Review of a Company s Accounting System

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1 CHAPTER Review of a Company s Accounting System Objectives After careful study of this chapter, you will be able to: 1. Understand the components of an accounting system. 2. Know the major steps in the accounting cycle. 3. Prepare journal entries in the general journal. 4. Post to the general ledger and prepare a trial balance. 5. Prepare adjusting entries. 6. Prepare financial statements. 7. Prepare closing entries. 8. Complete a worksheet (spreadsheet). 9. Prepare reversing entries. 10. Use subsidiary ledgers. 11. Understand special journals. 3-1

2 Synopsis The Accounting System 1. An accounting system is used to record and store a company s financial and managerial information from its transactions so that it can retrieve and report the information. 2. A basic accounting equation provides the framework for the accounting system and is the basis for recording transactions. This model for a corporation is called the residual equity theory and can be expressed as follows: Assets = Liabilities + Stockholders' Equity Assets are the corporation's economic resources, Liabilities are its obligations owed to creditors, and Stockholders' equity is the owners' residual interest in the corporate assets. Residual can be defined as the quantity left over at the end of a process and this is the key to the residual equity theory. The residual (stockholders equity) is what is left over after obligations to the creditors (liabilities) have been paid from the corporation s economic resources (assets). 3. The accounting equation may be expanded to include other components: Contributed capital includes stockholders' investments in shares of stock sold by the corporation. Retained earnings are the total amount of net income reinvested in the corporation rather than distributed to stockholders. Dividends (which are not expenses) are amounts distributed to stockholders as a return on their investment. Revenues are charges to customers for goods and services. Expenses are the costs incurred by the corporation in providing goods and services. 4. In financial accounting, a transaction involves the transfer of something of value between the company and another party. An event is a happening of consequence to the company. An event may be (a) internal, such as the use of equipment in operations, or (b) external, such as a decline in price. 5. Source documents are business documents (such as sales invoices, checks, and freight bills) that provide initial information for recording transactions or events. A company keeps its source documents to verify and substantiate the accounting records. 6. A company uses specific accounts to store the recorded monetary information from transactions and events. Accounts are organized by number in the company's chart of accounts, which is designed to arrange the accounts efficiently and to minimize recording errors. Under the double entry system, the total dollar amount of the debits that a company records for each transaction or event must equal the total dollar amount of the credits it records. 7. The balance of an account at a particular time is the difference between the total debits and total credits recorded in that account. Accounts are classified as permanent (real) accounts or temporary (nominal) accounts. Permanent accounts are the asset, liability, and stockholders' equity accounts that carry balances forward from period to period. Temporary accounts are the revenue, expense, and dividend accounts that are used to determine the change in retained earnings during a given accounting period. A company does not carry temporary account balances forward from period to period. 8. A company sometimes uses a contra (negative) account to emphasize a reduction in a related account. For example, Accumulated Depreciation is used as a contra account to Equipment. 3-2 Chapter 3 Review of a Company s Accounting System

3 9. Financial statements derived from the accounting equation are generally prepared by a company at the end of each accounting period. The annual set of financial statements and accompanying supporting schedules and notes with other data, distributed to external users, is called the company's annual report. Interim statements may also be prepared for shorter periods (such as three months). 10. The three major statements of a company are the income statement, balance sheet, and statement of cash flows. The income statement summarizes the results of the company's income-producing activities for the accounting period. The balance sheet summarizes the amounts of assets, liabilities, and stockholders' equity of the company on a particular date. The statement of cash flows summarizes the cash receipts and cash payments of the company during the accounting period. The income statement is tied to the balance sheet by a supporting schedule called the statement of retained earnings, which summarizes the amount of a company's net income retained in the business. The Accounting Cycle 11. The accounting cycle is the series of steps completed by a company during each accounting period to record, store, and report the accounting information contained in its transactions. The major steps include: (a) recording transactions in a journal, (b) posting the journal entries to the accounts in the ledger, (c) preparing and posting adjusting entries, (d) preparing the financial statements, and (e) preparing and posting closing entries for the revenue, expense, and dividend accounts. 12. A company's transactions and events are initially recorded in a journal. A company could record all transactions in a single general journal, although many companies also use special journals for particular types of transactions. A general journal includes columns for dates, account titles, account numbers, debits, and credits. A written explanation of each recorded transaction is included below each journal entry. 13. A general ledger is composed of all of the accounts of a particular company. Physical forms of general ledgers vary. A general ledger might, for example, be written on paper or stored on a computer disk. 14. Journal entries are transferred to accounts in the general ledger by a process called posting. In posting, the debit and credit amounts from each journal entry are transferred to the appropriate accounts, so that the general ledger accounts contain the same information as the journal. After all journal entries for a given accounting period have been posted, the balance in each account is determined, and often a trial balance is prepared. The trial balance lists all of the company's general ledger accounts and their balances. It is used to verify that the total of the debit balances equals the total of the credit balances. If the total debits are not equal to the total credits, an error has been made. 15. A company using accrual accounting records revenues in the period when they are earned and realized (or are realizable) and records (matches) expenses in the period when they are incurred, regardless of when cash is received or paid. Accounts that are not up to date at the end of an accounting period must be revised by the preparation and posting of adjusting entries. Adjusting entries may be classified into three categories: (a) apportionment of prepaid expenses and deferred revenues, (b) recording of accrued expenses and accrued revenues, and (c) recording of estimated items. 16. A prepaid expense (prepaid asset) represents goods or services purchased by a company for its operations, but not fully used as of the end of the period. Examples include prepaid rent, supplies, and prepaid insurance. The company usually records a prepaid expense initially as an asset. Consequently, an adjusting entry is necessary to reduce the asset account balance and record as an expense the portion of the prepaid expense that was used up during the period. Chapter 3 Review of a Company s Accounting System 3-3

4 17. Deferred (unearned) revenue represents payments received from a customer prior to the delivery of a product or performance of a service. A company usually records a liability for unearned revenue, because the company is obligated to provide future goods and services. When such goods and services have been provided during the accounting period, an adjusting entry is needed to reduce the liability and to recognize revenue earned. 18. Accrued expenses are expenses that have been incurred by a company during the accounting period, but have been neither paid nor recorded. Examples of accrued expenses include accrued salaries, interest, and income taxes. An adjusting entry is required to recognize the expense and associated liability, thereby matching the expense with related revenue of the appropriate time period. 19. Accrued revenues are revenues that have been earned by a company during the accounting period, but have been neither received nor recorded. An adjusting entry is necessary to recognize such revenue and the associated receivable. 20. A company also needs adjusting entries to recognize certain accounting estimates at the end of the accounting period. Two examples are estimation of depreciation on assets such as buildings and equipment, and estimation of uncollectible receivables from credit sales. The company systematically and rationally allocates the cost of depreciable assets as an expense to each period when the assets are used. It records depreciation in a contra (negative) asset account that is subtracted from the asset account to determine the book or carrying value of an asset. The company must recognize the bad debt expense from uncollectible accounts in the period of the sale, and must reduce net receivables. Because the identities of defaulting customers are not known in the period of sale, Accounts Receivable is not directly reduced. Instead, the company deducts a contra-asset account, Allowance for Doubtful Accounts, from Accounts Receivable on the balance sheet. 21. After a company records and posts adjusting entries to the general ledger, it recalculates account balances, if necessary. Next, it may prepare an adjusted trial balance. This adjusted trial balance lists all the accounts and their balances after adjusting entries. It verifies that the total of the general ledger debit balances still equals the total of the credit balances, after adjustments. The adjusted trial balance checks the accuracy of the accounting process and helps in the preparation of the financial statements. The income statement, statement of retained earnings, and balance sheet are prepared directly from information on the adjusted trial balance. 22. Closing entries are journal entries made by a company at the end of the period, after preparation of the financial statements, to (a) reduce the balances in all temporary accounts (revenue, expense, and dividend accounts) to zero, and (b) update the retained earnings and inventory accounts. Each temporary income statement account is closed, that is, debited or credited for the amount that will result in a zero balance in that account. The total of the credits to these accounts is recorded as a debit to the temporary closing account Income Summary. The total of the debits to these accounts is recorded as a credit to Income Summary. Closing entries are shown in specific order in the text: (1) The temporary income statement accounts with credit balances, including all the revenue accounts, are closed first. (2) The amount of the ending inventory, determined by the physical year-end count, is recorded. (3) The temporary income statement accounts with debit balances, including all the expense accounts, are closed. (4) The amount of the beginning inventory is eliminated. A credit balance in Income Summary at this point will appear on the income statement as net income for the period, while a debit balance will appear on the income statement as a net loss. (5) Income Summary is closed to Retained Earnings. (6) The balance in the Dividends Distributed account is closed to Retained Earnings. 23. Many companies prepare a post-closing trial balance after all closing entries have been recorded. This trial balance verifies that the total of the debit balances is equal to the total of the credit balances in the permanent accounts. It checks once again the accuracy of the accounting process. 3-4 Chapter 3 Review of a Company s Accounting System

5 Worksheet 24. A company often uses a worksheet to aid in preparation of adjusting and closing entries and financial statements. A worksheet is prepared with pairs of debit/credit columns for the trial balance, adjustments, income statement, retained earnings statement, and balance sheet. The worksheet process involves five steps: (a) prepare trial balance; (b) analyze accounts and enter necessary adjustments; (c) carry over adjusted amounts of each account to the proper column of the appropriate financial statement; (d) subtotal the income statement debit and credit columns to determine pretax income, and compute income tax; (e) total the financial statement debit and credit columns in sequential order, computing net income or loss and determining that the system is in balance. For formal financial statements, amounts from the worksheet columns for each statement are simply rearranged into proper order. Reversing Entries 25. After closing the temporary accounts of the current period, many companies prepare reversing entries dated on the first day of the new accounting period. Each reversing entry is the exact reverse in accounts and amounts of an adjusting entry. Reversing entries are optional. Their purpose is to simplify the recording of later transactions by eliminating the need to consider previous adjusting entries. As a general guideline, a reversing entry should be made for any adjusting entry that establishes a new balance sheet account. 26. To illustrate the adjusting and reversing entry process, assume that a company accepted, on December 1, 2011, a note that is payable in three months. The note earns interest of $30 a month, all of which is payable at the time the note is collected. The company would make the following adjusting and closing entries on December 31 (the end of its fiscal year): 12/31/11 Interest Receivable 30 Interest Revenue 30 To record accrued interest at year-end. (Adjusting entry) 12/31/11 Interest Revenue 30 Income Summary 30 To close Interest Revenue to Income Summary. (Closing entry) 1/1/12 Interest Revenue 30 Interest Receivable 30 To reverse the year-end adjusting entry. (Reversing entry) 2/28/12 Cash 90 Interest Revenue 90 To record collection of interest on the note. (Receipt of the principal would also be recorded at this time.) The Interest Revenue account at 2/28/12 now has a balance of $60 ($90 $30), which is the amount of interest earned on the note during If the reversing entry had not been made, the entry on February 28 would have been more complicated, as follows, and recording errors would have been more likely. 2/28/12 Cash 90 Interest Receivable 30 Interest Revenue 60 Chapter 3 Review of a Company s Accounting System 3-5

6 Subsidiary Ledgers 27. Instead of using only a general ledger for accounts, a company may also establish subsidiary ledgers, which are not part of the double-entry system. A subsidiary ledger is a group of accounts pertaining to one specific company activity. Subsidiary ledgers are usually established for accounts receivable and accounts payable. In addition, they are often maintained for property and equipment, selling expenses, and administrative expenses. A control account is maintained in the general ledger for each subsidiary ledger. The balance of a control account on any balance sheet date is equal to the total balance of its associated subsidiary ledger. For example, an accounts receivable subsidiary ledger contains the individual accounts of the company's charge customers, while the Accounts Receivable control account in the general ledger has a debit balance equal to that of the total accounts receivable subsidiary ledger. Special Journals 28. In a small business, a general journal may be used for all transactions. As a business becomes larger and more complex, a more efficient means of recording common, high-volume transactions is required. Special journals are, therefore, often used to group similar transactions. The major special journals are the sales journal (used to record all sales of merchandise on account), purchases journal (used to record all purchases of merchandise on account), cash receipts journal (used to record all receipts of cash), and cash payments journal (used to record all payments of cash). (Note, the text does not discuss a voucher system on page 31 during the discussion of special journals, nor anywhere else I found. A general journal is always necessary to record adjusting, closing, and reversing entries, and certain transactions that occur infrequently, such as purchases returns and sales returns on credit. Computer Software 29. Most companies use computers to process their accounting information. Software is the set of computer programs used to operate a computer. Software packages are available for the subsidiary ledgers and special journals, as well as other accounting functions such as accounts receivable, accounts payable, inventory, payroll, and the general ledger. Flexible spreadsheets, or "electronic worksheets," have also been developed and serve a variety of needs. 3-6 Chapter 3 Review of a Company s Accounting System

7 True-False Questions Determine whether each of the following statements is true or false. 1. Posting is the process of initially recording a financial transaction or event. 2. Unusual and infrequent items are recorded in the special journals. 3. "Contributed capital" is the term for company earnings that are reinvested rather than distributed to stockholders. 4. After closing entries have been completed, the asset, liability and capital accounts have a balance of zero. 5. A reversing entry is required whenever an adjusting entry is made. Answer: False A company initially records its transactions (and events) in a journal. Posting involves transferring the information from the general journal to general ledger. Thus, after posting, the general ledger accounts contain the same information as in the general journal, just in a different format. Answer: False A special journal is a journal used by a company to record its transactions with a similar characteristic, but these items are not usually unusual or infrequent. The most common special journals are sales, purchases, and cash. These journals are used extensively in the course of business. Answer: False Contributed capital includes the amounts of stockholder investments resulting from the sale of shares of stock by the corporation. Retained earnings is the term for company earnings that are reinvested in the corporation and not distributed to stockholders. Answer: False Closing entries are made by a company at the end of the accounting period to reduce the balance in the temporary accounts (namely, all the revenue, expense, and dividend accounts) to zero, and to update the retained earnings account. Therefore, the revenue, expense, and dividend accounts should have a zero balance after closing entries have been made. Answer: False While most companies do prepare reversing entries to simplify the recording of a later transaction related to the adjusting entry, they are not required entries. Chapter 3 Review of a Company s Accounting System 3-7

8 6. Prepaid expenses are expenses that have been incurred during the accounting period but have been neither paid nor recorded. Answer: False A prepaid expense (sometimes called a prepaid asset) is a good or service purchased by a company for its operations but not fully used up by the end of the accounting period. These prepaid items are recorded when purchased. 7. Adjusting entries are used to revise accounts that are not up to date at the end of the accounting period. Answer: True Adjusting entries are journal entries made at the end of the accounting period so that a company s financial statements include the correct amounts for the current period. 8. Certain accounting estimates, such as estimates of depreciation on assets, are entered at the end of the accounting period in closing entries. 9. "Permanent" accounts are also called "nominal" accounts. 10. Depreciation expense is an example of a contra account. 11. The balance sheet summarizes the amounts of assets, liabilities, and stockholders' equity as of a particular date. Answer: False Entries made at the end of the accounting period to record accounting estimates such as estimates of depreciation expense are called adjusting entries, not closing entries. Closing entries transfer the balances in the temporary accounts to the permanent accounts through the Income Summary account. Answer: False Permanent accounts are also called real accounts. Temporary accounts are also called nominal accounts. Answer: False Depreciation expense is not a contra account. It is a temporary account that records the amount of depreciation that has been estimated for the accounting period. A contra (or negative) account is used to show a reduction in a related account. In this example, Accumulated depreciation is a contra account that shows a reduction in the related asset account. Answer: True The balance sheet does summarize the amounts of assets, liabilities, and stockholders' equity as of a particular date at the end of an accounting period. This summarization is only correct on that date because new transactions will affect the amounts listed. 3-8 Chapter 3 Review of a Company s Accounting System

9 12. A post-closing trial balance verifies that the total of the debit balances is equal to the total of the credit balances in the permanent accounts. 13. In financial accounting, an "event" always involves the transfer of something between the company and another party. 14. Sales invoices and freight bills are examples of documents of original entry. 15. Adjusting entries ensure that the financial statements include the correct amounts for the current period under cash-basis accounting. 16. When a company uses the double-entry system, the total dollar amount of debits recorded for a transaction equals the total dollar amount of credits. 17. Statements that are prepared for a period shorter than one year are called temporary financial statements. Answer: True A post-closing trial balance is prepared after closing entries are completed. The closing entries zero out all of a company s temporary accounts leaving only balances in the permanent accounts, which must balance with debits equal to credits. Answer: False An event is a happening that affects the company and may be internal, such as using equipment in operations, or external, such as a decline in the value of an asset. A transaction involves the transfer of something valuable between the company and another party. Answer: False Sales invoices and freight bills are examples of source documents, not documents of original entry. There are no documents of original entry in accounting. Answer: False Under cash-basis accounting, a company records revenues and expenses when they are received or paid and does not need to use adjusting entries. Under the accrual basis of accounting, a company records revenue when earned and expenses when they are incurred and must adjust accounts at the end of accounting period so that all its revenues and expenses are recorded and its balance sheet accounts have correct ending balances. Answer: True In the double-entry system, for each transaction or event that a company records, the total dollar amount of the debits entered in all the related accounts must be equal to the total dollar amount of the credits. Answer: False A company often prepares financial statements for a shorter time period, such as three months. These are called interim or quarterly statements, not temporary statements. Chapter 3 Review of a Company s Accounting System 3-9

10 Multiple Choice Questions Select the one best answer for each of the following questions. 1. Accumulated Depreciation is an example of a: (a) corporate liability. (b) temporary account. (c) contra account. (d) control account. 2. The three major financial statements do not include the: (a) statement of retained earnings. (b) income statement. (c) balance sheet. (d) statement of cash flows. 3. The purposes of closing entries do not include : (a) reducing all temporary accounts to zero. (b) updating the Retained Earnings account. (c) updating the Inventory account. (d) apportioning prepaid expenses and unearned revenues to bring accounts up to date. Answer: (c) contra account Accumulated depreciation is a contra account. This contra (or negative) account is used to show a reduction in a related account while not actually affecting the related account. Accumulated depreciation would be a contra account to an asset account that is being used over one than more accounting period. Answer (a) is incorrect because accumulated depreciation is not a liability. A liability is an obligation owed. Answer (b) is incorrect because accumulated depreciation is a permanent account, not temporary. It is not closed during the closing process but remains on the books as long as the asset is owned. answer (d) is incorrect. A control account is an account that has subsidiary accounts, such as accounts receivable (control account) and each individual account receivable (subsidiary account). Answer: (a) statement of retained earnings The statement of retained earnings is a supporting schedule (statement) that is usually prepared to tie the income statement to the balance sheet. It is not a required statement although almost all companies provide a statement of retained earnings. Answers (b), (c), and (d) are all major financial statements. Answer: (d) apportioning prepaid expenses and unearned revenues to bring accounts up to date. Prepaid expenses and unearned revenues are apportioned to bring the accounts up to date during the adjusting process, not the closing process. Answers (a), (b), and (c) are all valid purposes of closing entries Chapter 3 Review of a Company s Accounting System

11 4. Which of the following is not a temporary account? (a) Retained Earnings (b) Warranty Expense (c) Sales Revenue (d) Interest Expense 5. Which of the following accounts will be reduced to zero by a year-end closing entry? (a) Accumulated Depreciation (b) Sales Returns and Allowances (c) Unearned Revenue (d) Allowance for Doubtful Accounts Answer: (a) Retained Earnings Permanent accounts are found on the balance sheet (assets, liabilities, or stockholders equity). Retained earnings is a stockholders equity account and is a permanent account. Answers (b), (c), and (d) are all temporary accounts. Temporary accounts consist of the revenue, expense, and dividend accounts. These accounts accumulate and summarize information for net income and dividends for that period. After the period is over and the company s financial statements are prepared, the balances in these accounts are no longer needed and they are closed; therefore, the amounts are temporary, emptying at the end of each period. Answer: (b) Sales Returns and Allowances Sales returns and allowances is a contra account to Sales, which is a revenue account. Revenue accounts are temporary accounts and will be reduced to zero during the closing process. Answer (a) Accumulated Depreciation is incorrect because it is a contra asset account and is listed on the balance sheet. Answer (c) Unearned Revenue is incorrect because it is a liability account and is listed on the balance sheet. Answer (d) Allowance for Doubtful Accounts is incorrect because it is a contra asset account and is listed on the balance sheet. Balance sheet accounts are permanent accounts and are not zeroed out during the closing process. Chapter 3 Review of a Company s Accounting System 3-11

12 6. Stockholders' equity is: (a) the amount paid by investors for stock at the time of original issuance. (b) the residual interest of owners. (c) corporate earnings reinvested in the corporation rather than distributed. (d) amounts received by stockholders as a return on investment. 7. Cash received from a customer prior to delivery of the product is: (a) an accrued expense. (b) an accrued revenue. (c) a prepaid expense. (d) a deferred revenue. Answer: (b) the residual interest of owners Stockholders equity is the residual interest of owners in the company. This can be expressed in the accounting equation as: Assets - Liabilities = Stockholders equity. Answer (a) The amount paid by investors for stock at the time of original issuance, is called Contributed Capital. While it is a part of stockholders equity, it does not represent all of stockholders equity and is not correct. Answer (c) Corporate earnings reinvested in the corporation rather than distributed, is called Retained Earnings, and like answer (a) it only represents a portion of stockholders equity, not all of stockholders equity; therefore it is an incorrect answer. Answer (d) Amounts received by stockholders as a return on investment is called Dividends. This is actually a reduction from stockholders' equity and is incorrect. Answer: (d) a deferred revenue In this question, payment from the customer is made before delivery of the product. Because payment from a customer is revenue, we know the correct answer is either (b) or (d). We now must determine whether this represents deferred revenue or accrued revenue. An accrued revenue is a revenue that a company has earned during the accounting period but has neither received nor recorded. On the other hand, deferred (or unearned) revenue is payment received by a company in advance for the future sale of inventory or performance of services. Therefore, the correct answer is (d) and answer (b) is incorrect. Answers (a) and (c) are incorrect because they refer to expenses, which represent payments by the company (prepaid expenses) or future payments by the company (accrued expenses) Chapter 3 Review of a Company s Accounting System

13 8. The three categories of adjusting entries necessary under accrual accounting do not include: (a) apportionment of prepaid expenses and deferred revenues. (b) apportionment of recorded revenues and incurred expenses. (c) recording of accrued expenses and accrued revenues. (d) recording of estimated items. 9. The accounting equation can be rewritten as: (a) Assets + Liabilities = Stockholders Equity (b) Assets + Stockholders Equity = Liabilities (c) Assets - Liabilities = Stockholders Equity (d) Liabilities - Stockholders Equity = Assets Answer: (b) apportionment of recorded revenues and incurred expenses The apportionment of recorded revenue and incurred expenses occurs during the period as these transactions occur. At the end of the period, these items would have already been recorded in the accounting records. Therefore, these items would not require adjusting entries and answer (b) is the correct answer. Answer (a) Apportionment of prepaid expenses and deferred revenues, refers to the process of determining which and by how much the prepaid expenses have been used and the deferred revenue has been earned. This answer is incorrect because the apportionment of these items is accomplished at the end of each period through the adjusting process. Answer (c) Recording of accrued expenses and accrued revenues, refers to the process of recording new expenses and earned revenue that have not been paid or received. This answer is also incorrect because it too occurs at the end of each period through the adjusting process. Like answers (a) and (c), answer (d) Recording of estimated items, is incorrect because these estimations are determined and entered at the end of the accounting period through the adjusting process. Answer: (c) Assets - Liabilities = Stockholders Equity The basic accounting equation is: Assets = Liabilities + Stockholders Equity. Through simple algebra, we can rearrange the equation by subtracting Liabilities from both sides of the equation to give us the new equation: Assets - Liabilities = Stockholders Equity, which is answer (c). Answers (a), (b), and (d) are all incorrect algebraically. Chapter 3 Review of a Company s Accounting System 3-13

14 10. Which of the following statements concerning deferred revenue is true? (a) A liability is usually recorded initially for deferred revenue. (b) When accrual accounting is used, no adjusting entry is necessary for deferred revenue. (c) Deferred revenue is usually recorded initially as an expense. (d) Deferred revenue is revenue that has been earned during an accounting period, but has been neither received nor recorded. 11. Reversing entries: (a) are generally made for adjusting entries, which establish new balance sheet accounts. (b) are required under accrual accounting. (c) are dated on the last day of the accounting period. (d) make the recording of later transactions more complex. Answer: (a) A liability is usually recorded initially for deferred revenue. With a deferred revenue the company initially records a liability because it has an obligation to provide the goods or services. When the company has provided the goods or services to the customer, it eliminates the liability and records the revenue in an adjusting entry. Therefore the correct answer is (a). Answer (b) When accrual accounting is used, no adjusting entry is necessary for deferred revenue, is incorrect because adjusting entries are required for accrual accounting. Adjusting entries and the recording of deferred revenue are not used in cash-basis accounting. Answer (c) Deferred revenue is usually recorded initially as an expense, is incorrect because this does not represent an expense to be paid by the company. Answer (d) Deferred revenue is revenue that has been earned during an accounting period, but has been neither received nor recorded, is incorrect because this is the definition of accrued revenue, not deferred revenue. Answer: (a) are generally made for adjusting entries, which establish new balance sheet accounts. A reversing entry is the exact reverse (accounts and amounts) of an adjusting entry; therefore, answer (a) is correct. The word "generally" is used in the answer choice because not all adjusting entries will have reversing entries. A company usually makes reversing entries at the same time as closing entries but dates them the first day of the next accounting period, not the last day of the accounting period; therefore, answer (c) is incorrect. A reversing entry is optional (therefore answer (b) is incorrect) and has one purpose: to simplify the recording of a later transaction related to the adjusting entry; therefore answer (d) is incorrect. A reversing entry enables a company to routinely record the later transaction, without having to consider the possible impact of the prior adjusting entry Chapter 3 Review of a Company s Accounting System

15 12. Which of the following statements is true regarding prepaid expenses? (a) Prepaid expenses represent payments received from customers before the delivery of products or the performance of services. (b) Prepaid rent and prepaid insurance are common examples of prepaid expenses. (c) Prepaid expenses are always recorded initially as expenses. (d) Prepaid expenses are estimated when preparing closing entries. 13. Usually financial transactions and events are initially recorded in a: (a) chart of accounts. (b) general journal. (c) trial balance. (d) general ledger. Answer: (b) Prepaid rent and prepaid insurance are common examples of prepaid expenses. Prepaid rent and prepaid insurance are examples of assets that have been created when expenses are paid in advance; therefore, answer (b) is the correct answer. Answer (a) Prepaid expenses represent payments received from customers before the delivery of products or the performance of services, is incorrect because this is the definition of deferred revenue, not prepaid expenses. When the company initially purchases a prepaid good or service, it records the cost as an asset (such as prepaid rent or prepaid insurance), not as an expense; therefore answer (c) is incorrect. Answer (d) is incorrect because prepaid expenses are not estimated during closing entries. The estimation and determination of the amounts of prepaid expenses made during the period is accomplished when adjusting entries are made. Answer: (b) general journal A company initially records its transactions (and events) in a general journal. The chart of accounts is a listing of all the accounts that a company keeps track of in their accounting system. Entries of transactions are not made in the chart of accounts; therefore, answer (a) is incorrect. A trial balance is a working paper that lists all of the company s general ledger accounts and their account balances. Entries are not initially made into the trial balance; therefore, answer (c) is incorrect. A general ledger is the entire group of accounts for a company. The general ledger maintains the balances of all of the accounts. Entries are transferred (or posted) to the general ledger after they have been recorded in the general journal; therefore, answer (d) is incorrect. Chapter 3 Review of a Company s Accounting System 3-15

16 14. Goods or services purchased for use by a company but not fully used at the end of the period are called: (a) accrued expenses. (b) accrued revenues. (c) deferred (unearned) revenue. (d) prepaid expenses. 15. A payment received from a customer before delivery of goods or performance of a service is: (a) accrued expenses. (b) accrued revenues. (c) deferred (unearned) revenue. (d) prepaid expenses. 16. Expenses that have been incurred during the period, but that have been neither paid nor recorded, are: (a) accrued expenses. (b) accrued revenues. (c) deferred (unearned) revenue. (d) prepaid expenses. Answer: (d) prepaid expenses A prepaid expense (sometimes called a prepaid asset) is a good or service purchased by a company for its operations but not fully used up by the end of the accounting period. An accrued expense is an expense that a company has incurred during the accounting period but has neither paid nor recorded; therefore answer (a) is incorrect. Accrued revenue is revenue that a company has earned during the accounting period but has neither received nor recorded, therefore answer (b) is incorrect. Deferred (or unearned) revenue is payment received by a company in advance for the future sale of inventory or performance of services; therefore answer (c) is incorrect. Answer: (c) deferred (unearned) revenue Deferred (or unearned) revenue is payment received by a company in advance for the future sale of inventory or performance of services. An accrued expense is an expense that a company has incurred during the accounting period but has neither paid nor recorded; therefore answer (a) is incorrect. Accrued revenue is revenue that a company has earned during the accounting period but has neither received nor recorded, therefore answer (b) is incorrect. A prepaid expense (sometimes called a prepaid asset) is a good or service purchased by a company for its operations but not fully used up by the end of the accounting period; therefore answer (d) is incorrect. Answer: (a) accrued expenses An accrued expense is an expense that a company has incurred during the accounting period but has neither paid nor recorded. Accrued revenue is revenue that a company has earned during the accounting period but has neither received nor recorded, therefore answer (b) is incorrect. Deferred (or unearned) revenue is payment received by a company in advance for the future sale of inventory or performance of services; therefore, answer (c) is incorrect. A prepaid expense (sometimes called a prepaid asset) is a good or service purchased by a company for its operations but not fully used up by the end of the accounting period; therefore, answer (d) is incorrect Chapter 3 Review of a Company s Accounting System

17 17. Revenues that have been earned during the period, but that have been neither received nor recorded, are: (a) accrued expenses. (b) accrued revenues. (c) deferred (unearned) revenue. (d) prepaid expenses. 18. The journal entries made at the end of the period to reduce temporary accounts to zero and to update the retained earnings and inventory accounts are: (a) adjusting entries. (b) temporary entries. (c) closing entries. (d) transaction entries. Answer: (b) accrued revenues Accrued revenue is revenue that a company has earned during the accounting period but has neither received nor recorded. An accrued expense is an expense that a company has incurred during the accounting period but has neither paid nor recorded; therefore, answer (a) is incorrect. Deferred (or unearned) revenue is payment received by a company in advance for the future sale of inventory or performance of services; therefore, answer (c) is incorrect. A prepaid expense (sometimes called a prepaid asset) is a good or service purchased by a company for its operations but not fully used up by the end of the accounting period; therefore, answer (d) is incorrect. Answer: (c) closing entries Closing entries are journal entries that a company makes at the end of the accounting period to reduce the balance in each temporary account to zero, and to update the retained earnings account. Adjusting entries are journal entries made at the end of the accounting period so that a company s financial statements include the correct amounts for the current period. These entries update account balances and do not reduce temporary accounts to zero. In fact, adjusting entries add to temporary accounts amounts that have been accrued or deferred during the period; therefore, answer (a) is incorrect. There is no such thing as a temporary entry ; therefore, answer (b) is incorrect. Transaction entries is not a commonly used term, however it could be applied to entries that record transactions. Because reducing temporary accounts to zero and updating the retained earnings and inventory accounts do not involve transactions, answer (d) is incorrect. Chapter 3 Review of a Company s Accounting System 3-17

18 19. Permanent accounts would not include: (a) Interest expense. (b) Salaries payable. (c) Prepaid rent. (d) Accumulated depreciation. 20. Which of the following would NOT be a correct form for an adjusting entry? (a) A debit to an expense and a credit to a liability (b) A debit to an asset and a credit to a liability (c) A debit to a liability and a credit to a revenue (d) A debit to a revenue and a credit to a liability 21. Why are adjusting entries necessary? (a) Transactions take place over more than one accounting period. (b) To make debits equal credits. (c) To close temporary accounts at yearend. (d) To correct erroneous balances in accounts. Answer: (a) Interest expense Permanent accounts are the asset, liability, and stockholders' equity accounts that carry balances forward from period to period. Therefore, permanent accounts would not include any accounts that are temporary. Temporary accounts are the revenue, expense, and dividend accounts that are used to determine the change in retained earnings during a given accounting period. Interest expense is a temporary account. Answers (b) Salaries payable, a liability account, (c) Prepaid rent, an asset account, and (d) Accumulated depreciation, a contra asset account, are all permanent accounts and are incorrect. Answer: (b) A debit to an asset and a credit to a liability An adjusting entry affects both a permanent (balance sheet) and a temporary (income statement) account. Therefore, a debit to an asset (a permanent account) and a credit to a liability (also a permanent account) would not be a correct form for an adjusting entry. Answers (a), (c), and (d) all contain one permanent account (asset or liability) and one temporary account (expense or revenue), therefore they could be correct adjusting entries and are incorrect answers for this question. Answer: (a) Transactions take place over more than one accounting period. Under accrual accounting, a company records revenues in the accounting period in which they are earned and realized (or realizable) and records (matches) expenses in the accounting period in which they are incurred, regardless of the inflow or outflow of cash. These transactions flow across accounting periods and need to be updated at the end of each period. Answer (b) is incorrect because while each adjusting entry (as well as all other entries) must have debits equal to credits, the purpose of adjusting entries is to update account balances. Closing entries are used to close temporary accounts, not adjusting entries, therefore answer (c) is incorrect. Adjusting entries are not used to correct erroneous balances, just to update the balances, therefore answer (d) is incorrect Chapter 3 Review of a Company s Accounting System

19 22. After closing all the temporary (nominal) accounts to the Income Summary account, there is a credit balance in the Income Summary account. This indicates that: (a) adjusting entries were incorrectly entered. (b) there was net income for the period. (c) there was a net loss for the period. (d) None of the above. There is always a debit balance in the Income Summary account. Answer: (b) there was net income for the period. A credit balance in the Income Summary account indicates that there was net income for the period. In the closing process, all expense accounts are closed by crediting the balance in the expense accounts and debiting the same amount in the Income Summary account. Therefore, the debit side of the Income Summary account is the total expense for the period. In a similar manner, all the revenue accounts for the period are closed by debiting the balance in the revenue accounts and crediting the same amount in the Income Summary account. Therefore, the credit side of the Income Summary account is the total revenue for the period. If there is more revenue than expense, there will be a credit balance remaining in the Income Summary account and this represents the Net Income for the period. Answer (c) is incorrect because there would have to be a debit balance in the Income Summary account for a net loss to occur. Whether the adjusting entries were done correctly or not cannot be determined from looking at the balances in the Income Summary. You would not expect the debit and credit balances in the Income Summary account to match unless the company did not experience a loss or net income (revenue = expenses) in the period; therefore answer (a) is incorrect. Answer (d) is incorrect because the balance in the Income Summary account can be a debit or credit depending on the amount of revenue and expenses recorded in the period. Chapter 3 Review of a Company s Accounting System 3-19

20 23. Which of the following is a temporary (nominal) account? (a) Salary Expense (b) Retained Earnings (c) Inventory (d) Unearned Revenue Answer: (a) Salary Expense Temporary accounts are the revenue, expense, and dividend accounts that are used to determine the change in retained earnings during a given accounting period. Salary expense is a temporary account. Permanent accounts are the asset, liability, and stockholders' equity accounts that carry balances forward from period to period. Therefore, permanent accounts would not include any accounts that are temporary. Answers (b) Retained earnings, a stockholders equity account, (c) Inventory, an asset account, and (d) Unearned revenue, a liability account, are all permanent accounts and are incorrect. Note that even though unearned revenue has the word revenue included, it is a liability because it represents an obligation that requires us to provide assets or services to satisfy. Problem-Solving Strategies Strategy: You will encounter numerous strategies that are general in nature in this chapter. Why? Because this chapter is the foundation to accounting studies and must be mastered for you to successfully complete this and future accounting courses. Despite this chapter being a review from the first course in accounting, it should not be taken lightly. You need to fully understand the concepts and steps associated with the accounting cycle before you move on to more advanced concepts in future chapters. The better you know the accounting cycle the more time you can devote to learning future topics. Strategy: Assets = Liabilities + Stockholders Equity is the basic accounting equation. By now you have seen this equation many times and are tired of looking at it, but in order to be successful in accounting you have to know and understand what changes in the basic accounting equation are taking place in each transaction. To understand the effects of transactions you need to recognize the individual components of the accounting equation. In other words, you need to understand what an asset, a liability, and stockholders equity are. Knowledge of these items will also be needed when entering transactions in journal entries. Analysis of Transaction For each of the following transactions, determine which components of the basic accounting equation are changing and whether the components increased or decreased. 1. June 1 Bobcat Computer Repair issued 1,000 shares of common stock in exchange for $10,000 in cash and furniture worth $12,000 with an estimated life of five years. 2. June 1 Bobcat purchased supplies to be used for computer repairs by paying $ Chapter 3 Review of a Company s Accounting System

21 3. June 2 Bobcat purchased a computer worth $3,600, with an estimated life of three years, by paying $750 in cash and the balance on account. 4. June 3 Rented a small office on Guadalupe Street for $500 per month. Bobcat paid the first six months' rent in advance. 5. June 5 Bobcat paid $150 for two ads placed in the Record and Star newspapers. 6. June 15 Bobcat received $950 for computer repairs through the first half of the month. 7. June 20 Bobcat received a contract to repair computers for the local high school. The school paid $8,000 in advance for a six-month service contract that will run from July 1 to December June 25 Bobcat paid the balance due on the computer purchased on June June 28 Bobcat received $500 for computer repairs worth $1,200 performed for a customer. The balance of the bill was to be paid next month. 10. June 30 Bobcat received $1,800 for computer repairs performed in the second half of the month. Answer: Assets = Liabilities + Shareholders Equity 1. Cash Common Stock Furniture 2. Supplies Cash 3. Computer Accounts Payable Cash 4. Prepaid Rent Cash 5. Cash Ad Expense (see note) 6. Cash Revenue 7. Cash Unearned Revenue 8. Cash Accounts Payable 9. Cash Revenue Accounts Receivable 10. Cash Revenue Note: In transaction 5, the account Ad Expense actually goes up, but because an expense causes a decrease in shareholders equity, the column shows a. Strategy: Many students initially have trouble with determining whether an account is going up or down. For instance, when we pay a bill for an expense, such as the ad expense in the problem above, many students have a hard time understanding that ad expense has gone up. The key is to look at the accounts before and after the transaction. We have had more expense AFTER this transaction then we had before, therefore ad expense has increased because of this transaction. Chapter 3 Review of a Company s Accounting System 3-21

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