
the assets is that they should generate cash flow and profit.

RETURN ON STOCKHOLDERS’ EQUITY

What it measures: how effectively a company uses the investment of its owners to generate net income.
248,000
Calculation :
Net income

Average total stockholders’ equity

=
(2,675,000+2,447,000)/2
= 9.7 %

Interpretation: The higher the better.

The ratio looks at how well the investments of preferred and common stockholders are leveraged to produce net income. One
goal of investing in a corporation is for stockholders to accumulate additional wealth as a result of the company making a
profit.

RETURN ON COMMON STOCKHOLDERS’ EQUITY (ROE)

What it measures: how effectively a company uses the investment of its common stockholders to generate net income; overall
performance of a business.
248,000−12,000
Calculation :
Net income - Preferred dividends

Average common stockholders’ equity

=
(83,000+2,426,000+83,000+2,198,000)/2
= 9.9 %

15.4.8 [Link]
Preferred dividends are removed from the net income amount since they are distributed prior to commonshareholders having
any claim on company profits.
In this example, shareholders saw a 9.9% return on their investment. The result indicates that every dollar of common
shareholder’s equity earned about $.10 this year.

Interpretation: The higher the better.

The ratio looks at how well the investments of preferred and common stockholders are leveraged to produce net income. One
goal of investing in a corporation is for stockholders to accumulate additional wealth as a result of the company making a
profit.

EARNINGS PER SHARE ON COMMON STOCK

What it measures: the dollar amount of net income associated with each share of common stock outstanding.
Net income - Preferred dividends 248,000−12,000
Calculation : = = $28.43
Number of shares of common stock outstanding 83,000/$10

Preferred dividends are removed from the net income amount since they are distributed prior to common shareholders having
any claim on company profits.
The number of common shares outstanding is determined by dividing the common stock dollar amount by the par value per
share given.

15.4.9 [Link]
Interpretation: The higher the better.
The ratio is critical in reporting net income at a micro level – per share – rather than in total. A greater net income amount will
result in a higher earnings per share given a fixed number of shares.

GROSS PROFIT PERCENTAGE

What it measures: how effectively a company generates gross profit from sales or controls cost of merchandise sold.
Gross profit 580,000
Calculation :
Sales
=
994,000
= 58.4 %

Interpretation: The higher the better.

The ratio looks at the main cost of a merchandising business – what it pays for the items it sells. The lower the cost of
merchandise sold, the higher the gross profit, which can then be used to pay operating expenses and to generate profit.

15.4.10 [Link]
 PROFIT MARGIN
What it measures: the amount of net income earned with each dollar of sales generated.
248,000
Calculation :
Net income

Sales
=
994,000
= 24.9 %

Interpretation: The higher the better.

The ratio shows what percentage of sales are left over after all expenses are paid by the business.

Finally, a Dupont analysis breaks down three components of the return on equity ratio to explain how a company can increase its
return for investors. It may be evaluated on a relative basis, comparing a company’s Dupont results with either another company’s
results, with industry standards, or with expected or desired results.

DUPONT ANALYSIS
What it measures: a company’s ability to increase its return on equity by analyzing what is causing the current ROE.

Calculation: Profit margin x Total asset turnover x Financial leverage

(Net income / (Sales / Average (Total assets / Total

x x
Sales) total assets) equity)
Example of a simple comparison of two similar companies with the same return on investment of 30%.
Profit margin x Total asset turnover x Financial leverage

Company A .30 .5 2.0

Company B .15 4.0 .5

Results indicate that Company A has a higher profit margin and greater financial leverage. Its weaker position on total asset
turnover as compared to Company B is what brings down its ROE. The analysis of the components of ROE provides insight of
areas to address for improvement.
Interpretation: Investors are not looking for large or small output numbers from this model. Investors want to analyze and
pinpoint what is causing the current ROE to identify areas for improvement. This model breaks down the return on equity ratio
to explain how companies can increase their return for investors.

Return-on-investment analysis looks at actual distributions of current earnings or expected future earnings.

DIVIDENDS PER SHARE ON COMMON STOCK

What it measures: the dollar amount of dividends associated with each share of common stock outstanding.
Common stock dividends 8,000
Calculation : = = $0.96
Number of shares of common stock outstanding 83,000/$10

The number of common shares outstanding is determined by dividing the common stock dollar amount by the par value per
share given.

15.4.11 [Link]
Interpretation: If stockholders desire maximum dividends payouts, then the higher the better. However, some stockholders
prefer to receive minimal or no dividends since dividend payouts are taxable or because they prefer that their returns be
reinvested. Then lower payouts would be better.
The ratio reports distributions of net income in the form of cash at a micro level – per share – rather than in total. A greater
dividends per share amount will result from a higher net income amount given a fixed number of shares.

DIVIDENDS YIELD

What it measures: the rate of return to common stockholders from cash dividends.
Assume that the market price per share is $70.00.
Common dividends / Common shares outstanding
Calculation :
Market price per share
=
$0.96

$70.00
= 1.4 %

The number of common shares outstanding is determined by dividing the common stock dollar amount by the par value per
share given.

Interpretation: If stockholders desire maximum dividend payouts, then the higher the better. However, some stockholders
prefer to receive minimal or no dividends since dividend payouts are taxable or because they prefer that their returns be
reinvested. Then lower payouts would be better.
The ratio compares common stock distributions to the current market price. This conversion allows comparison between
different companies and may be of particular interest to investors who wish to maximize dividend revenue.

PRICE EARNINGS RATIO

What it measures: the prospects of future earnings.
Assume that the market price per share is $70.00.

15.4.12 [Link]
 Market price per share $70.00
Calculation : = = 2.5
Common stock earnings per share $28.43

Recall that earnings per share is (Net income – Preferred stock dividends) / Number of shares of common stock.

Interpretation: The higher the better.

The more the market price exceeds earnings, the greater the prospect of value growth, particularly if this ratio increases over
[Link] the analytical measures discussed, taken individually and collectively, are used to evaluate a company’s operating
performance and financial strength. They are particularly informative when compared over time to expected or desired
standards. The ability to learn from the financial statements makes the processes of collecting, analyzing, summarizing, and
reporting financial information all worthwhile.

15.4: Ratio Analysis is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

15.4.13 [Link]
15.5: Time Value of Money
Present Value of $1 Table
alt text

Present Value of $1 Table.

Present Value of an Ordinary Annuity Table

alt text

Present Value of an Ordinary Annuity Table.

Future Value of $1 Table

alt text

Future Value of $1 Table.

Future Value of an Ordinary Annuity Table

alt text

Future Value of an Ordinary Annuity Table.

15.5: Time Value of Money is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts.

15.5.1 [Link]
Index
B F I
bad debts Fraud Triangle Internal controls
7.1: Account for Uncollectible Accounts Using the 8.1: Analyze Fraud in the Accounting Workplace 8.2: Define and Explain Internal Controls and Their
Balance Sheet and Income Statement Approaches Purpose within an Organization
G
C Goods available for sale M
Committee of Sponsoring Organizations 6.1: Describe and Demonstrate the Basic Inventory merchandise inventory
(COSO) Valuation Methods and Their Cost Flow Assumptions 6.1: Describe and Demonstrate the Basic Inventory
gross margin Valuation Methods and Their Cost Flow Assumptions
8.2: Define and Explain Internal Controls and Their
Purpose within an Organization 6.1: Describe and Demonstrate the Basic Inventory
Valuation Methods and Their Cost Flow Assumptions P
purchases
6.1: Describe and Demonstrate the Basic Inventory
Valuation Methods and Their Cost Flow Assumptions

1 [Link]
Glossary
Sample Word 1 | Sample Definition 1

1 [Link]
Glossary
Sample Word 1 | Sample Definition 1

1 [Link]
Detailed Licensing
Overview
Title: ACCT 301: Financial Accounting (Black)
Webpages: 91
Applicable Restrictions: Noncommercial
All licenses found:
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ACCT 301: Financial Accounting (Black) - Undeclared 4: Adjusting Journal Entries (AJE's) - Undeclared
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Merchandise Purchases Using the Perpetual
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1 [Link]
7: Bad Debt - Undeclared 12.3: Recording Entries for Bonds - Undeclared
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9.4: Explain and Apply Depreciation Methods to 14: Statement of Cash Flows - Undeclared
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11.3: Define and Apply Accounting Treatment for
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2 [Link]