Financial Statements

Financial Statements
Financial accounting generates the following general-purpose, external, financial statements:
1. Income statement (sometimes referred to as "results of operations" or "earnings

statement" or "profit and loss [P&L] statement")
2. Statement of comprehensive income
3. Balance sheet (sometimes referred to as "statement of financial position")
4. Statement of cash flows (sometimes referred to as "cash flow statement")
5. Statement of stockholders' equity
Income Statement
The income statement reports a company's profitability during a specified period of time. The
period of time could be one year, one month, three months, 13 weeks, or any other time interval
chosen by the company.
The main components of the income statement are revenues, expenses, gains, and losses.
Revenues include such things as sales, service revenues, and interest revenue. Expenses
include the cost of goods sold, operating expenses (such as salaries, rent, utilities, advertising),
and nonoperating expenses (such as interest expense). If a corporation's stock is publicly traded,
the earnings per share of its common stock are reported on the income statement. (To learn
more about the income statement, visit our Explanation of Income Statement.)
Statement of Comprehensive Income

The statement of comprehensive income covers the same period of time as the income
statement, and consists of two major sections:
 Net income (taken from the income statement)

 Other comprehensive income (adjustments involving foreign currency translation, hedging,
and postretirement benefits)
The sum of these two amounts is known as comprehensive income.
The amount of other comprehensive income is added/subtracted from the balance in the
stockholders' equity account Accumulated Other Comprehensive Income.
Balance Sheet
The balance sheet is organized into three parts: (1) assets, (2) liabilities, and (3) stockholders'
equity at a specified date (typically, this date is the last day of an accounting period).
The first section of the balance sheet reports the company's assets and includes such things as
cash, accounts receivable, inventory, prepaid insurance, buildings, and equipment. The next
section reports the company's liabilities; these are obligations that are due at the date of the
balance sheet and often include the word "payable" in their title (Notes Payable, Accounts
Payable, Wages Payable, and Interest Payable). The final section is stockholders' equity, defined
as the difference between the amount of assets and the amount of liabilities. (To learn more
about the balance sheet, visit our Explanation of Balance Sheet.)
Statement of Cash Flows

The statement of cash flows explains the change in a company's cash (and cash equivalents)
during the time interval indicated in the heading of the statement. The change is divided into
three parts: (1) operating activities, (2) investing activities, and (3) financing activities.
The operating activities section explains how a company's cash (and cash equivalents) have
changed due to operations. Investing activities refer to amounts spent or received in transactions
involving long-term assets. The financing activities section reports such things as cash received
through the issuance of long-term debt, the issuance of stock, or money spent to retire long-term
liabilities. (To learn more about the statement of cash flows, visit our Explanation of Cash Flow
Statement.)
Statement of Stockholders' Equity

The statement of stockholders' (or shareholders') equity lists the changes in stockholders' equity
for the same period as the income statement and the cash flow statement. The changes will
include items such as net income, other comprehensive income, dividends, the repurchase of
common stock, and the exercise of stock options.
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Financial Reporting
Financial reporting is a broader concept than financial statements. In addition to the financial
statements, financial reporting includes the company's annual report to stockholders, its annual
report to the Securities and Exchange Commission (Form 10-K), its proxy statement, and other
financial information reported by the company.
Introduction to Debits and Credits

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What are debits and credits?

Debits and credits are terms used by bookkeepers and accountants when recording transactions
in the accounting records. The amount in every transaction must be entered in one account as a
debit (left side of the account) and in another account as a credit (right side of the account).
This double-entry system provides accuracy in the accounting records and financial statements.
The initial challenge is understanding which account will have the debit entry and which account
will have the credit entry. Before we explain and illustrate the debits and credits in accounting
and bookkeeping, we will discuss the accounts in which the debits and credits will be entered or
posted.
What Is An Account?
To keep a company's financial data organized, accountants developed a system that sorts
transactions into records called accounts. When a company's accounting system is set up, the
accounts most likely to be affected by the company's transactions are identified and listed out.
This list is referred to as the company's chart of accounts. Depending on the size of a company
and the complexity of its business operations, the chart of accounts may list as few as thirty
accounts or as many as thousands. A company has the flexibility of tailoring its chart of accounts
to best meet its needs.
Within the chart of accounts the balance sheet accounts are listed first, followed by the income
statement accounts. In other words, the accounts are organized in the chart of accounts as
follows:
 Assets
 Liabilities
 Owner's (Stockholders') Equity
 Revenues or Income
 Expenses
 Gains
 Losses
Click here to see a sample chart of accounts.
Double-Entry Accounting
Because every business transaction affects at least two accounts, our accounting system is
known as a double-entry system. (You can refer to the company's chart of accounts to select the
proper accounts. Accounts may be added to the chart of accounts when an appropriate account
cannot be found.)
For example, when a company borrows $1,000 from a bank, the transaction will affect the
company's Cash account and the company's Notes Payable account. When the company repays
the bank loan, the Cash account and the Notes Payable account are also involved.
If a company buys supplies for cash, its Supplies account and its Cash account will be affected. If
the company buys supplies on credit, the accounts involved are Supplies and Accounts Payable.
If a company pays the rent for the current month, Rent Expense and Cash are the two accounts
involved. If a company provides a service and gives the client 30 days in which to pay, the
company's Service Revenues account and Accounts Receivable are affected.
Although the system is referred to as double-entry, a transaction may involve more than two
accounts. An example of a transaction that involves three accounts is a company's loan payment
to its bank of $300. This transaction will involve the following accounts: Cash, Notes Payable,
and Interest Expense.
(If you use accounting software you may not actually see that two or more accounts are being
affected due to the user-friendly nature of the software. For example, let's say that you write a
company check by means of your accounting software. Your software automatically reduces your
Cash account and prompts you only for the other accounts affected.)
Special Feature: Review what you are learning by working the three interactive crossword
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Click here for the Debits and Credits Crossword Puzzles
Debits and Credits

After you have identified the two or more accounts involved in a business transaction, you must
debit at least one account and credit at least one account.
To debit an account means to enter an amount on the left side of the account. To credit an
account means to enter an amount on the right side of an account.
Here's a Tip
Debit means left
Credit means right
Generally these types of accounts are increased with a debit:
Dividends (Draws)
Expenses
Assets
Losses
You might think of D - E - A - L when recalling the accounts that are increased with a debit.
Generally the following types of accounts are increased with a credit:
Gains
Income
Revenues
Liabilities
Stockholders' (Owner's) Equity
You might think of G - I - R - L - S when recalling the accounts that are increased with a credit.
To decrease an account you do the opposite of what was done to increase the account. For
example, an asset account is increased with a debit. Therefore it is decreased with a credit.
The abbreviation for debit is dr. and the abbreviation for credit is cr.
Debits and Credits(Crossword

Puzzles)
Debits and Credits #1
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Debits and credits are part of double-entry accounting and bookkeeping. Recording a transaction
in a double-entry system requires at least one account to have an amount entered as a debit—
which means entered on the left side of an account. It also requires that at least one account will
have an amount entered as a credit—which means entered on the right side of an account. Each
transaction must have the total of the debit amounts equal to the total of the credit amounts.
To increase the balance in an asset or expense account, you enter an amount as a debit. To
decrease the balance in an asset or expense account, you enter an amount as a credit.
Liabilities, revenues, and stockholders' (owner's) equity accounts are increased with a credit.
They are decreased with a debit.
Here are five examples to illustrate debits and credits:
 If a company borrows $5,000 from the bank, the company will debit Cash (because this
asset increased) and will credit Notes Payable (because this liability increased).
 When a company collects $400 from its customers who were billed earlier, the company
will debit Cash (because this asset is increased) and will credit Accounts Receivable
(because this asset decreased).
 If a company bills a client for a service, the company will debit Accounts Receivable
(because this asset increased) and will credit Service Revenues (because revenues
increased and that in turn increases owner's equity).
 When a company pays $600 for the current month's rent, the company will debit Rent
Expense (because expenses increased and that in turn decreases owner's equity) and will
credit Cash (because this asset decreased).
 If J. Smith, a sole proprietor, withdraws $300 from the business for personal use, the
business will debit the account J. Smith, Drawing (because owner's equity decreased) and
will credit Cash (because the asset decreased).
Periodically, a trial balance is prepared to prove that the total of the debit balances in the
accounts is equal to the total of the credit balances in the accounts.
Introduction to Chart of Accounts

A chart of accounts is a listing of the names of the accounts that a company has identified and
made available for recording transactions in its general ledger. A company has the flexibility to
tailor its chart of accounts to best suit its needs, including adding accounts as needed.
Within the chart of accounts you will find that the accounts are typically listed in the following
order:
Within the categories of operating revenues and operating expenses, accounts might be further
organized by business function (such as producing, selling, administrative, financing) and/or by
company divisions, product lines, etc.
A company's organization chart can serve as the outline for its accounting chart of accounts. For
example, if a company divides its business into ten departments (production, marketing, human
resources, etc.), each department will likely be accountable for its own expenses (salaries,
supplies, phone, etc.). Each department will have its own phone expense account, its own
salaries expense, etc.
A chart of accounts will likely be as large and as complex as the company itself. An international
corporation with several divisions may need thousands of accounts, whereas a small local
retailer may need as few as one hundred accounts.
T-accounts
Accountants and bookkeepers often use T-accounts as a visual aid to see the effect of a
transaction or journal entry on the two (or more) accounts involved.
To learn more about the role of bookkeepers and accountants, visit our topic Accounting Careers.
We will begin with two T-accounts: Cash and Notes Payable.
Let's demonstrate the use of these T-accounts with two transactions:
1. On June 1, 2020 a company borrows $5,000 from its bank. As a result, the company's
asset Cash must be increased by $5,000 and its liability Notes Payable must be
increased by $5,000. To increase the asset Cash the account needs to be debited. To
increase the company's liability Notes Payable this account needs to be credited. After
entering the debits and credits the T-accounts look like this:
2. On June 2, 2020 the company repays $2,000 of the bank loan. As a result, the
company's asset Cash must be decreased by $2,000 and its liability Notes Payable must
be decreased by $2,000. To reduce the asset Cash the account will need to be credited
for $2,000. To decrease the liability Notes Payable that account will need to be debited
for $2,000. The T-accounts now look like this:
Journal Entries
Another way to visualize business transactions is to write a general journal entry. Each general
journal entry lists the date, the account title(s) to be debited and the corresponding amount(s)
followed by the account title(s) to be credited and the corresponding amount(s). The accounts to
be credited are indented. Let's illustrate the general journal entries for the two transactions that
were shown in the T-accounts above.
When Cash Is Debited and Credited

Because cash is involved in many transactions, it is helpful to memorize the following:
 Whenever cash is received, debit Cash.

 Whenever cash is paid out, credit Cash.
With the knowledge of what happens to the Cash account, the journal entry to record the debits
and credits is easier. Let's assume that a company receives $500 on June 3, 2020 from a
customer who was given 30 days in which to pay. (In May the company had recorded the sale
and an accounts receivable.) On June 3 the company will debit Cash, because cash was
received. The amount of the debit and the credit is $500. Entering this information in the general
journal format, we have:
All that remains to be entered is the name of the account to be credited. Since this was the
collection of an account receivable, the credit should be Accounts Receivable. (Because the sale
was already recorded in May, you cannot enter Sales again on June 3.)
On June 4 the company paid $300 to a supplier for merchandise the company received in May.
(In May the company recorded the purchase and the accounts payable.) On June 4 the company
will credit Cash, because cash was paid. The amount of the debit and credit is $300. Entering
them in the general journal format, we have:
All that remains to be entered is the name of the account to be debited. Since this was the
payment on an account payable, the debit should be Accounts Payable. (Because the purchase
was already recorded in May, you cannot enter Purchases or Inventory again on June 4.)
To help you become comfortable with the debits and credits in accounting, memorize the
following tip:
Here's a Tip
Whenever cash is received, the Cash account is debited (and another account is credited).
Whenever cash is paid out, the Cash account is credited (and another account is debited).
Normal Balances
When looking at an account in the general ledger, the following is the debit or credit balance you
would normally find in the account:
Revenues and Gains Are Usually

Credited
Revenues and gains are recorded in accounts such as Sales, Service Revenues, Interest
Revenues (or Interest Income), and Gain on Sale of Assets. These accounts normally have credit
balances that are increased with a credit entry. In a T-account, their balances will be on the right
side.
The exceptions to this rule are the accounts Sales Returns, Sales Allowances, and Sales Discounts—
these accounts have debit balances because they are reductions to sales. Accounts with
balances that are the opposite of the normal balance are called contra accounts; hence contra
revenue accounts will have debit balances.
Let's illustrate revenue accounts by assuming your company performed a service and was
immediately paid the full amount of $50 for the service. The debits and credits are presented in
the following general journal format:
Whenever cash is received, the asset account Cash is debited and another account will need to
be credited. Since the service was performed at the same time as the cash was received, the
revenue account Service Revenues is credited, thus increasing its account balance.
Let's illustrate how revenues are recorded when a company performs a service on credit (i.e., the
company allows the client to pay for the service at a later date, such as 30 days from the date of
the invoice). At the time the service is performed the revenues are considered to have been
earned and they are recorded in the revenue account Service Revenues with a credit. The other
account involved, however, cannot be the asset Cash since cash was not received. The account
to be debited is the asset account Accounts Receivable. Assuming the amount of the service
performed is $400, the entry in general journal form is:
Accounts Receivable is an asset account and is increased with a debit; Service Revenues is
increased with a credit.
Expenses and Losses are Usually

Debited
Expenses normally have debit balances that are increased with a debit entry. Since expenses are
usually increasing, think "debit" when expenses are incurred. (We credit expenses only to reduce
them, adjust them, or to close the expense accounts.) Examples of expense accounts
include Salaries Expense, Wages Expense, Rent Expense, Supplies Expense, and Interest Expense. In a
T-account, their balances will be on the left side.
To illustrate an expense let's assume that on June 1 your company paid $800 to the landlord for
the June rent. The debits and credits are shown in the following journal entry:
Since cash was paid out, the asset account Cash is credited and another account needs to be
debited. Because the rent payment will be used up in the current period (the month of June) it is
considered to be an expense, and Rent Expense is debited. If the payment was made on June 1
for a future month (for example, July) the debit would go to the asset account Prepaid Rent.
As a second example of an expense, let's assume that your hourly paid employees work the last
week in the year but will not be paid until the first week of the next year. At the end of the year,
the company makes an entry to record the amount the employees earned but have not been
paid. Assuming the employees earned $1,900 during the last week of the year, the entry in
general journal form is:
As noted earlier, expenses are almost always debited, so we debit Wages Expense, increasing
its account balance. Since your company did not yet pay its employees, the Cash account
is not credited, instead, the credit is recorded in the liability account Wages Payable. A credit to a
liability account increases its credit balance.
To help you get more comfortable with debits and credits in accounting and bookkeeping,
memorize the following tip:
Here's a Tip
To increase an expense account, debit the account.
Permanent and Temporary Accounts

Asset, liability, and most owner/stockholder equity accounts are referred to as permanent
accounts (or real accounts). Permanent accounts are not closed at the end of the accounting
year; their balances are automatically carried forward to the next accounting year.
Temporary accounts (or nominal accounts) include all of the revenue accounts, expense accounts,
the owner's drawing account, and the income summary account. Generally speaking, the
balances in temporary accounts increase throughout the accounting year. At the end of the
accounting year the balances will be transferred to the owner's capital account or to a
corporation's retained earnings account.
Because the balances in the temporary accounts are transferred out of their respective accounts
at the end of the accounting year, each temporary account will have a zero balance when the
next accounting year begins. This means that the new accounting year starts with no revenue
amounts, no expense amounts, and no amount in the drawing account.
By having many revenue accounts and a huge number of expense accounts, a company will be
able to report detailed information on revenues and expenses throughout the year.
Bank's Debits and Credits
When you hear your banker say, "I'll credit your checking account," it means the transaction
will increase your checking account balance. Conversely, if your bank debits your account (e.g.,
takes a monthly service charge from your account) your checking account balance decreases.
If you are new to the study of debits and credits in accounting, this may seem puzzling. After all,
you learned that debiting the Cash account in the general ledger increases its balance, yet your
bank says it is crediting your checking account to increase its balance. Similarly, you learned
that crediting the Cash account in the general ledger reduces its balance, yet your bank says it
is debiting your checking account to reduce its balance.
Although the above may seem contradictory, we will illustrate below that a bank's treatment of
debits and credits is indeed consistent with the basic accounting procedure that you learned.
Let's look at three transactions and consider the related journal entries from both the bank's
perspective and the company's perspective.
Transaction #1
Let's say that your company, Debris Disposal, receives $100 of currency from a customer as a
down payment for a future site cleanup service. When the money is received your company
makes the following entry:
(Debris Disposal's journal entry)
Because it has received cash, Debris Disposal increases its Cash account with a debit of $100.
The rules of double-entry accounting require Debris Disposal to also enter a credit of $100 into
another of its general ledger accounts. Since the company has not yet earned the $100, it cannot
credit a revenue account. Instead, the liability account Unearned Revenues is credited because
Debris Disposal has a liability to do the work or to return the $100. (An alternate title for the
Unearned Revenues account is Customer Deposits.)
Now let's say you take that $100 to Trustworthy Bank and deposit it into Debris Disposal's
checking account. Since trustworthy Bank is receiving cash of $100, the bank debits its general
ledger Cash account for $100, thereby increasing the bank's assets. The rules of double-entry
accounting require the bank to also enter a credit of $100 into another of the bank's general
ledger accounts. Because the bank has not earned the $100, it cannot credit a revenue account.
Instead, the bank credits a liability account such as Customers' Checking Accounts to reflect the
bank's obligation/liability to return the $100 to Debris Disposal on demand. In general journal
format the bank's entry is:
(Trustworthy Bank's journal entry)
As the entry shows, the bank's assets increase by the debit of $100 and the bank's liabilities
increase by the credit of $100. The bank's detailed records show that Debris Disposal's checking
account is the specific liability that increased.
Transaction #2
Let's say Trustworthy Bank receives a $1,000 wire transfer on your company's behalf from a
person who owes money to Debris Disposal. Two things happen at the bank: (1) The bank
receives $1,000, and (2) the bank records its obligation to give the money to Debris Disposal on
demand. These two facts are entered into the bank's general ledger as follows:
(Trustworthy Bank's journal entry)
The debit increases the bank's assets by $1,000 and the credit increases the bank's liabilities by
$1,000. The bank's detailed records show that Debris Disposal's checking account is the specific
liability that increased.
At the same time the $1,000 wire transfer is received at the bank, Debris Disposal makes the
following entry into its general ledger:
(Debris Disposal's journal entry)
As a result of collecting $1,000 from one of its customers, Debris Disposal's Cash balance
increases and its Accounts Receivable balance decreases.
Transaction #3
Many banks charge a monthly fee on checking accounts. If Trustworthy Bank decreases Debris
Disposal's checking account balance by $13.00 to pay for the bank's monthly service charge, this
might be itemized on Debris Disposal's bank statement as a "debit memo." The entry in the
bank's records will show the bank's liability being reduced (because the bank owes Debris
Disposal $13 less). It also shows that the bank earned revenues of $13 by servicing the checking
account.
(Trustworthy Bank's general ledger)

On your company's records, the entry will look like this:
(Debris Disposal's general ledger)
Debris Disposal's cash is reduced with a credit of $13 and expenses are increased with a debit of
$13. (If the amount of the bank's service charges is not significant a company may debit the
charge to Miscellaneous Expense.)
Bank's Balance Sheet

Accounts such as Cash, Investment Securities, and Loans Receivable are reported as assets on the
bank's balance sheet. Customers' bank accounts are reported as liabilities and include the
balances in its customers' checking and savings accounts as well as certificates of deposit. In
effect, your bank statement is just one of thousands of subsidiary records that account for millions
of dollars that a bank owes to its depositors.
Recap
Here are some of the highlights from this explanation:
 Debit means left.

 Credit means right.
 Every transaction affects two accounts or more.
 At least one account will be debited and at least one account will be credited.
 The total of the amount(s) entered as debits must equal the total of the amount(s)
entered as credits.
 When cash is received, debit Cash.
 When cash is paid out, credit Cash.
 To increase an asset, debit the asset account.
 To increase a liability, credit the liability account.
 To increase owner's equity, credit an owner's equity account.
 To increase revenues, credit the revenues account
 A credit to a revenue account also causes an increase in owner's equity
 To increase expenses, debit the expense account
 A debit to an expense account also causes a decrease in owner's equity
Introduction to the Accounting

Equation
Did you know? To make the Accounting Equation topic even easier to understand, we created a collection
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accounting equation visual tutorial, cheat sheet, flashcards, quick test, and more.
From the large, multi-national corporation down to the corner beauty salon, every business
transaction will have an effect on a company's financial position. The financial position of a
company is measured by the following items:
1. Assets (what it owns)

2. Liabilities (what it owes to others)
3. Owner's Equity (the difference between assets and liabilities)
The accounting equation (or basic accounting equation) offers us a simple way to understand
how these three amounts relate to each other. The accounting equation for a sole proprietorship
is:
The accounting equation for a corporation is:
Assets are a company's resources—things the company owns. Examples of assets include cash,
accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and
goodwill. From the accounting equation, we see that the amount of assets must equal the
combined amount of liabilities plus owner's (or stockholders') equity.
Liabilities are a company's obligations—amounts the company owes. Examples of liabilities
include notes or loans payable, accounts payable, salaries and wages payable, interest payable,
and income taxes payable (if the company is a regular corporation). Liabilities can be viewed in
two ways:
(1) as claims by creditors against the company's assets, and
(2) as sources (along with owner's or stockholders' equity) of the company's assets.
Owner's equity or stockholders' equity is the amount remaining after liabilities are deducted from
assets:
Assets - Liabilities = Owner's (or Stockholders') Equity.
Owner's or stockholders' equity also reports the amounts invested into the company by the
owners plus the cumulative net income of the company that has not been withdrawn or distributed
to the owners.
If a company keeps accurate records using the double-entry system, the accounting equation will
always be "in balance," meaning the left side of the equation will be equal to the right side. The
balance is maintained because every business transaction affects at least two of a company's
accounts. For example, when a company borrows money from a bank, the company's assets will
increase and its liabilities will increase by the same amount. When a company purchases
inventory for cash, one asset will increase and one asset will decrease. Because there are two or
more accounts affected by every transaction, the accounting system is referred to as the double-
entry accounting or bookkeeping system.
A company keeps track of all of its transactions by recording them in accounts contained in the
company's general ledger. Each account in the general ledger is designated as to its type: asset,
liability, owner's equity, revenue, expense, gain, or loss account.
Balance Sheet and Income Statement

The balance sheet is also known as the statement of financial position and it reflects the
accounting equation. The balance sheet reports a company's assets, liabilities, and owner's (or
stockholders') equity at a specific point in time. Like the accounting equation, it shows that a
company's total amount of assets equals the total amount of liabilities plus owner's (or
stockholders') equity.
The income statement is the financial statement that reports a company's revenues and expenses
and the resulting net income. While the balance sheet is concerned with one point in time, the
income statement covers a time interval or period of time. The income statement will explain part
of the change in the owner's or stockholders' equity during the time interval between two balance
sheets.
Accounting Equation for a Sole

Proprietorship: Transactions 1-2
We present eight transactions to illustrate how a company's accounting equation stays in
balance.
When a company records a business transaction, it is not entered into an accounting

equation, per se. Rather, transactions are recorded into specific accounts contained in the
company's general ledger. Each account is designated as an asset, liability, owner's equity,
revenue, expense, gain, or loss account. The amounts in the general ledger accounts are then
used to prepare the balance sheets and income statements.
In our transactions, we will use the following accounts:
 Cash
 Accounts Receivable
 Equipment
 Notes Payable
 Accounts Payable
 J. Ott, Capital
 J. Ott, Drawing
 Service Revenues
 Advertising Expense
 Temp Service Expense
(To view a more complete listing of accounts for recording transactions, visit our Explanation of
Chart of Accounts.)
Sole Proprietorship Transaction #1.

Let's assume that J. Ott forms a sole proprietorship called Accounting Software Co. (ASC). On
December 1, 2020, J. Ott invests personal funds of $10,000 to start ASC. The effect of this
transaction on ASC's accounting equation is:
As you can see, ASC's assets increase by $10,000 and so does ASC's owner's equity. As a
result, the accounting equation will be in balance.
You can interpret the amounts in the accounting equation to mean that ASC has assets of
$10,000 and the source of those assets was the owner, J. Ott. Alternatively, you can view the
accounting equation to mean that ASC has assets of $10,000 and there are no claims by
creditors (liabilities) against the assets. As a result, the owner has a claim for the remainder or
residual of $10,000.
This transaction is recorded in the asset account Cash and the owner's equity account J. Ott,
Capital. The general journal entry to record the transaction in these accounts is:
After the journal entry is recorded in the accounts, a balance sheet can be prepared to show
ASC's financial position at the end of December 1, 2020:
The purpose of an income statement is to report revenues and expenses. Since ASC has not yet
earned any revenues nor incurred any expenses, there are no amounts to be reported on an
income statement.

On December 2, 2020, J. Ott withdraws $100 of cash from the business for his personal use. The
effect of this transaction on ASC's accounting equation is:
The accounting equation remains in balance since ASC's assets have been reduced by $100
and so has the owner's equity.
This transaction is recorded in the asset account Cash and the owner's equity account J. Ott,
Drawing. The general journal entry to record the transactions in these accounts is:
Since the transactions of December 1 and December 2 were in balance, the sum of both
transactions should also be in balance:
The totals indicate that ASC has assets of $9,900 and the source of those assets is the owner of
the company. You can also conclude that the company has assets or resources of $9,900 and
the only claim against those resources is the owner's claim.
The December 2 balance sheet will communicate the company's financial position as of midnight
on December 2:
Withdrawals of company assets by the owner for the owner's personal use are known as
"draws." Since draws are not expenses, the transaction is not reported on the company's income
statement.

On December 3, 2020, Accounting Software Co. spends $5,000 of cash to purchase computer
equipment for use in the business. The effect of this transaction on the accounting equation is:
The accounting equation reflects that one asset increases and another asset decreases. Since
the amount of the increase is the same as the amount of the decrease, the accounting equation
remains in balance.
This transaction is recorded in the asset accounts Equipment and Cash. The Equipment account
increases by $5,000, and the Cash account decreases by $5,000. The journal entry for this
transactions is:
The combined effect of the first three transactions is shown here:
The totals tell us that the company has assets of $9,900 and the source of those assets is the
owner of the company. It also tells us that the company has assets of $9,900 and the only claim
against those assets is the owner's claim.
The balance sheet dated December 3, 2020, will reflect the financial position as of midnight on
December 3:
The purchase of equipment is not an immediate expense. It will become part of depreciation
expense only after it is placed into service. We will assume that as of December 3 the equipment
has not been placed into service, therefore, no expense will appear on an income statement for
the period of December 1 through December 3.

On December 4, 2020, ASC obtains $7,000 by borrowing money from its bank. The effect of this
transaction on the accounting equation is:
As you can see, ASC's assets increase and ASC's liabilities increase by $7,000.
This transaction is recorded in the asset account Cash and the liability account Notes Payable as
shown in this accounting entry:
The combined effect on the accounting equation from the first four transactions is available here:
The totals indicate that the transactions through December 4 result in assets of $16,900. There
are two sources for those assets—the creditors provided $7,000 of assets, and the owner of the
company provided $9,900. You can also interpret the accounting equation to say that the
company has assets of $16,900 and the lenders have a claim of $7,000 and the owner has a
claim for the remainder.
The balance sheet dated December 4 will report ASC's financial position as of that date:
The proceeds of the bank loan are not considered to be revenue since ASC did not earn the
money by providing services, investing, etc. As a result, there is no income statement effect from
this transaction.

On December 5, 2020, Accounting Software Co. pays $600 for ads that were run in recent days.
The effect of this advertising transaction on the accounting equation is:
Since ASC is paying $600, its assets decrease. The second effect is a $600 decrease in owner's
equity, because the transaction involves an expense. (An expense is a cost that is used up or its
future economic value cannot be measured.)
Although owner's equity is decreased by an expense, the transaction is not recorded directly into
the owner's capital account at this time. Instead, the amount is initially recorded in the expense
account Advertising Expense and in the asset account Cash.
The general journal entry to record the transaction is:
The combined effect of the first five transactions is available here:
The totals now indicate that Accounting Software Co. has assets of $16,300. The creditors
provided $7,000 and the owner of the company provided $9,300. Viewed another way, the
company has assets of $16,300 with the creditors having a claim of $7,000 and the owner having
a residual claim of $9,300.
The balance sheet as of midnight on December 5 is:

**The income statement (which reports the company's revenues, expenses, gains, and losses during a
specified time interval) is a link between balance sheets. It provides the results of operations—an
important part of the change in owner's equity.
Since this transaction involves an expense, it will involve ASC's income statement. The
company's income statement for the first five days of December is:

On December 6, 2020, ASC performed consulting services for its clients. The clients were billed
for the agreed upon amount of $900. The amounts are to be paid within 30 days. The effect on
ASC's accounting equation is:
Since ASC has performed the services, it has earned revenues and it has the right to receive
$900 from the clients. This right (known as an account receivable) causes assets to increase.
The earning of revenues causes owner's equity to increase.
Although revenues cause owner's equity to increase, the revenue transaction is not recorded into
the owner's capital account at this time. Rather, the amount earned is recorded in the revenue
account Service Revenues. This will allow the company to report the revenues on its income
statement at any time. (After the year ends, the amount in the revenue accounts will be
transferred to the owner's capital account.)
The general journal entry to record the transaction is:
The combined effect of the first six transactions can be viewed here:
The totals tell us that as of midnight on December 6, the company had assets of $17,200. It also
shows the sources of the assets: creditors provided $7,000 and the owner of the company
provided $10,200. The totals also reveal that the company had assets of $17,200 and the
creditors had a claim of $7,000 and the owner had a claim for the remaining $10,200.
Below is the balance sheet as of midnight on December 6:

The Income Statement for Accounting Software Co. for the period of December 1 through
December 6 is:

Proprietorship: Transactions 7–8
On December 7, 2020, ASC uses a temporary help service for 6 hours at a cost of $20 per hour.
ASC will pay the invoice when it is due in 10 days. The effect on its accounting equation is:
ASC's liabilities increase by $120 and the expense causes owner's equity to decrease by $120.
The liability will be recorded in Accounts Payable and the expense will be reported in Temp
Service Expense. The journal entry for recording the use of the temp service is:
The effect of the first seven transactions on the accounting equation can be viewed here:
The totals indicate that as of midnight on December 7, the company had assets of $17,200 and
the sources were $7,120 from the creditors and $10,080 from the owner of the company. The
accounting equation totals also tell us that the company had assets of $17,200 with the creditors
having a claim of $7,120. This means that the owner's residual claim was $10,080.
The statement of financial position for ASC as of midnight on December 7, 2020 is:
**The income statement (which reports the company's revenues, expenses, gains, and losses for a
Accounting Software Co.'s income statement for the first seven days of December is:

On December 8, 2020, ASC received $500 from the clients it had billed on December 6, 2020.
The collection of accounts receivables has this effect on the accounting equation:
The company's asset (cash) increases and another asset (accounts receivable) decreases.
Liabilities and owner's equity are unaffected. (There are no revenues on this date. The revenues
were recorded when they were earned on December 6.)
The general journal entry to record the increase in Cash, and the decrease in Accounts
Receivable is:
The combined effect of the first eight transactions is shown here:
The totals for the first eight transactions indicate that the company had assets of $17,200. The
creditors provided $7,120 and the owner provided $10,080. The accounting equation also
indicates that the company's creditors had a claim of $7,120 and the owner had a residual claim
of $10,080.
ASC's balance sheet as of midnight December 8, 2020 is:

specified period of time) is a link between balance sheets. It provides the results of operations—an
The income statement for ASC for the eight days ending on December 8 is shown here:
Calculating a Missing Amount within

Owner's Equity
The income statement for the calendar year 2020 will explain a portion of the change in the
owner's equity between the balance sheets of December 31, 2019 and December 31, 2020. The
other items that account for the change in owner's equity are the owner's investments into the
sole proprietorship and the owner's draws (or withdrawals). A recap of these changes is
the statement of changes in owner's equity. Here is a statement of changes in owner's equity for the
year 2020 assuming that the Accounting Software Co. had only the eight transactions that we
covered earlier.
Example of Calculating a Missing Amount

The format of the statement of changes in owner's equity can be used to determine an unknown
component. For example, if the net income for the year 2020 is unknown, but you know the
amount of the draws and the beginning and ending balances of owner's equity, you can calculate
the net income. (This might be necessary if a company does not have complete records of its
revenues and expenses.) Let's demonstrate this by using some new hypothetical amounts:
Step 1.
The owner's equity at December 31, 2019 can be computed using the accounting equation:
Step 2.
The owner's equity at December 31, 2020 can be computed as well:
Step 3.
Insert into the statement of changes in owner's equity the information that was given and the
amounts calculated in Step 1 and Step 2:
Step 4.
The "Subtotal" can be calculated by adding the last two numbers on the statement: $94,000 +
$40,000 = $134,000. After this calculation we have:
Step 5.
Starting at the top of the statement we know that the owner's equity before the start of 2020 was
$60,000 and in 2020 the owner invested an additional $10,000. As a result we have $70,000
before considering the amount of Net Income. We also know that after the amount of Net Income
is added, the Subtotal has to be $134,000 (the Subtotal calculated in Step 4). The Net Income is
the difference between $70,000 and $134,000. Net income must have been $64,000.
Step 6.
Insert the previously missing amount (in this case it is the $64,000 of net income) into the
statement of changes in owner's equity and recheck the math:
Since the statement is mathematically correct, we are confident that the net income was
$64,000.
You can reinforce what you have learned by using our Quiz for the Accounting Equation and
our Crossword Puzzle on the Accounting Equation.
The remaining parts of this topic will illustrate similar transactions and their effect on the
accounting equation when the company is a corporation instead of a sole proprietorship.
Accounting Equation for a

Corporation: Transactions C1–C2
The accounting equation (or basic accounting equation) for a corporation is
Examples
In our examples below, we show how a given transaction affects the accounting equation for a
corporation. We also show how the same transaction will be recorded in the company's general
ledger accounts.
In addition, we show the effect of each transaction on the balance sheet and income statement.
(Our examples assume that the accrual basis of accounting is being followed.)
In the examples that follow, we will use the following accounts:
 Cash
 Accounts Receivable
 Equipment
 Notes Payable
 Accounts Payable
 Common Stock
 Retained Earnings
 Treasury Stock
 Service Revenues
 Advertising Expense
 Temp Service Expense
(To view a more complete listing of accounts for recording transactions, visit our Explanation of
Chart of Accounts.)
We also assume that the corporation is a Subchapter S corporation in order to avoid the income
tax accounting that would occur with a "C" corporation. (In a Subchapter S corporation the
owners are responsible for the income taxes instead of the corporation.)
Corporation Transaction C1
Let's assume that members of the Ott family form a corporation called Accounting Software, Inc.
(ASI). On December 1, 2020, several members of the Ott family invest a total of $10,000 to start
ASI. In exchange, the corporation issues a total of 1,000 shares of common stock. (The stock
has no par value and no stated value.) The effect on the corporation's accounting equation is:
As you see, ASI's assets increase by $10,000 and stockholders' equity increases by the same
amount. As a result, the accounting equation will be in balance.
The accounting equation tells us that ASI has assets of $10,000 and the source of those assets
was the stockholders. Alternatively, the accounting equation tells us that the corporation has
assets of $10,000 and the only claim to the assets is from the stockholders (owners).
This transaction is recorded in the asset account Cash and in the stockholders' equity account
Common Stock. The general journal entry to record the transaction is:
After the journal entry is recorded in the accounts, a balance sheet can be prepared to show
ASI's financial position at the end of December 1, 2020:
The purpose of an income statement is to report revenues and expenses. Since ASI has not yet
earned any revenues nor incurred any expenses, there are no amounts to be reported on an
income statement.
Corporation Transaction C2.

On December 2, 2020, ASI purchases $100 of its stock from one of its stockholders. The stock
will be held by the corporation as Treasury Stock. The effect of the accounting equation is:
The purchase of its own stock for cash causes ASI's assets to decrease by $100 and its
stockholders' equity to decrease by $100.
This transaction is recorded in the asset account Cash and in the stockholders' equity account
Treasury Stock. The accounting entry in general journal form is:
Since the transactions of December 1 and December 2 were in balance, the sum of both
transactions should also be in balance:
The totals indicate that ASI has assets of $9,900 and the source of those assets is the
stockholders. The accounting equation also shows that the corporation has assets of $9,900 and
the only claim against the assets is the stockholders' claim.
The December 2 balance sheet will communicate the corporation's financial position as of
midnight on December 2:
The purchase of a corporation's own stock will never result in an amount to be reported on the

income

On December 3, 2020, ASI spends $5,000 of cash to purchase computer equipment for use in
the business. The effect of this transaction on ASI's accounting equation is:
The accounting equation shows that one asset increases and one asset decreases. Since the
amount of the increase is the same as the amount of the decrease, the accounting equation
remains in balance.
This transaction is recorded in the asset accounts Equipment and Cash. The Equipment account
increases by $5,000 and the Cash account decreases by $5,000. The journal entry for this
transaction is:
The effect on the accounting equation from the first three transactions is:
The totals tell us that the corporation has assets of $9,900 and the source of those assets is the
stockholders. The totals tell us that the company has assets of $9,900 and that the only claim
against those assets is the stockholders' claim.
The balance sheet dated December 3, 2020, reflects the financial position of the corporation as
of midnight on December 3:
The purchase of equipment is not an immediate expense. It will become part of depreciation
expense only after the equipment is placed in service. We will assume that as of December 3 the
equipment has not been placed into service. Therefore, there is no expense to be reported on
the income statement for the period of December 1-3.

On December 4, 2020, ASI obtains $7,000 by borrowing money from its bank. The effect of this
transaction on the accounting equation is:
As you see, ACI's assets increase and its liabilities increase by $7,000.
This transaction is recorded in the asset account Cash and the liability account Notes Payable
with the following journal entry:
The following shows the effects on the accounting equation from the first four transactions:
These totals indicate that the transactions through December 4 result in assets of $16,900. There
are two sources for those assets: the creditors provided $7,000 of assets, and the stockholders
provided $9,900. You can also interpret the accounting equation to say that the corporation has
assets of $16,900 and the creditors have a claim of $7,000. The residual or remainder of $9,900
is the stockholders' claim.
The balance sheet dated December 4 reports the corporation's financial position as of that date:
The receipt of money from the bank loan is not revenue since ASI did not earn the money by
providing services, investing, etc. As a result, there is no income statement effect from this or
earlier transactions.
statement.
On December 5, 2020, Accounting Software, Inc. pays $600 for ads that were run in recent days.
The effect of the advertising transaction on the corporation's accounting equation is:
Since ASI is paying $600, its assets decrease. The second effect is a $600 decrease in
stockholders' equity, because the transaction involves an expense. (An expense is a cost that is
used up or its future economic value cannot be measured.)
Although stockholders' equity decreases because of an expense, the transaction is not recorded
directly into the retained earnings account. Instead, the amount is initially recorded in the
expense account Advertising Expense and in the asset account Cash. The journal entry for this
transaction is:
The combined effect of the first five transactions is:
The totals now indicate that Accounting Software, Inc. has assets of $16,300. The creditors
provided $7,000 and the stockholders provided $9,300. Viewed another way, the corporation has
assets of $16,300 with the creditors having a claim of $7,000 and the stockholders having a
residual claim of $9,300.
The balance sheet as of the end of December 5 is:

specified time period) is a link between balance sheets. It provides the results of operations—an important
part of the change in retained earnings and stockholders' equity.
Since this transaction involves an expense, it will affect ASI's income statement. The
corporation's income statement for the first five days of December is presented here:
Because we assumed that Accounting Services, Inc. is a Subchapter S corporation, income tax expense is
not reported on the corporation's income statement.

On December 6, 2020, ASI performed consulting services for its clients. The clients were billed
for the agreed upon amount of $900. The amounts are to be paid within 30 days. The effect on
ASI's accounting equation is:
Since ASI has performed the services, it has earned revenues and it has the right to receive
$900 from its clients. This right means that assets increased. The earning of revenues also
causes stockholders' equity to increase.
Although revenues cause stockholders' equity to increase, the revenue transaction is not
recorded directly into a stockholders' equity account at this time. Rather, the amount earned is
recorded in the revenue account Service Revenues. This will allow the corporation to report the
amount in the revenue account on its income statement at any time. (After the year ends, the
amount in the revenue accounts will be transferred to the retained earnings account.) The
general journal entry for this transaction is:
The effect on the accounting equation from the first six transactions can be viewed here:
The totals tell us that at the end of December 6, the corporation had assets of $17,200. It also
shows that $7,000 of the assets came from creditors and that $10,200 came from stockholders.
The totals can also be viewed another way: ASI had assets of $17,200 with its creditors having a
claim of $7,000 and the stockholders having a claim for the remainder or residual of $10,200.
The balance sheet as of midnight on December 6 is presented here:

part of the change in retained earnings and stockholders' equity.
The income statement for Accounting Software, Inc. for the period of December 1 through
December 6 is shown here:

On December 7, 2020, ASI uses a temporary help service for 6 hours at a cost of $20 per hour.
ASI records the invoice immediately, but it will pay the $120 when it is due in 10 days. This
transaction has the following effect on the accounting equation:
The accounting equation shows that ASI's liabilities increase by $120 and the expense causes
stockholders' equity to decrease by $120.
The liability will be recorded in Accounts Payable and the expense will be recorded in Temp
Service Expense. The general journal entry for utilizing the temp service is:
The effect of the first seven transactions on the accounting equation can be viewed here:
The totals show us that the corporation had assets of $17,200 and the sources were the creditors
with $7,120 and the stockholders with $10,080. The accounting equation totals also reveal that
the corporation's creditors had a claim of $7,120 and the stockholders had a claim for the
remaining $10,080.
The financial position of ASI as of midnight of December 7 is presented in the following balance
sheet:
**The income statement (which reports the corporations' revenues, expenses, gains, and losses for a
part of the change in stockholders' equity.
The income statement for the first seven days of December is shown here:

On December 8, 2020, ASI received $500 from the clients it had billed on December 6. The
effect on the accounting equation is:
The corporation's cash increases and one of its other assets (accounts receivable) decreases.
Liabilities and stockholders' equity are unaffected. (There are no revenues on this date. The
revenues were recorded when they were earned on December 6.)
The general journal entry to record the increase in Cash and the decrease in Accounts
Receivable is:
The effect on the accounting equation from the transactions through December 8 is shown here:
The totals after the first eight transactions indicate that the corporation had assets of $17,200.
The creditors had provided $7,120 and the company's stockholders provided $10,080. The
accounting equation also indicates that the company's creditors had a claim of $7,120 and the
stockholders had a residual claim of $10,080.
ASI's balance sheet as of midnight of December 8 is shown here:

**The income statement (which reports the corporation's revenues, expenses, gains, and losses for a
part of the change in stockholders' equity.
The income statement for ASI's first eight days of operations is shown here:
Introduction to Adjusting Entries

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Adjusting entries are accounting journal entries that convert a company's accounting records to
the accrual basis of accounting. An adjusting journal entry is typically made just prior to issuing a
company's financial statements.
To demonstrate the need for an accounting adjusting entry let's assume that a company
borrowed money from its bank on December 1, 2020 and that the company's accounting period
ends on December 31. The bank loan specifies that the first interest payment on the loan will be
due on March 1, 2021. This means that the company's accounting records as of December 31 do
not contain any payment to the bank for the interest the company incurred from December 1
through December 31. (Of course the loan is costing the company interest expense every day,
but the actual payment for the interest will not occur until March 1.)
For the company's December income statement to accurately report the company's profitability, it
must include all of the company's December expenses—not just the expenses that were paid.
Similarly, for the company's balance sheet on December 31 to be accurate, it must report
a liability for the interest owed as of the balance sheet date. An adjusting entry is needed so that
December's interest expense is included on December's income statement and the interest due
as of December 31 is included on the December 31 balance sheet. The adjusting entry will
debit Interest Expense and credit Interest Payable for the amount of interest from December 1 to
December 31.
Another situation requiring an adjusting journal entry arises when an amount has already been
recorded in the company's accounting records, but the amount is for more than the current
accounting period. To illustrate let's assume that on December 1, 2020 the company paid its
insurance agent $2,400 for insurance protection during the period of December 1, 2020 through
May 31, 2021. The $2,400 transaction was recorded in the accounting records on December 1,
but the amount represents six months of coverage and expense. By December 31, one month of
the insurance coverage and cost have been used up or expired. Hence the income statement for
December should report just one month of insurance cost of $400 ($2,400 divided by 6 months)
in the account Insurance Expense. The balance sheet dated December 31 should report the cost
of five months of the insurance coverage that has not yet been used up. (The cost not used up is
referred to as the asset Prepaid Insurance. The cost that is used up is referred to as the expired
cost Insurance Expense.) This means that the balance sheet dated December 31 should report
five months of insurance cost or $2,000 ($400 per month times 5 months) in the asset account
Prepaid Insurance. Since it is unlikely that the $2,400 transaction on December 1 was recorded
this way, an adjusting entry will be needed at December 31, 2020 to get the income statement
and balance sheet to report this accurately.
The two examples of adjusting entries have focused on expenses, but adjusting entries also
involve revenues. This will be discussed later when we prepare adjusting journal entries.
For now we want to highlight some important points.
There are two scenarios where adjusting journal entries are needed before the financial
statements are issued:
 Nothing has been entered in the accounting records for certain expenses or revenues,
but those expenses and/or revenues did occur and must be included in the current
period's income statement and balance sheet.
 Something has already been entered in the accounting records, but the amount needs to
be divided up between two or more accounting periods.
Adjusting entries almost always involve a
 balance sheet account (Interest Payable, Prepaid Insurance, Accounts Receivable, etc.)
and an
 income statement account (Interest Expense, Insurance Expense, Service Revenu
Adjusting Entries - Asset
Accounts
Adjusting entries assure that both the balance sheet and the income statement are up-to-date on
the accrual basis of accounting. A reasonable way to begin the process is by reviewing the amount
or balance shown in each of the balance sheet accounts. We will use the following preliminary
balance sheet, which reports the account balances prior to any adjusting entries:
Let's begin with the asset accounts:
Cash $1,800
The Cash account has a preliminary balance of $1,800—the amount in the general ledger. Before
issuing the balance sheet, one must ask, "Is $1,800 the true amount of cash? Does it agree to
the amount computed on the bank reconciliation?" The accountant found that $1,800 was indeed
the true balance. (If the preliminary balance in Cash does not agree to the bank reconciliation,
entries are usually needed. For example, if the bank statement included a service charge and a
check printing charge—and they were not yet entered into the company's accounting records—
those amounts must be entered into the Cash account. See the major topic Bank
Reconciliation for a thorough discussion and illustration of the likely journal entries.)
Accounts Receivable $4,600
To determine if the balance in this account is accurate the accountant might review the detailed
listing of customers who have not paid their invoices for goods or services. (This is often referred
to as the amount of open or unpaid sales invoices and is often found in the accounts receivable
subsidiary ledger.) When those open invoices are sorted according to the date of the sale, the
company can tell how old the receivables are. Such a report is referred to as an aging of accounts
receivable. Let's assume the review indicates that the preliminary balance in Accounts Receivable
of $4,600 is accurate as far as the amounts that have been billed and not yet paid.
However, under the accrual basis of accounting, the balance sheet must report all the amounts
the company has an absolute right to receive—not just the amounts that have been billed on a
sales invoice. Similarly, the income statement should report all revenues that have been earned—
not just the revenues that have been billed. After further review, it is learned that $3,000 of work
has been performed (and therefore has been earned) as of December 31 but won't be billed until
January 10. Because this $3,000 was earned in December, it must be entered and reported on
the financial statements for December. An adjusting entry dated December 31 is prepared in
order to get this information onto the December financial statements.
To assist you in understanding adjusting journal entries, double entry, and debits and credits,
each example of an adjusting entry will be illustrated with a T-account.
Here is the process we will follow:
1. Draw two T-accounts. (Every journal entry involves at least two accounts. One account to
be debited and one account to be credited.)
2. Indicate the account titles on each of the T-accounts. (Remember that almost always one
of the accounts is a balance sheet account and one will be an income statement account. In a
smaller font size we will indicate the type of account next to the account title and we will
also indicate some tips about debits and credits within the T-accounts.)
3. Enter the preliminary balance in each of the T-accounts.
4. Determine what the ending balance ought to be for the balance sheet account.
5. Make an adjustment so that the ending amount in the balance sheet account is correct.
6. Enter the same adjustment amount into the related income statement account.
7. Write the adjusting journal entry.
Let's follow that process here:
The adjusting entry for Accounts Receivable in general journal format is:
Notice that the ending balance in the asset Accounts Receivable is now $7,600—the correct
amount that the company has a right to receive. The income statement account balance has
been increased by the $3,000 adjustment amount, because this $3,000 was also earned in the
accounting period but had not yet been entered into the Service Revenues account. The balance
in Service Revenues will increase during the year as the account is credited whenever a sales
invoice is prepared. The balance in Accounts Receivable also increases if the sale was on credit
(as opposed to a cash sale). However, Accounts Receivable will decrease whenever a customer
pays some of the amount owed to the company. Therefore the balance in Accounts Receivable
might be approximately the amount of one month's sales, if the company allows customers to
pay their invoices in 30 days.
At the end of the accounting year, the ending balances in the balance sheet accounts (assets
and liabilities) will carry forward to the next accounting year. The ending balances in the income
statement accounts (revenues and expenses) are closed after the year's financial statements are
prepared and these accounts will start the next accounting period with zero balances.
Allowance for Doubtful Accounts $0

(It's common not to list accounts with $0 balances on balance sheets.)
Although the Allowance for Doubtful Accounts does not appear on the preliminary balance sheet,
experienced accountants realize that it is likely that some of the accounts receivable might not be
collected. (This could occur because some customers will have unforeseen hardships, some
customers might be dishonest, etc.) If some of the $4,600 owed to the company will not be
collected, the company's balance sheet should report less than $4,600 of accounts receivable.
However, rather than reducing the balance in Accounts Receivable by means of a credit amount,
the credit amount will be reported in Allowance for Doubtful Accounts. (The combination of the
debit balance in Accounts Receivable and the credit balance in Allowance for Doubtful Accounts
is referred to as the net realizable value.)
Let's assume that a review of the accounts receivables indicates that approximately $600 of the
receivables will not be collectible. This means that the balance in Allowance for Doubtful
Accounts should be reported as a $600 credit balance instead of the preliminary balance of $0.
The two accounts involved will be the balance sheet account Allowance for Doubtful Accounts
and the income statement account Bad Debts Expense.
The adjusting journal entry for Allowance for Doubtful Accounts is:
It is possible for one or both of the accounts to have preliminary balances. However, the
balances are likely to be different from one another. Because Allowance for Doubtful Accounts is
a balance sheet account, its ending balance will carry forward to the next accounting year.
Because Bad Debts Expense is an income statement account, its balance will not carry forward
to the next year. Bad Debts Expense will start the next accounting year with a zero balance.
Supplies $1,100
The Supplies account has a preliminary balance of $1,100. However, a count of the supplies
actually on hand indicates that the true amount of supplies is $725. This means that the
preliminary balance is too high by $375 ($1,100 minus $725). A credit of $375 will need to be
entered into the asset account in order to reduce the balance from $1,100 to $725. The related
income statement account is Supplies Expense.
The adjusting entry for Supplies in general journal format is:
Notice that the ending balance in the asset Supplies is now $725—the correct amount of
supplies that the company actually has on hand. The income statement account Supplies
Expense has been increased by the $375 adjusting entry. It is assumed that the decrease in the
supplies on hand means that the supplies have been used during the current accounting period.
The balance in Supplies Expense will increase during the year as the account is debited.
Supplies Expense will start the next accounting year with a zero balance. The balance in the
asset Supplies at the end of the accounting year will carry over to the next accounting year.
Prepaid Insurance $1,500
The $1,500 balance in the asset account Prepaid Insurance is the preliminary balance. The
correct balance needs to be determined. The correct amount is the amount that has been paid by
the company for insurance coverage that will expire after the balance sheet date. If a review of
the payments for insurance shows that $600 of the insurance payments is for insurance that will
expire after the balance sheet date, then the balance in Prepaid Insurance should be $600. All
other amounts should be charged to Insurance Expense.
The adjusting journal entry for Prepaid Insurance is:
Note that the ending balance in the asset Prepaid Insurance is now $600—the correct amount of
insurance that has been paid in advance. The income statement account Insurance Expense has
been increased by the $900 adjusting entry. It is assumed that the decrease in the amount
prepaid was the amount being used or expiring during the current accounting period. The
balance in Insurance Expense starts with a zero balance each year and increases during the
year as the account is debited. The balance at the end of the accounting year in the asset
Prepaid Insurance will carry over to the next accounting year.
Equipment $25,000
Equipment is a long-term asset that will not last indefinitely. The cost of equipment is recorded in
the account Equipment. The $25,000 balance in Equipment is accurate, so no entry is needed in
this account. As an asset account, the debit balance of $25,000 will carry over to the next
accounting year.
Accumulated Depreciation - Equipment $7,500

Accumulated Depreciation - Equipment is a contra asset account and its preliminary balance of
$7,500 is the amount of depreciation actually entered into the account since the Equipment was
acquired. The correct balance should be the cumulative amount of depreciation from the time
that the equipment was acquired through the date of the balance sheet. A review indicates that
as of December 31 the accumulated amount of depreciation should be $9,000. Therefore the
account Accumulated Depreciation - Equipment will need to have an ending balance of $9,000.
This will require an additional $1,500 credit to this account. The income statement account that is
pertinent to this adjusting entry and which will be debited for $1,500 is Depreciation Expense -
Equipment.
The adjusting entry for Accumulated Depreciation in general journal format is:
The ending balance in the contra asset account Accumulated Depreciation - Equipment at the
end of the accounting year will carry forward to the next accounting year. The ending balance in
Depreciation Expense - Equipment will be closed at the end of the current accounting period and
this account will begin the next accounting year with a balance of $0.
Accruals & Deferrals

Adjusting entries are often sorted into two groups: accruals and deferrals.
Accruals
Accruals (or accrual-type adjusting entries) involve both expenses and revenues and are
associated with the first scenario mentioned in the introduction to this topic:
 Nothing has been entered in the accounting records for certain expenses and/or
revenues, but those expenses and/or revenues did occur and must be included in the
current period's income statement and balance sheet.
Accrual of Expenses
An accountant might say, "We need to accrue the interest expense on the bank loan." That
statement is made because nothing had been recorded in the accounts for interest expense, but
the company did indeed incur interest expense during the accounting period. Further, the
company has a liability or obligation for the unpaid interest up to the end of the accounting
period. What the accountant is saying is that an accrual-type adjusting journal entry needs to be
recorded.
The accountant might also say, "We need to accrue for the wages earned by the employees on
Sunday, December 30, and Monday, December 31." This means that an accrual-type adjusting
entry is needed because the company incurred wages expenses on December 30-31 but nothing
will be entered routinely into the accounting records by the end of the accounting period on
December 31.
A third example is the accrual of utilities expense. Utilities provide the service (gas, electric,
telephone) and then bill for the service they provided based on some type of metering. As a
result the company will incur the utility expense before it receives a bill and before the accounting
period ends. Hence, an accrual-type adjusting journal entry must be made in order to properly
report the correct amount of utilities expenses on the current period's income statement and the
correct amount of liabilities on the balance sheet.
Accrual of Revenues
Accountants also use the term "accrual" or state that they must "accrue" when discussing
revenues that fit the first scenario. For example, an accountant might say, "We need to accrue
for the interest the company has earned on its certificate of deposit." In that situation the
company probably did not receive any interest nor did the company record any amounts in its
accounts, but the company did indeed earn interest revenue during the accounting period.
Further the company has the right to the interest earned and will need to list that as an asset on
its balance sheet.
Similarly, the accountant might say, "We need to prepare an accrual-type adjusting entry for the
revenues we earned by providing services on December 31, even though they will not be billed
until January."
Deferrals
Deferrals or deferral-type adjusting entries can pertain to both expenses and revenues and refer
to the second scenario mentioned in the introduction to this topic:
 Something has already been entered in the accounting records, but the amount needs to
be divided up between two or more accounting periods.
Deferral of Expenses
An accountant might say, "We need to defer some of the insurance expense." That statement is
made because the company may have paid on December 1 the entire bill for the insurance
coverage for the six-month period of December 1 through May 31. However, as of December 31
only one month of the insurance is used up. Hence the cost of the remaining five months is
deferred to the balance sheet account Prepaid Insurance until it is moved to Insurance
Expense during the months of January through May. If the company prepares monthly financial
statements, a deferral-type adjusting entry may be needed each month in order to move one-
sixth of the six-month cost from the asset account Prepaid Insurance to the income statement
account Insurance Expense.
The accountant might also say, "We need to defer some of the cost of supplies." This deferral is
necessary because some of the supplies purchased were not used or consumed during the
accounting period. An adjusting entry will be necessary to defer to the balance sheet the cost of
the supplies not used, and to have only the cost of supplies actually used being reported on the
income statement. The costs of the supplies not yet used are reported in the balance sheet
account Supplies and the cost of the supplies used during the accounting period are reported in
the income statement account Supplies Expense.
Deferral of Revenues
Deferrals also involve revenues. For example if a company receives $600 on December 1 in
exchange for providing a monthly service from December 1 through May 31, the accountant
should "defer" $500 of the amount to a liability account Unearned Revenues and allow $100 to be
recorded as December service revenues. The $500 in Unearned Revenues will be deferred until
January through May when it will be moved with a deferral-type adjusting entry from Unearned
Revenues to Service Revenues at a rate of $100 per month.
Avoiding Adjusting Entries

If you want to minimize the number of adjusting journal entries, you could arrange for each
period's expenses to be paid in the period in which they occur. For example, you could ask your
bank to charge your company's checking account at the end of each month with the current
month's interest on your company's loan from the bank. Under this arrangement December's
interest expense will be paid in December, January's interest expense will be paid in January,
etc. You simply record the interest payment and avoid the need for an adjusting entry. Similarly,
your insurance company might automatically charge your company's checking account each
month for the insurance expense that applies to just that one month.
Introduction to Accounting Principles

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The common rules that apply to the financial statements distributed by a U.S. company to
external users are referred to as accounting principles, generally accepted accounting
principles, GAAP (pronounced gap), or US GAAP. These rules or standards allow lenders,
investors, and others to make comparisons between companies' financial statements.
Since 1973, US GAAP has been developed and maintained by the Financial Accounting Standards
Board (FASB), a non-government, not-for-profit organization. In 2009, the FASB launched
the Accounting Standards Codification (ASC or Codification), which it continues to update. This
electronic database contains the official accounting standards (the equivalent of many thousands
of printed pages) which apply to the financial reporting of U.S companies and not-for-profit
organizations.
[There is also an International Accounting Standards Board (IASB) that issues International
Financial Reporting Standards (IFRS) which we will not be discussing.]
In addition to GAAP, U.S. corporations with capital stock trading on a stock exchange must also
comply with the regulations of the Securities and Exchange Commission (SEC) and the Internal
Revenue Service (IRS), both of which are U.S. government agencies.
In this explanation we begin with brief descriptions of many of the underlying principles,
assumptions, concepts, and qualities upon which the complex and detailed accounting standards are
based. Examples include historical cost, revenue recognition, full disclosure, materiality, and
consistency.
We then review the effect of those underlying principles and concepts on a company's financial
statements such as:
 Required set of financial statements

 Accrual method of accounting
 Revenues reported on the income statement
 Expenses reported on the income statement
 Assets reported on the balance sheet
 Liabilities reported on the balance sheet
 Stockholders' equity reported on the balance sheet
 Required notes to the financial statements
Underlying Accounting Principles,

Assumptions, etc.
The following chart shows an overview of the accounting profession's efforts in developing U.S.
generally accepted accounting principles (GAAP or US GAAP):
Some of the accounting principles in the Accounting Research Bulletins remain in effect today
and are included in the Accounting Standards Codification. However, due to the complexities and
sophistication of today's global business activities and financing, GAAP has become more
extensive and more detailed.
Our focus is on the basic, fundamental principles and concepts and what they mean for a
business's financial statements.
We begin with brief descriptions of many of the underlying principles, assumptions, concepts,
constraints, qualitative characteristics, etc.
Economic entity assumption

The economic entity assumption allows the accountant to keep the business transactions of a sole
proprietorship separate from the sole proprietor's personal transactions.
It also means that financial statements can be prepared for a group of separate legal
corporations that are controlled by one corporation. This group of commonly owned corporations
is referred to as the economic entity. The set of financial statements that reports the combined
activity of the group is referred to as consolidated financial statements.
Monetary unit assumption

For U.S. companies, the monetary unit assumption allows accountants to express a company's
wide-ranging assets as dollar amounts. Further, it is assumed that the U.S. dollar does not lose
its purchasing power over time. Because of this, the accountant combines the $10,000 spent on
land in 1960 with the $300,000 spent on a similar adjacent parcel of land in 2020. The result is
that the company's balance sheet will report the combined cost of two parcels at $310,000.
Going concern assumption

The going concern assumption means the accountant believes that the company will not be
liquidated in the foreseeable future. In other words, the company will be able to continue
operating long enough to meet its obligations and commitments. As a result, the accountant can
continue to report most assets at their historical cost and can defer some costs to future periods.
If the company is not considered to be a going concern (meaning the company will not be able to
continue in business), it must be disclosed, and liquidation values become the relevant amounts.
Time period (or periodicity) assumption

Accountants assume that a company's ongoing complex business operations and financial
results can be divided into distinct time periods such as months, quarters, and years.
To report a company's net income for each month, the company will prepare adjusting entries to
record each month's share of depreciation expense, property taxes, insurance, etc. It will also
prepare adjusting entries for expenses that occurred but were not paid. Examples include
repairs, interest, utitilities, etc.
Cost principle
The cost principle (historical cost principle) means the accountant will record transactions at the
cash (or equivalent) amount at the time of the transaction. As a result, a company's most
valuable assets are not recorded or reported. Examples include a company's trademarks,
talented team of researchers, unique website domain names, search engine rankings, etc.
Except for certain marketable investment securities, typically an asset's recorded cost will not be
changed due to inflation or market fluctuations.
Full disclosure principle
The full disclosure principle requires a company to provide sufficient information so that an
intelligent user can make an informed decision. As a result of this principle, a company's financial
statements will include many disclosures and schedules in the notes to the financial statements.
Revenue recognition principle

Revenues are to be recognized (reported) on a company's income statement when they
are earned. Therefore, a company will report some revenues on its income statement before a
customer pays for the goods or services it has received. In the case of cash sales, revenues will
be reported when customers pay for their merchandise. If customers pay in advance, the
revenues will be recognized (reported) after the money was received.
For example, if an insurance company receives $12,000 on Dec 28, 2020 to provide insurance
protection for the year 2021, the insurance company will report $1,000 of revenue in each of the
12 months in the year 2021.
Matching principle or expense recognition

The ideal way to recognize (report) expenses on the income statement is based on a cause-and-
effect relationship. For example, if a company sells 5,000 units of Product X, it should report the
cost of the 5,000 units on the same income statement as the sales revenues. (Since the cost of
sales may be 60% of the sales amount, it is imperative for the cost of goods sold to be calculated
accurately.)
When a cause-and-effect relationship isn't clear, expenses are reported in the accounting period
when the cost is used up. For example, the $120,000 cost of equipment with a 10-year life will be
charged to expense at a rate of $1,000 per month.
If neither of the above is logical, expenses are reported in the accounting period that the
expenses occur. Examples are advertising expense, research expense, salary expense, and
many others.
Materiality
The concept of materiality means an accounting principle can be ignored if the amount is
insignificant. For instance, large companies usually have a policy of immediately expensing the
cost of inexpensive equipment instead of depreciating it over its useful life of perhaps 5 years.
Materiality also allows for a mid-size company to report the amounts on its financial statements
to the nearest thousand dollars.
For example, if an insurance company receives $12,000 on Dec 28, 2020 to provide insurance
protection for the year 2021, the insurance company will report $1,000 of revenue in each of the
12 months in the year 2021.
Conservatism
If a company has two acceptable ways to record and/or report a transaction, conservatism
directs the accountant to choose the alternative that results in less net income or a smaller asset
amount. The accountant should be objective, but when doubt exists, conservatism should be
used to break the tie.
Consistency and comparability

Accountants are expected to apply accounting principles, procedures, and
practices consistently from period to period. If a change is justified, the change must be disclosed
on the financial statements.
Comparability means that the user is able to compare the financial statements of one company to
those of another company in the same industry. Comparability is enhanced by requiring the use
of generally accepted accounting principles.
Relevance and timeliness

For financial statements to be relevant they should be distributed as soon as possible after the
end of the accounting period. In other words, relevance is enhanced by timeliness.
To achieve these characteristics, it is likely that some amounts will need to be estimated.
Objectivity and reliability

Accountants are expected to be objective (unbiased). Many businesses are required to have
their financial statements audited to assure the users that the amounts are objective and reliable.
The Effect of Accounting Principles

on Financial Statements
Now that you have been introduced to many of the underlying accounting principles and
concepts, let's examine what they mean for a company's financial reporting.
Distributing a complete set of financial statements

The accounting profession believes that a single financial statement is not sufficient for someone
to understand a company's financial affairs. Therefore, if a company releases its financial
statement(s) to someone outside of the company, it should distribute a set of financial
statements containing the following:
 Income statement
 Statement of comprehensive income
 Balance sheet
 Statement of stockholders' (or owner's) equity
 Statement of cash flows
 Notes to the financial statements
The balance sheet reports the assets, liabilities, and stockholders' equity as of the final moment
of the accounting period (December 31, June 30, etc.).
The other financial statements report the amounts that occurred throughout the accounting
period shown in the heading (year ended December 31, three months ended June 30, etc.).
The notes to the financial statements are referenced on each financial statement to inform the user
that the notes are an integral part of each financial statement. The notes are necessary because
a company's business activity cannot be communicated completely by the amounts appearing on
the face of the financial statements.
In addition to complying with US GAAP, corporations with capital stock that is traded on a stock
exchange must also comply with some additional rules and communication required by the U.S.
Securities and Exchange Commission (SEC). Regular U.S. corporations must also comply with
federal and state income tax reporting regulations.
Accrual Method of Accounting

To properly (report) revenues and expenses on the income statement, and assets and liabilities
on the balance sheet, companies must use the accrual method of accounting (or accrual
accounting). The following examples illustrate accrual accounting:
 Revenues are reported on the income statement when they have been earned. Generally,
this means there will also be a related asset reported on the company's balance sheet,
such as cash or accounts receivable. In accounting terminology, the revenues and the
related asset are recognized (reported on the financial statements) when the revenues
and asset have been earned.
A simple example of revenue recognition occurs when a company completes a service for
$5,000 on December 28. On the same day, the company bills the customer $5,000 with
credit terms of net 30 days. A month later (on January 29) the company receives the
$5,000.
On December 28, the company records a $5,000 increase in its current asset account
Accounts Receivable and a $5,000 increase in its income statement account Revenues
Earned. On January 29, when the company receives the $5,000, it will increase its cash
by $5,000 and will reduce its accounts receivable by $5,000.
 Expenses are reported (recognized) on the income statement when an expense occurs.
The date of the company's payment to the vendor is not relevant.
To illustrate, assume that a company incurs a $3,000 repair expense on December 26.
On December 28, the company receives the vendor's invoice stating that the bill is to be
paid within 15 days. On January 8, the company pays $3,000 to the vendor.
The company must record the $3,000 increase in its expenses and liabilities as of
December 26 or 28. When the company pays the vendor $3,000 on January 8, the
company will decrease its cash balance and will decrease its liabilities.
In short, the company's financial statements are more complete when the accrual method is
used.
To comply with the accrual method, companies record adjusting entries as of the final day of the
accounting period. Adjusting entries make certain that the proper amount of expenses and
liabilities, and the proper amount of revenues and assets, are reported on the appropriate
period's financial statements.
Revenues Reported on the Income Statement

Under the accrual method, revenues are reported or recognized on the company's income
statement for the period in which the revenues were earned.
Depending on the transactions, revenues may be earned and reported on a company's income
statements at any of the following times:
 Before receiving the money from customers (sales and services were provided on credit)
 At the time customers pay (cash sales)
 After money is received from customers (some future services were required)
To achieve the accrual method, companies will make the following revenue-related adjusting
entries at the end of the accounting period to:
 Accrue revenues (and the related receivables) that were earned, but the company had
not yet billed the customer
 Defer revenues (and the related liabilities) for money received from customers, but not
yet earned by the company
In 2014, the FASB issued an Accounting Standards Update (ASU) entitled Revenue from Contracts
with Customers (Topic 606) which provides extensive guidance for reporting revenues on the
income statement.
Expenses Reported on the Income Statement

Under the accrual method, expenses are to be reported (recognized) on the company's income
statement during the accounting period in which the expenses:
 Were caused by revenues (e.g., matching the cost of goods sold and sales commissions
with the related revenues)
 Expired or were used up (e.g., matching prepaid insurance to the accounting periods in
which the prepaid amount had expired; systematically allocating the cost of equipment
used in the business to the accounting periods in the equipment's useful life)
 Had no future economic benefit that could be measured (e.g., advertising expense, office
salaries, research expenses)
To achieve the accrual method, companies will make accrual, deferral, depreciation, and other
adjusting entries for expenses at the end of each accounting period.
To learn more, visit our Explanation of Income Statement.
Assets Reported on the Balance Sheet

The cost principle (or historical cost principles) means that a company's assets are recorded at
their cost at the time of the transaction. Once recorded, the cost of most assets (some
marketable investment securities are an exception) will not be increased because of inflation or
increases in market value.
To illustrate, assume that 18 years ago a company purchased a parcel of land for its future use
at a cost of $50,000. Today, the market value of the land is $300,000. The company's current
balance sheet will report the land at its cost of $50,000.
A company that sells goods will report its inventory at its cost, not at the sales value.
The cost principle prevents a company from recording and reporting its talented employees as
assets. Similarly, a company's brands and logos that were developed internally and enhanced
through advertising expenses cannot be reported as assets.
If an asset's fair value drops below its book or carrying value, the asset's book value may have to
be decreased and an impairment loss reported on the income statement.
Liabilities Reported on the Balance Sheet

Liabilities are a company's obligations resulting from a past transaction. Typical liabilities include
accounts payable, notes or loans payable, wages payable, interest payable, taxes payable,
customer deposits, deferred revenue, and more.
At the end of each accounting period, there will be amounts owed by a company, but the
company has not yet been billed or has not yet processed the transaction. A few examples
include:
 Interest on loans payable
 Electricity and gas charges
 Wages for hourly paid employees that have been earned but not yet processed
 Repair work that was recently done by a contractor
These obligations and the related expense must be recorded for the financial statements to be
complete and to comply with the accrual method of accounting. This is done with accrual-type
adjusting entries.
Stockholders' Equity Reported on the Balance Sheet

Stockholders' equity or shareholders' equity is the difference between the amount of a
corporation's assets and liabilities that are reported on the balance sheet. (Owner's equity is the
difference between a sole proprietorship's assets and liabilities.)
Since most of a company's assets are reported at cost (or lower), the amount reported as
stockholders' equity is not an indicator of the corporation's market value. Picture a service
business that has developed amazing software that generates huge fees with little expenses and
the owners draw out most of the profits. As a result, this service business is extremely valuable
but has only a small amount reported on its balance sheet for assets and stockholders' equity.
To learn more, visit our Explanation of Balance Sheet.
Notes to the Financial Statements

The full disclosure principle requires that sufficient financial information be presented so that an
intelligent person can make an informed decision. As a result of this principle, it is common to
find many pages of notes to the financial statements.
A few examples of the many items disclosed in the notes to the financial statements include:
 Summary of significant accounting policies

 Leases
 Income taxes
 Employee benefit plans
 Stock options
 Commitments and contingencies
Introduction to the Income

Statement
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The income statement is one of the main financial statements of a business. Other names for the
income statement include:
 Statement of income
 Statement of operations
 Statement of earnings
 Profit and loss (P&L) statement
 Consolidated statement of income (operations, earnings)
The income statement reports revenues, expenses, gains, losses, and the resulting net income
which occurred during the accounting period shown in its heading. Typical periods or time
intervals covered by an income statement include:
 Year ended December 31, 2020

 Year ended June 30, 2020
 Nine months ended September 30, 2020
 Three months ended March 31, 2020
 Month ended August 31, 2020
 52/53 weeks ended February 1, 2020
The following is an outline of an income statement for a regular U.S. corporation:
Below are additional details for the lines in Example Corporation's income statement:
Operating revenues are the amounts earned from the company's main business activities.
Common operating revenues are:
 Net sales for a retailer or manufacturer
 Service fees or service revenues for a business that provides services
Operating expenses are the expenses associated with the company's main business activities.
Common operating expenses include:
 Cost of sales for a retailer or manufacturer
 Cost of services for a service business
 Selling, general and administrative (SG&A) expenses
Operating income is the result of subtracting the company's operating expenses from its operating
revenues.
Nonoperating revenues or income, nonoperating expenses, gains, and losses result from activities
outside of the company's main business activities. Common examples for retailers and
manufacturers include investment income, interest expense, and the gain or loss on the sale of
equipment that had been used in the business.
Income before income tax expense is the combination of the amount of operating income and the
nonoperating amounts.
Income tax expense is the federal, state, and local income taxes relating to the amounts appearing
on the income statement. (The actual amount paid will likely be different, since the amount paid
is based on the amounts on the corporation's income tax returns.)
Net income is the amount of earnings remaining after subtracting the income tax expense.
Notes to the financial statements refers the reader to important information that could not be
communicated by the amounts shown on the face of the income statement.
Note:
If a corporation's shares of common stock are traded on a stock exchange, the earnings per
share and the average number of shares outstanding must also be shown on the income
statement.
Additional deta Accrual Method of Accounting

The financial statements distributed by U.S. companies must comply with the U.S. generally
accepted accounting principles (GAAP or US GAAP). One of perhaps 1,000 rules in US GAAP is a
requirement that the income statement be prepared using the accrual method of accounting.
The accrual method of accounting is also referred to as the accrual basis of accounting, or accrual
accounting. (The accrual method is different from the cash basis or tax basis.)
For the income statement, the accrual method means:
 Revenues are reported (recognized) on the income statement in the accounting period

when they are earned, which is often different from the period when payment is received
from the customers.
For example, if a company delivers products to a customer in December 2020 but the
customer is allowed to pay in January 2021, the company will report the sale as part of its
December's revenues.
Common examples of revenues include the sales of products to customers and providing
services for clients.
 Expenses are the costs and expenses incurred to earn the company's revenues during
the period of the income statement. It is common for an expense to be reported on the
income statement in an accounting period different from when the company paid out the
money.
For example, in June a retailer purchased and paid for products at a cost of $6,000. In
July, the retailer sells the products for $10,000. There was no expense reported on the
June income statement since none of the products were sold. (The $6,000 cost reduced
the retailer's cash and increased its inventory, both of which are reported on June's
balance sheet.) The retailer's July income statement will recognize the expense cost of
sales $6,000 as necessary to earn the $10,000 in sales.
Some costs will not be directly caused by sales and must be allocated. For example, a
retailer may have purchased a delivery truck two years ago at a cost of $60,000. The
truck was expected to be used for 60 months and have no salvage value. Therefore,
every month for 60 months, the retailer's income statement will report depreciation
expense of $1,000.
Other costs such as salaries, advertising, rent, utilities, etc. have no future value that can
be measured. Those costs will be reported as expenses when the costs are incurred or
used up. In other words, July's rent and utilities will be reported as an expense on the
July income statement (even if the utilities used in July will be paid in August).
 A gain is reported on the income statement when a company sells a long-term asset for
more than the asset's book value. For example, if a company sells its old delivery truck
for $10,000 and its book value was $6,000, the income statement will report a $4,000
gain on the sale of the truck.
 A loss is reported on the income statement when a company sells a long-term asset for
less than the asset's book value. If the company sells its old delivery truck for $5,000 and
its book value was $6,000, the income statement will report a $1,000 loss on the sale of
the truck.
 Net income or net earnings is the amount by which the income statement's revenues and
gains exceeded the amount of expenses and losses. A net loss is reported when
revenues and gains were less than the amount of expenses and losses.
It is important to understand that the income statement's focus is to report a company's
profitability during a relatively short time interval such as a month, three months, six months, a
year, and so on.
The income statement does not report the company's cash receipts and disbursements. To learn
about the cash amounts, users should review the company's statement of cash flows. (You can
learn more about that financial statement by visiting our topic Cash Flow Statement.)
ils and examples of income statements will be provided later.
Example of an Income Statement

We will be referring to the following income statement for Example Corporation as we continue
our explanation of the income statement.
Example Corporation is engaged in the purchase and sale of goods (products, merchandise). It
is also a regular U.S. corporation which means the income statement will include income tax
expense.
Income statement is one in a set of five financial statements

Reading only the income statement is not sufficient for understanding the financial activities of a
business. Therefore, a business should distribute a set of five financial statements consisting of
the following:
 Balance sheet
 Statement of stockholders' equity
In addition to the above items, the set of financial statements must also include notes to the
financial statements. The notes are important because the amounts on the face of the financial
statements cannot adequately communicate the complexities of a business. To make readers of
the income statement (or any other financial statement) aware of the significant information in the
notes, one of the following sentences is shown near the bottom of every financial statement:
 See Notes to Financial Statements.
 See accompanying Notes to Financial Statements.
 See accompanying notes.
 The accompanying notes are an integral part of the financial statements.
 The accompanying Notes to Financial Statements are an integral part of this financial
statement.
Comparative income statement

A comparative income statement displays three columns of amounts. This gives the reader two
years of previous income statement amounts to put the most recent year's amounts in
perspective.
Since the column containing the amounts from the most recent year is the most relevant, it will
be positioned closest to the descriptions. The column containing the oldest amounts is positioned
furthest from the descriptions.
The heading of a comparative annual income statement will be changed to read "Years ended
December 31" (since three years of income statements are shown. The years will be indicated at
the top of each column of amounts.
Rounding of amounts
Except for small companies, the amounts shown on the income statement are likely rounded to
the nearest thousand or million dollars (along with a notation to inform the reader).
For example, the income statement of a large corporation with sales of $8,349,792,354.78 will
report $8,349.8 and a notation such as (In millions, except earnings per share).
The income statement of a mid-size corporation with sales of $24,340,290.88 might report
$24,340 and the notation (In thousands except per share amounts).
Rounding amounts is beneficial because it allows readers to focus on the most important digits.
Omitting insignificant digits is also justified by the concept of materiality, because a lender or
investor will not be misled without the least important digits.
Components of the Income

Statement
Below we will discuss each section of the income statement starting with the heading.
Heading of the income statement

In addition to the name of the company and the name of the financial statement, the heading of the
income statement informs the reader of the period or time interval during which the reported amounts
occurred. Typical periods of time are a year, year-to-date, three months, one month, 52 weeks,
13 weeks, 4 or 5 weeks, and others.
In the U.S., the annual time periods or time intervals could be:
 A calendar year, which covers the 12 months from January 1 through December 31
 A fiscal year, which covers the 12 months that ends on a date other than December 31.
An example is the 12 months from July 1 through June 30.
 A fiscal year, which covers a 52-week period (with a 53-week period every six years). An
example is a retailer whose fiscal year ends on the Saturday closest to February 1.
During the year, the retailer will have 4-week and 5-week periods instead of months and
will have 13-week periods instead of quarters.
Net sales
Net sales is the first amount shown on the income statement of a retailer, manufacturer, or other
companies which sell products. In other words, sales are generally the main operating revenues
for companies selling goods.
Net sales is the combination of the following amounts which occurred during the period shown in
the income statement's heading:
 Sales of goods, products, merchandise, etc. originally billed to customers

 Reductions for goods that were returned by customers
 Reductions for allowances granted to customers
 Reductions for customers paying the amount owed during a discount period
Sales are reported (recognized) on the income statement when the ownership of the goods
passes from the company to the customer. In many companies this occurs before the customer
pays for the goods. For example, if goods are sold to a customer in December 2020, but the
customer is allowed to pay in January 2021, the amount of the sale is reported on the December
2020 income statement (and a receivable is recorded on the balance sheet at the time of the
sale). When the customer's money is received in January 2021, the receivable is removed.
Sales of goods, products, and merchandise are operating revenues for a company in the business
of purchasing and selling goods. (If the merchant sells its old delivery truck, the amount received
is not included in net sales since the merchant is not in the business of selling trucks.)
Cost of sales (cost of goods sold, cost of products sold)

The cost of sales, cost of goods sold, or cost of products sold is the company's cost for the
products that it sold during the period indicated in the income statement's heading. The cost of
the sales is the dominating operating expense for companies that sell products. No other
operating expense will come close to a company's cost of sales since it is often 60-80% of the
net sales. Therefore, it is critical for the cost of the items sold to be calculated accurately.
The cost of sales is related to the cost of the items in inventory. If an error is made in counting or
calculating the cost of the ending inventory, it is likely to cause the cost of sales, gross profit and
net income to be incorrect.
A retailer's cost of sales includes the cost paid to the supplier plus any other costs to get the
items into the warehouse and ready for sale. For example, if a retailer purchases a product for
$300 and pays an additional $20 of shipping costs to get the item into its warehouse, the cost of
the product is $320.
A manufacturer's cost of sales is the cost of producing the goods that were sold. This includes the
cost of raw materials, direct labor, and manufacturing overhead related to the items sold.
Determining the manufacturer's cost of goods is complicated by the need to allocate the
manufacturing overhead costs.
In the U.S., a company can select from several cost flow assumptions when calculating its cost of
sales and ending inventory. However, the company cannot switch cost flow assumptions more
than once.
You can learn more by visiting our topic Inventory and Cost of Goods Sold.
Gross profit
Gross profit (sometimes shown as gross margin) is the result of subtracting the cost of sales from
net sales, as shown in Example Corporation's partial income statement:
For any company to be profitable (have a positive net income), its gross profit must be greater
than its selling, general and administrative expenses and nonoperating items such as interest
expense.
Some people use the term gross margin to mean the gross profit percentage, which is the amount
of gross profit divided by net sales. Expressing the gross profit as a percentage of net sales allows
the company's executives and financial analysts to see if the company was able to maintain its
selling prices and gross profit percentages. The percentage also allows a company to compare
its percentage to that of its competitors. Maintaining the gross profit percentages is often difficult
because of pricing pressure from other companies, higher costs from suppliers, general inflation,
and more.
The gross profit percentages (or gross margins) for Example Corporation have been improving as
shown by the following calculations:
 Year 2020 was 22.1% = gross profit of $880 / net sales of $3,980
Selling, general and administrative expenses

The selling, general and administrative expenses are commonly referred to as SG&A.
For a retailer, SG&A include the salaries, wages, rents, utilities, depreciation of assets,
advertising, insurance, and other expenses associated with the retailer's primary activities, which
are the purchasing and selling of merchandise.
[The expenses associated with secondary activities (such as the interest expense associated with
its financing activities) are not included in SG&A. The interest expense and other nonoperating
expenses will be shown on the income statement after the operating income is presented.]
A manufacturer's main or primary activities include both the production and sale of its products.
The costs in the production of the goods are included in the cost of sales (also known as the cost
of goods sold). The manufacturer's selling and general administrative expenses are reported as
SG&A expenses similar to those of a retailer.
Both the manufacturer's cost of sales and its SG&A expenses are operating expenses.
Operating income
Operating income = operating revenues – operating expenses
Example Corporation's operating revenues are its net sales. Its operating expenses are its cost of
sales and SG&A as shown in Example Corporation's partial income statement:
Recall that the operating revenues for retailers and manufacturers are the amounts earned from its
main activities including its net sales. The operating revenues of a service business are the
amounts earned from its main activity of providing services.
The operating expenses are the expenses associated with earning the operating revenues and
maintaining its operations. Operating expenses for a retailer and manufacturer are the cost of
sales and SG&A expenses. Operating expenses for a service business are the cost of services
and SG&A expenses.
Interest expense
Interest expense is a nonoperating expense for most businesses since financing is outside of
their main activities of purchasing/producing goods and selling goods and/or providing services.
[Interest expense for a bank would be an operating expense, since the bank's main activities
involve paying interest to attract deposits that can be lent to borrowers to earn interest revenue.]
Since the interest expense incurred by retailers, distributors, and manufacturers is a

nonoperating expense, it is presented after operating income as shown by hypothetical amounts
in Example Corporation's partial income statement:
Loss on sale of equipment

When a company sells or scraps a long-term asset that had been used in the business, the
asset's cost and accumulated depreciation must be removed from the company's accounts. In its
place will be the cash received for the asset.
Since the company is not in the business of selling long-term assets, the amount received
is not included in its operating revenues. Instead, only the gain or loss on the sale is shown on
the income statement after the operating income.
To illustrate, assume a company had purchased equipment 8 years ago at a cost of $70,000 and
its accumulated depreciation on the date of the sale was $55,000. The combination or net of
these two amounts is $15,000, which is known as the equipment's book value or carrying value.
If the company receives less than the book value, the difference is reported as a loss on the
company's income statement. If the asset had a book value of $15,000 and the company
received $10,000 the company will report loss on sale of equipment of $5,000.
You can see from Example Corporation that the loss is listed after the operating income on the
following partial income statement:
[If the company had received cash of $18,000 for the old equipment with a book value of
$15,000, the company would report a $3,000 gain on sale of equipment.]
Income before income taxes

To arrive at the corporation's income before income taxes or earnings before income taxes, the
corporation's nonoperating revenues and expenses, gains and losses on the sale of long-term
assets, and "other" items are added/subtracted from the operating income as seen in the
following partial income statement:
Income tax expense

Regular corporations (as opposed to other types of U.S. corporations and entities) must report on
its income statement the amount of income tax expense that is associated with the items and
amounts shown on the income statement. Typically there will be differences as to when the amounts
will be reported on the income statement versus the corporation's income tax return. As a result,
the income tax expense shown on the income statement will not be the amount paid by the
corporation for that year.
(The amount of income taxes paid by the corporation is available in the corporation's statement of
cash flows or notes to the financial statements.)
Net income
After subtracting the income tax expense, the resulting amount (referred to as the bottom line) is
the corporation's net income or net earnings. The net income for Example Corporation can be see
here:
How Net Income Affects

Stockholders' Equity
A positive net income reported on a corporation's income statement also increases the amount of
the corporation's retained earnings. Retained earnings is a separate item reported in the
stockholders' equity section of the balance sheet. Hence, the income statement and balance
sheet are connected. (A net loss, or negative net income on the income statement decreases the
amount of the corporation's retained earnings.)
In the case of a sole proprietorship, the net income reported on the income statement will increase
the owner's capital account, which is part of owner's equity. A net loss will decrease the owner's
capital account.
Statement of Comprehensive Income

The statement of comprehensive income contains a few amounts that are not reported on the
income statement. These items are referred to as other comprehensive income.
The other component of comprehensive income is the net income reported on the company's
income statement. Therefore, the two major components of the the statement of comprehensive
income are:
 Net income (or net loss) from the income statement
 Other comprehensive income
The specific items that comprise other comprehensive income will be listed on the statement of
comprehensive income. Items that commonly appear as other comprehensive income include
the following:
 Foreign currency adjustments
 Unrealized gains/losses on pension and other postretirement benefit plans
 Unrealized gains/losses on hedging derivatives
How Other Comprehensive Income

Affects Stockholders' Equity
A corporation's positive amount of other comprehensive income causes the
corporation's accumulated other comprehensive income to increase. (Other comprehensive
losses cause the corporation's accumulated other comprehensive income to decrease.)
Accumulated other comprehensive income is a separate item appearing in the stockholders' equity
section of the corporation's balance sheet.
Here's a Tip
 A corporation's net income increases its retained earnings
 A corporation's other comprehensive income increases its accumulated other comprehensive
income
 Net income + Other comprehensive income = Comprehensive income
 Retained earnings and accumulated other comprehensive income are shown separately within
stockholders' equity
Additional Information Regarding

the Income Statement
Owner's compensation does not appear on a sole proprietorship income
statement
The income statement of a sole proprietorship does not report an expense for the owner working
in the business. The reason is that the owner of the sole proprietorship is not paid a salary. As a
result, the net income of a sole proprietorship cannot be directly compared to the net income of a
regular corporation where the owner is paid a salary.
For instance, assume that the income statement of a business organized as a sole
proprietorship reported a net income of $100,000. The $100,000 reflects the combination of (1)
the owner's compensation for working in the business, and (2) the earnings of the business.
If the same business had been organized as a regular corporation and the owner/stockholder
received a salary of $80,000, the income statement will report a net income of $20,000. The
reason is that the $80,000 salary will be listed on the corporation's income statement as salary
expense.
Historical cost principle
The income statement amounts are generally based on the historical amounts at the time of the
original transaction. (Changes in the fair value of marketable securities are an exception.)
To illustrate, assume that XXL Company's office and warehouse building was constructed 20
years ago at a cost of $750,000 and was estimated to have a useful life of 25 years with no
salvage value. Each year's income statement will likely report depreciation expense of $30,000.
If the XXL Company or a competitor were to construct a similar building today, the cost might be
$1,500,000 and the income statement will be reporting depreciation expense of $60,000.
What is the cost of using the facilities this year? Is it logical to match the costs from 20 years ago
with the current year revenues? That's what occurs because of the historical cost principle.
Average costs and opportunity costs

Some important costs are not shown in the income statement. Two examples are (1) the cost of
making and selling one or more additional units of product, and (2) the cost of missing an
opportunity.
To illustrate, assume that in a typical week Artisan Bread Company (ABC) produces 3,000
loaves of bread which will be sold for $7 a loaf. The cost of the ingredients is $1 per loaf and the
other costs (bakers, rent, depreciation, etc.) are $6,000 every week regardless of the number of
loaves produced. Therefore,
 If 2,000 loaves are produced, the average cost is $4 per loaf ($2,000 for ingredients +
$6,000 of fixed costs = $8,000/2,000 loaves)
 If 4,000 loaves are produced, the average cost is $2.50 per loaf ($4,000 for ingredients +
$6,000 of fixed costs = $10,000/4,000 loaves)
 The cost of making one additional loaf is $1 since the cost of ingredients is the only cost
that will change
Now assume that ABC decides to sell its breads at a special event but is unsure of the number of
loaves to produce. To avoid baking loaves that will not sell and lose the average cost, ABC
decides to bake 100 loaves. It ends up that the 100 loaves were sold within an hour, and it
becomes clear that an additional 200 loaves could have been sold. What was the cost of not
producing 200 additional loaves? In other words, what was the opportunity cost or opportunity lost?
The cost of missing the opportunity to sell 200 additional loaves will never be listed on ABC's
income statement. However, we can compute the opportunity cost of not producing the 200
additional loaves:
 Additional revenues missed = $1,400 (200 loaves X $7 selling price)

 Additional expenses avoided = $200 (200 loaves X $1 of ingredients)
 Opportunity cost = $1,200 ($1,400 - $200)
Someone will say "Hindsight is 20/20! How would ABC have known?"
Well, ABC could have understood that the average costs of $2.50 to $4 per loaf were not relevant. In
our example, the only relevant amount is the $1 per loaf cost of ingredients.
If ABC understood that by spending an additional $1 it could possibly earn $7, it may have
produced more loaves. In other words, risking $200 in ingredients to potentially receive an
additional $1,400 may have motivated ABC to produce more loaves. Looking at it another way,
ABC would recover the additional $200 cost for ingredients by selling just 30 of the 200 additional
loaves. After the 30 loaves are sold, ABC will be increasing its net income by $7 for each
additional loaf sold.
Income Statements That Remain

Inside the Company
The income statement format that we discussed and the requirement for issuing the set of five
financial statements pertains to the financial statements that are distributed to people outside of
the company, such as investors, lenders, financial analysts, etc. The financial statements that
remain inside the company can be in a format different from those required by US GAAP.
More detailed and/or less complete

It is common for the internal income statements to contain schedules of expenses to support the
amount of a company's SG&A expenses. Some schedules will be limited to the expenses of a
specific department such as IT, accounting, international marketing, human resources, etc. This
allows each department's manager to closely monitor its expenses without being distracted by
the expenses of another department.
Income statements can also be prepared for a company's major segments, such as the
consumer products division and the industrial products division. Other formats are also possible.
Contribution Margin Format

An internal income statement can be prepared to emphasize the contribution margin of a
company's products and product lines. The contribution margin examines the amount of net
sales remaining after deducting only the costs and expenses that will vary in total as volume
changes. Here is the concept in the form of an equation:
Contribution margin = sales – all variable costs and variable expenses
A brief example using hypothetical amounts in an income statement arranged in the contribution
margin format is shown here:
After the contribution margin is shown, the $6,000 of fixed costs and fixed expenses that
are directly traceable to each product line are subtracted.
The subtotal tells the reader the amount of profit that is available to cover the $20,000
of common fixed expenses. Common expenses means they have to be arbitrarily assigned to the
product lines. Often the total amount of the common expenses will not decrease when a product
line is eliminated.
The contribution margin format allows the company's executives to see the relative profitability of
its products or other segments. Seeing how profits will change when the volumes increase or
decrease may be valuable.
Introduction to Balance Sheet

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The balance sheet (also known as the statement of financial position) reports a
corporation's assets, liabilities, and stockholders' equity as of the final moment of an accounting
period. For example, a balance sheet dated December 31 summarizes the balances in the
appropriate general ledger accounts after all transactions up to midnight of December 31 have
been accounted for.
The balance sheet is one in a set of five financial statements distributed by a U.S. corporation.
To get a complete understanding of the corporation's financial position, one must study all five of
the financial statements including the notes to the financial statements.
The structure of the balance sheet reflects the accounting equation: assets = liabilities +
stockholders' (or owner's) equity. The use of double-entry accounting keeps the balance sheet in
balance.
The amounts reported on the balance sheet are summations of the ending balances in the many
asset, liability, and stockholders' equity accounts. The summarized amounts are presented in the
following sections of the balance sheet:
 Current assets
 Investments
 Property, plant and equipment
 Intangible assets
 Other assets
 Current liabilities
 Noncurrent liabilities
 Stockholders' equity
Generally accepted accounting principles (GAAP)

To assist the users of the balance sheet, a U.S. company must prepare its externally distributed
financial statements according to common rules known as generally accepted accounting
principles (GAAP or US GAAP; pronounced 'gap'). US GAAP includes basic underlying accounting
principles, assumptions, and detailed accounting standards of the Financial Accounting Standards
Board (FASB).
Part of US GAAP is to have financial statements prepared by using the accrual method of
accounting (as opposed to the cash method). The accrual method means that the balance sheet
must report liabilities from the time they are incurred until the time they are paid. It also means the
balance sheet will report assets such as accounts receivable and interest receivable when the
amounts are earned (as opposed to waiting until the money is received). In short, the accrual
method of accounting results in a more complete set of financial statements.
US GAAP will also mean that some of a company's most valuable things (internally developed
brand names, trademarks, patents, creative employees, etc.) will not be included as assets on
the company's balance sheet.
Let's begin by looking at some balance sheet formats.
Sample Balance Sheets

We will present examples of three balance sheet formats containing the same hypothetical
amounts. (The notes to the financial statements are omitted as they will be identical regardless of
the format used.)
Example of a balance sheet using the account form

In the account form (shown above) its presentation mirrors the accounting equation. That is,
assets are on the left; liabilities and stockholders' equity are on the right.
With the account form it is easy to compare the totals. It is also convenient to compare the
current assets with the current liabilities.
A drawback of the account form is the difficulty in presenting an additional column of amounts on
an 8.5" by 11" page.
Example of a balance sheet using the report form

As you can see, the report form presents the assets at the top of the balance sheet. Beneath the
assets are the liabilities followed by stockholders' equity.
Example of a comparative balance sheet

The comparative balance sheet presents multiple columns of amounts, and as a result, the heading
will be Balance Sheets. The additional column allows the reader to see how the most recent
amounts have changed from an earlier date.
It is common to present the recent amounts in the column closest to the descriptions, and the
oldest amounts furthest from the descriptions. It is also common for the amounts to be rounded
to the nearest dollar or nearest thousand dollars.
As you can see, the report form is more conducive to reporting an additional column(s) of
amounts.
Balance Sheet Templates

Did you know? Our Business Forms Package offers 80+ different business forms including the
following balance sheet templates in Excel and PDF format:
 Balance Sheet Template: Manufacturer – Corporation
 Balance Sheet Template: Retail/Wholesale – Corporation
 Balance Sheet Template: Retail/Wholesale – Sole Proprietor
 Balance Sheet Template: Services – Corporation
 Balance Sheet Template: Services – Sole Proprietor
In addition to our balance sheet templates, our business forms also offer templates for the
income statement, statement of cash flows, and more.
Now that we have seen some sample balance sheets, we will describe each section of the
balance sheet in detail.
Balance Sheet Heading

The heading found at the top of the balance sheet contains the following:
 Company name
 Name of the financial statement: Balance Sheet or Statement of Financial Position
 Date
Typically, the balance sheet date is the final day of the accounting period. If a company issues
monthly financial statements, the date will be the final day of each month.
The date communicates to the reader that the amounts reported on the balance sheet represent
the balances in the company's asset, liability, and stockholders' equity accounts after all
transactions up to the final moment of the date have been accounted for.
NOTE: Of the five financial statements, only the balance sheet's heading indicates a point or
moment in time, such as December 31, 2020. This date means the amounts shown reflect all
transactions up to midnight on December 31, 2020.
The headings on the other four financial statements indicate a span of time (interval of time, period
of time) during which the amounts occurred. For instance, the heading of a company's income
statement might indicate "For the year ended December 31, 2020". This tells the reader that the
amounts reported for sales and expenses are the total amounts for the 365 days of the year.
Financial statements issued between the end-of-the-year financial statements are referred to
as interim financial statements. Accounting years which end on dates other than December 31 are
known as fiscal years.
Balance sheet heading when a corporation owns multiple corporations
Many large corporations own and control several corporations. When the main corporation
issues a comparative balance sheet for the entire group of corporations, the balance sheet
heading will state "Consolidated Balance Sheets".
Assets
Assets are a company's resources (things the company owns). Their amounts appear on the
company's balance sheet if they:
 Were acquired through a purchase or were received through a donation

 Have a future economic value that can be measured and expressed in amounts of
currency
 Include prepaid expenses that have not yet expired or been used up
Assets are recorded in the company's general ledger accounts at their cost when they were
acquired. In accounting cost means all costs that were necessary to get the assets in place and
ready for use. For example, the cost of new equipment to be used in a business will include the
cost of getting the equipment installed and operating properly.
(In a company's general ledger, the balances in the asset accounts are normally debit balances.
We often visualize the debit balances as appearing on the left side of a T-account. This is
consistent with the accounting equation where assets appear on the left side of the equal sign.
You can learn more by visiting our topic Debits and Credits.)
Reporting assets on the balance sheet

Some common examples of general ledger asset accounts include Cash, Accounts Receivable,
Inventory, Prepaid Expenses, Buildings, Equipment, Vehicles, and perhaps 50 additional
accounts.
The general rule (except for certain marketable securities) is that the cost recorded at the time of
an asset's purchase will not be increased for inflation or to the asset's current market value.
However, some accounting rules do require some recorded costs to be reduced through a contra
asset account. For example, the cost of buildings and equipment used in the business will be
depreciated and the amount of the depreciation will be recorded with a credit entry to the contra
asset account Accumulated Depreciation. It is also possible that the reported amount of these and
other long-term assets will be reduced when their book values (cost minus accumulated
depreciation) have been impaired.
The ending balances in the company's related asset accounts will be combined and presented on
perhaps 15 lines on the balance sheet. Those combined amounts will appear as lines under the
following balance sheet categories:
 Current assets
 Investments
 Property, plant and equipment
 Other assets
Current Assets
A quick definition of current assets is cash and assets that are expected to be converted to cash
within one year of the balance sheet's date.
NOTE: The complete definition of a current asset is cash and assets that are expected to turn to
cash within one year of the balance sheet's date, or within the company's operating cycle, whichever
is longer.
Since most industries have operating cycles of less than a year, our examples will assume that
one year is longer than the companies' operating cycles.
The operating cycle for a distributor of goods is the average time it takes for the distributor's cash
to return to its checking account after purchasing goods for sale. To illustrate, assume that a
distributor spends $200,000 to buy goods for its inventory. If it takes 3 months to sell the goods
on credit and then another month to collect the receivables, the distributor's operating cycle is 4
months. Because one year is longer than the 4-month operating cycle, the distributor's current
assets includes its cash and assets that are expected to turn to cash within one year.
Here is the current asset section from our sample balance sheets:
Within the current asset section of the balance sheet, we usually see amounts for the following:
 Cash and cash equivalents
 Short-term investments
 Accounts receivable – net
 Other receivables
 Inventory
 Supplies
 Prepaid expenses
Cash and cash equivalents

Cash and cash equivalents appear as the first current asset and will be the combined amount of the
following:
 Cash which includes the company's checking account balances, currency, checks
received but not yet deposited in the bank account, and petty cash.
 Cash equivalents include investments that will mature within three months of the date they
were purchased. In other words, cash equivalents will be investments where their market
values are not likely to fluctuate in the near term. Examples of cash equivalents include
90-day U.S. Treasury Bills and money market accounts.
Short-term investments
Short-term investments are temporary investments that do not qualify as cash equivalents but are
expected to turn to cash within one year.
Accounts receivable – net

The balance sheet item accounts receivable – net (or trade receivables – net) is the amount in the
company's account Accounts Receivable minus the amount in the contra account Allowance for
Doubtful Accounts. This net amount is also known as the net realizable value of the company's
accounts receivable.
Generally, a company's accounts receivable will turn to cash within a month or two depending on
the company's credit terms.
The balance in the general ledger account Accounts Receivable is the sales invoice amounts for
goods sold on credit terms minus the amounts collected from these customers. In other words,
the balance in Accounts Receivable is the amount of the open or uncollected sales invoices.
The balance in the general ledger account Allowance for Doubtful Accounts is an estimate of the
amount in Accounts Receivable that the company anticipates will not be collected.
You can learn more by visiting our topic Accounts Receivable and Bad Debts Expense.
Other receivables
The current asset other receivables is the amount other than accounts receivable that a company
has a right to receive. For example, if a company lent an employee $1,000 and the amount is
being repaid over a four-month period, the amount owed by the employee as of the balance
sheet date will be reported as part of other receivables (or miscellaneous receivables or nontrade
receivables).
Another example of other receivables is a corporation's income tax refund related to its recently
filed income tax return.
Inventory
Inventory is likely the largest current asset on a retailer's or manufacturer's balance sheet. The
reported amount on the retailer's balance sheet is the cost of merchandise that was purchased,
but not yet sold to customers.
In the accounting period when the items in inventory are sold, the cost of the items sold is
removed from the asset inventory and is reported on the income statement as cost of goods sold.
In the U.S., a company can elect which costs will be removed first from inventory (oldest, most
recent, average, or specific cost). During times of inflation or deflation this decision affects both
the cost of the inventory reported on the balance sheet and the cost of goods sold reported on
the income statement.
A manufacturer is required to report (on the face of the balance sheet or in the notes to the
financial statements) the following ending inventory amounts:
 The cost of the raw materials on hand

 The cost of the work-in-process inventory
 The cost of the finished goods inventory.
You can learn more about inventory and the related cost flows by visiting our topic Inventory and
Cost of Goods Sold.
Supplies
Supplies includes the cost of office supplies, packaging supplies, maintenance supplies, etc. that
the company has on hand.
Prepaid expenses
The current asset prepaid expenses reports the amount of future expenses that the company
had paid in advance and they have not yet expired (have not been used up).
To illustrate, assume that on December 1, a company pays its $1,800 insurance premium for
property insurance covering the next six months of December 1 through May 31. This means that
during each of the six months, 1/6 of the $1,800 = $300 will be reported on the monthly income
statements. The amount not yet used up (still prepaid) as of each balance sheet date is reported
as the current asset prepaid expenses.
Given the above information, the company's December 31 balance sheet will report $1,500 as
the current asset prepaid expenses. (This is the original $1,800 payment on December 1 minus
$300 that was used up during the month of December. The $1,500 is also calculated as 5
months of unexpired insurance X $300 per month.) On January 31 the current asset prepaid
expenses will report $1,200 (4 months still unexpired X $300 per month). On February 28
prepaid expenses will report $900 (3 months of the insurance cost that is unexpired/still prepaid
X $300 per month), and so on.
You can learn more about prepaid expenses by visiting our topic Adjusting Entries.
Long-Term Assets
Long-term assets are also described as noncurrent assets since they are not expected to turn to
cash within one year of the balance sheet date.
The long-term assets are usually presented in the following balance sheet categories:
 Investments
 Property, plant and equipment – net
 Other assets
Here is the long-term (or noncurrent) asset section from our sample balance sheets:
Investments
The first long-term asset Investments will include amounts such as the following:
 Long-term investments in investment securities, real estate, or other businesses
 Property that is in the process of being sold
 Cash surrender value of life insurance policies owned by the company
 Bond sinking funds and other assets restricted for a long-term purpose
While long-term investments in marketable securities are initially recorded at their cost, the amount
of these investments will be adjusted (increased or decreased) to report their market value as of
the date of the balance sheet.
Property, plant and equipment – net

The balance sheet category property, plant and equipment – net includes the cost of the noncurrent,
tangible assets that are used in a business minus the related accumulated depreciation. (These
assets are sometimes referred to as fixed assets, plant assets, long-lived assets, and capital
assets.)
An asset's cost minus its accumulated depreciation is known as the asset's book value or carrying
value.
NOTE: The depreciation and the accumulated depreciation reported on a company's financial
statements are typically based on the assets' years of useful life.
These amounts are likely different from the amounts reported on the company's income tax
return.
The following amounts often appear under property, plant and equipment – net or will be disclosed
in the notes to the financial statements:
 Land
 Land improvements
 Buildings and improvements
 Machinery and equipment
 Furniture and fixtures
 Construction in progress
 Less: accumulated depreciation
Land
Land refers to the land used in the business, such as the land on which the production facilities,
warehouses, and office buildings were (or will be) constructed. The cost of the land is recorded
and reported separately from the cost of buildings since the cost of the land is not depreciated.
Land improvements
Land improvements include parking lots, lighting, driveways, etc. These will be depreciated over
their useful lives.
Buildings and improvements

The line buildings and improvements reports the cost of the buildings and improvements but not the
cost of the land on which they were constructed. For financial statement purposes, the cost of
buildings and improvements will be depreciated over their useful lives.
Machinery and equipment

The cost of a company's production assets is reported on the balance sheet as equipment or
as machinery and equipment. Since the machinery and equipment will not last forever, their cost is
depreciated on the financial statements over their useful lives.
Furniture and fixtures

Furniture and fixtures reports the cost of these items. Their cost will be depreciated on the
financial statements over their useful lives.
Construction in progress
The long-term asset construction in progress accumulates a company's costs of constructing new
buildings, additions, equipment, etc. Each project's costs are accumulated separately and will be
transferred to the appropriate property, plant, or equipment account when the asset is placed into
service. At that point, the depreciation of the constructed asset will begin.
Accumulated depreciation
Accumulated depreciation reports the cumulative amount of depreciation that was recorded on the
financial statements since the time that the depreciable assets were purchased and put into
service. (The cost of land and the costs reported as construction in progress are not
depreciated.)
The general ledger account Accumulated Depreciation will have a credit balance that grows
larger when the current period's depreciation is recorded. As the credit balance increases, the
book (or carrying) value of these assets decreases.
You can learn more about depreciation expense and accumulated depreciation by visiting our
topic Depreciation.
Intangible assets
Intangible assets are described as assets without physical substance. The intangible assets that
were purchased (as opposed to the result of effective advertising, training, etc.) are reported on
two long-term asset lines:
 Goodwill
 Other intangible assets
Goodwill
Goodwill is an intangible asset that is recorded when a company buys another business for an
amount that is greater than the fair value of the identifiable assets. To illustrate, assume that a
corporation pays $5 million to acquire a business that has tangible and identifiable intangible
assets having a fair value of $4 million. The $1 million difference is recorded as the intangible
asset goodwill.
Goodwill is assumed to have an indefinite useful life. Therefore, the recorded amount of goodwill
is not amortized to expense. Instead, each year the recorded cost of the goodwill must be tested
to see if the cost must be reduced by what is known as an impairment loss.
Other intangible assets

The line other intangible assets refers to intangible assets other than goodwill that were purchased
from another party. Some examples include the following:
 Copyrights
 Mailing lists
 E-mail lists
 Trademarks
 Patents (including the cost of defending existing patents)
Except for trademarks, the amount paid to purchase any of these other intangible assets must be
amortized to expense over the shorter of their expected useful life or their legal life.
Other assets
The noncurrent balance sheet item other assets reports the company's deferred costs which will be
charged to expense more than a year after the balance sheet date.
Liabilities
Liabilities are a company's obligations (amounts owed). Their amounts appear on the company's
balance sheet if they:
 Are owed as the result of a past transaction
 Are owed as of the balance sheet date
 Include money received before it has been earned
Liabilities (and stockholders' equity) are generally referred to as claims to a corporation's assets.
However, the claims of the liabilities come ahead of the stockholders' claims.
Sometimes liabilities (and stockholders' equity) are also thought of as sources of a corporation's
assets. For example, when a corporation borrows money from its bank, the bank loan was a
source of the corporation's assets, and the balance owed on the loan is a claim on the
corporation's assets.
A few examples of general ledger liability accounts include Accounts Payable, Short-term Loans
Payable, Accrued Liabilities, Deferred Revenues, Bonds Payable, and many more.
The balance sheet reports two major categories or classifications of liabilities:
 Current liabilities
 Long-term liabilities
Current Liabilities
Current liabilities are a company's obligations that will come due within one year of the balance
sheet's date and will require the use of a current asset or create another current liability. Current
liabilities are sometimes known as short-term liabilities.
(If the company's operating cycle is longer than one year, the length of the operating cycle
determines whether a liability is reported as current or long-term.)
Examples of the descriptions used to report a company's current liabilities include:
 Short-term loans payable

 Current portion of long-term debt
 Accounts payable
 Accrued compensation and benefits
 Income taxes payable
 Other accrued liabilities
 Deferred revenues
The order in which the current liabilities will appear on the balance sheet can vary. However, it is
common to see three (listed in any order) at the top of the list: accounts payable, short-term
loans payable, and the current portion of long-term debt.
Here is the current liability section from our sample balance sheets:
Short-term loans payable

A short-term loan payable is an obligation usually in the form of a formal written promise to pay
the principal amount within one year of the balance sheet date. Interest is likely to be due
monthly. Short-term loans payable could appear as notes payable or short-term debt.
For instance, if a company obtains a 6-month bank loan on December 31, 2020 for $100,000 and
agrees to pay interest at the end of each month at the annual interest rate of 10%, the company's
balance sheet as of December 31, 2020 will report a current liability of $100,000. Since no
interest is owed as of December 31, 2020, no liability for interest is reported on this balance
sheet.
Current portion of long-term debt

The current portion of long-term debt is the amount of principal that must be paid within 12 months
of the balance sheet date. (The principal amount that comes due after 12 months is reported as a
noncurrent liability.)
To illustrate, assume that a corporation borrows $120,000 on December 31, 2020. The
promissory note requires each month's interest to be paid on the last day of each month. The
note also requires the company to make annual principal payments of $40,000 on December 31
of 2021, 2022, and 2023. On the December 31, 2020 balance sheet, the corporation's $120,000
of debt is reported as follows:
 A current liability (reported as current portion of long-term debt) of $40,000

 A long-term liability (reported as notes payable) of $80,000
Since no interest is payable on December 31, 2020, this balance sheet will not report a liability for
interest on this loan.
Accounts payable
Accounts payable represents the amounts owed to vendors or suppliers for goods or services the
company had received on credit. The amount is supported by the vendors' invoices which had
been received, approved for payment, and recorded in the company's general ledger
account Accounts Payable.
You can learn more by visiting our topic Accounts Payable.
Accrued compensation and benefits
The current liability accrued compensation and benefits reports the wages, salaries, bonuses,
employers' payroll taxes, and benefits that employees have earned as of the balance sheet date,
but they have not yet been paid by the company.
Income taxes payable

The current liability described as income taxes payable is the amount of income taxes that
a regular U.S. corporation must pay to the federal and state governments within one year of the
balance sheet date. (Sole proprietorships, partnerships, and some corporations will not have
income taxes payable since the business income is reported by the owners on their personal tax
returns.)
Other accrued expenses and liabilities

Other accrued expenses and liabilities is a current liability that reports the amounts that a company
has incurred (and therefore owes) other than the amounts already recorded in Accounts Payable.
Examples of accrued expenses include interest owed on loans payable, cost of electricity used
(but the electric bill was not yet received), repair expenses that occurred at the end of the
accounting period (but the repair bill was not yet processed), etc.
In order to issue a company's financial statements on a timely basis, it may require using an
estimated amount for the accrued expenses.
You can learn more about accrued expenses by visiting our topic Adjusting Entries.
Another item that could be included as part of other liabilities is the state and local sales and use
taxes. To illustrate, assume a company sold $10,000 of merchandise that was subject to sales
taxes of 8%. The retailer records this information in its general ledger accounts as follows:
 Debit Cash for $10,800
 Credit Sales for $10,000
 Credit the current liability Sales Taxes Payable for $800
Note that the sales taxes are not part of the company's sales revenues. Instead, any sales taxes
not yet remitted to the government is a current liability.
Deferred revenues
The current liability deferred revenues reports the amount of money a company received from a
customer for future services or future shipments of goods. Until the company delivers the services
or goods, the company has an obligation to deliver them or to refund the customer's money.
When they are delivered, the company will reduce this liability and increase its revenues.
Three examples of deferred (or unearned) revenues include:
 Deposits from customers for work to be done in a future accounting period

 Money received in advance by an insurance company for the next six months of
insurance coverage
 Money received for gift cards that have not been redeemed as of the balance sheet date.
You can learn more about deferred revenues by visiting our topic Adjusting Entries.
Long-Term Liabilities
Long-term liabilities, which are also known as noncurrent liabilities, are obligations that are not
due within one year of the balance sheet date.
Three examples of long-term liabilities include:
 Notes payable
 Bonds payable
 Deferred income taxes
Here is the long-term liability section from our sample balance sheets:
Notes payable
When notes payable appears as a long-term liability, it is reporting the amount of loan principal that
will not be payable within one year of the balance sheet date.
To illustrate, assume that a company signed a promissory note on December 31, 2020 for a loan
of $120,000. The loan requires the interest to be paid at the end of every month. The loan's
principal of $120,000 is required to be paid as follows:
 On December 31, 2021, a principal payment of $40,000

The company's December 31, 2020 balance sheet will report the $120,000 of principal owed as
follows:
 The long-term liability notes payable will report $80,000. This is the total of the two
principal payments due after December 31, 2021 (the payments due on December 31,
2022 and December 31, 2023).
 The current liability current portion of long-term debt will report $40,000. This is the
principal payment due within one year of December 31, 2020 (the payment due on
December 31, 2021).
The company's December 31, 2021 balance sheet will report the remaining $80,000 of principal
owed as follows:
 The long-term liability notes payable will report $40,000. This is the principal payment due
after December 31, 2022 (the payment due on December 31, 2023).
 The current liability current portion of long-term debt will report $40,000. This is the
principal payment due within one year of December 31, 2021 (the payment due on
December 31, 2022).
Another example of a long-term liability is a mortgage loan for a company's office building. (A
mortgage loan is a loan secured by a lien on real estate.) Assuming the mortgage loan requires
monthly payments of interest and principal, the total of the 12 loan principal payments following the
date of the balance sheet will be reported as the current liability current portion of long-term debt.
The principal balance remaining after those 12 principal payments is reported as the long-term
liability mortgage loan payable. (For an example of this calculation, see our Business Form G-7
Current Portion of Long-term Debt.)
Bonds payable
Bonds payable are long-term debt securities issued by a corporation. Typically, bonds require the
issuer to pay interest semi-annually (every six months) and the principal amount is to be repaid
on the date that the bonds mature. It is common for bonds to mature (come due) 10-20 years
after the bonds were issued.
A corporation that issues bonds will often have some balance sheet general ledger accounts
associated with the bonds (Bonds Payable, Bond Issue Costs, Discount on Bonds Payable, Premium on
Bonds). The balances in these accounts are likely combined into a single amount.
Any bond interest that has accrued but has not been paid as of the balance sheet date is
reported as the current liability other accrued liabilities.
You can learn about bonds by visiting our topic Bonds Payable.
Deferred income taxes

Often the amount reported as the long-term liability deferred income taxes pertains to the difference
between the amounts of depreciation expense reported on a regular U.S. corporation's financial
statements vs. the amounts of depreciation expense reported on the corporation's income tax
returns. The amount results from the timing of when the depreciation expense is reported.
Commitments and Contingencies

The final liability appearing on a company's balance sheet is commitments and contingencies along
with a reference to the notes to the financial statements. No amount is shown on the balance sheet
for this item.
The notes for commitments and contingencies could include the following disclosures:
 A company's guarantee of another party's debt. In other words, the company will have a
liability only if/when the other party fails to pay the amount owed.
 A lawsuit filed against the company and a loss is reasonably possible but not probable. (If a
loss is probable and the amount can be estimated, the amount is to be reported as a
liability on the face of the balance sheet.)
Stockholders' Equity
If a business is organized as a corporation, the balance sheet section stockholders'
equity (or shareholders' equity) is shown beneath the liabilities. The total amount of the
stockholders' equity section is the difference between the reported amount of assets and the
reported amount of liabilities. Similar to liabilities, stockholders' equity can be thought of as
claims to (and sources of) the corporation's assets.
(If the business is a sole proprietorship, this section appears as owner's equity. We will discuss
owner's equity later.)
The stockholders' equity section will report the following items as separate amounts:
 Common stock
 Retained earnings
 Accumulated other comprehensive income
 Treasury stock (a subtraction)
Here is the stockholders' equity section from our sample balance sheets:
Common stock
Common stock reports the amount a corporation received when the shares of its common stock
were first issued.
NOTE: Some of the states in the U.S. require that a corporation's shares of common stock have
a par value. If so, the amount the corporation received when the shares were issued is divided
between two lines that are reported within the stockholders' equity section:
 Common stock – par value
 Common stock – amount in excess of par value
A relatively small percent of corporations will issue preferred stock in addition to their common
stock. The amount received from issuing these shares will be reported separately in the
stockholders' equity section.
The amount the corporation received from issuing shares of stock is referred to as paid-in
capital and as permanent capital.
Retained earnings
For many successful corporations, the largest amount in the stockholders' equity section of the
balance sheet is retained earnings. Retained earnings is the cumulative amount of 1) its
earnings minus 2) the dividends it declared from the time the corporation was formed until the
balance sheet date.
It is important to realize that the amount of retained earnings will not be in the corporation's bank
accounts. The reason is that corporations will likely use the cash generated from its earnings to
purchase productive assets, reduce debt, purchase shares of its common stock from existing
stockholders, etc.
Accumulated other comprehensive income

The stockholders' equity section may include an amount described as accumulated other
comprehensive income. This amount is the cumulative total of the amounts that had been reported
over the years as other comprehensive income (or loss).
Three examples of other comprehensive income (or loss) that resulted in the amount reported in the
stockholders' equity section as accumulated other comprehensive income are:
 Foreign currency translation adjustments
 Unrealized gains/losses on hedge/derivative financial instruments
 Unrealized gains/losses on postretirement benefit plans
Treasury stock
Treasury stock is a subtraction within stockholders' equity for the amount the corporation spent to
purchase its own shares of stock (and the shares have not been retired).
When the corporation purchases shares of its stock, the corporation's cash declines, and the
amount of stockholders' equity declines by the same amount. Hence, the cumulative cost of
the treasury stock appears in parentheses.
NOTE: One of the financial statements issued by a corporation is the statement of stockholders'
equity. This financial statement summarizes the changes in the components of stockholders'
equity for each of the most recent three years.
To learn more about the components of stockholders' equity, visit our topic Stockholders' Equity.
Owner's Equity
Since our sample balance sheets focused on the stockholders' equity section of a corporation,
we want to discuss the comparable section for a business organized as a sole proprietorship.
The balance sheet of a sole proprietorship will report owner's equity instead of a

corporation's stockholders' equity. Hence, a sole proprietorship's balance sheet will resemble the
accounting equation: assets = liabilities + owner's equity.
The owner's equity section of a sole proprietorship owned by J. Ott will have two general ledger
accounts in which amounts are recorded:
 J. Ott, Capital
 J. Ott, Drawing
The account J. Ott, Capital is the main owner's equity account. Its balance is carried forward to
the following year.
The account J. Ott, Drawing is used to record the owner's withdrawals of cash (or other assets)
during the accounting year. The owner's draws are not reported as an expense on the company's
income statement, but they do cause a decrease in the owner's capital. (At the end of the
accounting year, a closing entry transfers the debit balance in J. Ott, Drawing to the account J.
Ott, Capital.)
Reasons for the Change in Owner's Equity

Typically, the change in the amount of owner's equity for a sole proprietorship business is the
result of:
 The owner personally investing money in the business
 The owner withdrawing money from the business for personal use
 The company earning revenues (and/or has gains)
 The company incurring expenses (and/or losses)
The combination of the last two bullet points is the amount of the company's net income.
How the Balance Sheet and Income

Statement Are Connected
The account Retained Earnings provides the connection between the balance sheet and the
income statement.
How revenues affect retained earnings

When revenues and gains are earned by a corporation, they have the effect of immediately
increasing the corporation's retained earnings. This is true even though they are not directly
recorded in the Retained Earnings account at the time they are earned.
To illustrate, let's examine what occurs when a company earns revenues by providing services on
credit:
 The asset account Accounts Receivable is increased.
 An income statement account such as Revenues Earned is increased. However, when
revenues are earned, they have the immediate effect of increasing the corporation's retained
earnings. This is true, even if the balance in the Revenues Earned account is transferred
to the Retained Earnings account only at the end of the accounting year.
How expenses affect retained earnings

When a corporation incurs expenses and losses, they have the effect of immediately decreasing the
corporation's retained earnings. This is true, even though they are not directly recorded in the
Retained Earnings account at the time the expenses or losses occurred. To illustrate, assume a
corporation issues monthly income statements and it pays each month's rent on the first day of
the month. Here is what occurs:
 The asset account Cash is decreased.
 The income statement account Rent Expense is increased. However, as the expense is
occurring, the immediate effect is to decrease the corporation's retained earnings. This is
true, even if the balance in the Rent Expense account is transferred to the Retained
Earnings account only at the end of the accounting year.
Notes To the Financial Statements

The notes to the financial statements are an integral (essential) part of the balance sheet. To
communicate this, there will be a notation on the face of the balance sheet that states "See notes
to the financial statements." or "The accompanying notes to the financial statements are an
integral part of this statement."
The notes to the financial statement are required by the accounting principle known as the full
disclosure principle and will include the following:
 Summary of significant accounting policies is the first note. It describes the use of estimates,
revenue recognition, inventories, property and equipment, goodwill and other intangible
assets, effects of recent accounting rules from the FASB, and more.
 Schedules of amounts and other details for inventories, accrued liabilities, income taxes,
employee benefit plans, leases, stock options, commitments, contingencies, related party
transactions, assets pledged as collateral, and more.
NOTE: U.S. corporations whose common stock is traded on a stock exchange are required to file
an annual report with the Securities and Exchange Commission (SEC). The report known
as Form 10-K contains the complete set of the corporation's financial statements with notes plus it
has additional information concerning the corporation's financial position, liquidity, operations,
risks, etc.
You can access a corporation's Form 10-K by going to the Investor Relations section of the
corporation's website.
Making Sure Your Company's

Balance Sheet Is Accurate
Before issuing a balance sheet, it is wise to do a final review of the amounts being reported. Here
are some steps we recommend:
 Compare the amounts to the amounts reported on earlier balance sheets.
 Make certain that the balance sheet amounts agree with the supporting workpapers and
other documentation. Here are some examples along with links to the related topics
found on AccountingCoach.com:
o The amount of cash and cash equivalents should be supported by bank

reconciliations for the company's bank accounts. You can learn more by visiting
our topic Bank Reconciliation.
o Accounts receivable – net should be compared to an aging of accounts receivable.
You can learn more by visiting our topic Accounts Receivable and Bad Debts
Expense.
o Inventory should be supported by a schedule of calculations to support the cost
reported as inventory. You can learn more by visiting our topic Inventory and Cost
of Goods Sold.
o The amount of prepaid expenses should agree with workpapers showing the
calculations of the amounts that had been paid in advance and are still prepaid
as of the date of the balance sheet. You can learn more by visiting our
topic Adjusting Entries.
o Accounts payable should be supported by a listing of amounts owed. You can learn
more by visiting our topic Accounts Payable.
o Accrued liabilities should agree with workpapers showing the calculation of the
amounts owed but have not yet been recorded. You can learn more by visiting
our topic Adjusting Entries.
o Deferred revenues should be supported by a workpaper documenting the amounts
received from customers in advance but have not yet been earned. You can learn
more by visiting our topic Adjusting Entries.
Monitoring Your Company's

Financial Position
Determining a company's liquidity
A critical need for small (and all) businesses is having sufficient money on hand to meet their
payroll and to pay the other obligations when they come due. This is associated with the
term liquidity, which is often assessed by comparing a company's current assets to its current
liabilities. In our topic Working Capital and Liquidity we discuss this and the following financial
ratios in detail:
 Working capital which is the amount of current assets minus the amount of current
liabilities.
 Current ratio which is the amount of current assets divided by the amount of current
liabilities.
 Quick ratio which is similar to the current ratio except that inventory and prepaid expenses
are excluded from the amount of current assets. The quick ratio is also known as the acid-
test ratio.
 Receivables turnover ratio which is the amount of sales on credit for a year divided by the
average balance in accounts receivable during the year. A related financial ratio is
the days' sales in receivables (average collection period).
 Inventory turnover ratio which is the cost of goods sold for a year divided by the average
cost of inventory during the year. A related financial ratio is the days' sales in inventory
(days to sell).
The two "turnover" ratios in the above list highlight that it is not sufficient to merely have accounts
receivable and inventory. These current assets must also be converted to cash in time to pay the
company's obligations when they come due.
Of course, the company must have practices and procedures to assure that credit is granted only
to credit worthy customers, that accounts receivables are monitored and collected when due, that
inventory levels are managed, and that internal controls are in place to safeguard all assets.
Determining a company's ability to obtain long-term loans

The balance sheet also provides information on a corporation's ability to obtain long-term loans.
For instance, if a corporation has a large amount of debt (the combination of current and long-
term liabilities) compared to the amount of its stockholders' equity, the corporation is said to
be highly leveraged. A high level of financial leverage may be viewed by lenders as a high level of
risk.
Here are two financial ratios which are often used for determining the level of a corporation's
financial leverage:
 Debt to equity ratio which compares a corporation's total debt (current liabilities + long-
term liabilities) to the amount of stockholders' equity.
 Debt to total assets ratio which compares a corporation's total debt to the total amount of its
assets.
If a corporation is highly leveraged, a lender may not be interested in making new or additional
loans to the corporation.
Of course, lenders will also exam other financial information including:
 The corporation's notes to its financial statements

 The corporation's income statements
 The corporation's statements of cash flows
Issuing additional common stock or additional bonds

Some corporations may be able to issue additional shares of its common stock and/or to issue
bonds to obtain money for purchasing long-term assets, expanding operations, reducing the
amount of its short-term debt, etc.
Issuing shares of common stock has advantages and disadvantages:

 It has the advantage of increasing the amount of stockholders' equity thereby reducing
the corporation's degree of financial leverage. The reduction in financial leverage could
also allow the corporation to obtain additional loans.
 It has the disadvantage of diluting an existing stockholder's percent of ownership in the
corporation.
Issuing bonds also has advantages and disadvantages:

 One advantage of bonds is their low cost since the interest paid to the bondholders will
be a deductible expense on the income tax return of a profitable corporation. Another
advantage is that an existing stockholder's percent of ownership is not reduced.
 A disadvantage of bonds is the increase in the corporation's liabilities, thereby increasing

the corporation's financial leverage. This will be interpreted to mean additional risk.
Some Limitations of the Balance

Sheet
Some assets are not included
Due to the accounting principle known as the cost principle (or historical cost principle), some
valuable trademarks developed internally by a company are not reported as assets on its balance
sheet. For example, the internationally recognized trademarks developed by Coca-
Cola and Nike might be among their most valuable assets. However, these trademarks are not
reported on their balance sheets since they were not purchased in a transaction with another
party.
NOTE: If a company purchases a brand name and trademark from another business at a cost of
$1 million, this cost will be recorded by the company at the time of the transaction. So long as
there is no impairment to the brand, the $1 million cost will be reported on the company's future
balance sheets.
However, if the same company creates and develops a successful, valuable brand and
trademark through its astute marketing, those marketing costs are expensed when they occur.
As a result, this valuable brand name and trademark will not be reported as assets on the
company's balance sheets.
Similarly, the cost principle prevents a company's balance sheet from including the value of its
highly effective management, its research team, customer allegiance, unique marketing
strategies, etc.
Balance Sheet Should Be Read With

the Other Financial Statements
A corporation's balance sheet and the notes to the financial statements should be read along
with the corporation's other financial statements:
The FASB's Highlights of FASB's Statement of Financial Accounting Concepts No. 5 (issued in 1984)
states, "no one financial statement is likely to provide all the financial statement information that
is useful for a particular kind of decision."
Introduction to the Cash Flow
Statement
Did you know? You can earn our Cash Flow Statement Certificate of Achievement when you join PRO
Plus. To help you master this topic and earn your certificate, you will also receive lifetime access to our
premium financial statements materials. These include our video training, visual tutorial, flashcards, cheat
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The cash flow statement is the name commonly used by practicing accountants for the statement of
cash flows or SCF. We will use these names interchangeably throughout our explanation, practice
quiz, and other materials.
The cash flow statement is required for a complete set of financial statements.
The SCF reports the cash inflows and cash outflows that occurred during the same time interval
as the income statement. The time interval (period of time) covered in the SCF is shown in its
heading. Two examples include "Year ended December 31, 2020" and "Three months ended
September 30, 2020".
The amounts on the SCF provide the reasons for the change in a company's cash and cash
equivalents during the period covered. For simplicity, we will assume that the company does not
have cash equivalents. Therefore, our SCF will explain the change in the company's cash from
the beginning of the year to the end of the year (or the beginning of the quarter to the end of the
quarter, etc.). Given our assumption that the company does not have cash equivalents, the
following is a skeleton of the SCF's format:
The cash flows from operating activities section provides information on the cash flows from the
company's operations (buying and selling of goods, providing services, etc.). With the most likely
used indirect method, the starting point of this section is the company's net income. It is followed
with adjustments to convert the amount of net income from the accrual method to the cash
amount.
The cash flows from investing activities lists the cash flows associated with the purchase and sale
of noncurrent (long-term) assets such as investments and property, plant and equipment.
The cash flows from financing activities section reports the cash flows associated with the issuance
and repurchase of a corporation's bonds and capital stock, the payment of dividends, and the
borrowing and repayment of short-term and long-term loans.
At the bottom of the SCF (and other financial statements) is a reference to inform the readers
that the notes to the financial statements should be considered as part of the financial statements.
The notes provide additional information such as disclosures of significant exchanges of items
that did not involve cash, the amount paid for income taxes, and the amount paid for interest.
We begin with reasons why the statement of cash flows (SCF, cash flow statement) is a required
financial statement.
Why the Cash Flow Statement is

Required
The accounting profession realizes that reading only one or two financial statements is not
sufficient for understanding a company's finances and operations. Accordingly, the generally
accepted accounting principles (GAAP, US GAAP) require that the statement of cash flows be
part of a set of financial statements distributed outside of a company. A complete set of financial
statements consists of five financial statements and the notes to the financial statements:
 Balance sheet
 Notes to the financial statements
While the income statement amounts make the news, the amounts are based on the accrual
basis of accounting. This method of accounting best measures a company's sales, expenses, and
earnings during a short time interval. However, the income statement does not measure and
report the amounts of cash that flowed in and out of the company. For example, the income
statement does not report the following:
 Cash collected from sales. (The cash might be collected from customers 45 days after
the sale.)
 Cash paid for goods sold. (Payment may have been made many months prior to their
sale.)
 Cash paid for buildings and equipment that will be expensed over the next 5 to 30 years.
 Cash received from the sale of long-term assets
 Cash received from bank loans
 Cash payments to reduce a loan's principal balance
 Cash withdrawn by owners or cash dividends paid to stockholders
A company's understanding of its cash inflows and outflows is critical for meeting its short-term
and long-term obligations to its suppliers, employees, and lenders. Current and potential lenders
and investors are also interested in the company's cash flows.
Financial analysts will review closely the first section of the cash flow statement, cash flows from
operating activities. Part of the review consists of comparing this section's total (described as net
cash provided by operating activities) to the company's net income. This is done to see whether
the revenues, expenses, and net income reported on the income statement are consistent with
the change in the company's cash balance.
If they are not consistent, they will seek to uncover the root causes for the differences. Perhaps
the company's inventory is no longer in demand or is being returned by customers. Perhaps
receivables are not being collected, and so on. (In short, the analyst believes that "Cash is king".
While there can be some leeway in applying accounting principles, there is no leeway when it
comes to reporting the amount of cash.)
Lastly, the SCF provides the cash amounts needed in some financial models.
Example of a Cash Flow Statement

The following is an example of the statement of cash flows, which is commonly referred to as
the cash flow statement or SCF. (The company and the amounts shown are hypothetical.)
The heading for Example Corporation's statement of cash flows indicates that the amounts
occurred during the year January 1 through December 31, 2020.
In bold font you see subheadings for the three sections of the SCF. Many corporations omit
"Cash flows from" and simply show the following as the subheadings:
 Operating activities
 Investing activities
 Financing activities
Some amounts are shown in parentheses, while other amounts are not. We will cover these in
detail later, but let's introduce the technique by looking at the amounts shown for investing
activities:
 The amount (300,000) communicates that cash of $300,000 was paid out, was a cash
outflow, or that it reduced the company's cash balance. Parentheses can also be thought of
as having a negative or unfavorable effect on the company's cash balance.
 The amount 40,000 indicates that cash of $40,000 was received, was a cash inflow, or that
it increased the company's cash balance. Amounts without parentheses can also be thought
of as having a positive or favorable effect on the company's cash balance.
 The (260,000) is described as the net cash used for investing activities. "Net" means the
combination of the cash inflow of (300,000) and the cash outflow of 40,000.
The amount 92,000 shown on the line Net increase in cash during the year is the combination of
each section's sum: 262,000 + (260,000) + 90,000. Since this net amount or grand total is a
positive amount, it is shown without parentheses and is described as net increase in cash during
the year.
Note that the net increase (or net decrease) in cash during the year is combined with the cash at
the beginning of the year to show the cash at the end of the year. In our example, it is 92,000 +
101,000 = $193,000. The end of the year balance of $193,000 should agree with the cash
balance on the company's balance sheet for December 31, 2020.
Lastly, at the bottom of all financial statements is a sentence that informs the reader to read the
notes to the financial statements. The reason is that not all business transactions can be
adequately expressed as amounts on the face of the financial statements.
Cash Flows from Operating Activities

The first section of the statement of cash flows is described as cash flows from operating
activities or shortened to operating activities. Operating activities are also referred to as company
operations.
Operating activities are the business activities other than the investing and financial activities.
Here is the operating activities section of Example Corporation's SCF which we will be referring
to in our discussion:
Note that the combination of the positive and negative amounts in this section add up to a
positive 262,000. Hence, it is described as "Net cash provided by operating activities". If the
amounts had added up to a negative amount, the description would be "Net cash used by
operating activities".
Indirect Method for Preparing the Cash Flow Statement

Companies may choose to use either the direct method or the indirect method when preparing
the SCF section cash flows from operating activities. However, the indirect method is the dominant
method used and the one we will explain.
Under the indirect method, the SCF section cash flows from operating activities begins with the
amount of net income, which is taken from the company's income statement. Since the net
income was based on the accrual method of accounting, the amount of net income must be
adjusted to the cash amount.
If an adjustment to the amount of net income is in parentheses, it is subtracted from net income.
It indicates that the cash amount was less than the related amount on the income statement.
Adjustments in parentheses can also be interpreted to be unfavorable for the company's cash
balance.
An adjustment to net income that is not in parentheses is a positive amount, which indicates
the cash amount was more than the related amount on the income statement. A positive
adjustment can also be interpreted to be favorable for the company's cash balance.
Adjustments to Convert the Net Income Amount to the Cash Amount

In the case of Example Corporation, the section cash flows from operating income begins with the
company's net income for the year: $230,000.
A large corporation often has 10 or more adjustments to convert the amount of net income to the
amount of cash. However, we will limit our discussion to some of the more common adjustments
shown on Example Corporation's statement of cash flows:
 Depreciation and amortization 63,000. Since this adjustment amount appears without
parentheses, it indicates that the cash amount will be $63,000 more than the amount of
net income. The reason is depreciation and amortization expense reduced the
company's net income, but it did not reduce the company's cash balance. In other words,
without this noncash expense of $63,000, the company would have seen its cash increase
by $230,000 + $63,000.
 Loss on sale of equipment 15,000. This amount appears without parentheses and therefore
the company's cash amount will be more than the net income. The reason is that
Example Corporation's net income had been reduced by this loss of $15,000. However,
the company did not pay out the $15,000. Therefore, it is added to the amount of net
income, causing the cash from operations to be greater by $15,000. (If cash is received
from the sale of this noncurrent asset, the amount received is reported as a positive
amount on the SCF in the section cash flows from investing activities.)
o If there was a gain on the sale of a noncurrent asset, the amount of the gain
would have increased net income. However, since the entire amount of cash
received from the sale of a noncurrent asset is reported under cash flows from
investing activities, the gain is subtracted from the amount of net income.
 Increase in accounts receivable (21,000). Since this amount is in parentheses, it
communicates that the company collected less cash than the amount of sales reported
on the income statement. This is determined by examining how the balance in accounts
receivable changed during the year. If the company's receivables increased, it indicates
that not all sales on the income statement were collected. This is viewed as unfavorable
for the company's cash balance. Therefore, the amount of the increase in accounts
receivable is deducted from the amount of net income.
o If the balance in the company's accounts receivable had decreased, it indicates
that the company collected more than the amount of sales reported on the
income statement. Therefore, the amount of the decrease in receivables would be
added to the amount of net income. The decrease in receivables is positive,
favorable, and good for the company's cash balance.
 Decrease in prepaid expenses 3,000. If the balance in the current asset prepaid expenses
had decreased, it meant that $3,000 of the amount of expenses on the income statement
did not require using $3,000 of cash. Therefore, we add $3,000 to the amount of net
income. In other words, using part of the prepaid amount instead of paying cash was
favorable/positive for the company's cash balance.
o If the balance in prepaid expenses had increased during the year, it means the
company had paid out more cash than the amount reported as expense on the
income statement. Therefore, the increase in this current asset is subtracted from the
amount of net income. In other words, increasing the balance in prepaid expense
was not good for the company's cash balance.
 Decrease in accounts payable (28,000). If the balance in the current liability accounts
payable had decreased, it indicates that the company paid its suppliers more than the
amount of expenses reported on the income statement. As a result, the decrease in
payables is shown in parentheses. Paying the suppliers more than the related expenses
reported on the income statement had a negative or unfavorable effect on the company's
cash balance.
 If the balance in accounts payable had increased, it would indicate the company paid its
suppliers less than the expenses reported on the income statement. Paying out less cash
is good/favorable for the company's cash balance. Therefore, an increase in payables is
added to the amount of net income.
Quick Guide to Changes in Current Asset Balances

When adjusting a company's net income for changes in the balances of the current assets, the
following may be a helpful guide:
 If a current asset's balance (other than cash) had increased, the amount of
the increase is subtracted from the amount of net income. The increase in a current asset
(other than cash) had a negative/unfavorable effect on the company's cash balance.
 If a current asset's balance (other than cash) had decreased, the amount of
the decrease is added to the amount of net income. The decrease in a current asset (other
than cash) had a positive/favorable effect on the company's cash balance.
Quick Guide to Changes in Current Liability Balances

When adjusting a company's net income for changes in the balances of the current liabilities, the
following may be a helpful guide:
 If a current liability's balance (other than loans payable) had increased, the amount of
the increase is added to the amount of net income. The increase in a current liability had a
positive/favorable effect on the company's cash balance.
 If a current liability's balance (other than loans payable) had decreased, the amount of
the decrease is subtracted from the amount of net income. The decrease in a current
liability had a negative/unfavorable effect on the company's cash balance.
The adjustments reported in the operating activities section will be demonstrated in detail in "A
Story To Illustrate How Specific Transactions and Account Balances Affect the Cash Flow
Statement" in Part 3.
Next, we will discuss the cash flows involving a company's investing activities.

Cash Flows from Investing Activities

The investing activities section of the SCF reports the cash inflows and cash outflows related to
the changes that occurred in the noncurrent (long-term) assets section of the balance sheet.
Examples of investing activities include the following:
 Capital expenditures (additions to property, plant and equipment)

 Proceeds from the sale of property, plant and equipment
 Purchase of long-term investments
 Proceeds from the sale of long-term investments
Our discussion uses Example Corporation's cash flows from investing activities:
Capital expenditures are the amounts spent for acquiring, adding, and/or improving noncurrent
assets used in a business. (Large amounts spent for repairing an existing asset are reported
as expenses on the current period's income statement.)
Since the amount spent by Example Corporation for capital expenditures required an outflow of
cash, the amount appears in parentheses: (300,000). You can also think of the amount spent as
unfavorable for the company's cash balance and/or cash used.
Proceeds from sale of equipment 40,000 is a positive amount since this is the amount of cash
that was received. In other words, the $40,000 was an inflow of cash and therefore favorable for
Example Corporation's cash balance.
(Also see our discussion of Cash Flows from Operating Activities for the reporting of the gains
and losses on the sale of noncurrent assets.)
Amounts spent to acquire long-term investments are reported in parentheses, since it required
an outflow or use of cash.
The proceeds (cash received) from the sale of long-term investments are reported as positive
amounts since the proceeds are favorable for the company's cash balance.
Cash Flows from Financing Activities

The cash inflows and outflows from financing activities are related to the changes in the following
balance sheet sections:
 Noncurrent (long-term) liabilities

 Stockholders' equity (or owner's equity)
 Loans and similar debt reported under current liabilities
Examples of the descriptions and amounts typically reported under cash flows from financing
activities include the following:
 Proceeds from long-term debt
 Repayment of long-term debt
 Proceeds from issuing capital stock
 Payment of dividends
 Purchase of treasury stock
 Change in short-term debt
Our discussion of financing activities will use the following section of Example Corporation's
SCF:
Assume that Example Corporation issued a long-term note/loan payable that will come due in
three years and received $200,000. As a result, the amount of the company's long-term liabilities
increased, as did its cash balance. Therefore, this inflow of $200,000 is reported as a positive
amount in the financing activities section of the SCF.
Next, assume that Example Corporation distributed $110,000 of cash dividends to its
stockholders. The $110,000 cash outflow has an unfavorable or negative effect on the
company's cash balance. As a result, the amount will be shown in the financing section of the
SCF as (110,000).
When Example Corporation repays its loan, the amount of the principal repayment will appear in
parenthesis (since it will be an outflow of cash).
If Example Corporation issues additional shares of its common stock, the amount received will be
reported as a positive amount.
Reconciling the Increase in Cash

from the SCF with the Change in
Cash Reported on the Balance Sheet
The three net cash amounts from the operating, investing, and financing activities are combined
into the amount often described as net increase (or decrease) in cash during the year.
In Example Corporation the net increase in cash during the year is $92,000 which is the sum of
$262,000 + $(260,000) + $90,000.
As was shown in the Example Corporation's SCF the net increase for the year was added to the
beginning cash balance to arrive at the ending cash balance.
The ending cash balance should agree with the amount reported as cash on the company's
December 31, 2020 balance sheet.
Supplemental Information
Since all transactions cannot be adequately communicated through the relatively few amounts
reported on the financial statements, companies are required to have notes to the financial
statements.
Some required information for the SCF that will be disclosed in the notes includes significant
exchanges that did not involve cash, the amount of interest paid, and the amount of income
taxes paid.
A Story To Illustrate How Specific

Transactions and Account Balances
Affect the Cash Flow Statement
The remainder of our SCF explanation illustrates how specific transactions and account balances
affect a company's cash flow satement (as well as its income statement and balance sheet).
We will use an easy-to-follow story with only one transaction per day to help you better
understand the cash flow statement. You will also see how the financial statements are
connected.
Matt is a college student who enjoys buying and selling merchandise using the Internet. On
January 2, 2020, he decided to turn his hobby into a business called "Good Deal Co." Each
month the Good Deal Co. had one or two transactions. Matt wants to prepare an income
statement, balance sheet, and a statement of cash flows for the current month and for the year-
to-date period. He asks our help in preparing and understanding the SCF.
January Transactions and Financial

Statements
On January 2, 2020 Matt invested $2,000 of his personal money into his sole proprietorship,
Good Deal Co. On January 20, Good Deal buys 14 graphing calculators at a cost of $50 per
calculator (which was about 50% of the selling price Matt has observed at the retail stores). The
total cost to Good Deal for all 14 calculators was $700. Good Deal had no other transactions
during January.
Matt prepared the income statement and balance sheet for his new business as of January 31,
2020 as shown below:
Note that the $50 cost of each calculator is not reported on the income statement as an expense
until a sale occurs. (This is part of the accrual basis of accounting and the related matching
principle.)
The cost of each unsold calculator will be reported as the asset inventory on the company's
balance sheet. Therefore, the 14 calculators purchased at $50 each will appear as $700 of
inventory. The company's balance sheet will report the remaining cash balance of $1,300
($2,000 - $700).
From the information on the company's income statement and balance sheet, we prepared the
statement of cash flows for the month of January:
Under the indirect method, the operating activities section of the statement of cash flows (SCF)
begins with the company's net income. Note that Good Deal Co.'s January net income of $0
appears as the first item in the operating activities section of the SCF. Since the net income was
determined through the accrual basis of accounting, we will list the adjustments needed to
convert the amount of net income to the net cash provided (used) by operating activities.
Amounts in parentheses indicate a negative effect on the company's cash balance. An amount in
parentheses can also be viewed as a cash outflow or cash used.
Amounts without parentheses indicate a positive effect on the company's cash balance. An amount
without parentheses can also be viewed as a cash inflow or cash provided.
For example, from Good Deal Co.'s balance sheet we know its inventory increased from $0 at
January 1 to $700 at January 31. Increasing inventory by $700 during January was not good for
the company's cash balance since the company paid out $700. Therefore, under Operating
Activities on Good Deal Co.'s SCF the Increase in inventory appears as (700) since it had
an unfavorable or negative effect on the company's cash balance.
If the inventory had decreased by $700, the adjustment would have been a positive 700. The
reason is that by decreasing its inventory the company avoided purchasing $700 of the cost of
goods sold that reduced net income. Not having to pay $700 of the cost of goods sold was
good/positive for the company's cash balance.
The financing activities section shows Investment by owner 2,000 which had a positive effect of
$2,000 on the company's cash. This amount could be discovered by examining the change in the
owner's capital account between the two balance sheet dates. Again, you can view the positive
$2,000 as cash that flowed in or was good for the company's cash balance.
The combination of the $700 cash outflow from operating activities and the $2,000
cash inflow from financing activities is shown as Net increase in cash. The net increase of $1,300
agrees with the change in the cash balances reported on the balance sheet: At January 1, the
cash balance was $0; and at January 31, the cash balance was $1,300.
Here's a Tip
For a change in assets (other than cash), the change in Cash is in the opposite direction. Recall
that when Inventory increased by $700, Cash decreased by $700.
For a change in liabilities and owner's equity, the change in Cash is in the same direction. Recall
that when the owner invested cash in the company, Owner's Equity increased and Cash
increased.
February Transactions and Financial
Statements
On February 29, 2020, Good Deal sold 10 calculators to a nearby high school for $80 each. Matt
delivered the calculators on February 29 and gave the school an $800 invoice due by March 10.
Matt received $800 from the school on March 8.
Matt prepared the following income statement for the month of February:
Under the accrual basis of accounting, revenues (such as sales of products) are reported on the
income statement in the period in which a sale occurs. Typically, the sale occurs when the
products or goods are shipped or delivered to the buyer (or services are provided). As the
February 29 transaction shows, revenues can occur before cash is received. Since Good Deal
Co. delivered 10 calculators at a selling price of $80 each to a reputable buyer, it had earned
revenues of $800 on February 29.
Under the accrual basis of accounting, expenses should be matched with revenues when there is
a cause and effect relationship. This means that a retailer should match its sales with the related
cost of goods sold. In the case of Good Deal Co., it needs to match the cost of the 10 calculators
sold with the revenues from selling 10 calculators. Therefore, its February income statement
shows expenses of $500 (10 X $50) being subtracted from its revenues of $800.
Other expenses such as selling, general, administrative, and interest expenses must also be
reported on the income statement when 1) they can be matched with the revenues, or 2) when a
cost has expired, has been used up, or has no future value. If Good Deal Co. was renting a
storage space for $50 per month, each month's income statement would also list rent expense of
$50.
In summary, Good Deal Co. correctly reported $800 of revenues, $500 of expenses, and $300 of
net income even though no cash flowed in or out during February.
The statement of cash flows (SCF) for the month of February begins with the accrual accounting
net income of $300, which must be converted/adjusted to the net cash from operating activities.
Recall that the income statement reported revenues of $800, and the balance sheets from January
31 and February 29 will indicate that accounts receivable increased from $0 to $800. This
increase in accounts receivable of $800 indicates that the company did not collect $800 of the
revenues that were reported on February's income statement. Allowing accounts receivable to
increase is not good for the company's cash balance. When something is not good for the company's
cash balance, the amount is shown in parentheses. Again, the (800) indicates the negative effect
on the company's cash caused by the company not yet collecting the cash from its credit sales,
reported on its income statement.
When a company's inventory decreases, it is good/positive for a company's cash. The reason is
the company is not paying out cash for the items it is removing from inventory. While Good Deal
Co.'s income statement for the month of February reported "Expenses 500" for the cost of its
goods sold, the company did not pay out the $500 during February. Therefore, the company shows
a positive $500 on its SCF as an adjustment to the net income amount. The $500 adjustment is
not reporting what happened to the amount of inventory, it is reporting the necessary adjustment
to convert the accrual accounting net income to the cash amount.
Now let's look at the year-to-date financial statements covering the two-month period of January
1 through February 29:
The year-to-date net income of $300 increases the owner's equity on the balance sheet. Note the
connection between the bottom line of the year-to-date income statement and the change in Matt
Jones, Capital on the balance sheet. Matt Jones, Capital has increased from $2,000 to $2,300.
The SCF for the two months of January 1 through February 29, begins with the accrual
accounting net income of $300. Since this is not the amount of cash from operating activities, the
net income must be adjusted to the net amount of cash from operating activities.
During this two-month time period, the company's accounts receivable increased from $0 to
$800. An increase in accounts receivable means that the customers purchasing on credit did not
yet pay for all the credits sales the company reported on the income statement. Therefore,
we subtract the increase in accounts receivable from the company's net income. Not having
collected the total amount of past credit sales was not good for the company's cash balance. For
these reasons, the amount of the company's accrual net income must be adjusted downward.
Again, the reported (800) is the adjustment to the net income amount because of the increase in
accounts receivable.
During the two-month time period, the company's inventory changed from $0 on January 1 to
$200 at February 29. (Recall that the company had purchased 14 calculators at a cost of $50
each and then sold 10 calculators. That left 4 calculators in inventory at a cost of $50 each.) The
increase in inventory from $0 to $200 during this two-month time period required the company to
spend (have a cash outflow of) $200. The use of cash for adding goods to inventory is also
viewed as not good for the company's cash balance and is therefore reported on the SCF as
(200).
Given these adjustments, the net cash flow from operating activities is a net cash outflow of (700).
(The calculation is $300 cash inflow - $800 cash outflow - $200 cash outflow.) The net cash
outflow is presented as a negative amount and is described as net cash used in operating activities.
The cash flow statement also shows $2,000 of financing by the owner. When this is combined
with the negative $700 from operating activities, the net change in cash for the first two months is
a positive $1,300. This agrees to the change in cash on the balance sheet—none on January 1,
but $1,300 on February 29.
March Transactions and Financial

Statements
On March 8 Good Deal receives $800 for the calculators sold to the school on February 29. No
other transactions occurred in March. (Note that this $800 is a March receipt but is not revenue in
March. The revenue was earned and was reported on February's income statement.)
The income statement for the one month ending on March 31 is shown here:
The income statement for the three months of January 1 through March 31 is:
Note that the 3-month year-to-date net income of $300 causes the amount in the owner's capital
account (on the following balance sheet) to increase from $2,000 to $2,300. The receipt of $800
caused the cash to increase from $1,300 to $2,100 and accounts receivable to decrease to zero.
The SCF for the period of January 1 through March 31 is shown here:
The statement of cash flows (SCF) for the first three months of the business (January 1 through March
31) begins with the company's accrual accounting net income of $300. This amount must be
adjusted to show the net cash from operating activities (which are the company's activities
pertaining to the purchasing/producing of goods and selling of goods and/or providing services).
For the 3-month period of the SCF the company's inventory increased from $0 to $200 at March 31.
Therefore, we know that $200 of the company's cash was used to increase its inventory. Recall
that the use of cash, cash outflows, and money spent have a negative effect on the company's cash
balance and are reported as a negative amount on the SCF. Therefore, the $200 increase in
inventory must be shown as (200). [If the inventory had decreased, the amount would have been
a positive 200, since selling items from inventory is positive/good for the company's cash
balance.]
Since the amount of the company's accounts receivable was $0 at January 1, and $0 at March
31, there is no adjustment and this line could have been omitted.
The combination of the positive net income of $300 and the adjustment for the cash used to
increase inventory (200) results in the net cash provided by operating activities of a positive $100.
The owner's $2,000 investment in January was a source of cash (hence it was a cash inflow,
was good for the company's cash balance, etc.) and is listed as a positive 2,000 in the section
described as financing activities.
Finally, the combination of the amounts from the three sections of the SCF is $2,100. This
agrees with the change in the amount of cash on the company's balance sheets: $0 on January
1, and $2,100 on March 31.
Next, we will prepare a SCF for the month of March. To do this we will compare the company's
balance sheet of March 31 with its balance sheet of February 29:
Look at the "Change" column above. The first amount, a positive $800 change in the Cash
account, will serve as a "check figure" for the line Net increase in cash on the cash flow statement
for the month of March. In other words, the cash flow statement for March must end up
explaining the $800 increase in the Cash reported on the balance sheet. The other balance
sheet amounts that changed will be used on the statement of cash flows to identify the reasons
for the $800 increase in cash.
Since there were no revenues and no expenses in March, the income statement for the one
month of March (shown earlier) reported no net income. This $0 of net income will be shown as
the first amount reported on the statement of cash flows. The changes in the balance sheet
accounts from February 29 to March 31 provided the other information needed for the following
SCF for the month of March:
Let's review the cash flow statement for the month of March 2020:
 Net income for March is $0, since there were no revenues, gains, expenses, or losses.
 Cash increased by $800 because $800 of accounts receivable were collected during
March.
 Inventory did not change, so Cash was not affected. (We could omit this line since it had
no effect on cash.)
 There were no changes in long-term assets during March, so nothing is reported in the
investing activities section.
 There were no changes in short-term loans payable, long-term liabilities, or owner's

equity. Therefore, nothing is reported in the financing activities section.
 The sum of the amounts on the statement of cash flows is a positive $800. This amount
agrees to the increase in the cash balance from $1,300 on February 29 to $2,100 on
March 31.
April Transactions and

On April 28 Good Deal ordered $150 of supplies on account. The supplies arrived on April 30
along with an invoice showing that the entire $150 is due by May 30. None of the supplies were
used in April. This was the only transaction during April.
Matt prepared the following financial statements for Good Deal Co. as of April 30:
Since no supplies were used in April, there is no Supplies Expense. The $150 will be reported on
the balance sheet in the asset account Supplies.
The balance sheet now includes $150 for the asset supplies and $150 for the liability accounts
payable.
A balance sheet comparing April 30 amounts to March 31 amounts and the resulting differences
or changes is shown here:
The changes that occured during the month of April will be used to prepare the SCF for the
month of April.
The cash flow statement for the month of April reports that there was no change in the Cash
account from March 31 through April 30. The operating activities section reports the increase in
Supplies and the resulting negative adjustment to the amount of net income. It also reports the
increase in Accounts Payable and the resulting positive adjustment to the amount of net income.
Here's a Tip
On the statement of cash flows, think of the positive amounts (the numbers not in parentheses)
as good for the company's cash balance. For example, if the company doesn't pay its bills, that's
good for the company's cash balance (but bad for the liability Accounts Payable which increases).
Think of the negative amounts (the numbers within parentheses) as not good for cash. For
example, if a company pays a bill, that's not good for its cash balance (but good for the liability
Accounts Payable which decreases).
The following comparative balance sheet shows the changes between December 31, 2019 and
April 30, 2020:
The changes will be used to prepare the SCF for the four months ended April 30.
The SCF for the period of January 1 through April 30 is:

Let's review the statement of cash flows for the four months ended April 30:
 The operating activities section of the SCF starts with the net income of $300 that was
earned during the four-month period. The increase in inventory was not good for cash, as
shown by the negative adjustment of $200. Similarly, increasing the amount of supplies
on hand was not good for cash and it is reported as a negative $150. The increase in
accounts payable was good for the cash balance (since some bills were not paid);
therefore, the increase in accounts payable appears as a positive $150. Combining the
amounts, the net change in cash that is explained by operating activities is a positive $100.
 There were no changes in long-term assets. As a result, no amount is shown for
investing activities.
 There were no changes in short-term loans payable or long-term liabilities. However,
there was a change in owner's equity since December 31. As a result, the financing
activities section reports the owner's $2,000 investment in Good Deal Co. as a positive
amount.
 Combining the amounts in operating, investing, and financing activities, the cash flow
statement reports an increase in cash of $2,100. This agrees with the change in the
balance sheet's Cash from $0 on December 31, 2019 to $2,100 on April 30, 2020.
May Transactions and Financial

Statements
On May 30 Good Deal pays its accounts payable of $150. On May 31 Good Deal purchases
office equipment (a new computer and printer) that will be used exclusively in the business. The
cost of the office equipment is $1,100 and is paid in cash. There were no other transactions in
May.
A balance sheet comparing May 31 amounts to April 30 amounts and the resulting differences or
changes is shown here:
May 31, 2020:
The SCF for the period of January 1 through May 31 is:
Let's review the cash flow statement for the five months ended May 31:
 The operating activities section starts with the net income of $300 for the five-month
period. The increase in Inventory was not good for cash, as shown by the negative
adjustment of $200. Similarly, the increase in Supplies was not good for cash and it is
reported as a negative adjustment of $150. Combining the amounts, the net change in
cash that is explained by operating activities is a negative $50.
 The investing activities section reports the increase in long-term assets as (1,100) since it
was a cash outflow of $1,100. The additions to property, plant and equipment are
frequently described as capital expenditures.
there was a change in owner's equity since December 31. As a result, the financing
activities section of the SCF reports the owner's investment of $2,000, which increased
Good Deal's cash balance.
 Combining the amounts from the operating, investing, and financing activities, the SCF
reports an increase in cash of $850. This agrees with the change in the Cash amounts
reported on the balance sheets dated December 31, 2019 and May 31, 2020.
Depreciation Expense
Depreciation moves the cost of an asset from the balance sheet to Depreciation Expense on the
income statement in a systematic manner during an asset's useful life. The accounts involved in
recording depreciation are Depreciation Expense and Accumulated Depreciation. As you see,
cash is not involved. In other words, depreciation reduces net income on the income statement,
but it does not reduce the company's cash that is reported on the balance sheet.
Since we begin the statement of cash flows with the net income figure taken from the income
statement, we need to adjust the amount of net income by adding back the amount of the
Depreciation Expense.
Depletion Expense and Amortization Expense are accounts similar to Depreciation Expense.
They involve allocating the cost of a long-term asset to an expense over the useful life of the
asset, but no cash is involved.
Here's a Tip
In the operating activities section of the cash flow statement, add back expenses that did not
require the use of cash. Examples are depreciation, depletion, and amortization expense.
Next, we examine how depreciation expense is reported on the Good Deal Co.'s financial
statement.
June Transactions and

The only transaction recorded by Good Deal during June was the depreciation of its office
equipment. Recall that on May 31 Good Deal purchased the office equipment (a new computer
and printer) for $1,100 and it was put into service on the next day. Let's assume that depreciation
expense of $20 per month is recorded by Good Deal. As a result, Good Deal's financial
statements at June 30 will be as follows:
A balance sheet comparing June 30 amounts to May 31 amounts and the resulting differences or
changes is shown here:
The cash flow statement for the month of June illustrates why depreciation expense needs to be
added back to net income. Good Deal did not spend any cash in June, however, the entry in the
Depreciation Expense account resulted in a net loss on the income statement. On the SCF, we
convert the bottom line of the income statement for the month of June (a loss of $20) to the net
amount of cash provided or used by operating activities, which was $0. This is done with a
positive adjustment which adds back the $20 of depreciation expense.
June 30, 2020:
The SCF for the period of January 1 through June 30 is:
Let's review the cash flow statement for the six months ended June 30:
 The operating activities section began with the net income of $280 for the six-month
period. Depreciation expense is added back to net income because it was a noncash
transaction (net income was reduced, but there was no cash outflow for depreciation).
The increase in the Inventory account was not good for cash, as shown by the negative
$200. Similarly, the increase in Supplies was not good for cash and it is reported as a
negative $150. Combining the amounts, the net change in cash that is explained by
operating activities is a negative $50.
 The investing activities section reports the cash outflow of $1,100 for the purchase of
office equipment.
there was the owner's $2,000 investment in the Good Deal Co. Therefore, the financing
activities section reports a positive 2,000.
 Combining the amounts from the operating, investing, and financing activities, the SCF
reports an increase in cash of $850. This agrees with the change in the Cash amounts
reported on the balance sheets dated December 31, 2019 and June 30, 2020.
Disposal of Assets
If a company disposes of (sells) a long-term asset for an amount different from the amount in the
company's accounting records (the asset's book value), an adjustment must be made to the
amount of net income appearing as the first item on the SCF.
To illustrate, assume a company sells one of its delivery trucks for $3,000. The truck is in the
accounting records at its original cost of $20,000. Its accumulated depreciation is $18,000.
Combining the $20,000 and the $18,000 results in a book value (or carrying value) of $2,000.
Because the cash received/proceeds from the sale of the truck was $3,000 and the book value
was $2,000 the difference of $1,000 is reported as a gain on the income statement. As a result,
the company's net income will increase by $1,000. (If the truck had sold for $1,500 there would
be a $500 loss, which would reduce the company's net income.)
One of the rules in preparing the SCF is that the entire proceeds received from the sale of a long-
term asset must be reported in the section of the SCF entitled investing activities. This presents a
problem because any gain or loss on the sale of an asset is included in the amount of net income
shown in the SCF section operating activities. To overcome this problem, each gain
is deducted from the net income and each loss is added to the net income in the operating
activities section of the SCF.
We will demonstrate the loss on the disposal of an asset in Good Deal's next transaction.
July Transactions and Financial

Statements
On July 1, Matt decides that his company no longer needs its office equipment. Good Deal used
the equipment for one month (June 1 through June 30) and had recorded one month's
depreciation of $20. This means the book value of the equipment is $1,080 (the original cost of
$1,100 less the $20 of accumulated depreciation). On July 1, Good Deal sells the equipment for
$900 in cash and reports the resulting $180 loss on sale of equipment on its income statement.
There were no other transactions in July.
The income statement for the month of July will show how the disposal of the equipment is
reported:
The income statement for the period of January 1 through July 31 is:
The following comparative balance sheet shows the changes that occurred during July:
The SCF for the one month of July is:

Let's review the cash flow statement for the month of July 2020:
 Net income for July was a net loss of $180. There were no revenues, expenses, or gains,
but there was a loss of $180 on the sale of equipment. However, the loss did not cause
the company's cash to decrease. The $900 of cash that was received is shown under
investing activities.
 There was no depreciation expense in July because the asset was sold on July 1. (We
could have omitted the line "Depreciation Expense".) Also, the current assets and current
liabilities did not change in July.
 The net amount of cash provided or used by operating activities during the month of July
was $0.
 The investing activities section reports the $900 received from the sale of its office
equipment.
 There was no change in short-term loans payable, long-term liabilities, or owner's equity
during July (other than the $180 loss on sale of equipment).
 The sum of the amounts on the SCF for the month of July was a positive cash inflow of
$900. This amount agrees to the increase in the company's cash balance from June 30
to July 31.
 The following comparative balance sheet shows the changes between December 31,
2019 and July 31, 2020:
The SCF for the period of January 1 through July 31 is:
Let's review the cash flow statement for the seven months of January through July 2020:
 Net income for the seven months was $100. This includes the company's revenues,
gains, expenses, and losses.
 Included in the net income for the seven months is $20 of depreciation expense. This
expense reduced net income but did not reduce the Cash account. Therefore, the $20 of
depreciation expense is a positive adjustment to the $100 of net income.
 Also included in the net income was the $180 loss on sale of equipment. This loss was
reported on the income statement thereby reducing net income. However, cash was not
reduced. Actually, cash of $900 was received from the sale of the equipment and it is
reported in its entirety in the investing activities section of the SCF.
 Inventory on July 31 is $200 (4 calculators at a cost of $50 each). Since the company
began with no inventory, this increase in the Inventory account means that $200 of cash
was used to increase inventory. Hence, the adjustment is shown in parentheses.
 Supplies increased from none to $150. The increase in the Supplies account is assumed
to have had a negative effect of $150 on the company's cash.
 Combining the amounts so far, we see that the net amount of cash from operating
activities is a negative $50. In other words, rather than providing cash, the operating
activities used a net $50 of cash.
 There is cash outflow (or payment) of $1,100 to purchase the office equipment on May
31. On July 1, there was also a $900 cash inflow (or receipt) from the sale of the office
equipment. Combining these two amounts results in the net outflow of $200 in the
investing activities section as a source of cash.
 The owner's investment of $2,000 made on January 2 is reported in the financing
activities section.
Net increase in cash during the seven months was a positive $1,750 (the combination of the
totals of the three sections—operating, investing, and financing activities). This $1,750 agrees to
the check figure—the increase in the cash from the beginning of January to July 31.

Financial Statements

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Financial Statements

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What are the main components of a company's financial statements?

What are the main components of a company's financial statements?

What does the income statement report?

What does the income statement report?

Financial Statements

Financial accounting generates the following general-purpose, external, financial statements:

1. Income statement (sometimes referred to as "results of operations" or "earnings

Statement of Comprehensive Income

 Net income (taken from the income statement)

Statement of Cash Flows

Statement of Stockholders' Equity

Confused? Send Feedback

Introduction to Debits and Credits

What are debits and credits?

Confused? Send Feedback

Debits and Credits

Debits and Credits(Crossword

Debits and Credits #2

Debits and Credits #3

Here are five examples to illustrate debits and credits:

Introduction to Chart of Accounts

Let's demonstrate the use of these T-accounts with two transactions:

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When Cash Is Debited and Credited

 Whenever cash is received, debit Cash.

Revenues and Gains Are Usually

Expenses and Losses are Usually

Permanent and Temporary Accounts

(Debris Disposal's journal entry)

(Trustworthy Bank's journal entry)

(Debris Disposal's journal entry)

(Trustworthy Bank's general ledger)

(Debris Disposal's general ledger)

Bank's Balance Sheet

 Debit means left.

Introduction to the Accounting

1. Assets (what it owns)

The accounting equation for a corporation is:

Balance Sheet and Income Statement

Accounting Equation for a Sole

When a company records a business transaction, it is not entered into an accounting

Sole Proprietorship Transaction #1.

Sole Proprietorship Transaction #2.

Accounting Equation for a Sole

The combined effect of the first three transactions is shown here:

Sole Proprietorship Transaction #4.

Accounting Equation for a Sole

The general journal entry to record the transaction is:

The combined effect of the first five transactions is available here:

The balance sheet as of midnight on December 5 is:

Sole Proprietorship Transaction #6.

The general journal entry to record the transaction is:

Below is the balance sheet as of midnight on December 6:

Accounting Equation for a Sole

Sole Proprietorship Transaction #8.

The combined effect of the first eight transactions is shown here:

ASC's balance sheet as of midnight December 8, 2020 is:

Calculating a Missing Amount within

Example of Calculating a Missing Amount

Accounting Equation for a