Financial Accounting

What is sales tax?

Sales tax is a tax on the price of a good or service. This tax is a percentage of the price and is added by the final seller.

There are only five states in the United States that do not have a state sales tax. There is little consistency in how states apply sales tax. Some states only collect sales tax on goods and not services. Some states give exemptions for items that are considered necessities, like food and clothing. Some states exempt some services like hair cuts and accounting services. There are a number of accountants who specialize in sales tax regulation because the laws can be so complicated.

Historically, in order for a company to be required to collect sales tax in a state, the company must have nexus in the state. Nexus refers to physical presence in the state. That means the company would need to have buildings or employees in a state in order to have nexus in the state. As the internet and online shopping has grown, states are losing out on billions of dollars in sales tax revenue. According to ,  states lose an estimated $23 billion per year in sales taxes from internet sales. This lead a number of states to pass “Amazon Tax Laws”. These laws redefined the definition of nexus to include companies with affiliates in a state. An affiliate is a blogger, website owner, or anyone who posts affiliate links online. When someone clicks on the link and purchases a product from a website, the affiliate earns revenue. The states argued that these affiliates are akin to sales people and therefore those affiliates create nexus in the state. Congress is also working on bills to force large online retailers to collect sales tax in all states. These laws are constantly evolving and accountants must stay on top of current legislation.

How is sales tax collected?

Sales tax is collected by retailers when goods and services are sold to the final user. Sales taxes are not imposed when materials that will be used to manufacture a product are sold to a manufacturer. When the manufacturer sells their products to a retailer, no taxes are imposed. It is only when the product is sold to the final customer that the taxes are charged. If the sale is not made to the final end user, no sales tax is collect. A few states have made exemptions to this rule, like charging contractors sales tax on materials.

There are two ways that companies can add sales tax to their products. Most companies add sales tax to the price of their products. To calculate the amount of sales tax, multiply the sales tax percentage by the total amount of the sale.

Example #1

A customer purchases $150.00 worth of taxable products from Jeff’s Geek-O-Rama on 2/15. The sales tax rate in the state the store resides is 6%. Calculate the amount of tax and the total amount the customer paid.  

First let’s calculate the tax. The sales tax is 6% of the total purchase, which in this case is $150.00.

$150.00 X .06 = $9

That is the total tax on the transaction. This must be added to the purchase price so the total cash collected is $159.00, but only $150 belongs to Jeff. The other $9 belongs to the state and should be remitted to the state when the next sales tax return is filed.

When recording the transaction, record the cash that was received, the revenue the company earned, and the sales tax that is payable to the state.

ST1

As the month goes on and more sales transactions occur, the sales tax payable account will grow. Most states require monthly payment for sales tax collected. When February’s sales tax is due in March, we will look at how much sales tax was collected and pay that amount.

Example #2

On March 20, Jeff’s Geek-O-Rama pays the sales tax due for February. The store generated $27,250 in taxable sales in February and has a balance in Sales Tax Payable of $1,635 at the end of the month. Record the journal entry to record the payment of the sales tax for February.

This entry is pretty straight forward. It is like recording any other debt payoff. We are paying down the debt. The normal balance in a liability account is a credit balance so in order to pay off that balance we would need to debit the account. How are we paying with sales tax? We are paying it with cash. Cash will decrease which would be our credit. The amount of the entry is $1,635.

ST2

What do we do with sales tax paid on purchases made by the company?

If a business purchases items for the company’s use, like office supplies or equipment, the cost of those items is subject to sales tax. What does a company do with that sales tax?

If you think back to the asset purchase rules, all costs associated with acquiring an asset must be added to the cost of the asset. These costs include sales tax. If a company purchases supplies and pays sales tax, the sales tax is added to the cost of the supplies. If the company purchases a machine and there is sales tax on the purchase, the sales tax is added to the cost of the machine.

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What is a liability?

liability is an obligation that the company has to another party. Typically when we think of liabilities, we think of accounts payable or notes payable, but there are many other liabilities that a company can have to other people or entities.

Whenever a company owes money or services to another party, there is a liability. A liability must be recorded if the company can estimate the amount of the liability and is reasonably sure that the liability is owed.

Liabilities have a normal credit balance. When a liability increases, we credit the account. When a liability is paid or an obligation is fulfilled, either in whole or in part, the account is debited.

What is a current liability?

Current liabilities are liabilities that are due in less than one year or one operating cycle. The most notable liability that most people think of when they think of current liabilities is accounts payable. There are however many other accounts qualify as current liabilities.

Accounts payable is a current liability used for normal day-to-day bills. Some textbooks will argue that accounts payable should only be used for the purchase of inventory and supplies, but in my experience, accounts payable is used for all routine bills that must be paid. This would include supplies, inventory, utility bills, telephone bills, and other bills which the company plans to pay at a later date.

Any other current amount owed must be placed in its own payable account. This includes salaries payable, taxes payable, interest payable and any other obligations a company would have.

Recording and paying accounts payable

When a company purchases something and does not pay for it at the time of purchase, a payable is created.

Example #1

On January 15, KLI, LLC purchases $1,500 worth of supplies on account, terms n/30.

In this example, the company is purchasing supplies but has not paid for them yet. How do we know the company has not paid for them? There are a few key things to look for. First, the statement does not use the word “paid.” “Paid” always indicates that cash is involved. Since cash is not involved, We know we have not paid for the purchase.

Second, we see “on account” in the statement. On account indicates either Accounts Payable or Accounts Receivable. When we see on account, we should ask “Are we going to pay cash later or receive cash later?” If we are going to pay cash later because we purchased something, we have Accounts Payable.

If you do not have either “paid” or “on account”, there is one additional give away in the transaction. If you see terms, the purchase was made on account. Payment terms, such as n/30, are only included if the transaction has not been paid for. If the transaction had been paid for, we wouldn’t need to know that the bill must be paid within 30 days.

Here is the journal entry for the transaction:

CL1

Example #2

On February 10, KLI, LLC paid for the supplies purchased on January 15.

In this transaction, we are paying for the supplies previously purchased. Be careful when recording a transaction like this. Many people studying accounting get this one wrong the first few times they try it.

The transaction states that the company paid for something. That is one of the keywords we discussed above. When we see “paid” in the transaction, Cash is involved.

What did the company actually pay for? We are told to refer back to the transaction on January 15. In that transaction, we recorded Supplies and Accounts Payable. Are we purchasing more supplies or are we paying off the Accounts Payable? The transaction indicates that we are paying for supplies that were previously purchased, not purchasing more supplies.

Let’s see if that fits into our journal entry. We know that Cash will be a credit. Does it make sense to debit Accounts Payable? Since we are paying off what we owed, we are fulfilling the obligation. We want the balance in Accounts Payable to decrease so we would debit Accounts Payable.

CL2

Lots of different liabilities

Over the next few posts, we will be covering a number of new current and long-term liabilities. All of these liabilities follow the same rules as described above. When classifying a liability ask yourself if the company has an obligation to anther party. If the answer is yes, then you have a liability.

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For many students, bank reconciliations are a difficult topic because most people don’t do them anymore. Twenty years ago, before debit cards and online banking, there was only one way to keep track of how much money you had in the bank: keep a checkbook and reconcile it.

Clearly, online banking has not made us better at managing our bank accounts. In 2012, U.S. consumers . That’s approximately $135 per adult in the United States! Maybe we should consider going back to writing down all our transactions and balancing our checkbooks!

What is a bank reconciliation?

A bank reconciliation is a monthly process by which we match up the activity on the bank statement to ensure that everything has been recorded in the company’s or individual’s books. As we all engage in more automatic and electronic transactions, this is a critically important step to ensure that the cash balance is correct.

There are two parts to a bank reconciliation, the book (company) side and the bank side. When the reconciliation is completed, both balances should match.

What are we looking for?

There are a number of items that can cause differences between your book and bank balances. Here is a list of the most common items you’ll encounter when doing a bank reconciliation:

  1. Deposits in Transit – A deposit in transit is a deposit that has been submitted to the bank but has not get been recorded by the bank. The account holder has recorded the deposit in his records but the bank has not. This occurs because a deposit was submitted after the bank closed for the day or because of lag in electronic deposits. We see this a lot with credit card deposits because there is typically a 1-3 day lag in the time the card is processed and when the funds are deposited to the merchant’s account. Deposits in Transit must be added to the bank side of the reconciliation because they have been added to the book side when the deposits were recorded by the company.
  2. Outstanding Checks – These are checks that have been written by the company but have not yet cleared the bank. When a check is written it takes a few days to clear. Most businesses have a number of outstanding checks at the end of the month. Outstanding Checks should be subtracted from the bank side of the reconciliation because they were subtracted from the book balance when the checks were written.
  3. Bank Service Charges – These are amounts that the bank withdraws from the account as a charge for having the account. Bank service charges include regular monthly fees, overdraft fees, returned check fees and credit card processing fees. Typically, the company does not record these fees until the bank statement is received. Bank service charges are subtracted from the book balance since they are a decrease in the account balance and have not yet been recorded.
  4. Interest Earned – Some banks pay interest on account. The account holder does not know how much the interest will be until the bank statement is received. Interest earned is deposited into the account by the bank causing the balance to increase. Interest earned is added to the book balance to reflect the increase in the balance from the deposit of interest.
  5. Returned Checks – A returned check is an item that was originally deposited into the company’s account (usually a customer check) and later bounced. When this happens the bank withdraws the funds from the company’s account and sends a notice to the company. Returned checks should be subtracted from the book balance since the bank removed the amount from the balance when the check bounced.
  6. Recording Errors – A recording error occurs when the company incorrectly records a transaction or when the bank clears an item for the incorrect amount. This sometimes occurs when checks are written and an incorrect amount is entered into the system. Sometimes the bank clears the transaction for the wrong amount. Say the company wrote a check for $452.00 but the bank cleared the check for $450.00. There is now a $2 error in the books. Since the bank has cleaned the transaction, you must adjust the books to match. Recording errors should be added or subtracted from the book balance. If the item cleared the bank for less than the amount in the books, add the amount of the error. If the item cleared the bank for more than the amount in the books, subtract the amount of the error.
  7. Other Unrecorded Items – With the number of transactions that occur digitally or automatically, it’s easy to forget to record transactions, especially if they occur infrequently. Look for remaining items that cleared the bank that have not been recorded on the books. Other unrecorded items can be either deposits or withdrawals. All other unrecorded items should be recorded on the book side of the reconciliation. To determine if you should add or subtract the item, mimic what the bank did. If the bank added it to the account balance, do the same to the book balance. 

How to start

To do a bank reconciliation, you’ll need a copy of the bank statement and a copy of all of the outstanding items in the checking account through the ending date of the bank statement. For some businesses, including my own, the bank statement does not close at the end of the month. Sometimes the statement end date is based on the date the account was opened.

Once you have those two items, use a pencil or highlighter to mark off all the items that appear on both the bank statement and the check register. If an item appears on both, that means that the item was properly recorded and has cleared. After going through all the items, anything that remains unmarked is a an item that will need to be dealt with in the reconciliation.

Create two columns on a piece of paper or use a spreadsheet to do the calculations for you. My bank reconciliations look like a large T-account.

Start by writing the ending balance for the book and the bank under the appropriate column.

BR1

I like to do the bank side first because it is generally easier than the book side. You are only dealing with outstanding checks and deposits in transit on the bank side. List the deposits in transit and the outstanding checks. Add the deposits in transit to the beginning balance and subtract the outstanding checks.

BR2

The bank side is relatively easy to do. That is why I like to do that side first. It is more likely to be correct if you have an error in your reconciliation. Most students who have errors have them on the book side. Being confident in the bank side helps resolve errors on the book side.

On the book side, most items are fairly simple. Subtract bank service charges and add interest income. Subtract returned checks. Add unrecorded deposits and subtract unrecorded withdrawals. The last item, recording errors, requires a bit more thinking.

Let’s imagine that you recorded a check for $715, but the bank cleared that check for $751. The check was used to pay for utilities and was recorded to utilities expense for $715. If the check cleared for $751, what happened to your utilities expense? Did it increase or decrease? It increased because more was paid for utilities. If the expense increased, cash must have decreased. Therefore, cash must be adjusted down or decreased by $36. This would be subtracted from book side of the reconciliation.

Thinking about what is happening to your expenses can help you work your way through the problem.

Once you have worked through all the remaining items on the book side, compute the reconciled balance for the books.

BR3

When you are finished, the reconciled balances should agree.

If they do not, take the difference between the two balances. Does that amount stick out in your mind. Check to see if there is a missing item for that amount that you might have forgotten to record. You may have forgotten multiple items. Place them in the reconciliation and see if you now balance.

If you do not have an item for that amount, take the difference and divide it by 2. Look for that amount. If that amount appears in your reconciliation, you added (or subtracted) the amount when you should have subtracted (or added) the amount. Reverse the sign and check your balance again.

Once you finish the bank reconciliation, there is one more step in the process. All the items that you recorded on the book side of the reconciliation must be recorded in the company’s accounting system. Prepare a journal entry (or several) to record those items. I usually record one large journal entry but you can also record a separate entry for each item in the reconciliation. Only record items on the book side!

Bank reconciliations become easier as you do more of them. Get all the practice you can. Here is the bank reconciliation problem I created for the video on this subject. You are provided with the check register and the bank statement. See if you can complete the reconciliation before watching the video.

BR4

Related Videos:

How to do a bank reconciliation

Journal entries for the bank reconciliation

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If you are currently enrolled in an accounting course (which I sure hope you are because most people don’t browse my site for fun) you’ve probably heard some pretty terrible things about accounting. I remember when I took my first accounting course. I was scared to death before I walked in the door.

The textbooks certainly don’t help. My first accounting book was over 1,000 pages. The book was filled with lots of small text and complicated charts. Today’s accounting textbooks are certainly prettier but I’m not sure the text has gotten any more interesting or understandable. My goal is to help guide you through your accounting classes in an easy straightforward manner. In order to do that, we need to discuss what accounting is and what it is not.

What is accounting?

I would argue that accounting is the most important business class you will take. It doesn’t matter how great your product or service is if you can’t make the numbers work. Accounting is the language of business. It lets businesses communicate with investors, creditors and other stakeholders so they can make decisions about the business. Knowing this language makes you a powerful player in the business community.

There are two major branches of accounting: financial and managerial.

Financial accounting is what most people think of when they think of accounting. Financial accounting is based on communicating information to external users (users who are outside the company). This includes investors, creditors, customers, suppliers and various government agencies. Financial accounting is all about following the rules. It deals mostly with historical information.

Managerial accounting, also called cost accounting, deals with compiling information to allow managers to make decisions and plan for future business needs. In managerial accounting, we frequently deal with “what if” scenarios. There are very few rules in managerial accounting, but there are lots of best practices. It deals mostly with the present and future.

Accounting is NOT a math class

I can’t stress this enough. Accounting is not a math class. It may look like a math class because there are numbers, but the numbers are just part of the language.

Many students get instantly discouraged because they see numbers and think “Oh but I’m terrible at math.” At that instant, the brain switches off. I have had plenty of students who were “terrible at math” do extremely well in my classes. They lived by the mantra “accounting is not a math class.” The most complicated math you will encounter in financial or managerial accounting is division. I usually require my students to purchase a basic four function calculator like the one shown here because that is about as complicated as it gets.

It’s true. Accounting really is a language and you should try to learn it in the same way you would approach a language class. The biggest mistake students make is ignoring the terminology in the course. They focus on formulas but without the conceptual understanding of the terminology, they don’t know when to use the formulas. It’s like trying to write a sentence in Spanish without knowing any of the vocabulary. You may know that the adjective goes after the noun, but without knowing any nouns you can’t write a sentence.

On the flip side, I have students who had such a good conceptual understanding of the terminology, they didn’t need to know the formulas because the calculations came naturally once the concepts were known. That is actually how I learned accounting. With a thorough knowledge of the concepts, I did not memorize a single formula.

How to study for your financial accounting course

There are three areas you should focus on when learning new material in a financial accounting course:

  1. The terminology and concepts – This includes the account names and types. This is critical to your ability to do well in the course.
  2. Structure – similar to learning sentence structure when learning a language, there is a lot of structure in financial accounting. Journal entries have a particular structure, as do trial balances and financial statements. Learning the structure and what goes where is extremely important.
  3. Calculations – Notice that I put this last. This really is the least important of the three. If you can add, subtract, multiply, and divide you have all the math skills you need. When you understand the terminology, concepts, and structure you will barely notice the calculations.

For the account names and types, I recommend flashcards. I know it it seems old school but it really works. For each account, create a card. This is what I put on my cards:

flashcard

On the front, I have the name of an account. On the back, I put the type of account it is and if the normal balance is a debit or credit. On some cards, I put a description for the account. Some students confuse accounts receivable and accounts payable, so it might be a good idea to put a description to make the difference between the two accounts more clear. Each time you encounter a new account, create a card for it.

After you have completed each chapter in the course, take a single sheet of printer paper and make yourself a page of notes. You should be able to boil down each chapter into a single page of notes. the accounts are already covered with your flash cards. The notes page should contain key terms and examples of journal entries. This quick reference guide will save you time when completing assignments or just to refresh your knowledge when needed,

Having the flash cards and the single page of notes will make studying for each exam so much easier. Whatever you do, do NOT reread the chapters. Studies show you only retain about 20% of what you read. Your best bet is to do more problems and study your flash cards and quick notes.

Related Video:

Introduction to Financial Accounting: Objectives and Overview

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Most interest calculations that you will encounter are simple interest calculations. In a simple interest calculation, interest is calculated for a defined period of time based on the outstanding balance. Simple interest is used for savings accounts, notes receivable, notes payable, bonds, student loans and lots of other applications. We will discuss how simple interest calculations apply to debt, but the methodology is the same for other applications.

PRT

The amount of interest charged on a loan is based on three factors: principal, interest rate and time.

Principal is the outstanding balance on a loan. As a loan is paid down, the principal balance decreases. Therefore the interest on the loan also decreases. If the monthly payment on the loan is an equal amount each month, over time, less of the payment will go to interest and more to the principal balance.

The interest rate is the amount of interest charged on the loan. Typically, interest is expressed as an annual percentage rate, also called APR. Although interest is expressed as an annual rate, most loans charge interest monthly. To calculate the monthly rate, divide the annual interest rate by 12.

Time is the duration over which the interest is accruing. If interest is charged monthly, typically we would use the number of days the month divided by 360. Yes, I know there are 365 days in a year, but before calculators and computers, it was much easier to calculate based on 360 days. This became the tradition even after the invention of calculators because banks found they would earn more interest on outstanding debt using 360. Pretty sneaky, huh?

To calculate the amount of interest on a loan, we use this formula:

Interest = P*R*T or Principal * Rate * Time

Example:

On February 1, Technorama borrows $10,000 from the bank on a 8%, 90-day note with interest due at the time of repayment. How much cash will Technorama need to pay off the note when it comes due?

First, we need to identify our PRT. Principal is the amount borrowed, $10,000. The rate is 8%. Remember that rates are expressed as an annual rate even though the loan is only for 90 days. The duration of the loan, time, is 90 days. Now we can set up our formula.

Interest = $10,000 * 8% * 90/360

Interest = $200

The question asks how much cash will be required to pay off the note. $200 is not the answer. To pay off the note, Technorama must pay the interest and the principal. Therefore, the cash required is $10,200.

When doing simple interest calculations, just remember PRT. Always use the annual rate and multiply it by the amount of time for which you are calculating the interest.

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