Accounting Basics(Explanation)

Statement of Cash Flows

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

Note: To learn more about the statement of cash flows, visit:Explanation of Cash Flow Statement Quiz for Cash Flow Statement

The three financial reports that Marilyn introduced to Joe—the income statement, the balance sheet, and the statement of cash flows—represent one segment of the valuable output that good accounting software can generate for business owners.

Marilyn now explains to Joe the basics of getting started with recording his transactions.

Double Entry System

The field of accounting—both the older manual systems and today's basic accounting software—is based on the 500-year-old accounting procedure known as double entry. Double entry is a simple yet powerful concept: each and every one of a company's transactions will result in an amount recorded into at least two of the accounts in the accounting system.

The Chart of Accounts

To begin the process of setting up Joe's accounting system, he will need to make a detailed listing of all the names of the accounts that Direct Delivery, Inc. might find useful for reporting transactions. This detailed listing is referred to as a chart of accounts. (Accounting software often provides sample charts of accounts for various types of businesses.)

As he enters his transactions, Joe will find that the chart of accounts will help him select the two (or more) accounts that are involved. Once Joe's business begins, he may find that he needs to add more account names to the chart of accounts, or delete account names that are never used. Joe can tailor his chart of accounts so that it best sorts and reports the transactions of his business.

Because of the double entry system all of Direct Delivery's transactions will involve a combination of two or more accounts from the balance sheet and/or the income statement. Marilyn lists out some sample accounts that Joe will probably need to include on his chart of accounts:

Note: To learn more about the chart of accounts, visit:Explanation of Chart of Accounts Quiz for Chart of Accounts

Balance Sheet accounts:

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

Income Statement accounts:

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

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

Sample Transaction #1

On December 1, 2014 Joe starts his business Direct Delivery, Inc. The first transaction that Joe will record for his company is his personal investment of $20,000 in exchange for 5,000 shares of Direct Delivery's common stock. Direct Delivery's accounting system will show an increase in its account Cash from zero to $20,000, and an increase in its stockholders' equity account Common Stock by $20,000. Both of these accounts are balance sheet accounts. There are no revenues because no delivery fees were earned by the company, and there were no expenses.

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

Marilyn asks Joe if he can see that the balance sheet is just that-in balance. Joe looks at the total of $20,000 on the asset side, and looks at the $20,000 on the right side, and says yes, of course, he can see that it is indeed in balance.

Marilyn shows Joe something called the basic accounting equation, which, she explains, is really the same concept as the balance sheet, it's just presented in an equation format:

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

Debits and Credits

Did the first sample transaction follow the double entry system and affect two or more accounts? Joe looks at the balance sheet again and answers yes, both Cash and Common Stock were affected by the transaction.

Marilyn introduces the next basic accounting concept: the double entry system requires that the same dollar amount of the transaction must be entered on both the left side of one account, and on the right side of another account. Instead of the word left, accountants use the word debit; and instead of the word right, accountants use the word credit. (The terms debit and credit are derived from Latin terms used 500 years ago.)

Here's a Tip

Debit means left.

Credit means right.

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

Here's a Tip

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

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

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

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

As with all rules, there are exceptions, but Marilyn's reference to the accounting equation may help you to learn whether an account should be debited or credited.

Since many transactions involve cash, Marilyn suggests that Joe memorize how the Cash account is affected when a transaction involves cash: if Direct Delivery receives cash, the Cash account is debited; when Direct Delivery pays cash, the Cash account is credited.

Here's a Tip

When a company receives cash, the Cash account is debited.

When the company pays cash, the Cash account is credited.

Marilyn refers to the example of December 1. Since Direct Delivery received $20,000 in cashfrom Joe in exchange for 5,000 shares of common stock, one of the accounts for this transaction is Cash. Since cash was received, the Cash account will be debited.

In keeping with double entry, two (or more) accounts need to be involved. Because the first account (Cash) was debited, the second account needs to be credited. All Joe needs to do is find the right account to credit. In this case, the second account is Common Stock. Common stock is part of stockholders' equity, which is on the right side of the accounting equation. As a result, it should have a credit balance, and to increase its balance the account needs to becredited.

Accountants indicate accounts and amounts using the following format:

Accountants usually first show the account and amount to be debited. On the next line, the account to be credited is indented and the amount appears further to the right than the debit amount shown in the line above. This entry format is referred to as a general journal entry.

(With the decrease in the price of computers and accounting software, it is rare to find a small business still using a manual system and making entries by hand. Accounting software has made the process of recording transactions so much easier that the general journal is rarely needed. In fact, entries are often generated automatically when a check or sales invoice is prepared.)

Sample Transactions #2 - #3

Sample Transaction #2

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

Marilyn explains to Joe what is happening within the software. Since the company pays $14,000, the Cash account is credited. (Accountants consider the checking account to be Cash, and the TIP you learned is that when cash is paid, you credit Cash.) So we know that the Cash account will be credited for $14,000 and we know the other account will have to be debited for $14,000. We need only identify the best account to debit. In this case we choose Vehicles (or Delivery Equipment) and the entry is:

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

The balance sheet and the accounting equation remain in balance:

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

Sample Transaction #3

The third sample transaction also occurs on December 2 when Joe contacts an insurance agent regarding insurance coverage for the vehicle Direct Delivery just purchased. The agent informs him that $1,200 will provide insurance protection for the next six months. Joe immediately writes a check for $1,200 and mails it in.

Let's consider this transaction. Using double entry, we know there must be a minimum of two accounts involved—one (or more) of the accounts must be debited, and one (or more) must becredited.

Since a check is written, we know that one of the accounts involved is Cash. Since cash waspaid, the Cash account will be credited. (Take another look at the last TIP.) While we have not yet identified the second account, what we do know for certain is that the second account will have to be debited.

At this point we have most of the entry-all we are missing is the name of the account to be debited:

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

Prepaid Insurance (an asset account reported on the balance sheet) andInsurance Expense (an expense account reported on the income statement)

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

The entry in the general journal format is:

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

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

Sample Transactions #4 - #6

Sample Transaction #4

The fourth transaction occurs on December 3, when a customer gives Direct Delivery a check for $10 to deliver two parcels on that day. Because of double entry, we know there must be a minimum of two accounts involved—one of the accounts must be debited, and one of the accounts must be credited.

Because Direct Delivery received $10, it must debit the account Cash. It must also credit a second account for $10. The second account will be Service Revenues, an income statement account. The reason Service Revenues is credited is because Direct Delivery must report that itearned $10 (not because it received $10). Recording revenues when they are earned results from a basic accounting principle known as the revenue recognition principle. The following tip reflects that principle.

Here's a Tip

Revenues accounts are credited when the company earns a fee (or sells merchandise) regardless of whether cash is received at the time.

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

Sample Transaction #5

Let's assume that on December 3 the company gets its second customer-a local company that needs to have 50 parcels delivered immediately. Joe's price of $250 is very appealing, so Joe's company is hired to deliver the parcels. The customer tells Joe to submit an invoice for the $250, and they will pay it within seven days.

Joe delivers the 50 parcels on December 3 as agreed, meaning that on December 3 Direct Delivery has earned $250. Hence the $250 is reported as revenues on December 3, even though the company did not receive any cash on that day. The effort needed to complete the job was done on December 3. (Depositing the check for $250 in the bank when it arrives seven days later is not considered to take any effort.)

Let's identify the two accounts involved and determine which needs a debit and which needs a credit.

Because Direct Delivery has earned the fees, one account will be a revenues account, such as Service Revenues. (If you refer back to the last TIP, you will read that revenue accounts—such as Service Revenues—are usually credited, meaning the second account will need to be debited.)

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

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

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

Sample Transaction #6

For simplicity, let's assume that the only expense incurred by Direct Delivery so far was a fee to a temporary help agency for a person to help Joe deliver parcels on December 3. The temp agency fee is $80 and is due by December 12.

If a company does not pay cash immediately, you cannot credit Cash. But because the company owes someone the money for its purchase, we say it has an obligation or liability to pay. Most accounts involved with obligations have the word "payable" in their name, and one of the most frequently used accounts is Accounts Payable. Also keep in mind that expenses are almost always debited.

The accounts and amounts for the temporary help are:

Here's a Tip

Expenses are (almost) always debited.

Here's a Tip

If a company does not pay cash right away for an expense or for an asset, you cannot credit Cash. Because the company owes someone the money for its purchase, we say it has an obligation or liability to pay. The most likely liability account involved in business obligations is Accounts Payable.

Revenues and expenses appear on the income statement as shown below:

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

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

Marilyn suggested that perhaps this introduction was enough material for their first meeting. She wrote out the following notes, summarizing for Joe the important points of their discussion:

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

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

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

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

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

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

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

§ If the amount received is a payment from a customer for a sale or service delivered earlier and has already been recorded as revenue, the account to be credited isAccounts Receivable.

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

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

Note: To learn more about debits and credits, go to Explanation of Debits and Credits and Quiz for Debits and Credits.

3. Revenues are recorded as Service Revenues or Sales when the service or sale has been performed, not when the cash is received. This reflects the basic accounting principle known as the revenue recognition principle.

4. Expenses are matched with revenues or with the period of time shown in the heading of the income statement, not in the period when the expenses were paid. This reflects the basic accounting principle known as the matching principle.

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

Accounting Equation(Explanation)

Introduction to the Accounting Equation

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

Assets (what it owns)
Liabilities (what it owes to others)
Owner's Equity (the difference between assets and liabilities)

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

The accounting equation for a corporation is:

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

Liabilities are a company's obligations—amounts the company owes. Examples of liabilities include notes or loans payable, accounts payable, salaries and wages payable, interest payable, and income taxes payable (if the company is a regular corporation). Liabilities can be viewed in two ways:

(1) as claims by creditors against the company's assets, and
(2) a source—along with owner or stockholder equity—of the company's assets.

Owner's equity or stockholders' equity is the amount left over after liabilities are deducted from assets:

Assets - Liabilities = Owner's (or Stockholders') Equity.

Owner's or stockholders' equity also reports the amounts invested into the company by the owners plus the cumulative net income of the company that has not been withdrawn or distributed to the owners.

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

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

We created a visual tutorial to demonstrate how a variety of transactions will affect the accounting equation and the financial statements. It is available in AccountingCoach PROalong with exam questions that pertain to the accounting equation.

Balance Sheet and Income Statement

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

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

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

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

Parts 2 - 6 illustrate transactions involving a sole proprietorship.

Parts 7 - 10 illustrate almost identical transactions as they would take place in a corporation.

Accounting Equation for a Sole Proprietorship: Transactions 1–2

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

When a company records a business transaction, it is not entered into an accounting equation,per se. Rather, transactions are recorded into specific accounts contained in the company's general ledger. Each account is designated as an asset, liability, owner's equity, revenue, expense, gain, or loss account. The general ledger accounts are then used to prepare the balance sheets and income statements throughout the accounting periods.

In the examples that follow, we will use the following accounts:

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

Sole Proprietorship Transaction #1.

Let's assume that J. Ott forms a sole proprietorship called Accounting Software Co. (ASC). On December 1, 2014, J. Ott invests personal funds of $10,000 to start ASC. The effect of this transaction on ASC's accounting equation is:

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

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

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

After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASC's financial position at the end of December 1, 2014:

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

Sole Proprietorship Transaction #2.

On December 2, 2014 J. Ott withdraws $100 of cash from the business for his personal use. The effect of this transaction on ASC's accounting equation is:

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

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

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

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

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

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

Accounting Equation for a Sole Proprietorship: Transactions 3–4

Sole Proprietorship Transaction #3.

On December 3, 2014 Accounting Software Co. spends $5,000 of cash to purchase computer equipment for use in the business. The effect of this transaction on the accounting equation is:

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

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

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

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

The balance sheet dated December 3, 2014 will reflect the financial position as of midnight on December 3:

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

Sole Proprietorship Transaction #4.

On December 4, 2014 ASC obtains $7,000 by borrowing money from its bank. The effect of this transaction on the accounting equation is:

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

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

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

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

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

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

Accounting Equation for a Sole Proprietorship: Transactions 5–6

Sole Proprietorship Transaction #5.

On December 5, 2014 Accounting Software Co. pays $600 for ads that were run in recent days. The effect of this advertising transaction on the accounting equation is:

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

Although owner's equity is decreased by an expense, the transaction is not recorded directly into the owner's capital account at this time. Instead, the amount is initially recorded in the expense account Advertising Expense and in the asset account Cash.

The general journal entry to record the transaction is:

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

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

The balance sheet as of the end of December 5, 2014 is:

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

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

Sole Proprietorship Transaction #6.

On December 6, 2014 ASC performs consulting services for its clients. The clients are billed for the agreed upon amount of $900. The amounts are due in 30 days. The effect on the accounting equation is:

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

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

The general journal entry to record the transaction is:

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

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

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

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

Accounting Equation for a Sole Proprietorship: Transactions 7–8

Sole Proprietorship Transaction #7.

On December 7, 2014 ASC uses a temporary help service for 6 hours at a cost of $20 per hour. ASC will pay the invoice when it is due in 10 days. The effect on its accounting equation is:

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

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

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

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

The financial position of ASC as of midnight on December 7, 2014 is:

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

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

Sole Proprietorship Transaction #8.

On December 8, 2014 ASC receives $500 from the clients it had billed on December 6, 2014. The collection of accounts receivables has this effect on the accounting equation:

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

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

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

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

ASC's balance sheet as of midnight December 8, 2014 is:

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

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

Calculating a Missing Amount within Owner's Equity

The income statement for the calendar year 2014 will explain a portion of the change in the owner's equity between the balance sheets of December 31, 2013 and December 31, 2014. The other items that account for the change in owner's equity are the owner's investments into the sole proprietorship and the owner's draws (or withdrawals). A recap of these changes is thestatement of changes in owner's equity. Here is a statement of changes in owner's equity for the year 2014 assuming that the Accounting Software Co. had only the eight transactions that we covered earlier.

Example of Calculating a Missing Amount

The format of the statement of changes in owner's equity can be used to determine one of these components if it is unknown. For example, if the net income for the year 2014 is unknown, but you know the amount of the draws and the beginning and ending balances of owner's equity, you can calculate the net income. (This might be necessary if a company does not have complete records of its revenues and expenses.) Let's demonstrate this by using the following amounts.

Step 1.
The owner's equity at December 31, 2013 can be computed using the accounting equation:

Step 2.
The owner's equity at December 31, 2014 can be computed as well:

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

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

Step 5.
Starting at the top of the statement we know that the owner's equity before the start of 2014 was $60,000 and in 2014 the owner invested an additional $10,000. As a result we have $70,000 before considering the amount of Net Income. We also know that after the amount of Net Income is added, the Subtotal has to be $134,000 (the Subtotal calculated in Step 4). The Net Income is the difference between $70,000 and $134,000. Net income must have been $64,000.

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

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

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

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

Accounting Equation for a Corporation: Transactions C1–C2

The accounting equation (or basic accounting equation) for a corporation is

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

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

In the examples that follow, we will use the following accounts:

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

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

Corporation Transaction C1

Let's assume that members of the Ott family form a corporation called Accounting Software, Inc. (ASI). On December 1, 2014, several members of the Ott family invest a total of $10,000 to start ASI. In exchange, the corporation issues a total of 1,000 shares of common stock. (The stock has no par value and no stated value.) The effect on the corporation's accounting equation is:

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

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

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

After the journal entry is recorded in the accounts, a balance sheet can be prepared to show ASI's financial position at the end of December 1, 2014:

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

Corporation Transaction C2.

On December 2, 2014 ASI purchases $100 of its stock from one of its stockholders. The stock will be held by the corporation as Treasury Stock. The effect of the accounting equation is:

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

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

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

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

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

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

Accounting Equation for a Corporation: Transactions C3–C4

Corporation Transaction C3.

On December 3, 2014 ASI spends $5,000 of cash to purchase computer equipment for use in the business. The effect of this transaction on its accounting equation is:

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

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

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

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

The balance sheet dated December 3, 2014 reflects the financial position of the corporation as of midnight on December 3:

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

Corporation Transaction C4.

On December 4, 2014 ASI obtains $7,000 by borrowing money from its bank. The effect of this transaction on the accounting equation is:

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

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

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

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

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

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

Accounting Equation for a Corporation: Transactions C5–C6

Corporation Transaction C5.

On December 5, 2014 Accounting Software, Inc. pays $600 for ads that were run in recent days. The effect of the advertising transaction on the corporation's accounting equation is:

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

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

The combined effect of the first five transactions is:

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

The balance sheet as of the end of December 5, 2014 is presented here:

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

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

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

Corporation Transaction C6.

On December 6, 2014 ASI performs consulting services for its clients. The clients are billed for the agreed upon amount of $900. The amounts are due in 30 days. The effect on the accounting equation is:

Since ASI has performed the services, it has earned revenues and it has the right to receive $900 from its clients. This right means that assets increased. The earning of revenues also causes stockholders' equity to increase.

Although revenues cause stockholders' equity to increase, the revenue transaction is not recorded directly into a stockholders' equity account at this time. Rather, the amount earned is recorded in the revenues account Service Revenues . This will allow the corporation to report the revenues account on its income statement at any time. (After the year ends, the amount in the revenues accounts will be transferred to the retained earnings account.) The general journal entry for providing services on credit is:

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

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

The balance sheet as of midnight on December 6, 2014 is presented here:

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

Accounting Equation for a Corporation: Transactions C7–C8

Corporation Transaction C7.

On December 7, 2014 ASI uses a temporary help service for 6 hours at a cost of $20 per hour. ASI records the invoice immediately, but it will pay the $120 when it is due in 10 days. This transaction has the following effect on the accounting equation:

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

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

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

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

The financial position of ASI as of midnight of December 7, 2014 is presented in the following balance sheet:

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

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

Corporation Transaction C8.

On December 8, 2014 ASI receives $500 from the clients it had billed on December 6. The effect on the accounting equation is:

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

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

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

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

ASI's balance sheet as of midnight of December 8, 2014 is shown here:

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

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

Expanded Accounting Equation for a Sole Proprietorship

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

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

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

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

Expanded Accounting Equation for a Corporation

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

Instead of the accounting equation, Assets = Liabilities + Stockholders' Equity, the expanded accounting equation is:

The eight transactions that we had listed under the basic accounting equation Transaction C8are shown in the following expanded accounting equation:

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

Accounting Principles(Explanation)

1. Part 1

Introduction to Accounting Principles, Basic Accounting Principles & Guidelines

2. Part 2

Other Characteristics of Accounting Information, How Principles and Guidelines Affect Financial Statements

Introduction to Accounting Principles

There are general rules and concepts that govern the field of accounting. These general rules–referred to as basic accounting principles and guidelines–form the groundwork on which more detailed, complicated, and legalistic accounting rules are based. For example, theFinancial Accounting Standards Board (FASB) uses the basic accounting principles and guidelines as a basis for their own detailed and comprehensive set of accounting rules and standards.

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

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

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

Basic Accounting Principles and Guidelines

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

1. Economic Entity Assumption

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

2. Monetary Unit Assumption

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

Because of this basic accounting principle, it is assumed that the dollar's purchasing power has not changed over time. As a result accountants ignore the effect of inflation on recorded amounts. For example, dollars from a 1960 transaction are combined (or shown) with dollars from a 2014 transaction.

3. Time Period Assumption

This accounting principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the five months ended May 31, 2014, or the 5 weeks ended May 1, 2014. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2013, the amount is known; but for the income statement for the three months ended March 31, 2014, the amount was not known and an estimate had to be used.

It is imperative that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders' equity, and statement of cash flows. Labeling one of thesefinancial statements with "December 31" is not good enough–the reader needs to know if the statement covers the one week ended December 31, 2014 the month ended December 31, 2014 the three months ended December 31, 2014 or the year ended December 31, 2014.

4. Cost Principle

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

Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact, as a general rule, asset amounts are not adjusted to reflect any type of increase in value. Hence, an asset amount does not reflect the amount of money a company would receive if it were to sell the asset at today's market value. (An exception is certain investments in stocks and bonds that are actively traded on a stock exchange.) If you want to know the current value of a company's long-term assets, you will not get this information from a company's financial statements–you need to look elsewhere, perhaps to a third-party appraiser.

5. Full Disclosure Principle

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

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

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

6. Going Concern Principle

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

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

7. Matching Principle

This accounting principle requires companies to use the accrual basis of accounting. The matching principle requires that expenses be matched with revenues. For example, sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid). Wages to employees are reported as an expense in the week when the employees worked and not in the week when the employees are paid. If a company agrees to give its employees 1% of its 2014 revenues as a bonus on January 15, 2015, the company should report the bonus as an expense in 2014 and the amount unpaid at December 31, 2014 as a liability. (The expense is occurring as the sales are occurring.)

Because we cannot measure the future economic benefit of things such as advertisements (and thereby we cannot match the ad expense with related future revenues), the accountant charges the ad amount to expense in the period that the ad is run.

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

8. Revenue Recognition Principle

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

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

9. Materiality

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

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

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

10. Conservatism

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

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

Other Characteristics of Accounting Information

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

We expect the accounting information to be reliable, verifiable, and objective.
We expect consistency in the accounting information.
We expect comparability in the accounting information.

1. Reliable, Verifiable, and Objective

In addition to the basic accounting principles and guidelines listed in Part 1, accounting information should be reliable, verifiable, and objective. For example, showing land at its original cost of $10,000 (when it was purchased 50 years ago) is considered to be more reliable, verifiable, and objective than showing it at its current market value of $250,000. Eight different accountants will wholly agree that the original cost of the land was $10,000—they can read the offer and acceptance for $10,000, see a transfer tax based on $10,000, and review documents that confirm the cost was $10,000. If you ask the same eight accountants to give you the land's current value, you will likely receive eight different estimates. Because the current value amount is less reliable, less verifiable, and less objective than the original cost, the original cost is used.

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

2. Consistency

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

3. Comparability

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

How Principles and Guidelines Affect Financial Statements

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

1. Balance Sheet

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

A balance sheet is a snapshot of a company's assets, liabilities, and owner's equity at one point in time. (In this case, that point in time is after all of the transactions through September 30, 2014 have been recorded.) Because of the economic entity assumption, only the assets, liabilities, and owner's equity specifically identified with Mary's Design Service are shown—the personal assets of the owner, Mary Smith, are not included on the company's balance sheet.

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

If Mary's Design Service were to purchase a second piece of land, the monetary unit assumptiondictates that the purchase price of the land bought today would simply be added to the purchase price of the land bought in 1956, and the sum of the two purchase prices would be reported as the total cost of land.

The Supplies account shows the cost of supplies (if material in amount) that were obtained by Mary's Design Service but have not yet been used. As the supplies are consumed, their cost will be moved to the Supplies Expense account on the income statement. This complies with thematching principle which requires expenses to be matched either with revenues or with the time period when they are used. The cost of the unused supplies remains on the balance sheet in the asset account Supplies.

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

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

2. Income Statement

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

An income statement covers a period of time (or time interval), such as a year, quarter, month, or four weeks. It is imperative to indicate the period of time in the heading of the income statement such as "For the Nine Months Ended September 30, 2014". (This means for the period of January 1 through September 30, 2014.) If prepared under theaccrual basis of accounting, an income statement will show how profitable a company was during the stated time interval.

Revenues are the fees that were earned during the period of time shown in the heading. Recognizing revenues when they are earned instead of when the cash is actually received follows the revenue recognition principle and the matching principle. (The matching principle is what steers accountants toward using the accrual basis of accounting rather than the cash basis. Small business owners should discuss these two methods with their tax advisors.)

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

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

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

3. The Notes To Financial Statements

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

Accounts Payable(Explanation)

1. Part 1

Introduction; An Account Payable is Another Company's Account Receivable

2. Part 2

Accounts Payable Process

3. Part 3

4. Part 4

Adding General Ledger Accounts; Invoice Credit Terms

5. Part 5

Early Payment Discounts vs. Need for Cash; Other

6. Part 6

General Ledger Account: Accounts Payable

Introduction to Accounts Payable

Account payable is defined in Webster's New Universal Unabridged Dictionary as:

account payable, pl. accounts payable. a liability to a creditor, carried on open account, usually for purchases of goods and services. [1935-40]

When a company orders and receives goods (or services) in advance of paying for them, we say that the company is purchasing the goods on account or on credit. The supplier (or vendor) of the goods on credit is also referred to as a creditor. If the company receiving the goods does not sign a promissory note, the vendor's bill or invoice will be recorded by the company in its liability account Accounts Payable (or Trade Payables).

As is expected for a liability account, Accounts Payable will normally have a credit balance. Hence, when a vendor invoice is recorded, Accounts Payable will be credited and another account must be debited (as required by double-entry accounting). When an account payable is paid, Accounts Payable will be debited and Cash will be credited. Therefore, the credit balance in Accounts Payable should be equal to the amount of vendor invoices that have been recorded but have not yet been paid.

Under the accrual method of accounting, the company receiving goods or services on credit must report the liability no later than the date they were received. The same date is used to record the debit entry to an expense or asset account as appropriate. Hence, accountants say that under the accrual method of accounting expenses are reported when they are incurred (not when they are paid).

The term accounts payable can also refer to the person or staff that processes vendor invoices and pays the company's bills. That's why a supplier who hasn't received payment from a customer will phone and ask to speak with "accounts payable."

The accounts payable process involves reviewing an enormous amount of detail to ensure that only legitimate and accurate amounts are entered in the accounting system. Much of the information that needs to be reviewed will be found in the following documents:

purchase orders issued by the company
receiving reports issued by the company
invoices from the company's vendors
contracts and other agreements

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

the timely processing of accurate and legitimate vendor invoices,
accurate recording in the appropriate general ledger accounts, and
the accrual of obligations and expenses that have not yet been completely processed.

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

An Account Payable Is Another Company's Account Receivable

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

The following table highlights the symmetry between a company's account payable and its vendor's account receivable.

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

Accounts Payable Process

The accounts payable process or function is immensely important since it involves nearly all of a company's payments outside of payroll. The accounts payable process might be carried out by an accounts payable department in a large corporation, by a small staff in a medium-sized company, or by a bookkeeper or perhaps the owner in a small business.

Regardless of the company's size, the mission of accounts payable is to pay only the company's bills and invoices that are legitimate and accurate. This means that before a vendor's invoice is entered into the accounting records and scheduled for payment, the invoice must reflect:

what the company had ordered
what the company has received
the proper unit costs, calculations, totals, terms, etc.

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

prevent paying a fraudulent invoice
prevent paying an inaccurate invoice
prevent paying a vendor invoice twice
be certain that all vendor invoices are accounted for

Periodically companies should seek professional assistance to improve its internal controls.

The accounts payable process must also be efficient and accurate in order for the company's financial statements to be accurate and complete. Because of double-entry accounting an omission of a vendor invoice will actually cause two accounts to report incorrect amounts. For example, if a repair expense is not recorded in a timely manner:

the liability will be omitted from the balance sheet, and
the repair expense will be omitted from the income statement.

If the vendor invoice for a repair is recorded twice, there will be two problems as well:

the liabilities will be overstated, and
repairs expense will be overstated.

In other words, without the accounts payable process being up-to-date and well run, the company's management and other users of the financial statements will be receiving inaccurate feedback on the company's performance and financial position.

A poorly run accounts payable process can also mean missing a discount for paying some bills early. If vendor invoices are not paid when they become due, supplier relationships could be strained. This may lead to some vendors demanding cash on delivery. If that were to occur it could have extreme consequences for a cash-strapped company.

Just as delays in paying bills can cause problems, so could paying bills too soon. If vendor invoices are paid earlier than necessary, there may not be cash available to pay some other bills by their due dates.

Purchase order

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

the person requesting that a PO be issued for the goods or services
the accounts payable department
the receiving department
the vendor
the person preparing the purchase order

The purchase order will indicate a PO number, date prepared, company name, vendor name, name and phone number of a contact person, a description of the items being purchased, the quantity, unit prices, shipping method, date needed, and other pertinent information.

One copy of the purchase order will be used in the three-way match, which we will discuss later.

Receiving report

A receiving report is a company's documentation of the goods it has received. The receiving report may be a paper form or it may be a computer entry. The quantity and description of the goods shown on the receiving report should be compared to the information on the company's purchase order.

After the receiving report and purchase order information are reconciled, they need to be compared to the vendor invoice. Hence, the receiving report is the second of the three documents in the three-way match (which will be discussed shortly).

Vendor Invoice

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

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

Three-way match

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

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

Good internal control of a company's resources is enhanced when the company assigns a separate employee with a specific, limited responsibility. The following chart illustrates the concept of the separation (or segregation) of duties involving accounts payable:

When the duties are separated, it will require more than one dishonest person to steal from the company. Hence, small companies without sufficient staff to separate employees' responsibilities will have a greater risk of theft.

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

The three-way match involves comparing the following information:

The description, quantity, cost and terms on the company's purchase order.
The description and quantity of goods shown on the receiving report.
The description, quantity, cost, terms, and math on the vendor invoice.

After determining that the information reconciles, the vendor invoice can be entered into the liability account Accounts Payable. The information entered into the accounting software will include invoice reference information (vendor name or code, invoice number and date, etc.), the amount to be credited to Accounts Payable, the amount(s) and account(s) to be debited and the date that the payment is to be made. The payment date is based on the terms shown on the invoice and the company's policy for making payments.

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

Vouchers

Some companies use a voucher in order to document or "vouch for" the completeness of the approval process. You can visualize a voucher as a cover sheet for attaching the supporting documents (purchase order, receiving report, vendor's invoice, etc.) and for noting the approvals, account numbers, and other information for each vendor invoice or bill.

When the vendor invoice is paid, the voucher and its attachments (including a copy of the check that was issued) will be stored in a paid voucher/invoice file. If paper documents are involved, an office machine could perforate the word "PAID" through the voucher and its attachments. This is done to assure that a duplicate payment will not occur.

The unpaid invoices and vouchers will be held in an open file.

Vendor invoices without purchase orders or receiving reports

Not all vendor invoices will have purchase orders or receiving reports. Hence, the three-way match is not always possible. For example, a company does not issue a purchase order to its electric utility for a pre-established amount of electricity for the following month. The same is true for the telephone, natural gas, sewer and water, freight-in, and so on.

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

Statements from vendors

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

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

Related Expense or Asset

The vendor invoices received by a company could involve the following:

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

The following table illustrates an insurance premium of $6,000 that is paid in December but the coverage is for the following January 1 through June 30:

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

End of the Period Cut-Off

At the end of every accounting period (year, quarter, month, 5-week period, etc.) it is important that the accounts payable processing be up-to-date. If it is not up-to-date, the income statement for the accounting period will likely be omitting some expenses and the balance sheet at the end of the accounting period will be omitting some liabilities.

During the first few days after an accounting period ends, it is important for the accounts payable staff to closely examine the incoming vendor invoices. For example, a $900 repair bill received on January 6 may be a December repair expense and a liability as of December 31. Another vendor invoice received on January 6 may not have been an obligation as of December 31 and is actually a January expense.

It is also necessary to review the receiving reports that have not yet been matched to vendor invoices. If items were ordered and received prior to December 31, the amounts must be recorded as of December 31 through an accrual-type adjusting entry.

Note: The proper cut-off at the end of each accounting period becomes more complicated and often more significant if a company has inventories of finished products, work-in-process and raw materials. It is possible that some goods will be included in the physical inventory counts, but the costs have not yet been recorded in Accounts Payable and in the Inventory or Purchases account.

Accruing Expenses and Liabilities

At the end of every accounting period there will be some vendor invoices and receiving reports that have not yet been approved or fully matched. As a result these amounts will not have been entered into the Accounts Payable account (and the related expense or asset account). These documents should be reviewed in order to determine whether a liability and an expense have actually been incurred by the company as of the end of the accounting period.

Since the accrual method of accounting requires that all of a company's liabilities and expenses must be reported on the financial statements, companies should prepare an accrual-type adjusting entry at the end of every accounting period. This adjusting entry will credit Accrued Liabilities and will debit the appropriate expense or other account for the amounts that were incurred but are not yet included in Accounts Payable. The balance in Accrued Liabilities will be reported in the current liability section of the balance sheet immediately after Accounts Payable.

It is also common for companies to prepare a reversing entry every month. The reversing entry removes the previous period's accrual adjusting entry and prevents the double-counting of an expense that could occur when the actual vendor invoice is processed.

Adding General Ledger Accounts

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

Balance sheet accounts

Asset accounts
Liability accounts
Stockholders' or owner's equity accounts

Income statement accounts

Operating revenue accounts
Operating expense accounts
Nonoperating revenue and gain accounts
Nonoperating expense and loss accounts

Many systems will allow for each account to have subaccounts. Subaccounts allow for summarizing or combining amounts while also maintaining the detailed amounts.

When the existing accounts are not sufficient, new accounts should be added. In other words, meaningful financial reporting of transactions should not be limited to a preconceived list of accounts.

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

Invoice Credit Terms

The invoice terms indicate when an invoice becomes due and whether a discount may be taken if the invoice is paid sooner. The invoice terms also dictate the point at which ownership of goods will transfer from the seller to the buyer.

The following payment terms are some of the more common ones for businesses without inventories.

Net due upon receipt

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

Net 30 days

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

1/10, n/30

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

Pay within 10 days and deduct 1% of the net amount owed (the invoice amount minus any authorized returns and/or allowances), or
Pay in 30 days and take no discount.

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

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

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

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

2/10, n/30

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

Pay within 10 days and deduct 2% of the net amount (invoice amount minus any authorized returns and/or allowances), or
Pay the full amount in 30 days with no discount.

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

If paying by June 10, the amount due to the vendor is $882. [The net amount of $900 minus $18 (which is 2% of $900).]
If paying by July 1, the net amount of $900 is due.

Early Payment Discounts vs. Need for Cash

Some vendors offer an early payment discount such as 2/10, net 30. This means that the buyer may deduct 2% of the amount owed if the vendor is paid within 10 days instead of the normal 30 days. For instance, an invoice amount of $1,000 can be settled in full if the buyer will pay $980 within 10 days. In this example, the buyer will save $20 (2% X $1,000) for paying 20 days earlier than the normal due date. If the buyer has the opportunity to do this every 20 days, it would occur 18 times during a year (365 days divided by 20 days = 18 times). That means the company could save up to $360 ($20 X 18 times per year) each year by using a single $980 amount. Hence the annual percentage rate is approximately 36% ($360 earned divided by $980 used).

Looking at it another way, if the buyer had to borrow $980 from its bank for the 20 days at a borrowing rate of 6% per year, the interest for 20 days would be only $3.22 ($980 X 6% X 20/365). By paying $3.22 of interest to the bank, the buyer will save paying the vendor $20 and therefore will be better off by $16.78 ($20.00 minus $3.22). If this occurs 18 times in a year, the net annual savings will be approximately $301 [$16.78 X 18 times; or $360 per year saved minus the annual interest paid to the bank of $59 ($980 X 6%)].

A discount of 1% for paying 20 days early equates to an annual interest rate of approximately18%.

It is clear that buyers with sufficient cash balances or a readily available line of credit should take advantage of the early payment discounts. However, some buyers are operating with very little cash and are unable to borrow additional money. These buyers may be wise to forgo the early payment discounts in order to avoid the risk of overdrawing their checking account. One overdraft fee could be greater than the early payment discount. If an overdraft causes several of the buyer's checks to be returned to its vendors, the total amount of overdraft fees will be even greater.

If a buyer's checks are returned because of insufficient funds its suppliers may become concerned about the buyer's ability to pay. This could lead to one or more of the suppliers demanding payment at the time of delivery. The elimination of 30 days of credit from suppliers could be devastating for a buyer with little money and a credit line that has been exhausted.

Be sure to consider your company's cash balances and cash needs before paying invoices prior to their due dates.

Other

Vendor or employee?

Occasionally an individual will provide services for a company and submits an invoice. The invoice is processed through accounts payable and in the U.S. the company may be required to issue the individual an IRS Form 1099-MISC in January of the following year.

While the company views the individual as an independent contractor, the Internal Revenue Service rules may dictate that the individual is actually a part-time employee. If a person is deemed to be an employee, the Internal Revenue Service requires that payroll taxes be withheld and a Form W-2 be issued instead of Form 1099-MISC.

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

Internal controls

In order to protect a company's assets it is important that a company have in place a variety of controls over issuing purchase orders, issuing checks, adding vendors to the accounts payable master vendor file, segregating duties, and other safeguards referred to as internal controls.

We recommend that a professional who is well-versed in internal controls perform a review of your company's policies and procedures.

Batching the payments to vendors

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

Sales and use taxes

Certain purchases of goods and/or services may be subject to state sales taxes. If a sales tax is not paid for the sales-taxable goods or services (even from out-of-state vendors), the buyer is likely to be liable for a state use tax. To further complicate the situation, some organizations may be exempt from both a sales tax and a use tax depending on the state laws.

The responsibility for compliance with sales and use taxes rests with each company. As a result, companies must be familiar with the laws of the states in which they operate.

Travel and entertainment

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

General Ledger Account: Accounts Payable

The general ledger account Accounts Payable or Trade Payables is a current liability account, since the amounts owed are usually due in 10 days, 30 days, 60 days, etc. The balance in Accounts Payable is usually presented as the first or second item in the current liability section of the balance sheet. (Many companies report Notes Payable due within one year as the first item.)

As a liability account, Accounts Payable is expected to have a credit balance. Hence, a credit entry will increase the balance in Accounts Payable and a debit entry will decrease the balance.

A bill or invoice from a supplier of goods or services on credit is often referred to as a vendor invoice. The vendor invoices are entered as credits in the Accounts Payable account, thereby increasing the credit balance in Accounts Payable. When a company pays a vendor, it will reduce Accounts Payable with a debit amount. As a result, the normal credit balance in Accounts Payable is the amount of vendor invoices that have been recorded but have not yet been paid. The unpaid invoices are sometimes referred to as open invoices.

Accounting software allows companies to sort its accounts payable according to the dates when payments will be due. This feature and the resulting report are known as the aging of accounts payable.

Entering a vendor invoice into Accounts Payable

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

After a vendor invoice has been approved, the recording of the invoice will include:

a credit to Accounts Payable, and
a minimum of one debit to another account. The debit amount usually involves one of the following:

o an expense (Repairs & Maintenance Expense, Advertising Expense, Rent Expense, etc.)

o a prepaid asset (Prepaid Expenses, Prepaid Insurance)

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

A listing of the accounts that a company has available for recording transactions is known as thechart of accounts.

A report that lists the accounts and amounts that are debited for a group of invoices entered into the accounting software is known as the accounts payable distribution.

Reductions to Accounts Payable

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

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

About Dinesh Lamichhane

आफ्नो परिचय खोज्नको लागी भौतारिरहेको एक आम मान्छे । भाग्यमा भन्दा कर्ममा बिश्वास गर्छु । परिचय सँगै जिवन लाई पनि बुझ्दैछु, र आफुलाई खुशी राख्ने सक्दो कोसिस गरिरहेको हुन्छु । नयाँ नयाँ ठाँउहरु घुम्न धेरै मन पर्छ । अँ कहिले काँहि मनमा लागेजति कुराहरु लेख्ने गर्छु र लेखेको कुराहरु यहि राखेको हुन्छु । हेरेपछी सुझाव दिन नबिर्सनुहोला ।

Accounting Knowledge

Statement of Cash Flows

Double Entry System

The Chart of Accounts

Sample Transaction #1

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Sample Transactions #2 - #3

Sample Transaction #2

Sample Transaction #3

Sample Transactions #4 - #6

Sample Transaction #4

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Sample Transaction #5

Sample Transaction #6

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Accounting Equation(Explanation)

Introduction to the Accounting Equation

Balance Sheet and Income Statement

Accounting Equation for a Sole Proprietorship: Transactions 1–2

Sole Proprietorship Transaction #1.

Sole Proprietorship Transaction #2.

Accounting Equation for a Sole Proprietorship: Transactions 3–4

Sole Proprietorship Transaction #3.

Sole Proprietorship Transaction #4.

Accounting Equation for a Sole Proprietorship: Transactions 5–6

Sole Proprietorship Transaction #5.

Sole Proprietorship Transaction #6.

Accounting Equation for a Sole Proprietorship: Transactions 7–8

Sole Proprietorship Transaction #7.

Sole Proprietorship Transaction #8.

Calculating a Missing Amount within Owner's Equity

Example of Calculating a Missing Amount

Accounting Equation for a Corporation: Transactions C1–C2

Corporation Transaction C1

Corporation Transaction C2.

Accounting Equation for a Corporation: Transactions C3–C4

Corporation Transaction C3.

Corporation Transaction C4.

Accounting Equation for a Corporation: Transactions C5–C6

Corporation Transaction C5.

Corporation Transaction C6.

Accounting Equation for a Corporation: Transactions C7–C8

Corporation Transaction C7.

Corporation Transaction C8.

Accounting Principles(Explanation)

Other Characteristics of Accounting Information

1. Reliable, Verifiable, and Objective

2. Consistency

3. Comparability

How Principles and Guidelines Affect Financial Statements

1. Balance Sheet

2. Income Statement

3. The Notes To Financial Statements

Accounts Payable(Explanation)

Accounts Payable Process

Purchase order

Receiving report

Vendor Invoice

Three-way match

Vouchers

Vendor invoices without purchase orders or receiving reports

Statements from vendors

Adding General Ledger Accounts

Invoice Credit Terms

Net due upon receipt

Net 30 days

1/10, n/30

2/10, n/30

Early Payment Discounts vs. Need for Cash

Other

Vendor or employee?

Internal controls

Batching the payments to vendors

Sales and use taxes

Travel and entertainment

General Ledger Account: Accounts Payable

Entering a vendor invoice into Accounts Payable