expenses

The trial balance is a list of all the accounts a company uses with the balances in debit and credit columns. There are three types of trial balances: the unadjusted trial balance, the adjusted trial balance and the post- closing trial balance. All three have exactly the same format.

The unadjusted trial balance is prepared before adjusting journal entries are completed. This trial balance reflects all the activity recorded from day-to-day transactions and is used to analyze accounts when preparing adjusting entries. For example, if you know that the remaining balance in prepaid insurance should be $600, you can look at the unadjusted trial balance to see how much is currently in the account.

The adjusted trial balance is completed after the adjusting entries are completed. This trial balance has the final balances in all the accounts and is used to prepare the financial statements.

The post-closing trial balance shows the balances after the closing entries have been completed. This is your starting trial balance for the next year. We will discuss the post-closing trial balance in the post regarding closing entries.

Accounts in the trial balance are listed in a specific order to aid in the preparation of the financial statements. Accounts should be listed in the following order:

  • Assets
  • Liabilities
  • Equity
  • Revenue
  • Expenses

Assets and liabilities should be listed in order from most liquid to least liquid. Liquidity refers to how quickly an asset could be converted to cash and how quickly a liability will be paid off with cash. The most liquid asset is cash, because it has already been converted to cash (who knew?). Typically, the next most liquid asset is accounts receivable because most companies collect their receivables within 30 days.

You can also think of assets and liabilities in terms of current and long-term. A current asset is one that will most likely be used up in less than 12 months. A current liability is one that will be paid off in less than 12 months. Long-term assets and liabilities are those that will be on the trial balance for more than 12 months.

Using the Adjusted Trial Balance

TB

Here is a sample adjusted trial balance. Notice the accounts are listed in the order described above. You might be wondering why it is such a big deal to organize the trial balance in this manner. The purpose of the trial balance is to make your life easier when preparing financial statements. Look what happens when we divide the trial balance by statement.

FS1
This is the same trial balance but I have color coded it. The orange section is for the accounts that will be used on the balance sheet, the blue is the statement of retained earnings and the green is the income statement. Because we took the time to organize the accounts, the preparation of the financial statements will be so much easier.

Related Videos:

T-Accounts

Creating Financial Statements

Share This:

I imagine some of you are starting to wonder if there is an end to the types of journal entries in the accounting cycle! So far we have reviewed day-to-day journal entries and adjusting journal entries. Closing entries are the last step in the accounting cycle.

Closing entries serve two objectives. The first is to close all of the temporary accounts in order to start with zero balances for the next year. The second is to update the balance in Retained Earnings to agree to the Statement of Retained Earnings.

Note: Closing entries are always dated the first day of the next year. If the year end for the company is September 30, 2013, the closing entries would be dated October 1, 2013. If we closed the accounts as of September 30, we would lose the information we need to do the income statement and statement of retained earnings.

Permanent Versus Temporary Accounts

The chart of accounts can be broken down into two categories: permanent and temporary accounts. A permanent account is one where the balance carries over into the next year. A temporary account is one where the balance resets each year.

Think about some accounts that would be permanent accounts, like Cash and Notes Payable. While some businesses would be very happy if the balance in Notes Payable reset to zero each year, I am fairly certain they would not be happy if their cash disappeared. Assets, liabilities and most equity accounts are permanent accounts. The balances carry over from year-to-year.

Temporary accounts include revenue, expenses and dividends. Each of these accounts must be zeroed out so that on the first day of the year, we can start tracking these balances for the new fiscal year. Remember that the periodicity principle states that financial statements should cover a defined period of time, generally one year. If we do not close out the balances in the revenue and expense accounts, these accounts would continue to contain the revenue and expense balances from previous years and would violate the periodicity principle.

Updating the Balance in Retained Earnings

Think back to all the journal entries you’ve completed so far. Have you ever done an entry that included Retained Earnings? If you have only done journal entries and adjusting journal entries, the answer is no. Let’s look at the trial balance we used in the Creating Financial Statements post.

Close1

The balance in Retained Earnings was $8,200 before completing the Statement of Retained Earnings. According to the statement, the balance in Retained Earnings should be $13,000.

Close2

We need to complete entries to update the balance in Retained Earnings so it reflects the balance on the Statement of Retained Earnings. We know the change in the balance includes net income and dividends. Net income includes revenue and expenses. Therefore, we need to transfer the balances in revenue, expenses and dividends (the temporary accounts) into Retained Earnings to update the balance.

Using Income Summary in Closing Entries

Rather than closing the revenue and expense accounts directly to Retained Earnings and possibly missing something by accident, we use an account called Income Summary to close these accounts. Income Summary allows us to ensure that all revenue and expense accounts have been closed.

The first accounts to close are the revenue accounts. The trial balance above only has one revenue account, Landscaping Revenue. If the account has a $90,000 credit balance and we wanted to bring the balance to zero, what do we need to do to that account? In order to cancel out the credit balance, we would need to debit the account. Sometimes it helps to visualize this with a T-account.

Close3

Debiting the account will get the desired result:

Close4

The other account in the entry will be Income Summary.

Close5

Now that the revenue account is closed, next we close the expense accounts. You must close each account; you cannot just do an entry to “expenses”. You can, however, close all the expense accounts in one entry. If the balances in the expense accounts are debits, how do you bring the balances to zero? Credit them! We will also close these accounts to Income Summary. The debit to income summary should agree to total expenses on the Income Statement.

Close6

Here is the journal entry to close the expense accounts:

Close7

After these two entries, the revenue and expense accounts have zero balances. Let’s look at the T-account for Income Summary.

Close8

Notice the balance in Income Summary matches the net income calculated on the Income Statement. We know that all revenue and expense accounts have been closed. If we had not used the Income Summary account, we would not have this figure to check, ensuring that we are on the right path.

The next step is to close Income Summary. This account is a temporary equity account that does not appear on the trial balance or any of the financial statements. It is a helper account, aiding us in the closing process. To close Income Summary, we will debit the account. What is our credit in the entry? What did we do with net income when preparing the financial statements? We added it to Retained Earnings on the Statement of Retained Earnings. To add something to Retained Earnings, which is an equity account with a normal credit balance, we would credit the account.

Close9

What else went into the calculation of Retained Earnings? If you said Distributions, you are correct. We now close the Distributions account to Retained Earnings. Distributions has a debit balance so we credit the account to close it. Our debit, reducing the balance in the account, is Retained Earnings.

Close10

Our T-account for Retained Earnings now has the desired balance.

Close11

The trial balance,  after the closing entries are completed, is now ready for the new year to begin. We call this trial balance the post-closing trial balance.

Close12

The balance in Retained Earnings agrees to the Statement of Retained Earnings and all of the temporary accounts have zero balances. Little Landscaping, LLC is now ready to start the new year.

When doing closing entries, try to remember why you are doing them and connect them to the financial statements. To update the balance in Retained Earnings, we must transfer net income and dividends/distributions to the account. Net income is simply revenue and expenses. By closing revenue, expense and dividend/distribution accounts, we get the desired balance in Retained Earnings.

 Related Videos:

Closing Entries

Share This:

What are adjusting journal entries?

The matching principle states expenses must be matched with the revenue generated during the period. The purpose of adjusting entries is to ensure that all revenue and expenses from the period are recorded. Many adjusting entries deal with balances from the balance sheet, typically assets and liabilities, that must be adjusted. In addition to ensuring that all revenue and expenses are recorded, we are also making sure that all asset and liability accounts have the proper balances. Adjusting entries are dated for the last day of the period.

When analyzing adjusting entry transactions involving assets and liabilities, remember that you are recording the change in the balance, not the new balance in the account. Ask yourself “what must I do to the account to get the adjusting balance?”

As a business goes through the normal day-to-day operations, many transactions are recorded. When work is done and the company is paid, revenue is recorded. Revenue is also recorded when invoices (accounts receivable) are created. Expenses are recorded when bills (accounts payable) are received. If the company has already recorded all those things, then what could possibly be left to do? You would be surprised!

NOTE: Cash should never appear in an adjusting entry. Most adjusting entries are done after year end and backdated to the end of the year. When cash is spent, the transactions are recorded immediately. With electronic banking, we can instantly check cash transactions. There is no reason why a business shouldn’t know about transactions affecting its cash accounts. Cash is never an account in an adjusting entry.

Unrecorded revenue

If a business has done work for a client but has not yet created an invoice, there is unrecorded revenue that must be recorded. Maybe the business just hasn’t gotten around to completing the invoice yet, or maybe the work is partially done but not completely finished. This entry looks exactly like an entry to record work that has been completed but have not yet been paid for.

Example #1

On December 31, KLI Video Production had completed $3,000 worth of work for clients which has not yet been billed.

AJE 1

Another type of unrecorded revenue deals with work the business was paid for before the work was completed (unearned revenue) which was completed by the end of the period. Transactions of this type can be written two different ways. We could be told how much revenue has been earned or we could be told the remaining balance in unearned revenue. Let’s look at how these transactions could be written so you can see the differences and identify which method to use.

Example #2

Unearned revenue has an unadjusted balance of $4,000. An analysis of the account shows that $2,500 of the balance has been earned.

When looking at transactions like this one, we need to determine what we are being given. You want to ask yourself if the transaction is giving you the amount of the adjustment (revenue or expense to be recorded) or the adjusted (correct) balance in the asset or liability account.  T-accounts are really helpful when doing adjusting entries because you can visualize what is happening. Here is the T-Account for unearned revenue.

AJE 2

We are told the account has an unadjusted balance of $4,000. Unearned revenue is a liability account and therefore the normal balance is a credit. We are told that $2,500 has been earned. Is that the new balance in the account? No, the $2,500 is the amount we need to remove from the account because it is no longer unearned. So if $2,500 is not the balance, then what is the balance? If the business has earned $2,500 of the $4,000, then the new balance is $1,500.

AJE 3

Now we can see the beginning balance and the ending balance in the T-account. Now, we have to determine how to get there. If we have a $4,000 credit balance and  then have a $1,500 credit balance, the balance decreased by $2,500. How do we decrease an account with a credit balance? We debit the account. The $2,500 was given in the transaction, but now we know what to do with it. If you can predict what the balance should be in the account, you can do a T-account to make sure your entry will actually do what you predicted.

AJE 4

AJE 5

The credit in the entry is fees earned (revenue) because we were told that $2,500 had been earned. When you see earned, you should always think revenue unless the transaction states the money has not yet been earned. That statement should make you think of unearned revenue because it has not been earned.

Example #3

The company had an unadjusted balance in unearned revenue of $4,000. An analysis of the account shows $1,500 is still unearned.

This transaction is worded a bit differently than the last. This transaction tells you what the ending balance in the account should be. Using a T-account in this scenario is a smart idea.

Notice, this example is exactly the same as Example #2. In order to get the balance from $4,000 credit to $1,500 credit, we need to debit unearned revenue $2,500.

AJE 4

AJE 5

Make sure to watch the wording in all adjusting entry transactions to ensure you understand what information you have.

Unrecorded Expenses

Typically, when we are looking for unrecorded expenses, we look to the balance sheet. There are two types of unrecorded expenses: those that are related to assets that have been used up or need to be adjusted and those related to unrecorded liabilities.

Assets and Expenses

The definition of an asset is something the company owns or has the right to which it can use to generate revenue. When we were recorded journal entries, we recorded transactions to various asset accounts that when used up, will generate an expense. Some of those accounts were supplies, prepaid expenses and long-term asset accounts, like equipment and buildings.

Supplies are initially recorded as an asset, but they get used up over time. Rather than record an entry every time a ream of paper or a bag of mulch is removed from storage, we do an adjusting entry at the end of the period to record the amount of supplies that have been used up. Recording an entry every time something is removed from the stockroom or garage would violate the cost-benefit constraint. At the end of the period, the company counts up what is left for supplies. The difference between the balance in the account (unadjusted) and the amount that is left (adjusted) is the value used in the journal entry.

Example #4

The balance in the supplies account at the end of the year was $5,600. A count of supplies shows that $1,400 worth of supplies are still on hand.

What does this transaction tell us? The unadjusted supplies balance is $5,600 but the adjusted balance should be $1,400. The transaction does not tell us the amount of the adjustment. That is something we will need to figure out. You may want to draw up a quick T-account to visualize the transaction.

AJE 6

To decrease the account balance, which is a debit balance, we need to credit the account. How much will we need to credit the account? What amount will bring the balance from $5,600 to $1,400? The difference is $4,200. So we need to credit the supplies account $4,200.

AJE 7

Where did the supplies go? They were used it. We call this supplies expense. Now we can write the journal entry.

AJE 8

Use the same methodology when doing entries involving prepaid expenses. Draw a T-account to help visualize what is happening.

Long-term assets and Expenses

When a company purchases a long-term asset, such as a vehicle to use in its business, we record the entire value of the purchase as an asset. That vehicle is used to generate revenue so shouldn’t that vehicle somehow be expensed? Yes, it should be. We call the expensing of a long-term asset depreciation. Do not confuse depreciation in accounting with how the term is used outside of accounting. Typically, we think of depreciation as a decline in market value. For example, I have heard it said many time that when you purchase a new car, it depreciates or loses 20% of its value when you drive off the lot. Depreciation in accounting has nothing to do with market value. Depreciation represents the using up of an asset to generate revenue.

The cost principle states that we must record assets at cost. In order to maintain that principle, when we record depreciation expense (which is a debit in the journal entry), we do not credit the asset directly. Instead we will use a contra account. A contra account is an account linked to another account but which has a normal balance opposite to the account it is linked to. A contra asset account would be linked to a specific asset account but would have a credit balance. For the vehicle described above, we would have a contra asset account called accumulated depreciation. This account would be linked to the vehicles account and would have a credit balance.

Some companies have one accumulated depreciation account used for all long-term assets and others have a separate accumulated depreciation account for each long-term asset account. In the next example, we will assume there is one accumulated depreciation account.

Example #5

The company calculates that the current year depreciation is $12,000.

As with all adjusting entries, we need to determine if we are being given an account balance (asset or liability) or the amount of the expense. In this case, as with all depreciation entries, we are given the amount of the expense. Therefore, there is nothing to calculate here. No T-account is needed.

AJE 9

For more information about long-term assets and depreciation, see the posts on long-term assets and calculating depreciation.

Adjusting Entries Involving Liabilities

Some adjusting entries involve expenses that have not yet been paid for nor has the obligation been recorded. However, in these cases an expense has been generated. Examples include unrecorded bills and unpaid wages, interest, and taxes. This is not an exhaustive list but it does cover most of the transactions you will see. These entries require the recording of an expense and a liability.

Example #6

The company received a bill for December’s utilities on January 5. The bill was for $235.

Although the bill was received in January, the utilities were used in December to generate revenue in December. The matching principle tells us that we must record the utilities expense in December.

AJE 10

Example #7

The company pays its employees every two weeks. On December 31, the employees had worked four days for which they had not been paid. The amount due to the employees was $4,300.

Are you thinking matching principle here? Our employees help us generate revenue. The wages that we pay them must be matched to the revenue they are creating. Therefore, the $4,300 must be recorded in December. The wages have not been paid so we must show a liability. The liability used in this case will be wages payable.

AJE 11

Note: Accounts payable should only be used for routine bills (utilities, supply and inventory purchases). Other short-term payables should be named based on the expense they are related to. That is why wages payable was used in this case.

Example #8

The company has a long-term note payable with Ginormic National Bank. As of December 31, $670 of interest had accrued on the loan but had not yet been paid.

Why do we have to record this? First, the interest is an expense for December even though it has not yet been paid. Second, to be accurate in our financial statements, the balance owed to the bank on December 31 includes not only the balance on the loan but also the unpaid interest. If we contact Ginormic National Bank to payoff the loan on December 31, we would need to pay the principal owed plus the $670 of interest. The interest is considered a separate payable and should not be added to the note payable.

AJE 12

Example #9

The company estimates its profit to be $42,000 for the year and is in a 35% tax bracket.

When reading this transaction, it doesn’t even sound like something we would need to record. It just sounds like a statement, but the matching principle should set off an alarm. Why are we paying income taxes? The company had a profit for the year of $42,000. Income taxes are an expense of doing business. Should the expense fall in the year that is completed or the year we are currently in? The expense is related to the year that is completed and, therefore, must be recorded as an adjusting entry.

To figure out how much to record for taxes, we need to calculate 35% of the profit, which would be $14,700 ($42,000 x 0.35). Now we can record the entry.

AJE 13

Things to Remember

Treat adjusting entries just like you would treat normal entries. Use these steps when completing adjusting journal entries.

  1. Read the transaction to determine what is going on. Is an entry required?
  2. Identify the accounts you will use in your entry. Remember, cash is never used in adjusting entries!
  3. Determine the amount. Did the transaction give you the amount to use or do you need to calculate it? T-accounts are helpful here.
  4. Determine which account(s) to debit and which account(s) to credit.

Share This:

Accounting is all about balance. Each time we engage in a transaction, there are at least two things that are happening. Usually, we give up something to receive something we need. For example, when you purchase supplies for school, you give up cash in order to get the supplies. When you take out a loan, you get cash today (or tuition or a car) by giving up the right to cash you will receive in the future so you can make your loan payments. Accounting principles work for individuals as well as businesses.

Note: As you progress through the course, think about transactions in your daily life and try to relate them to what you are doing in the course. Analyzing transactions in your own life will make the course easier to relate to and increase your understanding of the topic.

Because of this give and take, accounting is based on a double entry system. Whenever a transaction is recorded, at least two accounts must be effected. This allows us to remain in balance.

The accounting equation is the basis for all of accounting. The accounting equation states:

Assets = Liabilities + Equity

When recording transactions, the accounting equation must stay balanced.

Assets

An asset is something the business owns or has a right to, which can be used to generate future income. Examples of assets include cash, supplies, inventory, vehicles, machinery, equipment, and buildings. This is by no means an exhaustive list and you will spend most of any introductory financial accounting course studying assets.

Liabilities

A liability is an obligation that a business has to another person or entity. Typically, we think of liabilities as loans but there are many different types of liabilities a business can incur. For example, when the electric bill comes and the business has 30 days to pay it, that becomes a liability because the business used the electricity and is obligated to pay for it. If a business agrees to do work for a client and the client pays a deposit (puts money down) for work to be completed at a later date, the business has an obligation to complete the work or refund the money.

Equity

Equity is one of the most difficult concepts for most students to understand in accounting. Equity is the business’ worth to the owners. Let’s rearrange the accounting equation:

Assets – Liabilities = Equity

Now the equation tells us that what we own less what we owe others is equity. This is the value of the business to the owners, also called a business’s net worth. Equity has two main components: contributed capital and retained earnings.

Contributed capital is the value that the owners have contributed to the business. If you started a business tomorrow and put $1,000 cash plus a computer worth $500, the contributed capital in the business would be $1,500 because that is the amount the owner (you) have contributed.

Retained earnings is the amount of profit (earnings) the business has kept (retained) over the years. How is profit generated? When a business sells a product or service, the business generates revenue. When a business incurs costs associated with providing the product or service, the business generates an expense.

Revenue – Expenses = Profit

Once profits are generated the business can either keep those profits within the company to grow the business or protect against future downturns. The business can also choose to pay those profits out to the owners in the form of dividends or distributions. The profits that the business keeps are added to retained earnings.

Using the accounting equation to stay in balance

Let’s go back to the example we used above for contributed capital. You start a business by contributing $1,000 cash and a computer worth $500. Think about the exchange that is happening here. What is the business receiving? $1,000 cash and a computer. What are these? They are assets. The business is receiving $1,500 worth of assets. What is the business giving in exchange for these assets? It is giving you (the owner) $1,500 worth of capital (ownership) in the business. This value is considered contributed capital.

Accounting Equation 1

Our accounting equation is in balance. The business currently has $1,500 worth of assets and $1,500 worth of equity. There are currently no liabilities.

Let’s look at another transaction. The business takes out a loan for $10,000 to provide cash to purchase equipment and start operations. What is the business receiving? $10,000 cash. What is the business exchanging for that cash? The business is giving the bank a promise to pay in the future with assets generated from operations. This is a liability. A loan from the bank is more specifically called a note payable. Let’s add this to our existing balances.

Accounting Equation 2

The business now has $11,500 in assets, $10,000 in liabilities and $1,500 in equity. The equation still balances.

Let’s look at one more transaction. The business purchases a piece of equipment for $4,000 cash. Analyze the transaction to see what the business is receiving and exchanging. The business is receiving a piece of equipment worth $4,000 in exchange for $4,000 cash. Notice that both of these items are assets, therefore, we have one asset increasing and other decreasing.

Accounting Equation 3

*In accounting, a number in parenthesis indicates a negative number or a number that should be subtracted from the numbers around it. You will see this notation frequently.

Notice that the balances in our equation did not change. What did change was the makeup of the assets held by the business. In this part of the course, it is important to understand that the equation must be in balance at all times. As we progress through the course, we will look in greater detail at the individual accounts that make up total assets, liabilities, and equity.

You will also notice that we have not yet dealt with revenue or expenses. Let’s look at the effect those transactions will have on the equation. The business does $1,000 worth of work for a client and gets paid when the work is complete. Again, analyze the transaction and determine how the accounting equation will be affected. The business got paid. What does that mean? The business received cash. It does not matter if the business was paid by check, credit card or cash; the payment will end up in the business bank account and the cash can be spent to generate future revenue. Why did the business receive cash? Because it provided a service for a client. Providing goods or services for a customer is called revenue. You will see many different titles for revenue accounts. Because this revenue was generated because a service was provided, you might call it service revenue or fees earned. As you progress through the course, learn the terminology used in your course but also make sure to realize that other terminology can be used.

Let’s add this transaction to the equation. Clearly, an asset (cash) is increasing. How does the revenue effect the equation? We stated previously that profit increases equity. Profit is revenue less expenses, which means revenue increases profit and expenses decrease profit. Another way to look at the problem is to ask yourself if the revenue is increasing or decreasing the value of the business. Revenue coming in is good for the business and helps to increase its value. Therefore, revenue increases equity.

Accounting Equation 4

Still in balance! One more transaction to complete the lesson. We have looked at all the accounts except expenses. An expense is a cost of generating revenue. If the business rents an office, the cost of that office is an expense. How would we record the following transaction?

The business pays $400 cash for the current month’s office rent.

Analyze the transaction to determine the exchange. The business receives use of the office in exchange for $400 cash.

In this case, both sides of the equation decrease. An expense decreases equity because we are using up resources in the business which decreases the value of the business.

Accounting Equation 5

You’ll notice that we used three categories here because the accounting equation only has three: assets, liabilities, and equity. I tell my students to think as if there are five categories, the three above, plus revenue and expenses. Revenue makes equity go up and expenses make equity go down. As we start to discuss journal entries, it is important to think of revenue and expenses as separate categories.

Share This:


Related pages


what is ending inventorycalculate overhead rate formulacorrecting journal entryhow to treat disposal of fixed assetcalculate annuity present valuecomponents of accounting equationcost drivers accountinguncleared cheques in bank reconciliationexamples of fixed cost and variable cost in manufacturinghow do you calculate overhead rateperpetual system accountingoverhead rateaccrued revenue balance sheetwhat is included in cogsoutstanding deposit definitiondefine unearned incomesales commissions paid to the company's salespeoplemanagerial cost accountingfinished good inventory formulatotal variable cost graphwhat type of inventory system does walmart usehow to figure out ending inventoryuncollectible receivablesbank reconciliation journal entrieshow to calculate state unemployment tax payabledeferred expense journal entrypresent value of annuity due of 1 tableaverage variable cost formulaexpense increase debit or credita post-closing trial balance will showresponsibility accounting performance reportsjournal accounting entries examplesaccrued revenue entryexample of prepaid expensesaccounts receivable has a normal balance ofwhat is the purpose of adjusting journal entriesdebit accounts receivable creditis unearned revenue credit or debithow to book prepaid expensesshort term pricing decisionsbonds valuation formulacost of goods sold is computed from the following equationstatement of retained earnings definitionaccounting income summarythe purpose of closing entries is to transferdefine overhead expenseslimited liability of stockholdershow to do a statement of cash flows indirect methodpresent value interest factor of an annuitycontribution margin ratio formulahow to record depreciation expense in journal entryfederal withholding tax ratessalaries and wages payable journal entrygaap income statement formatmerchandise inventory debit or creditpresent value of an annuity due of 1 tableworkatfocuswhy is unearned revenue a liabilitybeginning finished goods inventory formulacalculate profit margin ratiohow to calculate cogsformula to find variable costactual overhead ratemanagerial accounting job order costing solutionscalculator for employer payroll taxespv of single sum tableprepaid expenses treatment in balance sheetcompute retained earnings200 declining balance depreciationwip accountsplantwide overhead rate formulaadjusting inventory journal entryhow to calculate depreciation expensenpv table annuityhow to calculate average inventory