Principles of Financial Accounting

🧭 Overview

🧠 One-sentence thesis

Accounting tracks "running totals" of business items through accounts organized into five categories—assets, liabilities, stockholders' equity, revenue, and expenses—so businesses always know "how much right now?" or "how much so far?"

📌 Key points (3–5)

• What accounting does: analyzes, classifies, records, summarizes, and interprets business transactions by keeping running totals.
• Accounts vs balances: an account is any item a business tracks; a balance is the current running total for that account.
• Five categories: every account falls into one of five types—assets, liabilities, stockholders' equity, revenue, or expenses.
• Common confusion: not every sale is revenue—only income from the business's main activities counts (e.g., a computer technician selling a van is not revenue).
• Why categories matter: organizing accounts by category (in a chart of accounts) ensures consistency and clarity in financial records.

💼 What accounting tracks

💼 The core process

Accounting: the process of analyzing, classifying, recording, summarizing, and interpreting business transactions.

• The excerpt emphasizes keeping running totals of "things" the business cares about.
• These running totals must be up to date so information is readily available when needed.
• Example: checking your bank cash balance before making a debit card purchase—you need to know "how much right now?"

🏷️ Accounts and balances

Account: any item a business is interested in keeping track of in terms of a running dollar balance to determine "how much right now?" or "how much so far?"

Balance: the current running total for an account.

• An account is not a single transaction; it is the ongoing record of all transactions affecting that item.
• Example items businesses track: amount of cash currently held, utilities paid for the month, money owed, income for the year, total cost of equipment purchased.

📂 The five account categories

📂 Why categories exist

A category is a classification that generally describes its contents.

• The excerpt uses an analogy: "Planets," "Colors," and "Food" are categories; Saturn belongs under Planets, Red under Colors, Pizza under Food.
• If "Red" appeared under "Planets," it would be an error—items must fit their category.
• In accounting, every account must fall into one of five categories.

📂 The five types

Category	Definition (from excerpt)	What it tracks
Assets	Anything of value that a business owns	Resources the business controls
Liabilities	Debts that a business owes; claims on assets by outsiders	What the business owes to others
Stockholders' equity	Worth of the owners of a business; claims on assets by the owners	Owners' stake in the business
Revenue	Income that results when a business operates and generates sales	Earnings from main business activities
Expenses	Costs associated with earning revenue	Costs paid to operate and earn revenue

• The excerpt states: "Different accounts fall into different categories."
• Example: Cash is an account that falls into the asset category because it is something of value the business owns.

💰 Revenue accounts

💰 What counts as revenue

Revenue: income that results from a business engaging in the activities that it is set up to do.

• Revenue is earned when a business does what it was created to do.
• Example: a computer technician earns revenue when repairing a computer for a customer.
• Don't confuse: if the same technician sells a van no longer needed for the business, that is not revenue—it is not part of the main business activity.

💰 Fees Earned account

• Fees Earned is a common account name for income from providing a service.
• Service businesses sell expertise, advice, action, or experience—not physical products.
• Examples of service businesses: consultants, dry cleaners, airlines, attorneys, repair shops.
• The Fees Earned account falls into the revenue category.

💸 Expense accounts

💸 What expenses are

Expenses: bills and other costs a business must pay in order for it to operate and earn revenue.

• The excerpt quotes: "It takes money to make money."
• Expenses are necessary costs to run the business and generate revenue.

💸 Common expense accounts

The excerpt lists typical expenses many businesses have:

Expense account	What it tracks
Wages Expense	Cost of paying hourly employees
Rent Expense	Cost for the use of property that belongs to someone else
Utilities Expense	Costs such as electricity, water, phone, gas, cable TV, etc.
Supplies Expense	Cost of small items used to run a business
Insurance Expense	Cost of protection from liability, damage, injury, theft, etc.
Advertising Expense	Cost of promoting the business
Maintenance Expense	Costs related to repair and upkeep
Miscellaneous Expense	Costs that are minor and/or non-repetitive

• Expense accounts differ from business to business, depending on individual company needs.
• The excerpt emphasizes: any expense is "any cost associated with earning revenue."

📋 Chart of accounts

📋 What it is

Chart of accounts: a list of all accounts used by a business.

• Accounts are presented by category in a specific order:

  1. Assets
  2. Liabilities
  3. Stockholders' equity
  4. Revenue
  5. Expenses

• This standard order ensures consistency across businesses and makes financial records easier to understand.

📋 Why order matters

• Organizing accounts by category (and in the prescribed order) provides structure.
• It ensures that anyone reading the chart of accounts can quickly locate and understand each account's purpose.

🧭 Overview

🧠 One-sentence thesis

Net income, calculated by subtracting total expenses from total revenue for a given period, represents the operating results that business people are extremely interested in knowing.

📌 Key points (3–5)

• The core formula: Revenue minus Expenses equals Net Income (for a particular period such as a month or year).
• When revenue is higher: the result is profit, now called net income; when expenses exceed revenue, the result is a net loss.
• Why it matters: net income represents the results of a firm's operations in a given period of time and is a critical figure for business decision-makers.
• Common confusion: net income vs net loss—net income occurs when revenue > expenses; net loss occurs when expenses > revenue for the same period.

💰 What net income is

💰 Definition and formula

Net income: the difference between total revenue and total expenses for a particular period (such as a month or year), assuming revenue is higher.

• The excerpt previously called this "profit" but now uses the term "net income."
• The key calculation:
  • Revenue minus Expenses equals Net Income
• This formula applies to a specific time period (a month or a year).

🔄 Net income vs net loss

Scenario	Formula result	Term used
Total revenue > Total expenses	Positive difference	Net income
Total expenses > Total revenue	Negative difference	Net loss

• Net income: revenue is higher than expenses for the period.
• Net loss: total expenses exceed total revenue for the same period.
• Don't confuse: both are outcomes of the same calculation; the sign (positive or negative) determines which term applies.

📈 Why net income matters

📈 Business significance

• The excerpt states that "business people are extremely interested in knowing" net income.
• Reason: it represents the results of a firm's operations in a given period of time.
• Net income is a key measure of how well the business performed during that month or year.
• Example: An organization calculates net income at the end of each month to see whether its activities generated profit or loss.

🧾 Revenue and expenses recap

🧾 Revenue

Revenue: income that results from a business engaging in the activities that it is set up to do.

• Example from the excerpt: a computer technician earns revenue when repairing a computer for a customer.
• Not revenue: selling a van the technician no longer needs (not part of the core business activity).
• Fees Earned is a common account name for recording income from providing a service.

🧾 Expenses

Expenses: bills and other costs a business must pay in order for it to operate and earn revenue.

• The excerpt quotes: "It takes money to make money."
• Common expense accounts include:
  • Wages Expense (hourly employees)
  • Rent Expense (use of property)
  • Utilities Expense (electricity, water, phone, etc.)
  • Supplies Expense (small items)
  • Insurance Expense (protection costs)
  • Advertising Expense (promotion)
  • Maintenance Expense (repair and upkeep)
  • Miscellaneous Expense (minor or non-repetitive costs)
• Any cost associated with earning revenue is an expense.

🗂️ Chart of accounts

Chart of accounts: a list of all accounts used by a business.

• Accounts are presented by category in this order:
  1. Assets
  2. Liabilities
  3. Stockholders' equity
  4. Revenue
  5. Expenses
• The excerpt provides a partial chart showing:
  • Assets: Cash
  • Revenue: Fees Earned
  • Expenses: Wages, Rent, Utilities, Supplies, Insurance, Advertising, Miscellaneous

📝 The accounting process context

📝 The journal

• Financial statements are key goals of the accounting process.
• To prepare them at the end of an accounting period, individual transactions must be analyzed, classified, and recorded throughout the period.
• This takes place in a record book called the journal, where financial events (transactions) are recorded as they happen, in chronological order.

📝 Journal structure

• The journal has five columns: Date, Account, Post. Ref., Debit, Credit.
• Debit means "left" (the left number column).
• Credit means "right" (the right number column).
• Don't confuse: these terms only indicate which column a dollar amount is entered in, not other familiar meanings of "debit" and "credit."
• As verbs:
  • "Debit an account" = enter its amount in the left column.
  • "Credit an account" = enter its amount in the right column.

🧭 Overview

🧠 One-sentence thesis

The accounting process systematically records transactions in a journal, posts them to individual account ledgers to maintain running balances, and uses those balances to prepare financial statements.

📌 Key points (3–5)

• The two core record books: the journal records all transactions chronologically as they happen; the ledger separates the same information by account and maintains a running balance for each account.
• Debit and credit are directional terms: "debit" means left column, "credit" means right column—not positive or negative—and which side to use depends on the account type and whether it is increasing or decreasing.
• Posting is copying, not creating: every entry in the ledger must be copied from the journal; you cannot have correct ledger balances if the journal entries are wrong.
• Common confusion—debit/credit vs. increase/decrease: debit does not always mean increase; for Cash and Expenses, debit means increase, but for Revenue, credit means increase.
• Trial balance checks accuracy: total debit balances across all ledger accounts must equal total credit balances; if they don't match, there is a recording error.

📖 The journal: where transactions are first recorded

📝 What the journal is

Journal: a record book where financial events called transactions are recorded as they happen, in chronological order.

• The journal is the first step in the accounting process.
• It captures every transaction throughout the accounting period so that financial statements can be prepared at the end.
• The journal has five columns: Date, Account, Post. Ref., Debit, Credit.

🔤 Debit and credit are column labels

• In the journal, Debit means "left" and Credit means "right."
• These terms refer only to which number column an amount is entered in, not familiar meanings like "good" or "bad."
• As verbs: "to debit an account" = enter its amount in the left column; "to credit an account" = enter its amount in the right column.
• Don't confuse: debit/credit with increase/decrease or positive/negative; they are purely directional labels.

🧮 Rules of debit and credit

🧮 Which side to use depends on account type and direction of change

Whether to debit or credit an account is based on:

1. The type of account (Cash, Revenue, Expense, etc.).
2. Whether the account is increasing or decreasing.

Account type	When it increases	When it decreases
Cash	Debit Cash (when you receive it)	Credit Cash (when you pay it out)
Expenses	Debit Expenses (when you incur them)	(Not shown in excerpt)
Revenue	Credit Revenue (when you earn it)	(Not shown in excerpt)

• Example: A company pays $2,000 rent. Rent Expense is increasing → debit Rent Expense. Cash is decreasing → credit Cash.
• Example: A customer pays $800 for services. Cash is increasing → debit Cash. Fees Earned (revenue) is increasing → credit Fees Earned.

⚠️ Common confusion: debit does not always mean "add"

• For Cash and Expenses, debit means increase.
• For Revenue, credit means increase.
• The rule depends on the account category, not a universal "debit = plus."

✍️ Journalizing transactions

✍️ The steps to make a journal entry

Journalizing: analyzing and writing down financial transactions in the journal using the language of accounting.

1. Select two (or more) accounts impacted by the transaction.
2. Determine the dollar amount for each account (given or calculated).
3. Based on the rules of debit and credit, decide which account(s) to debit and which to credit.
4. Enter the date on the first line of the transaction only.
5. Enter the account to be debited on the first line; enter its amount in the Debit column.
6. Enter the account to be credited on the second line (indent the account name three spaces); enter its amount in the Credit column.

• The debit entry is always listed first.
• No dollar signs are required in the journal.

📋 Sample transaction walkthrough

Transaction #1: On 6/1, a company paid rent of $2,000 for the month of June.

• Rent Expense is an expense account that is increasing → debit Rent Expense $2,000 (first line).
• Cash is an asset account that is decreasing → credit Cash $2,000 (second line, indented).

Transaction #2: On 6/5, a customer paid $800 cash for services the company provided.

• Cash is an asset account that is increasing → debit Cash $800 (first line).

• Fees Earned is a revenue account that is increasing → credit Fees Earned $800 (second line, indented).

• Transactions follow one after another in the journal.

• The same journal continues from period to period; you do not start a new journal for a new accounting period.

📚 The ledger: maintaining running balances by account

📚 What the ledger is

Ledger: the second accounting record book; a list of a company's individual accounts in order of account category.

• While the journal lists all types of transactions chronologically, the ledger separates the same information by account.
• Each account has its own ledger page with the account name at the top.
• The ledger form has six columns: Date, Item, Debit, Credit, Debit, Credit.
  • The first Debit and Credit columns are where amounts from the journal are copied.
  • The second Debit and Credit columns are where the account's running balance is maintained.

🔄 Running balance

Running balance: the cumulative total for an account, updated every time an amount is posted.

• An account's running balance typically appears in either the Debit or the Credit balance column, not both.
• Example: Cash ledger starts with $12,000 debit balance; a $2,000 debit is added → new balance $14,000 debit; a $3,000 credit is subtracted → new balance $11,000 debit.

📤 Posting: copying from journal to ledger

📤 What posting is

Posting: the process of copying from the journal to the ledger, one line at a time.

• Important: Information entered in the ledger is always copied from what is already in the journal.
• You cannot create new entries in the ledger; you can only transfer what the journal already contains.

📤 Step-by-step posting instructions

1. Note the account name in the first line of the journal; find that ledger account.
2. Copy the date from the journal to the first blank row in that ledger.
3. Leave the Item column blank at this point.
4. Note the amount on the first line of the journal and the column it is in.
5. Copy that amount to the same column in the ledger on the same line where you entered the date.
6. Update the account's running balance:
   • If there is no previous balance and the entry is a Debit, enter the same amount in the Debit balance column.
   • If there is no previous balance and the entry is a Credit, enter the same amount in the Credit balance column.
   • If the previous balance is in the Debit column and the entry is a Debit, add the two amounts and enter the total in the Debit balance column.
   • If the previous balance is in the Debit column and the entry is a Credit, subtract the credit amount from the balance and enter the difference in the Debit balance column.
   • If the previous balance is in the Credit column and the entry is a Credit, add the two amounts and enter the total in the Credit balance column.
   • If the previous balance is in the Credit column and the entry is a Debit, subtract the debit amount from the balance and enter the difference in the Credit balance column.
   • (Exception: if a calculation results in a negative number, the balance appears in the opposite balance column instead; no negative amounts should appear.)
7. Go back to the journal and enter an "x" or checkmark in the PR column to indicate you have posted that line item.
8. Repeat for the next line in the journal.

• Every time an account appears on a line in the journal, its amount is copied to the proper column in that account's ledger.
• Example: Cash appears five times in the journal; each time, the amount is copied to the Cash ledger in the appropriate Debit or Credit column, and the running balance is updated.

⚠️ Common mistake: inventing ledger entries

• Don't confuse: posting with creating. If you are making entries in the ledgers, you must be copying from the journal.
• The excerpt uses an analogy: you cannot have chocolate chip cookies from taco ingredients. Similarly, you cannot have correct ledger balances if the journal has errors.
• If there is an error in the journal, procedurally the mistake should carry through to the ledgers and the financial statements.
• It is more correct for an error to carry through to all parts than for one part to be incorrect and subsequent parts to be correct.

🧾 Normal balance and the balance columns

🧾 Which balance column to use

Normal balance: the column (Debit or Credit) in which an account's running total is maintained; also whatever it takes to increase that type of account.

• The first entry in each ledger (either Debit or Credit) dictates whether the running balance will appear in the Debit or Credit balance column.
• If the first entry is a Debit, the running balance accumulates in the Debit balance column; a debit is the "positive" for this type of account; subsequent debit entries are added and credit entries are subtracted.
• If the first entry is a Credit, the running balance accumulates in the Credit balance column; a credit is the "positive" for this type of account; subsequent credit entries are added and debit entries are subtracted.
• The other balance column will normally remain blank (grayed out in the excerpt's example).

🧾 Balancing rule

• The total of all the Debit balances in the ledgers MUST EQUAL the total of all the Credit balances in the ledgers.
• If this is not the case, there is a recording error that must be located and corrected.
• Example: in the excerpt's sample ledgers, Cash has a $3,000 debit balance, Supplies Expense has a $900 debit balance, and Fees Earned has a $3,900 credit balance. Total debits: 3,000 + 900 = 3,900; total credits: 3,900. They match.

🔁 Ledgers continue across periods

• The same ledgers continue on from period to period.
• You do not start new ledgers for a new accounting period (month or year).

✅ Trial balance: checking for accuracy

✅ What the trial balance is

Trial balance: a list of all a business's accounts and their current ledger balances (copied over from the ledger accounts).

• A trial balance may be generated at any time to test whether total debits equals total credits.
• It is simply a worksheet to check for accuracy before preparing financial statements.
• If both of the Total columns do not equal, there is an error that must be found and corrected.

✅ How to prepare a trial balance

• List all accounts and their corresponding balances at the end of the period.
• Copy each account's balance from its ledger.
• Sum the Debit column and the Credit column.
• The two totals must be equal.

Example from the excerpt (four accounts):

Account	Debit	Credit
Cash	3,000
Common Stock		2,000
Fees Earned		1,900
Supplies Expense	900
TOTAL	3,900	3,900

• The totals match, so the ledgers are in balance.

📊 Financial statements: the goal of the process

📊 Why we do all this

• The goal of journalizing, posting to the ledgers, and preparing the trial balance is to gather the information necessary to produce the financial statements.
• Financial statements are key goals of the accounting process.
• Most of the amounts on these statements are copied directly from the trial balance, and then appropriate calculations and summary amounts are also displayed.

📊 Time period concept

• The time period concept requires companies to produce financial statements on a regular basis over the same time interval, such as a month or year.
• This ensures consistent reporting and comparability.

🧭 Overview

🧠 One-sentence thesis

Financial statements—especially the income statement—are the ultimate goal of the accounting cycle, requiring temporary revenue and expense accounts to be closed out each period to ensure accurate, period-specific reporting.

📌 Key points (3–5)

• What financial statements are: reports produced regularly (monthly or yearly) that summarize a business's financial activity, with amounts copied from the trial balance.
• Income statement purpose: shows revenue minus expenses to calculate net income (or net loss) for a specific period, answering "How much profit is the business making?"
• Temporary vs permanent accounts: income statement accounts (revenue and expenses) are temporary and must be reset to zero each period; balance sheet accounts (assets, liabilities, equity) are permanent and carry forward.
• Common confusion: without closing entries, the next period's income statement would incorrectly include amounts from the previous period—like a stopwatch that wasn't reset between laps.
• Why closing entries matter: they transfer revenue and expense balances into Retained Earnings, resetting temporary accounts to zero so each period's income statement reflects only that period's activity (matching principle).

📊 The income statement

📊 What it reports

Income statement: a report that lists and summarizes revenue, expense, and net income information for a period of time, usually a month or a year.

• It is based on the equation: Revenue - Expenses = Net income (or Net loss).
• Revenue is shown first; expenses are listed and totaled; the total is subtracted from revenue.
• If the result is positive → net income (profit); if negative → net loss (shown in parentheses).

🎯 Why it matters

• The income statement answers the most important business question: How much profit is it making?
• It is limited to a specific period of time (month or year) from beginning to end.
• It relies on the matching principle: only revenue and expenses within that time window are reported; amounts from before or after are excluded.

📝 Formatting tips

Element	Rule
Heading	Company name, statement name, date
Columns	Left for items to be subtotaled; right for results
Dollar signs	At the top of each list and on the final net income
Expense order	Highest to lowest dollar amounts, except Miscellaneous Expense (always last)
Underlines	Single underline above calculation results; double underline below final net income

🔄 The accounting cycle and temporary accounts

🔄 What the accounting cycle is

Cycle: a period of time in which a series of accounting activities are performed.

• Accounting follows the time period assumption: ongoing business activities are divided into periods (year, quarter, month).
• The cycle is repetitive: journalizing and posting happen daily; financial statements are prepared on the last day of the cycle.
• Once the cycle is complete, the same recording and reporting activities repeat in the next period.
• Example: like a college semester—register, attend, test, receive grades, then repeat the same steps next semester.

⏱️ Temporary accounts

Temporary accounts: accounts on the income statement used to record operational transactions for a specific period of time.

• These are revenue and expense accounts.
• Once the income statement is prepared, their balances are set back to zero by transferring them to another account.
• When the next period begins, temporary accounts start with a zero balance for a fresh start.
• Don't confuse: balance sheet accounts (assets, liabilities, equity) are permanent—they carry forward and are not closed out.

🔐 Closing entries

🔐 What closing entries do

Closing entries: special journal entries made at the end of the accounting period (month or year) after the financial statements are prepared but before the first transaction in the next period is recorded.

• Purpose: set the balances of income statement accounts back to zero so you can start fresh and begin accumulating new balances for the next period.
• This ensures the next period's income statement does not include amounts from the previous period.
• Closing entries transfer revenue and expense balances into Retained Earnings.

🏦 Retained Earnings account

Retained Earnings: an account where profit is "stored"; think of it as "accumulated profit," or all the net income the business has ever generated since it began operations.

• Only used for closing entries.
• For the first month of operations, beginning Retained Earnings is zero (no previous periods).
• At the end of the first month, Retained Earnings equals the net income for that month.
• After the first month, each period's net income is added to the existing Retained Earnings balance.
• Since Revenue - Expenses = Net Income, moving revenue and expense balances into Retained Earnings is the same as moving net income.
• Retained Earnings is not closed out; instead, revenue and expense accounts are closed into it.

📝 How to record closing entries

The process involves two steps:

1. Close revenue accounts:

   • Debit each revenue account (e.g., Fees Earned) for its credit balance to bring it to zero.
   • Credit Retained Earnings for the same amount.
   • Example: If Fees Earned has a $2,100 credit balance, debit Fees Earned $2,100 and credit Retained Earnings $2,100.

2. Close expense accounts:

   • Credit each expense account (e.g., Rent Expense) for its debit balance to bring it to zero.
   • Debit Retained Earnings for the same amount.
   • Example: If Rent Expense has a $500 debit balance, credit Rent Expense $500 and debit Retained Earnings $500.

• Net effect: Retained Earnings increases by the net income amount ($2,100 - $500 = $1,600 in the example).
• Revenue and expense accounts now have zero balances.

🏃 The stopwatch analogy

Example: A runner completes a lap in 50 seconds. The timekeeper forgets to reset the stopwatch. On the second lap, the stopwatch shows 95 seconds—but the runner only took 45 seconds. The problem: the first lap's 50 seconds was included.

• Similarly, without closing entries, the second month's income statement would include the first month's revenue and expenses.
• Closing entries are like the "reset button" on the stopwatch—they ensure each period's results can be easily compared.

⚠️ What happens without closing entries

⚠️ The problem illustrated

Assume June has:

• Fees Earned: $2,100 credit balance
• Rent Expense: $500 debit balance
• Wages Expense: $300 debit balance
• Net income for June: $1,300

If closing entries are not made on 6/30, then when July transactions are posted:

• 7/1 Rent Expense $500 is posted → running balance becomes $1,000 (includes June's $500).
• 7/2 Fees Earned $900 is posted → running balance becomes $3,000 (includes June's $2,100).

The inconsistency:

• July's income statement would show $1,000 in rent, but only $500 was incurred in July.
• July's income statement would show $3,000 in fees earned, but only $900 was earned in July.
• This violates the matching principle: revenue and expenses for a period must be reported together, without amounts from other periods.

✅ With closing entries

If closing entries are made on 6/30:

• Fees Earned is debited $2,100 and Retained Earnings is credited $2,100 → Fees Earned balance becomes zero.
• Rent Expense is credited $500 and Retained Earnings is debited $500 → Rent Expense balance becomes zero.
• Wages Expense is credited $300 and Retained Earnings is debited $300 → Wages Expense balance becomes zero.
• Retained Earnings increases by $1,300 (net income).

When July transactions are posted:

• 7/1 Rent Expense $500 is posted → running balance is $500 (correct for July).
• 7/2 Fees Earned $900 is posted → running balance is $900 (correct for July).
• Each July transaction becomes the beginning balance for the new period.
• June's income statement reports only June; July's income statement reports only July; the two can be easily compared.

💳 Revenue and expense transactions on account

💳 Revenue on account (Accounts Receivable)

When a business provides a service, the customer may:

• Pay immediately with cash → debit Cash, credit Fees Earned.
• Be billed and pay later (on account) → use Accounts Receivable.

Accounts Receivable: an asset account that keeps track of how much customers owe because a business sent invoices for goods or services rather than immediately receiving cash.

Rules:

• Debit Accounts Receivable when you invoice a customer (asset increases).
• Credit Fees Earned when you provide the service (revenue increases).
• Debit Cash when the customer pays the invoice (asset increases).
• Credit Accounts Receivable when the customer pays (asset decreases).

Example:

• 6/1: Provide service for $200 on account → debit Accounts Receivable $200, credit Fees Earned $200.
• 6/30: Receive payment → debit Cash $200, credit Accounts Receivable $200.
• By 6/30, Accounts Receivable has a zero balance (one debit and one credit for the same amount negate each other).
• Ultimately, the company received cash and the customer received service—both parties have received what they are due.

💳 Expense on account (Accounts Payable)

When a business purchases a product or service, it may:

• Pay immediately with cash → debit the expense account, credit Cash.
• Be billed and pay later (on account) → use Accounts Payable.

Accounts Payable: a liability account that keeps track of how much a business owes because it was billed by vendors rather than immediately paying cash.

Liability: a debt a business owes.

Rules:

• Debit an expense account when you incur the expense by buying a product or service (expense increases).
• Credit Accounts Payable when you are billed on account (liability increases).
• Debit Accounts Payable when you pay down what you owe (liability decreases).
• Credit Cash when you pay off the account (asset decreases).

Example:

• 6/1: Purchase supplies for $200 on account → debit Supplies Expense $200, credit Accounts Payable $200.
• 6/30: Pay the invoice → debit Accounts Payable $200, credit Cash $200.
• By 6/30, Accounts Payable has a zero balance (one credit and one debit for the same amount negate each other).
• Ultimately, the company received the product/service and the vendor received cash—both parties have received what they are due.

📋 Accounts summary

📋 All accounts at a glance

Account Type	Accounts	To Increase	To Decrease	Normal Balance	Financial Statement	Close Out?
Asset	Cash, Accounts Receivable	Debit	Credit	Debit	Balance Sheet	NO
Liability	Accounts Payable	Credit	Debit	Credit	Balance Sheet	NO
Stockholders' Equity	Retained Earnings	Credit	Debit	Credit	Balance Sheet	NO
Revenue	Fees Earned	Credit	Debit	Credit	Income Statement	YES
Expense	Wages Expense, Rent Expense, Utilities Expense, Supplies Expense, Insurance Expense, Advertising Expense, Maintenance Expense, Miscellaneous Expense	Debit	Credit	Debit	Income Statement	YES

📋 Key distinctions

• Income statement accounts (revenue and expenses) are temporary and are closed out at the end of each period.
• Balance sheet accounts (assets, liabilities, stockholders' equity) are permanent and carry forward to the next period.
• The summary number on the income statement is net income (revenue minus expenses).
• Assets are recorded at what they cost the business (the cost principle).
• Current assets: cash or assets expected to be converted to cash within one year (e.g., Cash, Accounts Receivable).

🧭 Overview

🧠 One-sentence thesis

Balance sheet accounts—assets, liabilities, and stockholders' equity—are permanent accounts whose balances carry forward from period to period, unlike temporary revenue and expense accounts that close out each period.

📌 Key points (3–5)

• Permanent vs. temporary accounts: Balance sheet accounts (assets, liabilities, equity) carry balances forward; income statement accounts (revenue, expense) close out each period.
• The cost principle: Assets are recorded at what the business paid to acquire them, not at current market value or other measures.
• Common confusion—expense vs. asset: Long-lasting items (equipment, buildings) are assets, not expenses, because they benefit multiple accounting periods.
• Stockholders' equity has two sources: Common Stock (outside investment) and Retained Earnings (accumulated profits from inside the company).
• Cash Dividends mechanics: Dividends use a temporary contra equity account that closes into Retained Earnings, ultimately reducing both equity and cash.

💰 Asset accounts

💵 What assets are

Assets are anything of value to a business, including things a business owns so it can operate.

• Assets represent resources the business controls.
• They are recorded using the cost principle: at what the business paid to acquire them.
• Don't confuse: the recorded amount is historical cost, not current worth.

🔄 Current assets

Current assets are cash or items expected to convert to cash within one year.

Account	What it represents
Cash	Money the business possesses
Accounts Receivable	Amount customers owe from being invoiced on account

🏗️ Fixed assets

Fixed assets are relatively expensive and last more than one accounting year.

• Because they benefit multiple periods, they are treated as assets rather than expenses.
• Examples: Land, Building, Truck, Equipment, Furnishings.

Example: A business buys a truck for $30,000. The truck is recorded as an asset (debit Truck), not as "Truck Expense," because it will be used for many years.

Don't confuse: Equipment is an asset account; Equipment Expense would be an expense account. Use the asset account when purchasing long-lasting items.

📋 Liability accounts

🔗 What liabilities are

Liabilities are debts a business has on the assets it possesses. They are claims on the assets by people and entities that are not owners of the business.

• Liabilities represent what the business owes to outsiders.
• Rules: Credit to increase a liability; debit to decrease it.

🆚 Accounts Payable vs. Note Payable

Both are debts, but they differ in formality and terms:

Account	Description
Accounts Payable	Payment agreement with a vendor, usually thirty days to pay for products/services
Note Payable	Formal, signed loan contract that may include interest and spells out repayment terms over time

Example: Buying equipment on account creates Accounts Payable; taking out a bank loan creates Note Payable.

🏢 Stockholders' equity accounts

🤝 What stockholders' equity is

Stockholders' equity is the stockholders' share of ownership of the assets that the business possesses, or the claim on the business's assets by its owners.

• A corporation is a separate legal entity from its owners.
• Stockholders (owners) receive shares of stock as receipts for their investments.
• Limited liability: Owners can only lose what they invested; their personal assets are protected.

🎯 Two sources of equity

Account	Source	What it represents
Common Stock	Outside the company	Ownership value from investors who pay their own money into the business
Retained Earnings	Inside the company	Ownership value from profits the business makes that are shared by stockholders

Example: An individual invests $10,000 to start a corporation. The journal entry debits Cash and credits Common Stock—recognizing the investor's ownership claim.

💸 Cash Dividends mechanism

Cash Dividends are payouts of profits (retained earnings) to stockholders.

• Cash Dividends is a contra equity account (opposite normal balance).
• It substitutes for a direct debit to Retained Earnings during the period.
• At period-end, Cash Dividends closes into Retained Earnings, ultimately reducing both equity and cash.

Two-step process:

1. When paid: Debit Cash Dividends, Credit Cash
2. At period-end closing: Debit Retained Earnings, Credit Cash Dividends

Why this matters: The temporary account lets the business track dividend payments separately before reducing Retained Earnings at closing.

Don't confuse: Dividends come from Retained Earnings (accumulated profits), not from Common Stock (owner investments).

📊 Balance sheet transaction patterns

🛒 Purchasing fixed assets

Three common payment patterns when acquiring equipment:

Payment method	Journal entry pattern
Full cash payment	Debit Equipment; Credit Cash
Full credit (on account)	Debit Equipment; Credit Accounts Payable
Partial cash + loan	Debit Equipment; Credit Cash (partial); Credit Note Payable (remainder)

Example of compound transaction: Equipment costs $5,000. The company pays $1,000 down and takes a $4,000 loan. Entry: Debit Equipment $5,000; Credit Cash $1,000; Credit Note Payable $4,000. Total debits equal total credits.

💼 Sole proprietorship vs. corporation comparison

Scenario: You invest $2,000 in a lawn care business. A customer claims $10,000 in damages.

Business form	Liability exposure
Sole proprietorship	You could lose more than your $2,000 investment—personal assets at risk, future wages could be garnished
Corporation	Maximum loss is what you invested and earned in the business; personal assets protected

Why it matters: Corporations require filing articles of incorporation with the state and paying a fee, but they provide limited liability protection.

🔄 Permanent vs. temporary nature

Balance sheet accounts are permanent:

• Balances at period-end carry forward and become starting balances for the next period.
• They are not closed out.

Income statement accounts are temporary:

• Revenue and expense accounts close out each period.
• Their balances reset to zero at the start of the next period.

Don't confuse: Cash Dividends appears on the Retained Earnings Statement and closes out (like temporary accounts), but it is classified as a contra stockholders' equity account, not an expense.

🧭 Overview

🧠 One-sentence thesis

The accounting cycle consists of seven steps—five primarily involving copying and calculating, and two requiring analytical thinking to translate transactions into debits and credits—all built on the foundation that the accounting equation must always remain in balance.

📌 Key points (3–5)

• The five account types: Asset, Liability, Stockholders' Equity (balance sheet accounts), plus Revenue and Expense (income statement accounts).
• Contra accounts: accounts with intentionally opposite normal balances that allow reporting both original amounts and changes without altering the original account directly.
• Seven-step accounting cycle: most steps are mechanical (copying/calculating); only journalizing transactions and closing entries require analytical thinking.
• Common confusion: contra accounts vs. regular accounts—a contra asset has a credit balance (opposite of the normal debit), but it's still presented with the original asset account to show the net amount.
• The accounting equation foundation: Assets = Liabilities + Stockholders' Equity must always balance, ensuring total debits equal total credits in every transaction.

📚 Account types and classifications

📊 The five core account types

The excerpt identifies five fundamental account types organized by financial statement:

Account Type	Examples from Excerpt	Financial Statement	Closed Out?
Asset	Cash, Accounts Receivable, Land, Truck, Equipment, Building, Furnishings	Balance Sheet	NO
Liability	Accounts Payable, Note Payable	Balance Sheet	NO
Stockholders' Equity	Common Stock, Retained Earnings	Balance Sheet	NO
Revenue	Fees Earned	Income Statement	YES
Expense	Wages, Rent, Utilities, Supplies, Insurance, Advertising, Maintenance, Miscellaneous	Income Statement	YES

• Balance sheet accounts (Asset, Liability, Stockholders' Equity) are permanent; they carry forward period to period.
• Income statement accounts (Revenue, Expense) are temporary; they close out at period end.

🔄 Contra accounts explained

Contra account: an account whose normal balance is intentionally the opposite of the normal balance for its account classification.

• Purpose: allows a company to report both the original amount and changes without directly altering the original account.
• How it works: the original account and its contra account(s) are presented together on financial statements to show:
  • Original amount
  • Total changes
  • Net (carrying) amount
• Example from excerpt: Cash Dividends is a contra equity account with a debit balance (opposite of the normal credit balance for equity).
• Don't confuse: a contra asset account still relates to assets and appears with asset accounts, even though it has a credit balance instead of a debit balance.

📋 Normal balances and debit/credit rules

The excerpt provides a complete summary:

• Assets: increase with debit, decrease with credit, normal balance is debit.
• Liabilities: increase with credit, decrease with debit, normal balance is credit.
• Stockholders' Equity: increase with credit, decrease with debit, normal balance is credit.
• Contra Stockholders' Equity (Cash Dividends): increase with debit, decrease with credit, normal balance is debit (opposite of regular equity).
• Revenue: increase with credit, decrease with debit, normal balance is credit.
• Expense: increase with debit, decrease with credit, normal balance is debit.

🔁 The seven-step accounting cycle

📝 Overview of the cycle

The excerpt assumes financial statements are prepared at the end of each month and lists seven steps:

Step	Action	When	Task Type
1	Journalize transactions	Daily	THINK; analyze transactions
2	Post to ledgers	Daily	COPY from journal; CALCULATE
3	Income statement	End of month	COPY from ledgers; CALCULATE
4	Retained earnings statement	End of month	COPY from ledgers and income statement; CALCULATE
5	Balance sheet	End of month	COPY from ledgers and retained earnings statement; ADD
6	Journalize closing entries	End of month	THINK; same three entries
7	Post closing entries to ledgers	End of month	COPY from journal; CALCULATE

🧠 Where thinking is required

The excerpt emphasizes that five of the seven steps primarily involve only copying and/or calculating—procedures that may be tedious but not difficult.

Thinking is involved in two places:

1. Step #1 (Journalize transactions): you must analyze what is happening and translate the transaction into accounting language by selecting accounts to debit and credit; you often have to calculate amounts as well.
2. Step #6 (Journalize closing entries): requires thinking, but the excerpt notes that closing entries are "the same three every time," so they should become relatively routine.

• Key insight: the accounting cycle involves numerous steps, yet the majority are mechanical.
• Example: posting to ledgers (step 2 and 7) means copying information from the journal and calculating new balances—no analysis needed.

🔚 Closing entries for dividends

The excerpt illustrates the Cash Dividends closing process:

When dividends are paid (during the period):

• Debit Cash Dividends (contra equity account increasing)
• Credit Cash (asset decreasing)
• This records the distribution but does not directly reduce Retained Earnings yet.

At period end (closing entry):

• Debit Retained Earnings (equity decreasing)
• Credit Cash Dividends (contra equity decreasing to zero)
• This closes the Cash Dividends account balance back to zero and ultimately reduces Retained Earnings by the profit paid out to stockholders.

Don't confuse: payment of dividends is not a closing entry; the closing entry happens at period end to transfer the Cash Dividends balance to Retained Earnings.

⚖️ The accounting equation foundation

🧮 The fundamental equation

The accounting equation: Assets = Liabilities + Stockholders' Equity

• Why it matters: it is the basis for all transactions in accounting and provides the foundation for the rules of debit and credit in the journalizing process.
• Balance requirement: for each transaction, total debits must equal total credits; as a result, the accounting equation must be in balance at all times for a business's financial records to be correct.
• Scope: it involves the three types of accounts that do not appear on the income statement (Asset, Liability, Stockholders' Equity).

🚚 Conceptual explanation: buying a truck

The excerpt uses a truck purchase to illustrate the equation:

Concept: when you purchase an asset, there are two ways to pay for it—with your own money and with other people's money.

Scenario 1: Pay cash in full

• Journal entry: Debit Truck 30,000 / Credit Cash 30,000
• If you pay in full, you own the entire vehicle and receive title to it.
• Accounting equation: Assets (30,000) = Liabilities (0) + Stockholders' Equity (30,000)
• Interpretation: the truck (asset) is entirely owned by stockholders; no outside debt.

Scenario 2: Down payment plus loan

• Journal entry begins: Debit Truck 30,000 / Credit... (excerpt cuts off, but implies a combination of Cash and Note Payable)
• Interpretation: the truck (asset) is partially owned by stockholders (down payment) and partially owed to outsiders (loan = liability).

Key insight: businesses own assets, which may be partially owned by the owners (stockholders) and partially owned by outsiders (debtors). The accounting equation captures this ownership structure.

🧭 Overview

🧠 One-sentence thesis

The accounting equation (Assets = Liabilities + Stockholders' Equity) must remain in balance at all times because every transaction affects at least two accounts, ensuring that what a business owns is always funded by either creditors or owners.

📌 Key points (3–5)

• The equation is the foundation: Assets = Liabilities + Stockholders' Equity underlies all accounting transactions and the debit/credit rules.
• Two ways to pay for assets: any asset can be financed with the owner's own money (equity) or other people's money (liabilities), and the sum of these two sources always equals the asset's cost.
• Revenue and expenses indirectly affect the equation: they impact Retained Earnings through closing entries, which in turn changes total stockholders' equity.
• Common confusion: the accounting equation involves only Balance Sheet accounts (assets, liabilities, stockholders' equity); revenue and expense accounts appear on the Income Statement but ultimately flow into Retained Earnings.
• The equation must always balance: total debits must equal total credits in every transaction, keeping the equation in equilibrium and ensuring correct financial records.

💰 The fundamental equation and its components

💰 What the accounting equation states

The accounting equation: Assets = Liabilities + Stockholders' Equity

• Assets: what the business owns.
• Liabilities: amounts owed to outsiders (debtors).
• Stockholders' Equity: the portion owned by the owners (stockholders).
• The equation shows that businesses own assets, which are partially owned by stockholders and partially owed to creditors.

🔑 Why the equation must balance

• The accounting equation is the basis for all transactions in accounting.
• It provides the foundation for the rules of debit and credit in the journalizing process.
• For each transaction, total debits must equal total credits.
• As a result, the accounting equation must be in balance at all times for a business's financial records to be correct.

🧩 Two ways to pay for assets

• When you purchase an asset, there are two ways to pay for it: with your own money and with other people's money.
• This concept is a simple description of the accounting equation.
• Example: buying a truck—you can pay cash in full (all equity) or make a down payment and take out a loan (part equity, part liability).
• The combined total of the down payment and the loan equals the cost of the asset.

🚚 Truck purchase illustration

🚚 Scenario 1: Full cash payment

• Journal entry: Debit Truck 30,000; Credit Cash 30,000.
• If you pay in full, you own the entire vehicle and receive title to it.
• Accounting equation: Assets 30,000 = Liabilities 0 + Stockholders' Equity 30,000.

🚚 Scenario 2: Down payment plus loan

• Journal entry: Debit Truck 30,000; Credit Cash 10,000; Credit Note Payable 20,000.
• Accounting equation: Assets 30,000 = Liabilities 20,000 + Stockholders' Equity 10,000.
• The buyer receives the entire asset (the truck) but pays for it with two forms of payment: their own money (equity, the down payment of 10,000) and other people's money (the loan of 20,000).
• The asset is the truck, the liability is the loan, and the down payment is the owner's equity.

🌳 The expanded accounting equation

🌳 How revenue and expenses fit in

Indirectly, revenue and expense accounts are part of the accounting equation since they impact the value of stockholders' equity by affecting the value of Retained Earnings.

• The Retained Earnings account normally has a credit balance.
• Closing entries move the credit balances of revenue accounts into Retained Earnings and cause that account to increase.
• Closing entries also transfer the debit balances of expense accounts into Retained Earnings, causing it to decrease.
• Common Stock plus Retained Earnings equals total stockholders' equity.

🌳 The expanded form

The expanded accounting equation breaks out stockholders' equity:

Assets = Liabilities + Stockholders' Equity

Where Stockholders' Equity splits into:

• Common Stock
• Retained Earnings

And Retained Earnings is affected by:

• Revenue (increases it)
• Expenses (decreases it)

📊 Transaction grid example

The excerpt provides a grid showing how transactions fit into the equation:

Transaction	Cash	Accounts Receivable	Accounts Payable	Common Stock	Retained Earnings	Fees Earned	Rent Expense	Supplies Expense
Issued stock for cash, 1,000	1,000			1,000
Paid cash for rent, 700	(700)						(700)
Sold to customers for cash, 900	900					900
Purchased supplies on account, 200			200					(200)
Sold to customers on account, 500		500				500
Paid cash on account, 200	(200)		(200)
Purchased supplies on account, 100			100					(100)
Sold to customers on account, 400		400				400
Received cash on account, 500	500	(500)
Closed revenue account					1,800	(1,800)
Closed expense accounts					(1,000)		700	300
Ending balances	1,500	400	100	1,000	800	0	0	0

• Each transaction impacts two accounts.
• Positive numbers represent increases; negative amounts indicate decreases.
• The ending balances prove that total assets of 1,900 (1,500 + 400) equal total liabilities and stockholders' equity of 1,900 (100 + 1,000 + 800).
• Revenue and expense accounts were used temporarily and were ultimately closed to Retained Earnings, setting income statement account balances to zero and increasing Retained Earnings by the net income amount of 800.

📋 Financial statements and the equation

📋 Retained Earnings Statement

The retained earnings statement is a report that shows the change in the Retained Earnings account balance from the beginning of the month to the end of the month due to net income (or loss) and any cash dividends declared during the accounting period.

Steps to prepare:

1. Start with Retained Earnings balance at the beginning of the month.
2. Add net income from the current month's income statement.
3. Subtract from net income any dividends declared during the month.
4. End with new Retained Earnings balance at the end of the month.

Why it matters:

• Profit is such an important concept in business that two financial statements are devoted to talking about it.
• The income statement reports net income for one period (such as a month or a year).
• The retained earnings statement deals with a company's net income over the entire life of the business.
• The retained earnings statement is a bridge between the income statement and the balance sheet.
• The net income amount that appears on the retained earnings statement comes from the income statement.
• The ending retained earnings balance feeds to the stockholders' equity section of the balance sheet.

Analogy to bank statement:

Bank Statement (tracks your cash)	Retained Earnings Statement (tracks a corporation's accumulated profit)
Balance at the beginning of the month	Balance at the beginning of the month
Deposits	Net Income
Withdrawals	Dividends
Balance at the end of the month	Balance at the end of the month

📋 Balance Sheet

The balance sheet is a report that summarizes a business's financial position as of a specific date.

• It is the culmination of all the financial information about the business—everything else done in the accounting cycle leads up to it.
• The balance sheet is an expanded version of the accounting equation: Assets = Liabilities + Stockholders' Equity.
• The balance sheet lists and summarizes asset, liability, and stockholders' equity accounts and their ledger balances as of a point in time.
• Assets are listed first; liabilities and stockholders' equity accounts follow, and these amounts are added together.
• The only exception is that the amount reported on the balance sheet for Retained Earnings comes from the ending balance on the retained earnings statement rather than from its ledger.
• Note that Cash Dividends is not listed at all on the balance sheet.

Don't confuse: The balance sheet shows balances at a point in time, whereas the income statement and retained earnings statement cover a period of time.

🔗 How the three statements connect

The excerpt emphasizes that three financial statements are prepared at the end of each accounting period, in order:

1. Income Statement (prepared first):

   • Summarizes revenue and expenses for the month.
   • Amounts come from the ledger balances.
   • The result is either net income or net loss.

2. Retained Earnings Statement (prepared next):

   • Adjusts the month's beginning retained earnings balance by adding net income from the income statement and subtracting out dividends declared.
   • The net income comes from the income statement.
   • The result is a new retained earnings balance at the end of the month.

3. Balance Sheet (prepared last):

   • Shows assets, liabilities, and stockholders' equity as of the last day of the month.
   • All amounts except retained earnings come from the ledger balances.
   • The Retained Earnings amount comes from the ending amount on the retained earnings statement.
   • The balance sheet is an exploded version of the accounting equation.

🔄 Changes in Stockholders' Equity

🔄 What affects stockholders' equity

Any change in the Common Stock, Retained Earnings, or Cash Dividends accounts affects total stockholders' equity.

Formula: Common Stock + Retained Earnings = Total Stockholders' Equity

🔄 Increases and decreases

• Stockholders' equity increases due to:
  • Additional stock investments
  • Additional net income
• Stockholders' equity decreases due to:
  • A net loss
  • Dividend payouts
• Retained earnings increases when revenue accounts are closed out into it.

Don't confuse: Revenue increases Retained Earnings only after closing entries; during the period, revenue accounts are separate from Retained Earnings.

🧭 Overview

🧠 One-sentence thesis

Stockholders' equity changes through four main events—stock investments and net income increase it, while dividends and net losses decrease it—and these changes flow through the Common Stock and Retained Earnings accounts.

📌 Key points (3–5)

• The equity equation: Total Stockholders' Equity = Common Stock + Retained Earnings.
• Two ways equity increases: owners invest (credits Common Stock) or the business earns net income (credits Retained Earnings).
• Two ways equity decreases: dividends are paid out (debits Retained Earnings) or the business experiences a net loss (debits Retained Earnings).
• Common confusion: Retained Earnings changes from multiple sources—revenue closes into it (increase), expenses close into it (decrease), and dividends close into it (decrease).
• Calculating ending equity: Beginning equity + Additional investments + Net income (or – Net loss) – Dividends = Ending equity.

💰 The stockholders' equity structure

💰 Two components of total equity

Total Stockholders' Equity = Common Stock + Retained Earnings

• Any change in Common Stock, Retained Earnings, or Cash Dividends affects total stockholders' equity.
• Common Stock tracks owner investments.
• Retained Earnings accumulates profits (or losses) that stay in the business after dividends.

📊 How closing entries affect Retained Earnings

• Revenue accounts close into Retained Earnings (increase it).
• Expense accounts close into Retained Earnings (decrease it).
• Cash Dividends closes into Retained Earnings (decrease it).
• This is why Retained Earnings is the "accumulator" account—it captures the net effect of operations and distributions.

⬆️ How stockholders' equity increases

⬆️ Stock investments

• When owners invest cash, the journal entry is:
  • Debit Cash
  • Credit Common Stock
• Effect: Common Stock increases → Total Stockholders' Equity increases.
• Example: 30 stockholders invest $1,000 each for a total of $30,000. Each investor is now worth $1,000 in the business. Total equity = $30,000.

⬆️ Net income from operations

• When the business earns more revenue than expenses, net income results.
• The closing entry credits Retained Earnings for total revenue and debits it for total expenses.
• Effect: Retained Earnings increases by the net income amount → Total Stockholders' Equity increases.
• Example: Fees Earned is $65,000 and total expenses are $5,000, so net income is $60,000. After closing, Retained Earnings increases by $60,000. Each of the 30 investors is now worth $3,000 ($1,000 original investment + $2,000 share of profit).

⬇️ How stockholders' equity decreases

⬇️ Dividend payments

• When cash dividends are declared and paid, the journal entry is:
  • Debit Retained Earnings (or Cash Dividends, which later closes to Retained Earnings)
  • Credit Cash
• Effect: Retained Earnings decreases → Total Stockholders' Equity decreases.
• Example: Each of the 30 investors receives a $500 dividend (total $15,000). Each investor is now worth $2,500 ($1,000 original + $2,000 profit – $500 dividend paid out).

⬇️ Net loss from operations

• When expenses exceed revenue, a net loss results.
• The closing entry debits Retained Earnings for the net loss amount.
• Effect: Retained Earnings decreases → Total Stockholders' Equity decreases.
• Don't confuse: a net loss is not the same as paying dividends—both decrease Retained Earnings, but a loss means the business consumed resources in operations, while dividends are distributions of profits.

🧮 Calculating changes in equity

🧮 The equity change formula

The excerpt provides two equivalent formulas:

Formula 1:

• Beginning stockholders' equity
• + Additional investments in stock
• + Net income (or – Net loss)
• \– Dividends
• = Ending stockholders' equity

Formula 2 (expanded):

• Beginning stockholders' equity
• + Additional investments in stock
• + Revenue
• \– Expenses
• \– Dividends
• = Ending stockholders' equity

🧮 Solving for net income algebraically

If net income is not given, you can solve for it using the formula:

• Beginning equity + Additional investments + Net income – Dividends = Ending equity
• Example: $12,000 + $6,000 + x – $1,000 = $20,000
• Solve: x = $20,000 – $12,000 – $6,000 + $1,000 = $3,000

📋 Summary table

Event	Account affected	Debit/Credit	Effect on Total Equity
Stock investment	Common Stock	Credit	Increases
Net income	Retained Earnings	Credit	Increases
Dividends paid	Retained Earnings	Debit	Decreases
Net loss	Retained Earnings	Debit	Decreases

🧭 Overview

🧠 One-sentence thesis

The accounting cycle transforms chronological financial transactions into organized ledger balances and professional financial statements, then resets temporary accounts to begin the cycle anew.

📌 Key points (3–5)

• The full cycle flow: transactions → journal (chronological) → ledgers (by account) → financial statements → closing entries.
• Key mechanism: ledgers maintain running balances for every account throughout the period.
• Three main statements: income statement, retained earnings statement, and balance sheet summarize account balances in a structured, professional format.
• Closing process: temporary accounts (revenue, expense, dividends) are zeroed out to Retained Earnings at period-end so the cycle can restart.
• Common confusion: the journal records events chronologically, but ledgers reorganize the same information by account type—both contain the same data, just in different structures.

📝 The recording and reorganization flow

📝 From transactions to journal

• Businesses experience financial transactions (events that affect the company's finances).
• These events are recorded by selecting the appropriate accounts and amounts to represent them.
• Entries are made in the journal in chronological order—the order in which events happen.

🗂️ From journal to ledgers

• Journal entries are then copied to the ledgers.
• The ledgers reorganize the same information by account rather than by date.
• Example: all cash transactions are grouped in the Cash ledger, all revenue transactions in the Revenue ledger, etc.

⚙️ Maintaining running balances

One of the key aspects of the process is maintaining current running balances in all of the ledger accounts.

• Each ledger account keeps a running balance that updates with every entry.
• This running balance is essential for knowing the current status of each account at any time.
• Don't confuse: the journal shows the full transaction (debits and credits together); the ledger shows how each individual account's balance changes over time.

📊 From ledgers to financial statements

📊 Transferring balances to statements

• Account balances from the ledgers are transferred to three main financial statements.
• These statements provide a professional, well-structured summary that is meaningful to readers.

📄 The three statements

Statement	What it shows
Income statement	Revenue and expense account balances (performance for the period)
Retained earnings statement	Changes in retained earnings (net income minus dividends)
Balance sheet	Asset, liability, and stockholders' equity account balances (financial position at period-end)

• The statements are interconnected: net income from the income statement flows into the retained earnings statement, which then flows into the balance sheet.

🔄 Closing the cycle

🔄 What closing entries do

• At the end of the accounting period, temporary accounts are closed.
• Temporary accounts include:
  • Revenue accounts
  • Expense accounts
  • Dividends account
• These accounts are closed to Retained Earnings.

🔄 Why closing is necessary

• Closing sets the balances of temporary accounts back to zero.
• This allows the cycle to begin again in the next period with a clean slate.
• Don't confuse: only temporary accounts are closed; permanent accounts (assets, liabilities, stockholders' equity) carry their balances forward into the next period.

🔄 The cycle repeats

• After closing, the accounting cycle starts over:
  • New transactions are recorded in the journal
  • Posted to ledgers with updated running balances
  • Summarized in financial statements
  • Closed at period-end
• This continuous cycle ensures accurate, up-to-date financial reporting period after period.

🧭 Overview

🧠 One-sentence thesis

The accrual basis of accounting recognizes economic events when they occur—not when cash changes hands—so that revenues and expenses are matched within the same time period to show the true cost of generating income.

📌 Key points (3–5)

• What accrual basis means: revenue is reported when earned and expenses when incurred, regardless of cash timing.
• The matching principle: expenses incurred in a period should relate to revenues earned in the same period, showing the cost of producing that revenue.
• Common confusion: a transaction may span multiple periods; only the portion that belongs to the current period should be included in that period's statements.
• How to match correctly: adjusting entries "chop off" parts of transactions that do not belong in the current period, bringing account balances up to date.
• Why it matters: matching lets you see how much it cost to produce the revenue in a specific window of time, such as a month.

💡 What accrual basis recognizes

💡 Economic events vs. cash timing

The accrual basis of accounting recognizes economic events when they take place, regardless of when the related cash transactions occur.

• Revenue is reported in the period you earn it, even if you have not received cash yet.
• Expenses are reported in the period you incur them to produce revenues, even if you have not paid yet.
• Example: You mow a yard and leave a bill in the mailbox. You have earned $50 today, even though you have not received payment, because you completed the work.

🔍 Earned vs. received

• "Earned" means the work is done or the service is complete.
• "Received" means cash has changed hands.
• Don't confuse: under accrual accounting, these two events may happen in different periods.

🔗 The matching principle

🔗 What matching means

The matching principle states that expenses incurred during a period should relate to (or match up with) the revenues earned during the same period.

• It applies to income statement accounts.
• It lets you know how much it cost to produce the revenue you generated in a given period of time, such as a month.
• Analogy: "It takes money to make money." The matching principle looks at a window of time—how much income came in versus how much was spent to generate that income.

⏱️ The "window of time"

• The key is the window of time, such as a month.
• Compare how much came in in sales in a month versus how much was spent.
• Any revenue or expenses before or after that month are not considered in that month's income statement.

📐 How matching works across periods

📐 Transactions that span multiple periods

The excerpt provides a timeline example with three months (May, June, July) and three jobs:

Job	Total revenue	When started	When completed	June portion
Job 1	$100	May	June	$50 (half earned in June)
Job 2	$100	June	June	$100 (all earned in June)
Job 3	$100	June	July	$50 (half earned in June)

• Total revenue from all three jobs: $300.
• Only the portion earned in June is included in June's income statement: $50 + $100 + $50 = $200.

📐 Expenses that span multiple periods

The excerpt also shows three expenses:

Expense	Total cost	When began	When incurred	June portion
Expense 4	$60	May	Partially May, partially June	$30 (half incurred in June)
Expense 5	$60	June	All in June	$60 (all incurred in June)
Expense 6	$60	June	Partially June, partially July	$30 (half incurred in June)

• Total expenses from all three: $180.
• Only the portion incurred in June is included in June's income statement: $30 + $60 + $30 = $120.

📐 Calculating net income for the period

• For June, $200 of revenue was earned and matched with $120 of expenses incurred in the same month.
• Net income for June: $200 - $120 = $80.
• You have to "chop off" the pieces of transactions that did not occur in June to be left with only the parts that belong in June.

🛠️ Adjusting entries

🛠️ What adjusting entries do

Adjusting entries are special entries made just before financial statements are prepared—at the end of the month and/or year. They bring the balances of certain accounts up to date if they are not already current to properly match revenues and expenses.

• They help do the job of matching revenue with expenses by "chopping off" amounts of transactions that do not belong in a given month.
• Many ledger account balances are already correct at the end of the accounting period; however, some account balances may have changed during the period but have not yet been updated.

🛠️ When adjusting entries are needed

• Under the cash basis of accounting, the companies dealt with so far did not need adjusting entries.
• Under the accrual basis of accounting, adjusting entries are necessary to update account balances that have changed but have not yet been recorded.
• Don't confuse: adjusting entries are not regular journal entries; they are made specifically at period-end to ensure proper matching.

🧭 Overview

🧠 One-sentence thesis

The matching principle ensures that expenses incurred during a period are matched with the revenues earned in that same period, so financial statements accurately reflect the cost of generating income within a specific window of time.

📌 Key points (3–5)

• What the matching principle does: relates expenses to revenues in the same time period (e.g., a month) to show how much it cost to produce that period's revenue.
• When revenue and expenses are recognized: based on when they are earned or incurred, not when cash is paid or received.
• How adjusting entries support matching: they "chop off" parts of transactions that belong to other periods, leaving only the portion that belongs in the current period.
• Common confusion: the matching principle focuses on a specific window of time—revenues and expenses before or after that window are excluded, even if they relate to the same job or transaction.
• Why it matters: adjusting entries are made just before financial statements to update account balances and ensure proper matching, which is essential under accrual accounting.

💡 What the matching principle means

💡 Core definition and purpose

The matching principle states that expenses incurred during a period should relate to (or match up with) the revenues earned during the same period.

• This principle applies to income statement accounts.
• It lets you know how much it cost to produce the revenue generated in a given period of time, such as a month.
• The key is the window of time: you compare how much income came in during that window versus how much was spent to generate it.
• Revenues or expenses before or after that window are not considered.

🔍 Earned vs. received

• Revenue is earned when the work is completed, not when cash is received.
• Expenses are incurred when they relate to producing revenue, not when they are paid.
• Example: You mow a yard and leave a bill in the mailbox. You have earned $50 today, even though you have not received the cash payment yet, because you completed the work.

🎯 The "window of time" concept

• The matching principle looks at a specific period (e.g., one month).
• Only the revenue earned and expenses incurred within that month are included in that month's income statement.
• Any revenue or expenses before or after that month are excluded.
• Don't confuse: a single job or transaction may span multiple months; only the portion that belongs to the current month is included.

📅 How matching works across time periods

📅 Timeline example: three months

The excerpt provides a timeline with three jobs (revenue) and three expenses spanning May, June, and July:

Item	Total amount	Timing	June portion
Job 1 (revenue)	$100	Started in May, completed in June	$50 (half)
Job 2 (revenue)	$100	Started and completed in June	$100 (all)
Job 3 (revenue)	$100	Started in June, completed in July	$50 (half)
Expense 4	$60	Partially in May, partially in June	$30 (half)
Expense 5	$60	All in June	$60 (all)
Expense 6	$60	Partially in June, partially in July	$30 (half)

• Total revenue from all three jobs: $300, but only $200 earned in June.
• Total expenses: $180, but only $120 incurred in June.
• Net income for June: $200 revenue minus $120 expenses = $80.

✂️ "Chopping off" transactions

• To produce an income statement for June, you must include all revenue and expenses that occurred in June, but none that occurred in May or July.
• You "chop off" the pieces of transactions that did not occur in June to be left with only the parts that belong in June.
• This is the essence of matching: isolating the portion of each transaction that belongs to the current period.

🔧 Adjusting entries: the tool for matching

🔧 What adjusting entries do

Adjusting entries are special entries made just before financial statements are prepared—at the end of the month and/or year. They bring the balances of certain accounts up to date if they are not already current to properly match revenues and expenses.

• Adjusting entries help do the job of matching by "chopping off" amounts of transactions that do not belong in a given month.
• They are necessary under the accrual basis of accounting (not the cash basis).
• Many ledger account balances are already correct at the end of the period, but some may have changed and not yet been updated.

🕒 When adjusting entries are needed

• Adjusting entries are typically necessary for transactions that extend over more than one accounting period.
• You want to include the part of the transaction that belongs in the current period and exclude the part that belongs in a previous or future period.
• This relates directly to the matching process.

📊 What adjusting entries affect

• Important: Each adjusting entry will always affect at least one income statement account (revenue or expense) and one balance sheet account (asset or liability).
• This ensures that both the income statement and balance sheet are updated and accurate.

🔄 The complete accounting cycle

🔄 Nine steps in order

The complete accounting cycle involves these nine steps, done in this order:

Step	Action	When	Your job
1	Journalize transactions	Daily	THINK
2	Post to ledgers	Daily	COPY from journal; CALCULATE
3	Journalize the adjusting entries	End of month	THINK
4	Post the adjusting entries	End of month	COPY from journal; CALCULATE
5	Income statement	End of month	COPY from ledgers; CALCULATE
6	Retained earnings statement	End of month	COPY net income from income statement
7	Balance sheet	End of month	COPY from ledgers; ADD
8	Journalize the closing entries	End of month	THINK (same three entries)
9	Post the closing entries	End of month	COPY from journal; CALCULATE

⚙️ Where adjusting entries fit

• Steps 3 and 4 (adjusting entries) are new and involve updating account balances that are not current just before preparing the financial statements.
• Important: Adjusting entries are recorded BEFORE the financial statements are prepared (steps 5–7).
• Closing entries are recorded AFTER financial statements are prepared (steps 8–9).
• Don't confuse: adjusting entries update balances for the current period; closing entries reset temporary accounts for the next period.

🔁 Cyclical nature

• Accounting is a cyclical process: a series of steps that take place in a particular order during a period of time.
• Once this period is over, the same steps are repeated in the next period of equal length.

🧭 Overview

🧠 One-sentence thesis

Adjusting entries are special journal entries made at the end of an accounting period to update account balances so that revenues and expenses are properly matched to the correct time period.

📌 Key points (3–5)

• When adjusting entries are made: just before financial statements are prepared (end of month/year), not during daily recording.
• What they update: account balances that have changed during the period but have not yet been recorded, ensuring financial statements are current and correct.
• Two main types: deferrals (for items purchased or received in advance) and accruals (for items earned or incurred but not yet recorded).
• Common confusion: adjusting entries come BEFORE financial statements are prepared; closing entries come AFTER—don't mix up the order.
• Key rule: every adjusting entry affects at least one income statement account (revenue or expense) AND one balance sheet account (asset or liability).

📅 The matching principle and timing

📅 Why timing matters

• Transactions often extend over more than one accounting period.
• You need to include only the part of a transaction that belongs in the period you're reporting on.
• Example: A job that spans May, June, and July—only the June portion should appear in June's income statement.

✂️ The "chopping" process

• Adjusting entries "chop off" amounts that don't belong in the current period.
• This ensures revenues earned in June are matched with expenses incurred in June, not May or July.
• Example from excerpt: $200 June revenue matched with $120 June expenses = $80 net income for June only.

🔄 Where adjusting entries fit in the cycle

🔄 The complete accounting cycle (9 steps)

The excerpt lists these steps in order:

Step	Action	When	Notes
1	Journalize transactions	Daily	Regular recording
2	Post to ledgers	Daily	Transfer from journal
3	Journalize adjusting entries	End of month	Update balances
4	Post adjusting entries	End of month	Transfer adjustments
5	Income statement	End of month	After adjusting
6	Retained earnings statement	End of month	After adjusting
7	Balance sheet	End of month	After adjusting
8	Journalize closing entries	End of month	After statements
9	Post closing entries	End of month	After statements

⚠️ Critical sequence

• Adjusting entries (steps 3–4) happen BEFORE financial statements (steps 5–7).
• Closing entries (steps 8–9) happen AFTER financial statements.
• Don't confuse: adjusting ≠ closing; they serve different purposes and occur at different times.

🧩 Two main categories of adjusting entries

🧩 Deferrals vs accruals

The excerpt identifies four subcategories:

1. Deferred expenses – purchased in advance, used up later
2. Deferred revenue – cash received in advance, earned later
3. Accrued expenses – incurred but not yet recorded
4. Accrued revenue – earned but not yet recorded

Deferrals: adjusting entries that update a previous transaction; the first entry was general, the adjusting entry updates it before preparing financial statements.

🛒 Deferred expenses explained

• What "deferred" means: postponed into the future.
• You purchase something in bulk that lasts longer than one month (supplies, insurance, rent, equipment).
• Initial recording: record as an asset (not an expense) because you haven't used it all yet.
• At month-end: make an adjusting entry for the portion you did use up.
  • Debit: the appropriate expense account (increases expense).
  • Credit: the asset account (decreases the asset).
• Remaining balance: what's left in the asset account is what you still have for future use.

📋 The 10 standard adjusting entries

📋 Deferred expense entries (5 types)

The excerpt shows five deferred expense adjusting entries, all following the same pattern:

Entry	Debit (increases)	Credit (decreases)
1	Supplies Expense	Supplies (asset)
2	Insurance Expense	Prepaid Insurance (asset)
3	Rent Expense	Prepaid Rent (asset)
4	Taxes Expense	Prepaid Taxes (asset)
5	Depreciation Expense	Accumulated Depreciation (contra asset)*

*Note: Accumulated Depreciation is a contra asset that increases with a credit (opposite of normal assets).

📋 Other adjusting entries (5 more)

The excerpt lists five additional entries:

Entry	Debit	Credit	Type
6	Unearned Fees (liability ↓)	Fees Earned (revenue ↑)	Deferred revenue
7	Wages Expense (expense ↑)	Wages Payable (liability ↑)	Accrued expense
8	Taxes Expense (expense ↑)	Taxes Payable (liability ↑)	Accrued expense
9	Interest Expense (expense ↑)	Interest Payable (liability ↑)	Accrued expense
10	Accounts Receivable (asset ↑)	Fees Earned (revenue ↑)	Accrued revenue

🔑 The universal rule

Every adjusting entry affects:

• One income statement account (revenue or expense), AND
• One balance sheet account (asset or liability).

This ensures the matching principle is followed and both statements are updated correctly.

🧭 Overview

🧠 One-sentence thesis

Deferral adjusting entries update previously recorded transactions to accurately reflect what has been used or earned by the end of an accounting period, ensuring financial statements show the correct asset, liability, expense, and revenue balances.

📌 Key points (3–5)

• What deferrals are: adjusting entries that update a previous transaction before preparing financial statements, covering items purchased/received in advance.
• Two types of deferrals: deferred expenses (prepaid items used over time) and deferred revenue (cash received before service is earned).
• The transfer mechanism: deferrals move amounts from balance sheet accounts (assets or liabilities) to income statement accounts (expenses or revenues) as items are consumed or earned.
• Common confusion: don't confuse the initial recording method—if an item will last more than one month, record it as an asset (or liability for revenue); if it's used within one month, record it directly as an expense (or revenue).
• Why timing matters: without adjusting entries, financial statements would overstate assets/liabilities and understate/overstate expenses/revenues, distorting net income and equity.

💰 Deferred expenses fundamentals

💰 What deferred expenses mean

Deferred expenses: items purchased in advance ("bulk") that will last longer than one month and are used up in the future.

• "Deferred" means "postponed into the future."
• When you buy something that will last beyond one month, you record it as an asset (something of value), not immediately as an expense.
• At month-end, you make an adjusting entry for the portion you actually used—that portion becomes an expense.
• The credit side reduces the asset account by the amount consumed.
• Any remaining balance stays as an asset for future use.

🔄 The adjustment pattern

All deferred expense adjusting entries follow the same structure:

• Debit an expense account (increases expense on income statement)
• Credit an asset account (decreases asset on balance sheet)

Example: If you used $100 of supplies, you debit Supplies Expense $100 and credit Supplies $100.

📋 Five types covered

The excerpt discusses five deferred expense categories:

1. Supplies
2. Prepaid Insurance
3. Prepaid Rent
4. Prepaid Taxes (business license)
5. Fixed Assets (depreciation)

🧾 Supplies, insurance, rent, and taxes

🧾 Supplies adjustment

Two recording methods:

• Method #1: Buy $100 of supplies used within one month → record directly as Supplies Expense (debit) and Cash (credit).
• Method #2: Buy $1,000 of supplies lasting multiple months → record as Supplies (asset) initially.

Adjusting entry scenario:

• You purchased $1,000 of supplies on 6/1.
• By 6/30, you used $100.
• Without adjustment: balance sheet shows $1,000 supplies (wrong—should be $900); income statement shows $0 supplies expense (wrong—should be $100).
• Adjusting entry on 6/30: Debit Supplies Expense $100, Credit Supplies $100.
• Result: $100 expense on income statement, $900 asset on balance sheet.

Two ways the information may be worded:

1. "The company used $100 of supplies" → $900 remains
2. "The company has $900 of supplies on hand" → $100 was used

🛡️ Prepaid insurance adjustment

Insurance: protection from damages associated with business risks.

Pattern (same as supplies):

• Purchase $1,200 insurance for 12 months → record as Prepaid Insurance (asset).
• Each month, 1/12 expires ($100).
• Adjusting entry: Debit Insurance Expense $100, Credit Prepaid Insurance $100.
• After adjustment: $100 expense on income statement, $1,100 asset on balance sheet.
• Repeat monthly for 12 months until fully expired.

🏢 Prepaid rent adjustment

Rent: the right to occupy premises owned by another party.

Same mechanism:

• Prepay $12,000 rent for 12 months → record as Prepaid Rent (asset).
• Each month, $1,000 expires.
• Adjusting entry: Debit Rent Expense $1,000, Credit Prepaid Rent $1,000.
• After 12 months, all prepaid rent is used; must prepay again to continue occupancy.

📜 Prepaid taxes adjustment

Business license: a right to do business in a particular jurisdiction, considered a tax.

Identical pattern:

• Prepay $1,200 business license for 12 months → record as Prepaid Taxes (asset).
• Each month, $100 expires.
• Adjusting entry: Debit Taxes Expense $100, Credit Prepaid Taxes $100.

Real-world example from excerpt: College tuition is a prepayment—you pay "up front" for about three months of service. As each month passes, you have one fewer month remaining of what you paid for.

🏗️ Fixed assets and depreciation

🏗️ What fixed assets are

Fixed asset: a tangible/physical item owned by a business that is relatively expensive and has a permanent or long life—more than one year.

Examples: equipment, furnishings, vehicles, buildings, and land.

Key difference from other deferrals:

• Fixed assets are NOT initially recorded as expenses.
• They are recorded as assets at their cost (what was paid).
• The cost is gradually "expensed off" over time through depreciation.

⚙️ Depreciation mechanism

Depreciation: the process of "expensing off" the cost of a fixed asset as it is "used up" over its estimated useful life.

Example scenario:

• Equipment purchased for $6,000 on 1/1.
• Expected useful life: 5 years (60 months).
• Monthly depreciation: $6,000 ÷ 60 = $100 per month.

Why not credit Equipment directly?

Cost principle: requires that a fixed asset's ledger balance be the cost of the asset, or what was paid for it.

• The Equipment account balance must always remain at $6,000 (its cost).
• Instead, credit Accumulated Depreciation (a contra asset account).

🔧 Depreciation adjusting entry

Monthly adjusting entry:

• Debit Depreciation Expense $100 (increases expense on income statement)
• Credit Accumulated Depreciation $100 (increases contra asset on balance sheet)

Important distinctions:

• Do NOT use "Equipment Expense" (that's for maintenance, oil, parts, etc.).
• Use "Depreciation Expense" for recognizing the asset's cost over time.
• Do NOT credit Equipment directly; credit Accumulated Depreciation instead.

📊 Book value calculation

Book value: what a fixed asset is currently worth, calculated by subtracting Accumulated Depreciation from cost.

Formula: Cost − Accumulated Depreciation = Book Value

After	Cost	Accumulated Depreciation	Book Value
1 month	$6,000	$100	$5,900
3 months	$6,000	$300	$5,700
12 months	$6,000	$1,200	$4,800
60 months	$6,000	$6,000	$0

Balance sheet presentation after 3 months:

• Equipment: $6,000
• Less: Accumulated Depreciation: $300
• Book value: $5,700

After full depreciation:

• Accumulated Depreciation reaches $6,000.
• Book value becomes $0.
• The business may continue using the equipment, but no value appears on the balance sheet.
• No further adjusting entries are made.

Note: Land is NOT depreciated because it does not "get used up."

🎁 Deferred revenue

🎁 What deferred revenue means

Deferred revenue: when cash is received in advance and earned in the future.

• A customer pays you before you perform the service.
• You cannot credit revenue (Fees Earned) yet because you haven't earned it.
• Instead, credit Unearned Fees (a liability)—you owe the customer service.
• At month-end, adjust for the portion you did earn by performing some work.

🎁 The adjustment pattern

All deferred revenue adjusting entries follow this structure:

• Debit a liability account (decreases what you owe)
• Credit a revenue account (increases revenue on income statement)

Example: Customer prepays $1,000 on 6/1; you earn $600 by 6/30.

• Adjusting entry on 6/30: Debit Unearned Fees $600, Credit Fees Earned $600.
• Result: $600 revenue on income statement, $400 liability on balance sheet.

💇 Real-world example

The excerpt uses a hair stylist scenario:

• Customer B buys a $100 gift card (you receive cash but owe service).
• Record: Debit Cash $100, Credit Unearned Fees $100.
• Customer B's mother uses the card for a $40 haircut.
• You reduce what you owe by $40 and recognize $40 revenue.
• You still owe $60 in service.

🔄 Three timing scenarios for revenue

The excerpt summarizes three possible points when cash is received relative to service:

Timing	Debit Account	Credit Account	Meaning
Past	Unearned Fees	Fees Earned	Cash received before service; adjust when work is done
Present	Cash	Fees Earned	Cash received when service is provided
Future	Accounts Receivable	Fees Earned	Cash will be received after service is provided

Don't confuse: Only the "Past" scenario (prepayment) requires a deferral adjustment.

⚠️ Consequences of omitting adjustments

⚠️ Impact on financial statements

The excerpt emphasizes that omitting adjusting entries causes multiple errors on financial statements.

For deferred expenses (e.g., supplies, insurance, rent, taxes): If you omit the adjusting entry:

1. Income statement: Expense is too low (should be $100, shows $0).
2. Income statement: Net income is too high (expense not deducted from revenues).
3. Balance sheet: Asset is too high (should be reduced by amount used).
4. Balance sheet: Total assets are too high.
5. Balance sheet: Total stockholders' equity is too high (because inflated net income closes to Retained Earnings).

For deferred revenue (e.g., unearned fees): If you omit the adjusting entry:

1. Income statement: Revenue is too low (should include earned amount).
2. Income statement: Net income is too low (revenue not included).
3. Balance sheet: Liability is too high (should be reduced by amount earned).
4. Balance sheet: Total liabilities are too high.
5. Balance sheet: Total stockholders' equity is too low (because understated net income closes to Retained Earnings).

⚠️ Why adjustments must be made before financial statements

• Adjusting entries are journalized and posted BEFORE financial statements are prepared.
• This ensures the income statement and balance sheet show correct, up-to-date amounts.
• Without adjustments, the statements would not reflect economic reality—what was actually used, expired, or earned during the period.

🧭 Overview

🧠 One-sentence thesis

Accrual adjusting entries record transactions that are in progress but not yet complete, ensuring that the portion of revenue earned or expense incurred during an accounting period appears on that period's financial statements even when cash has not yet changed hands.

📌 Key points (3–5)

• What accruals capture: transactions in progress that would otherwise not be recorded because they are not yet complete—no journal entry has been made yet, but the revenue or expense is accumulating over time.
• Two types of accruals: accrued expenses (you owe others for services already performed for you) and accrued revenue (others owe you for services you have already performed for them).
• Timing pattern: accrued expenses involve debiting an expense and crediting a payable (liability); accrued revenue involves debiting Accounts Receivable (asset) and crediting revenue.
• Common confusion: accruals vs deferrals—accruals record what has already happened but not yet been paid/received; deferrals record what has been paid/received but not yet earned/used.
• Why adjusting entries matter: omitting them causes multiple errors on financial statements—expenses/revenues, net income, assets/liabilities, and stockholders' equity will all be misstated.

💼 Accrued expenses

💼 What accrued expenses are

Accrued expenses: adjusting entries for transactions in progress where someone is already performing a service for you but you have not paid them or recorded any journal entry yet.

• The expense is building up like a "tab," but nothing has been written down yet.
• Common examples: employee wages, property taxes, and interest—what you owe is growing over time, but you typically don't record a journal entry until you incur the full expense.
• At the end of an accounting period, you make an adjusting entry to include the part of the expense that belongs in that period.

📝 The adjusting entry pattern

• Debit: the appropriate expense account for the amount you owe through the end of the accounting period (so this expense appears on your income statement).
• Credit: an appropriate payable (liability) account to indicate on your balance sheet that you owe this amount.
• Example pattern:

Account	Debit	Credit
Expense (e.g., Wages Expense)	Amount owed
Payable (e.g., Wages Payable)		Amount owed

💰 Wages—accrued expense

Scenario: A company pays employees $1,000 every Friday for a five-day work week. June 30 (the last day of the month) is a Tuesday. The next payday is Friday, July 3.

• Employees earn $200 per day ($1,000 ÷ 5 days).
• For the week ending July 3, two days (June 29 and 30) belong in June = $400; three days (July 1–3) belong in July = $600.

Adjusting entry on June 30:

• Debit Wages Expense $400 (increases expense).
• Credit Wages Payable $400 (increases liability).
• This splits the wages expense for that week: two days in June, three days in July.
• Cash cannot be credited on June 30 because employees will not be paid until Friday.

After the adjusting entry:

• Wages Expense ledger shows $4,400 total for June (four weeks at $1,000 each + $400 for two extra days).
• Wages Payable ledger shows $400 owed at June 30.

Next payday (July 3):

• Debit Wages Expense $600 (for three days in July).
• Debit Wages Payable $400 (clears the liability from June).
• Credit Cash $1,000 (total payment).
• Wages Payable balance becomes zero since employees have been paid.

Don't confuse: The $1,000 wages for the week beginning June 29 is split over two months: $400 in June, $600 in July.

🏛️ Taxes—accrued expense

Scenario: A company's annual property taxes (January 1 to December 31) are estimated to be $6,000. The company prepares 12 monthly financial statements. Payment for the entire year is due at the end of the year.

• Each month, 1/12 of the annual estimate ($6,000 ÷ 12 = $500) should be included on that month's statements since this expense is accruing over time.
• No journal entry is made at the beginning of each month.

Adjusting entry at the end of each month (e.g., January 31):

• Debit Taxes Expense $500 (increases expense).
• Credit Taxes Payable $500 (increases liability).
• This recognizes that 1/12 of the annual property tax amount is now owed and includes 1/12 of the annual expense on the month's income statement.

Over the year:

• The same adjusting entry is made at the end of each month for 12 months.
• By December 31, Taxes Payable has accumulated to $6,000.
• When the bill is paid on December 31: debit Taxes Payable $6,000, credit Cash $6,000.
• Taxes Payable balance becomes zero since the annual taxes have been paid.

Key insight: Some expenses accrue over time and are paid at the end of a year. An estimated amount is applied to each month so that each month reports a proportionate share of the annual cost.

🔧 Interest—accrued expense

Pattern (from the excerpt's summary table):

• Debit Interest Expense (increases expense).
• Credit Interest Payable (increases liability).
• This follows the same logic as wages and taxes: interest accumulates over time on borrowed money, and the adjusting entry records the portion that belongs in the current period.

📈 Accrued revenue

📈 What accrued revenue is

Accrued revenue: adjusting entries for transactions in progress where a customer will only pay you well after you complete a job that extends more than one accounting period.

• "Accrued" means "accumulated over time."
• At the end of each accounting period, you record the part of the job that you did complete as a sale.
• This involves a debit to Accounts Receivable (to acknowledge that the customer owes you for what you have completed) and a credit to Fees Earned (to record the revenue earned thus far).

💵 Fees Earned—accrued revenue

Scenario: A company begins a job for a customer on June 1. It will take two full months to complete the job. When complete, the company will bill the customer for the full price of $4,000. The company earned $2,500 of the $4,000 in June.

• No journal entry is made at the beginning of June when the job is started.
• At the end of June, the amount earned during the month must be reported on the income statement.

Adjusting entry on June 30:

• Debit Accounts Receivable $2,500 (increases asset).
• Credit Fees Earned $2,500 (increases revenue).
• Revenue is earned as a job is performed. Sometimes an entire job is not completed within the accounting period, and the company will not bill the customer until the job is completed. The earnings from the part of the job that has been completed must be reported on the month's income statement for this accrued revenue.

After the adjusting entry:

• Before the adjustment, Accounts Receivable had a debit balance of $1,000 and Fees Earned had a credit balance of $3,600 (from other transactions during the month).
• After the adjustment, Accounts Receivable has a debit balance of $3,500 and Fees Earned has a credit balance of $5,100 on June 30.
• These final amounts appear on the financial statements.

Key insight: Some revenue accrues over time and is earned over more than one accounting period. The amount earned must be split over the months involved in completing the job based on when the work is done.

⚠️ Consequences of omitting adjusting entries

⚠️ Errors from omitting accrued expense entries

If an accrued expense adjusting entry (e.g., wages, taxes, interest) is omitted, the following errors result:

Item	Error	Direction
Expense on income statement	Too low	Understated (e.g., $4,000 instead of $4,400 for wages)
Net income on income statement	Too high	Overstated (expense should have been deducted but was not)
Payable on balance sheet	Too low	Understated (e.g., $0 instead of $400 for wages payable)
Total liabilities on balance sheet	Too low	Understated (one liability was too low)
Total stockholders' equity on balance sheet	Too high	Overstated (net income that was too high was closed out to Retained Earnings)

⚠️ Errors from omitting accrued revenue entries

If an accrued revenue adjusting entry is omitted, the following errors result:

Item	Error	Direction
Revenue on income statement	Too low	Understated (e.g., $3,600 instead of $5,100 for fees earned)
Net income on income statement	Too low	Understated (additional revenue should have been included but was not)
Accounts Receivable on balance sheet	Too low	Understated (e.g., $1,000 instead of $3,500)
Total assets on balance sheet	Too low	Understated (one asset was too low)
Total stockholders' equity on balance sheet	Too low	Understated (net income that was too low was closed out to Retained Earnings)

Don't confuse: Omitting accrued expense entries overstates net income and equity; omitting accrued revenue entries understates net income and equity.

🕒 Timing and purpose of adjusting entries

🕒 When adjusting entries are made

• Adjusting entries are journalized and posted before financial statements are prepared.
• This ensures that the company's income statement and balance sheet show the correct, up-to-date amounts.
• The adjusting entry updates account balances so they are accurate at the end of the month.

🎯 Why adjusting entries are necessary

• Adjusting entries ensure that the part of a transaction that has occurred during a particular month appears on that same month's financial statements.
• Without them, transactions in progress would not be recorded because they are not yet complete.
• Example: Employees have worked Monday and Tuesday but won't be paid until Friday—the two days of work belong in the current period's expenses, even though cash won't be paid until the next period.

📋 Summary of accrual adjusting entries

Three accrued expense adjusting entries (from the excerpt):

Expense Type	Debit	Credit
Wages	Wages Expense	Wages Payable
Taxes	Taxes Expense	Taxes Payable
Interest	Interest Expense	Interest Payable

One accrued revenue adjusting entry (from the excerpt):

Revenue Type	Debit	Credit
Fees Earned	Accounts Receivable	Fees Earned

Pattern:

• Accrued expenses: debit an expense account, credit a payable (liability) account.
• Accrued revenue: debit Accounts Receivable (asset), credit a revenue account.

🧭 Overview

🧠 One-sentence thesis

Merchandising businesses differ from service businesses by buying and reselling physical products, which requires tracking inventory and matching the cost of goods sold to sales revenue.

📌 Key points (3–5)

• Service vs merchandising: service businesses sell expertise/experiences without transferring ownership of physical products; merchandising businesses buy finished products and resell them.
• Inventory is distinct: inventory consists of items purchased for resale, not supplies (used in operations) or equipment (used to run the business).
• Perpetual inventory system: keeps a running total of inventory quantity and dollar value at all times—increases when purchased, decreases when sold.
• Common confusion: the same physical item (e.g., Windex or computers) can be inventory, supplies, or equipment depending on whether it will be resold or used in operations.
• New revenue account: merchandising businesses use "Sales" instead of "Fees Earned" to record income from selling products.

🏢 Service vs merchandising businesses

🏢 What service businesses sell

• Service businesses sell expertise, knowledge, experiences, or the use of something.
• Customers do not purchase or take ownership of a physical product.
• Revenue account used: Fees Earned.

🛒 What merchandising businesses sell

A merchandising business buys finished and packaged manufactured products, marks them up, and sells them to customers.

• The merchandiser may be either the buyer (purchasing and adding to inventory) or the seller (selling and removing from inventory) in a given transaction.
• Revenue account used: Sales (replaces Fees Earned).

🔄 Key roles in merchandising

Term	Definition (from excerpt)
Merchandiser	The buyer or seller in a transaction, depending on whether product is being purchased or sold
Vendor	A company or individual that a merchandiser purchases goods from
Customer	A company or individual that a merchandiser sells goods to

📦 Inventory and related concepts

📦 What inventory is

Inventory consists of items that are purchased for resale.

• Inventory is tracked as an asset on the balance sheet.
• Under the perpetual inventory system, inventory immediately increases when product is purchased and immediately decreases when product is sold.

🧴 Inventory vs supplies

• Supplies are items purchased to be used in the operation of the business, not to be sold to customers.
• Example: Windex glass cleaner is inventory if it will be resold to customers; it is a supply if it is used to keep the check-out counters clean.
• Don't confuse: the same physical item can be classified differently depending on its intended use.

💻 Inventory vs equipment

• Equipment are fixed assets used to run the business operations.
• Example: desktop computers are inventory if they are to be resold (e.g., at a retailer); they are equipment if the merchandiser uses them to run its own business operations.
• Don't confuse: classification depends on whether the item will be sold or used internally.

🔄 Common transaction sequences

🔄 When you are the buyer

1. Purchase product on account.
2. Return product (if needed).
3. Pay for the product.

🔄 When you are the seller

1. Sell product on account and reduce the inventory balance.
2. Accept returns and increase the inventory balance.
3. Receive payment for sales.

🧮 Perpetual inventory system

🧮 How it works

Perpetual inventory system: the process of keeping a current running total of inventory, both in number of units on hand and its dollar value, at all times.

• When product is purchased for resale, inventory immediately increases.
• When product is sold, the total value of the inventory on hand is immediately reduced.
• This system provides real-time visibility into inventory levels and value.

📊 New accounts for merchandising businesses

The excerpt introduces new accounts used by merchandising businesses under the perpetual inventory system:

Account Type	Account Name	Purpose	Normal Balance	Close Out?
Asset	Merchandise Inventory	Tracks items in stock for resale	Debit	NO
Contra Asset	Estimated Inventory Returns	Tracks cost of inventory expected to be returned	Credit	NO
Revenue	Sales	Tracks dollar amount of purchases made by customers	Credit	YES
Contra Revenue	Sales Returns	Tracks dollar amount of merchandise actually returned	Debit	YES
Contra Revenue	Allowance for Sales Returns	Tracks dollar amount of merchandise estimated to be returned	Debit	YES
Contra Revenue	Sales Discounts	Tracks discounts taken by customers (gross method)	Debit	YES
Contra Revenue	Sales Discounts Not Taken	Tracks discounts not taken by customers (net method)	Credit	YES
Expense	Cost of Merchandise Sold	Tracks what the company paid for inventory it sold	Debit	YES
Expense	Delivery Expense	Tracks transportation charges absorbed by seller	Debit	YES

🔑 Key rule for account usage

• When BUYING: only Merchandise Inventory (from the new accounts) may be used.
• When SELLING: any of the seven new accounts may be used.

📈 Multi-step income statement overview

📈 Why it matters

• The multi-step income statement is used to report revenue and expense activities for a merchandising business.
• It is an expanded, more detailed version of the single-step income statement.
• The most significant cost for a merchandising business is the cost of acquiring the inventory that is sold.
• The multi-step format makes it easy to match what was paid for an item to what it sells for.

🧮 Three calculated amounts

The excerpt identifies three key calculations on the multi-step income statement:

1. Net Sales = Sales − Sales Returns − Sales Discounts
   (Actual sales after returns and discounts are removed)

2. Gross Profit = Net Sales − Cost of Merchandise Sold
   (Mark-up, or the difference between selling price and cost)

3. Net Income = Gross Profit − Operating Expenses
   (Profit for the period)

📊 Structure of the multi-step income statement

Line Item	Meaning
Sales	Prices charged to customers on all inventory sold
Less: Sales Returns	Reduction in sales for items customers brought back
Less: Sales Discounts	Amount of discounts taken by customers for early payment
Net Sales	Actual sales after returns and discounts are removed
Cost of Merchandise Sold	What the company paid for the inventory that was sold
Gross Profit	Mark-up (difference between selling price and cost)
Operating Expenses	Costs unrelated to the cost of inventory (e.g., wages, supplies, depreciation)
Net Income	Profit for the period

💰 Key definitions from the excerpt

Net sales is the actual sales generated by a business. It represents everything that "went out the door" in sales minus all that came back in returns and in the form of sales discounts.

Gross profit is the same as "markup." It is the difference between what a company paid for a product and what it sells the product for to its customer.

• Don't confuse gross profit with net income: gross profit only accounts for the cost of merchandise sold, while net income also subtracts operating expenses.

🧭 Overview

🧠 One-sentence thesis

The multi-step income statement for merchandising businesses explicitly matches the cost of acquiring inventory with sales revenue to reveal gross profit (markup) before operating expenses are deducted to arrive at net income.

📌 Key points (3–5)

• Purpose of multi-step format: expands the single-step income statement to show the relationship between what a business paid for inventory and what it sold it for.
• Three calculated amounts: net sales (actual sales after returns/discounts), gross profit (markup = net sales minus cost of merchandise sold), and net income (profit after all expenses).
• Most significant cost: the cost of acquiring inventory that is sold—this must be matched to sales revenue.
• Common confusion: gross profit vs net income—gross profit is only the markup on inventory; net income subtracts all other operating expenses from gross profit.
• Optional breakdown: more complex businesses may separate operating expenses into selling expenses (marketing/promotion) and administrative expenses (general management).

📊 Structure of the multi-step income statement

📊 What makes it "multi-step"

The multi-step income statement is an expanded, more detailed version of the single-step income statement used to report revenue and expense activities for a merchandising business.

• It presents financial information so the relationship between cost and selling price can easily be seen.
• The key feature: Cost of Merchandise Sold (an expense account) is matched up with net sales at the top of the statement, not buried with other expenses.

🧮 The three calculated amounts

The statement produces three key figures in sequence:

Calculated Amount	Formula	What it represents
Net Sales	Sales − Sales Returns − Sales Discounts	Actual sales generated; everything that "went out the door" minus returns and discounts
Gross Profit	Net Sales − Cost of Merchandise Sold	Markup; the difference between what the company paid for inventory and what it sold it for
Net Income	Gross Profit − Operating Expenses	Business's profit after all expenses have been deducted from net sales

💰 Revenue section: calculating net sales

💰 Starting with gross sales

• Sales: the prices charged to customers on all inventory sold (the top line).
• This is the total before any adjustments.

🔻 Deductions from sales

Two items reduce gross sales to arrive at net sales:

• Sales Returns: reduction in sales for items customers brought back (actual returns).
• Sales Discounts: amount of discounts taken by customers for early payment.

Example: Sales of $1,000 minus Sales Returns of $40 and Sales Discounts of $20 equals Net Sales of $940.

📌 Why net sales matters

Net sales represents the actual revenue the business earned—what really "stuck" after customers returned items or took discounts for paying early.

📦 Cost of merchandise sold and gross profit

📦 Matching cost to revenue

The most significant cost that a merchandise business incurs is the cost of acquiring the inventory that is sold. It is important to match what was paid for an item to what it sells for.

• Cost of Merchandise Sold: what the company paid for the inventory that was sold.
• This is an expense account, but it appears immediately after net sales (not grouped with operating expenses) to highlight the cost-revenue relationship.

💵 Gross profit as markup

Gross profit is the same as "markup." It is the difference between what a company paid for a product and what it sells the product for to its customer.

• Formula: Gross Profit = Net Sales − Cost of Merchandise Sold.
• Example: Net Sales of $940 minus Cost of Merchandise Sold of $340 equals Gross Profit of $600.
• This $600 is the "markup"—the amount above cost that the business charges customers.

⚠️ Don't confuse gross profit with net income

• Gross profit is not the final profit; it only accounts for the cost of inventory.
• Operating expenses (wages, supplies, depreciation, etc.) still need to be subtracted to get net income.

🏢 Operating expenses and net income

🏢 What operating expenses include

• Operating expenses: list of costs to the business unrelated to the cost of inventory.
• Basic format lists all operating expenses together (wages, supplies, depreciation).
• Example: Wages Expense $150, Supplies Expense $30, Depreciation Expense $20 totaling $200.

🔀 Optional: selling vs administrative expenses

More complex businesses may break operating expenses into two categories:

Category	What it includes	Example from excerpt
Selling Expenses	Costs related to marketing and promoting products to customers	Sales salaries, sales supplies, depreciation (on sales equipment)
Administrative Expenses	Costs related to general management of the business	Office salaries, office supplies, depreciation (on office equipment); may include president's office, HR, accounting departments

• Both categories are summed into "Total selling and administrative expenses."
• This breakdown helps management see how much is spent on selling vs running the business.

🎯 Arriving at net income

Net income is the business's profit after all expenses have been deducted from the net sales amount.

• Formula: Net Income = Gross Profit − Operating Expenses.
• Example: Gross Profit of $600 minus Operating Expenses of $200 equals Net Income of $400.
• This is the final "profit for the month" (or period).

🧾 Sample income statement walkthrough

🧾 Basic merchandising income statement

The excerpt provides a simple example:

• Sales: $1,000
• Less: Sales Returns $40 + Sales Discounts $20 = $60
• Net Sales: $940
• Cost of Merchandise Sold: $340
• Gross Profit: $600
• Operating Expenses: Wages $150, Supplies $30, Depreciation $20 = $200
• Net Income: $400

🧾 Income statement with selling/administrative breakdown

The second example shows the same totals but splits operating expenses:

• Selling Expenses: Sales salaries $50, Sales supplies $30, Depreciation $10
• Administrative Expenses: Office salaries $80, Office supplies $20, Depreciation $10
• Total Selling and Administrative Expenses: $200
• Net Income: $400 (same result, more detailed presentation)

📌 Key insight

Both formats arrive at the same net income; the choice depends on how much detail management or external users need about where operating costs are incurred.

🧭 Overview

🧠 One-sentence thesis

The perpetual inventory system tracks inventory continuously by recording every purchase, sale, return, and discount as it occurs, ensuring that both the Merchandise Inventory account and Cost of Merchandise Sold are always up to date.

📌 Key points (3–5)

• Perpetual vs periodic: Under perpetual, inventory and cost of goods sold are updated with every transaction; under periodic, these are calculated only at period-end after a physical count.
• Dual entries for sales: Every sale requires two journal entries—one to record revenue (debit Accounts Receivable, credit Sales) and one to reduce inventory (debit Cost of Merchandise Sold, credit Merchandise Inventory).
• Discounts and payment timing: Buyers record purchase discounts by reducing Merchandise Inventory when paying early; sellers use either the gross method (record at full price, expect late payment) or net method (record at discounted price, expect early payment).
• Shipping terms determine who pays: FOB destination means the seller owns goods in transit and pays freight (Delivery Expense); FOB shipping means the buyer owns goods in transit and pays freight (added to Merchandise Inventory).
• Common confusion: Discounts apply only to merchandise cost, not to transportation charges; also, under perpetual, inventory is adjusted immediately, whereas under periodic, adjustments happen only at period-end.

📦 Purchase transactions under perpetual

📦 Recording purchases

• When you purchase inventory, debit Merchandise Inventory (asset increasing) and credit Accounts Payable (liability increasing).
• Example: Purchase 50 items at $10 each on account → debit Merchandise Inventory $500, credit Accounts Payable $500.

🔄 Handling purchase returns

• To record a return, "flip" the original purchase entry: debit Accounts Payable (liability decreasing) and credit Merchandise Inventory (asset decreasing).
• Example: Return 10 items originally purchased at $10 each → debit Accounts Payable $100, credit Merchandise Inventory $100.

💵 Payment and purchase discounts

• When paying for inventory, debit Accounts Payable and credit Cash.
• If a discount is taken (e.g., 2/10, net 30 means 2% discount if paid within 10 days), reduce Merchandise Inventory by the discount amount.
• Example: Pay $400 balance within discount period → debit Accounts Payable $400, credit Cash $392, credit Merchandise Inventory $8 (the 2% discount).
• Why reduce inventory: The inventory's actual cost is the cash paid, so the discount adjusts the recorded value down to match.

🛒 Sales transactions under perpetual

🛒 Recording sales (dual entry)

Every sale requires two simultaneous journal entries:

1. Record the revenue:

   • Debit Accounts Receivable (asset increasing), credit Sales (revenue increasing).
   • Example: Sell 50 items at $15 each → debit Accounts Receivable $750, credit Sales $750.

2. Reduce inventory and record cost:

   • Debit Cost of Merchandise Sold (expense increasing), credit Merchandise Inventory (asset decreasing).
   • Example: If those 50 items cost $10 each → debit Cost of Merchandise Sold $500, credit Merchandise Inventory $500.

🔙 Estimated vs actual returns

• At year start: Estimate total returns for the year (e.g., $450) and record:
  • Debit Sales Returns (contra revenue increasing), credit Allowance for Sales Returns (contra account increasing).
  • Simultaneously, debit Estimated Inventory Returns (asset increasing), credit Cost of Merchandise Sold (expense decreasing) for the estimated cost of returns (e.g., $300).
• When actual return occurs: Reduce the allowance and accounts receivable; increase inventory and reduce the estimated returns account.
• Example: Customer returns 10 items sold for $15 each (cost $10 each) → debit Allowance for Sales Returns $150, credit Accounts Receivable $150; debit Merchandise Inventory $100, credit Estimated Inventory Returns $100.

💰 Receiving payment

• Debit Cash (asset increasing), credit Accounts Receivable (asset decreasing).
• Example: Receive payment for sale minus return ($750 − $150 = $600) → debit Cash $600, credit Accounts Receivable $600.

💳 Sales discounts: gross vs net method

💳 Gross method (expect full payment)

• At sale: Record at full selling price.
  • Example: Sell 50 items at $15 each, terms 2/10 net 30 → debit Accounts Receivable $750, credit Sales $750.
• If customer pays within discount period (unexpected): Debit Cash for the reduced amount, debit Sales Discounts (contra revenue) for the discount, credit Accounts Receivable for the full amount.
  • Example: Customer pays early → debit Cash $735, debit Sales Discounts $15, credit Accounts Receivable $750.
• If customer pays after discount period (as expected): Debit Cash $750, credit Accounts Receivable $750.

💳 Net method (expect discounted payment)

• At sale: Record at selling price minus the discount.
  • Example: Sell 50 items at $15 each, 2/10 net 30 → (50 × $15) − (50 × $15 × 0.02) = $735 → debit Accounts Receivable $735, credit Sales $735.
• If customer pays within discount period (as expected): Debit Cash $735, credit Accounts Receivable $735.
• If customer pays after discount period (unexpected): Debit Cash $750, credit Sales Discounts Not Taken (a contra revenue account, but here it increases revenue), credit Accounts Receivable $735.

🧩 Key distinction

Method	When to use	What you record at sale	What happens if timing differs
Gross	Expect late payment	Full price	Use Sales Discounts if paid early
Net	Expect early payment	Discounted price	Use Sales Discounts Not Taken if paid late

• Goal: Match revenue to the period in which it is earned by recording the most likely outcome.
• Don't confuse: Sales Discounts (gross method, reduces revenue) vs Sales Discounts Not Taken (net method, increases revenue when customer pays late).

🚚 Transportation costs and FOB terms

🚚 FOB destination

FOB destination: Ownership transfers at the destination; the seller owns the merchandise while in transit.

• Who pays: The seller absorbs the cost.
• Seller's entry: Debit Delivery Expense (expense increasing), credit Accounts Payable or Cash.
• Buyer's entry: None—the buyer does not record transportation at all.
• Example: Seller ships 50 items, UPS bills seller $20 → seller debits Delivery Expense $20, credits Accounts Payable $20.

🚚 FOB shipping (buyer contracts directly)

FOB shipping: Ownership transfers at the origin (shipping point); the buyer owns the merchandise while in transit.

• Who pays: The buyer absorbs the cost.
• Buyer's entry: Debit Merchandise Inventory (transportation becomes part of inventory cost), credit Accounts Payable or Cash.
• Seller's entry: None—the seller does not record transportation at all.
• Example: Buyer purchases 50 items for $500, UPS bills buyer $20 → buyer debits Merchandise Inventory $20, credits Accounts Payable $20 (separate from the $500 owed to the seller).

🚚 FOB shipping (seller prepays and adds to invoice)

• Who pays ultimately: The buyer, but the seller pays UPS first and then bills the buyer.
• Seller's entry: Debit Accounts Receivable for merchandise + freight, credit Sales for merchandise only, credit Accounts Payable for freight owed to UPS.
  • Example: Sell 50 items at $10 each, prepay $20 freight → debit Accounts Receivable $520, credit Sales $500, credit Accounts Payable $20.
• Buyer's entry: Debit Merchandise Inventory for merchandise + freight, credit Accounts Payable to the seller.
  • Example: Purchase 50 items at $10 each, seller adds $20 freight to invoice → debit Merchandise Inventory $520, credit Accounts Payable $520.
• Important: When a discount applies, calculate it only on the merchandise cost, not on the transportation charge.
  • Example: If terms are 2/10 net 30 and buyer pays early → discount is 2% of $500 = $10, so buyer pays ($500 − $10) + $20 = $510.

🧩 Summary table

FOB term	Who owns in transit	Who pays freight	Buyer's account	Seller's account
Destination	Seller	Seller	(none)	Delivery Expense
Shipping (direct)	Buyer	Buyer	Merchandise Inventory	(none)
Shipping (prepaid)	Buyer	Buyer (via seller)	Merchandise Inventory	Accounts Receivable / Accounts Payable

📉 Inventory shrinkage

📉 What is shrinkage

Inventory shrinkage: The difference when actual inventory physically counted is less than the amount recorded in the accounting system.

• Causes: Miscounts, loss, or theft.
• Under perpetual, the system assumes inventory is accurate; a physical count reveals discrepancies.

📉 Recording shrinkage

• When a shortage is discovered, reduce Merchandise Inventory and increase Cost of Merchandise Sold.
• Entry: Debit Cost of Merchandise Sold (expense increasing), credit Merchandise Inventory (asset decreasing).
• Example: Physical count shows $300 shortage → debit Cost of Merchandise Sold $300, credit Merchandise Inventory $300.
• Why this entry: The missing inventory is treated as if it were sold (or lost), so it becomes part of the cost of goods sold.

🔄 Periodic inventory system (contrast)

🔄 How periodic differs

• No continuous tracking: Merchandise Inventory is not updated with each purchase or sale during the period.
• Temporary accounts used: Purchases, Purchases Returns, Purchases Discounts, and Freight-in are used instead of Merchandise Inventory during the period.
• At period-end: Conduct a physical count, then calculate Cost of Merchandise Sold and adjust Merchandise Inventory in one closing entry.

🔄 Purchase transactions under periodic

• Purchase: Debit Purchases (temporary account for asset), credit Accounts Payable.
• Return: Debit Accounts Payable, credit Purchases Returns (temporary account).
• Discount: When paying, debit Accounts Payable, credit Cash, credit Purchases Discounts (temporary account).
• Freight: Debit Freight-in (temporary account), credit Accounts Payable or Cash.

🔄 Sales transactions under periodic

• Sale: Debit Accounts Receivable, credit Sales—no second entry to reduce inventory or record cost.
• Return: Debit Allowance for Sales Returns, credit Accounts Receivable—no inventory adjustment.
• Why no inventory entries: The system does not track inventory continuously; cost of goods sold is calculated only at period-end.

🔄 Period-end adjustment

• Calculate cost of goods sold:
  • Beginning Inventory + Purchases + Freight-in − Purchases Discounts − Purchases Returns = Cost of Goods Available for Sale.
  • Cost of Goods Available for Sale − Ending Inventory (from physical count) = Cost of Merchandise Sold.
• Journal entry: Debit Cost of Merchandise Sold, debit Merchandise Inventory (ending balance), credit Purchases Discounts, credit Purchases Returns, credit Purchases, credit Freight-in, credit Merchandise Inventory (beginning balance).
• Example: Beginning inventory $10,000, Purchases $30,000, Freight-in $5,000, Purchases Discounts $1,000, Purchases Returns $2,000, Ending inventory $8,000 → Cost of Merchandise Sold = $10,000 + $30,000 + $5,000 − $1,000 − $2,000 − $8,000 = $34,000.

🔄 Key distinction: perpetual vs periodic

Aspect	Perpetual	Periodic
When inventory is updated	With every transaction	Only at period-end
Accounts used for purchases	Merchandise Inventory	Purchases, Purchases Returns, Purchases Discounts, Freight-in
Entry at time of sale	Two entries (revenue + cost)	One entry (revenue only)
Cost of goods sold	Updated continuously	Calculated at period-end
Physical count purpose	Detect shrinkage	Determine ending inventory and cost of goods sold

📊 Merchandising income statement

📊 Structure

A merchandising income statement has three key sections:

1. Net Sales:
   • Sales − Sales Returns − Sales Discounts = Net Sales.
2. Gross Profit:
   • Net Sales − Cost of Merchandise Sold = Gross Profit.
   • Gross profit is the "mark-up" or difference between selling price and cost.
3. Net Income:
   • Gross Profit − Operating Expenses = Net Income.
   • Operating expenses may be split into Selling Expenses (e.g., sales salaries, sales supplies) and Administrative Expenses (e.g., office salaries, office supplies).

📊 Example layout

Line item	Amount	Explanation
Sales	$1,000	Prices charged to customers
Less: Sales Returns	$40	Items customers returned
Less: Sales Discounts	$20	Discounts for early payment
Net Sales	$940	Actual sales after adjustments
Cost of Merchandise Sold	$340	What the company paid for inventory sold
Gross Profit	$600	Mark-up (selling price − cost)
Selling Expenses	$90	Marketing and sales costs
Administrative Expenses	$110	General management costs
Net Income	$400	Profit after all expenses

📊 Closing entries

• At period-end, close all income statement accounts (revenue, contra revenue, expense) to Retained Earnings.
• Example closing entries:
  • Debit Sales $1,000, credit Retained Earnings $1,000.
  • Debit Retained Earnings $40, credit Sales Returns $40.
  • Debit Retained Earnings $20, credit Sales Discounts $20.
  • Debit Retained Earnings $340, credit Cost of Merchandise Sold $340.
  • Debit Retained Earnings for each operating expense, credit the expense account.

🧭 Key decision questions

When recording merchandising transactions, always ask:

1. Are you the buyer or the seller? (Determines which accounts to use.)
2. Are there any returns? (Requires reversal or adjustment entries.)
3. What is the form of payment? (Cash or on account—affects whether you credit Cash or Accounts Payable.)
4. Does the discount apply? (Check payment timing: within discount period or after.)
5. Who is to absorb the transportation cost? (FOB destination = seller; FOB shipping = buyer.)
6. If the buyer absorbs freight, did the seller prepay it? (If yes, buyer reimburses seller; if no, buyer pays carrier directly.)

Don't confuse: Discounts apply only to merchandise cost, never to transportation charges.

🧭 Overview

🧠 One-sentence thesis

Transportation costs are allocated to either the seller or the buyer depending on the shipping terms (FOB destination or FOB shipping), which determine who owns the merchandise during transit and therefore who must absorb the expense.

📌 Key points (3–5)

• Ownership determines cost: the company that owns the merchandise while it is in transit must absorb the transportation cost as a business expense.
• FOB destination vs FOB shipping: these shipping terms specify ownership transfer location and thus who pays for transportation.
• Common confusion: under FOB shipping, the seller may pre-pay shipping and pass it along to the buyer, but the buyer still owns the merchandise and absorbs the cost (the seller is just acting as a middleman).
• Account usage differs by term: sellers use Delivery Expense only for FOB destination; buyers use Merchandise Inventory for FOB shipping (transportation becomes part of inventory cost).
• Discounts apply only to merchandise: when payment discounts are involved, calculate the discount on the merchandise cost only, not on the transportation charges.

🚚 Ownership and cost responsibility

🏷️ The core principle

The company that owns the merchandise must absorb the transportation cost as a business expense.

• Ownership is not always obvious when goods are in transit with a third-party carrier (e.g., UPS).
• The shipping terms determine who owns the merchandise during transit.
• Whoever owns it during transit pays for the transportation.

📦 FOB terminology

FOB stands for "Free On Board" and is a shipping term used in retail to indicate who is responsible for paying transportation charges. It is also the location where ownership of the merchandise transfers from seller to buyer.

• FOB is followed by a location: either "destination" or "shipping."
• The location indicates where ownership transfers.
• Two main types:
  • FOB destination: ownership transfers at the destination (buyer's location).
  • FOB shipping: ownership transfers at the origin (seller's location).

🏁 FOB destination: seller pays

🏁 How FOB destination works

• Ownership transfers at the destination, so the seller owns the merchandise all the while it is in transit.
• Therefore, the seller absorbs the transportation cost.
• The buyer records nothing related to transportation.

📝 Seller's journal entry

• The seller debits Delivery Expense (an expense account).
• The seller credits either Accounts Payable (if billed/invoiced by the carrier) or Cash (if paid immediately).
• Example: Seller sells 50 items on account for $10 each, terms FOB destination. Transportation charges are $20 on account.
  • Seller records the sale: debit Accounts Receivable $500, credit Sales $500.
  • Seller records the cost of goods sold: debit Cost of Merchandise Sold $200, credit Merchandise Inventory $200.
  • Seller records transportation: debit Delivery Expense $20, credit Accounts Payable $20.

🚫 Buyer's journal entry

• The buyer does not record transportation charges at all since terms are FOB destination.
• Example: Buyer purchases 50 items on account for $10 each, terms FOB destination. Transportation charges are $20 on account.
  • Buyer records only: debit Merchandise Inventory $500, credit Accounts Payable $500.

🚢 FOB shipping: buyer pays

🚢 How FOB shipping works

• Ownership transfers at the origin as it leaves the seller's facility, so the buyer owns the merchandise all the while it is in transit.
• Therefore, the buyer absorbs the transportation cost.
• The transportation charges become part of the purchase price of the inventory.

📝 Buyer's journal entry

• The buyer debits Merchandise Inventory (an asset account) for both the merchandise and the transportation.
• The buyer credits either Accounts Payable (if billed/invoiced by the carrier) or Cash (if paid immediately).
• Example: Buyer purchases 50 items on account for $10 each, terms FOB shipping. Transportation charges are $20 on account.
  • Buyer records the purchase: debit Merchandise Inventory $500, credit Accounts Payable $500.
  • Buyer records transportation: debit Merchandise Inventory $20, credit Accounts Payable $20.
  • Note: The buyer is dealing with two different parties (the seller and the transportation company), so the buyer records two journal entries.

🚫 Seller's journal entry

• The seller does not record transportation charges at all since terms are FOB shipping.
• Example: Seller sells 50 items on account for $10 each, terms FOB shipping. Each item cost $4.
  • Seller records the sale: debit Accounts Receivable $500, credit Sales $500.
  • Seller records the cost of goods sold: debit Cost of Merchandise Sold $200, credit Merchandise Inventory $200.
  • No transportation entry.

🔄 FOB shipping with seller pre-payment: buyer still pays

🔄 The convenience scenario

• Terms are FOB shipping, so the buyer owns the merchandise in transit and must absorb the cost.
• However, as a courtesy and convenience, the seller calls the carrier, is billed by the carrier, and adds the transportation charge to the buyer's invoice.
• When the buyer pays the invoice, the buyer pays for the product and reimburses the seller for prepaying the transportation.

📝 Buyer's journal entry (combined)

• The buyer can combine the merchandise and transportation costs into one journal entry because the buyer receives one invoice from the seller.
• Example: Purchase 50 items on account for $10 each, terms FOB shipping. Transportation charges are $20 on account.
  • Buyer records: debit Merchandise Inventory $520, credit Accounts Payable $520.
  • The $520 includes $500 for merchandise and $20 for transportation.

📝 Seller's journal entry (combined)

• The seller can combine both the sale and the transportation into one journal entry and send one invoice.
• Example: Sell 50 items on account for $10 each, terms FOB shipping. Each item cost $4. Transportation charges are $20 on account.
  • Seller records the sale and transportation receivable: debit Accounts Receivable $520, credit Sales $500, credit Accounts Payable $20.
  • The seller is owed $520 total: $500 for merchandise and $20 reimbursement for transportation.
  • The seller still owes the $20 to the shipping company (Accounts Payable).
  • Notice: the transportation cost pre-paid by the seller does not become part of the Sales account.

📝 Alternative: split entries

• Both the buyer and the seller may split the transaction into two journal entries instead of combining them.
• Buyer:
  • Entry 1: debit Merchandise Inventory $500, credit Accounts Payable $500.
  • Entry 2: debit Merchandise Inventory $20, credit Accounts Payable $20.
• Seller:
  • Entry 1: debit Accounts Receivable $500, credit Sales $500.
  • Entry 2: debit Accounts Receivable $20, credit Accounts Payable $20.
• Regardless of which alternative is used, the final payment amounts are the same.

⚠️ Don't confuse: who really pays

• Even though the seller pre-pays the shipping, the buyer still absorbs the cost because terms are FOB shipping.
• The seller is just acting as a middleman for convenience.
• The buyer reimburses the seller, so the seller's net cost is zero for transportation.

💰 Payment and discounts

💰 Payment with discounts

• When payment terms include a discount (e.g., 2/10, net 30), the discount applies only to the merchandise cost, not to the transportation charges.
• Example: Buyer pays for a purchase of $500 merchandise plus $20 transportation, with 2/10 discount terms, within the discount period.
  • Discount calculation: $500 × 0.02 = $10 discount on merchandise only.
  • Payment amount: ($500 - $10) + $20 = $510.
  • Buyer's entry: debit Accounts Payable $520, credit Cash $510, credit Merchandise Inventory $10.
• Example: Seller receives payment from a customer for a sale of $500 plus $20 transportation, with 2/10 discount terms, within the discount period.
  • Discount calculation: $500 × 0.02 = $10 discount on sales only.
  • Payment received: ($500 - $10) + $20 = $510.
  • Seller's entry: debit Cash $510, debit Sales Discounts $10, credit Accounts Receivable $520.

⚠️ Important reminder

When a purchases or sales discount is involved, be sure to only take the discount on the merchandise cost or sales price, respectively, and not on the transportation cost.

📊 Three scenarios summary

Scenario	Terms	Who calls carrier?	Who is billed by carrier?	Who absorbs cost?	Buyer's account	Seller's account
1	FOB destination	Seller	Seller	Seller	(no entry)	Delivery Expense
2	FOB shipping	Buyer	Buyer	Buyer	Merchandise Inventory	(no entry)
3	FOB shipping (seller pre-pays)	Seller	Seller (then passes to buyer)	Buyer (reimburses seller)	Merchandise Inventory	Accounts Receivable (for reimbursement) and Accounts Payable (to carrier)

🔍 How to distinguish

• FOB destination: seller owns during transit → seller pays → seller uses Delivery Expense → buyer records nothing.
• FOB shipping: buyer owns during transit → buyer pays → buyer uses Merchandise Inventory → seller records nothing (unless seller pre-pays and passes along, in which case seller records a receivable and a payable).
• Key question: Who owns the merchandise while it is in transit? That party absorbs the cost.

🧭 Overview

🧠 One-sentence thesis

The periodic inventory system uses temporary accounts during the period and calculates cost of merchandise sold only at period-end through a physical count, rather than tracking inventory continuously with each transaction.

📌 Key points (3–5)

• Core difference from perpetual: the periodic system does not update Merchandise Inventory or Cost of Merchandise Sold during the period; instead, it uses four temporary accounts (Purchases, Purchases Returns, Purchases Discounts, Freight-in) that are closed at year-end.
• How cost of goods sold is determined: at period-end, a physical count establishes ending inventory; cost of goods sold = (beginning inventory + purchases + freight-in − purchases discounts − purchases returns) − ending inventory.
• Sales transactions: sales and returns are recorded without any corresponding inventory or cost-of-goods-sold entry during the period.
• Common confusion: under periodic, there is no ongoing adjustment to inventory or cost of merchandise sold when a sale or return occurs—this is the key distinction from the perpetual system.
• Closing process: the four temporary purchase accounts are closed into Merchandise Inventory, and cost of merchandise sold is recorded in a single end-of-period entry.

🛒 Purchase transactions under periodic

🛒 Recording purchases

• Instead of debiting Merchandise Inventory, the periodic system debits a temporary account called Purchases.
• Purchases is a temporary asset account that accumulates the cost of merchandise bought during the period.
• Example: purchase 50 items at $10 each on account → debit Purchases $500, credit Accounts Payable $500.

🚚 Freight-in (transportation costs)

• When the buyer pays transportation charges for merchandise purchases, debit Freight-in (a temporary asset account).
• Freight-in is added to the cost of goods available for sale at period-end.
• Don't confuse: Freight-in is for purchases; delivery expense (an operating expense) is for sales under FOB destination.

🔄 Purchases returns

• When merchandise is returned to the vendor, debit Accounts Payable and credit Purchases Returns (a temporary contra-asset account).
• Purchases Returns reduces the total cost of purchases.
• Example: return 10 items originally purchased at $10 each → debit Accounts Payable $100, credit Purchases Returns $100.

💰 Purchases discounts

• When paying within the discount period, credit Purchases Discounts (a temporary contra-asset account).
• Important: the discount applies only to the merchandise cost, not to transportation charges.
• Example: pay for $400 of merchandise (after $100 return) with 2% discount → debit Accounts Payable $400, credit Cash $392, credit Purchases Discounts $8.

🏷️ Sales transactions under periodic

🏷️ Recording sales

• Sales are recorded by debiting Accounts Receivable (or Cash) and crediting Sales (a revenue account).
• Key difference: there is no entry to Cost of Merchandise Sold or Merchandise Inventory at the time of sale under the periodic system.
• Example: sell 50 items at $15 each on account → debit Accounts Receivable $750, credit Sales $750.

🔙 Sales returns

• When a customer returns merchandise, debit Allowance for Sales Returns (a contra-asset account) and credit Accounts Receivable.
• The allowance account is an estimate set up at the beginning of the period; actual returns reduce the estimate.
• Example: customer returns 10 items sold at $15 each → debit Allowance for Sales Returns $150, credit Accounts Receivable $150.
• No inventory or cost adjustment is made at the time of the return.

💵 Receipt of payment

• When the customer pays, debit Cash and credit Accounts Receivable.
• If a sales discount applies, debit Sales Discounts (a contra-revenue account) for the discount amount.
• Example: receive payment for $600 (after $150 return) → debit Cash $600, credit Accounts Receivable $600.

📊 Period-end inventory and cost of goods sold

📊 Physical inventory count

• At the end of the accounting period, the company conducts a physical count to determine:
  1. Ending inventory (how much is still in stock).
  2. Cost of merchandise sold (calculated, not counted).

🧮 Calculating cost of goods sold

Cost of goods sold = (Beginning inventory + Purchases + Freight-in − Purchases Discounts − Purchases Returns) − Ending inventory.

• Total cost of goods available for sale = beginning inventory + net purchases (purchases + freight-in − discounts − returns).
• Whatever is not in ending inventory must have been sold.
• Example from the excerpt:
  • Beginning inventory: $10,000
  • Purchases: $30,000
  • Freight-in: $5,000
  • Purchases Discounts: ($1,000)
  • Purchases Returns: ($2,000)
  • Total available: $42,000
  • Ending inventory (counted): $8,000
  • Cost of goods sold: $42,000 − $8,000 = $34,000

🔐 Closing the temporary accounts

• A single journal entry at period-end:
  • Debit Cost of Merchandise Sold (the calculated amount).
  • Debit Merchandise Inventory (the new ending balance).
  • Credit Purchases, Freight-in (to close them out).
  • Debit Purchases Discounts, Purchases Returns (to close them out).
  • Credit Merchandise Inventory (the old beginning balance).
• This entry closes all four temporary purchase accounts into Merchandise Inventory and records the year's cost of goods sold.

Account	Debit	Credit	Effect
Cost of Merchandise Sold	$34,000		Expense increases
Merchandise Inventory	$8,000		Asset increases (new ending)
Purchases Discounts		$1,000	Temporary account closes
Purchases Returns		$2,000	Temporary account closes
Purchases		$30,000	Temporary account closes
Freight-in		$5,000	Temporary account closes
Merchandise Inventory		$10,000	Asset decreases (old beginning)

🔍 Inventory shrinkage (perpetual system note)

🔍 What is shrinkage

Inventory shrinkage: the difference when actual inventory physically counted is less than the amount in the accounting records.

• Shrinkage may result from miscounts, loss, or theft.
• This concept applies to the perpetual system, where a running balance is maintained.

🔍 Recording shrinkage

• When a shortage is discovered, debit Cost of Merchandise Sold and credit Merchandise Inventory.
• Example: discover a $300 shortage → debit Cost of Merchandise Sold $300, credit Merchandise Inventory $300.
• This adjusts the records to match the physical count and recognizes the "missing" inventory as an expense.

🔚 Closing entries for merchandising accounts

🔚 Which accounts are closed

• Six merchandising accounts appear on the income statement and must be closed to Retained Earnings:
  1. Sales (revenue)
  2. Sales Returns (contra-revenue)
  3. Sales Discounts (contra-revenue)
  4. Cost of Merchandise Sold (expense)
  5. Delivery Expense (operating expense)
  6. Bank Card Expense (operating expense)

🔚 Closing process

• Sales (credit balance) is closed by debiting Sales and crediting Retained Earnings.
• Sales Returns, Sales Discounts, Cost of Merchandise Sold, and operating expenses (debit balances) are closed by debiting Retained Earnings and crediting each account.
• Example entries from the excerpt:
  • Close Sales: debit Sales $1,000, credit Retained Earnings $1,000.
  • Close Sales Returns: debit Retained Earnings $40, credit Sales Returns $40.
  • Close Sales Discounts: debit Retained Earnings $20, credit Sales Discounts $20.
  • Close Cost of Merchandise Sold: debit Retained Earnings $340, credit Cost of Merchandise Sold $340.
  • Close Delivery Expense: debit Retained Earnings $140, credit Delivery Expense $140.

🔚 Merchandise Inventory is not closed

• Merchandise Inventory is an asset account (permanent account) and does not close at period-end.
• It carries forward to the next period as the new beginning inventory.

🧭 Key decision points for merchandising transactions

🧭 Six questions to ask

1. Are you the buyer or the seller? (Determines whether to use purchase or sales accounts.)
2. Are there any returns? (Use Purchases Returns or Sales Returns accounts.)
3. What is the form of payment? (Cash or on account—affects whether to use Cash or Accounts Receivable/Payable.)
4. Does the discount apply? (Check payment timing and terms; discount applies only to merchandise, not freight.)
5. Who absorbs the transportation cost? (FOB shipping point = buyer pays; FOB destination = seller pays.)
6. If the buyer absorbs freight, did the seller prepay it? (Buyer must reimburse seller if seller paid on buyer's behalf.)

🧭 Don't confuse

• Discount timing: only applies if payment is made within the discount period (e.g., 2/10, net 30 means 2% discount if paid within 10 days).
• Discount scope: the discount percentage applies only to the merchandise cost, not to transportation charges.
• Example: invoice is $500 merchandise + $20 freight, terms 2/10, net 30 → discount is $500 × 0.02 = $10; total payment = ($500 − $10) + $20 = $510.

🧭 Overview

🧠 One-sentence thesis

At the end of an accounting period, six new merchandising accounts (sales-related revenues, contra revenues, and cost of merchandise sold) must be closed to Retained Earnings to reset temporary accounts for the next period.

📌 Key points (3–5)

• Which accounts close: Six of the seven new merchandising accounts appear on the income statement and therefore close to Retained Earnings; only Merchandise Inventory (a balance sheet account) does not close.
• What closing means: Temporary accounts (revenues, contra revenues, expenses) are reduced to zero and their balances transferred to Retained Earnings.
• Direction of entries: Revenue accounts are debited to decrease them; contra revenue and expense accounts are credited to decrease them; Retained Earnings is adjusted accordingly.
• Common confusion: Sales Returns and Sales Discounts are contra revenue accounts, not expense accounts—they reduce revenue but are closed separately from operating expenses.
• Why it matters: Closing entries prepare the books for the next accounting period by zeroing out temporary accounts while preserving the net effect in equity.

📋 Which accounts close and why

📋 The six accounts that close

The excerpt identifies six merchandising accounts that appear on the income statement and therefore close at period-end:

1. Sales (revenue)
2. Sales Returns (contra revenue)
3. Sales Discounts (contra revenue)
4. Cost of Merchandise Sold (expense)
5. Delivery Expense (operating expense)
6. Bank Card Expense (operating expense)

• The seventh new account, Merchandise Inventory, is an asset account on the balance sheet and does not close.
• Only temporary accounts (revenues, expenses, and their contra accounts) close; permanent accounts (assets, liabilities, equity) carry forward.

🔄 The closing destination: Retained Earnings

Retained Earnings is an equity account that accumulates the net effect of all temporary accounts.

• All six accounts transfer their balances to Retained Earnings.
• Revenues increase Retained Earnings; expenses and contra revenues decrease it.
• After closing, temporary accounts have zero balances, ready for the next period.

🧾 How closing entries work

🧾 Closing revenue accounts

Sales is a revenue account that must be reduced to zero:

Date	Account	Debit	Credit	Explanation
6/30	Sales	1,000		Sales is decreasing (debit)
	Retained Earnings		1,000	Retained Earnings is increasing (credit)

• Revenue accounts normally have credit balances.
• To close them, debit the revenue account (decrease it to zero) and credit Retained Earnings (increase equity).
• Example: If Sales has a $1,000 credit balance, debit Sales $1,000 and credit Retained Earnings $1,000.

🔻 Closing contra revenue accounts

Sales Returns and Sales Discounts are contra revenue accounts that reduce net sales:

Date	Account	Debit	Credit	Explanation
6/30	Retained Earnings	40		Retained Earnings is decreasing (debit)
	Sales Returns		40	Sales Returns is decreasing (credit)
6/30	Retained Earnings	20		Retained Earnings is decreasing (debit)
	Sales Discounts		20	Sales Discounts is decreasing (credit)

• Contra revenue accounts normally have debit balances (they offset revenue).
• To close them, credit the contra account (decrease it to zero) and debit Retained Earnings (decrease equity).
• Don't confuse: These are not expenses; they are reductions of revenue and appear in the revenue section of the income statement.

💸 Closing expense accounts

Cost of Merchandise Sold, Delivery Expense, and Bank Card Expense are expense accounts:

Date	Account	Debit	Credit	Explanation
6/30	Retained Earnings	340		Retained Earnings is decreasing (debit)
	Cost of Merchandise Sold		340	Cost of Merchandise Sold is decreasing (credit)
6/30	Retained Earnings	140		Retained Earnings is decreasing (debit)
	Delivery Expense		140	Delivery Expense is decreasing (credit)

• Expense accounts normally have debit balances.
• To close them, credit the expense account (decrease it to zero) and debit Retained Earnings (decrease equity).
• Example: Cost of Merchandise Sold of $340 is credited to zero; Retained Earnings is debited $340 to reflect the expense's reduction of equity.

📊 Income statement structure before closing

📊 The June income statement example

The excerpt provides a sample income statement showing how the six accounts appear:

Line Item	Amount	Type
Sales	$1,000	Revenue
Less: Sales Returns	$40	Contra revenue
Less: Sales Discounts	$20	Contra revenue
Net Sales	$940	Subtotal
Cost of Merchandise Sold	$340	Expense (COGS)
Gross Profit	$600	Subtotal
Delivery Expense	$140	Operating expense
Bank Card Expense	$60	Operating expense
Total Operating Expenses	$200	Subtotal
Net Income	$400	Bottom line

• Net Sales = Sales − Sales Returns − Sales Discounts.
• Gross Profit = Net Sales − Cost of Merchandise Sold.
• Net Income = Gross Profit − Operating Expenses.
• All six accounts contribute to Net Income, which ultimately flows into Retained Earnings through closing entries.

🔍 Why these accounts are temporary

• They measure activity for a specific period (e.g., June).
• After closing, they start fresh at zero for the next period (e.g., July).
• Retained Earnings accumulates the cumulative net income (or loss) over time, so it is a permanent account.

🛠️ Practical reminders

🛠️ Inventory shortage adjustment (related but not a closing entry)

The excerpt mentions an inventory shortage entry:

Date	Account	Debit	Credit	Explanation
17	Cost of Merchandise Sold	300		Expense increases (debit)
	Merchandise Inventory		300	Asset decreases (credit)

• This adjusts for a $300 shortage discovered during physical inventory count.
• It is not a closing entry; it is an adjusting entry to correct the inventory balance.
• Don't confuse: This entry increases Cost of Merchandise Sold (an expense) but does not close it—closing happens separately at period-end.

🗂️ Key questions for merchandising transactions

The excerpt lists six questions to guide transaction analysis (not directly about closing, but useful context):

1. Are you the buyer or the seller?
2. Are there any returns?
3. What is the form of payment (cash or on account)?
4. Does the discount apply?
5. Who absorbs the transportation cost?
6. If the buyer absorbs freight, did the seller prepay it?

• These questions help determine which accounts to use and how to record transactions.
• Closing entries come after all transactions and adjustments are recorded.

🧭 Overview

🧠 One-sentence thesis

Inventory valuation methods (FIFO, LIFO, and average cost) produce different cost-of-merchandise-sold and ending-inventory amounts from the same purchase and sale data, directly affecting gross profit and balance-sheet asset values.

📌 Key points (3–5)

• What inventory valuation solves: when identical items are purchased at different prices over time, a business must choose which cost to assign to each item sold.
• Three main methods: FIFO (oldest costs first), LIFO (newest costs first), and average cost (weighted average of all units).
• Key difference in results: under rising prices, FIFO produces higher ending inventory and higher gross profit; LIFO produces lower ending inventory and lower gross profit; average cost falls in between.
• Common confusion: perpetual vs periodic systems—perpetual updates inventory after every transaction; periodic calculates cost of goods sold only at period-end using a physical count.
• Additional adjustments: lower-of-cost-or-market ensures inventory is not overstated when market prices drop; physical count errors directly misstate assets, cost of goods sold, and net income.

🧮 Core inventory valuation problem

🧮 Why a valuation method is needed

Inventory: items that are purchased for resale.

• Items in inventory are not always purchased at the same price; the same items may cost different amounts at different times.
• When a company sells one item, it must decide which historical purchase cost to use as the expense (Cost of Merchandise Sold).
• Example: A company buys 10 units at $1, 10 at $2, and 10 at $3. When it sells one unit for $10, should the cost be $1, $2, or $3?
• The choice affects both the expense (Cost of Merchandise Sold) and the remaining asset (Merchandise Inventory).

📊 Four key inventory questions

Every inventory method must answer:

1. What is total sales?
2. What is total cost of merchandise sold?
3. What is gross profit? (Sales minus cost of merchandise sold)
4. What is the ending inventory balance?

🔄 Perpetual inventory system methods

🔄 What the perpetual system does

Perpetual inventory system: the process of keeping a current running total of inventory, both in number of units on hand and its dollar value, at all times.

• When product is purchased for resale, inventory immediately increases.
• When inventory is sold, its total value is immediately reduced.
• An inventory cost grid organizes purchases, sales, and running balances by date, tracking both units and dollar amounts.

🥇 FIFO (First-In, First-Out)

FIFO method: withdraws inventory beginning with those units purchased earliest.

• The oldest costs are assigned to Cost of Merchandise Sold.
• The ending inventory balance is comprised of the costs of items purchased most recently.
• Example (from the excerpt): 19 units sold cost $85; 11 units remain at $65.
• Under rising prices, FIFO produces the lowest cost of goods sold and the highest ending inventory and gross profit.

🥈 LIFO (Last-In, First-Out)

LIFO method: withdraws inventory beginning with those units purchased most recently.

• The newest costs are assigned to Cost of Merchandise Sold.
• The ending inventory balance is comprised of the costs of items purchased earliest.
• Example (from the excerpt): 19 units sold cost $98; 11 units remain at $52.
• Under rising prices, LIFO produces the highest cost of goods sold and the lowest ending inventory and gross profit.

⚖️ Average cost method

Average cost method: each time there is a purchase or sale, the dollar value of the remaining inventory on hand is divided by the number of units in stock to arrive at an average cost per unit.

• Both cost of merchandise sold and ending inventory use the same weighted-average unit cost.
• Example (from the excerpt): 19 units sold cost $90.70; 11 units remain at $58.74.
• Results typically fall between FIFO and LIFO.

🔍 Comparing the three methods (perpetual system)

Method	Total sales (19 units)	Cost of goods sold	Gross profit	Ending inventory (11 units)
FIFO	$190.00	$85.00	$105.00	$65.00
LIFO	$190.00	$98.00	$92.00	$52.00
Average	$190.00	$90.70	$99.30	$58.74

• The $13 difference between FIFO and LIFO (in this example) appears in both cost of goods sold and ending inventory.
• FIFO includes that $13 as part of ending inventory; LIFO considers it part of cost of merchandise sold.
• Don't confuse: this pattern holds when costs are rising; if costs decrease over time, the results reverse.

📅 Periodic inventory system methods

📅 What the periodic system does

• Companies do not keep an ongoing running inventory balance.
• Instead, they wait until the end of the accounting period to conduct a physical inventory count.
• Ending inventory is counted; cost of merchandise sold is calculated as: (beginning inventory + purchases) − ending inventory.
• The same three flow methods (FIFO, LIFO, average cost) are used, but the periodic system disregards the dates of individual sales and looks at totals collectively.

🥇 FIFO under periodic

• The units sold are drawn from the earliest inventory in stock.
• Example (from the excerpt): 19 units sold cost $85; 11 units remain at $65.
• Key point: FIFO results are the same under perpetual and periodic systems.

🥈 LIFO under periodic

• The units sold are drawn from the latest inventory in stock.
• Example (from the excerpt): 19 units sold cost $105; 11 units remain at $45.
• Don't confuse: LIFO results differ between perpetual and periodic because the periodic system ignores the timing of individual sales.

⚖️ Average cost under periodic

• The total cost of goods available for sale is divided by total units available to get a single average cost per unit.
• Example (from the excerpt): $150 ÷ 30 units = $5 per unit; 19 units sold cost $95; 11 units remain at $55.

🔍 Comparing the three methods (periodic system)

Method	Total sales (19 units)	Cost of goods sold	Gross profit	Ending inventory (11 units)
FIFO	$190	$85	$105	$65
LIFO	$190	$105	$85	$45
Average	$190.00	$95	$95	$55

• The $30 difference between FIFO and LIFO (in this example) appears in both cost of goods sold and ending inventory.
• Under rising prices, FIFO gross profit is $30 higher than LIFO.

📉 Lower-of-cost-or-market valuation

📉 Why it is used

Lower-of-cost-or-market: an additional calculation used to value inventory if the cost of a product declines after the item has been purchased for inventory.

• Follows the principle of conservatism: if there is more than one way to report financial information, the approach that shows results in the least favorable light should be presented.
• Ensures that the value of inventory reported is not misinterpreted or overstated.
• "Market" can be interpreted as replacement cost, or what the item is selling for today.

📉 How to apply it

• For each product, compare the price paid (cost) to the current market value.
• The lower of the two numbers is used to report the value of that product's inventory on the balance sheet.
• Example (from the excerpt): Model #2 phones were purchased for $100 per unit but now sell for $60 per unit; inventory is reported at $60 per unit, reducing total inventory from $40,000 to $32,000.

🔢 Physical inventory count

🔢 What to include and exclude

• Companies using a perpetual system still conduct a physical inventory count to verify that the amount in records matches what is actually on hand.
• Include (items the company owns):
  • Items on hand on the company's premises.
  • Items returned by customers (re-possessed).
  • Items held aside for customers that have not been paid for yet (ownership not yet transferred).
  • Items on consignment to someone else (the company owns them).
  • Items out for warranty repair (the company still owns them).
  • Items purchased that are in transit if shipping terms are FOB shipping.
  • Items sold that are in transit if shipping terms are FOB destination.
• Exclude (items the company does not own):
  • Items on consignment from someone else.
  • Items in for warranty repair (not re-possessed).
  • Items held aside for customers that have been paid for already (ownership transferred).
• Key rule: Whoever is responsible for absorbing the transportation cost (buyer or seller) also owns the merchandise while it is in transit.

⚠️ Effect of count errors on financial statements

• Understating inventory (reporting too low):
  • Merchandise Inventory is understated.
  • Total assets are understated.
  • Cost of merchandise sold is overstated (because ending inventory is subtracted in the calculation).
  • Net income is understated.
  • Retained earnings and stockholders' equity are understated.
• Overstating inventory (reporting too high):
  • Merchandise Inventory is overstated.
  • Total assets are overstated.
  • Cost of merchandise sold is understated.
  • Net income is overstated.
  • Retained earnings and stockholders' equity are overstated.
• Example (from the excerpt): If correct inventory is $20,000 but only $19,500 is counted, the $500 error flows through to understate assets and net income.

🧭 Overview

🧠 One-sentence thesis

Bank reconciliation is a critical control process that verifies a company's cash records by comparing them to the bank statement, updating both sides for unrecorded transactions and errors, and ensuring the adjusted balances match.

📌 Key points (3–5)

• Why reconcile: Cash is susceptible to theft, fraud, and loss, so continuous verification of the ledger balance against the bank statement is essential.
• Two-fold process: Update the company's Cash ledger for items the bank recorded but the company hasn't yet seen, and update the bank balance for items the company recorded but the bank hasn't yet processed.
• Common confusion: Not all transactions appear simultaneously in both records—deposits in transit and outstanding checks are normal timing differences, not errors.
• When to reconcile: At least monthly, but can be done more frequently using online statements for up-to-date information.
• Final step: After reconciliation, the company must journalize all newly discovered transactions and corrections to update its Cash ledger.

💰 Cash tracking and bank accounts

💰 The Cash ledger

• Companies journalize many cash transactions and maintain a Cash ledger to track:
  • Inflows (deposits, receipts)
  • Outflows (payments, withdrawals)
  • Running balance after each entry
• The excerpt shows a sample ledger for a new business starting June 1.

🏦 Why use a bank account

Almost all companies open a checking account at a bank for several reasons:

• Safeguard cash: Physical security
• Accept and write checks: Payment flexibility
• Electronic transfers: Modern payment methods
• Loan payments: Make and receive
• Independent record: The bank provides an external verification of transactions via bank statements (available online)

📄 Bank statements

A bank statement typically lists a beginning balance, deposits, withdrawals, and an ending balance for a time period (usually monthly).

• The bank's record is independent of the company's internal ledger.
• Online statements provide up-to-date information for more frequent reconciliation.

🔍 The bank reconciliation process

🔍 What reconciliation does

A bank reconciliation compares the company's record of cash on hand to the bank statement, adjusts for missing or incorrect entries, and is complete when the result equals the ending balance on the bank statement.

• Purpose: Verify that the ledger balance matches what the business actually has.
• Key goal: Notify the account holder of transactions the bank processed on the company's behalf so the company can record them.
• Frequency: At least monthly, but can be more frequent.

✅ Step 1: Compare and check off matching items

• Compare the company's Cash ledger to the bank statement line by line.
• Check off all transactions that match in both records (shown as red checkmarks in the excerpt's example).
• This identifies which items are recorded by both parties and which are not.

📊 Step 2: Update the company's Cash ledger balance

Start with the end-of-month balance in the company's Cash ledger, then adjust:

Adjustment type	Examples from excerpt	Effect
Add deposits on bank statement not in ledger	Electronic transfer in/customer payment; note receivable collection; interest earned	Increase Cash
Deduct withdrawals on bank statement not in ledger	Electronic transfer out/auto payment; NSF (not sufficient funds) check; bank service charge	Decrease Cash
Correct errors in the ledger	Check #1115 entered as $80 instead of $800 (deduct remaining $720)	Adjust Cash

Example from excerpt:

• Start: $8,455
• Add: $2,500 (electronic transfer) + $100 (note collection)
• Deduct: $150 (auto payment) + $900 (NSF check) + $50 (service charge)
• Correct: -$720 (ledger error)
• Adjusted result: $9,235

🏦 Step 3: Update the bank statement balance

Start with the end-of-month balance on the bank statement, then adjust:

Adjustment type	Examples from excerpt	Effect
Add deposits in ledger not yet on bank statement	Deposits in transit	Increase bank balance
Deduct checks/withdrawals in ledger not yet on bank statement	Outstanding checks	Decrease bank balance
Correct errors on the bank statement	(None in this example)	Adjust bank balance

Example from excerpt:

• Start: $9,375
• Add: $600 (deposit in transit)
• Deduct: $150 + $450 + $140 (outstanding checks)
• Adjusted result: $9,235

✔️ Step 4: Verify the two results match

• Compare the adjusted company ledger balance to the adjusted bank statement balance.
• They must be equal.
• In the excerpt's example: both equal $9,235 ✓

Don't confuse: Timing differences (deposits in transit, outstanding checks) are normal and expected—they don't mean either party made an error; they simply reflect items one party knows about but the other doesn't yet.

📝 Journalizing reconciliation adjustments

📝 Why journal entries are needed

After reconciliation, the company must update its Cash ledger by journalizing all transactions it learned about from the bank statement, plus any error corrections.

Important: Only the company's books are updated with journal entries; the bank does not need adjustments (it already processed those transactions).

💵 Adding items to Cash

💵 Electronic payment from customer

When a customer pays electronically and it appears on the bank statement:

Entry:

• Debit Cash (asset increases)
• Credit Accounts Receivable (asset decreases)

Example: $2,500 electronic payment from Hammond Co.

💵 Note receivable collection

When the bank collects a note on the company's behalf:

Entry:

• Debit Cash (asset increases)
• Debit Interest Revenue (revenue increases) [for interest earned]
• Credit Note Receivable (asset decreases)

Example: $100 total collected ($98 principal + $2 interest) from Arctic Co.

💸 Deducting items from Cash

💸 Scheduled automatic payment

When the bank processes a pre-authorized payment to a vendor:

Entry:

• Debit Maintenance Expense (or relevant expense; expense increases)
• Credit Cash (asset decreases)

Example: $150 payment to Ace Pest Control.

💸 NSF (Not Sufficient Funds) check

When a customer's check bounces (returned for insufficient funds):

Entry:

• Debit Accounts Receivable (asset increases—customer owes again)
• Credit Cash (asset decreases—the deposit is reversed)

Example: $900 NSF check.

Why this happens: The company deposited the check and recorded it as Cash, but the customer's bank rejected it, so the company must reverse the deposit and bill the customer again.

💸 Bank service charge

Monthly fees charged by the bank:

Entry:

• Debit Bank Card Expense (or Bank Service Charge; expense increases)
• Credit Cash (asset decreases)

Example: $50 monthly charge.

🔧 Correcting errors

🔧 Ledger error correction

When the company discovers it recorded a transaction incorrectly:

Entry: Adjust the original account and Cash by the difference.

Example from excerpt:

• Check #1115 was for $800 (rent payment) but entered as $80.
• Correction needed: deduct the remaining $720.

Entry:

• Debit Rent Expense $720 (expense increases)
• Credit Cash $720 (asset decreases)

📋 Updated Cash ledger

After all six adjustments are journalized and posted, the Cash ledger shows the corrected balance of $9,235, matching the reconciled amount.

💳 Bank card expense

💳 What it is

Bank Card Expense is an account that keeps track of costs related to accepting credit and debit cards.

• Businesses that accept credit/debit cards pay processing fees to a company that handles electronic transactions.
• Fees may be:
  • Flat fees
  • Per-transaction fees
  • Various combinations

💳 How it's recorded

• The processing company automatically withdraws fees from the business's bank account.
• Monthly, the processing company sends a statement of fees.
• The business then records the expense.

Entry (example: $300 in processing fees):

• Debit Bank Card Expense (expense increases)
• Credit Cash (asset decreases)

Account	Type	To increase	To decrease	Normal balance	Financial statement	Close out?
Bank Card Expense	Expense	Debit	Credit	Debit	Income Statement	YES

🧭 Overview

🧠 One-sentence thesis

A note receivable tracks short-term loans made by a business, recording both the principal and interest earned when the loan matures, with different accounting treatments depending on whether the borrower pays, renews, or defaults.

📌 Key points (3–5)

• What a note receivable is: a current asset account that tracks short-term loans (due within one year) made to individuals or customers, including a formal contract specifying principal, interest rate, and term.
• Two ways notes arise: either a direct cash loan to someone, or converting an overdue accounts receivable into an interest-bearing note to give the customer more time to pay.
• Maturity date accounting: when the note comes due, the company records both the principal repayment and interest revenue earned, calculated as Principal × Rate × Time.
• Three possible outcomes at maturity: the borrower pays cash, issues a new replacement note for an extension, or dishonors the note (fails to pay or arrange extension).
• Common confusion: interest is not recorded on the issue date—only when the note matures; also, the same $1,000 owed shifts from interest-free (Accounts Receivable) to interest-bearing (Note Receivable).

📝 What is a note receivable

📝 Definition and characteristics

A note receivable is a loan contract that specifies the principal (amount of the loan), the interest rate stated as an annual percentage, and the terms stated in number of days or months.

• It is a current asset because these loans are typically short-term, due within one year.
• The Note Receivable account keeps track of amounts owed to the business from loans.
• Unlike Accounts Receivable (which tracks amounts owed from sales), Note Receivable tracks formal loan agreements that earn interest.

💰 Interest concept

• Interest is the cost of renting money from its owner, similar to rent paid to a landlord.
• The borrower pays to use someone else's money.
• Important: interest is not recorded on the issue date—wait until the note comes due.

🎬 How notes receivable originate (Issue date)

🎬 Situation 1: Direct cash loan

• An employee or individual asks to borrow money, and the company agrees and distributes cash.
• Journal entry: Debit Note Receivable (asset increasing), Credit Cash (asset decreasing).
• Example: A company lends $1,000 cash to an executive on January 1 for 60 days at 12%.

🔄 Situation 2: Converting accounts receivable

This is a two-step process:

Step a: Company sells merchandise on account (30-day payment terms).

• Debit Accounts Receivable, Credit Sales.

Step b: After 30 days, the customer cannot pay, so both parties agree to convert the balance to a note.

• Journal entry: Debit Note Receivable (asset increasing), Credit Accounts Receivable (asset decreasing).
• This gives the customer an extension of time, but now an interest charge applies.
• The same $1,000 owed is reclassified from an interest-free invoice amount to an interest-bearing loan.

Don't confuse: The customer still owes $1,000, but the type of debt changes—from Accounts Receivable (no interest) to Note Receivable (with interest).

🧮 Maturity date accounting

🧮 Calculating interest

Formula: Principal × Rate × Time = Interest Earned

• The rate is always annual (12 months).
• Time must be pro-rated: use 60/360 days or 2/12 months for a 60-day note.
• Simplified assumption: every month has 30 days, every year has 360 days.

Example: $1,000 principal, 12% annual rate, 60-day term:

• $1,000 × 12% × 60/360 = $20 interest

📆 What happens on the maturity date

At the end of the loan term, the note is void and must be removed from the books.

Always credit:

• Note Receivable (for the principal amount, to set its balance back to zero)
• Interest Revenue (for the interest earned, regardless of whether cash is received yet)

The debit depends on what the customer does—see next section.

🔀 Three possible outcomes at maturity

💵 Outcome 1: Customer pays cash

• Journal entry: Debit Cash $1,020, Credit Note Receivable $1,000, Credit Interest Revenue $20.
• The company receives the full amount owed (principal + interest) in cash.

🔁 Outcome 2a: Customer issues a new note (principal + interest)

• The customer cannot pay but arranges another extension; the new note covers both the original principal and the interest.
• Journal entry: Debit Note Receivable $1,020 (new note), Credit Note Receivable $1,000 (old note voided), Credit Interest Revenue $20.
• Example: New note is for another 60 days at 10%.
• Follow-up: When the second note matures, calculate new interest on $1,020 at 10% for 60 days = $17. Total cash received eventually: $1,037.

🔁 Outcome 2b: Customer issues a new note (principal only) and pays interest in cash

• The customer pays the $20 interest now but issues a new note for the $1,000 principal.
• Journal entry: Debit Cash $20, Debit Note Receivable $1,000 (new note), Credit Note Receivable $1,000 (old note), Credit Interest Revenue $20.

❌ Outcome 3: Customer dishonors the note

• The customer does not pay and does not arrange a new note.
• Journal entry: Debit Accounts Receivable $1,020, Credit Note Receivable $1,000, Credit Interest Revenue $20.
• Why Accounts Receivable? The note is void, but the customer still owes the money. Recording it in Accounts Receivable immediately flags that the account is overdue.

Don't confuse: Even though the customer didn't pay, Interest Revenue is still credited because it was earned during the loan term.

🔚 What happens after dishonor

🔚 Possibility 1: Customer eventually pays with penalty

• Two more months pass; the customer finally pays on 4/30.
• The company charges a 10% penalty on the outstanding $1,020 balance: $1,020 × 10% × 60/360 = $17.
• Penalties are recorded as Interest Revenue.
• Journal entry: Debit Cash $1,037, Credit Accounts Receivable $1,020, Credit Interest Revenue $17.

🔚 Possibility 2: Customer will never pay (write-off)

• The company realizes the customer will never be able to pay.
• Journal entry: Debit Allowance for Doubtful Accounts $1,037, Credit Accounts Receivable $1,020.
• This is a write-off—forgiveness of the customer's debt—done only when the company is absolutely certain the customer can never pay (due to death, bankruptcy, etc.).
• The excerpt notes this topic is covered in the next section (Uncollectible Accounts).

📊 Summary comparison table

Maturity outcome	Debit account(s)	Why
Customer pays cash	Cash	Full payment received
Customer issues new note (principal + interest)	Note Receivable (new)	Extension granted, new loan replaces old
Customer issues new note (principal only) + pays interest	Cash, Note Receivable (new)	Interest paid now, principal extended
Customer dishonors note	Accounts Receivable	Flags overdue account; note is void but debt remains

🧭 Overview

🧠 One-sentence thesis

Companies that extend credit must choose between two methods—direct write-off or allowance—to account for customers who will never pay, depending on how frequently they experience bad debt.

📌 Key points (3–5)

• When to write off: A write-off is forgiveness of a customer's debt, done only when the company is absolutely certain the customer can never pay (due to death, bankruptcy, admission, etc.).
• Two methods exist: Direct write-off (for companies that rarely have bad debt) vs. allowance method (for companies that consistently have bad debt).
• Key account difference: Direct write-off uses Bad Debt Expense at the time of write-off; allowance method uses Allowance for Doubtful Accounts (a contra asset) and only uses Bad Debt Expense in the annual adjusting entry.
• Common confusion: Under the allowance method, the adjusting entry amount depends on the estimation approach—analysis of receivables targets a final balance, while percent of sales adds to the existing balance.
• Net realizable value: The allowance method shows on the balance sheet the amount the company actually expects to collect (Accounts Receivable minus Allowance for Doubtful Accounts).

💳 Normal credit sales cycle

💳 Sale on account

• When a company extends credit, it invoices customers and gives them time (usually 30 days) to pay.
• At the time of sale, debit Accounts Receivable (asset increasing) and credit Sales (revenue increasing).
• Example: On 4/1, sell $3,000 on account → debit Accounts Receivable $3,000, credit Sales $3,000.

💰 Receipt of payment

• When customers pay within the allowed time, debit Cash (asset increasing) and credit Accounts Receivable (asset decreasing).
• Example: On 4/30, customer pays $3,000 → debit Cash $3,000, credit Accounts Receivable $3,000.
• The customer now owes nothing.

❌ When customers default

• There may be cases when customers default and can or will never pay.
• If the company is certain it will never be paid, it can write off the customer's account and claim the non-payment as a business expense.
• The method chosen depends on how frequently the company anticipates bad debt.

🎯 Direct write-off method

🎯 Who uses it

Direct write-off method: used by companies that rarely experience any bad debt.

• Example: A movie theater that primarily accepts cash from customers would not write off bad debt often, if ever.
• The ONLY account that is written off is Accounts Receivable—it is credited to remove the customer's balance.

📝 Write-off entries

Full write-off

• If none of what the customer owes will ever be received, debit Bad Debt Expense (expense increasing) instead of Cash to close out the account.
• Example: On 4/30, write off $3,000 → debit Bad Debt Expense $3,000, credit Accounts Receivable $3,000.

Partial write-off

• If the customer pays some but will never pay the rest, record both the cash receipt and the write-off.
• Example: Customer pays $1,000 and company writes off remaining $2,000 → debit Cash $1,000, debit Bad Debt Expense $2,000, credit Accounts Receivable $3,000.

🔄 Reinstatement entries

Full reinstatement

• If the customer returns to pay the entire bill AFTER the write-off, "flip over" the previous transaction to void it (this is called reinstating), then record the cash collection.
• Two journal entries are required.
• Example: On 6/17, customer pays $3,000 previously written off → (1) debit Accounts Receivable $3,000, credit Bad Debt Expense $3,000; (2) debit Cash $3,000, credit Accounts Receivable $3,000.

Partial reinstatement

• If the customer returns to pay only part of what was owed AFTER the write-off, reinstate only the amount the customer repays, not the entire amount that was written off.
• Example: Customer pays $1,000 of $3,000 written off → (1) debit Accounts Receivable $1,000, credit Bad Debt Expense $1,000; (2) debit Cash $1,000, credit Accounts Receivable $1,000.

🛡️ Allowance method

🛡️ Who uses it

Allowance method: used by companies that frequently experience bad debt.

• Example: A utility company that provides electricity to homeowners constantly must write off bad debt as customers cannot pay or move and do not pay their last bill.
• A new account—Allowance for Doubtful Accounts—is a contra asset account that absorbs non-payment when the account receivable is closed out.

📊 Annual adjusting entry

• An allowance is an estimate.
• Companies that have continuous bad debt make an adjusting entry at the beginning of the year to estimate how much of Accounts Receivable they believe they will never collect.
• This is recorded before any customer's account actually defaults during the year.
• Example: Estimate $15,000 bad debt for the year → debit Bad Debt Expense $15,000, credit Allowance for Doubtful Accounts $15,000.
• Key distinction: The only time Bad Debt Expense is used under the allowance method is in the annual adjusting entry.

📝 Write-off entries

Full write-off

• If none of what the customer owes will ever be received, debit Allowance for Doubtful Accounts (contra asset decreasing) instead of Cash to close out the account.
• Example: On 4/30, write off $3,000 → debit Allowance for Doubtful Accounts $3,000, credit Accounts Receivable $3,000.

Partial write-off

• If the customer pays some but will never pay the rest, record both the cash receipt and the write-off.
• Example: Customer pays $1,000 and company writes off remaining $2,000 → debit Cash $1,000, debit Allowance for Doubtful Accounts $2,000, credit Accounts Receivable $3,000.

🔄 Reinstatement entries

Full reinstatement

• If the customer returns to pay the entire bill AFTER the write-off, "flip over" the previous transaction to void it (reinstating), then record the cash collection.
• Two journal entries are required.
• Example: On 6/17, customer pays $3,000 previously written off → (1) debit Accounts Receivable $3,000, credit Allowance for Doubtful Accounts $3,000; (2) debit Cash $3,000, credit Accounts Receivable $3,000.

Partial reinstatement

• If the customer returns to pay only part of what was owed AFTER the write-off, reinstate only the amount the customer repays.
• Example: Customer pays $1,000 of $3,000 written off → (1) debit Accounts Receivable $1,000, credit Allowance for Doubtful Accounts $1,000; (2) debit Cash $1,000, credit Accounts Receivable $1,000.

💎 Net realizable value

Net Realizable Value: the amount of a company's total Accounts Receivable that it expects to collect.

• It appears on the Balance Sheet as follows:
  • Accounts Receivable: $97,000 (amount owed to a company)
  • Less: Allowance for Doubtful Accounts: $12,000 (amount the company expects will "go bad")
  • Net Realizable Value: $85,000
• In fairness to balance sheet readers, the company admits that even though it is owed $97,000 from customers (an asset), it does not expect to ever receive $12,000 of it.
• The Accounts Receivable and Allowance for Doubtful Accounts amounts on the balance sheet are the current ledger balances.

🔢 Estimating bad debt: analysis of receivables

🔢 How it works

• Analysis of receivables involves analyzing and/or contacting all customers, determining who is likely to default, and adding the amounts for all customers who are likely to become bad debt.
• The adjusting entry should include the amount necessary to bring the Allowance for Doubtful Accounts ledger balance up to this number.
• Key distinction: This method targets a final balance in the allowance account.

📐 Three scenarios

Assume that after analyzing receivables on 1/1, it is estimated that there will be $8,000 of bad debt during the upcoming year.

Scenario 1: No balance in the allowance account

• Since there is no balance "left over" from last year, it will take a credit of $8,000 to bring the year's beginning balance up to $8,000.
• Adjusting entry: debit Bad Debt Expense $8,000, credit Allowance for Doubtful Accounts $8,000.

Scenario 2: $600 credit balance in the allowance account

• This means the company overestimated its Bad Debt Expense last year—it had less bad debt than it had estimated.
• Since there is already a $600 credit balance "left over" from last year, it will only take an additional credit of $7,400 to bring the year's beginning balance up to $8,000.
• Adjusting entry: debit Bad Debt Expense $7,400, credit Allowance for Doubtful Accounts $7,400.

Scenario 3: $600 debit balance in the allowance account

• This means the company underestimated its Bad Debt Expense last year—it had more bad debt than it had estimated.
• Since there is already a $600 debit balance "left over" from last year, it will take an additional credit of $8,600 to bring the year's beginning balance up to $8,000.
• Adjusting entry: debit Bad Debt Expense $8,600, credit Allowance for Doubtful Accounts $8,600.

📈 Estimating bad debt: percent of sales

📈 How it works

• Percent of sales involves a simple calculation: Sales on account in previous year times the historical percent of sales that default.
• The adjusting entry should include the result of the calculation; the credit to Allowance for Doubtful Accounts increases the account's ledger balance.
• Key distinction: This method adds to the existing balance, regardless of what that balance is.

📐 Three scenarios

Assume that sales on account for the previous year were $400,000 and an estimated 2% of those sales will have to be written off. The amount is $400,000 × 2% = $8,000.

Scenario 1: No balance in the allowance account

• There is no balance "left over" from last year.
• Adjusting entry: debit Bad Debt Expense $8,000, credit Allowance for Doubtful Accounts $8,000.
• The adjusting entry brings the Allowance for Doubtful Accounts credit balance to $8,000.

Scenario 2: $600 credit balance in the allowance account

• This means the company overestimated its Bad Debt Expense last year—it had less bad debt than it had estimated.
• There is a $600 credit balance "left over" from last year.
• Adjusting entry: debit Bad Debt Expense $8,000, credit Allowance for Doubtful Accounts $8,000.
• The adjusting entry adds the additional $8,000 to the previous credit balance, resulting in a balance of $8,600.

Scenario 3: $600 debit balance in the allowance account

• This means the company underestimated its Bad Debt Expense last year—it had more bad debt than it had estimated.
• There is a $600 debit balance "left over" from last year.
• Adjusting entry: debit Bad Debt Expense $8,000, credit Allowance for Doubtful Accounts $8,000.
• The adjusting entry adds the additional $8,000 to the previous debit balance, resulting in a credit balance of $7,400.

⚖️ Don't confuse the two estimation methods

• Analysis of receivables: The adjusting entry amount is calculated to bring the allowance account to a target ending balance.
• Percent of sales: The adjusting entry amount is always the same calculation (prior year sales × historical default rate), and it is added to whatever balance already exists.

📋 Account summary

Account Type	Account Name	To Increase	To Decrease	Normal Balance	Financial Statement	Close Out?
Asset	Accounts Receivable	Debit	Credit	Debit	Balance Sheet	NO
Asset	Notes Receivable	Debit	Credit	Debit	Balance Sheet	NO
Contra Asset	Allowance for Doubtful Accounts	Credit	Debit	Credit	Balance Sheet	NO
Revenue	Interest Revenue	Credit	Debit	Credit	Income Statement	YES
Expense	Bad Debt Expense	Debit	Credit	Debit	Income Statement	YES

🧭 Overview

🧠 One-sentence thesis

Fixed assets are capitalized at cost and systematically depreciated over their useful lives rather than expensed immediately, while intangible assets are similarly amortized, ensuring that the expense of long-lived assets is matched to the periods in which they generate value.

📌 Key points (3–5)

• Capitalization vs. expensing: Fixed assets are recorded as assets (debited to Equipment, Building, etc.) at purchase rather than immediately expensed, then depreciated over time.
• Book value calculation: Book value equals cost minus accumulated depreciation; accumulated depreciation is a contra asset account that increases over time while book value decreases.
• Three depreciation methods: Straight-line (even amounts), units of production (based on usage), and declining balance (accelerated, more in early years).
• Common confusion: The asset account balance never changes from its original cost due to the cost principle—only the accumulated depreciation account changes to reflect "used up" value.
• Disposal outcomes: Comparing book value to what is received (cash, trade-in allowance, or nothing) determines whether there is a gain, loss, or break-even on disposal.

💰 Core concept: Fixed assets and the cost principle

💰 What are fixed assets

Fixed assets: Relatively expensive physical items such as equipment, furnishings, vehicles, buildings, and land that typically last for several years. Also called Property, Plant and Equipment.

• These are costs of running a business, but they are not expensed at purchase.
• Instead, the company debits an asset account (Equipment, Building, Truck, etc.) for the cost.
• Expensing immediately would distort the income statement: one year would show a huge expense, while other years using the asset would show none.

🔒 The cost principle requirement

• The cost principle requires that a fixed asset's ledger balance always equal what was originally paid for it.
• You cannot credit the asset account to show it is losing value—its debit balance must stay at cost as long as the company owns it.
• Example: Equipment purchased for $27,900 must always show a $27,900 debit balance in the Equipment account.

Don't confuse: The asset account balance (cost) vs. book value (cost minus accumulated depreciation). The asset account never changes; book value decreases over time.

📉 Depreciation mechanics

📉 What depreciation means

Depreciation: The periodic expiration of a fixed asset, meaning its cost is gradually claimed as an expense over its useful life rather than all at once at purchase.

• The company recognizes that a portion of the asset is "used up" as time passes or as the asset is used.
• The value that a fixed asset loses each year becomes an expense.
• All fixed assets except Land are depreciated—land is considered permanent and not "used up."

🧮 Key depreciation terms

Term	Definition
Cost	Amount paid plus everything needed to get the asset ready (transportation, sales tax, installation, site preparation); excludes damage during shipment
Residual value	Minimal guaranteed amount someone will pay for the asset at any time, even if non-functional (e.g., scrap value)
Useful life	Length of time or amount of activity an asset is expected to last; measured in years, miles, hours, or units of output
Book value	Current worth = Cost - Accumulated Depreciation

Example of cost calculation:

• Equipment $9,000 + transportation $350 + sales tax $450 + installation $200 = $10,000 depreciable cost

🔄 The depreciation adjusting entry

The adjusting entry uses two accounts:

Depreciation Expense (income statement account, closed annually):

• Debit this account for the amount "used up" during the period
• Do NOT use specific accounts like "Equipment Expense" or "Building Expense"—use one Depreciation Expense account

Accumulated Depreciation (contra asset account, NOT closed):

• Credit this account instead of crediting the asset directly
• Appears on the balance sheet just under the related asset
• Credit balance increases each year as the asset loses more value
• Each fixed asset has its own Accumulated Depreciation account

Standard entry format:

Debit: Depreciation Expense
Credit: Accumulated Depreciation

📊 Balance sheet presentation

Equipment purchased for $27,900 with $8,700 accumulated depreciation appears as:

Equipment                           $27,900
Less: Accumulated depreciation       8,700
                                   ________
                                   $19,200

The $19,200 is the book value—what the asset is currently worth.

Important limit: A company must stop depreciating once book value equals residual value, since the asset will always be worth at least what someone will pay for it. However, the company may continue using the asset even with no remaining depreciable value.

🔢 Three depreciation methods

🔢 Method 1: Straight-line (most common)

Formula: (Cost - Residual value) ÷ Useful life in years = Annual depreciation

• Simplest and most commonly used
• Expenses the depreciable base evenly over useful life
• Asset is fully depreciated when useful life years have passed

Full-year example: Equipment costs $27,000, residual value $900, 3-year life, purchased January 1

• Annual depreciation: ($27,000 - $900) ÷ 3 = $8,700 per year
• Same $8,700 entry each December 31 for three years
• After year 3: Accumulated depreciation = $26,100, Book value = $900 (the residual value)

Partial-year adjustment: If purchased mid-year, pro-rate by months owned

Purchase month	Months owned by Dec 31	Fraction to use
January	12	12/12
April	9	9/12
July	6	6/12
October	3	3/12

Example: Equipment purchased April 1 with $8,700 annual depreciation

• Year 1 (April-December): $8,700 × 9/12 = $6,525
• Years 2-3: $8,700 each (full years)
• Year 4 (January-March): $8,700 × 3/12 = $2,175

Note: Although useful life is 3 years, there are 4 adjusting entries because the 36 months don't align with calendar years.

🔢 Method 2: Units of production

Formula: (Cost - Residual value) ÷ Useful life in units = Rate per unit

Then: Rate per unit × Units used during the year = Depreciation expense

• Uses activity (miles, hours, units of output) instead of time
• Better matches depreciation to actual usage

Example: Equipment costs $27,000, residual value $900, 8,700-hour useful life

• Rate: ($27,000 - $900) ÷ 8,700 hours = $3.00 per hour
• Year 1 (2,100 hours used): 2,100 × $3.00 = $6,300
• Year 2 (2,300 hours used): 2,300 × $3.00 = $6,900
• Continue until total hours reach 8,700

Important: If actual usage in the final year would exceed total useful life, only depreciate up to the useful life limit.

🔢 Method 3: Declining balance (accelerated)

Formula: Book value at beginning of year × (2 ÷ Useful life in years) = Depreciation

Exception for last year: Current book value - Residual value = Final year depreciation

• Accelerated method: more depreciation in early years, less in later years
• Do NOT subtract residual value in the formula (unlike straight-line)—it's only subtracted in the last year
• The "2" in the formula is why it's sometimes called "double declining balance"

Full-year example: Equipment costs $27,000, residual value $900, 3-year life

Year	Beginning book value	Rate	Calculation	Depreciation
1	$27,000	2/3	$27,000 × 2/3	$18,000
2	$9,000	2/3	$9,000 × 2/3	$6,000
3	$3,000	n/a	$3,000 - $900	$2,100

After year 3: Book value = $900 (residual value)

Partial-year adjustment: Pro-rate first year by months owned (same fractions as straight-line)

Example: Equipment purchased April 1 (9 months in year 1)

• Year 1: $27,000 × 2/3 × 9/12 = $13,500
• Year 2: $13,500 × 2/3 = $9,000
• Year 3: $4,500 × 2/3 = $3,000
• Year 4: $1,500 - $900 = $600

Note: Four calendar years of entries even though useful life is 3 years.

📋 Method comparison table

Method	Process	When fully depreciated
Straight-line	(Cost - Residual) ÷ Years	After the number of years in useful life
Units of production	(Cost - Residual) ÷ Total units, then × units used	After total units in useful life are used
Declining balance	Book value × (2 ÷ Years); last year: Book value - Residual	After the number of years in useful life

🗑️ Disposing of fixed assets

🗑️ Gains and losses: operational vs. non-operational

Gain: Results when an asset is disposed of in exchange for something of greater value; increases in wealth from peripheral activities unrelated to main operations.

Loss: Decreases in wealth due to non-operational transactions; not the same as expenses, which are costs of earning revenues.

Key distinction:

• Revenue and expenses = operational (the business doing what it was set up to do)
• Gains and losses = non-operational (outside normal business activities)

Both gains and losses appear on the income statement under "other revenue and expenses" below the net income from operations line, keeping them separate from operational results.

🗑️ Three disposal methods

1. Discard - receive nothing for it
2. Sale - receive cash for it
3. Exchange (trade-in) - receive a similar asset for the original one

🗑️ Determining gain, loss, or break-even

Step 1: Calculate book value = Cost - Accumulated Depreciation

Step 2: Compare book value to what you receive

Comparison	Result
Book value = Amount received (or both zero)	Break even
Book value < Amount received	Gain
Book value > Amount received	Loss

🗑️ Partial-year depreciation before disposal

If disposing of an asset mid-year, first record an additional depreciation adjusting entry to bring accumulated depreciation current as of the disposal date.

Example: Equipment depreciates $1,200 annually ($100/month), last annual entry was December 31, disposal is April 1 (3 months later)

• Additional entry on April 1: Debit Depreciation Expense $300, Credit Accumulated Depreciation $300
• This updates book value to be accurate at disposal date

🗑️ Standard disposal entry format

Every disposal entry includes these steps:

1. Credit the asset account for its cost (zeros it out)
2. Debit Accumulated Depreciation for its balance (zeros it out)
3. Debit Cash or new asset if received
4. Debit Loss or Credit Gain if applicable

🚮 Discarding fixed assets

🚮 Discarding fully depreciated asset (break-even)

When cost equals accumulated depreciation (book value = zero) and nothing is received:

Example: Truck cost $35,000, accumulated depreciation $35,000, discarded

Debit: Accumulated Depreciation    $35,000
Credit: Truck                      $35,000

Result: Both accounts now have zero balances; no gain or loss.

🚮 Discarding partially depreciated asset (loss)

When book value > zero and nothing is received:

Example: Truck cost $35,000, accumulated depreciation $28,000 (book value $7,000), discarded

Debit: Loss on Disposal of Truck   $7,000
Debit: Accumulated Depreciation    $28,000
Credit: Truck                      $35,000

Result: $7,000 loss because the asset still had value but nothing was received.

💵 Selling fixed assets

💵 Sale process steps

1. Make adjusting entry to update accumulated depreciation (if mid-year)
2. Calculate book value
3. Compare book value to cash received → determine gain/loss/break-even
4. Zero out asset account (credit it)
5. Zero out accumulated depreciation (debit it)
6. Debit Cash for amount received
7. Debit Loss or Credit Gain if applicable

💵 Sale at break-even

Example: Truck cost $35,000, accumulated depreciation $28,000, sold for $7,000 cash (= book value)

Debit: Cash                        $7,000
Debit: Accumulated Depreciation   $28,000
Credit: Truck                     $35,000

💵 Sale at a loss

Example: Same truck sold for $5,000 cash (< $7,000 book value)

Debit: Loss on Sale of Truck      $2,000
Debit: Cash                        $5,000
Debit: Accumulated Depreciation   $28,000
Credit: Truck                     $35,000

Loss = $7,000 book value - $5,000 received = $2,000

💵 Sale at a gain

Example: Same truck sold for $10,000 cash (> $7,000 book value)

Debit: Cash                       $10,000
Debit: Accumulated Depreciation   $28,000
Credit: Truck                     $35,000
Credit: Gain on Sale of Truck      $3,000

Gain = $10,000 received - $7,000 book value = $3,000

💵 Partial-year sale example

Truck depreciates $7,000 annually, accumulated depreciation $28,000 as of Dec 31, 2013, sold April 1, 2014 for $5,000

First, update depreciation for Jan-March 2014:

Debit: Depreciation Expense        $1,750  (= $7,000 × 3/12)
Credit: Accumulated Depreciation   $1,750

New accumulated depreciation: $29,750; New book value: $5,250

Then record the sale:

Debit: Loss on Sale of Truck        $250
Debit: Cash                        $5,000
Debit: Accumulated Depreciation   $29,750
Credit: Truck                     $35,000

🔄 Exchanging/trading in fixed assets

🔄 Exchange process

Similar to sale, but receive a trade-in allowance applied toward a new asset instead of cash.

Payment for new asset may combine: Trade-in allowance + Cash + Note Payable

🔄 Exchange steps

1. Update accumulated depreciation if mid-year
2. Calculate book value
3. Compare book value to trade-in allowance → determine gain/loss/break-even
4. Zero out old asset (credit it)
5. Zero out accumulated depreciation (debit it)
6. Debit new asset account for its full cost
7. Credit Cash and/or Note Payable for amounts paid
8. Debit Loss or Credit Gain if applicable

🔄 Exchange at break-even

Old truck: cost $35,000, accumulated depreciation $28,000, book value $7,000 New truck: costs $40,000 Trade-in allowance: $7,000 (= book value) Cash payment: $33,000

Debit: Truck (new)                $40,000
Debit: Accumulated Depreciation   $28,000
Credit: Truck (old)               $35,000
Credit: Cash                      $33,000

🔄 Exchange with loan (break-even)

Same facts, but cash payment $20,000, loan $13,000

Debit: Truck (new)                $40,000
Debit: Accumulated Depreciation   $28,000
Credit: Truck (old)               $35,000
Credit: Cash                      $20,000
Credit: Note Payable              $13,000

Calculation: $40,000 cost - $7,000 trade-in - $20,000 cash = $13,000 loan needed

🔄 Exchange at a loss with loan

Trade-in allowance: $5,000 (< $7,000 book value) Loss: $2,000

Debit: Loss on Exchange            $2,000
Debit: Truck (new)                $40,000
Debit: Accumulated Depreciation   $28,000
Credit: Truck (old)               $35,000
Credit: Cash                      $20,000
Credit: Note Payable              $15,000

Loan calculation: $40,000 - $5,000 trade-in - $20,000 cash = $15,000

🔄 Exchange at a gain with loan

Trade-in allowance: $10,000 (> $7,000 book value) Gain: $3,000

Debit: Truck (new)                $40,000
Debit: Accumulated Depreciation   $28,000
Credit: Truck (old)               $35,000
Credit: Cash                      $20,000
Credit: Note Payable              $10,000
Credit: Gain on Exchange           $3,000

Loan calculation: $40,000 - $10,000 trade-in - $20,000 cash = $10,000

📊 Income statement presentation

📊 Gains and losses section

Gains and losses appear below "Net income from operations" to keep them separate from operational results.

Structure:

Sales                                    $XXX
Cost of merchandise sold                  XXX
Gross Profit                             $XXX
Operating Expenses                        XXX
Net income from operations               $XXX

Gain on sale of investments              $XXX
Loss on sale of equipment                (XXX)
                                         ____
Net income                               $XXX

This format shows:

• Operational performance (top section)
• Non-operational gains/losses (middle section)
• Final net income (bottom line)

🌫️ Intangible assets

🌫️ What are intangible assets

Intangible assets: Longer-term assets that are not physical items; may include patents, copyrights, internet domain names, franchises, trademarks, and goodwill.

• Represent exclusive rights to use or do something other businesses cannot (without permission)
• Examples: Patents, copyrights give exclusive usage rights

🌫️ Amortization vs. depreciation

Similarities:

• Both expense long-lived assets over time
• Both match expense to periods generating value

Key difference:

• Depreciation = for physical fixed assets
• Amortization = for intangible assets
• No separate contra asset account for intangibles—the asset account itself is credited and declines over time

🌫️ Which intangibles are amortized

Finite (defined) useful lives → Amortize:

• Patents (maximum legal life 20 years, but company may use shorter period)
• Copyrights (specific useful lives)
• Franchises (specific useful lives)

Infinite useful lives → Do NOT amortize:

• Internet domain names (continuously renewable)
• Trade names (continuously renewable)
• Exception: Only if company assigns a specific usage period

Goodwill → Never amortized:

• Results only when buying another company for more than fair value of its net assets
• No useful life can reasonably be determined
• Most common intangible with indefinite life

🌫️ Amortization entry example

Patent cost $12,000, useful life 12 years Annual amortization: $12,000 ÷ 12 = $1,000

Debit: Amortization Expense    $1,000
Credit: Patents                $1,000

Note: The Patents asset account is credited directly (no Accumulated Amortization account).

📋 Classified balance sheet presentation

📋 Asset categories

Classified balance sheet: Organizes asset and liability accounts into categories for clearer presentation.

Four asset sections:

1. Current assets: Relatively liquid assets converted to cash or used within one year

   • Cash, Accounts Receivable, Merchandise Inventory, Supplies, Prepaid Rent

2. Long-term assets: Financial assets held for more than one year

   • Investment in equity securities

3. Property, plant and equipment: Physical assets with useful life > one year

   • Shows: Original cost, Accumulated Depreciation, Book value for each asset
   • Equipment, Building, Land

4. Intangible assets: Non-physical long-term assets

   • Patents, Copyrights, Trademarks, Goodwill

📋 Property, plant and equipment format

Equipment                           $16,000
Less: accumulated depreciation       2,000    $14,000

Building                           200,000
Less: accumulated depreciation      70,000    130,000

Land                                          110,000

Total property, plant and equipment          $254,000

Each category total appears in the far right column, with grand total at bottom.

📋 Account summary

Account type	Examples	Increase	Decrease	Normal balance	Statement	Close?
Asset	Building, Land, Truck, Equipment, Patent	Debit	Credit	Debit	Balance Sheet	NO
Contra Asset	Accumulated Depreciation	Credit	Debit	Credit	Balance Sheet	NO
Liability	Note Payable	Credit	Debit	Credit	Balance Sheet	NO
Revenue/Gain	Gain on Disposal	Credit	Debit	Credit	Income Statement	YES
Expense/Loss	Depreciation Expense, Loss on Disposal	Debit	Credit	Debit	Income Statement	YES

🧭 Overview

🧠 One-sentence thesis

When a held-to-maturity bond is sold before maturity, the investor must amortize the discount or premium up to the sale date, recognize accrued interest revenue, and record a gain or loss based on the difference between the sale price and the carrying amount.

📌 Key points (3–5)

• Discount amortization: the difference between face value and purchase price is spread evenly over the bond's life, increasing the investment account and interest revenue each period.
• Partial-year accounting: when a bond is sold mid-period, amortization and interest revenue are calculated pro-rata for the months held.
• Sale mechanics: the seller receives cash equal to the sale price plus accrued interest; the buyer reimburses the seller for interest earned during the seller's holding period.
• Gain or loss recognition: compare the sale price to the carrying amount (original cost plus accumulated amortization) to determine if a gain or loss occurred.
• Common confusion: the cash received at sale includes both the sale price and accrued interest; these are recorded separately in the journal entry.

💰 Discount amortization mechanics

📈 How amortization increases the investment account

The discount is the difference between the bond's face value and its purchase price, amortized (spread) evenly over the bond's life.

• Calculation: (Face value − Purchase price) ÷ Number of years
• Example from excerpt: ($5,000,000 − $4,700,000) ÷ 4 years = $75,000 per year
• Each year, the investment account increases by the amortization amount, and interest revenue is recognized for the same amount.

🧾 Journal entry pattern (full year)

Account	Debit	Credit	Explanation
Investment in ABC Bonds	75,000		Asset increasing
Interest Revenue		75,000	Revenue increasing

• The investment "grows" toward face value over time.
• The ledger shows the carrying amount rising: $4,700,000 → $4,775,000 → $4,850,000 → $4,925,000.

⏱️ Partial-year amortization

• When a bond is held for only part of a year, amortization is prorated by months held.
• Example from excerpt: $75,000 × (4 months ÷ 12 months) = $25,000
• The same journal entry structure applies, but with the prorated amount.

🔄 Sale transaction components

💵 What the seller receives

• Sale price: the agreed-upon amount for the bond itself.
• Accrued interest: the portion of the next interest payment earned during the seller's holding period.
• Example from excerpt: the seller owned the bond for 4 months of a 6-month interest period, so receives 4/6 (two-thirds) of the $15,000 interest payment = $10,000.
• The buyer pays this $10,000 to the seller at closing and is reimbursed when the full $15,000 interest payment arrives on the scheduled date.

📊 Full-year sale example (after 3 years)

Scenario: Bond sold on 12/31/18 for $4,875,000; carrying amount is $4,925,000.

Account	Debit	Credit	Explanation
Cash	4,885,000		Sale price + accrued interest
Loss on Sale of Investment	50,000		Carrying amount > sale price
Investment in ABC Bonds		4,925,000	Asset decreasing
Interest Revenue		10,000	Accrued interest earned

• Loss calculation: $4,925,000 (carrying amount) − $4,875,000 (sale price) = $50,000 loss.
• Cash received = $4,875,000 (sale price) + $10,000 (accrued interest) = $4,885,000.

📊 Partial-year sale example (after 2 years 4 months)

Scenario: Bond sold on 4/30/18 for $4,875,000; carrying amount is $4,825,000.

Account	Debit	Credit	Explanation
Cash	4,885,000		Sale price + accrued interest
Gain on Sale of Investment		50,000	Sale price > carrying amount
Investment in ABC Bonds		4,825,000	Asset decreasing
Interest Revenue		10,000	Accrued interest earned

• Gain calculation: $4,875,000 (sale price) − $4,825,000 (carrying amount) = $50,000 gain.
• The carrying amount is lower because less amortization has occurred (only 2 years 4 months vs. 3 full years).

🔍 Gain or loss determination

🧮 The comparison that matters

• Carrying amount = Original purchase price + Accumulated amortization to date.
• Sale price = The amount agreed upon for the bond.
• If sale price > carrying amount → Gain.
• If sale price < carrying amount → Loss.

⚠️ Don't confuse carrying amount with cash received

• The cash received includes both the sale price and accrued interest.
• The gain/loss is calculated using only the sale price vs. carrying amount; accrued interest is recorded separately as interest revenue.
• Example: In the partial-year sale, cash = $4,885,000, but the gain is calculated as $4,875,000 (sale price) − $4,825,000 (carrying amount) = $50,000.

📂 Classification context (brief mention)

🏷️ Trading securities

A bond investment is classified as trading when the investor intends to sell it quickly within one year.

• Trading securities appear at fair value in current assets.
• Unrealized gains/losses are reported on the income statement in the "Unrealized Holding Gain/Loss – Net Income" account.

🏷️ Available-for-sale securities

A bond investment is classified as available-for-sale when it is neither held-to-maturity nor trading.

• The excerpt does not provide further detail on available-for-sale accounting in this section.

🧭 Overview

🧠 One-sentence thesis

When an investment is sold, the difference between the cash received and the carrying amount of the asset determines whether a gain or loss is recognized on the income statement.

📌 Key points (3–5)

• How gain/loss is calculated: compare the sale proceeds (cash received) to the carrying amount (book value) of the investment at the time of sale.
• Gain occurs when: cash received exceeds the carrying amount of the investment.
• Loss occurs when: cash received is less than the carrying amount of the investment.
• Partial-year sales: when an investment is sold mid-period, accrued interest must be recorded up to the sale date, and the seller receives a prorated portion of the interest payment.
• Common confusion: the carrying amount changes over time due to amortization or accretion, so the same investment can produce different gains/losses depending on when it is sold.

💰 Calculating gain or loss on disposal

💰 The basic formula

Gain or Loss = Cash received - Carrying amount of the investment at sale date

• The carrying amount (also called book value) is the balance in the investment account at the moment of sale.
• If cash received is higher → Gain on Sale of Investment (increases income).
• If cash received is lower → Loss on Sale of Investment (decreases income).

📊 Full-year vs partial-year examples

Scenario	Sale date	Carrying amount	Cash received	Result
Full year	12/31/18 (after 3 full years)	$4,925,000	$4,885,000	Loss of $50,000
Partial year	4/30/18 (after 2 years, 4 months)	$4,825,000	$4,885,000	Gain of $50,000

• Notice: the same sale price ($4,885,000) produces opposite results because the carrying amount differs.
• The carrying amount grows over time as discount amortization is recorded (the excerpt shows annual increases of $75,000).

🔍 Why carrying amounts change

• The excerpt shows a bond purchased at a discount ($4,700,000 face value $5,000,000).
• Each year, the discount is amortized: ($5,000,000 - $4,700,000) / 4 years = $75,000 per year.
• This amortization increases the carrying amount annually:
  • 1/1/16: $4,700,000
  • 12/31/16: $4,775,000
  • 12/31/17: $4,850,000
  • 12/31/18: $4,925,000
• For a partial year (4 months), the amortization is prorated: $75,000 × 4/12 = $25,000.

📝 Journal entries for disposal

📝 Recording a loss on sale

Full-year example (12/31/18):

Account	Debit	Credit
Cash (asset ↑)	4,885,000
Loss on Sale of Investment (loss ↑)	50,000
Investment in ABC Bonds (asset ↓)		4,925,000
Interest Revenue (revenue ↑)		10,000

• Cash increases by the amount received.
• Loss on Sale of Investment is debited (increases the loss, which reduces net income).
• Investment in ABC Bonds is credited to remove the asset from the books.
• Interest Revenue of $10,000 is recorded (the seller receives part of the interest payment).

📝 Recording a gain on sale

Partial-year example (4/30/18):

Account	Debit	Credit
Cash (asset ↑)	4,885,000
Gain on Sale of Investment (gain ↑)		50,000
Investment in ABC Bonds (asset ↓)		4,825,000
Interest Revenue (revenue ↑)		10,000

• Gain on Sale of Investment is credited (increases the gain, which increases net income).
• The structure is otherwise the same: remove the investment, record cash, and recognize accrued interest.

🔄 Ledger account effects

After the sale, the investment account balance goes to zero:

Full-year ledger:

• 12/31/18 before sale: $4,925,000
• 12/31/18 after sale: $0

Partial-year ledger:

• 4/30/18 before sale: $4,825,000
• 4/30/18 after sale: $0

The gain or loss account shows the recognized amount:

• Loss on Sale of Investment ledger (full year): debit balance of $50,000
• Gain on Sale of Investment ledger (partial year): credit balance of $50,000

🕒 Partial-year interest considerations

🕒 Prorating interest for the seller

• When an investment is sold mid-period, the seller is entitled to interest earned up to the sale date.
• The excerpt explains: if the bond pays $15,000 interest every six months (June 30 and December 31), and the seller owned the bond for four months of a six-month period, the seller receives 4/6 (two-thirds) of the interest.
• Calculation: $15,000 × 4/6 = $10,000.

🕒 How the transaction works

• At closing (sale date): the buyer pays the seller $10,000 for accrued interest.
• On the next interest payment date (June 30): the buyer receives the full $15,000 from the issuing company, which reimburses the buyer for the $10,000 paid to the seller.
• Example: Your Corporation sells on April 30, 2018. The buyer pays $10,000 at closing; on June 30, the buyer collects the full $15,000 interest payment.

⚠️ Don't confuse

• The $10,000 interest revenue recorded at sale is not the same as the regular semi-annual interest payment.
• It represents only the portion of interest earned by the seller during the period they held the investment.
• The full interest payment goes to the buyer, who is reimbursed for the amount paid to the seller at closing.

🧭 Overview

🧠 One-sentence thesis

Gains and losses from selling investments appear on the income statement, while unrealized holding gains/losses are reported differently depending on whether the security is classified as trading (on the income statement) or available-for-sale (in stockholders' equity).

📌 Key points (3–5)

• Realized gains/losses: when an investment is sold, the difference between sale proceeds and carrying amount creates a gain or loss reported on the income statement.
• Unrealized gains/losses for trading securities: changes in fair value are recorded in the "Unrealized Holding Gain/Loss – Net Income" account, which flows through the income statement and is closed to Retained Earnings.
• Unrealized gains/losses for available-for-sale securities: changes in fair value are recorded in "Unrealized Holding Gain/Loss – Available-for-Sale Securities," which appears in stockholders' equity under "Other Accumulated Comprehensive Income" and is not closed at year-end.
• Common confusion: trading vs. available-for-sale—both are adjusted to fair value, but the unrealized gain/loss goes to different financial statement locations (income statement vs. balance sheet equity section).
• Timing matters: before selling any security, the investment must first be adjusted to fair value on the sale date, which may change the unrealized gain/loss balance.

💼 Investment classification and reporting location

💼 Trading securities

A bond investment is classified as trading when the investor intends to sell it quickly within one year.

• Trading securities appear in the current assets section of the balance sheet at fair value.
• Unrealized gains or losses are reported on the income statement as a component of comprehensive income.
• The account used is "Unrealized Holding Gain/Loss – Net Income."
• Example: An organization buys bonds intending to sell them in 9 months → classified as trading.

💼 Available-for-sale securities

A bond investment is classified as available-for-sale when it is neither held-to-maturity nor trading.

• Available-for-sale securities typically appear under Long-Term Investments in the assets section of the balance sheet at fair value.
• Unrealized gains or losses are reported on the balance sheet in the stockholders' equity section under "Other Accumulated Comprehensive Income."
• The account used is "Unrealized Holding Gain/Loss – Available-for-Sale Securities."
• Example: An organization buys bonds with an uncertain sale date → classified as available-for-sale.

🔍 Key distinction table

Classification	Balance sheet location	Unrealized gain/loss location	Closed at year-end?
Trading	Current assets	Income statement (Net Income)	Yes, to Retained Earnings
Available-for-sale	Long-term investments	Stockholders' equity (Other Accumulated Comprehensive Income)	No, remains on balance sheet

📊 Recording unrealized gains and losses

📊 Adjusting to fair value annually

• Both trading and available-for-sale securities are adjusted to fair value at least once annually, typically just before financial statements are prepared (e.g., December 31).
• The adjustment changes the Investment account balance and creates an unrealized gain or loss.
• Formula: Fair value minus cost (or previous carrying amount) equals the adjustment amount.

📈 Trading securities fair value adjustment

Example from the excerpt:

• On December 31, 2018, fair value is 5,010,000 and cost is 5,000,000.
• The adjustment is 10,000 (5,010,000 − 5,000,000).
• Journal entry:
  • Increase Investment in ABC Bonds by 10,000 (asset increasing).
  • Increase Unrealized Holding Gain/Loss – Net Income by 10,000 (gain increasing).
• This gain appears on the income statement.

📉 Available-for-sale securities fair value adjustment

Example from the excerpt:

• On December 31, 2018, fair value is 5,010,000 and cost is 5,000,000.
• The adjustment is 10,000 (5,010,000 − 5,000,000).
• Journal entry:
  • Increase Investment in ABC Bonds by 10,000 (asset increasing).
  • Increase Unrealized Holding Gain/Loss – Available-for-Sale by 10,000 (gain increasing).
• This gain appears in stockholders' equity, not on the income statement.

🔄 Closing income statement accounts

• After financial statements are prepared, income statement accounts are closed to Retained Earnings.
• For trading securities: the "Unrealized Holding Gain/Loss – Net Income" account is closed (set to zero) by transferring the balance to Retained Earnings.
• For available-for-sale securities: the "Unrealized Holding Gain/Loss – Available-for-Sale Securities" is a balance sheet account and is not closed.

Example closing entry for trading securities:

• Decrease Unrealized Holding Gain/Loss – Net Income by 10,000 (setting it to zero).
• Increase Retained Earnings by 10,000 (stockholders' equity increasing).

🏦 Selling investments and realized gains/losses

🏦 Step before sale: adjust to fair value on sale date

• Before recording the sale, the investment must be adjusted to its fair value on the date of sale.
• This may create an additional unrealized gain or loss entry.
• Example from the excerpt: Trading securities sold on March 31, 2019, when fair value is 5,008,000 (previously 5,010,000 on December 31, 2018).
  • The investment decreased in value by 2,000.
  • Journal entry: Increase Unrealized Holding Gain/Loss – Net Income by 2,000 (recording a loss) and Decrease Retained Earnings by 2,000.

💰 Recording the sale and realized gain/loss

• Once adjusted to fair value, the sale is recorded.
• The difference between cash received and the carrying amount (fair value on sale date) creates a realized gain or loss.
• Realized gains and losses appear on the income statement under "Other income and expenses."

Example from earlier in the excerpt (held-to-maturity sale):

• Investment sold for 4,885,000 cash; carrying amount was 4,825,000.
• Gain on Sale of Investment = 4,885,000 − 4,825,000 = 60,000 (not shown in detail, but implied).
• Journal entry:
  • Increase Cash by 4,885,000 (asset increasing).
  • Increase Gain on Sale of Investment by 50,000 (gain increasing).
  • Decrease Investment in ABC Bonds by 4,825,000 (asset decreasing).
  • Increase Interest Revenue by 10,000 (revenue increasing).

⚠️ Don't confuse unrealized vs. realized

• Unrealized gain/loss: the investment is still held; only the fair value changed.
• Realized gain/loss: the investment is sold; the gain or loss is "locked in."
• Both types can appear on the income statement, but unrealized gains/losses for available-for-sale securities do not appear on the income statement—they stay in stockholders' equity until the security is sold.

📋 Financial statement presentation

📋 Comprehensive Income Statement structure

The excerpt provides a template showing where investment-related items appear:

Revenues and expenses section:

• Revenues: XXX,XXX
• Expenses: XXX,XXX
• Income from operations: XXX,XXX

Other income and expenses section:

• Investment Income: XXX,XXX (interest revenue from bonds)
• Gain on sale of investment: XXX,XXX (related to held-to-maturity securities)
• Loss on sale of investment: (XXX,XXX) (related to held-to-maturity securities)
• Net income: XXX,XXX

Other comprehensive income section:

• Unrealized holding gain/loss on investments (related to trading securities): XXX,XXX
• Comprehensive income: XXX,XXX

📋 Balance Sheet structure

Assets section:

• Current assets:
  • Trading securities: XXX,XXX (at fair value)
• Long-term investments:
  • Available-for-sale securities: XXX,XXX (at fair value)
  • Held-to-maturity securities: XXX,XXX

Stockholders' Equity section:

• Common Stock: XXX,XXX
• Retained Earnings: XXX,XXX
• Other accumulated comprehensive income:
  • Unrealized holding gain/loss on available-for-sale securities: XXX,XXX

🔑 Key takeaway on presentation

• Trading securities' unrealized gains/losses flow through the income statement and eventually into Retained Earnings (via closing entries).
• Available-for-sale securities' unrealized gains/losses bypass the income statement entirely and accumulate in a separate equity account until the security is sold.
• Realized gains and losses (from actual sales) always appear on the income statement, regardless of the original classification.

🧭 Overview

🧠 One-sentence thesis

Bond investments classified as trading securities report unrealized gains/losses on the income statement, while available-for-sale securities report them in stockholders' equity until sale, creating different financial statement impacts despite similar underlying transactions.

📌 Key points (3–5)

• Two classifications compared: trading securities (expected short-term sale) vs. available-for-sale securities (uncertain sale date) follow parallel accounting but differ in where unrealized gains/losses appear.
• Fair value adjustment: both types are adjusted to fair value at year-end, but trading securities' unrealized gains/losses flow to net income immediately, while available-for-sale securities' unrealized gains/losses accumulate in stockholders' equity.
• Common confusion: the investment account balance increases/decreases identically for both types, but the offsetting account differs—trading uses an income statement account; available-for-sale uses a balance sheet equity account.
• Closing entries: trading securities' unrealized gain/loss accounts close to Retained Earnings annually (like all income statement accounts), but available-for-sale's unrealized gain/loss account remains open as a balance sheet account.
• Sale mechanics: available-for-sale securities require an extra step at sale—transferring the accumulated unrealized gain/loss from equity to the income statement—while trading securities skip this because their unrealized amounts already hit income.

🛒 Purchase and interest accounting

💰 Initial purchase entry

• Both trading and available-for-sale securities record the purchase identically:
  • Debit: Investment in Bonds (asset increases)
  • Credit: Cash (asset decreases)
• The excerpt shows $5,000,000 of four-year, 6% bonds purchased at face amount (no discount or premium).
• Classification decision: trading securities are expected to be sold soon (the example says approximately 9 months); available-for-sale securities have an uncertain sale date.

💵 Recording interest receipts

• Semi-annual interest is recorded the same way for both classifications:
  • Debit: Cash (asset increases)
  • Credit: Interest Revenue (revenue increases)
• Amount = (face amount × annual rate) / 2. Example: ($5,000,000 × 6%) / 2 = $15,000 every six months.
• The investment account balance is not affected by interest receipts; only cash and revenue change.
• This entry repeats every six months (June 30 and December 31 in the example) as long as the investment is held.

🚫 No discount or premium amortization

• The excerpt notes there is no discount or premium for either security because the bonds were purchased at face amount.
• If purchased above or below face value, amortization would be required, but that scenario is not covered here.

📊 Fair value adjustments at year-end

📈 Adjusting trading securities to fair value

Trading securities: unrealized gains or losses are reported on the income statement under "Unrealized Holding Gain/Loss – Net Income."

• At December 31, 2018, the fair value is $5,010,000 vs. cost of $5,000,000 → $10,000 unrealized gain.
• Journal entry:
  • Debit: Investment in ABC Bonds $10,000 (asset increases)
  • Credit: Unrealized Holding Gain/Loss – Net Income $10,000 (gain increases)
• This gain appears on the income statement and flows into net income for the year.
• Why it matters: the gain affects earnings immediately, even though the bonds have not been sold.

📉 Adjusting available-for-sale securities to fair value

Available-for-sale securities: unrealized gains or losses are reported in the stockholders' equity section under "Other Accumulated Comprehensive Income" in the "Unrealized Holding Gain/Loss – Available-for-Sale Securities" account.

• Same fair value scenario: $5,010,000 vs. $5,000,000 → $10,000 unrealized gain.
• Journal entry:
  • Debit: Investment in ABC Bonds $10,000 (asset increases)
  • Credit: Unrealized Holding Gain/Loss – Available-for-Sale $10,000 (gain increases)
• This gain appears on the balance sheet in stockholders' equity, not on the income statement.
• Don't confuse: the investment account balance is identical ($5,010,000) for both types; only the offsetting account differs.

🔄 Closing entries after financial statements

• Trading securities: the Unrealized Holding Gain/Loss – Net Income account is an income statement account, so it closes to Retained Earnings after year-end:
  • Debit: Unrealized Holding Gain/Loss – Net Income $10,000 (set to zero)
  • Credit: Retained Earnings $10,000 (equity increases)
• Available-for-sale securities: the Unrealized Holding Gain/Loss – Available-for-Sale account is a balance sheet account and does not close; it remains in stockholders' equity.
• After closing, the trading securities' unrealized gain/loss account balance is zero; the available-for-sale account still shows $10,000.

🏷️ Sale of bond investments

🔧 Step 1: Adjust to fair value on sale date

• Before recording the sale, adjust the investment to its fair value on the sale date.
• Trading securities example (sold March 31, 2019 at fair value $5,008,000):
  • Carrying amount was $5,010,000 → fair value $5,008,000 → $2,000 unrealized loss.
  • Journal entry:
    • Debit: Unrealized Holding Gain/Loss – Net Income $2,000 (loss increases)
    • Credit: Investment in ABC Bonds $2,000 (asset decreases)
  • Investment account now shows $5,008,000.
• Available-for-sale securities example (sold October 31, 2019 at fair value $5,008,000):
  • Same calculation: $5,010,000 → $5,008,000 → $2,000 unrealized loss.
  • Journal entry:
    • Debit: Unrealized Holding Gain/Loss – Available-for-Sale $2,000 (loss increases)
    • Credit: Investment in ABC Bonds $2,000 (asset decreases)
  • Investment account now shows $5,008,000; the equity account balance drops from $10,000 to $8,000.

🔄 Step 2: Transfer unrealized gain/loss (available-for-sale only)

• Available-for-sale securities only: transfer the accumulated unrealized gain/loss from the balance sheet equity account to the income statement so it is included in net income for the year of sale.
• The excerpt states: "There is no such transfer for trading securities since the Unrealized Holding Gain/Loss – Net Income account is already an income statement account."
• This transfer ensures that the total gain or loss over the holding period eventually appears in net income, even though it was deferred in equity during the holding period.
• Common confusion: trading securities' unrealized amounts hit income each year as they occur; available-for-sale securities' unrealized amounts accumulate in equity and transfer to income only at sale.

📋 Financial statement presentation

📄 Where accounts appear

Account	Trading Securities	Available-for-Sale Securities
Investment in Bonds	Current assets (if short-term)	Long-term investments
Unrealized Holding Gain/Loss	Income statement (Other income and expenses section)	Balance sheet (Other Accumulated Comprehensive Income in stockholders' equity)
Interest Revenue	Income statement (Other income and expenses section)	Income statement (Other income and expenses section)
Gain/Loss on Sale	Income statement (Other income and expenses section)	Income statement (Other income and expenses section)

📊 Comprehensive income statement structure

• The excerpt shows a comprehensive income statement format:
  • Net income includes investment income, gain/loss on sale, and (for trading securities) unrealized holding gain/loss.
  • Other comprehensive income includes unrealized holding gain/loss on available-for-sale securities.
  • Comprehensive income = net income + other comprehensive income.
• Why it matters: available-for-sale securities affect comprehensive income but not net income until sold; trading securities affect net income immediately.

🏦 Balance sheet structure

• Trading securities appear under current assets (if expected to be sold soon).
• Available-for-sale securities appear under long-term investments.
• Held-to-maturity securities (mentioned in the table but not detailed in the excerpt) also appear under long-term investments.
• Other Accumulated Comprehensive Income in stockholders' equity includes the unrealized holding gain/loss for available-for-sale securities.

🧭 Overview

🧠 One-sentence thesis

Bond investments are classified and accounted for differently depending on the investor's intent to hold or sell them, with held-to-maturity bonds carried at amortized cost, while trading and available-for-sale bonds are adjusted to fair value with unrealized gains/losses reported in different financial statement locations.

📌 Key points (3–5)

• Three classifications: held-to-maturity (amortized cost), trading (current assets at fair value), and available-for-sale (long-term investments at fair value).
• Discount/premium amortization: when bonds are purchased below or above face value, the difference is amortized over the bond's life, adjusting the investment account and interest revenue.
• Fair value adjustments: trading and available-for-sale securities are adjusted to fair value at least annually, but unrealized gains/losses are reported in different places—trading on the income statement, available-for-sale in stockholders' equity.
• Common confusion: unrealized holding gains/losses for trading securities go to net income and are closed to retained earnings, while those for available-for-sale securities remain on the balance sheet in stockholders' equity until the investment is sold.
• Sale mechanics: selling available-for-sale securities requires transferring the unrealized gain/loss from the balance sheet to the income statement, while trading securities do not need this step because their unrealized gains/losses are already on the income statement.

💰 Held-to-maturity bonds

💰 Purchase and intent

Held-to-maturity bonds: bonds the investor intends to hold until they mature.

• These bonds are recorded at cost and appear on the balance sheet at amortized cost (not fair value).
• The investor does not plan to sell them before maturity.

📉 Discount amortization

When bonds are purchased below face value (at a discount):

• The discount is the difference between face value and purchase price.
• The discount is amortized (spread) evenly over the bond's remaining life.
• Each period, the investment account increases and interest revenue increases by the amortization amount.
• Formula: (Face value − Purchase price) / Number of years.

Example: A bond with face value $5,000,000 purchased for $4,700,000 with 4 years remaining has a discount of $300,000. Annual amortization = $300,000 / 4 = $75,000. Each year, debit Investment in ABC Bonds $75,000 and credit Interest Revenue $75,000.

📈 Premium amortization

When bonds are purchased above face value (at a premium):

• The premium is the difference between purchase price and face value.
• The premium is amortized over the bond's life, reducing interest revenue each period.
• The investment account decreases and interest revenue decreases by the amortization amount.

🗓️ Partial-year amortization

If a bond is sold partway through a year:

• Amortize the discount or premium for the fraction of the year the bond was held.
• Example: For a bond sold after 4 months of a 12-month period, amortization = annual amount × 4/12.

💸 Sale of held-to-maturity bonds

When the bond is sold:

• Compare the sale price to the carrying amount (original cost ± accumulated amortization).
• If sale price > carrying amount → gain on sale.
• If sale price < carrying amount → loss on sale.
• The seller also receives accrued interest for the period they owned the bond during the current interest period; the buyer pays this amount and is reimbursed when the full interest payment is received.

Example: A bond with carrying amount $4,925,000 sold for $4,875,000 results in a $50,000 loss. If sold for $4,875,000 when carrying amount is $4,825,000, there is a $50,000 gain. Additionally, if sold partway through an interest period, the seller receives a portion of the next interest payment (e.g., 4 months out of 6 months = two-thirds of the semi-annual interest).

📊 Trading securities

📊 Classification and reporting

Trading securities: bond investments the investor intends to sell quickly within one year.

• Appear in the current assets section of the balance sheet.
• Reported at fair value, not cost.
• Unrealized gains or losses (difference between cost and fair value) are reported on the income statement as part of comprehensive income in the Unrealized Holding Gain/Loss – Net Income account.

🔄 Fair value adjustment

At least once annually (typically at year-end):

• Adjust the investment account to its current fair value.
• The adjustment increases or decreases the investment account and the Unrealized Holding Gain/Loss – Net Income account.
• Formula: Fair value − Carrying amount.

Example: If fair value is $5,010,000 and cost is $5,000,000, debit Investment in ABC Bonds $10,000 and credit Unrealized Holding Gain/Loss – Net Income $10,000.

🔚 Closing entries

After financial statements are prepared:

• The Unrealized Holding Gain/Loss – Net Income account (an income statement account) is closed to Retained Earnings.
• This is because all income statement accounts are closed at year-end.

🏷️ Sale of trading securities

Three steps:

1. Adjust to fair value on sale date: Update the investment to fair value and adjust the Unrealized Holding Gain/Loss – Net Income account.
2. No transfer needed: The unrealized gain/loss is already on the income statement, so no separate Gain or Loss on Sale of Investment account is used.
3. Receive cash: Debit Cash and credit Investment in ABC Bonds for the fair value amount.

Example: If fair value on sale date is $5,008,000 and carrying amount is $5,010,000, debit Unrealized Holding Gain/Loss – Net Income $2,000 (a loss) and credit Investment in ABC Bonds $2,000. Then debit Cash $5,008,000 and credit Investment in ABC Bonds $5,008,000.

Don't confuse: Trading securities do not use a separate Gain or Loss on Sale of Investment account because the unrealized gain/loss account is updated immediately before the sale, bringing the investment to fair value.

🏦 Available-for-sale securities

🏦 Classification and reporting

Available-for-sale securities: bond investments that are neither held-to-maturity nor trading.

• Typically appear under Long-Term Investments on the balance sheet.
• Reported at fair value.
• Unrealized gains or losses are reported in the stockholders' equity section under Other Accumulated Comprehensive Income in the Unrealized Holding Gain/Loss – Available-for-Sale Securities account (a balance sheet account, not an income statement account).

🔄 Fair value adjustment

At least once annually:

• Adjust the investment account to fair value.
• The adjustment increases or decreases the investment account and the Unrealized Holding Gain/Loss – Available-for-Sale account.

Example: If fair value is $5,010,000 and cost is $5,000,000, debit Investment in ABC Bonds $10,000 and credit Unrealized Holding Gain/Loss – Available-for-Sale $10,000.

🔚 No closing entry

• The Unrealized Holding Gain/Loss – Available-for-Sale Securities account is a balance sheet account and is not closed at year-end.
• It remains in stockholders' equity until the investment is sold.

Don't confuse: Available-for-sale unrealized gains/losses stay on the balance sheet in stockholders' equity, while trading securities' unrealized gains/losses go to the income statement and are closed to retained earnings.

🏷️ Sale of available-for-sale securities

Three steps:

1. Adjust to fair value on sale date: Update the investment to fair value and adjust the Unrealized Holding Gain/Loss – Available-for-Sale account.
2. Transfer unrealized gain/loss to income statement: Debit (or credit) Unrealized Holding Gain/Loss – Available-for-Sale to zero it out, and credit (or debit) Gain on Sale of Investment (or Loss on Sale of Investment) to move the amount to the income statement so it is included in net income.
3. Receive cash: Debit Cash and credit Investment in ABC Bonds for the fair value amount.

Example: If fair value on sale date is $5,008,000 and carrying amount is $5,010,000, first debit Unrealized Holding Gain/Loss – Available-for-Sale $2,000 and credit Investment in ABC Bonds $2,000. Then debit Unrealized Holding Gain/Loss – Available-for-Sale $8,000 (to close the remaining balance) and credit Gain on Sale of Investment $8,000. Finally, debit Cash $5,008,000 and credit Investment in ABC Bonds $5,008,000.

Why the transfer? The unrealized gain/loss for available-for-sale securities has been sitting in stockholders' equity on the balance sheet. When the investment is sold, the gain or loss becomes "realized" and must be included in net income, so it is transferred to the income statement via the Gain or Loss on Sale of Investment account.

📝 Interest revenue

📝 Semi-annual interest receipts

• Bond issuers typically pay interest semi-annually (every six months).
• The investor records cash received and interest revenue.
• Formula: (Face amount × Annual contract rate) / 2.

Example: For a $5,000,000 bond with a 6% annual rate, semi-annual interest = ($5,000,000 × 6%) / 2 = $15,000. Debit Cash $15,000 and credit Interest Revenue $15,000.

📝 Interest and the investment account

• The receipt of interest does not affect the investment account balance for bonds purchased at face value.
• For bonds purchased at a discount or premium, the investment account is adjusted separately through amortization entries.

📝 Accrued interest on sale

When a bond is sold between interest payment dates:

• The seller receives a portion of the next interest payment based on how long they held the bond during the current interest period.
• The buyer pays this amount to the seller at closing and is reimbursed when the full interest payment is received from the issuer.

Example: If a bond pays $15,000 interest every six months and is sold after 4 months, the seller receives 4/6 (two-thirds) of $15,000 = $10,000. The buyer pays this $10,000 to the seller and receives the full $15,000 from the issuer on the next payment date.

📋 Financial statement presentation

📋 Balance sheet

Classification	Location	Valuation
Trading securities	Current assets	Fair value
Available-for-sale securities	Long-term investments	Fair value
Held-to-maturity securities	Long-term investments	Amortized cost

• Other Accumulated Comprehensive Income (in stockholders' equity) includes the Unrealized Holding Gain/Loss – Available-for-Sale Securities account.

📋 Income statement

Item	Related to	Where it appears
Interest Revenue	All bond types	Other income and expenses
Unrealized Holding Gain/Loss – Net Income	Trading securities	Other comprehensive income
Gain on Sale of Investment	Held-to-maturity and available-for-sale	Other income and expenses
Loss on Sale of Investment	Held-to-maturity and available-for-sale	Other income and expenses

• Comprehensive income = Net income + Other comprehensive income (which includes unrealized holding gains/losses on trading securities).

📋 Key distinction

• Trading securities: Unrealized gains/losses appear on the income statement and are closed to retained earnings after financial statements are prepared.
• Available-for-sale securities: Unrealized gains/losses appear on the balance sheet in stockholders' equity and are not closed; they are transferred to the income statement only when the investment is sold.
• Held-to-maturity securities: No fair value adjustments; gains or losses are recognized only when sold.

🧭 Overview

🧠 One-sentence thesis

Sales tax collected from customers creates a liability that merchandising businesses must periodically remit to state agencies, and it is not a business expense because it represents customers' money rather than the business's own funds.

📌 Key points (3–5)

• Who collects sales tax: merchandising businesses selling to end-users (customers who will use the product themselves, not resell it).
• How it's recorded: sales tax collected accumulates in a liability account called Sales Tax Payable, separate from the Sales account.
• When it's paid: businesses send the accumulated balance to the state sales tax agency periodically (every two weeks, month, or quarter, depending on size and location).
• Common confusion: sales tax is NOT a business expense—it is customers' money being passed through to the government, not the business's own money.

💰 What sales tax is and who collects it

💰 Which businesses collect sales tax

• Merchandising businesses that sell products to end-users are often required to collect state sales tax.
• End-users are defined as customers who intend to use the product themselves rather than sell it to another party.
• The requirement depends on state law and the nature of the sale.

🏛️ Where the money goes

• The collected sales tax is sent to the state sales tax agency.
• Payment frequency varies by business size and location: every two weeks, month, or quarter.

📒 How sales tax is recorded

📒 The Sales Tax Payable account

Sales Tax Payable: a liability account where collected sales tax accumulates until it is remitted to the state.

• This is a liability because the business owes the collected tax to the government.
• The balance grows as sales tax is collected and decreases when payments are made to the state agency.

🧾 Recording sales with sales tax

The excerpt provides four scenarios showing how sales tax affects journal entries:

Transaction type	What happens	Journal entry structure
Sale on account without sales tax	Only the sale amount is recorded	Debit Accounts Receivable; Credit Sales
Sale for cash without sales tax	Only the sale amount is recorded	Debit Cash; Credit Sales
Sale on account with 8% sales tax	Sale amount + tax are recorded separately	Debit Accounts Receivable (total); Credit Sales (base amount); Credit Sales Tax Payable (tax)
Sale for cash with 8% sales tax	Sale amount + tax are recorded separately	Debit Cash (total); Credit Sales (base amount); Credit Sales Tax Payable (tax)

Example: A $1,000 sale with 8% sales tax means the customer pays $1,080 total. The business records $1,000 as Sales revenue and $80 as Sales Tax Payable (a liability).

🔑 Key distinction: Sales vs. Sales Tax Payable

• Sales tax does NOT become part of the Sales account.
• The Sales account reflects only the business's revenue from selling goods.
• The Sales Tax Payable account holds the tax portion, which belongs to the state.

Don't confuse: The total amount received from the customer ($1,080 in the example) is split between two accounts—Sales (revenue) and Sales Tax Payable (liability)—not recorded entirely as Sales.

💸 Paying sales tax to the state

💸 The payment entry

When the business remits the accumulated sales tax to the state agency:

• Debit Sales Tax Payable (decreases the liability)
• Credit Cash (decreases the asset)

Example: If the Sales Tax Payable balance is $5,500 at the end of the month, the business pays $5,500 to the state and records:

• Debit Sales Tax Payable $5,500
• Credit Cash $5,500

❌ Why sales tax is NOT an expense

• Sales tax is customers' money, not the business's money.
• The business acts as a collection agent, passing the tax through to the government.
• Because it is not the business's own funds being spent, it does not appear as an expense on the income statement.

Don't confuse: Even though the business writes a check to the state, this payment reduces a liability (Sales Tax Payable), not an expense account. The business is simply forwarding money it collected on behalf of the government.

🧭 Overview

🧠 One-sentence thesis

Payroll accounting requires employers to withhold legally mandated taxes from employees' gross pay and also to pay matching and additional payroll taxes themselves, making the true cost of an employee significantly higher than their gross pay.

📌 Key points (3–5)

• Gross pay vs net pay: employees earn gross pay but receive net pay (gross minus all withheld taxes).
• Employee withholding taxes: federal income tax, Social Security (6.2%), Medicare (1.45%), and state income tax are deducted from gross pay and held in liability accounts until paid to government agencies.
• Employer matching and additional taxes: employers must match Social Security and Medicare contributions and also pay federal and state unemployment insurance taxes.
• Common confusion: the employee's gross pay is not the employer's total cost—employer payroll taxes add significant expense on top of the gross pay amount.
• Two separate journal entries: one entry records the employee's gross pay, withholdings, and net pay; a second entry records the employer's own payroll tax expense.

💰 Employee compensation basics

💵 Salary vs wage

• Salary: a fixed annual amount (e.g., $52,000 per year), divided by the number of pay periods to determine each paycheck.
• Wage: an hourly rate (e.g., $10 per hour) multiplied by hours worked in the pay period.
• Example: an employee earning $52,000 annually paid weekly receives $1,000 per week gross pay; an employee earning $10/hour working 40 hours weekly receives $400 per week gross pay.

📅 Pay period

Pay period: the span of time included in each paycheck an employee receives.

• Typical pay periods: weekly, bi-weekly, semi-monthly, and monthly.
• The pay period determines how gross pay is calculated (annual salary divided by number of periods, or hourly rate times hours in the period).

💵 Gross pay

Gross pay: the amount an employee earns in a pay period before any payroll taxes or other deductions are subtracted.

• This is the starting point for all payroll calculations.
• Employees do not receive this full amount because taxes are withheld by law.

🏛️ Taxes withheld from employees

🧾 What must be withheld

Employers are required by law to withhold certain taxes from employees' gross pay and pay them to government agencies on the employee's behalf.

Tax	Rate / Method	Purpose
Federal income tax	Use IRS tax tables	Needs of the U.S. population
Social Security tax	6.2% of gross pay	Monthly income when employee reaches retirement age
Medicare tax	1.45% of gross pay	Health insurance benefits at retirement age
State income tax (Georgia)	Use state tax tables	Needs of the state population

📊 Using tax tables for federal and state income tax

Four pieces of information are needed to look up withholding amounts in tax tables:

1. Gross pay amount
2. Pay period (weekly, monthly, etc.)
3. Marital status (single or married)
4. Number of allowances (from employee's Form W4)

• Social Security and Medicare are simple percentages of gross pay.
• Federal and state income taxes require looking up the amount in published tables based on the employee's specific situation.
• Don't confuse: the tax tables provide the withholding amount, not the employee's actual annual tax liability.

💸 Net pay

Net pay: the amount of cash the employee receives in his/her paycheck; gross pay minus taxes withheld.

Formula:
Gross pay − Federal income tax − Social Security tax − Medicare tax − State tax = Net pay

• This is the actual check or deposit the employee receives.
• Example (from Marta Stoward, monthly): $4,000 gross − $620 federal − $248 Social Security − $58 Medicare − $215.19 state = $2,858.81 net pay.

🏢 Employer payroll taxes and costs

🔁 Employer matching requirement

By law, the employer must match what the employee pays in Social Security and Medicare taxes.

• If an employee pays $248 Social Security and $58 Medicare, the employer must also pay $248 and $58.
• These are additional costs to the employer, not deducted from the employee's pay.

🏭 Unemployment insurance taxes

Employers must also pay federal and state unemployment insurance taxes based on a percentage of gross pay.

• Federal unemployment insurance (FUTA): the excerpt uses 0.8% of gross pay.
• State unemployment insurance (SUTA): the excerpt uses 5.4% of gross pay (Georgia example).
• These taxes fund unemployment benefits for workers who lose their jobs.

💡 True cost to employer

The employer's total cost is gross pay plus all employer payroll taxes.

• Example (Marta): $4,000 gross pay + $248 Social Security + $58 Medicare + $32 federal unemployment + $216 state unemployment = $4,554 total monthly cost.
• Common confusion: an employee earning $4,000 per month actually costs the company $4,554 due to required employer taxes—13.85% more than gross pay.

📒 Journal entries for payroll

📝 First entry: recording employee pay and withholdings

When the employee is paid, one journal entry records:

• Debit Salary (or Wage) Expense for the gross pay amount.
• Credit multiple liability accounts for each tax withheld (Federal Income Tax Payable, Social Security Tax Payable, Medicare Tax Payable, State Income Tax Payable).
• Credit Cash for the net pay amount actually paid to the employee.

Example (Marta, 10/31):

Account	Debit	Credit
Salary Expense	4,000.00
Federal Income Tax Payable		620.00
Social Security Tax Payable		248.00
Medicare Tax Payable		58.00
State Income Tax Payable		215.19
Cash		2,858.81

• The liability accounts accumulate withheld taxes until the employer pays them to government agencies (typically by the 15th of the following month).

📝 Second entry: recording employer payroll tax expense

A separate journal entry records the employer's own payroll tax obligations:

• Debit Payroll Tax Expense for the total of all employer taxes.
• Credit Social Security Tax Payable and Medicare Tax Payable for the matching amounts.
• Credit Federal Unemployment Insurance Tax Payable and State Unemployment Insurance Tax Payable for the unemployment taxes.

Example (Marta, 10/31):

Account	Debit	Credit
Payroll Tax Expense	554.00
Social Security Tax Payable		248.00
Medicare Tax Payable		58.00
Federal Unemployment Insurance Tax Payable		32.00
State Unemployment Insurance Tax Payable		216.00

• Don't confuse: this entry does not involve the employee's pay; it records only the employer's additional tax burden.
• The same Social Security Tax Payable and Medicare Tax Payable accounts are used for both employee withholdings and employer matching, so the liability accumulates from both sources.

🔍 Worked example walkthrough

👤 Marta Stoward (monthly, single, 0 allowances)

• Salary: $48,000 per year → $4,000 per month gross pay
• Federal tax: $620.00 (looked up in IRS table for single, monthly, 0 allowances, $4,000 gross)
• Social Security: $248.00 (6.2% × $4,000)
• Medicare: $58.00 (1.45% × $4,000)
• State tax: $215.19 (looked up in Georgia table for single, monthly, 0 allowances, $4,000 gross)
• Net pay: $2,858.81

Employer cost calculation:

• Gross pay: $4,000.00
• Employer Social Security match: $248.00
• Employer Medicare match: $58.00
• Federal unemployment (0.8%): $32.00
• State unemployment (5.4%): $216.00
• Total employer cost: $4,554.00

👤 Ronald Tramp (weekly, married, 2 allowances)

• Wage: $15/hour × 40 hours = $600 per week gross pay

• Federal tax: $30.00 (looked up in IRS table)

• Social Security: $37.20 (6.2% × $600)

• Medicare: $8.70 (1.45% × $600)

• State tax: $26.14 (looked up in Georgia table)

• Net pay: $497.96

• The excerpt provides both examples to show how the same principles apply to different pay structures (salary vs wage) and pay periods (monthly vs weekly).

🧭 Overview

🧠 One-sentence thesis

Bonds allow corporations to raise cash by borrowing from many smaller investors, with the bond's selling price determined by comparing the contract interest rate to the market rate, and the resulting discount or premium is amortized over the bond's term.

📌 Key points (3–5)

• What bonds are: loans from smaller lenders (individuals or corporations) that corporations repay at maturity while paying periodic interest; bondholders are creditors, not owners.
• Three pricing scenarios: bonds sell at face amount when contract rate equals market rate, at a discount when contract rate is less than market rate, and at a premium when contract rate is more than market rate.
• Amortization mechanism: discounts and premiums are expensed (or credited) gradually over the bond term through annual adjusting entries, bringing the carrying amount closer to face amount each year.
• Common confusion—discount vs premium: a discount means the corporation receives less cash upfront but pays full face amount at maturity; a premium means it receives more cash upfront but still pays back only face amount—both compensate for the difference between contract and market interest rates.
• Carrying amount: the bond's book value at any point in time, calculated as Bonds Payable ± Discount/Premium balance; it starts at the issue price and equals face amount at maturity.

💰 What bonds are and why corporations issue them

💰 Definition and purpose

Bonds: loans made by smaller lenders, such as other corporations and individual people.

• Corporations need cash for operations, purchases, or expansion.
• Two main options: issue stock (ownership shares) or borrow money.
• Bonds are a form of debt—an alternative to bank loans—issued in increments (typically $1,000).
• The corporation borrows from many smaller investors collectively to raise the needed amount.
• Bonds are traded on the bond market, similar to stocks on the stock market.

🔑 Key bond terms

Debenture: a loan contract that spells out the terms and conditions of the bond agreement.

The debenture states at minimum:

• Face amount: the amount the bondholder lends to the corporation (e.g., $100,000).
• Contract rate of interest: the annual percentage the corporation commits to pay (e.g., 6% per year); similar to a rental fee for using the lenders' money.
• Term: the number of years the bond covers.
• Maturity date: the date the corporation must pay back the full face amount; no principal is repaid before this date.

👥 Bondholders vs stockholders

• Bondholders: lend money as an investment and earn interest; they are creditors, not owners.
• Stockholders: contribute cash and receive ownership shares.
• Don't confuse: bondholders do not become owners of the corporation.

📅 Payment structure

• Interest is paid semi-annually (twice per year, every six months).
• Number of payments = (2 × number of years in term) + 1 final repayment of face amount.
• Example: a 5-year bond → 10 semi-annual interest payments + 1 principal repayment = 11 total payments.

🎯 How contract rate vs market rate determines bond pricing

🎯 The market rate concept

Market rate of interest: the interest rate that competing corporations are offering to the same prospective investors.

• The market rate may be the same, higher, or lower than the issuing corporation's contract rate.
• This comparison determines the bond's selling price.

📊 Three pricing scenarios

Scenario	Contract vs Market	Bond sells at	Cash received	Why
Equal	Contract = Market	Face amount	$100,000	Total interest payments are competitive; no adjustment needed
Discount	Contract < Market	Less than face	e.g., $96,321	Corporation pays less interest over time, so it compensates by charging less upfront
Premium	Contract > Market	More than face	e.g., $103,769	Corporation pays more interest over time, so it can charge more upfront

🧮 Why discounts and premiums exist

• Discount example: Corporation offers 11% when market offers 12%.
  • Corporation pays $55,000 total interest over 5 years; market pays $60,000.
  • Difference: $5,000 less.
  • To compensate, corporation charges investors $5,000 less upfront (receives $95,000 instead of $100,000).
  • Still pays back full $100,000 at maturity—essentially paying the $5,000 difference upfront.
• Premium example: Corporation offers 12% when market offers 11%.
  • Corporation pays $60,000 total interest; market pays $55,000.
  • Difference: $5,000 more.
  • Corporation charges investors $5,000 more upfront (receives $105,000 instead of $100,000).
  • Still pays back only $100,000 at maturity—collects the extra $5,000 upfront to fund higher interest payments.

🔄 Time value of money adjustment

• The simple discount/premium amounts must be adjusted to present value.
• Example: a $5,000 discount becomes $3,679; a $5,000 premium becomes $3,769.
• Reason: "$1 today is worth more than $1 in the future."
• Don't confuse: the adjusted amounts ($3,679 or $3,769) are the same as the simple amounts ($5,000), just expressed in present-value terms.

📝 Four journal entries for bond transactions

📝 1. Issuing the bond

When contract rate equals market rate (bond sells at face amount):

• Debit Cash for face amount (e.g., $100,000).
• Credit Bonds Payable for face amount ($100,000).
• Example: Issued $100,000 of 5-year, 12% bonds when market rate was 12%.

When contract rate is less than market rate (bond sells at a discount):

• Debit Cash for issue price (e.g., $96,321).
• Debit Discount on Bonds Payable for the discount (e.g., $3,679).
• Credit Bonds Payable for face amount ($100,000).
• Discount on Bonds Payable is a contra liability account (increases with a debit).

When contract rate is more than market rate (bond sells at a premium):

• Debit Cash for issue price (e.g., $103,769).
• Credit Premium on Bonds Payable for the premium (e.g., $3,769).
• Credit Bonds Payable for face amount ($100,000).
• Premium on Bonds Payable is a contra liability account (increases with a credit).

📝 2. Paying semi-annual interest

• Debit Interest Expense for (face amount × contract rate) ÷ 2.
• Credit Cash for the same amount.
• Example: $100,000 × 12% ÷ 2 = $6,000 every six months.
• This entry is recorded every six months (e.g., June 30 and December 31) for the life of the bond.
• The corporation always pays the contract rate, regardless of the market rate.

📝 3. Amortizing the discount or premium

Amortization: expensing a transaction off over time; applies to intangibles (similar to depreciation for physical assets).

Amortizing a discount:

• Debit Interest Expense for discount ÷ number of years.
• Credit Discount on Bonds Payable for the same amount.
• Example: $3,679 discount ÷ 5 years = $736 per year.
• Recorded annually on December 31 as an adjusting entry.
• After 5 years, Discount on Bonds Payable balance is zero.
• Why: the discount is a cost of doing business; it's expensed gradually rather than all at once.

Amortizing a premium:

• Debit Premium on Bonds Payable for premium ÷ number of years.
• Credit Interest Expense for the same amount.
• Example: $3,769 premium ÷ 5 years = $754 per year.
• Recorded annually on December 31 as an adjusting entry.
• After 5 years, Premium on Bonds Payable balance is zero.
• Why: the premium is income; it reduces interest expense gradually (similar to recognizing revenue).

📝 4. Redeeming the bond

• Debit Bonds Payable for face amount (e.g., $100,000).
• Credit Cash for face amount ($100,000).
• Recorded on the maturity date.
• This is the 11th payment to bondholders (after 10 semi-annual interest payments).
• By maturity, the Discount or Premium account has a zero balance, so no adjustment is needed.

📐 Carrying amount: the bond's book value

📐 Definition and calculation

Carrying amount: the bond's book value, or what it is worth at a given point in time.

For bonds issued at a discount:

• Carrying amount = Bonds Payable credit balance − Discount on Bonds Payable debit balance.
• Example: $100,000 − $3,679 = $96,321 at issue.

For bonds issued at a premium:

• Carrying amount = Bonds Payable credit balance + Premium on Bonds Payable credit balance.
• Example: $100,000 + $3,769 = $103,769 at issue.

📐 How carrying amount changes over time

Discount scenario:

• Each year, the Discount on Bonds Payable debit balance decreases (via amortization).
• Carrying amount increases and gets closer to face amount.
• At maturity, carrying amount = face amount ($100,000).

Premium scenario:

• Each year, the Premium on Bonds Payable credit balance decreases (via amortization).
• Carrying amount decreases and gets closer to face amount.
• At maturity, carrying amount = face amount ($100,000).

Example table (discount):

Date	Discount balance	Carrying amount
1/1/11	$3,679	$96,321
12/31/11	$2,943	$97,057
12/31/12	$2,207	$97,793
12/31/13	$1,471	$98,529
12/31/14	$735	$99,265
12/31/15	$0	$100,000

📞 Calling bonds: early redemption

📞 What calling means

Calling bonds: paying them back early, before the maturity date.

• Not all bonds are callable; this must be stipulated in the bond contract.
• The contract determines the call price: at face amount, below face amount (e.g., "called at 99" = 99% of face), or above face amount (e.g., "called at 102" = 102% of face).

📞 Four steps to record a bond call

1. Determine carrying amount: what the bond is currently worth.
2. Determine redemption amount: how much the corporation will pay to redeem early.
3. Compare: carrying amount vs redemption amount → determines gain or loss.
4. Record the journal entry:
   • Debit Bonds Payable for face amount (to zero out).
   • Credit Discount on Bonds Payable (to zero out) OR Debit Premium on Bonds Payable (to zero out).
   • Credit Cash for redemption amount.
   • Debit Loss on Redemption of Bonds OR Credit Gain on Redemption of Bonds (if applicable).

📞 Gain vs loss on redemption

• Loss: corporation pays more cash than the carrying amount.
  • Example: carrying amount $97,000, redemption $102,000 → loss of $5,000.
• Gain: corporation pays less cash than the carrying amount.
  • Example: carrying amount $97,000, redemption $96,000 → gain of $1,000.
• Don't confuse: gains and losses are non-operational (not part of normal business operations); they are similar to revenue and expenses but involve transactions outside the core business.

📞 Analogy: airline ticket pricing

• You pay $400 for a flight; the person next to you paid $250 for the same flight.
• You feel cheated (paid too much) → similar to a loss on bond redemption (paying more than carrying amount).
• If you paid $250 and they paid $400, you feel pleased → similar to a gain (paying less than carrying amount).

📞 Four examples of calling bonds

Bond type	Call price	Carrying amount	Redemption amount	Result	Loss/Gain
Discount	102	$97,000	$102,000	Loss	$5,000
Discount	96	$97,000	$96,000	Gain	$1,000
Premium	104	$103,000	$104,000	Loss	$1,000
Premium	98	$103,000	$98,000	Gain	$5,000

🗓️ Special cases: partial years and partial redemptions

🗓️ Partial years

• Bonds may be issued or redeemed mid-year (not on January 1 or December 31).
• Amortization must be pro-rated to reflect the portion of the year the bond was held.
• Example: bond issued April 1, 2012; premium is $12,000/year = $1,000/month.
  • Held for 9 months in 2012 → amortize $9,000 on December 31, 2012.
• Example: bond redeemed April 1, 2012; discount is $12,000/year = $1,000/month.
  • Held for 3 months in 2012 → amortize $3,000 on April 1, 2012 (before redemption).
• Don't confuse: if redeeming mid-year, record an adjusting entry as of the redemption date to bring the carrying amount up to date.

🗓️ Partial redemptions

• A corporation may redeem only some of its bonds.
• Example: Bonds Payable = $600,000; Discount = $30,000; redeem one-third for $195,000.
  • Debit Bonds Payable $200,000 ($600,000 ÷ 3).
  • Credit Discount on Bonds Payable $10,000 ($30,000 ÷ 3).
  • Credit Cash $195,000.
  • Debit Loss on Redemption $5,000 [$195,000 − ($200,000 − $10,000)].

🧾 Bond accounts summary

🧾 New accounts introduced

Account	Type	Normal balance	Financial statement	To increase	To decrease	Close out?
Bonds Payable	Liability	Credit	Balance Sheet	Credit	Debit	NO
Discount on Bonds Payable	Contra liability	Debit	Balance Sheet	Debit	Credit	NO
Premium on Bonds Payable	Contra liability	Credit	Balance Sheet	Credit	Debit	NO
Interest Expense	Expense	Debit	Income Statement	Debit	Credit	YES
Gain on Redemption of Bonds	Revenue	Credit	Income Statement	Credit	Debit	YES
Loss on Redemption of Bonds	Expense	Debit	Income Statement	Debit	Credit	YES

🧾 Balance sheet presentation

• Current liabilities: installments due within one year (including bonds maturing within one year).
• Long-term liabilities: bonds with maturity dates beyond one year.
• For bond issuances, show:
  • Bonds Payable (face amount).
  • Unamortized discount or premium (if any).
  • Carrying amount (net book value).
• A classified balance sheet organizes assets and liabilities into categories for clearer presentation.

🧭 Overview

🧠 One-sentence thesis

The accounting equation (Assets = Liabilities + Stockholders' Equity) is the foundation for all accounting transactions and must always remain in balance, with stockholders' equity representing the portion of assets owned by stockholders through their investments and the company's accumulated profits.

📌 Key points (3–5)

• The equation must balance: Assets = Liabilities + Stockholders' Equity must be in balance at all times; assets are paid for either by the corporation's own money (equity) or by borrowing (liabilities).
• Two components of stockholders' equity: Common Stock (value from outside investors) and Retained Earnings (value from inside the company through accumulated profits minus dividends).
• How equity increases: issuing stock (increases Common Stock) and/or making a profit (increases Retained Earnings).
• How equity decreases: distributing dividends and/or taking a loss (both decrease Retained Earnings).
• Common confusion: Revenue and expenses don't appear directly in the equation but affect it indirectly—they impact Retained Earnings through closing entries.

💰 The fundamental equation

💰 What the accounting equation is

Accounting equation: Assets = Liabilities + Stockholders' Equity. The basis for all transactions in accounting; it must be in balance at all times.

• It involves the three types of accounts that appear on the balance sheet.
• The corporation has assets, and it must pay for these assets in two ways:
  • Use its own money (stockholders' equity)
  • Borrow and use other people's money (liabilities/debts)

🔗 How revenue and expenses fit in

• Revenue and expense accounts are part of the accounting equation indirectly.
• They impact the value of stockholders' equity through closing entries.
• Closing entries move revenue and expense account balances into Retained Earnings.
• The structure: Common Stock + Retained Earnings = Total Stockholders' Equity, where Retained Earnings breaks down into Revenue and Expenses.

🏢 Stockholders' equity components

🏢 What stockholders' equity is

Stockholders' equity (account category): the amount of a business's total assets that is owned by the stockholders.

• It is the total of the balances in the Common Stock and Retained Earnings accounts.
• Any change in Common Stock, Retained Earnings, or Dividends accounts affects total stockholders' equity.

📥 Common Stock

Common Stock (account): the ownership value in the business that comes from outside the company—investors put their own money into the business.

• This represents contributions from external investors.
• When stock is issued, Common Stock increases.

📊 Retained Earnings

Retained Earnings (account): the ownership value in the business that comes from inside the company—the business makes a profit that is shared by its stockholders.

• It is a company's accumulated profit since it began operations minus any dividends distributed over that time.
• It grows when the business makes a profit.
• It shrinks when dividends are distributed or the business takes a loss.

💸 Dividends

Dividends (account): distributions of profits from Retained Earnings to stockholders.

• Dividends reduce Retained Earnings.
• They represent a way stockholders receive value from the company's profits.

⬆️⬇️ Changes in stockholders' equity

⬆️ How stockholders' equity increases

Stockholders' equity can increase in two ways:

1. Stock is issued → Common Stock increases
2. Business makes a profit → Retained Earnings increases

• Both pathways add to the total ownership value in the company.
• Example: An organization issues new shares to investors (pathway 1) or generates net income from operations (pathway 2).

⬇️ How stockholders' equity decreases

Stockholders' equity can decrease in two ways:

1. Dividends are distributed → Retained Earnings decreases
2. Business takes a loss → Retained Earnings decreases

• Both pathways reduce the total ownership value in the company.
• Don't confuse: dividends are not expenses; they are distributions of already-earned profits, so they reduce Retained Earnings directly, not through the income statement.

🧭 Overview

🧠 One-sentence thesis

Stockholders' equity represents the ownership value in a corporation, which increases through stock issuance and retained profits and decreases through dividends and losses, with detailed accounts tracking the sources and changes in this ownership value.

📌 Key points (3–5)

• Two sources of equity: Common Stock (outside money from investors) and Retained Earnings (inside money from accumulated profits).
• Four ways equity changes: increases when stock is issued or profit is earned; decreases when dividends are distributed or losses occur.
• Corporation characteristics: separate legal entity with ongoing existence and limited liability for stockholders.
• Common confusion: the generic Common Stock account is replaced by six more specific accounts (par value, paid-in capital in excess of par, preferred stock, treasury stock, etc.) for detailed tracking.
• Key relationship: Total stockholders' equity = Paid-in capital + Retained Earnings, which answers "what are the owners worth?"

🏢 What a corporation is

🏢 Legal structure and characteristics

A corporation is a form of business organization that is a separate legal entity; it is distinct from the people who own it.

• The corporation itself can own property, enter contracts, borrow money, conduct business, earn profit, pay taxes, and make investments—just like an individual.
• Owners are called stockholders: people who invest cash or other assets and receive shares of stock (transferable units of ownership) in return.
• The value of stock received equals the value of assets contributed.

♾️ Ongoing existence

• Corporations are ongoing: stockholders can buy and sell shares without interrupting operations.
• A corporation may be owned by one stockholder or millions.
• Very small companies can incorporate by filing articles of incorporation with a state.

🛡️ Limited liability

• Stockholders can lose no more than the amount they invested.
• If the corporation fails, individual owners do not personally have to cover the corporation's liabilities.
• Example: An investor puts in $10,000; even if the corporation owes $1 million, the investor's personal assets are protected.

💰 Two sources of stockholders' equity

💵 Common Stock (outside money)

Common Stock (account) is the ownership value in the business that comes from outside the company—investors put their own money into the business.

• This is value contributed by stockholders when they invest their personal assets.
• It represents the initial and ongoing capital raised by issuing stock.

🏦 Retained Earnings (inside money)

Retained Earnings (account) is the ownership value in the business that comes from inside the company—the business makes a profit that is shared by its stockholders.

Retained earnings is a company's accumulated profit since it began operations minus any dividends distributed over that time.

• This is the running balance of profit the company has earned and kept (not distributed).
• It reflects the business "doing what it was set up to do" and generating profit.
• Stockholders are attracted to invest because of this earnings potential over time.

🧮 The accounting equation connection

Assets = Liabilities + Stockholders' Equity

• Stockholders' Equity = Common Stock + Retained Earnings
• Revenue and expense accounts indirectly affect this equation: they impact Retained Earnings through closing entries.
• The corporation pays for assets either with its own money (equity) or by borrowing (liabilities/debts).

📈 How stockholders' equity changes

⬆️ Two ways equity increases

1. Stock is issued → Common Stock increases
2. Business makes a profit → Retained Earnings increases

• Issuing stock brings in outside capital.
• Earning profit builds inside value.

⬇️ Two ways equity decreases

1. Dividends are distributed → Retained Earnings decreases
2. Business takes a loss → Retained Earnings decreases

Dividends (account) are distributions of profits from Retained Earnings to stockholders.

• Dividends reduce the accumulated profit on hand.
• Losses directly reduce the profit balance.
• Don't confuse: dividends are not expenses; they are distributions of already-earned profit.

🔄 Summary of changes

Change	Account affected	Direction	Source
Stock issued	Common Stock	Increase	Outside investors
Profit earned	Retained Earnings	Increase	Business operations
Dividends paid	Retained Earnings	Decrease	Distribution to owners
Loss incurred	Retained Earnings	Decrease	Business operations

📊 Detailed stockholders' equity accounts

📋 From generic to specific

• Previously: only Common Stock and Retained Earnings were used.
• Now: six new accounts describe equity in more specific detail.
• The goal: arrive at one number—total stockholders' equity—which tells owners "what they are worth."

🧾 New account categories

The excerpt introduces these accounts in a summary table:

Stockholders' Equity accounts (all have credit normal balance):

• Common Stock (CS)
• Paid-in Capital in Excess of Par - CS
• Preferred Stock (PS)
• Paid-in Capital in Excess of Par - PS
• Paid-in Capital from Sale of Treasury Stock
• Stock Dividends Distributable

Contra Stockholders' Equity accounts (debit normal balance):

• Treasury Stock
• Cash Dividends
• Stock Dividends

💡 Paid-in capital concept

The total value of the first five stockholders' equity accounts (tracking owner investments) is called paid-in capital.

• Total stockholders' equity = Total paid-in capital + Retained Earnings
• Common Stock, Preferred Stock, and Stock Dividends Distributable amounts can only be in multiples of par value.
• Use Paid-in Capital in Excess of Par for any differences between issue price and par value.

📄 Balance sheet presentation

The excerpt shows a comparison:

• Left (simple): Common Stock $30,000 + Retained earnings $46,000
• Right (detailed):
  • Common stock, $5 par (20,000 shares authorized, 4,000 shares issued): $20,000
  • Paid-in capital in excess of par - common stock: $3,000
  • Preferred stock $1, $10 par (10,000 shares authorized, 500 shares issued): $5,000
  • Paid-in capital in excess of par - preferred stock: $1,000
  • Paid-in capital from sale of treasury stock: $4,000
  • Retained earnings: $46,000
  • Deduct treasury stock: $3,000

📝 Dividends on the retained earnings statement

• Cash dividends reduce Retained Earnings (as before).
• Stock dividends also reduce Retained Earnings (new concept introduced).
• Example from the excerpt: Net income $11,000 less Cash dividends $2,000 and Stock dividends $3,000 = Increase in retained earnings $6,000.

🎫 Stock authorization and issuance

🎫 Shares authorized

Shares authorized is the number of shares a corporation is allowed to issue (sell).

• For large corporations, this is based on a decision by the Board of Directors (a group elected to represent stockholders).
• Authorization is just permission; no actual transaction has occurred.
• Therefore, no journal entry is recorded for stock authorization.

🎫 Shares issued

Shares issued is the number of shares a corporation has sold to stockholders for the first time.

• The number of shares issued cannot exceed the number of shares authorized.
• "Issue" means to sell the shares of stock for the first time.
• When a company issues stock, it raises money; investors become owners (stockholders).
• A journal entry must be recorded when stock is issued (the excerpt notes this but does not provide the entry details).

🔍 Don't confuse authorized vs issued

• Authorized: permission to sell (no transaction, no entry).
• Issued: actually sold to stockholders (transaction occurs, entry required).
• Example: A corporation is authorized to issue 20,000 shares but has only issued 4,000 shares so far.

🧭 Overview

🧠 One-sentence thesis

When a corporation issues stock for cash, it records the par value in the stock account and any premium above par in a separate paid-in capital account, thereby increasing both assets and stockholders' equity.

📌 Key points (3–5)

• What "issuing stock" means: selling shares to investors for the first time to raise money; investors become stockholders (owners).
• Par value vs. issue price: par value is an assigned amount per share; if the issue price exceeds par, the excess goes to a separate "Paid-in Capital in Excess of Par" account.
• Common confusion: the Common Stock account is always credited at par value only, never at the actual issue price—the difference is captured in the excess account.
• Two types of stock: common stock (standard ownership) and preferred stock (more predictable dividends); both follow similar journal entry rules.
• Authorization vs. issuance: authorization is permission to sell shares (no journal entry); issuance is the actual sale (requires a journal entry).

📋 Key terminology and structure

📋 Shares authorized vs. shares issued

Shares authorized: the number of shares a corporation is allowed to issue (sell), based on a decision by the Board of Directors.

• Authorization is just permission; no transaction has occurred yet, so no journal entry is recorded.
• Think of it like a credit card limit: you're approved for up to $5,000, but you don't have to charge that amount immediately.

Shares issued: the number of shares a corporation has sold to stockholders for the first time.

• The number of shares issued cannot exceed the number authorized.
• If the company wants to issue more shares than authorized, it must request an increase from the Board of Directors (like requesting a higher credit limit).

💰 Paid-in capital

Paid-in capital: the total value of owner investments, tracked through stockholders' equity accounts.

• Paid-in capital + Retained Earnings = total stockholders' equity.
• Retained Earnings keeps a running balance of accumulated profit on hand.

🏷️ Par value

Par value: an amount assigned to each share of stock when it is authorized.

• Par value is not necessarily the same as the issue price (the actual selling price).
• The Common Stock account can only be credited in multiples of the par value per share.

💵 Issuing common stock for cash

💵 When issue price equals par value

Scenario: Issued 15,000 shares of $10 par common stock for $10 per share.

Journal entry:

• Debit Cash: 150,000 (15,000 shares × $10)
• Credit Common Stock: 150,000 (15,000 shares × $10)

What happens:

• Cash (an asset account) increases.
• Common Stock (a stockholders' equity account) increases.
• Because the issue price equals par value, no additional account is needed.

💵 When issue price exceeds par value

Scenario: Issued 15,000 shares of $10 par common stock for $12 per share.

Journal entry:

• Debit Cash: 180,000 (15,000 shares × $12)
• Credit Common Stock: 150,000 (15,000 shares × $10 par)
• Credit Paid-in Capital in Excess of Par - Common Stock: 30,000 (15,000 shares × $2 premium)

Why the split:

• The Common Stock account can only be credited at par value ($10 per share).
• The extra $2 per share (the premium) is credited to a separate account: Paid-in Capital in Excess of Par - Common Stock.
• All three accounts (Cash, Common Stock, and Paid-in Capital in Excess of Par) increase.

Don't confuse: The issue price is what investors actually pay; par value is just an assigned amount. The Common Stock account never reflects the issue price directly—only the par value portion.

🎯 Issuing preferred stock for cash

🎯 How preferred stock differs

Preferred stock: a type of stock with a more predictable dividend payment (covered later in the material).

• The journal entry mechanics are very similar to common stock.
• Instead of Common Stock and Paid-in Capital in Excess of Par - Common Stock, you use Preferred Stock and Paid-in Capital in Excess of Par - Preferred Stock.

🎯 Example entry

Scenario: Issued 1,000 shares of $100 par preferred stock for $105 per share.

Journal entry:

• Debit Cash: 105,000 (1,000 shares × $105)
• Credit Preferred Stock: 100,000 (1,000 shares × $100 par)
• Credit Paid-in Capital in Excess of Par - Preferred Stock: 5,000 (1,000 shares × $5 premium)

What increases:

• Cash (asset account)
• Preferred Stock (stockholders' equity account)
• Paid-in Capital in Excess of Par - Preferred Stock (stockholders' equity account)

🎯 Dividend information in preferred stock descriptions

Preferred stock information may include a dollar amount or percentage:

• Example 1: "$1 preferred, $100 par" means a $1 dividend per share.
• Example 2: "1% preferred, $100 par" means 1% of $100 = $1 dividend per share.

Important: This dividend information ($1 or 1%) is not a factor in the journal entry for issuing the stock—it only affects future dividend payments.

🏗️ Issuing stock for non-cash assets

🏗️ When and why

• Stock may be issued for assets other than cash: services, land, equipment, vehicles, accounts receivable, inventory.
• More common in small corporations than large ones.
• The assumption: the value of the asset and the value of the stock are equal.

🏗️ When issue price equals par value

Scenario: Issued 10,000 shares of $20 par common stock for land. The fair market value of the stock is $20 per share.

Journal entry:

• Debit Land: 200,000 (10,000 shares × $20)
• Credit Common Stock: 200,000 (10,000 shares × $20 par)

How it works:

• The value of the stock can be calculated (10,000 × $20 = $200,000).
• The value of the land is set equal to that same amount.
• Land (an asset account) increases; Common Stock (a stockholders' equity account) increases.

🏗️ When issue price exceeds par value

Scenario: Issued 10,000 shares of $20 par common stock for land. The fair market value of the stock is $25 per share.

Journal entry:

• Debit Land: 250,000 (10,000 shares × $25)
• Credit Common Stock: 200,000 (10,000 shares × $20 par)
• Credit Paid-in Capital in Excess of Par - Common Stock: 50,000 (10,000 shares × $5 premium)

Why the split:

• The value of the stock ($25 per share) is given; the land's value equals the stock's value.
• The Common Stock account is credited only for the par value per share ($20).
• The Paid-in Capital in Excess of Par - Common Stock account captures the difference between the land's value and the stock's total par value.

Don't confuse: Whether the company receives cash or a non-cash asset, the rule is the same—Common Stock is always credited at par value, and any premium goes to the excess account.

🧭 Overview

🧠 One-sentence thesis

Corporations can issue stock in exchange for non-cash assets or services, recording the transaction by assuming the stock and the asset have equal value and splitting the credit between par value and any premium.

📌 Key points (3–5)

• What non-cash issuance means: stock is exchanged for assets (land, equipment, services) or other items instead of cash, more common in small corporations.
• Core assumption: the value of the asset received and the value of the stock issued are assumed to be equal.
• How to record: debit the asset account for its value; credit Common Stock for total par value; credit Paid-in Capital in Excess of Par for any premium.
• Common confusion: which value to use—either the stock's fair market value or the asset's fair market value must be known; the other is set equal to it.
• Key rule: the Common Stock account can only be credited for par value per share; any excess goes to Paid-in Capital in Excess of Par.

💼 What non-cash issuance covers

💼 Types of non-cash assets

• Stock may be issued for:
  • Physical assets: land, equipment, vehicles, inventory
  • Financial assets: accounts receivable
  • Services: legal fees, engineering services (recorded as Organization Costs)
• The excerpt notes this is more common in small corporations than in larger ones.

🔄 Journal entry structure

• The journal entries are similar to issuing stock for cash, but instead of debiting Cash, you debit the specific asset or expense account.
• The credit side follows the same rules: Common Stock at par, and any premium to Paid-in Capital in Excess of Par.

🧮 Recording transactions: the core assumption

🧮 Equal value assumption

The assumption is that both the asset and the stock have the same value.

• When stock is issued for a non-cash asset, the corporation assumes the value of what it receives equals the value of the stock it gives up.
• In practice: either the stock's fair market value or the asset's fair market value must be known; the other is set equal to it.

🔍 Which value is known?

The excerpt shows three scenarios:

Scenario	What is known	What is calculated
Stock value known	Fair market value of stock per share	Asset value = stock value
Asset value known	Fair market value of the asset	Stock value = asset value
Either can be known	One of the two	The other is set equal

• Example (Scenario 1): 10,000 shares issued, stock fair market value $25 per share → land value is set at $250,000.
• Example (Scenario 2): Land fair market value is $250,000 → stock value is set at $250,000.

📝 Recording at par value vs. above par

📝 When stock is issued at par

• Situation: the fair market value of the stock equals its par value.
• Journal entry:
  • Debit the asset (e.g., Land) for total value
  • Credit Common Stock for total par value (shares × par value per share)
• Example: 10,000 shares of $20 par stock issued at $20 per share for land:
  • Debit Land $200,000
  • Credit Common Stock $200,000
• No premium, so no Paid-in Capital in Excess of Par account is used.

📝 When stock is issued above par

• Situation: the fair market value of the stock is higher than par value.
• Journal entry:
  • Debit the asset for total value (shares × fair market value per share)
  • Credit Common Stock for total par value (shares × par value per share)
  • Credit Paid-in Capital in Excess of Par – Common Stock for the difference (premium)
• Example: 10,000 shares of $20 par stock issued at $25 per share for land:
  • Debit Land $250,000
  • Credit Common Stock $200,000 (10,000 × $20)
  • Credit Paid-in Capital in Excess of Par $50,000 (10,000 × $5)
• Key rule: the Common Stock account can only be credited for par value per share; the premium must go to a separate equity account.

🚫 Don't confuse: total value vs. par value

• The total value of the transaction is the fair market value (either of the stock or the asset).
• The par value is a fixed amount per share set in the corporate charter.
• The Common Stock account reflects only par value; any excess is recorded separately.

🛠️ Issuing stock for services

🛠️ Organization Costs

Organization Costs are expenses incurred to start a business, such as legal fees. This is an asset account.

• When a corporation issues stock to pay for services (e.g., attorney fees, engineering services), the debit goes to Organization Costs instead of a tangible asset like Land.
• Organization Costs is treated as an asset account that is increasing.

🛠️ Recording service transactions

• The same rules apply: assume the value of the services equals the value of the stock issued.
• Example (at par): 1,000 shares of $10 par stock issued at $10 per share for attorney services:
  • Debit Organization Costs $10,000
  • Credit Common Stock $10,000
• Example (above par): 1,000 shares of $10 par stock issued at $12 per share for engineer services:
  • Debit Organization Costs $12,000 (1,000 × $12)
  • Credit Common Stock $10,000 (1,000 × $10)
  • Credit Paid-in Capital in Excess of Par $2,000 (1,000 × $2)
• The fair market value of the stock determines the value of the services received.

🏦 Account classifications

🏦 Which accounts increase

Every transaction in the excerpt involves:

Account	Type	Direction
Asset (Land, Organization Costs, etc.)	Asset	Increasing (debit)
Common Stock	Stockholders' Equity	Increasing (credit)
Paid-in Capital in Excess of Par – Common Stock	Stockholders' Equity	Increasing (credit, if premium exists)

• Asset accounts increase by debiting.
• Stockholders' equity accounts increase by crediting.
• The excerpt consistently notes that all three accounts are increasing in these transactions.