Basic activities of businesses:

Financial activities acquire capital (from investors and

creditors)
Investing activities invest in productive resources (i.e.
equipment)
Operating activities generate wealth (i.e. manufacture and
sell television sets)
Chapter 3
Overview of Financial Statements
Balance Sheet

Asset

Liability

Owners Equity
Overview of Financial Statements
Income Statement

Net income =

Revenue:
Expense:
Gain:
Loss
Overview of Financial Statements
Statement of Cash flows

Net cash flows
Operating
Investing
Financing
Overview of Financial Statements
How do the B/S and I/S fit together?
Called Articulation
Assets = Liabilities + Owners Equity

Overview of Financial Statements
The Accounting Cycle:
During the period:
1. Analyze and record transactions

At the end of the period:
2. Adjusting entries and Adjusted Trial Balance
3. Closing entries
Review of the Mechanics
Asset
Expense
Debit
Debit
Revenue
Liability Equity
Credit Credit
Credit
Normal balance in account
The Account and the Debit-Credit
Convention
TYPE OF
ACCOUNT
IMPACT OF
DEBITING
ACCOUNT
IMPACT OF
CREDITING
ACCOUNT
ASSET
LIABILITY
EQUITY
REVENUE
EXPENSE
DIVIDEND
GAIN
LOSS
Review of the Mechanics
The T-Account
A T-Account can help you simplify and solve
seemingly complex problems
Put in what you know
If there only one unknown, you can solve for it
If there are multiple unknowns, you can recognize where you
need more information
Example:
Given:
12/31/07 balance in supplies inventory: $700 DR.
Supplies expense for y/e 12/31/07: $950 DR
$850 of supplies were purchased during the year ended 12/31/07
Question: What is the balance in supplies inventory on 1/1/07?
Accrual Accounting
Accrual accounting provides a better basis for predicting future
cash flows than does cash flow accounting.

Cash flow accounting reports cash receipts and disbursements as
they occur.

Accrual accounting reports on effects of events that ultimately
have cash effects.
Focuses on economically meaningful event (revenue recognition)
Matches outflows with the inflows they help to generate (expense
recognition)

Revenue and Expense Recognition
Revenues are recognized when they are both:
Earned business has substantially accomplished what it must do to be
entitled to the benefits represented by the revenue.
Realized business has received cash or claim to cash (can estimate
how much the business will ultimately receive).

Expenses are recognized according to one of the following
practices:
Direct - match expense to the specific revenue it helps generate
Systematic and rational match expense to periods in which it helps to
generate revenue
Immediate expense in period the cost is incurred
Adjusting Entries are required for:
Recognizing revenue for the period.
Matching expenses with revenues they helped generate.
Adjusting entries are required every time financial statements are prepared to
comply with GAAP

What to record:
Events not journalized during period (e.g. consumption of supplies)
Costs that expire with passage of time (e.g. rent, insurance, building
deterioration)
Any unrecorded items (e.g. wages earned in current period but not paid until
next period)
Adjusting Entries
Prepayments (deferrals):
Prepaid expenses the cash flow precedes the expense recognition (i.e.,
prepaid rent)
Unearned revenue the cash flow precedes the revenue recognition (i.e.
unearned rent revenue)
Accruals:
Accrued expense the expense recognition precedes the cash flow (i.e.
interest payable)
Accrued revenue the revenue recognition precedes the cash flow (i.e.
interest receivable)
Estimated items:
Accounts are updated based on subjective estimates as of the end of the
period (i.e., bad debt expense, depreciation expense).
Periodic inventory:
Inventory-related accounts (i.e. inventory, cost of goods sold) are adjusted
based on an end of period physical count).
Types of Adjusting Entries
Adjusting
Prepayments for
Expenses
Recording
Accrued Expense
Prepayments made in
cash and recorded
as assets
(cash precedes
expense)
Expense incurred
but not yet
recorded
in books
(expense precedes cash)
Adjusting Entries: Matching
Expenses
Example:
On December 1, 2007, a firm paid its landlord $9,000 for
rent for the following 12 months. The payment was
recorded by debiting Prepaid Rent and crediting
Cash. What adjusting entry will be necessary on
December 31?
Adjusting Entries Prepaid Asset
Adjusting Entry:
Debit Credit
Rent Expense $750
Prepaid Rent $750

If no adjusting entry is made, will
Assets be under or overstated on the Dec. 31 Balance Sheet?
Rent Expense be under or overstated on the Income Statement?
NI be under or overstated on the Income Statement?
OE be under or overstated on the Balance Sheet?
Adjusting Entries Prepaid Asset
Example of Prepaid Adjustment
You pay a property tax assessment of $6,000 on
December 1, 2005, to cover the period from December 1,
2005 to May 31, 2006. What is the adjusting entry
needed for December 31? Two scenarios:
(1) you recorded the December 1 payment as a prepaid asset, and
(2) you recorded the December 1 payment as an expense
Note that a time line can be very useful in organizing data on
these types of questions
Example of Accrued Expense
On January 15, 2006, you receive an invoice for
$8,000 for copier maintenance for the last quarter
of 2005. Is any entry needed on the books at
December 31, 2005?
Example:
A firm purchases $1,000 of supplies on July 14 (there
were 0 supplies on hand at that time). On December 31,
an end of the year count indicates that the firm has $328
of these supplies remaining.
1. What is the required adjusting entry if the firm recorded the
initial acquisition of supplies by debiting Supplies Inventory?
2.What is the required adjusting entry is the firm recorded the
initial acquisition by debiting Supplies Expense?
Adjusting Entries Supplies
Expense
Adjusting Entry Case 1:
Debit Credit
Supplies Expense $672
Supplies $672
* If no adjusting entry is made, Assets will be overstated
on the Dec. 31 Balance Sheet and Supplies Expense will
be understated on the Income Statement (NI will be
overstated).
Adjusting Entries Supplies
Expense
Adjusting Entry Case 2:
Debit Credit
Supplies $328
Supplies Expense $328
* If no adjusting entry is made, Assets will be
understated on the Dec. 31 Balance Sheet and Supplies
Expense will be overstated on the Income Statement (NI
will be understated).
Adjusting Entries Supplies
Expense
Adjusting
Unearned Revenue
Recording
Accrued Revenue
Revenues received
in cash
and
recorded as liabilities
(cash received before
revenue earned)
Revenues earned
but not yet
recorded
in books
(revenue earned before
cash received)
Adjusting Entries: Recognizing
Revenue
Example Adjusting Entry - Unearned Revenue
On Oct 31, 2006, you receive a $12,000 payment for
rent from November 1, 2006 to October 31,
2007. Your fiscal y/e is December 31.
Consider two possibilities:
(1) Initial entry on Oct 31 debits cash, credits unearned
rent revenue
(2) Initial entry debits cash, credits rent revenue
Example Accrued Revenue
Rent is due to you on December 31, 2006 for the
2006 year, but the deadline is missed by the
client. He pays you on $12,000 on January 15,
2007. What is the appropriate adjusting entry on
December 31?
(Assume that you have not made any entries to
record accrued rental revenue for 2006)
After all adjusting entries have been made, a firm will
generally prepare a report called an Adjusted Trial
Balance.
A trial balance is list of all accounts of a firm and their
balances, which will be used to prepare the financial
statements.
The sum of the debit balances must equal the sum of
the credit balances.
Adjusted Trial Balance
Closing Entries are used to:
Update the R/E account
To reset all temporary accounts (i.e. Revenue, Expense,
Dividend, Gain, and Loss accounts) to zero to start the
next accounting period.
Closing Entries
1. Debit each Revenue and Gain account in the amount
of the balance. Credit a temporary account called
Income Summary or R/E for the same amount.
2. Credit each Expense and Loss account in the amount
of the balance. Debit Income Summary or R/E
for the same amount.
3. If Income Summary account is used, close it to
R/E.
4. Credit Dividends account by the amount of its
balance. Debit R/E for the same amount.
Closing Entries
Closing Journal Entries
Dr. All Revenue Accounts
Cr. All Expense Accounts
Dr/Cr. Income Summary (plug to balance)

[Assuming net income is positive]:
Dr. Income Summary
Cr. Retained Earnings

Dr. Retained Earnings
Cr. Dividends
Cash Basis accounting equates expenditures
(when cash moves) with expenses (I/S
recognition of a decrease in resources)
So under cash basis:
no cash moves, no recognition
Cash moves, recognition
Violates matching, plus you get a lot of
surprises because you have no record of
upcoming payables
Cash Basis vs. Accrual Basis
Cash to accrual basis conversion:
The A/R account has a balance on 12/31/2000
of $100, and on 12/31/2001 of $25. Cash
receipts for the year ending on 12/31/2001 are
$500.
What is the accrual basis revenue for the year?
Cash Basis vs. Accrual Basis