What is a liability?
A liability is an obligation that the company has to another party. Typically when we think of liabilities, we think of accounts payable or notes payable, but there are many other liabilities that a company can have to other people or entities.
Whenever a company owes money or services to another party, there is a liability. A liability must be recorded if the company can estimate the amount of the liability and is reasonably sure that the liability is owed.
Liabilities have a normal credit balance. When a liability increases, we credit the account. When a liability is paid or an obligation is fulfilled, either in whole or in part, the account is debited.
What is a current liability?
Current liabilities are liabilities that are due in less than one year or one operating cycle. The most notable liability that most people think of when they think of current liabilities is accounts payable. There are however many other accounts qualify as current liabilities.
Accounts payable is a current liability used for normal day-to-day bills. Some textbooks will argue that accounts payable should only be used for the purchase of inventory and supplies, but in my experience, accounts payable is used for all routine bills that must be paid. This would include supplies, inventory, utility bills, telephone bills, and other bills which the company plans to pay at a later date.
Any other current amount owed must be placed in its own payable account. This includes salaries payable, taxes payable, interest payable and any other obligations a company would have.
Recording and paying accounts payable
When a company purchases something and does not pay for it at the time of purchase, a payable is created.
On January 15, KLI, LLC purchases $1,500 worth of supplies on account, terms n/30.
In this example, the company is purchasing supplies but has not paid for them yet. How do we know the company has not paid for them? There are a few key things to look for. First, the statement does not use the word “paid.” “Paid” always indicates that cash is involved. Since cash is not involved, We know we have not paid for the purchase.
Second, we see “on account” in the statement. On account indicates either Accounts Payable or Accounts Receivable. When we see on account, we should ask “Are we going to pay cash later or receive cash later?” If we are going to pay cash later because we purchased something, we have Accounts Payable.
If you do not have either “paid” or “on account”, there is one additional give away in the transaction. If you see terms, the purchase was made on account. Payment terms, such as n/30, are only included if the transaction has not been paid for. If the transaction had been paid for, we wouldn’t need to know that the bill must be paid within 30 days.
Here is the journal entry for the transaction:
On February 10, KLI, LLC paid for the supplies purchased on January 15.
In this transaction, we are paying for the supplies previously purchased. Be careful when recording a transaction like this. Many people studying accounting get this one wrong the first few times they try it.
The transaction states that the company paid for something. That is one of the keywords we discussed above. When we see “paid” in the transaction, Cash is involved.
What did the company actually pay for? We are told to refer back to the transaction on January 15. In that transaction, we recorded Supplies and Accounts Payable. Are we purchasing more supplies or are we paying off the Accounts Payable? The transaction indicates that we are paying for supplies that were previously purchased, not purchasing more supplies.
Let’s see if that fits into our journal entry. We know that Cash will be a credit. Does it make sense to debit Accounts Payable? Since we are paying off what we owed, we are fulfilling the obligation. We want the balance in Accounts Payable to decrease so we would debit Accounts Payable.
Lots of different liabilities
Over the next few posts, we will be covering a number of new current and long-term liabilities. All of these liabilities follow the same rules as described above. When classifying a liability ask yourself if the company has an obligation to anther party. If the answer is yes, then you have a liability.
For many students, bank reconciliations are a difficult topic because most people don’t do them anymore. Twenty years ago, before debit cards and online banking, there was only one way to keep track of how much money you had in the bank: keep a checkbook and reconcile it.
Clearly, online banking has not made us better at managing our bank accounts. In 2012, U.S. consumers paid $32 billion in overdraft fees. That’s approximately $135 per adult in the United States! Maybe we should consider going back to writing down all our transactions and balancing our checkbooks!
What is a bank reconciliation?
A bank reconciliation is a monthly process by which we match up the activity on the bank statement to ensure that everything has been recorded in the company’s or individual’s books. As we all engage in more automatic and electronic transactions, this is a critically important step to ensure that the cash balance is correct.
There are two parts to a bank reconciliation, the book (company) side and the bank side. When the reconciliation is completed, both balances should match.
What are we looking for?
There are a number of items that can cause differences between your book and bank balances. Here is a list of the most common items you’ll encounter when doing a bank reconciliation:
- Deposits in Transit – A deposit in transit is a deposit that has been submitted to the bank but has not get been recorded by the bank. The account holder has recorded the deposit in his records but the bank has not. This occurs because a deposit was submitted after the bank closed for the day or because of lag in electronic deposits. We see this a lot with credit card deposits because there is typically a 1-3 day lag in the time the card is processed and when the funds are deposited to the merchant’s account. Deposits in Transit must be added to the bank side of the reconciliation because they have been added to the book side when the deposits were recorded by the company.
- Outstanding Checks – These are checks that have been written by the company but have not yet cleared the bank. When a check is written it takes a few days to clear. Most businesses have a number of outstanding checks at the end of the month. Outstanding Checks should be subtracted from the bank side of the reconciliation because they were subtracted from the book balance when the checks were written.
- Bank Service Charges – These are amounts that the bank withdraws from the account as a charge for having the account. Bank service charges include regular monthly fees, overdraft fees, returned check fees and credit card processing fees. Typically, the company does not record these fees until the bank statement is received. Bank service charges are subtracted from the book balance since they are a decrease in the account balance and have not yet been recorded.
- Interest Earned – Some banks pay interest on account. The account holder does not know how much the interest will be until the bank statement is received. Interest earned is deposited into the account by the bank causing the balance to increase. Interest earned is added to the book balance to reflect the increase in the balance from the deposit of interest.
- Returned Checks – A returned check is an item that was originally deposited into the company’s account (usually a customer check) and later bounced. When this happens the bank withdraws the funds from the company’s account and sends a notice to the company. Returned checks should be subtracted from the book balance since the bank removed the amount from the balance when the check bounced.
- Recording Errors – A recording error occurs when the company incorrectly records a transaction or when the bank clears an item for the incorrect amount. This sometimes occurs when checks are written and an incorrect amount is entered into the system. Sometimes the bank clears the transaction for the wrong amount. Say the company wrote a check for $452.00 but the bank cleared the check for $450.00. There is now a $2 error in the books. Since the bank has cleaned the transaction, you must adjust the books to match. Recording errors should be added or subtracted from the book balance. If the item cleared the bank for less than the amount in the books, add the amount of the error. If the item cleared the bank for more than the amount in the books, subtract the amount of the error.
- Other Unrecorded Items – With the number of transactions that occur digitally or automatically, it’s easy to forget to record transactions, especially if they occur infrequently. Look for remaining items that cleared the bank that have not been recorded on the books. Other unrecorded items can be either deposits or withdrawals. All other unrecorded items should be recorded on the book side of the reconciliation. To determine if you should add or subtract the item, mimic what the bank did. If the bank added it to the account balance, do the same to the book balance.
How to start
To do a bank reconciliation, you’ll need a copy of the bank statement and a copy of all of the outstanding items in the checking account through the ending date of the bank statement. For some businesses, including my own, the bank statement does not close at the end of the month. Sometimes the statement end date is based on the date the account was opened.
Once you have those two items, use a pencil or highlighter to mark off all the items that appear on both the bank statement and the check register. If an item appears on both, that means that the item was properly recorded and has cleared. After going through all the items, anything that remains unmarked is a an item that will need to be dealt with in the reconciliation.
Create two columns on a piece of paper or use a spreadsheet to do the calculations for you. My bank reconciliations look like a large T-account.
Start by writing the ending balance for the book and the bank under the appropriate column.
I like to do the bank side first because it is generally easier than the book side. You are only dealing with outstanding checks and deposits in transit on the bank side. List the deposits in transit and the outstanding checks. Add the deposits in transit to the beginning balance and subtract the outstanding checks.
The bank side is relatively easy to do. That is why I like to do that side first. It is more likely to be correct if you have an error in your reconciliation. Most students who have errors have them on the book side. Being confident in the bank side helps resolve errors on the book side.
On the book side, most items are fairly simple. Subtract bank service charges and add interest income. Subtract returned checks. Add unrecorded deposits and subtract unrecorded withdrawals. The last item, recording errors, requires a bit more thinking.
Let’s imagine that you recorded a check for $715, but the bank cleared that check for $751. The check was used to pay for utilities and was recorded to utilities expense for $715. If the check cleared for $751, what happened to your utilities expense? Did it increase or decrease? It increased because more was paid for utilities. If the expense increased, cash must have decreased. Therefore, cash must be adjusted down or decreased by $36. This would be subtracted from book side of the reconciliation.
Thinking about what is happening to your expenses can help you work your way through the problem.
Once you have worked through all the remaining items on the book side, compute the reconciled balance for the books.
When you are finished, the reconciled balances should agree.
If they do not, take the difference between the two balances. Does that amount stick out in your mind. Check to see if there is a missing item for that amount that you might have forgotten to record. You may have forgotten multiple items. Place them in the reconciliation and see if you now balance.
If you do not have an item for that amount, take the difference and divide it by 2. Look for that amount. If that amount appears in your reconciliation, you added (or subtracted) the amount when you should have subtracted (or added) the amount. Reverse the sign and check your balance again.
Once you finish the bank reconciliation, there is one more step in the process. All the items that you recorded on the book side of the reconciliation must be recorded in the company’s accounting system. Prepare a journal entry (or several) to record those items. I usually record one large journal entry but you can also record a separate entry for each item in the reconciliation. Only record items on the book side!
Bank reconciliations become easier as you do more of them. Get all the practice you can. Here is the bank reconciliation problem I created for the video on this subject. You are provided with the check register and the bank statement. See if you can complete the reconciliation before watching the video.
How to do a bank reconciliation
Journal entries for the bank reconciliation
When to Recognize Revenue
Revenue recognition is one of the most important concepts in accounting. Deciding when to record revenue and expenses can have a huge impact on the financial statements. Incorrectly recording revenue that has not been earned can inflate profits and give potential investors or lenders incorrect information about the company’s future profitability.
Revenue should be recorded when it is earned, essentially when the work is done. For some businesses, this is fairly simple. When I complete a tax return for a client, I have earned revenue. When a retailer sells a product, revenue is earned. It does not matter when payment is received; the work is completed and therefore the revenue should be recorded. Payments do not affect the recognition of revenue.
When deciding how to record transactions involving revenue, there are two important questions you should ask yourself:
- Did the company do the work?
- Did the company get paid?
The following chart should help guide you through the process of determining if revenue should be recognized.
Notice the first question is regarding the work. This is the most important factor. Once we have determined it work has been done, then we can look at payment information to determine what the debit should be in the entry.
Let’s look at some examples.
K’s Bounce House Adventures rents bounce houses to individuals and corporations for parties. K’s has the following transactions during the month of February. Record the necessary journal entries.
Feb 2 – K’s agrees to provide a bounce house for a corporate function on February 10 for $300. The companies sign a contract stating that payment will be made on the date of the function.
Feb 4 – K’s provides a bounce house for a birthday party and gets paid at the end of the party, $250.
Feb 5 – K’s provides two bounce houses for a town picnic, $700. K’s must bill the town and will receive payment within 30 days.
Feb 7 – K’s signs a contract to provide a bounce house for a birthday party on Feb 20 for $350. The contract requires the customer to pay 50% of the balance today and the rest the day of the party.
Feb 10 – K’s provides the bounce house for the contract signed on Feb 2 and is paid.
Feb 13 – K’s provides a bounce house for a function booked in January. The customer paid the entire amount of the contract, $275, when the function was booked.
Feb 20 – K’s provides the bounce house for the contract signed on Feb 7 and is paid the remaining balance.
Feb 25 – K’s receives the payment from the town event on Feb 5.
For each of the transactions, ask yourself the two questions above. The solutions are listed below with explanations. Try working through the transactions before looking at the solutions. Take notes on the transactions you had trouble identifying. Usually there is a pattern. Find your weaknesses and work on them. Write your own transactions for those types of entries.
Click here for the solutions to the transactions.
Basic Journal Entries, Part 1
Basic Journal Entries, Part 2