ACC 205
lstoe2p
chapter3.pdf
chapter 3
Income Measurement and the Accounting Cycle
Learning Goals
• Understand fundamental concepts of income measurement and the accrual basis of accounting.
• Apply the core principles that define revenue and expense recognition methods.
• Know why adjusting entries are needed and prepare them for the illustrated types of transaction and events.
• Implement the accounting cycle and the steps that lead to preparing correct financial statements.
• Construct a worksheet to aid in preparing financial statements.
• Cite examples of alternative reporting periods and show how the closing process is used at the end of a typical accounting year.
• Calculate income under the cash basis of accounting and know when it is an acceptable alternative to the accrual basis.
Copyright Barbara Chase/Corbis/AP Images
waL80144_03_c03_053-088.indd 1 8/29/12 2:43 PM
CHAPTER 3Section 3.1 An Emphasis on Transactions and Events
Chapter Outline 3.1 An Emphasis on Transactions and Events 3.2 The Periodicity Assumption 3.3 Revenue Recognition 3.4 Expense Recognition 3.5 Adjusting Entries
The Adjusting Process for Revenues The Adjusting Process for Expenses Understanding When to Adjust
3.6 The Accounting Cycle A Comprehensive Example The Adjusted Trial Balance Financial Statement Preparation
3.7 Reporting Periods and Worksheets Closing the Accounts Classified Balance Sheets Notes to the Financial Statements
3.8 Cash Basis of Accounting
Chapter 2 showed how transactions are entered into the journal and posted to the ledger. The resulting ledger balances were drawn into a trial balance to verify that debit and credit figures matched. In some cases, the trial balance can be used to prepare financial statements. Also pointed out was that accountants often need to adjust certain accounts before up-to-date and correct financial statements can be prepared.
3.1 An Emphasis on Transactions and Events
The basis for determining which accounts require adjustment is tied to understanding the fundamental nature of accounting income. Accounting income is primarily tied to a model based on transactions and events. This means that accountants are not neces- sarily measuring all changes in value as they occur. The historical cost principle is the foundation to many accounting rules. For example, land is recorded at its purchase price, and that historical cost price is maintained in the balance sheet, even though market value may increase over time. Historical cost data are viewed as objective and verifiable. The prevailing income measurement model is primarily driven by a transactions-and-events, historical cost-based approach.
The historical cost information incorporated into the accounting system is drawn from exchange transactions. Exchange transactions generally signify that independent buyers and sellers have agreed on the price for which goods are services are to be delivered.
waL80144_03_c03_053-088.indd 2 8/29/12 2:43 PM
55
CHAPTER 3Section 3.2 The Periodicity Assumption
These exchanges are often termed arm’s length exchange transactions, and the amount of consideration forms the basis for accounting measurement. Business revenues are the resource (generally, cash and receivables) inflows from exchange transactions. Business expenses are the exchange-related resource outflows arising from the production of goods and services. Income is generally regarded as revenues minus expenses.
One seemingly unavoidable problem with the approach based on transactions and events is the dynamic nature of business activity. Revenue- and expense-generating activities are in constant flux. Each day a business may provide services to customers, but payment occurs only on a specified billing cycle. When is the revenue viewed as being earned for purposes of inclusion in an income statement? Similarly, many business expenses are being continuously generated. Consider the consumption of electricity. At the moment you are reading this, you may be sitting in a heated or air conditioned room, illuminated by an overhead light, with your computer on. Electricity is being consumed constantly. From a business perspective, the cost associated the electricity usage is constantly ongo- ing. How should the measure of electricity expense be pulled into the measure of account- ing income?
3.2 The Periodicity Assumption
The periodicity assumption holds that that business activity can be divided into spe-cific time intervals, such as months, quarters, and years. Indeed, recall that an income statement measures income for a specific time period. Furthermore, a balance sheet reflects the financial condition as of a specific date.
The significance of the periodicity assumption and the related financial statement dat- ing cannot be underestimated. The transactional basis of accounting measurement is not to be interpreted as measuring only the exchange of cash. The cash basis of accounting will be discussed later in this chapter. For now, the focus is on the accrual basis. Accrual is a term that means “to accumulate over time, based on a natural observable increase.” For example, a business will constantly use utilities. The cost of those utilities accrues, or accumulates, with the passage of time. The accrual basis attempts to measure these costs as they accumulate. In contrast, the cash basis would measure the utilities expense only when the utility bill is paid. A key challenge of the accrual basis of accounting is properly identifying the portion of ongoing business activity that occurred during a particular accounting period, as Exhibit 3.1 shows.
Exhibit 3.1: Measuring ongoing activity
BUSINESS ACTIVITY
Accounting Year
waL80144_03_c03_053-088.indd 3 8/29/12 2:43 PM
CHAPTER 3Section 3.3 Revenue Recognition
Identifying the amount of business activity to measure in each period involves both rev- enue and expense issues. Principles that guide the measurement of each are discussed in the following sections of this chapter.
3.3 Revenue Recognition
Under the accrual basis of accounting, revenues are to be recorded when they are earned. The measurement of revenue is called revenue recognition and is synony- mous with recording revenues into the accounts. Revenue recognition normally occurs at the time when services are rendered or when goods are sold and delivered to a customer. Revenue recognition normally requires both an exchange transaction and the earnings process to be complete (Exhibit 3.2).
Exhibit 3.2: Revenue recognition
For a manufactured product, revenue should not be recorded until the product is sold and delivered to an end customer. Payment can occur before, after, or at the time of product delivery. What matters is that the customer has accepted the product and the associated duty to pay for it. It is also imperative that the product be completed, such that the manu- facturer has no significant remaining duties (other than honoring routine commitments related to warranty services or occasional estimable returns). Service revenue is not as closely tied to the handoff to an end customer. A law firm may have a large staff that is researching a unique problem. The work is ongoing, and the client is being regularly updated on findings. So long as the law firm reasonably expects to be paid, the earnings process and the related revenue recognition is continuous.
Business transactions are fraught with complexity and give rise to numerous revenue recognition challenges. A majority of significant accounting mistakes relate to misappli- cation of generally accepted accounting principles related to revenue recognition issues. Consider the complexity of revenue recognition for cases like those related to long-term service agreements. Perhaps you have had an offer for a $99 cell phone, satellite dish, or burglar alarm system. The item you are buying likely costs more than $99, and the terms of the offer probably require you to agree to a multiyear monthly service contract. How should the seller record such transactions?
+ =
Production Earnings Process
Complete
Salesman Customer Exchange
Transaction
Accounting Revenue
Recognition
waL80144_03_c03_053-088.indd 4 8/29/12 2:43 PM
CHAPTER 3Section 3.4 Expense Recognition
What about an online retailer whose business model only requires routing a customer order to a supplier who handles all logistics? If an item is sold for $100, but the online com- pany only retains $2 of the total as a marketing fee, how much revenue is to be reported on the income statement? These are complex questions, which can lead to more complex questions. It is no wonder that many accounting failures involve misapplication of rev- enue recognition concepts. Accountants have literally thousands of specific rules to draw on in reaching correct accounting conclusions. Those specific rules are generally framed around the principles in Table 3.1, all of which should be satisfied.
Table 3.1: General principles for revenue recognition
There is persuasive evidence of an arrangement.
Delivery of goods has occurred or services have been rendered.
The seller’s price is fixed or determinable.
Collectability is reasonably assured.
Remember from Chapter 2 that accounting is not bookkeeping. Perhaps you are now begin- ning to appreciate the difference. Accountants are highly skilled professionals who are trained to research and apply proper accounting solutions to complex measurement issues.
For now, it bears repeating that payment is not a criterion for initial revenue recognition. Revenues are recognized at the point of sale, whether that sale is for cash or a receivable. Accrual basis accounting contemplates more than just recording cash receipts. Severe mis- representations of income could result if the focus was simply on cash receipts.
3.4 Expense Recognition
Accrual accounting principles also apply to expense recognition. Expense recognition principles have a slightly different theoretical framework. There are three alternative models to apply, depending on the nature of a particular cost.
Some costs are created by and directly associated with a particular revenue-producing event. For example, the sale of an inventory item produces revenue, and it makes sense to offset the revenue by the cost of the inventory. Remember, income is equal to revenues minus expenses. Failure to record the expenses associated with producing revenue would overstate income. Sales commissions would similarly be recorded in the same period as a sale. Many costs bear a direct relationship to revenue and are to be recorded concurrent with the revenue recognition. This concept is referred to as the matching principle. The matching principle explains the manner in which a large proportion of business costs are to be recorded.
Some costs occur on an ongoing basis without regard to the level of revenue produc- tion. Rent, insurance, depreciation of equipment, and so forth are costs that display this pattern. As such, accountants adopt systematic allocation schemes. These schemes can be as simple as recording an equal portion of cost each period. Other patterns might be
waL80144_03_c03_053-088.indd 5 8/29/12 2:43 PM
CHAPTER 3Section 3.5 Adjusting Entries
deployed, such as accounting for long-term assets (see Chapter 6). Therefore, accountants use defined allocation models to systematically attribute some costs to expense over time.
Lastly, some costs occur that are not seen as benefiting any future periods and are not linked to any revenue production. If a business asset is consumed by fire, its cost would be expensed immediately; there is no future benefit and no discernible revenue! Therefore, the third approach to recording expenses is immediate recognition.
Recapping, expenses are recognized by matching, systematic allocation, or immediate rec- ognition, as shown in Exhibit 3.3.
Exhibit 3.3: The three approaches to expense allocation
Accountants use the logic just described in trying to decide which approach to apply to a particular cost. As was the case with revenue recognition, note that expense recognition guidelines look well beyond just the payment of cash. Many costs are charged to expense in advance of or after the date of the related cash payment. For instance, the purchase of equipment for cash is initially recorded as follows:
7-1-X2 Equipment 1,000.00
Cash 1,000.00
To record purchase of equipment
Over time, the equipment cost will be transferred to expense in a systematic fashion that approximates the consumption of the equipment via its usage. This process is called depreciation and is discussed later in this chapter.
3.5 Adjusting Entries
The revenue and expense recognition principles provide a foundation for understanding the potential need to adjust account balances prior to preparing financial statements. Revenues may have been earned and expenses incurred that have not yet been recorded.
$$ $ $$
20XX
Matching Allocation Immediate
Expenses Revenues
Year 2 Year 1
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
waL80144_03_c03_053-088.indd 6 8/29/12 2:43 PM
CHAPTER 3Section 3.5 Adjusting Entries
Conversely, asset and liability accounts may contain balances that are no longer valid. Actu- ally, there are countless scenarios of potential adjustments that go well beyond what can be illustrated in a text. The good news is that if you develop a conceptual understanding of the basis on which adjustments are to be prepared, that knowledge can be extended to develop logical solutions for almost any adjustment-related problem you may encounter.
Adjusting entries are journal entries that are necessary to cause asset, liability, revenue, expense, and all other accounts to contain their correct balance as of a particular reporting date. As a frame of reference, Table 3.2 describes various types of adjusting entries that are necessary for selected revenue and expense items. Notice that revenue and expense accounts are both subject to adjustments for accruals and unearned/prepaid elements.
Table 3.2: Types of adjusting entries
Adjusting Revenues
Accrued revenues
Unearned revenue
Adjusting Expenses
Typical expense accruals (payroll, interest, rent)
Prepaids (Insurance, rent, supplies)
Depreciation
The Adjusting Process for Revenues
To begin, let’s consider the concept of accrued revenue. As mentioned earlier, accruals relate to items that accumulate with the passage of time. A law firm that provides ser- vices to clients accrues additional revenue with each hour of service provided to a client. Hours of service are tracked and periodically billed. Accordingly, revenues may be earned during one month and billed the following. Notwithstanding the billing cycle, revenues should be recorded as earned. When financial statements are prepared, an adjusting entry may be necessary to accrue earned but unbilled revenue. To illustrate, assume that a com- pany is owed $900 as of December 31, 20X5, for services rendered but not yet billed:
12-31-X5 Accounts Receivable 900.00
Revenue 900.00
Year-end adjusting entry to reflect services provided by year-end
An alternative revenue scenario arises when payments are received in advance of provid- ing services. A law firm might require an advance payment from a new client. Because work has yet to be performed, the amounts collected are said to be unearned revenue. A liability is shown on the balance sheet representing the duty to perform in the future. The following entry is used to record the initial cash collection:
waL80144_03_c03_053-088.indd 7 8/29/12 2:43 PM
CHAPTER 3Section 3.5 Adjusting Entries
7-1-X2 Cash 1,000.00
Unearned Revenue 1,000.00
To record advance collection from client
If 60% of the work contemplated by the preceding entry was performed by year-end, the following entry would be needed to transfer $600 of the unearned revenue:
12-31-X2 Unearned Revenue 600.00
Revenue 600.00
Year-end adjusting entry to reflect earned portion of advance payment
The income statement for 20X2 would reflect the $600 of earned revenue, and the balance sheet would reflect the remaining $400 of unearned revenue ($1,000 2 $600). This may seem like a lot of trouble to you. Why not just record the initial $1,000 all as revenue when it is collected? The simple answer is that it violates the fundamental revenue recognition principles. Granted, the monetary amounts were very small in this example. However, the amounts can mount into the hundreds of millions for actual companies. Airlines often presell tickets, funeral homes may presell funeral plans, software companies grant long- term licenses, insurance companies presell coverage, magazine publishers presell multi- year subscriptions, and so forth. Correctly measuring revenue is essential to determining the success or failure of a business enterprise, and proper application of revenue recogni- tion concepts is paramount.
The Adjusting Process for Expenses
Properly accounting for expenses requires logic very similar to that for revenues. Many expenses accrue with the passage of time. Payroll is a significant cost for many businesses and is an excellent example of an accruing expense. If you think about a job you may have held, you recall showing up daily for work but only being paid periodically. Businesses usually pay employees on a regular interval, such as “every other Friday.” If an accounting period ended on a Wednesday and the daily payroll (assume a Monday through Friday workweek, and the last payday was the previous Friday) averaged $5,000, then $15,000 (3 days) of payroll is accrued at the end of the period. The following entry would be needed to accrue this expense:
12-31-X6 Salaries Expense 15,000.00
Salaries Payable 15,000.00
To record accrued salaries at end of period
Failure to record this adjusting entry would result in understating expenses (and over- stating income!) by $15,000. Further, the balance sheet would fail to reflect that $15,000 is owed to employees.
waL80144_03_c03_053-088.indd 8 8/29/12 2:43 PM
CHAPTER 3Section 3.5 Adjusting Entries
You may be wondering what will happen on the next payday? If $50,000 is paid (10 days at $5,000 per day) on the next payday, the appropriate entry needs to reflect that $15,000 of the amount relates to the previous accrual (i.e., it is paid to satisfy the already recorded liability), and the other $35,000 relates to work performed in the new accounting period:
1-9-X7 Salaries Expense 35,000.00
Salaries Payable 15,000.00
Cash 50,000.00
To record payment of payroll overlapping the end of an accounting period
You should carefully compare the preceding entries to Exhibit 3.4 and note how they result in the assignment of the correct amount of expense to each of the affected account- ing periods.
Exhibit 3.4: Assigning expenses to accounting periods
Another example of an accruing expense is interest on a loan. Interest is the cost for using money and is ordinarily assessed as a stated percentage of the amount borrowed and further based on the length of the borrowing period. Therefore, accrued interest on a loan can be calculated using the borrowed amount (principal), the interest rate (rate), and the length of the borrowing period (time). A simple formula becomes
Principal Rate Time
For example, if $10,000 is borrowed at 8% per year for 24 months, the total interest will amount to $1,600 ($10,000 8% 2 years). Agreements with respect to the frequency of interest payments vary considerably. Some lenders may require monthly checks for accu- mulated interest. Other times, a loan may stipulate that interest only be paid quarterly, annually, or at maturity of the loan. Therefore, it is often necessary to record an adjusting entry to record the amount of accrued interest at the end of an accounting period. If our
December 20X6
M
1
8
15
22
29
S
7
14
21
28
T
2
9
16
23
30
W
3
10
17
24
31
T
4
11
18
25
F
5
12
19
26
S
6
13
20
27
January 20X7
M
5
12
19
26
S
4
11
18
25
T
6
13
20
27
W
7
14
21
28
T
1
8
15
22
29
F
2
9
16
23
30
S
3
10
17
24
31
Paydays Paid Holiday Days Paid for on 9thAccruals
waL80144_03_c03_053-088.indd 9 8/29/12 2:43 PM
CHAPTER 3Section 3.5 Adjusting Entries
24-month loan was taken out on July 1, 20X3, and all amounts became due on June 30, 20X5, then all the following entries would be needed over the lifecycle of the transaction:
20X3 ———————————————
7-1-X3 Cash 10,000.00
Loan Payable 10,000.00
Borrowed $10,000 at 8% per annum; principal and interest due on 6-30-X5
12-31-X3 Interest Expense 400.00
Interest Payable 400.00
To record accrued interest for 6 months ($10,000 8% 6412)
20X4 ———————————————
12-31-X4 Interest Expense 800.00
Interest Payable 800.00
To record accrued interest for 12 months ($10,000 8% 12412)
20X5 ———————————————
6-30-X5 Interest Expense 400.00
Interest Payable 1,200.00
Loan Payable 10,000.00
Cash 11,600.00
To record repayment of loan and interest
The complexity is growing, as you can tell. It is important for you to note that the loan spanned three accounting periods and expense was allocated to each via these entries. Because the loan was outstanding for 6 months in 20X3, 12 months for 20X4, and 6 months for 20X5, the interest expense was similarly allocated as $400, $800, and $400, respectively.
Rent sometimes gives rise to an adjusting entry. If a business actually pays rent after the period of time for which facilities are used, then the accumulated unpaid rent at any time is the amount of accrued rent. If a company had accrued rent expense amounting to $4,000 at the end of period, the following entry would be needed:
12-31-X3 Rent Expense 4,000.00
Rent Payable 4,000.00
To record accrued rent at end of period
In contrast to accrued expenses are prepaid expenses. Prepaid expenses would be costs you pay in advance. You probably have some experience with this in the form of rent or insurance. Your landlord might collect a month’s rent in advance each period, or your insurance company might collect on your car insurance every 6 months. The initial expen- diture represents a future economic benefit and is recorded as an asset. As time passes, the asset is consumed and should be transferred to expense with an adjusting entry.
waL80144_03_c03_053-088.indd 10 8/29/12 2:43 PM
CHAPTER 3Section 3.5 Adjusting Entries
To illustrate, assume you purchased a $600 6-month auto insurance policy on October 1. The following entry would be needed to record the initial policy purchase:
10-1-X8 Prepaid Insurance 600.00
Cash 600.00
Prepaid a 6-month insurance policy for cash
By December 31, half of the insurance coverage has been used up. This adjusting entry transfers $300 of the asset to expense:
12-31-X8 Insurance Expense 300.00
Prepaid Insurance 300.00
To adjust prepaid insurance to reflect portion expired
The income statement for 20X8 would show an insurance expense of $300, reflecting the amount of coverage purchased and used. The balance sheet would reflect the other $300 of prepaid insurance relating to January, February, and March.
Prepaid rent arises when you pay rent in advance. Assume that an office is leased on August 1 by paying $3,000 that covers the right to use the property for August, Septem- ber, and October. The following entry would be needed to record the initial payment on August 1:
8-1-X7 Prepaid Rent 3,000.00
Cash 3,000.00
Prepaid a 3-month lease
At the end of each month (August, September, and October), the following entry would be need to transfer $1,000 of the prepaid rental asset to an expense account. This reflects consumption of the service via its conversion to an expense.
End of Month
Rent Expense 1,000.00
Prepaid Rent 1,000.00
To adjust prepaid rent to reflect portion consumed
waL80144_03_c03_053-088.indd 11 8/29/12 2:43 PM
CHAPTER 3Section 3.5 Adjusting Entries
Supplies are another form of prepaid expenses. When supplies are purchased, the following entry will probably be recorded:
12-1-X5 Supplies 5,000.00
Cash 5,000.00
Purchased $5,000 of office supplies
If $3,000 of these supplies is used during the month, the end-of-month adjusting entry would be as follows:
12-31-X5 Supplies Expense 3,000.00
Supplies 3,000.00
Purchased $3,000 of office supplies
The T-accounts in Exhibit 3.5 illustrate the rental payment and the related assignment to expense over time.
Exhibit 3.5: T-accounts for 3 months of prepaid rent
waL80144_03_c03_053-088.indd 12 8/29/12 2:43 PM
CHAPTER 3Section 3.5 Adjusting Entries
The preceding entry both reduces the Supplies account (from $5,000 to $2,000) to equal the amount still on hand and transfers the amount consumed to Supplies Expense.
You may be wondering how you would actually determine the supplies used during a period, especially if there is a beginning supply already on hand. It is probably not prac- tical to track each item (and its cost) as it is used. Instead a business would rely on the formulations in Table 3.3.
Table 3.3 Determining supplies used
Beginning balance of supplies
Plus: Purchases
Equals: Supplies available
Supplies available
Less: Ending supplies on hand
Amount used that should be expensed
If you can visualize a supplies closet, imagine that it contained $500 of supplies (deter- mined by a physical count) at the beginning of an accounting period. During the period, an additional $1,000 of goods were purchased and placed in the closet. If a physical count at the end of the period revealed $300 of supplies, you could conclude that $1,200 worth of supplies was actually used (Table 3.4).
Table 3.4
Beginning balance $ 500
Plus: Purchases 1,000
Supplies available $1,500
Less: Ending supplies on hand 300
Supplies used $1,200
Certain assets have a much longer life than that shown for the prepaid insurance, and they may be tangible in nature (you can touch them). Examples include a business’s buildings and equipment. The accounting logic that must be deployed is to record the purchase of such assets and then gradually (remember systematic and rational allocation concepts) transfer their cost to expense. We call this process depreciation. The logic is not that much different from that applied to prepaid insurance; it just spans a much longer horizon.
waL80144_03_c03_053-088.indd 13 8/29/12 2:43 PM
CHAPTER 3Section 3.5 Adjusting Entries
Importantly, depreciation is not a matter of valuing assets of a business but is the trans- ference of an asset’s cost to expense over the expected life of the asset. Accountants have devised several methods for measuring periodic depreciation, but the easiest is just a straight-line approach. With this technique, an equal amount of asset cost is assigned to each year of service life.
For example, if an item of equipment has a $6,000 cost and 3-year life, it is as simple as recording $2,000 of expense each year. It is important for you to note that the depreciation has nothing to do with cash or providing cash for an asset’s eventual replacement. The only cash flow occurs at the time an asset is purchased. As you will see from the following entries, the depreciation transfers the cost to expense over time but has not further bear- ing on cash.
The basic journal entry to record annual depreciation entails a debit to Depreciation Expense. The way in which accountants prepare the offsetting credit is unique. Rather than crediting the asset account directly (as we did for prepaid insurance), they instead credit an account called Accumulated Depreciation:
12-31-XX Depreciation Expense 2,000.00
Accumulated Depreciation 2,000.00
To record annual depreciation expense
Accumulated depreciation is shown on the balance sheet as a subtraction from the equip- ment that it relates to. Contra is a term that means “opposed to,” and an account that is subtracted from another related account is called a contra asset. In other words, contra assets are subtracted from the account to which they relate.
Each year’s balance sheet would report the asset at its $5,000 cost but with a reducing offset for the cumulative depreciation to date. This approach helps balance sheet users’ ability determine at a glance the investment and relative age of a business’s productive asset pool. Exhibit 3.6 illustrates how this item of equipment would appear in the financial statements over its 3-year life.
waL80144_03_c03_053-088.indd 14 8/29/12 2:43 PM
CHAPTER 3Section 3.5 Adjusting Entries
Perhaps it is obvious, but do take special note that contra accounts have opposite debit and credit rules. For instance, accumulated depreciation is a contra asset and is increased with a credit.
Understanding When to Adjust
A person must be very familiar with the workings of a particular business to know which accounts need adjustment at the end of each accounting period. This is a task that requires someone who understands accounting measurement and has a deep knowledge of a
Exhibit 3.6: The cumulative depreciation of equipment over 3 years
$6,000 is paid on January 1, 20X1, for equipment with a three-year life
Depreciation Expense $ 2,000
Income Statement For the Year Ending December 31, 20X1
Depreciation Expense $ 2,000
Income Statement For the Year Ending December 31, 20X3
Assets
Truck $ 6,000
(4,000) $ 2,000
Balance Sheet December 31, 20X2
Assets
Truck
Less: Accumulated Depreciation
$ 6,000
– $ 6,000
Balance Sheet January 1, 20X1
Assets
Truck $ 6,000
(2,000) $ 4,000
Balance Sheet December 31, 20X1
Assets
Truck $ 6,000
(6,000) $ 0
Balance Sheet December 31, 20X3
Depreciation Expense $ 2,000
Income Statement For the Year Ending December 31, 20X2
Less: Accumulated Depreciation
Less: Accumulated Depreciation
Less: Accumulated Depreciation
20X1 Income Statement
20X2 Income Statement
20X3 Income Statement
waL80144_03_c03_053-088.indd 15 8/29/12 2:43 PM
CHAPTER 3Section 3.6 The Accounting Cycle
particular business. It is easy to overlook selected adjustments, and when that happens, the information communicated by the financial statements is in error. Auditors routinely keep a sharp eye on the need for adjustments that might otherwise go overlooked.
In Chapter 2, you saw how a trial balance could be used to prepare financial statements. You were also cautioned that the trial balance may not be up-to-date and the actual prepa- ration of financial statements would normally follow the adjusting process that you are now familiar with. Therefore, after adjusting entries are prepared and posted, you would construct an adjusted trial balance showing that the equality of debits and credits was preserved throughout the journalization and posting of all adjustments.
3.6 The Accounting Cycle
Reviewing thus far, you should now recognize that the accounting process reflects the following steps: 1. Examine source documents. 2. Record transactions in the journal. 3. Post journal entries to the indicated ledger accounts. 4. Perhaps construct a trial balance. 5. Determine and post adjusting entries. 6. Prepare an adjusted trial balance. 7. Prepare financial statements from the adjusted trial balance.
These steps are customarily referred to as the accounting cycle (Exhibit 3.7), and it is vital that you comprehend how this process leads to the capture and communication of essential accounting information.
Exhibit 3.7: The accounting cycle
$$ $
$$$
3
7
1 2 4
65
waL80144_03_c03_053-088.indd 16 8/29/12 2:43 PM
CHAPTER 3Section 3.6 The Accounting Cycle
A Comprehensive Example
At this juncture, it may prove helpful to review a comprehensive example. Assume that Clark Gliders is in the process of preparing financial statements for the year ending 20X5, its first year of operation. Clark Gliders operates out of the Windy Draft Airfield and pro- vides glider rides and tours for paying passengers.
On January 1, 20X5, Clark Gliders received a $40,000 initial investment from sharehold- ers and borrowed an additional $100,000 (at 6% per annum). Much of this money was invested in gliders with estimated lives of 10 years. Its trial balance reflecting 20X5 activ- ity, prior to considering the need for adjusting entries, contained the balances shown in Exhibit 3.8.
Exhibit 3.8: Trial balance for Clark Gliders
Assume that Clark determined that the following adjusting entries were needed at the end of 20X5.
Debits Credits
$ 32,000
5,000
100,000
40,000
143,000
–
$ 320,000
Cash
Accounts receivable
Prepaid hangar rent
Gliders
Accounts payable
Unearned revenue
Loans payable
Capital stock
Dividends
Revenue
Flight expense
Wages expense
$ 110,000
15,000
12,000
90,000
6,000
60,000
27,000
$ 320,000
Clark Gliders Trial Balance
December 31, 20X5
waL80144_03_c03_053-088.indd 17 8/29/12 2:43 PM
CHAPTER 3Section 3.6 The Accounting Cycle
12-31-X5 Depreciation Expense 9,000.00
Accumulated Depreciation 9,000.00
To record annual depreciation expense of gliders ($90,000410)
12-31-X5
Wages Expense 3,000.00
Wages Payable 3,000.00
To record accrued wages due to employees at the end of December
12-31-X5
Interest Expense 6,000.00
Interest Payable 6,000.00
To record accrued interest on note payable ($100,000 6%)
12-31-X5
Unearned Revenue 3,000.00
Revenue 3,000.00
Year-end adjusting entry to reflect earned portion of rides sold in advance
12-31-X5
Rent Expense 4,000.00
Prepaid Hanger Rent 4,000.00
Year-end adjusting entry to reflect consumed portion of hanger rent paid in advance
The Adjusted Trial Balance Review the preceding entries and consider why they might be necessary (the amounts are simply assumed). Then, examine the adjusted trial balance in Exhibit 3.9 and take careful note of how the trial balance was updated for the effects of the adjusting entries.
waL80144_03_c03_053-088.indd 18 8/29/12 2:43 PM
CHAPTER 3Section 3.6 The Accounting Cycle
Exhibit 3.9: Adjusted trial balance for Clark Gliders
Financial Statement Preparation
The adjusted trial balance is used to prepare financial statements. Trace the amounts from Clark’s adjusted trial balance to the financial statements in Exhibits 3.10, 3.11, and 3.12.
Exhibit 3.10: Balance sheet for Clark Gliders
Debits Credits
9,000
$ 32,000
2,000
3,000
6,000
100,000
40,000
146,000
–
$ 338,000
Cash
Accounts receivable
Prepaid hangar rent
Gliders
Accumulated depreciation
Accounts payable
Unearned revenue
Wages payable
Interest payable
Loans payable
Capital stock
Dividends
Revenue
Flight expense
Wages expense
Depreciation expense
Interest expense
Rent expense
$ 110,000
15,000
8,000
90,000
6,000
60,000
30,000
9,000
6,000
4,000
$ 338,000
Clark Gliders Adjusted Trial Balance
December 31, 20X5
Assets Liabilities
Cash
Accounts receivable
Prepaid hangar rent
Gliders
Less: Accumulated depreciation
Total assets
$ 110,000
15,000
8,000
81,000
–
$ 214,000
$ 32,000
2,000
3,000
6,000
100,000
$ 40,000
31,000
$ 143,000
71,000
$ 214,000
Accounts payable
Unearned revenue
Wages payable
Interest payable
Loans payable
Stockholders’ equity
Capital stock
Retained earnings
Total liabilities and equity
Clark Gliders Balance Sheet
December 31, 20X5
$ 90,000
(9,000)
waL80144_03_c03_053-088.indd 19 8/29/12 2:43 PM
CHAPTER 3Section 3.7 Reporting Periods and Worksheets
Exhibit 3.11: Income statement for Clark Gliders
Exhibit 3.12: Statement of retained earnings for Clark Gliders
Notice that the information in the adjusted trial balance is scattered throughout the three financial statements: (1) Assets and liabilities are placed on the balance sheet. (2) Revenues and expenses are placed on the income statement. (3) The statement of retained earnings includes the beginning retained earnings balance (zero, in this case, because this was a new business—but would otherwise be found in the adjusted trial balance), plus the net income carried forward from the income statement, and minus the dividends from the adjusted trial balance.
3.7 Reporting Periods and Worksheets
A company’s annual reporting period may follow the natural calendar and run from January 1 to December 31. This is known as a calendar year. In the alternative, some companies report on a fiscal year that runs from one point of beginning to one year later. Fiscal years are often chosen to follow natural business cycles. Such is the case for agricul- tural companies that may report to match growing and harvesting seasons, retailers that await holiday return cycles, and so forth.
Revenues
Expenses
Net income
Services to customers $ 146,000
$ 60,000
30,000
9,000
6,000
4,000
109,000
$ 37,000
Clark Gliders Income Statement
For the Month Ending December 31, 20X5
Flight
Wages
Depreciation
Interest
Rent
Total expenses
Beginning balance – December 1, 20X5
Plus: Net income
$ –
37,000
Clark Gliders Statement of Retained Earnings
For the Month Ending December 31, 20X5
6,000
$ 31,000 Less: Dividends
Ending balance – December 31, 20X5
$ 37,000
waL80144_03_c03_053-088.indd 20 8/29/12 2:43 PM
CHAPTER 3Section 3.7 Reporting Periods and Worksheets
In addition to the annual report, a company may prepare monthly and/or quarterly reports. The shorter the reporting cycle, the more assumptions and estimating calcula- tions become necessary. Continuous business activity must be divided and apportioned among periods. Despite the inherent reliance on assumptions, investors and creditors pre- fer frequent reports. Information timeliness is critical to decision making.
A worksheet is often used to prepare monthly and quarterly financial reports. Formal adjusting entries may not be prepared and entered into the journals and ledgers; however, the effects of adjustments must still be taken into consideration. The worksheet aids in this process. Exhibit 3.13 shows a typical worksheet.
The data and adjustments found in the worksheet correspond to information previously presented for Clark Gliders. The first pair of columns is the unadjusted trial balance. The next pair reflects all adjustments. The third pair of columns combines the trial balance with the adjustments to produce an adjusted trial balance. Information from the adjusted trial balance is extended to the appropriate financial statement. For example, Cash is an asset account with a debit balance and is extended to the debit column of the balance sheet. A similar extension occurs for every item in the adjusted trial balance. Study this process closely.
After all adjusted trial balance amounts have been extended to the appropriate columns, the income statement columns are subtotaled. If credits exceed debits, the company has more revenues than expenses (e.g., $146,000 vs. $109,000 $37,000 net income). An excess of debits over credits would represent a net loss. The amount of net income or loss is transferred from the income statement columns to the statement of retained earnings col- umns, as shown. Similarly, the ending retained earnings (the excess of credits over debits in the retained earnings columns) is transferred to the balance sheet, as shown. This final transfer should bring the debit and credit columns of the balance sheet into balance (e.g., $223,000 $223,000).
Closing the Accounts
Reporting periods rarely exceed a year. This means that Revenue, Expense, and Dividend accounts must be reset to a zero balance at the end of an accounting year, prior to begin- ning the accounting cycle for a new accounting year. This process has resulted in these accounts often being called temporary accounts. This reset is often called “closing the books.” Sophisticated computer programs easily accomplish this task (or may skip it all together because it is possible to query a database structure for any designated time inter- val). However accomplished, the key point is that the temporary accounts are readied to begin accounting anew for the next year’s activity.
You might think this closing process could be as simple as starting a fresh ledger page for each temporary account. Keep in mind, however, that the ongoing recording of each item of revenue, expense, or dividend does not result in an update of retained earnings. Throughout the accounting cycle, the retained earnings balance reflected in the ledger only shows the beginning-of-period balance. An added goal of closing is to update the retained earnings balance to reflect the end-of period balance. Remember that retained earnings is increased for net income and decreased for dividends.
waL80144_03_c03_053-088.indd 21 8/29/12 2:43 PM
CHAPTER 3Section 3.7 Reporting Periods and Worksheets
Exhibit 3.13: Worksheet to prepare financial statements for Clark Gliders
Tr ia
l B a la
n ce C re
d it
D e b it
C re
d it
D e b it
C re
d it
D e b it
C re
d it
D e b it
C re
d it
D e b i t
C re
d it
D e b it
A d ju
st m
e n ts
A d ju
st e d T
ri a l B
a la
n ce
In co
m e S
ta te
m e n t
B a la
n ce
S h e e t
S ta
te m
e n t o f
R e ta
in e d E
a rn
in g s
C a sh
A cc
o u n ts
r e ce
iv a b le
P re
p a id
h a n g a r
re n t
G lid
e rs
A cc
o u n ts
p a ya
b le
U n e a rn
e d r
e ve
n u e
L o
a n s
p a ya
b le
C a p ita
l s to
ck
D iv
id e n d s
R e ve
n u e s
F lig
h t e xp
e n se
s
W a g e s
e xp
e n se
D e p re
ci a tio
n e
xp e n se
s
In te
re st
e xp
e n se
R e n t e xp
e n se
s
A cc
u m
u la
te d d
e p re
ci a tio
n
W a g e s
p a ya
b le
In te
re st
p a ya
b le
N e t in
co m
e
R e ta
in e d e
a rn
in g s
$ 1 1 0 ,0
0 0
1 5 ,0
0 0
1 2 ,0
0 0
9 0 ,0
0 0
6 ,0
0 0
6 0 ,0
0 0
2 7 ,0
0 0 –
$ 3 2 0 ,0
0 0
$ 3 2 ,0
0 0
5 ,0
0 0
1 0 0 ,0
0 0
4 0 ,0
0 0
1 4 3 ,0
0 0 –
$ 3 2 0 ,0
0 0
$ 3 ,0
0 0
3 ,0
0 0
9 ,0
0 0
6 ,0
0 0
4 ,0
0 0 –
$ 2 5 ,0
0 0
$ 4 ,0
0 0
3 ,0
0 0
9 ,0
0 0
3 ,0
0 0
6 ,0
0 0 –
$ 2 5 ,0
0 0
$ 1 1 0 ,0
0 0
1 5 ,0
0 0
8 ,0
0 0
9 0 ,0
0 0
6 ,0
0 0
6 0 ,0
0 0
3 0 ,0
0 0
9 ,0
0 0
6 ,0
0 0
4 ,0
0 0 –
$ 3 3 8 ,0
0 0
$ 3 2 ,0
0 0
2 ,0
0 0
1 0 0 ,0
0 0
4 0 ,0
0 0
1 4 6 ,0
0 0
9 ,0
0 0
3 ,0
0 0
6 ,0
0 0 –
$ 3 3 8 ,0
0 0
$ 6 0 ,0
0 0
3 0 ,0
0 0
9 ,0
0 0
6 ,0
0 0
4 ,0
0 0 –
$ 1 0 9 ,0
0 0
3 7 ,0
0 0
$ 1 4 6 ,0
0 0
$ 1 4 6 ,0
0 0 –
$ 1 4 6 ,0
0 0 –
$ 1 4 6 ,0
0 0
$ 6 ,0
0 0 –
$ 6 ,0
0 0
3 1 ,0
0 0
$ 3 7 ,0
0 0
$ 1 1 0 ,0
0 0
1 5 ,0
0 0
8 ,0
0 0
9 0 ,0
0 0 –
$ 2 2 3 ,0
0 0
$ 3 2 ,0
0 0
2 ,0
0 0
1 0 0 ,0
0 0
4 0 ,0
0 0
9 ,0
0 0
3 ,0
0 0
6 ,0
0 0
3 1 ,0
0 0
$ 2 2 3 ,0
0 0
$ 3 7 ,0
0 0
$ 3 7 ,0
0 0 –
$ 3 7 ,0
0 0
C la
rk G
li d
e rs
W o
rk s h
e e t
to P
re p
a re
F in
a n
c ia
l S
ta te
m e n
ts
D e c e m
b e r
3 1 , 2
0 X
6
waL80144_03_c03_053-088.indd 22 8/29/12 2:43 PM
CHAPTER 3Section 3.7 Reporting Periods and Worksheets
Closing can entail a series of journal entries to zero out the revenue accounts, the expense accounts, and the dividend accounts and then move their balances into retained earnings. Following is an example of the closing entries necessary for Clark Gliders.
12-31-X5
Revenues 146,000.00
Retained Earnings 146,000.00
To close revenues to retained earnings
12-31-X5
Retained Earnings 109,000.00
Flight Expense 60,000.00
Wages Expense 30,000.00
Depreciation Expense 9,000.00
Interest Expense 6,000.00
Rent Expense 4,000.00
To close all expense accounts to retained earnings
12-31-X5
Retained Earnings 6,000.00
Dividends 6,000.00
To close dividends to retained earnings
Notice that the preceding entries produced a net credit to Retained Earnings of $31,000 ($146,000 — $109,000 — $6,000), reflective of the periods increase in retained earnings. In other words, the firm’s $37,000 of net income, less its $6,000 in dividends, resulted in the $31,000 increase in ending retained earnings. The closing process brings the firm’s ledger fully up to date and sets the temporary accounts back to zero. Everything is now ready for the next accounting period to commence!
The Asset, Liability, and Equity accounts are called real accounts because their balances are carried forward from period to period. Real accounts are not closed, and their balances carry forward into the future (e.g., cash does not go away just because a calendar page is flipped). Real accounts are also called permanent accounts and relate exclusively to items that appear on a balance sheet. Companies might prepare a post-closing trial balance (Exhibit 3.14) to reveal the balance of the real accounts following the closing process.
CHAPTER 3Section 3.7 Reporting Periods and Worksheets
Exhibit 3.14: The post-closing trial balance for Clark Gliders
Classified Balance Sheets
You likely noticed that the balance sheet for Clark Gliders began to expand quickly to include more accounts. In an actual business setting, many more asset, liability, and even equity accounts can be introduced. To bring order to a report that could quickly become voluminous and disorganized, accountants have devised a somewhat standardized means of presentation called a classified balance sheet. Classified balance sheets include important groupings of accounts, usually listed in an expected order of appearance.
The asset side of the balance sheet may include separate groups for the following:
• Current assets are items expected to be converted into cash or consumed within one year or the operating cycle, whichever is longer. The operating cycle (Exhibit 3.15) is the amount of time that a business needs to convert credit back into cash. For instance, a business may buy inventory, resell it on credit, and then eventually collect the resulting receivable.
Exhibit 3.15: The operating cycle
Debits Credits
9,000
$ 32,000
2,000
3,000
6,000
100,000
40,000
31,000
$ 223,000
Cash
Accounts receivable
Prepaid hangar rent
Gliders
Accumulated depreciation
Accounts payable
Unearned revenue
Wages payable
Interest payable
Loans payable
Capital stock
Retained earnings
$ 110,000
15,000
8,000
90,000
$ 223,000
Clark Gliders Post-Closing Trial Balance
December 31, 20X5
–
Cash
Inventory Accounts
Receivable
OPERATING CYCLE
waL80144_03_c03_053-088.indd 24 8/29/12 2:43 PM
CHAPTER 3Section 3.7 Reporting Periods and Worksheets
• Specific current assets are customarily listed in order of liquidity (i.e., nearness to cash). Thus, cash is usually listed first, followed by receivables, inventory, and prepaid expenses.
• Long-term investments are items held for investment purposes, including shares of stock in other companies, idle land, cash surrender value of life insur- ance, and similar items.
• Property, plant, and equipment are items of land, buildings, and equipment that are used in production or services
• Intangible assets are items that lack physical existence but were purchased for the rights they convey. This list includes obvious assets like patents and copy- rights but can also include brand names and more general business goodwill.
• Other assets are items that defy classification in one of the preceding categories, like selected long-term receivables.
The liability side of the balance sheet may include separate groups for the following:
• Current liabilities are obligations that will likely be liquidated with current assets, typically within the next year or operating cycle, whichever is longer.
• Long-term liabilities are obligations that are not current, including bank loans and mortgages.
The appearance of the equity section of the balance sheet depends on the nature of the business organization. Future chapters will cover unique equity elements related to sole proprietorships and partnerships. For now, we focus on the corporation, and stockhold- ers’ equity usually includes the following:
• Capital stock is the amount received from investors for company shares. The attributes of stock can become more complex and result in expanded presenta- tions for issues such as preferred stock, common stock, paid-in capital in excess of par, and so on. (Future chapters introduce these additional details.)
• Retained earnings is the accumulated income less dividends.
Exhibit 3.16 is an example of a classified balance sheet showing typical accounts and their manner of presentation.
waL80144_03_c03_053-088.indd 25 8/29/12 2:43 PM
CHAPTER 3Section 3.7 Reporting Periods and Worksheets
Exhibit 3.16: A classified balance sheet
Notes to the Financial Statements
In addition to financial statements, companies are also expected to add notes to the state- ments that elaborate on account balance details and more. These notes describe key account- ing policies, significant events, pending litigation, and similar details about the business. The principle of full disclosure dictates that financial statements and related notes are sufficient to allow financial statement users a legitimate basis for making informed judg- ments about the company. Exhibit 3.17 is a typical example of the notes you might encoun- ter on a close review of financial statements. Some of these concepts will already appear familiar to you, and they will all make more sense by the end of this course.
A s s e ts
L ia
b il it
ie s
C u
rr e n
t A
s s e ts
C
a sh
A
cc o u n ts
r e ce
iv a b le
I n ve
n to
ri e s
P
re p a id
in su
ra n ce
L o
n g
-t e rm
I n
v e s tm
e n
ts
S
to ck
in ve
st m
e n ts
C
a sh
v a
lu e o
f in
su ra
n ce
P ro
p e rt
y, P
la n
t, &
E q
u ip
.
L
a n d
B
u ild
in g a
n d e
q u ip
m e n t
L
e ss
: A cc
u m
u la
te d d
e p re
ci a tio
n
In ta
g ib
le A
s s e ts
P
a te
n t
O th
e r
A s s e ts
R
e ce
iv a b le
f ro
m e
m p lo
ye e
To ta
l A
s s e ts
$ 4
2 5 ,0
0 0
1 1 5 ,0
0 0
1 3 5 ,0
0 0
1 0 0 ,0
0 0
5 ,0
0 0
$ 7
8 0 ,0
0 0
$ 6
0 ,0
0 0
8 ,0
0 0
7 ,0
0 0
1 5 ,0
0 0
$ 1
0 0 ,0
0 0
2 2 5 ,0
0 0
$ 2
5 0 ,0
0 0
1 1 5 ,0
0 0
$ 9
0 ,0
0 0
3 2 5 ,0
0 0
$ 4
1 5 ,0
0 0
3 6 5 ,0
0 0
$ 7
8 0 ,0
0 0
C u
rr e n
t li a b
il it
ie s
A
cc o u
n ts
p a ya
b le
I n te
re st
p a ya
b le
T
a xe
s p a ya
b le
C
u rr
e n
t p o rt
io n o
f n o te
L o
n g
-t e
rm L
ia b
il it
ie s
N
o te
p a ya
b le
M
o rt
g a
g e li
a b ity
To ta
l L
ia b
il it
e s
S to
c k h
o ld
e rs
’ e q
u it
y
C
a p ita
l s to
ck
R
e ta
in e d e
a rn
in g s
To ta
l S
to c k h
o ld
e rs
’ E q
u it
y
To ta
l L
ia b
il it
ie s a
n d
E q
u it
y
C o
m p
le x C
o m
p a n
y B
a la
n c e S
h e e t
D e c e m
b e r
3 1 , 2
0 X
7
$ 8
5 ,0
0 0
(5 0 ,0
0 0 )
$ 7
5 ,0
0 0
1 2 5 ,0
0 0
1 8 0 ,0
0 0
4 5 ,0
0 0
$ 9
0 ,0
0 0
2 5 ,0
0 0
$ 1
0 0 ,0
0 0
3 5 ,0
0 0
waL80144_03_c03_053-088.indd 26 8/29/12 2:43 PM
CHAPTER 3Section 3.8 Cash Basis of Accounting
Exhibit 3.17: Notes that might be added to financial statements
3.8 Cash Basis of Accounting
The measurement, recording, and adjusting process presented thus far has relied on the accrual basis of accounting. The accrual basis is required under generally accepted accounting principles (GAAP). However, not all businesses necessarily apply GAAP. Small businesses that do not have an external user base (i.e., privately held companies without significant creditors) may be less concerned with particular details of how to measure income exactly correct for each period. They may be more interested in expe- diency and efficiency in the accounting process. Sometimes, these businesses will forgo GAAP and the accrual basis and opt for the much simpler cash basis of accounting.
Although the cash basis is simpler to apply, it can result in misleading financial state- ments. With the cash basis, revenue is recorded as cash is received (regardless of when it is earned), and expenses are recorded concurrent with their payment. To illustrate, assume
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Ultimate results could differ from those estimates.
Use of Estimates
The Company’s cash, accounts receivable, other current assets, accounts payable, and certain accrued liabilities are carried at amounts which reasonably approximate their fair value due to their short-term nature.
Fair Value
are stated at the lower of cost or market, valued on the first-in, first-out (“FIFO”) method.
Inventories
is stated at cost and depreciated using the straight-line method over the estimated useful lives of the assets.
Property, Plant, and Equipment
is upon delivery of product to the Company’s customer and collectability is reasonably assured. The Company’s ordering process creates persuasive evidence of the sale arrangement and the sales amount is determined. The delivery of the goods to the customer completes the earnings process.
Revenue Recognition
are charged to selling, general, and administrative expense in the periods incurred.
Design, Research, and Development Costs
waL80144_03_c03_053-088.indd 27 8/29/12 2:43 PM
CHAPTER 3Concept Check
that Tanner Company recently provided $5,000 of services on account, 60% of which has been collected. The company additionally received a $1,000 advance payment from a new customer for which work has yet to be performed and provided $10,000 of services for cash. On the cash basis, revenues would amount to $14,000 as follows:
Collections of accounts ($5,000 3 60%) $ 3,000
Advance payment 1,000
Services rendered for cash 10,000
Total cash collections $14,000
This amount can be verified by checking deposits in Tanner’s bank account. It is a simple matter to measure deposits. How much was Tanner’s accrual basis revenue? It would be $15,000, representing the $5,000 of services rendered on account and the $10,000 of ser- vices rendered for cash. Sometimes accrual basis revenues are higher, sometimes lower, than cash basis revenues. In the long run, once all services have been provided and all cash collected, the two approaches should yield the same final outcome. Like revenues, expenses also differ between cash and accrual methods.
Many companies use the cash basis of accounting for purposes of tax return preparation. By accelerating payments, expenses can be reported in an earlier time period. This results in lower income and therefore taxes for that period. Again, however, the long-run effects should work out the same. It is perfectly acceptable to have two sets of books—one for tax purposes and one for accounting purposes—so long as the tax records comply with tax law. Tax accounting methods and approaches sometimes depart from the methods and approaches in use for financial accounting purposes.
Concept Check
The following questions relate to several issues raised in the chapter. Test your knowledge of the issues by selecting the best answer. (The answers appear on p. 235.)
1. The accrual basis of accounting a. is less popular than the cash basis with respect to use by large businesses. b. better matches expenses and revenues than does the cash basis of accounting. c. recognizes revenues when earned and expenses when paid. d. recognizes revenues when received and expenses when paid.
2. Joe Hamilton contacted Denver Painting Contractors in July to paint his office build- ing. The price was agreed on in August, the painting took place in September, and Hamilton paid Denver in October. In which month would Hamilton recognize an expense under the accrual basis of accounting? Under the cash basis of accounting?
Accrual Basis Cash Basis a. July September b. August September c. September October d. August October
waL80144_03_c03_053-088.indd 28 8/29/12 2:43 PM
CHAPTER 3
accounting cycle Key steps include examining source documents, record- ing transactions in the journal, posting journal entries to the indicated ledger accounts, perhaps constructing a trial bal- ance, determining and posting adjusting entries, preparing an adjusted trial bal- ance, and preparing financial statements from the adjusted trial balance.
accrual basis The idea that transactions and events are to be measured based on their natural growth or increase, not their specific payment.
adjusting entries Journal entries that are necessary to cause asset, liability, revenue, expense, and all other accounts to contain their correct balance as of a particular reporting date.
arm’s length exchange transactions Exchange transactions that generally sig- nify that independent buyers and sellers have agreed on the price for which goods are services are to be delivered.
Key Terms
3. The Supplies account of Design Limited contained a $3,200 balance before adjust- ment on December 31. If $2,400 worth of supplies remains on hand at year-end, what will be the proper adjusting entry?
Debit Credit Amount
a. Supplies Expense Supplies $2,400 b. Supplies Expense Supplies $ 800 c. Supplies Supplies Expense $2,400 d. Supplies Supplies Expense $ 800
4. Kip’s Appliances sells 3-month service contracts to buyers of new appliances. The $32,800 balance in the company’s Unearned Service Contract Revenue account is properly classified as a. an expense. b. revenue. c. an asset. d. a liability.
5. As of August 31, Sun Shade Auto Tinting owes $600 of interest (as yet unrecorded) to First Bank and Trust. If payment will take place on September 5, Sun Shade would classify the interest on August 31 as a. a prepaid expense. b. an unearned revenue. c. an accrued expense. d. an accrued revenue.
Key Terms
Collections of accounts ($5,000 60%) $ 3,000
Advance payment 1,000
Services rendered for cash 10,000
Total cash collections $14,000
waL80144_03_c03_053-088.indd 29 8/29/12 2:43 PM
CHAPTER 3Key Terms
calendar year A company’s annual report- ing period that follows the natural calendar and runs from January 1 to December 31.
capital stock The amount of money received from investors for company shares.
cash basis Revenue that is recorded as cash is received (regardless of when earned) and expenses that are recorded concurrent with their payment.
classified balance sheet Important group- ings of accounts, usually listed in an expected order of appearance.
contra asset an account related to an asset account, but that carries the opposite sign. Accumulated depreciation would be an example.
current assets Items expected to be con- verted into cash or consumed within one year, or the operating cycle, whichever is longer.
current liabilities Obligations that will likely be liquidated with current assets, typically within the next year or operating cycle, whichever is longer.
depreciation The process by which the purchase of an asset is gradually trans- ferred from a cost to an expense.
fiscal year A reporting period that follows a natural business cycle rather than calen- dar year.
historical cost principle Recording cost in a balance sheet according to its history rather than market value this cost is objec-tive and verifiable.
intangible assets Items that lack physical existence but were purchased for the rights they convey and includes patents, copy-rights, brand names, and the more general business goodwill.
intermediate recognition An account- ing model that records assets that have no future benefit and no discernible revenue.
long-term investments Items held for investment purposes, including shares of stock in other companies, idle land, cash surrender value of life insurance, and simi- lar items.
long-term liabilities Obligations that are not current, including bank loans and mortgages.
matching principle The manner in which a large proportion of business costs are to be recorded.
operating cycle The amount of time a busi- ness needs to convert credit back into cash.
other assets Items that defy classification.
periodicity assumption Business activity can be divided into specific time intervals, such as months, quarters, and years.
post-closing trial balance Reveals the balance of the real accounts following the closing process.
prepaid expenses Costs that are paid in advance.
principle of full disclosure Dictates that financial statements and related notes are sufficient to allow financial statement users a legitimate basis for making informed judgments about the company.
property, plant, and equipment Items of land, buildings, and equipment that are used in production or services.
real accounts Asset, Liability, and Equity accounts that are not closed at the end of the accounting period.
waL80144_03_c03_053-088.indd 30 8/29/12 2:43 PM
CHAPTER 3
Critical Thinking Questions
1. Differentiate between a fiscal year and a natural business year. 2. When is revenue generally recognized in the accounting records? 3. Explain the matching principle. 4. What types of items frequently require adjusting entries? 5. In reviewing the records of Yager Company, you find that 3 months’ rent of $750
was prepaid to Savage Property Management on November 1. Both companies use the accrual basis of accounting. In view of this transaction, a. What account and amount would you show on Yager’s income statement for the
month ending November 30? On Savage’s income statement for the month end- ing November 30?
b. What account and amount would you show on Yager’s November 30 balance sheet? On Savage’s November 30 balance sheet?
6. Why is the net income amount (as derived from the income statement columns of the worksheet) also entered as a credit in the balance sheet columns?
7. What are the objectives of the closing process? 8. What is meant by the term accounting cycle? 9. Discuss the limitations of the balance sheet.
10. What is an intangible asset? Give three examples of intangible assets.
Exercises
1. Revenue and expense recognition, accrual basis. Dave Morris began a law practice several years ago, shortly after graduating from law school. During 20X1, he was approached by Delores Silva, who had recently suffered a back injury in an automo- bile accident. Morris accepted Silva as a client and in 20X2 proceeded with a lawsuit against Maddox Motors. The suit alleged that Maddox had knowingly sold Silva an automobile with defective brakes. Late in 20X2, the courts awarded Silva $240,000 in damages. Morris was entitled to 40% of this settlement for his fees. In 20X3, Maddox Motors paid Silva and Morris their respective shares of the judgment.
Morris incurred secretarial and photocopy charges in 20X2 of $12,000—all related to the Silva case. Of this amount, $8,000 was paid in 20X2 and the balance was paid in 20X3.
Assuming that Morris uses the accrual basis of accounting, in what year(s) should the revenue and expense amounts be recognized? Why?
Exercises
revenue recognition The measurement of revenue that is synonymous with record- ing revenues into the accounts.
systemic allocation An accounting model that systematically attributes some costs over time.
temporary accounts Revenue, Expense, and Dividend accounts that have been reset to a zero balance at the end of an accounting year, to be ready for the new accounting year.
unearned revenue Amounts collected in advance of services being provided.
waL80144_03_c03_053-088.indd 31 8/29/12 2:43 PM
CHAPTER 3Exercises
2. Recognition of concepts. Ron Carroll operates a small company that books enter- tainers for theaters, parties, conventions, and so forth. The company’s fiscal year ends on June 30. Consider the following items and classify each as either (1) pre- paid expense, (2) unearned revenue, (3) accrued expense, (4) accrued revenue, or (5) none of the foregoing.
a. Amounts paid on June 30 for a 1-year insurance policy b. Professional fees earned but not billed as of June 30 c. Repairs to the firm’s copy machine, incurred and paid in June d. An advance payment from a client for a performance next month at a convention e. The payment in part (d) from the client’s point of view f. Interest owed on the company’s bank loan, to be paid in early July g. The bank loan payable in part (f) h. Office supplies on hand at year-end
3. Analysis of prepaid account balance. The following information relates to Action Sign Company for 20X2:
Insurance expense $4,350
Prepaid insurance, December 31, 20X2 1,900
Cash outlays for insurance during 20X2 6,200
Compute the balance in the Prepaid Insurance account on January 1, 20X2.
4. Accounting for prepaid expenses and unearned revenues. Hawaii-Blue began business on January 1 of the current year and offers deep-sea fishing trips to tour- ists. Tourists pay $125 in advance for an all-day outing off the coast of Maui. The company collected monies during January for 210 outings, with 30 of the tourists not planning to take their trips until early February.
Hawaii-Blue rents its fishing boat from Pacific Yacht Supply. An agreement was signed at the beginning of the year, and $72,000 was paid for the rights to use the boat for 2 full years.
a. Prepare journal entries to record (1) the collection of monies from tourists and (2) the revenue generated during January.
b. Calculate Hawaii-Blue’s total obligation to tourists at the end of January. On what financial statement and in which section would this amount appear?
c. Prepare journal entries to record (1) the payment to Pacific Yacht Supply and (2) the subsequent adjustment on January 31.
d. On what financial statement would Hawaii-Blue’s January boat rental cost appear?
waL80144_03_c03_053-088.indd 32 8/29/12 2:43 PM
CHAPTER 3Exercises
5. Adjustment error. The accountant for Stringer Services failed to adjust the Supplies account to recognize the amount consumed during March. As a result of this error, will the following items be overstated, understated, or unaffected?
a. March revenues will be ________________. b. March expenses will be ________________. c. March net income will be _______________. d. Ending owner’s equity as of March 31 will be _________________. e. Assets as of March 31 will be __________________. f. Liabilities as of March 31 will be _________________.
6. Overview of the closing process. Evaluate the comments that follow as being true or false. If the comment is false, briefly explain why.
a. The closing process is performed after adjusting entries have been journalized and posted.
b. Because they both possess a debit balance, Salaries Expense and Susan Franklin, Drawing, are treated in the same manner when accounts are closed at the end of the period.
c. The Equipment account is closed at the end of the period by a debit to Income Summary and a credit to Equipment.
d. If MultiTech incurred a net loss for the period just ended, the Income Summary account would contain a debit balance after the revenue and expense accounts have been closed.
e. If a $4,900 balance is listed in the adjusted trial balance for Dave Miller, Capital, it stands to reason that Miller’s capital account in the post- closing trial balance would be listed at $4,900 as well.
7. Understanding the closing process. Examine the following list of accounts:
Interest Payable Accumulated Depreciation: Equipment
Alex Kenzy, Drawing Accounts Payable
Service Revenue Cash
Accounts Receivable Supplies Expense
Interest Expense
Which of the preceding accounts
a. appear on a post-closing trial balance? b. are commonly known as temporary, or nominal, accounts? c. generate a debit to Income Summary in the closing process? d. are closed to the capital account in the closing process?
waL80144_03_c03_053-088.indd 33 8/29/12 2:43 PM
CHAPTER 3Problems
8. Closing entries. Gomez Company had the following adjusted trial balance on December 31:
Cash $ 2,300 Accounts Receivable 16,500 Prepaid Insurance 1,200 Land 40,000 Accounts Payable $ 1,800 Miguel Gomez, Capital 43,700 Miguel Gomez, Drawing 2,500 Service Revenue 38,000 Rent Expense 9,000 Insurance Expense 5,400 Advertising Expense 3,500 Utilities Expense 3,100
$83,500 $83,500
Prepare the closing entries that Gomez would record on December 31.
Problems
1. Accrual and cash basis. The following information pertains to Beta Company for October:
Services rendered during October to customers on account $14,380
Cash receipts from
Owner investment 7,000
Customers on account 5,650
Cash customers for services rendered in October 6,800
Cash payments to
Creditors for expenses incurred during October 4,400
Creditors for expenses incurred prior to October 2,100
Monroe Equipment for purchase of new machinery on October 1 8,400
Expenses incurred during October, to be paid in future months 3,725
The machinery is expected to have a service life of 5 years.
Instructions Calculate Beta’s net income for October, using the following methods:
a. Accrual basis of accounting b. Cash basis of accounting
waL80144_03_c03_053-088.indd 34 8/29/12 2:43 PM
CHAPTER 3Problems
2. Adjusting entries and financial statements. The following information pertains to Fixation Enterprises:
• The company previously collected $1,500 as an advance payment for services to be rendered in the future. By the end of December, one third of this amount had been earned.
• Fixation provided $2,500 of services to Artech Corporation; no billing had been made by December 31.
• Salaries owed to employees at year-end amounted to $1,650. • The Supplies account revealed a balance of $8,800, yet only $3,300 of supplies
were actually on hand at the end of the period. • The company paid $18,000 on October 1 of the current year to Vantage Property
Management. The payment was for 6 months’ rent of Fixation’s headquarters, beginning on November 1.
Fixation’s accounting year ends on December 31.
Instructions Analyze the five preceding cases individually and determine the following:
a. The type of adjusting entry needed at year-end (Use the following codes: A, adjust- ment of a prepaid expense; B, adjustment of an unearned revenue; C, adjustment to record an accrued expense; or D, adjustment to record an accrued revenue.)
b. The year-end journal entry to adjust the accounts c. The income statement impact of each adjustment (e.g., increases total revenues
by $500)
3. Adjusting entries. You have been retained to examine the records of Kathy’s Day Care Center as of December 31, 20X3, the close of the current reporting period. In the course of your examination, you discover the following:
• On January 1, 20X3, the Supplies account had a balance of $2,350. During the year, $5,520 worth of supplies was purchased, and a balance of $1,620 remained unused on December 31.
• Unrecorded interest owed to the center totaled $275 as of December 31. • All clients pay tuition in advance, and their payments are credited to the
Unearned Tuition Revenue account. The account was credited for $75,500 on August 31. With the exception of $15,500, which represented prepayments for 10 months’ tuition from several well-to-do families, all amounts were for the current semester ending on December 31.
• Depreciation on the school’s van was $3,000 for the year. • On August 1, the center began to pay rent in 6-month installments of $21,000.
Kathy wrote a check to the owner of the building and recorded the check in Pre- paid Rent, a new account.
• Two salaried employees earn $400 each for a 5-day week. The employees are paid every Friday, and December 31 falls on a Thursday.
• Kathy’s Day Care paid insurance premiums as follows, each time debiting Pre- paid Insurance:
waL80144_03_c03_053-088.indd 35 8/29/12 2:43 PM
CHAPTER 3Problems
Date Paid Policy No. Length of Policy Amount
Feb. 1, 20X2 1033MCM19 1 year $540
Jan. 1, 20X3 7952789HP 1 year 912
Aug. 1, 20X3 XQ943675ST 2 years 840
Instructions The center’s accounts were last adjusted on December 31, 20X2. Prepare the adjusting entries necessary under the accrual basis of accounting.
waL80144_03_c03_053-088.indd 36 8/29/12 2:43 PM
