Materials To read Based on Blue Print

Apply principles of accounting and reporting

Introduction to Accounting Principles

We then review the effect of those underlying principles and concepts on a company's financial
statements such as:

 Required set of financial statements

 Accrual method of accounting
 Revenues reported on the income statement
 Expenses reported on the income statement
 Assets reported on the balance sheet
 Liabilities reported on the balance sheet
 Stockholders' equity reported on the balance sheet
 Required notes to the financial statements

Underlying Accounting Principles, Assumptions, etc.

Economic entity assumption

The economic entity assumption allows the accountant to keep the business transactions of a sole
proprietorship separate from the sole proprietor's personal transactions.

Monetary unit assumption

The monetary unit assumption allows accountants to express a company's wide-ranging assets as
dollar amounts.

Going concern assumption

The going concern assumption means the accountant believes that the company will not be
liquidated in the foreseeable future.

Time period (or periodicity) assumption

Accountants assume that a company's ongoing complex business operations and financial results
can be divided into distinct time periods such as months, quarters, and years.

Cost principle

The cost principle (historical cost principle) means the accountant will record transactions at the
cash (or equivalent) amount at the time of the transaction. As a result, a company's most valuable
assets are not recorded or reported. Examples include a company's trademarks, talented team of
researchers, unique website domain names, search engine rankings, etc.

Except for certain marketable investment securities, typically an asset's recorded cost will not be
changed due to inflation or market fluctuations.

Full disclosure principle

The full disclosure principle requires a company to provide sufficient information so that an
intelligent user can make an informed decision. As a result of this principle, a company's
financial statements will include many disclosures and schedules in the notes to the financial
statements.

Revenue recognition principle

Revenues are to be recognized (reported) on a company's income statement when they are
earned. Therefore, a company will report some revenues on its income statement before a
customer pays for the goods or services it has received. In the case of cash sales, revenues will be
reported when customers pay for their merchandise. If customers pay in advance, the revenues
will be recognized (reported) after the money was received.

Matching principle or expense recognition

The ideal way to recognize (report) expenses on the income statement is based on a cause-and-
effect relationship.

Materiality

The concept of materiality means an accounting principle can be ignored if the amount is
insignificant.

Conservatism

If a company has two acceptable ways to record and/or report a transaction, conservatism directs
the accountant to choose the alternative that results in less net income or a smaller asset amount.
The accountant should be objective, but when doubt exists, conservatism should be used to break
the tie.

Consistency and comparability

Accountants are expected to apply accounting principles, procedures, and practices consistently
from period to period. If a change is justified, the change must be disclosed on the financial
statements.
Comparability means that the user is able to compare the financial statements of one company to
those of another company in the same industry. Comparability is enhanced by requiring the use
of generally accepted accounting principles.

Relevance and timeliness

For financial statements to be relevant they should be distributed as soon as possible after the end
of the accounting period. In other words, relevance is enhanced by timeliness.

To achieve these characteristics, it is likely that some amounts will need to be estimated.

Objectivity and reliability

Accountants are expected to be objective (unbiased). Many businesses are required to have their
financial statements audited to assure the users that the amounts are objective and reliable.

The Effect of Accounting Principles on Financial Statements

Now that you have been introduced to many of the underlying accounting principles and
concepts, let's examine what they mean for a company's financial reporting.

Accrual Method of Accounting

To properly (report) revenues and expenses on the income statement, and assets and liabilities on
the balance sheet, companies must use the accrual method of accounting (or accrual
accounting). The following examples illustrate accrual accounting:

 Revenues are reported on the income statement when they have been earned.
 Expenses are reported (recognized) on the income statement when an expense occurs.
 In short, the company's financial statements are more complete when the accrual method
is used.

To comply with the accrual method, companies record adjusting entries as of the final day of the
accounting period

Revenues Reported on the Income Statement

Under the accrual method, revenues are reported or recognized on the company's income
statement for the period in which the revenues were earned.

Depending on the transactions, revenues may be earned and reported on a company's income
statements at any of the following times:

 Before receiving the money from customers (sales and services were provided on credit)
 At the time customers pay (cash sales)
  After money is received from customers (some future services were required)

To achieve the accrual method, companies will make the following revenue-related adjusting
entries at the end of the accounting period to:

 Accrue revenues (and the related receivables) that were earned, but the company had not yet
billed the customer
 Defer revenues (and the related liabilities) for money received from customers, but not yet
earned by the company

Expenses Reported on the Income Statement

Under the accrual method, expenses are to be reported (recognized) on the company's income
statement during the accounting period in which the expenses:

 Were caused by revenues

 Expired or were used up
 Had no future economic benefit that could be measured

To achieve the accrual method, companies will make accrual, deferral, depreciation, and other
adjusting entries for expenses at the end of each accounting period.

Assets Reported on the Balance Sheet

The cost principle (or historical cost principles) means that a company's assets are recorded at
their cost at the time of the transaction. Once recorded, the cost of most assets (some marketable
investment securities are an exception) will not be increased because of inflation or increases in
market value.

Liabilities Reported on the Balance Sheet

Liabilities are a company's obligations resulting from a past transaction. Typical liabilities
include accounts payable, notes or loans payable, wages payable, interest payable, taxes payable,
customer deposits, deferred revenue, and more.

At the end of each accounting period, there will be amounts owed by a company, but the
company has not yet been billed or has not yet processed the transaction. A few examples
include:

 Interest on loans payable

 Electricity and gas charges
 Wages for hourly paid employees that have been earned but not yet processed
 Repair work that was recently done by a contractor
Stockholders' Equity Reported on the Balance Sheet

Stockholders' equity or shareholders' equity is the difference between the amount of a

corporation's assets and liabilities that are reported on the balance sheet. (Owner's equity is the
difference between a sole proprietorship's assets and liabilities.)

Notes to the Financial Statements

The full disclosure principle requires that sufficient financial information be presented so that an
intelligent person can make an informed decision. As a result of this principle, it is common to
find many pages of notes to the financial statements.

A few examples of the many items disclosed in the notes to the financial statements include:

 Summary of significant accounting policies

 Leases
 Income taxes
 Employee benefit plans
 Stock options
 Commitments and contingencies

Introduction to Financial Statements

The five financial statements are:

1. Income statement
2. Statement of comprehensive income
3. Balance sheet
4. Statement of stockholders' equity
5. Statement of cash flows

The annual financial statements should also include notes to the financial statements. The notes
disclose important information regarding the amounts appearing or not appearing on the financial
statements.

Where the Amounts Come From

Generally, the amounts reported on the financial statements originated from the corporation's
business transactions that were recorded and stored in the general ledger accounts. The
accounting records are often referred to as the corporation's books.

In addition to recording business transactions, accountants will also record adjusting entries
before issuing the financial statements. The following are three examples of why adjusting
entries is necessary:
 1. Some of the transaction amounts that were recorded pertain to more than one accounting
period.
2. Some expenses may occur so late in an accounting period that they were not processed
and recorded in the general ledger accounts.

Accrual Method of Accounting

Under the accrual method of accounting the financial statements will report sales and receivables
when products or services have been delivered (as opposed to reporting sales when the
corporation receives money from its customers). It also means that expenses and liabilities will
be reported on the financial statements when they occur (as opposed to reporting expenses when
the corporation remits payment).

The accrual method of accounting results in more complete and accurate financial statements
than the cash method of accounting for the following reasons:

 All of the revenues that were earned during the accounting period will be included
 All of the expenses that were incurred during the accounting period will be included
 All of the assets as of the end of the accounting period will be included
 All of the liabilities as of the end of the accounting period will be included

When the accrual method of accounting is used, you will see the following balance sheet
accounts:

 Accounts Receivable
 Interest Receivable
 Prepaid Expenses
 Accounts Payable
 Accrued Expenses Payable
 Deferred Revenues

Accounting Periods

A corporation is required to issue annual financial statements, but it is common for a corporation
to prepare monthly financial statements for its management. Financial statements issued between
the annual financial statements are known as interim financial statements. Interim financial
statements could be prepared for periods such as one month, four weeks, three months, 13
weeks, eight months, eleven months, etc.
Users of the Financial Statements

The financial statements issued by a U.S. corporation and distributed outside of the corporation
could find their way into the hands of the following people and/or organizations:

 current stockholders
 current lenders
 financial analysts
 potential future investors
 potential future lenders
 current and future suppliers of goods or services
 certain customers
 government agencies
 labor unions
 competitors and others

The users often compare a corporation's financial statements to those of 1) previous accounting
periods, and 2) other companies. Therefore, for the financial statements to be useful they must
consistently follow common reporting rules.

Five Financial Statement

1. Income statement
2. Statement of comprehensive income
3. Balance sheet
4. Statement of stockholders' equity
5. Statement of cash flows

Income Statement

The income statement reports a corporation's net income for the period of time indicated in its
heading. The income statement is also known as the following:

 Statement of income
 Statement of earnings
 Statement of operations
 Profit and loss statement
 P&L

*The period of time could be a year, quarter, month, 13 weeks, eight months, etc.
**The earnings per share must be reported if a corporation's shares of stock are traded on a stock
exchange.
***Every financial statement should inform the reader that the notes are an integral part of the
financial statements and should be read for important information.
Amounts on the Income Statement

The historical cost principle means that most of the amounts shown on the income statement
reflect a corporation's vast number of actual transactions that occurred with parties outside of the
corporation

Revenues

Revenues are the amounts earned by a corporation through its main activities such as:

 Selling products. These are reported as net sales, net product revenue, revenues from net sales,
revenues, etc.
 Providing services. These are likely reported as net service revenues or revenues.

Under the accrual method of accounting, revenues are reported on the income statement in the
accounting period in which they are earned (and there is a reasonable assurance that the amounts
will be collected). The revenues (and the related assets) are likely captured at the time that the
sales invoice is prepared. At the end of the accounting period, accountants will also prepare
adjusting entries for revenues that were earned but were not yet fully processed through the
accounting system.

(Keep in mind that under the accrual method of accounting the term revenues is different from
cash receipts.)

Expenses

Expenses are the historical costs that are associated with a corporation's main business activities,
and are reported on the income statement. Examples of a retailer's expenses include:

 The cost of the merchandise (or goods) that it had sold

 Sales commissions that its employees and agents earned
 Ads that ran
 Store rent
 Other costs that had occurred or were used up during the accounting period

Under the accrual method of accounting, expenses will be reported on the income statement
when they are best matched with 1) the revenues, or 2) the accounting period. The following are
four ways in which costs will end up as expenses on the income statement:

1. When they best match revenues. The cost of goods sold and sales commission expense
should be reported in the same period as the related sales are reported.
2. When they have expired or were used. The $400,000 cost of a building that is expected
to be used for 40 years will often be reported as annual depreciation expense of $10,000.
3. When they have no future value which can be measured. The current year's $50,000
advertising campaign will be reported as an expense on the current year's income
 statement. The reason is that the future value of the current year's ads cannot be
determined.
4. When costs are too small to justify allocating them to future periods. As an example,
the entire $300 cost of a paper shredder will be expensed immediately even though it is
expected to be used for several years.

Gains and Losses

If a corporation disposes of an asset that is no longer used in its business, the amount received
should not be included in its sales revenues. Instead a gain or loss on the disposal is recorded.

Gross Profit

An important metric that is available from the income statement of a retailer or manufacturer is
the gross profit. Gross profit is defined as net sales minus the cost of goods sold.

The gross margin or gross profit percentage is monitored by the readers of the financial
statements to determine if the corporation was able to maintain the usual percentage during
periods when its product costs had increased. This is important because the corporation's gross
profit amount must be sufficient to cover its selling, general and administrative (SG&A)
expenses and to provide a sufficient amount of net income.

Net Income

A corporation's net income is often referred to as the bottom line of the income statement. In
other words, net income is the amount remaining after all of the corporation's expenses, gains,
and losses are considered. Depending on the industry, the net income as a percentage of net sales
is often a very small percentage, such as 3% to 5% of net sales.

Net Income's Impact on Retained Earnings and Comprehensive Income

The positive net income reported on the income statement also causes an increase in the
corporation's retained earnings (a component of stockholders' equity). A negative net income (a
net loss) will cause a decrease in retained earnings. This provides a link between a corporation's
income statement and its balance sheet.

Net income is also one component of a corporation's comprehensive income. The other
component is other comprehensive income, which will be discussed shortly.

Earnings Per Share (EPS)

When a corporation's shares of stock are publicly traded, the income statement must display the
earnings per share of common stock or EPS.

Income Statement Amounts are History

The historical cost principle means that most of the expenses reported on the income statement
are the actual costs from past transactions.

Statement of Comprehensive Income

The statement of comprehensive income should be presented immediately after the income
statement. (However, it could be combined with the income statement.)

The term comprehensive income consists of 1) a corporation's net income (which is detailed on
the corporation's income statement), and 2) a few additional items which make up what is known
as other comprehensive income.

The items which make up other comprehensive income include:

 Unrealized gains or losses on derivatives used in hedging

 Unrealized gains or losses on pension and postretirement liabilities
 Foreign currency translation adjustments

The following shows the format of the statement of comprehensive income:

*Every financial statement should inform the reader that the notes are an integral part of the
financial statements and should be read for important information.

The adjustments for the items defined as other comprehensive income will be included in the
amount of accumulated other comprehensive income, which is reported in the stockholders'
equity section of the balance sheet:

Balance Sheet

The balance sheet, which is also known as the statement of financial position, reports a
corporation's assets, liabilities, and stockholders' equity account balances as of a point in time.
The format of the balance sheet is similar to the accounting equation:

Assets = Liabilities + Stockholders' Equity

As result of the double-entry system of accounting, the balance sheet and the accounting
equation should always be in balance.

Assets

Assets are often described as:

 a corporation's resources
 things the corporation owns (as a result of a previous transaction)
  costs that have not yet expired

Some of the accounts used to record a corporation's assets include:

 Cash
 Marketable Securities
 Accounts Receivable
 Other Receivables
 Inventory
 Prepaid Expenses
 Long-term Investments
 Land
 Buildings
 Equipment
 Vehicles
 Patents
 and many others

Normally, the balance sheet will present the asset accounts under one of the following headings:

 Current assets
 Investments (long-term)
 Property, plant and equipment
 Other assets

Liabilities

Liabilities are often described as:

 a corporation's obligations
 amounts the corporation owes
 customer deposits or customer prepayments which a corporation has not yet earned
 Sources (along with stockholders' equity) of the corporation's assets
 Claims against the corporation's assets

Some of the accounts used to record liabilities include:

 Notes Payable
 Accounts Payable
 Wages Payable
 Interest Payable
 Income Taxes Payable
 Other Accrued Expenses Payable
 Customer Deposits
 Loans Payable
 Deferred Income Taxes
 and many others
Liability accounts are usually presented on the balance sheet under one of the following
headings:

 Current liabilities
 Noncurrent liabilities or Long-term liabilities

Stockholders' Equity

Stockholders' equity (which is also known as shareholders' equity) is defined as a corporation's

assets minus its liabilities. Stockholders' equity can be viewed as:

 a residual claim on the corporation's assets (after liabilities)

 a source (along with liabilities) of the corporation's assets

The major components of stockholders' equity include:

 Paid-in capital
 Retained earnings
 Accumulated other comprehensive income
 Treasury stock (a deduction)

Format of the Balance Sheet

The following shows the headings and classifications found in a classified balance sheet:
*Every financial statement should inform the reader that the notes are an integral part of the
financial statements and should be read for additional important information.

Current assets include cash and the assets that will turn to cash within one year of the balance
sheet date (or within the operating cycle, if it is longer than one year). In other words, current
assets include:

 Cash
 Cash equivalents
 Temporary investments
 Accounts receivable (net of the allowance for uncollectible accounts)
 Inventory
 Prepaid expenses

Current liabilities are a corporation's obligations that are due within one year of the balance
sheet date (or within the operating cycle, if it is longer than one year) and will require the use of
a current asset or will create another current liability. The following are examples of current
liabilities:

 Accounts payable
 Wages payable
  Payroll withholdings that need to be remitted
 Bank loans and other borrowings due within a year
 Principal portion of long-term loans (the principal that must be paid within the next 12 months)
 Customer deposits
 Unearned/deferred revenue
 Income taxes payable

Statement of Stockholders' Equity

The financial statement that lists the components of stockholders' equity, their balances, and the
changes that occurred during an accounting year is also known by the following titles:

 Statement of stockholders' equity

 Statement of shareholders' equity
 Statement of changes in stockholders' equity
 Statement of changes in shareholders' equity

The major components and headings in the statement of stockholders' equity include:

Paid-in capital – common stock

Paid-in capital – excess of par value
Retained earnings (or accumulated deficit when negative)
Accumulated other comprehensive income (or loss)
Treasury stock (an amount that is a subtraction)

A common format of the statement of stockholders' equity is shown here:

Statement of Cash Flows (SCF)

The statement of cash flows (SCF) or cash flow statement reports a corporation's significant cash
inflows and outflows that occurred during an accounting period. This financial statement is
needed because many investors and financial analysts believe that "cash is king" and cash
amounts are required for various analyses. The SCF is necessary because the income statement is
prepared using the accrual method of accounting (as opposed to the cash method).

The statement of cash flows highlights the major reasons for the changes in a corporation's cash
and cash equivalents from one balance sheet date to another. For example, the SCF for the year
2022 reports the major cash inflows and cash outflows that caused the corporation's cash and
cash equivalents to change between December 31, 2021 and December 31, 2022.
The cash inflows are the cash amounts that were received and/or have a favorable effect on a
corporation's cash balance. Hence, they will appear on the SCF as positive amounts.

The cash outflows are the cash amounts that were used and/or have an unfavorable effect on a
corporation's cash balance. Hence, these amounts will appear in parentheses to indicate that they
had a negative effect on the cash balance.

The major cash flows occurring during an accounting period are reported under the following
headings or sections of the SCF:

1. Cash flows provided or used in operating activities

2. Cash flows provided or used in investing activities
3. Cash flows provided or used in financing activities

In addition, the following supplementary or supplemental information must be disclosed:

 Interest paid
 Income taxes paid
 Significant amounts involving investing and/or financing activities that did not involve cash (such
as the exchange of common stock for long-term debt, or the exchange of common stock for
land)

Cash Flows from Operating Activities

The first section of a SCF is described as the cash flows from operations or cash flows from
operating activities. The following is an example of the cash flows from operating activities
section prepared using the indirect method, which is used by nearly all corporations:

Under the indirect method, the first amount shown is the corporation's net income (or net
earnings) from the income statement. Assuming the net income was $100,000 it is listed first and
is followed by many adjustments to convert the net income (computed under the accrual method
of accounting) to the approximate amount of cash.
The first adjustment to the net income is the amount of depreciation expense that had reduced net
income. Assuming the depreciation expense was $30,000, this amount will be added back to the
net income. The reason is that it was an expense that did not use cash. (It was merely an
adjusting entry that debited Depreciation Expense and credited Accumulated Depreciation.)

Cash Flows from Investing Activities

The second section of the SCF reports 1) the cash outflows that were used to acquire noncurrent
assets, and 2) the cash inflows received from the sale of noncurrent assets.

The cash outflows spent to purchase noncurrent assets are reported as negative amounts since the
payments have an unfavorable effect on the corporation's cash balance. A common outflow is
connected to a corporation's capital expenditures. This is the property, plant and equipment that
will be used in the business and was acquired during the accounting period.

The positive amounts in this section of the SCF indicate the cash inflows or proceeds from the
sale of property, plant and equipment and/or other long-term assets.

Here is an example of what might be reported in the second section of the statement of cash
flows:

Note that the $95,000 appears as a negative amount because the outflow of cash for capital
expenditures has an unfavorable or negative effect on the corporation's cash balance. The
$15,000 is a positive amount since the money received has a favorable effect on the corporation's
cash balance. The $30,000 received from selling an investment also had a favorable effect on the
corporation's cash balance.

Cash Flows from Financing Activities

The third section of the statement of cash flows reports the cash received when the corporation
borrowed money or issued securities such as stock and/or bonds. Since the cash received is
favorable for the corporation's cash balance, the amounts received will be reported as positive
amounts on the SCF.

Cash outflows used to repay debt, to retire shares of stock, and/or to pay dividends to
stockholders are unfavorable for the corporation's cash balance. As a result the amounts paid out
will be shown as negative amounts.
Here is an example of what might appear in the third section of the statement of cash flows:

In the above example we see that the payment of cash dividends of $10,000 had an unfavorable
effect on the corporation's cash balance. This is also true of the $20,000 of cash that was used to
repay short-term debt and to purchase treasury stock for $2,000. On the other hand, the
borrowing of $60,000 had a favorable or positive effect on the corporation's cash balance. The
net result of the four financing activities caused cash and cash equivalents to increase by
$28,000.
Format of a Complete SCF

The following shows all three sections of the statement of cash flows:

Note that near the bottom of the SCF there is a reconciliation of the cash and cash equivalents
between the beginning and the end of the year.

Free Cash Flow

Some financial analysts also calculate what is known as free cash flow. This is defined as the
amount of cash from operating activities minus the amount of cash required for capital
expenditures.
Notes to Financial Statements

The following are some examples of the reference found at the bottom of each financial
statement:

 See accompanying notes.

 See accompanying notes to the financial statements.
 The accompanying notes are an integral part of these financial statements.
 The accompanying Notes to the Financial Statements are an integral part of this statement.
 See Notes to Consolidated Financial Statements.

The notes (or footnote disclosures) are required by the full disclosure principle because the
amounts and line descriptions on the face of the financial statements cannot provide sufficient
information. In fact, there may be some large potential losses that cannot be expressed as a
specific amount, but they are critical information for lenders, investors, and others.

The notes usually begin with the corporation's significant accounting policies. This note
describes how revenues were recognized on the income statement, how inventory is accounted
for, etc.

Other Information Pertaining to Financial Statements

Consolidated Financial Statements

It is common for a large business to consist of several legal corporations. However, those
separate legal corporations (called subsidiaries) are owned and controlled by one of the
corporations (the parent corporation).

Comparative Financial Statements

When a financial statement reports the amounts for the current year and for one or two additional
years, the financial statement is referred to as a comparative financial statement

Audited Financial Statements

Some corporations may be required to have their external financial statements audited.

Introduction to Bank Reconciliation

In accounting, a company's cash includes the money in its checking account(s). To safeguard this
critical and tempting asset, a company should establish internal controls over its cash. These
controls include separating the accounting duties of its employees, depositing all receipts into the
company's checking account, paying all bills through the checking account, and having an
independent person routinely prepare a bank reconciliation (bank rec, bank statement
reconciliation), and more.
The purpose of the bank reconciliation is to be certain that the company's general ledger Cash
account is complete and accurate. With the true cash balance reported in the Cash account, the
company could prevent overdrawing its checking account or reporting the incorrect amount of
cash on its balance sheet. The bank reconciliation also provides a way to detect potential errors
in the bank's records.

The bank reconciliation process requires some tedious tasks. For example,

 Every check amount on the bank statement must be compared to the check amounts in the
company's general ledger Cash account. Any differences, such as the company's
outstanding checks and errors, will become part of the adjustments listed on the bank
reconciliation.
 Every deposit on the bank statement must be compared to the receipts recorded in the
company's Cash account. Any differences, such as a deposit in transit and/or errors, will
become part of the adjustments listed on the bank reconciliation.
 Other items on the bank statement must be compared to the other items in the company's
Cash account. Any differences, such as bank fees, checks returned because of insufficient
funds, collections made by the bank, etc., will be part of the adjustments listed on the
bank reconciliation.

Checking Account Terminology

We grouped the terms into the following categories:

 General terms for checking accounts

 Terms for adjustments to the balance per bank
 Terms for adjustments to the balance per books

General Terms for Checking Accounts

Checking accounts are known as demand deposit accounts since the bank must pay/return the
depositors' account balances (except for uncollected funds) on demand

Checks are a company's written orders to its bank to pay an amount from the company's
checking account.

Cancelled checks are the checks the company issued and were paid by the company's bank.
Voided checks are checks that were written in error.

Stop payment order is a company's instruction to its bank to not pay a specific check that the
company had already written but was not yet paid by the bank

Deposits often consist of currency and checks (received from customers) that a company takes to
its bank with instructions to add the amount to the company's checking account.
Authorized signers are a limited number of people designated to sign checks drawn on the
company's checking account.

Bank overdraft occurs when checks written by a company are presented to its bank for payment
and the company's checking account balance is not sufficient to pay the checks.

Uncollected funds occur when a company deposits a check into its bank account, but the check
is drawn on an account at a different bank. Since the company's bank is not certain that the check
will be honored by the bank on which it is drawn, the company's bank will not allow the
company/depositor to use the amount until the deposited check is paid by the other bank. (Some
people refer to the amount of outstanding checks as the company's float.)

Terms for Adjustments to the Balance per Bank

Outstanding checks are checks that a company had written and recorded in its Cash account,
but the checks have not yet been paid by the company's bank (or have not "cleared" the bank

Deposits in transit are the cash and checks a company has received and recorded in its general
ledger accounts, but the cash and checks have not been processed by the bank as of the date of
the bank reconciliation.

Bank errors are mistakes made by the bank that were discovered when the company prepared
the bank reconciliation.

Terms for Adjustments to the Balance per Books

Bank credit memos indicate that the bank increased the balance in a company's checking
account.

Bank debit memos indicate that the bank has decreased the balance in a company's checking
account.

ACH, EFT, Zelle transfers, and wire transfers can indicate additions to or subtractions from a
company's bank account without the company preparing a deposit slip or writing a check.
NSF check is a check issued by a company, but the bank did not pay/honor the check because
the company's bank balance was less than the amount of the check.
Return item is typically a check that was not paid/honored by the bank on which it was drawn.
Company errors may require additions or subtractions from the company's general ledger Cash
account.

Introduction to Manufacturing Overhead

1. Manufacturing overhead (also referred to as factory overhead, factory burden, and

manufacturing support costs) refers to indirect factory-related costs that are incurred
when a product is manufactured. Along with costs such as direct material and direct
 labor, the cost of manufacturing overhead must be assigned to each unit produced so that
Inventory and Cost of Goods Sold

Manufacturing overhead includes such things as the electricity used to operate the factory
equipment, depreciation on the factory equipment and building, factory supplies and
factory personnel (other than direct labor). How these costs are assigned to products has
an impact on the measurement of an individual product's profitability.

2. Nonmanufacturing costs (sometimes referred to as administrative overhead) represent a

manufacturer's expenses that occur apart from the actual manufacturing function. In
accounting and financial terminology, the nonmanufacturing costs include Selling,
General and Administrative (SG&A) expenses, and Interest Expense. Since
accounting principles do not consider these expenses as product costs, they are not
assigned to inventory or to the cost of goods sold. Instead, nonmanufacturing costs are
simply reported as expenses on the income statement at the time they are incurred.

Nonmanufacturing costs include activities associated with the Selling and General
Administrative functions. Examples include the compensation of nonmanufacturing
personnel; occupancy expenses for nonmanufacturing facilities (rent, light, heat, property
taxes, maintenance, etc.); depreciation of nonmanufacturing equipment; expenses for
automobiles and trucks used to sell and deliver products; and interest expenses. (Note that
factory administration expenses are considered part of manufacturing overhead.)

Although nonmanufacturing costs are not assigned to products for purposes of reporting
inventory and the cost of goods sold on a company's financial statements, they should
always be considered as part of the total cost of providing a specific product to a specific
customer. For a product to be profitable, its selling price must be greater than the sum of
the product cost (direct material, direct labor, and manufacturing overhead) plus the
nonmanufacturing costs and expenses.

Manufacturing Overhead Costs

On financial statements, each product must include the costs of the following:

1. Direct material
2. Direct labor
3. Manufacturing (or factory) overhead

According to generally accepted accounting principles (GAAP), manufacturing overhead must

be included in the cost of Work in Process Inventory and Finished Goods Inventory on a
manufacturer's balance sheet, as well as in the Cost of Goods Sold on its income statement.

As their names indicate, direct material and direct labor costs are directly traceable to the
products being manufactured. Manufacturing overhead, however, consists of indirect factory-
related costs and as such must be divided up and allocated to each unit produced. Some of the
costs that would typically be included in manufacturing overhead include:
  Material handlers (forklift operators who move materials and units).
 People who set up the manufacturing equipment to the required specifications.
 People who inspect products as they are being produced.
 People who perform maintenance on the equipment.
 People who clean the manufacturing area.
 People who perform record keeping for the manufacturing processes.
 Factory management team.

(Note: For the items above, the company will incur costs for salaries, wages, Social
Security and Medicare taxes, unemployment compensation tax, worker compensation
insurance, health insurance, holiday pay, vacation pay, sick pay, pension or retirement
plan, seminars and training, and perhaps more.)

 Electricity, natural gas, water, and sewer for operating the manufacturing facilities and
equipment.
 Computer and communication systems for the manufacturing function.
 Repair parts for the manufacturing equipment and facilities.
 Supplies for operating the manufacturing process.
 Depreciation on the manufacturing equipment and facilities.
 Insurance and property taxes on the manufacturing equipment and facilities.
 Safety and environmental costs.

Note that all of the items in the list above pertain to the manufacturing function of the business.
Since the costs and expenses relating to a company's administrative, selling, and financing
functions are not considered to be part of manufacturing overhead, they are not reported as part
of the final product cost on financial statements. Rather, nonmanufacturing expenses are reported
separately (as SG&A and interest expense) on the income statement during the accounting period
in which they are incurred.

Traditional Methods of Allocating Manufacturing Overhead

Let's look at several methods used to allocate manufacturing overhead. Keep in mind that if the
method does not allocate the true amount of factory overhead, the cost per unit of product will be
wrong and could result in management making a flawed decision. As you review these methods,
ask yourself for each given product, will the allocated amount of overhead reflect the actual
amount of overhead used in that item's production? If a cause-and-effect relationship is not
evident, is there at least an obvious correlation between manufacturing overhead and the basis
for the allocation (such as machine hours)? If there is no correlation, the allocation method is
suspect and could result in the improper amount of overhead being assigned to individual
products.

Allocating Manufacturing Overhead Via Direct Labor

The manufacturing process was not automated, there were hardly any variations in the products
made (think Model T cars), and customers did not demand such things as just-in-time (JIT)
deliveries or bar coding. In those days, when manufacturers increased the amount of direct labor,
there was likely to be a related increase in such things as the number of factory supervisors, the
factory space to be maintained, and factory supplies and utilities consumed. In other words, there
was a high degree of correlation between the quantity of direct labor used and the amount of
manufacturing overhead used. By allocating manufacturing overhead on the basis of direct labor
hours, a product requiring 30 direct labor hours would be allocated twice as much manufacturing
overhead as a product requiring 15 direct labor hours.

Let's illustrate an overhead rate based on direct labor hours for a company that manufactures just
two products, X and Y. (An annual rate is developed in order to have a constant overhead rate
even when production volumes fluctuate from month to month.) For the upcoming year the
company expects the following:

As shown in the above table, each unit of Product X will be assigned $30 of overhead, and each
unit of Product Y will be assigned $60 of overhead. This is reasonable so long as there is a
correlation between the quantity of direct labor hours and the cost of manufacturing overhead.

Allocating Manufacturing Overhead Via Departmental Machine Hours

As the 20th century moved on, manufacturers studied and controlled direct labor's time and
motion (think of Frederick Taylor's work) and began replacing direct labor with machines. The
increased use of machines resulted in an increase in factory overhead due to such things as
additional depreciation of the machinery, maintenance of the machinery, and machine setups.
With direct labor being reduced and manufacturing overhead increasing, the correlation between
direct labor and manufacturing overhead began to wane. A logical response was to begin
allocating manufacturing overhead on the basis of machine hours instead of direct labor hours.

Companies also began to create new departments to help manage the changing character of the
factories. Production departments such as machining, finishing, and assembling were
established. Other departments such as quality control, maintenance, and factory administration
were designated as service departments (or production service departments), since these
departments served the production departments. The company's costs were contained in the
accountant's general ledger, which was organized by departments so as to mirror the organization
chart and to provide for budgeting and control. Because some of the production departments
used more of some service departments' efforts/costs than others, accountants responded by first
allocating the service department costs to the production departments, and then developing
manufacturing overhead rates for each of the production departments. These rates were
computed by dividing each production department's costs (its own direct costs plus the service
departments' costs allocated to it) by its machine hours.

Basing the manufacturing overhead rates on a company's production departments was an

improvement over using just one rate for the entire plant—particularly when companies began
manufacturing a greater variety of products. Some products being manufactured may have
required many machine hours in one department but very few hours in another department, while
other products may have used a much different combination of machine hours.

Let's illustrate this method by assuming just two products (X and Y) are being manufactured in a
factory that has one service department (Factory Administration, S1) and two production
departments (Machining, P1; Finishing, P2).

Had the company used a plant-wide rate, the manufacturing overhead rate would have been
$33.33 per MH ($500,000 divided by 15,000 MH), instead of $40 for the machining department
and $20 for the finishing department. By using departmental rates, products requiring more
machine hours in a high-cost department will be assigned a higher cost than would be assigned if
using one established plant-wide rate. Products requiring more time in a low-cost department
will be assigned a lower cost as compared to one plant-wide rate.
Nonmanufacturing Overhead Costs

We use the term nonmanufacturing overhead costs or nonmanufacturing costs to mean the
Selling, General & Administrative (SG&A) expenses and Interest Expense. Under generally
accepted accounting principles (GAAP), these expenses are not product costs. (Product costs
only include direct material, direct labor, and manufacturing overhead.) Nonmanufacturing costs
are reported on a company's income statement as expenses in the accounting period in which
they are incurred. Expressed another way, nonmanufacturing costs are not allocated to products
via overhead rates since they are not included in the amounts reported as inventory on the
balance sheet or in the cost of goods sold that is reported on the income statement.

Even though nonmanufacturing overhead costs are not product costs according to GAAP, these
expenses (along with product costs and profit) must be covered by the selling prices of a
company's products. In other words, selling prices must be large enough to cover SG&A
expenses, interest expense, manufacturing overhead, direct labor, direct materials, and profit.

Some of the costs that would typically be included in nonmanufacturing costs include:

 Salaries and fringe benefits of selling, general and administrative personnel. This would include
the company president, vice presidents, managers, and other employees in the
nonmanufacturing functions of the company.
 Rent, property taxes, utilities for the space used by the nonmanufacturing functions of the
company.
 Insurance for areas outside of the factory.
 Interest on business loans.
 Marketing and advertising.
 Depreciation and maintenance of equipment and buildings outside of manufacturing.
 Supplies for the offices.

Financial Reporting vs. Individual Products and Customers

As mentioned above, nonmanufacturing costs cannot be included in inventory or the cost of

goods sold; rather, nonmanufacturing costs are reported as SG&A expenses and Interest Expense
in the accounting period in which they occur.

However, if management wants to determine the profitability of a specific product or customer, it

is necessary to allocate or assign nonmanufacturing costs to the products and/or customers
outside of the financial statements. This information stays within the company—it is only used
internally to assist management with decisions such as pricing; choosing which products to
promote or to phase out; choosing which products to review for possible production processing
changes; etc. In the end, management should know whether each product's selling price is
adequate to cover the product's manufacturing costs, nonmanufacturing costs, and required
profit.

If management does not allocate the nonmanufacturing costs to specific products, a product that
requires a significant amount of sales support and administrative costs may actually be
unprofitable even though its gross profit (sales minus manufacturing costs) indicates that it is
very profitable. On the other hand, a product with a low gross profit may actually be very
profitable, if it uses only a minimal amount of administrative and selling expense.

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Methods of Allocating Nonmanufacturing Overhead Costs

As mentioned previously, nonmanufacturing costs are allocated internally to products and

customers for the purpose of giving management information that is useful for decision-making,
but not for the purpose of financial reporting. When doing the internal allocation of
nonmanufacturing costs it is logical to follow these four steps: (1) identify the activities that
cause the nonmanufacturing costs, (2) measure the cost of those activities, (3) identify the
products and customers requiring the activities, and (4) assign the cost of the activities to those
products and customers. In short, the best way to allocate nonmanufacturing costs is to use
activity based costing (ABC).

Some activities involving nonmanufacturing expenses include:

 Servicing existing accounts (product designs and other needs)

 Invoicing customers for shipments of products
 Processing payments from customers
 Maintaining the company's computer information system
 Financing the inventories and other business assets
 Prospecting for new accounts
 Preparing financial statements and reports to government agencies
 Overall management of the company

It is likely that you will have to estimate the cost of these activities. Next, you will need to
allocate the cost of the activities to the individual products. Estimates and allocations based on
logical assumptions are better than precise amounts based on faulty assumptions.

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Recap

1. Allocations are, by definition, arbitrary. Allocations of manufacturing overhead to inventory and

the cost of goods sold are required by generally accepted accounting principles (GAAP).
However, for financial reporting under GAAP, nonmanufacturing costs are not allocated to
products; rather, they are expensed when they occur.
2. Information provided to management on the profitability of specific products and customers will
require the allocation of nonmanufacturing costs in addition to the allocation of manufacturing
overhead.
3. Allocations based on a single factor—such as direct labor hours or machine hours—are too
simplistic for today's complex manufacturing environment. Hence, activity based costing (ABC)
came into existence. ABC can be used for allocating both manufacturing overhead and
nonmanufacturing costs.
Introduction to Activity Based Costing

Activity based costing (ABC) assigns manufacturing overhead costs to products in a more
logical manner than the traditional approach of simply allocating costs on the basis of machine
hours. Activity based costing first assigns costs to the activities that are the real cause of the
overhead. It then assigns the cost of those activities only to the products that are actually
demanding the activities.

Let's discuss activity based costing by looking at two products manufactured by the same
company. Product 124 is a low volume item which requires certain activities such as special
engineering, additional testing, and many machine setups because it is ordered in small
quantities. A similar product, Product 366, is a high volume product—running continuously—
and requires little attention and no special activities. If this company used traditional costing, it
might allocate or "spread" all of its overhead to products based on the number of machine hours.
This will result in little overhead cost allocated to Product 124, because it did not have many
machine hours. However, it did demand lots of engineering, testing, and setup activities. In
contrast, Product 366 will be allocated an enormous amount of overhead (due to all those
machine hours), but it demanded little overhead activity. The result will be a miscalculation of
each product's true cost of manufacturing overhead. Activity based costing will overcome this
shortcoming by assigning overhead on more than the one activity, running the machine.

Activity based costing recognizes that the special engineering, special testing, machine setups,
and others are activities that cause costs—they cause the company to consume resources. Under
ABC, the company will calculate the cost of the resources used in each of these activities. Next,
the cost of each of these activities will be assigned only to the products that demanded the
activities. In our example, Product 124 will be assigned some of the company's costs of special
engineering, special testing, and machine setup. Other products that use any of these activities
will also be assigned some of their costs. Product 366 will not be assigned any cost of special
engineering or special testing, and it will be assigned only a small amount of machine setup.

Activity based costing has grown in importance in recent decades because (1) manufacturing
overhead costs have increased significantly, (2) the manufacturing overhead costs no longer
correlate with the productive machine hours or direct labor hours, (3) the diversity of products
and the diversity in customers' demands have grown, and (4) some products are produced in
large batches, while others are produced in small batches.

Note: Our Guide to Managerial & Cost Accounting is designed to deepen your understanding of
topics such as product costing, overhead cost allocations, estimating cost behavior, costs for
decision making, and more. It is only available when you join AccountingCoach PRO.

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Activity Based Costing with Two Activities

Let's illustrate the concept of activity based costing by looking at two common manufacturing
activities: (1) the setting up of a production machine for running batches of products, and (2) the
actual production of the units of product.

We will assume that a company has annual manufacturing overhead costs of $2,000,000—of
which $200,000 is directly involved in setting up the production machines. During the year the
company expects to perform 400 machine setups. Let's also assume that the batch sizes vary
considerably, but the setup efforts for each machine are similar.

The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups per
year). Under activity based costing, $200,000 of the overhead will be viewed as a batch-level
cost. This means that $200,000 will first be allocated to batches of products to be manufactured
(referred to as a Stage 1 allocation), and then be assigned to the units of product in each batch
(referred to as Stage 2 allocation). For example, if Batch X consists of 5,000 units of product,
the setup cost per unit is $0.10 ($500 divided by 5,000 units). If Batch Y is 50,000 units, the cost
per unit for setup will be $0.01 ($500 divided by 50,000 units). For simplicity, let's assume that
the remaining $1,800,000 of manufacturing overhead is caused by the production activities that
correlate with the company's 100,000 machine hours.

For our simple two-activity example, let's see how the rates for allocating the manufacturing
overhead would look with activity based costing and without activity based costing:

Next, let's see what impact these different allocation techniques and overhead rates would have
on the per unit cost of a specific unit of output. Assume that a company manufactures a batch of
5,000 units and it produces 50 units per machine hour, here is how the cost assigned to the units
with activity based costing and without activity based costing compares:
If a company manufactures a batch of 50,000 units and produces 50 units per machine hour, here
is how the cost assigned to the units with ABC and without ABC compares:

As the tables above illustrate, with activity based costing the cost per unit decreases from $0.46
to $0.37 because the cost of the setup activity is spread over 50,000 units instead of 5,000 units.
Without ABC, the cost per unit is $0.40 regardless of the number of units in each batch. If
companies base their selling prices on costs, a company not using an ABC approach might lose
the large batch work to a competitor who bids a lower price based on the lower, more accurate
overhead cost of $0.37. It's also possible that a company not using ABC may find itself being the
low bidder for manufacturing small batches of product, since its $0.40 is lower than the ABC
model of $0.46 for a batch size of 5,000 units. With its bid price based on manufacturing
overhead of $0.40—but a true cost of $0.46—the company may end up doing lots of production
for little or no profit.

Our example with just two activities (production and setup) illustrates how the cost per unit
using the activity based costing method is more accurate in reflecting the actual efforts
associated with production. As companies began measuring the costs of activities (instead of
focusing on the accountant's departmental classifications), they began using ABC cost
information to practice activity based management. For example, with the cost of setting up a
machine now being measured and discussed, managers began to ask questions such as:
Why is the cost of setting up a production machine so expensive?
What can be done to reduce the setup cost?
If the setup costs cannot be reduced, are the selling prices adequate to cover all of the company's
costs—including the setup cost that was previously buried in the overall machine-hour overhead
rate?

Activity Based Costing with Four Activities

Let's add two more activities to our example: procurement and material handling. The costs of
these two activities are not caused by—nor do they correlate with—machine hours. Rather, we
will assume that both of these activities are related to the physical weight of the direct material
used in making the product.

The company determines that $300,000 of its annual manufacturing overhead is associated with
procurement and material handling. As a result, the company removes $300,000 from the
manufacturing overhead that will be allocated via machine hours, and instead plans to allocate
the $300,000 to the products based on the weight of the materials used. The company expects
that during the year it will procure and handle 3,000,000 pounds of material. Under activity
based costing, the company will assign $0.10 ($300,000 divided by 3,000,000 pounds) per pound
of product weight to each unit manufactured. The end result is that the heavier parts will not only
have more direct material cost, they will also be assigned more factory overhead than the lighter
parts. By assigning some manufacturing overhead to a product based on the product's weight, the
remaining manufacturing overhead assigned via machine hours will be reduced. These points are
illustrated in the following table:
In the table below we can see how ABC would assign costs to the following:

1. A product that weighs 0.5 pound and is produced in a batch of 50,000 units at a rate of 50 per
hour.
2. A product that weighs 1.5 pounds and is produced in a batch of 50,000 units at a rate of 50 per
hour.
3. No activity based costing allocations—all manufacturing overhead costs are allocated entirely
via machine hours.
If the manufacturing overhead costs are caused by a number of activities such as setup,
procurement, handling, and production, then using the activity based costing method of
determining costs will give you a result that is closer to the true costs. As you can see, the
product that weighs 0.5 pound is assigned $0.36 of manufacturing overhead, while the product
weighing 1.5 pounds is assigned $0.46 of manufacturing overhead. Under the traditional costing
allocations the procurement and handling costs would be assigned on production hours. Keep in
mind that whenever manufacturers have a diverse lineup of products, allocating costs on a single
basis (such as machine hours) will result in inaccurate per-unit manufacturing overhead costs.

Introduction to Standard Costing

Standard costing is an important subtopic of cost accounting. Historically, standard costs have
been associated with a manufacturing company's costs of direct materials, direct labor, and
manufacturing overhead.

Rather than assigning the actual costs of direct materials, direct labor, and manufacturing
overhead to a product, some manufacturers assign the expected or standard costs. This means
that a manufacturer's inventories and cost of goods sold will begin with amounts that reflect the
standard costs, not the actual costs, of a product. Since a manufacturer must pay its suppliers and
employees the actual costs, there are almost always differences between the actual costs and the
standard costs, and the differences are noted as variances.

NOTE:
Standard costs can also be thought of as:

 Planned costs
 Expected costs
 Budgeted costs
 "Should be" costs
  Benchmark costs

Standard costing (and the related variances) is a valuable management tool. If a variance arises,
it tells management that the actual manufacturing costs are different from the standard costs.
Management can then direct its attention to the cause of the differences from the planned
amounts.

If we assume that a company uses the perpetual inventory system and that it carries all of its
inventory accounts at standard cost (including Direct Materials Inventory or Stores), then the
standard cost of a finished product is the sum of the standard costs of these inputs:

1. Direct materials
2. Direct labor
3. Manufacturing overhead
1. Variable manufacturing overhead
2. Fixed manufacturing overhead

Usually there will be two variances computed for each input:

Since the calculation of variances can be difficult, we developed several business forms (for
PRO members) to help you get started and to understand what the variances tell us. Learn more
about AccountingCoach PRO.

Note: Our Guide to Managerial & Cost Accounting is designed to deepen your understanding of
topics such as product costing, overhead cost allocations, estimating cost behavior, costs for
decision making, and more. It is only available when you join AccountingCoach PRO.

Confused? Send Feedback

Sample Standards Table

Let's assume that your Uncle Pete runs a retail outlet that sells denim aprons in two sizes. Pete
suggests that you get into the manufacturing side of the business, so on January 1, 2022, you start
up an apron production company called DenimWorks. Using the best information at hand, the
two of you compile the following information to establish the standard costs for 2022:

Standards Table for DenimWorks

The aprons are easy to produce, and no apron is ever left unfinished at the end of any given day.
This means that DenimWorks will never have work-in-process inventory at the end of an
accounting period.

When we make the journal entries for completed aprons, we'll use an account called Inventory-
FG which means Finished Goods Inventory. We'll also be using the account Direct Materials
Inventory or Raw Materials Inventory or Stores. Most manufacturers will also have an account
entitled Work-in-Process Inventory, which is commonly referred to as WIP Inventory.

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Direct Materials Purchased: Standard Cost and Price Variance

Direct materials are the raw materials that are directly traceable to a product. In your apron
business the main direct material is the denim. (In a food manufacturer's business the direct
materials are the ingredients such as flour and sugar; in an automobile assembly plant, the direct
materials are the cars' component parts).

DenimWorks purchases its denim from a local supplier with terms of net 30 days, FOB
destination. This means that title to the denim passes from the supplier to DenimWorks when
DenimWorks receives the material. When the denim arrives, DenimWorks will record the denim
received in its Direct Materials Inventory at the standard cost of $3 per yard (see the standards
table above) and will record a liability for the actual cost of the material received. Any difference
between the standard cost of the material and the actual cost of the material received is recorded
as a purchase price variance.
Examples of Standard Cost of Materials and Price Variance

Let's assume that on January 2, 2022, DenimWorks ordered 1,000 yards of denim at $2.90 per
yard. On January 8, DenimWorks receives the 1,000 yards of denim and the supplier's invoice
for the actual cost of $2,900. On January 8, DenimWorks becomes the owner of the material and
has a liability to its supplier. On January 8, DenimWorks' Direct Materials Inventory is increased
by the standard cost of $3,000 (1,000 yards of denim at the standard cost of $3 per yard),
Accounts Payable is credited for $2,900 (the actual amount owed to the supplier), and the
difference of $100 is credited to Direct Materials Price Variance. Putting this information in a
general journal entry looks like this:

The $100 credit to the Direct Materials Price Variance account indicates that the company is
experiencing actual costs that are more favorable than the planned, standard costs.

In February, DenimWorks orders 3,000 yards of denim at $3.05 per yard. On March 1,
DenimWorks receives the 3,000 yards of denim and the supplier's invoice for $9,150 due in 30
days. On March 1, the Direct Materials Inventory account is increased by the standard cost of
$9,000 (3,000 yards at the standard cost of $3 per yard), Accounts Payable is credited for $9,150
(the actual cost of the denim), and the difference of $150 is debited to Direct Materials Price
Variance as an unfavorable price variance:

After the March 1 transaction is posted, the Direct Materials Price Variance account shows a
debit balance of $50 (the $100 credit on January 8 combined with the $150 debit on March 1). A
debit balance in any variance account means it is unfavorable. It means that the actual costs are
higher than the standard costs and the company's profit will be $50 less than planned unless
some action is taken.

On June 1 your company receives an additional 3,000 yards of denim at an actual cost of $2.92
per yard for a total of $8,760 due in 30 days. The entry is:
Direct Materials Inventory is debited for the standard cost of $9,000 (3,000 yards at $3 per yard),
Accounts Payable is credited for the actual amount owed, and the difference of $240 is credited
to Direct Materials Price Variance. The $240 variance is favorable since the company paid $0.08
per yard less than the standard cost per yard x the 3,000 yards of denim.

NOTE:
A debit to a variance account indicates unfavorable.
A credit to a variance account indicates favorable.

After this transaction is recorded, the Direct Materials Price Variance account shows a credit
balance of $190. A credit balance in a variance account is always favorable. In other words, your
company's profit will be $190 greater than planned due to the lower than expected cost of direct
materials.

Note that the entire price variance pertaining to all of the direct materials received was recorded
immediately (as opposed to waiting until the materials were used).

We will discuss later how to handle the balances in the variance accounts under the heading
What To Do With Variance Amounts.

Direct Materials Usage Variance

In a standard costing system, the costs of production, inventories, and the cost of goods sold are
initially recorded using the standard costs. In the case of direct materials, it means the standard
quantity of direct materials that should have been used to make the good output. If the
manufacturer uses more direct materials than the standard quantity of materials for the products
actually manufactured, the company will have an unfavorable direct materials usage variance. If
the quantity of direct materials actually used is less than the standard quantity for the products
produced, the company will have a favorable usage variance. The amount of a favorable and
unfavorable variance is recorded in a general ledger account Direct Materials Usage Variance.
(Alternative account titles include Direct Materials Quantity Variance or Direct Materials
Efficiency Variance.) We will demonstrate this variance with the following information.

January 2022

In order to calculate the direct materials usage (or quantity) variance, we start with the number of
acceptable units of products that have been manufactured—also known as the good output. At
DenimWorks this is the number of good aprons physically produced. If DenimWorks produces
100 large aprons and 60 small aprons during January, the production and the finished goods
inventory will begin with the cost of the direct materials that should have been used to make
those aprons. Any difference will be a variance.

Note:

We are not determining the quantity of aprons that DenimWorks should have made. Rather, we
are determining whether the 100 large aprons and 60 small aprons that were actually
manufactured were produced efficiently. In the case of direct materials, we want to determine
whether or not the company used the proper amount of denim to make the 160 aprons that were
actually produced. (For the purposes of calculating the direct materials usage variance, it doesn't
matter whether DenimWorks had a goal to produce 100 aprons, 200 aprons, or 250 aprons. The
direct materials usage variance is computed for the actual number of aprons produced.)

Standard costs are sometimes referred to as the "should be costs." DenimWorks should be using
278 yards of denim to make 100 large aprons and 60 small aprons as shown in the following
table.

We determine the total standard cost of the denim that should have been used to make the 160
aprons by multiplying the standard quantity of denim (278 yards) by the standard cost of a yard
of denim ($3 per yard):

An inventory account (such as F.G. Inventory or Work-in-Process) is debited for $834; this is
the standard cost of the direct materials component in the aprons manufactured in January 2022.
The Direct Materials Inventory account is reduced by the standard cost of the denim that was
removed from the direct materials inventory. Let's assume that the actual quantity of denim
removed from the direct materials inventory and used to make the aprons in January was 290
yards. Because Direct Materials Inventory reports the standard cost of the actual materials on
hand, we reduce the account balance by $870 (290 yards used $3 standard cost per yard). After
removing 290 yards of materials, the balance in the Direct Materials Inventory account as of
January 31 is $2,130 (710 yards x $3 standard cost per yard).

The Direct Materials Usage Variance is: [the standard quantity of material that should have been
used to make the good output minus the actual quantity of material used] X the standard cost per
yard.

In our example, DenimWorks should have used 278 yards of material to make 100 large aprons
and 60 small aprons. Because the company actually used 290 yards of denim, we say that
DenimWorks did not operate efficiently. When we multiply the additional 12 yards times the
standard cost of $3 per yard, the result is an unfavorable direct materials usage variance of $36.

For the remainder of our explanation, we will use a common format for calculating variances.
The amounts for each column are computed in the order indicated in the headings.

Direct Materials Usage/Quantity/Efficiency Variance Analysis

The journal entry for the direct materials used for the January production is:
February 2022

Let's assume that in February 2022 DenimWorks produces 200 large aprons and 100 small
aprons and that 520 yards of denim are actually used. From this information we can compute the
following:

Let's put the February 2022 information into our format:

Direct Materials Usage (or Quantity) Variance Analysis

The journal entry for the direct materials used for the February production is:

Direct Labor: Standard Cost, Rate Variance, Efficiency Variance

Direct labor refers to the work done by employees who work directly on the goods being
produced. (Indirect labor refers to the employees who work in the production area, but do not
work directly on the products. An example of indirect labor is the employees who set up or
maintain the equipment.)

Unlike direct materials (which are obtained prior to being used) direct labor is obtained and used
at the same time. This means that for the given good output, we can compute the following at the
same time (when goods are produced):

 Standard direct labor cost

 Direct labor rate variance
 Direct labor efficiency variance

January 2022

Let's begin by determining the standard cost of direct labor for the good output produced in
January 2022:

Assuming that the actual direct labor in January adds up to 50 hours and the actual hourly rate of
pay (including payroll taxes) is $9 per hour, our analysis will look like this:
Direct Labor Variance Analysis for January 2022:

In January, the direct labor efficiency variance (#3 in the above analysis) is unfavorable because
the company actually used 50 hours of direct labor, which is 8 hours more than the standard
quantity of 42 hours allowed for the good output. The additional 8 hours multiplied by the
standard rate of $10 results in an unfavorable direct labor efficiency variance of $80. (The direct
labor efficiency variance could also be referred to as the direct labor quantity variance or usage
variance.)

Note that DenimWorks paid $9 per hour for labor when the standard rate is $10 per hour. This $1
difference is multiplied by the 50 actual hours, resulting in a $50 favorable direct labor rate
variance. (The direct labor rate variance could be referred to as the direct labor price variance.)

The journal entry for the direct labor used in the January production is:

February 2022

In February DenimWorks manufactured 200 large aprons and 100 small aprons. The standard
cost of direct labor and the variances for the February 2022 output is computed next.
If we assume that the actual labor hours in February add up to 75 and the hourly rate of pay
(including payroll taxes) is $11 per hour, the total equals $825. The analysis for February 2022
looks like this:

Direct Labor Variance Analysis for February 2022:

Notice that for February's good output, the total actual labor costs amounted to $825 and the total
standard cost of direct labor amounted to $800. This unfavorable difference of $25 agrees to the
sum of the two labor variances:
The journal entry for the direct labor used in the February production is:

Later in Part 6 we will discuss what to do with the balances in the direct labor variance accounts
under the heading What To Do With Variance Amounts.

Variable Manufacturing Overhead: Standard Cost, Spending Variance,

Efficiency Variance

Manufacturing overhead costs refer to the costs within a manufacturing facility other than direct
materials and direct labor. Manufacturing overhead includes items such as indirect labor, indirect
materials, utilities, quality control, material handling, and depreciation on the manufacturing
equipment and facilities, and more.

Variable manufacturing overhead costs will increase in total as output increases. An example is
the cost of the electricity needed to operate the machines that cut and sew the denim. Another
example is the cost of the manufacturing supplies (such as needles and thread) that increase
when production increases. We will assume that these variable manufacturing overhead costs
fluctuate in response to the number of direct labor hours. Recall the following information in our
Standards Table in Part 1.

January 2022

Let's begin by determining the standard cost of variable manufacturing overhead for
DenimWorks' good output in January 2022:
Recall that there were 50 actual direct labor hours in January. Now let's assume that the actual
cost for the variable manufacturing overhead (electricity and manufacturing supplies) during
January was $90.

Based on the above information, our analysis will look like this:

Variable Manufacturing Overhead Analysis for January 2022:

Notice that for the good output produced in January, the actual cost of variable manufacturing
overhead was $90 and the total standard cost of variable manufacturing overhead cost for the
good output was $84. This unfavorable difference of $6 agrees to the sum of the two variances:
Variable Manufacturing Overhead Efficiency Variance

As our analysis shows, DenimWorks did not produce the good output efficiently since it used 50
actual direct labor hours instead of the 42 standard direct labor hours.

It is assumed that the additional 8 hours caused the company to use additional electricity and
supplies. Measured at the originally estimated rate of $2 per direct labor hour, this amounts to
$16 (8 hours x $2). As a result, this is an unfavorable variable manufacturing overhead efficiency
variance.

Variable Manufacturing Overhead Spending Variance

In our previous analysis, item 2 shows that based on the 50 direct labor hours actually used,
electricity and supplies could cost $100 (50 hours x $2 per hour) instead of the standard cost of
$84. However, the actual cost of the electricity and supplies was $90, not $100. This $10
favorable variance indicates that the company did not spend the planned $2 per direct labor hour.
(Perhaps electricity rates were lower than the rates anticipated when the standard costs were
established.)

Actual variable manufacturing overhead costs are debited to overhead cost accounts. The credits
are made to accounts such as Accounts Payable. For example:

Another entry records how the overhead costs were assigned to the product based on the standard
costs:
Our analysis and the journal entries illustrate that DenimWorks had actual variable
manufacturing overhead of $90, but only $84 (the standard amount) was applied to the products.
The $6 difference is "explained" by the two variances:

February 2022

Recall that in February 2022 the company produced 200 large aprons and 100 small aprons. With
that information we can compute the standard cost of variable manufacturing overhead for
February 2022:

Given that there were 75 actual direct labor hours in February and assuming that the actual cost
for the variable manufacturing overhead in February was $156, our analysis is:

Variable Manufacturing Overhead Analysis for February 2022:

The favorable difference between the actual cost of $156 and the standard cost of $160 agrees
with the sum of the following two variances:

Actual variable manufacturing overhead costs are debited to overhead cost accounts. The credits
are made to accounts such as Accounts Payable. For example:

Another entry records how these overheads were assigned to the product:
As our analysis notes above and as these entries illustrate, even though DenimWorks had actual
variable manufacturing overhead of $156, the standard amount of $160 was applied to the
products. Accountants might say that for the month of February 2022, the company overapplied
variable manufacturing overhead.

We will discuss how to report the balances in the variance accounts under the heading What To
Do With Variance Amounts.

Fixed Manufacturing Overhead: Standard Cost, Budget Variance, Volume

Variance

Fixed manufacturing overhead costs remain the same in total even though the production volume
increased by a modest amount. For example, the property tax on a large manufacturing facility
might be $50,000 per year and it arrives as one tax bill in December. The amount of the property
tax bill did not depend on the number of units produced or the number of machine hours that the
plant operated. A few of the many examples of fixed manufacturing overhead costs include the
depreciation or rent on production facilities; salaries of production managers and maintenance
supervisors; and professional memberships and training for managers in the manufacturing area.
Although the fixed manufacturing overhead costs present themselves as large monthly or annual
expenses, they are part of each product's cost.

DenimWorks has two fixed manufacturing overhead costs:

A portion of these fixed manufacturing overhead costs must be allocated to each apron produced.
This is known as absorption costing and it explains why some accountants say that each product
must "absorb" a portion of the fixed manufacturing overhead costs.

A simple way to assign or allocate the fixed costs is to base it on things such as direct labor
hours, machine hours, or pounds of direct material. Accountants realize that this is simplistic;
they know that overhead costs are caused by many different factors. Nonetheless, we will assign
the fixed manufacturing overhead costs to the aprons by using the direct labor hours.
Establishing a Predetermined Rate

Companies typically establish a standard fixed manufacturing overhead rate prior to the start of
the year and then use that rate for the entire year. Let's assume it is December 2021 and
DenimWorks is developing the standard fixed manufacturing overhead rate for use in 2022. As
mentioned above, we will assign the fixed manufacturing overhead on the basis of direct labor
hours.

Step 1.

Estimate the fixed manufacturing overhead costs for the year 2022.

We indicated above that the fixed manufacturing overhead costs are the rents of $700 per month,
or $8,400 for the year 2022.

Step 2.

Estimate the total number of standard direct labor hours that are needed to manufacture your
products during 2022.

We can estimate the direct labor hours from the information given earlier (and repeated here):

Step 3.

Compute the standard fixed manufacturing rate to be used in 2022.

Note:

One reason a company develops a predetermined annual rate is to have a uniform rate for all
months. If the company used monthly rates, the rate would be high in the months when few units
are produced (monthly fixed costs of $700 ÷ 100 units produced = $7 per unit) and low when
many units are produced (monthly fixed costs of $700 ÷ 350 units = $2 per unit).

Fixed Manufacturing Overhead Budget Variance

The difference between the actual amount of fixed manufacturing overhead and the estimated
amount (the amount budgeted when setting the overhead rate prior to the start of the year) is
known as the fixed manufacturing overhead budget variance.

In our example, we budgeted the annual fixed manufacturing overhead at $8,400 (monthly rents
of $700 x 12 months). If DenimWorks pays more than $8,400 for the year, there is an
unfavorable budget variance; if the company pays less than $8,400 for the year, there is a
favorable budget variance.

Fixed Manufacturing Overhead Volume Variance

Recall that the fixed manufacturing overhead costs (such as the large amount of rent paid at the
start of every month) must be assigned to the aprons produced. In other words, each apron must
absorb a small portion of the fixed manufacturing overhead costs. At DenimWorks, the fixed
manufacturing overhead is assigned to the good output by multiplying the standard rate by the
standard hours of direct labor in each apron. Hopefully, by the end of the year there will be
enough good aprons produced to absorb all of the fixed manufacturing overhead costs.

The fixed manufacturing overhead volume variance is the difference between the amount of
fixed manufacturing overhead budgeted to the amount that was applied to (or absorbed by) the
good output. If the amount applied is less than the amount budgeted, there is an unfavorable
volume variance. This means there was not enough good output to absorb the budgeted amount
of fixed manufacturing overhead. If the amount applied to the good output is greater than the
budgeted amount of fixed manufacturing overhead, the fixed manufacturing overhead volume
variance is favorable.

Illustration of Fixed Manufacturing Overhead Variances for 2022

Let's assume that in 2022 DenimWorks manufactures (has actual good output of) 5,300 large
aprons and 2,600 small aprons. Let's also assume that the actual fixed manufacturing overhead
costs for the year are $8,700. As we calculated earlier, the standard fixed manufacturing
overhead rate is $4 per standard direct labor hour.
We begin by determining the fixed manufacturing overhead applied to (or absorbed by) the good
output produced in the year 2022. Recall that we apply the overhead costs to the aprons by using
the standard amount of direct labor hours.

Our analysis looks like this:

Fixed Manufacturing Overhead Analysis for the Year 2022:

This analysis shows that the actual fixed manufacturing overhead costs are $8,700 and the fixed
manufacturing overhead costs applied to the good output are $8,440. This unfavorable difference
of $260 agrees to the sum of the two variances:
The actual fixed manufacturing overhead costs are debited to overhead cost accounts. The credits
are made to accounts such as Accounts Payable or Cash. For example:

Another entry records how these overheads are assigned to the product:

We will discuss how to report the balances in the variance accounts under the heading What To
Do With Variance Amounts.

Relationship Between Variances

If the direct labor is not efficient when producing the good output, there will be an unfavorable
labor efficiency variance. That inefficiency will likely cause additional variable manufacturing
overhead which will result in an unfavorable variable manufacturing overhead efficiency
variance. If the inefficiencies are significant, the company might not be able to produce enough
good output to absorb the planned fixed manufacturing overhead costs. This in turn can also
cause an unfavorable fixed manufacturing overhead volume variance.

We will pursue the interdependence of variances in the following examples.

Example 1

Assume your company's standard cost for denim is $3 per yard, but you buy some denim at a
bargain price of $2.50 per yard. For each yard of denim purchased, DenimWorks reports a
favorable direct materials price variance of $0.50.
Let's also assume that the quality of the low-cost denim ends up being slightly lower than the
quality to which your company is accustomed. This lesser quality denim causes the production to
be a bit slower as workers spend additional time working around flaws in the material. In
addition to this decline in productivity, you also find that some of the denim is of such poor
quality that it has to be discarded. Further, some of the finished aprons don't pass the final
inspection due to occasional defects not detected as the aprons were made.

You get the picture. If the favorable $0.50 per yard price variance correlates with lower quality,
that denim was no bargain. The $0.50 per yard favorable variance may be more than offset by
the following unfavorable quantity variances:

 Direct material usage variance

 Direct labor efficiency variance
 Variable manufacturing overhead efficiency variance

Keep in mind that the standard cost is the cost allowed on the good output. Putting material,
labor, and manufacturing overhead costs into products that will not end up as good output will
likely result in unfavorable variances.

Example 2

Let's assume that you decide to hire an unskilled worker for $9 per hour instead of a skilled
worker for the standard cost of $15 per hour. Although the unskilled worker will create a
favorable direct labor rate variance of $6 per hour, you may see significant unfavorable variances
such as a direct material usage variance, a direct labor efficiency variance, a variable
manufacturing overhead efficiency variance, and possibly a fixed manufacturing overhead
volume variance.

These two examples highlight what experienced managers know: you need to look at more than
price. A low cost for an inferior input is no bargain if it results in costly inefficiencies.

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What To Do With Variance Amounts

Throughout our explanation of standard costing we showed you how to calculate the variances.
In the case of direct materials and direct labor, the variances were recorded in specific general
ledger accounts. The manufacturing overhead variances were the differences between the
accounts containing the actual costs and the accounts containing the applied costs. Now we'll
discuss what we do with those variance amounts.

Direct Materials Price Variance

Let's begin by assuming that the account Direct Materials Price Variance has a debit balance of
$3,500 at the end of the accounting year resulting from one purchase:
Because of the cost principle, the financial statements for DenimWorks report the company's
actual cost. If none of the direct materials purchased in this journal entry was used in production
(all of the direct materials remain in the direct materials inventory), the company's balance sheet
must report the direct materials inventory at $13,500. In other words, the balance sheet will
report the standard cost of $10,000 plus the price variance of $3,500.

If all of the materials were used in making products, and all of the products have been sold, the
$3,500 price variance is added to the company's standard cost of goods sold.

If 20% of the materials remain in the direct materials inventory and 80% of the materials are in
the finished goods that have been sold, then $700 of the price variance (20% of $3,500) is added
to the standard cost of the direct materials inventory, $2,800 (80% of $3,500) is added to the
standard cost of goods sold.

Now let's assume the direct materials are in various stages of use:

 20% have not been used yet

 5% are in work-in-process
 15% are in finished goods on hand
 60% are in finished goods that have been sold

We need to assign or allocate the unfavorable $3,500 direct materials price variance to the four
places where the direct materials are now located. Since the $3,500 is an unfavorable amount, the
following amounts are added to the standard costs:

Accounting professionals have a materiality guideline which allows a company to make an

exception to an accounting principle if the amount in question is insignificant. (For example, a
large company may report amounts to the nearest $1,000 on its financial statements, or an
inexpensive item like a wastebasket can be expensed immediately instead of being depreciated
over its useful life.) This means that if the total variance of $3,500 shown above is a very, very
small amount relative to the company's net income, the company can assign the entire $3,500 to
the cost of goods sold instead of allocating some of the amount to the inventories.

If the balance in the Direct Materials Price Variance account is a credit balance of $3,500
(instead of a debit balance) the procedure and discussion would be the same, except that the
standard costs would be reduced instead of increased.

Direct Materials Usage Variance

Let's assume that the Direct Materials Usage Variance account has a debit balance of $2,000 at
the end of the accounting year. A debit balance is an unfavorable balance resulting from more
direct materials being used than the standard amount allowed for the good output.

The first question to ask is "Why do we have this unfavorable variance of $2,000?" If it was
caused by errors and/or inefficiencies, it cannot be assigned to the inventory. Errors and
inefficiencies are never considered to be assets; therefore, the entire amount must be expensed
immediately.

On the other hand, if the unfavorable $2,000 variance is the result of an unrealistic standard for
the quantity of direct materials needed, then we should allocate the $2,000 variance to wherever
the standard costs of direct materials are now located. If 90% of the related direct materials have
been sold and 10% are in the finished goods inventory, then the $2,000 should be allocated and
added to the standard direct material costs as follows:

If $2,000 is an insignificant amount relative to a company's net income, the entire $2,000
unfavorable variance can be added to the cost of goods sold. This is permissible because of the
materiality guideline.

If the $2,000 balance is a credit balance, the variance is favorable. This means that the actual
direct materials used were less than the standard quantity of materials called for by the good
output. We should allocate this $2,000 to wherever those direct materials are physically located.
However, if $2,000 is an insignificant amount, the materiality guideline allows for the entire
$2,000 to be deducted from the cost of goods sold on the income statement.

Introduction to Debits and Credits

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access to our premium debits and credits materials. These include our visual tutorial, flashcards,
cheat sheet, quick tests, quick test with coaching, and more.

What are debits and credits?

Debits and credits are terms used by bookkeepers and accountants when recording transactions
in the accounting records. The amount in every transaction must be entered in one account as a
debit (left side of the account) and in another account as a credit (right side of the account). This
double-entry system provides accuracy in the accounting records and financial statements.

The initial challenge is understanding which account will have the debit entry and which account
will have the credit entry. Before we explain and illustrate the debits and credits in accounting
and bookkeeping, we will discuss the accounts in which the debits and credits will be entered or
posted.

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What Is An Account?

To keep a company's financial data organized, accountants developed a system that sorts
transactions into records called accounts. When a company's accounting system is set up, the
accounts most likely to be affected by the company's transactions are identified and listed out.
This list is referred to as the company's chart of accounts. Depending on the size of a company
and the complexity of its business operations, the chart of accounts may list as few as thirty
accounts or as many as thousands. A company has the flexibility of tailoring its chart of accounts
to best meet its needs.

Within the chart of accounts the balance sheet accounts are listed first, followed by the income
statement accounts. In other words, the accounts are organized in the chart of accounts as
follows:

 Assets
 Liabilities
 Owner's (Stockholders') Equity
 Revenues or Income
 Expenses
 Gains
 Losses

Click here to see a sample chart of accounts.

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Double-Entry Accounting

Because every business transaction affects at least two accounts, our accounting system is known
as a double-entry system. (You can refer to the company's chart of accounts to select the proper
accounts. Accounts may be added to the chart of accounts when an appropriate account cannot
be found.)

For example, when a company borrows $1,000 from a bank, the transaction will affect the
company's Cash account and the company's Notes Payable account. When the company repays
the bank loan, the Cash account and the Notes Payable account are also involved.

If a company buys supplies for cash, its Supplies account and its Cash account will be affected.
If the company buys supplies on credit, the accounts involved are Supplies and Accounts
Payable.

If a company pays the rent for the current month, Rent Expense and Cash are the two accounts
involved. If a company provides a service and gives the client 30 days in which to pay, the
company's Service Revenues account and Accounts Receivable are affected.

Although the system is referred to as double-entry, a transaction may involve more than two
accounts. An example of a transaction that involves three accounts is a company's loan payment
to its bank of $300. This transaction will involve the following accounts: Cash, Notes Payable,
and Interest Expense.

(If you use accounting software you may not actually see that two or more accounts are being
affected due to the user-friendly nature of the software. For example, let's say that you write a
company check by means of your accounting software. Your software automatically reduces
your Cash account and prompts you only for the other accounts affected.)

Special Feature: Review what you are learning by working the three interactive crossword
puzzles dedicated to this topic. They are completely free.

Click here for the Debits and Credits Crossword Puzzles

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Debits and Credits

After you have identified the two or more accounts involved in a business transaction, you must
debit at least one account and credit at least one account.

To debit an account means to enter an amount on the left side of the account. To credit an
account means to enter an amount on the right side of an account.
Here's a Tip

Debit means left

Credit means right

Generally these types of accounts are increased with a debit:

Dividends (Draws)
Expenses
Assets
Losses

You might think of D - E - A - L when recalling the accounts that are increased with a debit.

Generally the following types of accounts are increased with a credit:

Gains
Income
Revenues
Liabilities
Stockholders' (Owner's) Equity

You might think of G - I - R - L - S when recalling the accounts that are increased with a credit.

To decrease an account you do the opposite of what was done to increase the account. For
example, an asset account is increased with a debit. Therefore it is decreased with a credit.

The abbreviation for debit is dr. and the abbreviation for credit is cr.

T-accounts

Accountants and bookkeepers often use T-accounts as a visual aid to see the effect of a
transaction or journal entry on the two (or more) accounts involved.

To learn more about the role of bookkeepers and accountants, visit our topic Accounting
Careers.

We will begin with two T-accounts: Cash and Notes Payable.

Let's demonstrate the use of these T-accounts with two transactions:

1. On June 1, 2022 a company borrows $5,000 from its bank. As a result, the company's asset Cash
must be increased by $5,000 and its liability Notes Payable must be increased by $5,000. To
increase the asset Cash the account needs to be debited. To increase the company's liability
Notes Payable this account needs to be credited. After entering the debits and credits the T-
accounts look like this:
 2. On June 2, 2022 the company repays $2,000 of the bank loan. As a result, the company's asset
Cash must be decreased by $2,000 and its liability Notes Payable must be decreased by $2,000.
To reduce the asset Cash the account will need to be credited for $2,000. To decrease the
liability Notes Payable that account will need to be debited for $2,000. The T-accounts now look
like this:

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Journal Entries

Another way to visualize business transactions is to write a general journal entry. Each general
journal entry lists the date, the account title(s) to be debited and the corresponding amount(s)
followed by the account title(s) to be credited and the corresponding amount(s). The accounts to
be credited are indented. Let's illustrate the general journal entries for the two transactions that
were shown in the T-accounts above.
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When Cash Is Debited and Credited

Because cash is involved in many transactions, it is helpful to memorize the following:

 Whenever cash is received, debit Cash.

 Whenever cash is paid out, credit Cash.

With the knowledge of what happens to the Cash account, the journal entry to record the debits
and credits is easier. Let's assume that a company receives $500 on June 3, 2022 from a customer
who was given 30 days in which to pay. (In May the company had recorded the sale and an
accounts receivable.) On June 3 the company will debit Cash, because cash was received. The
amount of the debit and the credit is $500. Entering this information in the general journal
format, we have:

All that remains to be entered is the name of the account to be credited. Since this was the
collection of an account receivable, the credit should be Accounts Receivable. (Because the sale
was already recorded in May, you cannot enter Sales again on June 3.)

On June 4 the company paid $300 to a supplier for merchandise the company received in May.
(In May the company recorded the purchase and the accounts payable.) On June 4 the company
will credit Cash, because cash was paid. The amount of the debit and credit is $300. Entering
them in the general journal format, we have:
All that remains to be entered is the name of the account to be debited. Since this was the
payment on an account payable, the debit should be Accounts Payable. (Because the purchase
was already recorded in May, you cannot enter Purchases or Inventory again on June 4.)

Normal Balances

When looking at an account in the general ledger, the following is the debit or credit balance you
would normally find in the account:

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Revenues and Gains Are Usually Credited

Revenues and gains are recorded in accounts such as Sales, Service Revenues, Interest
Revenues (or Interest Income), and Gain on Sale of Assets. These accounts normally have
credit balances that are increased with a credit entry. In a T-account, their balances will be on the
right side.
The exceptions to this rule are the accounts Sales Returns, Sales Allowances, and Sales
Discounts—these accounts have debit balances because they are reductions to sales. Accounts
with balances that are the opposite of the normal balance are called contra accounts; hence
contra revenue accounts will have debit balances.

Let's illustrate revenue accounts by assuming your company performed a service and was
immediately paid the full amount of $50 for the service. The debits and credits are presented in
the following general journal format:

Whenever cash is received, the asset account Cash is debited and another account will need to be
credited. Since the service was performed at the same time as the cash was received, the revenue
account Service Revenues is credited, thus increasing its account balance.

Let's illustrate how revenues are recorded when a company performs a service on credit (i.e., the
company allows the client to pay for the service at a later date, such as 30 days from the date of
the invoice). At the time the service is performed the revenues are considered to have been
earned and they are recorded in the revenue account Service Revenues with a credit. The other
account involved, however, cannot be the asset Cash since cash was not received. The account to
be debited is the asset account Accounts Receivable. Assuming the amount of the service
performed is $400, the entry in general journal form is:

Accounts Receivable is an asset account and is increased with a debit; Service Revenues is
increased with a credit.

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Expenses and Losses are Usually Debited

Expenses normally have debit balances that are increased with a debit entry. Since expenses are
usually increasing, think "debit" when expenses are incurred. (We credit expenses only to
reduce them, adjust them, or to close the expense accounts.) Examples of expense accounts
include Salaries Expense, Wages Expense, Rent Expense, Supplies Expense, and Interest
Expense. In a T-account, their balances will be on the left side.

To illustrate an expense let's assume that on June 1 your company paid $800 to the landlord for
the June rent. The debits and credits are shown in the following journal entry:

Since cash was paid out, the asset account Cash is credited and another account needs to be
debited. Because the rent payment will be used up in the current period (the month of June) it is
considered to be an expense, and Rent Expense is debited. If the payment was made on June 1
for a future month (for example, July) the debit would go to the asset account Prepaid Rent.

As a second example of an expense, let's assume that your hourly paid employees work the last
week in the year but will not be paid until the first week of the next year. At the end of the year,
the company makes an entry to record the amount the employees earned but have not been paid.
Assuming the employees earned $1,900 during the last week of the year, the entry in general
journal form is:

As noted earlier, expenses are almost always debited, so we debit Wages Expense, increasing its
account balance. Since your company did not yet pay its employees, the Cash account is not
credited, instead, the credit is recorded in the liability account Wages Payable. A credit to a
liability account increases its credit balance.

To help you get more comfortable with debits and credits in accounting and bookkeeping,
memorize the following tip:

Here's a Tip

To increase an expense account, debit the account.

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Permanent and Temporary Accounts

Asset, liability, and most owner/stockholder equity accounts are referred to as permanent
accounts (or real accounts). Permanent accounts are not closed at the end of the accounting year;
their balances are automatically carried forward to the next accounting year.

Temporary accounts (or nominal accounts) include all of the revenue accounts, expense
accounts, the owner's drawing account, and the income summary account. Generally speaking,
the balances in temporary accounts increase throughout the accounting year. At the end of the
accounting year the balances will be transferred to the owner's capital account or to a
corporation's retained earnings account.

Because the balances in the temporary accounts are transferred out of their respective accounts at
the end of the accounting year, each temporary account will have a zero balance when the next
accounting year begins. This means that the new accounting year starts with no revenue amounts,
no expense amounts, and no amount in the drawing account.

By having many revenue accounts and a huge number of expense accounts, a company will be
able to report detailed information on revenues and expenses throughout the year.

Bank's Debits and Credits

When you hear your banker say, "I'll credit your checking account," it means the transaction will
increase your checking account balance. Conversely, if your bank debits your account (e.g.,
takes a monthly service charge from your account) your checking account balance decreases.

If you are new to the study of debits and credits in accounting, this may seem puzzling. After all,
you learned that debiting the Cash account in the general ledger increases its balance, yet your
bank says it is crediting your checking account to increase its balance. Similarly, you learned
that crediting the Cash account in the general ledger reduces its balance, yet your bank says it is
debiting your checking account to reduce its balance.

Although the above may seem contradictory, we will illustrate below that a bank's treatment of
debits and credits is indeed consistent with the basic accounting procedure that you learned. Let's
look at three transactions and consider the related journal entries from both the bank's
perspective and the company's perspective.

Transaction #1

Let's say that your company, Debris Disposal, receives $100 of currency from a customer as a
down payment for a future site cleanup service. When the money is received your company
makes the following entry:

(Debris Disposal's journal entry)

Because it has received cash, Debris Disposal increases its Cash account with a debit of $100.
The rules of double-entry accounting require Debris Disposal to also enter a credit of $100 into
another of its general ledger accounts. Since the company has not yet earned the $100, it cannot
credit a revenue account. Instead, the liability account Unearned Revenues is credited because
Debris Disposal has a liability to do the work or to return the $100. (An alternate title for the
Unearned Revenues account is Customer Deposits.)

Now let's say you take that $100 to Trustworthy Bank and deposit it into Debris Disposal's
checking account. Since Trustworthy Bank is receiving cash of $100, the bank debits its general
ledger Cash account for $100, thereby increasing the bank's assets. The rules of double-entry
accounting require the bank to also enter a credit of $100 into another of the bank's general
ledger accounts. Because the bank has not earned the $100, it cannot credit a revenue account.
Instead, the bank credits a liability account such as Customers' Checking Accounts to reflect the
bank's obligation/liability to return the $100 to Debris Disposal on demand. In general journal
format the bank's entry is:

(Trustworthy Bank's journal entry)

As the entry shows, the bank's assets increase by the debit of $100 and the bank's liabilities
increase by the credit of $100. The bank's detailed records show that Debris Disposal's checking
account is the specific liability that increased.

Transaction #2

Let's say Trustworthy Bank receives a $1,000 wire transfer on your company's behalf from a
person who owes money to Debris Disposal. Two things happen at the bank: (1) The bank
receives $1,000, and (2) the bank records its obligation to give the money to Debris Disposal on
demand. These two facts are entered into the bank's general ledger as follows:

(Trustworthy Bank's journal entry)

The debit increases the bank's assets by $1,000 and the credit increases the bank's liabilities by
$1,000. The bank's detailed records show that Debris Disposal's checking account is the specific
liability that increased.

At the same time the $1,000 wire transfer is received at the bank, Debris Disposal makes the
following entry into its general ledger:

(Debris Disposal's journal entry)

As a result of collecting $1,000 from one of its customers, Debris Disposal's Cash balance
increases and its Accounts Receivable balance decreases.

Transaction #3

Many banks charge a monthly fee on checking accounts. If Trustworthy Bank decreases Debris
Disposal's checking account balance by $13.00 to pay for the bank's monthly service charge, this
might be itemized on Debris Disposal's bank statement as a "debit memo." The entry in the
bank's records will show the bank's liability being reduced (because the bank owes Debris
Disposal $13 less). It also shows that the bank earned revenues of $13 by servicing the checking
account.

(Trustworthy Bank's general ledger)

On your company's records, the entry will look like this:

(Debris Disposal's general ledger)

Debris Disposal's cash is reduced with a credit of $13 and expenses are increased with a debit of
$13. (If the amount of the bank's service charges is not significant a company may debit the
charge to Miscellaneous Expense.)

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Bank's Balance Sheet

Accounts such as Cash, Investment Securities, and Loans Receivable are reported as assets on
the bank's balance sheet. Customers' bank accounts are reported as liabilities and include the
balances in its customers' checking and savings accounts as well as certificates of deposit. In
effect, your bank statement is just one of thousands of subsidiary records that account for
millions of dollars that a bank owes to its depositors.

Recap

Here are some of the highlights from this explanation:

 Debit means left.

 Credit means right.
 Every transaction affects two accounts or more.
 At least one account will be debited and at least one account will be credited.
 The total of the amount(s) entered as debits must equal the total of the amount(s) entered as
credits.
 When cash is received, debit Cash.
 When cash is paid out, credit Cash.
 To increase an asset, debit the asset account.
 To increase a liability, credit the liability account.
 To increase owner's equity, credit an owner's equity account.
 To increase revenues, credit the revenues account
 A credit to a revenue account also causes an increase in owner's equity
 To increase expenses, debit the expense account
 A debit to an expense account also causes a decrease in owner's equity
Introduction to Chart of Accounts

A chart of accounts is a listing of the names of the accounts that a company has identified and
made available for recording transactions in its general ledger. A company has the flexibility to
tailor its chart of accounts to best suit its needs, including adding accounts as needed.

Within the chart of accounts you will find that the accounts are typically listed in the following
order:

Within the categories of operating revenues and operating expenses, accounts might be further
organized by business function (such as producing, selling, administrative, financing) and/or by
company divisions, product lines, etc.

A company's organization chart can serve as the outline for its accounting chart of accounts.
For example, if a company divides its business into ten departments (production, marketing,
human resources, etc.), each department will likely be accountable for its own expenses (salaries,
supplies, phone, etc.). Each department will have its own phone expense account, its own
salaries expense, etc.

Sample Chart of Accounts For a Large Corporation

Each account in the chart of accounts is typically assigned a name and a unique number by
which it can be identified. (Software for some small businesses may not require account
numbers.) Account numbers are often five or more digits in length with each digit representing a
division of the company, the department, the type of account, etc.

As you will see, the first digit might signify if the account is an asset, liability, etc. For example,
if the first digit is a "1" it is an asset. If the first digit is a "5" it is an operating expense.

A gap between account numbers allows for adding accounts in the future. The following is a
partial listing of a sample chart of accounts.

Current Assets (account numbers 10000 - 16999)

 10100 Cash - Regular Checking
10200 Cash - Payroll Checking
10600 Petty Cash Fund
12100 Accounts Receivable
12500 Allowance for Doubtful Accounts
13100 Inventory
14100 Supplies
15300 Prepaid Insurance

Property, Plant, and Equipment (account numbers 17000 - 18999)

17000 Land
17100 Buildings
17300 Equipment
17800 Vehicles
18100 Accumulated Depreciation - Buildings
18300 Accumulated Depreciation - Equipment
18800 Accumulated Depreciation - Vehicles

Current Liabilities (account numbers 20000 - 24999)

20100 Notes Payable - Credit Line #1
20200 Notes Payable - Credit Line #2
21000 Accounts Payable
22100 Wages Payable
23100 Interest Payable
24500 Unearned Revenues

Long-term Liabilities (account numbers 25000 - 26999)

25100 Mortgage Loan Payable
25600 Bonds Payable
25650 Discount on Bonds Payable

Stockholders' Equity (account numbers 27000 - 29999)

27100 Common Stock, No Par
27500 Retained Earnings
29500 Treasury Stock

Operating Revenues (account numbers 30000 - 39999)

31010 Sales - Division #1, Product Line 010
31022 Sales - Division #1, Product Line 022
32015 Sales - Division #2, Product Line 015
33110 Sales - Division #3, Product Line 110

Cost of Goods Sold (account numbers 40000 - 49999)

 41010 COGS - Division #1, Product Line 010
41022 COGS - Division #1, Product Line 022
42015 COGS - Division #2, Product Line 015
43110 COGS - Division #3, Product Line 110

Marketing Expenses (account numbers 50000 - 50999)

50100 Marketing Dept. Salaries
50150 Marketing Dept. Payroll Taxes
50200 Marketing Dept. Supplies
50600 Marketing Dept. Telephone

Payroll Dept. Expenses (account numbers 59000 - 59999)

59100 Payroll Dept. Salaries
59150 Payroll Dept. Payroll Taxes
59200 Payroll Dept. Supplies
59600 Payroll Dept. Telephone

Other (account numbers 90000 - 99999)

91800 Gain on Sale of Assets
96100 Loss on Sale of Assets

Sample Chart of Accounts for a Small Company

This is a partial listing of another sample chart of accounts. Note that each account is assigned a
three-digit number followed by the account name. The first digit of the number signifies if it is
an asset, liability, etc. For example, if the first digit is a "1" it is an asset, if the first digit is a "3"
it is a revenue account, etc. The company decided to include a column to indicate whether a debit
or credit will increase the amount in the account. This sample chart of accounts also includes a
column containing a description of each account in order to assist in the selection of the most
appropriate account.
Asset Accounts
Liability Accounts

Owner's Equity Accounts

Operating Revenue Accounts

Operating Expense Accounts

Non-Operating Revenues and Expenses, Gains, and Losses

At Least Two Accounts for Every Transaction

The chart of accounts lists the accounts that are available for recording transactions. In keeping
with the double-entry system of accounting, a minimum of two accounts is needed for every
transaction—at least one account is debited and at least one account is credited.

Some general rules about debiting and crediting the accounts are:

 Expense accounts are debited and have debit balances

 Revenue accounts are credited and have credit balances

 Asset accounts normally have debit balances

 To increase an asset account, debit the account
 To decrease an asset account, credit the account

 Liability accounts normally have credit balances

 To increase a liability account, credit the account
 To decrease a liability account, debit the account

To learn more about debits and credits, visit our Explanation of Debits and Credits and our
Practice Quiz for Debits and Credits.