3 1 PREVIEW OF CHAPTER 3 Intermediate Accounting

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PREVIEW OF CHAPTER 3 Intermediate Accounting IFRS 2 nd Edition Kieso, Weygandt, and Warfield 3 -2

3 The Accounting Information System LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Understand basic accounting terminology. 6. Prepare financial statements from the adjusted trial balance. 2. Explain double-entry rules. 7. Prepare closing entries. 3. Identify steps in the accounting cycle. 8. Prepare financial statements for a merchandising company. 4. Record transactions in journals, post to ledger accounts, and prepare a trial balance. 5. Explain the reasons for preparing adjusting entries. 3 -3

ACCOUNTING INFORMATION SYSTEM Accounting Information System (AIS) 3 -4 u Collects and processes transaction data. u Disseminates financial information to interested parties. u Varies widely from business to business. ► Nature of business ► Type of transactions ► Size of business ► Volume of data ► Informational demands LO 1

ACCOUNTING INFORMATION SYSTEM Helps management answer such questions as: 3 -5 u How much and what kind of debt is outstanding? u Were our sales higher this period than last? u What assets do we have? u What were our cash inflows and outflows? u Did we make a profit last period? u Are any of our product lines or divisions operating at a loss? u Can we safely increase our dividends to shareholders? u Is our rate of return on net assets increasing? LO 1

ACCOUNTING INFORMATION SYSTEM Basic Terminology 3 -6 u Event u Journal u Transaction u Posting u Account u Trial Balance u Real Account u Adjusting Entries u Nominal Account u Financial Statements u Ledger u Closing Entries LO 1

3 The Accounting Information System LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Understand basic accounting terminology. 6. Prepare financial statements from the adjusted trial balance. 2. Explain double-entry rules. 7. Prepare closing entries. 3. Identify steps in the accounting cycle. 8. Prepare financial statements for a merchandising company. 4. Record transactions in journals, post to ledger accounts, and prepare a trial balance. 5. Explain the reasons for preparing adjusting entries. 3 -7

ACCOUNTING INFORMATION SYSTEM Debits and Credits u An account shows the effect of transactions on a given asset, liability, equity, revenue, or expense account. 3 -8 u Double-entry accounting system (two-sided effect). u Recording done by debiting at least one account and crediting another. u DEBITS must equal CREDITS. LO 2

Debits and Credits Account u An arrangement that shows the effect of transactions on an account. u Debit = “Left” u Credit = “Right” An Account can be illustrated in a T-Account form. 3 -9 LO 2

Debits and Credits If the sum of Debit entries are greater than the sum of Credit entries, the account will have a debit balance. Transaction #1 $10, 000 Transaction #3 8, 000 Balance 3 -10 $3, 000 Transaction #2 $15, 0 00 LO 2

Debits and Credits If the sum of Credit entries are greater than the sum of Debit entries, the account will have a credit balance. Transaction #1 Balance 3 -11 $10, 000 0 $3, 000 Transaction #2 8, 000 Transaction #3 $1, 00 LO 2

Debits and Credits Summary Normal Balance Debit 3 -12 Normal Balance Credit LO 2

Debits and Credits Summary Statement of Financial Position Income Statement Asset = Liability + Equity Revenue - Expense Debit Credit 3 -13 LO 2

The Accounting Equation Relationship among the assets, liabilities and equity of ILLUSTRATION 3 -3 a business: Expanded Equation and Debit/Credit Rules and Effects The equation must be in balance after every transaction. For every Debit there must be a Credit. 3 -14 LO 2

Double-Entry System Illustration 1. Owners invest $40, 000 in exchange for ordinary shares. Assets + 40, 000 3 -15 = Liabilities + Equity + 40, 000 LO 2

Double-Entry System Illustration 2. Disburse $600 cash for secretarial wages. Assets - 600 3 -16 = Liabilities + Equity - 600 (expense) LO 2

Double-Entry System Illustration 3. Purchase office equipment priced at $5, 200, giving a 10 percent promissory note in exchange. Assets + 5, 200 3 -17 = Liabilities + Equity + 5, 200 LO 2

Double-Entry System Illustration 4. Received $4, 000 cash for services performed. Assets + 4, 000 3 -18 = Liabilities + Equity + 4, 000 (revenue) LO 2

Double-Entry System Illustration 5. Pay off a short-term liability of $7, 000. Assets - 7, 000 3 -19 = Liabilities + Equity - 7, 000 LO 2

Double-Entry System Illustration 6. Declared a cash dividend of $5, 000. Assets = Liabilities + 5, 000 3 -20 + Equity - 5, 000 LO 2

Double-Entry System Illustration 7. Convert a non-current liability of $80, 000 into ordinary shares. Assets = Liabilities - 80, 000 3 -21 + Equity + 80, 000 LO 2

Double-Entry System Illustration 8. Pay cash of $16, 000 for a delivery van. Assets = Liabilities + Equity - 16, 000 + 16, 000 Note that the accounting equation equality is maintained after recording each transaction. 3 -22 LO 2

Financial Statements and Ownership Structure Ownership structure dictates the types of accounts that are part of the equity section. Proprietorship or Partnership l l 3 -23 Capital account Drawing account Corporation l Share capital l Share premium l Dividends l Retained Earnings LO 2

ILLUSTRATION 3 -4 Financial Statements and Ownership Structure Investments by shareholders Net income retained in the business Financial Statements and Ownership Structure 3 -24 LO 2

Financial Statements and Ownership Structure ILLUSTRATION 3 -5 Effects of Transactions on Equity Accounts 3 -25 LO 2

3 The Accounting Information System LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Understand basic accounting terminology. 6. Prepare financial statements from the adjusted trial balance. 2. Explain double-entry rules. 7. Prepare closing entries. 3. Identify steps in the accounting cycle. 8. Prepare financial statements for a merchandising company. 4. Record transactions in journals, post to ledger accounts, and prepare a trial balance. 5. Explain the reasons for preparing adjusting entries. 3 -26

THE ACCOUNTING CYCLE Transactions ILLUSTRATION 3 -6 Reversing entries Journalization Post-closing trail balance Posting Closing Trial balance Statement preparation Work Sheet Adjustments Adjusted trial balance 3 -27 LO 3

THE ACCOUNTING CYCLE Identifying and Recording Transactions and Other Events An item should be recognized in the financial statements if it 1. meets the definition of an element, 2. is probable that any future economic benefit associated with the item will flow to or from the entity, and 3. has a cost or value that can be measured reliably. 3 -28 LO 3

3 The Accounting Information System LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Understand basic accounting terminology. 6. Prepare financial statements from the adjusted trial balance. 2. Explain double-entry rules. 7. Prepare closing entries. 3. Identify steps in the accounting cycle. 8. Prepare financial statements for a merchandising company. 4. Record transactions in journals, post to ledger accounts, and prepare a trial balance. 5. Explain the reasons for preparing adjusting entries. 3 -29

Journalizing General Journal – a chronological list of transactions and other events, expressed in terms of debits and credits to accounts. Journal Entries are recorded in the journal. September 1: Shareholders invested ₺ 15, 000 cash in the corporation in exchange for ordinary shares. 3 -30 ILLUSTRATION 3 -7 LO 4

Posting – The process of transferring amounts from the journal to the ledger accounts. ILLUSTRATION 3 -7 ILLUSTRATION 3 -8 3 -31 Advance slide in presentation mode to reveal answers. LO 4

ILLUSTRATION 38 Posting a Journal Entry Posting – Transferring amounts from journal to ledger. 3 -32 LO 4

Posting An Expanded Example The purpose of transaction analysis is (1) to identify the type of account involved, and (2) to determine whether a debit or a credit is required. Keep in mind that every journal entry affects one or more of the following items: assets, liabilities, equity, revenues, or expense. 3 -33 LO 4

Posting 1. October 1: Shareholders invest ₺ 100, 000 cash in an advertising venture to be known as Pioneer Advertising Agency Inc. ILLUSTRATION 3 -9 Oct. 1 Cash 100, 000 Share Capital—Ordinary Cash Debit 100, 000 3 -34 100, 000 Share Capital—Ordinary Credit Debit Credit 100, 000 LO 4

Posting 2. October 1: Pioneer purchases office equipment costing ₺ 50, 000 by signing a 3 -month, 12%, ₺ 50, 000 note payable. Oct. 1 Equipment 50, 000 Notes payable Equipment Debit 50, 000 3 -35 Credit ILLUSTRATION 310 50, 000 Notes Payable Debit Credit 50, 000 LO 4

Posting 3. October 2: Pioneer receives a ₺ 12, 000 cash advance from KC, a client, for advertising services that are expected to be completed by December 31. Oct. 2 Cash 12, 000 Unearned Service Revenue Cash Debit 100, 000 12, 000 3 -36 ILLUSTRATION 311 12, 000 Unearned Service Revenue Credit Debit Credit 12, 000 LO 4

Posting 4. October 3: Pioneer pays ₺ 9, 000 office rent, in cash, for October. ILLUSTRATION 3 -12 Oct. 3 Rent Expense 9, 000 Cash Debit 100, 000 12, 000 3 -37 Rent Expense Credit 9, 000 Debit Credit 9, 000 LO 4

Posting 5. October 4: Pioneer pays ₺ 6, 000 for a one-year insurance policy that will expire next year on ILLUSTRATION 3 -13 September 30. Oct. 4 Prepaid Insurance 6, 000 Cash Debit 100, 000 12, 000 3 -38 Prepaid Insurance Credit 9, 000 6, 000 Debit Credit 6, 000 LO 4

Posting 6. October 5: Pioneer purchases, for ₺ 25, 000 on account, an estimated 3 -month supply of advertising materials from Aero Supply. Oct. 5 Supplies 25, 000 Accounts Payable Supplies Debit 25, 000 3 -39 Credit ILLUSTRATION 314 25, 000 Accounts Payable Debit Credit 25, 000 LO 4

Posting 7. October 9: Pioneer signs a contract with a local newspaper for advertising inserts (flyers) to be distributed starting the last Sunday in November. Pioneer will start work on the content of the flyers in November. Payment of ₺ 7, 000 is due following delivery of the Sunday papers containing the flyers. ILLUSTRATION 3 -15 A business transaction has not occurred. There is only an agreement between Pioneer Advertising and the newspaper for the services to be provided in November. Therefore, no journal entry is necessary in October. 3 -40 LO 4

Posting 8. October 20: Pioneer’s board of directors declares and pays a ₺ 5, 000 cash dividend to shareholders. Oct. 20 Dividends 5, 000 Cash Debit 100, 000 12, 000 3 -41 ILLUSTRATION 316 Dividends Credit 9, 000 6, 000 5, 000 Debit Credit 5, 000 LO 4

Posting 9. October 26: Employees are paid every four weeks. The total payroll is ₺ 2, 000 per day. The pay period ended on Friday, October 26, with salaries of ₺ 40, 000 being ILLUSTRATION 3 paid. 17 Oct. 26 Salaries and Wages Expense 40, 000 Cash Debit 100, 000 12, 000 3 -42 Salaries and Wages Expense Credit 9, 000 6, 000 5, 000 40, 000 Debit Credit 40, 000 LO 4

Posting 10. October 31: Pioneer receives ₺ 28, 000 in cash and bills Copa Company ₺ 72, 000 for advertising services of ₺ 100, 000 provided in October. ILLUSTRATION 3 Oct. 31 Cash Accounts Receivable Service Revenue Cash Debit 100, 000 12, 000 28, 000 80, 000 3 -43 28, 000 72, 000 100, 000 Accounts Receivable Credit 9, 000 6, 000 5, 000 40, 000 Debit 72, 000 18 Credit Service Revenue Debit Credit 100, 000

Trial Balance A Trial Balance u List of each account and its balance in the order in which they appear in the ledger. u Debit balances listed in the left column and credit balance in the right column. u Used to prove the mathematical equality of debit and credit balances. u 3 -44 Uncovers errors in journalizing and posting. LO 4

ILLUSTRATION 3 -19 3 -45 LO 4

3 The Accounting Information System LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Understand basic accounting terminology. 6. Prepare financial statements from the adjusted trial balance. 2. Explain double-entry rules. 7. Prepare closing entries. 3. Identify steps in the accounting cycle. 8. Prepare financial statements for a merchandising company. 4. Record transactions in journals, post to ledger accounts, and prepare a trial balance. 5. Explain the reasons for preparing adjusting entries. 3 -46

Adjusting Entries Makes it possible to: u Report on the statement of financial position the appropriate assets, liabilities, and equity at the statement date. u Report on the income statement the proper revenues and expenses for the period. ► Revenues are recorded in the period in which services are performed. ► Expenses are recognized in the period in which they are incurred. 3 -47 LO 5

Adjusting Entries Types of Adjusting Entries 3 -48 Illustration 3 -20 Deferrals Accruals 1. Prepaid Expenses paid in cash before they are used or consumed. 3. Accrued Revenues for services performed but not yet received in cash or recorded. 2. Unearned Revenues. Cash received before services are performed. 4. Accrued Expenses incurred but not yet paid in cash or recorded. LO 5

Adjusting Entries for Deferrals are expenses or revenues that are recognized at a date later than the point when cash was originally exchanged. Two types of deferrals u Prepaid expenses u Unearned revenues If a company does not make an adjustment for these deferrals, 3 -49 u the asset and liability are overstated, and u the related expense and revenue are understated. LO 5

3 -50 ILLUSTRATION 3 -21 Adjusting Entries for Deferrals LO 5

Adjusting Entries for Prepaid Expenses. Assets paid for and recorded before a company uses them. Cash Payment BEFORE Expense Recorded Prepayments often occur in regard to: 3 -51 u Insurance u Rent u Supplies u Buildings and equipment u Advertising LO 5

Adjusting Entries for Prepaid Expenses Supplies. Pioneer purchased advertising supplies costing ₺ 25, 000 on October 5. Prepare the journal entry to record the purchase of the supplies. Oct. 5 Supplies 25, 000 Cash 25, 000 Supplies Debit 25, 000 3 -52 Credit Cash Debit Credit 25, 000 LO 5

Adjusting Entries for Prepaid Expenses Supplies. An inventory count at the close of business on October 31 reveals that ₺ 10, 000 of supplies are still on hand. Oct. 31 Supplies Expense 15, 000 Supplies Expense Supplies Debit 25, 000 15, 000 Credit 15, 000 Debit Credit 15, 000 10 , 000 3 -53 LO 5

Adjusting Entries for Prepaid Expenses Statement Presentation: Supplies identifies that portion of the asset’s cost that will provide future economic benefit. 3 -54 ILLUSTRATION 3 -35

Adjusting Entries for Prepaid Expenses Statement Presentation: Supplies expense shows a balance of ₺ 15, 000, which equals the cost of supplies used in October ILLUSTRATION 3 -35 3 -55 LO 5

Adjusting Entries for Prepaid Expenses Insurance. On Oct. 4 th, Pioneer paid ₺ 6, 000 for a one-year fire insurance policy, beginning October 1. Show the entry to record the purchase of the insurance. Oct. 4 Prepaid Insurance 6, 000 Cash 6, 000 Prepaid Insurance Debit 6, 000 3 -56 Credit Cash Debit Credit 6, 000 LO 5

Adjusting Entries for Prepaid Expenses Insurance. An analysis of the policy reveals that ₺ 500 (₺ 6, 000 ÷ 12) of insurance expires each month. Thus, Pioneer makes the following adjusting entry. Oct. 31 Insurance Expense 500 Prepaid Insurance Debit 6, 000 Credit 500 Insurance Expense Debit Credit 500 5, 500 3 -57 LO 5

Adjusting Entries for Prepaid Expenses Statement Presentation: Prepaid Insurance represents the unexpired cost for the remaining 11 months of coverage. 3 -58 ILLUSTRATION 3 -35

Adjusting Entries for Prepaid Expenses Statement Presentation: Insurance expense identifies that portion of the asset’s cost that expired in October. ILLUSTRATION 3 -35 3 -59 LO 5

Adjusting Entries for Prepaid Expenses Depreciation. Pioneer estimates depreciation on its office equipment to be ₺ 400 per month. Pioneer recognizes depreciation for October by the following adjusting entry. Oct. 31 Depreciation Expense 400 Accumulated Depreciation Expense Debit 400 3 -60 Credit 400 Accumulated Depreciation Debit Credit 400 LO 5

Adjusting Entries for Prepaid Expenses Statement Presentation: Accumulated Depreciation—is a contra asset account. 3 -61 ILLUSTRATION 3 -35

Adjusting Entries for Prepaid Expenses Statement Presentation: Depreciation expense identifies that portion of the asset’s cost that expired in October. ILLUSTRATION 3 -35 3 -62 LO 5

Adjusting Entries for Unearned Revenues Receipt of cash before the services are performed is recorded as a liability called unearned revenues. Cash Receipt BEFORE Revenue Recorded Unearned revenues often occur in regard to: 3 -63 u Rent u Magazine subscriptions u Airline tickets u Customer deposits u Tuition LO 5

Adjusting Entries for Unearned Revenues Unearned Revenue. Pioneer received ₺ 12, 000 on October 2 from KC for advertising services expected to be completed by December 31. Show the journal entry to record the receipt on Oct. 2 nd. Oct. 2 Cash 12, 000 Unearned Service Revenue Cash Debit 12, 000 3 -64 Credit 12, 000 Unearned Service Debit. Revenue Credit 12, 000

Adjusting Entries for Unearned Revenues. An evaluation of the service Pioneer performed for Knox during October, the company determines that it should recognize 4, 000 of revenue in October. Oct. 31 Unearned Service 4, 000 Revenue Service Revenue 4, 000 Service Revenue Debit Credit 100, 000 4, 000 3 -65 Unearned Service Debit. Revenue Credit 4, 000 12, 000 8, 000 LO 5

Adjusting Entries for Unearned Revenues Statement Presentation: Unearned service revenue represents the remaining advertising services expected to be performed in the future. 3 -66 ILLUSTRATION 3 -35

Adjusting Entries for Unearned Revenues Statement Presentation: Service revenue shows total revenue recognized in October. ILLUSTRATION 3 -35 3 -67 LO 5

Adjusting Entries for Accruals are made to record u revenues for services performed and u expenses incurred in the current accounting period. Without an accrual adjustment, the 3 -68 u revenue account (and the related asset account) or the u expense account (and the related liability account) are understated. LO 5

3 -69 ILLUSTRATION 3 -27 Adjusting Entries for Accruals LO 5

Adjusting Entries for Accrued Revenues recorded for services performed for which cash has yet to be received at statement date are accrued revenues. Adjusting entry results in: Revenue Recorded BEFORE Cash Receipt Accrued revenues often occur in regard to: 3 -70 u Rent u Interest u Services performed LO 5

Adjusting Entries for Accrued Revenues. In October Pioneer performed services worth ₺ 2, 000 that were not billed to clients on or before October 31. Pioneer makes the following adjusting entry. Oct. 31 Accounts Receivable 2, 000 Service Revenue Accounts Receivable Debit 3 -71 Credit 2, 000 Service Revenue Debit Credit 72, 000 100, 000 4, 000 2, 000 74, 000 106, 000

Adjusting Entries for Accrued Revenues ILLUSTRATION 3 -35 3 -72 Statement Presentation LO 5

Adjusting Entries for Accrued Expenses incurred but not yet paid in cash or recorded. Adjusting entry results in: Expense Recorded BEFORE Cash Payment Accrued expenses often occur in regard to: 3 -73 u Rent u Taxes u Interest u Salaries LO 5

Adjusting Entries for Accrued Expenses Accrued Interest. Pioneer signed a three-month, 12%, note payable in the amount of ₺ 50, 000 on October 1. The note requires interest at an annual rate of 12 percent. Three factors determine the amount of the interest accumulation: 1 3 -74 2 3 ILLUSTRATION 3 -29 Formula for Computing Interest LO 5

Adjusting Entries for Accrued Expenses Accrued Interest. Pioneer signed a three-month, 12%, note payable in the amount of ₺ 50, 000 on October 1. Prepare the adjusting entry on Oct. 31 to record the accrual of interest. Oct. 31 Interest Expense 500 Interest Payable Interest Expense Debit 500 3 -75 Credit 500 Interest Payable Debit Credit 500 LO 5

Adjusting Entries for Accrued Expenses ILLUSTRATION 3 -35 3 -76 Statement Presentation LO 5

Adjusting Entries for Accrued Expenses Accrued Salaries. At October 31, the salaries and wages for these days represent an accrued expense and a related liability to Pioneer. The employees receive total salaries of ₺ 10, 000 for a five-day work week, or ₺ 2, 000 per day. 3 -77 LO 5

Adjusting Entries for Accrued Expenses Accrued Salaries. Employees receive total salaries of ₺ 10, 000 for a five-day work week, or ₺ 2, 000 per day. Prepare the adjusting entry on Oct. 31 to record accrual for salaries. Oct. 31 Salaries and Wages Expense Salaries and Wages Payable Salaries and Wages Expense Debit 40, 000 6, 000 Credit 6, 000 Salaries and Wages Payable Debit Credit 6, 000 46, 000 3 -78 LO 5

Adjusting Entries for Accrued Expenses ILLUSTRATION 3 -35 3 -79 Statement Presentation LO 5

Adjusting Entries for Accrued Expenses Accrued Salaries. On November 23, Pioneer will again pay total salaries of ₺ 40, 000. Prepare the entry to record the payment of salaries on November 23. Nov. 23 Salaries and Wages Payable 6, 000 Salaries and Wages Expense 34, 000 Cash 40, 000 Salaries and Wages Expense Debit 34, 000 3 -80 Credit Salaries and Wages Payable Debit 6, 000 Credit 6, 000 LO 5

Adjusting Entries for Accrued Expenses Bad Debts. Assume Pioneer reasonably estimates a bad debt expense for the month of ₺ 1, 600. It makes the adjusting entry for bad debts as follows. Oct. 31 Bad Debt Expense 1, 600 Allowance for Doubtful Accounts 1, 600 ILLUSTRATION 3 -32 Adjustment for Bad Debt Expense 3 -81 LO 5

Adjusting Entries for Accrued Expenses ILLUSTRATION 3 -35 3 -82 Statement Presentation LO 5

Adjusted Trial Balance Shows the balance of all accounts, after adjusting entries, at the end of the accounting period. Proves the equality of the total debit and credit balances 3 -83 ILLUSTRATION 3 -33

3 The Accounting Information System LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Understand basic accounting terminology. 6. Prepare financial statements from the adjusted trial balance. 2. Explain double-entry rules. 7. Prepare closing entries. 3. Identify steps in the accounting cycle. 8. Prepare financial statements for a merchandising company. 4. Record transactions in journals, post to ledger accounts, and prepare a trial balance. 5. Explain the reasons for preparing adjusting entries. 3 -84

Preparing Financial Statements are prepared directly from the Adjusted Trial Balance. Income Statement 3 -85 Retained Earnings Statement of Financial Position LO 6

3 -86 ILLUSTRATION 3 -34 Preparation of the Income Statement and Retained Earnings Statement from the Adjusted Trial Balance

3 -87 ILLUSTRATION 3 -35 Preparation of the Statement of Financial Position from the Adjusted Trial Balance LO 6

24/7 ACCOUNTING WHAT’S YOUR PRINCIPLE To achieve the vision of “ 24/7 accounting, ” a company must be able to update revenue, income, and statement of financial position numbers every day within the quarter (and potentially publish them on the Internet). Such real-time reporting responds to the demand for more timely financial information made available to all investors—not just to analysts with access to company management. Two obstacles typically stand in the way of 24/7 accounting: having the necessary accounting systems to close the books on a daily basis, and reliability concerns associated with unaudited real -time data. Only a few companies have the necessary accounting capabilities. 3 -88 LO 6

3 The Accounting Information System LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Understand basic accounting terminology. 6. Prepare financial statements from the adjusted trial balance. 2. Explain double-entry rules. 7. Prepare closing entries. 3. Identify steps in the accounting cycle. 8. Prepare financial statements for a merchandising company. 4. Record transactions in journals, post to ledger accounts, and prepare a trial balance. 5. Explain the reasons for preparing adjusting entries. 3 -89

Closing Entries Basic Process 3 -90 u Reduce the balance of nominal (temporary) accounts to zero in preparation for the next period’s transactions. u Transfer all revenue and expense account balances (income statement accounts) to Retained Earnings. u Statement of financial position (asset, liability, and equity) accounts are not closed. u Dividends are closed directly to Retained Earnings. u Income Summary account may be used however it has no effect on the financial statements. LO 7

Closing Entries ILLUSTRATION 3 -33 Closing Journal Entries: Retained Earnings Dividends Service Revenue 5, 000 106, 000 Salaries & Wages Expense 46, 000 Supplies Expense 15, 000 Rent Expense 9, 000 Insurance Expense 500 Interest Expense 500 Depreciation Expense 400 3 -91 Bad Debt Expense 1, 600 LO 7

Illustration 3 -38 ILLUSTRATION 3 -38 3 -92 LO 7

Accounting Cycle Summarized 1. Enter the transactions of the period in appropriate journals. 2. Post from the journals to the ledger (or ledgers). 3. Prepare an unadjusted trial balance (trial balance). 4. Prepare adjusting journal entries and post to the ledger(s). 5. Prepare a trial balance after adjusting (adjusted trial balance). 6. Prepare the financial statements from the adjusted trial balance. 7. Prepare closing journal entries and post to the ledger(s). 8. Prepare a trial balance after closing (post-closing trial balance). 9. Prepare reversing entries (optional) and post to the ledger(s). Reversing entries are covered in Appendix 3 B. 3 -93 LO 7

HEY, IT’S COMPLICATED WHAT’S YOUR PRINCIPLE The economic volatility of the past few years has left companies hungering for more timely and uniform financial information to help them react quickly to fast-changing conditions. As one expert noted, companies were extremely focused on trying to reduce costs as well as better plan for the future, but a lot of them discovered that they didn’t have the information they needed and they didn’t have the ability to get that information. The unsteady recession environment also made it risky for companies to interrupt their operations to get new systems up to speed. So what to do? Try to piecemeal upgrades each year or start a major overhaul of their internal systems? One company, for example, has standardized as many of its systems as possible and has been steadily upgrading them over the past decade. Acquisitions can also wreak havoc on reporting systems. This company is choosy about when to standardize for companies it acquires, but it sometimes has to implement new systems after international deals. In other situations, a major overhaul is needed. For example, it is common for companies with a steady stream of acquisitions to have 50 to 70 general ledger systems. In those cases, a company cannot react well unless its systems are made compatible. So is it the big bang (major overhaul) or the piecemeal approach? It seems to depend. One thing is certain—good accounting LO 7 3 -94 systems are. Chasan, a necessity. Without one, the risk of. Street failure is high. Source: Emily ”The Financial-Data Dilemma, ” Wall Journal (July 24, 2012),

3 The Accounting Information System LEARNING OBJECTIVES After studying this chapter, you should be able to: 1. Understand basic accounting terminology. 6. Prepare financial statements from the adjusted trial balance. 2. Explain double-entry rules. 7. Prepare closing entries. 3. Identify steps in the accounting cycle. 8. Prepare financial statements for a merchandising company. 4. Record transactions in journals, post to ledger accounts, and prepare a trial balance. 5. Explain the reasons for preparing adjusting entries. 3 -95

ILLUSTRATION 3 -39 Merchandisin g Company 3 -96

Financial Statements of a Merchandising Company ILLUSTRATION 3 -40 3 -97 LO 8

Financial Statements of a Merchandising Company ILLUSTRATION 3 -41 3 -98

GLOBAL ACCOUNTING INSIGHTS ACCOUNTING INFORMATION SYSTEMS As indicated in this chapter, companies must have an effective accounting system. In the wake of accounting scandals at U. S. companies like Sunbeam, Rite-Aid, Xerox, and World. Com, U. S. lawmakers demanded higher assurance on the quality of accounting reports. Since the passage of the Sarbanes-Oxley Act of 2002 (SOX), companies that trade on U. S. exchanges are required to place renewed focus on their accounting systems to ensure accurate reporting. 3 -99

GLOBAL ACCOUNTING INSIGHTS Relevant Facts Following are the key similarities and differences between U. S. GAAP and IFRS related to accounting information systems. Similarities • International companies use the same set of procedures and records to keep track of transaction data. Thus, the material in Chapter 3 dealing with the account, general rules of debit and credit, and steps in the recording process—the journal, ledger, and chart of accounts— is the same under both U. S. GAAP and IFRS. • Transaction analysis is the same under U. S. GAAP and IFRS but, as you will see in later chapters, different standards sometimes impact how transactions are recorded. 3 -100

GLOBAL ACCOUNTING INSIGHTS Relevant Facts Similarities • Both the FASB and IASB go beyond the basic definitions provided in this textbook for the key elements of financial statements, that is, assets, liabilities, equity, revenues, and expenses. • A trial balance under U. S. GAAP follows the same format as shown in the textbook. As shown in the textbook, currency signs are typically used only in the trial balance and the financial statements. The same practice is followed under U. S. GAAP. 3 -101

GLOBAL ACCOUNTING INSIGHTS Relevant Facts Differences • Rules for accounting for specific events sometimes countries. For example, European companies rely less cost and more on fair value than U. S. companies. differences, the double- entry accounting system is accounting systems worldwide. differ across on historical Despite the basis of • 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 them nor had an independent auditor attest to their effectiveness. Both of these actions are required under SOX. Enhanced internal control standards apply only to large public companies listed on U. S. exchanges. 3 -102

GLOBAL ACCOUNTING INSIGHTS About The Numbers Debate about requiring 3 -103 foreign companies to comply with SOX centers on whether the higher costs of a good information system are making the U. S. securities markets less competitive. Presented are statistics for initial public offerings (IPOs) in the years since the passage of SOX.

GLOBAL ACCOUNTING INSIGHTS About The Numbers Note the U. S. share of IPOs has steadily declined, and some critics of the SOX provisions attribute the decline to the increased cost of complying with the internal control rules, others are not so sure. These commentators argue markets is a in natural consequence of general globalization of capital flows. that growth non-U. S. 3 -104

GLOBAL ACCOUNTING INSIGHTS On the Horizon High-quality international accounting requires both high-quality accounting standards and high-quality auditing. Similar to the convergence of U. S. GAAP and IFRS, there is a movement to improve international auditing standards. The International Auditing and Assurance Standards Board (IAASB) functions as an independent standard-setting body. It works to establish high-quality auditing and assurance and quality-control standards throughout the world. Whether the IAASB adopts internal control provisions similar to those in SOX remains to be seen. You can follow developments in the international audit arena at http: // www. ifac. org/iaasb/. 3 -105

APPENDIX 3 A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING Most companies use accrual-basis accounting. They u recognize revenue when the performance obligation is satisfied and u expenses in the period incurred, without regard to the time of receipt or payment of cash. Under the strict cash-basis, companies u record revenue only when they receive cash, and u record expenses only when they disperse cash. Cash basis financial statements are not in conformity with IFRS. 3 -106 LO 9 Differentiate the cash basis of accounting from the accrual basis of

APPENDIX 3 A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING Illustration: Quality Contractor signs an agreement to construct a garage for ₺ 22, 000. In January, Quality begins construction, incurs costs of ₺ 18, 000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Quality collects ₺ 22, 000 cash from the customer. In March, Quality pays the ₺ 18, 000 due the creditors. ILLUSTRATION 3 A-1 3 -107 Advance slide in presentation mode to reveal answers. LO 9

APPENDIX 3 A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING Illustration: Quality Contractor signs an agreement to construct a garage for ₺ 22, 000. In January, Quality begins construction, incurs costs of ₺ 18, 000 on credit, and by the end of January delivers a finished garage to the buyer. In February, Quality collects ₺ 22, 000 cash from the customer. In March, Quality pays the ₺ 18, 000 due the creditors. ILLUSTRATION 3 A-2 3 -108 Advance slide in presentation mode to reveal answers. LO 9

APPENDIX 3 A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING CONVERSION FROM CASH TO ACCRUAL BASIS Illustration: Dr. Diane Windsor, like many small business owners, keeps her accounting records on a cash basis. In the year 2015, Dr. Windsor received ₺ 300, 000 from her patients and paid ₺ 170, 000 for operating expenses, resulting in an excess of cash receipts over disbursements of ₺ 130, 000 (₺ 300, 000 - ₺ 170, 000). At January 1 and December 31, 2015, she has accounts receivable, unearned service revenue, accrued liabilities, and prepaid expenses as shown below. ILLUSTRATION 3 A-5 3 -109 LO 9

APPENDIX 3 A SERVICE REVENUE COMPUTATION To convert the amount of cash received from patients to service revenue on an accrual basis, we must consider changes in accounts receivable and unearned service revenue during the ILLUSTRATION 3 A-8 year. ILLUSTRATION 3 A-5 3 -110 Advance slide in presentation mode to reveal answers. LO 9

APPENDIX 3 A OPERATING EXPENSE COMPUTATION To convert cash paid for operating expenses during the year to operating expenses on an accrual basis, we must consider changes in prepaid expenses and accrued liabilities. ILLUSTRATION 3 A-11 ILLUSTRATION 3 A-5 3 -111 Advance slide in presentation mode to reveal answers. LO 9

APPENDIX 3 A CONVERSION FROM CASH BASIS TO ACCRUAL BASIS ILLUSTRATION 3 A-12 3 -112 LO 9

APPENDIX 3 A CASH-BASIS ACCOUNTING VERSUS ACCRUAL-BASIS ACCOUNTING THEORETICAL WEAKNESSES OF THE CASH BASIS 3 -113 u Today’s economy is considerably more lubricated by credit than by cash. u The accrual basis, not the cash basis, recognizes all aspects of the credit phenomenon. u Investors, creditors, and other decision makers seek timely information about a company’s future cash flows. LO 9

APPENDIX 3 B USING REVERSING ENTRIES ILLUSTRATION OF REVERSING ENTRIES-ACCRUALS ILLUSTRATION 3 B 1 3 -114 LO 10 Identifying adjusting entries that may be

APPENDIX 3 B USING REVERSING ENTRIES ILLUSTRATION OF REVERSING ENTRIES-DEFERRALS ILLUSTRATION 3 B 2 3 -115 LO 10

APPENDIX 3 B USING REVERSING ENTRIES SUMMARY OF REVERSING ENTRIES 1. All accruals should be reversed. 2. All deferrals for which a company debited or credited the original cash transaction to an expense or revenue account should be reversed. 3. Adjusting entries for depreciation and bad debts are not reversed. Reversing entries do not have to be used. 3 -116 LO 10

APPENDIX 3 C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED A company prepares a worksheet either on u columnar paper or u within a computer spreadsheet. A company uses the worksheet to adjust 3 -117 u account balances and u to prepare financial statements. LO 11 Prepare a 10 -column worksheet.

APPENDIX 3 C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED WORKSHEET COLUMNS 3 -118 u Trial Balance Columns u Adjustment Columns LO 11

APPENDIX 3 C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED ILLUSTRATION 3 C-1 (Partial) Use of a Worksheet 3 -119 LO 11

APPENDIX 3 C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED ILLUSTRATION 3 C-1 Use of a Worksheet 3 -120

APPENDIX 3 C USING A WORKSHEET: THE ACCOUNTING CYCLE REVISITED PREPARING FINANCIAL STATEMENTS FROM A WORKSHEET The Worksheet: 3 -121 u provides information needed for preparation of the financial statements. u Sorts data into appropriate columns, which facilitates the preparation of the statements. LO 11

ILLUSTRATION 3 -39 3 -122

ILLUSTRATION 3 -40 3 -123 LO 11

ILLUSTRATION 3 -41 3 -124 LO 11

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