Basics
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Overview
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What is an intangible asset? An intangible asset is an asset that you cannot touch. Examples of intangible assets include copyrights, patents, mailing lists, trademarks, brand names, domain names, and so on. Often the market value of an intangible asset is far greater than the market value of a company’s tangible assets such as its buildings and equipment. Accounting principles require that intangible assets be reported on a company’s balance sheet at cost or less. Since many intangible assets are not purchased, they may not have a reportable cost. As a result, many valuable intangible assets are not even reported as assets on the company’s balance sheet.
What is the difference between a debit and a debit balance? A debit is an entry on the left side of an account. For example, the account Cash is debited when cash is received. The account Cash will be credited when cash is paid out. (A credit is an entry on the right side of an account.) If a company’s Cash account has $394,000 of debit amounts and $392,000 of credit amounts, the Cash account will have a debit balance of $2,000. Most asset accounts and expense accounts will have debit balances. If the Cash account had $394,000 of debit amounts and $395,000 of credit amounts, the Cash account will have a credit balance of $1,000. This indicates that it has a negative amount of cash—that the amount of checks written is greater than the money it has received. If a bank deposit is not made prior to its checks clearing the bank, the company’s bank account will overdraw.
What is an account? One definition of an account is a record in the general ledger that is used to collect and store debit and credit amounts. For example, a company will have a Cash account in which every transaction involving cash is recorded. If the company sells merchandise for cash, the Cash account will be debited and the Sales account will be credited. Another definition of an account is a record of a customer relationship. For example, if a company sells merchandise to a customer on credit, there seller will have an account receivable and the purchaser will have an account payable. The term on account means not for cash. For example, if a company purchases merchandise with the terms net 30 days, it means the company has 30 days in which to pay.
Why are assets and expenses increased with a debit? Let’s use two transactions to illustrate why assets and expenses are increased with a debit: 1) A company pays $25,000 for a new delivery van, and 2) A company pays $800 for the current month’s rent. In both of the transactions the company pays cash at the time of the transaction. In each of the transactions the Cash account is credited. Therefore, each transaction will require a debit to another account. (Recall that double entry bookkeeping requires at least one debit and one credit when recording a transaction.) In the first transaction, the debit will be to a long term asset account such as Delivery Vehicles. In this transaction the asset Delivery Vehicles was increased with a debit and the asset Cash was decreased with a credit. The accounting equation (A=L+OE) remains in balance because one asset increased by $25,000 and one asset decreased by $25,000.
In the second transaction, the debit will be to Rent Expense since the amount will be used up in the current accounting period. (If the amount was a prepayment of a future period’s rent, the amount would have been debited to the asset account Prepaid Rent.) Since Rent Expense reduces net income, it also reduces owner’s or stockholders’ equity, which normally have credit balances. The accounting equation will show assets decreasing by the reduction in cash and owner’s or stockholders’ equity decreasing because of the expense. The asset Delivery Vehicle is an asset, but will become Depreciation Expense over the life of the vehicle. The rent is an immediate expense because there is no future accounting period benefiting from the current month’s rent.
How does the accounting equation stay in balance when the monthly rent is paid? A company’s payment of each month’s rent is recorded with a credit to Cash and a debit to Rent Expense. The credit to Cash causes a reduction in the company’s assets. The debit to Rent Expense causes owner’s equity (or stockholders’ equity) to decrease. The reason the debit causes owner’s equity to decrease is that expenses are temporary accounts that will be closed to the owner’s capital account (or to a corporation’s retained earnings account within stockholders’ equity). More examples and explanations of the effect of revenues, expenses, and other transactions can be found at
Which accounts are debited in the closing entries? The closing entry or entries at the end of the accounting year will include 1) a debit to each revenue account that has a credit balance, 2) a debit to each gain account, and 3) a debit to each contra expense account. The amount of each debit entered into an account will be the amount of each account’s credit balance. The closing entry or entries will also include 4) a credit to each expense account that has a debit balance, 5) a credit to each loss account, and 6) a credit to each contra revenue account such as sales returns and allowances. The amount of each credit entered will be the amount of the debit balance in each account. If the debits to the revenue, gain, and contra expense accounts have a total that is greater than the closing entry credits to the expense, loss, and contra revenue accounts, the corporation had a positive net income. The net income amount will be credited to Retained Earnings, either directly or through an Income Summary account. Let’s illustrate this with some numbers. Assume that the revenue, gain, and contra expense accounts had credit balances totaling $600,000; and the expense, loss, and contra revenue accounts had debit balances that totaled $530,000. This will require closing entries resulting in $600,000 of debit amounts, $530,000 of credit amounts, and a $70,000 credit to Retained Earnings. If the expenses and losses were greater than the revenues and gains, there will be a debit to Retained Earnings. The purpose of the closing entries is to end up with a zero balance in every temporary account before starting the next accounting year.
How, when and why do you prepare closing entries? We prepare closing entries for the temporary accounts such as the revenue and expense accounts (see earlier Q&A). The closing entries are recorded after the financial statements for the accounting year are prepared. The reason for the closing entries is to ensure that each revenue and expense account will begin the next accounting year with a zero balance. The closing entries require that a debit be entered into each of the temporary accounts having a credit balance. The debit entered must be exactly the amount of the credit balance prior to the closing entry. The objective is to get the account balance to be zero. The closing entries also require that a credit be entered into each of the temporary accounts having a debit balance. The credit amount that is entered must be exactly the amount of the debit balance prior to the closing entry. The net amount of the debits and credits in the closing entries for the income statement accounts is the amount of the income or loss. This net amount will end up in the balance sheet account Retained Earnings (part of stockholders’ equity of a corporation) or in the owner’s capital account (part of owner’s equity in a sole proprietorship). In manual systems, there is often an Income Summary account before the entry into the equity account. With some accounting software the closing entries are prepared and posted by selecting “closing entries.” With other accounting software, formal closing entries are not used. Instead, the user specifies the beginning and ending dates of the information needed.
What is the difference between adjusting entries and closing entries? Adjusting entries are made at the end of the accounting period (but prior to preparing the financial statements) in order for a company’s accounting records and financial statements to be up-to-date on the accrual basis of accounting. For example, each day the company incurs wages expense but the payroll involving workers’ wages for the last days of the month won’t be entered in the accounting records until after the accounting period ends. Similarly, the company uses electricity each day but receives only one bill per month, perhaps on the 20th day of the month. The electricity expense for the last 10-15 days of the month must get into the accounting records if the financial statements are to show all of the expenses and the amounts owed for the current accounting period. Other adjusting entries involve amounts that the company paid prior to amounts becoming expenses. For examples, the company probably paid its insurance premiums for a six month period prior to the start of the six month period. The company may have deferred the expense by recording the amount in the asset account Prepaid Insurance. During the accounting period some of those premiums expired (were used up) and need to appear as expense in the current accounting period and the asset balance reduced. Closing entries are dated as of the last day of the accounting period, but they are entered into the accounts after the financial statements are prepared. For the most part, closing entries involve the income statement accounts. The closing entries set the balances of all of the revenue accounts and the expense accounts to zero. This means that the revenue and expense accounts will start the new year with nothing in the accounts–allowing the company to easily report the new year revenues and expenses. The net amount of all of the balances from the revenue and expense accounts at the end of the year will end up in retained earnings (for corporations) or owner’s equity (for sole proprietorships). Thanks to accounting software, the closing entries are quite effortless
What are reversing entries and why are they used? Reversing entries are made of the first day of an accounting period in order to remove certain adjusting entries made in the previous accounting period. Reversing entries are used in order to avoid the double counting of revenues or expenses and to allow for the efficient processing of documents. Reversing entries are most often used with accrual-type adjusting entries. To illustrate reversing entries, let’s assume that a retailer uses a temporary help service from December 15 - 31. The temp agency will bill the retailer on January 10 and the retailer agrees to pay the invoice by January 15. If the retailer’s accounting year ends on December 31, the retailer will make an accrual-type adjusting entry for the estimated amount. If the estimated amount is $18,000 the retailer will debit Temp Service Expense for $18,000 and will credit Accrued Expenses Payable for $18,000. This adjusting entry assures that the retailer’s income statement and balance sheet as of December 31 will include the temp service expense and obligation. On January 1, the retailer enters the following reversing entry: debit Accrued Expenses Payable for $18,000 and credit Temp Service Expense for $18,000. When the actual invoice arrives from the temp agency on January 11, the retailer can simply debit the invoice amount to Temp Service Expense. If the invoice is $18,000 the Temp Service Expense will show $-0-. (The credit from the reversing entry and the debit from the invoice entry.) Thanks to the reversing entry, the retailer did not have to stop and consider whether the invoice amount pertains to December or January. If the invoice amount is $18,180 the entire amount is debited to Temp Service Expense and $180 will appear as a January expense. This insignificant amount is acceptable since the adjusting entry amount was an estimate.
Why is the P&L profit entered on the credit side of the balance sheet? The profit or net income belongs to the owner of a sole proprietorship or to the stockholders of a corporation. The owner’s or stockholders’ equity is reported on the credit side of the balance sheet. Recall that the balance sheet reflects the accounting equation, Assets = Liabilities + Owner’s Equity. Let’s illustrate this with an example. Assume that you own a sole proprietorship and you provided a service to a customer. One of your business assets (cash or accounts receivable) increased and your liabilities were not involved. Therefore, your business liabilities will remain the same and your equity in the business will increase. Accountants prepare an income statement or P&L to report the revenues and expenses, but the ultimate effect is that the business assets and owner’s equity will increase when there is a profit or net income.
What is stock? In accounting there are two common uses of the term stock. One meaning of stock refers to the goods on hand which is to be sold to customers. In that situation, stock means inventory. The term stock is also used to mean the ownership shares of a corporation. For example, an owner of a corporation will have a stock certificate which provides evidence of his or her ownership of a corporation’s common stock or preferred stock. The owner of the corporation’s common or preferred stock is known as a stockholder.
What is the difference between a debit and a debit balance? A debit is an entry on the left side of an account. For example, the account Cash is debited when cash is received. The account Cash will be credited when cash is paid out. (A credit is an entry on the right side of an account.) If a company’s Cash account has $394,000 of debit amounts and $392,000 of credit amounts, the Cash account will have a debit balance of $2,000. Most asset accounts and expense accounts will have debit balances. If the Cash account had $394,000 of debit amounts and $395,000 of credit amounts, the Cash account will have a credit balance of $1,000. This indicates that it has a negative amount of cash—that the amount of checks written is greater than the money it has received. If a bank deposit is not made prior to its checks clearing the bank, the company’s bank account will overdraw.
What is an account? One definition of an account is a record in the general ledger that is used to collect and store debit and credit amounts. For example, a company will have a Cash account in which every transaction involving cash is recorded. If the company sells merchandise for cash, the Cash account will be debited and the Sales account will be credited. Another definition of an account is a record of a customer relationship. For example, if a company sells merchandise to a customer on credit, there seller will have an account receivable and the purchaser will have an account payable. The term on account means not for cash. For example, if a company purchases merchandise with the terms net 30 days, it means the company has 30 days in which to pay.
Why are assets and expenses increased with a debit? Let’s use two transactions to illustrate why assets and expenses are increased with a debit: 1) A company pays $25,000 for a new delivery van, and 2) A company pays $800 for the current month’s rent. In both of the transactions the company pays cash at the time of the transaction. In each of the transactions the Cash account is credited. Therefore, each transaction will require a debit to another account. (Recall that double entry bookkeeping requires at least one debit and one credit when recording a transaction.) In the first transaction, the debit will be to a long term asset account such as Delivery Vehicles. In this transaction the asset Delivery Vehicles was increased with a debit and the asset Cash was decreased with a credit. The accounting equation (A=L+OE) remains in balance because one asset increased by $25,000 and one asset decreased by $25,000.
In the second transaction, the debit will be to Rent Expense since the amount will be used up in the current accounting period. (If the amount was a prepayment of a future period’s rent, the amount would have been debited to the asset account Prepaid Rent.) Since Rent Expense reduces net income, it also reduces owner’s or stockholders’ equity, which normally have credit balances. The accounting equation will show assets decreasing by the reduction in cash and owner’s or stockholders’ equity decreasing because of the expense. The asset Delivery Vehicle is an asset, but will become Depreciation Expense over the life of the vehicle. The rent is an immediate expense because there is no future accounting period benefiting from the current month’s rent.
How does the accounting equation stay in balance when the monthly rent is paid? A company’s payment of each month’s rent is recorded with a credit to Cash and a debit to Rent Expense. The credit to Cash causes a reduction in the company’s assets. The debit to Rent Expense causes owner’s equity (or stockholders’ equity) to decrease. The reason the debit causes owner’s equity to decrease is that expenses are temporary accounts that will be closed to the owner’s capital account (or to a corporation’s retained earnings account within stockholders’ equity). More examples and explanations of the effect of revenues, expenses, and other transactions can be found at
Which accounts are debited in the closing entries? The closing entry or entries at the end of the accounting year will include 1) a debit to each revenue account that has a credit balance, 2) a debit to each gain account, and 3) a debit to each contra expense account. The amount of each debit entered into an account will be the amount of each account’s credit balance. The closing entry or entries will also include 4) a credit to each expense account that has a debit balance, 5) a credit to each loss account, and 6) a credit to each contra revenue account such as sales returns and allowances. The amount of each credit entered will be the amount of the debit balance in each account. If the debits to the revenue, gain, and contra expense accounts have a total that is greater than the closing entry credits to the expense, loss, and contra revenue accounts, the corporation had a positive net income. The net income amount will be credited to Retained Earnings, either directly or through an Income Summary account. Let’s illustrate this with some numbers. Assume that the revenue, gain, and contra expense accounts had credit balances totaling $600,000; and the expense, loss, and contra revenue accounts had debit balances that totaled $530,000. This will require closing entries resulting in $600,000 of debit amounts, $530,000 of credit amounts, and a $70,000 credit to Retained Earnings. If the expenses and losses were greater than the revenues and gains, there will be a debit to Retained Earnings. The purpose of the closing entries is to end up with a zero balance in every temporary account before starting the next accounting year.
How, when and why do you prepare closing entries? We prepare closing entries for the temporary accounts such as the revenue and expense accounts (see earlier Q&A). The closing entries are recorded after the financial statements for the accounting year are prepared. The reason for the closing entries is to ensure that each revenue and expense account will begin the next accounting year with a zero balance. The closing entries require that a debit be entered into each of the temporary accounts having a credit balance. The debit entered must be exactly the amount of the credit balance prior to the closing entry. The objective is to get the account balance to be zero. The closing entries also require that a credit be entered into each of the temporary accounts having a debit balance. The credit amount that is entered must be exactly the amount of the debit balance prior to the closing entry. The net amount of the debits and credits in the closing entries for the income statement accounts is the amount of the income or loss. This net amount will end up in the balance sheet account Retained Earnings (part of stockholders’ equity of a corporation) or in the owner’s capital account (part of owner’s equity in a sole proprietorship). In manual systems, there is often an Income Summary account before the entry into the equity account. With some accounting software the closing entries are prepared and posted by selecting “closing entries.” With other accounting software, formal closing entries are not used. Instead, the user specifies the beginning and ending dates of the information needed.
What is the difference between adjusting entries and closing entries? Adjusting entries are made at the end of the accounting period (but prior to preparing the financial statements) in order for a company’s accounting records and financial statements to be up-to-date on the accrual basis of accounting. For example, each day the company incurs wages expense but the payroll involving workers’ wages for the last days of the month won’t be entered in the accounting records until after the accounting period ends. Similarly, the company uses electricity each day but receives only one bill per month, perhaps on the 20th day of the month. The electricity expense for the last 10-15 days of the month must get into the accounting records if the financial statements are to show all of the expenses and the amounts owed for the current accounting period. Other adjusting entries involve amounts that the company paid prior to amounts becoming expenses. For examples, the company probably paid its insurance premiums for a six month period prior to the start of the six month period. The company may have deferred the expense by recording the amount in the asset account Prepaid Insurance. During the accounting period some of those premiums expired (were used up) and need to appear as expense in the current accounting period and the asset balance reduced. Closing entries are dated as of the last day of the accounting period, but they are entered into the accounts after the financial statements are prepared. For the most part, closing entries involve the income statement accounts. The closing entries set the balances of all of the revenue accounts and the expense accounts to zero. This means that the revenue and expense accounts will start the new year with nothing in the accounts–allowing the company to easily report the new year revenues and expenses. The net amount of all of the balances from the revenue and expense accounts at the end of the year will end up in retained earnings (for corporations) or owner’s equity (for sole proprietorships). Thanks to accounting software, the closing entries are quite effortless
What are reversing entries and why are they used? Reversing entries are made of the first day of an accounting period in order to remove certain adjusting entries made in the previous accounting period. Reversing entries are used in order to avoid the double counting of revenues or expenses and to allow for the efficient processing of documents. Reversing entries are most often used with accrual-type adjusting entries. To illustrate reversing entries, let’s assume that a retailer uses a temporary help service from December 15 - 31. The temp agency will bill the retailer on January 10 and the retailer agrees to pay the invoice by January 15. If the retailer’s accounting year ends on December 31, the retailer will make an accrual-type adjusting entry for the estimated amount. If the estimated amount is $18,000 the retailer will debit Temp Service Expense for $18,000 and will credit Accrued Expenses Payable for $18,000. This adjusting entry assures that the retailer’s income statement and balance sheet as of December 31 will include the temp service expense and obligation. On January 1, the retailer enters the following reversing entry: debit Accrued Expenses Payable for $18,000 and credit Temp Service Expense for $18,000. When the actual invoice arrives from the temp agency on January 11, the retailer can simply debit the invoice amount to Temp Service Expense. If the invoice is $18,000 the Temp Service Expense will show $-0-. (The credit from the reversing entry and the debit from the invoice entry.) Thanks to the reversing entry, the retailer did not have to stop and consider whether the invoice amount pertains to December or January. If the invoice amount is $18,180 the entire amount is debited to Temp Service Expense and $180 will appear as a January expense. This insignificant amount is acceptable since the adjusting entry amount was an estimate.
Why is the P&L profit entered on the credit side of the balance sheet? The profit or net income belongs to the owner of a sole proprietorship or to the stockholders of a corporation. The owner’s or stockholders’ equity is reported on the credit side of the balance sheet. Recall that the balance sheet reflects the accounting equation, Assets = Liabilities + Owner’s Equity. Let’s illustrate this with an example. Assume that you own a sole proprietorship and you provided a service to a customer. One of your business assets (cash or accounts receivable) increased and your liabilities were not involved. Therefore, your business liabilities will remain the same and your equity in the business will increase. Accountants prepare an income statement or P&L to report the revenues and expenses, but the ultimate effect is that the business assets and owner’s equity will increase when there is a profit or net income.
What is stock? In accounting there are two common uses of the term stock. One meaning of stock refers to the goods on hand which is to be sold to customers. In that situation, stock means inventory. The term stock is also used to mean the ownership shares of a corporation. For example, an owner of a corporation will have a stock certificate which provides evidence of his or her ownership of a corporation’s common stock or preferred stock. The owner of the corporation’s common or preferred stock is known as a stockholder.
