Lesson 4 Financial Accounting (Information useful to investors and creditors.) The primary tool for investors and creditors are the financial statements to be prepared in accordance with generally accepted accounting principles. Lesson 4 Accounting Cycle Part 2 Businesses need an accounting system in place that is designed to generate information to be included in the financial statements. Basic elements in an accounting system - All of the transactions of a business must be: - Identified - Recorded - Summarized Create financial statements. 1 2 What kind of a balance, debit or credit, would you typically expect for an asset account at the end of a period? Notes Payable Capital Stock Rent Expenses Stephen's Sweet Shop Trial Balance Debit 17 175 1 3 2 675 Credit 2 1 375 675 3 4 Beg. Balance 1 2 275 1 End. Balance 225 1 25 2 2 3 Liability Notes Payable 21 21 Receivable Notes Payable Beg. Balance 2 21 1 End. Balance 5 6 4-1
Problem #13 A. Indicate for the following accounts whether they would typically have a debt or credit balance at the end of an accounting period. Capital Stock Sales Revenue B. What would cause cash to have a credit balance? C. If cash has a credit balance at the end of the period, is it really an asset? D. Is it possible for retained earnings to have a debit balance? What would cause such a balance? A. C. Capital Stock Sales Revenue Problem #13 - Answer Typical End of Year Balance DR DR CR CR CR CR DR DR B. If checks are written on cash checking account in excess of the account balance and the bank honors those checks, then a credit balance will result. Such a credit balance is not really an asset. In fact, it is a liability because there is an obligation to the bank to deposit sufficient funds in the account to cover those checks. 7 8 Problem #13 - Answer D. is the net result of revenues minus expenses, less dividends. If expenses exceed revenues from inception then there will be a negative or debit balance in retained earnings, which we would call retained losses, cumulative losses, or retained deficit. The Steps of an Accounting System Designed to Produce Financial Statements 1. Identify each business transaction. 2. Analyze each transaction to determine its effect on the financial position of the business (A=L+OE). 3. Record the transactions and their effect on financial position in a journal (computerized or hard copy record). 4. Summarize the effect of all transactions on each account by posting the journal entries to the general ledger. 5. Prepare a trial balance. 6. Journalize and post to the general ledger any necessary adjusting entries at the end of the period. 9 1 Accrual Basis Accounting Accrual basis accounting deals with the timing of revenues and expenses and comprises the following two principles: 1. Revenue Recognition Principle: timing of revenues Revenues are to be recognized/recorded in the period in which they are earned, not necessarily when cash is received. 2. Matching Principle: timing of expenses Expenses are to be recognized in the period in which those costs provide benefit to the business operations. In other words, expenses are to be matched against the revenues that they helped produce and not necessarily in the period in which cash is paid. Example: costing $5, is purchased on 12/15/X1 with half paid in cash at the date of purchase and half to be paid on 1/1/X2. The inventory is sold to a customer for $9, on account on. Collection of the $9, receivable takes place on 1/15/X2. The recording of these transactions would be: 12/15/X1 'X1 1/1/X2 'X2 5, 9, 5, 25, 25, 9, 5, 1/15/X2 25, 9, 25, 9, 11 12 4-2
Income Statements: 2X1: Accrual Basis Basi s basis accounting is used for personal income taxation. Cost of () Goods Sold Profit (Loss) on Sale $ 9, 5, $ 4, $ 25, $ (25,) - Allowed by IRS - Ability to pay concept 2X2: Cost of () Goods Sold Profit on Sale $ $ $ 9, 25, $ 65, There are opportunities for income manipulation through cash basis accounting. Why is accrual basis required for GAAP? Combined Profit for X1 and X2 $ 4, $ 4, 13 14 Accrual Basis Accounting Accrual basis accounting deals with the timing of revenues and expenses and comprises the following two principles: 1. Revenue Recognition Principle: timing of revenues Revenues are to be recognized/recorded in the period in which they are earned, not necessarily when cash is received. 2. Matching Principle: timing of expenses Expenses are to be recognized in the period in which those costs provide benefit to the business operations. In other words, expenses are to be matched against the revenues that they helped produce and not necessarily in the period in which cash is paid. Adjusting Entries Required to Comply with Accrual Basis Accounting 1. Prepaid Expenses: Example: Assuming a company pays an insurance premium of $1,2 on 1/1/X1 for 12 months of coverage extending through 1/1/X2 the original journal entry would be: 1/1/X1: Prepaid Insurance Expense 1,2 Adjusting entry required at year-end: : Insurance Expense 3 P r e p a i d I n s u r a n c e E x p e n s e 1,2 15 16 3 What should be the balance in the Prepaid Insurance Expense account after the year-end adjusting entry? Prepaid Insurance Expense 1/1/X1 1,2 B a l a n c e 9 3 Adjust If the proper adjusting entry had not been made, then the following would have been over or understated? 1. Assets OVER 2. Expenses 3. Net Income OVER 4. OVER 5. Owners' Equity OVER What principle of accounting requires the adjusting entry in this case? Matching Principle Example: Assuming a company pays property taxes of $3,6 on 3/1/X1 for the tax period (1 year) through 2/28/X2, the original journal entry would be: 3/1/X1: Prepaid Property Tax Expense 3,6 3,6 Adjusting entry required at year-end: : Property Tax Expense 3, Prepaid Property Tax Expense 3, What should be the balance in the Prepaid Property Tax Expense account after the year-end adjusting entry? Prepaid Property Tax Expense 3/1/X1 3,6 3, Adjust Balance 6 2 mo. x $3 17 18 4-3
Problem #14 A) For the following transactions, prepare the original journal entry and any adjusting entries at required to comply with accrual basis accounting. (Assume payments for both transactions are properly recorded as "Prepaid Expenses.") i. Rent amounting to $2,4 ($4/per month) is prepaid on 8/1/X1 for the following six months' rental cost and properly accounted for as "Prepaid Rent Expense." (In this problem you are accounting from the perspective of the tenant.) ii. A one year insurance premium totaling $1,2 is prepaid on 11/1/X1 for insurance coverage through 11/1/X2. B) C) D) Additional questions: Problem #14 Determine the correct balance of prepaid rent expense and prepaid insurance expense after adjustment of. What principle of accounting required the adjusting entries in this case? If the proper 12/31/X2 adjusting entries had not been made, then the following would have been over or understated: Assets Expenses Net Income Owner Equity Liabilities 19 2 A)i. 8/1/X1 Original Entry: Prepaid Rent Expense Problem #14 - Answer 2,4 2,4 Adjusting Entry: Rent Expense 2, Prepaid Rent Expense 2, A)ii. 11/1/X1 Original Entry: Prepaid Insurance Expense 1,2 1,2 Adjusting Entry: Insurance Expense Prepaid Insurance Expense 2 2 Problem #14 - Answer B. Prepaid Rent Expense @ = $4 Prepaid Rent Expense 8/1/X1 2,4 2, Adjust Balance 4 or 1 month future benefit = 1 x $4 = $4 Prepaid Insurance Expense @ = $1, Prepaid Insurance Expense 11/1/X1 1,2 2 Balance 1, or 1 months of future benefit = 1 x $1/month = $1, 21 22 C. Matching Principle Assets Expenses Net Income Owners' Equity Liabilities Problem #14 - Answer D. Over or Understated Over Under Over Over Over No effect Unearned Revenues: Example: Assuming a company receives $3, of cash in advance on 12/1/X1 from a client for consulting services to be provided by the company equally over the next three months, the original entry would be: 12/1/X1: Unearned Fee Revenues Adjusting entry required at year-end: : 3, 3, Unearned Fee Revenues 1, F e e R e v e n u e s 1, 23 24 4-4
What should be the balance in the Unearned Fee Revenue account following the proper year-end adjusting entry? Unearned Fee Revenues Adjust 1, If the proper adjusting entry had not been made at year-end, then the following would have been under or overstated? 1. Liabilities 2. Revenues 3. Net Income 4. 5. Owners' Equity 3, 12/1/X1 2, OVER Balance (2 mo. $1,) A = L + OE No change What principle of accounting requires the adjusting entry in this case? Revenue Recognition 12/1/X1: U ne ar n ed F ee Re ve n u es Adjusting entry required at year-end: : 3, 3, Unearned Fee Revenues 1, F e e Re v en u es 1, 25 26 Example: Assuming a company receives $3, of cash in advance on 8/1/X1 from a tenant for six months rent through 1/31/X2, the original entry would be: 8/1/X1: 3, Unearned Rent Revenue 3, Adjusting entry required at year-end? : Unearned Rent Revenue 2, Rent Revenue 2, What should be the balance in the Unearned Rent Revenue account following the proper year-end adjusting entry? Unearned Rent Revenue 3, 12/1/X1 2, Adjust Balance Problem #15 A. Prepare the original journal entries and the required adjusting entries for the transactions described in the previous problem as noted below from the perspective of the landlord and the insurance company, respectively. Assume the original entries were properly recorded as "unearned revenue". i. Rent amounting to $2,4 ($4/per month) is received in advance on 8/1/X1 for the following six months' rent. ii. A one year insurance premium totaling $1,2 is received in advance on 11/1/X1 for insurance coverage provided through 11/1/X2. Additional questions: B. What principle of accounting requires the adjusting entries in these cases? 27 28 Problem #15 C. If the proper adjusting entries had not been made, then the following would be over or understated for the landlord and insurance company: Assets Revenues Net Income Owner's Equity Liabilities Problem #15 - Answer A. Prepare the original journal entries and the required adjusting entries for the transactions described in the previous problem from the perspective of the landlord and the insurance company, respectively. Assume the original entries were properly recorded as "unearned revenue". i. Rent amounting to $2,4 ($4/per month) is received in advance on 8/1/X1 for the following six months' rental cost. 8/1/X1 Original Entry: Unearned Rent Revenue Adjusting Entry: 2,4 2,4 Unearned Rent Revenue 2, Rent Revenue 2, 29 3 4-5
Problem #15 - Answer A. Prepare the original journal entries and the required adjusting entries for the transactions described in the previous problem from the perspective of the landlord and the insurance company, respectively. Assume the original entries were properly recorded as "unearned revenue". ii. A one year insurance premium totaling $1,2 is prepaid on 11/1/X1 for insurance coverage through 11/1/X2. 11/1/X1 Original Entry: Unearned Premium Revenue Adjusting Entry: 1,2 1,2 Unearned Premium Revenue 2 Premium Revenue 2 Problem #15 - Answer B. What principle of accounting requires the adjusting entries in these cases? Revenue Recognition Principle C. If the proper adjusting entries had not been made, then the following would be over or understated for the landlord and insurance company: Assets Revenues Net Income Owners' Equity Liabilities Over or Understated No effect Under Under Under Under Over 31 32 Unpaid and Unrecorded Expenses: Example: A company has employees work for the full month of 12/X1 but pays the $1, wage payroll for December on 1/15/X2. Assuming that at these wages have not been recorded in the company's books or records, what adjusting entry should be made on? Adjusting Entry at : Wage Expense 1, Wage Payable 1, If the proper adjusting entry had not been made, then the following would have been over or understated? 1. Liabilities 2. Expenses 3. Net Income OVER 4. OVER 5. Owners' Equity OVER Uncollected and Unrecorded Revenues: Example: A company has earned $ of interest on a loan as of the end of the year X1. What adjusting entry should be made as of assuming the interest is unrecorded and collection is expected in X2? Adjusting entry at : Interest Receivable Interest Income (Revenue) What principle of accounting requires this adjusting entry at the end of the year? Revenue Recognition If the company failed to make this adjustment at the end of the year, then net income would be over or understated? Understate Revenues = Understate Net Income 33 34 Problem #16 Given the following two fact circumstances: A. Prepare the proper adjusting entries at for i. and ii. below to comply with accrual basis accounting. i. Utility costs for any month are paid on the 15th of the following month. December's utilities amounted to $1, and were unpaid and unrecorded as of. ii. Consulting services were provided to a customer in December. At these consulting fees amounting to $2, had not been received from the customer or recorded in the books. Additional questions: B. What specific accounting principles require the entries for i. and ii., respectively. C. A failure to make the necessary entry for ii. above would cause net income to be over or understated? A)i. B. C. ii. Utilities Expense Utilities Payable Consulting Fees Receivable Consulting Fee Revenue Problem #16 - Answer Matching Principle and Revenue Recognition Principle, respectively. Understated. 1, 2, 1, 2, 35 36 4-6
The Steps of the Accounting System Designed to Produce Financial Statements 1. Identify each business transaction. 2. Analyze each transaction to determine its effect on the financial position of the business (A=L+OE). 3. Record the transactions and their effect on financial position in a journal (computerized or hard copy record). 4. Summarize the effect of all transactions on each account by posting the journal entries to the general ledger. 5. Prepare a trial balance. 6. Journalize and post to the general ledger any necessary adjusting entries at the end of the period. 7. Prepare the financial statements. 8. Journalize and post closing entries. Real vs. Nominal Accounts Real Accounts: All accounts which appear on a balance sheet (assets, liabilities, capital stock, and retained earnings) are referred to as real accounts, meaning that the balance of the account is a cumulative running balance reflecting all transactions affecting that account since the inception of the business. 1/1/X4 'X4 Transactions 12, 1, 12/31/X4 'X5 Transactions 2, 13, 126, 12/31/X5 'X6 Transactions 12/31/X6 6, 151, 4, 153, 37 38 Income Statement Accounts 6 7 1/1/X4 55, 'X4 Transactions 55, 12/31/X4 65, 'X5 Transactions 1,2, 12/31/X5 7, 'X6 Transactions 1,9, 12/31/X6 7 39 4 Closing Entry 55, Closing Entry 65, Closing Entry at 12/31/X5: 1/1/X4 55, 'X4 Transactions 55, 12/31/X4 1/1/X5 65, 'X5 Transactions 65, 12/31/X5 1/1/X6 65, 65, Nominal Account: All income statement accounts (revenues and expenses) and even the dividends account does not maintain a cumulative running balance from inception, but instead accumulates amounts period by period (usually year by year) and, as a result, are referred to as nominal rather than real accounts. Nominal accounts are closed at the end of an accounting period and their amounts are transferred to. 41 42 4-7
Closing Entries Closing entries are made at the end of an accounting period to accomplish two objectives: 1. All revenue, expense, and dividend accounts must be reset to zero to start the next accounting period. 2. The account must be updated to include the amount of net income (revenues - expenses) less dividends for the current year. Example: Given the following trial balance at 12/31/X2 after adjusting entries at the end of the year, prepare the necessary closing entries before the start of the next accounting period: Ending Adjusted Balances From General Ledger Buildings Notes Payable Capital Stock at Wage Expense Debits 1, 15, 4, 5, 5, 15, 135, Credits 17, 23, 5, 1, 8, 135, 43 44 CLOSING ENTRIES Wage Expense xxx 8, CE 8, Wage Expense xxx 15, 15, CE 8, 8, 5, 5, 15, 15, 5, 5, xxx 5, 5, CE xxx 5, 5, CE 1, 8, CE CE 5, CE 15, CE 5, 2, 12/31/X2 Alternative approach to closing entries: Wage Expense 8, 5, Statement of :, 1/1/X2 Add: Net Income for 'X2 Less: for 'X2, 12/31/X2 5, 15, 1, 1/1/X2 15, 15, Net Income 5, 5, 2, 12/31/X2 $1, 15, (5,) $2, 45 46 Problem #17 Problem #17 - Answer East Coast Company's first year of operations is in the year 2X1. The company's trial balance as of August 31, 2X2 and 2X1, are shown as follows: Trial Balance August 31, 2X2 and 2X1 East Coast Company 2X2 2X1 Debits Credits Debits Credits Land Capital Stock (Balances at beginning of years) Sales Revenue Office Expense Salaries Expense Totals 33,4 6,4 2,8 12, 1,4 1, 66, 1,9 36,6 6,8 21,2 66, 12, 7, 8,6 14,8 16,4 1,4 8,4 7,1 36,6 -- 33, 7,1 Required: A. Prepare the journal entries to close the books as of August 31, 2X1. B. In 2X2, the company suffered a net loss, which reduced. Prepare closing entries as of August 31, 2X2. How much was the loss? Can a company pay dividends even in a year in which there was no profit? A. Office Expense Salaries Expense 16,4 1,4 8,4 33, 16,4 1,4 8,4 33, 16,4 1,4 8,4 Beginning Balance 33, 6,8 8/31/X1 Balance 47 48 4-8
Alternative Approach: Problem #17 - Answer Office Expense Salaries Expense 33, 16,4 1,4 8,4 7,3 Beginning Balance 7,3 6,8 8/31/X1 Balance B. Office Expense Salaries Expense Problem #17 - Answer 21,2 12, 1,4 1, 12, 1,4 1, 6,8 9/1/X1 21,2 4,1 8/31/X2 21,2 12, 1,4 1, 49 5 Problem #17 - Answer Alternative Approach: Office Expense Salaries Expense 2,2 21,2 12, 1,4 1, 6,8 9/1/X1 2,2 4,1 8/31/X2 Questions: - The 2X2 loss was $2,2. - A company may pay dividends in a year of losses only if and to the extent there are retained earnings from prior years. COMPUTERIZED ACCOUNTING SYSTEM 1. Identify Transactions 2. Interpret Effect of Transactions 3. Record the Transactions 4. Summarize the Transactions by Account 5. Accomodate Adjustments 6. Prepare the Financial Statements 7. Prepare Closing Entries 51 52 Account Analysis Understanding the transactions that affect various accounts Example: Beg. Balance 1, A. 5, 45, B. End. Balance 15, A. Sales made on account: 5, Sales Revenue 5, B. Collections on : 45, 45, Example: Given the following information: Beginning balance of office supplies $2, Ending balance of office supplies $2, Office supplies purchased during the period $4, Calculate office supplies expense for the period. Office Supplies Beg. Balance 2, A. 4, 3, B. End. Balance 2, A. Purchased office supplies: Office Supplies (A/P) 4, 4, B. Office supplies used up: Office Supplies Expense Office Supplies 3, 3, 53 54 4-9
Example: Given the following information: Beg. balance of accounts payable $ 25, End. balance of accounts payable 23, payments on accounts payable made during the period 4, Determine the amount of inventory purchases made on account during the period. 25, Beg. Balance Payments on accounts payable A. 4, 38, B. Purchases of inventory on Account 23, End. Balance Problem #18 Determine the amount of insurance expense in 2X3 if all insurance premiums are prepaid and given the following information: Prepaid Insurance, 1/1/X3 Prepaid Insurance, 12/31/X3 Premium payments in 2X3 $1, $1,7 $2, A. Payments on B. Purchases on Account: 4, 38, 4, 38, 55 56 Problem #18 - Answer Problem #19 Prepaid Insurance 1/1/X3 1, A. 2, 1,8 B. 12/31/X3 1,7 Determine the total amount of inventory purchases for 2X3 given the following information: A. Prepaid Insurance 2, B. 2, Ins. Expense Prepaid Ins. 1,8 1,8 at 1/1/X3 at 12/31/X3 for 2X3 $25, $23, $1, Insurance expense in 2X3 = $1,8 57 58 Problem #19 - Answer 1/1/X3 25, A. 98, 1, B. 12/31/X3 23, A. 98, B. (A/P) 98, 1, 1, Purchases in 2X3 = $98, 59 4-1