Balance Sheet and Income Statement Accounts

                            Balance Sheet and Income Statement Accounts

Balance Sheet and Income Statement Accounts

Lecture and Reading Material

Introduction

There are four steps to the Accounting Cycle:

1) Record transactions in the accounting records.  Every transaction that has an economic impact requires a  journal entry.  Hiring a new employee does not require a journal entry until the employee has actually started working.  Once the employee has started working, an economic impact has occurred, thus requiring a journal entry.

2) Prepare accounting adjustments to update Balance sheet and income statement accounts.

These are adjusting entries.

3) Prepare financial statements.

4) Close the books to prepare for a new accounting cycle.

Let’s focus on steps 1, 2, and 4.

Recording Transactions

You were introduced to the Balance Sheet equation which is the foundation of accounting last week.  The Balance sheet equation is: Assets equals Liabilities plus Stockholders’ equity. The left side of the Balance sheet equation is the debit side and the right side of the equation is the credit side.  The Balance Sheet equation must remain in balance for every journal entry meaning the left side and the right side of the equation must be equal.  To increase the left side of the equation, we debit the account.  To increase the right side of the equation, we credit the account.  Of course, to decrease the left side of the equation, we credit the account and to decrease the right side we debit the account.

Here are a few common journal entry transactions:

1) The company issued $200,000 worth of common stock for Cash.

Since cash is an asset that has increased, we will debit Cash on the left side of the Balance Sheet equation for $200,000.

Since common stock is an equity account that has increased, we will credit Common stock on the right side of the Balance Sheet equation for $200,000.

The journal entry would look like this:

Debit Cash   $200,000

Credit Common stock   $200,000

To record the issuance of $200,000 worth of Common stock for Cash

The impact of this transaction on the Balance sheet equation is that the left side of the equation increased by $200,000 and the right side also increased by $200,000.

2) The company purchased $50,000 worth of inventory with Cash.

Since inventory is an asset that has increased, we will debit Inventory on the left side of the Balance sheet equation.

Since Cash is an asset that has decreased, we will credit Cash on the left side of the Balance sheet equation.

The journal entry would look like this:

Debit Inventory  $50,000

Credit Cash          $50,000

To record the purchase of $50,000 worth of inventory with Cash

The impact of this transaction is that one asset account, Inventory, has increased by $50,000 and another asset account, Cash, has decreased by $50,000.

Please note that the Balance sheet equation still remains in balance even though both accounts are on the left side of the Balance sheet equation.

Important Point: We should always debit Cash when cash is received and credit Cash when cash is spent.  

3) The company purchased $7,000 worth of Supplies using credit.

Since Supplies is an asset that has increased, we will debit Supplies on the left side of the Balance Sheet equation.

Since the supplies were purchased using credit, we will credit the Accounts Payable liability account on the right side of the Balance Sheet equation.

The journal entry for this transaction would look like this:

Debit Supplies $7,000

Credit Accounts Payable     $7,000

To record the purchase of $7,000 worth of Supplies using credit

The impact of this transaction on the Balance sheet equation is that the left side of the equation increased by $7,000 and the right side also increased by $7,000.

Using the Balance Sheet equation is one way to know whether to debit or credit an account.

Normal Balances

Another method is to use the normal balance of each account.  The normal balance for an account on the left side of the Balance Sheet equation is a debit balance so we increase these accounts with a debit.  The normal balance for accounts on the right side of the Balance Sheet equation is a credit balance so we increase these accounts with a credit.

Balance Sheet Equation Normal Balances

Please note that Stockholders’ equity has some accounts that add to equity and other accounts that take away from equity.  Revenue adds to equity so we credit Revenue while expenses and dividends take away from equity so we debit these accounts.  In summary,

Stockholders’ Equity Normal Balances

Accounting Adjustments

Accounting adjustments are needed to ensure that revenue and expenses are properly recorded on the Income statement and assets and liabilities are properly reported on the Balance Sheet.  Accounting adjustments are accomplished through the creation of adjusting journal entries.  There are four types of adjusting entries:

1)  Prepaid expenses result from cash payments made in advance for expenses.

For example, a company pays $15,000 for an annual insurance policy.  The journal entry would be as follows:

Debit Prepaid Insurance $15,000

Credit Cash                             $15,000

To record cash paid in advance for insurance

Please note the above entry is not an adjusting entry since the Cash account is never used in an adjusting entry.

Monthly, an adjusting entry is needed to charge for the insurance used.  This entry would be as follows:

Debit Insurance Expense ($18,000 divided by 12 months)  $1,500

Credit Prepaid Insurance      $1,500

To charge for monthly insurance used

2)  Unearned revenues result when cash is received from customers prior to any goods or services being provided.

For example, a customer pays $10,000 cash in advance for house painting.

Debit Cash   $10,000

Credit Unearned Revenue $10,000

To record cash received in advance of painting services

Please note Unearned Revenue is a liability account.  The $10,000 will not become revenue until the house has been painted.

An adjusting entry is needed when the painting has been completed. The adjusting entry would look like this:

Debit Unearned Service Revenue $10,000

Credit Service Revenue                          $10,000

To record earned revenue

3)  Accrued expenses are expenses incurred but not yet paid.

For example, a company at year-end needs to record payroll for December 28 through December 31 of the current year even though payment will not go out until January 2 of the new year.  Daily payroll is $20,000.

The adjusting journal entry would look like this:

Debit Wage Expense ($20,000 times 4 days)  $80,000

Credit Wages Payable          $80,000

To accrue for 4 days of wage expense

4)  Accrued revenues are revenues earned even though cash is not yet received.

For example, a company performs $2,000 worth of services for a customer paying using credit. The journal entry would look like this:

Debit Accounts Receivable $2,000

Credit           Service Revenue $2,000

To accrue for service revenue

Closing Process

Balance sheet accounts are permanent accounts meaning they are never closed.  On the other hand, Income Statement accounts are temporary accounts that must be closed at the end of the accounting period to prepare them for the next accounting cycle.  The Income Statement accounts are closed to Retained Earnings.

Let’s suppose at the end of the accounting period that these balances remain in the temporary accounts:

Revenue                     $200,000

Cost of Goods Sold     $60,000

Salaries Expense        $46,000

Rent Expense             $36,000

Insurance Expense     $18,000

Dividends                     $20,000

1) Since we normally credit revenue, to close out this account balance, we need to debit revenue and credit Retained Earnings.  The journal entry will look like this:

Debit Revenue $200,000

Credit Retained Earnings     $200,000

To close out revenue to retained earnings

2) Since we normally debit expenses, to close out this account balance, we need to credit each of the expenses and debit Retained Earnings for the total.  The journal entry will look like this:

Debit Retained Earnings $160,000

Credit Cost of Goods Sold                    $60,000

Credit Salaries Expense                       $46,000

Credit Rent Expense                            $36,000

Credit Insurance Expense                    $18,000

To close out expense accounts to retained earnings

3) Since we normally debit dividends to close out this account balance, we need to credit dividends and debit Retained Earnings.  The journal entry will look like this:

Debit Retained Earnings $20,000

Credit Dividends                     $20,000

To close dividends to retained earnings

Balance Sheet and Income Statement Accounts

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