Chapter 3
Special Accounting Problems
IN THIS CHAPTER
Sorting out accounts receivable and accounts payable
Keeping track of inventory
Figuring out fixed assets
Finding out about asset write-downs
Recognizing liability
Handling revenue and expense account closings
Even if you understand the principles of accounting (which I describe in Book 1, Chapter 1) and the basics of double-entry bookkeeping (which I describe in Book 1, Chapter 2), you still may not have all the information that you need to keep good records. Tracking the amounts that customers owe you and the amounts that you owe vendors can be a bit tricky, for example. Inventory can also present challenging record-keeping problems — a fact that’s not surprising to you as a retailer. And things like fixed assets — oh, don’t even get me started.
For these reasons, this chapter describes the most common complexities that business owners confront. You don’t need to be an accountant or an experienced bookkeeper to understand the material in this chapter. You do need to proceed carefully, take your time, and think a bit about how the material I describe here applies to your specific business situation.
Working with Accounts Receivable
If you read Book 1, Chapter 1, you already know that accounting principles state that sales revenue needs to be recognized when a sale is made and that the sale is made when a business provides goods or services to a customer.
In other words — and this point is really important — sales revenue doesn’t get recorded when you receive payment from a customer. Sales revenue gets recorded when a customer has a legal obligation to pay you because you have (or your business has) provided the customer the goods or services.
Recording a sale
This requirement to record sales revenue at the time that goods or services are provided means that accounting for sales revenue is slightly more complicated than you may have first guessed. The first transaction — the transaction that records a sale — is shown in Table 3-1.
TABLE 3-1 Journal Entry 1: Recording a Credit Sale
Account | Debit | Credit |
|---|---|---|
Accounts receivable |
$1,000 |
|
Sales revenue |
$1,000 |
Journal Entry 1 shows how a $1,000 sale may be recorded. The journal entry shows a $1,000 debit to accounts receivable (sometimes abbreviated A/R) and a $1,000 credit to sales revenue. To record a $1,000 sale — a credit sale — the journal entry needs to show both the $1,000 increase in accounts receivable and the $1,000 increase in sales revenue.
Recording a payment
When the business receives payment from the customer for the $1,000 receivable, the business records a journal entry like that shown in Table 3-2.
Journal Entry 2 shows a $1,000 debit to cash, which is the $1,000 increase in the cash account that occurs because the customer has just paid you $1,000. Journal Entry 2 also shows a $1,000 credit to accounts receivable. This credit to the accounts receivable asset account reduces the accounts receivable balance.
TABLE 3-2 Journal Entry 2: Recording the Customer Payment
Account | Debit | Credit |
|---|---|---|
Cash |
$1,000 |
|
Accounts receivable |
$1,000 |
At the point when you record Journal Entries 1 and 2, the net effect is a $1,000 debit to cash (showing that cash has increased by $1,000) and a $1,000 credit to sales revenue (showing that sales revenue has increased by $1,000). The $1,000 debit to accounts receivable and the $1,000 credit to accounts receivable net to zero.
If you think about this accounts receivable business a bit, you should realize that it makes sense. Although the accounts receivable account includes a $1,000 receivable balance, this just means that the customer owes you $1,000. But when the customer finally pays off the $1,000 bill, you need to zero out that receivable.
QuickBooks, by the way, automatically records Journal Entries 1 and 2 for you. Journal Entry 1 gets recorded whenever you issue or create a customer invoice. Therefore, you don’t need to worry about the debits and credits shown in Journal Entry 1 except on one special occasion: When you set up QuickBooks and QuickBooks items, you do specify which account should be credited to track sales revenue. So although you may not need to worry much about the mechanics of Journal Entry 1, you should understand how this journal entry works so that you can set up QuickBooks correctly. (Book 2, Chapter 1 describes the mechanics of setting up QuickBooks.)
Items are things that get included in the invoices.
Journal Entry 2 also gets recorded automatically by QuickBooks. QuickBooks records Journal Entry 2 for you whenever you record a cash payment from a customer. You don’t need to worry, then, about the debits and credits necessary for recording customer payments. I find that it’s helpful, however, to understand how this journal entry works and how QuickBooks records this customer payment transaction.
Estimating bad-debt expense
One other important journal entry to understand is shown in Table 3-3.
TABLE 3-3 Journal Entry 3: Recording an Allowance for Uncollectible Accounts
Account | Debit | Credit |
|---|---|---|
Bad-debt expense |
$100 |
|
Allowance for uncollectible A/R |
$100 |
Journal Entry 3 records an estimate of the uncollectible portion of accounts receivable. (Businesses that don’t want to keep accrual-based accounting statements may not need to worry about Journal Entry 3.) Unfortunately, some of the money you bill customers may be uncollectible. Yet Journal Entry 1 records every dollar that you bill your customers as revenue. Therefore, you need a way to offset, or reduce, some of the sales revenue by the amount that ultimately turns out to be uncollectible.
Journal Entry 3 shows a common way of doing this. This entry debits bad-debt expense — which is an expense account that you may use to record uncollectible customer receivables. Journal Entry 3 also credits another account shown as allowance for uncollectible A/R. This allowance account is called a contra-asset account, which means that it basically reduces the balance reported on the balance sheet of an asset account. In the case of the allowance for uncollectible A/R accounts, for example, this $100 credit reduces the accounts receivable balance shown in the balance sheet by $100.
Where the bad-debt expense shown in Journal Entry 3 appears varies from business to business. Some businesses report the bad-debt expense with the other sales revenue, thereby allowing the income statement to show net sales revenue; other businesses report it with the other operating expenses. You should report bad-debt expense wherever it makes most sense in terms of managing your business.
QuickBooks doesn’t automatically record the transaction in Journal Entry 3. You record estimates of bad-debt expense yourself by using the QuickBooks Make General Journal Entries command. You can find out more about these types of entries in Book 4, Chapter 1.
Removing uncollectible accounts receivable
If you do set up an allowance for uncollectible accounts, you also need to remove the uncollectible accounts periodically from both the accounts receivable balance and the allowance for uncollectible accounts. You don’t want to do this while any chance to collect on the accounts exists. But at some point, obviously, you may as well clean out the bad receivables from your records. It makes no sense, for example, to have uncollectible receivables from 17 years ago still appearing in your balance sheet. Table 3-4 illustrates how to clean out bad receivables.
TABLE 3-4 Journal Entry 4: Writing Off an Uncollectible Receivable
Account | Debit | Credit |
|---|---|---|
Allowance for uncollectible |
$100 |
|
Accounts receivable |
$100 |
This journal entry debits the allowance from the uncollectible A/R account for $100. The journal entry also credits the accounts receivable account for $100. In combination, these two entries zero out the allowance for the uncollectible A/R account and remove the uncollectible amount from the accounts receivable account.
Writing off an actual, specific uncollectible receivable for invoice should be done on a case-by-case basis, which is what Journal Entry 4 shows.
None of these entries is particularly tricky as long as you understand the logic — something that I hope I’ve illuminated for you in this discussion. If you do have trouble with these journal entries or with recording the economic events that they attempt to summarize, you may want to consult your CPA. Most likely, you’d record these same transactions (with different customers and amounts, of course) many, many times over the year. If you can get a bit of help or a template that shows you how to record these transactions, you should be able to record them yourself without any outside help.
To write off an uncollectible account receivable, you record a credit memo and then apply the credit memo to the uncollectible account. The item shown in your credit memo should cause the allowance for uncollectible accounts to be debited.
Recording Accounts Payable Transactions
Within QuickBooks, you have the option of working with or without an accounts payable account. If you want to, you can record expenses when you write checks. This means that to have a complete list of all your expenses, you must have recorded checks that pay all your expenses. This approach works fine — and, in fact, is the approach that I’ve always used in my businesses.
QuickBooks also supports a more precise approach of recording expenses. By answering a few questions during the QuickBooks setup process, you can set up an accounts payable account, which is an account that tracks the amounts that you owe your vendors and other suppliers.
Recording a bill
When you use an accounts payable account, you enter the bills that you get from vendors when you receive them.
Table 3-5 shows the way this transaction is recorded. Journal Entry 5 automatically debits office-supplies expense for $1,000 and credits accounts payable for $1,000. QuickBooks would record this journal entry if you purchased $1,000 of office supplies and then entered that bill into the QuickBooks system.
TABLE 3-5 Journal Entry 5: Recording a Credit Purchase
Account | Debit | Credit |
|---|---|---|
Office supplies |
$1,000 |
|
Accounts payable |
$1,000 |
Paying a bill
When you later pay that bill, QuickBooks records Journal Entry 6, shown in Table 3-6. In Journal Entry 6, QuickBooks debits accounts payable for $1,000 and credits cash for $1,000. The net effect on accounts payable combining both the purchase and the payment is zero. That makes sense, right? The approach shown in Journal Entries 5 and 6 counts the amount that you owe some vendor or supplier as a liability — accounts payable — only while you owe the money.
TABLE 3-6 Journal Entry 6: Recording the Payment to Vendor
Account | Debit | Credit |
|---|---|---|
Accounts payable |
$1,000 |
|
Cash |
$1,000 |
When you record Journal Entry 6 in QuickBooks, you must supply the name of the account that gets debited. QuickBooks obviously knows which account to credit: the accounts payable account. But QuickBooks also has to know the expense or asset account to debit.
QuickBooks does need to know which cash account to credit when you pay an accounts payable amount. You identify this account when you write the check to pay the bill.
Taking some other accounts payable pointers
Let me make a couple of additional points about Journal Entries 5 and 6:
- The accounts payable method is more accurate. The accounts payable method, which Journal Entries 5 and 6 show, is the best way to record your bills. The accounts payable method means that you record expenses when the expenses actually occur. As you may have already figured out, the accounts payable method is the mirror image of the accounts receivable approach described in the early paragraphs of this chapter. The accounts payable method, as you may intuit, delivers two big benefits: It keeps track of the amounts that you owe vendors and suppliers, and it recognizes expenses as they occur rather than when you pay them (which may be some time later).
- Not every debit is for an expense. Journal Entry 5 shows the debit going to an office-supplies expense account. Many of the accounts payable that you record are amounts owed for expenses. Not every accounts payable transaction stems from incurring some expense, however. You may also need to record the purchase of an asset, such as a piece of equipment. In this case, the debit goes not to an expense account, but to an asset account. Except for this minor change, however, the transaction works the same way. I describe how fixed asset accounting works later in this chapter, in the “Accounting for Fixed Assets” section.
Can you guess how an expense or fixed asset purchase gets recorded if you don’t use an accounts payable account? In the case in which you paid $1,000 for office supplies, QuickBooks debits office-supplies expense for $1,000 and credits cash for $1,000 when you write a $1,000 check. As part of writing the check, you identify which expense account to debit.
If you’re purchasing a $1,000 piece of equipment, the journal entry looks and works roughly the same way. When you record the purchase, QuickBooks debits the asset account for $1,000 and credits cash for $1,000. Again, this transaction gets recorded when you write the check to pay for the asset.
Inventory Accounting
Fortunately, most of the inventory accounting that goes on in a business gets handled automatically by QuickBooks. When you purchase an inventory item by writing a check or recording an accounts payable bill, for example, QuickBooks automatically adjusts your inventory accounts for both the dollar value of the inventory and the quantity of the items. When you sell an inventory item to a customer, QuickBooks again automatically adjusts the dollar value of your inventory and adjusts the quantity counts of the items you sell.
Basically, all this means is that QuickBooks maintains a perpetual inventory system — an inventory system that lets you know at any time what quantity of items you have in inventory and what value your inventory amounts to. (In the past, smaller firms often used a periodic inventory system, which meant that business owners never really knew with any precision the dollar value of their inventory or the quantity counts for the inventory items that they held.)
Although everything in the preceding paragraph represents good news, several inventory-related headaches do require a bit of accounting magic. Specifically, if your firm carries inventory, you need to know how to deal with obsolete inventory, disposal of obsolete inventory, and inventory shrinkage. I discuss all three accounting gambits in the following sections.
Dealing with obsolete inventory
Obsolete inventory refers to items that you’ve purchased for sale but turn out not to be saleable. Perhaps customers no longer want it. Perhaps you have too much of the inventory item and will never be able to sell everything that you hold.
In either case, you record the fact that your inventory value is actually less than what you purchased it for. And you want to record the fact that really, the money you spent on the obsolete item is an expense. Suppose that you purchased some $100 item that you now realize is obsolete. How do you record this obsolescence? Table 3-7 shows the conventional approach.
TABLE 3-7 Journal Entry 7: Recording an Allowance for Obsolete Inventory
Account | Debit | Credit |
|---|---|---|
Inventory obsolescence |
$100 |
|
Allowance for obsolete inventory |
$100 |
As Journal Entry 7 shows, to record the obsolescence of a $100 inventory item, you first debit an expense account called something like “Inventory obsolescence” for $100. Then you credit a contra-asset account named something like “Allowance for obsolete inventory” for $100. As I mention in the discussion of accounts receivable, a contra-asset account gets reported on the balance sheet immediately below the asset account to which it relates. The contra-asset account, with its negative credit balance, reduces the net reported value of the asset account. If the inventory account balance is $3,100, and you have an allowance for an obsolete inventory contra-asset account of $100, the net inventory balance shows up as $3,000. In other words, the contra-asset account gets subtracted from the related asset account.
QuickBooks requires you to record Journal Entry 7 yourself by using the Make General Journal Entries command. You can find out more about these types of entries in Book 4, Chapter 1.
Disposing of obsolete inventory
When you ultimately do dispose of obsolete inventory, you record a journal entry like the one shown in Table 3-8. This journal entry debits the contra-asset account for $100 and credits inventory for $100. In other words, this journal entry removes the value of the obsolete inventory from both the allowance for obsolete inventory account and the inventory account itself. You record this journal entry when you actually, physically dispose of the inventory — when you pay the junk man to haul away the inventory, for example, or when you toss the inventory into the large Dumpster behind your office or factory.
TABLE 3-8 Journal Entry 8: Recording Disposal of Inventory
Account | Debit | Credit |
|---|---|---|
Allowance for obsolete inventory |
$100 |
|
Inventory |
$100 |
In general, one thing you should do every year for tax accounting reasons is deal with your obsolete inventory. The tax rules generally state that you can’t write off obsolete inventory unless you actually dispose of it for income purposes. Typically, however, you can write down inventory to its liquidation value. Such a write-down works the same way as a write-down for obsolete inventory. A write-down can be a little tricky if you’ve never done it before, however, so you may want to confer with your tax adviser.
One more really important point about recording disposal of obsolete inventory: Within QuickBooks, you record inventory disposal by adjusting the physical item count of the inventory items. I describe how adjusting the physical inventory accounts works in Book 3, Chapter 3. So even though I won’t go down that path here, you should know that you don’t actually enter a journal entry like the one shown in Journal Entry 8. You adjust the inventory accounts for the obsolete inventory. This adjustment automatically reduces the inventory account balance. When QuickBooks asks you which account to debit, you specify the allowance for obsolete inventory account.
Dealing with inventory shrinkage
The other chronic inventory headache that many business owners and business managers have to deal with is inventory shrinkage. It’s very likely, sometimes for the most innocent reasons, that your inventory records overstate the quantity counts of items. When this happens, you must adjust your records. Essentially, you want to reduce both the dollar value of your inventory and the quantity counts of your inventory items.
Table 3-9 shows the journal entry that QuickBooks makes for you to record this event. This journal entry debits an appropriate expense account — in Journal Entry 9, I call the expense account “Shrinkage expense” — for $100. A journal entry also needs to credit the inventory account for $100.
TABLE 3-9 Journal Entry 9: Recording Inventory Shrinkage
Account | Debit | Credit |
|---|---|---|
Shrinkage expense |
$100 |
|
Inventory |
$100 |
Within QuickBooks, as I’ve mentioned, you don’t actually record a formal journal entry like the one shown here. You use something called a physical count worksheet to adjust the quantities of your inventory item counts to whatever they actually are. When you make this adjustment, QuickBooks automatically credits the inventory account balance and adjusts the quantity counts. QuickBooks also requires you to supply the expense account that it should debit for the shrinkage.
In the old days (by the old days, I mean a few decades ago), businesses compared their accounting records with the physical counts of inventory items only once a year. In fact, the annual inventory physical count was a painful ritual that many distributors and retailers went through. These days, I think, most businesses have found that it works much better to stage physical inventory counts throughout the year. This approach, called cycle counting, means that you’re probably comparing your accounting records with physical counts for your most valuable items several times a year. For your moderately valuable items, you’re probably comparing your inventory accounting records with physical counts once or twice a year. With your least valuable inventory items, you probably compare inventory records with physical counts only irregularly, and you may accept a degree of imprecision. Rather than count screws in some bin, for example, you may weigh the bin and then make an estimate of the screw count. In any case, you want some system that allows you to compare your accounting records with your physical counts. Inventory shrinkage and inventory obsolescence represent real costs of doing business that won’t get recorded in your accounting records in any other way.
Accounting for Fixed Assets
Fixed assets are those items that you can’t immediately count as expenses when purchased. Fixed assets include such things as vehicles, furniture, equipment, and so forth. These assets are tricky for two reasons: Typically, you must depreciate them (more on that in a bit), and you need to record their disposal at some point in the future for either a gain or a loss.
Purchasing a fixed asset
Accounting for the purchase of a fixed asset is pretty straightforward. Table 3-10 shows how a fixed-asset purchase typically looks.
TABLE 3-10 Journal Entry 10: Recording Fixed-Asset Purchase
Account | Debit | Credit |
|---|---|---|
Delivery truck |
$12,000 |
|
Cash |
$12,000 |
If you purchase a $12,000 delivery truck with cash, for example, the journal entry that you use to record this purchase debits “Delivery truck” for $12,000 and credits “Cash” for $12,000.
Within QuickBooks, this journal entry gets made when you write the check to pay for the purchase. The one thing that you absolutely must do is set up a fixed-asset account for the specific asset. In other words, you don’t want to debit a general catch-all fixed-asset account. If you buy a delivery truck, you set up a fixed-asset account for that specific delivery truck. If you buy a computer system, you set up a fixed-asset account for that particular computer system. In fact, the general rule is that any fixed asset that you buy individually or dispose of later individually needs its own asset account. The reason is that if you don’t have individual fixed-asset accounts, the job of calculating gains and losses on the disposal of the fixed asset turns into a Herculean task later.
Dealing with depreciation
Depreciation is an accounting gimmick to recognize the expense of using a fixed asset over a period of time. Although you may not be all that familiar with the mechanics of depreciation, you probably do understand the logic. For the sake of illustration, suppose that you bought a $12,000 delivery truck. Also suppose that because you know how to do your own repair work and take excellent care of your vehicles, you’ll be able to use this truck for ten years. Further suppose that at the end of the ten years, the truck will have a $2,000 salvage value (your best guess). Depreciation says that if you buy something for $12,000 and later sell it for $2,000, that decrease in value can be apportioned to expense. In this case, the $10,000 decrease in value is counted as expense over ten years. That expense is called depreciation.
Accountants and tax accounting laws use a variety of methods to apportion the cost of using an asset over the years in which it’s used. A common method is called straight-line depreciation. Straight-line depreciation divides the decrease in value by the number of years that an asset is used. An asset that decreases $10,000 over ten years, for example, produces $1,000 a year of depreciation expense.
To record depreciation, you use a journal entry like the one shown in Table 3-11.
TABLE 3-11 Journal Entry 11: Recording Fixed Asset Depreciation
Account | Debit | Credit |
|---|---|---|
Depreciation expense |
$1,000 |
|
Acc. dep. — delivery truck |
$1,000 |
Journal Entry 11 debits an expense account called “Depreciation expense” for $1,000. Journal Entry 11 also credits a contra-asset account called “Acc. dep. — delivery truck” for $1,000. (By convention, because the phrase accumulated depreciation is so long, accountants and bookkeepers usually abbreviate it as acc. dep.) Note also that you need specific individual accumulated depreciation contra-asset accounts for each specific individual fixed asset account. You don’t want to lump all your accumulated depreciation together into a single catch-all account. Down that way lie madness and ruin.
Disposing of a fixed asset
The final wrinkle of fixed-asset accounting concerns disposal of a fixed asset for a gain or for a loss. When you ultimately sell a fixed asset or trade it in or discard it because it’s now junk, you record any gain or loss on the disposal of the asset. You also remove the fixed asset from your accounting records.
To show you how this works, consider again the example of the $12,000 delivery truck. Suppose that you’ve owned and operated this truck for two years. Over that time, you’ve depreciated $2,000 of the truck’s original purchase price. Further suppose that you’re going to sell the truck for $11,000 in cash. Table 3-12 shows the journal entry that you’d make to record this disposal.
TABLE 3-12 Journal Entry 12: Recording Fixed-Asset Sale for Gain
Account | Debit | Credit |
|---|---|---|
Delivery truck |
$12,000 |
|
Cash |
$11,000 |
|
Acc. dep. — delivery truck |
$2,000 |
|
Gain on sale |
$1,000 |
The first component of Journal Entry 12 shows the $12,000 credit of the delivery truck asset. This makes sense, right? You remove the delivery truck from your fixed-asset amounts by crediting the account for the same amount that you originally debited the account when you purchased the asset.
The next component of the journal entry shows the $11,000 debit to cash. This component, again, is pretty straightforward. It shows the cash that you receive by selling the asset.
The third component of the journal entry backs out the accumulated depreciation. If you depreciated the truck $1,000 a year for two years, the accumulated depreciation contra-asset account for the truck should equal $2,000. To remove this accumulated depreciation from your balance sheet, you debit the accumulated depreciation account for $2,000.
The final piece of the disposal journal entry is a plug — a calculated amount. You know the amount and whether that amount is a debit or credit by looking at the other accounts affected. In the case of Journal Entry 12, you know that a $1,000 credit is necessary to balance the journal entry. Debits must equal credits.
A credit is a gain. A credit is essentially revenue, as you may remember from the discussion of double-entry bookkeeping in Book 1, Chapter 2.
If the plug was a debit amount, the disposal produces a loss. This makes sense; a loss is like an expense, and expenses are debits.
If you’re confused about the gain component of Journal Entry 12, let me make this observation. Over the two years of use, the business depreciated the truck by $2,000. In other words, the business, through the depreciation expense, said that the truck lost $2,000 of value. If, however, the $12,000 delivery truck is sold two years later for $11,000, the loss in value doesn’t equal $2,000; it equals $1,000. The $1,000 gain essentially recaptures the unnecessary extra depreciation that was charged incorrectly.
You can enter Journal Entries 11 and 12 as journal entries within QuickBooks by using the Make General Journal Entries command.
Recognizing Liabilities
Liabilities are amounts that a business owes to other parties. If a business owes a bank money because of a loan, that’s a liability. If a business owes an employee wages or benefits, that’s a liability. If a business owes the federal, state, or local government taxes, those are liabilities.
Borrowing money
Liabilities, fortunately, aren’t too tricky to record after you’ve seen how the journal entries look. Table 3-13, for example, shows how you record money borrowed on a loan. In the case of a $10,000 loan, you would debit cash for $10,000 and credit a loan payable liability account for $10,000.
TABLE 3-13 Journal Entry 13: Borrowing Money via a Loan
Account | Debit | Credit |
|---|---|---|
Cash |
$10,000 |
|
Loan payable |
$10,000 |
Sometimes, you may purchase an asset with a loan. Suppose that you purchased $10,000 worth of furniture by using a note payable or a loan. Even though there’s no immediate cash effect, you still record the transaction. Table 3-14 shows how you record this transaction. A furniture account gets debited for $10,000, and a loan payable account gets credited for $10,000.
TABLE 3-14 Journal Entry 14: Buying an Asset with a Loan
Account | Debit | Credit |
|---|---|---|
Furniture |
$10,000 |
|
Loan payable |
$10,000 |
You can record Journal Entry 13 directly in your checkbook when you record the $10,000 cash deposit. You can also record Journal Entry 13, as well as Journal Entry 14, by using the Make General Journal Entries command that QuickBooks provides. By the way, you can record Journal Entry 14 only by using the Make General Journal Entries command.
Making a loan payment
To record the payment on a loan, you or QuickBooks makes a journal entry like the one shown in Table 3-15. Suppose that in connection with the loan shown in Journal Entry 13, you need to pay $2,200. Further suppose that this amount is for $1,200 of loan interest and $1,000 of principal. In this case, you debit loan payable for $1,000, debit loan interest expense for $1,200, and credit cash for $2,200.
TABLE 3-15 Journal Entry 15: Paying a Loan Payment
Account | Debit | Credit |
|---|---|---|
Loan payable |
$1,000 |
|
Loan interest expense |
1,200 |
|
Cash |
$2,200 |
Sometimes, the tricky thing about loan payments is breaking the payment amount into its principal and interest components. Ideally, the lender will provide you an amortization schedule that breaks down payments into principal and interest.
If a lender doesn’t provide such an amortization schedule, you can calculate the interest expense yourself by using either a spreadsheet or a calculator. In Microsoft Excel, right-click on any worksheet tab, select Insert, and double-click the Amortization Table on the Spreadsheet Solutions tab. Then, after you’ve calculated the interest expense, you can deduce the principal component by subtracting the interest from the payment amount.
Accruing liabilities
I want to show you one other liability-related journal entry. Very commonly, a business owes money for some goods or services or taxes that must be recorded in the accounting system. If, at the end of an accounting period — say, at the end of the year — you owe $1,200 of interest on some loan, you really need to record that interest expense in your accounting system. You want to record the fact that although the loan balance may show as $10,000 in your accounting records, you probably really owe $11,200 because you owe both the $10,000 of principal and $1,200 of accrued interest.
To accrue a liability, you use a journal entry like the one shown in Table 3-16. This journal entry shows the accrual of $1,200 of interest expense on a loan payable.
TABLE 3-16 Journal Entry 16: Accruing a Liability
Account | Debit | Credit |
|---|---|---|
Loan interest expense |
$1,200 |
|
Loan interest payable |
$1,200 |
The journal entry shows a $1,200 debit to loan interest expense and a $1,200 credit to loan interest payable. This journal entry records amounts that you owe as of the end of the accounting period that don’t get recorded in some other way.
You need to be careful about using journal entries like the one shown in Table 3-16. Typically, you want to use such journal entries when it’s very important to count all your expenses and to measure all your liabilities accurately.
One common situation in which you want to be especially careful about making such accruals occurs if you sell your firm. Any prospective purchaser wants to have not only a very good estimate of your true expenses for the accounting period, but also a very accurate estimate of liabilities at the time the business is being evaluated.
Liability accruals like the one shown in Journal Entry 16 present a problem to the accountant or bookkeeper, however. To return to the example of the accrued interest shown in Journal Entry 16, suppose that at a later time, the business makes a $3,000 payment, which includes the interest accrued in Journal Entry 16. When the accountant or bookkeeper later records this loan payment, he or she must remember or recognize the earlier journal entry. You don’t want the accountant or bookkeeper to double-count interest expense by recording the same interest again. This makes sense, right?
Because accountants and bookkeepers can’t reliably remember these sorts of accrual entries — they may need to recall them months later — they typically back out the effect of the accrual from the first day of the new accounting period.
If Journal Entry 16 were recorded at the end of year 1 to accurately estimate interest expense and liability balances, an accountant or bookkeeper could, on the first day of year 2, enter a reversing journal entry. This reversing journal entry would credit loan interest expense for $1,200 and debit loan interest payable for $1,200. In other words, this reversing journal entry reverses the earlier accrual. Because the accrual entry is still in year 1, however, year 1’s estimates of interest expense and liability account balances are still correct.
Table 3-17 shows how a reversing entry looks. Again, notice that it’s simply the mirror image of Journal Entry 16. The debits and credits are flip-flopped.
TABLE 3-17 Journal Entry 17: Reversing an Accrual
Account | Debit | Credit |
|---|---|---|
Loan interest expense |
$1,200 |
|
Loan interest payable |
$1,200 |
When the actual loan interest payment is made, the journal entry appears as though no accrual or reversal ever existed, as Table 3-18 shows. Suppose that at some time in year 2, the business pays $1,800 in interest by making a cash payment. Journal Entry 18 shows how this transaction gets recorded.
TABLE 3-18 Journal Entry 18: The “Real” Loan Interest Payment
Account | Debit | Credit |
|---|---|---|
Loan interest expense |
$1,800 |
|
Cash |
$1,800 |
Let me quickly summarize what happens with Journal Entries 16, 17, and 18:
- Journal Entry 16 enables you to show that at the end of year 1, the business owes $1,200 of interest on a loan — even though that interest hasn’t yet been paid. Journal Entry 16 also shows that even though the money wasn’t paid, loan interest expense of $1,200 was incurred.
- Journal Entries 17 and 18 need to be combined to be understood. Journal Entry 17, for example, reduces the loan interest payable to zero. Remember that the loan interest payable would be a balance sheet liability account. The combination of the $1,200 debit and credit zero this account out. The $1,200 credit to loan interest expense in Journal Entry 17 must be combined with the $1,800 debit to loan interest expense in Journal Entry 18. This seems funny, because after all, aren’t you really paying $1,800 of interest? That’s true. But looking back at Journal Entry 16, you can see that you’ve already recorded $1,200 of loan interest expense. That interest expense has been recorded for year 1 in this example. If you have $1,800 of loan interest in total, what’s left over for year 2 is the remaining $600. The combination of the $1,200 credit to loan interest expense and the $1,800 debit to loan interest expense produces this $600 of loan interest expense. The only other component of these two journal entries is the $1,800 credit to cash. This credit to cash represents just the actual cash payment that’s made to pay the loan interest amount.
You need to be careful when working with accrual entries, reversing entries, and then the real entries that follow and correct everything in the end. These tools can be enormously helpful when it’s important to measure expenses and liabilities accurately. You must remember to complete the entire sequence of transactions, however; you can’t stop halfway.
One last important point: In Journal Entries 16, 17, and 18, I talk about how to accrue loan interest expense. You can use this accrual technique to recognize any liability — a fact that I want to emphasize. You can use the technique demonstrated in these journal entries to deal with liabilities for things such as wages owed to employees, taxes owed to the government, and so forth.
Some firms, particularly those with sophisticated accounting systems, can even use this technique to record hard-to-quantify liabilities, such as warranty liabilities. (A warranty is a promise that you make to a customer. You might promise that your product won’t break, for example.) These promises create liabilities and expenses. An accurate accounting system requires that you record these expenses as they occur and recognize these liabilities as they come into existence.
Closing Out Revenue and Expense Accounts
You’re about to enter the twilight zone of accounting. In this section, I talk about what happens to revenue and expense accounts at the end of the year in traditional manual accounting systems. Then I explain why QuickBooks doesn’t quite work that way and what you need to do about it.
If you want to skip anything in this chapter, this section may be that material. On the other hand, if you (like me) have a compulsive personality and deem it essential to read everything in this chapter (even stuff that’s not particularly exciting), read on.
Book 1, Chapter 1 and Book 1, Chapter 2 describe an imaginary hot dog stand, a one-day business that (in my imagination) you operate. (If you’ve been reading this chapter and have no questions, you don’t even need to worry about the two preceding chapters.) Table 3-19 shows the trial balance for this business at the end of the day of operation.
The traditional close
As I hope you already know, revenue and expense accounts count revenue and expenses for a particular period of time. Revenue and expense accounts may count for the month, the quarter, or the year, for example.
One thing that accounting systems traditionally do is zero out the revenue and expense accounts at the end of the year. This makes sense if you think about it a bit. You want your counters reset at the beginning of the year so that counting the new year’s revenue and the new year’s expenses is easy. In the case of a trial balance like the one shown in Table 3-19, for example, you’d typically make the journal entry shown in Table 3-20.
TABLE 3-19 A Trial Balance at the End of the Period
Account | Debit | Credit |
|---|---|---|
Cash |
$5,000 |
|
Inventory |
0 |
|
Accounts payable |
$0 |
|
Loan payable |
0 |
|
S. Nelson, capital |
1,000 |
|
Sales revenue |
13,000 |
|
Cost of goods sold |
3,000 |
|
Rent |
1,000 |
|
Wages expense |
4,000 |
|
Supplies |
1,000 |
_____ |
Totals |
$14,000 |
$14,000 |
TABLE 3-20 Journal Entry 19: Closing the Period
Account | Debit | Credit |
|---|---|---|
Sales revenue |
$13,000 |
|
Cost of goods sold |
$3,000 |
|
Rent |
1,000 |
|
Wages expense |
4,000 |
|
Supplies |
1,000 |
|
Owner’s equity |
4,000 |
If you look at Journal Entry 19 (Table 3-20), for example, you see that the first line in the journal entry is a $13,000 debit for sales revenue. If you look back at the trial balance shown in Table 3-19, you see that sales revenue has a $13,000 credit balance. The combination of the account balance shown in Table 3-19 and the closing entry shown in Journal Entry 19 (Table 3-20) effectively zeros out the sales revenue account.
The same sort of accounting magic occurs for each of the other expense accounts shown in the trial balance. The cost-of-goods-sold balance is equal to a $3,000 debit in Table 3-19 and is zeroed out in Journal Entry 19 with a $3,000 credit. And so it goes.
The QuickBooks close
The sort of accounting taught at local community colleges makes just the sort of closing entry shown in Journal Entry 19, but you actually don’t need or even want to make such a closing entry within QuickBooks.
The closing entry shown in Journal Entry 19 gets made in a manual system so that the revenue and expense accounts can be reset to zero. By comparison, QuickBooks, relying on the power of the computer, doesn’t need to have these accounts reset to zero to calculate the revenue and expense for the new accounting period correctly. QuickBooks, as you discover throughout this book, can calculate revenue or sales for any period and for any interval of time, using its report generation tool to summarize the revenue and expenses that occur within a particular time interval.
This seemingly missed step doesn’t cause any idiosyncratic behavior on the part of QuickBooks. QuickBooks lumps the revenue and expenses from all the previous years into a retained earnings amount reported on the balance sheet. Net income for the current year is also reported in the equity portion of the balance sheet. In addition, if you have a corporation, QuickBooks typically includes a dividends paid account in the equity portion of the balance sheet. I’m getting ahead of myself, however.
The main thing that I want you to know is that this seemingly critical textbook journal entry for closing out revenue and expense accounts isn’t made within QuickBooks. This is okay, because QuickBooks doesn’t need to make the traditional closing entry.
You may want to ask your accountant about this entry. Typically, however, any dividends paid by a corporation are zeroed out or combined with retained earnings at the end of the year. If you want to combine dividends paid for the current year with accumulative retained earnings, you do this with a journal entry. The journal entry credits the dividends paid account and debits retained earnings for the amount of dividends paid for the year. I hesitate to encourage you to make this journal entry willy-nilly, however. I think it’s okay to skip making the entry. And before you make it, consult your tax adviser.
One More Thing …
In this chapter, I try to address some of the common, complicated journal entries and accounting transactions that business owners encounter. I know that I can’t answer every question here, but I do want to provide as thorough a set of instructions as possible. All this is leading up to a special request: If you’ve read this chapter and didn’t find a discussion of the sort of journal entry or accounting transaction that you need to record, send me an email or write me a letter that tells me what help you hoped to find here … but didn’t. (You can get contact information at https://stephenlnelson.com.)
I can’t promise you that I’ll be able to supply an answer. But if you describe a journal entry that I should have included, I’ll try to respond to your email with instructions on how to make the journal entry. I’ll also include a description of the journal entry in the next edition of this book.