Closing entries, also called closing journal entries, are entries made at the end of an accounting period to zero out all temporary accounts and transfer their balances to permanent accounts. In other words, the temporary accounts are closed or reset at the end of the year. This is commonly referred to as closing the books. Show
Temporary accounts are income statement accounts that are used to track accounting activity during an accounting period. For example, the revenues account records the amount of revenues earned during an accounting period—not during the life of the company. We don’t want the 2015 revenue account to show 2014 revenue numbers. Permanent accounts are balance sheet accounts that track the activities that last longer than an accounting period. For example, a vehicle account is a fixed asset account that is recorded on the balance. The vehicle will provide benefits for the company in future years, so it is considered a permanent account. At the end of the year, all the temporary accounts must be closed or reset, so the beginning of the following year will have a clean balance to start with. In other words, revenue, expense, and withdrawal accounts always have a zero balance at the start of the year because they are always closed at the end of the previous year. This concept is consistent with the matching principle. Closing Entry TypesTemporary accounts can either be closed directly to the retained earnings account or to an intermediate account called the income summary account. The income summary account is then closed to the retained earnings account. Both ways have their advantages. Closing all temporary accounts to the income summary account leaves an audit trail for accountants to follow. The total of the income summary account after the all temporary accounts have been close should be equal to the net income for the period. Closing all temporary accounts to the retained earnings account is faster than using the income summary account method because it saves a step. There is no need to close temporary accounts to another temporary account (income summary account) in order to then close that again. Both closing entries are acceptable and both result in the same outcome. All temporary accounts eventually get closed to retained earnings and are presented on the balance sheet. ExampleIn this example we will close Paul’s Guitar Shop, Inc.’s temporary accounts using the income summary account method from his financial statements in the previous example. There are three general closing entries that must be made. Close all revenue and gain accountsAll of Paul’s revenue or income accounts are debited and credited to the income summary account. This resets the income accounts to zero and prepares them for the next year. Remember that all revenue, sales, income, and gain accounts are closed in this entry. Paul’s business or has a few accounts to close. Close all expense and loss accountsAll expense accounts are then closed to the income summary account by crediting the expense accounts and debiting income summary. Close all dividend or withdrawal accountsSince dividend and withdrawal accounts are not income statement accounts, they do not typically use the income summary account. These accounts are closed directly to retained earnings by recording a credit to the dividend account and a debit to retained earnings. Now that all the temporary accounts are closed, the income summary account should have a balance equal to the net income shown on Paul’s income statement. Now Paul must close the income summary account to retained earnings in the next step of the closing entries. Accounting WorksheetIncome Summary Account
In order to continue enjoying our site, we ask that you confirm your identity as a human. Thank you very much for your cooperation. In order for a company's financial statements to be complete and to reflect the accrual method of accounting, adjusting entries must be processed before the financial statements are issued. Here are three situations that describe why adjusting entries are needed: Situation 1 Not all of a company's financial transactions that pertain to an accounting period will have been processed by the accounting software as of the end of the accounting period. For example, the bill for the electricity used during December might not arrive until January 10. (The reason for the 10-day lag is that the electric utility reads the meters on January 1 in order to compute the electricity actually used in December. Next the utility has to prepare the bill and mail it to the company.) Situation 2 Sometimes a bill is processed during the accounting period, but the amount represents the expense for one or more future accounting periods. For example, the bill for the insurance on the company's vehicles might be $6,000 and covers the six-month period of January 1 through June 30. If the company is required to pay the $6,000 in advance at the end of December, the expense needs to be deferred so that $1,000 will appear on each of the monthly income statements for January through June. Situation 3 Something similar to Situation 2 occurs when a company purchases equipment to be used in the business. Let's assume the equipment is acquired, paid for, and put into service on May 1. However, the equipment is expected to be used for ten years. If the cost of the equipment is $120,000 and will have no salvage value, then each month's income statement needs to report $1,000 for 120 months in order to report depreciation expense under the straight-line method. These three situations illustrate why adjusting entries need to be entered in the accounting software in order to have accurate financial statements. Unfortunately the accounting software cannot compute the amounts needed for the adjusting entries. A bookkeeper or accountant must review the situations and then determine the amounts needed in each adjusting entry. Some of the necessary steps for recording adjusting entries are: We will sort the adjusting entries into five categories. 1. Accrued revenues Under the accrual method of accounting, a business is to report all of the revenues (and related receivables) that it has earned during an accounting period. A business may have earned fees from having provided services to clients, but the accounting records do not yet contain the revenues or the receivables. If that is the case, an accrual-type adjusting entry must be made in order for the financial statements to report the revenues and the related receivables. If a business has earned $5,000 of revenues, but they are not recorded as of the end of the accounting period, the accrual-type adjusting entry will be as follows: 2. Accrued expenses Under the accrual method of accounting, the financial statements of a business must report all of the expenses (and related payables) that it has incurred during an accounting period. For example, a business needs to report an expense that has occurred even if a supplier's invoice has not yet been received. To illustrate, let's assume that a company utilized a worker from a temporary personnel agency on December 27. The company expects to receive an invoice on January 2 and remit payment on January 9. Since the expense and the payable occurred in December, the company needs to accrue the expense and liability as of December 31 with the following adjusting entry: 3. Deferred revenues Under the accrual method of accounting, the amounts received in advance of being earned must be deferred to a liability account until they are earned. Let's assume that Servco Company receives $4,000 on December 10 for services it will provide at a later date. Prior to issuing its December financial statements, Servco must determine how much of the $4,000 has been earned as of December 31. The reason is that only the amount that has been earned can be included in December's revenues. The amount that is not earned as of December 31 must be reported as a liability on the December 31 balance sheet. If $3,000 has been earned, the Service Revenues account must include $3,000. The remaining $1,000 that has not been earned will be deferred to the following accounting period. The deferral will be evidenced by a credit of $1,000 in a liability account such as Deferred Revenues or Unearned Revenues. The adjusting entry for this deferral depends on how the receipt of $4,000 was recorded on December 10. If the receipt of $4,000 was recorded with a credit to Service Revenues (and a debit to Cash), the December 31 adjusting entry will be: If the entire receipt of $4,000 had been credited to Deferred Revenues on December 10 (along with a debit to Cash), the adjusting entry on December 31 would be: 4. Deferred expenses Under the accrual method of accounting, any payments for future expenses must be deferred to an asset account until the expenses are used up or have expired. To illustrate, let's assume that a new company pays $6,000 on December 27 for the insurance on its vehicles for the six-month period beginning January 1. For December 27 through 31, the company should have an asset Prepaid Insurance or Prepaid Expenses of $6,000. In each of the months January through June, the company must reduce the asset account by recording the following adjusting entry: 5. Depreciation expense Depreciation is associated with fixed assets (or plant assets) that are used in the business. Examples of fixed assets are buildings, machinery, equipment, vehicles, furniture, and other constructed assets used in a business and having a useful life of more than one year. (However, land is not depreciated.) Depreciation allocates the asset's cost (minus any expected salvage value) to expense in the accounting periods in which the asset is used. Hence, office equipment with a useful life of 5 years and no salvage value will mean monthly depreciation expense of 1/60 of the equipment's cost. A building with a useful life of 25 years and no salvage value will result in a monthly depreciation expense of 1/300 of the building's cost. To learn more about adjusting entries use any of the following links: The first two categories of adjusting entries that we had discussed above were: These categories are also referred to as accrual-type adjusting entries or simply accruals. Accrual-type adjusting entries are needed because some transactions had occurred but the company had not entered them into the accounts as of the end of the accounting period. In order for a company's financial statements to include these transactions, accrual-type adjusting entries are needed. In all likelihood, an actual transaction (that required an accrual-type adjusting entry) will get routinely processed and recorded in the next accounting period. This presents a potential problem in that the transaction could get entered into the accounting records twice: once through the adjusting entry and also when it is routinely processed in the subsequent accounting period. The purpose of reversing entries is to remove the accrual-type adjusting entries. Reversing entries will be dated as of the first day of the accounting period immediately following the period of the accrual-type adjusting entries. In other words, for a company with accounting periods which are calendar months, an accrual-type adjusting entry dated December 31 will be reversed on January 2. To illustrate, let's assume that the company had accrued repairs expenses with the following adjusting entry on December 31: This accrual-type adjusting entry was needed so that the December repairs would be reported as 1) part of the expenses on the December income statement, and 2) a liability on the December 31 balance sheet. On January 2, the following reversing entry is recorded in order to remove the accrual-type adjusting entry of December 31: The reversing entry removes the liability established on December 31 and also puts a credit balance in the Repairs Expense account on January 2. When the vendor's invoice is processed in January, it can be debited to Repairs Expenses (as would normally happen). If the vendor's invoice is $6,000 the balance in the account Repairs Expenses will show a $0 balance after the invoice is entered. (The $6,000 credit from the reversing entry on January 2, plus the $6,000 debit from the vendor's invoice equals $0.) Zero is the correct amount because the expense of $6,000 belonged in December and was reported in December as the result of the December 31 adjusting entry. Some accounting software will allow you to indicate the adjusting entries you would like to have reversed automatically in the next accounting period. Page 2The balance sheet is one of the four main financial statements of a business: The balance sheet reports a company's assets, liabilities, and stockholders' equity as of a moment in time. (The other three financial statements report amounts for a period of time such as a year, quarter, month, etc.) The balance sheet is also known as the statement of financial position and it reflects the accounting equation: Assets = Liabilities + Stockholders' Equity. Bankers will look at the balance sheet to determine the amount of a company's working capital, which is the amount of current assets minus the amount of current liabilities. They will also review the assets and the liabilities and compare these amounts to the amount of stockholders' equity. When a balance sheet reports at least one additional column of amounts from an earlier balance sheet date, it is referred to as a comparative balance sheet. Typically, companies issue a classified balance sheet. This means that the amounts are presented according to the following classifications: The following are brief descriptions of the classifications usually found on a company's balance sheet. Current assets Investments Property, plant and equipment Intangible assets Other assets Current liabilities Current liabilities include loans payable that will be due within one year of the balance sheet date, the current portion of long-term debt, accounts payable, income taxes payable and liabilities for accrued expenses. Noncurrent liabilities Stockholders' equity
Additional information on the balance sheetTo learn more about the balance sheet use any of the following links:
Income StatementThe income statement is also known as the statement of operations, the profit and loss statement, or P&L. It presents a company's revenues, expenses, gains, losses and net income for a specified period of time such as a year, quarter, month, 13 weeks, etc. Income Statement FormatsThere are two formats for presenting a company's income statement:
The difference in formats has to do with the number of subtractions and subtotals that appear on the income statement before getting to the company's bottom line net income. Multiple-step income statement Note that in the following multi-step income statement, there are three subtractions:
Single-step income statement In the single-step format, the income statement will have only one subtraction—all of the expenses (both operating and non-operating) are subtracted from all of the revenues (both operating and non-operating). In this format, there is no subtotal for gross profit or operating income. The bottom line, net income, results from a single subtraction (a single step) as shown here: Balance Sheet and Income Statement are LinkedAs we had discussed earlier, revenues cause stockholders' equity to increase while expenses cause stockholders' equity to decrease. Therefore, a positive net income reported on the income statement (which is the result of revenues being greater than expenses) will cause stockholders' equity to increase. A negative net income will cause stockholders' equity to decrease. The income statement accounts are temporary accounts because their balances will be closed at the end of each accounting year to the stockholders' equity account Retained Earnings. (The balances in a sole proprietorship's income statement accounts will be closed to the owner's capital account.) The link between the balance sheet and income statement is helpful for bookkeepers and accountants who want some assurance that the amount of net income appearing on the income statement is correct. If you verify the ending balances in the relatively few balance sheet accounts, you can have confidence that the income statement has the proper net income. Hence, you are wise to establish a routine to verify all of the balance sheet amounts.
Note: This technique does not guarantee that the details within the income statement are perfect. Here is our suggestion for reviewing the balance sheet amounts. Additional reviewAnother review that should be done routinely is to compare each item on the income statement to the same item on an earlier income statement. For example, the amounts for the 5-month period of the current year should be compared to the 5-month period of the previous year. If budgets are prepared, also compare this year's actual amounts for the 5-month period to the budgeted amounts for this year's 5-month period. The same holds for the balance sheet: compare the recent amounts to the amounts on the balance sheets from a year earlier and from a month earlier. Page 3While the balance sheet and the income statement are the most frequently referenced financial statements, the statement of cash flows or cash flow statement is a very important financial statement. The cash flow statement is important because the income statement and balance sheet are normally prepared using the accrual method of accounting. Hence the revenues reported on the income statement were earned but the company may not have received the money from its customers. (Many times companies allow customers to pay in 30 days or 60 days and often customers pay later than the agreed upon terms.) Similarly the expenses that are reported on the income statement have occurred, but the company may not have paid for the expense in the same period. In order to understand how cash has changed, and because many believe that "cash is king" the cash flow statement should be distributed and read at the same time as the income statement and balance sheet. Within the cash flow statement, the cash receipts or cash inflows are reported as positive amounts. The cash paid out or cash outflows are reported as negative amounts. The following table provides various ways for you to think of the positive and negative amounts that are shown on the cash flow statement: The net total of all of the positive and negative amounts reported on the cash flow statement should equal the change in the amount of the company's cash and cash equivalents. (The company's cash and cash equivalents are reported on its balance sheets.) The cash inflows and cash outflows which explain the change in a company's cash and cash equivalents are reported in three main sections of the cash flow statement: In addition to the three main sections, the cash flow statement requires the following disclosures: 1. Operating activities The cash flows reported in the operating activities section of the cash flow statement can be presented using one of two methods: The direct method is recommended by the FASB. However, a survey of 500 annual reports of large U.S. corporations revealed that only about 1% had used the recommended direct method. Nearly all of the U.S. corporations in the survey used the indirect method. Hence, we will limit our discussion to the indirect method. When the indirect method is used, the first section of the cash flow statement, Cash Flows from Operating Activities, begins with the company's net income (which is the bottom line of the income statement). Since the net income was computed using the accrual method of accounting, it needs to be adjusted in order to reflect the cash received and paid. The very first adjustment involves depreciation. The amount of Depreciation Expense reported on the income statement had reduced the company's net income, but the depreciation entry did not involve cash. (The journal entry for the current period's depreciation was a debit to Depreciation Expense and a credit to Accumulated Depreciation. Cash was not used.) Since the depreciation expense reduced net income, but did not use any cash, the amount of depreciation expense is added back to the net income amount. So far, the Cash Flows from Operating Activities is $28,000 Any amortization or depletion expense is also added back. Next, the operating activities will adjust the net income to reflect the changes in the amounts of current assets and current liabilities during the accounting period. For example, if accounts receivable increased from $9,500 to $9,800 during the period, we conclude that the company did not collect cash for all of the sales revenues shown on the income statement. Not collecting all of the sales amounts (or seeing accounts receivable increase) is viewed as negative for the company's cash. Hence the $300 increase in accounts receivable is shown as a negative adjustment of $300: So far, the Cash Flows from Operating Activities is $27,700 If accounts payable increased from $3,100 to $3,350 during the period, that indicates that the company did not pay all of its expenses. Not paying the bills is good for the company's cash. Hence, the $250 increase in accounts payable will be shown as a positive amount: So far, the Cash Flows from Operating Activities is $27,950 The changes in the current asset and the current liability accounts are reported as adjustments to the company's net income in the operating activities section—except that the change in short-term notes payable will be reported in the financing activities section. 2. Investing activities The purchasing and selling of long-term assets are reported in the second section of the cash flow statement, investing activities. The cash flows that involve long-term assets include: 3. Financing activities The changes in the noncurrent liabilities, stockholders' (or owner's) equity, and short-term loans are reported in the financing activities section of the cash flow statement. The positive amounts in the financing activities section could indicate that cash was received from: The negative amounts indicate that cash was used for: Other At the bottom of the cash flow statement, the net totals of the three sections are reconciled with the change in the cash and cash equivalents that are reported on the company's balance sheet. The reporting requirements for the cash flow statement also include disclosing the amounts paid for interest and income taxes and significant noncash investing and financing activities. (Two examples of noncash investing and financing activities are converting bonds to common stock and exchanging bonds payable for land.) Page 4There are two main methods of accounting (or bookkeeping): The accrual method of accounting is the preferred method because it provides: As a result, US GAAP requires most corporations to use the accrual method of accounting. The following table compares the accrual and cash methods of accounting: Note: Some small companies may be allowed to use the cash method of accounting and in turn may experience an income tax benefit. Since our website does not provide income tax information, you should seek tax advice from a tax professional or from IRS.gov. Under the accrual method, revenues are to be reported in the accounting period in which they are earned (which may be different from the period in which the money is received). To illustrate the reporting of revenues under the accrual method, let's assume that the hypothetical business Servco provides a service to a customer on December 27. Servco prepares a sales invoice for the agreed upon amount of $1,000. The invoice is dated December 27 and states that the amount is due in 30 days. Under the accrual method, on December 27 Servco: If Servco uses accounting software to prepare the invoice, the following will be recorded automatically as of December 27: In addition to updating the general ledger accounts (which are used in preparing the financial statements), the software will update and store the customer's information for generating an aging of accounts receivable and a statement of each customer's activity. Under the accrual method, expenses should be reported on the income statement in the period in which they best match with the revenues. If a cause and effect relationship is not obvious, the expense should be reported on the income statement when the cost is used up or expires. In any event, the payment of cash is not the primary factor for determining the accounting period in which an expense is reported on the income statement. To illustrate, let's assume that Servco uses a temporary help agency at a cost of $200 in order to assist in earning revenues on December 27. The invoice from the temp agency is received on December 27, but it will not be paid until January 4. Under the accrual method, on December 27 Servco: If accounting software is used to record the temp agency invoice, the following will occur automatically as of December 27: When Servco issues its check on January 4: If Servco had only the two transactions described above, its net income under the accrual method for the day of December 27 will consist of the following: Earned a net income of $800 ($1,000 of revenues minus $200 of expenses). [The cash method of accounting would have reported a much different picture: Obviously, the accrual method does a better job of reporting what occurred on December 27, the date that Servco actually provided the services and incurred the expense. Page 5Except for some very small companies, the standard method for recording transactions is double-entry. Double-entry bookkeeping or double-entry accounting means that every transaction will involve at least two accounts. To illustrate, here are a few transactions and the two accounts that will be affected: Note: Double-entry bookkeeping means that every transaction will involve a minimum of two accounts. The words debit and credit have been associated with double-entry bookkeeping and accounting for more than 500 years. Here are the meanings of those words: debit: an entry on the left side of an account credit: an entry on the right side of an account The debit and credit rule in double-entry bookkeeping can be stated several ways:
In short... Dependable accounting software will be written/coded to enforce the rule of debits equal to credits. In other words, a transaction will be accepted and processed only if the amount of the debits is equal to the amount of the credits. The accuracy of accounting software will also ensure that the accounts and the trial balance will always be in balance. Here is an example of a partial trial balance: Even though the accounting software has eliminated the clerical errors that occurred because amounts were handwritten and the account balances were calculated manually, some other errors can still occur. Here are some errors that will not be detected by the accounting software:
Even with the above errors, the trial balance will remain in balance. The reason is that the total of the debit balances will still be equal to the total of the credit balances. T-AccountsTo assist in visualizing the effect of recording a debit or credit amount and the resulting balances of general ledger accounts, it is helpful to draw a T-account, as shown here: Debit amounts will be entered on the left side of the T-account, and credit amounts will be entered on the right side. The title of the account will appear at the top of each "T". Since every transaction will involve at least two accounts, we recommend that you always begin by drawing two T-accounts. For example, if a company pays its rent of $2,000 for the current month, the transaction could be depicted with the following T-accounts: Note that one T-account (Rent Expense) has a debit of 2,000 and that one T-account (Cash) has a credit amount of 2,000. Hence, the transaction had debits equal to credits. Page 6The fourth financial statement is the statement of stockholders' equity. This statement lists the changes to the stockholders' equity section of the balance sheet during the current accounting period. A common format of the statement of stockholders' equity is shown here: To see additional examples of the statement of stockholders' equity we recommend that you identify a few U.S. corporations with stock that is publicly traded. On each corporation's website, select Investor Relations and then select each corporation's Form 10-K (the annual report to the Securities and Exchange Commission). Go to the section of the 10-K which presents the corporation's financial statements and view the statement of stockholders' equity. At a minimum of once per year, companies must prepare financial statements. In addition companies often prepare quarterly and monthly financial statements which are referred to as interim financial statements. For any of the financial statements to be accurate it is necessary to have a proper cut-off. This means including all of a company's business transactions in the proper accounting period. For example, the electricity bill arriving on January 10 might be the cost of the electricity that was actually used in December. (The time lag resulted from the utility company reading the electric meters and preparing and mailing the bill.) Hence under the accrual method of accounting, the bill received on January 10 needs to be included in December's expenses and must also be reported by the company as a liability as of December 31. Similarly, the hourly payroll processed during the first few days in January and paid on January 6 is likely to include the cost of employees working during the last few days in December. The cost of the hours worked through December 31 must be included in the company's December expenses and in the liabilities as of December 31. As you read the previous paragraph, you may have been reminded of our discussion of adjusting entries. That's because the adjusting entries are part of each period's closing process. The adjusting entries are prepared in order to report a company's revenues and expenses in the proper accounting period. To achieve a proper cut-off and to distribute the financial statements in a timely manner, it is helpful to have a timeline (or PERT chart) that indicates the necessary steps in the closing process. The timeline will indicate what needs to be done and the sequence in which things need to occur. It will also reveal what is preventing the financial statements from being distributed sooner. In addition, a checklist of the closing tasks should be prepared and distributed to the appropriate employees as to what is required, who is responsible, and the day it is due. If some journal entries must be written every month, it is helpful to assign journal entry numbers to these standard journal entries or recurring journal entries. For example, a company may designate JE33 (Journal Entry #33) to be the recurring accrual of expenses that have occurred but have not yet been recorded in Accounts Payable as of the end of a month. Perhaps the timeline/checklist will indicate that JE33 must be submitted by the accounts payable clerk six days after each month ends. The company may also have its computer automatically prepare JE34 which is the entry that automatically reverses the previous month's accrual entry JE33. Some recurring journal entries will have the same amount each month. For example, a company's JE10 might be $10,800 every month of the year for the company's depreciation expense. (Some companies will refer to the entries that have the same amounts and accounts every month as standard entries.) Another recurring entry may involve the same accounts each month, but the amounts will vary from month to month. For example, a company's JE03 might be the recurring monthly entry for bad debts expense. The company has determined in advance that the amount of JE03 will be 0.002 of the company's monthly credit sales. Since the amount of sales is different every month, the amounts on JE03 will be different each month. Having entry numbers and standard entries should help to make the monthly closings more routine and efficient. The use of accounting software has eliminated some of the tedious tasks previously associated with bookkeeping. This could result in fewer people involved in the bookkeeping, accounting and administrative tasks. A side effect of fewer people handling more tasks is the potential for concealing some dishonest activity. For example, if the person who processes the cash receipts is also the person that records the amounts in customers' accounts, stealing some cash will be easier than if the tasks were separated. Having a third person mailing statements to customers with instructions to report any discrepancies to a fourth person will further safeguard the company's assets. Accountants refer to the practices and policies for safeguarding assets as internal controls. Very large corporations may have a staff of internal auditors that ensure there are controls in place (including the separation of duties) so that fraud and misappropriation will not occur. Small companies or organizations with a small staff are therefore at a disadvantage. Nonetheless owners and managers of even the smallest companies and organizations must be aware of the need for internal controls. Here is a partial list of some internal controls that smaller organizations can implement: We are not experts in internal controls, but we realize their importance. We strongly recommend that you seek assistance from your professional accountant regarding internal controls that are appropriate for your business or organization.
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You should consider our materials to be an introduction to selected accounting and bookkeeping topics, and realize that some complexities (including differences between financial statement reporting and income tax reporting) are not presented. Therefore, always consult with accounting and tax professionals for assistance with your specific circumstances. Page 7The accounts that are used to sort and store transactions are found in the company's general ledger. The general ledger is often arranged according to the following seven classifications. (A few examples of the related account titles are shown in parentheses.) The first three classifications are referred to as balance sheet accounts since the balances in these accounts are reported on the financial statement known as the balance sheet. The balance sheet accounts are also known as permanent accounts (or real accounts) since the balances in these accounts will not be closed at the end of an accounting year. Instead, these account balances are carried forward to the next accounting year. The four remaining classifications of accounts are referred to as income statement accounts since the amounts in these accounts will be reported on the financial statement known as the income statement. The income statement accounts are also known as temporary accounts since the balances in these accounts will be closed at the end of the accounting year. Each income statement account is closed in order to begin the next accounting year with a zero balance. The year-end balances from all of the income statement accounts will be combined and entered as a single net amount in Retained Earnings (a balance sheet account within stockholders' equity) or in a proprietor's capital account. Note: If an account has not had any activity in the current or recent periods, it is often omitted from the current general ledger. The chart of accounts is simply a list of all of the accounts that are available for recording transactions. This means that the number of accounts in the chart of accounts will be greater than the number of accounts in the general ledger. (The reason is that accounts with zero balances and no recent entries are often omitted from the general ledger until there is a transaction for the account.) The chart of accounts is organized similar to the general ledger: balance sheet accounts followed by the income statement accounts. However, the chart of accounts does not contain any entries or account balances. The chart of accounts allows you to find the name of an account, its account number, and perhaps a brief description. It is important to expand and/or alter the chart of accounts to accommodate the changes to an organization and when there is a need for improved reporting of information. In some accounting software, the chart of accounts is also used to designate where an account will be reported in the financial statements. Page 8If you already understand debits and credits, the following table summarizes how debits and credits are used in the accounts. If you are not familiar with debits and credits or if you want a better understanding, we will provide a few insights to help you. We will also provide links to our visual tutorial, quiz, puzzles, etc. that will further assist you. The accounting equation is a central part of bookkeeping and accounting. It can also provide insights into debits and credits. The basic accounting equation is: Assets = Liabilities + Stockholders' equity (if a corporation) or Assets = Liabilities + Owner's equity (if a sole proprietorship) With double-entry accounting, the accounting equation should always be in balance. In other words, not only will debits be equal to credits, but the amount of assets will be equal to the amount of liabilities plus the amount of owner's equity. The accounting equation is also the framework of the balance sheet, one of the main financial statements. Hence the balance sheet must also be in balance. We will use the accounting equation to explain why we sometimes debit an account and at other times we credit an account. Assets are on the left side of the accounting equation. In the accounting equation you can see that assets are on the left side of the equation: Earlier you learned that debit means left side. Recall our T-account that showed debits on the left side: Hence, asset accounts such as Cash, Accounts Receivable, Inventory, and Equipment should have debit balances. Liabilities are on the right side of the accounting equation. In the accounting equation you can see that liabilities are on the right side of the equation: Earlier you learned that credit means right side. Recall our T-account that showed credits on the right side: Thus liability accounts such as Accounts Payable, Notes Payable, Wages Payable, and Interest Payable should have credit balances. Stockholders' equity is on the right side of the accounting equation. In the accounting equation you can see that stockholders' equity is on the right side of the equation: Again, credit means right side and our T-account showed credits on the right side. This means that stockholders' equity accounts such as Common Stock, Retained Earnings, and M J Smith, Capital should have credit balances. Example To demonstrate the debits and credits of double-entry with a transaction, let's assume that a new corporation is formed and the stockholders invest $100,000 in exchange for shares of common stock. There are two effects of this transaction: Here's how the transaction will impact the accounting equation and the company's balance sheet: Here is what will occur in the general ledger accounts: If this transaction is entered in a general journal, it would appear as follows: Revenues increase stockholders' equity (which is on the right side of the accounting equation). To illustrate, let's assume that a company provides a service and bills the customer $400 with the amount due in 30 days. Two things occur: Here's the effect on the accounting equation and the company's balance sheet as a result of earning the revenues: Here is what occurs in the general ledger accounts:
If this transaction were entered in a general journal, it would appear as follows: Expenses decrease stockholders' equity (which is on the right side of the accounting equation). To reduce the normal credit balance in stockholders' equity accounts, a debit will be needed. Hence, the accounts such as Rent Expense, Advertising Expense, etc. will have their balances on the left side. For example, when a company pays cash of $150 for advertising materials that are distributed immediately at a local event, two things occur:
The effect on the accounting equation and the company's balance sheet is: The effect on the company's general ledger accounts is shown here:
If this transaction were entered in a general journal, it would appear as follows: A few tips about debits and credits:
Here are some common transactions with the appropriate debits and credits: Page 9Asset accounts are one of the three major classifications of balance sheet accounts: The ending balances in the balance sheet accounts will be carried forward to the next accounting year. Hence the balance sheet accounts are called permanent accounts or real accounts. The asset accounts are usually listed first in the company's chart of accounts and in the general ledger. In the general ledger the asset accounts will normally have debit balances. The balances in some of the asset accounts will be combined and presented as a single amount when the balance sheet is prepared. For example, if a company has ten checking accounts, the balances will be combined and the total amount will be reported on the balance sheet as the asset Cash. Assets include the things or resources that a company owns, that were acquired in a transaction, and have a future value that can be measured. Assets also include some costs that are prepaid or deferred and will become expenses as the costs are used up over time. Here are some examples of asset accounts: The following are brief descriptions of some common asset accounts. Cash Short-term Investments Accounts Receivable Allowance for Doubtful Accounts Accrued Revenues/Receivables Prepaid Expenses *The expense is the amount that is expiring during the month. Inventory Supplies Long-term Investments Land Buildings Equipment Vehicles Furniture and Fixtures Accumulated Depreciation Page 10A company's liability accounts appear in the chart of accounts, general ledger, and balance sheet immediately following the asset accounts. In the general ledger, the liability accounts will usually have credit balances. Note: Liabilities are a company's obligations. They are the amounts that the company owes. Liabilities also include amounts received from customers in advance of being earned. Here are some examples of liability accounts: The following are brief descriptions of some common liability accounts. Short-term Loans Payable Current Portion of Long-term Debt Accounts Payable Accrued Expenses/Liabilities Unearned or Deferred Revenues Installment Loans Payable Mortgage Loans Payable The stockholders' equity accounts of a corporation will appear in the chart of accounts, general ledger, and balance sheet immediately following the liability accounts. In the general ledger most of the stockholders' equity accounts will have credit balances. The following are brief descriptions of typical stockholders' equity accounts. Paid-in Capital The paid-in capital accounts report the amounts received when the corporation's stock was issued. Often there are two accounts for the common stock: If a corporation also issued preferred stock, there will also be two additional accounts. Common Stock Paid-in Capital in Excess of Par Value - Common Stock Retained Earnings The current accounting period's earnings (or net income) will be added to this account and the current period's dividends will be deducted. Retained earnings is a component of stockholders' equity, but it is separate from paid-in capital. Hence, the amounts reported under retained earnings are not considered to be permanent capital. Page 11The income statement accounts are categorized in a variety of ways. Here are the classifications we will be using: The amounts in these accounts at the end of an accounting year will not be carried forward to the subsequent year. Rather, the balances in the income statement accounts will be transferred to Retained Earnings (for a corporation) or to the owner's capital account (for a sole proprietorship). This will allow for all of the income statement accounts to begin each accounting year with zero balances. This explains why the income statement accounts are referred to as temporary accounts. Operating revenues are the amounts earned from carrying out the company's main activities. For example, the sales of merchandise are a retailer's operating revenues. A few examples of accounts for recording operating revenues include: The revenue accounts are expected to have credit balances (since revenues cause the stockholders' or owner's equity to increase). Contra revenue accounts such as Sales Returns and Allowances and Sales Discounts will have debit balances. Under the accrual method of accounting, revenues are reported as of the date the goods are sold or the services have been performed. If a service is provided on December 27, but the customer is allowed to pay in February, the revenues are reported on the income statement that includes December 27. At the end of the accounting year, the balance in each of the accounts for recording operating revenues will be closed in order to start the next accounting year with a zero balance. Operating expenses are the expenses incurred in earning operating revenues. For example, advertising expense is one of the operating expenses of a retailer. A few of the many accounts used to record operating expenses include: The accounts for operating expenses should have debit balances. Under the accrual method of accounting, the expenses should be reported in the same accounting period as the related revenues. If that is not certain, then an expense should be reported in the accounting period in which its cost expires or is used up. Expenses are often organized by function such as manufacturing, selling, and general administrative. At other times expenses will be organized by responsibility such as Department #1, Sales Region #5, Warehouse #2, Legal Department, etc. At the end of the accounting year, the balance in each of the accounts used for recording operating expenses will be closed in order to start the next accounting year with a zero balance. Revenues earned outside of a company's main business activities are referred to as non-operating revenues or as other revenues. For example, the interest earned by a retailer on its idle cash balances is part of non-operating or other revenues. Gains often occur when a company sells an asset that was used in the business, and the cash received was greater than the asset's carrying amount on the company's books. For example, if a company car is sold for $10,000 and its book value is $9,000, there will be a gain of $1,000. The accounts that report non-operating revenues, other revenues, and gains are expected to have credit balances since they cause stockholders' equity to increase. The expenses incurred in order to earn non-operating revenues are reported as non-operating expenses or other expenses. In addition, interest expense for a retailer is a non-operating expense or other expense. (On the other hand, the interest expense paid by a bank for the use of depositors' money is one of the bank's operating expenses.) Losses are reported when a company disposes of a long-term asset for the cash, and the amount of cash received is less than the book value of the asset. For example, if a company car is sold for $7,500 and its book value is $9,000, a loss of $1,500 will be reported. Another example of a loss is the loss from a lawsuit. The accounts for non-operating expenses and losses will have debit balances since they cause stockholders' equity to decrease. Page 12With sophisticated accounting software and inexpensive computers, it is no longer practical for most businesses to manually enter transactions into journals and then to post to the general ledger accounts and subsidiary ledger accounts. Today, software such as QuickBooks* will update the relevant accounts and provide more information with a minimum of data entry. *QuickBooks is a registered trademark of Intuit Inc. AccountingCoach LLC is not affiliated with Intuit Inc. and does not receive any affiliate marketing commissions from Intuit. In this section we will highlight how the accounting software will capture financial transactions and then automatically update the general ledger and store the information for management's future use. Accounts payable A company should have internal controls so that only legitimate invoices are recorded and paid. Check writing Again, a company should have internal controls to ensure that only legitimate payments are processed. Sales on credit Payroll (AccountingCoach is not affiliated with any of these companies and it does not receive affiliate marketing commissions from any of them.) To learn more about payroll use any of the following links: The purpose of the bank reconciliation is to be certain that the financial statements are reporting the correct amount of cash and the proper amounts for any related accounts (since every transaction affects a minimum of two accounts). The bank reconciliation process involves: The common reasons for a difference between the bank balance and the general ledger book balance are: The outstanding checks and deposits in transit do not involve errors by either the company or the bank. Since these items are already recorded in the company's accounts, no additional entries to the company's general ledger accounts will be needed. Bank charges, check printing fees and errors in the company's accounts do require the company to make accounting entries. The company should make the entries before the financial statements are prepared since a minimum of two accounts have the incorrect balances (due to double-entry accounting). Here is an entry for a bank service charge that was listed on the bank statement: If the reconciliation reveals that an incorrect amount has been recorded in the company's Cash account, perhaps the easiest way to correct the error is to remove the incorrect amount and then enter the correct amount. Accounting software is likely to include a feature for reconciling the bank statement. To learn more about bank reconciliation use any of the following links: Page 13
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