A Story for Relating to Accounting Basics
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Transcript of A Story for Relating to Accounting Basics
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A Story for Relating to Accounting Basics
We will present the basics of accounting through a story of a person starting a new
business. The person is Joe Perez—a savvy man who sees the need for a parcel
delivery service in his community. Joe has researched his idea and has prepared a
business plan that documents the viability of his new business.
Joe has also met with an attorney to discuss the form of business he should use.
Given his specic situation they concluded that a corporation will be best. Joe
decides that the name for his corporation will be !irect !elivery "nc. The attorney
also advises Joe on the various permits and government identication numbers that
will be needed for the new corporation.
Joe is a hard wor#er and a smart man but admits he is not comfortable with matters
of accounting. $e assumes he will use some accounting software but wants to meet
with a professional accountant before ma#ing his selection. $e as#s his ban#er to
recommend a professional accountant who is also s#illed in e%plaining accounting to
someone without an accounting bac#ground. Joe wants to understand the nancial
statements and wants to #eep on top of his new business. $is ban#er recommends
&arilyn an accountant who has helped many of the ban#'s small business customers.
(t his rst meeting with &arilyn Joe as#s her for an overview of accounting nancial
statements and the need for accounting software. )ased on Joe's business plan
&arilyn sees that there will li#ely be thousands of transactions each year. *he states
that accounting software will allow for the electronic recording storing and retrieval
of those many transactions. (ccounting software will permit Joe to generate the
nancial statements and other reports that he will need for running his business.
Joe seems puzzled by the term transaction so &arilyn gives him ve e%amples of
transactions that !irect !elivery "nc. will need to record+
,. Joe will no doubt start his business by putting some of his own personal money
into it. "n e-ect he is buying shares of !irect !elivery's common stoc#.. !irect !elivery will need to buy a sturdy dependable delivery vehicle.
/. The business will begin earning fees and billing clients for delivering their
parcels.
0. The business will be collecting the fees that were earned.
1. The business will incur e%penses in operating the business such as a salary
for Joe e%penses associated with the delivery vehicle advertising etc.
With thousands of such transactions in a given year Joe is smart to start using
accounting software right from the beginning. (ccounting software will generate
sales invoices and accounting entries simultaneously prepare statements for
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be paying Direct Delivery until January 10, the accrual basis of accounting requires that the
$4,000 be recorded asDecember revenues, since that is when the delivery work actually took
place. After expenses are matched with these revenues, the income statement for December will
show just how proftable the company was in delivering parcels in December.
When Joe receives the $4,000 worth of payment checks from his customers on January 10, he
will make an accounting entry to show the money was received. This $4,000 of receipts will not be
considered to be January revenues, since therevenues were already reported as revenues in
December when they were earned. This $4,000 of receipts will be recorded in January as a
reduction in(ccounts ;eceivable. (In December Joe had made an entry to Accounts
Receivable and to *ales.)
B. Expenses
Now Marilyn turns to the second part of the income statement—expenses. The December income
statement should show expensesincurred during December regardless of when the company
actually paid for the expenses. For example, if Joe hires someone to help him with December
deliveries and Joe agrees to pay him $500 on January 3, that $500 expense needs to be shown
on theDecember income statement. The actual date that the $500 is paid out doesn't matter.
What matters is when the work was done—when the expense wasincurred—and in this case,
the work was done in December. The $500 expense is counted as a December expense even
though the money will not be paid out until January 3. The recording of expenses with the related
revenues is associated with another basic accounting principle known as thematching
principle.
Marilyn explains to Joe that showing the $500 of wages expense on the December income
statement will result in amatching of the cost of the labor used to deliver the December parcels
with the revenues from delivering the December parcels. This matching principle is very important
in measuring just how profitable a company was during a given time period.
Marilyn is delighted to see that Joe already has an intuitive grasp of this basic accounting
principle. In order to earn revenues in December, the company had to incur some business
expenses in December, even if the expenses won't be paid until January. Other expenses to be
matched with December's revenues would be such things as gas for the delivery van and
advertising spots on the radio.
Joe asks Marilyn to provide another example of a cost that wouldn't be paid in December, but
would have to be shown/matched as an expense on December's income statement. Marilyn uses
the"nterest
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Now even though the interest is being paid out to his aunt only once per year as a lump sum, Joe
can see that in reality, a little bit of that interest expense isincurred each and every day he's in
business. If Joe is preparingmonthly income statements, Joe should report one month of
Interest Expense on each month's income statement. The amount that Direct Delivery will incur
as Interest Expense will be $100 per month all year long ($20,000 x 6% ÷ 12). In other words, Joe
needs to match $100 of interest expense with each month's revenues. The interest expense is
considered a cost that is necessary to earn the revenues shown on the income statements.
Marilyn explains to Joe that the income statement is a bit more complicated than what she just
explained, but for now she just wants Joe to learn some basic accounting concepts and some of
the accounting terminology. Marilyn does make sure, however, that Joe understands one simple
yet important point: anincome statement, doesnot report thecash coming in—rather, its
purpose is to (1) report therevenues earned by the company's efforts during the period, and (2)
report theexpenses incurred by the company during the same period. The purpose of the
income statement is to show a company's proftability during a specific period of time. The
difference (or "net") between the revenues and expenses for Direct Delivery is often referred to as
thebottom line and it is labeled as either=et "ncome or=et >oss.
Balance Sheet - Assets
&arilyn moves on to e%plain the balance sheet a nancial statement that
reports the amount of a company's (A)assets (B) liabilities
and (C) stoc#holders' 5or owner's6 e?uity at a specic point in time.
)ecause the balance sheet re@ects a specic point in time rather than
a period o time &arilyn li#es to refer to the balance sheet as a 2snapshot2
of a company's nancial position at a given moment. :or e%ample if a
balance sheet is dated !ecember /, the amounts shown on the balance
sheet are the balances in the accounts after all transactions pertaining to
!ecember /, have been recorded.
(A) Assets
(ssets are things that a company owns and are sometimes referred to as
the resources of the company. Joe readily understands this—o- the top of
his head he names things such as the company's vehicle its cash in the
ban# all of the supplies he has on hand and the dolly he uses to help
move the heavier parcels. &arilyn nods and shows Joe how these are
reported in accounts called Aehicles 9ash *upplies and
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owed to !irect !elivery is an asset #nown as (ccounts ;eceivable.
Prepaids
&arilyn brings up another less obvious asset—the une%pired portionof prepaid e%penses. *uppose !irect !elivery pays 3,44 on !ecember ,
for a si%Bmonth insurance premium on its delivery vehicle. That divides out
to be 344 per month 53,44 C D months6. )etween !ecember , and
!ecember /, 344 worth of insurance premium is 2used up2 or 2e%pires2.
The expired amount will be reported as "nsurance et's say that
!irect !elivery purchased ,44 bo%es wholesale for 3,.44 each. *ince the
time when Joe bought them however the wholesale price of bo%es has
been cut by 04 and at today's price he could purchase them for 34.D4
each. )ecause the replacement cost of his inventory 53D46 is less than
the original recorded cost 53,446 the principle of conservatism directs the
accountant to report the lower amount 53D46 as the asset's value on the
balance sheet.
http://www.accountingcoach.com/terms/P/prepaid-expensehttp://www.accountingcoach.com/terms/I/insurance-expensehttp://www.accountingcoach.com/terms/P/prepaid-insurancehttp://www.accountingcoach.com/terms/P/prepaid-insurancehttp://www.accountingcoach.com/terms/C/cost-principlehttp://www.accountingcoach.com/terms/C/cost-principlehttp://www.accountingcoach.com/terms/C/conservatismhttp://www.accountingcoach.com/terms/P/prepaid-expensehttp://www.accountingcoach.com/terms/I/insurance-expensehttp://www.accountingcoach.com/terms/P/prepaid-insurancehttp://www.accountingcoach.com/terms/P/prepaid-insurancehttp://www.accountingcoach.com/terms/C/cost-principlehttp://www.accountingcoach.com/terms/C/cost-principlehttp://www.accountingcoach.com/terms/C/conservatism
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"n short the cost principle generally prevents assets from being reported
at more than cost while conservatism might re?uire assets to be reported
at less than their cost.
Depreciation
Joe also needs to #now that the reported amounts on his balance sheet for
assets such as e?uipment vehicles and buildings are routinely reduced by
depreciation. !epreciation is re?uired by the basic accounting principle
#nown as the matching principle. !epreciation is used for assets whose life
is not indenite—e?uipment wears out vehicles become too old and costly
to maintain buildings age and some assets 5li#e computers6 become
obsolete. !epreciation is the allocation of the cost of the asset
to !epreciation ongBterm assets 5such as
buildings e?uipment and furnishings6 are reported at their cost minus the
amounts already sent to the income statement as !epreciation
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its original cost even if the land is now worth one hundred times more than
its cost.
*hortBterm 5current6 asset amounts are li#ely to be close to their mar#et
values since they tend to 2turn over2 in relatively short periods of time.
&arilyn cautions Joe that the balance sheet reports only the assets
ac?uired and only at the cost reported in the transaction. This means that
a company's reputation—as e%cellent as it might be—will not be listed as
an asset. "t also means that Je- )ezos will not appear as an asset on
(mazon.com's balance sheetF =i#e's logo will not appear as an asset on its
balance sheetF etc. Joe is surprised to hear this since in his opinion these
items are perhaps the most valuable things those companies have. &arilyn
tells Joe that he has Hust learned an important lesson that he should
remember when reading a balance sheet.
Balance Sheet - Liabilities and Stockholders' Equity
(B) Liabilities
The balance sheet reports Direct Delivery'sliabilities as of the date noted in the heading of the
balance sheet. Liabilities are obligations of the company; they are amounts owed to others as of
the balance sheet date. Marilyn gives Joe some examples of liabilities: the loan he received from
his aunt5=otes Payable or Loan Payable), the interest on the loan he owes to his
aunt5"nterest Payable6, the amount he owes to the supply store for items purchased on credit
((ccounts Payable), the wages he owes an employee but hasn't yet paid to him5Wages
Payable6.
Another liability is money received in advance of actuallyearning the money. For example,
suppose that Direct Delivery enters into an agreement with one of its customers stipulating that
the customer prepays $600 in return for the delivery of 30 parcels every month for 6 months.
Assume Direct Delivery receives that $600 payment on December 1 for deliveries to be made
between December 1 and May 31. Direct Delivery has a cashreceipt of $600 on December 1,
but it doesnot have revenues of $600 at this point. It will have revenues only when itearnsthem
by delivering the parcels. On December 1, Direct Delivery will show that its asset9ash increased
by $600, but it will also have to show that it has a liability of $600. (It has theliability to deliver
$600 of parcels within 6 months, or return the money.)
The liability account involved in the $600 received on December 1 isInearned ;evenue. Each
month, as the 30 parcels are delivered, Direct Delivery will be earning $100, and as a result, each
month $100 moves from the account Unearned Revenue to*ervice ;evenues. Each month
Direct Delivery's liability decreases by $100 as it fulfills the agreement by delivering parcels and
each month its revenues on the income statement increase by $100.
http://www.accountingcoach.com/terms/L/liabilitieshttp://www.accountingcoach.com/terms/N/notes-payablehttp://www.accountingcoach.com/terms/I/interest-payablehttp://www.accountingcoach.com/terms/A/accounts-payablehttp://www.accountingcoach.com/terms/W/wages-payablehttp://www.accountingcoach.com/terms/W/wages-payablehttp://www.accountingcoach.com/terms/C/cashhttp://www.accountingcoach.com/terms/U/unearned-revenueshttp://www.accountingcoach.com/terms/S/service-revenueshttp://www.accountingcoach.com/terms/L/liabilitieshttp://www.accountingcoach.com/terms/N/notes-payablehttp://www.accountingcoach.com/terms/I/interest-payablehttp://www.accountingcoach.com/terms/A/accounts-payablehttp://www.accountingcoach.com/terms/W/wages-payablehttp://www.accountingcoach.com/terms/W/wages-payablehttp://www.accountingcoach.com/terms/C/cashhttp://www.accountingcoach.com/terms/U/unearned-revenueshttp://www.accountingcoach.com/terms/S/service-revenues
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(C) Stockolders! E"uit#
If the company is a corporation, the third section of a corporation's balance sheet is Stockholders'
Equity. (If the company is a sole proprietorship, it is referred to as Owner's Equity.) The amount of
Stockholders' Equity is exactly the difference between the asset amounts and the liability
amounts. As a result accountants often refer to Stockholders' Equity as the difference (or
residual) of assets minus liabilities. Stockholders' Equity is also the "book value" of the
corporation.
Since the corporation's assets are shown at cost or lower (and not at their market values) it is
important that you donot associate the reported amount of Stockholders' Equity with the market
value of the corporation. (Hence, it is a poor choice of words to refer to Stockholders' Equity as
the corporation's "net worth".) To find the market value of a corporation, you should obtain the
services of a professional familiar with valuing businesses.
Within the Stockholders' Equity section you may see accounts such as9ommon *toc#PaidBin
9apital in
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The field of accounting—both the older manual systems and today's basic accounting software—
is based on the 500-year-old accounting procedure known asdouble entr#. Double entry is a
simple yet powerful concept: each and every one of a company's transactions will result in an
amount recorded intoat least two of the accounts in the accounting system.
The Chart of Accounts
To begin the process of setting up Joe's accounting system, he will need to make a detailed listing
of all the names of the accounts that Direct Delivery, Inc. might find useful for reporting
transactions. This detailed listing is referred to as a chart of accounts. (Accounting software
often provides sample charts of accounts for various types of businesses.)
As he enters his transactions, Joe will find that the chart of accounts will help him select the two
(or more) accounts that are involved. Once Joe's business begins, he may find that he needs toadd more account names to the chart of accounts, or delete account names that are never used.
Joe can tailor his chart of accounts so that it best sorts and reports the transactions of his
business.
Because of the double entry system all of Direct Delivery's transactions will involve a combination
of two or more accounts from the balance sheet and/or the income statement. Marilyn lists out
some sample accounts that Joe will probably need to include on his chart of accounts:
Balance Sheet accounts:
• (sset accounts 5
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Marilyn asks Joe if he can see that the balance sheet is just that-in balance. Joe looks at the
total of $20,000 on the asset side, and looks at the $20,000 on the right side, and says yes, of
course, he can see that it is indeed in balance.
Marilyn shows Joe something called thebasic accountin$ e"uation, which, she explains,is really the same concept as the balance sheet, it's just presented in an equation format:
The accounting e?uation 5and the balance sheet6 should always be inbalance.
Debits and Credits!id the rst sample transaction follow the double entry system and a-ect
two or more accountsK Joe loo#s at the balance sheet again and answersyes both 9ash and 9ommon *toc# were a-ected by the transaction.
&arilyn introduces the ne%t basic accounting concept+ the double entrysystem re?uires that the same dollar amount of the transaction must beentered on both the let side of one account and on the right side ofanother account. "nstead of the word let accountants use the word debit Fand instead of the word right accountants use the word credit . 5Theterms debit and credit are derived from >atin terms used 144 years ago.6
Here's a Tip
Debit meanslet .
Credit meansright .
Joe as#s &arilyn how he will #now which accounts he should debit—meaning he should enter the numbers on the left side of one account—andwhich accounts he should credit—meaning he should enter the numberson the right side of another account. &arilyn points bac# to the basicaccounting e?uation and tells Joe that if he memorizes this simplee?uation it will be easier to understand the debits and credits.
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Here's a Tip
Memorizing the simple accounting equation will help you learn the debit and credit rules for
entering amounts into the accounting records
Let's take a look at the accounting equation again:
Just as assets are on the left side 5or debit side6 of the accounting
e?uation the asset accounts in the general ledger have their balances on
the left side. To increase an asset account's balance you put more on the
left side of the asset account. "n accounting Hargon you debit the assetaccount . To decrease an asset account balance you credit the account
that is you enter the amount on the right side.
Just as liabilities and stoc#holders' e?uity are on the right side 5or credit
side6 of the accounting e?uation the liability and e?uity accounts in the
general ledger have their balances on the right side. To increase the
balance in a liability or stoc#holders' e?uity account you put more on the
right side of the account. "n accounting Hargon you credit the liability or
the e?uity account. To decrease a liability or e?uity you debit the account
that is you enter the amount on the left side of the account.
(s with all rules there are e%ceptions but &arilyn's reference to the
accounting e?uation may help you to learn whether an account should be
debited or credited.
*ince many transactions involve cash &arilyn suggests that Joe memorize
how the 9ash account is a-ected when a transaction involves cash+ if
!irect !elivery receives cash the 9ash account is debitedF when !irect
!elivery pays cash the 9ash account is credited.
Here's a Tip
When a companyreceives cash, the Cash account isdebited.
When the company pays cash, the Cash account iscredited.
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Marilyn refers to the example of December 1. Since Direct Delivery received $20,000in
cash from Joe in exchange for 5,000 shares of common stock, one of the accounts for this
transaction is Cash. Since cash wasreceived, the Cash account will bedebited.
In keeping with double entry, two (or more) accounts need to be involved. Because the first
account (Cash) wasdebited, the second account needs to becredited. All Joe needs to do is
find the right account to credit. In this case, the second account is Common Stock. Common
stock is part of stockholders' equity, which is on the right side of the accounting equation. As a
result, it should have a credit balance, and to increase its balance the account needs to
becredited.
Accountants indicate accounts and amounts using the following format:
Accountants usually first show the account and amount to be debited. On the next line, the
account to be credited is indented and the amount appears further to the right than the debit
amount shown in the line above. This entry format is referred to as a general journal entry.
(With the decrease in the price of computers and accounting software, it is rare to find a small
business still using a manual system and making entries by hand. Accounting software has madethe process of recording transactions so much easier that the general journal is rarely needed. In
fact, entries are often generated automatically when a check or sales invoice is prepared.)
Sample Transactions #2 - #3
Sample Transaction #2
Marilyn illustrates for Joe a second transaction. On December 2, Direct Delivery purchases a
used delivery van for $14,000 by writing a check for $14,000. The two accounts involved are
Cash and Vehicles (or!elivery
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The balance sheet will look like this after the vehicle transaction is recorded:
The balance sheet and the accounting equation remain in balance:
As you can see in the balance sheet, the asset Cash decreased by $14,000 and another assetVehicles increased by $14,000. Liabilities and stockholders' equity were not involved and did not
change.
Sample Transaction #3
The third sample transaction also occurs on December 2 when Joe contacts an insurance agent
regarding insurance coverage for the vehicle Direct Delivery just purchased. The agent informs
him that $1,200 will provide insurance protection for the next six months. Joe immediately writes a
check for $1,200 and mails it in.
Let's consider this transaction. Using double entry, we know there must be a minimum of two
accounts involved—one (or more) of the accounts must bedebited, and one (or more) must
becredited.
Since a check is written, we know that one of the accounts involved is Cash. Since cash
was paid, the Cash account will becredited. (Take another look at the last%&P.) While we have
not yet identified the second account, what we do know for certain is that the second account will
have to bedebited.
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At this point we have most of the entry-all we are missing is thename of the account to be
debited:
We know the transaction involves insurance, and a quick look through the chart of accounts
reveals two possibilities:
Prepaid Insurance (an asset account reported on the balance sheet) and Insurance
Expense (an expense account reported on the income statement)
Assets include costs that are not yet expired (not yet used up), while expenses are costs that
have expired (have been used up). Since the $1,200 payment is for an expense that will not
expire in its entirety within the current month, it would be logical to debit the account Prepaid
Insurance. (At the end of each month, when $200 has expired, $200 will be moved from Prepaid
Insurance to Insurance Expense.)
The entry in the general journal format is:
After the first three transactions have been recorded, the balance sheet will look like this:
(gain the balance sheet and the accounting e?uation are in balance andall of the changes occurred on the assetLleftLdebit side of the accounting
e?uation. >iabilities and *toc#holders'
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Sample Transactions #4 - #
Sample Transaction #4
The fourth transaction occurs on December 3, when a customer gives Direct Delivery a check for
$10 to deliver two parcels on that day. Because of double entry, we know there must be a
minimum of two accounts involved—one of the accounts must be debited, and one of the
accounts must be credited.
Because Direct Deliveryreceived $10, it mustdebit the account Cash. It must alsocredit a
second account for $10. The second account will be Service Revenues, an income statement
account. The reason Service Revenues iscredited is because Direct Delivery must report that
itearned $10 (not because it received $10). Recording revenues when they are earned resultsfrom a basic accounting principle known as the revenue recognition principle. The following tip
reflects that principle.
Here's a Tip
Revenues accounts arecredited when the companyearns a fee (or sells merchandise)
regardless of whether cash is received at the time.
Here are the two parts of the transaction as they would look in the general journal format:
Sample Transaction #5
Let's assume that on December 3 the company gets its second customer-a local company that
needs to have 50 parcels delivered immediately. Joe's price of $250 is very appealing, so Joe's
company is hired to deliver the parcels. The customer tells Joe to submit an invoice for the $250,
and they will pay it within seven days.
Joe delivers the 50 parcels on December 3 as agreed, meaning that on December 3 Direct
Delivery hasearned$250. Hence the $250 is reported as revenues onDecember 3, even
though the company did not receive any cash on that day. Theeort needed to complete the job
was done on December 3. (Depositing the check for $250 in the bank when it arrives seven days
later is not considered to take any effort.)
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Let's identify the two accounts involved and determine which needs a debit and which needs a
credit.
Because Direct Delivery has earned the fees, one account will be a revenues account, such as
Service Revenues. (If you refer back to the last%&P you will read that revenue accounts—such
as Service Revenues—are usually credited, meaning the second account will need to be
debited.)
In the general journal format, here's what we have identified so far:
We know that the unnamed account cannot be Cash because the company did not receive
money on December 3. However, the company has earned the right to receive the money in
seven days. The account title for the money that Direct Delivery has a right to receive for having
provided the service is Accounts Receivable (an asset account).
Ag
ain, reporting revenues when they are earned results from the basic accounting principle known
as therevenue recognition principle.
Sample Transaction #6
For simplicity, let's assume that the only expense incurred by Direct Delivery so far was a fee to a
temporary help agency for a person to help Joe deliver parcels on December 3. The temp agency
fee is $80 and is due by December 12.
If a company does not pay cash immediately, you cannot credit Cash. But because the company
owes someone the money for its purchase, we say it has anobli$ation orliabilit# to pay.
Most accounts involved with obligations have the word "payable" in their name, and one of the
most frequently used accounts is Accounts Payable. Also keep in mind that expenses are almost
alwaysdebited.
The accounts and amounts for the temporary help are:
http://www.accountingcoach.com/accounting-basics/explanation/7#accounting-basics-tip-twohttp://www.accountingcoach.com/terms/R/revenue-recognition-principlehttp://www.accountingcoach.com/accounting-basics/explanation/7#accounting-basics-tip-twohttp://www.accountingcoach.com/terms/R/revenue-recognition-principle
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Here's a Tip
Expenses are (almost) always debited.
Here's a Tip
If a company does not pay cash right away for an expense or for an asset, you cannot credit
Cash. Because the companyo!es someone the money for its purchase, we say it has an
obligation or liability to pay. The most likely liability account involved in business obligations isAccounts Payable.
Revenues and expenses appear on the income statement as shown below:
After the entries through December 3 have been recorded, the balance sheet will look like this:
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