The three other categories of accounts—assets, liabilities, and stockholders’ equity—are reported on another financial statement called the balance sheet. Unlike the temporary accounts on the income statement, these are permanent accounts because they are not closed out at the end of the accounting period. Instead, the account balances of the balance sheet accounts at the end of the period are carried forward and become the starting balances at the beginning of the next period.
Assets are anything of value to a business, including things a business owns so it can operate. Assets are recorded in the journal at what they cost the business, or what the business paid to acquire them. This is called the cost principle.
The first two asset accounts are those you are familiar with so far. These are current assets, which means they are either cash or are expected to be converted to cash within one year.
|Cash||Money a business possesses|
|Accounts Receivable||Amount customers owe to a business from being invoiced on account|
The following assets are fixed assets. They are relatively expensive and will last for more than one accounting year. Therefore, they are considered assets rather than expenses, which are costs related to a particular accounting period.
|Land||Real estate property a business owns|
|Building||Real estate property a business owns|
|Truck||Motor vehicle a business owns|
|Equipment||Electronic machinery a business owns|
|Furnishings||Furniture a business owns|
RULES OF DEBIT AND CREDIT FOR LIABILTIES
Debit Any ASSET when it increases
Credit Any ASSET when it decreases
Liabilities are debts a business has on the assets it possesses. They are claims on the assets by people and entities that are not owners of the business.
The following are liability accounts.
|Accounts Payable||Amount a business owes to vendors from being invoiced on account|
|Note Payable||Loan for cash or on any of the assets owned|
|ANY Payable||Debt owed for a specific reason|
RULES OF DEBIT AND CREDIT FOR LIABILTIES
Credit Any LIABILITY when it increases
Debit Any LIABILITY when it decreases
Both Accounts Payable and Note Payable are liability accounts, or debts. They are different, however. Accounts Payable is a payment agreement with a vendor who gives you time—usually thirty days—to pay for a product or service your business purchases. A note payable is a formal, signed loan contract that may include an interest rate and that spells out the terms and conditions of repayment over time.
1.5.3 Stockholders’ Equity
Stockholders’ equity is the stockholders’ share of ownership of the assets that the business possesses, or the claim on the business’s assets by its owners.
A corporation is a form of business that is a separate legal entity from its owners. The people and/or organizations who own a corporation are called stockholders. Stockholders (owners) receive shares of stock as receipts for theirinvestments in the business. This form of business offers limited liability to stockholders—the owners can only lose what they invested in the business. Their other assets cannot be taken to satisfy the obligations of the company they invest in.
SOLE PROPRIETORSHIP VS. CORPORATION
Let’s say you start a lawn care business and invest $500 of your own cash and spend $1,500 for lawnmowers for a total investment of $2,000. If you do not incorporate, your business is a sole proprietorship. If you do incorporate, your business is a corporation. To form a corporation, a business needs to file paperwork called articles of incorporation (and pay a fee) with the state in which it will be operating. The state grants the business its corporate status.
If you damage the property of one of your customers and he submits a claim against you for $10,000, the most that you can be liable for as a corporation is the amount you have invested and earned in the business. As a sole proprietorship, however, it is possible the customer can be awarded more than the value of your ownership in the business. You would then have to pay out the difference using your personal money. If you don’t have enough, youcould even be forced to sell some of the things you own or make payments from your future wages to pay the claim off. If you are not organized as a corporation, your risk is not limited to the amount you invested and earned in the business.
The following are stockholders’ equity accounts:
|Common Stock||Account that shows the value of shares of stock issued to stockholders|
|Retained Earnings||Account where the corporation’s profits accumulate and are “stored”|
|Cash Dividends||Payouts of profits (retained earnings) to stockholders|
Stockholders’ equity is the amount of a business’s total assets that is owned by the stockholders. Only two accounts fall in this category: stockholders’ equity is the total of the balances in the Common Stock and Retained Earnings accounts.
Common stock is the ownership value in the business that comes from outside the company—investors who pay their own money into the business. Retained earnings is the ownership value in the business that comes from inside thecompany—the business makes a profit that is shared by the stockholders.
Cash dividends are payouts of profits from retained earnings to stockholders. Cash Dividends is a temporary account that substitutes for a debit to Retained Earnings and is classified as a contra (opposite) stockholders’ equity account. Cash dividends will reduce the Retained Earnings balance. This is ultimately accom- plished by closing the Cash Dividends balance into Retained Earnings at the end of the accounting period.
RULES OF DEBIT AND CREDIT FOR STOCKHOLDERS’ EQUITY
Credit Common Stock or Retained Earnings when it increases
Debit Retained Earnings when it decreases
Debit Cash Dividends when it increases
Credit Cash Dividends when it decreases
1.5.4 Balance Sheet Account Transactions
Six very typical business transactions that involve balance sheet accounts will be shown next.
- A company purchases equipment, paying $5,000 cash.
Date Account Debit Credit 6/1 Equipment 5,000 ▲ Equipment is an asset account that is increasing. Cash 5,000 ▼ Cash is an asset account that is decreasing.
- A company purchases equipment for $5,000 on account.
Date Account Debit Credit 6/1 Equipment 5,000 ▲ Equipment is an asset account that is increasing. Accounts Payable 5,000 ▲ Accounts Payable is a liability account that is increasing.
- A company purchases equipment that costs $5,000. The company pays a down payment of $1,000 and takes a loan for the remaining $4,000.
Date Account Debit Credit 6/1 Equipment 5,000 ▲ Equipment is an asset account that is increasing. Cash 1,000 ▼ Cash is an asset account that is decreasing. Note Payable 4,000 ▲ Note Payable is a liability account that is increasing.
NOTE: Transaction #3 is called a compound transaction because there is more than one credit. (A compound transaction could also have more than one debit, if required.) The total of the debits must equal the total of the credits in each transaction. In this case one asset is being purchased, but there are two forms of payment—cash and the loan.
Also notice that in transactions #1, 2, and 3 above, the account debited is Equipment, an asset (and not Equipment Expense, which would be an expense account). The same holds true for the purchase of real estate: the assets Building and/or Land would be debited (not Building Expense or Land Expense). This is because these assets will last more than one accounting period.
Usually one of the first steps in starting a business is opening the business’s bank account.
- An individual invests $10,000 of his own cash to open a new corporation’s checking account.
Date Account Debit Credit 6/1 Cash 10,000 ▲ Cash is an asset account that is increasing. Common Stock 10,000 ▲ Common Stock is an equity account that is increasing.
Think of common stock as a receipt for an investor infusing money or other assets into the business. It recognizes that person’s ownership. A running total of all the investments that people make in a corporation is maintained in theCommon Stock account.
Transaction #4 is recorded when an investor puts money or other assets into a corporation. There are also times when investors take money out of a business. This can only be done if the corporation has generated a profit over time, which is what the investors will draw from. The accumulated profit over time appears in the corporation’s Retained Earnings account.
The board of directors of large corporations or the owner(s) of small, closely- held corporations may decide to pay cash dividends to stockholders if there are sufficient retained earnings and sufficient cash to do so. Cash dividends are payouts of profit to stockholders; in other words, distributions of retained earnings. Cash dividends are not paid out of owner investments, or common stock.
- The corporation pays $1,000 in dividends to its stockholders.
It might seem logical to debit Retained Earnings to reduce that stockholders’ equity account and credit Cash to reduce that asset account. That is not entirely wrong. However, we are going to reserve Retained Earnings for closing entries only, and payment of dividends is not a closing entry. Instead of a debit to Retained Earnings, therefore, we will substitute the Cash Dividends account in this transaction.
Date Account Debit Credit 6/15 Cash Dividends 1,000 ▲ Cash Dividends is a contra equity account that is increasing. Cash 1,000 ▼ Cash is an asset account that is decreasing.
- The corporation closes the Cash Dividends account at the end of the month.
Finally, at the end of the accounting period (in this case a month), there is one final closing entry in addition to the ones you already know for revenue and expense accounts. This closes the Cash Dividends account to Retained Earnings, so ultimately the Retained Earnings account is reduced by the profit paid out to stockholders. The Cash Dividends account balance is set back to zero as a result.
Date Account Debit Credit 6/30 Retained Earnings 1,000 Cash Dividends 1,000
▼ Retained Earnings is an equity account that is decreasing.
▼ Cash Dividends is an equity account that is decreasing.
The following summarizes the two cash dividends transactions in #5 and #6— paying the dividends and closing the Cash Dividends account at the end of the month. If the debit and credit to Cash Dividends is struck through since the two combined would result in a balance of zero in the Cash Dividends account, you are ultimately left with a debit to Retained Earnings (reducing it) and a credit to Cash (reducing it) for the payment of a dividend.