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FINANCIAL ACCOUNTING BOOK
Introduction to AccountingAccounting is the language of business. It is the
system of recording, summarizing, and analyzing an economic entity's financial
transactions. Effectively communicating this information is key to the success
of every business. Those who rely on financial information include internal
users, such as a company's managers and employees, and external users, such as
banks, investors, governmental agencies, financial analysts, and labor unions.
These users depend upon data supplied by accountants to answer the following
types of questions: ·
Is the company profitable? ·
Is there enough cash to meet payroll needs? ·
How much debt does the company have? ·
How does the company's net income compare to its
budget? ·
What is the balance owed by customers? ·
Has the company consistently paid cash
dividends? ·
How much income does each division generate? ·
Should the company invest money to expand? Accountants must present an organization's
financial information in clear, concise reports that help make questions like
these easy to answer. The most common accounting reports Understanding Financial StatementsThe financial statements shown on the next
several pages are for a sole proprietorship, which is a
business owned by an individual. Corporate financial statements are slightly
different. The four basic financial statements are the income statement,
statement of owner's equity, balance sheet, and statement of cash flows. The
income statement, statement of owner's equity, and statement of cash flows report
activity for a specific period of time, usually a month, quarter, or year. The
balance sheet reports balances of certain elements at a specific time. All four
statements have a three-line heading in the following format:
Income statement. The income
statement, which is sometimes called the statement of earnings or
statement of operations, is prepared first. It lists revenues and expenses and
calculates the company's net income or net loss for a period of time. Net
income means total revenues are greater than total expenses. Net
loss means total expenses are greater than total revenues. The
specific items that appear in financial statements are explained later. The
Greener Landscape Group Income Statement For the Month Ended April 30, 20X2
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Statement of owner's equity. The
statement of owner's equity is prepared after the income statement. It shows
the beginning and ending owner's equity balances and the items affecting
owner's equity during the period. These items include investments, the net
income or loss from the income statement, and withdrawals. Because the specific
revenue and expense categories that determine net income or loss appear on the
income statement, the statement of owner's equity shows only the total net
income or loss. Balances enclosed by parentheses are subtracted from unenclosed
balances.
| The Greener Landscape Group Statement of Owner's Equity For the Month Ended April 30, 20X2
|
Balance sheet. The balance sheet
shows the balance, at a particular time, of each asset, each liability, and
owner's equity. It proves that the accounting equation (Assets
= Liabilities + Owner's Equity) is in balance. The ending balance on the
statement of owner's equity is used to report owner's equity on the balance sheet.
| The Greener Landscape Group Balance Sheet April 30, 20X2
|
Statement of cash flows. The
statement of cash flows tracks the movement of cash during a specific
accounting period. It assigns all cash exchanges to one of three
categories—operating, investing, or financing—to calculate the net change in
cash and then reconciles the accounting period's beginning and ending cash
balances. As its name implies, the statement of cash flows includes items that
affect cash. Although not part of the statement's main body, significant
non-cash items must also be disclosed.
According to current accounting standards,
operating cash flows may be disclosed using either the direct or the indirect
method. The direct method simply lists the net cash flow by type of cash
receipt and payment category. For purposes of illustration, the direct method appears
below.
| The Greener Landscape Group Statement of Cash Flows For the Month Ended April 30, 20X2
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The Accounting Equation
The ability to read financial statements requires
an understanding of the items they include and the standard categories used to
classify these items. The accounting equation identifies the relationship
between the elements of accounting.
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Assets. An asset
is something of value the company owns. Assets can be tangible or intangible. Tangible
assets are generally divided into three major categories: current
assets (including cash, marketable securities, accounts receivable, inventory,
and prepaid expenses); property, plant, and equipment; and long-term
investments. Intangible assets lack physical substance, but
they may, nevertheless, provide substantial value to the company that owns
them. Examples of intangible assets include patents, copyrights, trademarks,
and franchise licenses. A brief description of some tangible assets follows.
·
Current assets typically
include cash and assets the company reasonably expects to use, sell, or collect
within one year. Current assets appear on the balance sheet (and in the
numbered list below) in order, from most liquid to least liquid. Liquid
assets are readily convertible into cash or other assets, and they are
generally accepted as payment for liabilities.
1.
Cash includes cash on hand (petty
cash), bank balances (checking, savings, or money-market accounts), and cash
equivalents. Cash equivalents are highly liquid investments,
such as certificates of deposit and U.S. treasury bills, with maturities of
ninety days or less at the time of purchase.
2.
Marketable securities include
short-term investments in stocks, bonds (debt), certificates of deposit, or
other securities. These items are classified as marketable securities—rather
than long-term investments—only if the company has both the ability and the
desire to sell them within one year.
3.
Accounts receivable are amounts owed
to the company by customers who have received products or services but have not
yet paid for them.
4.
Inventory is the cost to acquire or
manufacture merchandise for sale to customers. Although service enterprises
that never provide customers with merchandise do not use this category for
current assets, inventory usually represents a significant portion of assets in
merchandising and manufacturing companies.
5.
Prepaid expenses are amounts paid by
the company to purchase items or services that represent future costs of doing
business. Examples include office supplies, insurance premiums, and advance
payments for rent. These assets become expenses as they expire or get used up.
·
Property, plant, and equipment
is the title given to long-lived assets the business uses to help generate
revenue. This category is sometimes called fixed assets. Examples include land,
natural resources such as timber or mineral reserves, buildings, production
equipment, vehicles, and office furniture. With the exception of land, the cost
of an asset in this category is allocated to expense over the asset's estimated
useful life.
·
Long-term investments include
purchases of debt or stock issued by other companies and investments with other
companies in joint ventures. Long-term investments differ from marketable
securities because the company intends to hold long-term investments for more
than one year or the securities are not marketable.
Liabilities. Liabilities are the
company's existing debts and obligations owed to third parties. Examples
include amounts owed to suppliers for goods or services received (accounts
payable), to employees for work performed (wages payable), and to banks for
principal and interest on loans (notes payable and interest payable).
Liabilities are generally classified as short-term (current) if they are due in
one year or less. Long-term liabilities are not due for at least one year.
Owner's equity. Owner's equity
represents the amount owed to the owner or owners by the company.
Algebraically, this amount is calculated by subtracting liabilities from each
side of the accounting equation. Owner's equity also represents the net
assets of the company.
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In a sole proprietorship or partnership, owner's
equity equals the total net investment in the business plus the net income or
loss generated during the business's life. Net investment
equals the sum of all investment in the business by the owner or owners minus
withdrawals made by the owner or owners. The owner's investment is recorded in
the owner's capital account, and any withdrawals are recorded in a separate
owner's drawing account. For example, if a business owner contributes $10,000
to start a company but later withdraws $1,000 for personal expenses, the
owner's net investment equals $9,000. Net income or net
loss equals the company's revenues less its expenses. Revenues
are inflows of money or other assets received from customers in exchange for
goods or services. Expenses are the costs incurred to generate
those revenues.
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Capital investments and revenues increase owner's
equity, while expenses and owner withdrawals (drawings) decrease owner's
equity. In a partnership, there are separate capital and drawing accounts for
each partner.
Stockholders' equity. In a
corporation, ownership is represented by shares of stock, so the owners'
equity. is called stockholders' equity or shareholders'
equity. Corporations use several types of accounts to record
stockholders' equity activities: preferred stock, common stock, paid-in capital
(these are often referred to as contributed capital), and retained earnings. Contributed
capital accounts record the total amount invested by stockholders in
the corporation. If a corporation issues more than one class of stock, separate
accounts are maintained for each class. Retained earnings
equal net income or loss over the life of the business less any amounts given
back to stockholders in the form of dividends. Dividends affect stockholders'
equity in the same way that owner withdrawals affect owner's equity in sole
proprietorships and partnerships.
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Financial Reporting Objectives
Financial statements are prepared according to
agreed upon guidelines. In order to understand these guidelines, it helps to
understand the objectives of financial reporting. The objectives of financial
reporting, as discussed in the Financial Accounting standards Board (FASB) Statement
of Financial Accounting Concepts No. 1, are to provide information that is
useful to existing and potential investors and creditors and other users in
making rational investment, credit, and similar decisions;
1. helps
existing and potential investors and creditors and other usear to assess the
amounts, timing, and uncertainty of pro spective net cash inflows to the
enterprise;
2. identifies
the economic resources of an enterprise, the claims to those resources, and the
effects that transactions, events, and circumstances have on those resources.
Generally Accepted Accounting Principles
Accountants use generally accepted
accounting principles (GAAP) to guide them in recording and reporting
financial information. GAAP comprises a broad set of principles that have been
developed by the accounting profession and the Securities and Exchange
Commission (SEC). Two laws, the Securities Act of 1933 and the Securities
Exchange Act of 1934, give the SEC authority to establish reporting and
disclosure requirements. However, the SEC usually operates in an oversight
capacity, allowing the FASB and the Governmental Accounting Standards Board
(GASB) to establish these requirements. The GASB develops accounting standards
for state and local governments.
The current set of principles that accountants
use rests upon some underlying assumptions. The basic assumptions and
principles presented on the next several pages are considered GAAP and apply to
most financial statements. In addition to these concepts, there are other, more
technical standards accountants must follow when preparing financial
statements. Some of these are discussed later in this book, but other are left
for more advanced study.
Economic entity assumption.
Financial records must be separately maintained for each economic entity.
Economic entities include businesses, governments, school districts, churches,
and other social organizations. Although accounting information from many
different entities may be combined for financial reporting purposes, every
economic event must be associated with and recorded by a specific entity. In
addition, business records must not include the personal assets or liabilities
of the owners.
Monetary unit assumption. An
economic entity's accounting records include only quantifiable transactions.
Certain economic events that affect a company, such as hiring a new chief
executive officer or introducing a new product, cannot be easily quantified in
monetary units and, therefore, do not appear in the company's accounting
records. Furthermore, accounting records must be recorded using a stable
currency. Businesses in the United States usually use U.S. dollars for this purpose.
Full disclosure principle.
Financial statements normally provide information about a company's past
performance. However, pending lawsuits, incomplete transactions, or other
conditions may have imminent and significant effects on the company's financial
status. The full disclosure principle requires that financial statements
include disclosure of such information. Footnotes supplement financial
statements to convey this information and to describe the policies the company
uses to record and report business transactions.
Time period assumption. Most
businesses exist for long periods of time, so artificial time periods must be
used to report the results of business activity. Depending on the type of
report, the time period may be a day, a month, a year, or another arbitrary
period. Using artificial time periods leads to questions about when certain
transactions should be recorded. For example, how should an accountant report
the cost of equipment expected to last five years? Reporting the entire expense
during the year of purchase might make the company seem unprofitable that year
and unreasonably profitable in subsequent years. Once the time period has been
established, accountants use GAAP to record and report that accounting period's
transactions.
Accrual basis accounting. In
most cases, GAAP requires the use of accrual basis accounting rather than cash
basis accounting. Accrual basis accounting, which adheres to
the revenue recognition, matching, and cost principles discussed below,
captures the financial aspects of each economic event in the accounting period
in which it occurs, regardless of when the cash changes hands. Under cash basis
accounting, revenues are recognized only when the company receives cash or its
equivalent, and expenses are recognized only when the company pays with cash or
its equivalent.
Revenue recognition principle.
Revenue is earned and recognized upon product delivery or service completion,
without regard to the timing of cash flow. Suppose a store orders five hundred
compact discs from a wholesaler in March, receives them in April, and pays for
them in May. The wholesaler recognizes the sales revenue in April when delivery
occurs, not in March when the deal is struck or in May when the cash is
received. Similarly, if an attorney receives a $100 retainer from a client, the
attorney doesn't recognize the money as revenue until he or she actually
performs $100 in services for the client.
Matching principle. The costs of
doing business are recorded in the same period as the revenue they help to
generate. Examples of such costs include the cost of goods sold, salaries and
commissions earned, insurance premiums, supplies used, and estimates for
potential warranty work on the merchandise sold. Consider the wholesaler who
delivered five hundred CDs to a store in April. These CDs change from an asset
(inventory) to an expense (cost of goods sold) when the revenue is recognized
so that the profit from the sale can be determined.
Cost principle. Assets are
recorded at cost, which equals the value exchanged at the time of their
acquisition. In the United States, even if assets such as land or buildings
appreciate in value over time, they are not revalued for financial reporting
purposes.
Going concern principle. Unless
otherwise noted, financial statements are prepared under the assumption that
the company will remain in business indefinitely. Therefore, assets do not need
to be sold at fire-sale values, and debt does not need to be paid off before
maturity. This principle results in the classification of assets and
liabilities as short-term (current) and long-term. Long-term assets
are expected to be held for more than one year. Long-term liabilities
are not due for more than one year.
Relevance, reliability, and consistency.
To be useful, financial information must be relevant, reliable, and prepared in
a consistent manner. Relevant information helps a decision
maker understand a company's past performance, present condition, and future
outlook so that informed decisions can be made in a timely manner. Of course,
the information needs of individual users may differ, requiring that the
information be presented in different formats. Internal users often need more
detailed information than external users, who may need to know only the company's
value or its ability to repay loans. Reliable information is
verifiable and objective. Consistent information is prepared
using the same methods each accounting period, which allows meaningful
comparisons to be made between different accounting periods and between the
financial statements of different companies that use the same methods.
Principle of conservatism.
Accountants must use their judgment to record transactions that require
estimation. The number of years that equipment will remain productive and the
portion of accounts receivable that will never be paid are examples of items
that require estimation. In reporting financial data, accountants follow the principle
of conservatism, which requires that the less optimistic estimate be
chosen when two estimates are judged to be equally likely. For example, suppose
a manufacturing company's Warranty Repair Department has documented a
three-percent return rate for product X during the past two years, but the
company's Engineering Department insists this return rate is just a statistical
anomaly and less than one percent of product X will require service during the
coming year. Unless the Engineering Department provides compelling evidence to
support its estimate, the company's accountant must follow the principle of
conservatism and plan for a three-percent return rate. Losses and costs—such as
warranty repairs—are recorded when they are probable and reasonably estimated.
Gains are recorded when realized.
Materiality principle.
Accountants follow the materiality principle, which states
that the requirements of any accounting principle may be ignored when there is
no effect on the users of financial information. Certainly, tracking individual
paper clips or pieces of paper is immaterial and excessively burdensome to any
company's accounting department. Although there is no definitive measure of
materiality, the accountant's judgment on such matters must be sound. Several
thousand dollars may not be material to an entity such as General Motors, but
that same figure is quite material to a small, family-owned business.
Internal Control
Internal control is the process
designed to ensure reliable financial reporting, effective and efficient
operations, and compliance with applicable laws and regulations. Safeguarding
assets against theft and unauthorized use, acquisition, or disposal is also
part of internal control.
Control environment. The management style and the
expectations of upper-level managers, particularly their control policies,
determine the control environment. An effective control environment helps
ensure that established policies and procedures are followed. The control
environment includes independent oversight provided by a board of directors
and, in publicly held companies, by an audit committee; management's integrity,
ethical values, and philosophy; a defined organizational structure with
competent and trustworthy employees; and the assignment of authority and
responsibility.
Control activities. Control activities
are the specific policies and procedures management uses to achieve its
objectives. The most important control activities involve segregation of
duties, proper authorization of transactions and activities, adequate documents
and records, physical control over assets and records, and independent checks
on performance. A short description of each of these control activities appears
below.
·
Segregation of duties requires
that different individuals be assigned responsibility for different elements of
related activities, particularly those involving authorization, custody, or
recordkeeping. For example, the same person who is responsible for an asset's
recordkeeping should not be respon sible for physical control of that asset
Having different indi viduals perform these functions creates a system of
checks and balances.
·
Proper authorization of
transactions and activities helps ensure that all company activities adhere to
established guide lines unless responsible managers authorize another course of
action. For example, a fixed price list may serve as an official authorization
of price for a large sales staff. In addition, there may be a control to allow
a sales manager to authorize reason able deviations from the price list.
·
Adequate documents and records
provide evidence that financial statements are accurate. Controls designed to
ensure adequate recordkeeping include the creation of invoices and other
documents that are easy to use and sufficiently informa tive; the use of
prenumbered, consecutive documents; and the timely preparation of documents.
·
Physical control over assets
and records helps protect the company's assets. These control activities may
include elec tronic or mechanical controls (such as a safe, employee ID cards,
fences, cash registers, fireproof files, and locks) or computer-related
controls dealing with access privileges or established backup and recovery
procedures.
·
Independent checks on
performance, which are carried out by employees who did not do the work being
checked, help ensure the reliability of accounting information and the
efficiency of operations. For example, a supervisor verifies the accuracy of a
retail clerk's cash drawer at the end of the day. Internal auditors may also
verity that the supervisor performed the check of the cash drawer.
In order to identify and establish effective
controls, management must continually assess the risk, monitor control
implementation, and modify controls as needed. Top managers of publicly held
companies must sign a statement of responsibility for internal controls and include
this statement in their annual report to stockholders.
Analyzing Transactions
The first step in the accounting process is to
analyze every transaction (economic event) that affects the business. The
accounting equation (Assets = Liabilities + Owner's Equity) must remain in
balance after every transaction is recorded, so accountants must analyze each
transaction to determine how it affects owner's equity and the different types
of assets and liabilities before recording the transaction.
Assume Mr. J. Green invests $15,000 to start a
landscape business. This transaction increases the company's assets,
specifically cash, by $15,000 and increases owner's equity by $15,000. Notice
that the accounting equation remains in balance.
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Mr. Green uses $5,000 of the company's cash to
place a down-payment on a used truck that costs $15,000, and he signs a note
payable that requires him to pay the remaining $10,000 in eighteen months. This
transaction decreases one type of asset (cash) by $5,000, increases another
type of asset (vehicles) by $15,000, and increases a liability (notes payable)
by $10,000. The accounting equation remains in balance, and Mr. Green now has two
types of assets ($10,000 in cash and a vehicle worth $15,000), a liability (a
$10,000 note payable), and owner's equity of $15,000.
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Given the large number of transactions that
companies usually have, accountants need a more sophisticated system for
recording transactions than the one shown on the previous page. Accountants use
the double-entry bookkeeping system to keep the accounting equation in balance
and to double-check the numerical accuracy of transaction entries. Under this
system, each transaction is recorded using at least two accounts. An account
is a record of all transactions involving a particular item.
Companies maintain separate accounts for each
type of asset (cash, accounts receivable, inventory, etc.), each type of
liability (accounts payable, wages payable, notes payable, etc.), owner
investments (usually referred to as the owner's capital account in a sole
proprietorship), owner drawings (withdrawals made by the owner), each type of
revenue (sales revenue, service revenue, etc.), and each type of expense (rent
expense, wages expense, etc.). All accounts taken together make up the general
ledger. For organizational purposes, each account in the general
ledger is assigned a number, and companies maintain a chart of accounts,
which lists the accounts and account numbers.
Account numbers vary significantly from one
company to the next, depending on the company's size and complexity. A sole
proprietorship may have few accounts, but a multinational corporation may have
thousands of accounts and use ten- or even twenty-digit numbers to track
accounts by location, department, project code, and other categories. Most
companies numerically separate asset, liability, owner's equity, revenue, and
expense accounts. A typical small business might use the numbers 100–199 for
asset accounts, 200–299 for liability accounts, 300–399 for owner's equity
accounts, 400–499 for revenue accounts, and 500–599 for expense accounts.
T Accounts
The simplest account structure is shaped like the
letter T. The account title and account number appear above the T.
Debits (abbreviated Dr.) always go on the left side of the T, and credits
(abbreviated Cr.) always go on the right.
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Accountants record increases in asset, expense,
and owner's drawing accounts on the debit side, and they record increases in
liability, revenue, and owner's capital accounts on the credit side. An
account's assigned normal balance is on the side where
increases go because the increases in any account are usually greater than the
decreases. Therefore, asset, expense, and owner's drawing accounts normally
have debit balances. Liability, revenue, and owner's capital accounts normally
have credit balances. To determine the correct entry, identify the accounts
affected by a transaction, which category each account falls into, and whether
the transaction increases or decreases the account's balance. You may find the
following chart helpful as a reference.
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Occasionally, an account does not have a normal
balance. For example, a company's checking account (an asset) has a credit
balance if the account is overdrawn.
The way people often use the words debit
and credit in everyday speech is not how accountants use these words.
For example, the word credit generally has positive associations when
used conversationally: in school you receive credit for completing a course, a
great hockey player may be a credit to his or her team, and a hopeless romantic
may at least deserve credit for trying. Someone who is familiar with these uses
for credit but who is new to accounting may not immediately associate
credits with decreases to asset, expense, and owner's drawing accounts. If a
business owner loses $5,000 of the company's cash while gambling, the cash
account, which is an asset, must be credited for $5,000. (The accountant who
records this entry may also deserve credit for realizing that other job offers
merit consideration.) For accounting purposes, think of debit and credit
simply in terms of the left-hand and right-hand side of a T account.
Double‐Entry Bookkeeping
Under the double-entry bookkeeping system, the
full value of each transaction is recorded on the debit side of one or more
accounts and also on the credit side of one or more accounts. Therefore, the
combined debit balance of all accounts always equals the combined credit
balance of all accounts.
Suppose a new company obtains a long-term loan
for $50,000 on August 1. The company's cash account (an asset) increases by
$50,000, so it is debited for this amount. Simultaneously, the company's notes
payable account (a liability) increases by $50,000, so it is credited for this
amount. Both sides of the accounting equation increase by $50,000, and total
debits and credits remain equal.
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Some transactions affect only one side of the
accounting equation, but the double-entry bookkeeping system nevertheless
ensures that the accounting equation remains in balance. For example, if the
company pays $30,000 on August 3 to purchase equipment, the cash account's
decrease is recorded with a $30,000 credit and the equipment account's increase
is recorded with a $30,000 debit. These two asset-account entries offset each
other, so the accounting equation remains in balance. Since the cash balance
was $50,000 before this transaction occurred, the company has $20,000 in cash
after the equipment purchase.
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A compound entry is necessary
when a single transaction affects three or more accounts. Suppose the company's
owner purchases a used delivery truck for $20,000 on August 6 by making a
$2,000 cash down payment and obtaining a three-year note payable for the
remaining $18,000. This transaction is recorded by debiting (increasing) the
vehicles account for $20,000, crediting (increasing) the notes payable account
for $18,000, and crediting (decreasing) the cash account for $2,000.
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The debits and credits total $20,000, and the
accounting equation remains in balance because the $18,000 net increase in
assets is matched by an $18,000 increase in liabilities. After these three
transactions, the company has $68,000 in assets (cash $18,000; equipment
$30,000; vehicles $20,000) and $68,000 in liabilities (notes payable).
Journal Entries
Tracking business activity with T accounts would
be cumbersome because most businesses have a large number of transactions each
day. These transactions are initially recorded on source documents,
such as invoices or checks. The first step in the accounting process is to
analyze each transaction and identify what effect it has on the accounts. After
making this determination, an accountant enters the transactions in
chronological order into a journal, a process called journalizing
the transactions. Although many companies use specialized journals for certain
transactions, all businesses use a general journal. In this
book, the terms general journal and journal are used
interchangeably.
The journal's page number appears near the upper
right corner. In the example below, GJ1 stands for page 1 of the general
journal. Many general journals have five columns: Date, Account Title and
Description, Posting Reference, Debit, and Credit.
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To record a journal entry, begin
by entering the date of the transaction in the journal's date column. For
convenience, include the year and month only at the top of each page and next
to each month's first entry. In the next column, list each account affected by
the transaction on a separate line, and enter a short description of the
transaction immediately below the list of accounts. The accounts being debited
always appear above the accounts being credited, which are indented slightly.
The posting reference column remains blank until the journal entry is
transferred to the accounts, a process called posting, at
which time the account's number is placed in this column. Finally, enter the
debit or credit amount for each account in the appropriate columns on the right
side of the journal. Generally, one blank line separates each transaction.
The General Ledger
After journalizing transactions, the next step in
the accounting process is to post transactions to the accounts in the general
ledger. Although T accounts provide a conceptual framework for understanding
accounts, most businesses use a more informative and structured spreadsheet
layout. A typical account includes date, explanation, and reference columns to
the left of the debit column and a balance column to the right of the credit
column. The reference column identifies the journal page containing the
transaction. The balance column shows the account's balance after every
transaction.
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When an account does not have a normal balance,
brackets enclose the balance. Assets normally have debit balances, for example,
so brackets enclose a checking account's balance only when the account is
overdrawn.
As the numbered arrows below indicate, you should
post a transaction's first line item to the correct ledger account, completing
each column and calculating the account's new balance. Then you should enter
the account's reference number in the journal. Repeat this sequence of steps
for every account listed in the journal entry.
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Referencing the account's number on the journal after
posting the entry ensures that every line item that has a reference number in
the journal has already been posted. This practice can be helpful if phone
calls or other distractions interrupt the posting process.
The Recording Process Illustrated
To understand how to record a variety of
transactions, consider the description and analysis of the Greener Landscape
Group's first thirteen transactions. Then see how each transaction appears in
the company's general journal and general ledger accounts.
Transaction 1: On April 1, 20X2, the owner of the Greener
Landscape Group, J. Green, invests $15,000 to open the business. Therefore, an
asset account (cash) increases and is debited for $15,000, and the owner's
capital account (J. Green, capital) increases and is credited for $15,000.
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The Trial Balance
After posting all transactions from an accounting period, accountants prepare a trial balance to verify that the total of all accounts with debit balances equals the total of all accounts with credit balances. The trial balance lists every open general ledger account by account number and provides separate debit and credit columns for entering account balances. The Greener Landscape Group's trial balance for April 30,20X2 appears below.| The Greener Landscape Group Trial Balance April 30,20X2
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Although dollar signs are not used in journals or
ledger accounts, trial balances generally include dollar signs next to the
first figure in each column and next to each column's total. Trial balances
usually include accounts that had activity during the accounting period but
have a zero balance at the end of the period.
An error has occurred when total debits on a
trial balance do not equal total credits. There are standard techniques for
uncovering some of the errors that cause unequal trial balances. After
double-checking each column's total to make sure the problem is not simply an
addition error on the trial balance, find the difference between the debit and
credit balance totals. If the number 2 divides evenly into this
difference, look for an account balance that equals half the difference and
that incorrectly appears in the column with the larger total. If the Greener
Landscape Group's $50 accounts payable balance were mistakenly put in the debit
column, for example, total debits would be $100 greater than total credits on
the trial balance.
If the number 9 divides evenly into the
difference between the debit and credit balance totals, look for a transposition
error in one of the account balances. For example, suppose the cash account's
balance of $6,355 were incorrectly entered on the trial balance as $6,535. This
would cause total debits to be $180 greater than total credits on the trial
balance, an amount evenly divisible by 9 ($180 ÷ 9 = $20).
Incidentally, the number of digits in the resulting quotient—the quotient 20
has two digits–always indicates that the transposition error begins this number
of digits from the right side of an account balance. Also, the value of the
leftmost digit in the quotient— 2 in this case— always equals the
difference between the two transposed numbers. Test this by transposing any two
adjacent numbers in the trial balance and performing the calculations yourself.
If the difference between the debit and credit
balance totals is not divisible by 2 or 9, look for a ledger
account with a balance that equals the difference and is missing from the trial
balance. Of course, two or more errors can combine to render these techniques
ineffective, and other types of mistakes frequently occur. If the error is not
apparent, return to the ledger and recalculate each account's balance. If the
error remains, return to the journal and verify that each transaction is posted
correctly.
Some errors do not cause the trial balance's
column totals to disagree. For example, the columns in a trial balance agree
when transactions are not journalized or when journal entries are not posted to
the general ledger. Similarly, recording transactions in the wrong accounts
does not lead to unequal trial balances. Another common error a trial balance
does not catch happens when a single transaction is posted twice. The trial
balance is a useful tool, but every transaction must be carefully analyzed, journalized,
and posted to ensure the reliability and usefulness of accounting records.
Adjusting Entries
Before financial statements are prepared,
additional journal entries, called adjusting entries, are made
to ensure that the company's financial records adhere to the revenue
recognition and matching principles. Adjusting entries are necessary because a
single transaction may affect revenues or expenses in more than one accounting
period and also because all transactions have not necessarily been documented during
the period.
Each adjusting entry usually affects one income
statement account (a revenue or expense account) and one balance sheet account
(an asset or liability account). For example, suppose a company has a $1,000
debit balance in its supplies account at the end of a month, but a count of
supplies on hand finds only $300 of them remaining. Since supplies worth $700
have been used up, the supplies account requires a $700 adjustment so assets
are not overstated, and the supplies expense account requires a $700 adjustment
so expenses are not understated.
Adjustments fall into one of five categories:
accrued revenues, accrued expenses, unearned revenues, prepaid expenses, and
depreciation.
Accrued Revenues
An adjusting entry to accrue revenues is necessary
when revenues have been earned but not yet recorded. Examples of unrecorded
revenues may involve interest revenue and completed services or delivered goods
that, for any number of reasons, have not been billed to customers. Suppose a
customer owes 6% interest on a three-year, $10,000 note receivable but has not
yet made any payments. At the end of each accounting period, the company
recognizes the interest revenue that has accrued on this long-term receivable.
Unless otherwise specified, interest is calculated
with the following formula: principal x annual interest rate x time period in
years.
|
Most textbooks use a 360-day year for interest
calculations, which is done here. In practice, however, most lenders make more
precise calculations by using a 365-day year.
Since the company accrues $50 in interest revenue
during the month, an adjusting entry is made to increase (debit) an asset
account (interest receivable) by $50 and to increase (credit) a revenue account
(interest revenue) by $50.
 |
If a plumber does $90 worth of work for a
customer on the last day of April but doesn't send a bill until May 4, the
revenue should be recognized in April's accounting records. Therefore, the
plumber makes an adjusting entry to increase (debit) accounts receivable for
$90 and to increase (credit) service revenue for $90.
 |
Accounting records that do not include adjusting
entries for accrued revenues understate total assets, total revenues, and net
income.
Accrued Expenses
An adjusting entry to accrue expenses is
necessary when there are unrecorded expenses and liabilities that apply to a
given accounting period. These expenses may include wages for work performed in
the current accounting period but not paid until the following accounting period
and also the accumulation of interest on notes payable and other debts.
Suppose a company owes its employees $2,000 in unpaid wages at the end
of an accounting period. The company makes an adjusting entry to accrue the
expense by increasing (debiting) wages expense for $2,000 and by increasing
(crediting) wages payable for $2,000.
 |
If a long-term note payable of $10,000 carries an
annual interest rate of 12%, then $1,200 in interest expense accrues each year.
At the close of each month, therefore, the company makes an adjusting entry to
increase (debit) interest expense for $100 and to increase (credit) interest
payable for $100.
 |
Accounting records that do not include adjusting
entries for accrued expenses understate total liabilities and total expenses
and overstate net income.
Unearned Revenues
Unearned revenues are payments
for future services to be performed or goods to be delivered. Advance customer
payments for newspaper subscriptions or extended warranties are unearned
revenues at the time of sale. At the end of each accounting period, adjusting
entries must be made to recognize the portion of unearned revenues that have
been earned during the period.
Suppose a customer pays $1,800 for an insurance policy to protect her
delivery vehicles for six months. Initially, the insurance company records this
transaction by increasing an asset account (cash) with a debit and by
increasing a liability account (unearned revenue) with a credit. After one
month, the insurance company makes an adjusting entry to decrease (debit)
unearned revenue and to increase (credit) revenue by an amount equal to one
sixth of the initial payment.
 |
Accounting records that do not include adjusting
entries to show the earning of previously unearned revenues overstate total
liabilities and understate total revenues and net income.
Prepaid Expenses
Prepaid
expenses are assets that become expenses as
they expire or get used up. For example, office supplies are considered an
asset until they are used in the course of doing business, at which time they
become an expense. At the end of each accounting period, adjusting entries are
necessary to recognize the portion of prepaid expenses that have become actual
expenses through use or the passage of time.
Consider the previous example from the point of
view of the customer who pays $1,800 for six months of insurance coverage.
Initially, she records the transaction by increasing one asset account (prepaid
insurance) with a debit and by decreasing another asset account (cash) with a
credit. After one month, she makes an adjusting entry to increase (debit)
insurance expense for $300 and to decrease (credit) prepaid insurance for $300.
 |
Prepaid expenses in one company's accounting
records are often—but not always—unearned revenues in another company's
accounting records. Office supplies provide an example of a prepaid expense
that does not appear on another company's books as unearned revenue.
Accounting records that do not include adjusting
entries to show the expiration or consumption of prepaid expenses overstate
assets and net income and understate expenses.
Depreciation
Depreciation is the process of
allocating the depreciable cost of a long-lived asset, except for land which is
never depreciated, to expense over the asset's estimated service life. Depreciable
cost includes all costs necessary to acquire an asset and make it
ready for use minus the asset's expected salvage value, which
is the asset's worth at the end of its service life, usually
the amount of time the asset is expected to be used in the business. For
example, if a truck costs $30,000, has an expected salvage value of $6,000, and
has an estimated service life of sixty months, then $24,000 is allocated to
expense at a rate of $400 each month ($24,000 ÷ 60 = $400). This method of
calculating depreciation expense, called straight-line depreciation,
is the simplest and most widely used method for financial reporting purposes.
Some accountants treat depreciation as a special type of prepaid expense
because the adjusting entries have the same effect on the accounts. Accounting
records that do not include adjusting entries for depreciation expense
overstate assets and net income and understate expenses. Nevertheless, most
accountants consider depreciation to be a distinct type of adjustment because
of the special account structure used to report depreciation expense on the
balance sheet.
Since the original cost of a long-lived asset
should always be readily identifiable, a different type of balance-sheet
account, called a contra-asset account, is used to record
depreciation expense. Increases and normal balances appear on the credit side
of a contraasset account. The net book value of long-lived
assets is found by subtracting the contra-asset account's credit balance from
the corresponding asset account's debit balance. Do not confuse book value with
market value. Book value is the portion of the asset's cost that has not been
written off to expense. Market value is the price some-one
would pay for the asset. These two values are usually different.
Suppose an accountant calculates that a $125,000
piece of equipment depreciates by $1,000 each month. After one month, he makes
an adjusting entry to increase (debit) an expense account (depreciation
expense–equipment) by $1,000 and to increase (credit) a contra-asset account
(accumulated depreciation–equipment) by $1,000.
 |
On a balance sheet, the accumulated depreciation
account's balance is subtracted from the equipment account's balance to show
the equipment's net book value.
| ACME Manufacturing Partial Balance Sheet December 31, 20X7
|
The Adjustment Process Illustrated
Accountants prepare a trial balance both before
and after making adjusting entries. Reexamine the Greener Landscape Group's
unadjusted trial balance for April 30, 20X2.
|
Consider eight adjusting entries recorded in Mr.
Green's general journal and posted to his general ledger accounts. Then, see
the adjusted trial balance, which shows the balance of all
accounts after the adjusting entries are journalized and posted to the general
ledger accounts.
Adjustment A: During the
afternoon of April 30, Mr. Green cuts one lawn, and he agrees to mail the
customer a bill for $50, which he does on May 2. In accordance with the revenue
recognition principle, Mr. Green makes an adjusting entry in April to increase
(debit) accounts receivable for $50 and to increase (credit) lawn cutting
revenue for $50.
 |
Adjustment B: Mr. Green's
$10,000 note payable, which he signed on April 2, carries a 10.2% interest
rate. Interest calculations usually exclude the day that loans occur and
include the day that loans are paid off. Therefore, Mr. Green uses the formula
below to calculate how much interest expense accrued during the final
twenty-eight days of April.
|
Since the matching principle requires that
expenses be reported in the accounting period to which they apply, Mr. Green
makes an adjusting entry to increase (debit) interest expense for $79 and to
increase (credit) interest payable for $79.
 |
Adjustment C: Mr. Green's
part-time employee earns $80 during the last four days of April but will not be
paid until May 10. This requires an adjusting entry that increases (debits)
wages expense for $80 and that increases (credits) wages payable for $80.
 |
Adjustment D: On April 20 Mr.
Green received a $270 prepayment for six future visits. Assuming Mr. Green
completed one of these visits in April, he must make a $45 adjusting entry to
decrease (debit) unearned revenue and to increase (credit) lawn cutting
revenue.
 |
Adjustment E: Mr. Green
discovers that he used $25 worth of office supplies during April. He therefore
makes a $25 adjusting entry to increase (debit) supplies expense and to
decrease (credit) supplies.
 |
Adjustment F: Mr. Green must
record the expiration of one twelfth of his company's insurance policy. Since
the annual premium is $1,200, he makes a $100 adjusting entry to increase
(debit) insurance expense and to decrease (credit) prepaid insurance.
 |
Adjustment G: If depreciation
expense on Mr. Green's $15,000 truck is $200 each month, he makes a $200
adjusting entry to increase (debit) an expense account (depreciation
expense–vehicles) and to increase (credit) a contra-asset account (accumulated
depreciation–vehicles).
 |
The truck's net book value is now $14,800, which
is calculated by subtracting the $200 credit balance in the accumulated
depreciation–vehicles account from the $15,000 debit balance in the vehicles
account. Many accountants calculate the depreciation of long-lived assets to
the nearest month. Had Mr. Green purchased the truck on April 16 or later, he
might not make this adjusting entry until the end of May.
Adjustment H: If depreciation
expense on Mr. Green's equipment is $35 each month, he makes a $35 adjusting
entry to increase (debit) depreciation expense–equipment and to increase
(credit) accumulated depreciation–equipment.
 |
After journalizing and posting all of the
adjusting entries, Mr. Green prepares an adjusted trial balance. The Greener
Landscape Group's adjusted trial balance for April 30,20X2 appears below.
| The Greener Landscape Group Adjusted Trial Balance April 30,20X2
|
Financial Statements
Financial statements are prepared immediately
after the adjusted trial balance. Knowing how to record transactions, make
adjusting entries, and create trial balances gives you a greater under-standing
of the information financial statements contain.
Income statement. The income
statement, which is sometimes called the statement of earnings or statement of
operations, lists all revenue and expense account balances and shows the
company's net income or net loss for a particular period of time. This
statement may be prepared using a single-step or multiple-step format. The
single-step format puts revenue and expense accounts into separate groups.
Then, total expenses are subtracted from total revenues to determine the net
income or loss.
| The Greener Landscape Group Income Statement For the Month Ended April 30,20X2
|
| The Greener Landscape Group Income Statement For the Month Ended April 30,20X2
|
Companies may use slightly different categories
for expenses, but the overall structure for this type of income statement is
essentially the same. For example, merchandising companies include a category
for the cost of goods sold, and many companies break operating expenses into
two subcategories: selling expenses and general and administrative expenses
Statement of owner's equity. The
statement of owner's equity shows activity in the owner's equity accounts for a
particular period of time. The capital account's opening balance is followed by
a list of increases and decreases, and the account's closing balance is
calculated from this information. Increases include investments made by the
owner and net income. Decreases include owner withdrawals and net loss. Since
the income statement already shows all revenue and expense account balances,
only the company's net income or loss appears on this statement.
| The Greener Landscape Group Statement of Owner's Equity For the Month Ended April 30,20X2
|
Balance sheet. The balance sheet
lists the asset, liability, and owner's equity balances at a specific time. It
proves that the accounting equation (Assets = Liabilities + Owner's Equity) is
in balance. The ending balance on the statement of owner's equity is used to
report owner's equity on the balance sheet.
| The Greener Landscape Group Balance Sheet April 30,20X2
|
To aid readers, most companies prepare a
classified balance sheet, which categorizes assets and liabilities. The
standard asset categories on a classified balance sheet are current assets;
property, plant, and equipment; long-term investments; and intangible assets.
Liabilities are generally divided into current liabilities and long-term
liabilities.
| The Greener Landscape Group Balance Sheet April 30,20X2
| ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Statement of cash flows. The statement of cash flows places all cash exchanges into one of three categories—operating, investing, or financing—to calculate the net change in cash during the accounting period. Operating cash flows arise from day-to-day business operations such as inventory purchases, sales revenue, and payroll expenses. Note that interest and dividends received from long-term assets (investing activities) and interest payments for long-term loans (financing activities) appear on the income statement, so they would appear as operating cash flows on the statement of cash flows. Income taxes are also included with operating cash flows. Investing cash flows relate to cash exchanges involving long-term assets, such as the purchase or sale of land, buildings, equipment, or long-term investments in another company's stock or debt. Financing cash flows involve changes in long-term liabilities and owner's equity. Examples include the receipt or early retirement of long-term loans, the sale or repurchase of stock, and the payment of dividends to shareholders. The Greener Landscape Group Statement of Cash Flows For the Month Ended April 30,20X2
|
As its name implies, this statement focuses on
cash flows rather than income. For example, the $870 Mr. Green receives from
customers includes unearned revenues and excludes accounts receivable. At the
bottom of the statement, the net increase or decrease in cash is used to
reconcile the accounting period's beginning and ending cash balances.
Significant noncash transactions likely to impact cash flow in other accounting
periods must also be disclosed, but this does not occur in the body of the statement.
The footnote in the illustration shows one way to accomplish such disclosures.
According to current accounting standards, operating cash flows may be
disclosed using either the direct or the indirect method. The direct
method simply lists operating cash flows by type of cash receipt and
payment. The direct method is straightforward and easy to interpret, but only a
small percentage of companies actually use this method. The indirect
method reports operating cash flows by listing the company's net income
or loss and then adjusting this figure because net income is not calculated on
the cash basis.
The Work Sheet
Many accountants use a work sheet to prepare the
unadjusted trial balance, to assign the adjusting entries to the correct
accounts, to create the adjusted trial balance, and then to prepare preliminary
financial statements. A work sheet is an optional step in the accounting cycle.
It is an informal document that is not considered a financial statement,
although it gives management some information about results for a period. Work
sheets usually have five sets of debit and credit columns, which are completed
from left to right one set at a time. Have a look at the following Greener
Landscape Group's work sheet for the month of April.
Use the first set of columns to prepare a trial
balance. List all open accounts on the left side of the work sheet and enter
each account's debit or credit balance in the appropriate columns immediately
to the right.
The second set of columns shows how the adjusting
entries affect the accounts. While completing these columns, list additional
accounts as needed along the left side of the work sheet. Use a letter to index
the debit and credit portion of each adjusting entry so that, latter, it is
easier to journalize and post the adjustments. An explanation of each
adjustment may be written at the bottom of the work sheet. If an account has
more than one adjustment, each is shown separately, using as many lines as
necessary. After entering all the adjustments on the work sheet, make sure the
column totals are equal.
The third set of columns contains the adjusted
trial balance. The adjusted account balances in these columns equal the sum of
the trial balance and adjustments columns. Consider the first three accounts on
the Greener Landscape Group's work sheet. Since no adjustments affect the cash
account, that account's debit balance carries across to the debit column of the
adjusted trial balance. Accounts receivable begins with a $150 debit balance
and has a $50 debit in the adjustments column. These amounts combine to give
the account a $200 debit balance in the adjusted trial balance. In the supplies
account, a $50 debit balance combines with a $25 credit in the adjustments
column to yield a $25 debit balance. Although each individual account works
this way, the totals at the bottom of the trial balance and adjustments columns
cannot be combined to determine the column totals at the bottom of the adjusted
trial balance—adding $26,070 to $614 clearly does not yield $26,514. After
entering each balance in the work sheet's adjusted trial balance, total each
column to make sure the debits and credits are equal.
Each account's adjusted trial balance transfers
directly to either the fourth or fifth set of columns. Move all revenue and
expense account balances to the income statement columns, and move all other
account balances (assets, liabilities, owner's capital, and owner's drawing) to
the balance sheet columns. Then total each of the final four columns. Unless
net income is zero, the columns have unequal debit and credit totals. If total
credits are greater than total debits in the income statement columns, the
company has net income, and the difference between these columns is added to
the work sheet's income statement debit column and balance sheet credit column
on a line labeled Net Income. The difference is added to the balance
sheet credit column because net income increases owner's equity, and increases
to owner's equity are recorded with credits. If total debits are greater than
total credits in the income statement columns, a net loss occurs, and the
difference between these column totals is added to the work sheet's income
statement credit column and balance sheet debit column on a line labeled Net
Loss. Once the company's net income or net loss is added to the correct
income statement and balance sheet columns, each set of debit and credit
columns balance, and the work sheet is complete.
Prepare the income statement, statement of
owner's equity, and balance sheet from the completed work sheet. The accounts
and balances in the work sheet's income statement columns transfer directly to
the income statement, which is prepared first. Next, from the work sheet's
balance sheet columns, use the owner's capital and drawing account balances and
the company's net income or loss to complete the statement of owner's equity.
Complete the balance sheet last. When preparing the balance sheet, be careful not
to use the capital account balance on the work sheet because it shows the capital
account's beginning balance for the accounting period. Instead, use the ending
balance on the statement of owner's equity, which has already adjusted the
capital account's balance to reflect the company's net income or loss and any
withdrawals made by the owner. After the financial statements are prepared, the
adjusting entries are journalized and posted.
| The Greener Landscape Group Work Sheet For the Month Ended April 30,20X2
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Closing Entries
To update the balance in the owner's capital
account, accountants close revenue, expense, and drawing accounts at the end of
each fiscal year or, occasionally, at the end of each accounting period. For
this reason, these types of accounts are called temporary or nominal
accounts. Assets, liabilities, and the owner's capital account, in
contrast, are called permanent or real accounts
because their ending balance in one accounting period is always the starting
balance in the subsequent accounting period. When an accountant closes an
account, the account balance returns to zero. Starting with zero balances in
the temporary accounts each year makes it easier to track revenues, expenses,
and withdrawals and to compare them from one year to the next. There are four closing
entries, which transfer all temporary account balances to the owner's
capital account
1.
Close the income statement accounts with credit balances (normally
revenue accounts) to a special temporary account named income summary.
2. Close
the income statement accounts with debit balances (normally expense accounts)
to the income summary account. After all revenue and expense accounts are
closed, the income summary account's balance equals the company's net income or
loss for the period.
3. Close
income summary to the owner's capital account or, in corporations, to the
retained earnings account. The purpose of the income summary account is simply
to keep the permanent owner's capital or retained earnings account uncluttered.
4. Close
the owner's drawing account to the owner's capital account. In corporations,
this entry closes any dividend accounts to the retained earnings account. For
purposes of illustration, closing entries for the Greener Landscape Group
follow.
Closing entry 1: The lawn
cutting revenue account is Mr. Green's only income statement account with a
credit balance. Debit this account for an amount equal to the account's
balance, and credit income summary for the same amount.
 |
Closing entry 2: Mr. Green has
eight income statement accounts with debit balances; they are all expense
accounts. Close these accounts by debiting income summary for an amount equal
to the combined debit balances of all eight expense accounts and by crediting
each expense account for an amount equal to its own debit balance.
 |
 |
Closing entry 3: The income
summary account's $61 credit balance equals the company's net income for the
month of April. To close income summary, debit the account for $61 and credit
the owner's capital account for the same amount.
 |
In partnerships, a compound entry transfers each
partner's share of net income or loss to their own capital account. In corporations,
income summary is closed to the retained earnings account.
Closing entry 4: Mr. Green's
drawing account has a $50 debit balance. To close the account, credit it for
$50 and debit the owner's capital account for the same amount.
 |
In a partnership, separate entries are made to
close each partner's drawing account to his or her own capital account. If a
corporation has more than one class of stock and uses dividend accounts to
record dividend payments to investors, it usually uses a separate dividend
account for each class. If this is the case, the corporation's accounting
department makes a compound entry to close each dividend account to the
retained earnings account
The Post‐Closing Trial Balance
After the closing entries are journalized and
posted, only permanent, balance sheet accounts remain open. A post-closing
trial balance is prepared to check the clerical accuracy of the closing entries
and to prove that the accounting equation is in balance before the next
accounting period begins.
| The Greener Landscape Group Post-Closing Trial Balance April 30, 20X2
|
Since there are several types of errors that
trial balances fail to uncover, each closing entry must be journalized and
posted carefully.
Reversing Entries
At the beginning of each accounting period, some
accountants use reversing entries to cancel out the adjusting
entries that were made to accrue revenues and expenses at the end of the
previous accounting period. Reversing entries make it easier to record
subsequent transactions by eliminating the need for certain compound entries.
Suppose Mr. Green makes an adjusting entry at the end of April to
account for $80 in unpaid wages. This adjustment involves an $80 debit to the
wages expense account and an $80 credit to the wages payable account.
 |
 |
To avoid the need for a compound entry, Mr. Green
may choose to reverse the April 30 adjustment for accrued wages when the May
accounting period begins. The reversing entry decreases (debits) wages payable
for $80 and decreases (credits) wages expense for $80.
 |
 |
Between May 1 when the reversing
entry is made and May 10 when the payroll entry is recorded, the company's
total liabilities and total expenses are understated. This temporary inaccuracy
in the books is acceptable only because financial statements are not prepared
during this period.
When the temporary accounts are closed at the end
of an accounting period, subsequent reversing entries create abnormal balances
in the affected expense and revenue accounts. For example, if the wages expense
account is closed on April 30, a reversing entry on May 1 creates a credit
balance in the account. The credit balance is offset by the May 10 debit entry,
and the account balance then shows current period expenses.
 |
Correcting Entries
Accountants must make correcting entries
when they find errors. There are two ways to make correcting entries: reverse
the incorrect entry and then use a second journal entry to record the
transaction correctly, or make a single journal entry that, when combined with
the original but incorrect entry, fixes the error.
After making a credit purchase for supplies worth
$50 on April 5, suppose Mr. Green accidently credits accounts receivable
instead of accounts payable.
 |
Mr. Green discovers the error on May 2, after
receiving a bill for the supplies. He may use two entries to fix the error: one
that reverses the incorrect entry by debiting accounts receivable for $50 and
crediting supplies for $50, and another that records the transaction correctly
by debiting supplies for $50 and crediting accounts payable for $50.
 |
 |
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