Look at Chapter 2 of Horngren. Make sure that you understand and can describe the following:

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1 Week 1 Revise the introduction to Financial Accounting from CMA100, Chapters 1 and 2, Horngren and then look at Week 1 s topic The Adjusting Process, Chapter 3. Look at Chapter 1 of Horngren. Make sure that you understand and can describe the following: The users of accounting information, The uses of accounting information, The difference between financial and management accounting, The accounting profession in Australia, The rôle of ethics in business, The structure of business entities, The goal of the financial accounting process, The accounting concepts and principles: Entity concept, Accounting period concept, Cost principle, Reliability/relevance/and fair value, Matching principle, Profit recognition principle, Conservatism/prudence principle, Going concern principle Using the accounting equation to describe an organisation s financial position, The accounting equation, Define assets, liabilities, owner s equity, The causes behind increases and decreases in owner s equity, Using the accounting equation to analyses business transactions, Preparing and using financial statements, including: The content of financial reports, the income statement, the balance sheet, and the cash flow statement, Evaluating the performance of a business. You may wish to test your knowledge by doing the following exercises: Chapter 1, S 1-3, 1-13, E1-5, 1-6, 1-8, 1-10, The solutions to these will be posted under tutorial solutions next week 1/7

2 Look at Chapter 2 of Horngren. Make sure that you understand and can describe the following: What is an account, What is a ledger, What is a debit, What is a credit, Understand the link between accounts, ledgers, debits, credits and the balance sheet, Be able to apply the rules of debit and credit, What are debit entries for, What are credit entries for, Be able to record transactions on a journal by going through the 4 steps, Identify transaction from source documents, Specify the accounts affected by it and classify it by type of account, Has the account been increased or decreased, use the rules of debit and credit, Enter the data in the journal, debit & credit, together with a narrative, Look at the exhibits that appear in Chapter 2, make sure that you understand them, Work through the summary problems, try covering up the analysis and working out which account to debit and which to credit. Be familiar with the running balance four column account format, The Chart of Accounts, Expanding the accounting equation to account for revenues and expenses, Preparation and use of a trial balance, What is it used for, How do you find errors, You may wish to test your knowledge by doing the following exercises: S 2-4, 2-5, 2-6, 2-7, E2-8, 2-9, The solutions to these will be posted under tutorial solutions next week Chapter 3, The Adjusting Process The Accounting Period Concept, where the life of a business is broken down into equal time periods for reporting purposes, and the Matching Principle, where the revenue that we earn in an accounting period is matched against the expenses incurred in that same period. Quite often transactions relate to more than one accounting period. Rent and insurance are usually paid in advance. Take an insurance premium that is paid 12 months in advance. 9 months might be an expense for this financial year and 3 months an expense for next year. 2/7

3 Revenue can also be spread over more than one period. You run a club and members pay 12 months in advance from the date that they join. Someone joining on 30 th September will have 9 months revenue recognised in the year to the following 30 th June and 3 months the year after that. This chapter will enable you to: Distinguish between accrual based accounting and cash based accounting, Make adjusting entries at the end of the accounting period, Prepare an adjusted trial balance prepare the financial statements from the adjusted trial balance, Understand the alternative accounting treatment for prepayments. Cash accounting only records items when cash is paid or received. No attempt is made to try to relate the payment or receipt to the period in which an item is earned or incurred. With accrual accounting the payment or receipt date is irrelevant. What is important is to identify when the expense was incurred and when the revenue was earned and then to allocate the expense and revenue to the accounting period on that basis. We may end up time apportioning amounts so that we can allocate expenses and revenue to the correct period, or we may have to make an estimate of the expense or revenue because the invoice hasn t been received or the interest hasn t been credited to our account yet. If we incur an expense for the telephone or electricity we don t receive the invoice until after we have had the benefit. We account for the expense on the basis of receiving the benefit, so if we receive a power bill in July for electricity received up to the 30 th June 2007, the expense will be recognised in the y/e 30 th June 2007, and not in y/e 30 th June 2008 when the bill will be paid. Financial statements in Australia are to be prepared using the accrual basis with adjustments being made at the end each accounting period for prepayments, accruals, depreciation etc. The reason that adjustments have to be made is to ensure that the accounts have the correct balances in them. Every adjusting entry will affect both the Income Statement and the Balance Sheet. Expense and revenue accounts will be adjusted to the correct amounts so that the net profit will also be correct, and assets, contra assets, and liability accounts will also be adjusted to their correct figures. As a result, every adjusting entry will have an expense or a revenue account and an asset or a contra asset or a liability account. Cash at bank is never used in an adjusting entry. With prepayments a business will pay an amount in advance of receiving the benefit as an expense. This benefit which will be used at a later date is treated as an asset. The entry to 3/7

4 create this would be, for example, to Debit Prepaid Rent Account and to Credit Cash at Bank Account. When the time comes for the business to receive the benefit and to incur the expense an adjusting entry is made to recognise the expense by Debiting Rent Account and reducing the asset by Crediting Prepaid Rent Account. With supplies the expense will be determined by the amount of supplies that have been consumed or used up during the period. The balance of supplies on hand at the end of the period will be the asset that appears in the Balance Sheet. Have a look at pages 105, 106 and 107 for the examples on Prepayments and Supplies. Depreciation is a way of recording the using up of the cost of a non current asset over the assets life. It enables the business to match the cost to the business of the asset against the revenues generated by the asset over its lifetime. For example we might buy a truck that has a six year life for $290,000. At the end of the six years we might be able to trade it in for $50,000, so the net cost to us will be $240,000 that will be spread over six years, which on a straight line basis will be $40,000 each year. We recognise that there is an expense, Depreciation Expense, which will be debited with $40,000 for each year s use, and there will be a reduction from the cost, Accumulated Depreciation, a contra asset account, which will be credited. As the Depreciation Expense only represents the expense during a twelve month period then at the end of that period the expense account gets cleared so that it can be used to record the depreciation for the next year. The Accumulated Depreciation account is a contra asset account, which is an amount that has been set aside for the reduction in an asset s value, and the balance in the account is carried forward from one year to another, with the balance growing by each year s additional depreciation. At the end of year 1 we have an Depreciation Expense of $40,000 in the Income Statement, with the Balance Sheet showing the Truck at a cost of $290,000 less Accumulated Depreciation of $40,000, giving it a carrying amount of $250,000. At the end of year 2 we have an Depreciation Expense of $40,000 in the Income Statement, with the Balance Sheet showing the Truck at a cost of $290,000 less Accumulated Depreciation of $80,000, giving it a carrying amount of $210,000. This carries on until the end of the Truck s life or until it is disposed of if earlier. Have a look at pages 107 to 110 in Horngren. 4/7

5 Accrued expenses are expenses that a business has incurred as it has received the benefit, but hasn t paid for yet. Examples are electricity, telephone, gas, and salary expenses. Employees work for the business before they get paid. If the pay period straddles the year end date at the end if the accounting period, than staff will have worked in one accounting period before they get paid in the next. We will need to calculate how much salary relates to the period before the year end and then debit the Salary Expense with the amount and credit the Salary Payable account (liability). Have a look at page 110 and 111 in Horngren. Accrued revenues are revenues that we have earned but haven t received just yet and no entry will have been entered in the books. We may have performed a task as a part of a contract at the end of June but don t issue the invoice until the beginning of July. Another example is where we have money on term deposit. It earns interest on a daily basis, but we don t receive the interest payment until the end of the term. At the accounting period end we will accrue for the interest that we have earned but not yet received. The adjusting entries for accrued revenue will be to debit an asset account, which will be a receivable account, eg interest receivable and to credit the revenue account, eg interest revenue. Have a look at Horngren page 111 Unearned revenues are revenues that a business has received in advance of performing their part of the contract, so at the point that they have received the revenues they haven t yet earned them. They have received money in advance. Because they haven t performed their task yet that money still belongs to the other party to the contract and must be treated as a liability. The entry will be to debit the Cast at Bank Account with the monies received and then Credit the liability account Unearned Revenue. If we provide services then that account will be Unearned Service Revenue Account. It is a liability account because the business still has an obligation to perform their part of the bargain. Once the task is performed and the business has now earned the revenue the liability account is reduced by the amount earned which increase the revenue account. The entry will be Debit Unearned Service Revenue Account and Credit Service Revenue Account. Have a look at pages 111 and 112 in Horngren. There s also a good summary of the entries in Exhibits 3-4 and 3-5on page 113. Study it and then work your way through the Exhibit 3-6 on page /7

6 The way an Adjusted Trial Balance is prepared is by extracting the balances from the ledger accounts to create an Unadjusted Trial Balance. By doing that first it enables you to see whether your previous entries are correct. Once that is done you the gather all the information that you need to make the adjusting entries. These you then have to journalise and post to the accounts in the ledger. Once that is done you then extract the balances again form the accounts in the ledger to create an Adjusted Trial Balance. If it balances your adjustments are correct and you are then able to produce the financial statements. A useful tool in this process is to use a worksheet, so that you can see whether you have made the correct entries before you enter them in the journal and then post them to the accounts. This worksheet isn t part of the double entry and is just an aid. The journal entries still have to be made and then posted to the accounts for the double entry to be updated. An example of a worksheet is given in Exhibit 3-7 on page 115. Study it. We will look at this in more detail in next week s lecture when we complete the accounting cycle. The Adjusted Trial Balance provides all the information that you need to enable you to prepare a set of Financial Statements consisting of the Income Statement, The State of Changes in Equity, and The Balance Sheet. One of the benefits of the Worksheet is that you can have a snapshot of the business in just the Adjusted Trial Balance without the need of preparing a full blown set of accounts. This can be a very useful management tool. The Income Statement is prepared first and this calculates the net profit or net loss for the period. This net profit is needed when calculating the Statement of Changes in Equity, which in turn is needed to help complete the Balance Sheet. Have a look at pages 116 and 117 in Horngren and note the links between exhibits 3-8, 3-9, 3-10 and Pay particular attention to the Ethical Issues in Accrual Accounting on page 118 and to the Decision Guide lines. Accrual Accounting can provide the unscrupulous accountant with opportunities for unethical accounting by manipulating figures to produce a desired outcome even though those figures did not represent faithfully what had happened within the business during the period and misstated the net worth of the business at the Balance Sheet date. Please have a look at page 138 and 139 of Horngren. Some businesses do not bother to isolate prepaid expenses, or unearned revenues, in their own accounts but put them directly into the expense or revenue account. This means that an adjustment must be made at the end of the period to take that part of the expense or revenue that relates to the next period and to show those amounts either as assets or liabilities in the balance sheet..these two pages explain the accounting treatment. 6/7

7 Now attempt the tutorial exercises as stated in the Unit Outline, Ch3 S3-1, 3-5, E3-7, 3-12, 3-13,E3-14, E3A-2 p140. 7/7