I imagine some of you are starting to wonder if there is an end to the types of journal entries in the accounting cycle! So far we have reviewed day-to-day journal entries and adjusting journal entries. Closing entries are the last step in the accounting cycle.
Closing entries serve two objectives. The first is to close all of the temporary accounts in order to start with zero balances for the next year. The second is to update the balance in Retained Earnings to agree to the Statement of Retained Earnings.
Note: Closing entries are always dated the first day of the next year. If the year end for the company is September 30, 2013, the closing entries would be dated October 1, 2013. If we closed the accounts as of September 30, we would lose the information we need to do the income statement and statement of retained earnings.
Permanent Versus Temporary Accounts
The chart of accounts can be broken down into two categories: permanent and temporary accounts. A permanent account is one where the balance carries over into the next year. A temporary account is one where the balance resets each year.
Think about some accounts that would be permanent accounts, like Cash and Notes Payable. While some businesses would be very happy if the balance in Notes Payable reset to zero each year, I am fairly certain they would not be happy if their cash disappeared. Assets, liabilities and most equity accounts are permanent accounts. The balances carry over from year-to-year.
Temporary accounts include revenue, expenses and dividends. Each of these accounts must be zeroed out so that on the first day of the year, we can start tracking these balances for the new fiscal year. Remember that the periodicity principle states that financial statements should cover a defined period of time, generally one year. If we do not close out the balances in the revenue and expense accounts, these accounts would continue to contain the revenue and expense balances from previous years and would violate the periodicity principle.
Updating the Balance in Retained Earnings
Think back to all the journal entries you’ve completed so far. Have you ever done an entry that included Retained Earnings? If you have only done journal entries and adjusting journal entries, the answer is no. Let’s look at the trial balance we used in the Creating Financial Statements post.
The balance in Retained Earnings was $8,200 before completing the Statement of Retained Earnings. According to the statement, the balance in Retained Earnings should be $13,000.
We need to complete entries to update the balance in Retained Earnings so it reflects the balance on the Statement of Retained Earnings. We know the change in the balance includes net income and dividends. Net income includes revenue and expenses. Therefore, we need to transfer the balances in revenue, expenses and dividends (the temporary accounts) into Retained Earnings to update the balance.
Using Income Summary in Closing Entries
Rather than closing the revenue and expense accounts directly to Retained Earnings and possibly missing something by accident, we use an account called Income Summary to close these accounts. Income Summary allows us to ensure that all revenue and expense accounts have been closed.
The first accounts to close are the revenue accounts. The trial balance above only has one revenue account, Landscaping Revenue. If the account has a $90,000 credit balance and we wanted to bring the balance to zero, what do we need to do to that account? In order to cancel out the credit balance, we would need to debit the account. Sometimes it helps to visualize this with a T-account.
Debiting the account will get the desired result:
The other account in the entry will be Income Summary.
Now that the revenue account is closed, next we close the expense accounts. You must close each account; you cannot just do an entry to “expenses”. You can, however, close all the expense accounts in one entry. If the balances in the expense accounts are debits, how do you bring the balances to zero? Credit them! We will also close these accounts to Income Summary. The debit to income summary should agree to total expenses on the Income Statement.
Here is the journal entry to close the expense accounts:
After these two entries, the revenue and expense accounts have zero balances. Let’s look at the T-account for Income Summary.
Notice the balance in Income Summary matches the net income calculated on the Income Statement. We know that all revenue and expense accounts have been closed. If we had not used the Income Summary account, we would not have this figure to check, ensuring that we are on the right path.
The next step is to close Income Summary. This account is a temporary equity account that does not appear on the trial balance or any of the financial statements. It is a helper account, aiding us in the closing process. To close Income Summary, we will debit the account. What is our credit in the entry? What did we do with net income when preparing the financial statements? We added it to Retained Earnings on the Statement of Retained Earnings. To add something to Retained Earnings, which is an equity account with a normal credit balance, we would credit the account.
What else went into the calculation of Retained Earnings? If you said Distributions, you are correct. We now close the Distributions account to Retained Earnings. Distributions has a debit balance so we credit the account to close it. Our debit, reducing the balance in the account, is Retained Earnings.
Our T-account for Retained Earnings now has the desired balance.
The trial balance, after the closing entries are completed, is now ready for the new year to begin. We call this trial balance the post-closing trial balance.
The balance in Retained Earnings agrees to the Statement of Retained Earnings and all of the temporary accounts have zero balances. Little Landscaping, LLC is now ready to start the new year.
When doing closing entries, try to remember why you are doing them and connect them to the financial statements. To update the balance in Retained Earnings, we must transfer net income and dividends/distributions to the account. Net income is simply revenue and expenses. By closing revenue, expense and dividend/distribution accounts, we get the desired balance in Retained Earnings.
The four basic financial statements are the income statement, the statement of retained earnings, the balance sheet and the statement of cash flows. Due to the complexity of the statement of cash flows, you can find information on that statement in a separate post. Our purpose here is to get a basic feel for what goes on each of the statements and the purpose of each statement.
The first thing you should do when starting any statement is the heading. The heading tells the reader what he or she is looking at. The heading for all statements is as follows:
Name of the Statement
The date can be a bit tricky but we will discuss that in the context of each of the statements.
You must prepare the financial statements in a particular order:
- Income Statement
- Statement of Retained Earnings
- Balance Sheet
- Cash Flow
The reason for this is because you will need information from the previous statement to complete the next one. You will see the flow of information as we complete an example. It is important to note that you will only use each number from the trial balance one time. Once a number has been used, it will not be used again. Notice that I did not write once you use an account, you will not use it again. There is one account that will be used on two different statements. Can you guess which one?
The Income Statement
From the name, you should be able to tell that the statement has something to do with income. Income makes me think of revenue, but when working with businesses, most of us think of income in terms of profit. Revenue is nice but at the end of the day, those of us who are small business owners don’t get to take home our revenue because we have to pay expenses. Another name for the income statement is the profit and loss statement. The basic format for the income statement is revenue – expenses = net income.
The income statement is like a movie that tells us everything that happened in the business for the year. It includes all revenue generated and all expenses incurred. We can tell if the business borrowed money at any point in the year by looking for interest expense. We can tell if the company owns or rents the space it occupies by looking for rent expense. Does the company have employees? Look for wage expense. The income statement covers the entire period, whether that is a month, a quarter or a year. Therefore, when completing the income statement, the date in the heading should be For the (month/quarter/year) ended (date). For financial statements generated for a year long period of time that ends on December 31, 2013, the date on the income statement would read For the year ended December 31, 2013.
Where do we get the information for the income statement? From the trial balance! I like to think of the trial balance was the primer for financial statement preparation. Here is the trial balance used in the post discussing them.
The trial balance is organized to help us prepare the financial statements. Notice that revenue and expenses are listed together to make preparation of the income statement fairly easy.
Notice in our statement, we listed revenue on top. If there were multiple revenue accounts, we would list them all and then get total revenue like we did for expenses. We then used our formula, revenue – expenses = net income to complete the statement.
Remember that this is a basic income statements. There are more complicated formats for the income statement but this is the basis for all income statements.
The Statement of Retained Earnings
The statement of retained earnings helps us update the balance in the retained earnings account. You will note that we have not completed a single journal entry to Retained Earnings through this process. We will use retained earnings in entries when we discuss closing entries. Because we have not entered any entries into the Retained Earnings accounts, the current balance in the account is last year’s balance. It has not yet been updated to reflect the change for this year. The statement of retained earnings is the first step in updating that balance.
Retained earnings is the amount of earnings that the company has kept (retained) over the years that the company has been in business. Each year the company generates earnings, also called net income. Some of these earnings may be paid out to the owners in the form of dividends or distributions. The difference between net income and distributions to owners is the amount that is added to the previous retained earnings balance. Therefore, the format for the statement of retained earnings is:
Beginning Balance, Retained Earnings (from the adjusted trial balance)
Plus: Net Income
Less: Dividends or Distributions
Equals: Ending Balance, Retained Earnings
Net income is taken from the income statement and dividends or distributions are taken from the trial balance.
Notice on our trial balance, the items we need are highlighted in blue. We look to the income statement which tells us our net income is $29,800. We have everything we need to complete the statement.
Note: For the date on the statement of retained earnings, we use “For the year ended December 31, 2013” because the income statement is involved in the statement. The statement of retained earnings covers all the changes to retained earnings over the course of the year, just like the income statement.
The Balance Sheet
If you look at the trial balance, you will notice that the only accounts we haven’t used are assets, liabilities and equity. Hopefully, this makes you think of the accounting equation, which states that Assets = Liabilities + Equity. We know that this equation always has to balance. The balance sheet is essentially the representation of the accounting equation. We are showing on a statement that assets do indeed equal liabilities and equity.
Unlike the income statement and statement of retained earnings, which tells us the story of the year, the balance sheet is a snapshot of the balances on the last day of the year. It is like a photograph rather than a movie. The balance sheet does not show us all the fluctuations in the balances throughout the year. It does not even show us the high and low balances for the year. It literally only shows us the balance on the last day. Therefore, when writing the date for the heading, we only put the last day. For the example we have been using, we would write “December 31, 2013”. That is all. No “For the year ended” here because it is not for the entire year, it is just for December 31.
At the beginning of the post, I stated that each statement would require something from the previous statement. What do we need from the statement of retained earnings? What type of account is retained earnings? It’s an equity account, which means that it needs to go on the balance sheet. I asked in the first section if you could guess which account is used on multiple statements. The answer is Retained Earnings, which appears on the statement of retained earnings and the balance sheet. Do not take the Retained Earnings balance from the trial balance. Use the ending balance from the statement of retained earnings.
Here is our basic balance sheet:
Notice that the equation does balance. The amount in Retained Earnings is the amount from the statement of retained earnings and not the trial balance. This is a basic, non-classified balance sheet. There are some balance sheets that show current and long-term assets, current and long-term liabilities and a separate equity section. More complex forms of the statements will be discussed in future posts.
Note: If your balance sheet does not balance, here are a few things to check:
- Did you only use revenue and expenses on your income statement? Remember that you can draw a line above your first income account and everything below that line should go on the income statement. Only the items below the line should go on the income statement.
- Did you subtract Dividends/Distributions on the statement of retained earnings?
- Did you use the ending Retained Earnings balance on your balance sheet?
A few other quick tips to keep in mind when preparing your statements.
- Prepaid Expenses are an asset, not an expense. It goes on the balance sheet!
- Accumulated Depreciation is a contra asset, not a liability. Subtract it from assets!
- Unearned Revenue is a liability, not revenue. It goes on the balance sheet!
Use your trial balance as a guide. Know where to separate the accounts and you will be much less likely to make a mistake.
Creating the Financial Statements
Journal entries are probably the most important part of any financial accounting class. They are the language of accounting.
This is a journal entry. It describes a transaction. The entry above tells us that on January 17, the company purchased land worth $100,000 and a building worth $225,000. The company put down $125,000 cash and took out a note with the bank for $200,000. Once you understand how journal entries are constructed, you will be able to read and write them yourself.
Debits and Credits
Debits and credits are the heart of the journal entry because they tell us if we are acquiring something or giving something up. Depending on the type of account, it will increase or decrease when it is debited or credited.
Remember the accounting equation? Assets = Liabilities + Equity. Just as we need to keep the accounting equation in balance, we must keep our debits and credit in balance. Each journal entry must contain equal debits and credits. Notice the entry above: $325,000 in debits and $325,000 in credits. In order for that to occur, each journal entry must have at least two accounts. You can never have a one line journal entry because it would not balance.
In accounting, we frequently refer to the normal balance in the account. The normal balance is a positive balance or what would need to be done to increase the balance.
Because the accounting equation tells us that assets must equal liabilities and equity, it makes sense that the normal balance for assets is a debit and the normal balance for liabilities and equity is a credit. Remember that normal balance means positive or increasing balance. What do you do to decrease the balance of an asset? If a debit increases the balance, than a credit to the account would decrease the balance. As we saw in the example entry above when we wanted to decrease cash, we credited the account.
What about revenue and expenses? Why is revenue’s normal balance a credit while expense’s is a debit? First, let’s discuss the relation these two accounts have to equity. Retained Earnings is a major component of equity. What causes retained earnings to increase? Profit. What causes profit to increase? Revenue. If revenue increases equity, then it should act the same way that equity does. Therefore, revenue has a credit balance. Since expenses decrease profit and equity, it makes sense that the normal balance is a debit.
If you still are not sure, put revenue or expenses in a journal entry with cash. Most people who study accounting quickly learn how cash behaves in most situations. If you know how cash will behave, you can figure out the other account. When a company does work and gets paid, cash increases so we debit cash. The other account, revenue, would be the credit. When a company pays for its rent, cash decreases so we credit Cash. To balance the entry, we debit Rent Expense.
Steps for Completing Journal Entries
- Read the transaction to get a feel for what is happening. Do you understand what happened? Try to put it into your own words.
- Identify the accounts you will put in your journal entry. Identify the type of account for each account used.
- For each account, determine if the balance is increasing or decreasing. Then determine if that increase or decrease is a debit or credit.
- Determine the amount that each account is changing.
On January 4, Lisa decides to start a bookkeeping business and invests $10,000 cash and $5,000 worth of computer equipment in exchange for stock in the company.
- The company received cash and computer equipment in exchange for stock.
- Cash (asset), Computer Equipment (asset) and Common Stock (equity).
- Cash – increasing, debit. Computer Equipment – increasing, debit. Common Stock – Increasing, credit.
- Cash – $10,000. Computer Equipment – $5,000. Common Stock – $15,000
This may seem like a lot of steps but when you are first learning how to do journal entries, it really helps to go through each of the steps as you write the entry. You don’t need to write out the answers to each of the steps as I did above, but you should do it mentally as you figure out the entry. I have had many students who will put the abbreviation for the account type next to the account name.
If you are going to do that, I recommend using Eq for equity and Ex for expense.
When learning to do journal entries, take your time and go through the steps. Make sure to learn the accounts and what type each account is. You may want to make flash cards with the name of the account on one side and the type of account on the other. You should also learn when to use a particular account, for example, when to use Unearned Revenue instead of Revenue or Prepaid Insurance rather than Insurance Expense.
This may seem difficult at first, but if you learn the terminology and practice, you will get better at it. For most students, a lightbulb goes off in their minds somewhere in the first six weeks of the course; everything clicks and they no longer need to use the steps above. Until you have your lightbulb moment, make sure to use the steps outlined above.
Basic Journal Entries Part 1
Basic Journal Entries Part 2
What are adjusting journal entries?
The matching principle states expenses must be matched with the revenue generated during the period. The purpose of adjusting entries is to ensure that all revenue and expenses from the period are recorded. Many adjusting entries deal with balances from the balance sheet, typically assets and liabilities, that must be adjusted. In addition to ensuring that all revenue and expenses are recorded, we are also making sure that all asset and liability accounts have the proper balances. Adjusting entries are dated for the last day of the period.
When analyzing adjusting entry transactions involving assets and liabilities, remember that you are recording the change in the balance, not the new balance in the account. Ask yourself “what must I do to the account to get the adjusting balance?”
As a business goes through the normal day-to-day operations, many transactions are recorded. When work is done and the company is paid, revenue is recorded. Revenue is also recorded when invoices (accounts receivable) are created. Expenses are recorded when bills (accounts payable) are received. If the company has already recorded all those things, then what could possibly be left to do? You would be surprised!
NOTE: Cash should never appear in an adjusting entry. Most adjusting entries are done after year end and backdated to the end of the year. When cash is spent, the transactions are recorded immediately. With electronic banking, we can instantly check cash transactions. There is no reason why a business shouldn’t know about transactions affecting its cash accounts. Cash is never an account in an adjusting entry.
If a business has done work for a client but has not yet created an invoice, there is unrecorded revenue that must be recorded. Maybe the business just hasn’t gotten around to completing the invoice yet, or maybe the work is partially done but not completely finished. This entry looks exactly like an entry to record work that has been completed but have not yet been paid for.
On December 31, KLI Video Production had completed $3,000 worth of work for clients which has not yet been billed.
Another type of unrecorded revenue deals with work the business was paid for before the work was completed (unearned revenue) which was completed by the end of the period. Transactions of this type can be written two different ways. We could be told how much revenue has been earned or we could be told the remaining balance in unearned revenue. Let’s look at how these transactions could be written so you can see the differences and identify which method to use.
Unearned revenue has an unadjusted balance of $4,000. An analysis of the account shows that $2,500 of the balance has been earned.
When looking at transactions like this one, we need to determine what we are being given. You want to ask yourself if the transaction is giving you the amount of the adjustment (revenue or expense to be recorded) or the adjusted (correct) balance in the asset or liability account. T-accounts are really helpful when doing adjusting entries because you can visualize what is happening. Here is the T-Account for unearned revenue.
We are told the account has an unadjusted balance of $4,000. Unearned revenue is a liability account and therefore the normal balance is a credit. We are told that $2,500 has been earned. Is that the new balance in the account? No, the $2,500 is the amount we need to remove from the account because it is no longer unearned. So if $2,500 is not the balance, then what is the balance? If the business has earned $2,500 of the $4,000, then the new balance is $1,500.
Now we can see the beginning balance and the ending balance in the T-account. Now, we have to determine how to get there. If we have a $4,000 credit balance and then have a $1,500 credit balance, the balance decreased by $2,500. How do we decrease an account with a credit balance? We debit the account. The $2,500 was given in the transaction, but now we know what to do with it. If you can predict what the balance should be in the account, you can do a T-account to make sure your entry will actually do what you predicted.
The credit in the entry is fees earned (revenue) because we were told that $2,500 had been earned. When you see earned, you should always think revenue unless the transaction states the money has not yet been earned. That statement should make you think of unearned revenue because it has not been earned.
The company had an unadjusted balance in unearned revenue of $4,000. An analysis of the account shows $1,500 is still unearned.
This transaction is worded a bit differently than the last. This transaction tells you what the ending balance in the account should be. Using a T-account in this scenario is a smart idea.
Notice, this example is exactly the same as Example #2. In order to get the balance from $4,000 credit to $1,500 credit, we need to debit unearned revenue $2,500.
Make sure to watch the wording in all adjusting entry transactions to ensure you understand what information you have.
Typically, when we are looking for unrecorded expenses, we look to the balance sheet. There are two types of unrecorded expenses: those that are related to assets that have been used up or need to be adjusted and those related to unrecorded liabilities.
Assets and Expenses
The definition of an asset is something the company owns or has the right to which it can use to generate revenue. When we were recorded journal entries, we recorded transactions to various asset accounts that when used up, will generate an expense. Some of those accounts were supplies, prepaid expenses and long-term asset accounts, like equipment and buildings.
Supplies are initially recorded as an asset, but they get used up over time. Rather than record an entry every time a ream of paper or a bag of mulch is removed from storage, we do an adjusting entry at the end of the period to record the amount of supplies that have been used up. Recording an entry every time something is removed from the stockroom or garage would violate the cost-benefit constraint. At the end of the period, the company counts up what is left for supplies. The difference between the balance in the account (unadjusted) and the amount that is left (adjusted) is the value used in the journal entry.
The balance in the supplies account at the end of the year was $5,600. A count of supplies shows that $1,400 worth of supplies are still on hand.
What does this transaction tell us? The unadjusted supplies balance is $5,600 but the adjusted balance should be $1,400. The transaction does not tell us the amount of the adjustment. That is something we will need to figure out. You may want to draw up a quick T-account to visualize the transaction.
To decrease the account balance, which is a debit balance, we need to credit the account. How much will we need to credit the account? What amount will bring the balance from $5,600 to $1,400? The difference is $4,200. So we need to credit the supplies account $4,200.
Where did the supplies go? They were used it. We call this supplies expense. Now we can write the journal entry.
Use the same methodology when doing entries involving prepaid expenses. Draw a T-account to help visualize what is happening.
Long-term assets and Expenses
When a company purchases a long-term asset, such as a vehicle to use in its business, we record the entire value of the purchase as an asset. That vehicle is used to generate revenue so shouldn’t that vehicle somehow be expensed? Yes, it should be. We call the expensing of a long-term asset depreciation. Do not confuse depreciation in accounting with how the term is used outside of accounting. Typically, we think of depreciation as a decline in market value. For example, I have heard it said many time that when you purchase a new car, it depreciates or loses 20% of its value when you drive off the lot. Depreciation in accounting has nothing to do with market value. Depreciation represents the using up of an asset to generate revenue.
The cost principle states that we must record assets at cost. In order to maintain that principle, when we record depreciation expense (which is a debit in the journal entry), we do not credit the asset directly. Instead we will use a contra account. A contra account is an account linked to another account but which has a normal balance opposite to the account it is linked to. A contra asset account would be linked to a specific asset account but would have a credit balance. For the vehicle described above, we would have a contra asset account called accumulated depreciation. This account would be linked to the vehicles account and would have a credit balance.
Some companies have one accumulated depreciation account used for all long-term assets and others have a separate accumulated depreciation account for each long-term asset account. In the next example, we will assume there is one accumulated depreciation account.
The company calculates that the current year depreciation is $12,000.
As with all adjusting entries, we need to determine if we are being given an account balance (asset or liability) or the amount of the expense. In this case, as with all depreciation entries, we are given the amount of the expense. Therefore, there is nothing to calculate here. No T-account is needed.
For more information about long-term assets and depreciation, see the posts on long-term assets and calculating depreciation.
Adjusting Entries Involving Liabilities
Some adjusting entries involve expenses that have not yet been paid for nor has the obligation been recorded. However, in these cases an expense has been generated. Examples include unrecorded bills and unpaid wages, interest, and taxes. This is not an exhaustive list but it does cover most of the transactions you will see. These entries require the recording of an expense and a liability.
The company received a bill for December’s utilities on January 5. The bill was for $235.
Although the bill was received in January, the utilities were used in December to generate revenue in December. The matching principle tells us that we must record the utilities expense in December.
The company pays its employees every two weeks. On December 31, the employees had worked four days for which they had not been paid. The amount due to the employees was $4,300.
Are you thinking matching principle here? Our employees help us generate revenue. The wages that we pay them must be matched to the revenue they are creating. Therefore, the $4,300 must be recorded in December. The wages have not been paid so we must show a liability. The liability used in this case will be wages payable.
Note: Accounts payable should only be used for routine bills (utilities, supply and inventory purchases). Other short-term payables should be named based on the expense they are related to. That is why wages payable was used in this case.
The company has a long-term note payable with Ginormic National Bank. As of December 31, $670 of interest had accrued on the loan but had not yet been paid.
Why do we have to record this? First, the interest is an expense for December even though it has not yet been paid. Second, to be accurate in our financial statements, the balance owed to the bank on December 31 includes not only the balance on the loan but also the unpaid interest. If we contact Ginormic National Bank to payoff the loan on December 31, we would need to pay the principal owed plus the $670 of interest. The interest is considered a separate payable and should not be added to the note payable.
The company estimates its profit to be $42,000 for the year and is in a 35% tax bracket.
When reading this transaction, it doesn’t even sound like something we would need to record. It just sounds like a statement, but the matching principle should set off an alarm. Why are we paying income taxes? The company had a profit for the year of $42,000. Income taxes are an expense of doing business. Should the expense fall in the year that is completed or the year we are currently in? The expense is related to the year that is completed and, therefore, must be recorded as an adjusting entry.
To figure out how much to record for taxes, we need to calculate 35% of the profit, which would be $14,700 ($42,000 x 0.35). Now we can record the entry.
Things to Remember
Treat adjusting entries just like you would treat normal entries. Use these steps when completing adjusting journal entries.
- Read the transaction to determine what is going on. Is an entry required?
- Identify the accounts you will use in your entry. Remember, cash is never used in adjusting entries!
- Determine the amount. Did the transaction give you the amount to use or do you need to calculate it? T-accounts are helpful here.
- Determine which account(s) to debit and which account(s) to credit.
Accounting is all about balance. Each time we engage in a transaction, there are at least two things that are happening. Usually, we give up something to receive something we need. For example, when you purchase supplies for school, you give up cash in order to get the supplies. When you take out a loan, you get cash today (or tuition or a car) by giving up the right to cash you will receive in the future so you can make your loan payments. Accounting principles work for individuals as well as businesses.
Note: As you progress through the course, think about transactions in your daily life and try to relate them to what you are doing in the course. Analyzing transactions in your own life will make the course easier to relate to and increase your understanding of the topic.
Because of this give and take, accounting is based on a double entry system. Whenever a transaction is recorded, at least two accounts must be effected. This allows us to remain in balance.
The accounting equation is the basis for all of accounting. The accounting equation states:
Assets = Liabilities + Equity
When recording transactions, the accounting equation must stay balanced.
An asset is something the business owns or has a right to, which can be used to generate future income. Examples of assets include cash, supplies, inventory, vehicles, machinery, equipment, and buildings. This is by no means an exhaustive list and you will spend most of any introductory financial accounting course studying assets.
A liability is an obligation that a business has to another person or entity. Typically, we think of liabilities as loans but there are many different types of liabilities a business can incur. For example, when the electric bill comes and the business has 30 days to pay it, that becomes a liability because the business used the electricity and is obligated to pay for it. If a business agrees to do work for a client and the client pays a deposit (puts money down) for work to be completed at a later date, the business has an obligation to complete the work or refund the money.
Equity is one of the most difficult concepts for most students to understand in accounting. Equity is the business’ worth to the owners. Let’s rearrange the accounting equation:
Assets – Liabilities = Equity
Now the equation tells us that what we own less what we owe others is equity. This is the value of the business to the owners, also called a business’s net worth. Equity has two main components: contributed capital and retained earnings.
Contributed capital is the value that the owners have contributed to the business. If you started a business tomorrow and put $1,000 cash plus a computer worth $500, the contributed capital in the business would be $1,500 because that is the amount the owner (you) have contributed.
Retained earnings is the amount of profit (earnings) the business has kept (retained) over the years. How is profit generated? When a business sells a product or service, the business generates revenue. When a business incurs costs associated with providing the product or service, the business generates an expense.
Revenue – Expenses = Profit
Once profits are generated the business can either keep those profits within the company to grow the business or protect against future downturns. The business can also choose to pay those profits out to the owners in the form of dividends or distributions. The profits that the business keeps are added to retained earnings.
Using the accounting equation to stay in balance
Let’s go back to the example we used above for contributed capital. You start a business by contributing $1,000 cash and a computer worth $500. Think about the exchange that is happening here. What is the business receiving? $1,000 cash and a computer. What are these? They are assets. The business is receiving $1,500 worth of assets. What is the business giving in exchange for these assets? It is giving you (the owner) $1,500 worth of capital (ownership) in the business. This value is considered contributed capital.
Our accounting equation is in balance. The business currently has $1,500 worth of assets and $1,500 worth of equity. There are currently no liabilities.
Let’s look at another transaction. The business takes out a loan for $10,000 to provide cash to purchase equipment and start operations. What is the business receiving? $10,000 cash. What is the business exchanging for that cash? The business is giving the bank a promise to pay in the future with assets generated from operations. This is a liability. A loan from the bank is more specifically called a note payable. Let’s add this to our existing balances.
The business now has $11,500 in assets, $10,000 in liabilities and $1,500 in equity. The equation still balances.
Let’s look at one more transaction. The business purchases a piece of equipment for $4,000 cash. Analyze the transaction to see what the business is receiving and exchanging. The business is receiving a piece of equipment worth $4,000 in exchange for $4,000 cash. Notice that both of these items are assets, therefore, we have one asset increasing and other decreasing.
*In accounting, a number in parenthesis indicates a negative number or a number that should be subtracted from the numbers around it. You will see this notation frequently.
Notice that the balances in our equation did not change. What did change was the makeup of the assets held by the business. In this part of the course, it is important to understand that the equation must be in balance at all times. As we progress through the course, we will look in greater detail at the individual accounts that make up total assets, liabilities, and equity.
You will also notice that we have not yet dealt with revenue or expenses. Let’s look at the effect those transactions will have on the equation. The business does $1,000 worth of work for a client and gets paid when the work is complete. Again, analyze the transaction and determine how the accounting equation will be affected. The business got paid. What does that mean? The business received cash. It does not matter if the business was paid by check, credit card or cash; the payment will end up in the business bank account and the cash can be spent to generate future revenue. Why did the business receive cash? Because it provided a service for a client. Providing goods or services for a customer is called revenue. You will see many different titles for revenue accounts. Because this revenue was generated because a service was provided, you might call it service revenue or fees earned. As you progress through the course, learn the terminology used in your course but also make sure to realize that other terminology can be used.
Let’s add this transaction to the equation. Clearly, an asset (cash) is increasing. How does the revenue effect the equation? We stated previously that profit increases equity. Profit is revenue less expenses, which means revenue increases profit and expenses decrease profit. Another way to look at the problem is to ask yourself if the revenue is increasing or decreasing the value of the business. Revenue coming in is good for the business and helps to increase its value. Therefore, revenue increases equity.
Still in balance! One more transaction to complete the lesson. We have looked at all the accounts except expenses. An expense is a cost of generating revenue. If the business rents an office, the cost of that office is an expense. How would we record the following transaction?
The business pays $400 cash for the current month’s office rent.
Analyze the transaction to determine the exchange. The business receives use of the office in exchange for $400 cash.
In this case, both sides of the equation decrease. An expense decreases equity because we are using up resources in the business which decreases the value of the business.
You’ll notice that we used three categories here because the accounting equation only has three: assets, liabilities, and equity. I tell my students to think as if there are five categories, the three above, plus revenue and expenses. Revenue makes equity go up and expenses make equity go down. As we start to discuss journal entries, it is important to think of revenue and expenses as separate categories.