The accrued expenses and accrued revenues may require estimated amounts.

Using estimated
amounts will get the financial statements closer to reality than ignoring the revenues and assets that
have been earned and the expenses and liabilities that have been incurred.

Another fact associated with accruals is that the actual bill, invoice, or other documentation will
be received or will be generated shortly after the accrual-type adjusting entries are recorded. For
instance, the actual electric bill will likely be sent by the utility and received by the customer within a
couple of weeks after the accrual entry. Hence, bookkeepers must be aware of potentially double-
counting accrued revenues and accrued expenses. Later we will discuss how reversing entries can
assist in avoiding the double counting.

Adjusting entries – deferrals/prepayments

A deferral or prepayment-type adjusting entry is needed when a transaction has been recorded but
the amount involves more than one accounting period. A classic example is a payment on December
1 for six months of property insurance. Part of the payment needs to be expensed during the month
of December and part of the payment needs to be deferred to the balance sheet until it is expensed
in the following year.

The company’s payment on December 1 poses a similar bookkeeping problem for the insurance
company that receives the payment. One month of the payment is part of the insurance company’s
revenues for December while the remainder needs to be deferred to the balance sheet until it is
earned and reported as revenues in the following year.

As with all adjusting entries, the concept is to

• get the expenses and revenues matched

• have each period’s income statement report the proper amount of revenues
• have each period’s income statement report the proper amount of expenses
• have each balance sheet report the proper amount of assets, liabilities and stockholders’
equity

This means that at the end of each accounting period the unexpired insurance premiums paid
by a company will be reported as a current asset. The insurance company that has received the
insurance premiums will report the unearned amount as a current liability.

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Adjusting entries – other
Depreciation is an example of an adjusting entry under the category of other. Depreciation is similar
to a deferral in that a transaction (such as the purchase of equipment to be used in a business) has
been recorded but the cost will be expensed over several accounting periods. The adjusting entry will
include:

• a debit to the income statement account Depreciation Expense, and

• a credit to the balance sheet account Accumulated Depreciation.

Depreciation is covered as a separate topic on AccountingCoach.com.

Another example in the “other” category of adjusting entries involves Accounts Receivable. Instead
of waiting to learn of a specific uncollectible account receivable, a company could anticipate that
some of its receivables will not be collected. In this situation the company estimates the amount and:

• debits Bad Debts Expense, and

• credits Allowance for Doubtful Accounts.

This adjusting entry is preferred by accountants but is not allowed for U.S. income taxes.
(Accountants believe that entering an estimated expense or loss in its accounting records is better
than ignoring the likelihood that some accounts will not be collected in full.)

Learn more about Adjusting Entries.

Reversing entries
Reversing entries are usually associated with accrual-type adjusting entries.

Accrual-type adjusting entries were made because:

• the company had incurred an expense but had not yet received the invoice or other
documentation, or
• the company had earned revenues but had not yet billed the customer

Electricity expense is an example of an expense that should have been accrued. The reason is
that the company received the electricity from the utility prior to being billed. Hence the company
records the estimated expense and liability. For example, if the company estimates it used and owes
approximately $1,000 for the electricity it used during December (but had not yet received a bill when
preparing its December financial statements) it should make the following accrual adjusting entry:

Date Account Name Debit Credit

Dec. 31 Electricity Expense 1,000

Accrued Electricity Payable 1,000

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In early January, the company will receive the actual bill for the electricity it used in December.
Certainly, the company should not record the December electricity expense twice. In order to avoid
double-counting, many companies will reverse out the December accrual. However, the amount
cannot be reversed until January.

The reversing entry to remove the accrual adjusting entry of December 31 will be:

Date Account Name Debit Credit

Jan. 2 Accrued Electricity Payable 1,000

Electricity Expense 1,000

Since the accounts for expenses begin each accounting year with zero balances, this reversing entry
will cause Electricity Expense to have a credit balance of $1,000 on January 2. However, when the
actual electric bill for December’s usage is processed in January, the Electricity Expense will bring
the account balance close to $0. (There is no problem with a small difference/balance in January
because the estimated amount was not precise.)

At the end of January, another accrual-type adjusting entry will be needed since the electric bill for
January’s electricity will not be received until February.

Accounting principles
In the U.S. the accounting standards and rules are established by the Financial Accounting
Standards Board. Many of the accounting rules are complex because many financial transactions
are complex. However, you should be aware of accounting’s basic underlying guidelines or concepts
such as the cost principle, matching principle, full disclosure principle, revenue recognition principle,
conservatism, materiality, going concern, and more. (You can learn more about these under the
AccountingCoach topic Accounting Principles.)

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Balance sheet (or statement of financial position)
The balance sheet is also known as the statement of financial position. It reports an organization’s
assets, liabilities and equity as of an instant, moment, or point in time. The instant is usually the final
moment of the accounting period such as midnight of December 31, June 30, etc. and is indicated in
the heading.

Here is an example of the heading in the balance sheet:

ABC Corp.
Balance Sheet
March 31, 2016

The format of the balance sheet reflects the accounting equation:

Assets = Liabilities + Stockholders’ Equity

Typically the balance sheet has the following sections:

• Assets
• Current assets
• Long-term investments
• Property, plant and equipment
• Other assets
• Liabilities
• Current liabilities
• Noncurrent liabilities
• Deferred credits
• Stockholders’ equity
• Paid-in capital (or contributed capital)
• Retained earnings
• Treasury stock (if any)

Usually two columns of amounts will be presented on the balance sheet. The first column will report
the most recent amounts and the second column will report the comparable amounts from one year
earlier. Having more than one column of amounts is referred to as a comparative balance sheet.

Generally, the noncurrent assets are reported on the balance sheet at the cost when they were
acquired minus accumulated depreciation. As a result, some valuable assets such as trademarks
and patents that were developed by the company (as opposed to recently purchased from another
company) will not be listed as assets. For instance, the value of Coca-Cola’s logo will not be included
in the total amount of its assets or stockholders’ equity.

Learn more about the Balance Sheet.

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Income statement
The income statement is also referred to as the statement of earnings, statement of operations,
statement of income, and profit and loss statement (or P&L). The income statement reports the
revenues and expenses occurring during the accounting period such as the year 2015, the month of
January, the nine months ended September 30, etc. The period covered by the income statement is
shown in its heading:

ABC Corp.
Income Statement
For the Year Ended December 31, 2015

The income statement will report a company’s operating revenues, other revenues (non-operating
and gains), operating expenses, other expenses (non-operating and losses). The income statements
of corporations with stock that is publicly traded must also include the earnings per share of common
stock.

Corporations with stock that is publicly traded will issue comparative income statements which
include three columns of amounts. The first column could be the amounts for the most recent
accounting year. The second column will be the amounts for the year prior, and the third column will
be the amounts for two years prior.

Private companies often issue multiple-step income statements which have the following format:

Sales
Cost of goods sold
Gross profit
Selling, general & admin expenses
Operating profit
Other income
Earnings before tax
Income tax expense
Net earnings

Under the accrual method, the revenues reported on the income statement will be different from
the amount of cash received, and the expenses will be different from the amount of cash paid. As a
result, a company could report positive net income and yet experience a decrease in cash. It is also
possible that the income statement will report a net loss but the company’s cash actually increased.
This is why the statement of cash flows should be presented whenever a company’s income
statement and balance sheet are issued.

Learn more about the Income Statement.

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Statement of cash flows
The statement of cash flows (or cash flow statement) summarizes how a company’s cash and cash
equivalents have changed during the same period of time as the company’s income statement. The
statement has three sections in which to report the change in cash:

1. Cash flows from operating activities

2. Cash flows from investing activities
3. Cash flows from financing activities

Some of the details for the three sections of the statement of cash flows include:

1. Cash flows from operating activities. Using the indirect method this section begins
with the net income reported on the income statement and then adds back the amount of
depreciation expense. The reason is that depreciation expense had reduced the net income
but the depreciation entry did not reduce the company’s cash. There are also adjustments
for losses and gains as well as the changes in accounts receivable, inventory, accounts
payable and other current assets and current liabilities.
2. Cash flows from investing activities. This section lists the amounts spent on capital
expenditures (property, plant and equipment), long-term investments, and other noncurrent
assets. It also lists the cash received from the sale of long-term investments, property, plant
and equipment, and other noncurrent assets.
3. Cash flows from financing activities. This section lists the amounts received from
issuing debt and stock as well as the amounts spent to retire debt, buy back shares of the
company’s stock and the amount paid in dividends.

The amounts from the three sections are added and the total must reconcile with the change in the
company’s cash and cash equivalents.

The inflows of cash are presented on the statement of cash flows as positive amounts while the
outflows of cash are presented as negative amounts.

In addition to the amounts reported in the three sections, the statement of cash flows must include
supplemental disclosures including the income taxes paid, interest paid, significant noncash
exchanges, and stock dividends issued.

The statement of cash flows is one of the required financial statements because users need
information on a company’s cash. Recall that the income statement prepared under the accrual
method does not report cash amounts.

Learn more about the Statement of Cash Flows.

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