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Introduction to Financial

Statements

Kimmel ● Weygandt ● Kieso

Accounting, Sixth Edition

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CHAPTER OUTLINE
Identify the forms of business organization and the uses of accounting information.
1
Explain the three principal types of business activity.
2
LEARNING OBJECTIVES
Describe the four financial statements and how they are prepared.
3

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LEARNING OBJECTIVE
LO 1

FORMS OF BUSINESS ORGANIZATION
Identify the forms of business organization and the uses of accounting information.
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USERS AND USES OF FINANCIAL INFORMATION

Internal Users
Illustration 1-1
Questions that internal users ask

LO 1

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ACCOUNTING ACROSS THE ORGANIZATION
Owning a Piece of the Bar
The original Clif Bar® energy bar was created in 1990 after six months of experimentation by Gary Erickson and his mother in her kitchen. Today, the company has almost 300 employees and is considered one of the leading Landor’s Breakaway Brands®. One of Clif Bar & Company’s proudest moments was the creation of an employee stock ownership plan (ESOP) in 2010. This plan gives its employees 20% ownership of the company. The ESOP also resulted in Clif Bar enacting an open-book management program, including the commitment to educate all employee-owners about its finances. Armed with basic accounting knowledge, employees are more aware of the financial impact of their actions, which leads to better decisions.
LO 1

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External Users
Illustration 1-2
Questions that external users ask

USERS AND USES OF FINANCIAL INFORMATION

LO 1

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ACCOUNTING ACROSS THE ORGANIZATION
Spinning the Career Wheel
How will the study of accounting help you? A working knowledge of accounting is desirable for virtually every field of business. Some examples of how accounting is used in business careers include the following.
General management: Managers of Ford Motors, Massachusetts General Hospital, California State University–Fullerton, a McDonald’s franchise, and a Trek bike shop all need to understand accounting data in order to make wise business decisions.
Marketing: Marketing specialists at Procter & Gamble must be sensitive to costs and benefits, which accounting helps them quantify and understand. Making a sale is meaningless unless it is a profitable sale.
LO 1

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ACCOUNTING ACROSS THE ORGANIZATION
Spinning the Career Wheel
Finance: Do you want to be a banker for Citicorp, an investment analyst for Goldman Sachs, or a stock broker for Merrill Lynch? These fields rely heavily on accounting knowledge to analyze financial statements. In fact, it is difficult to get a good job in a finance function without two or three courses in accounting.
Real estate: Are you interested in being a real estate broker for Prudential Real Estate? Because a third party—the bank—is almost always involved in financing a real estate transaction, brokers must understand the numbers involved: Can the buyer afford to make the payments to the bank? Does the cash flow from an industrial property justify the purchase price? What are the tax benefits of the purchase?
LO 1

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Ethics In Financial Reporting
United States regulators and lawmakers were very concerned that the economy would suffer if investors lost confidence in corporate accounting because of unethical financial reporting.
Recent financial scandals include: Enron, WorldCom, HealthSouth, AIG, and others.
Congress passed Sarbanes-Oxley Act (SOX).
Effective financial reporting depends on sound ethical behavior.
USERS AND USES OF FINANCIAL INFORMATION
LO 1

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USERS AND USES OF FINANCIAL INFORMATION

Illustration 1-3
Steps in analyzing ethics cases
LO 1

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LO 1
ETHICS INSIGHT
I Felt the Pressure—Would You?
“I felt the pressure.” That’s what some of the employees of the now-defunct law firm of Dewey & LeBoeuf LLP indicated when they helped to overstate revenue and use accounting tricks to hide losses and cover up cash shortages. These employees worked for the former finance director and former chief financial officer (CFO) of the firm. Here are some of their comments:
• “I was instructed by the CFO to create invoices, knowing they would not be sent to clients. When I created these invoices, I knew that it was inappropriate.”
• “I intentionally gave the auditors incorrect information in the course of the audit.”
Dewey & LeBoeuf LLP
(continued)

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ETHICS INSIGHT
I Felt the Pressure—Would You?
What happened here is that a small group of lower-level employees over a period of years carried out the instructions of their bosses. Their bosses, however, seemed to have no concern as evidenced by various e-mails with one another in which they referred to their financial manipulations as accounting tricks, cooking the books, and fake income.
Source: Ashby Jones, “Guilty Pleas of Dewey Staff Detail the Alleged Fraud,” Wall Street Journal (March 28, 2014).
Dewey & LeBoeuf LLP
LO 1

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In choosing the organizational form for your outdoor guide service, you should consider the pros and cons of each. Identify each of the following organizational characteristics with the organizational form or forms with which it is associated.
Corporation.
Sole proprietorship and partnership.
Corporation.
SOLUTION
DO IT!
Business Organization Forms
1
1. Easier to raise funds. 4. Tax advantages.
2. Simple to establish. 5. Easier to transfer ownership.
3. No personal legal liability.
Sole proprietorship and partnership.
Corporation.
LO 1

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USERS AND USES OF FINANCIAL INFORMATION
Review Question
Which of the following did not result from the Sarbanes-Oxley Act?
Top management must now certify the accuracy of financial information.
Penalties for fraudulent activity increased.
Independence of auditors increased.
Tax rates on corporations increased.
LO 1

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LEARNING OBJECTIVE
Explain the three principal types of business activity.
2
All businesses are involved in three types of activity —
financing,
investing, and
operating.
The accounting information system keeps track of the results of each of these business activities.
LO 2

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FINANCING ACTIVITIES
Two primary sources of outside funds are:
Borrowing money (debt)
Amounts owed are called liabilities.
Party to whom amounts are owed are creditors.
Notes payable and bonds payable are different types of liabilities.
Issuing (selling) shares of stock for cash (equity).
Common stock is the term used to describe the amount paid by stockholders for shares they purchase.
Payments to stockholders are called dividends.
LO 2

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INVESTING ACTIVITIES
Purchase of resources a company needs to operate.
Computers, delivery trucks, furniture, buildings.
Resources owned by a business are called assets.

Investments are another example of an investing activity.
LO 2

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OPERATING ACTIVITIES
Once a business has the assets it needs, it can begin its operations.
Revenues – Amounts earned from the sale of products and other sources (sales revenue, service revenue, and interest revenue).
Inventory – Goods available for sale to customers.
Accounts receivable – Right to receive money from a customer as the result of a sale.
LO 2

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OPERATING ACTIVITIES
Once a business has the assets it needs, it can begin its operations.
Expenses – cost of assets consumed or services used. (cost of goods sold, selling, marketing, administrative, interest, and income taxes expense).
Liabilities arising from expenses include accounts payable, interest payable, wages payable, sales taxes payable, and income taxes payable.
Net income – when revenues exceed expenses.
Net loss – when expenses exceed revenues.
LO 2

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Classify each item as an asset, liability, common stock, revenue, or expense.
Cost of renting property.
Truck purchased.
Notes payable.
Issuance of ownership shares.
Amount earned from providing service.
Amounts owed to suppliers.
Expense.
Asset.
Liabilities.
Common stock.
Revenue.
Liabilities.
SOLUTION
DO IT!
Business Activities
2
LO 2

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LEARNING OBJECTIVE
LO 3
Describe the four financial statements and how they are prepared.
3

Income Statement
Companies prepare four financial statements from the summarized accounting data:
Statement of Cash Flows
Retained Earnings Statement
Balance Sheet
INTERNATIONAL NOTE The primary types of financial statements required by International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (GAAP) are the same.

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LO 3
Reports revenues and expenses for a specific period of time.
Net income – revenues exceed expenses.
Net loss – expenses exceed revenues.
Past net income provides information for predicting future net income.
Illustration 1-4
▼Helpful Hint The financial statement heading identifies the company, the type of statement, and the time period covered. Sometimes, another line indicates the unit of measure, e.g., “in thousands” or “in millions.”
FINANCIAL STATEMENTS

Income Statement

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Illustration 1-4
FINANCIAL STATEMENTS

Income Statement
Retained Earnings Statement
Net income is needed to determine the ending balance in retained earnings.
Illustration 1-5
LO 3

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Statement shows amounts and causes of changes in retained earnings during the period.
Time period is the same as that covered by the income statement.
Users can evaluate dividend payment practices.
Retained Earnings Statement
▼Helpful Hint The heading of this statement identifies the company, the type of statement, and the time period covered by the statement.
FINANCIAL STATEMENTS
Illustration 1-5
LO 3

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Retained Earnings Statement
Ending balance in retained earnings is needed in preparing the balance sheet.
Balance Sheet

Illustration 1-7
Illustration 1-5
FINANCIAL STATEMENTS
LO 3

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Balance Sheet

Reports assets and claims to assets at a specific point in time.
Assets = Liabilities + Stockholders’ Equity.
Lists assets first, followed by liabilities and stockholders’ equity.
▼Helpful Hint The heading of a balance sheet must identify the company, the statement, and the date.
FINANCIAL STATEMENTS

Illustration 1-7
LO 3

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Illustration 1-8

Statement of Cash Flows
Balance Sheet
FINANCIAL STATEMENTS

Illustration 1-7
LO 3

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Provides answers to:
Where did cash come from during the period?
How was cash used during the period?
What was the change in the cash balance during the period?
Illustration 1-8
▼Helpful Hint The heading identifies the company, the type of statement, and the time period covered by the statement. Negative numbers are shown in parentheses.
FINANCIAL STATEMENTS

Statement of Cash Flows
LO 3

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Net income will result during a time period when:
assets exceed liabilities.
assets exceed revenues.
expenses exceed revenues.
revenues exceed expenses.
FINANCIAL STATEMENTS
Review Question
LO 3

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Which of the following financial statements is prepared as of a specific date?
Balance sheet.
Income statement.
Retained earnings statement.
Statement of cash flows.
FINANCIAL STATEMENTS
Review Question
LO 3

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PEOPLE, PLANET, AND PROFIT INSIGHT
Beyond Financial Statements
Should we expand our corporate reports beyond the income statement, retained earnings statement, balance sheet, and statement of cash flows? Some believe we should take into account ecological and social performance, in addition to financial results, in evaluating a company. The argument is that a company’s responsibility lies with anyone who is influenced by its actions. In other words, a company should be interested in benefiting many different parties, instead of only maximizing stockholders’ interests. A socially responsible business does not exploit or endanger any group of individuals. It follows fair trade practices, provides safe environments for workers, and bears responsibility for environmental damage. Granted, measurement of these factors is difficult. How to report this information is also controversial. But many interesting and useful efforts are underway. Throughout this textbook, we provide additional insights into how companies are attempting to meet the challenge of measuring and reporting their contributions to society, as well as their financial results, to stockholders.
LO 3

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Financial Statements
CSU Corporation began operations on January 1, 2017. The following information is available for CSU on December 31, 2017:
Accounts receivable 1,800 Retained earnings ?
Supplies expense 200 Accounts payable 2,000
Equipment 16,000 Cash 1,400
Rent expense 9,000 Insurance expense 1,000
Dividends 600 Notes payable 5,000
Service revenue 17,000 Common stock 10,000
Supplies 4,000
Prepare an income statement, a retained earnings statement, and a balance sheet.
DO IT!
3a
LO 3

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Prepare an income statement using the following accounts.
Accounts receivable 1,800 Retained earnings ?
Supplies expense 200 Accounts payable 2,000
Equipment 16,000 Cash 1,400
Rent expense 9,000 Insurance expense 1,000
Dividends 600 Notes payable 5,000
Service revenue 17,000 Common stock 10,000
Supplies 4,000

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Prepare a retained earnings statement using the following accounts.
Accounts receivable 1,800 Retained earnings ?
Supplies expense 200 Accounts payable 2,000
Equipment 16,000 Cash 1,400
Rent expense 9,000 Insurance expense 1,000
Dividends 600 Notes payable 5,000
Service revenue 17,000 Common stock 10,000
Supplies 4,000

LO 3

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Financial Statements
CSU Corporation began operations on January 1, 2017. The following information is available for CSU on December 31, 2017:
Accounts receivable 1,800 Retained earnings ?
Supplies expense 200 Accounts payable 2,000
Equipment 16,000 Cash 1,400
Rent expense 9,000 Insurance expense 1,000
Dividends 600 Notes payable 5,000
Service revenue 17,000 Common stock 10,000
Supplies 4,000
Prepare an a balance sheet.
DO IT!
3a
LO 3

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LO 3

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OTHER ELEMENTS OF AN ANNUAL REPORT
U.S. companies that are publicly traded must provide shareholders with an annual report.
The annual report always includes:
Financial statements.
Management discussion and analysis.
Notes to the financial statements.
Auditor’s report.
LO 3

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Management Discussion and Analysis
Management discussion and analysis (MD&A) presents management’s view on the company’s ability to pay near-term obligations, its ability to fund operations and expansion, and its results of operations.
Management must highlight favorable or unfavorable trends and identify significant events and uncertainties that affect these three factors.
ELEMENTS OF AN ANNUAL REPORT
LO 3

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Management Discussion and Analysis
ELEMENTS OF AN ANNUAL REPORT

ILLUSTRATION 1-10
Columbia Sportswear’s
management discussion and analysis
LO 3

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LO 3
Notes to the Financial Statements
Clarify the financial statements.
Provide additional detail.
Notes are essential to understanding a company’s operating performance and financial position.
ELEMENTS OF AN ANNUAL REPORT

ILLUSTRATION 1-11

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Auditor’s Report
Auditor’s opinion as to the fairness of the presentation of the financial position and results of operations and their conformance with generally accepted accounting principles.
Only certified public accountants (CPA) may perform audits.
ELEMENTS OF AN ANNUAL REPORT
LO 3

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Auditor’s Report
ELEMENTS OF AN ANNUAL REPORT

ILLUSTRATION 1-12
Excerpt from auditor’s report on
Columbia Sportswear’s financial
statements
LO 3

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State whether each of the following items is most closely associated with the management discussion and analysis (MD&A), the notes to the financial statements, or the auditor’s report.
Descriptions of significant accounting policies.
Unqualified opinion.
Explanations of uncertainties and contingencies.
Description of ability to fund operations and expansion.
Description of results of operations.
Certified public accountant (CPA).
Notes
Auditor’s report
Notes
MD&A
MD&A
Auditor’s report
SOLUTION
Components of Annual Report
DO IT!
3b
LO 3

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KEY POINTS
Similarities
The basic techniques for recording business transactions are the same for U.S. and international companies.
Both international and U.S. accounting standards emphasize transparency in financial reporting. Both sets of standards are primarily driven by meeting the needs of investors and creditors.

A Look at IFRS
LEARNING OBJECTIVE
Describe the impact of international accounting standards on U.S. financial reporting.
4
LO 4

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KEY POINTS
Similarities
The three most common forms of business organizations, proprietorships, partnerships, and corporations, are also found in countries that use international accounting standards.
Differences
International standards are referred to as International Financial Reporting Standards (IFRS), developed by the International Accounting Standards Board. Accounting standards in the United States are referred to as generally accepted accounting principles (GAAP) and are developed by the Financial Accounting Standards Board.

A Look at IFRS
LO 4

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KEY POINTS
Differences
IFRS tends to be simpler in its accounting and disclosure requirements; some people say it is more “principles-based.” GAAP is more detailed; some people say it is more “rules-based.”
The internal control standards applicable to Sarbanes-Oxley (SOX) apply only to large public companies listed on U.S. exchanges. There is continuing debate as to whether non-U.S. companies should have to comply with this extra layer of regulation.

A Look at IFRS
LO 4

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LOOKING TO THE FUTURE
Both the IASB and the FASB are hard at work developing standards that will lead to the elimination of major differences in the way certain transactions are accounted for and reported.

A Look at IFRS
LO 4

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A Look at IFRS
IFRS Practice
Which of the following is not a reason why a single set of high-quality international accounting standards would be beneficial?
Mergers and acquisition activity.
Financial markets.
Multinational corporations.
GAAP is widely considered to be a superior reporting system.
LO 4

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A Look at IFRS
IFRS Practice
The Sarbanes-Oxley Act determines:
international tax regulations.
internal control standards as enforced by the IASB.
internal control standards of U.S. publicly traded companies.
U.S. tax regulations.
LO 4

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A Look at IFRS
IFRS Practice
IFRS is considered to be more:
principles-based and less rules-based than GAAP.
rules-based and less principles-based than GAAP.
detailed than GAAP.
None of the above.
LO 4

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“Copyright © 2016 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.”
COPYRIGHT

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A Further Look at Financial

Statements

Kimmel ● Weygandt ● Kieso

Accounting, Sixth Edition

2

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Use ratios to evaluate a company’s profitability, liquidity, and solvency.
CHAPTER OUTLINE
Identify the sections of a classified balance sheet.
1
2
LEARNING OBJECTIVES
Discuss financial reporting concepts.
3

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Presents a snapshot at a point in time.
To improve understanding, companies group similar assets and similar liabilities together.
Standard Classifications
LEARNING OBJECTIVE
LO 1
Identify the sections of a classified balance sheet.
1
Assets Liabilities and Stockholders’ Equity
Current assets Current liabilities
Long-term investments Long-term liabilities
Property, plant, and equipment Stockholders’ equity
Intangible assets
ILLUSTRATION 2-1
Standard balance sheet classifications

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LO 1
ILLUSTRATION 2-2
Classified balance sheet

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LO 1

ILLUSTRATION 2-2
Classified balance sheet

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Assets that a company expects to convert to cash or use up within one year or the operating cycle, whichever is longer.
Operating cycle is the average time it takes from the purchase of inventory, to the sale of goods, and then to the collection of cash from customers.
Common types of current assets are (1) cash, (2) investments, (3) receivables, (4) inventories, and (5) prepaid expenses.
Current Assets
THE CLASSIFIED BALANCE SHEET
LO 1

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Companies list current asset accounts in the order they expect to convert them into cash.
Illustration 2-3
Current assets section
Current Assets
THE CLASSIFIED BALANCE SHEET

LO 1

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Cash, and other resources that are reasonably expected to be realized in cash or sold or consumed in the business within one year or the operating cycle, are called:
Current assets.
Intangible assets.
Long-term investments.
Property, plant, and equipment.
THE CLASSIFIED BALANCE SHEET
Review Question
LO 1

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LO 1
Investments in stocks and bonds of other corporations that are held for more than one year.
Long-term assets such as land or buildings that a company is not currently using in its operating activities.
Long-term notes receivable.
Long-Term Investments
THE CLASSIFIED BALANCE SHEET

ILLUSTRATION 2-4
Long-term investments section

2-‹#›

Property, Plant, and Equipment
Long useful lives.
Currently used in operations.
Includes land, buildings, equipment, delivery vehicles, and furniture.
Depreciation – allocating the cost of assets to a number of years.
Accumulated depreciation – total amount of depreciation expensed thus far in the asset’s life.
Alternative Terminology
Property, plant, and equipment is sometimes called fixed assets or plant assets.
THE CLASSIFIED BALANCE SHEET
LO 1

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Property, Plant, and Equipment

ILLUSTRATION 2-5
Property, plant, and equipment section
LO 1

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Intangible Assets
Assets that do not have physical substance.
Includes goodwill, patents, copyrights, and trademarks or trade names.
▼Helpful Hint Sometimes intangible assets are reported
under a broader heading called “Other assets.”
THE CLASSIFIED BALANCE SHEET
LO 1

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Intangible Assets
Illustration 2-6
THE CLASSIFIED BALANCE SHEET

ILLUSTRATION 2-6
Intangible assets section
LO 1

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Review Question
Patents and copyrights are
Current assets.
Intangible assets.
Long-term investments.
Property, plant, and equipment.
THE CLASSIFIED BALANCE SHEET

LO 1

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Assets Section of Classified Balance Sheet
Baxter Hoffman recently received the following information related to Hoffman Corporation’s December 31, 2017, balance sheet.
Prepaid insurance $ 2,300 Inventory $3,400
Cash 800 Accumulated depreciation—
Equipment 10,700 equipment 2,700
Accounts receivable 1,100
Prepare the assets section of Hoffman Corporation’s classified balance sheet.
DO IT!
1a
LO 1

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Prepare the assets section of the classified balance sheet.
Prepaid insurance $ 2,300 Inventory $3,400
Cash 800 Accumulated depreciation—
Equipment 10,700 equipment 2,700
Accounts receivable 1,100

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Obligations the company is to pay within the next year or operating cycle, whichever is longer.
Common examples are accounts payable, salaries and wages payable, notes payable, interest payable, and income taxes payable.
Also included as current liabilities are current maturities of long-term obligations—payments to be made within the next year on long-term obligations.
Current Liabilities
THE CLASSIFIED BALANCE SHEET
LO 1

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Current Liabilities
THE CLASSIFIED BALANCE SHEET

ILLUSTRATION 2-7
Current liabilities section
LO 1

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Obligations a company expects to pay after one year.
Include bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities.
Long-Term Liabilities
THE CLASSIFIED BALANCE SHEET

ILLUSTRATION 2-8
Long-term liabilities section
LO 1

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Review Question
Which of the following is not a long-term liability?
Bonds payable.
Current maturities of long-term debt.
Long-term notes payable.
Mortgages payable.
THE CLASSIFIED BALANCE SHEET

LO 1

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Illustration 2-2
Common stock – investments of assets into the business by the stockholders.
Retained earnings – income retained for use in the business
Stockholders’ Equity
THE CLASSIFIED BALANCE SHEET

Stockholders’ Equity section for Franklin Corporation
LO 1

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CL Salaries and wages payable LTI Investment in real estate
NA Service revenue PPE Equipment
CL Interest payable PPE Accumulated depreciation
IA Goodwill CA Debt investments (short-term)
NA Depreciation expense SE Retained earnings
LTL Mortgage payable CL Unearned service revenue
(due in 3 years)
Match each of the items to its proper balance sheet classification, shown below. If the item would not appear on a balance sheet, use “NA.”
Current assets (CA) Current liabilities (CL)
Long-term investments (LTI) Long-term liabilities (LTL)
Property, plant, and equipment (PPE) Stockholders’ equity (SE)
Intangible assets (IA)
Solution

LO 1
Balance Sheet Classifications
DO IT!
1b

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Ratio Analysis
Ratio analysis expresses the relationship among selected items of financial statement data.
A ratio expresses the mathematical relationship between one quantity and another.
A single ratio by itself is not very meaningful.
LEARNING OBJECTIVE
LO 2
Use ratios to evaluate a company’s profitability, liquidity, and solvency.
2

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ILLUSTRATION 2-9
Financial ratio classifications
RATIO ANALYSIS
LO 2

2-‹#›

Illustration 2-10
USING THE INCOME STATEMENT

ILLUSTRATION 2-10
Best Buy’s income statement
LO 2

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Illustration: Earnings per share (EPS) measures the net income earned on each share of common stock.
Earnings per Share
Profitability Ratio

LO 2

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For 2017 Stoneland Corporation reported net income $26,000; net sales $400,000; and average shares outstanding 6,000. There were preferred stock dividends of $2,000. What was the 2017 earnings per share?
$4.00
$0.06
$16.67
$66.67
$26,000
– $2,000
6,000
= $4.00
Review Question

USING THE INCOME STATEMENT
LO 2

2-‹#›

Illustration 2-12
Best Buy’s balance sheet
USING A CLASSIFIED BALANCE SHEET

2-‹#›

Liquidity—the ability to pay obligations expected to become due within the next year or operating cycle.
Working capital is the difference between the amounts of current assets and current liabilities.
Best Buy had working capital in 2014 of $3,049 million ($10,485 million − $7,436 million).
USING A CLASSIFIED BALANCE SHEET
ILLUSTRATION 2-13
Working capital
LO 2

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Liquidity ratios measure the short-term ability to pay maturing obligations and to meet unexpected needs for cash.
For every dollar of current liabilities, Best Buy has $1.41 of current assets.
USING A CLASSIFIED BALANCE SHEET
ILLUSTRATION 2-14
Current ratio
LO 2
2014

2-‹#›

ACCOUNTING ACROSS THE ORGANIZATION
Can a Company Be Too Liquid?
There actually is a point where a company can be too liquid—that is, it can have too much working capital. While it is important to be liquid enough to be able to pay short-term bills as they come due, a company does not want to tie up its cash in extra inventory or receivables that are not earning the company money. By one estimate from the REL Consultancy Group, the thousand largest U.S. companies had cumulative excess working capital of $1.017 trillion in a recent year. This was an 18% increase, which REL said represented a“ deterioration in the management of operations.” Given that managers throughout a company are interested in improving profitability, it is clear that they should have an eye toward managing working capital. They need to aim for a “Goldilocks solution”—not too much, not too little, but just right.
Source: Maxwell Murphy, “The Big Number,” Wall Street Journal (November 9, 2011).
LO 2

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Solvency—the ability to pay interest as it comes due and to repay the balance of a debt due at its maturity.
Solvency ratios measure the ability of the company to survive over a long period of time.
▼Helpful Hint Some users evaluate solvency using a ratio of liabilities divided by stockholders’ equity. The higher this “debt to equity” ratio, the lower is a company’s solvency.
USING A CLASSIFIED BALANCE SHEET
LO 2

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The 2014 ratio means that every dollar of assets was financed by 72 cents of debt.
Debt to assets ratio measures the percentage of total financing provided by creditors rather than stockholders.
USING A CLASSIFIED BALANCE SHEET
ILLUSTRATION 2-15
Debt to assets ratio
LO 2

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INVESTOR INSIGHT
When Debt Is Good
Debt financing differs greatly across industries and companies. Here are some debt to assets ratios for selected companies in a recent year:
Debt to
Assets Ratio
Google 23%
Nike 41%
Microsoft 48%
ExxonMobil 48%
General Motors 74%
LO 2

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In the Statement of Cash Flows, cash provided by operating activities fails to take into account that a company must invest in new property, plant, and equipment and must maintain dividends at current levels to satisfy investors.
Free cash flow describes the net cash provided by operating activities after adjusting for capital expenditures and dividends paid.
USING THE STATEMENT OF CASH FLOWS
ILLUSTRATION 2-16
Free cash flow
LO 2

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Illustration: MPC produced and sold 10,000 personal computers this year. It reported $100,000 cash provided by operating activities. In order to maintain production at 10,000 computers, MPC invested $15,000 in equipment. It chose to pay $5,000 in dividends. Calculate free cash flow.
Cash provided by operating activities $100,000
Less: Expenditures on property, plant, and equipment -15,000
Dividends paid 5,000
Free cash flow $ 80,000

USING THE STATEMENT OF CASH FLOWS
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Ratio Analysis
The following information is available for Ozone Inc.
2017 2016
Current assets $ 88,000 $ 60,800
Total assets 400,000 341,000
Current liabilities 40,000 38,000
Total liabilities 120,000 150,000
Net income 100,000 50,000
Net cash provided by operating activities 110,000 70,000
Preferred dividends 10,000 10,000
Common dividends 5,000 2,500
Expenditures on PP&E 45,000 20,000
Shares outstanding at beginning of year 60,000 40,000
Shares outstanding at end of year 120,000 60,000
DO IT!
2
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Ratio Analysis
(a) Compute earnings per share for 2017 and 2016 for Ozone. Ozone’s primary competitor, Frost Corporation, had earnings per share of $2 in 2017.
DO IT!
2
SOLUTION
Earnings per
share

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Ratio Analysis
Compute the current ratio and debt to assets ratio for 2017.
DO IT!
2
SOLUTION

Current
Ratio
Debt to Assets ratio

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Net cash provided by operating activities $110,000 $70,000
Expenditures on PP&E − 45,000 − 20,000
Preferred dividend − 10,000 − 10,000
Common dividends − 5,000 − 2,500
$ 50,000 $ 37,500
Ratio Analysis
Compute free cash flow for each year.
DO IT!
2
SOLUTION
2017
2016
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The Standard-Setting Environment
Generally Accepted Accounting Principles (GAAP) – A set of rules and practices, having substantial authoritative support, that the accounting profession recognizes as a general guide for financial reporting purposes.
Standard-setting bodies determine these guidelines:
Securities and Exchange Commission (SEC)
Financial Accounting Standards Board (FASB)
International Accounting Standards Board (IASB)
Public Company Accounting Oversight Board (PCAOB)
International Note Over 115 countries use international standards (called IFRS).
LEARNING OBJECTIVE
LO 3
Discuss financial reporting concepts.
3

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Generally accepted accounting principles are:
a set of standards and rules that are recognized as a general guide for financial reporting.
usually established by the Internal Revenue Service.
the guidelines used to resolve ethical dilemmas.
fundamental truths that can be derived from the laws of nature.
Review Question

THE STANDARD-SETTING ENVIRONMENT
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INTERNATIONAL INSIGHT
The Korean Discount
If you think that accounting standards don’t matter, consider recent events in South Korea. For many years, international investors complained that the financial reports of South Korean companies were inadequate and inaccurate. Accounting practices there often resulted in huge differences between stated revenues and actual revenues. Because investors did not have faith in the accuracy of the numbers, they were unwilling to pay as much for the shares of these companies relative to shares of comparable companies in different countries. This difference in share price was often referred to as the “Korean discount.” In response, Korean regulators decided that companies would have to comply with international accounting standards. This change was motivated by a desire to “make the country’s businesses more transparent” in order to build investor confidence and spur economic growth. Many other Asian countries, including China, India, Japan, and Hong Kong, have also decided either to adopt international standards or to create standards that are based on the international standards.
Source: Evan Ramstad, “End to ‘Korea Discount’?” Wall Street Journal (March 16, 2007).
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According to the FASB, useful information should possess two fundamental qualities, relevance and faithful representation.
Relevance Accounting information has relevance if it would make a difference in a business decision. Information is considered relevant if it provides information that has predictive value, that is, helps provide accurate expectations about the future, and has confirmatory value, that is, confirms or corrects prior expectations. Materiality is a company-specific aspect of relevance. An item is material when its size makes it likely to influence the decision of an investor or creditor.
QUALITIES OF USEFUL INFORMATION
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According to the FASB, useful information should possess two fundamental qualities, relevance and faithful representation.
Faithful Representation Faithful representation means that information accurately depicts what really happened. To provide a faithful representation, information must be complete (nothing important has been omitted), neutral (is not biased toward one position or another), and free from error.
QUALITIES OF USEFUL INFORMATION
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Enhancing Qualities
Comparability results when different companies use the same accounting principles.
Consistency means that a company uses the same accounting
principles and methods from year to year.
Information is verifiable if independent
observers, using the same methods, obtain similar results.
For accounting information to have relevance, it must be timely.
Information has the quality of understandability
if it is presented in a clear and concise fashion.
QUALITIES OF USEFUL INFORMATION
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ACCOUNTING ACROSS THE ORGANIZATION
What Do These Companies Have in Common?
Another issue related to comparability is the accounting time period. An accounting period that is one-year long is called a fiscal year. But a fiscal year need not match the calendar year. For example, a company could end its fiscal year on April 30 rather than on December 31. Why do companies choose the particular year-ends that they do? For example, why doesn’t every company use December 31 as its accounting year-end? Many companies choose to end their accounting year when inventory or operations are at a low point. This is advantageous because compiling accounting information requires much time and effort by managers, so they would rather do it when they aren’t as busy operating the business. Also, inventory is easier and less costly to count when its volume is low. Some companies whose year-ends differ from December 31 are Delta Air Lines, June 30; The Walt Disney Company, September 30; and Dunkin’ Donuts, Inc., October 31. In the notes to its financial statements, Best Buy states that its accounting year-end is the Saturday nearest the end of January.
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Monetary Unit
Economic Entity
Requires that only those things that can be expressed in money are included in the accounting records.
States that every economic entity can be separately identified and accounted for.
ASSUMPTIONS IN FINANCIAL REPORTING

ILLUSTRATION 2-19
Key assumptions in financial reporting
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Going Concern
The business will remain in operation for the foreseeable future.
Periodicity
States that the life of a business can be divided into artificial time periods.

ASSUMPTIONS IN FINANCIAL REPORTING

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Measurement Principles
Historical Cost
Or cost principle, dictates that companies record assets at their cost.

PRINCIPLES IN FINANCIAL REPORTING
Fair Value
Indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).
Full Disclosure Principle
Requires that companies disclose all circumstances and events that would make a difference to financial statement users.
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Cost Constraint
Accounting standard-setters weigh the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.

PRINCIPLES IN FINANCIAL REPORTING
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Comparability
Going concern
Materiality
The following items guide the FASB when it creates accounting standards.
Relevance Periodicity assumption
Faithful representation Going concern assumption
Comparability Historical cost principle
Consistency Full disclosure principle
Monetary unit assumption Materiality
Economic entity assumption
Match each item above with a description below.
Ability to easily evaluate one company’s results relative to another’s.
Belief that a company will continue to operate for the foreseeable future.
The judgment concerning whether an item is large enough to matter to decision-makers.
Financial Accounting Concepts and Principles
DO IT!
3
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The following items guide the FASB when it creates accounting standards.
Relevance Periodicity assumption
Faithful representation Going concern assumption
Comparability Historical cost principle
Consistency Full disclosure principle
Monetary unit assumption Materiality
Economic entity assumption
Financial Accounting Concepts and Principles
DO IT!
3
Full disclosure
Periodicity
Relevance
Match each item above with a description below.
The reporting of all information that would make a difference to financial statement users.
The practice of preparing financial statements at regular intervals.
The quality of information that indicates the information makes a difference in a decision.
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The following items guide the FASB when it creates accounting standards.
Relevance Periodicity assumption
Faithful representation Going concern assumption
Comparability Historical cost principle
Consistency Full disclosure principle
Monetary unit assumption Materiality
Economic entity assumption
Financial Accounting Concepts and Principles
DO IT!
3
Historical cost
Consistency
Economic entity
Match each item above with a description below.
Belief that items should be reported on the balance sheet at the price that was paid to acquire the item.
A company’s use of the same accounting principles and methods from year to year.
Tracing accounting events to particular companies.
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The following items guide the FASB when it creates accounting standards.
Relevance Periodicity assumption
Faithful representation Going concern assumption
Comparability Historical cost principle
Consistency Full disclosure principle
Monetary unit assumption Materiality
Economic entity assumption
Financial Accounting Concepts and Principles
DO IT!
3
Faithful representation
Monetary unit
Match each item above with a description below.
The desire to minimize errors and bias in financial statements.
Reporting only those things that can be measured in dollars.
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What is the primary criterion by which accounting information can be judged?
Consistency.
Predictive value.
Usefulness for decision making.
Comparability.
Review Question
THE STANDARD-SETTING ENVIRONMENT

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KEY POINTS
A Look at IFRS
LEARNING OBJECTIVE
Compare the classified balance sheet format under GAAP and IFRS.
4
Similarities
IFRS generally requires a classified statement of financial position similar to the classified balance sheet under GAAP.
IFRS follows the same guidelines as this textbook for distinguishing between current and noncurrent assets and liabilities.
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A Look at IFRS
KEY POINTS
Differences
IFRS recommends but does not require the use of the title “statement of financial position” rather than balance sheet.
The format of statement of financial position information is often presented differently under IFRS. Although no specific format is required, many companies that follow IFRS present statement of financial position information in this order:
Non-current assets
Current assets
Equity
Non-current liabilities
Current liabilities
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A Look at IFRS
KEY POINTS
Differences
Under IFRS, current assets are usually listed in the reverse order of liquidity. For example, under GAAP cash is listed first, but under IFRS it is listed last.
IFRS has many differences in terminology from what are shown in your textbook.
Both GAAP and IFRS are increasing the use of fair value to report assets. However, at this point IFRS has adopted it more broadly. As examples, under IFRS companies can apply fair value to property, plant, and equipment, and in some cases intangible assets.
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A Look at IFRS
LOOKING TO THE FUTURE
The IASB and the FASB are working on a project to converge their standards related to financial statement presentation. A key feature of the proposed framework is that each of the statements will be organized in the same format, to separate an entity’s financing activities from its operating and investing activities and, further, to separate financing activities into transactions with owners and creditors. Thus, the same classifications used in the statement of financial position would also be used in the income statement and the statement of cash flows. The project has three phases. You can follow the joint financial presentation project at the following link: http://ww.fasb.org/project/-financial_statement_presentation.shtml.
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IFRS Practice
A company has purchased a tract of land and expects to build a production plant on the land in approximately 5 years. During the 5 years before construction, the land will be idle. Under IFRS, the land should be reported as:
land expense.
property, plant, and equipment.
an intangible asset.
a long-term investment.

A Look at IFRS

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IFRS Practice
Current assets under IFRS are listed generally:
by importance.
in the reverse order of their expected conversion to cash.
by longevity.
alphabetically.

A Look at IFRS

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IFRS Practice
Companies that use IFRS:
may report all their assets on the statement of financial position at fair value.
may offset assets against liabilities and show net assets and net liabilities on their statements of financial position, rather than the underlying detailed line items.
may report non-current assets before current assets on the statement of financial position.
do not have any guidelines as to what should be reported on the statement of financial position.

A Look at IFRS

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“Copyright © 2016 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.”
COPYRIGHT

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The Accounting Information System

Kimmel ● Weygandt ● Kieso

Accounting, Sixth Edition

3

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Explain how accounts, debits, and credits are used to record business transactions.
CHAPTER OUTLINE
Analyze the effect of business transactions on the basic accounting equation.
1
2
LEARNING OBJECTIVES
Indicate how a journal is used in the recording process.
3
Explain how a ledger and posting help in the recording process.
4
Prepare a trial balance.
5

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Accounting Information System
System of
collecting and
processing transaction data and
communicating financial information to decision-makers.
LEARNING OBJECTIVE
Analyze the effect of business transactions on the basic accounting equation.
1
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Accounting information systems rely on a process referred to as the accounting cycle.
Accounting Information System
Analyze business transactions
Journalize
Post
Trial Balance
Adjusting Entries
Adjusted Trial Balance
Financial Statements
Closing Entries
Post-Closing Trial Balance
Most businesses use computerized accounting systems.
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Transactions are economic events that require recording in the financial statements.
Not all activities represent transactions.
Assets, liabilities, or stockholders’ equity items change as a result of some economic event.
Dual effect on the accounting equation.
ACCOUNTING TRANSACTIONS
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Question: Are the following events recorded in the accounting records?
Event
Purchase computer
Criterion

Pay rent
Record/ Don’t Record
Discuss guided trip options with potential customer
Illustration 3-1
Transaction identification process
ACCOUNTING TRANSACTIONS
Is the financial position (assets, liabilities, or stockholders’ equity) of the company changed?
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Assets
Liabilities
Stockholders’ Equity
=
+
Basic Accounting Equation
The process of identifying the specific effects of economic events on the accounting equation.
ANALYZING TRANSACTIONS
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Illustration 3-2
Expanded accounting equation
ANALYZING TRANSACTIONS
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Event (1). On October 1, cash of $10,000 is invested in Sierra Corporation by investors in exchange for $10,000 of common stock.
1. +10,000 +10,000

ANALYZING TRANSACTIONS
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Event (2). On October 1, Sierra borrowed $5,000 from Castle Bank by signing a 3-month, 12%, $5,000 note payable.
1. +10,000 +10,000
2. +5,000 +5,000

ANALYZING TRANSACTIONS
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Event (3). On October 2, Sierra purchased equipment by paying $5,000 cash to Superior Equipment Sales Co.
3. -5,000 +5,000
1. +10,000 +10,000
2. +5,000 +5,000

ANALYZING TRANSACTIONS
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Event (4). On October 2, Sierra received a $1,200 cash advance from R. Knox, a client.
4. +1,200 +1,200
3. -5,000 +5,000
1. +10,000 +10,000
2. +5,000 +5,000

ANALYZING TRANSACTIONS
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Event (5). On October 3, Sierra received $10,000 in cash from Copa Company for guide services performed.
4. +1,200 +1,200
5. +10,000 +10,000
3. -5,000 +5,000
1. +10,000 +10,000
2. +5,000 +5,000

ANALYZING TRANSACTIONS
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Event (6). On October 3, Sierra Corporation paid its office rent for the month of October in cash, $900.
4. +1,200 +1,200
5. +10,000 +10,000
6. -900 -900
3. -5,000 +5,000
1. +10,000 +10,000
2. +5,000 +5,000

ANALYZING TRANSACTIONS
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Event (7). On October 4, Sierra paid $600 for a one-year insurance policy that will expire next year on September 30.
4. +1,200 +1,200
5. +10,000 +10,000
6. -900 -900
7. -600 +600
3. -5,000 +5,000
1. +10,000 +10,000
2. +5,000 +5,000

ANALYZING TRANSACTIONS
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Event (8). On October 5, Sierra purchased an estimated three months of supplies on account from Aero Supply for $2,500.
4. +1,200 +1,200
5. +10,000 +10,000
6. -900 -900
7. -600 +600
8. +2,500 +2,500
3. -5,000 +5,000
1. +10,000 +10,000
2. +5,000 +5,000

ANALYZING TRANSACTIONS
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Event (9). On October 9, Sierra hired four new employees to begin work on October 15.
4. +1,200 +1,200
5. +10,000 +10,000
6. -900 -900
7. -600 +600
8. +2,500 +2,500
3. -5,000 +5,000
1. +10,000 +10,000
2. +5,000 +5,000
An accounting transaction has not occurred.
ANALYZING TRANSACTIONS
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Event (10). On October 20, Sierra paid a $500 dividend.
4. +1,200 +1,200
5. +10,000 +10,000
6. -900 -900
7. -600 +600
8. +2,500 +2,500
10. -500 -500
3. -5,000 +5,000
1. +10,000 +10,000
2. +5,000 +5,000

ANALYZING TRANSACTIONS
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Event (11). Employees have worked two weeks, earning $4,000 in salaries, which were paid on October 26.
4. +1,200 +1,200
5. +10,000 +10,000
6. -900 -900
7. -600 +600
8. +2,500 +2,500
10. -500 -500
11. -4,000 -4,000
3. -5,000 +5,000
1. +10,000 +10,000
2. +5,000 +5,000

ANALYZING TRANSACTIONS
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INVESTOR INSIGHT
Why Accuracy Matters
While most companies record transactions very carefully, the reality is that mistakes still happen. For example, bank regulators fi ned Bank One Corporation (now JPMorgan Chase) $1.8 million because they felt that the unreliability of the bank’s accounting system caused it to violate regulatory requirements. Also, in recent years Fannie Mae, the government chartered mortgage association, announced a series of large accounting errors. These announcements caused alarm among investors, regulators, and politicians because they feared that the errors might suggest larger, undetected problems. This was important because the home-mortgage market depends on Fannie Mae to buy hundreds of billions of dollars of mortgages each year from banks, thus enabling the banks to issue new mortgages. Finally, before a major overhaul of its accounting system, the financial records of Waste Management Company were in such disarray that of the company’s 57,000 employees, 10,000 were receiving pay slips that were in error. The Sarbanes-Oxley Act was created to minimize the occurrence of errors like these by increasing every employee’s responsibility for accurate financial reporting.
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Transaction Analysis
A tabular analysis of the transactions for the month of August is shown below. Describe each transaction.
DO IT!
1
LO 1
1. Company issued shares of stock for $25,000 cash.
2. Company purchased $7,000 of equipment on account.
3. Company received $8,000 cash in exchange for services performed.
4. Company paid $850 for this month’s rent.

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Double-entry system
Each transaction must affect two or more accounts to keep the basic accounting equation in balance.
Recording done by debiting at least one account and crediting another.
DEBITS must equal CREDITS.
Debit and Credit Procedures
LEARNING OBJECTIVE
Explain how accounts, debits, and credits are used to record business transactions.
2
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If Debits are greater than Credits, the account will have a debit balance.
$10,000
Transaction #2
$3,000
$15,000
8,000
Transaction #3
Balance
Transaction #1
DEBIT AND CREDIT PROCEDURES
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$10,000
Transaction #2
$3,000
Balance
Transaction #1
$1,000
8,000
Transaction #3
DEBIT AND CREDIT PROCEDURES
If Debits are greater than Credits, the account will have a debit balance.
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Assets – Debits should exceed credits.
Liabilities – Credits should exceed debits.

Procedures for Assets and Liabilities
▼ HELPFUL HINT
The normal balance is the side where increases in the account are recorded.
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Investments by stockholders and revenues increase stockholders’ equity (credit).
Dividends and expenses decrease stockholder’s equity (debit).

Procedures for Stockholders’ Equity
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Revenues increase stockholder’s equity.
Expenses have the opposite effect: expenses decrease stockholders’ equity.
The effect of debits and credits on revenue and expense accounts is the same as their effect on stockholders’ equity.

Procedures for Stockholders’ Equity
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INVESTOR INSIGHT
Keeping Score
The Chicago Cubs baseball team has these major revenue and expense accounts:
Revenues Expenses
Admissions (ticket sales) Players’ salaries
Concessions Administrative salaries
Television and radio Travel
Advertising Ballpark maintenance
Chicago Cubs
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STOCKHOLDERS’ EQUITY RELATIONSHIPS
ILLUSTRATION 3-15
Stockholders’ equity
relationships
LO 2

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LO 2

Normal Balance Credit
Normal Balance Debit
DEBIT/CREDIT RULES

3-‹#›

Balance Sheet Income Statement
=
+
=
–
Asset
Liability
Equity
Revenue
Expense
Debit
Credit

SUMMARY OF DEBIT/CREDIT RULES

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Relationship among the assets, liabilities and stockholders’ equity of a business:
The equation must be in balance after every transaction. For every Debit there must be a Credit.
ILLUSTRATION 3-16
Assets
Liabilities
=
Stockholders’ Equity
Basic Equation
Expanded Basic Equation
+
SUMMARY OF DEBIT/CREDIT RULES

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SUMMARY OF DEBIT/CREDIT RULES
Review Question
Debits:
increase both assets and liabilities.
decrease both assets and liabilities.
increase assets and decrease liabilities.
decrease assets and increase liabilities.
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SUMMARY OF DEBIT/CREDIT RULES
Review Question
Accounts that normally have debit balances are:
assets, expenses, and revenues.
assets, expenses, and equity.
assets, liabilities, and dividends.
assets, dividends, and expenses.
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The Recording Process
LEARNING OBJECTIVE
Indicate how a journal is used in the recording process.
3
LO 3
Analyze business transactions
Journalize the transaction
Post to ledger accounts
Analyze each transaction in terms of its effect on the accounts.
Enter the transaction information in a journal.
Transfer the journal information to the appropriate accounts in the ledger.

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THE RECORDING PROCESS
Analyze business transactions
Journalize the transaction
Post to ledger accounts
Analyze transaction
Enter
transaction
Transfer from journal to ledger
ILLUSTRATION 3-17
The recording process
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Transactions recorded in chronological order in a journal before they are transferred to the accounts.
Contributions to the recording process:
Discloses the complete effects of a transaction.
Provides a chronological record of transactions.
Helps to prevent or locate errors because the debit and credit amounts can be easily compared.
THE JOURNAL
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Journalizing – Entering transaction data in the journal.
Illustration: Presented below is information related to Sierra Corporation.
Oct. 1 Sierra issued common stock in exchange for $10,000 cash.
1 Sierra borrowed $5,000 by signing a note.
2 Sierra purchased equipment for $5,000.
Instructions – Journalize these transactions.
THE JOURNAL
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THE JOURNAL
Oct. 1 Sierra issued common stock in exchange for $10,000 cash.

General Journal
Cash
Common Stock
10,000
10,000
Oct. 1
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THE JOURNAL
Oct. 1 Sierra borrowed $5,000 by signing a note.

General Journal
Cash
Notes Payable
5,000
5,000
Oct. 1
LO 3

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THE JOURNAL
Oct. 2 Sierra purchased equipment for $5,000.

General Journal
Equipment
Cash
5,000
5,000
Oct. 2
LO 3

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THE JOURNAL

ILLUSTRATION 3-18
Recording transactions in
journal form
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ACCOUNTING ACROSS THE ORGANIZATION
Boosting Profits
Microsoft originally designed the Xbox 360 to have 256 megabytes of memory. But the design department said that amount of memory wouldn’t support the best special effects. The purchasing department said that adding more memory would cost $30—which was 10% of the estimated selling price of $300. The marketing department, however, “determined that adding the memory would let Microsoft reduce marketing costs and attract more game developers, boosting royalty revenue. It would also extend the life of the console, generating more sales.” As a result of these changes, Xbox enjoyed great success. But, it does have competitors. Its newest video game console, Xbox One, is now in a battle with Sony’s Playstation4 for market share. How to compete? First, Microsoft bundled the critically acclaimed Titan fall with its Xbox One. By including the game most Xbox One buyers were going to purchase anyway, Microsoft was making its console more attractive. In addition, retailers are also discounting the Xbox, which should get the momentum going for increased sales. What Microsoft is doing is making sure that Xbox One is the center of the home entertainment system in the long run.
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Journal Entries
The following events occurred during the first month of business of Hair It Is Inc., Kate Browne’s beauty salon:
Issued common stock to shareholders in exchange for $20,000 cash.
Purchased $4,800 of equipment on account (to be paid in 30 days).
Interviewed three people for the position of stylist.
The three activities are recorded as follows:
DO IT!
3
1. Cash 20,000
Common Stock 20,000
2. Equipment 4,800
Accounts Payable 4,800
3. No entry because no transaction occurred.
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The Accounting Cycle
LEARNING OBJECTIVE
Explain how a ledger and posting help in the recording process.
4
LO 4
Analyze business transactions
Post to ledger accounts
Journalize the transaction
Trial Balance
Adjusting Entries
Adjusted Trial Balance
Financial Statements
Closing Entries
Post-Closing Trial Balance

3-‹#›

The Ledger is comprised of the entire group of accounts maintained by a company.
THE LEDGER

ILLUSTRATION 3-19
The general ledger
LO 4

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Listing of accounts used by a company to record transactions.
CHART OF ACCOUNTS

ILLUSTRATION 3-20
Chart of accounts for Sierra
Corporation
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General Ledger
J1
The process of transferring journal entry amounts to ledger accounts.
POSTING

General Journal
Cash
Common Stock
10,000
10,000
Oct. 1
J1
Oct. 1
Stock issued
10,000
10,000
101
LO 4

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POSTING
Review Question
Posting:
normally occurs before journalizing.
transfers ledger transaction data to the journal.
is an optional step in the recording process.
transfers journal entries to ledger accounts.
LO 4

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ETHICS INSIGHT
A Convenient Overstatement
Sometimes a company’s investment securities suffer a permanent decline in value below their original cost. When this occurs, the company is supposed to reduce the recorded value of the securities on its balance sheet (“write them down” in common financial lingo) and record a loss. It appears, however, that during the financial crisis of 2008, employees at some financial institutions chose to look the other way as the value of their investments skidded. A number of Wall Street traders that worked for the investment bank Credit Suisse Group were charged with intentionally overstating the value of securities that had suffered declines of approximately $2.85 billion. One reason that they may have been reluctant to record the losses is out of fear that the company’s shareholders and clients would panic if they saw the magnitude of the losses. However, personal self-interest might have been equally to blame—the bonuses of the traders were tied to the value of the investment securities.
Source: S. Pulliam, J. Eaglesham, and M. Siconolfi , “U.S. Plans Changes on Bond Fraud,” Wall Street Journal Online (February 1, 2012).
Credit Suisse Group
LO 4

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Follow these steps:
1. Determine what type of account is involved.
2. Determine what items increased or decreased and by how much.
3. Translate the increases and decreases into debits and credits.
RECORDING PROCESS ILLUSTRATED
ILLUSTRATION 3-21
Investment of cash by
stockholders
LO 4

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LO 4
ILLUSTRATION 3-22

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LO 4
ILLUSTRATION 3-23

3-‹#›

ILLUSTRATION 3-24
LO 4

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ILLUSTRATION 3-25
LO 4

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ILLUSTRATION 3-26
LO 4

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ILLUSTRATION 3-27
LO 4

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LO 4
ILLUSTRATION 3-28

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ILLUSTRATION 3-29
LO 4

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ILLUSTRATION 3-30
LO 4

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ILLUSTRATION 3-31
LO 4

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LO 4

JOURNALIZING SUMMARY
ILLUSTRATION 3-32
General journal for Sierra Corporation

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LO 4
Illustration 3-32

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ILLUSTRATION 3-33
General ledger for Sierra Corporation
POSTING SUMMARY

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Selected transactions from the journal of Faital Inc. during its first month of operations are presented below. Post these transactions to T-accounts.
Posting
DO IT!
4

LO 4

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The Accounting Cycle
LEARNING OBJECTIVE
Prepare a trial balance.
5
LO 5
Analyze business transactions
Post to ledger accounts
Journalize the transaction
Prepare a Trial Balance
Adjusting Entries
Adjusted Trial Balance
Financial Statements
Closing Entries
Post-Closing Trial Balance

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A list of accounts and their balances at a given time.
Accounts are listed in the order in which they appear in the ledger.

Purpose is to prove that debits equal credits.
May also uncover errors in journalizing and posting.
Useful in the preparation of financial statements.
TRIAL BALANCE
▼ HELPFUL HINT
Note that the order of
presentation in the trial balance is:
Assets
Liabilities
Stockholders’ equity
Revenues
Expenses
LO 5

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TRIAL BALANCE
ILLUSTRATION 3-34
Sierra Corporation
trial balance
LO 5

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The trial balance may balance even when
a transaction is not journalized,
a correct journal entry is not posted,
a journal entry is posted twice,
incorrect accounts are used in journalizing or posting, or
offsetting errors are made in recording the amount of a transaction.
ETHICS NOTE An error is the result of an unintentional mistake. It is neither ethical nor unethical. An irregularity is an intentional misstatement, which is viewed as unethical.
LIMITATIONS OF A TRIAL BALANCE
LO 5

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Review Question
A trial balance will not balance if:
a correct journal entry is posted twice.
the purchase of supplies on account is debited to Supplies and credited to Cash.
a $100 cash dividends is debited to the Dividends account for $1,000 and credited to Cash for $100.
a $450 payment on account is debited to Accounts Payable for $45 and credited to Cash for $45.
TRIAL BALANCE
LO 5

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Trial Balance
DO IT!
5
The following accounts come from the ledger of SnowGo Corporation at December 31, 2017.
Equipment $88,000
Dividends 8,000
Accounts Payable 22,000
Salaries and Wages
Expense 42,000
Accounts Receivable 4,000
Service Revenue 95,000
Common Stock $20,000
Salaries and Wages
Payable 2,000
Notes Payable (due in
3 months) 19,000
Utilities Expense 3,000
Prepaid Insurance 6,000
Cash 7,000
Prepare a trial balance in good form.
LO 5

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LO 5

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KEY POINTS
A Look at IFRS
LEARNING OBJECTIVE
Compare the procedures for the recording process under GAAP and IFRS.
6
Similarities
Transaction analysis is the same under IFRS and GAAP.
Both the IASB and the FASB go beyond the basic definitions provided in the textbook for the key elements of financial statements, that is assets, liabilities, equity, revenues, and expenses. The implications of the expanded definitions are discussed in more advanced accounting courses.
LO 6

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A Look at IFRS
KEY POINTS
Similarities
As shown in the textbook, dollar signs are typically used only in the trial balance and the financial statements. The same practice is followed under IFRS, using the currency of the country where the reporting company is headquartered.
A trial balance under IFRS follows the same format as shown in the textbook.
LO 6

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A Look at IFRS
KEY POINTS
Differences
IFRS relies less on historical cost and more on fair value than do FASB standards.
Internal controls are a system of checks and balances designed to prevent and detect fraud and errors. While most public U.S. companies have these systems in place, many non-U.S. companies have never completely documented the controls nor had an independent auditor attest to their effectiveness.
LO 6

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A Look at IFRS
LOOKING TO THE FUTURE
The basic recording process shown in this textbook is followed by companies around the globe. It is unlikely to change in the future. The definitional structure of assets, liabilities, equity, revenues, and expenses may change over time as the IASB and FASB evaluate their overall conceptual framework for establishing accounting standards.
LO 6

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IFRS Practice
Which statement is correct regarding IFRS?
IFRS reverses the rules of debits and credits, that is, debits are on the right and credits are on the left.
IFRS uses the same process for recording transactions as GAAP.
The chart of accounts under IFRS is different because revenues follow assets.
None of the above statements are correct.

A Look at IFRS

LO 6

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IFRS Practice
A trial balance:
is the same under IFRS and GAAP.
proves that transactions are recorded correctly.
proves that all transactions have been recorded.
will not balance if a correct journal entry is posted twice.

A Look at IFRS

LO 6

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IFRS Practice
One difference between IFRS and GAAP is that:
GAAP uses accrual-accounting concepts and IFRS uses primarily the cash basis of accounting.
IFRS uses a different posting process than GAAP.
IFRS uses more fair value measurements than GAAP.
the limitations of a trial balance are different between IFRS and GAAP.

A Look at IFRS

LO 6

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“Copyright © 2016 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.”
COPYRIGHT

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Account Name
Debit / Dr.
Credit / Cr.

Account Name
Debit / Dr.
Credit / Cr.

Account Name
Debit / Dr.
Credit / Cr.

Chapter
3-23
Assets
Assets
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance
Chapter
3-24
Liabilities
Liabilities
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance

Chapter 3-*

Assets
Debit / Dr.
Credit / Cr.
Normal Balance

Chapter 3-*

Liabilities
Debit / Dr.
Credit / Cr.
Normal Balance

Chapter
3-25
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance
Common Stock
Common Stock
Chapter
3-23
Dividends
Dividends
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance
Chapter
3-25
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance
Stockholders
Stockholders
’
’
Equity
Equity
Chapter
3-25
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance
Retained Earnings
Retained Earnings

Chapter 3-*

Debit / Dr.
Credit / Cr.
Normal Balance
Retained Earnings

Chapter 3-*

Debit / Dr.
Credit / Cr.
Normal Balance
Common Stock

Chapter 3-*

Dividends
Debit / Dr.
Credit / Cr.
Normal Balance

Chapter 3-*

Debit / Dr.
Credit / Cr.
Normal Balance
Stockholders’ Equity

Chapter
3-27
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance
Expense
Expense
Chapter
3-26
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance
Revenue
Revenue

Chapter 3-*

Debit / Dr.
Credit / Cr.
Normal Balance
Expense

Chapter 3-*

Debit / Dr.
Credit / Cr.
Normal Balance
Revenue

Chapter
3-23
Assets
Assets
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance
Chapter
3-27
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance
Expense
Expense
Chapter
3-24
Liabilities
Liabilities
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance
Chapter
3-25
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance
Stockholders
Stockholders
’
’
Equity
Equity
Chapter
3-26
Debit / Dr.
Credit / Cr.
Normal Balance
Normal Balance
Revenue
Revenue

Chapter 3-*

Debit / Dr.
Credit / Cr.
Normal Balance
Stockholders’ Equity

Chapter 3-*

Debit / Dr.
Credit / Cr.
Normal Balance
Revenue

Chapter 3-*

Assets
Debit / Dr.
Credit / Cr.
Normal Balance

Chapter 3-*

Debit / Dr.
Credit / Cr.
Normal Balance
Expense

Chapter 3-*

Liabilities
Debit / Dr.
Credit / Cr.
Normal Balance

Account TitleRef.DebitCreditDate
Sheet1

Date Account Title Ref. Debit Credit

Sheet1

Date Account Title Ref. Debit Credit

Sheet1

Date Account Title Ref. Debit Credit

Cash
Acct. No. 101
ExplanationRef.DebitCreditBalanceDate
Account TitleRef.DebitCreditDate
Chart of Accounts

Chart of Accounts
Acct. No. Account
100 Cash
105 Accounts receivable
110 Inventory
130 Building
200 Accounts payable
220 Note payable
300 Common stock
330 Retained earnings
400 Sales
500 Cost of goods sold

General Ledger

General Journal
Date Account Title Ref. Debit Credit
Jan. 3 Cash 100 100,000
Common stock 300 100,000
10 Building 130 150,000
Note payable 220 150,000
15 Inventory 110 60,000
Accounts payable 200 60,000
20 Accounts receivable 105 75,000
Sales 400 75,000
20 Cost of goods sold 500 30,000
Inventory 110 30,000
29 Cash 100 40,000
Accounts receivable 105 40,000
General Ledger
Cash Acct. No. 100
Date Explanation Ref. Debit Credit Balance
Jan. 3 Sale of common stock GJ 100,000 100,000
20 GJ 40,000 140,000
Accounts Receivable Acct. No. 105
Date Explanation Ref. Debit Credit Balance
Jan. 20 GJ 75,000 75,000
GJ 40,000 35,000
Inventory Acct. No. 110
Date Explanation Ref. Debit Credit Balance
Jan. 15 GJ 60,000 60,000
20 GJ 30,000 30,000
Building Acct. No. 130
Date Explanation Ref. Debit Credit Balance
Jan. 10 GJ 150,000 150,000
Accounts payable Acct. No. 200
Date Explanation Ref. Debit Credit Balance
Jan. 15 GJ 60,000 (60,000)
Notes payable Acct. No. 220
Date Explanation Ref. Debit Credit Balance
Jan. 10 GJ 150,000 (150,000)
Common stock Acct. No. 300
Date Explanation Ref. Debit Credit Balance
Jan. 3 Sale for cash GJ 100,000 (100,000)
Retained Earnings Acct. No. 330
Date Explanation Ref. Debit Credit Balance
– 0
Sales Acct. No. 400
Date Explanation Ref. Debit Credit Balance
Jan. 20 GJ 75,000 (75,000)
Cost of Goods Sold Acct. No. 500
Date Explanation Ref. Debit Credit Balance
Jan. 20 GJ 30,000 30,000

Trial Balance

Trial Balance
Acct. No. Account Debit Credit
100 Cash 140,000
105 Accounts receivable 35,000
110 Inventory 30,000
130 Building 150,000
200 Accounts payable 60,000
220 Note payable 150,000
300 Common stock 100,000
330 Retained earnings
400 Sales 75,000
500 Cost of goods sold 30,000
385,000 385,000

Journal Entry

No. Account Debit Credit
1 10,000

Sheet1 (2)

Date Account Title Ref. Debit Credit
Jan. 3 Cash 100 100,000
Common stock 300 100,000
Cash Acct. No. 101
Date Explanation Ref. Debit Credit Balance

Sheet1

Date Account Title Ref. Debit Credit

Accrual Accounting Concepts

Kimmel ● Weygandt ● Kieso

Accounting, Sixth Edition

4

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Prepare adjusting entries for deferrals.
CHAPTER OUTLINE
Explain the accrual basis of accounting and the reasons for adjusting entries.
1
2
LEARNING OBJECTIVES
Prepare adjusting entries for accruals.
3
Prepare an adjusted trial balance and closing entries.
4

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LEARNING OBJECTIVE
Explain the accrual basis of accounting and the reasons for adjusting entries.
1
LO 1
Generally a month, a quarter, or a year.
Fiscal year vs. calendar year.
Accountants divide the economic life of a business into artificial time periods (Periodicity Assumption).

Jan.
Feb.
Mar.
Apr.
Dec.
. . . . .

▼ HELPFUL HINT
An accounting time period that is one year long is called a fiscal year.

4-‹#›

Periodicity Assumption
Review Question
What is the periodicity assumption?
Companies should recognize revenue in the accounting period in which it is earned.
Companies should match expenses with revenues.
The economic life of a business can be divided into artificial time periods.
The fiscal year should correspond with the calendar year.
LO 1

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Companies recognize revenue in the accounting period in which the performance obligation is satisfied.
REVENUE RECOGNITION PRINCIPLE
LO 1

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TEACHING TIP
Service businesses recognize revenue when the services are performed, although many customers may have been billed for the services (on account). The cash has not been received; however, the services have been performed. Therefore, revenue should be recognized.

Illustration: Assume Conrad Dry Cleaners cleans clothing on June 30, but customers do not claim and pay for their clothes until the first week of July. The journal entries for June and July would be:
REVENUE RECOGNITION PRINCIPLE
LO 1

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“Let the expenses follow the revenues.”
ILLUSTRATION 4-1
EXPENSE RECOGNITION PRINCIPLE
LO 1

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ILLUSTRATION 4-1
GAAP relationships in revenue and expense recognition
EXPENSE RECOGNITION PRINCIPLE
LO 1

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INVESTOR INSIGHT
Reporting Revenue Accurately
The Until recently, electronics manufacturer Apple was required to spread the revenues from iPhone sales over the two-year period following the sale of the phone. Accounting standards required this because Apple was obligated to provide software updates after the phone was sold. Since Apple had service obligations after the initial date of sale, it was forced to spread the revenue over a two-year period. As a result, the rapid growth of iPhone sales was not fully reflected in the revenue amounts reported in Apple’s income statement. A new accounting standard now enables Apple to report much more of its iPhone revenue at the point of sale. It was estimated that under the new rule revenues would have been about 17% higher and earnings per share almost 50% higher.
Apple Inc.
LO 1

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Accrual-Basis Accounting
Transactions recorded in the periods in which the events occur.
Revenues are recognized when services performed, even if cash was not received.
Expenses are recognized when incurred, even if cash was not paid.
ACCRUAL VERSUS CASH BASIS
LO 1

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Cash-Basis Accounting
Revenues are recognized only when cash is received.
Expenses are recognized only when cash is paid.
Not in accordance with generally accepted accounting principles (GAAP).
ACCRUAL VERSUS CASH BASIS
LO 1

4-‹#›
TEACHING TIP
Explain to students that many businesses use the cash basis of accounting. These businesses outgrow the method when accounts receivable and accounts payable become substantial. Also, if the businesses need audited financial statements, they must comply with GAAP and use the accrual basis. Remind them that companies can use the cash method and that its use does not mean that income is being manipulated. Without this discussion, some students may unfairly criticize an employer, relative or friend who is using the cash basis of accounting.

2016
2017
Illustration: Suppose that Fresh Colors paints a large building in 2016. In 2016, it incurs and pays total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000, but does not receive payment until 2017.

ACCRUAL VERSUS CASH BASIS
ILLUSTRATION 4-2
Accrual-versus cash-basis accounting
LO 1

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Periodicity Assumption
Review Question
Which one of these statements about the accrual basis of accounting is false?
Companies record events that change their financial statements in the period in which events occur, even if cash was not exchanged.
Companies recognize revenue in the period in which the performance obligation is satisfied.
This basis is in accord with generally accepted accounting principles.
Companies record revenue only when they receive cash, and record expense only when they pay out cash.
LO 1

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Adjusting entries
ensure that the revenue recognition and expense recognition principles are followed.
are required every time a company prepares financial statements.
includes one income statement account and one balance sheet account.
THE NEED FOR ADJUSTING ENTRIES
LO 1

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Adjusting entries are made to ensure that:
a. expenses are recognized in the period in which they are incurred.
b. revenues are recognized in the period in which the performance obligation is satisfied.
c. balance sheet and income statement accounts have correct balances at the end of an accounting period.
d. All of the above.
Review Question
THE NEED FOR ADJUSTING ENTRIES
LO 1

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Deferrals:
1. Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed.
2. Unearned revenues: Cash received before service 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.
TYPES OF ADJUSTING ENTRIES
ILLUSTRATION 4-3
Categories of adjusting entries
LO 1

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LO 1
Trial Balance – Each account is analyzed to determine whether it is complete and up-to-date.
TYPES OF ADJUSTING ENTRIES
ILLUSTRATION 4-4
Trial balance

4-‹#›

Timing Concepts
Below is a list of concepts in the left column, with descriptions of the concepts in the right column. There are more descriptions provided than concepts. Match the description of the concept to the concept.
DO IT!
1
LO 1
1. ____ Accrual-basis accounting.
2. ____ Calendar year.
3. ____ Periodicity assumption.
4. ____ Expense recognition principle.
(a) Monthly and quarterly time periods.
(b) Efforts (expenses) should be matched with results (revenues).
(c) Accountants divide the economic life of a business into time periods.
(d) Companies record revenues when they receive cash and record expenses when they pay out cash.
(e) An accounting time period that starts on January 1 and ends on December 31.
(f) Companies record transactions in the period in which the events occur.
f
e
c
b

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Analyze business transactions
Journalize
Post
Trial Balance
Journalize and Post Adjusting Entries
Adjusted Trial Balance
Financial Statements
Closing Entries
Post-Closing Trial Balance
To defer means to postpone or delay.
LO 2
LEARNING OBJECTIVE
Prepare adjusting entries for deferrals.
2

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Deferrals are either:
Prepaid expenses
OR
Unearned revenues.
Deferrals
LO 2

4-‹#›

Expenses paid in cash before they are used or consumed.
insurance
supplies
advertising
Cash Payment
Expense Recorded
BEFORE
rent
equipment
buildings
Prepayments often occur in regard to:
PREPAID EXPENSES
LO 2

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Prepaid Expenses
Costs that expire either with the passage of time or through use.
Adjusting entry results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account.
PREPAID EXPENSES
LO 2

4-‹#›

Adjusting entries for prepaid expenses
Increases (debits) an expense account and
Decreases (credits) an asset account.
ILLUSTRATION 4-5
Adjusting entries for prepaid expenses
PREPAID EXPENSES
LO 2

4-‹#›

Illustration: Sierra Corporation purchased supplies costing $2,500 on October 5. Sierra recorded the purchase by increasing (debiting) the asset Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand.
Supplies
1,500
Supplies Expense
1,500
Oct. 31
ILLUSTRATION 4-6
($2,500 – 1,000 = $1,500)
Supplies
LO 2

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Illustration: On October 4, Sierra Corporation paid $600 for a one-year fire insurance policy. Coverage began on October 1. Sierra recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the October 31 trial balance. Insurance of $50 ($600 ÷ 12) expires each month.
Prepaid Insurance
50
Insurance Expense
50
Oct. 31
ILLUSTRATION 4-7
Insurance
LO 2

4-‹#›

Buildings, equipment, and motor vehicles (long-lived assets) are recorded as assets, rather than an expense, in the year acquired.
Depreciation is the process of allocating the cost of an asset to expense (depreciation) over its useful life.
Depreciation does not attempt to report the actual change in the value of the asset.
Depreciation
LO 2

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Illustration: For Sierra Corporation, assume that depreciation on the office equipment is $480 a year, or $40 per month.
Accumulated Depreciation-Equipment
40
Depreciation Expense
40
Oct. 31
ILLUSTRATION 4-8
Depreciation
LO 2

4-‹#›

Statement Presentation
Accumulated Depreciation-Equipment is a contra asset account.
Appears just after the account it offsets (Equipment) on the balance sheet.
ILLUSTRATION 4-9
Balance sheet presentation of
accumulated depreciation
Depreciation
▼ HELPFUL HINT
All contra accounts have increases, decreases, and normal balances opposite to the account to which they relate.
LO 2

4-‹#›

ILLUSTRATION 4-10
Accounting for prepaid expenses

PREPAID EXPENSES
LO 2

4-‹#›

Receipt of cash recorded as a liability before services are performed.
rent
airline tickets
Cash Receipt
Revenue Recorded
BEFORE
magazine subscriptions
customer deposits
Unearned revenues often occur in regard to:
UNEARNED REVENUES
LO 2

4-‹#›

Adjusting entry is made to record the revenue for services performed during the period and to show the liability that remains.
Adjusting entry results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.
UNEARNED REVENUES
LO 2

4-‹#›

Adjusting entries for unearned revenues
Decrease (a debit) to a liability account.
Increase (a credit) to a revenue account.
ILLUSTRATION 4-11
UNEARNED REVENUES
LO 2

4-‹#›

Illustration: Sierra Corporation received $1,200 on October 2 from R. Knox for guide services for multi-day trips expected to be completed by December 31. Unearned Service Revenue shows a balance of $1,200 in the October 31 trial balance. From an evaluation of the service Sierra performed for Knox during October, the company determines that it has earned $400 in October.
Service Revenue
400
Unearned Service Revenue
400
Oct. 31
ILLUSTRATION 4-12
UNEARNED REVENUES
LO 2

4-‹#›

ILLUSTRATION 4-13
Accounting for unearned revenues
Unearned Revenues recorded in liability accounts are now recognized as revenue for services performed.
ACCOUNTING FOR UNEARNED REVENUES
Examples
Reason for
Adjustment
Accounts Before
Adjustment
Adjusting
Entry
Rent, magazine subscriptions, customer deposits for future service.
Liabilities overstated.
Revenues understated.
Dr. Liabilities
Cr. Revenues
UNEARNED REVENUES
LO 2

4-‹#›

ACCOUNTING ACROSS THE ORGANIZATION
Turning Gift Cards into Revenue
Those of you who are marketing majors (and even most of you who are not) know that gift cards are among the hottest marketing tools in merchandising today. Customers purchase gift cards and give them to someone for later use. In a recent year, gift-card sales were expected to exceed $124 billion. Although these programs are popular with marketing executives, they create accounting questions. Should revenue be recorded at the time the gift card is sold, or when it is exercised? How should expired gift cards be accounted for? In a recent balance sheet, Best Buy reported unearned revenue related to gift cards of $406 million.
Source: “2014 Gift Card Sales to Top $124 Billion, But Growth Slowing,” PRNewswire (December 10, 2014).
LO 2

4-‹#›

Adjusting Entries for Deferrals
The ledger of Hammond, Inc. on March 31, 2017, includes these selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
An analysis of the accounts shows the following.
1. Insurance expires at the rate of $100 per month.
2. Supplies on hand total $800.
3. The equipment depreciates $200 a month.
4. During March, services were performed for $4,000 of the unearned service revenue reported.
Prepare the adjusting entries for the month of March.
DO IT!
2
LO 2

4-‹#›

Adjusting Entries for Deferrals
The ledger of Hammond, Inc. on March 31, 2017, includes these selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.
Insurance expires at the rate of $100 per month.
SOLUTION
DO IT!
2
Insurance Expense 100
Prepaid Insurance 100
LO 2

4-‹#›

Adjusting Entries for Deferrals
The ledger of Hammond, Inc. on March 31, 2017, includes these selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.
Supplies on hand total $800.
SOLUTION
DO IT!
2
Supplies Expense 2,000
Supplies 2,000
LO 2

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Adjusting Entries for Deferrals
The ledger of Hammond, Inc. on March 31, 2017, includes these selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.
The equipment depreciates $200 a month.
SOLUTION
DO IT!
2
Depreciation Expense 200
Accumulated Depreciation 200
LO 2

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Adjusting Entries for Deferrals
The ledger of Hammond, Inc. on March 31, 2017, includes these selected accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.
During March, services were performed for $4,000 of the unearned service revenue reported.
SOLUTION
DO IT!
2
Unearned Service Revenue 4,000
Service Revenue 4,000
LO 2

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Analyze business transactions
Journalize
Post
Trial Balance
Journalize and Post Adjusting Entries
Adjusted Trial Balance
Financial Statements
Closing Entries
Post-Closing Trial Balance
Increase both a balance sheet and an income statement account.
LO 3
LEARNING OBJECTIVE
Prepare adjusting entries for accruals.
3

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Made to record:
Revenues for services performed and
OR
Expenses incurred
in the current accounting period that have not been recognized through daily entries.
Adjusting Entries for Accruals
LO 3

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Revenues for services performed but not yet received in cash or recorded.
rent
interest
services performed
BEFORE
Accrued revenues often occur in regard to:
Cash Receipt
Revenue Recorded
Adjusting entry results in:
ACCRUED REVENUES
LO 3

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Accrued Revenues
An adjusting entry serves two purposes:
Shows the receivable that exists, and
Records the revenues for services performed.
ACCRUED REVENUES
LO 3

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Adjusting entries for accrued revenues
Increases (debits) an asset account.
Increases (credits) a revenue account.
ILLUSTRATION 4-14
ACCRUED REVENUES
LO 3

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Illustration: In October, Sierra Corporation performed guide services for $200 that were not billed to clients before October 31.
Service Revenue
200
Accounts Receivable
200
Oct. 31
ILLUSTRATION 4-15
ACCRUED REVENUES
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ILLUSTRATION 4-16
Accounting for accrued revenues
Services performed but not yet received in cash or recorded.
ACCOUNTING FOR ACCRUED REVENUES
Examples
Reason for
Adjustment
Accounts Before
Adjustment
Adjusting
Entry
Interest, rent, services performed but not collected.
Assets understated.
Revenues understated.
Dr. Assets
Cr. Revenues
ACCRUED REVENUES
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Expenses incurred but not yet paid in cash or recorded.
BEFORE
Accrued expenses often occur in regard to:
Cash Payment
Expense Recorded
utilities
salaries
Adjusting entry results in:
Interest
taxes
ACCRUED EXPENSES
LO 3

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An adjusting entry serves two purposes:
Records the obligations, and
Recognizes the expenses.
ACCRUED EXPENSES
LO 3

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Adjusting entries for accrued expenses
Increases (debits) an expense account.
Increases (credits) a liability account.
ILLUSTRATION 4-17
ACCRUED EXPENSES
LO 3

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Illustration: Sierra Corporation signed a three-month note payable in the amount of $5,000 on October 1. The note requires Sierra to pay interest at an annual rate of 12%.
Interest Payable
50
Interest Expense
50
Oct. 31
ILLUSTRATION 4-19
ILLUSTRATION 4-18
Formula for computing interest
Accrued Interest
$5,000 x 12% x 1/12 = $50
LO 3

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ILLUSTRATION 4-20
Illustration: Sierra Corporation last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 × 3 days).
Accrued Salaries
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Salaries and Wages Payable
1,200
Salaries and Wages Expense
1,200
Oct. 31
ILLUSTRATION 4-21
Illustration: Sierra Corporation last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 × 3 days).
Accrued Salaries
LO 3

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ILLUSTRATION 4-22
Accounting for accrued expenses

ACCRUED EXPENSES
LO 3

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PEOPLE, PLANET, AND PROFIT INSIGHT
Got Junk?
Do you have an old computer or two in your garage? How about an old TV that needs replacing? Many people do. Approximately 163,000 computers and televisions become obsolete each day. Yet, in a recent year, only 11% of computers were recycled. It is estimated that 75% of all computers ever sold are sitting in storage somewhere, waiting to be disposed of. Each of these old TVs and computers is loaded with lead, cadmium, mercury, and other toxic chemicals. If you have one of these electronic gadgets, you have a responsibility, and a probable cost, for disposing of it. Companies have the same problem, but their discarded materials may include lead paint, asbestos, and other toxic chemicals.
LO 3

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ILLUSTRATION 4-23
Summary of adjusting entries
SUMMARY OF BASIC RELATIONSHIPS
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Adjusting Entries for Accruals
Micro Computer Services Inc. began operations on August 1, 2017. At the end of August 2017, management attempted to prepare monthly financial statements. The following information relates to August.
At August 31, the company owed its employees $800 in salaries that will be paid on September 1.
On August 1, the company borrowed $30,000 from a bank on a 15-year mortgage. The annual interest rate is 10%.
Revenue for services performed but unrecorded for August totaled $1,100.
Prepare the adjusting entries needed at August 31, 2017.
DO IT!
3
LO 3

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Adjusting Entries for Accruals
Micro Computer Services Inc. began operations on August 1, 2017. At the end of August 2017, management attempted to prepare monthly financial statements. Prepare the adjusting entries needed at August 31, 2017.
At August 31, the company owed its employees $800 in salaries that will be paid on September 1.
SOLUTION
DO IT!
3
Salaries and Wages Expense 800
Salaries and Wages Payable 800
LO 3

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Adjusting Entries for Accruals
Micro Computer Services Inc. began operations on August 1, 2017. At the end of August 2017, management attempted to prepare monthly financial statements. Prepare the adjusting entries needed at August 31, 2017.
On August 1, the company borrowed $30,000 from a bank on a 15-year mortgage. The annual interest rate is 10%.
SOLUTION
DO IT!
3
Interest Expense 250
Interest Payable 250
LO 3

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Adjusting Entries for Accruals
Micro Computer Services Inc. began operations on August 1, 2017. At the end of August 2017, management attempted to prepare monthly financial statements. Prepare the adjusting entries needed at August 31, 2017.
Revenue for services performed but unrecorded for August totaled $1,100.
SOLUTION
DO IT!
3
Accounts Receivable 1,100
Service Revenue 1,100
LO 3

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Analyze business transactions
Journalize
Post
Trial Balance
Adjusting Entries
Adjusted trial balance
Prepare financial statements
Journalize and post closing entries
Prepare a post-closing trial balance
LO 4
LEARNING OBJECTIVE
Prepare an adjusted trial balance and closing entries.
4

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After all adjusting entries are journalized and posted the company prepares another trial balance from the ledger accounts (Adjusted Trial Balance).
The adjusted trial balance’s purpose is to prove the equality of debit balances and credit balances in the ledger.
The adjusted trial balance is the primary basis for the preparation of the financial statements.
PREPARE ADJUSTED TRIAL BALANCE
LO 4

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LO 4
ILLUSTRATION 4-26
Adjusted trial balance

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PREPARE ADJUSTED TRIAL BALANCE
Which of the following statements is incorrect concerning the adjusted trial balance?
An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made.
The adjusted trial balance provides the primary basis for the preparation of financial statements.
The adjusted trial balance lists the account balances segregated by assets and liabilities.
The adjusted trial balance is prepared after the adjusting entries have been journalized and posted.
Review Question
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Financial statements are prepared directly from the Adjusted Trial Balance.
Balance Sheet
Income Statement
Retained Earnings Statement
PREPARING FINANCIAL STATEMENTS
LO 4

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ILLUSTRATION 4-27
Preparation of the income statement and retained earnings statement from the adjusted trial balance
4-68

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Tell students to look at the date on the income statement in Illustration 4-27. The date is “For the Month Ending October 31, 2014.” How can one be sure the revenues and expenses reported on the income statement are just for that period? Closing entries transfer the temporary account balances to the stockholders’ equity account and reduce the balances in the temporary accounts to zero. Therefore, at the beginning of the period the temporary accounts have a balance of zero and the revenues and expenses accumulated are for that particular period.

ILLUSTRATION 4-28
Preparation of the balance sheet from the adjusted trial balance
LO 4

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Quality of Earnings – company provides full and transparent information.
Earnings Management – the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. Companies may manage earnings by:
one-time items to prop up earnings numbers.
inflating revenue numbers in the short-run.
improper adjusting entries.
As a result of the Sarbanes-Oxley Act, many companies are trying to improve the quality of their financial reporting.
QUALITY OF EARNINGS
LO 4

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Trial Balance
DO IT!
4a

LO 4

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Trial Balance
DO IT!
(a) Determine the net income for the quarter April 1 to June 30.

LO 4
4a

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Trial Balance
DO IT!
Determine the total assets and total liabilities at June 30, 2017.

LO 4
4a

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Trial Balance
DO IT!
Determine the balance in Retained Earnings at June 30, 2017.
Retained earnings, April 1 $ 0
Add: Net income 2,490
Less: Dividends 600
Retained earnings, June 30 $1,890
LO 4
4a

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At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders’ equity account—Retained Earnings.
ILLUSTRATION 4-29
Temporary versus permanent accounts
CLOSING THE BOOKS
LO 4

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In addition to updating Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account.
ILLUSTRATION 4-30
The closing process
Preparing Closing Entries
LO 4

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LO 4
ILLUSTRATION 4-31

4-‹#›

Illustration 4-32
Posting of closing entries
Preparing Closing Entries
LO 4

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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.
All temporary accounts will have zero balances.
Preparing a Post-Closing Trail Balance
LO 4

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1. Analyze business transactions

2. Journalize the transactions

6. Prepare an adjusted trial balance
7. Prepare financial statements
8. Journalize and post closing entries
9. Prepare a post-closing trial balance
4. Prepare a trial balance
3. Post to ledger accounts
Journalize and post adjusting entries:
Deferrals/Accruals

ILLUSTRATION 4-33
Required steps in the accounting cycle
SUMMARY OF THE ACCOUNTING CYCLE
LO 4

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SUMMARY OF THE ACCOUNTING CYCLE
ILLUSTRATION 4-33
Required steps in the accounting cycle
LO 4

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SUMMARY OF THE ACCOUNTING CYCLE
ILLUSTRATION 4-33
Required steps in the accounting cycle
LO 4

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SUMMARY OF THE ACCOUNTING CYCLE
ILLUSTRATION 4-33
Required steps in the accounting cycle
LO 4

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SUMMARY OF THE ACCOUNTING CYCLE
ILLUSTRATION 4-33
Required steps in the accounting cycle
LO 4

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SUMMARY OF THE ACCOUNTING CYCLE
ILLUSTRATION 4-33
Required steps in the accounting cycle
LO 4

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SUMMARY OF THE ACCOUNTING CYCLE
ILLUSTRATION 4-33
Required steps in the accounting cycle
LO 4

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SUMMARY OF THE ACCOUNTING CYCLE
ILLUSTRATION 4-33
Required steps in the accounting cycle
LO 4

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SUMMARY OF THE ACCOUNTING CYCLE
ILLUSTRATION 4-33
Required steps in the accounting cycle
LO 4

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SUMMARY OF THE ACCOUNTING CYCLE
ILLUSTRATION 4-33
Required steps in the accounting cycle
LO 4

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Sierra Corporation’s income statement shows net income of $2,860. Net income and net cash provided by operating activities often differ.
Net income on a cash basis is referred to as “Net cash provided by operating activities.”
The statement of cash flows, reports net cash provided by operating activities.
Illustration 4-27
KEEPING AN EYE ON CASH
LO 4

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The difference for Sierra is $2,840 ($5,700 – $2,860). The following summary shows the causes of this difference.

LO 4
KEEPING AN EYE ON CASH

4-‹#›

Closing Entries
Hancock Company has the following balances in selected accounts of its adjusted trial balance.
Accounts Payable $27,000 Dividends $15,000
Service Revenue 98,000 Retained Earnings 42,000
Rent Expense 22,000 Accounts Receivable 38,000
Salaries and Wages Expense 51,000 Supplies Expense 7,000
Prepare the entries to close the revenue and expense accounts.
SOLUTION
DO IT!
4b
Service Revenue 98,000
Income Summary 98,000
Income Summary 80,000
Salaries and Wages Expense 51,000
Rent Expense 22,000
Supplies Expense 7,000
LO 4

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Closing Entries
Hancock Company has the following balances in selected accounts of its adjusted trial balance.
Accounts Payable $27,000 Dividends $15,000
Service Revenue 98,000 Retained Earnings 42,000
Rent Expense 22,000 Accounts Receivable 38,000
Salaries and Wages Expense 51,000 Supplies Expense 7,000
Prepare the entries to close income summary and dividends.
SOLUTION
DO IT!
4b
Income Summary 18,000
Retained Earnings 18,000
Retained Earnings 15,000
Dividends 15,000
LO 4

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LO 5
LEARNING OBJECTIVE
APPENDIX 4A: Describe the purpose and the basic form of a worksheet.
*5
Worksheet
A multiple-column form that may be used in the adjustment process and in preparing financial statements.
Manual or computer spreadsheet.
A working tool, not a permanent accounting record.
Neither a journal nor a part of the general ledger.

4-‹#›

ILLUSTRATION 4A-1
Form and procedure for a worksheet
SIERRA CORPORATION
Worksheet
For the Month Ended October 31, 2017
LO 5

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(a)
(b)
(a)
(g)
(c)
(d)
(d)
(e)
(b)
(e)
(f)
(f)
(g)
(c)
ILLUSTRATION 4A-1
Form and procedure for a worksheet
SIERRA CORPORATION
Worksheet
For the Month Ended October 31, 2017
LO 5

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KEY POINTS
A Look at IFRS
LEARNING OBJECTIVE
Compare the procedures for adjusting entries under GAAP and IFRS.
6
Similarities
Companies applying IFRS also use accrual-basis accounting to ensure that they record transactions that change a company’s financial statements in the period in which events occur.
Similar to GAAP, cash-basis accounting is not in accordance with IFRS.
LO 6

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A Look at IFRS
KEY POINTS
Similarities
IFRS also divides the economic life of companies into artificial time periods. Under both GAAP and IFRS, this is referred to as the periodicity assumption.
The general revenue recognition principle required by GAAP that is used in this textbook is similar to that used under IFRS.
Revenue recognition fraud is a major issue in U.S. financial reporting. The same situation occurs in other countries, as evidenced by revenue recognition breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer Ahold NV.
LO 6

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A Look at IFRS
KEY POINTS
Differences
Under IFRS, revaluation (using fair value) of items such as land and buildings is permitted. IFRS allows depreciation based on revaluation of assets, which is not permitted under GAAP.
The terminology used for revenues and gains, and expenses and losses, differs somewhat between IFRS and GAAP. For example, income under IFRS includes both revenues, which arise during the normal course of operating activities, and gains, which arise from activities outside of the normal sales of goods and services.
LO 6

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A Look at IFRS
KEY POINTS
Differences
Under IFRS, expenses include both those costs incurred in the normal course of operations as well as losses that are not part of normal operations. This is in contrast to GAAP, which defines each separately.
LO 6

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A Look at IFRS
LOOKING TO THE FUTURE
The IASB and FASB are completing a joint project on revenue recognition. The purpose of this project is to develop comprehensive guidance on when to recognize revenue. It is hoped that this approach will lead to more consistent accounting in this area. For more on this topic, see www.fasb.org/project/revenue_recognition.shtml.
LO 6

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IFRS Practice
IFRS:
uses accrual accounting.
uses cash-basis accounting.
allows revenue to be recognized when a customer makes an order.
requires that revenue not be recognized until cash is received.

A Look at IFRS

LO 6

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IFRS Practice
Which of the following statements is false?
IFRS employs the periodicity assumption.
IFRS employs accrual accounting.
IFRS requires that revenues and costs must be capable of being measured reliably.
IFRS uses the cash basis of accounting.

A Look at IFRS

LO 6

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IFRS Practice
Accrual-basis accounting:
is optional under IFRS.
results in companies recording transactions that change a company’s financial statements in the period in which events occur.
has been eliminated as a result of the IASB/FASB joint project on revenue recognition.
is not consistent with the IASB conceptual framework.

A Look at IFRS

LO 6

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COPYRIGHT

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Account TitlesDr.Cr.Dr.Cr.Dr.Cr.Dr.Cr.Dr.Cr.
Cash15,200
Supplies2,500
Prepaid Insurance600
Equipment5,000
Notes Payable5,000
Accounts Payable2,500
Unearned Service Revenue1,200
Common Stock10,000
Dividends500
Service Revenue10,000
Salaries & Wages Exp.4,000
Rent Expense900
Totals28,700 28,700
Balance Sheet
AdjustedIncome
Trial BalanceAdjustmentsTrial BalanceStatement
Sheet1

Adjusted Income
Trial Balance Adjustments Trial Balance Statement Balance Sheet
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200
Supplies 2,500
Prepaid Insurance 600
Equipment 5,000
Notes Payable 5,000
Accounts Payable 2,500
Unearned Service Revenue 1,200
Common Stock 10,000
Dividends 500
Service Revenue 10,000
Salaries & Wages Exp. 4,000
Rent Expense 900
Totals 28,700 28,700
Miscellaneous Expense 200
55,970 55,970

Account TitlesDr.Cr.Dr.Cr.Dr.Cr. Dr. Cr. Dr. Cr.
Cash15,200 15,200 15,200
Supplies2,500 1,500 1,000 1,000
Prepaid Insurance600 50 550 550
Equipment5,000 5,000 5,000
Notes Payable5,000 5,000 5,000
Accounts Payable2,500 2,500 2,500
Unearned Service Revenue1,200 400 800 800
Common Stock10,000 10,000 10,000
Dividends500 500 500
Service Revenue10,000 400 10,600 10,600
200
Salaries & Wages Exp.4,000 1,200 5,200 5,200
Rent Expense900 900 900
Totals28,700 28,700
Supplies Expense1,500 1,500 1,500
Insurance Expense50 50 50
Accumulated Depreciation40 40 40
Depreciation Expense40 40 40
Accounts Receivable200 200 200
Interest Expense50 50 50
Interest Payable50 50 50
Salaries and Wages Payable1,200 1,200 1,200
Totals3,440 3,440 30,190 30,190 7,740 10,600 22,450 19,590
Net Income2,860 2,860
Totals10,600 10,600 22,450 22,450
Balance Sheet
Adjusted Income
Trial BalanceAdjustmentsTrial Balance Statement
Sheet1

Adjusted Income
Trial Balance Adjustments Trial Balance Statement Balance Sheet
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200 15,200 15,200
Supplies 2,500 1,500 1,000 1,000
Prepaid Insurance 600 50 550 550
Equipment 5,000 5,000 5,000
Notes Payable 5,000 5,000 5,000
Accounts Payable 2,500 2,500 2,500
Unearned Service Revenue 1,200 400 800 800
Common Stock 10,000 10,000 10,000
Dividends 500 500 500
Service Revenue 10,000 400 10,600 10,600
200
Salaries & Wages Exp. 4,000 1,200 5,200 5,200
Rent Expense 900 900 900
Totals 28,700 28,700
Supplies Expense 1,500 1,500 1,500
Insurance Expense 50 50 50
Accumulated Depreciation 40 40 40
Depreciation Expense 40 40 40
Accounts Receivable 200 200 200
Interest Expense 50 50 50
Interest Payable 50 50 50
Salaries and Wages Payable 1,200 1,200 1,200
Totals 3,440 3,440 30,190 30,190 7,740 10,600 22,450 19,590
Net Income 2,860 2,860
Totals 10,600 10,600 22,450 22,450
Miscellaneous Expense 200
55,970 55,970