Accounting for Treasury Stock Using the Cost Method

There are mainly two methods of accounting for treasury stock shares: the cost method and the par value method. This section discusses the cost method.

The cost method of accounting for treasury stock shares is the most common method because of its simplicity. When companies use the cost method, the purchase of treasury stock is viewed as a temporary reduction in shareholders equity. The reason for this is that the company expects to reissue the shares instead of retiring them. When the company reissues the treasury shares, the temporary account is eliminated. The cost of treasury stock shares reacquired is charged to a contra account, in this case a contra equity account that reduces the stockholder equity balance. The purchase of treasury shares leaves the common stock and contributed balances intact.

For example, consider the following balance sheet:

Common Stock @ Par, $1
Authorized 100,000 Shares
Issued 25,000 Shares

If Sunny acquires 1,000 shares of common stock at $5 per share, he would make the following accounting journal entry:

Both stockholders equity and net assets are reduced from the purchase of treasury share stock. Debiting the contra equity account, treasury stock, reduces stockholders equity, and net assets are reduced from the decrease in the cash balance.

The cost method of accounting for treasury stock shares affects the accounting balance sheet as follows:

Common Stock @ Par, $1
Authorized 100,000 Shares
Issued 25,000 Shares,
1,000 Shares of which are Treasury StockRetained Earnings ($5,000 restricted for cost of treasury stock held)Less: Cost of 1,000 treasury shares

The stockholders equity section has decreased by $5,000. The capital accounts remain intact as originally reported, since the cost method treats the purchase of treasury share stock as a temporary reduction in stockholders equity.

In this example, Sunny issued 25,000 shares. Treasury stock is stock taken off the market and not yet retired, thereby reducing the number of shares outstanding. The amount of stock issued does not change, since the portion of the stock issued is now treasury stock held by the company, reducing only the amount outstanding by the amount of the treasury share stock.

Most states restrict earnings distributions and dividends to the balance of retained earnings less the cost of treasury shares held. GAAP therefore requires a disclosure in the form of a footnote or parenthetically which would be included with the balance sheet to signify the reduction of retained earnings from the acquisition of treasury stock. This is important since a company can only pay dividends to the extent of its available retained earnings less any treasury stock held, in this case $10,283 ($15,283 – $5,000). The amount of shareholder equity that cannot be distributed to shareholders is often referred to as legal capital.

When the shares are reissued, treasury stock is credited for the cost of the reissued shares. If the treasury stock is reissued at a price greater than the original cost, the company credits a separate contributed capital from treasury stock account. If the company reissues the treasury shares at less than cost, the difference is first taken out of the contributed capital account for treasury shares. If the difference remains after reducing the contributed capital account to zero, retained earnings is then reduced.

Companies cannot create earnings through buying or selling their own capital stock. Treasury stock transactions generally increase and decrease contributed capital. Occasionally treasury stock transactions may decrease retained earnings, but a company cannot increase retained earnings through treasury stock transactions.

Sunny reissues 200 shares of treasury shares at $7 per share.

Contributed Capital from treasury stock transactions – common

Sunny reissues 300 shares of treasury shares at $3 per share.

Contributed Capital from treasury stock transactions – common

After the above transactions, the equity section of the balance sheet for Sunny Sunglasses Shop now appears as follows:

Common Stock @ Par, $1
Authorized 100,000 Shares
Issued 25,000 Shares,
500 Shares of which are Treasury StockRetained Earnings ($2,500 restricted for cost of treasury stock held)Less: Cost of 500 treasury shares

Total treasury stock decreased by $2,500, the amount of the 500 treasury shares sold at the original cost of $5. The stockholders equity account increased by $2,300, the amount of the treasury shares sold ($2,500) less the loss to retained earnings of $200. The $200 loss occurred when Sunny reissued 300 treasury shares at $3. The loss not only absorbed the original gain recorded in the contributed capital from treasury stock transactions – common for $400, but then reduced retained earnings for the remaining loss of $200.

Since retained earnings cannot be increased in treasury share transactions, Sunny recorded the gain in the contributed capital account. However, when a loss occurred, the loss is first taken from the contributed capital account and then, if a loss remains, from retained earnings.

Sunny formally retires the remaining 500 shares of treasury shares.

Contributed Capital in excess of par – common

The common stock, contributed capital, and treasury stock shares are retired based on the original values in each account, with the difference going to retained earnings.

 

Accounting for Treasury Stock Using the Par Value Method

There are mainly two methods of accounting for treasury stock shares: the cost method and the par value method. This section discusses the par value method.

Under the cost method, the purchase of treasury stock is viewed as a temporary reduction in stockholders equity, and purchases are recorded in a contra equity account to reduce owners equity.

Unlike the cost method of accounting for treasury stock, the par value method assumes that the treasury stock shares acquired will eventually be retired.

This is accomplished by debiting treasury stock at the par value for the issued stock, the additional contributed capital account at the original amount received in excess of par, and crediting cash.

For example, consider the same balances used in the cost method:

Common Stock @ Par, $1
Authorized 100,000 Shares
Issued 25,000 Shares

If Sunny Sunglasses Shop acquires 1,000 shares of its own common stock at $5 per share, Sunny would make the following accounting journal entry:

Contributed capital in excess of par – commonRetained Earnings ($3 x 1,000 shares)

The treasury stock is recorded at the original par value of $1. Additionally, Sunny debits the contributed capital in excess of par at the original amount received in excess of par, which was $1. The debit to retained earnings is the difference between the amount that the stock was acquired for ($5) and the original amount including excess of par ($2). The difference debited to retained earnings is considered a dividend to retiring stockholders, as the par value assumes the retirement of the stock.

The effect on the accounting balance sheet from the par value method of accounting for treasury stock shares is as follows:

Common Stock @ Par, $1
Authorized 100,000 Shares
Issued 25,000 Shares,
of which 1,000 shares are held in the treasury

The stockholders equity section has decreased by $5,000 and now equals the same amount as the balance when accounting for treasury stock shares using the cost method. The difference is that the par value method reduces the equity accounts directly, though preserving the distinction of treasury shares until actually retired, whereas the cost method temporarily reduces stockholders equity through a contra equity account listed separately on the balance sheet. The temporary reduction through the contra equity account is eliminated when the company reissues the shares under the cost method.

When the company reissues the treasury stock, Sunny debits cash for the proceeds, credits treasury stock for the original par value of the reissued shares, and credits contributed capital for the excess of cash proceeds over the original par value. This transaction is very similar to issuing original stock, except the common stock at par is replaced with treasury stock shares.

Sunny reissues 200 shares of treasury shares at $7 per share.

Contributed Capital in excess of par – common

Sunny reissues 300 shares of treasury shares at $3 per share.

Contributed Capital in excess of par – common

After the above transactions, the equity section of the balance sheet for Sunny Sunglasses Shop now appears as follows:

Common Stock @ Par, $1
Authorized 100,000 Shares
Issued 25,000 Shares,
of which 500 shares are held in the treasuryRetained Earnings ($2,500 restricted for cost of treasury stock held)

The stockholders equity section equals the same amount as the balance when using the cost method. The difference is that the treasury stock balance is deducted directly from the par value of the original stock, consistent with the view that acquisition of treasury stock under the par value method is the same as retiring the shares. Since Sunny acquired 1,000 shares and reissued 500 shares, the transactions reduced common stock at par by $500. Similarly, contributed capital was also reduced by the original amount of capital of treasury shares in excess of par, and increased by any amount over par upon reissuing the treasury shares.

Sunny formally retires the remaining 500 shares of treasury shares.

The company credits treasury stock to eliminate the balance, and transfer the reduction to common stock which now equals $24,500.

The par value method uses the treasury stock account to make the distinction between actual retired shares and treasury stock shares outstanding. When the company retires the treasury stock shares, the treasury stock is eliminated and the common stock account is reduced directly.

 

Accounting Software Packages and Accounting Software Small Business

Small business accounting software can save you countless hours by maintaining bookkeeping, eliminating manual calculation errors, and providing one click automated reporting capabilities.

Small business accounting software makes the process of maintaining the books much simpler and more efficient, while providing business owners with one-click business reports during the year. Below are the top five reasons why accounting software for small business should be considered for your business.

The ability to quickly produce reports to track inventory, monitor expenses, analyze your business, pay tax liabilities timely, and review the overall performance of your business makes business accounting software a necessity. This is even truer today as small business accounting software has become extremely versatile for your industry, easier to use, and more powerful and cost-effective than ever.

Your financial statements, tax returns, and business analysis tools are only as good as the information used to create them. Inaccurate bookkeeping creates inaccurate financial reports that can result in tax penalties, unexpected cash flow problems, and inaccurate business information that is used to measure business profitability. Accounting software for small business quickly compiles accounting information to provide business owners with financial information required to make better decisions and monitor business performance.

Business owners often avoid the time consuming and laborious task of maintaining the books, but accounting software for small business simplifies the process greatly. Entering accounting transactions each day is worth the benefits of one click reporting, real time business reports, and no longer playing catch-up from gathering data for year-end tax reporting and financial reporting.

The IRS requires tax deductions to be substantiated with receipts, schedules, and other source documents. Business tax software makes the process of filing tax returns much simpler, but you still must take the time to set aside files for your business expenses. After you enter your business expenses into business tax software, file the receipts into your business expense files to validate the expenses.

Software programs allow you to receive the latest tax rates for payroll taxes and sales taxes, while simplifying the tax filing process by automatically filling in tax forms for various jurisdictions with correct tax rates and amounts due. Several accounting software packages allow you to simply print the form, sign, and pay your taxes. It may be helpful to have a system accountant set up the software correctly before you begin entering transactions and updating tax rates. When your accounts are set up correctly, you can update tax rates in a few simple steps. Software vendors can help you set up the software for your business for an extra fee.

You may choose to outsource your payroll altogether so that you do not have to pay your employees or taxes directly. Many small business accounting software vendors offer full service payroll and payroll tax filing options. These options are highly recommended for businesses with a large amount of employees in multiple tax jurisdictions to prevent costly tax filing penalties, or if you just want a hands off approach to paying taxes timely.

Manual bookkeeping systems or computerized spreadsheet systems are susceptible to manual entry errors and miscalculations since the transactions are not properly set up to maintain double entry bookkeeping.

Small business accounting software packages calculate totals for general ledger accounts, trial balances, and financial statements, eliminating posting errors. Accounting software packages flag accounting entries that do not balance with the accounting equation before they are entered into the accounting journal, preventing posting errors and time-consuming mistakes due to data entry errors.

Of course, mistakes are inevitable and can still be entered into an incorrect account. A bookkeeper can still enter an insurance expense as an interest expense. Accounting software packages include safeguards to prevent these errors that include associating vendors with specific expense categories. Business accounting software also makes finding mistakes easier with powerful search features that comb through accounts and amounts entered to find data entry errors.

Accounting software for small business eliminates the most common mistakes of entering amounts that do not balance, posing errors, and summing accounts totals in preparation of issuing the financial statements.

Modern accounting software packages now have the ability to maintain various modules of business transactions, such as payroll, accounts receivable, accounts payable, inventory management, fixed assets, and tax management. These business accounting modules provide business owners with the ability to enter the data into one system and quickly retrieve specialized reports. Do you need to know which customers owe you the most money in your accounts receivable? Simply view, sort, or filter a listing of customers from accounts receivable reporting. You can view everything from which products are top sellers, to which bills are coming due.

You can also link your bank accounts with the software to download the latest transactions, and transfer data to your accountant to prepare tax returns, conduct audits, or manage your financial records.

Many business accounting software features offer enhanced capabilities that allow you to produce virtually any type of report and even download the latest tax sales or payroll tax rates for a given jurisdiction to greatly simplify tax reporting and compliance. Depending on your business needs, you can print, sign, and file the tax forms and pay them yourself, provide this information to you accountant, or choose full service filing options offered with the best software accounting packages.

If you have your accountant review and file the tax information, you can also negotiate lower rates for well-kept records and low maintenance tax filing.

 

Accounting Software Reviews: Compare Accounting Software

The best accounting software packages on the market today are extremely powerful, versatile, and affordable, and make them a wise investment for any small business. The question is what is the best accounting software package for your particular business needs?

The three main questions to ask when you begin to compare accounting software for your business needs are:

1). Is it easy for you to use?
2). Is the accounting software program one your accountant can work with?
3). Do you have any specific business needs that require specialized software or software add on options?

The easiest way to answer these questions is to download a free trial of the accounting software package you are considering. Most manufacturers offer free trials of fully functioning accounting software for 30 days so you can decide which accounting software package is best for your small business needs.

Ask your accountant about special features your business may need, and test-drive the accounting software package during the free trial period before committing to the full purchase price.

When considering the best accounting software for your business needs, the best accounting software packages each offer powerful reporting features and options to analyze your business. Though the details may differ, the standard and customizable reports offered in each of the best small business accounting software packages provide businesses with powerful reporting and analysis tools and are therefore a wash when considering the best accounting software.

Additionally, each of the best accounting software packages below are highly customizable to your business needs, each offering excellent set-up procedures for your specific business and industry.

The main difference is in the features listed below, and which ones are the most important for your business.

Inventory Management

If you have substantial amounts of inventory, consider Peachtree or AccountEdge (MYOB) accounting software, which received the highest inventory management marks in our accounting software reviews.

Overall, Peachtree has the most complete inventory management and tracking tools, and is a standout feature in the below accounting software reviews.

Fixed Asset Management

Peachtree offers the most complete fixed asset management module. If you have many fixed assets to manage, consider Peachtree Premium ($499) that can track 200 assets with various depreciation methods.

If you have few to no fixed assets to manage in your business, then this module is not necessary and is in fact not offered in some the best accounting software packages listed below.

AccountEdge (MYOB Business Essentials) does not offer a fixed asset module.

QuickBooks offers limited fixed asset tracking, from which you can record when the asset was purchased, and other asset details. This information can be forwarded to your accountant to create depreciation schedules, but is not part of the standard QuickBooks accounting software packages for business (only QuickBooks Premier Accountant offers detailed depreciation schedules, which is used by accountants).

Best Accounting SoftwareStrengthsWeaknessesPriceOverall RatingPeachtree Complete Accounting SoftwareExceptional inventory management and tracking tools.Exceptional time-billing module with billing details.Comprehensive payroll support and options.Full service online banking options, providing online bill payment to anyone.More expensive than other accounting software packages.More features require more time to learn navigation and the interface.Video tutorials, QuickBooks Coach, and live community all provide solid support and help.Accepts all major credit card and debit card payments directly into the program.Easy navigation.Versatile add on payroll options provide complete payroll solutions.Company snapshot feature that gives you an overview of key financial data.Limited fixed asset tracking.Does not offer estimated shipping costs for items ordered from inventory.AccountEdge

(Formerly MYOB Business Essentials)

Clean, intuitive, well organized interface and command center.Easily customize professional forms.Offers complete payroll support and solutions.Strong inventory management and tracking tools.Excellent time-billing features.No option to estimate shipping costs or track packages.Does not offer inventory drop shipment options.Does not have fixed asset module.

When you know the needs of your business, you can make the most of small business accounting software reviews by identifying the most important accounting software features for your specific business needs, while not paying a premium for features you may not use or rarely need.

You can also spend wisely on those features that will save you the most time and money, such as payroll tax filing options and other cost-effective features offered in today’s best small business accounting software.

 

Basic Accounting Principles, Business Accounting Terms, and Financial Ratios

Basic Accounting Principle

What It Means in Relationship to a Financial Statement

1. Economic Entity Assumption	The accountant keeps all of the business transactions of a sole proprietorship separate from the business owner's personal transactions. For legal purposes, a sole proprietorship and its owner are considered to be one entity, but for accounting purposes they are considered to be two separate entities.
2. Monetary Unit Assumption	Economic activity is measured in U.S. dollars, and only transactions that can be expressed in U.S. dollars are recorded. Because of this basic accounting principle, it is assumed that the dollar's purchasing power has not changed over time. As a result accountants ignore the effect of inflation on recorded amounts. For example, dollars from a 1960 transaction are combined (or shown with) dollars from a 2010 transaction.
3. Time Period Assumption	This accounting principle assumes that it is possible to report the complex and ongoing activities of a business in relatively short, distinct time intervals such as the five months ended May 31, 2010, or the 5 weeks ended May 1, 2010. The shorter the time interval, the more likely the need for the accountant to estimate amounts relevant to that period. For example, the property tax bill is received on December 15 of each year. On the income statement for the year ended December 31, 2010, the amount is known; but for the income statement for the three months ended March 31, 2010, the amount was not known and an estimate had to be used. It is imperative that the time interval (or period of time) be shown in the heading of each income statement, statement of stockholders' equity, and statement of cash flows. Labeling one of these financial statements with "December 31" is not good enough—the reader needs to know if the statement covers the one week ending December 31, 2010 the month ending December 31, 2010 thethree months ending December 31, 2010 or the year ended December 31, 2010.
4. Cost Principle	From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cash equivalent) when an item was originally obtained, whether that purchase happened last year or thirty years ago. For this reason, the amounts shown on financial statements are referred to as historical cost amounts. Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact, as a general rule, asset amounts are not adjusted to reflectany type of increase in value. Hence, an asset amount does not reflect the amount of money a company would receive if it were to sell the asset at today's market value. (An exception is certain investments in stocks and bonds that are actively traded on a stock exchange.) If you want to know the current value of a company's long-term assets, you will not get this information from a company's financial statements—you need to look elsewhere, perhaps to a third-party appraiser.
5. Full Disclosure Principle	If certain information is important to an investor or lender using the financial statements, that information should be disclosed within the statement or in the notes to the statement. It is because of this basic accounting principle that numerous pages of "footnotes" are often attached to financial statements. As an example, let's say a company is named in a lawsuit that demands a significant amount of money. When the financial statements are prepared it is not clear whether the company will be able to defend itself or whether it might lose the lawsuit. As a result of these conditions and because of the full disclosure principle the lawsuit will be described in the notes to the financial statements. A company usually lists its significant accounting policies as the first note to its financial statements.
6. Going Concern Principle	This accounting principle assumes that a company will continue to exist long enough to carry out its objectives and commitments and will not liquidate in the foreseeable future. If the company's financial situation is such that the accountant believes the company will not be able to continue on, the accountant is required to disclose this assessment. The going concern principle allows the company to defer some of its prepaid expenses until future accounting periods.
7. Matching Principle	This accounting principle requires companies to use the accrual basis of accounting. The matching principle requires that expenses be matched with revenues. For example, sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid). Wages to employees are reported as an expense in the week when the employees worked and not in the week when the employees are paid. If a company agrees to give its employees 1% of its 2010 revenues as a bonus on January 15, 2011, the company should report the bonus as an expense in 2010 and the amount unpaid at December 31, 2010 as a liability. (The expense is occurring as the sales are occurring.) Because we cannot measure the future economic benefit of things such as advertisements (and thereby we cannot match the ad expense with related future revenues), the accountant charges the ad amount to expense in the period that the ad is run. (To learn more about adjusting entries go to Explanation of Adjusting Entriesand Drills for Adjusting Entries.)
8. Revenue Recognition Principle	Under the accrual basis of accounting (as opposed to the cash basis of accounting), revenues are recognized as soon as a product has been sold or a service has been performed, regardless of when the money is actually received. Under this basic accounting principle, a company could earn and report $20,000 of revenue in its first month of operation but receive $0 in actual cash in that month. For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should recognize $1,000 of revenue as soon as its work is done—it does not matter whether the client pays the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.
9. Materiality	Because of this basic accounting principle or guideline, an accountant might be allowed to violate another accounting principle if an amount is insignificant. Professional judgement is needed to decide whether an amount is insignificant or immaterial. An example of an obviously immaterial item is the purchase of a $150 printer by a highly profitable multi-million dollar company. Because the printer will be used for five years, the matching principle directs the accountant to expense the cost over the five-year period. The materiality guideline allows this company to violate the matching principle and to expense the entire cost of $150 in the year it is purchased. The justification is that no one would consider it misleading if $150 is expensed in the first year instead of $30 being expensed in each of the five years that it is used. Because of materiality, financial statements usually show amounts rounded to the nearest dollar, to the nearest thousand, or to the nearest million dollars depending on the size of the company.
10. Conservatism	If a situation arises where there are two acceptable alternatives for reporting an item, conservatism directs the accountant to choose the alternative that will result in less net income and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct accountants to be conservative. Accountants are expected to be unbiased and objective. The basic accounting principle of conservatism leads accountants to anticipate or disclose losses, but it does not allow a similar action for gains. For example,potential losses from lawsuits will be reported on the financial statements or in the notes, but potential gains will not be reported. Also, an accountant may write inventory down to an amount that is lower than the original cost, but will not write inventory up to an amount higher than the original cost.

Fair Value Accounting - Ripe for Fraud?

I think fair value has too broad of a range and Wall Street has demonstrated an inclination to take profits whenever they can. This means they will show a tendency to overstate assets, understate liabilities, and classify gains as profits, even when accounting rules determine some gains are not profits. The concept of writing assets up to fair value gives them more opportunity to do this. Just as they want a bailout for losses, but want to run with profits, it is more likely firms will jump at the chance to write up assets, and not be as willing to write down assets to fair value when the market devalues them. Just look at the mark to market backlash that occurred for banks when assets were devalued, but no one was concerned when they were seriously overvalued.

At least now, with historical cost, everyone is on the same page, and everyone knows exactly what the asset was actually purchased for. Who knows what logic firms will use to write up their assets in the future. Under audit is must be appraised, but this invites a broad range of possible prices. Of course the company will want the highest appraisal. We know the collusion that took place in the mortgage crisis. Let's hope fair value does not afford companies the same opportunity to creatively book gains and inflated assets. The historical cost basis of recording assets prevents this type of scheme since what you paid for it is what you paid for it.

 

Sitemap for GAAP, Small Business Accounting Terms, and Financial Ratios

Income Statement

Sample Income Statement
Income Statement Format
Gross Profit Margin
Operating Profit Margin
Net Profit Margin
Preparing Income Statements: Income Statement Example

Balance Sheet

Accounting Balance Sheet
The Accounting Equation
Sample Balance Sheet
Creating a Balance Sheet
Examples of Balance Sheets and Applying Financial Ratios
Balance Sheet Formats

Statement of Cash Flows

Statement of Cash Flows Introduction
Understanding the Cash Flow Statement
Sample Cash Flow Statement
How to Prepare the Cash Flow Statement
Cash Flow Statement Analysis
Examples of Cash Flow Statements

Owners Equity

Owners Equity
Retained Earnings
Statement of Retained Earnings
Stockholders Equity
Statement of Stockholders Equity

Treasury Stock

Treasury Stock
Accounting for Treasury Stock Cost Method
Accounting for Treasury Stock Par Value Method

Inventory Accounting

Cost of Goods Sold
Perpetual Inventory System
Periodic Inventory System

Inventory Valuation Methods

First in First Out (FIFO)
Last in First Out (LIFO)
Average Cost
Specific Identification

Depreciation Expense

Depreciation Expense
Straigh Line Depreciation
Accelerated Depreciation
Double Declining Depreciation
MACRS Depreciation
Accumulated Depreciation

Financial Ratios

Financial Ratios
Current Ratio
Quick Ratio
Working Capital
Book Value
Debt Equity Ratio
Interest Coverage Ratio
Debt Service Coverage Ratio
Leverage Ratio
Accounts Receivable Turnover
Asset Turnover Ratio
Inventory Turnover Ratio
Return on Equity
Return on Assets

The Accounting Cycle

The Accounting Cycle and Double Entry Accounting
Accounting Journal Entries
Sample General Ledger Journal Entry
Sample Chart of Accounts
Unadjusted Trial Balance Sheet
Adjusting Entries
Adjusting Entries Illustrated
Adjusted Trial Balance Sheet
Closing Entries
Final Trial Balance Sheet
Reversing Entries

Generally Accepted Accounting Principles (GAAP)

GAAP Accounting Introduction
GAAP Accounting: Relevance and Reliability
Other GAAP Accounting Principles
Historical Cost
The Historical Cost Principle

Straight Line Depreciation: the most common of accounting depreciation methods

Straight line depreciation is the simplest and most frequently used depreciation method for financial reporting purposes.

Straight line depreciation is based on the assumption that the assets usefulness declines evenly over time. Increased activity or use of the asset has no bearing on the amount of depreciation each year since it is the same every period.

To calculate asset depreciation under the straight line method, simply divide the depreciation basis (cost – salvage value) by the estimated useful life.

Calculate Depreciation: Straight Line Depreciation Method

(Acquisition cost – Estimated salvage value)
Estimated Useful Life

If Sunny places a vehicle he purchased for $12,800 in service as of the beginning of 2010 with an estimated life of five years, and a $1,000 salvage value, Sunny would calculate straight line depreciation as $2,360 per year:

The straight line depreciation method can also be expressed as a depreciation rate:

In this case, the depreciation rate = 20% (1/5). The depreciation rate is then multiplied by the cost less any salvage value, to arrive at the same amount: $2,360.

Graphically, straight line depreciation is a straight line spread over the course of 5 years, with a $2,360 depreciation expense taken each year on the income statement.

Straight Line Depreciation Method

When viewed graphically, it is easy to see where the straight line depreciation method gets its name. The depreciation expense holds steady during the time period, resulting in a linear graph.

Straight Line Depreciation Book Value

Similarly, the book value of the asset declines steadily over the course of the asset depreciation period, since an even amount of depreciation is taken each period. Notice that the depreciation is taken from the total acquisition cost of $12,800, not the depreciation base of $11,800.

The accounting journal entry at the end of each year is entered as:

To record annual depreciation expense of company vehicle.

At the end of year five, the book value equals the salvage value of $1,000. The company vehicle is listed on the balance sheet at the original acquisition or historical cost, less the accumulated depreciation amount:

Accumulated depreciation is a contra account to the property plant and equipment account that reduces the asset balance to the carrying value of the asset, or its historical cost less the total accumulated depreciation.

The Accounting Trial Balance Sheet with Sample Trial Balance Workshseet

The unadjusted trial balance sheet lists the account balances in the general ledger before adjusting entries are made in the accounting cycle.

The unadjusted trial balance is used to verify the balance of debits and credits, and to review the balances of each account in preparation of the adjusting entries in the next step in the accounting cycle.

Companies will generally prepare the trial balance sheet on a monthly or quarterly basis, in addition to year-end, to ensure that the accounts balance and adjusting entries are made timely throughout the year.

A sample unadjusted trial balance sheet appears below for Sunny Sunglasses Shop for January 2010.

Unadjusted Trial Balance

The unadjusted trial balance shows a listing of each account after one month of business activity in January of 2010. Notice the asset and expense accounts appear on the left side as debits, and the liabilities, owner’s equity, and revenue accounts appear on the right side as credits. This format ensures that each side balances with the other according to the accounting equation. Sales and expenses are reported on the income statement. Income Statement accounts are called nominal or temporary accounts because they are closed to the permanent balance sheet accounts.

The income statement accounts are reported for the specific period, such as a month, quarter, or year, and then closed to assets, liabilities, or owner’s equity on the balance sheet. Closing entries occur at the end of a reporting period to start the income statement balances at zero for the next period. We discuss closing entries later in the accounting cycle.

Real or permanent accounts are accounts with ongoing balances and appear on the balance sheet as assets, liabilities, and owner’s equity. Examples are cash, accounts receivable, loans payable, and owners equity.

Retained earnings represent the accumulated net earnings and losses of the business. Since this is the first year of operations for Sunny Sunglasses Shop, the balance is zero. Sunny will close net income to retained earnings in the closing entry process.

The unadjusted trial balance serves two main purposes: It verifies the equality of the debits and credits.It provides a listing of each account balance to facilitate the adjusting entry process.

From Unadjusted Trial Balance to the Fifth Step in the Accounting Cycle: Adjusting Entries

Understanding Basic Accounting Principles and Basic Accounting

Basic accounting principles require that the financial statements report information that is primarily useful and understandable to financial statement users.

Accountants follow a common set of rules to create the financial statements. Without these basic rules in place, it would be difficult for lenders, investors, and other financial statement users to compare, analyze, or even trust the information reported on financial statements.

If one company, for example, reports sales or expenses differently from another company, this reporting difference can give the appearance of more profits for one company, when in fact profits are the same for both companies had they both used the same accounting methods. For this reason, rules are set in place to determine what activities to measure, when to measure them, and how to measure them.

Information can only be useful if it is both relevant and reliable.

What is relevant information?

Relevance includes any information that helps the financial statement user determine the value and performance of the company. Reporting the ratio of males to females working in the company is irrelevant. Reporting total salaries and wage of employees is relevant.

Similarly, reporting the type of machinery the company has is not relevant. Reporting the original cost of the machinery is relevant.

What is reliable information?

Basic accounting principles also centers on the reliability of the information reported. Companies report information that is not biased towards an objective, such as getting investors to invest in its stock, or creditors to lend the company money. Instead, financial reports are reliable when users can rely on the information to represent that which it is intended to represent.

Information that is reliable can be verified independently and repeatedly. Reliability is the main reason companies are audited. Auditing tests and verifies that the financial information reported is accurate, reliable, and represents what it claims to represent so that financial statement users can depend on it to make financial decisions.

Financial statements are only useful to financial statement users if they are understandable. To be understandable, financial statements must be consistent with past reports of the same company and comparable to other companies.

This means that the company must use the same accounting practices that it has been using for previous periods to remain consistent. In addition, it must use the same practices as other companies for the same transaction so the user of the information can make meaningful and useful comparisons.

The primary means of communicating useful financial information are the main business financial statements called the balance sheet, the income statement, and the statement of cash flows. Click the link above for a discussion of the basic financial statements and the purpose of each.

Basic Accounting Equation

Cash Accounting and Accrual Accounting

T-Accounts: A Great Tool for Solving Accounting Transactions

A T-Account is a template or format shaped like a “T” that represents a particular general ledger account. Debit entries are recorded on the left side of the “T” and credit entries are recorded on the right side of the “T”. It is a tool for organizing journal entries and analyzing accounting transactions.

There are a few business owners or managers who have a fantastic ability to remember details, but I would venture to say that most of us find our memory diminishing over time. T-Accounts come in handy when a series of journal entries are required and it becomes too difficult to keep all of them in your head.

When solving accounting problems, you have to think of accounting transactions in terms of the “accounting model”. Click this link if you need to refresh your memory regarding the accounting model:

The “accounting model” is a template you can use to remember how debits and credits work. The two most common scenarios for using T-Accounts are: 1) determining why certain transactions were previously posted to the general ledger; or, 2) working out the most appropriate place to post certain accounting
transactions.

T-Accounts work because they are visually effective. This means they are simple to understand and usually it is possible to portray all the T-Accounts on one page. Let’s look at a basic accounting transaction and then translate it into T-Account form. Assume you sold an accessory to one of your rental inventory assets for $35 cash and deposited the money into the bank. You originally bought the accessory for $20 and put it into inventory until it was sold. The journal entries for the transaction would look like this:

The T-Accounts would look like this:

You can easily see that the debits equal the credits. Let’s look at a more complex accounting transaction. You bought a company van to delivery your rental inventory for $25,000 and you did this by putting $5,000 down and setting up a liability (Notes Payable) for $20,000. You made your first payment of $380, of which $80 was interest, and your first month’s depreciation was $833. To the unfamiliar, these transactions might appear confusing until T-Accounts are used.

A critical step is to make sure that the debits equal the credits. If not, you have made a mistake that must be solved.

 

The Historical Cost Concept Accounting Principle

Imagine, for a moment, trying to read a financial statement that had listed assets such as: cash $5,000; 14 boxes of oranges; 25 boxes of apples; 1000 board feet of lumber; 3 acres of land; and, 8 machines. A first question that might pop into your mind is: “How in the world do I add these assets to one another?”

It is immediately clear that for financial statements to be meaningful, amounts of dissimilar items must be stated in similar units. Money becomes the obvious choice of “similar units”. By converting different kinds of objects into monetary amounts, they can be dealt with arithmetically. This is called the “money-measurement concept” and is a fundamental principle of accounting.

This is great, but the problem is not yet solved. An asset may be recorded in dollars and cents (or whatever currency is appropriate for the country in which you live), but at what value? If I were allowed to choose the value I thought was appropriate for my assets, my tendency would be to state their value at the highest amount possible. That way, my financial statement would indicate that my business was strong, healthy, and worth a lot of money. Remember the “accounting equation”:

ASSETS – LIABILITIES = EQUITY

Higher assets mean higher equity. Wonderful, but what if I’m wrong? My banker and my investors are trusting that my financial statements are stated accurately. Furthermore, it is not reasonable to expect that every reader of my financial statements can or should have to appraise my assets.

In order to avoid the subjectivity of market value, an objective way of valuing assets had to be established. This was solved by using the “historical cost” concept. This concept states that the numbers reported on accounting financial statements shall be recorded at the amount that was actually paid for an asset, i.e., historical cost. Therefore, accounting does not record what an asset is actually worth, that is, its market value. This works out okay because most businesses are using their assets to conduct operations and are not trying to sell them. When a business offers an asset for sale, or perhaps the entire business, an appraisal to determine fair-market-value of the assets must be performed.

So we (preparers of financial statements) are going to use money as a measurement system and we will record our assets at the amount actually paid for them. This will keep us out of trouble and make it easier to understand what others are doing.