Cost of Debt: Understanding its Impact on Financial Decisions

what is the cost of debt

Equity value can then be be estimated by taking enterprise value and subtracting net debt. To obtain equity value per share, divide equity value by the fully diluted shares outstanding. Revolving debt, also called open-ended credit, lets someone borrow money and pay back the loans at their discretion so long as their account is in good standing. Debt is all around us, from credit cards to car payments to home mortgages.

Business credit cards often come with different interest rates than other forms of debt. To figure out the cost of this debt, you need to look at your card’s annual percentage rate (APR). By dividing the yearly interest what is the cost of debt by the full loan figure, firms find out their cost of debt. For example, if the interest totals $2 million and debts are $20 million, dividing those numbers—$2 million by $20 million—gets you 0.10 or 10%.

Interest Rate Basics

This is probably the easiest and simplest way to calculate cost of debt. The process of discounting future cash flows is a focal theme/concept within Finance. If you’re after specific aspects of the cost of debt, feel free to explore individual sections. Where sections depend on one another, you’ll be pointed to the appropriate section when it’s relevant.

what is the cost of debt

Conversely, when the economy is slowing down, interest rates tend to fall which makes it cheaper for a company to borrow. In some cases, a high-interest rate can reflect conditions in the overall economy. In other cases, a high interest rate may be a reflection of a company’s overall credit rating (i.e. their worthiness to receive credit).

Impact of Interest Rate Fluctuations on Cost of Debt

Refinancing or consolidating your debt doesn’t automatically diminish the debt itself. It’s only a reorganization of your existing debts with more favorable terms. Therefore, it’s imperative to remain disciplined with your repayment plans and avoid falling back into high-cost debt in the future.

  • Remember, even small changes in your interest rate can have a significant impact on your cost of debt.
  • At the beginning of the term, the bulk of your payment goes toward interest.
  • The first step is to find out your business’s average income tax rate, which you’ll plug in for “tax rate” in the formula.
  • Beta is a measure of a stock’s volatility of returns relative to the overall stock market (often proxied by a large stock index like the S&P 500 index).

If the cost of debt is less than that $2,000, the loan is a smart idea. But if it’s more, you might want to look at other options with lower interest cost. On the other hand, you might still decide to take out that loan, even if you spend more on interest than you save in tax deductions, if you need the money to grow your business. As mentioned, there are two ways to calculate the cost of your loans, depending on whether you look at it as a pre- or post-tax cost. The effective interest rate is your weighted average interest rate, as we calculated above. Now, back to that formula for your cost of debt that includes any tax cost at your corporate tax rate.

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Chart of Accounts Definition, How to Set Up, Categories

charts of accounts definition

Revenue is the amount of money your business brings in by selling its products or services to clients. There are a few things that you should keep in mind when you are building a chart of accounts for your business. As you can see, each account is listed numerically in financial statement order with the number in the first column and the name or description in the second column. That doesn’t mean recording every single detail about every single transaction. You don’t need a separate account for every product you sell, and you don’t need a separate account for each utility.

charts of accounts definition

Because transactions are displayed as line items, they can quickly be found and assessed. This is crucial for providing investors and other stakeholders a bird’s-eye view of a company’s financial data. Many organizations structure their COAs so that expense information is separately compiled by department. Thus, the sales department, engineering department, and accounting department all have the same set of expense accounts. Examples of expense accounts include the cost of goods sold (COGS), depreciation expense, utility expense, and wages expense.

The average small business shouldn’t have to exceed this limit if its accounts are set up efficiently. Your accounting software should come with a standard COA, but it’s up to you and your bookkeeper or accountant to keep it organized. Here are tips for how to do this, plus details about what a COA is, examples of a COA and more. Groups of numbers are assigned to each of the five main categories, while blank numbers are left at the end to allow for additional accounts to be added in the future. Also, the numbering should be consistent to make it easier for management to roll up information of the company from one period to the next. Finally, businesses must ensure that their chart of accounts is consistent across all departments and locations.

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An added bonus of having a properly organized chart of accounts is that it simplifies tax season. The COA tracks your business income and expenses, which you’ll need to report on your income tax return every year. Size – Set up your chart to have enough accounts to record transactions properly, but don’t go over board. The more accounts you have, the more difficult it will be consolidate them into financial statements and reports. Also, it’s important to periodically look through the chart and consolidate duplicate accounts.

  1. Liabilities are obligations that a company owes to external parties, such as suppliers, lenders, or customers.
  2. It shows peaks and valleys in your income, how much cash flow is at your disposal, and how long it should last you given your average monthly business expenses.
  3. You can get a handle on your necessary recurring expenses, like rent, utilities, and internet.
  4. An expense account balance, for example, shows how much money has been spent to operate your business, whereas a liabilities account balance shows how much money your business still owes.

It’s not always fun seeing a straightforward list of everything you spend your hard-earned money on, but the chart of accounts can give you an important view of your spending habits. You can get a handle on your necessary recurring expenses, like rent, utilities, and internet. You can also examine your other expenses and see where you may be able to cut down on costs if needed. Assets are resources your business owns that can be converted into cash and therefore have a monetary value. Examples of assets include your accounts receivable and physical assets like vehicles, property, and equipment.

How to set up the chart of accounts

Changes – It’s inevitable that you will need to add accounts to your chart in the future, but don’t drastically change the numbering structure and total number of accounts in the future. A big change will make it difficult to compare accounting record between these years. Your chart of accounts is a living document for your business and because of that, accounts will inevitably need to be added or removed over time. The general rule for adding or removing accounts is to add accounts as they come in, but wait until the end of the year or quarter to remove any old accounts.

charts of accounts definition

Traditionally, each account in the COA is numbered, and accountants can quickly identify its type by the first digit. For example, asset accounts for larger businesses are generally numbered 1000 to 1999 (or 100 to 199), and liabilities are generally numbered 2000 to 2999 (or 200 to 299). Small businesses with fewer than 250 accounts might have a different numbering system. A simple management accounting and functions way to organize the expense accounts is to create an account for each expense listed on IRS Tax Form Schedule C and adding other accounts that are specific to the nature of the business. Each of the expense accounts can be assigned numbers starting from 5000. It is a very important financial tool that organizes a lot of financial transactions in a way that is easy to access.

Assign account numbers to business accounts

The chart makes it easy to prepare information for evaluating the financial performance of the company at any given time. In addition, the operating revenues and operating expenses accounts might be further organized by business function and/or by company divisions. Here is a way to think about a COA as it relates to your own finances. Say you have a checking account, a savings account, and a certificate of deposit (CD) at the same bank.

Similar to a chart of accounts, an accounting template can give you a clear picture of your business’s financial information at a glance. Utilizing accounting tools like these will ensure a better workflow, helping you grow your company. FreshBooks offers a wide variety of accounting tools, like accounting software, that make it easier to stay organized. The chart of accounts provides the name of each account listed, a brief description, and identification codes that are specific to each account. The balance sheet accounts are listed first, followed by the accounts in the income statement. The COA is typically set up to display information in the order that it appears in financial statements.

This would include Owner’s Equity or Shareholder’s Equity, depending on your business’s structure. The basic equation for determining equity is a company’s assets minus its liabilities. The chart of accounts is a list of every account in the general ledger of an accounting system. Unlike a trial balance that only lists accounts that are active or have balances at the end of the period, the chart lists all of the accounts in the system.

This way you can compare the performance of different accounts over time, providing valuable insight into how you are managing your business’s finances. In the interest of not messing up your books, it’s best to wait until the end of the year to delete old accounts. An expense account balance, for example, shows how much money has been spent to operate your business, whereas a liabilities account balance shows how much money your business still owes. In accounting, each transaction you record is categorized according to its account and subaccount to help keep your books organized. These accounts and subaccounts are located in the COA, along with their balances.

This structure can avoid confusion in the bookkeeper process and ensure the proper account is selected when recording transactions. A chart of accounts is a catalog of account names used to categorize transactions and keep your business’s financial history organized. The list typically displays account names, details, codes and balances.

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Contra Account Definition + Journal Entry Examples

what is a contra expense

By closely analyzing contra assets and contra liabilities, businesses can identify areas where cost-saving measures can be implemented to optimize financial performance. Utilizing strategies such as adjusting contra accounts to reflect realistic valuations and actively managing contra liabilities can lead to improved cash flow and profitability. The intricate nature of contra expenses poses challenges for businesses, as ensuring precise monitoring and allocation can be time-consuming and prone to errors.

what is a contra expense

Allowance for doubtful accounts is a common contra asset listed on a company’s balance sheet under accounts receivable. When a company sells its products or services to customers on credit, the company records the amount sold in its accounts receivable account. Regularly reviewing and updating contra asset and liability balances can help in reducing unnecessary expenses and maintaining a healthy balance sheet. Implementing a well-thought-out contra account management plan is crucial for companies looking to enhance their overall financial health and sustainability. Both contra expenses and contra revenues play crucial roles in ensuring financial statements reflect economic reality.

How Is a Contra Expense Account Used in Accounting?

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what is a contra expense

This type of account could be called the allowance for doubtful accounts or a bad debt reserve. The balance in the allowance for doubtful accounts represents the dollar amount of the current accounts receivable balance that is expected to be uncollectible. The amount is reported on the balance sheet in the asset section immediately below accounts receivable. When evaluating accounts receivable, give proper weight to the difference between gross and net accounts receivable, as well. Gross accounts receivable is the total assets included on a company’s balance sheet.

By properly accounting for contra expenses, businesses can present a more holistic view of their financial performance, leading to informed decision-making and strategic planning. They serve as a complementary component to regular expense accounts, offsetting specific expenses to prevent overstatement and provide a clear presentation of net income. Contra expenses aid in highlighting the true cost of goods sold or services rendered, allowing for more informed decision-making by stakeholders.

What Are the Different Types of Contra Accounts?

Make sure that you report contra accounts on the same financial statement as the related accounts. If you’re the one managing your company’s books of accounts, be sure to report the contra account on your financial statement on the line item directly beneath the main account. For instance, in retail businesses, contra expense accounts may be utilized to track employee discounts provided on merchandise sales.

  1. These adjustments are crucial as they directly impact the company’s net income and overall financial performance.
  2. If the company withholds $2,000 from its employees’ wages to pay part of the cost of the insurance, the company will credit its contra expense account 4211 Employee Withholdings for Health Ins.
  3. A contra expense is an account in the general ledger that offsets a specific expense account.
  4. Contra expense accounts have a natural credit balance, as opposed to the natural debit balance of a typical expense account.
  5. Furthermore, revenue is reported on the income statement while contra expense is not.

By utilizing contra expense accounts, businesses can provide a clearer picture of their operational costs and profit margins. Whereas assets normally have positive debit balances, contra assets, though still reported along with other assets, have an opposite type of natural balance. Contra accounts are special accounts that are established to decrease the balance in another account indirectly.

What Is a Contra Expense?

Precision in recording these transactions is vital for providing stakeholders with reliable information for decision-making and assessing the overall financial performance of the organization. We can see how the $10,000 allowance for doubtful accounts offsets the $100,000 A/R account from our illustrative example above (i.e. the account decreases the carrying value of A/R). Master accounting topics that pose a particular challenge to finance professionals.

Analyzing and adjusting contra expenses requires a thorough examination of contra revenue and contra expense accounts to ensure financial accuracy and alignment with business goals. While contra expenses offset regular expenses, contra revenues offset revenue accounts, impacting the overall financial statement in distinct ways. If a company has receivables, this means it has made a sale on credit but has yet to collect the money from the purchaser.

By optimizing contra expenses, a company can streamline its financial reporting and improve profit margins. This process involves identifying areas where expenses can be reduced or eliminated without sacrificing quality or operational efficiency. Maintaining a balanced approach to contra expenses is essential for long-term sustainability and strategic growth. By adjusting the contra expenses, a company can accurately reflect the actual revenue earned and expenses incurred, leading to a more transparent financial picture. This practice enhances the overall financial health and integrity of the company, fostering trust and credibility with investors and regulatory bodies. However, that $1.4 billion is used to reduce the balance of gross accounts receivable.

A contra account is an entry on the general ledger with a balance contrary to the normal balance for that categorization (i.e. asset, liability, or equity). In the world of finance, this term carries significant weight in the realm of accounting. From its purpose in financial reporting to the types of accounts it encompasses, there is much to explore.

By receiving guidance from professionals, one can navigate complex contra account scenarios with confidence and accuracy. These experts are adept at interpreting accounting regulations and can offer strategic solutions to streamline financial reporting processes. Their expertise can help businesses implement best practices and make informed decisions to improve their financial health and sustainability.

By recording these discounts as contra expenses, the company can offset the revenue generated from the sales, giving a clearer view of the true profitability of each transaction. Contra accounts are used to reduce the original account directly, keeping financial accounting records clean. The difference between an asset’s balance and the contra account asset balance is the book value. A debit will be made to the bad debt expense for $4,000 to balance the journal entry. Although the accounts receivable is not due in September, the company still has to report credit losses of $4,000 as bad debts expense in its income statement for the month. If accounts receivable is $40,000 and allowance for doubtful accounts is $4,000, the net book value reported on the balance sheet will be $36,000.

By incorporating contra accounts in financial reporting, companies can present a more precise depiction of their financial health, facilitating better decision-making for stakeholders. This practice aids in balancing out the impact of regular expenses, ensuring that the financial statements accurately represent the organization’s financial position and profitability. By incorporating contra expenses into financial accounting practices, companies can ensure a more accurate depiction of their financial position.

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Amortization Financial Accounting

amortization meaning in accounting

When applied to an asset, amortization is slightly similar to depreciation. Amortization in accounting is a technique that is used to gradually write-down the cost of an intangible asset over its expected period of use or, in other words, useful life. For example, a company benefits from the use of a long-term asset over a number of years. Thus, it writes off the expense incrementally over the useful life of that asset. Amortization is an accounting technique used to periodically lower the book value of a loan or an intangible asset over a set period of time.

amortization meaning in accounting

For instance, development costs to create new products are expensed under GAAP (in most cases) but capitalized (amortized) under IFRS. GAAP does not allow for revaluing the value of an intangible, but IFRS does. This means that GAAP changes in value can be accounted for through changing amortization schedules, or potentially writing down the value of an intangible, which would be considered permanent. Amortization is known as an accounting technique used to periodically reduce the book value of a loan or intangible asset across a set period. In relation to a loan, amortization concentrates on casting out loan payments over time.

What are the different amortization methods?

Amortization is the systematic write-off of the cost of an intangible asset to expense. A portion of an intangible asset’s cost is allocated to each accounting period in the economic (useful) life of the asset. Only recognized intangible assets with finite useful lives are amortized. The finite useful life of such an asset is considered to be the length of time it is expected to contribute to the cash flows of the reporting entity. Pertinent factors that should be considered in estimating useful life include legal, regulatory, or contractual provisions that may limit the useful life. The method of amortization should be based upon the pattern in which the economic benefits are used up or consumed.

amortization meaning in accounting

The formulas for depreciation and amortization are different because of the use of salvage value. The depreciable base of a tangible asset is reduced by the salvage value. The amortization base of an intangible asset is not reduced by the salvage value. Instead, there is accounting guidance that determines whether it is correct to amortize or depreciate an asset. Both terminologies spread the cost of an asset over its useful life, and a company doesn’t gain any financial advantage through one as opposed to the other.

Is It Better to Amortize or Depreciate an Asset?

AOL paid $162 billion for Time Warner, but AOL’s value plummeted in subsequent years, and the company took a goodwill impairment charge of $99 billion. In previous years, this amount would have been amortized over time, but it must now be evaluated annually and written down if, as in the case of AOL, the value is no longer there. A good way to think of this is to consider amortization to be the cost of an asset as it is consumed or used up while generating sales for a company. Along with the useful life, major inputs into the amortization process include residual value and the allocation method, the last of which can be on a straight-line basis. Since part of the payment will theoretically be applied to the outstanding principal balance, the amount of interest paid each month will decrease.

A rule of thumb on this is to amortize an asset over time if the benefits from it will be realized over a period of several years or longer. With a short expected duration, such as days or months, it is probably best and most efficient to expense the cost through the income statement and not count the item as an asset at all. Bureau of Economic Analysis announced a change to the way it estimates gross domestic product (GDP).

  1. Depending on the asset and materiality, the credit side of the amortization entry may go directly to to the intangible asset account.
  2. That means that the same amount is expensed in each period over the asset’s useful life.
  3. Negative amortization is particularly dangerous with credit cards, whose interest rates can be as high as 20% or even 30%.
  4. The term depreciate means to diminish in value over time, while the term amortize means to gradually write off a cost over a period.
  5. Another catch is that businesses cannot selectively apply amortization to goodwill arising from just specific acquisitions.

Accounting rules stipulate that physical, tangible assets (with exceptions for non-depreciable assets) are to be depreciated, while intangible assets are amortized. Intangible assets are purchased, versus developed internally, and have a useful life of at least one accounting period. It should be noted that if an intangible asset is deemed to have an indefinite life, then that asset is not amortized. A higher percentage of the flat monthly payment goes toward interest early in the loan, but with each subsequent payment, a greater percentage of it goes toward the loan’s principal.


On the other hand, there are several depreciation methods a company can choose from. Amortization is similar to depreciation but there are some differences. Perhaps the biggest point of differentiation is that amortization expenses intangible assets while depreciation expenses tangible(physical) assets over their useful life. This is especially true when comparing depreciation to the amortization of a loan.

This means that for a mortgage, for example, very little equity is being built up early on, which is unhelpful if you want to sell a home after just a few years. Amortization can refer to the process of paying off debt over time in regular installments of interest and principal sufficient to repay the loan in full by its how much is too much to pay for tax returns maturity date. Amortization, on the other hand, is recorded to allocate costs over a specific period. There are, however, a few catches that companies need to keep in mind with goodwill amortization. For instance, businesses must check for goodwill impairment, which can be triggered by both internal and external factors.

It can be presented either as a table or in graphical form as a chart. Amortized loans feature a level payment over their lives, which helps individuals budget their cash flows over the long term. Amortized loans are also beneficial in that there is always a principal component in each payment, so that the outstanding balance of the loan is reduced incrementally over time. The two basic forms of depletion allowance are percentage depletion and cost depletion. The percentage depletion method allows a business to assign a fixed percentage of depletion to the gross income received from extracting natural resources. The cost depletion method takes into account the basis of the property, the total recoverable reserves, and the number of units sold.

Though the notes may contain the payment history, a company only needs to record its currently level of debt as opposed to the historical value less a contra asset. Other examples of intangible assets include customer lists and relationships, licensing agreements, service contracts, computer software, and trade secrets (such as the recipe for Coca-Cola). It used to be amortized over time but now must be reviewed annually for any potential adjustments.

The change significantly boosted economic growth over the last 50 years and made the economy nearly $560 billion larger than previously estimated. Now that intangible assets are considered long-lived assets in the economy, accountants will have to amortize their amount over time when preparing financial statements. Methodologies for allocating amortization to each accounting period are generally the same as these for depreciation. In accounting, amortization is a method of obtaining the expenses incurred by an intangible asset arising from a decline in value as a result of use or the passage of time.

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Allowance for Uncollectible Accounts Bad Debt

allowance for uncollectible accounts

As the accountant for a large publicly traded food company, youare considering whether or not you need to change your bad debtestimation method. You currently use the income statement method toestimate bad debt at 4.5% of credit sales. You are consideringswitching to the balance sheet aging of receivables method. Thiswould split accounts receivable into three past- due categories andassign a percentage to each group.

The aggregate balance in the allowance for doubtful accounts after these two periods is $5,400. The sales method applies a flat percentage to the total dollar amount of sales for the period. For example, based on previous experience, a company may expect that 3% of net sales are not collectible. If the total net sales for the what is creditors turnover ratio period is $100,000, the company establishes an allowance for doubtful accounts for $3,000 while simultaneously reporting $3,000 in bad debt expense. By establishing two T-accounts, a company such as Dell can manage a total of $4.843 billion in accounts receivables while setting up a separate allowance balance of $112 million.

allowance for uncollectible accounts

In a few rare cases, you might have a customer pay his debt after you’ve given up on it and written it off. If it does, you’ll have to make some general journal entries to reflect the payment. Hey, there are worse things that could happen than having to account for the fact that someone unexpectedly gave you money. For the taxpayer, this means that if a company sells an item oncredit in October 2018 and determines that it is uncollectible inJune 2019, it must show the effects of the bad debt when it filesits 2019 tax return.

The longer the time passes with a receivable unpaid, the lower the probability that it will get collected. An account that is 90 days overdue is more likely to be unpaid than an account that is 30 days past due. The balance sheet method (also known as thepercentage of accounts receivable method) estimates bad debtexpenses based on the balance in accounts receivable. The balance sheet method isanother simple method for calculating bad debt, but it too does notconsider how long a debt has been outstanding and the role thatplays in debt recovery. With this method, accounts receivable is organized intocategories by length of time outstanding, and an uncollectiblepercentage is assigned to each category. For example,a category might consist of accounts receivable that is 0–30 dayspast due and is assigned an uncollectible percentage of 6%.

By a miracle, it turns out the company ended up being rewarded a portion of their outstanding receivable balance they’d written off as part of the bankruptcy proceedings. Of the $50,000 balance that was written off, the company is notified that they will receive $35,000. 2Because the focus of the discussion here is on accounts receivable and their collectability, the recognition of cost of goods sold as well as the possible return of any merchandise will be omitted.

Aging of Accounts Receivable Method Example

The following table reflects how the relationship would be reflected in the current (short-term) section of the company’s Balance Sheet. The bad debt expense is then the difference between the calculated allowance for doubtful accounts at the end of the account period and the current allowance for doubtful accounts before adjustment. The first step in accounting for the allowance for doubtful accounts is to establish the allowance. This is done by using one of the estimation methods above to predict what proportion of accounts receivable will go uncollected. For this example, let’s say a company predicts it will incur $500,000 of uncollected accounts receivable.