🔹 Understanding the Five Types of Accounts
Asset Accounts
📌 One-word definition = "OWN"What it means: Everything that a company "OWNS" that can be used to generate future benefits.
📌 These are assets that a company expects to convert to cash or use up within one year or the operating cycle, whichever is longer.
It includes currency, coins, balances in checking accounts, and undeposited receipts.
These are items that are used in the operation of a business. They might include office supplies, cleaning supplies, or manufacturing supplies.
These are amounts owed to the company by its customers for services or goods sold on credit. The company expects to collect these receivables within the operating cycle.
- Accounts Receivable is considered an asset because it represents the amount of cash that we expect to receive from customers, particularly after we’ve sold goods or provided services “on credit.
- In essence, Accounts Receivable represents the company's ownership of future cash inflows. Since these outstanding balances are expected to be collected and converted into cash within a reasonably short period, usually within one year, they are categorized as current assets on the balance sheet.
These are expenses paid in advance for future services or benefits. Examples can include prepaid insurance, prepaid rent, and prepaid advertising.
📌 These are assets that a business uses in its operations and that have a useful life of more than one year.
These are structures used in operations, such as stores, offices, and warehouses. The cost of buildings includes all expenditures related to their acquisition or construction, including purchase price, legal fees, and renovation costs.
This category includes machinery, office furniture, computers, vehicles, and any other tangible items used in the production of goods or services.
This is the ground on which a company’s buildings or other structures are constructed. Land is considered a long-term asset and it is not depreciated.
These are enhancements to a plot of land to make it more useful or valuable. These can include things like landscaping, paving, fencing, lighting, and sprinkler systems. Unlike land itself, land improvements are subject to depreciation over their useful life.
These are devices that allow work to be done more efficiently. In a manufacturing company, for example, this might include lathes, drill presses, or 3D printers.
These are vehicles owned by the company and used for business operations, such as delivery of goods, transportation of employees, or other company tasks. As assets, they are subject to depreciation over their useful life.
Accumulated depreciation is a contra asset account that offsets the balance of the related asset account, such as equipment or buildings. This account is used to record the reduction in value or wear and tear of an asset over time. Accumulated depreciation represents the total depreciation expense recognized for an asset since its acquisition. It is deducted from the historical cost of the asset to determine its net book value or carrying value on the balance sheet.
📌 These are non-physical assets that have value due to the special rights or privileges they grant to a company. They're usually long-term assets, as the company utilizes them over several years.
This is a special type of intangible asset that arises when a company purchases another business for more than the fair market value of its individual assets and liabilities. Goodwill typically reflects the value of intangible factors like a strong brand name, good customer relations, good employee relations, and any patents or proprietary technology.
These are legal rights that protect the creators of original works, such as literature, music, and art. When a company owns a copyright, it has the exclusive right to reproduce and sell the work. Copyrights generally last for the life of the creator plus 70 years.
These are words, phrases, symbols, or designs that identify and distinguish the source of goods or services of one party from those of others. Trademarks have an indefinite life as long as they are continually used and defended against infringement.
These are exclusive rights granted to an inventor or their assignee for a set period of time in exchange for a detailed public disclosure of an invention. A patent provides a company the right to exclude others from making, using, selling, or importing the patented invention. Patents typically last for 20 years.
Liability Accounts
📌 One-word definition = "OWE"What it means: Everything that a company "OWES" to others, like loans or bills that must be paid in the future.
📌 These are obligations that a company must pay within the next year or operating cycle.
These are amounts the company owes to suppliers for goods or services purchased on credit, meaning the company received the goods or services now but will pay for them at a later date.
These are formal commitments, usually involving a written contract, to pay a specific amount at a certain future date. As an example, this account would be used when borrowing money from a bank that must be paid back.
These are amounts owed to employees for services rendered that have not yet been paid. When a company owes its employees for work done during a particular period, but has not paid them by the end of that period, it records a salaries payable liability.
Similar to salaries payable, wages payable represents the amounts owed to hourly workers for their work that has not yet been paid at the end of an accounting period.
This is the amount of interest that a company owes but has not yet paid for loans and other debt.
This is the amount of taxes owed to the government that has not yet been paid. It can include taxes like income tax payable, sales tax payable, and property tax payable.
These are expenses that a business has incurred but not yet paid. An example might be utilities used during a month for which the company has not yet received a bill.
This is for cash received in advance for products or services yet to be provided. It is considered a liability because, despite already being paid upfront, the company still owes the goods or services.
See Common Mistakes below:
📌 What is Unearned Revenue? This is for cash received in advance for products or services yet to be provided. It is considered a liability because, despite already being paid upfront, the company still owes the goods or services.
- You might be asking yourself, 'How can receiving cash become a liability, suggesting we owe something?' Though this seems counterintuitive, understanding the revenue recognition principle clarifies it.
- The principle asserts that revenue is only recognized when earned, i.e., when the service is delivered. Therefore, money received for a service not yet provided is 'unearned revenue' until we actually deliver the service.
- Consider this another way: you've received upfront cash, but the service remains undelivered. What if the service isn't provided, or the customer cancels the contract?
- In that case, you might need to refund the money! Given these uncertainties, can we truly claim we've 'earned' that cash?
- Isn't it logical to set up a liability account to earmark these funds until we genuinely earn them?
- That's exactly our strategy. At the year end, we'll evaluate how much of our unearned revenue has been earned (i.e., the proportion of the service actually delivered and what remains outstanding).
- Following this, we'll record an adjusting entry to effectively convert unearned revenue into earned revenue.
- We’ll expand much deeper on Unearned Revenue adjusting entries in Chapter 3. With practice, it'll become second nature to you.
⚠️ CAUTION ⚠️ Often, students confuse revenue to only refer to receiving cash. This is not always the case!
- Example #1: When we provide services on credit, the customer pays later, but the revenue is recognized as soon as the services are delivered, as per the revenue recognition principle.
- Example #2: If we receive cash in advance for services we will provide later, this is recorded as Unearned Revenue — a prime example that receiving cash doesn’t always equate to generating revenue!
- Example #3: What if we receive cash immediately upon providing services — is this reveune? Yes, this is considered revenue.
- Nevertheless, it's important to understand that revenue is attributed to the services rendered, not the cash received. The cash received does not trigger the revenue; it is the completion of the services that does.
- Refer back to example #1, where revenue is generated without any cash received yet. It's revenue because the services are delivered!
- This can be confusing, but it's a vital distinction to grasp. For determining revenue under accrual accounting, the key factor isn't whether we've received cash, but rather if we've completed the work. Understanding this is best achieved through practicing problems!
When mentioned as long-term liabilities, these are formal debt agreements where the repayment period extends beyond the next year or operating cycle. These can be considered as an extension of a short-term note, often with a fixed interest rate and defined repayment schedule.
These are obligations that are due to bondholders or investors who have purchased bonds issued by the company. A bond is a written promise to pay both the principal amount borrowed and interest at specific dates in the future. The repayment period is typically longer than one year.
These are contractual commitments where the company agrees to make regular payments to lease an asset over a period of time. If this period extends beyond one year, these lease obligations are considered long-term liabilities.
These are obligations the company has to pay retirement benefits to employees in the future. This is considered a long-term liability because the payment will typically occur over many years.
Equity Accounts
📌 One-word definition = "VALUE" or “NET WORTH”What it means: Also known as shareholders' equity or owners' equity, this is the portion of the company's assets that would remain after all its liabilities have been paid off. In simpler terms, it's what owners would theoretically "own" outright if all debts were paid. Equity shows the true value of a company to its owners.
This represents the primary ownership interest in a corporation. Owners of common stock generally have voting rights in the corporation and may receive dividends, which are a portion of the corporation's profits distributed to its owners. When owners invest cash or other assets in the business, the company often issues common stock in return.
This is a value that represents the excess amount paid by investors above the par value of common stock. It indicates how much shareholders have invested into the company beyond the nominal value of the shares.
This represents the accumulated net income (profits) of the company that has not been distributed to shareholders in the form of dividends. Retained earnings are reinvested in the business for purposes such as paying off debt or buying assets.
Dividends represent the allocation of a portion of a company's profits to its shareholders. They are NOT considered an expense. Instead, they are distributions of earnings, often referred to as 'drawings', which go back to owners and investors, reducing the Retained Earnings account—a part of equity. From this perspective, dividends can be viewed as a "contra equity” account. Contrary to other equity accounts, an increase in dividends leads to a decrease in total equity.
This is a company's own stock that it has repurchased from shareholders. It's considered a "contra" equity account because it reduces total shareholders' equity. Unlike other accounts, increases in treasury stock are recorded as debits because they reduce total shareholders' equity. We will delve into this account much further in Chapter 11.
Revenue Accounts
📌 One-word definition = "EARN" or “DO WORK”What it means: Revenue records the income earned from the sale of goods or provision of services as part of the normal operations of the business.
⚠️ CAUTION ⚠️ Often, students confuse revenue to only refer to receiving cash. This is not always the case!
- Example #1: When we provide services on credit, the customer pays later, but the revenue is recognized as soon as the services are delivered, as per the revenue recognition principle.
- Example #2: If we receive cash in advance for services we will provide later, this is recorded as Unearned Revenue — a prime example that receiving cash doesn’t always equate to generating revenue!
- Example #3: What if we receive cash immediately upon providing services — is this reveune? Yes, this is considered revenue.
- Nevertheless, it's important to understand that revenue is attributed to the services rendered, not the cash received. The cash received does not trigger the revenue; it is the completion of the services that does.
- Refer back to example #1, where revenue is generated without any cash received yet. It's revenue because the services are delivered!
- This can be confusing, but it's a vital distinction to grasp. For determining revenue under accrual accounting, the key factor isn't whether we've received cash, but rather if we've completed the work. Understanding this is best achieved through practicing problems!
Expense Accounts
📌 One-word definition = "COST"What it means: Expenses record costs incurred in the normal operations of the business to generate revenues.
- Understanding the timing of expense recognition is crucial for interpreting its impact on financial statements. This is where the matching principle comes in handy: expenses are recognized when the resources or services are used to generate revenue, not necessarily when cash is paid.
- Let's consider an example. If we purchase supplies by paying cash, we're essentially trading one asset (cash) for another (supplies). At this point, no expense is recognized. Why not? Because we haven't used these supplies yet.
- The expense hits our books only when we actually use the supplies in our operations. The act of buying the supplies doesn't equate to an expense—it's the usage that counts!
Confused? Check out more examples below.
- Paying cash for a building (an asset) is NOT an expense.
- However, as it depreciates over time, we will recognize depreciation expense!
- Paying cash for inventory (an asset) is NOT an expense.
- However, we will record Cost of Goods Sold (an expense) once it’s sold!
- Paying cash for Prepaid Rent (an asset) is NOT an expense.
- However, we will record Rent Expense later as the lease term elapses.
- Paying cash for Prepaid Insurance (an asset) is NOT an expense.
- However, we will record Insurance Expense later as our coverage expires or is used.
- Consider the one-word definition of expenses: "costs." Can costs occur without involving any cash payment? Absolutely!
- One example that illustrates this well is depreciation expense. Depreciation refers to the gradual decrease in value over time of long-term assets such as buildings and equipment.
- Let's paint a scenario: You've owned a building for a year, and your accountant estimates that its value has decreased by $10,000. This depreciation is undoubtedly an expense or "cost."
- However, did you have to make any cash payment to anyone for this decline in value? Certainly not! There's no need to write a check to anyone.
- Depreciation is a cost that simply “occurs” as time passes, completely independent of any cash payment!
- Amortization: Similar to depreciation, amortization represents the gradual reduction in value of intangible assets (e.g., patents, copyrights) over time.
- Therefore, Amortization is an expense recorded without any cash payment associated with it, a topic we’ll elaborate further in Chapter 8.
- Accrued Expenses: Suppose a company has incurred employee salaries and wages for the current month but hasn't yet paid them.
- Even without a cash outflow, the company recognizes the expense by accruing the salaries and wages payable, a topic we’ll elaborate further in Chapter 3.
- Bad Debts: If a company has provided goods or services to a customer on credit and later determines that the customer is unable to pay, it records a bad debt expense.
- This expense is recognized despite no cash payment being received from the customer, a topic we’ll elaborate further in Chapter 7.
- Of course! However, it's vital to understand that expense is attributed to the cost incurred, not the cash paid.
- The cash paid does not trigger the expense; it is the incurring of costs or usage of resources that does.
- For example, if we pay cash for utilities consumed, we would immediately record a debit to Utilities Expense as the same time we paid cash — since the Utilities have already been used, so the cost has been incurred!
Remember: expenses aren't about cash payments but about resource consumption. This understanding will be particularly useful in Chapter 3, where we delve into adjusting journal entries. So keep practicing!
🔹 Accounting Processes and Procedures
The Accounting Cycle
- The cycle always starts with recording individual journal entries.
- Posting always comes directly after journal entries.
- You always see the next three items in this logical order:
- Unadjusted trial balance
- followed by adjusting entries…
- creates the adjusted trial balance
- Remember it as: Unadjusted > Adjusting Entries > Adjusted!
- Preparing financial statements comes right after preparing the adjusted trial balance.
- This is due to the fact that the financial statements are formulated from this "adjusted" data.
- The cycle always ends (i.e. closes) with closing entries, followed by the post-closing trial balance.
- Use these logical associations to your advantage for memorizing the correct order on exams!
This is a systematic process used by businesses to record and organize their financial transactions during an accounting period, as well as to prepare their financial statements.
The following are the steps in the accounting cycle:
This is the process of identifying the business transactions that have a monetary impact on the company.
Once the transactions have been identified, they are recorded in the general journal in chronological order. This record, called a journal entry, includes the date of the transaction, the accounts affected, the amounts to be debited or credited, and a brief description of the transaction.
The next step is to transfer the journal entries to the appropriate ledger accounts. This process of transferring entries is called posting. A ledger account, or T-account, provides a detailed record of all changes that have occurred in an individual account during a period.
Once all transactions have been posted to the ledger, a trial balance is prepared. This is a list of all accounts and their balances at a particular date, showing that total debits equal total credits.
At the end of the accounting period, some accounts may need to be updated with adjusting entries. These include prepayments, accruals, and estimates, to ensure the revenue recognition and matching principles are followed.
After all adjusting entries have been posted to the ledger accounts, a new trial balance is prepared to verify that total debits still equal total credits after the adjustments.
Using the adjusted trial balance, the financial statements are prepared. This typically includes the income statement, statement of retained earnings, balance sheet, and statement of cash flows.
These are journal entries made at the end of an accounting period to transfer the balances of temporary accounts (like revenues, expenses, and dividends) to a permanent equity account, such as retained earnings.
This is the last step in the accounting cycle. It involves preparing a trial balance after the closing entries have been made. This is done to ensure that all temporary accounts have a zero balance and are ready to track transactions in the next accounting period.
Ledger
This is a book or electronic file that contains a separate account for each item affecting the company's financial position, including each revenue and expense.
T-Accounts
T-Accounts are a simplified ledger account, shaped like a T, with debits on the left and credits on the right. It serves as a record of all debits and credits within an account, representing the underlying journal entries that contribute to the ending balance. See below for an example of a T-Account for cash, and how the ending balance can be calculated.
To the following "not-staggered" T-Account:
Which one do you find easier to read? (I’d imagine it’s the staggered one!)
- Remember, what's easier for you to read is also easier for your professor to read while grading your exams!
Chart of Accounts
This is an organized listing of all the company's accounts (assets, liabilities, equity, revenues, expenses, and any contra accounts) along with their account numbers.
Source Documents
These are the original business documents that provide the evidence of a transaction and are the basis for recording transactions. Examples include sales invoices, purchase orders, receipts.
Double Entry Accounting
This is a system that records in appropriate accounts the dual effect of each transaction, ensuring that the accounting equation (Assets = Liabilities + Equity) remains in balance.
🔹 Debits & Credits
📌 For a comprehensive understanding of debits and credits and their impact on the five types of accounts, please refer to the detailed notes provided in the "Items to memorize" section on the right.