Set-Up and Follow-Up Transactions for Revenue and Expenses
Set-up and follow-up transactions are supporting transactions for the profit-making activities of a business that take place before or after revenue and expenses are recorded. These set-up and follow-up transactions are necessary, as you can see in the following examples:
Buying products for inventory (the goods are held in inventory until they’re sold and delivered to customers)
Collecting receivables from customers
Paying liabilities for products, supplies, and services that were bought on credit
Paying certain expenses in advance, such as for insurance policies, shipping containers, and office supplies
Profit-making activities are reported in the income statement, and investing and financing activities are reported in the statement of cash flows. In contrast, set-up and follow-up transactions for revenue and expenses aren’t reported in a financial statement.
These housekeeping activities have financial consequences and must be recorded in the accounts of a business. Although no revenue or expense account is involved in recording these activities, these transactions change assets and liabilities.
As an example, a business purchases fire insurance on its building and contents. The insurance policy covers the next six months. The business writes a check for $25,000 to the insurance company. Also, the business recently purchased $328,000 of products for inventory on credit. The products were delivered to the company’s warehouse, and after inspection, the company accepted the products.
The journal entries for the two transactions are as follows:
The cost of insurance policies is entered in the asset account called prepaid expenses. Over the six months of insurance coverage, the cost is allocated to insurance expense. The payment for the insurance policy decreases one asset (cash) and increases another asset (prepaid expenses).
The purchase of products doesn’t result in an expense; rather, the transaction is the acquisition of an asset called inventory. The cost of products remains in the asset account until the products are sold to customers, at which time the cost of goods sold expense is recorded, and the asset inventory is decreased. Because the purchase was made on credit, the liability accounts payable is credited (increased). When this liability is paid later, the account is debited (decreased), and cash is decreased.