CH 3: The Accounting Information System

7. Which of the following is not a recordable event or item? (LO 1) (a) Changes in managerial policy. (b) Sales of the company's product in overseas markets. (c) Declaration of dividends. (d) Purchase of supplies.

(a) Changes in managerial policy. All sales, the declaration of dividends, and the purchase of supplies are recordable events. While changes in managerial policy may be important, the company does not record them in the accounts.

2. _________ is the process of transferring the accounts and amounts from the book of original entry to the ledger accounts. (LO 1) (a) Journalizing. (b) Posting. (c) Closing. (d) Ledgerizing.

(b) Posting. Posting is the process of transferring the accounts and amounts from the book of original entry to the ledger accounts.

5. Which of the following is not transferred to Retained Earnings at the end of the period? (LO 1) (a) Revenues. (b) Dividends. (c) Common stock. (d) Expenses.

(c) Common stock. A company transfers dividends, revenues and expenses to retained earnings at the end of the period. Common stock is a stockholders' equity account, and is not closed to retained earnings at the end of the period.

Closing Cautions

A couple of cautions about preparing closing entries. (1) Avoid unintentionally doubling the revenue and expense balances rather than zeroing them. (2) Do not close Dividends through the Income Summary account. Dividends are not expenses, and they are not a factor in determining net income.

ledger

The book (or computer printouts) containing the accounts. A general ledger is a collection of all the asset, liability, stockholders' equity, revenue, and expense accounts. A subsidiary ledger contains the details related to a given general ledger account.

closing entries

The formal process by which the enterprise reduces all nominal accounts to zero and determines and transfers the net income or net loss to a stockholders' equity account. Also known as "closing the ledger," "closing the books," or merely "closing."

posting

The process of transferring the essential facts and figures from the book of original entry to the ledger accounts.

Stockholders' Equity T-Ledgers for: Common Stock? Retained Earnings? Dividends? Revenues? Expenses?

Common Stock : DR - ; CR + Retained Earnings? DR - ; CR + Dividends? DR + ; CR - Revenues? DR - ; CR + Expenses? DR + ; CR -

Assets T-Ledger

Debit + Credit -

Included in Pro Engineering's December 31 trial balance is unearned revenue of $12,000. Management reviewed the company's progress on the underlying contracts and determined that $7,000 of revenue should be recognized. Prepare Pro Engineering's December 31 adjusting entry.

Dec. 31 Unearned Revenue 7,000 Service Revenue 7,000

Types of adjusting entries

Deferrals: 1.Prepaid expenses: Expenses paid in cash before they are used or consumed. 2.Unearned revenues: Cash received before services are performed. Accruals: 1.Accrued revenues: Revenues for services performed but not yet received in cash or recorded. 2.Accrued expenses: Expenses incurred but not yet paid in cash or recorded.

Summary of Reversing Entries

We summarize guidelines for reversing entries as follows. 1.All accruals should be reversed. 2.All deferrals for which a company debited or credited the original cash transaction to an expense or revenue account should be reversed. 3.Adjusting entries for depreciation and bad debts are not reversed. Recognize that reversing entries do not have to be used. Therefore, some accountants avoid them entirely.

real (permanent) accounts

are asset, liability, and equity accounts; they appear on the balance sheet.

normal (temporary) accounts

are revenue, expense, and dividend accounts; except for dividends, they appear on the income statement. Companies periodically close nominal accounts; they do not close real accounts.

accounting information system

collects and processes transaction data and then disseminates the financial information to interested parties

Companies periodically close nominal accounts; they do not close ____________

real accounts.

Misey Masonry was founded in January 2013. Presented below are adjusted and unadjusted trial balances as of December 31, 2017. MISEY MASONRY TRIAL BALANCE DECEMBER 31, 2017 Unadjusted Adjusted Dr. Cr. Dr. Cr. Cash $ 15,000 $ 15,000 Accounts Receivable 20,000 24,500 Supplies 8,400 2,000 Prepaid Insurance 3,350 2,500 Equipment 65,000 65,000 Accumulated Depreciation—Equipment $ 33,000 $ 38,000 Accounts Payable 5,000 5,000 Interest Payable -0- 300 Notes Payable 10,000 10,000 Unearned Service Revenue 7,000 5,600 Salaries and Wages Payable -0- 1,300 Common Stock 12,000 12,000 Retained Earnings 5,500 5,500 Service Revenue 58,600 64,500 Salaries and Wages Expense 15,000 16,300 Insurance Expense 850 Interest Expense 350 650 Depreciation Expense 5,000 Supplies Expense 6,400 Rent Expense 4,000 4,000 $131,100 $131,100 $142,200 $142,200 Instructions (a)Journalize the annual adjusting entries that were made. (Omit explanations.) (b)Prepare an income statement and a statement of retained earnings for the year ending December 31, 2017, and an unclassified balance sheet at December 31. (c)Answer the following questions. 1.If the note has been outstanding 3 months, what is the annual interest rate on that note? 2.If the company paid $17,500 in salaries and wages in 2017, what was the balance in Salaries and Wages Payable on December 31, 2016?

(a) Dec. 31 Accounts Receivable 4,500 Service Revenue 4,500 31 Unearned Service Revenue 1,400 Service Revenue 1,400 31 Supplies Expense 6,400 Supplies 6,400 31 Depreciation Expense 5,000 Accumulated Depreciation—Equipment 5,000 31 Interest Expense 300 Interest Payable 300 31 Insurance Expense 850 Prepaid Insurance 850 31 Salaries and Wages Expense 1,300 Salaries and Wages Payable 1,300 (b) MISEY MASONRY Income Statement For the Year Ended December 31, 2017 Revenues Service revenue $64,500 Expenses Salaries and wages expense $16,300 Supplies expense 6,400 Depreciation expense 5,000 Rent expense 4,000 Insurance expense 850 Interest expense 650 Total expenses 33,200 Net income $31,300 MISEY MASONRY Statement of Retained Earnings For the Year Ended December 31, 2017 Retained earnings, January 1 $5,500 Add: Net income 31,300 Retained earnings, December 31 $36,800 MISEY MASONRY Balance Sheet December 31, 2017 Assets Cash $15,000 Accounts receivable 24,500 Supplies 2,000 Prepaid insurance 2,500 Equipment $65,000 Less: Accumulated depreciation—equipment 38,000 27,000 Total assets $71,000 Liabilities and Stockholders' Equity Liabilities Notes payable $10,000 Accounts payable 5,000 Unearned service revenue 5,600 Salaries and wages payable 1,300 Interest payable 300 Total liabilities $22,200 Stockholders' equity Common stock $12,000 Retained earnings 36,800 48,800 Total liabilities and stockholders' equity $71,000 (c) 1. Interest is $100 per month or 1% of the note payable. 1% × 12 = 12%% interest per year. 2. Salaries and Wages Expense, $16,300 less Salaries and Wages Payable 12/31/17, $1,300 = $15,000. Total Payments, $17,500 - $15,000 = $2,500 Salaries and Wages Payable 12/31/16.

4. When a dividend is declared: (LO 1) (a) assets decrease. (b) liabilities increase. (c) stockholders' equity increases. (d) All of these answer choices are correct.

(b) liabilities increase. When a dividend is paid assets decrease and liabilities decrease. When a dividend is declared, liabilities increase and stockholders' equity decreases.

1. . Factors that shape an accounting information system include the (LO 1) (a) transactions in which the business engages. (b) informational demands of management. (c) volume of data to be handled. (d) All of these answer choices are correct.

(d) All of these answer choices are correct. The transaction in which the business engages, the information demands of management, and the volume of data to be handled are all factors that shape the accounting information system.

3. Which of the following is an incorrect depiction of the accounting equation? (LO 1) (a) Assets = Liabilities +Stockholders' Equity (b) Assets - Stockholders' Equity = Liabilities. (c) Assets - Liabilities = Stockholders' Equity. (d) Assets + Stockholder's Equity = Liabilities.

(d) Assets + Stockholder's Equity = Liabilities. The accounting equation is A = L + SE. It can be rearranged as A - SE = L or A - L - SE. An incorrect depiction of the accounting equation is A + SE = L.

8. Which of the following statements about a trial balance is incorrect? (LO 2) (a) Its primary purpose is to prove the mathematical equality of debits and credits after posting. (b) It uncovers errors in journalizing and posting. (c) It is useful in the preparation of financial statements. (d) It proves that all transactions have been recorded.

(d) It proves that all transactions have been recorded. A trail balance does not prove that all transactions have been recorded.

6. When a corporation purchases a computer for cash, (LO 1) (a) liabilities increase. (b) stockholders' equity decreases. (c) assets increase. (d) the account Cash will be credited.

(d) the account Cash will be credited. When a corporation purchases a computer for cash, total assets are unchanged (because one asset is exchanged for another) and there are no changes to liabilities or stockholders' equity. When a purchase is made for cash, the cash account is credited.

event

. A happening of consequence. An event generally is the source or cause of changes in assets, liabilities, and equity. Events may be external or internal.

The top 5 economic crimes are ______________

1. asset misappropriation 2. procurement fraud 3. IP infringement 4. cybercrime 5. accounting fraud

19. To convert cash receipts from customers to revenue on an accrual basis, which of the following adjustments is necessary? (LO *7) (a) Add ending Accounts Receivable. (b) Subtract ending Unearned Service Revenue. (c) Subtract beginning Accounts Receivable. (d) All of these answer choices are correct. ANSWER (d) All of these answer choices are correct. To convert cash receipts from customers to revenue on an accrual basis, the following adjustments are made: Cash receipts from customers Subtract beginning A/R Add ending A/R Add beginning Unearned Service Revenue Subtract ending Unearned Service Revenue 20. Which one of the following guidelines (a - c) regarding reversing entries is incorrect? (LO *8) (a) All accruals should be reversed. (b) All deferrals for which a company debited or credited the original cash transaction to an expense or revenue account should be reversed. (c) Adjusting entries for bad debts are reversed. (d) None of these answer choices are correct. ANSWER (c) Adjusting entries for bad debts are reversed. Adjusting entries for bad debts are not reversed.

19_20

Supplies

A business may use several different types of supplies. For example, a CPA firm will use office supplies such as stationery, envelopes, and accounting paper. An advertising firm will stock advertising supplies such as whiteboard markers and printer cartridges. Supplies are generally debited to an asset account when they are acquired. Recognition of supplies used is generally deferred until the adjustment process. At that time, a physical inventory (count) of supplies is taken. The difference between the balance in the Supplies (asset) account and the cost of supplies on hand represents the supplies used (an expense) for the period. For example, Pioneer Advertising purchased advertising supplies costing $25,000 on October 5. Pioneer therefore debited the asset Supplies. This account shows a balance of $25,000 in the October 31 trial balance (see Illustration 3.19). An inventory count at the close of business on October 31 reveals that $10,000 of supplies are still on hand. Thus, the cost of supplies used is 15,000( aka 25,000 - 10,000). The analysis and adjustment for advertising supplies is summarized in Illustration 3.22.

bed debts

A company generally computes bad debts by adjusting Allowance for Doubtful Accounts to a certain percentage of the trade accounts receivable and trade notes receivable at the end of the period.

Journalizing Section of CH 3

A company records in accounts those transactions and events that affect its assets, liabilities, and equities. The general ledger contains all the asset, liability, and stockholders' equity accounts. An account (see Illustration 3.3) shows the effect of transactions on particular asset, liability, equity, revenue, and expense accounts. In practice, companies do not record transactions and selected other events originally in the ledger. A transaction affects two or more accounts, each of which is on a different page in the ledger. Therefore, in order to have a complete record of each transaction or other event in one place, a company uses a journal (also called "the book of original entry"). In its simplest form, a general journal chronologically lists transactions and other events, expressed in terms of debits and credits to accounts.

The Accounting Cycle Summarized

A summary of the steps in the accounting cycle shows a logical sequence of the accounting procedures used during a fiscal period: 1.Enter the transactions of the period in appropriate journals. 2.Post from the journals to the ledger (or ledgers). 3.Take an unadjusted trial balance (trial balance). 4.Prepare adjusting journal entries and post to the ledger(s). 5.Take a trial balance after adjusting (adjusted trial balance). 6.Prepare the financial statements from the second trial balance. 7.Prepare closing journal entries and post to the ledger(s). 8.Take a post-closing trial balance (optional). 9.Prepare reversing entries (optional) and post to the ledger(s). A company normally completes all of these steps in every fiscal period.

account

A systematic arrangement that shows the effect of transactions and other events on a specific element (asset, liability, and so on). Companies keep a separate account for each asset, liability, revenue, and expense, and for capital (stockholders' equity). Because the format of an account often resembles the letter T, it is sometimes referred to as a T-Account

Numerous errors may exist even though the trial balance columns agree. For example, the trial balance may balance even when a company (1) fails to journalize a transaction, (2) omits posting a correct journal entry, (3) posts a journal entry twice, (4) uses incorrect accounts in journalizing or posting, or (5) makes offsetting errors in recording the amount of a transaction. In other words, as long as a company posts equal debits and credits, even to the wrong account or in the wrong amount, the total debits will equal the total credits.

A trial balance does not prove that a company recorded all transactions or that the ledger is correct.

trial balance

A trial balance is a list of accounts and their balances at a given time. A company usually prepares a trial balance at the end of an accounting period. The trial balance lists the accounts in the order in which they appear in the ledger, with debit balances listed in the left column and credit balances in the right column. The totals of the two columns must agree. The trial balance proves the mathematical equality of debits and credits after posting. Under the double-entry system, this equality occurs when the sum of the debit account balances equals the sum of the credit account balances. A trial balance also uncovers errors in journalizing and posting. In addition, it is useful in the preparation of financial statements. The procedures for preparing a trial balance consist of: 1.List the account titles and their balances in the appropriate debit or credit column. 2.Total the debit and credit columns. 3.Prove the equality of the two columns. Illustration 3.19 presents the trial balance prepared from the ledger of Pioneer Advertising Inc. Note that the total debits ($287,000) equal the total credits ($287,000). A trial balance also often shows account numbers to the left of the account titles.

Statement Presentation

Accumulated Depreciation—Equipment is a contra asset account. A contra asset account offsets an asset account on the balance sheet. This means that the Accumulated Depreciation—Equipment account offsets the Equipment account on the balance sheet. Its normal balance is a credit. Pioneer Advertising uses this account instead of crediting Equipment in order to disclose both the original cost of the equipment and the total expired cost to date. In the balance sheet, Pioneer deducts Accumulated Depreciation—Equipment from the related asset account as follows. The book value of any depreciable asset is the difference between its cost and its related accumulated depreciation. In Illustration 3.25, the book value of the equipment at the balance sheet date is $49,600. Note that the asset's book value generally differs from its fair value. The reason: Depreciation is an allocation concept, not a valuation concept. That is, depreciation allocates an asset's cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset.

adjusted trial balance

After journalizing and posting all adjusting entries, Pioneer Advertising prepares another trial balance from its ledger accounts (shown in Illustration 3.33). This trial balance is called an adjusted trial balance. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments. Because the accounts contain all data needed for financial statements, the adjusted trial balance is the primary basis for the preparation of financial statements.

Prepaid expenses

Assets paid for and recorded before a company uses them are called prepaid expenses. When expenses are prepaid, a company debits an asset account to show the service or benefit it will receive in the future. Examples of common prepayments are insurance, supplies, advertising, and rent. In addition, companies make prepayments when they purchase buildings and equipment. Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use and consumption (e.g., supplies). The expiration of these costs does not require daily entries, an unnecessary and impractical task. Accordingly, a company like Walgreens usually postpones the recognition of such cost expirations until it prepares financial statements. At each statement date, Walgreens makes adjusting entries to record the expenses that apply to the current accounting period and to show the remaining amounts in the asset accounts. As shown above, prior to adjustment, assets are overstated and expenses are understated. Thus, an adjusting entry for prepaid expenses results in a debit to an expense account and a credit to an asset account.

Depreciation

Companies like Caterpillar or Boeing typically own various productive facilities, such as buildings, equipment, and motor vehicles. These assets provide a service for a number of years. The term of service is commonly referred to as the useful life of the asset. Because Caterpillar, for example, expects an asset such as a building to provide service for many years, Caterpillar records the building as an asset, rather than an expense, in the year the building is acquired. Caterpillar records such assets at cost, as required by the historical cost principle. To follow the expense recognition principle, Caterpillar reports a portion of the cost of a long-lived asset as an expense during each period of the asset's useful life. Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner.

Liabilities T-Ledger

Debit - Credit +

Depreciation Expense

Depreciation expense identifies that portion of the asset's cost that expired during the period (in this case, October). Without this adjusting entry, total assets, total stockholders' equity, and net income are overstated, and depreciation expense is understated. A company records depreciation expense in a single account for each piece of equipment, such as trucks or machinery, and for all buildings. A company also establishes related accumulated depreciation accounts for the above, such as Accumulated Depreciation—Trucks, Accumulated Depreciation—Machinery, and Accumulated Depreciation—Buildings.

Journal Entry Info

Each general journal entry consists of four parts: (1) the accounts and amounts to be debited (Dr.), (2) the accounts and amounts to be credited (Cr.), (3) a date, and (4) an explanation. A company enters debits first, followed by credits (slightly indented). The explanation begins below the name of the last account to be credited and may take one or more lines. A company completes the "Ref." column at the time it posts the accounts. In some cases, a company uses special journals in addition to the general journal. Special journals summarize transactions possessing a common characteristic (e.g., cash receipts, sales, purchases, cash payments). As a result, using them reduces bookkeeping time.

adjusting entries

Entries made at the end of an accounting period to bring all accounts up to date on an accrual basis, so that the company can prepare correct financial statements.

accrued expenses

Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Interest, rent, taxes, and salaries are common examples. Accrued expenses result from the same causes as accrued revenues. In fact, an accrued expense on the books of one company is an accrued revenue to another company. For example, the $2,000 accrual of service revenue by Pioneer Advertising is an accrued expense to the client that received the service. Adjustments for accrued expenses record the obligations that exist at the balance sheet date and recognize the expenses that apply to the current accounting period. Prior to adjustment, both liabilities and expenses are understated. Therefore, the adjusting entry for accrued expenses results in a debit (increase) to an expense account and a credit (increase) to a liability account. Accrued Interest. Pioneer Advertising signed a three-month note payable in the amount of $50,000 on October 1. The note requires interest at an annual rate of 12 percent. Three factors determine the amount of the interest accumulation: (1) the face value of the note; (2) the interest rate, which is always expressed as an annual rate; and (3) the length of time the note is outstanding. For Pioneer, the total interest due on the $50,000 note at its maturity date three months' in the future is , or $500 for one month. Illustration 3.29 shows the formula for computing interest and its application to Pioneer. Note that the formula expresses the time period as a fraction of a year.

Need for depreciation adjustment

Generally accepted accounting principles (GAAP) view the acquisition of productive facilities as a long-term prepayment for services. The need for making periodic adjusting entries for depreciation is, therefore, the same as we described for other prepaid expenses. That is, a company recognizes the expired cost (expense) during the period and reports the unexpired cost (asset) at the end of the period. The primary causes of depreciation of a productive facility are actual use, deterioration due to the elements, and obsolescence. For example, at the time Caterpillar acquires an asset, the effects of these factors cannot be known with certainty. Therefore, Caterpillar must estimate them. Thus, depreciation is an estimate rather than a factual measurement of the expired cost. To estimate depreciation expense, Caterpillar often divides the cost of the asset by its useful life. For example, if Caterpillar purchases equipment for $10,000 and expects its useful life to be 10 years, Caterpillar records annual depreciation of $1,000. In the case of Pioneer Advertising, it estimates depreciation on its office equipment to be $4,800 a year (cost $50,000 less salvage value $2,000 divided by useful life of 10 years), or $400 per month. The analysis and adjustment for depreciation is summarized in Illustration 3.24.

Posting closing entries

Illustration 3.37 shows the posting of closing entries and the underlining (ruling) of accounts. All temporary accounts have zero balances after posting the closing entries. In addition, note that the balance in Retained Earnings represents the accumulated undistributed earnings of Pioneer Advertising at the end of the accounting period. Pioneer reports the ending balance in retained earnings in the balance sheet. As noted above, Pioneer uses the Income Summary account only in closing. It does not journalize and post entries to this account during the year. As part of the closing process, Pioneer totals, balances, and double-underlines the temporary accounts—revenues, expenses, and dividends—as shown in T-account form in Illustration 3.37. It does not close the permanent accounts—assets, liabilities, and stockholders' equity (Common Stock and Retained Earnings). Instead, Pioneer draws a single underline beneath the current period entries for the permanent accounts. The account balance is then entered below the single underline and is carried forward to the next period (see, for example, Retained Earnings). After the closing process, each income statement account and the dividend account are balanced out to zero and are ready for use in the next accounting period.

Learning Objective 3

In order for revenues to be recorded in the period in which services are performed and for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. In short, adjustments ensure that a company like McDonald's follows the revenue recognition and expense recognition principles. The use of adjusting entries makes it possible to report on the balance sheet the appropriate assets, liabilities, and stockholders' equity at the statement date. Adjusting entries also make it possible to report on the income statement the proper revenues and expenses for the period. However, the trial balance—the first pulling together of the transaction data—may not contain up-to-date and complete data. This occurs for the following reasons. 1.Some events are not recorded daily because it is not efficient to do so. Examples are the use of supplies and the earning of salaries and wages by employees. 2.Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions. Examples of such costs are building and equipment depreciation and rent and insurance. 3.Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period. Adjusting entries are required every time a company, such as Coca-Cola, prepares financial statements. At that time, Coca-Cola must analyze each account in the trial balance to determine whether it is complete and up-to-date for financial statement purposes. The analysis requires a thorough understanding of Coca-Cola's operations and the interrelationship of accounts. Because of this involved process, usually a skilled accountant prepares the adjusting entries. In gathering the adjustment data, Coca-Cola may need to make inventory counts of supplies and repair parts. Further, it may prepare supporting schedules of insurance policies, rental agreements, and other contractual commitments. Companies often prepare adjustments after the balance sheet date. However, they date the entries as of the balance sheet date.

Prepare an annual income statement from the following adjusted trial balance. Lucky Enterprises Adjusted Trial Balance December 31, 2017 Account Debit Credit Cash $1,200 Accounts Receivable 15,300 Allowance for Doubtful Accounts $900 Prepaid Insurance 2,100 Equipment 26,500 Accumulated Depreciation 4,800 Notes Payable 10,000 Accounts Payable 3,300 Salaries and Wages Payable 1,800 Interest Payable 100 Common Stock 16,000 Retained Earnings 7,600 Dividends 2,500 Service Revenue 125,400 Salaries and Wages Expense 85,900 Rent Expense 23,600 Supplies Expense 4,500 Insurance Expense 4,000 Interest Expense 800 Bad Debt Expense 1,200 Depreciation Expense 2,300 $169,900 $169,900

Lucky Enterprises Adjusted Trial Balance December 31, 2017 Revenues Service Revenue $125,400 Expenses Salaries and Wages Expense $85,900 Rent Expense 23,600 Supplies Expense 4,500 Insurance Expense 4,000 Interest Expense 800 Bad Debt Expense 1,200 Depreciation Expense 2,300 Total Expenses 122,300 Net Income $3,100

Pro Engineering, Inc. had the following transactions during the first month of business as a proprietorship. Journalize the transactions. (Omit explanations.) Mar. 1 Invested $25,000 cash. 3 Purchased $7,200 of equipment for the business with cash. 6 Purchased supplies on account for $800 (Debit asset account). 15 Paid March rent of $2,000. 28 Performed engineering services for clients, for which $1,600 was collected in cash and $5,800 was billed to the clients.

Mar. 1 Cash 25,000 Owner's Capital 25,000 3 Equipment 7,200 Cash 7,200 6 Supplies 800 Accounts Payable 800 15 Rent Expense 2,000 Cash 2,000 28 Cash 1,600 Accounts Receivable 5,800 Service Revenue 7,400

Insurance

Most companies maintain fire and theft insurance on merchandise and equipment, personal liability insurance for accidents suffered by customers, and automobile insurance on company cars and trucks. The extent of protection against loss determines the cost of the insurance (the amount of the premium to be paid). The insurance policy specifies the term and coverage. The minimum term usually covers one year, but three-to five-year terms are available and may offer lower annual premiums. A company usually debits insurance premiums to the asset account Prepaid Insurance when paid. At the financial statement date, it then debits Insurance Expense and credits Prepaid Insurance for the cost that expired during the period. For example, on October 4, Pioneer Advertising paid $6,000 for a one-year fire insurance policy. Coverage began on October 1. Pioneer debited the cost of the premium to Prepaid Insurance at that time. This account still shows a balance of $6,000 in the October 31 trial balance. The analysis and adjustment for insurance is summarized in Illustration 3.23.

Learning Objective 7

Most companies use accrual-basis accounting: They recognize revenue when the performance obligation is satisfied and expenses in the period incurred, without regard to the time of receipt or payment of cash. Some small companies and the average individual taxpayer, however, use a strict or modified cash-basis approach. Under the strict cash basis, companies record revenue only when they receive cash. They record expenses only when they disperse cash. Determining income on the cash basis rests upon collecting revenue and paying expenses. The cash basis ignores two principles: the revenue recognition principle and the expense recognition principle. Consequently, cash-basis financial statements are not in conformity with GAAP. An illustration will help clarify the differences between accrual-basis and cash-basis accounting. Assume that Quality Contractor signs an agreement to construct a garage for $22,000. In January, Quality begins construction, incurs costs of $18,000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Quality collects $22,000 cash from the customer. In March, Quality pays the $18,000 due the creditors. Illustrations 3A-1 and 3A-2 show the net incomes for each month under cash-basis accounting and accrual-basis accounting, respectively.

post-closing trial balance

Recall that a trial balance is prepared after entering the regular transactions of the period, and that a second trial balance (the adjusted trial balance) occurs after posting the adjusting entries. A company may take a third trial balance after posting the closing entries. The trial balance after closing is called the post-closing trial balance. The purpose of the post-closing trial balance is to prove the equality of the permanent account balances that the company carries forward into the next accounting period. Since all temporary accounts will have zero balances, the post-closing trial balance will contain only permanent (real)—balance sheet—accounts.

accrued revenues

Revenues for services performed but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, as in the case of interest revenue. These are unrecorded because the earning of interest does not involve daily transactions. Companies do not record interest revenue on a daily basis because it is often impractical to do so. Accrued revenues also may result from services that have been performed but not yet billed nor collected, as in the case of commissions and fees. These may be unrecorded because only a portion of the total service has been performed and the clients will not be billed until the service has been completed. An adjusting entry records the receivable that exists at the balance sheet date and the revenue for the services performed during the period. Prior to adjustment, both assets and revenues are understated. Accordingly, an adjusting entry for accrued revenues results in a debit (increase) to an asset account and a credit (increase) to a revenue account. In October, Pioneer Advertising performed services worth $2,000 that were not billed to clients on or before October 31. Because these services are not billed, they are not recorded. The accrual of unrecorded service revenue increases an asset account, Accounts Receivable. It also increases stockholders' equity by increasing a revenue account, Service Revenue, as shown in Illustration 3.28.

WOW Consulting has year-end account balances of Sales Revenue $525,400, Interest Revenue $2,500, Salary and Wages Expense $238,800, Rent Expense $122,000, Administrative Expense $62,500, Income Tax Expense $38,000, and Dividends $35,400. Prepare the year-end closing entries.

Sales Revenue 525,400 Interest Revenue 2,500 Income Summary 527,900 Income Summary 461,300 Salary and Wages Expense 238,800 Rent Expense 122,000 Administrative Expense 62,500 Income Tax Expense 38,000 Income Summary 66,600 Retained Earnings 66,600 Retained Earnings 35,400 Dividends 35,400

reversing entries

Some accountants prefer to reverse the effects of certain adjusting entries by making a reversing entry at the beginning of the next accounting period. A reversing entry is the exact opposite of the adjusting entry made in the previous period. Use of reversing entries is an optional bookkeeping procedure; it is not a required step in the accounting cycle. Accordingly, we have chosen to cover this topic in Appendix 3B at the end of the chapter.

Southern Wood Floors has year-end account balances of Sales Revenue $683,000, Interest Revenue $2,000, Cost of Goods Sold $408,200, Salaries and Wages Expense $98,000, Administrative Expense $67,500, and Income Tax Expense $42,000. Prepare an income statement.

Southern Wood Floors Income Statement Year ended December 31, 2017 Sales Revenue $683,000 Cost of Goods Sold 408,200 Gross Profit on Sales 274,800 Salaries and Wages Expense $98,000 Administrative Expense 67,500 Total Expenses 165,500 Income from Operations 109,300 Other Revenue and Gains Interest Income 2,000 Income Before Income Taxes 111,300 Income Tax 42,000 Net Income $69,300

financial statements

Statements that reflect the collection, tabulation, and final summarization of the accounting data. Four statements are involved. (1) The balance sheet shows the financial condition of the enterprise at the end of a period. (2) The income statement measures the results of operations during the period. (3) The statement of cash flows reports the cash provided and used by operating, investing, and financing activities during the period. (4) The statement of retained earnings reconciles the balance of the retained earnings account from the beginning to the end of the period.

journal

The "book of original entry" where the company initially records transactions and selected other events. Various amounts are transferred from the book of original entry, the journal, to the ledger. Entering transaction data in the journal is known as journalizing.

Events?

The FASB uses the phrase "transactions and other events and circumstances that affect a business enterprise" to describe the sources or causes of changes in an entity's assets, liabilities, and equity.2 Events are of two types. (1) External events involve interaction between an entity and its environment, such as a transaction with another entity, a change in the price of a good or service that an entity buys or sells, a flood or earthquake, or an improvement in technology by a competitor. (2) Internal events occur within an entity, such as using buildings and machinery in operations, or transferring or consuming raw materials in production processes. Many events have both external and internal elements. For example, hiring an employee, which involves an exchange of salary for labor, is an external event. Using the services of labor is part of production, an internal event. Further, an entity may initiate and control events, such as the purchase of merchandise or use of a machine. Or, events may be beyond its control, such as an interest rate change, theft, or a tax hike.

Theoretical Weaknesses of the Cash Basis

The cash basis reports exactly when cash is received and when cash is disbursed. To many people, that information represents something concrete. Isn't cash what it is all about? Does it make sense to invent something, design it, produce it, market and sell it, if you aren't going to get cash for it in the end? Many frequently say, "Cash is the real bottom line," and also, "Cash is the oil that lubricates the economy." If so, then what is the merit of accrual accounting? Today's economy is considerably more lubricated by credit than by cash. The accrual basis, not the cash basis, recognizes all aspects of the credit phenomenon. Investors, creditors, and other decision-makers seek timely information about a company's future cash flows. Accrual-basis accounting provides this information by reporting the cash inflows and outflows associated with earnings activities as soon as these companies can estimate these cash flows with an acceptable degree of certainty. Receivables and payables are forecasters of future cash inflows and outflows. In other words, accrual-basis accounting aids in predicting future cash flows by reporting transactions and other events with cash consequences at the time the transactions and events occur, rather than when the cash is received and paid.

Closing

The closing process reduces the balance of nominal (temporary) accounts to zero in order to prepare the accounts for the next period's transactions. In the closing process, Pioneer Advertising transfers all of the revenue and expense account balances (income statement items) to a clearing or suspense account called Income Summary. The Income Summary account matches revenues and expenses. Pioneer uses this clearing account only at the end of each accounting period. The account represents the net income or net loss for the period. It then transfers this amount (the net income or net loss) to a stockholders' equity account. (For a corporation, the stockholders' equity account is retained earnings; for proprietorships and partnerships, it is a capital account.) Companies post all such closing entries to the appropriate general ledger accounts.

double-entry accounting

The equality of debits and credits provides the basis for the double-entry system of recording transactions (sometimes referred to as double-entry bookkeeping). Under the universally used double-entry accounting system, a company records the dual (two-sided) effect of each transaction in appropriate accounts. This system provides a logical method for recording transactions. It also offers a means of proving the accuracy of the recorded amounts. If a company records every transaction with equal debits and credits, then the sum of all the debits to the accounts must equal the sum of all the credits.

First step in the accounting cycle?

The first step in the accounting cycle is analysis of transactions and selected other events. The first problem is to determine what to record. Although GAAP provides guidelines, no simple rules exist that state which events a company should record. Although changes in a company's personnel or managerial policies may be important, the company should not record these items in the accounts. On the other hand, a company should record all cash sales or purchases—no matter how small.

trial balance

The list of all open accounts in the ledger and their balances. The trial balance taken immediately after all adjustments have been posted is called an adjusted trial balance. A trial balance taken immediately after closing entries have been posted is called a post-closing (or after-closing) trial balance. Companies may prepare a trial balance at any time.

Posting a Journal continued

The numbers in the "Ref." column of the general journal refer to the ledger accounts to which a company posts the respective items. For example, the "101" placed in the column to the right of "Cash" indicates that the company posted this $15,000 item to Account No. 101 in the ledger. The posting of the general journal is completed when a company records all of the posting reference numbers opposite the account titles in the journal. Thus, the number in the posting reference column serves two purposes. (1) It indicates the ledger account number of the account involved. (2) It indicates the completion of posting for the particular item. Each company selects its own numbering system for its ledger accounts. Many begin numbering with asset accounts and then follow with liabilities, stockholders' equity, revenue, and expense accounts, in that order. The ledger accounts in Illustration 3.8 show the accounts after completion of the posting process. The reference J1 (General Journal, page 1) indicates the source of the data transferred to the ledger account.

accruals

The second category of adjusting entries is accruals. Companies make adjusting entries for accruals to record revenues for services performed and expenses incurred in the current accounting period. Without an accrual adjustment, the revenue account (and the related asset account) or the expense account (and the related liability account) are understated. Thus, the adjusting entry for accruals will increase both a balance sheet and an income statement account. Illustration 3.27 shows adjusting entries for accruals.

Financial Statements + Ownership Structures?

The stockholders' equity section of the balance sheet reports common stock and retained earnings. The income statement reports revenues and expenses. The statement of retained earnings reports net income/loss and dividends. Because a company transfers dividends, revenues, and expenses to retained earnings at the end of the period, a change in any one of these three items affects stockholders' equity.

Debt and Credit

The terms debit (Dr.) and credit (Cr.) mean left and right, respectively. These terms do not mean increase or decrease, but instead describe where a company makes entries in the recording process. That is, when a company enters an amount on the left side of an account, it debits the account. When it makes an entry on the right side, it credits the account.

deferrals

To defer means to postpone or delay. Deferrals are expenses or revenues that are recognized at a date later than the point when cash was originally exchanged. The two types of deferrals are prepaid expenses and unearned revenues. If a company does not make an adjustment for these deferrals, the asset and liability are overstated, and the related expense and revenue are understated. For example, in Pioneer Advertising's trial balance (Illustration 3.19), the balance in the asset Supplies shows only supplies purchased. This balance is overstated; the related expense account, Supplies Expense, is understated because the cost of supplies used has not been recognized. Thus, the adjusting entry for deferrals will decrease a balance sheet account and increase an income statement account. Illustration 3.21 shows the effects of adjusting entries for deferrals.

transactions

Transactions are types of external events. They may be an exchange between two entities where each receives and sacrifices value, such as purchases and sales of goods or services. Or, transactions may be transfers in one direction only. For example, an entity may incur a liability without directly receiving value in exchange, such as charitable contributions. Other examples include investments by owners, distributions to owners, payment of taxes, gifts, casualty losses, and thefts.

Posting

Transferring journal entries to the ledger accounts is called posting. Posting involves the following steps. 1.In the ledger, in the appropriate columns of the account(s) debited, enter the date, journal page, and debit amount shown in the journal. 2.In the reference column of the journal, write the account number to which the debit amount was posted. 3.In the ledger, in the appropriate columns of the account(s) credited, enter the date, journal page, and credit amount shown in the journal. 4.In the reference column of the journal, write the account number to which the credit amount was posted. Illustration 3.8 diagrams these four steps, using the first journal entry of Softbyte, Inc. The illustration shows the general ledger accounts in standard account form. Some companies call this form the three-column form of account because it has three money columns—debit, credit, and balance. The balance in the account is determined after each transaction. The explanation space and reference columns provide special information about the transaction. The boxed numbers indicate the sequence of the steps.

Unearned Revenues

When companies receive cash before services are performed, they record a liability by increasing (crediting) a liability account called unearned revenues. In other words, a company now has a performance obligation (liability) to provide service to one of its customers. Items like rent, magazine subscriptions, and customer deposits for future service may result in unearned revenues. Airlines, such as Delta, American, and Southwest, treat receipts from the sale of tickets as unearned revenue until they satisfy the performance obligation (provide the flight service). Tuition received prior to the start of a semester is another example of unearned revenue. Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue on the books of one company is likely to be a prepayment on the books of the company that made the advance payment. For example, if we assume identical accounting periods, a landlord will have unearned rent revenue when a tenant has prepaid rent. When a company such as Intel receives payment for services to be performed in a future accounting period, it credits an unearned revenue (a liability) account to recognize the liability that exists. Intel subsequently recognizes revenue when it performs the service. However, making daily entries to record this revenue is impractical. Instead, Intel delays recognition of revenue until the adjustment process. Then, Intel makes an adjusting entry to record the revenue for services performed during the period and to show the liability that remains at the end of the accounting period. In the typical case, liabilities are overstated and revenues are understated prior to adjustment. Thus, the adjusting entry for unearned revenues results in a debit (decrease) to a liability account and a credit (increase) to a revenue account. For example, Pioneer Advertising received $12,000 on October 2 from R. Knox for advertising services expected to be completed by December 31. Pioneer credited the payment to Unearned Service Revenue. This liability account shows a balance of $12,000 in the October 31 trial balance. Based on an evaluation of the service Pioneer performed for Knox during October, the company determines that it should recognize $4,000 of revenue in October. The liability (Unearned Service Revenue) is therefore decreased and stockholders' equity (Service Revenue) is increased, as shown in Illustration 3.26.

debit balance and credit balance

When comparing the totals of the two sides, an account shows a debit balance if the total of the debit amounts exceeds the credits. An account shows a credit balance if the credit amounts exceed the debits.

The adjusting entry to record an accrued expense includes a debit to: (LO 3) (a) a liability account and a credit to an expense account. (b) a liability account and a credit to a revenue account. (c) an expense account and a credit to a revenue account. (d) an expense account and a credit to a liability account. ANSWER (d) an expense account and a credit to a liability account. The adjusting entry for accrued expenses includes a debit to an expense account and a credit to a liability account. 10. The difference between the cost of a depreciable asset and its related contra account, Accumulated Depreciation is referred to as the asset's: (LO 3) (a) book value. (b) fair value. (c) market value. (d) real value. ANSWER (a) book value. The depreciated cost of an asset is its book value. 11. An adjusting entry would never include a: (LO 3) (a) debit to an expense account and a credit to an asset account. (b) debit to an expense account and a credit to a liability account. (c) debit to a liability account and a credit to a revenue account. (d) debit to an asset account and a credit to a liability account. ANSWER (d) debit to an asset account and a credit to a liability account. An adjusting entry including a debit to an asset account and a credit to a liability account would never occur because income statement amounts would not be adjusted. 12. If the adjusting entry for an accrued revenue is not made: (LO 3) (a) assets will be overstated. (b) revenues will be overstated. (c) liabilities will be understated. (d) equity will be understated. ANSWER (d) equity will be understated. An accrued revenue relates to services performed but not yet received in cash or recorded. When an adjusting entry is not made to record the accrued revenue, assets are understated, revenues are understated, and equity will be understated. There is no impact on liabilities for accrued revenues. 13. All of the following statements about contra asset accounts are true except: (LO 3) (a) Contra asset accounts have normal credit balances. (b) Contra asset accounts are permanent accounts. (c) Contra asset accounts are not reported in the financial statements. (d) Contra asset accounts are increased with credits. ANSWER (c) Contra asset accounts are not reported in the financial statements. Contra asset accounts are reported on the balance sheet as deductions from the associated asset account. 14. An accrued expense is (LO 3) (a) an expense which is recorded when cash is received. (b) an expense that has been incurred but for which payment has not yet been made. (c) an expense for which cash is paid before the expense is incurred. (d) initially recorded as an asset. ANSWER (b) an expense that has been incurred but for which payment has not yet been made. An accrued expense is an expense that has been incurred but for which payment has not yet been made. 15. An adjusting entry would never include a: (LO 3) (a) debit to an expense account and a credit to an asset account. (b) debit to an expense account and a credit to a liability account. (c) debit to a liability account and a credit to a revenue account. (d) debit to an asset account and a credit to a liability account. ANSWER (d) debit to an asset account and a credit to a liability account. An adjusting entry including a debit to an asset account and a credit to a liability account would never occur because income statement amounts would not be adjusted. 16. The proper sequence of financial statement preparation is: (LO 4) (a) The Retained Earnings Statement, the Balance Sheet, the Income Statement, and then the Statement of Cash Flows. (b) The Income Statement, the Retained Earnings Statement, the Balance Sheet, and then the Statement of Cash Flows. (c) The Balance Sheet, the Retained Earnings Statement, the Income Statement, and then the Statement of Cash Flows. (d) The Statement of Cash Flows, the Income Statement, the Retained Earnings Statement, and then the Balance Sheet. ANSWER (b) The Income Statement, the Retained Earnings Statement, the Balance Sheet, and then the Statement of Cash Flows. The proper sequence of financial statement preparation is the Income Statement, the Retained Earnings Statement, the Balance Sheet, and then the Statement of Cash Flows. 17. If the entry to close Income Summary to Retained Earnings includes a debit to Income Summary: (LO 5) (a) The company has incurred a net loss. (b) Retained Earnings will be increased by the current period's net income. (c) Dividends paid exceed the net income earned for the period. (d) Expenses exceed revenues. ANSWER (b) Retained Earnings will be increased by the current period's net income. If the Income Summary has a credit balance, the company has net income because revenues exceeded expenses. To close the account, Income Summary is debited and the current period's net income is transferred to Retained Earnings. 18. If the balances in both accounts receivable and accounts payable decrease during the year (LO *7) (a) the decrease in both the accounts receivable and accounts payable balances will result in a decrease in cash for the period. (b) the decrease in both the accounts receivable and accounts payable balances will result in a increase in cash for the period. (c) the decrease in the accounts receivable balance would result in an increase in cash for the period. (d) the decrease in the accounts payable balance would result in a increase in cash for the period. ANSWER (c) the decrease in the accounts receivable balance would result in an increase in cash for the period. If the balances in both accounts receivable and accounts payable decreased during the year the decrease in the accounts receivable balance would result in an increase in cash for the period while the decrease in the accounts payable balance would result in a decrease in cash for the period.

q's 9-18

What factors shape accounting information systems?

the nature of the business and the transactions in which it engages, the size of the firm, the volume of data to be handled, and the informational demands that management and others require

A good accounting information system helps management answers such questions as:

•How much and what kind of debt is outstanding? •Were our sales higher this period than last? •What assets do we have? •What were our cash inflows and outflows? •Did we make a profit last period? •Are any of our product lines or divisions operating at a loss? •Can we safely increase our dividends to stockholders? •Is our rate of return on net assets increasing?

transaction

. An external event involving a transfer or exchange between two or more entities.