Previous Posts:
Accounting for Kossaks (pt 1) - Intro, Balance Sheet, Assets, Liabilities, Equity
Accounting for Kossaks (pt 2) - Debits, Credits, T Accounts, General Ledger
Welcome back!
In the last two posts, we've given the basic overview of the balance sheet and the asset, liability, and equity accounts it contains. We've shown how to record transactions using double-entry bookkeeping by recording journal entries that show which accounts get debited and credited with each transaction. How about all that bolding, eh? Anyway, now we can more-or-less see the financial position of a company at a point in time using the balance sheet.
But what if we want to see how a company has done over a period of time? Well, that's what the income statement is for. During the course of a reporting period (usually a quarter or a year), two accounts get created and destroyed. The first account is called Revenue. It is an account that has a credit balance, and tracks all of the gross sales we make during the period. The other account is called Expenses - a debit-balance account. This is the account that keeps track of all of the company's expenses during the period. At the end of the period, we'll net the two, pay taxes on any excess, and dump the remainder into a new equity account on the balance sheet called retained earnings.
On a side note, knowing how a company is doing over discrete periods of time is very important, because these days, most corporations are owned by shareholders - who change over time. We need to know how the company is performing during the time that a shareholder owns the stock so that the company can pay the shareholder an appropriate dividend for the money the company is making while that shareholder owns the stock.
So, let's get back to our DailyKos example. DailyKos has some cash, a server, and some outstanding loans as shown by the balance sheet:
Balance Sheet for DailyKos 9/1/2011 |
Assets |
Liabilities |
$18,000 cash
$2,000 server |
$10,000 bank loan |
Owner's Equity |
$10,000 Markos paid in capital |
$20,000 |
$20,000 |
For the sake of simplicity, I'm rolling time back to 9/1/2011, and we'll pretend all our transactions up until this point happened on 9/1/2011. Oh how I wish I could roll back time in real life... Now DailyKos wants to make some money. Let's say DailyKos sells 20 monthly subscriptions for $4 a piece ($80 total). How do we record that? Let's first think about the journal entry in the GL. Obviously, $80 in cash is coming in. That means we're going to need to debit cash by $80, but what is the credit side of the transaction?
Journal for Daily Kos |
Date |
Narration/Account |
Debit (Dr) |
Credit (Cr) |
9/1/2011 |
Sold 20 Monthly Subscriptions |
|
|
|
Cash |
$80 |
|
|
??? |
|
$80 |
The answer is our temporary account called
Revenue (sometimes it's also called Sales), which has a credit balance. This is basically the account for any product or service sold and delivered in the period. You can set up a T account for Revenue just like every other balance sheet account, but again, this account isn't on the balance sheet - it's temporary. So our journal entry looks like this:
Journal for Daily Kos |
Date |
Narration/Account |
Debit (Dr) |
Credit (Cr) |
9/1/2011 |
Sold 20 Monthly Subscriptions |
|
|
|
Cash |
$80 |
|
|
Revenue |
|
$80 |
Let's make this a little more tricky. What happens when DailyKos sells one of those yearly subscriptions for $40? Well, just like before, we're getting $40 in cash, so the debit side of our journal entry is easy. But what goes on the credit side? Well, we close our books out each quarter, so we can't really claim that whole $40 is for this quarter, because we still have to deliver that subscription service for a year. Most of that money is actually paying for DailyKos providing a service in future reporting periods. Effectively, we are getting the cash for a service that will be partially delivered this period, but also partially delivered in future periods. In other words, we have a liability that we actually have to deliver that subscription service! So here's what we do. 1/12 of the subscription will be delivered this period, so we can go ahead and treat 1/12 of that $40 (or $3.33 - we'll just use $3 for simplicity) as revenue. So most of our journal entry looks like what follows, but we still need to credit something to make the transaction balanced:
Journal for Daily Kos |
Date |
Narration/Account |
Debit (Dr) |
Credit (Cr) |
9/1/2011 |
Sold a Yearly Subscription |
|
|
|
Cash |
$40 |
|
|
Revenue |
|
$3 |
|
??? |
|
$37 |
Remember how we said that we have a liability to deliver our subscription service to the person? Well, now we're going to introduce a new balance sheet liability account called
Advances from Customers. This account will track the money value of the products/services we've promised to deliver to our customers. Our full journal entry looks like this (and yes, it's okay to have more than two lines in a journal entry - the important thing is that the debit side and credit side have total equal values for each journal entry):
Journal for Daily Kos |
Date |
Narration/Account |
Debit (Dr) |
Credit (Cr) |
9/1/2011 |
Sold a Yearly Subscription |
|
|
|
Cash |
$4 |
|
|
Revenue |
|
$3 |
|
Advances from Customers |
|
$37 |
Are you with me so far? I suspect there will be some questions at this point. That's what the comments are for.
Let's fast forward to 9/30/2011. We need to close our books on Q3, 2011. Closing the books at the end of a reporting period basically means taking all the revenue of the period (our Revenue account), subtracting the expenses (which we're about to get to), and dumping the difference into an equity account called Retained Earnings. All the calculations that do this are reflected on the income statement. Please reread this paragraph.
Go back and read that last paragraph again, it's kinda an important process. So, let's show a super simplified structure of an income statement:
Income Statement for Quarter Ending 9/30/2011 |
|
Dr |
Cr |
Revenue |
|
??? |
Some Expenses |
??? |
|
Earnings Before Income Taxes (EBIT) |
|
??? |
Income Tax Expense (@ 30%) |
??? |
|
Net Income |
|
??? |
We can go ahead and fill in our revenue ($80 from the 20 monthly subscriptions plus the $3 piece of the one annual subscription):
Income Statement for Quarter Ending 9/30/2011 |
|
Dr |
Cr |
Revenue |
|
$83 |
Some Expenses |
??? |
|
Earnings Before Income Taxes (EBIT) |
|
??? |
Income Tax Expense (@ 30%) |
??? |
|
Net Income |
|
??? |
So what were our expenses for the period? Well, we bought that computer. Is that $2,000 an expense for the period? Answer: no. On 10/1/2011, we'll still have that computer and presumably, it will still be working for us, providing us value as one of our assets. On the other hand, it is losing value over time. So what do we do? Well, we depreciate it, and treat the difference between the old value and the new value as an expense for the period. Usually in this situation, an accountant will make an estimate that the computer will be used for 5 years (or 60 months), so we can call 1/60th of the $2,000 an expense for this period (which works out to about $33). So let's do a journal entry for this depreciation. Our server is included in our Equipment account, which has a debit balance because it is an asset. We're decreasing its value, so we'll need to credit the Equipment account by $33. The debit side of the transaction is the
Expense account. Here's our journal entry:
Journal for Daily Kos |
Date |
Narration/Account |
Debit (Dr) |
Credit (Cr) |
9/1/2011 |
Q3 2011 Depreciation |
|
|
|
Equipment |
|
$33 |
|
Expenses (Depreciation) |
$33 |
|
We'll pretend like that's our only expense besides tax so we can go ahead and finish up our income statement:
Income Statement for Quarter Ending 9/30/2011 |
|
Dr |
Cr |
Revenue |
|
$83 |
Expenses |
$33 |
|
Earnings Before Income Taxes (EBIT) |
|
$50 |
Income Tax Expense |
??? |
|
Net Income |
|
??? |
Do a journal entry for the tax expense (we'll pay our tax bill with cash, meaning we'll have to credit the cash account), by multiplying that EBIT by the tax rate:
Journal for Daily Kos |
Date |
Narration/Account |
Debit (Dr) |
Credit (Cr) |
9/1/2011 |
Paid Income Taxes |
|
|
|
Income Tax Expense |
$15 |
|
|
Cash |
|
$15 |
...and we can complete our income statement:
Income Statement for Quarter Ending 9/30/2011 |
|
Dr |
Cr |
Revenue |
|
$83 |
Expenses |
$33 |
|
Earnings Before Income Taxes (EBIT) |
|
$50 |
Income Tax Expense |
$15 |
|
Net Income |
|
$35 |
Yay! Let's dump that $35 into retained earnings and display our final Q3 balance sheet:
Balance Sheet for DailyKos 9/30/2011 |
Assets |
Liabilities |
$18,105 cash
$1,967 server |
$10,000 bank loan
$37 advances from customers |
Owner's Equity |
$10,000 Markos paid in capital
$35 Retained earnings |
$20,072 |
$20,072 |
If you're with me up to this point, you're through the initial hard stuff. We can begin looking at some interesting ways corporations can play with their financal statements. Unfortunately, due to my never having taught anything, much less accounting, I suspect virtually nobody is with me up to this point. So, let's take a break and use the comments to catch you all up. The next installment will be a review to reinforce the concepts I've laid out here by showing the ways that corporations can manipulate their financials.
As a teaser, what would happen to the taxes DailyKos would owe if the accountant decided that server was only good for three years?
As always, professional accountants, please fix my mistakes and help me out in the comments. I appreciate it. :-)