liabilities

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:

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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.

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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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It could be argued that the statement of cash flow is the most important of all the financial statements. It is also the least understood. Understanding the purpose of the statement of cash flow is the key. Once you understand the purpose of the statement, wrapping your brain around how to complete it is much easier.

Most people have a difficult time understanding the concept of accrual accounting. I believe this is because most people live in a cash basis world. As individuals, we do not consider income when it is earned. We recognize our income when it is paid. We recognize expenses when they are paid. It is important to remember that most businesses do not operate that way. Most businesses recognize income when the work is done, whether or not the job has been paid for. These businesses recognize expenses when the cost is incurred, regardless of payment status. In business, we are frequently recording income and expenses when no money has changed hands.

This causes a problem for many people looking at the financial statements. Individuals think in terms of cash so when an individual sees a company with a profit of $500,000, he or she may think that there is an additional $500,000 worth of cash sitting in the bank at the end of the year. Cash might have only increased slightly. It could have even decreased! When that money is not there, the person may believe there is a problem with the income statement.

The purpose of the statement of cash flow is to explain the difference net income and the change in cash over the same period. If there was a $500,000 profit, the statement of cash flow explains why the increase in cash is not also $500,000. The statement begins with net income. Each line on the statement explains where cash is coming from, called a source of cash, or where cash is going, called a use of cash. The statement ends with the amount that cash has increased or decreased over the course of the period and the ending balance in cash.

Every source or use of cash can fit into one of three categories: operating activities, investing activities or financing activities.

Operating Activities

These are activities related to operations or the income statement. In other words, these are items related to income and expenses. There are two main types of operating activities: noncash and those related to current assets and current liabilities.

Noncash operating activities relate to items that appear on the income statement, yet cash was not affected by that item. The most common noncash item is depreciation. Think about the entry recorded for depreciation.

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The entry creates an expense, which appears on the income statement but no cash changes hands. On the income statement, the expense lowers net income but there is no corresponding decrease in cash. This leads to one of the differences between net income and change in cash.

Since the depreciation was subtracted on the income statement, we need to add it back to net income on the statement of cash flow. Adding it back removes it from net income, helping us get closer to the change in cash.

Other noncash items include amortization, gains and losses. While some cash may change hands when an asset is sold, the amount of cash received relates to the removal of the asset. The gain or loss on the transaction is considered to be a noncash part of the transaction. It is essentially there to balance the transaction.

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Notice that $5,000 in cash was received, not $2,000. We eliminate the $2,000 gain in the operating section. Later, we will see what happens to the $5,000.

Any noncash item that is added on the income statement, a gain for example, is subtracted on the statement of cash flows to remove it. Noncash items that are subtracted on the income statement are added back on the statement of cash flows.

Changes in current assets and current liabilities are the second type of operating item. Think of some common current assets and current liabilities: accounts receivable and accounts payable. Both of these items are linked to the income statement.

Current Assets and Changes in Cash

Accounts receivable is created when a company does work and creates revenue. The work has not yet been paid for. However, the income appears on the income statement. This could create a difference between net income and the change in cash. When trying to determine if there is an effect on the change in cash, we need to look at how much accounts receivable has changed. Let’s look at three different scenarios.

Example #1

2012 ending balance in Accounts Receivable was $230,000
2013 ending balance in Accounts Receivable was $230,000
Sales were $3,000,000

If Accounts Receivable was $230,000 at the end of 2012 and is still $230,000 at the end of 2013, that means that $3,000,000 worth of sales were collected in 2013.

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The amount of sales and the amount of cash collected are equal. Therefore, no timing difference exists. There difference between net income and cash is not affected by accounts receivable.

Example #2

2012 ending balance in Accounts Receivable was $330,000
2013 ending balance in Accounts Receivable was $230,000
Sales were $3,000,000

In this example, Accounts Receivable decreased by $100,000. Let’s see how this decrease affects the amount of cash collected.

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The company reported $3,000,000 in sales on the income statement but actually collected $3,100,000 in cash related to sales. The decrease in accounts receivable results in an increase in cash. That makes sense because when accounts receivable balances are paid (and the balance decreases), the company receives cash.

The $100,000 difference creates a positive change in cash. You could also say that the $100,000 decrease in accounts receivable is a $100,000 source of cash.

Example #3

2012 ending balance in Accounts Receivable was $230,000
2013 ending balance in Accounts Receivable was $330,000
Sales were $3,000,000

Now we have a $100,000 increase in accounts receivable. What effect do you think this has on cash? If accounts receivable is increasing, the company doesn’t have the cash. Let’s look at the calculation.

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Only $2,900,000 was collected over the course of the year but sales of $3,000,000 appear on the income statement. The $100,000 creates a negative change in cash. My change in cash in this case is less than net income because the company did not collect those funds.

You might be concerned at this point because this seems like a lot of work to do for every line of the cash flow statement. This is just to illustrate what happens. If accounts receivable increases, the change in cash decreases by the same amount. If accounts receivable decreases, the change in cash increases by the same amount.

When completing the statement of cash flow, calculate the change in the account balance. Ask yourself who has the money resulting from that change. Go back to example #2. Accounts receivable decreased by $100,000. Who has the $100,000? The company does because customers paid the additional $100,000. This results in an increase in cash. In example #3, the customers had the $100,000 because they had not paid their bills. This results in a decrease in cash for the company. This method works for all current assets and current liabilities.

All assets behave like accounts receivable. If the balance in prepaid expenses increases, more cash is trapped in that account, resulting in a decrease in cash. If the balance in inventory decreases, the company used up some of the previous inventory rather than spending cash to purchase more. Cash increases because of this.

Current Liabilities and Changes in Cash

Current liabilities, like accounts payable, react the opposite way that assets do. Again, we are examining the differences in current liabilities to determine how these changes affect the change in cash. Let’s run through a few examples just to get the hang of it.

Example #4

2012 ending balance in Accounts Payable was $150,000
2013 ending balance in Accounts Payable was $105,000
Expenses were $2,500,000

Accounts payable decreased by $45,000. Why did accounts payable decrease? Because the company paid all the current expenses and paid off some of last year’s balance. The company paid down debt. This has a negative impact on the change in cash. Let’s look at the full calculation to confirm.

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The company paid $45,000 more in cash than it recorded in expense. This causes a decrease in cash. It can also be said that the decrease in accounts payable is a use of cash.

Example #5

2012 ending balance in Accounts Payable was $150,000
2013 ending balance in Accounts Payable was $175,000
Expenses were $2,500,000

Now, accounts payable is increasing. The company charged more to accounts payable over the course of the year than the company paid off. The $25,000 difference is a source of cash. The company was able to write off expenses that it has not yet paid for.

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The company’s income statement shows expenses of $2,500,000 but the company only spent $2,475,000. It kept the $25,000. Because of the $25,000 increase in accounts payable, the change in cash increased by $25,000.

All current liabilities behave like accounts payable. When accounts payable decreases, cash decreases because cash was used to pay down the liability. When accounts payable increases, cash increases as well because the company used debt rather than cash to finance its activities.

Steps to Complete the Operating Section

  1. First calculate the change in the account balance.
  2. Ask yourself who has the cash from that change. If the company has the cash, it is an increase in cash.  If someone else has the cash, customers or vendors for example, it is a decrease in cash.
  3. Don’t forget to look for noncash items as you work your way down the balance sheet: depreciation, amortization, gains and losses.

Investing Activities

In this section, we are concerned with investments that the company has made. What do companies invest in? Long-term assets that will help with company increase revenue. This includes buildings, machinery, intangible assets, investments in other companies and other long-term investments.

In the investing section, we are not allowed to explain a difference in an account balance by listing “change in fixed assets.” The investing section requires us to explain each change. Let’s look at an example.

Example #1

2012 ending balance in Vehicles was $250,000
2013 ending balance in Vehicles was $235,000
In 2013 the company sold a vehicle which was originally purchased for $35,000 for $5,000. The vehicle had $33,000 of accumulated depreciation recorded at the time of sale.

When dealing with assets, we may not have all the transactions listed, but we will always have all the information we need to do the calculation. Let’s start with the beginning balance and run through the information we have so far.

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This does not make sense because the account balance was $235,000. Clearly, something else happened which was not listed in the information. What would cause the balance in the vehicles account to increase? The company must have purchased another vehicle. How much was the new vehicle? It must have been $20,000.

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Now that we have identified all the activity in the vehicles account and were able to reconcile the change in the balance. We now must figure out what we need to record. We must forget for a moment the vehicles and turn our attention to the cash that changed hands.

The company sold a vehicle. How much cash was received? $5,000. It does not matter that the vehicle originally cost $35,000. Now we are only concerned with cash. The company also purchased a vehicle. How much cash was paid? $20,000. On the statement of cash flow, we would record these two items.

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Notice, we listed each item separately. We need to explain to the reader what happened.

You might have noticed that there was a gain on the sale of the vehicle. The vehicle had a book value of $2,000 ($35,000 cost – $33,000 accumulated depreciation). If $5,000 was received, there was a $3,000 gain. Remember when we discussed noncash items in the operating section. This gain would be listed in the operating section and subtracted from net income.

You should follow this procedure for all noncurrent assets on the balance sheet.

  1. Reconcile the beginning and ending balance in the account using the information you have in the problem.
  2. If the balance matches your reconciliation, you are finished. Record the items listed.
  3. If the balance does not match your reconciliation, there must have been additional activity that was not listed. This activity must be an asset purchase. Calculate how much the asset purchase was.
  4. In the statement of cash flow, list all transactions separately, as shown above.

Financing Activities

In our analysis of the balance sheet, we have covered current assets, current liabilities and long-term assets. The only items remaining are long-term liabilities and equity. Both of these items go into the financing section.

The financing section is similar to the investing section. We must explain what happened, not just list the changes in each account balance.

Example #1

2012 ending balance in Notes Payable was $95,000
2013 ending balance in Notes Payable $75,000
The company borrowed $35,000 in additional loans

Looking at this example, it is clear that there is information missing. The company borrowed additional money but the Notes Payable balance decreased. That just doesn’t make sense with the information we are given. There are two ways to work this calculation. we can reconcile the balance, similar to the method used in the investing section.

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What is causing the balance to be $55,000 less than anticipated? Think about the reason that the balance in Notes Payable would decrease. Debts decrease when they are repaid. The company must have repaid $55,000 on the debt.

Here is how we would list this on the statement of cash flow in the financing section:

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You should follow this procedure for all noncurrent liabilities on the balance sheet.

  1. Reconcile the beginning and ending balance in the account using the information you have in the problem.
  2. If the balance matches your reconciliation, you are finished. Record the items listed.
  3. If the balance does not match your reconciliation, there must have been additional activity that was not listed. Calculate the amount you are off and the reason for the change.
  4. In the statement of cash flow, list all transactions separately, as shown above.

Completing the Statement of Cash Flows

Whenever I am working on a cash flow statement, I use the balance sheet as a guide.

First, calculate how much each account has changed from the previous year.

Starting at the top of the balance sheet, I work my way through each account. The first account should be cash. We can skip that one since the purpose of the statement of cash flow is to match the change in cash. The next account is most likely accounts receivable. Determine which section accounts receivable would go into: operating, investing or financing (if you said operating, you are correct). Then ask yourself if the change in the balance is a source of cash or a use of cash. Add it to your statement.

Use this same procedure, explaining all the differences and adding them to the correct section of the cash flow statement. When you have explained all the differences, total each section and then add all three sections together to calculate your change in cash. The change in cash you calculate should equal the difference between your beginning and ending cash balance.

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Cash Flow Statement Basics

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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

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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.

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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.

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Journal entries are probably the most important part of any financial accounting class. They are the language of accounting.

JE 1

This is a journal entry. It describes a transaction. The entry above tells us that on January 17, the company purchased land worth $100,000 and a building worth $225,000. The company put down $125,000 cash and took out a note with the bank for $200,000. Once you understand how journal entries are constructed, you will be able to read and write them yourself.

Debits and Credits

Debits and credits are the heart of the journal entry because they tell us if we are acquiring something or giving something up. Depending on the type of account, it will increase or decrease when it is debited or credited.

Remember the accounting equation? Assets = Liabilities + Equity. Just as we need to keep the accounting equation in balance, we must keep our debits and credit in balance. Each journal entry must contain equal debits and credits. Notice the entry above: $325,000 in debits and $325,000 in credits. In order for that to occur, each journal entry must have at least two accounts. You can never have a one line journal entry because it would not balance.

In accounting, we frequently refer to the normal balance in the account. The normal balance is a positive balance or what would need to be done to increase the balance.

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Because the accounting equation tells us that assets must equal liabilities and equity, it makes sense that the normal balance for assets is a debit and the normal balance for liabilities and equity is a credit. Remember that normal balance means positive or increasing balance. What do you do to decrease the balance of an asset? If a debit increases the balance, than a credit to the account would decrease the balance. As we saw in the example entry above when we wanted to decrease cash, we credited the account.

What about revenue and expenses? Why is revenue’s normal balance a credit while expense’s is a debit? First, let’s discuss the relation these two accounts have to equity. Retained Earnings is a major component of equity. What causes retained earnings to increase? Profit. What causes profit to increase? Revenue. If revenue increases equity, then it should act the same way that equity does. Therefore, revenue has a credit balance. Since expenses decrease profit and equity, it makes sense that the normal balance is a debit.

If you still are not sure, put revenue or expenses in a journal entry with cash. Most people who study accounting quickly learn how cash behaves in most situations. If you know how cash will behave, you can figure out the other account. When a company does work and gets paid, cash increases so we debit cash. The other account, revenue, would be the credit. When a company pays for its rent, cash decreases so we credit Cash. To balance the entry, we debit Rent Expense.

Steps for Completing Journal Entries

  1. Read the transaction to get a feel for what is happening. Do you understand what happened? Try to put it into your own words.
  2. Identify the accounts you will put in your journal entry. Identify the type of account for each account used.
  3. For each account, determine if the balance is increasing or decreasing. Then determine if that increase or decrease is a debit or credit.
  4. Determine the amount that each account is changing.

Example:

On January 4, Lisa decides to start a bookkeeping business and invests $10,000 cash and $5,000 worth of computer equipment in exchange for stock in the company.

  1. The company received cash and computer equipment in exchange for stock.
  2. Cash (asset), Computer Equipment (asset) and Common Stock (equity).
  3. Cash – increasing, debit. Computer Equipment – increasing, debit. Common Stock – Increasing, credit.
  4. Cash – $10,000. Computer Equipment – $5,000. Common Stock – $15,000

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This may seem like a lot of steps but when you are first learning how to do journal entries, it really helps to go through each of the steps as you write the entry. You don’t need to write out the answers to each of the steps as I did above, but you should do it mentally as you figure out the entry. I have had many students who will put the abbreviation for the account type next to the account name.

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If you are going to do that, I recommend using Eq for equity and Ex for expense.

When learning to do journal entries, take your time and go through the steps. Make sure to learn the accounts and what type each account is. You may want to make flash cards with the name of the account on one side and the type of account on the other. You should also learn when to use a particular account, for example, when to use Unearned Revenue instead of Revenue or Prepaid Insurance rather than Insurance Expense.

This may seem difficult at first, but if you learn the terminology and practice, you will get better at it. For most students, a lightbulb goes off in their minds somewhere in the first six weeks of the course; everything clicks and they no longer need to use the steps above. Until you have your lightbulb moment, make sure to use the steps outlined above.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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

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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.

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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.

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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.

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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.

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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.

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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.

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