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© 2009 The Mc. Graw-Hill Companies, Inc. Chapter 3 The Financial Reporting Process © 2009 The Mc. Graw-Hill Companies, Inc. Chapter 3 The Financial Reporting Process

© 2009 The Mc. Graw-Hill Companies, Inc. Part A Accrual-Basis Accounting © 2009 The Mc. Graw-Hill Companies, Inc. Part A Accrual-Basis Accounting

3 -3 LO 1 Revenue and Expense Reporting ¡ Accounting information – necessary for 3 -3 LO 1 Revenue and Expense Reporting ¡ Accounting information – necessary for decision making. ¡ To be useful in decision making – accountants must report revenues and expenses in a way that reflects the ability of the company to create value for its owners. ¡ Accrual-basis accounting records revenues when earned (the revenue recognition principle) and expenses with related revenues (the matching principle).

3 -4 Revenue Recognition Principle Recognize revenue when it is earned Calvin books a 3 -4 Revenue Recognition Principle Recognize revenue when it is earned Calvin books a cruise with Carnival Cruise Lines, the world’s largest cruise line. He makes reservations and pays for the cruise in November 2010, but the cruise is not scheduled to sail until April 2011. When does Carnival report revenue from the ticket sale?

3 -5 Revenue Recognition Principle In November 2010? ? ? No. Because it has 3 -5 Revenue Recognition Principle In November 2010? ? ? No. Because it has not substantially fulfilled its obligation to Calvin. In April 2011? ? ? Yes. Because it is in April 2011 that the cruise occurs.

3 -6 Revenue Recognition Principle Suppose that, anticipating the cruise, Calvin buys a Jimmy 3 -6 Revenue Recognition Principle Suppose that, anticipating the cruise, Calvin buys a Jimmy Buffet CD from Best Buy. Rather than paying cash, Calvin uses his Best Buy card to buy the CD on account. When does Best Buy recognize revenue?

3 -7 Revenue Recognition Principle Even though Best Buy doesn’t receive cash immediately from 3 -7 Revenue Recognition Principle Even though Best Buy doesn’t receive cash immediately from Calvin, it still records the revenue at the time it sells the CD.

3 -8 Matching Principle Expenses are reported with the revenues they help to generate 3 -8 Matching Principle Expenses are reported with the revenues they help to generate

3 -9 3 -9

3 -10 LO 2 Accrual–Basis Compared with Cash–Basis Accounting Point of Difference Accrual Basis 3 -10 LO 2 Accrual–Basis Compared with Cash–Basis Accounting Point of Difference Accrual Basis Cash Basis Revenue Recognition When revenue is earned When cash is received Recording expenses With related revenues When cash is paid GAAP Part of GAAP Not a part of GAAP

3 -11 Accrual–Basis Compared with Cash– Basis Accounting Recognize Revenue? Accrual- Cash. Basis May 3 -11 Accrual–Basis Compared with Cash– Basis Accounting Recognize Revenue? Accrual- Cash. Basis May Company provides services to customers on account. Yes No June Company receives cash from customers for services provided No in May. Yes

3 -12 Accrual–Basis Compared with Cash– Basis Accounting Recognize Expense? Accrual- Cash. Basis May 3 -12 Accrual–Basis Compared with Cash– Basis Accounting Recognize Expense? Accrual- Cash. Basis May Company purchases supplies on account and uses them. Yes No June Company pays cash No Yes for supplies purchased in May.

© 2009 The Mc. Graw-Hill Companies, Inc. Part B The Measurement Process © 2009 The Mc. Graw-Hill Companies, Inc. Part B The Measurement Process

3 -14 LO 3 Adjusting Entries Closing Process Reporting Process 3 -14 LO 3 Adjusting Entries Closing Process Reporting Process

3 -15 Purpose of Adjusting Entries ¡ To record events that have occurred but 3 -15 Purpose of Adjusting Entries ¡ To record events that have occurred but which have not been recorded. ¡ To record revenues in the period earned. ¡ To record expenses in the period they are incurred in the generation of those revenues. ¡ To correctly state assets and liabilities in the balance sheet.

3 -16 Grouping Adjusting Entries § § Prepayments: Prepaid expenses – we paid cash 3 -16 Grouping Adjusting Entries § § Prepayments: Prepaid expenses – we paid cash (or had an obligation to pay cash) for the purchase of an asset before we incurred the expense. Unearned revenues – we received cash and recorded a liability before we earned the revenue. Accruals: Accrued expenses – we paid cash after we incurred the expense and recorded a liability. Accrued revenues – we received cash after we earned the revenue and recorded an asset.

3 -17 Prepaid Expenses Costs of assets acquired in one period that will be 3 -17 Prepaid Expenses Costs of assets acquired in one period that will be expensed in a future period. Examples: Purchase of supplies, payment of rent in advance, payment of insurance in advance. Adjusting Entry: Debit expense account Credit asset account

3 -18 Example: Prepaid Rent $6, 000 Cash paid for prepaid rent Jan. 1 3 -18 Example: Prepaid Rent $6, 000 Cash paid for prepaid rent Jan. 1 $5, 500 Remaining prepaid rent Jan. 31 Prepaid rent expires $500 Adjusting entry

3 -19 Example: Prepaid Rent January 31 Debit Rent Expense (+E, −SE). . . 3 -19 Example: Prepaid Rent January 31 Debit Rent Expense (+E, −SE). . . . . Credit 500 Prepaid Rent (−A). . . . . 500 (Decrease in prepaid rent due to the passage of time) Balance Sheet Income Statement Stockholders’ Equity Assets − 500 = = Liabilities + Common Stock + Retained Earnings − 500 Revenues − Expenses +500 = = Net Income − 500

3 -20 Unearned Revenues Company receives cash in advance from a customer for products 3 -20 Unearned Revenues Company receives cash in advance from a customer for products or services to be provided in the future. Adjusting entry: Debit liability account Credit revenue account

3 -21 Example: Unearned Training Revenue $540 Unearned revenue remains Jan. 31 $600 Cash 3 -21 Example: Unearned Training Revenue $540 Unearned revenue remains Jan. 31 $600 Cash received in advance Jan. 26 Services provided $60 Adjusting entry

3 -22 Example: Prepaid Rent January 31 Debit Unearned Revenue (−L). . . . 3 -22 Example: Prepaid Rent January 31 Debit Unearned Revenue (−L). . . . . Credit 60 Training Revenue (+R, +SE). . . 60 (Provide training to customers who paid in advance) Balance Sheet Income Statement Stockholders’ Equity Assets = = Liabilities − 60 + Common Stock + Retained Earnings +60 Revenues − +60 Expenses = = Net Income +60

3 -23 Accrued Expenses When a company has incurred an expense but hasn’t yet 3 -23 Accrued Expenses When a company has incurred an expense but hasn’t yet paid cash or recorded an obligation to pay, it still should record the expense. Examples: Accrued salaries, accrued interest, accrued utility costs. Adjusting entry: Debit expense account Credit liability account

3 -24 Example: Accrued Utility Costs At the end of January, Woods receives a 3 -24 Example: Accrued Utility Costs At the end of January, Woods receives a utility bill for $960 associated with operations in January. Woods plans to pay the bill on February 6. Even though it won’t pay the cash until February, Woods must record the utility costs for January as an expense in January.

3 -25 Example: Accrued Utility Costs $960 Utilities owed Jan. 31 Jan. 1 Utilities 3 -25 Example: Accrued Utility Costs $960 Utilities owed Jan. 31 Jan. 1 Utilities used $960 Adjusting entry $960 Cash paid for utilities Feb. 6

3 -26 Example: Accrued Utility Costs January 31 Debit Utilities Expense (+E, −SE). . 3 -26 Example: Accrued Utility Costs January 31 Debit Utilities Expense (+E, −SE). . . . . Utilities Payable (+L). . . . . Credit 960 (Unpaid utilities costs for the current month) Balance Sheet Income Statement Stockholders’ Equity Assets = = Liabilities +960 + Common Stock + Retained Earnings − 960 Net Revenues − Expenses = Income +960 = − 960

3 -27 Accrued Revenues When a company has earned revenue but hasn’t yet received 3 -27 Accrued Revenues When a company has earned revenue but hasn’t yet received cash or recorded an amount receivable, it still should record the revenue. This is referred to as an accrued revenue. Examples: Interest receivable, accounts receivable Adjusting entry: Debit asset account Credit revenue account

3 -28 Example: Accounts Receivable Suppose, Woods provides $200 of golf training to customers 3 -28 Example: Accounts Receivable Suppose, Woods provides $200 of golf training to customers from January 28 to January 31. However, it usually takes Woods one week to mail bills to customers and another week for customers to pay. Therefore, Woods expects to receive cash from these customers during February 8 -14. Irrespective of when cash will be received, the revenue should be recognized in January.

3 -29 Example: Accounts Receivable $200 Owed from Cash received customers from Jan. 31 3 -29 Example: Accounts Receivable $200 Owed from Cash received customers from Jan. 31 customers Feb. 8 -14 Jan. 28 Revenues earned $200 Adjusting entry

3 -30 Example: Accounts Receivable January 31 Debit Accounts Receivable (+A). . . . 3 -30 Example: Accounts Receivable January 31 Debit Accounts Receivable (+A). . . . . Training Revenue (+R, +SE). . . Credit 200 (Revenues earned with no cash receipt) Balance Sheet Income Statement Stockholders’ Equity Assets +200 = = Liabilities + Common Stock + Retained Earnings +200 Net Revenues − Expenses = Income +200 = +200

3 -31 LO 4 Post Adjusting Entries Post adjusting entries to the T-accounts in 3 -31 LO 4 Post Adjusting Entries Post adjusting entries to the T-accounts in the general ledger to update the account balances. Prepare an adjusted trial balance. An adjusted trial balance is a list of all accounts and their balances after we have updated account balances for adjusting entries.

3 -32 Trial Balance and Adjusted Trial Balance of Woods Golf Academy Trial Balance 3 -32 Trial Balance and Adjusted Trial Balance of Woods Golf Academy Trial Balance and Adjusted Trial Balance January 31 Account Title Trial Balance Debit Credit $ 6, 200 Adjustments Debit Credit Adjusted Trial Balance Debit Credit $ 6, 200 Cash Accounts receivable 2, 500 Supplies 2, 300 800 1, 500 6, 000 24, 000 5, 500 24, 000 Prepaid rent Equipment Accum. depr. , equip Accounts payable Unearned revenue Salaries payable Utilities payable Interest payable Notes payable Common stock Retained earnings Dividends Training revenue Supplies expense Total debits equal total credits Rent expense Depreciation expense Salaries expense Utilities expense Interest expense Totals 200 $ 2, 300 600 2, 700 400 $ 400 2, 300 540 300 960 100 60 300 960 10, 000 25, 000 0 200 6, 100 260 6, 360 800 500 400 300 960 100 2, 800 $44, 000 800 500 400 3, 100 960 100 $45, 960

© 2009 The Mc. Graw-Hill Companies, Inc. Part C The Reporting Process © 2009 The Mc. Graw-Hill Companies, Inc. Part C The Reporting Process

3 -34 LO 5 Financial Statements STATEMENT OF STOCKHOLDERS’ EQUITY Common Stock + Retained 3 -34 LO 5 Financial Statements STATEMENT OF STOCKHOLDERS’ EQUITY Common Stock + Retained Earnings (= RE, Jan. 1 + NI – Div) = Stockholders’ Equity Woods Golf Academy Adjusted Trial Balance January 31 Account Title Debit Cash $ 6, 200 Accounts receivable 2, 700 Supplies 1, 500 Prepaid rent 5, 500 Equipment 24, 000 Accum. depr. , equip. Accounts payable Unearned revenue Salaries payable Interest payable Utilities payable Notes Payable Common stock Retained earnings Dividends 200 Training revenue Supplies expense 800 Rent expense 500 Depreciation 400 expense Salaries expense 3, 100 Utilities expense 960 Interest expense 100 Totals $45, 960 Credit $ 400 2, 300 540 300 100 960 10, 000 25, 000 0 BALANCE SHEET Assets = Liabilities + Stockholders’ Equity 6, 360 INCOME STATEMENT Revenues $45, 960 − Expenses = Net Income

3 -35 Income Statement Woods Golf Academy Income Statement For the month ended January 3 -35 Income Statement Woods Golf Academy Income Statement For the month ended January 31 Revenues: Training revenue $6, 360 Salaries expense Expenses: Rent expense $3, 100 Supplies expense 800 Depreciation expense 400 Interest expense 100 Utilities expense 960 Total expenses Net income 500 5, 860 $ 500

3 -36 Statement of Stockholders’ Equity 3 -36 Statement of Stockholders’ Equity

3 -37 Classified Balance Sheet Total assets equal current plus long-term assets. Total liabilities 3 -37 Classified Balance Sheet Total assets equal current plus long-term assets. Total liabilities equal current plus long-term liabilities. Total stockholders’ equity includes common stock and retained earnings from the statement of stockholders’ equity. Total assets must equal total liabilities plus stockholders’ equity. Woods Golf Academy Classified Balance Sheet January 31 Assets Liabilities Current assets: Current liabilities: Cash $ 6, 200 Accounts payable Accounts receivable 2, 700 Unearned revenue Supplies 1, 500 Salaries payable Prepaid rent 5, 500 Utilities payable Total current assets 15, 900 Interest payable Total current liabilities Long-term assets: Equipment 24, 000 Long-term liabilities: Accum. depr. , equip. (400) Notes payable Total liabilities Total long-term assets $ 2, 300 540 300 960 100 4, 200 10, 000 $ 14, 200 23, 600 Stockholders’ Equity Common stock 25, 000 Retained earnings 300 Total stockholders’ equity $ 25, 300 Total assets $ 39, 500 Total liabilities and stockholders’ equity $ 39, 500

© 2009 The Mc. Graw-Hill Companies, Inc. Part D The Closing Process © 2009 The Mc. Graw-Hill Companies, Inc. Part D The Closing Process

3 -39 LO 6 Closing Entries ¡ Transfer the balance of all revenue, expense, 3 -39 LO 6 Closing Entries ¡ Transfer the balance of all revenue, expense, and dividend accounts to the balance of retained earnings. ¡ Increase the retained earnings account by the amount of revenues and decrease retained earnings by the amount of expenses and dividends. ¡ The balance of each revenue, expense, and dividend account equals zero after closing entries. ¡ Do not affect the balances of permanent accounts other than retained earnings.

3 -40 Closing Entries for Woods Golf Academy 31 -Jan (a) Revenue (–R, –SE). 3 -40 Closing Entries for Woods Golf Academy 31 -Jan (a) Revenue (–R, –SE). . . . Debit Credit 6, 360 Retained Earnings (+SE). . . . (Close revenues to retained earnings) 6, 360 5, 860 (b) Retained Earnings (–SE). . Supplies Expense (–E, +SE). . . . 800 Rent Expense (–E, +SE). . 500 Depreciation Expense (–E, +SE). . . 400 Salaries Expense (–E, +SE). . . . 3, 100 Utilities Expense (–E, +SE). . . . 960 Interest Expense (–E, +SE). . . . 100 (Close expenses to retained earnings) (c) Retained Earnings (–SE). . . (Close dividends to retained earnings) 200 Dividends (–D, +SE). . . 200

3 -41 Close to Retained Earnings Total expenses 5, 860 Total dividends 200 0 3 -41 Close to Retained Earnings Total expenses 5, 860 Total dividends 200 0 Beginning balance 6, 360 Total revenues 300 Ending balance

3 -42 LO 7 Post Closing Entries and Prepare Post–Closing Trial Balance Woods Golf 3 -42 LO 7 Post Closing Entries and Prepare Post–Closing Trial Balance Woods Golf Academy Post-Closing Trial Balance January 31 Account Title Cash Debit Credit $ 6, 200 Accounts receivable 2, 700 Supplies 1, 500 Prepaid rent 5, 500 Equipment 24, 000 Accum. depr. , equipment $ 400 Accounts payable 2, 300 Unearned revenue 540 Salaries payable 300 Interest payable 100 Utilities payable 960 Notes payable 10000 Common stock 25000 Retained earnings Totals 300 $39, 900

3 -43 End of Chapter 3 3 -43 End of Chapter 3