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Basic activities of businesses:• Financial activities – acquire capital (from investors and

creditors)• Investing activities – invest in productive resources (i.e.

equipment)• Operating activities – generate wealth (i.e. manufacture and

sell television sets)

Chapter 3Chapter 3Overview of Financial StatementsOverview of Financial Statements

Balance Sheet

Asset

Liability

Owners’ Equity

Overview of Financial StatementsOverview of Financial Statements

Income Statement

Net income =

Revenue:

Expense:

Gain:

Loss


Statement of Cash flows

Net cash flows

Operating

Investing

Financing


How do the B/S and I/S fit together?• Called “Articulation”• Assets = Liabilities + Owners’

Equity


The Accounting Cycle:

During the period:

1. Analyze and record transactions

At the end of the period:2. Adjusting entries and Adjusted Trial Balance3. Closing entries

Review of the MechanicsReview of the Mechanics

Asset

ExpenseDebit

Debit

Revenue

Liability EquityCredit Credit

Credit

Normal balance in account

The Account and the The Account and the Debit-Credit ConventionDebit-Credit Convention

TYPE OFACCOUNT

IMPACT OFDEBITINGACCOUNT

IMPACT OFCREDITINGACCOUNT

ASSET

LIABILITY

EQUITY

REVENUE

EXPENSE

DIVIDEND

GAIN

LOSS

Review of the MechanicsReview of the Mechanics

The T-AccountA T-Account can help you simplify and solve

seemingly complex problems– Put in what you know

• If there only one unknown, you can solve for it• If there are multiple unknowns, you can recognize where you

need more information– Example:

• Given:– 12/31/07 balance in supplies inventory: $700 DR. – Supplies expense for y/e 12/31/07: $950 DR – $850 of supplies were purchased during the year ended 12/31/07

• Question: What is the balance in supplies inventory on 1/1/07?

Accrual Accounting

Accrual accounting provides a better basis for predicting future cash flows than does cash flow accounting.

Cash flow accounting reports cash receipts and disbursements as they occur.

Accrual accounting reports on effects of events that ultimately have cash effects.– Focuses on economically meaningful event (revenue recognition)– Matches outflows with the inflows they help to generate (expense

recognition)

Revenue and Expense Recognition Revenues are recognized when they are both:

– Earned – business has substantially accomplished what it must do to be entitled to the benefits represented by the revenue.

– Realized – business has received cash or claim to cash (can estimate how much the business will ultimately receive).

Expenses are recognized according to one of the following practices:– Direct - match expense to the specific revenue it helps generate – Systematic and rational – match expense to periods in which it helps to

generate revenue – Immediate – expense in period the cost is incurred

Adjusting Entries are required for:Recognizing revenue for the period.Matching expenses with revenues they helped generate.Adjusting entries are required every time financial statements are prepared to comply with GAAP

What to record:Events not journalized during period (e.g. consumption of supplies)Costs that expire with passage of time (e.g. rent, insurance, building deterioration)Any unrecorded items (e.g. wages earned in current period but not paid until next period)

Adjusting EntriesAdjusting Entries

Prepayments (deferrals):– Prepaid expenses – the cash flow precedes the expense recognition (i.e.,

prepaid rent)– Unearned revenue – the cash flow precedes the revenue recognition (i.e.

unearned rent revenue)Accruals:

– Accrued expense – the expense recognition precedes the cash flow (i.e. interest payable)

– Accrued revenue – the revenue recognition precedes the cash flow (i.e. interest receivable)

Estimated items:– Accounts are updated based on subjective estimates as of the end of the

period (i.e., bad debt expense, depreciation expense).Periodic inventory:

– Inventory-related accounts (i.e. inventory, cost of goods sold) are adjusted based on an end of period physical count).

Types of Adjusting EntriesTypes of Adjusting Entries

AdjustingPrepayments for

ExpensesRecording

Accrued Expense

Prepayments made in cash and recorded

as assets (cash precedes

expense)

Expense incurredbut not yet

recordedin books

(expense precedes cash)

Adjusting Entries: Adjusting Entries: Matching Matching ExpensesExpenses

Example:

On December 1, 2007, a firm paid its landlord $9,000 for rent for the following 12 months. The payment was recorded by debiting “Prepaid Rent” and crediting “Cash”. What adjusting entry will be necessary on December 31?

Adjusting Entries – Prepaid Adjusting Entries – Prepaid AssetAsset

Adjusting Entry:

Debit Credit

Rent Expense $750Prepaid Rent $750

If no adjusting entry is made, will

•Assets be under or overstated on the Dec. 31 Balance Sheet?

•Rent Expense be under or overstated on the Income Statement?

•NI be under or overstated on the Income Statement?

•OE be under or overstated on the Balance Sheet?

Adjusting Entries – Prepaid Adjusting Entries – Prepaid AssetAsset

Example of Prepaid Adjustment

• You pay a property tax assessment of $6,000 on December 1, 2005, to cover the period from December 1, 2005 to May 31, 2006. What is the adjusting entry needed for December 31? Two scenarios: (1) you recorded the December 1 payment as a prepaid asset, and (2) you recorded the December 1 payment as an expense – Note that a time line can be very useful in organizing data on

these types of questions

Example of Accrued Expense

• On January 15, 2006, you receive an invoice for $8,000 for copier maintenance for the last quarter of 2005. Is any entry needed on the books at December 31, 2005?

Example:

A firm purchases $1,000 of supplies on July 14 (there were 0 supplies on hand at that time). On December 31, an end of the year count indicates that the firm has $328 of these supplies remaining.1. What is the required adjusting entry if the firm recorded the initial acquisition of supplies by debiting “Supplies Inventory”?

2.What is the required adjusting entry is the firm recorded the initial acquisition by debiting “Supplies Expense”?

Adjusting Entries – Adjusting Entries – Supplies ExpenseSupplies Expense

Adjusting Entry – Case 1:

Debit Credit

Supplies Expense $672Supplies $672

* If no adjusting entry is made, Assets will be overstated on the Dec. 31 Balance Sheet and Supplies Expense will be understated on the Income Statement (NI will be overstated).


Adjusting Entry – Case 2:

Debit Credit

Supplies $328Supplies Expense $328

* If no adjusting entry is made, Assets will be understated on the Dec. 31 Balance Sheet and Supplies Expense will be overstated on the Income Statement (NI will be understated).


AdjustingUnearned Revenue

Recording Accrued Revenue

“Revenues” receivedin cash

andrecorded as liabilities

(cash received before revenue earned)

Revenues earnedbut not yet

recordedin books

(revenue earned before cash received)

Adjusting Entries: Adjusting Entries: Recognizing RevenueRecognizing Revenue

Example – Adjusting Entry - Unearned Revenue

On Oct 31, 2006, you receive a $12,000 payment for rent from November 1, 2006 to October 31, 2007. Your fiscal y/e is December 31.

– Consider two possibilities: (1) Initial entry on Oct 31 debits cash, credits unearned

rent revenue(2) Initial entry debits cash, credits rent revenue

Example – Accrued Revenue

Rent is due to you on December 31, 2006 for the 2006 year, but the deadline is missed by the client. He pays you on $12,000 on January 15, 2007. What is the appropriate adjusting entry on December 31?(Assume that you have not made any entries to

record accrued rental revenue for 2006)

After all adjusting entries have been made, a firm will generally prepare a report called an “Adjusted Trial Balance”.

A trial balance is list of all accounts of a firm and their balances, which will be used to prepare the financial statements.

The sum of the debit balances must equal the sum of the credit balances.

Adjusted Trial BalanceAdjusted Trial Balance

Closing Entries are used to:

Update the R/E account

To reset all temporary accounts (i.e. Revenue, Expense, Dividend, Gain, and Loss accounts) to zero to start the next accounting period.

Closing EntriesClosing Entries

1. Debit each Revenue and Gain account in the amount of the balance. Credit a temporary account called “Income Summary” or “R/E” for the same amount.

2. Credit each Expense and Loss account in the amount of the balance. Debit “Income Summary” or “R/E” for the same amount.

3. If “Income Summary” account is used, close it to “R/E”.

4. Credit “Dividends” account by the amount of its balance. Debit “R/E” for the same amount.

Closing EntriesClosing Entries

Closing Journal EntriesDr. All Revenue Accounts Cr. All Expense AccountsDr/Cr. Income Summary (plug to balance)

[Assuming net income is positive]:Dr. Income Summary Cr. Retained Earnings

Dr. Retained Earnings Cr. Dividends

• Cash Basis accounting equates expenditures (when cash moves) with expenses (I/S recognition of a decrease in resources)– So under cash basis:

• no cash moves, no recognition• Cash moves, recognition

– Violates matching, plus you get a lot of surprises because you have no record of upcoming payables

Cash Basis vs. Accrual BasisCash Basis vs. Accrual Basis

• Cash to accrual basis conversion:– The A/R account has a balance on 12/31/2000

of $100, and on 12/31/2001 of $25. Cash receipts for the year ending on 12/31/2001 are $500.

– What is the accrual basis revenue for the year?

Cash Basis vs. Accrual Cash Basis vs. Accrual BasisBasis

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