Answer: The interest paid on bank loans is included in the operating activities section of the statement of cash flows. This is the case for both short-term and long-term bank loans. However, the principal amounts that were borrowed and the amounts that were repaid are reported separately under financing activities.

Under the indirect method, the interest expense is part of the corporation’s net income which then gets adjusted to the cash amount. The amount of interest paid is required to be disclosed separately and is usually shown at the bottom of the statement of cash flows or in the notes to the financial statements.

Answer: Let’s assume that a company obtains a 9-month bank loan and the bank deposits the loan proceeds into the company’s checking account at the same bank.

The double entry to be recorded by the company is: 1) a debit to the company’s current asset account Cash (or Checking Account) for the amount that the bank deposited into the company’s checking account, and 2) a credit to the company’s current liability account Notes Payable (or Loans Payable) for the amount of principal that it must repay to the bank. (If there is a difference between the two amounts, it may pertain to bank fees or prepaid interest that will also have to be recorded.)

The double entry to be recorded by the bank is: 1) a debit to the bank’s current asset account Loans (or Loans Receivable) for the principal amount it will collect, and 2) a credit to the bank’s current liability account Noninterest Bearing Demand Deposits. (If there is a difference between the two amounts, it may pertain to bank fees or prepaid interest that will also have to be recorded.)

Answer: An expense is reported on the income statement. An expense is a cost that has expired, was used up, or was necessary in order to earn the revenues during the time period indicated in the heading of the income statement. For example, the cost of the goods that were sold during the period are considered to be expenses along with other expenses such as advertising, salaries, interest, commissions, rent, and so on.

An expenditure is a payment or disbursement. The expenditure may be for the purchase of an asset, a reduction of a liability, a distribution to the owners, or it could be an expense. For instance, an expenditure to eliminate a liability is not an expense, while expenditures for advertising, salaries, etc. will likely be recorded immediately as expenses.

Here’s another example to illustrate the difference between an expense and an expenditure. A company makes an expenditure of $255,500 to purchase equipment. The expenditure occurs on a single day and the equipment is placed in service. Assuming the equipment will be used for seven years, the cost of the equipment will be reported as depreciation expense of $100 per day for the next 2,555 days (7 years of service with 365 days each year).

Answer: Signing a contract will not require a journal entry unless cash, a promissory note, or another asset is exchanged at the time. Signing a contract causes a commitment but does not necessarily create a liability or asset at the time of signing.

For example, an electric utility may sign a contract with a coal producer for 100 million tons of coal to be delivered over a one-year period beginning in three months. On the day the two parties sign the contract, the electric utility does not own any of the coal specified in the contract and does not have a liability to the coal producer. Likewise, on the day of signing the contract, the coal producer does not have a sale of any of the coal specified in the contract  nor does it have an account receivable from the electric utility. In three months, when the first trainload of coal arrives at the electric utility, the utility will record the purchase of that trainload of coal and the related account payable to the producer. Also at that time, the coal producer will record the sale of that trainload of coal and an account receivable.

Answer: Recording a loan payment which contains both interest and principal payments will involve a debit to Interest Expense, a debit to Loan Payable, and a credit to Cash.

The credit balance in your liability account Loan Payable should agree with the principal balance on your lender’s records. You can confirm that your balance in Loan Payable is correct by comparing it to the loan balance shown on the loan statement furnished by your lender. If such a statement is not provided, you can phone your lender and ask for the principal balance on your loan.

Answer: The accounting equation and the double entry system provide an explanation why a company’s profit appears as a credit on its balance sheet.

Asset accounts usually have debit balances while liabilities and owner’s or stockholders’ equity usually have credit balances. When a company provides services for cash, its asset Cash is increased by a debit and its owner’s equity is increased by a credit. The credit is initially recorded in a revenue account, but revenue accounts are temporary accounts that cause owner’s equity to increase.

If the owner withdraws some cash for personal use, the asset Cash will decrease through a credit and the owner’s equity will decrease through the debit part of the accounting entry. The debit might initially be recorded in the sole proprietor’s Drawing account but this account is also a temporary account that will cause the owner’s equity to decrease.

Generally speaking, the credit balance reported in the owner’s or stockholders’ equity section of the balance sheet reflects the owners’ investments in the company plus the profits earned minus the amounts distributed to the owners since the time that the company began.

Answer: Several situations could cause a credit balance in the asset account Prepaid Insurance. For example, let’s assume a company’s insurance has a cost of $600 every six months. As a result, the company decides to debit Prepaid Insurance when the amount is paid semiannually. It also prepares an automatic monthly adjusting entry to debit Insurance Expense $100 and to credit Prepaid Insurance for $100. If one of the $600 payments is debited to Insurance Expense (or another account) instead of Prepaid Insurance, the monthly adjusting entries will cause the balance in the Prepaid Insurance account to become a credit balance.

Another possibility is that the company simply failed to pay the insurance company and the monthly adjusting entries caused the balance in Prepaid Insurance to become a credit balance. Whatever the cause of the credit balance in Prepaid Insurance, the account balance needs to be adjusted before issuing a balance sheet. The Prepaid Insurance account must report the true amount that is prepaid (paid but not yet expired) as of the date of the balance sheet. If nothing is prepaid then the Prepaid Insurance account must show a zero balance. If an amount is owed to the insurance company, there should be a liability account with a credit balance for the amount owed as of the balance sheet date.

Because adjusting entries involve a balance sheet account and an income statement account, it is wise to also look at the amount being reported in the income statement account Insurance Expense. You should monitor both the Insurance Expense account balance and the Prepaid Insurance account balance throughout the year. The amount paid to the insurance company that has expired needs to be reported as an expense and the amount that has not yet expired needs to be reported as the asset Prepaid Insurance.