For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.
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Introduction
If we imagine buying something, such as groceries, it’s easy to picture ourselves standing at the checkout, writing out a personal check, and taking possession of the goods. It’s a simple transaction—we exchange our money for the store’s groceries.
In the world of business, however, many companies must be willing to sell their goods (or services) on credit. This would be equivalent to the grocer transferring ownership of the groceries to you, issuing a sales invoice, and allowing you to pay for the groceries at a later date.
Whenever a seller decides to offer its goods or services on credit, two things happen: (1) the seller boosts its potential to increase revenues since many buyers appreciate the convenience and efficiency of making purchases on credit, and (2) the seller opens itself up to potential losses if its customers do not pay the sales invoice amount when it becomes due.
Under the accrual basis of accounting (which we will be using throughout our discussion) a sale on credit will:
A reduction of accounts receivable on its balance sheet.
With respect to financial statements, the seller should report its estimated credit losses as soon as possible using the allowance method. For income tax purposes, however, losses are reported at a later date through the use of the direct write-off method.
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Recording Services Provided on Credit
Assume that on June 3, Malloy Design Co. provides $4,000 of graphic design service to one of its clients with credit terms of net 30 days. (Providing services with credit terms is also referred to as providing services on account.)
Under the accrual basis of accounting, revenues are considered earned at the time when the services are provided. This means that on June 3 Malloy will record the revenues it earned, even though Malloy will not receive the $4,000 until July. Below are the accounts affected on June 3, the day the service transaction was completed:
In this transaction, the debit to Accounts Receivable increases Malloy’s current assets, total assets, working capital, and stockholders’ (or owner’s) equity—all of which are reported on its balance sheet. The credit to Service Revenues will increase Malloy’s revenues and net income—both of which are reported on its income statement.
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Recording Sales of Goods on Credit
When a company sells goods on credit, it reports the transaction on both its income statement and its balance sheet. On the income statement, increases are reported in sales revenues, cost of goods sold, and (possibly) expenses. On the balance sheet, an increase is reported in accounts receivable, a decrease is reported in inventory, and a change is reported in stockholders’ equity for the amount of the net income earned on the sale.
If the sale is made with the terms FOB Shipping Point, the ownership of the goods is transferred at the seller’s dock. If the sale is made with the terms FOB Destination, the ownership of the goods is transferred at the buyer’s dock.
In principle, the seller should record the sales transaction when the ownership of the goods is transferred to the buyer. Practically speaking, however, accountants typically record the transaction at the time the sales invoice is prepared and the goods are shipped.
FOB Shipping Point
Quality Products Co. just sold and shipped $1,000 worth of goods using the terms FOB Shipping Point. With its cost of goods at 80% of sales value, Quality makes the following entries in its general ledger:
(While there may be additional expenses with this transaction—such as commission expense—we are not considering them in our example.)
FOB Shipping Point means the ownership of the goods is transferred to the buyer at the seller’s dock. This means that the buyer is responsible for transporting the goods from Quality Product’s shipping dock. Therefore, all shipping costs (as well as any damage that might be incurred during transit) are the responsibility of the buyer.
FOB Destination
FOB Destination means the ownership of the goods is transferred at the buyer’s dock. This means the seller is responsible for transporting the goods to the customer’s dock, and will factor in the cost of shipping when it sets its price for the goods.
Let’s assume that Gem Merchandise Co. makes a sale to a customer that has a sales value of $1,050 and a cost of goods sold at $800. This transaction affects the following accounts in Gem’s general ledger:
Because Gem chooses to ship its goods FOB Destination, the ownership of the goods transfers at the buyer’s dock. Therefore, Gem Merchandise assumes all the risks and costs associated with transporting the goods.
Now let’s assume that Gem pays an independent shipping company $50 to transport the goods from its warehouse to the buyer’s dock. Gem records the $50 as an operating expense or selling expense (in an account such as Delivery Expense, Freight-Out Expense, or Transportation-Out Expense). If the shipping company allows Gem to pay in 7 days, Gem will make the following entry in its general ledger:
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Credit Terms with Discounts
When a seller offers credit terms of net 30 days, the net amount for the sales transaction is due 30 days after the sales invoice date.
To illustrate the meaning of net, assume that Gem Merchandise Co. sells $1,000 of goods to a customer. Upon receiving the goods the customer finds that $100 of the goods are not acceptable. The customer contacts Gem and is instructed to return the unacceptable goods. This means that Gem’s net sale ends up being $900; the customer’s net purchase will also be $900 ($1,000 minus the $100 returned). It also means that Gem’s net receivable from this customer will be $900.
Unfortunately, companies who sell on credit often find that they don’t receive payments from customers on time. In fact, one study found that if the credit term is net 30 days, the money, on average, arrived 45 days after the invoice date. In order to speed up these payments, some companies give credit terms that offer a discount to those customers who pay within a shorter period of time. The discount is referred to as a sales discount, cash discount, or an early payment discount, and the shorter period of time is known as the discount period. For example, the term 2/10, net 30 allows a customer to deduct 2% of the net amount owed if the customer pays within 10 days of the invoice date. If a customer does not pay within the discount period of 10 days, the net purchase amount (without the discount) is due 30 days after the invoice date.
Using the example from above, let’s illustrate how the credit term of 2/10, net 30 works. Gem Merchandise Co. ships $1,000 of goods and the customer returns $100 of unacceptable goods to Gem within a few days. At that point, the net amount owed by the customer is $900. If the customer pays Gem within 10 days of the invoice date, the customer is allowed to deduct $18 (2% of $900) from the net purchase of $900. In other words, the $900 amount can be settled for $882 if it is paid within the 10-day discount period.
Let’s assume that the sale above took place on the first day that Gem was open for business, June 1. On June 6 Gem receives the returned goods and restocks them, and on June 11 it receives $882 from the buyer. Gem’s cost of goods is 80% of their original selling prices (before discounts). The above transactions are reflected in Gem’s general ledger as follows:
If the customer waits 30 days to pay Gem, the June 11 entry shown above will not occur. In its place will be the following entry on July 1:
Examples of Amounts Due Under Varying Credit Terms
The following chart shows the amounts a seller would receive under various credit terms for a merchandise sale of $1,000 and an authorized return of $100 of goods.
Costs of Discounts
Some people believe that the credit term of 2/10, net 30 is far too generous. They argue that when a $900 receivable is settled for $882 (simply because the customer pays 20 days early) the seller is, in effect, giving the buyer the equivalent of a 36% annual interest rate (2% for 20 days equates to 36% for 360 days). Some sellers won’t offer terms such as 2/10, net 30 because of these high percentage equivalents. Other sellers are discouraged to find that some customers take the discount and ignore the obligation to pay within the stated discount period.
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Credit Risk
When a seller provides goods or services on credit, the resultant account receivable is normally considered to be an unsecured claim against the buyer’s assets. This makes the seller (the supplier) an unsecured creditor, meaning it does not have a lien on any of the buyer’s assets—not even on the goods that it just sold to the buyer.
Sometimes a supplier’s customer gets into financial difficulty and is forced to liquidate its assets. In this situation the customer typically owes money to lending institutions as well as to its suppliers of goods and services. In such cases, it’s the secured creditors (the banks and other lenders that have a lien on specific assets such as cash, receivables, inventory, equipment, etc.) who are paid first from the sale of the assets. Often there is not enough money to pay what is owed to the secured lenders, much less the unsecured creditors. In other words, the suppliers will never be paid what they are owed.
To avoid this kind of risk, some suppliers may decide not to sell anything on credit, but require instead that all of its goods be paid for with cash or a credit card. Such a company, however, may lose out on sales to competitors who offer to sell on credit.
To minimize losses, sellers typically perform a thorough credit check on any new customer before selling to them on credit. They obtain credit reports and check furnished references. Even when a credit check is favorable, however, a credit loss can still occur. For example, a first-rate customer may experience an unexpected financial hardship caused by one of its customers, something that could not have been known when the credit check was done. The point is this: any company that sells on credit to a large number of customers should assume that, sooner or later, it will probably experience some credit losses along the way.
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Allowance Method for Reporting Credit Losses
Accounts receivable are reported as a current asset on a company’s balance sheet. Since current assets by definition are expected to turn to cash within one year (or within the operating cycle, whichever is longer), a company’s balance sheet could overstate its accounts receivable (and therefore its working capital and stockholders’ equity) if any part of its accounts receivable is not collectible.
To guard against overstatement, a company will estimate how much of its accounts receivable will never be collected. This estimate is reported in a balance sheet contra asset account called Allowance for Doubtful Accounts. (Some companies call this account Provision for Doubtful Accounts or Allowance for Uncollectible Accounts.) Any increases to Allowance for Doubtful Accounts are also recorded in the income statement account Bad Debts Expense (or Uncollectible Accounts Expense).
This method of anticipating the uncollectible amount of receivables and recording it in the Allowance for Doubtful Accounts is known as the allowance method. (If a company does not use an allowance account, it is following the direct write-off method, which is discussed later.)
Allowance for Doubtful Accounts and Bad Debts Expense – June
As we stated above, the account Allowance for Doubtful Accounts is a contra asset account containing the estimated amount of the accounts receivable that will not be collected. For example, let’s assume that Gem Merchandise Co.’s Accounts Receivable has a debit balance of $100,000 at June 30. Gem anticipates that approximately $2,000 of this is not likely to turn to cash, and as a result, Gem reports a credit balance of $2,000 in Allowance for Doubtful Accounts. The accounting entry to adjust the balance in the allowance account will involve the income statement account Bad Debts Expense.
Since June was Gem’s first month in business, its Allowance for Doubtful Accounts began June with a zero balance. At June 30, when it issues its first balance sheet and income statement, its Allowance for Doubtful Accounts will have a credit balance of $2,000. This is done using the following adjusting journal entry:
Here are some of the accounts in a T-account format:
With Allowance for Doubtful Accounts now reporting a credit balance of $2,000 and Accounts Receivable reporting a debit balance of $100,000, Gem’s balance sheet will report a net amount of $98,000. Since this net amount of $98,000 is the amount that is likely to turn to cash, it is referred to as the net realizable value of the accounts receivable.
Under the allowance method, the Gem Merchandise Co. does not need to know specifically which customer will not pay, nor does it need to know the exact amount. This is acceptable because accountants believe it is better to report an approximate amount that is uncollectible rather than imply that every penny of the accounts receivable will be collected.
Gem’s Bad Debts Expense will report credit losses of $2,000 on its June income statement. This expense is being reported even though none of the accounts receivables were due in June. (Recall the credit terms were net 30 days.) Gem is attempting to follow the matching principle by matching the bad debts expense as best it can to the accounting period in which the credit sales took place.
Here’s a Tip
Since the net realizable value of a company’s accounts receivable cannot be more than the debit balance in Accounts Receivable, the balance in the Allowance for Doubtful Accounts must be a credit balance or a zero balance.
Allowance for Doubtful Accounts and Bad Debts Expense – July
Assume that during July, the company had sales on credit of $225,000 and it collected $95,000 on its accounts receivable. As a result, on July 31 the Gem Merchandise Co. has a debit balance in Accounts Receivable of $230,000.
The Allowance for Uncollectible Accounts still has the credit balance of $2,000 from the adjustment on June 30. This means Gem’s general ledger accountsbefore the July 31 adjustment to Allowance for Uncollectible Accounts will be reporting a net realizable value of $228,000 ($230,000 minus $2,000).
Gem reviews the details of its accounts receivable and estimates that as of July 31 approximately $10,000 of the $230,000 will not be collectible. In other words, the net realizable value (or net cash value) of its accounts receivable as of July 31 is only $220,000 ($230,000 minus $10,000). Before the July 31 financial statements are released, Gem must adjust the Allowance for Doubtful Accounts so that its ending balance is a credit of $10,000 (instead of the present credit balance of $2,000). This requires the following adjusting entry:
After this journal entry is recorded, Gem’s July 31 balance sheet will report the net realizable value of its accounts receivables at $220,000 ($230,000 debit balance in Accounts Receivable minus the $10,000 credit balance in Allowance for Doubtful Accounts).
Here’s a recap of the Allowance for Doubtful Accounts and Bad Debts Expense in T-account form:
As seen in the T-accounts above, Gem estimated that the total bad debts expense for the first two months of operations (June and July) is $10,000. It is likely that as of July 31 Gem will not know the precise amount of actual bad debts, nor will Gem know which customers are the ones that won’t be paying their account balances. However, the matching principle is better met by Gem making these estimates and recording the credit loss as close as possible to the time the sales were made.
By reporting the $10,000 credit balance in Allowance for Doubtful Accounts, Gem is also adhering to the accounting principle of conservatism. In other words, if there is some doubt as to whether there are $10,000 of credit losses or no credit losses, Gem’s accountant “breaks the tie” by choosing the alternative that reports a smaller amount of profit and a smaller amount of assets. (It is reporting a net realizable value of $220,000 instead of the $230,000 of accounts receivable.) If a company knows with certainty that every penny of its accounts receivable will be collected, then the Allowance for Doubtful Accounts will report a zero balance. However, if it is likely that some of the accounts receivable will not be collected in full, the principle of conservatism requires that there be a credit balance in Allowance for Doubtful Accounts.
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Writing Off an Account under the Allowance Method
Under the allowance method, if a specific customer’s accounts receivable is identified as uncollectible, it is written off by removing the amount from Accounts Receivable. The entry to write off a bad account affects only balance sheet accounts: a debit to Allowance for Doubtful Accounts and a credit to Accounts Receivable. No expense or loss is reported on the income statement because this write-off is “covered” under the earlier adjusting entries for estimated bad debts expense.
Let’s illustrate the write-off with the following example. On June 3, a customer purchases $1,400 of goods on credit from Gem Merchandise Co. On August 24, that same customer informs Gem Merchandise Co. that it has filed for bankruptcy. The customer states that its bank has a lien on all of its assets. It also states that the liquidation value of those assets is less than the amount it owes the bank, and as a result Gem will receive nothing toward its $1,400 accounts receivable. After confirming this information, Gem concludes that it should remove, or write off, the customer’s account balance of $1,400.
Under the allowance method of recording credit losses, Gem’s entry to write off the customer’s account balance is as follows:
The two accounts affected by this entry contain this information:
Note that prior to the August 24 entry of $1,400 to write off the uncollectible amount, the net realizable value of the accounts receivables was $230,000 ($240,000 debit balance in Accounts Receivable and $10,000 credit balance in Allowance for Doubtful Accounts). After writing off the bad account on August 24, the net realizable value of the accounts receivable is still $230,000 ($238,600 debit balance in Accounts Receivable and $8,600 credit balance in Allowance for Doubtful Accounts).
The Bad Debts Expense remains at $10,000; it is not directly affected by the journal entry write-off. The bad debts expense recorded on June 30 and July 31 had anticipated a credit loss such as this. It would be double counting for Gem to record both an anticipated estimate of a credit loss and the actual credit loss.
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Recovery of Account under Allowance Method
After a seller has written off an accounts receivable, it is possible that the seller is paid part or all of the account balance that was written off. Under the allowance method, if such a payment is received (whether directly from the customer or as a result of a court action) the seller will take the following two steps:
Reinstate the account that was written off by reversing the write-off entry. If we assume that the $1,400 written off on Aug 24 is collected on October 10, the reinstatement of the account looks like this:
Process the $1,400 received on October 10:
The seller’s accounting records now show that the account receivable was paid, making it more likely that the seller might do future business with this customer.
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Bad Debts Expense as a Percent of Sales
Another way sellers apply the allowance method of recording bad debts expense is by using the percentage of credit sales approach. This approach automatically expenses a percentage of its credit sales based on past history.
For example, let’s assume that a company prepares weekly financial statements. Past experience indicates that 0.3% of its sales on credit will never be collected. Using the percentage of credit sales approach, this company automatically debits Bad Debts Expense and credits Allowance for Doubtful Accounts for 0.3% of each week’s credit sales. Let’s assume that in the current week this company sells $500,000 of goods on credit. It estimates its bad debts expense to be $1,500 (0.003 x $500,000) and records the following journal entry:
The percentage of credit sales approach focuses on the income statement and the matching principle. Sales revenues of $500,000 are immediately matched with $1,500 of bad debts expense. The balance in the account Allowance for Doubtful Accounts is ignored at the time of the weekly entries. However, at some later date, the balance in the allowance account must be reviewed and perhaps further adjusted, so that the balance sheet will report the correct net realizable value. If the seller is a new company, it might calculate its bad debts expense by using an industry average until it develops its own experience rate.
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Difference between Expense and Allowance
The account Bad Debts Expense reports the credit losses that occur during the period of time covered by the income statement. Bad Debts Expense is a temporary account on the income statement, meaning it is closed at the end of each accounting year. (Closed means the account balance is transferred to retained earnings, perhaps through an income summary account.) By closing Bad Debts Expense and resetting its balance to zero, the account is ready to receive and tally the credit losses for the next accounting year.
The Allowance for Doubtful Accounts reports on the balance sheet the estimated amount of uncollectible accounts that are included in Accounts Receivable. Balance sheet accounts are almost always permanent accounts, meaning their balances carry forward to the next accounting period. In other words, they are not closed and their balances are not reset to zero.
Because the Bad Debts Expense account is closed each year, while the Allowance for Doubtful Accounts is not, these two balances will most likely not be equal after the company’s first year of operations.
For example, let’s assume that at the end of its first year of operations a company’s Bad Debts Expense had a debit balance of $14,000 and its Allowance for Doubtful Accounts had a credit balance of $14,000. Because the income statement account balances are closed at the end of the year, the company’s opening balance in Bad Debts Expense for the second year of operations is $0. The credit balance of $14,000 in Allowance for Doubtful Accounts, however, carries forward to the second year. If an adjusting entry of $3,000 is made during year 2, Bad Debts Expense will report a $3,000 debit balance, while Allowance for Doubtful Accounts might report a credit balance of $17,000.
Again, the reasons for the account balance differences are 1) Bad Debts Expense is a temporary account that reports credit losses only for the period shown on the income statement, and 2) Allowance for Doubtful Accounts is a permanent account that reports an estimated amount for all of the uncollectible receivables reported in the asset Accounts Receivable as of the balance sheet date.
The general ledger account Accounts Receivable usually contains only summary amounts and is referred to as a control account. The details for the control account—each credit sale for every customer—is found in the subsidiary ledger for Accounts Receivable. The total amount of all the details in the subsidiary ledger must be equal to the total amount reported in the control account.
The detailed information in the accounts receivable subsidiary ledger is used to prepare a report known as the aging of accounts receivable. This report directs management’s attention to accounts that are slow to pay. It is also useful in determining the balance amount needed in the account Allowance for Doubtful Accounts.
The aging of accounts receivable report is typically generated by sorting unpaid sales invoices in the subsidiary ledger—first by customer and then by the date of the sales invoices. If a company sells merchandise (or provides services) and allows customers to pay 30 days later, this report will indicate how much of its accounts receivable is past due. It also reports how far past due the accounts are.
With the click of a mouse, most accounting software will provide the aging of accounts receivable report. For example, Gem Merchandise Co.’s software looks at each of its customer’s accounts receivable activity and compares the date of each unpaid sales invoice to the date of the report. If we assume the report is dated August 31 and that Gem’s credit terms are net 30 days, any unpaid sales invoices with an August date will be classified as current. Any unpaid invoices with a date in July are classified as 1 – 30 days past due. Any unpaid invoices with a date of June are classified as 31 – 60 days past due, and so on. The sorted information is present in a report that looks similar to the following:
If a customer realizes that one of its suppliers is lax about collecting its account receivable on time, it may take advantage by further postponing payment in order to pay more demanding suppliers on time. This puts the seller at risk since an older, unpaid accounts receivable is more likely to end up as a credit loss. The aging of accounts receivable report helps management monitor and collect the accounts receivable in a more timely manner.
Aging Used in Calculating the Allowance
The aging of accounts receivable can also be used to estimate the credit balance needed in a company’s Allowance for Doubtful Accounts. For example, based on past experience, a company might make the assumption that accounts not past due have a 99% probability of being collected in full. Accounts that are 1-30 days past due have a 97% probability of being collected in full, and the accounts 31-60 days past due have a 90% probability. The company estimates that accounts more than 60 days past due have only a 60% chance of being collected. With these probabilities of collection, the probability of not collecting is 1%, 3%, 10%, and 40% respectively.
If we multiply the totals from the aging of accounts receivable report by the probabilities of not collecting, we arrive at the expected amount of uncollectible receivables. This is illustrated below:
This computation estimates the balance needed for Allowance for Doubtful Accounts at August 31 to be a credit balance of $8,585.
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Mailing Statements to Customers
To improve the probability of collection (and avoid bad debts expense) many sellers prepare and mail monthly statements to all customers that have accounts receivable balances. If worded skillfully, the seller can use the statement to say “thank you for your continued business” while at the same time “reminding” the customer that receivables are being monitored and payment is expected. To further prompt customers to pay in a timely manner, the statement may indicate that past due accounts are assessed interest at an annual rate of 18% (1.5% per month). Because transactions are usually itemized on the statement, some customers use the statement as a means to compare its records with those of the seller.
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Pledging or Selling Accounts Receivable
A company’s accounts receivable are considered to be a type of asset, and as such can be pledged as collateral for a loan. Asset-based lenders will often lend a company an amount equal to 80% of the value of its accounts receivable.
Some companies sell their accounts receivable to a factor. A factor buys the accounts receivables at a discount and then goes about the business of collecting and keeping the money owed through the receivables. Sometimes the factor will purchase the accounts receivables with recourse. This means the company that sold the receivables remains financially responsible if a customer does not remit the full amount to the factor. When the factor purchases the receivables without recourse, the company selling the receivables is not responsible for unpaid amounts.
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Accounts Receivable Ratios
There are two commonly used financial ratios that address the relationship between the amount of a company’s accounts receivable as reported on the balance sheet and the amount of credit sales as reported on the income statement. These ratios are:
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Direct Write-off Method
(Generally accepted accounting principles GAAP) require that companies use the allowance method when preparing financial statements. The use of the allowance method is not permitted, however, for purposes of reporting income taxes in the United States because the Internal Revenue Service (IRS) does not allow companies to anticipate these credit losses. As a result, companies must use the direct write-off method for income tax reporting.
In the direct write-off method, a company will not use an allowance account to reduce its Accounts Receivable. Accounts Receivable is only reduced if and when a company knows with certainty that a specific amount will not be collected from a specific customer.
For example, let’s assume that on October 21, Gem Merchandise Co. is convinced that a specific customer’s account receivable originating on June 5 in the amount of $1,238 is definitely uncollectible. Using the direct write-off method, the following entry is made:
Usually many months will pass between the time of the sale on credit and the time that the seller knows with certainty that a customer is not going to pay. It is difficult to adhere to the matching principle and the concept of conservatism when a significant amount of time elapses between the time of the sales revenues and the time that the bad debts expense is reported. This is why, for purposes of financial reporting (not tax reporting), companies should use the allowance method rather than the direct write-off method.
Where to Go From Here
We recommend taking our Practice Quiz next, and then continuing with the rest of our Accounts Receivable and Bad Debts Expense materials (see the full outline below).
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Fees earned from providing services and the amounts of merchandise sold. Under the accrual basis of accounting, revenues are recorded at the time of delivering the service or the merchandise, even if cash is not received at the time of delivery. Often the term income is used instead of revenues.
Examples of revenue accounts include: Sales, Service Revenues, Fees Earned, Interest Revenue, Interest Income. Revenue accounts are credited when services are performed/billed and therefore will usually have credit balances. At the time that a revenue account is credited, the account debited might be Cash, Accounts Receivable, or Unearned Revenue depending if cash was received at the time of the service, if the customer was billed at the time of the service and will pay later, or if the customer had paid in advance of the service being performed.
If the revenues earned are a main activity of the business, they are considered to be operating revenues. If the revenues come from a secondary activity, they are considered to be nonoperating revenues. For example, interest earned by a manufacturer on its investments is a nonoperating revenue. Interest earned by a bank is considered to be part of operating revenues.
The accounting method under which revenues are recognized on the income statement when they are earned (rather than when the cash is received). The balance sheet is also affected at the time of the revenues by either an increase in Cash (if the service or sale was for cash), an increase in Accounts Receivable (if the service was performed on credit), or a decrease in Unearned Revenues (if the service was performed after the customer had paid in advance for the service).
Under the accrual basis of accounting, expenses are matched with revenues on the income statement when the expenses expire or title has transferred to the buyer, rather than at the time when expenses are paid. The balance sheet is also affected at the time of the expense by a decrease in Cash (if the expense was paid at the time the expense was incurred), an increase in Accounts Payable (if the expense will be paid in the future), or a decrease in Prepaid Expenses (if the expense was paid in advance).
A revenue account that reports the sales of merchandise. Sales are reported in the accounting period in which title to the merchandise was transferred from the seller to the buyer.
One of the main financial statements (along with the balance sheet, the statement of cash flows, and the statement of stockholders’ equity). The income statement is also referred to as the profit and loss statement, P&L, statement of income, and the statement of operations. The income statement reports the revenues, gains, expenses, losses, net income and other totals for the period of time shown in the heading of the statement. If a company’s stock is publicly traded, earnings per share must appear on the face of the income statement.
A current asset resulting from selling goods or services on credit (on account). Invoice terms such as (a) net 30 days or (b) 2/10, n/30 signify that a sale was made on account and was not a cash sale.
Things that are resources owned by a company and which have future economic value that can be measured and can be expressed in dollars. Examples include cash, investments, accounts receivable, inventory, supplies, land, buildings, equipment, and vehicles.
Assets are reported on the balance sheet usually at cost or lower. Assets are also part of the accounting equation: Assets = Liabilities + Owner’s (Stockholders’) Equity.
Some valuable items that cannot be measured and expressed in dollars include the company’s outstanding reputation, its customer base, the value of successful consumer brands, and its management team. As a result these items are not reported among the assets appearing on the balance sheet.
One of the main financial statements. The balance sheet reports the assets, liabilities, and owner’s (stockholders’) equity at a specific point in time, such as December 31. The balance sheet is also referred to as the Statement of Financial Position.
This is an operating expense resulting from making sales on credit and not collecting the customers’ entire accounts receivable balances.
Usually financial statements refer to the balance sheet, income statement, statement of cash flows, statement of retained earnings, and statement of stockholders’ equity.
The balance sheet reports information as of a date (a point in time). The income statement, statement of cash flows, statement of retained earnings, and the statement of stockholders’ equity report information for a period of time (or time interval) such as a year, quarter, or month.
The terms which indicate when payment is due for sales made on account (or credit). For example, the credit terms might be 2/10, net 30. This means the amount is due in 30 days; however, if the amount is paid in 10 days a discount of 2% will be permitted. Other terms might be net 10 days, due upon receipt, net 60 days, etc.
The accounting term that means an entry will be made on the left side of an account.
Cash and other resources that are expected to turn to cash or to be used up within one year of the balance sheet date. (If a company’s operating cycle is longer than one year, an item is a current asset if it will turn to cash or be used up within the operating cycle.) Current assets are presented in the order of liquidity, i.e., cash, temporary investments, accounts receivable, inventory, supplies, prepaid insurance.
Current assets minus current liabilities.
The difference between assets and liabilities, such as stockholders’ equity, owner’s equity, or a nonprofit organization’s net assets.
Also used to indicate an owner’s interest in a personal asset. For example, the owner of a $200,000 house with a $75,000 mortgage loan is said to have equity of $125,000.
This is the bottom line of the income statement. It is the mathematical result of revenues and gains minus the cost of goods sold and all expenses and losses (including income tax expense if the company is a regular corporation) provided the result is a positive amount. If the net amount is a negative amount, it is referred to as a net loss.
Cost of goods sold is usually the largest expense on the income statement of a company selling products or goods. Cost of Goods Sold is a general ledger account under the perpetual inventory system.
Under the periodic inventory system there will not be an account entitled Cost of Goods Sold. Instead, the cost of goods sold is computed as follows: cost of beginning inventory + cost of goods purchased (net of any returns or allowances) + freight-in – cost of ending inventory.
This account balance or this calculated amount will be matched with the sales amount on the income statement.
Costs that are matched with revenues on the income statement. For example, Cost of Goods Sold is an expense caused by Sales. Insurance Expense, Wages Expense, Advertising Expense, Interest Expense are expenses matched with the period of time in the heading of the income statement. Under the accrual basis of accounting, the matching is NOT based on the date that the expenses are paid.
Expenses associated with the main activity of the business are referred to as operating expenses. Expenses associated with a peripheral activity are nonoperating or other expenses. For example, a retailer’s interest expense is a nonoperating expense. A bank’s interest expense is an operating expense.
Generally, expenses are debited to a specific expense account and the normal balance of an expense account is a debit balance. When an expense account is debited, the account credited might be Cash (if cash was paid at the time of the expense), Accounts Payable (if cash will be paid after the expense is recorded), or Prepaid Expense (if cash was paid before the expense was recorded.)
A current asset whose ending balance should report the cost of a merchandiser’s products awaiting to be sold. The inventory of a manufacturer should report the cost of its raw materials, work-in-process, and finished goods. The cost of inventory should include all costs necessary to acquire the items and to get them ready for sale.
When inventory items are acquired or produced at varying costs, the company will need to make an assumption on how to flow the changing costs. See cost flow assumption.
If the net realizable value of the inventory is less than the actual cost of the inventory, it is often necessary to reduce the inventory amount.
Terms indicating that the buyer must pay to get the goods delivered. (The buyer will record freight-in and the seller will not have any delivery expense.) With terms of FOB shipping point the title to the goods usually passes to the buyer at the shipping point. This means that goods in transit should be reported as a purchase and as inventory by the buyer. The seller should report a sale and an increase in accounts receivable.
Terms indicating that the seller will incur the delivery expense to get the goods to the destination. With terms of FOB destination the title to the goods usually passes from the seller to the buyer at the destination. This means that goods in transit should be reported as inventory by the seller, since technically the sale does not occur until the goods reach the destination.
That part of the accounting system which contains the balance sheet and income statement accounts used for recording transactions.
A record in the general ledger that is used to collect and store similar information. For example, a company will have a Cash account in which every transaction involving cash is recorded. A company selling merchandise on credit will record these sales in a Sales account and in an Accounts Receivable account.
This account shows the amount of delivery expense incurred (occurring) during the accounting period shown in the heading of the income statement. The title of this account could also be Freight Out or Transportation Out.
Delivery expense to be paid by the seller when its merchandise is sold with terms of FOB destination. This is an operating expense and is not included in the cost of merchandise.
Also known as freight-out or as delivery expense. This is an operating expense further classified as a selling expense. It results when merchandise is sold with terms of FOB destination.
A bill issued by a seller of merchandise or by the provider of services. The seller refers to the invoice as a sales invoice and the buyer refers to the same invoice as a vendor invoice.
A contra revenue account that reports the discounts allowed by the seller if the customer pays the amount owed within a specified time period. For example, terms of “1/10, n/30” indicates that the buyer can deduct 1% of the amount owed if the customer pays the amount owed within 10 days. As a contra revenue account, sales discount will have a debit balance and is subtracted from sales (along with sales returns and allowances) to arrive at net sales.
A contra revenue account that reports the discounts allowed by the seller if the customer pays the amount owed within a specified time period. For example, terms of “1/10, n/30” indicates that the buyer can deduct 1% of the amount owed if the customer pays the amount owed within 10 days. As a contra revenue account, sales discount will have a debit balance and is subtracted from sales (along with sales returns and allowances) to arrive at net sales.
A lender or supplier who is owed money but does not have a lien on any of the assets of the company that owes the money. If the company that owes the money is liquidated, the unsecured lender receives money only after the secured lenders have been paid.
Usually a claim on an asset that is pledged as collateral. The lien is usually filed with a government office.
The average time it takes for a retailer’s or manufacturer’s inventory to turn to cash. If a manufacturer turns its inventory six times per year (every two months) and allows customers to pay in 30 days, its operating cycle is approximately three months.
An asset account which is expected to have a credit balance (which is contrary to the normal debit balance of an asset account). The contra asset account is related to another asset account. For example, the contra asset account Allowance for Doubtful Accounts is related to Accounts Receivable. The contra asset account Accumulated Depreciation is related to a constructed asset(s), and the contra asset account Accumulated Depletion is related to natural resources.
The net of the asset and its related contra asset account is referred to as the asset’s book value or carrying value.
Allowance for Doubtful Accounts is a contra current asset account associated with Accounts Receivable. When the credit balance of the Allowance for Doubtful Accounts is subtracted from the debit balance in Accounts Receivable the result is known as the net realizable value of the Accounts Receivable.
The credit balance in this account comes from the entry wherein Bad Debts Expense is debited. The amount in this entry may be a percentage of sales or it might be based on an aging analysis of the accounts receivables (also referred to as a percentage of receivables).
When the allowance account is used, the company is anticipating that some accounts will be uncollectible in advance of knowing the specific account. As a result the bad debts expense is more closely matched to the sale. When a specific account is identified as uncollectible, the Allowance for Doubtful Accounts should be debited and Accounts Receivable should be credited.
A revenue, expense, gain, or loss account.
A balance on the left side of an account in the general ledger. Typically expenses, losses, and assets have debit balances.
A balance on the right side (credit side) of an account in the general ledger.
The entry made in a journal. It will contain the date, the account name and amount to be debited, and the account name and amount to be credited. Each journal entry must have the dollars of debits equal to the dollars of credits.
In the context of inventory, net realizable value or NRV is the expected selling price in the ordinary course of business minus the costs of completion, disposal, and transportation.
In the context of accounts receivable it is the amount of accounts receivable that is expected to be collected. This should be the debit balance in Accounts Receivable minus the credit balance in Allowance for Doubtful Accounts.
You could think of NRV as the cash realizable value.
The principle that requires a company to match expenses with related revenues in order to report a company’s profitability during a specified time interval. Ideally, the matching is based on a cause and effect relationship: sales causes the cost of goods sold expense and the sales commissions expense. If no cause and effect relationship exists, accountants will show an expense in the accounting period when a cost is used up or has expired. Lastly, if a cost cannot be linked to revenues or to an accounting period, the expense will be recorded immediately. An example of this is Advertising Expense and Research and Development Expense.
Sales made on account. Sales where the customer is allowed to pay at a later date. Noncash sales.
An account in the general ledger, such as Cash, Accounts Payable, Sales, Advertising Expense, etc.
The entry made in a journal. It will contain the date, the account name and amount to be debited, and the account name and amount to be credited. Each journal entry must have the dollars of debits equal to the dollars of credits.
This accounting guideline states that if doubt exists between two acceptable alternatives (in other words the accountant needs to break a tie), the accountant should choose the alternative that will result in a lesser asset amount and/or a lesser profit. A classic example is inventory where the net realizable value (NRV) is less than the actual cost. The accountant must decide whether to leave the inventory at cost or to reduce the inventory amount to its NRV. Conservatism directs the accountant to reduce the inventory to the lower amount (NRV). This results in a lower asset amount and a debit to an income statement account, such as Loss from Reducing Inventory to NRV
Journal entries usually dated the last day of the accounting period to bring the balance sheet and income statement up to date on the accrual basis of accounting.
Adjusting entries are made to report (1) revenues that have been earned but not yet entered into the accounting records, (2) expenses that have been incurred but have not yet been entered into the accounting records, (3) revenues already recorded that pertain to a future accounting period, or (4) expenses already recorded that pertain to a future accounting period.
A stockholders’ equity account that generally reports the net income of a corporation from its inception until the balance sheet date less the dividends declared from its inception to the date of the balance sheet.
A temporary account to which the income statement accounts are closed. This account is then closed to the owner’s capital account or a corporation’s retained earnings account. This and other summary accounts can be thought of as a clearing account.
A general ledger account containing the correct total amount without containing the details. For example, Accounts Receivable could be a control account in the general ledger. Each day the total of the day’s credit sales and the day’s collections are posted to this account. However, the details involving specific customers’ accounts will be found in a subsidiary ledger.
A record of the details to support a general ledger account. The general ledger account is often referred to as the control account. For example, the accounts receivable subsidiary ledger provides the details to support the balance in the general ledger control account Accounts Receivable.
The financial ratio which indicates the speed at which a company collects its accounts receivable. If a company’s turnover is 10, this means the company’s accounts receivable are turning over 10 times per year. It indicates that the company, on average, is collecting its receivables in 36.5 days (365 days per year divided by 10)
The general guidelines and principles, standards and detailed rules, plus industry practices that exist for financial reporting. Often referred to by its acronymn GAAP.
Includes the main financial statements (income statement, balance sheet, statement of cash flows, statement of retained earnings, statement of stockholders’ equity) plus other financial information such as annual reports, press releases, etc.
For the past 52 years, Harold Averkamp (CPA, MBA) has
worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.
