Review of Chapter 2

Name the steps in the accounting cycle discussed so far. What is the normal balance for an asset, liability, equity, revenue and expense? What causes each of those accounts to increase? Decrease? Why is the trial balance prepared?

Review of Chapter 2: Question #1

During the year of the companys business, expenses exceeded revenues by $42,000. Dividends in the amount of $20,000 were declared and common shares issued were $100,000. If beginning retained earnings was $500,000, then the closing balance is: a. $522,000 d. $622,000 b. $438,000 c. $538,000

Accrual Accounting and Income Chapter 3

Learning Objective 1 Relate accrual accounting and cash flows.

The Business Cycle

Collection of the receivable 1 Entity has cash Purchase of inventory

3 Entity has a receivable Sale of inventory on account

2 Entity holds inventory

Accounting Cycle
1. Transaction occurs 2. Analyze the transaction 3. Record in a journal 4. Transfer to general ledger 5. Trial Balance

Accounting Cycle Continued

6. Adjust the records to make sure all income and expenses are reported for the period, journalize in the general journal, post to the individual accounts 7. Take an adjusted trial balance 8. Prepare the financial statements 9. Close the Income Statement accounts

10. Prepare a post closing trial balance

Accrual Basis of Accounting

Revenues are recorded when earned Expenses are recorded when incurred regardless of when cash is received or paid

Cash Basis of Accounting

Transactions are only recorded when cash is received or paid

Accrual Accounting
Records cash transaction + noncash transactions Examples of noncash transactions: Purchase of inventory on account Sales on account Expenses used but not yet paid Revenue earned but not yet received Depreciation expense Usage of prepaid rent, insurance and supplies

The Time-Period Concept

Businesses need regular progress reports, so accountants prepare financial statements for specific periods and at regular intervals. Monthly Quarterly Yearly

Learning Objective 2 Recognize revenue and record expenses

Revenue Principle
The revenue principle governs two things: a) When to record revenue and b) The amount of revenue to record

Recording Expenses
As revenue is earned, companies incur expenses a) Identify all expenses incurred during the period b) Measure the expenses and record

Ethical Issues in Accrual Accounting

Managing earnings to meet or beat Bay Street forecasts. Questionable timing of recognizing revenues, and expenses; affects quality of earnings.

Learning Objective 3 Adjust the accounts.

Updating the Accounts: The Adjustment Process

The adjustment process begins with the trial balance. The unadjusted trial balance lists the accounts and their balances after the periods transactions have been recorded.

Falk Consulting Inc. One Year Later Unadjusted Trial Balance Month of May 31/11
Cash Accounts receivable Supplies Prepaid rent Land Furniture Accounts payable Notes payable Unearned service revenue Common shares Retained earnings Dividends Service revenue Salary expense Utilities expense Total $26,685 3,225 530 3,000 50,000 16,500 500 10,200 3,175 70,000 5,050 15,125

1,500 2,100 510 $104,050

$104,050

Categories of Accounting Adjustments

Deferrals Depreciation Accruals

Adjustments
Deferrals Expenses paid in advance but not yet incurred Revenue collected in advance but not yet earned Depreciation is the allocation of the cost of property, plant & equipment to expense over the assets useful life Accruals Expenses incurred but not recorded or paid Revenues earned but not yet recorded or collected

Example Month of May, 2011

1. 2. 3. 4. 5. 6. Prepaid rent was for 3 months rent paid on May 1. An inventory at month end indicated that $350 in office supplies remain on hand. During May, $1,325 of unearned revenue has now been earned. The furniture was bought on May 1, 2011 and is expected to last 4 years. On May 1, the company signed a note payable due in two years. Interest on the note payable is 10% and is paid yearly The company performed consulting services but has not yet billed the customer for $2,300.

Deferrals: Prepaid Rent

On May 1, 2011, Falk Consulting Inc. paid 3 months rent Prepaid Rent 3,000 Cash 3,000

Deferrals: Prepaid Rent

What is the adjusting entry on May 31? May 31 To record rent expense for May

Deferrals: Prepaid Expenses

On May 1, 2011, Falk Consulting Inc. paid cash of $530 for office supplies. Supplies 530 Cash 530

Deferrals: Prepaid Expenses

An inventory count at month end indicated that $350 in supplies remained. Supplies May1 530 May 31 180 Bal. 350 Dr Cr Supplies Expense 180 Bal. 180

Question #2
The company purchased a one-year insurance policy on April 2, 2010 for $1,000. The amount of prepaid insurance reported on the balance sheet and the amount of insurance expense reported on the income statement at December 31, 2010 are respectively: a. $250; b. $750; c. $333; d. $667; $750 $250 $667 $333

Deferrals: Unearned Revenue

On May 1, 2011, Falk Consulting Inc. had received $5,300 for future services Unearned revenue 5,300 Cash 5,300

Deferrals: Unearned revenue

On May 31, $1,325 of revenue has now been earned May 31 To record revenue earned for May

Depreciation of Property, Plant & Equipment

- spreads the cost of property, plant & equipment over its useful life - a company buys buildings, equipment and furniture for use in the business - as the company uses these assets, it records depreciation for their wear and tear and obsolescence

Depreciation of Property, Plant & Equipment

On May 1, the business purchased furniture for $16,500 cash. The furniture is expected to last 4 years. Furniture 16,500 Cash 16,500

Depreciation of Property, Plant & Equipment

Since the furniture for Falk Consulting Inc. is expected to last four years, the depreciation is:

4. Depreciation expense Accumulated depreciation On the balance sheet, it is reported at its carrying amount: Furniture $16,500 $16,156 Less: Accumulated depreciation 344

Accrued Expenses
The term accrued expense refers to a liability that arises from an expense that has not yet been paid. Suppose on May 1, Falk Consulting signed a note payable due in two years. Interest on the note is 10% and is paid yearly.

Accrued Expenses
On May 31, the interest has accrued for one month but has not yet been paid.

Dr Cr

Accrued Revenues
An accrued revenue is a revenue that has been earned but not received in cash. Falk Consulting has provided consulting services but has not yet billed the customer for $2,300

Accrued Revenues
May 31 To record revenue earned but not yet billed

Question #3
If a company fails to accrue revenue, a. Liabilities are overstated and owners equity is understated b. Assets are understated and net income is understated c. Net income is understated and shareholders equity is overstated d. Revenues are understated and net income is overstated

Falk Consutling Inc. Adjusted Trial Balance May 31, 2011

Account Title Cash Accounts receivable Supplies Prepaid rent Land Furniture Accumulated depreciation-furniture Accounts payable Notes payable Unearned service revenue Interest payable Common shares Retained earnings Dividends Totals Adjusted Trial Balance Debit Credit 26,685 5,525 350 2,000 50,000 16,500 344 500 10,200 1,850 85 70,000 5,050 1,500 102,560 88,029

Balance Sheet

Retained Earnings

Falk Consulting Inc. Adjusted Trial Balance May 31, 2011

Account Title Service revenue Rent expense Salary expense Supplies expense Depreciation expense Utilities expense Interest expense Totals Adjusted Trial Balance Debit Credit 18,750 1,000 2,100 180 344 510 85 4,219 18,750

Income Statement

Learning Objective 4 Prepare the financial statements.

Falk Consulting Inc.- Income Statement For the month ended May 31, 2011
Revenue: Service revenue Expenses: Salary expense Rent expense Utilities expense Supplies expense Depreciation expense Interest expense Net income**
**income taxes are ignored

$18,750 $2,100 1,000 510 180 344 85

4,219 $14,531

Falk Consulting Inc. Statement of Changes in Equity

For the Month Ended May 31, 2011
Common shares Balance, May 1 $70,000 Issued shares Profit Dividends Balance, May 31 $70,000 Retained Earnings Total Equity $ 5,050 $75,050 $14,531 (1,500) $18,081 14,531 (1,500) $88,081

Falk Consulting Inc. Balance Sheet

May 31, 2011 Assets Cash $26,685 Accounts receivable 5,525 Supplies 350 Prepaid rent 2,000 Land 50,000 Furniture $16,500 Less: Accumulated depreciation 344 16,156 Total assets $100,716 Liabilities Accounts payable $ 500 Note payable 10,200 Unearned revenue 1,850 Interest payable 85 Total liabilities $12,635 Shareholders Equity Contributed capital $70,000 Retained earnings 18,081 Total $88,081 Total liabilities and shareholders equity $100,716

Learning Objective 5 Close the books.

Closing the Accounts

Closing the books means to prepare the accounts for the next periods transactions Temporary accounts such as revenue, expenses and dividends are closed at the end of the accounting period Closing entries transfer the revenue, expenses and dividends balances to Retained Earnings

Closing the Accounts

Permanent accounts (assets, liabilities, and shareholders equity) are not closed at the end of the period because their balances are not used to measure income. Closing entries transfer the revenue, expense, and dividends balances to Retained Earnings.

Journalizing the Closing Entries

May 31 Service Revenue 18,750 Retained Earnings May 31 Retained Earnings 4,219 Rent Expense Salary Expense Supplies Expense Depreciation Expense Utilities Expense Interest Expense May 31 Retained Earnings 1,500 Dividends 18,750 1,000 2,100 180 344 510 85 1,500

Posting the Closing Entries

Salary Expense 2,100 2,100 Rent Expense 1,000 1,000 Utilities Expense 510 510 Supplies Expenses 180 180 Depreciation Expense 344 344 Interest Expense 85 85 Retained Earnings 4,219 5,050 1,500 18,750 18,081 Service Revenue 15,125 1,325 2,300 18,750 18,750

Dividends 1,500 1,500

Learning Objective 6

Use the financial statements in decision making

Classifying Assets and Liabilities

Liquidity measures how quickly an item can be converted to cash A balance sheet lists assets and liabilities in the order of their relative liquidity: Current Assets Long-term Assets Liabilities Current Liabilities Long-term

Using Accounting Ratios

- accounting provides information for decision making - the current ratio and debt ratio are used by creditors in deciding whether or not to loan the company money - they must predict whether or not the loan will be repaid along with the interest

Financial Ratios
Current ratio = Current assets Current liabilities It measures the companys ability to pay short-term debt Debt ratio = Total liabilities Total assets It measures the businesss ability to pay all debt

Income Statement Format

Single-Step Income Statement

Revenues

Expenses

= Net income

Multi-Step Income Statement

Sales Revenue Less: Cost of goods sold = Gross Margin Less: Selling and administrative expenses = Operating income Add: Other revenues and gains Less: Other expenses and losses Earnings before taxes Income taxes = Net earnings

Financial Ratios
Return on sales = Net income Sales revenue It determines how much of the companys sales revenue ends up as net income

Question #4
Common shares $40,000 Sales Inventory 30,000 Land Current liabilities 45,000 Cash Retained earnings 20,000 Building Bank loan (due in 2 yrs) 30,000 Expenses Using the above data, the debt ratio is (rounded): a. 28.8 b. 37.5 c. 22.5 d. 30.6 100,000 60,000 10,000 100,000 60,000

End of Chapter 3