Accounting Basics (Word Scramble)

The balance sheet is a snapshot of a company’s financial position at a specific point in time. It lists the company’s assets, liabilities, and owner’s or stockholders’ equity as of the final moment of the date shown in the heading of the balance sheet.

Example: A retailer’s balance sheet dated December 31 will report the amounts of its cash, accounts receivable, inventory, equipment and other assets, as well as the amounts it owes to others (accounts payable and other liabilities) as of midnight on December 31. The difference between the total assets and total liabilities appears as owner’s or stockholders’ equity.

The accrual basis of accounting reports revenues when they are earned and expenses when they are incurred, regardless of when cash is received or paid out. This provides a better measure of a company’s performance and financial position than the cash basis.

Example: Assume a company incurs $5,000 of consulting services expense in December but pays the consultant in January. Under the accrual basis the company will record the $5,000 expense in December when it was incurred.

Depreciation is the systematic allocation of the cost of a long-term tangible asset with a limited useful life. Land is an asset that is not depreciated because land is assumed to have an unlimited useful life.

Example: Assume a company purchases real estate for $500,000. The appraisal shows that 80% of the cost is associated with the building and 20% is associated with the land. The $400,000 associated with the building will be depreciated over the building’s estimated useful life but $100,000 associated with the land is not depreciated.

Accumulated depreciation is a contra asset account that reports the total amount of depreciation expense that has been recorded for an asset up to the date of the balance sheet. This account will have a credit balance that is related to the asset’s cost.

Example: If equipment that cost $50,000 has accumulated depreciation of $20,000 at the end of the year, the book value or carrying value of the equipment is $30,000 ($50,000 cost - $20,000 accumulated depreciation). Each year’s depreciation expense increases the credit balance in the accumulated depreciation account.

The amount of prepaid insurance that has expired or has been used up during an accounting period is reported as insurance expense on the income statement for that period.

Example: If a company pays $12,000 on January 1 for a 12-month insurance policy, each month $1,000 of the prepaid amount expires and is recorded as Insurance Expense ($12,000 / 12 months = $1,000 per month). The remaining prepaid amount is reported as an asset on the balance sheet until it is used up.

When a credit entry is made to the Cash account, it decreases the account balance. Cash is an asset account, and asset accounts normally have debit balances. Therefore, credits decrease the debit balances.

Example: If a company’s Cash account has a debit balance of $5,000 and it writes a check for $2,000 to pay a bill, the $2,000 credit to Cash decreases the account’s debit balance to $3,000.

The basic accounting equation states that Assets = Liabilities + Owner’s (or Stockholders’) Equity. This must always hold true - the two sides must have the same total amount. The equation forms the framework for the balance sheet.

Example: If a corporation has total assets of $100,000 and liabilities of $40,000, the stockholders’ equity must be $60,000 for the equation to balance ($100,000 = $40,000 + $60,000). An increase in assets must be balanced by an equal increase in liabilities and/or stockholders’ equity, or another asset must decrease.

Revenues cause a corporation’s stockholders’ equity to increase. Revenues increase net income which flows into retained earnings, a component of stockholders’ equity. Expenses have the opposite effect, decreasing net income and stockholders’ equity.

Example: If a corporation earns $50,000 of revenues and has $30,000 of expenses, the $20,000 net income increases retained earnings and total stockholders’ equity by $20,000. The revenues increased equity; expenses will decrease it.

The chart of accounts is a listing of the general ledger accounts that are available for recording transactions. The chart of accounts does not include any amounts, only the account names and numbers.

Example: A company’s chart of accounts will list all the asset, liability, equity, revenue and expense accounts in the order they appear in the general ledger, such as Cash, Accounts Receivable, Accounts Payable, Common Stock, Sales Revenue, Salaries Expense, etc.

The income statement accounts, which are the revenue, expense, gain and loss accounts, are temporary or nominal accounts that accumulate amounts for a period of time. The temporary account balances are closed out to an equity account at the end of the accounting year.

Example: During the year, a corporation records its sales in a Sales Revenue account and its various expenses in expense accounts. At the end of the year, it closes all these income statement accounts to Income Summary and then closes Income Summary to the Retained Earnings balance sheet account. This results in the income statement accounts starting in the new year with zero balances.

Nearly all companies use the indirect method for the statement of cash flows. It begins with the company’s net income and then adjusts it for expenses that didn’t use cash and revenues that didn’t involve cash.

Example: The statement of cash flows is one of the 5 main financial statements that corporation’s must issue at the end of each accounting year. The operating activites section shows the cash generated or used by the company’s main business operations.

The amount of prepaid insurance that has not yet expired or not used up as of the balance sheet date is reported as an asset, typically a current asset (if it will expire within one year). Only the unexpired portion is an asset; the expired portion is an expense.

Example: Assume a company paid $12,000 on January 1 for a 12-month insurance policy. As of June 30, half of the insurance has expired and half is still an asset. The June 30 balance sheet would report Prepaid Insurance of $6,000 as a current asset ($12,000 x 6/12 months for the insurance that has not yet expired). The other $6,000 would have been expensed over the first 6 months on the income statement.

The cost (or historical cost) principle is the accounting principle that states that land should be recorded at it’s cost at the time of the transaction and not be adjusted for changes in it’s market value. This provides an objective, reliable measurement basis for the asset land.

Example: If a company purchased land for $500,000, it would report the land on its balance sheet at the $500,000 historical cost. The $500,000 is not increased even if the market value of the land later increases to $750,000. (Land is assumed to have an unlimited useful life and therefore it is not depreciated).

The double-entry system of accounting means that every transaction affects at least two general ledger accounts, with debit amounts equal to credit amounts. This keeps the accounting equation in balance and provides accuracy and completeness to the records.

Example: If a company buys supplies for $1,000 cash, it will debit Supplies for $1,000 and credit Cash for $1,000. The asset Supplies increases and the asset Cash decreases; the total amount of assets remains unchanged.

Unearned revenues arise when a company receives money in advance from a customer for goods or services that have not yet been provided. Since the revenues are not yet earned, the amount is reported as a liability on the balance sheet until it is earned. (When it is earned, it will be reported as revenues on the income statement).

Example: Assume a company receives $5,000 from a customer on December 1 for services to be performed over the next 6 months. The company should record a liability Unearned Revenues for $5,000 on December 1. Each month, as 1/6 of the services are provided, $833.33 should be moved from Unearned Revenues to Service Revenues. By the end of the 6 months, the entire $5,000 will be earned and the liability will be $0.

Under the accrual basis of accounting, a company records revenues when they are earned, even if cash has not yet been received. The amount that customers owe for sales made with credit terms are recorded as an increase to the asset Accounts Receivable

Example: If a company makes a $1,000 sale on credit on March 1, it will debit Accounts Receivable for $1,000 and credit Sales Revenue for $1,000 on that date. When the customer pays the $1,000 on April 15, the company will debit Cash and credit Accounts Receivable. Accounts Receivable represents amounts the company has a right to receive from customers for sales already made.

Under the accrual basis of accounting, revenues are reported on the income statement when the revenues are earned, not necessarily when cash is received.

Example: If a company provides a service for a client in December for $4,000, it will record $4,000 of revenues in December (even if the client does not pay until January). The revenues are earned and the company has a right to receive the $4,000 as of December.

After confirming that the information on the supplier’s invoice agrees with the company’s purchase order and the goods received, the company records the transaction with a credit to Accounts Payable, thereby increasing this liability account’s balance.

Example: If a company purchases $6,000 of inventory on credit on June 5, terms n/30, the company will record the purchase with a debit to Inventory (or Purchases) and a credit to Accounts Payable for $6,000. Accounts Payable represents amounts the company owes to suppliers for goods or services received but not yet paid for as of the balance sheet date.

Depreciation is the process of allocating the cost of a company’s plant assets to expense over the assets’ useful lives. The purpose is to match the cost to the periods when the assets are being used to generate revenues. The purpose is NOT to value the assets.

Example: A company buys a $50,000 machine with a 5-year life and no salvage value. Each year, it records $10,000 of depreciation expense ($50,000 / 5 years). This expense reflects the portion of the asset’s cost that was used up each year. After 5 years, the asset’s cost has been fully depreciated. Depreciation is an allocation process, not a valuation process.

Retained Earnings is a balance sheet account that represents the cumulative net income a corporation has earned over its life, minus the cumulative amount of dividends it has paid out to stockholders. It is a key part of stockholders’ equity and a link between the income statement and balance sheet.

Example: If a corporation has earned a total of $500,000 of net income since it began and has paid out $100,000 of dividends, its ending Retained Earnings balance would be $400,000. Each year, a positive net income will increase the balance in Retained Earnings. Dividends will decrease the balance in Retained Earnings.