PART 1. BASIC CONCEPTS AND ACCOUNTING MODEL

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1 CHAPTER 1 PART 1. BASIC CONCEPTS AND ACCOUNTING MODEL OBJECTIVES The objectives of this part are: To introduce a definition of accounting, the need for accounting information, and the various accounting activities, To discuss the two principal financial statements. To relate generally accepted accounting principles and their development. To illustrate the basic recording of business transactions and their impact on the basic accounting model To trace the transactions recorded into the financial statements. HIGHLIGHTS Business event Record transaction according to GAAP Financial Statement s Users of financial statement s Decision making 1. Basic entities: 1- Profit: a. Corporations b. Partnerships c. Proprietorships 2. Not-for-profit 2. The two basic types of entities are: a. Profit-motivated entities. These include: (1) Corporations. These are legal entities in themselves. (2) Partnerships. Entities owned by more than one person, (3) Proprietorships. Entities owned by one person. b. Not-for-profit entities. 4. Two types of reports exist: a. Internal. Available to management to make decisions for the entity. b. External. General purpose, used by those outside of the entity to base legislation and to decide on lending and investing activities. 5. Management accounting deals primarily with the preparation of internal reports. Financial accounting is concerned with external reports. 6. Accounting activities include: a. General financing. To record all business transactions, summarize and prepare external reports, and summarize and prepare internal reports. b. Accounting system design. To develop an organized way of processing volumes of similar data, determine the needs of the accounting process, examine potential improvements, and assure compliance with accounting operating procedure. c. Cost accounting. To provide management data relative to basic costs of products or service, control or reduction of these costs, and special reports using cost data.

2 d. Budgeting. To provide forecasts for given periods of time and then compare and analyze actual results with the forecasts. e. Taxation. To prepare records that will satisfy federal, state, and local tax requirements. f. Internal auditing. To review and ensure that accounting and operating policies are adhered to. g. Data processing. To perform actual processing of ail transactions. 7. The income statement shows: Revenues expenses = net income (for a given period of time) a. Revenues represent the inflows for services rendered or products sold during a given period of time. Examples of revenues are: sales, rental fees, and sales commissions earned. b. Expenses are the costs of the business incurred in generating revenue during a given period of time. Examples of expenses are: salaries expense, advertising expense, supplies expense, and depreciation expense. 8. The balance sheet shows the financial position of the business at a particular date. The statement shows that Assets (resources) = Liabilities (obligations) + Owners' Equity (residual interest) a. Assets are the resources for an entity. b. Liabilities are the obligations of an entity. c. Owner's Equity Is the residual interest (net assets of an entity, i.e., assets liabilities). Any transaction can be analyzed based on the effect it has on the balance sheet equation. Every time a transaction occurs the elements of the equation change, but the basic equality remains. Ask yourself: a. Which accounts are involved in the transaction? b. Has each account increased or decreased! c. Which type of account is each (asset, liability, or owners' equity)? Examples of some transactions being analyzed: Transaction Assets = Liabilities + Owners' Equity (1) Invest money in business Cash + = Capital + (2) Purchase supplies on account Supplies + = Accounts Payable + 9. The changes in Capital (Owners' Equity) are: Expanded, changes in Capital are: Capital + Net Income Withdrawals Capital + Revenue Expenses Withdrawals 10. Some of the groups that influence the standard-setting process are: Financial Accounting Standards Board, Securities and Exchange Commission, practitioners, and Internal Revenue Service. 11. Generally accepted accounting principles include: a. Cost principle. Assets (resources) are recorded at acquisition price (historical cost) and kept at that original price on the balance sheet, b. Objectivity principle. Costs used can be verified and are based upon fact. c. Business entity concept. Transactions of the business must be kept separate from those of the owner. d. Going-concern concept. The entity is assumed to be permanently in business. e. Stable-dollar concept. Historical costs are not adjusted in the basic financial statements to Accounting course materials Page 2

3 reflect changes in the unit of measure, the dollar. Supplemental financial statements are permitted to show adjustments for inflation. 12. Profitability relates to having positive net income. Solvency relates to being able to meet creditor obligations. TRUE OR FALSE Circle either T (True) or F (False) for each of the following: TF 1. The internal auditor is the chief financial officer of the company. T F 2. Budgeting is the accounting activity concerned with providing management data relative to basic costs of products or services. T F 3. Transactions of the business should be recorded in accordance with generally accepted accounting principles. T F 4. Every time a transaction is recorded, the components of the equation change, but the basic equality must remain. T F 5. The Securities and Exchange Commission is the basic governing body which establishes generally accepted accounting principles. T F 6. Financial reports are generally prepared by the internal auditor. T F 7. Tax laws are established by the Internal Revenue Service. T F 8. Internal auditing is primarily concerned with discovering fraud. T F 9. Financial statements represent the end product of the general financial accounting activity. T F 10. The main objective of general financial accounting is the preparation of the financial statements. T F 11. If a business entity is unable to pay debts as they become due, it is said to be unprofitable. T F 12. Proprietorships are separate legal entities. T F 13. Depreciation, salaries, and cost of goods sold are all expense accounts. T F 14. The income statement and balance sheet both give information at a point in time T F 15. Assets are physical items owned by the entity. T F 16. Current liabilities represent claims of creditors against the current assets of the business entity. T F 17. Assets are generally stated at their current market value. MULTIPLE CHOICE Circle the best alternative. Choose only one alternative per question. 1. Responsibilities of a CPA may include: a. Conducting an audit upon which to base his/her report on the fairness of the financial statements. b. Tax services. c. Management advisory services. d. Co-signing checks for the company he/she is auditing. e. Some of the above. f. All of the above. 2. The two principal financial statements are: a. The income statement and the CPA's opinion. b. The income statement and the statement of changes in the Owners' Equity account. c. The balance sheet and the company's tax return. d. The income statement and the balance sheet. e. None of the above. 3. The accounting principle which states that costs used to record transactions can be verified is: a. The business entity concept. b. The cost principle. c. The stable-dollar concept. Accounting course materials Page 3

4 d. None of the above. 4. The accounting activity concerned with gathering accounting information to determine the cost of a product or service is: a. Budgeting. b. Accounting systems design. c. General financial accounting. d. Data processing. e. None of the above. 5. Which of the following is not a revenue account? a. Dividends received and earned this period. b. Commissions earned. c. Fees for professional services. d. Accounts receivable. e. More than one of the above is not a revenue account. 6. With respect to the balance sheet, which of the following statements is true? a. The balance sheet provides assurance that all the accounts have a positive balance at all times. The balance sheet expresses the equality between the resources of the entity and the profits (net income) of the entity. c. The balance sheet provides information about the relative solvency of the firm. d. More than one of the above is true. 7. With respect to depreciation, which of the following statements is true? a. Depreciation represents a decrease in owners' equity. b. Depreciation represents the cash use of the asset for a given period. c. The contra asset, accumulated depreciation, may be used to show the decrease in the asset or the asset may be directly decreased. d. Depreciation allocates the cost of the asset over the entity's expected business life (40-year maximum). e. More than one of the above is true. 8. As of December 31, 2004, West Company has assets of $6,500 and owners' equity of $3,500. Its revenues for the year are $500. What are the liabilities for West Company as of December 31, 2004? a. $3,000 b. $3,500 c. $6,000 d. $8,500 e. None of the above 9. Lasseter Company has assets of 8,000 as of December 31, If the company has liabilities of $3,000 and net income for 2005 was $2,200 with $400 withdrawals, what was beginning capital, January 1,2005? a. $2,800 b. $3,200 c. $5,000 d. $5,500 e. None of the above 10. Siebel Company had assets as of January 1 of $300. During the month the company acquired supplies of $100 and also paid accounts payable of $50. What were the assets at the end of January? a. $150 b. $200 c. $250 d. $400 e. None of the above Accounting course materials Page 4

5 EXERCISES 1. For each of the following transactions, give the effects on Assets, Liabilities, and Owners' Equity by providing a + (increase), (decrease), or 0 (no effect). Transaction Assets Liabilities Owners' Equity a. An owner withdraw money from the business b. Acquire supplies with cash c. Acquire equipment on account d. Bill customer for services rendered e. Record depreciation f. Pay salaries for the month g. Sell goods for cash h. An owner invests money in a business i. Record the using of supplies j. Collect on customer's bill k. Pay for part of the equipment previously acquired on credit 2. On January 1, 2005, Instant Decorators, Inc., had assets of $22,000, and capital of $16,000. If, during 2005, the business repays $2,000 of loans outstanding, buys $1,000 of office supplies, has revenues of $7,000 with expenses of $10,000, and the owner withdraws $500 from the business, how much is in assets, liabilities, and capital as of December 31,2005? 3. Mr. Goodman, an engineer, has been in business for a month. The business has cash of $4,000, accounts receivable of $2,000, office furniture of $1,500, supplies of $100, and liabilities of $3,000. Listed at the top of page 7 are the transactions for the month of November: November: 2 Pays rent for office space, $250 for the next month, 4 Acquires equipment issuing a note for $700. Goodman feels he could have built the equipment himself for $ Employs a second part-time secretary-receptionist. 9 Receives $500 in cash from a customer for a project finished last month. 12 Pays miscellaneous office expenses, $40. Bills a customer for services rendered, $ Pays Caro Company on account, $ Withdraws $600 from the business. 23 Pays the office salary, $ Invests another $1,000 in the business. 30 Uses $45 for supplies during the month of November, Required: Record the above transactions using the equation format given below. Accounting course materials Page 5

6 Transaction Number Cash Accounts Receivable Assets = Liabilities + Owners' Equity Office Prepaid Equipment = Accounts Notes Capital Supplies Rent Payable Payable PART 2. PROCEDURE OF RECORDING THE TRANSACTIONS OBJECTIVES The objectives of this part are: To illustrate the nature and significance of accounts. To explain how journals and ledgers are used in the accounting system. To discuss how business transactions are recorded using the double entry accounting system and the rules of debits and credits. To show how to determine account balances. To illustrate the recording and summarizing of financial accounting activity as follows: Record entries in the general journal and prepare the financial statements. HIGHLIGHTS 1. a. An account is a record of each item appearing in the financial statements. Thus, there is an account for each asset, each liability, each owners' equity item, each revenue, and each expense. The account is the basic building block for any accounting system. The complete listing of all numbered accounts found in the accounting system of an entity is called the chart of accounts. b. The account has three parts: (1) the account title, (2) location for increasing the account, and (3) location for decreasing the account. For learning purposes, accounts are depicted with in creases on one side and decreases on another and the title above-the account looks like a T and thus is called a T-account. c. A ledger is a group of accounts. The general ledger is a book containing all the accounts of the economic entity. Several general ledger accounts such as accounts receivable and accounts pay Accounting course materials Page 6

7 able contain only the balances and the detailed records are reflected in a separate subsidiary ledger. In this case, the general ledger account is called the control account. The amounts in the control account and the balance in the subsidiary ledger of course must equal. d. The general ledger contains the accounts in the following order: all asset accounts, then all liability accounts, then owners' equity, then withdrawals, followed by revenue accounts, and finally, the expense accounts. As you can see, balance sheet accounts appear first followed by the income statement accounts. e. Assets can be subdivided into two classifications: current assets and noncurrent assets. Current assets are those resources which are expected to be used up or provide benefit within one year and noncurrent assets are resources which are used in the business and are expected to provide benefit for longer than one year. f. Several typical current asset accounts found in a business are: (1) Cash. Coins, currency, checks, money orders, certificates of deposit, savings accounts, and "NOW" accounts of the entity. (2) Notes receivable. Contractual agreement whereby the entity has lent money or provided services to someone else ("the maker") and the entity has a promise of payment at a specified time from the maker. (3) Accounts receivable. Agreement from customers of future payment for goods and services provided by the entity. (4) Inventory. Goods sold by retail stores, wholesale companies, and manufacturing concerns. (5) Prepaid expenses. Prepaid economic benefits that will not be used until they contribute to the earnings process. Examples are prepaid rent, prepaid insurance, and prepaid supplies. g. Several typical noncurrent assets found in a business are: (1) Land. Land used by the entity (not just held as investment). Land is considered to have an infinite life and therefore is not depreciated. (2) Buildings. Structures which are used by the entity in its operations. Buildings are depreciated over their useful lives. Depreciation refers to the process of cost allocation over the useful life of the asset by recognizing as a period expense. (3) Equipment. Items used in the business with limited useful lives such as office machines, desks, autos, trucks, and cabinets. Depreciation expense is also recognized on equipment. (4) Accumulated depreciation. A contra-asset account (offset to buildings or equipment) that reflects the cumulative depreciation recognized to date on the building or equipment. Thus, depreciation expense appears on the income statement as the cost allocation for the current period and accumulated depreciation reflects on the balance sheet the total of all periods depreciation recognized as of a given date for buildings or equipment. h. Liability accounts are classified as current liabilities and long-term liabilities. Current liabilities are those expected to mature within a year and long-term liabilities mature in longer than a year. i. Typical current liabilities include: (1) Notes payable. Written agreement whereby the entity borrows money and promises to repay at a specific future date. (2) Accounts payable. Agreement to pay a vendor for goods or services provided by the vendor. (3) Salaries payable. Unpaid salaries due to employees. (4) Unearned revenues. Obligation to provide goods or services in the future-and for which the entity has already received payment. j. Typical long-term liabilities include: (1) Mortgage payable. Debt for which the entity has pledged certain assets as security to the debtor. (2) Bonds payable. Financing accomplished through the issuance of bond certificates. Accounting course materials Page 7

8 k. The Owners' Equity accounts include: (1) Capital. Represents the investments made by the owners of the entity and permanent increases or decreases in ownership. (2) Drawing. Represents the owners' withdrawals during the period. l. A separate revenue account is established for each source of earnings for the period. Typical revenue accounts are: sales, commission earned, and interest income. m. A separate expense account is also set up for each cost incurred by the entity during the period. Typical expense accounts are: cost of goods sold, depreciation expense, rent expense, supplies expense, insurance expense, and salaries expense. The efficient recording process has been designed as follows: A journal is a chronological record of all business transactions. It is also known as book of original entry. Each transaction has a debit and a credit. Debits must equal credits (double-entry accounting system). The ledger contains the activity for each and all accounts; thus, each ledger (T-account) is a picture of what happened involving that account. All T-accounts have debits on the left side of the account and credits on the right side. The accounts in the general ledger are called control accounts; detailed data for the control account are found in the subsidiary ledger. A trial balance is a list of all accounts and their respective debit or credit balances. If a trial balance does not balance, look for errors (transposition, slide, posting, math, and account balance errors). From the trial balance, select the income statement accounts and prepare first the income statement, then the statement of owners' equity, and finally, the balance sheet. 4. a. Debits and credits are terms used to refer to whether a particular account is increased or de creased when recording a transaction. b. Remember: Assets = Liabilities + Owners' Equity Current assets + noncurrent assets = current liabilities + long-term liabilities + capital at end of period Current assets + noncurrent assets = current liabilities + long-term liabilities + capital at beginning + revenue expenses withdrawals Normally, increase accounts on this side of the equation with debits, decrease with credits = Normally, on this side of the equation, increase with credits, decrease with debits. c. Note, expenses and withdrawals have negative sign (they are negative owners' equity accounts) so they behave in the opposite manner to other accounts on that side of the equation: They increase with a debit and decrease with a credit. d. From the foregoing, we arrive at the following table: To Increase To Decrease Accounting course materials Page 8

9 Assets Debit Credit Liabilities Credit Debit Capital Credit Debit Revenue Credit Debit Expense Debit Credit Withdrawals Debit Credit e. The way to increase each account indicates the normal balance of that account. Thus, an asset normally has a debit balance. f. The contra-asset account, accumulated depreciation, would be increased the opposite of an asset with a credit. g. So, Asset Liability Capital Revenue Expense Withdrawal Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit To decide how to record a transaction, ask four simple questions: a. Which accounts are involved in the transaction (i.e., cash, accounts payable, etc.)? b. Is each account being increased or decreased! c. What type of account is each (i.e., asset, liability, etc.)? d. How is that type of account increased or decreased? With a debit or a credit? Example: Purchase of office supplies with cash. a. Cash and office supplies are accounts affected. b. Office supplies should be increased, cash decreased. c. Each is an asset account. d. Assets are increased with debits, decreased with credits. So debit office supplies, credit cash Office Supplies... (dr.) Cash.. (cr.) 6. a. Each journal entry should have six components: (1) date, (2) account to be debited, (3) amount to be debited, (4) account to be credited, (5) amount to be credited, and (6) explanation of the transaction. b. Each posting should consist of the following steps: (1) locate in ledger the account debited in the journal entry and record date and amount and journal page number in ledger, (2) enter ledger account number in journal's posting reference column, (3) repeat steps (1) and (2) for credit account. TRUE OR FALSE Circle either T (True) or F (False) for each of the following: T F 1. The book of original entry, also known as the general ledger book, contains all transactions recorded for the period. T F 2. Common noncurrent asset accounts include buildings, land, and inventory. T F 3. Examples of expense accounts are: supplies expense, prepaid expenses, and rent expense. T F 4. The trial balance provides only an assurance and not positive proof that the recording process was Accounting course materials Page 9

10 accurately accomplished. T F 5. Land is normally depreciated over a 40-year useful life. T F 6. Bonds payable has a normal credit balance T F 7. The first step in the recording process is to post to the ledger. T F 8. Accumulated depreciation normally has a credit balance. T F 9. An account is a record of each item appearing in the financial statements. T F 10. In the trial balance, noncurrent assets are normally listed first, then current assets. T F 11. The trial balance ensures that all entries were posted correctly. T F 12. Withdrawals and expenses are synonymous terms. T F 13. Capital is synonymous with revenues. T F 14. The general ledger is also called the control account. T F 15. All T-accounts have debits on the left, credits on the right. MULTIPLE CHOICE Circle the best alternative. Choose only one alternative per question. 1. Which of the following group of accounts increases with a debit? a. Assets, capital, and expenses. b. Liabilities, revenues, and capital. c. Assets, liabilities, and revenues. d. Expenses and assets. e. None of the above. 2. A company's total assets would be increased by: a. Its investment in the entity. b. Its cash collection of an account receivable. c. Its sale of equipment for a price equal to its cost, d. Each of the above transactions. 3. The bookkeeper left work early on December 31, 2007 and did not get to record the cash purchase of new equipment. What is the effect of the error in 2007? a. Total assets are understated. b. Net income is understated. c. Total liabilities are understated. d. No effect on total assets or total liabilities. 4. An event that should be formally recorded as a transaction by a company would be: a. Mailing an order for merchandise to be purchased next month. b. The conviction of the company president for fraud. c. The acquisition of land by trading equipment equal in value to the land cost. d. The resignation of the company's chief accountant. Problem 5 is based on the following information extracted from comparative balance sheets of C.I.B. Co.: Ending Capital $5,000; Ending Liabilities $6,000; Beginning Assets $18,000; Withdrawals made during the period $3,000; Beginning Liabilities $15,000; and Investment made during the period $1, Net income for the period and ending assets are: a. Cannot be determined from the data given. b. $4,000 net income and $11,000 ending assets. c. $6,000 net income and $15,000 ending assets. d. None of the above. 6. Which of the following is true? a. Every transaction that affects an income statement ac Accounting course materials Page 10

11 count also affects a balance sheet account. b. Every transaction that affects a balance sheet account also affects an income statement account. c. Every transaction that affects an expense account also affects an asset account. d. Every transaction that affects a revenue account also affects another income statement account. e. None of the above. 7. A trial balance will indicate the existence of an error if: A journal entry debiting Building is posted as a debit to the Repairs Account. b. A ledger account with a credit balance is listed as a debit amount in the trial balance. c. A purchase of a desk for $800 is entered in the accounting records as a debit of $80 to Office Supplies and a credit of $80 to Accounts Payable. d. The collection of $375 cash is recorded by a debit to Accounts Receivable and credit to Cash. e. None of the above errors will be indicated by the preparation of a trial balance. EXERCISES 1. Give the effects of each of the following errors on assets, liabilities, and capital. Use (+) for overstated, ( ) for understated, and (0) for no effect. Transaction Assets Liabilities Capital a. Machine purchased was recorded as an expense. b. No depreciation was recorded. c. Payment made on outstanding note payable was recorded as receipt from customers for payment on their account. d. Recorded cash expense as $100 instead of correct $40 amount. e. Tools instead of Equipment was increased when equipment was purchased. f. Withdrawal was recorded as investment. g. Revenue received in cash was recorded as revenue on account. h. Revenue collected and earned was recorded as unearned. Accounting course materials Page 11

12 2. The Trial Balance of the Plants Company is presented below and does not balance. PLANTS CO. Trial Balance As of August 31,2007 Cash $ 700 Accounts Receivable 850 Office Supplies 250 Equipment 620 Accounts Payable $ 530 Plants Co. Capital 1500 Fees Revenue 510 Office Expenses 240 $ 2660 $ 2540 An examination of the General Ledger reveals the following errors. a. Accounts Receivable was debited $180 and Fees Revenue credited $18. The correct amount was $180. b. Office equipment with cost of $65 was charged to Office Expenses when purchased on account. The credit was made to Accounts Payable. c. The Office Supplies account was totaled as $250 instead of the correct $292. d. Payments made on accounts payable were recorded as $45 instead of $55 (both debit and credit were entered as $45). Required: (1) State whether each of the above items would cause the Trial Balance to be out of balance. (2) Prepare a corrected Trial Balance. 3. The Balance sheet of PHD TUTOR as of May 1, 2006 is presented below. Account numbers are provided PHD TUTOR Balance Sheet As of May 1, Cash $ Accounts Receivable Supplies on Hand Teaching Equipment Accounts Payable $ Tutor on Wheels Capital 2803 $ 4425 $ 4425 The following transactions occurred during the month of May, May: 2 Paid Learning Equipment, Inc. $106 for equipment purchased in April. 5 Received payment of $894 on Accounts Receivable, 6 Purchased special supplies on account from Book Center, Inc., $95. 9 Billed students for classes given, $ Received $110 for class taught that afternoon. 15 Paid monthly salaries, $720. Accounting course materials Page 12

13 19 Paid lease for teaching van, $288, 22 Paid gasoline expense, $ Received $240 from students previously billed. 28 Withdrew $600 for owner's personal use. Required: a. Set up ledger accounts for each of the balance sheet accounts. In addition, you will need the following accounts: no. 7 Tutoring Revenues, no. 8 Salaries Expense, no. 9 Lease Expense, no. 10 Gasoline Expense, and no. 11 Withdrawals. Enter the balance amounts in the corresponding ledger balances. b. Prepare general journal entries for the transactions for the month of May. c. Post the transactions to the general ledger. d. Prepare the trial balance as of May 31, e. Prepare an income statement, statement of changes in owners' equity, and a balance sheet. General Journal Entries Debit Credit Accounting course materials Page 13

14 General Ledger (1) Cash (2) Accounts Receivable (3) Supplies on Hand (4) Teaching Equipment (5) Accounts Payable (6) PHD TUTOR Capital (7) Tutoring Revenues (8) Salaries Expense (9) Lease Expense (10) Gasoline Expense (11) Withdrawals PHD TUTOR Accounting course materials Page 14

15 Trial Balance As of May 1,2006 PHD TUTOR Income Statement As of May 1,2006 PHD TUTOR Statement of Changes in Owners Equity As of May 1,2006 Accounting course materials Page 15

16 CHAPTER 2 PART 1. PERIODIC PROCEDURES, FINANCIAL STATEMENTS OBJECTIVES The objectives of this part are: To distinguish between external and internal transactions. To discuss the nature and preparation of adjusting entries. To explain the various steps involved in the accounting process including the adjusted trial balance. To contrast the cash and the accrual basis of income and explain the revenue recognition principle and matching concept, both of which are found in the accrual basis of accounting. To illustrate a classified balance sheet. HIGHLIGHTS 1. In the accounting model developed in earlier parts, we discussed the recording of external transactions (exchange with an outside party and thus an event for which a signal is received to record the event). After all external transactions were recorded, the data were summarized into financial statements and these statements were given to users for decision-making. 2. In this part, we will discuss internal transactions called adjustments, which are necessary to update at the end of a period, the income statement and balance sheet accounts before the data are all summarized and the financial statements prepared. Adjusting entries do not involve a signal to record them since there is no exchange with an external party at that point in time. Accounting course materials Page 16

17 Also, each adjusting entry affects a balance sheet account and an income statement account 3. There are four basic adjusting entries and two types (prepayments and accruals) of adjusting entries: PREPAYMENTS (1) To recognize that prepaid asset have expired or been used up and expense has arisen: During period: We prepaid expense (unexpired cost or asset) Now: At end of period, we have used up asset or "expired the cost" Depreciation is similar but instead of decreasing asset directly, use accumulated depreciation (contraasset account). Entry:... Depreciation Expense (dr.) Accumulated Depreciation.. - (cr.) Noncurrent asset (other than land) acquired As time passes, allocate cost through depreciation expense (2) To recognize that prepaid revenue has now been earned and no longer is unearned: Entry: Unearned Revenue (dr.) Revenue. (cr) During period: We were prepaid for revenue. Since we had not performed, we recorded as i lability, unearned revenue Now: At end of period, we have performed so decrease liability and recognize revenue ACCRUALS Expense has been incurred or revenue has been earned but cash is not involved yet and no entry has been made. Notice, with accruals, there is no previous entry as is the case with prepayments. (3) Accrued Expenses: Entry: Accounting course materials Page 17

18 Salaries Expense.... (dr.) Salaries Payable.... (cr.) We have incurred expense and recognize liability (4) Accrued Revenues: Entry: Interest Receivable... (dr.) Interest Revenue.... (cr.) Have earned revenue and recognize asset 5. The balance sheet can be prepared on a more classified basis (instead of just current assets and non-current assets). There are really 5 categories of assets: current assets; investments; property, plant and equipment; intangible assets; and other assets. 6. The income statement can be prepared also more specifically by categories or functions of revenue and expenses. This is known as a multiple-step income statement and is illustrated below. The basic categories are: (1) the gross margin for merchandise, (2) selling expense, (3) general administrative expense, and (4) tax expense. X CO. Income Statement For the Year Ended Sales Less: Cost of Goods Sold Gross Margin $xx xx $xx Less: Selling Expenses $xx Freight xx Sales Commissions $xx (xx) Other Expenses Less: General and Administrative Expenses: Depreciation Expense $xx Salaries Expense xx Other Expenses xx (xx) Operating Income $ Less: Tax Expense ( ) Net Income XX X CO. Statement of Changes in Owners Equity For the Year Ended Capital, Beginning Balance $xx Add: Net Income + xx Less: Withdrawals ( ) Capital, Ending Balance $xx Accounting course materials Page 18

19 X CO. Balance Sheet For the Year Ended Current Assets: Current Liabilities: Cash Accounts Payable Accounts Receivable Interest Payable Inventory Salaries Payable Prepaid Expenses Unearned Revenue Investments: Long-Term Liabilities: Investment in C Co. Stock Notes Payable Property, Plant and Equipment: Bonds Payable Buildings Total Liabilities Less: Accumulated Depreciation Owners Equity: Equipment Capital Less: Accumulated Depreciation Intangible Assets: Goodwill Other Assets: Land Held for Speculation TOTAL ASSETS TOTAL LIABILITIES & OWNERS EQUITY 8. Current assets are those expected to be used during the year or the operating cycle, whichever is longer. They are listed in order of liquidity (closest to cash form). Operating cycle refers to the time it takes from the original purchase of merchandise to the collection of accounts receivable of the credit sales from cash to cash. Most operating cycles are less than a year so normally current assets are those to be used up during the year. Typical current assets are: cash, accounts receivable, marketable securities, inventory, and prepaid expenses. Purchase merchandise Sell merchandise on credit sales Operating cycle Collect cash from A/R 9. Investments are those bond or stock securities intended to be kept for longer than a year. 10. Plant and Equipment. Tangible long-term assets used to produce goods or services in business. Typical property, plant, and equipment accounts are land, buildings, and equipment. Buildings and equipment are the only accounts for which depreciation is taken. The cost minus the accumulated depreciation to date is called book value. 11. Intangibles. Legal or economic future benefits of a business. Examples are goodwill, patents, and copyrights. 12. Current liabilities are obligations due within a year and long-term liabilities are those that mature after a year. Both are listed in order of liquidity. 13. Accrual basis refers to recognizing expenses and revenues when incurred or earned rather than when paid or received. The accrual basis of accounting rather than cash basis is the only acceptable basis for adjusting entries. 14. Additional generally accepted accounting principles discussed in this part are: a. Time period principle. Convention stating that financial statements should be prepared on a regular basis. b. Revenue recognition principle. Revenues must be recognized when earned (not when cash is Accounting course materials Page 19

20 received). c. Matching principle. Expenses incurred during the period must be associated with revenues earned during that period. 15. Remember, a T-account gives you a full picture of an account. It is very useful when trying to deter mine any component of the account. If you need to determine supplies bought during a period and you know that the Beginning Balance = $25, the Ending Balance = $10, and Supplies Used = $30, then you can reconstruct a T-account to show that Supplies Bought = $ ? 30 = 10? = ? = 15 Supplies on Hand MULTIPLE CHOICE Circle the best alternative. Choose only one alternative per question. 1. With respect to property, plant, and equipment (P.P.E.), which of the following is false? a. Depreciation is not recorded for all P.P.E. accounts. b. The cumulative depreciation is reflected in a contra asset rather than as a decrease of the original account. c. Book value refers to the cash payment (historical cost) originally recorded far- a particular asset. d. Original cost is preserved to indicate to users potential needs for replacement of the assets. 2. Which one of the following statements is true? a. Current assets include cash, marketable securities, capital, accounts receivable, and prepaid expenses. b. The operating cycle is the length of time the entity expects to be in business. c. Current assets are listed in order of their liquidity. d. Investments refers to the total capital invested in the business entity. 3. Generally accepted accounting principles dictate that accrual and not cash be used as the basis for recognition of expenses and revenues. The reason for this is: a. Investors are not interested in the cash flow of a business entity. b. A cash basis system is more difficult to maintain. c. Accrual basis better reflects the economic substance of all transactions. d. More than one of the above are valid. 4. Stewart Company had the following adjustments in February: Accrued Salaries $100, Accrued Interest Revenue $65, and recognized that $180 of Unearned Revenue previously recorded had now been earned. What is the net effect of these adjustments on cash? a. Decrease of $35. b. Zero effect. c. Increase of $145. d. None of the above. e. Cannot be determined from the above information. 5. Which of the following is a revenue account? a. Unearned Revenue. Accounting course materials Page 20

21 b. Capital. c. Service Fees Revenue. d. More than one of the above. 6. An example of the recognition of an expired cost transaction is: a. Purchase of a building. b. Investment made. c. Payment of a liability.. d. None of the above. 7. Assets would be overstated if which of the following necessary adjusting entries was omitted? a. Expired Insurance. b. Accrued Salaries. c. Accrued Interest Earned. d. Revenue was earned which had been collected in advance during the period it was earned. 8. The Even Company purchased a truck on January 1, The bookkeeper erroneously entered it into the Building Account. The offsetting credit was correctly recorded to Notes Payable. What effect will this error have on Net Income and Total Assets for 2006? (Disregard Depreciation.) a. No effect on Net Income and overstates Total Assets. b. Overstates Net Income and understates Total Assets. c. No effect on Net Income and understates Total Assets. d. Understates Net Income and overstates Total Assets. e. None of the above. 9. Carol Company bought on January 1, 1978, land with useful life of at least 20 years for $30,000. On December 31, 1980, it sold the land for $50,000. The company uses straight-line depreciation for depreciable assets. What amount did the company report in its 1980 income statement as a result of this transaction? a. $7,000 b. $20,000 c. $33,000 d. None of the above, EXERCISES Which of the following would require adjusting entries? Answer "yes" or "no". If answer is yes, provide the entry. a. A count of the supplies on hand at the end of the period revealed that $100 was on hand. Beginning balance of supplies on hand was $60 and $55 was purchased during period. b. Rent expense of $20 for the month is paid. c. Collection of accounts receivable, $15 d. Cash received to perform services in the future, $20. e. Depreciation recorded, $10. f. Revenue previously reflected as an obligation is earned for $18, Accounting course materials Page 21

22 g. Salaries accrued in previous period for $20 are paid this period. Total payment is $35. h. Interest for two months on $5,000,6%, 9-month note is accrued. i. Salaries are accrued, $21. j. A withdrawal of capital for $45 is made. k. A $300 3-year insurance policy was bought 6 months ago. It is now time to prepare financial statements. 2, The accounts presented below for the Green Gardening Company are taken from the unadjusted trial balance and are in alphabetical order without any amounts. Accounts Payable Inventory Accounts Receivable Investment in Stock Accumulated Depreciation: Buildings & Equipment Land Advertising Expense Mortgage Payable (10-year) Buildings Patents Cash Prepaid Advertising Depreciation Expense Salaries Expense Equipment Salaries Payable Gardening Revenue Taxes Payable Goodwill Unearned Revenue Green, Capital Withdrawals Required: Prepare a classified balance sheet and income statement from the above accounts for Green for yearend As of December 31,2007, Anna Company had the following account balances: Inventory $ 21,000 Accumulated Depreciation $10,000 Capital 36,000 Land 15,000 Plant and Equipment 60,000 Accounts Payable 50,000 Notes Payable (3-year) 40,000 Accounts Receivable 34,000 Cash 17,400 Notes Receivable (1-year) 10,000 Prepaid Insurance (2-yr.) 3,600 Unearned Revenue 25,000 During January 2008, the following occurred: a. The company was notified that it could borrow up to $25,000 if it wanted. Accounting course materials Page 22

23 b. $12,000 was invested in the business. c. The company purchased merchandise for $5,000 cash and $9,000 on account. d. It collected $23,000 of the accounts receivable. e. It sold merchandise for $10,000 cash and $18,000 on account. f. It paid 3-months rent, $6,000. g. It paid $32,000 of the balance for previous credit purchases. h. The president of the company put a $30,000 down payment on his new $150,000 home and took a mortgage for the balance. i i. The company withdrew $1,400 during the month. The following adjustments were made at the end of January: a. Accrued one month's interest on the 12% notes receivable. b. Depreciated the plant and equipment for 1 month, assuming a 5-year useful life. c. Adjusted for 1 month's rent expired. d. Adjusted for 1 month's insurance expired. e. Accrued for 1 month's interest on 6% notes payable. f. Earned one-half of the unearned revenue. Required: (1) Enter the account balances in the ledger. (2) Journalize the transactions during January 2008 as well as the adjustments at the end of January (3) Post the information to the ledger, (4) Prepare an adjusted trial balance. (5) Prepare the income statement, statement of changes in owners' equity, and balance sheet. General Journal Entries Debit Credit Accounting course materials Page 23

24 General Ledger: Accounting course materials Page 24

25 ANNA CO. Adjusted Trial Balance As of Jan. 31,2008 ANNA CO. Income Statement As of Jan. 31,2008 ANNA CO. Statement of Changes in Owners Equity As of Jan. 31,2008 ANNA CO. Balance Sheet Accounting course materials Page 25

26 As of Jan. 31,2008 PART 2. ACCOUNTING CYCLE AND THE WORKSHEET OBJECTIVES The objectives of this part are: To explain the nature of and accounting procedures for closing entries. To describe the purpose of a worksheet and how it is used. To expand on the steps in the accounting process to include the postclosing trial balance and optional reversing entries. To analyze the rationale for and significance of reversing entries if used in a business. HIGHLIGHTS Business event Record transaction according to GAAP Financial Statement s Users of financial statement s Decision making 1. a. The closing of revenue and expense accounts (temporary or nominal accounts) is necessary to determine the net income for each separate period and to the transfer net income of each period to the capital account. Accounting course materials Page 26

27 b. There are four basic closing entries: (1) Close Expenses: Entry: Expense and Revenue Summary.... (dr.) Expenses.... (cr.) Expense accounts normally have debit balances, so to zero out each expense account would be credited. (2) Close Revenues: Revenues.... (dr.) Expense and Revenue Summary.... (cr.) Revenue accounts normally have credit balances, so to zero out each revenue account would be debited. Entry: (3) Close Expense and Revenue Summary: Expense and Revenue Summary.... (dr.) Capital.... (cr.) The Expense and Revenue Summary is an account used only to aid in the closing process and does not appear on any of the financial statements. Therefore, it too must be zeroed out and the balance of net income transferred to the capital account. Normally, the Expense and Revenue Summary will have a credit balance before closing and so would be debited to zero out. However, if expenses exceeded revenues (resulting in a loss), the Expense and Revenue Summary would have a debit balance and would have to be credited to close it out. (4) In addition, the withdrawal account must be closed to the capital account so that the capital account on the balance sheet reflects all the cumulative changes to that account. Note that the withdrawal account is not an expense account; it represents the owners withdrawal of funds at various times but is not a necessary operating expense of the entity. The closing entry could be: Capital..... (dr.) Withdrawal.... (cr.) Now in the general ledger, the Capital account would show Capital at the Beginning + Net Income Withdrawals = Capital at the end. Accounting course materials Page 27

28 c. The Capital account, as well as other balance sheet accounts, are called real or permanent accounts since the balances carry over from period to period. 2. a. A worksheet is a multi-column paper designed to assist in the period-end accounting procedures. It contains the following column headings: Unadjusted Trial Balance Adjustments Adjusted Trial Balance Income Statement Balance Sheet Debit Credit Debit Credit Debit Credit Debit Credit Debit Credit b. The accounts are listed in balance sheet order (assets, liabilities, capital, withdrawal) and then income statement order.(revenues, expenses). If additional accounts are necessary, they can be added at the bottom. c. The adjusted trial balance contains ths.net balance of each account after considering the adjustments (i.e., unadjusted trial balance amount + or adjustment amount). d. The account balances in the adjusted trial balance columns are then entered either in the Income Statement columns or the Balance Sheet columns, depending on which one they should appear in. e. The net income is transferred to Capital as follows (the bottom part of the worksheet). Income Balance Sheet Statement Debit Credit Debit Credit Totals Net Income/Loss $11 9 $20 $114 $105 9 Totals $20 $20 $114 $114 In this case the $9 represents the net income and thus is entered as a credit on the Balance Sheet column in order to add to the capital account. 3. Monthly or quarterly financial statements are known as interim statements. Interim statements can be prepared directly from the worksheet each month and the adjusting and closing entries for each month can be entered on the worksheet. However, the adjusting and closing entries are not formally recorded in the books until year-end. Company policy would dictate the frequency of the formal journalization and posting of adjusting and closing entries. 4. Trial balances can be prepared not only before and after adjustments but also after all the closing entries are journalized and posted to the ledger. A post-closing trial balance would contain only assets, liabilities, and capital since the revenue, expenses, and withdrawal accounts would have been zeroed out in the closing steps. 5. An entity may select initially to enter prepayments as expenses or revenue rather than, as discussed so far and which is a theoretically superior method, as assets or liabilities. If entered as expenses or revenue the adjusting entry would differ. Both methods are illustrated and contrasted below. Assume (1) supplies of $20 are bought and at the end of the period only $4 of supplies are on hand and that (2) subscriptions of $35 are received and at the end of the period $15 worth of subscriptions are still not delivered and thus not earned. If initially recorded as asset If initially recorded as expense Accounting course materials Page 28

29 Initial Entry: Supplies on Hand Expenses...20 Initial Entry: Supplies Expense Cash...20 Adjustment: Supplies Expense Supplies on Hand...16 If initially recorded as liability Supplies on Hand... 4 Supplies Expense... 4 If initially recorded as revenue Initial Entry: Cash Unearned Revenue...35 Initial Entry: Cash Subscription Revenue...35 Adjustment: 6. Unearned Revenue Subscription Revenue...20 Subscription Revenue Unearned Revenue...15 a. Reversing entries are optional entries made at the beginning of a period to "facilitate the recordkeeping process and to achieve internal consistency. If an entity chooses to use reversing entries, the entity would reverse (do the opposite of) certain adjusting entries. Reversing entries would be made for (1) all accrued revenues and accrued expenses and (2) for prepayments which are originally entered as expense or revenue/nominal accounts. b. Example of accrued salaries expense: (1) Regular entry each week for 5 days work: Salaries Expense Cash (2) Adjusting entry each at end of month, June 30 (on Wednesday): Salaries Expense Salaries Payable (3) Closing entry at end of month: Income Summary Salaries Expense (4) Reversing entry (opposite of adjusting entry) on Thursday, July 1: Salaries Payable Salaries Expense Accounting course materials Page 29

30 (5) Regular entry on Friday, July 2 (end of first week of July): Salaries Expense Cash As you can see, by choosing to make reversing entries the clerk or computer can make the same regular entry even if an adjusting entry had been made at the end of the previous period. If the entity did not make reversing entries, the entry on Friday, July 2 would be: Salaries Payable Salaries Expense Cash c. Example of accrued rent income: (1) Regular entry for receipt each Saturday for 7 days rent: Cash Rent Income (2) Adjusting entry at end of January 31 (on Wednesday): Rent Receivable Rent Income (3) Closing entry at end of month: (4) Reversing entry : Rent Income Income Summary Rent Income Rent Receivable (5) Regular entry on Saturday, February 3: Cash Rent Income If the entity did not make reversing entries, the entry on Friday, February 3 would be: Salaries Payable Rent Receivable Rent Income d. Example prepaid supplies (entered originally as expense). It is assumed that the supplies will Accounting course materials Page 30

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