“They say, ‘Practice makes perfect’.
Then they say, ‘Nobody’s perfect.’
I wish they would make up their minds!”
Source: A comedian whose name I cannot recall.
We discussed the ideas of net income, revenues, expenses and the use of temporary accounts to capture value flows, and we explored revenue recognition and the matching of expenses to revenues. Really understanding these ideas requires applying them in increasingly realistic scenarios. Before getting to that, though, there is one final issue to discuss: gains and losses.
Gains & Losses
IWe now introduce two more types of temporary accounts: Gains and Losses. Gain and Loss accounts are used when we only want to show the net effects of a transaction instead of tracking the inflows and outflows separately. We do this when the transactions are not the primary business of the entity about which we are reporting.
For example, suppose a retail grocery store sells one of its delivery vans. The grocery store is in the business of selling groceries, not delivery vans. So we do not track the revenue and expenses of the van sale separately. Instead, we record the whole transaction at once and use a gain or loss account to balance the entry.
Suppose the store sells for $25 a case of tomatoes that cost it $10. Also suppose it sells a delivery van for $25 thousand that had cost it $60 thousand, but had accumulated depreciation at the time of sale of $50 thousand. Here are the entries for to record these two transactions and to close all related temporary accounts. First, the tomato sale:
That is, tomatoes with a book value of $10 were sold for $25. $25 in cash came in, and $10 of book value went out. We record these separately. When we close the temporary accounts, Cost of Goods Sold and Sales, Retained Earnings gets increased by their difference: $15.
Here is how we would record the sale of the delivery van:
In thousands, $25 in cash came in. $10 in net book value of assets went out. That is, the book value of the van at the time of sale was $60 - $50 = $10. The difference of $15 is recorded as Gain on Sale of Delivery Van which, when closed to Retained Earnings, ends up increasing Retained Earnings by $15.
With the delivery van, we don’t record in temporary accounts the gross inflow of $25 and outflow of $10. We simply record the difference of $15 in a temporary account.
In either case, the book value of what was given up had to be taken off the books. For the tomatoes, their cost of $10 was no longer attached to a future benefit that the grocery store owned for controlled. For the delivery van, things were a bit more complicated because the book value of the van had to be compiled from amounts in two different places. The $60 cost was in Property, Plant & Equipment. But the total depreciation of $50 on the van was in Accumulated Depreciation. Both the $60 and the $50 had to be taken off the books because they were no longer attached to something that the grocery store owned or controlled.
- Revenue and expense accounts are used to compile what happened over a period of time. Therefore, after that period of time has passed, revenue and expense accounts are closed . Closing an account is the act of making an entry to bring the account’s balance to zero . Revenue and expense accounts are closed at the date of each balance sheet and the net income for the period is rolled into the Retained Earnings account in stockholder’s equity.
- Revenues and expenses are simply temporary accounts - they start each period with a balance of zero, accumulate balance over a period of time, used to make an income statement, and then closed to zero.
- You may find that debits and credits work a bit counter-intuitively for revenues and expenses. Credits to revenues increase their balance. On the other hand, expenses are increased through debits. This is because they are temporary equity accounts. In the closing entry, revenues increase Retained Earnings (credit) and expenses decrease Retained Earnings (debit). So things end up okay. Try not to get lost in the long and winding road to the financial statements.
Practice
What is needed now is a lot of practice. Here are some good problems:
Note: Grow Co. greatly ups the ante on complexity, mostly in the way information is provided. You might be told a flow, such as Cost of Goods Sold was $X, and you might be told that the ending balance in the Inventories account was $Y. You have to deduce the remaining flow, purchases of inventory. Using T-account notation to organize what you are being told is the key.
This problem really gets you started on being able to process information given in financial statements - that’s your main task as a user of financial statements. You will begin to acquire a deeper understanding of where various items appear in financial statements but, more importantly, how asset, liability, equity, revenue and expense accounts work together to paint the financial picture of an entity.